Back to Overview
Review Question

Lagging Doubts

When Gerald Ford became president, he and his economic advisors fixed on inflation as the number one economic problem facing the nation. In a highly publicized search for solutions, President Ford hosted a two-day "summit" meeting of academic, political, and private sector leaders early in October of 1974. Shortly after this meeting, the president proposed a 5% income tax surcharge on some individuals and corporations as a measure to curb excess demand and pull down inflation. However, in the next few months the unemployment rate soared, and in his State of The Union message in January of 1975, the president had abandoned his proposed tax increase in favor of a $15 billion tax cut to fight recession.

The sudden switch in proposed policy would have made the Ford administration look good if the economy had peaked between October of 1974 and January of 1975. Then it could have boasted that they had quickly changed policy recommendations when conditions changed. Unfortunately the dates that the National Bureau of Economic Research gives to the peaks and troughs of business activity show that the Ford administration had its timing wrong. The Bureau dates the peak of business activity in December of 1973, and the trough in November of 1974. Thus, the Ford Administration was gearing up to fight inflation just as the recession was about to hit bottom, and began preparing its fight against the recession a few months after it had already ended.

The Ford Administration suffered from a dramatic case of a common problem, the problem of recognition lag. Usually policy makers need several months to recognize that a problem is developing. Although many statistics are available fairly quickly, sometimes within a few weeks, revisions months later can change the message that they give. Also, there is much random movement in many series, so that a one or two month movement may not indicate that anything important is happening. Only when several months have passed can one see any patterns that are developing.

After a problem is recognized, policy makers need time to decide what to do, a time period called the decision lag. They then must enact their decision, which can also take time, the implementation or action lag. Once the policy has begun, it does not affect peoples' behavior immediately. A change in taxes, for example, will affect consumption, but the permanent-income hypothesis suggests that sizable changes take time. Similarly, an increase in money stock will not immediately affect spending. The increase in money stock will throw the market for money balances into disequilibrium. As people adjust in this market, they will throw other markets, such as financial markets out of equilibrium. As these markets adjust, the goods market will be thrown out of equilibrium. Only with time, which perhaps may be measured in years, will full adjustment to these disequilibrium situations take place. We can call this time required for the actions to change behavior the take-effect lag.

The existence of lags may mean that by the time policy has its full effect, the problem with which it was meant to deal may have disappeared. The graph below illustrates with the dotted line a path that the economy might follow in the absence of any government actions. This path does not coincide with the best possible path, or the ideal path, of the economy. If economists could fine-tune the economy, they would make the economy follow the ideal path. But if they actually try to fine tune, they may find that they do not recognize the problem until time b and do not take action until time c. The major impact of their action may not show up in the economy until time d, by which time the problem has changed. It is possible that attempts to stabilize the economy can, because of the problem of lags, make the economy less stable rather than more stable.

Lags make government less reliable as a stabilizer

Recognition, decision, and take-effect lags occur in most decision-making processes, not just in macroeconomic policy. Businesses have these lags in many different places. For example, automobile manufacturers occasionally discover that slow sales have allowed inventories to rise too high. Car sales fluctuate a lot from day to day and week to week, so that car manufacturers cannot discover that they have a problem on the first day it begins, but only after several weeks or months of slow sales. Once they decide that they have a problem they must decide how to solve it. They can cut their work force, advertise more, cut prices, find a sales promotion, or some combination of these. Once they decide what to do, it takes a while for unwanted inventory to be sold.

Although both fiscal and monetary policy have lags, a special problem of fiscal policy, at least in the United States, is that the decision-making part of the process can be long and unpredictable. The executive branch usually proposes fiscal policy, but the legislature must enact it. The political process in a democracy is designed to take time, to allow a variety of inputs and opinions, and to avoid hasty judgment. Hearings are held by subcommittees and committees, there are largely symbolic debate on the floors of the House and Senate, and there are often alterations to the President's original proposal inspired either by principle or narrow interests. If the executive and legislative branches are in a cooperative mood, the process may be fairly quick, but if they are in conflict, as they often are in the United States, fiscal legislation may take years to pass if it passes at all. Macroeconomic policy with this sort of unpredictability cannot be used on a regular basis.

In contrast, monetary policy in the United States has almost no decision lag, though it has other sorts of lags. The decision-making body consists of the twelve voting members of the Federal Open Market Committee, a structure designed for making decisions quickly. A simple majority of the FOMC can change policy in a telephone conference and open-market operations can begin within hours of a decision.

Even if the Keynesian multiplier model correctly describes the power of fiscal policy, there would be strong reasons not to use it as a discretionary tool. The uncertainties and delays of the political process can make it unreliable, plus it has important side-effects. However, there is reason to believe that fiscal policy is not nearly as potent as the simple model suggests, and this drives a final nail into the coffin of fiscal policy.

Back to OverviewReview QuestionExploreNext
Copyright Robert Schenk