Self-Adjustment in a Market Economy

Richard A. Stanford

Professor of Economics, Emeritus
Furman University
Greenville, SC 29613

All rights reserved. No part of this work may be reproduced,
stored, or transmitted by any means without written permission
of the author except for brief excerpts used in critical analyses
and reviews. Unauthorized reproduction of any part of this work
is illegal and is punishable under the copyright laws of the
United States of America.

Self-Adjustment in a Market Economy

The genius of an economy organized around markets is that it contains self-adjusting mechanisms that come into operation automatically at the microeconomic level when disequilibrium conditions occur. A market economy needs no commissariat to direct production, allocate resources, or distribute product. The question that continues to be debated is whether the self-adjusting internal mechanisms work adequately to achieve and maintain macroeconomic stability. The negative argument is that some force greater than the markets is necessary to pursue stability. The only force that appears to be sufficient to this task is government.

Self-Adjustment at the Microeconomic Level

Equilibrium in a market may be described as a condition of balance of the intentions of buyers and sellers so that there are no incentives to either raise or lower price, or to increase or decrease quantities being sold. Such an equilibrium is a delicate state that is easily disturbed by actions of business firms to increase sales at the expense of sellers by raising or lowering price. One or more sellers will experience inventory accumulation or depletion. When price is too high for equilibrium, market forces will cause it to fall until quantity demanded is just equal to quantity supplied and inventories are no longer accumulating. Or, when price is too low for equilibrium, market forces will cause price to rise until quantity demanded is just equal to quantity supplied, and inventories are no longer depleting. The resulting equilibrium is a “state of rest” with no further change until the mechanism is disturbed by a change in one or more of the determinants of demand or supply that have been assumed constant.

What are the market forces that actually cause market price to fall or to rise? Demand is understood to be an expression of the collective intentions of all of those who hope to acquire quantities of the good from the market at different possible prices. Likewise, supply is an expression of the collective intentions of those who wish to offer quantities of the good on the market at different possible prices. At any price other than the equilibrium price, the intentions of only one set of market participants (either demanders or suppliers) can be met. The intentions of the other set of market participants are not met. Only in equilibrium can the intentions of both sets of market participants be met. It is in this sense that it is sometimes said that equilibrium describes a sort of “bliss state” in a market.

When price is too high for equilibrium, only the intentions of demanders can be fully met because they can purchase all of the good that they want to purchase at the too-high price. The intentions of suppliers, wishing to offer a larger quantity of the good on the market than demanders wish to purchase, are at least partially frustrated. Either all suppliers will sell some of what they offered, or some suppliers will sell as much as they want to sell while others sell little or none. In any case, it is the quantity demanded that will actually be transacted on the market. It is thus suppliers who are unhappy at the outcome, and it is suppliers who can be expected to become the activists in the market to do something about their discomfort. The immediate response to the problem of increasing inventories is to cut price.

When price is too low for equilibrium, only the intentions of suppliers can be fully met because they can sell all of the good that they want to sell at the too-low price. In this case, it is the intentions of demanders, wishing to acquire a larger quantity of the good from the market, which are at least partially frustrated. Some demanders (perhaps the first to arrive at the market) may be able to purchase all of the good that they want at the too-low price, but others (the later arrivals) will have to leave the market empty-handed or with less than they would like to have purchased. The quantity supplied is the quantity that is transacted on the market. It is demanders whose intentions cannot be fully met, and who wish to acquire more of the good at the too-low price and offer higher prices in hopes of capturing a larger quantity of the good.

In bazaar trading situations where there is interactive bidding and offering (dickering, haggling, higgling) between buyers and sellers, demanders can acquire more of the good by bidding the market price upward, and price will continue to be bid upward by demanders until their intentions can be met. Bazaar trading is a common mode of commerce in many of the so-called “third-world” countries. Examples of this possibility in the “first world" include auctions, flea markets, yard sales, and new and used real estate and automobile markets.

Peoples in Western nations are perhaps more accustomed to purchasing their needs in fixed-price retail shops where the prices of items are specified on stickers on the items themselves or on labels on the racks or shelves holding the items. There is no opportunity to dicker over the price in such a shop (unless some flaw or damage can be identified). The customer's only options are to purchase an item at the specified price or leave it in order to search for a better price at another shop. In fixed-price retail shops, it is up to the seller to lower price when price is too high for equilibrium, and to perceive the opportunity to raise the price when it is too low for equilibrium. In a fixed-price retail environment, unmet intentions of demanders are manifested by search behavior.

The forces of market adjustment are the unmet intentions of market participants. These forces are inherent in the market mechanism, although they may lay dormant as long as a market is in equilibrium. The forces are called into action when the intentions of one set or the other of the market participants cannot be met at the going price. But once price has adjusted to a new level at which all intentions of market participants can be met, the forces of adjustment go dormant again.

This functioning of the market mechanism gives rise to a description of a market as an “automatic, self-correcting mechanism,” much in the same sense that a thermostat-controlled heating and air conditioning (HVAC) system works automatically. When the ambient temperature departs from the set criterion temperature, the thermostat calls the heating or cooling mechanism into operation. The unmet intentions of market participants function as the adjustment triggering mechanism in a market.

Both markets and HVAC systems may also be described as “adjustment self-limiting mechanisms" in the sense that adjustment continues until the respective criterion is met, but then adjustment ceases. The HVAC system continues to heat or cool until the ambient temperature reaches the criterion temperature, and then the thermostat shuts down the HVAC system and it remains in an idle state until something again disturbs the ambient temperature to cause it to diverge from the criterion temperature. Likewise, price adjustment continues to occur in a market until the intentions of demanders and suppliers can be met by matching the quantity demanded with the quantity supplied in the market. Then, price adjustment ceases, and price remains at the equilibrium level until changes occur in the determinants of demand or supply.

In a dynamic world, equilibrium may not ever be an observable state because the determinants of demand and supply are ever changing. This does not mean that equilibrium is an irrelevant mental construct that exists only in the minds of economists. It is a real phenomenon that functions as an ever-moving target toward which the market mechanism continually attempts to adjust. Its usefulness to the economic analyst is in the attempt to predict the direction in which price (or quantity) will move toward a new equilibrium once changes in demand or supply occur.

Self-Adjustment at the Macroeconomic Level

Disequilibria and adjustments to them take place at the microeconomic level of the consumer, the worker, and the business firm, but the effects can be observed at the macroeconomic level of aggregation for an entire economy. The ability to observe disequilibrium conditions at the macro level leads government authorities to consider the possibility of implementing "stabilization policy."

While it is possible to aggregate individual consumer demands for a particular item into a market demand or the demand faced by a single seller of the item, it is not feasible to extend the aggregation process to the whole economy because of the so-called "adding-up" problem. In such an aggregation it would be necessary to add unlike units of different goods (e.g., apples and oranges). In the case of "aggregate demand," price must be an index of the general price level rather than the price of any single good or service. Quantity must be the level of real output rather than the quantity of any single good or service which is part of real output.

An economy's performance and condition can be assessed against what may be called its "normal operating capacity." An economy's normal operating capacity is not universally defined so it is necessary to specify a working definition: the unstressed output level when the labor force is increasing at a rate commensurate with population growth, the labor force participation rate is stable, unemployment does not exceed normal frictional levels, price inflation is occurring at a rate considered acceptable by monetary and fiscal authorities, and trade and manufacturing inventories are stable.

Against this working definition of normal operating capacity, a working conjecture is that the normal operating capacity of the United States in 2020 was a Gross Domestic Product around $19 trillion current dollars, with population growing at about one-third percent per annum, the labor force also growing at one-third percent per annum, labor force participation rate of about 65 percent, unemployment of around 4 percent of the labor force (i.e., no more than frictional unemployment), and price inflation at about 2 percent per annum. In late 2020, the U.S. economy suffered a Pandemic supply shock as GDP fell below its potential to around $17 trillion; population was growing at only a third of a percent per annum; the labor force grew slightly faster at a half percent per annum; and the labor force participation rate fell to 60 percent.

In the long run, an economy's normal operating capacity tends to increase with economic growth, that is, as population grows and productivity increases with technological advance and capital investment. Recent experience in Western market economies indicates that the normal operating capacities increase between 1 and 2 percent per annum but vary significantly with cyclical or irregular macroeconomic fluctuations. If aggregate spending fails to keep up with the pace of economic growth, the economy may experience persistent unemployment and falling prices.

At the aggregate level of an entire economy, disequilibrium results when aggregate spending decreases and the output of the economy falls below its normal operating capacity. Such a disequilibrium manifests itself as an accumulation of inventories by business firms at the microeconomic level. Data about increasing inventories at the microeconomic level serve as indicator that aggregate demand has decreased. Unwanted inventory accumulation (or decumulation) reflects the unmet intentions of business decision makers. Unemployment worsens as production levels are cut in response to the increasing inventories, and prices begin to soften. However, prices may be somewhat sticky in the downward direction. If prices do not decrease to absorb some of the aggregate demand collapse, the brunt of the adjustment must be borne by falling output.

If some price deflation does occur in response to decreasing aggregate spending, the lower prices eventually will stimulate increased spending so that the economy can begin to recover. As recovery ensues, inventories may begin to deplete, and employers and production planners can begin to increase output. Aggregate output can continue to increase until there is a return to the normal operating capacity of the economy. Since output tends to return to its level before the collapse of aggregate demand, it may be more appropriate for managers to try to hold production rates constant while letting inventory variation absorb the effects of the demand collapse.

Disequilibrium may also occur when aggregate spending increases so that the excess of spending relative to output manifests itself in the form of inventory depletion. If the economy is below its normal operating capacity, firms experiencing falling inventories and rising order backlogs can increase production rates by employing more labor and increasing materials usage, and they may consider raising prices. Increased labor employment is accomplished by calling back to work people who have been laid off, by extending the work day or work week with overtime or additional shifts, or by hiring additional workers. But if the economy is already at or near its normal operating capacity, firms will raise prices, but they may not be able to increase output. In many cases it may not be possible to implement desired price increases until new menus or catalogs can be distributed.

An increase of aggregate demand may induce the economy's output temporarily to exceed its normal operating capacity. The availability of additional materials inputs may be limited by supply bottlenecks which eventually will result in rising materials costs. An attempted output expansion beyond normal operating capacity will tighten the labor market and bid wage rates upward. When upward materials price and wage pressures become translated into rising input costs, businesses will begin to increase their product prices. Although an apparent response to rising input costs, this stage of increasing product prices is referred to as "demand-pull inflation" because it is attributable to the initiating increase of aggregate demand. Consumers will respond to the rising product prices by cutting back on purchases so that inventories begin to accumulate.

As inventories continue to build up, business managers likely will revise production targets and schedules downward, causing a decrease of aggregate supply until output returns to the economy's normal operating capacity. A second stage of price level increase may be understood as "cost-push inflation" which is attributable to the decrease of aggregate supply. The cost-push inflation comes to an end only when the output level has returned to the economy's normal operating capacity which is sustainable in the long run. The aggregate demand increase achieved no lasting increase of real output but resulted in permanently higher prices, i.e., price inflation.

A supply shock manifested as a sudden aggregate supply decrease may quickly cause product shortages as inventories begin to shrink. In such a market environment, prices become firmer and managers may be tempted to take the occasion to announce price increases. As the higher prices become translated into increased production costs, cost-push inflation ensues. With worsening unemployment which lowers spendable income, aggregate demand can be expected to fall, tending to bring prices back to original level before the shock.

As the COVID-19 Pandemic shock unfolded during 2020 and early 2021, the U.S. departed from its normal operating capacity.

The U.S. population growth rate had fallen from 0.946% per annum in 2008 to 0.351% in 2020 (https://data.worldbank.org/indicator/SP.POP.GROW?locations=US).
The labor force growth rate was projected to fall below 0.5% per annum (https://www.bls.gov/opub/mlr/2015/article/labor-force-projections-to-2024.htm).
The labor force participation rate fell to 60.2 percent in April 2020 (https://fred.stlouisfed.org/series/CIVPART).
The unemployment rate jumped to more that 14 percent in April 2020 before gradually subsiding to 4.5 percent by October 2021 (https://www.bls.gov/news.release/pdf/empsit.pdf).
The CPI inflation rate increased from 1.4% per annum in January, 2021, to 5.4% in June where it remained until October when it jumped to 6.2% (https://tradingeconomics.com/united-states/inflation-cpi).
U.S. manufacturing and trade inventories averaged around 1.4% of sales from 2016 through 2019, then spiked to 1.7% (a 22 percent increase) early in 2020 before falling to 1.25% by late 2021 (a 26 percent decrease) (https://www.census.gov/mtis/www/data/pdf/mtis_current.pdf).

When the falling prices become translated into decreasing production costs, managers may revise production plans and increase output to replenish depleted inventories. With the fall of prices and the recovery of the economy, aggregate demand can increase toward its original level until output returns to its normal operating capacity. Market and inventory realities may force managers to make the adjustments in production rates and prices, but since both aggregate output and prices will tend to return to their pre-shock levels, a better strategy may be to weather the storm by holding constant both prices and production levels while letting inventories serve as the shock absorber.

Aggregate demand and supply analysis points to several important macroeconomic conclusions:

1. Any initiating change of aggregate demand in a market economy is likely to induce a subsequent opposite-direction change of aggregate supply in the short-run as people "wake up" to what is happening to their incomes and costs of living. This may also happen with respect to an initiating change of aggregate supply.

2. A first-stage of demand-pull inflation (responsive to a change of aggregate demand) in a market economy is likely to elicit a second stage of cost-push inflation (responsive to a change of aggregate supply).

3. A market economy may be induced by an increase of aggregate demand to produce temporarily at a rate of output exceeding its normal operating capacity, but subsequent adjustment forces will tend to return the output rate to its normal operating capacity but leave prices permanently higher.

4. A collapse of aggregate demand (as may have occurred in the Great Depression of the 1930s) will result in falling output and price level, but with sufficient time subsequent adjustment forces will tend to return both the output rate and the price level to their former levels. The time required for recovery may be excessive relative to political realities.

5. A supply shock in a market economy will lead to a temporary decrease of the rate of output and corresponding cost-push increase of the price level, but subsequent adjustment forces will tend to return both the output rate and the price level to their former levels.

6. Although the market economy's output rate tends to gravitate toward its normal operating capacity, increases of aggregate demand or aggregate supply may lead to permanent changes of the price level.

Self-Adjustment in Financial Markets

Natural adjustment processes in a market economy tend to cause market-determined interest rates to gravitate toward the economy's natural rate of interest. The yield rates on long-term riskless financial instruments cannot diverge significantly or for long from this "true" interest rate determined by the scarcity of real capital relative to the demand for it.

Economists conventionally identify four “factors of production,” land, labor, capital, and entrepreneurship, and the so-called returns to them, respectively, rent, wage, interest, and profit. Since interest is the return to real capital (physical productive capacity, e.g., plant, equipment, housing), the "true" interest rate in any region is a measure of the scarcity of capital in the region relative to the demand for it.

The true (or scarcity) interest rate is region specific. Due to the effect of diminishing returns, the true rate of interest is higher in regions where capital is scarce and lower in regions where capital is more abundant. The true interest rate would be expected to fall as capital becomes more abundant with on-going economic development. It would rise if capital were to become scarcer, e.g., when equipment is destroyed by a natural disaster or war, or if gross investment in the region should become less than depreciation so that the capital stock actually shrinks.

In a financial sense, interest is the price for the use of a dollar's (or other local currency unit's) worth of credit for a year. The issuance or sale of a financial instrument by a business firm or a government agency is an implicit demand for credit. The prices of financial instruments are determined by the interaction between forces of demand for and supply of them in loanable funds markets (i.e., bank borrowing and bond markets). Yield rates on financial instruments are understood to be their interest rates. Yield rates, which vary inversely with the market prices of financial instruments, also may vary by risk factors and terms to maturity.

Interest rates on U.S. Treasury securities are market-determined prices because they are closing market bid quotations on the most recently auctioned Treasury securities in the over-the-counter bond market. Parties other than the Treasury may engage in the market in which Treasury securities are traded. Banks and other financial interests, both domestic and foreign, may enter the bond market to purchase and sell Treasury and corporate securities by bidding and offering bond prices. If they can get better price deals than offered by the Treasury, market participants will trade with each other rather than with the Treasury. Market yield rates by terms to maturity are calculated from the average prices of bond trades each day. Market yield rates may differ from administered rates set by the central bank of the region.

Commentators, pundits, and even financial professionals often personify financial markets, speaking as if they are persons who behave and know things about the economy and financial markets. Is there reason to think that market bond prices and the yield rates calculated from them contain any special information apart from interest rates set by monetary authorities? The bond market is comprised of the many individual and institutional traders who buy and sell bonds. Their knowledge and expectations are exhibited in the demands for and supplies of bonds by term categories. The bond prices from which the yield rates are calculated change to reflect increasing or decreasing demands for the bonds relative to the supplies of such bonds. Increasing bond prices (and falling yield rates) indicate that the demand for bonds in that term category recently have increased relative to supply (or that supply has decreased). Decreasing bond prices (and increasing yield rates) indicate that demand for such bonds recently has decreased relative to supply (or that supply has increased).

Changing bond prices (and their yield rates) percolate through the financial markets by arbitrage as bond traders buy low and sell high to cause lower prices to rise and higher prices to fall until prices converge. In so doing, bond traders capture profits and eliminate the price and yield rate differences across markets. So, yes, recent changes of the average yields by terms to maturity represent the collective understandings and expectations of bond traders about economic and financial conditions, and they may reflect market adjustments relative to the natural rate of interest in the region.

The yield rates on long-term riskless financial instruments cannot diverge significantly or for long from the true interest rate determined by the scarcity of real capital relative to the demand for it. Natural adjustment processes in an economy tend to cause market interest rates to gravitate toward the economy's natural rate. But central banks may implemet monetary policy that may induce market interest rates to diverge from the natural rate in their regions. Monetary policy that induces market rates to fall below the natural rate will stimulate spending in the economy and may cause inflation. Monetary policy that causes market rates to rise above the natural rate will have depressive effects on the economy to diminish the rate of inflation (or possibly even to cause deflation).

A problem is that the natural rate of interest is not an observable rate and cannot be tracked, but it might be inferred from market behavior or the yield rates on long-term bonds. If investment increases following a decrease of the rate at which the central lends to commercial banks or the rate that it pays to commercial banks on their reserves, the implication may be that market rates are below the natural rate. The increasing investment may increase the supply of corporate bonds relative to bond demand, causing their prices to fall and their yield rates to rise back toward the natural rate. If investment decreases following an increase of the central bank's rate, the implication may be that market rates are above the natural rate. The decreasing investment may decrease the supply of corporate bonds relative to bond demand, causing their prices to rise and their yield rates to fall back toward the natural rate.

The international trading of securities tends to eliminate bond price differences globally, and thus to equalize yield rates globally on same-term securities. As soon as international bond price differences are detected, securities traders will engage in international arbitrage to capture profits and eliminate the price and yield rate differences. Buying low and selling high will cause lower prices to rise and higher prices to fall until prices converge. But the international arbitrage that eliminates international price and yield rate differences may cause bond yield rates to become higher or lower than region-specific natural interest rates. These differences may induce local decreases or increases of investment spending.

Arbitrage is the behavioral factor that renders market interest rate adjustment toward the natural rate of interest an automatic adjustment feature of a market economy.

Are the Inherent Adjustment Forces Sufficient?

The rationale for bringing the offices of government to bear upon the stability of the economy is based upon the view that inherent adjustment forces are inadequate, that market economies are naturally unstable, that the degree of instability is intolerable, and that some force must be applied to counteract the natural instability of the market economy. Of course, the only entity in the economy which can possibly bring enough force to bear upon the problem of instability is government.

When the economy experiences either an increase of aggregate demand or a decrease of aggregate supply, there is a natural tendency for the adjustment process to return the economy to its normal operating capacity, although there may be lasting effects upon the price level. However, the natural adjustment process takes time, perhaps extending beyond a few quarters and to several years. Belated responses or overreactions by business decision makers may set in motion cyclical oscillations that are felt with dampening effects for years, especially if managers attempt to control inventories within narrow limits. The modern industrial or post-industrial economy typically takes four or more years to complete all of the phases of a business cycle.

Even though a market economy incorporates significant self-adjusting mechanisms at the micro level, the burning questions debated by economists for decades are whether government can prevent such instability at the macro level, offset adverse changes of aggregate demand or supply, hasten natural adjustment processes, or diminish the amplitude of oscillation.

Monetary policy might be used to effect off-setting changes of aggregate demand. In order to counter a predicted aggregate demand decrease, the monetary authority would have to pursue an expansionary monetary policy by lowering bank reserve requirements, lowering the short-term bank rate (in the U.S., the discount rate, i.e., the interest rate charged by the central bank to commercial banks when they borrow from it), or buying bonds or other financial instruments from banks or parties in the private sector. The resulting monetary expansion, if it is not otherwise offset, would be expected to result in falling interest rates to stimulate interest-sensitive expenditures and increased liquidity to stimulate liquidity-sensitive consumption purchases.

A predicted aggregate demand increase might be offset by implementing a restrictive monetary policy, i.e., by the monetary authority raising bank reserve requirements, increasing the discount rate, or selling financial instruments. The ensuing monetary contraction, if it is not otherwise neutralized, would be expected to result in rising interest rates and diminishing liquidity to elicit the desired offset to the increase of aggregate demand.

The fiscal authority may attempt to implement fiscal policy to offset an increase of aggregate demand or a decrease of aggregate supply by reducing government spending and/or selling financial instruments (bonds). The fiscal authority could attempt to offset a decrease of aggregate demand or an increase of aggregate supply by increasing government spending. Political procedures for government budget manipulation are likely to make the implementation of fiscal policies more difficult and time consuming than for the monetary authority to reach decisions to adjust reserve requirements, change its bank rate, or buy or sell financial instruments for its portfolio.

Responding to changes of aggregate supply in a market economy is difficult since the fiscal authority has no direct control over production capacity or cost conditions (it would have such control in a regime of socialism). It may be able to exert some influence over the long run by taking actions to make markets work more efficiently, to remove market imperfections which impede the mobility or availability of resources, to diminish reporting or compliance costs, or to remove disincentives to work or assume risks.

It may be possible to implement a fiscal stimulus that will counter an unexpected supply shock. Suppose that a supply shock causes aggregate supply to decrease as during the 2019-20 COVID-19 Pandemic. The ensuing consequence is a fall of real output below the economy's normal operating capacity, accompanied by rising unemployment and cost-push inflation that occurred during the second half of 2021 in the run-up to the end-of-year holidays. If the government can be patient, it is possible that aggregate supply will recover to its earlier position after the shock has abated so that output can return to the normal operating capacity and the rate of inflation diminish. However, if this does not happen, or if it takes too long to happen, the government may implement a fiscal stimulus (by increasing bond purchases or cutting tax rates) to increase aggregate demand. While this may hasten the return of real output to the normal operating capacity of the economy and relieve unemployment, it likely will result in some more inflation, this time of the demand-pull variety.

Discretionary Policy Realities

Unfortunately, the world does not work like this in many respects. For one, changes of government purchases or tax collections have impacts on the government's budget. If an expansionary fiscal policy causes the government's budget to go into deficit (or even deeper deficit), the deficit must be financed. This can be done in only two ways, either by creating money or by borrowing from private sector capital markets. The former will likely cause inflationary pressures, while the latter will result in rising interest rates which may crowd-out some private sector investment. A crowding-out effect would "snub" the fiscal stimulus so that there would be only a partial recovery. Also, there may be further changes of aggregate demand or supply to disrupt the best-laid plans to neutralize demand shifts.

Even if it were possible to accurately predict the magnitude of an autonomous aggregate demand or supply shift, with our present knowledge and limited ability to control fiscal variables, it is highly unlikely that the right fiscal change can be implemented with any degree of precision. Thus, the fiscal measure taken likely would be either inadequate or excessive relative to the amount of autonomous change to be offset. An inadequate fiscal stimulus would leave the economy in recession operating below its normal capacity. An excessive fiscal stimulus might cause the economy to attempt to produce above its normal operating capacity with even more demand-pull inflation.

It is even more difficult to use monetary policy as a means of attempting to offset private-sector changes of aggregate demand because the linkages between money-supply changes and spending are only indirect and imprecise. The monetary policy transmission mechanism works either through changing interest rates that affect interest-sensitive purchases, or through the so-called real-balance effect of a change in liquidity that induces consumer spending changes. At this stage of our understanding, it is not possible with any degree of precision to effect the right change of any monetary aggregate to elicit just the right offsetting change of aggregate demand.

Even more troubling than these minor difficulties is the fact that it is never possible to perfectly predict changes of aggregate demand or supply, and it may not be possible to predict such changes at all. More often than not, the first evidence of a change of aggregate demand or supply becomes evident some number of months or quarters after the fact. This puts the government in the position of reacting to such changes rather than concurrently offsetting them.

The most serious problem of implementing any government policy in the interest of stabilizing the economy is that the natural adjustment mechanisms of the economy may have reversed the direction of change of the economy by the time that the policy designed to deal with the original problem finally has its effect. For example, in a contracting economy, expansionary fiscal and monetary policies are called for. But by the time the contraction can be confirmed, expansionary policy implemented, and the spending process under weigh, the economy of its own volition may have begun its recovery. So, the expansionary monetary policy impacts an already-expanding economy. A similar, but reversed, scenario can be depicted for an economy entering a period of expansion. Because of variable and unpredictable time lags in the implementation of macropolicy, government's well-intentioned efforts to stabilize the economy often end up destabilizing it--"booming the boom," or "depressing the depression."

The inherent automatic adjustment mechanisms of the market economy may be sufficient to achieve stabilization naturally, if only the social and political processes can allow sufficient patience. A shocked economy will eventually "right itself," much in the same way that a listing ship will return to an "even keel" if it has adequate ballast. The ballast of the market economy consists in the inherent adjustment mechanisms in the microeconomic decision units which compose the markets of the economy. The political problem is that reliance upon the natural stabilization properties of the market economy requires that elected or appointed officials to "don't just do something, stand there" and wait patiently while the economy takes care of itself. And this is something which neither government officials seem able to do, nor their electorates tolerate.

The exercise of discretionary policy is fraught with the potential for inflation, especially in response to supply shocks. For example, some natural disaster such as a massive hurricane may cause aggregate supply to decrease, setting in motion a process of contraction accompanied by cost-push inflation and rising unemployment. In order to alleviate the ensuing unemployment, government authorities will be tempted to compensate for the supply shock with an expansionary fiscal or monetary policy that will stimulate aggregate demand to increase. While such a policy action may stem the tide of rising unemployment, an unintended and undesired side effect likely will be demand pull inflation.

An alternative policy response by the government, and one that will avert further inflation, is to ignore the unemployment effects of the supply shock and simply wait for the economy to naturally recover and return the aggregate supply curve to its earlier position. But we can expect that most government officials would find this strategy repugnant because it requires them to "Don't just do something, stand there!" Such a response makes them appear to be either incapable or unwilling to respond to an ensuing crisis.

An even tougher policy alternative would be to greet the supply shock with a contractionary fiscal or monetary policy to cause aggregate demand to decrease. This would tend to reverse the cost-push inflation of the supply shock, but at the cost of even more unemployment. However, the recovery of the economy from the supply shock would tend to return aggregate supply to its original position with fewer inflationary ill effects. Needless to say, such a policy likely would appear to be too harsh to be politically tolerable, especially in a democracy.

Economic decision making is facilitated when a government behaves predictably and rationally, and is willing to let the economy "mind itself." But we can be fairly confident that government officials, whether in democratic or authoritarian polities, will have agenda to pursue, and that the fiscal requirements of such agenda likely will usurp any capacity of the government to stabilize its economy.

To Act or Be Patient

At the middle of the twentieth century, macroeconomists thought that by engaging in fiscal and monetary policies they could fine tune a market economy to avert both cyclical swings and oscillating pressures of inflation and deflation. But experience has demonstrated in both developed and less-developed economies that government budgets are much more attuned to the requisites of program finance than to the needs of macroeconomic stability. Especially in democratic polities, legislative assemblies often perceive the need or the desire to mount new programs or enhance existing programs. But each expanded program or newly enacted program has to be financed. If financing provision is not made by way of increasing some tax, new or expanded programs contribute to growing deficits. The deficits result in inflationary pressures if they are financed with direct money creation or if the central bank feels compelled to expand the money supply to prevent interest rates from rising. Program-oriented budget finance thus has an inherent inflationary bias.

Even if a government does attempt to manage its budget in the interest of economic stability, deliberate fiscal actions by the government may elicit counterproductive changes in the private sector that tend to neutralize the deliberate fiscal stimulus. For example, increases of government spending to alleviate recession may increase the budget deficit, causing interest rates to rise, thus crowding out private sector borrowing to finance investment or interest-sensitive consumer spending. Or, decreases of government spending during a period of contraction may so lower market interest rates as to elicit crowding in of private sector borrowing to finance more investment or consumer spending. Both crowding-out and crowding-in effects in the private sector tend to neutralize the deliberate fiscal policy actions taken in the public sector.

During the late-twentieth century and early in the twenty-first century, governments in a number of Western countries attempted to use monetary and fiscal policies in efforts to stabilize their economies. Experience with these efforts yields convincing evidence that deliberate policy activism often involves policy overreactions due to time lags in recognizing changing conditions, initiating policy actions, and the completion of adjustments. It is not certain that deliberate manipulation of the government's budget in efforts to diminish macroeconomic instability doesn't inject more instability into the economy than would be present if the government simply left the macroeconomy to manage itself. Similar statements can be made with respect to monetary policy actions by the central bank that are intended to stabilize the economy, but which, because of various time lags, may tend to destabilize the economy.

When unemployment or inflation have “reared their ugly heads,” politicians usually have felt compelled to follow the admonition, “Don’t just sit there, do something!” Because discretionary policy overreactions may destabilize a macroeconomy rather than stabilize it, some macroeconomists have become discretionary policy skeptics. But politicians have difficulty following the reverse admonition: “Don’t just do something, sit there!” The ability to wait patiently is simply not in the genes of political animals. Political inaction may be worse for a politician’s career than policy overreaction.

Discretionary policy skeptics place faith in the automatic self-correcting features that are inherent to any well-functioning market economy than in the ability of government officials to exert stabilizing macropolicies. Policy skeptics have come to favor so-called automatic stabilizers such as a progressive tax rate system and a limited-duration unemployment compensation program. During a period of economic expansion as more people gain employment, wages and salaries increase due to rising wage rates and overtime work, and bonuses increase. Because people's incomes reach ever-higher tax brackets, the increase of tax payments to the government has the effect of siphoning purchasing power out of the economy to dampen the expansion. The process also works in reverse to leave more purchasing power in the economy during an economic contraction.

A Final Word

Since self-correcting adjustments to market imbalances occur at the microeconomic level of individual decision makers (consumers, businesses, workers) and are only reflected in aggregate data for the economy as a whole, any macro-level discretionary policy actions that fail to address the unmet intentions of market participants may be ineffective.

DS Legacy