Knowledge that Transforms

Budget decision making at the federal level in the United States can hardly be described as casual, haphazard, or ill-informed. The budgeting process is lengthy and elaborate. The principal decision makers-the president and the Congress-are assisted at every stage by an army of highly trained economists and budget analysts who assemble masses of information, use sophisticated forecasting models, and have access to state-of-the-art computers. Everyone works very hard. No government in the world devotes as much time, energy, and talent to budget decision making as our's does. Nevertheless, almost everyone is unhappy, with both the outcome of all of this effort and the process itself. Of course, some dissatisfaction with the outcome is normal. No matter how smoothly the mechanics of budget decision making are carried out, some will feel that the government spends too much or too little, spends on the wrong things, or taxes in the wrong way. But the current situation is not normal. Unless recent budget decisions are changed, they will lead to high and rising structural deficits that almost no one defends as desirable fiscal policy, a rapidly escalating burden of debt service, and a mix of fiscal and monetary policies that is reducing U.S. competitiveness in international markets and seems likely to retard growth. Moreover, quite apart from its unsatisfactory outcome, both participants and observers decry the shortcomings of the budget-making process itself. Budget decision documents are complex, technical, and difficult to understand. Even the experts have a hard time following what is going on. There never seems to be enough time for debate or deliberate decision making at any stage of the process, but the whole process takes too much time. Executive officials and members of Congress seem to do nothing but defend, question, and debate the budget and still they never finish before the budget year begins-and sometimes not before it ends. On top of all this, the economic assumptions are always proving wrong. Decisions are out of date almost before they are made. It is all very frustrating. It is tempting to ask whether there are not some procedural reforms that could solve all of these problems. Couldn't we change the budgeting process so that it would be easier to understand, less time consuming, less uncertain, and, above all, less prone to produce large budget deficits? I will argue that our current problems are not primarily procedural. The budgeting process is complex and time consuming primarily because the federal government does so many different kinds of things, and because Congress is so reluctant to concentrate on major directions of policy while leaving the details to executive departments or state and local governments. We can simplify the budget process only by simplifying the government itself and changing the role of the Congress. We can make the budget process less time consuming only if we are willing to make decisions less often, or to give up some checks and balances. Moreover, the world is an unpredictable place, and, while we could perhaps handle unpredictability in the budget process better than we do, no procedural changes can eliminate it. Nor does the failure to make the hard decisions neces* Director, Economics Studies Program, The Brookings Institution, 1775 Massachusetts Avenue, NW, Washington, D.C. 20036. The views expressed in this paper are my own and should not be ascribed to the officers, trustees, or other staff members of the Brookings Institution.

Anne Krueger and Baran Tuncer (1982) present some interesting results on rates of effective protection and of productivity growth for various sectors of the Turkish economy. From these measures, the authors develop an empirical test for the validity of the infant industry (p. 1149). Being perhaps the first attempt to test directly the commonly cited infant industry grounds for protection, the paper by Krueger and Tuncer is especially valuable. Clearly, the approach is readily applicable in other contexts for further testing but, before so doing, it seems worth pursuing certain implications of that test little more precisely. test proposed by Krueger-Tuncer for the validity of the infant industry argument is founded on the premise that a necessary (but not sufficient) condition is that costs in (temporarily) assisted or protected should have fallen over time more rapidly than costs in nonprotected or less-protected industries (p. 1144). The test is simple and straightforward: input per unit of output must fall more rapidly in more protected if there is to be any rationale for infant industry protection. In the Turkish case, there was no such tendency over the period covered (p. 1149). But is this sufficient test of the necessary conditions? case for infant industry assistance is derived either from an externality associated with learning-by-others-doing or learningby-own-doing combined with capital market failure. For the instance of within industry learning, this is commonly modelled by inserting the integral of past output as an argument in the production function, which may be written for industry i at time t:

Decision makers performing cost-benefit analysis must often deal with the problem of how to aggregate the benefits across states of nature accruing from an uncertain public investment project.' Option price and the expected value of consumer's surplus are two potential measures of these aggregate benefits.2 The expected value of surplus has been proposed because it is readily measured and because risk pooling (Paul Samuelson, William Vickrey; 1964) and risk spreading (Kenneth Arrow and Robert Lind, 1970) tend to encourage risk neutral behavior. Option price has been favored on the vague notion that people would be willing to pay something extra above expected surplus to preserve the opportunity to purchase a good (Burton Weisbrod, 1964). As Daniel Graham cogently argues in this Review (1981), however, option price is but one of an infinite number of contingent payment schemes. The literature has provided no justification for focusing upon it as an ideal measure of benefits under individual risk. Graham further argues that policymakers ought to adopt the compensating contingent payment plan which maximizes expected revenue. This maximum payment plan, by definition, is never less and will often exceed any other contingent payment scheme. Consequently, Graham argues that both the expected value of surplus and option price are underestimates of the true value of project benefits. Our purpose in this comment is twofold: first, we show the role of project and nonproject insurance in a model of individual risk; and, second, we argue that option price, not the maximum payment plan, is the optimal rule when no fair insurance is available. In Section II, we show that if fair insurance is available against all risks, all contingent payment plans yield identical revenue. A similar result holds if insurance is available for nonproject risks and the effect of the project to an individual is small (the Arrow-Lind model). In Section III, we explore the case where either the project has a large uninsurable effect on the individual, or there is no insurance against even nonproject risks. We argue that the very phenomena (moral hazard, adverse selection, and complexity) that eliminate the market for private insurance also prevent the government from making otherwise desirable contingent payments. If contingent payments are too costly, the government's only remaining choice is to collect payments that are constant across states, which makes option price the relevant measure of benefits.

In October 1979, the Federal Reserve announced a new commitment to fight inflation. It signalled its resolve by a shift in policy tactics that placed greater emphasis on reducing the growth of money and less emphasis on limiting short-run fluctuations in interest rates. This shift in tactics was accomplished by a change in operating procedures that placed primary emphasis on controlling the growth of reserves available to depository institutions while greatly expanding the allowable range of fluctuations in the federal funds rate. The growth of MI and other monetary aggregates did slow on average, but money growth experienced large short-term fluctuations. Interest rate movements increased, as advertised, but the extent of their fluctuation was severe. Inflation slowed markedly, but this was primarily the consequence of a severe recession. Events gave grim testimony to the truth that it is possible to reduce inflation quickly by producing a sufficiently severe recession. In the second half of 1982, with the economy in disarray and with growing concern about the ability of the financial system to withstand further strain, the Federal Reserve abandoned its new operating procedures. There was a shift back to the more comfortable world of stabilizing fluctuations in the federal funds rate. There is considerable controversy over whether the Federal Reserve actually pursued a policy strategy that was consistent with the teachings of the Book of Monetarism. Concern about limiting money growth and using reserves as the operating variable are consistent with monetarism. The extreme fluctuations in money growth during the period are not consistent with monetarist doctrine, however. Perhaps the Fed had not really embraced monetarism. It may have found that focusing on money growth was a convenient means of absolving itself from responsibility for the record-high interest rates that occurred. Conversely, perhaps the Fed did embrace the principles of monetarism, but was unable to achieve steady money growth. We shall never know for sure whether or not the Federal Reserve was really trying to perform a monetarist experiment on the American economy. We do known, however, that the experiment was far from pure because of the substantial moneygrowth volatility that occurred. There is also substantial controversy over the of the Some observers argue that the primary aim of reducing inflation was achieved; they proclaim the experiment a success. Others point out that this success was the consequence of a severe recession produced by high real interest rates and had nothing to do with monetarism per se. This paper does not contribute to the debates concerning the nature and of the monetarist experiment. Rather, it looks at the role played by financial innovation in complicating the pursuit of monetary policy during the period. Was the great experiment hurt by financial innovation? More specifically, did rapid financial innovation make it infeasible to target on MI (or some other monetary aggregate), and did innovation contribute to the extreme fluctuations in money growth and interest rates that occurred? The conclusions from the discussion that follows is that financial innovation did not make it any less feasible to target on MI during 1979-82 than for other periods. Financial innovation does not appear to have made money growth an unusually unreliable target, and innovation was not the source of the volatility of money growth and interest rates that occurred.

Has the macroeconomic policy changed in the United States in the last few years? If so, has this change had an effect on macroeconomic relationships, and, in particular, on the relationship between inflation and unemployment? These two questions have been on the minds of most macroeconomists since the October 1979 switch from interest rates to reserves as an intermediate target for the Federal Reserve and the explicit endorsement of monetarism by the Reagan Administration in early 1981. The questions are important not only for predicting the course of the economy in the future, but also for assessing the practical significance of the Lucas critique.' According to this critique a change in policy regime should cause changes in the way the economy operates. Comparing economic relations before and after a change in regime should provide a test of the critique. The approach in many recent studies has been to assume that the answer to the first question is yes-that there has been a significant change in the macroeconomic policy regime-and to look for changes in the Phillips curve as a test of the Lucas critique. Thus far, the results have been mixed. Otto Eckstein (1983), Steven Englander and Cornelis Los (1983), and George Perry (1983) conclude that there has been no significant change in the Phillips curve relationship. Phillip Cagan and William Fellner (1983) and Wayne Vroman (1983) find some evidence of a change: wage inflation has come down more quickly-especially in 1982 and early 1983-than would be predicted from a Phillips curve. However, the assumption that there has been a regime change has received little empirical attention. The October 1979 switch from interest rate targetting to reserve targetting at the Fed is usually taken as prima facie evidence of a significant change in policy regime. But such changes in operating procedures per se do not necessarily entail a change in policy regime relevant for macroeconomic purposes. If they did, then the renewed emphasis on interest rates rather than reserves starting in late 1982 should be cited as evidence of a return to the old regime-a view which few researchers have taken. In fact, studies have shown that either interest rates or reserves can be used as intermediate targets for controlling the money supply and ultimately aggregate demand. (The choice between the two depends on whether shocks to the money markets are from the demand side or the supply side.) The issue of importance for assessing whether a regime change has taken place is how much the Fed reacts by adjusting the money supply (appropriately defined) in response to conditions in the economy. The procedure it uses to bring about this response is irrelevant.2 Implicit in a macroeconomic policy regime is a rule relating the money supply to economic con*404 Woodrow Wilson School, Princeton University, Princeton, NJ 08544. This research was supported by a grant from the National Science Foundation at the National Bureau of Economic Research and conducted in part at the Federal Reserve Bank of Philadelphia. I am grateful to Steve Fries for research assistance, and to Steven Englander and Comelis Los for comments on an earlier draft. 'See Robert Lucas (1976). William Fellner's (1978) credibility hypothesis is similar to the Lucas Critique in this context and has been tested in similar ways. 2Some have argued that, for political reasons, by focusing on reserves the Fed would be able to let interest rates go higher than under interest rate targetting. With reserve targetting, Fed officials could shift the blame for high interest rates elsewhere.