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So far, we have been discussing some of the broad lessons about which most economists would agree. We now turn to four questions about which there is continuing debate. Some of the disagreements concern the validity of alternative economic theories; others concern how economic theory should be applied to economic policy.

The economy’s natural level of output depends on the amount of capital, the amount of labour, and the level of technology. Any policy designed to raise output in the long run must aim to increase the amount of capital, improve the use of labour, or enhance the available technology. There is, however, no simple and costless way to achieve these goals.

The Solow growth model of Chapters 7 and 8 shows that increasing the amount of capital requires raising the economy’s rate of saving and investment. Therefore, many economists advocate policies that are designed to increase national saving. Yet the Solow model also shows that raising the capital stock requires a period of reduced consumption for current generations. Some argue that policymakers should not encourage current generations to make this sacrifice, because technological progress will ensure that future generations are better off than current generations. (One waggish economist asked, “What has posterity ever done for me?”) Even those who advocate increased saving and investment disagree about how to encourage additional saving and whether the investment should be in privately owned plants and equipment or in public infrastructure, such as roads and schools. Finally, when trying to decide how much current consumption should be discouraged, we must take a position on the importance of positional goods (a recent research topic we discussed in Chapter 16). We know that the bigger is the negative externality generated by consumption, the more we should use the tax system to stimulate saving. But there is no definitive evidence on the size of this consumption externality.

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To improve the economy’s use of its labour force, most policymakers would like to lower the natural rate of unemployment. As we discussed in Chapter 6, the large differences in unemployment that we observe across countries, as well as the large changes in unemployment we observe over time within countries, suggest that the natural rate is not an immutable constant but depends on a nation’s policies and institutions. Yet reducing unemployment is a task fraught with perils. The natural rate of unemployment could likely be reduced by decreasing employment-insurance benefits (and thus increasing the search effort of the unemployed) or by decreasing the minimum wage (and thus bringing wages closer to equilibrium levels). Yet these policies would also hurt some of those members of society most in need and, therefore, do not command a consensus among economists.

In many countries, the natural level of output is depressed by a lack of institutions that people in developed nations take for granted. Canadian citizens today do not worry about revolutions, coups, or civil wars. For the most part, they trust the police and the court system to respect the laws, maintain order, protect property rights, and enforce private contracts. In nations without such institutions, however, people face the wrong incentives: if creating something of economic value is a less reliable path to riches than is stealing from a neighbour, an economy is unlikely to prosper. All economists agree that setting up the right institutions is a prerequisite for increasing growth in the world’s poor nations, but changing a nation’s institutions requires overcoming difficult political hurdles.

Raising the rate of technological progress is, according to some economists, the most important objective for public policy. The Solow growth model shows that persistent growth in living standards ultimately requires continuing technological progress. Despite much work on the new theories of endogenous growth, which highlight some of the societal decisions that determine technologicial progress, economists cannot offer a reliable recipe to ensure rapid advances in technology. The good news is that around 1995, in the United States at least, productivity growth accelerated. Perhaps this means the end of the productivity slowdown that began in the mid-1970s. Yet it remains unclear how long this propitious development will last and whether it will spread to the rest of the world.

The model of aggregate supply and aggregate demand developed in Chapters 9 through 13 shows how various shocks to the economy cause economic fluctuations and how monetary and fiscal policy can influence these fluctuations. Some economists believe that policymakers should use this analysis in an attempt to stabilize the economy. They believe that monetary and fiscal policy should try to offset shocks in order to keep output and employment close to their natural levels.

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Yet, as we discussed in Chapter 15, others are skeptical about our ability to stabilize the economy. These economists cite the long and variable lags inherent in economic policymaking, the poor record of economic forecasting, and our still-limited understanding of the economy. They conclude that the best policy is a passive one. In addition, many economists believe that policymakers are all too often opportunistic or follow time-inconsistent policies. They conclude that policymakers should not have discretion over monetary and fiscal policy but should be committed to following a fixed policy rule. Or, at the very least, their discretion should be somewhat constrained, as is the case when central banks adopt a policy of inflation targeting.

There is also debate among economists about which macroeconomic tools are best suited for purposes of economic stabilization. Typically, monetary policy is the front line of defense against the business cycle. In the deep downturn of 2008–2009, however, western central banks cut interest rates to their lower bound of zero, and with the ability of central banks to provide further stimulus in doubt, the focus of many macroeconomic discussions turned to fiscal policy. Among economists, there was widespread disagreement about the extent to which fiscal policy should be used to stimulate the economy in downturns and whether tax cuts or spending increases are the preferred policy tool.

A related question is whether the benefits of economic stabilization—assuming stabilization could be achieved—would be large or small. Without any change in the natural rate of unemployment, stabilization policy can only reduce the magnitude of fluctuations around the natural rate. Thus, successful stabilization policy would eliminate booms as well as recessions. Some economists have suggested that the average gain from stabilization would be small.

Finally, not all economists endorse the model of economic fluctuations developed in Chapters 9 through 14, which assumes sticky prices and monetary non-neutrality. According to real business cycle theory, discussed in the appendices to Chapters 8 and 14, economic fluctuations are the optimal response of the economy to changing technology. This theory suggests that policymakers should not stabilize the economy, even if this were possible.

Whenever prices are rising, policymakers confront the question of whether to pursue policies to reduce the rate of inflation. To make this decision, they must compare the cost of allowing inflation to continue at its current rate to the cost of reducing inflation. Yet economists cannot offer accurate estimates of either of these two costs.

The cost of inflation is a topic on which economists and laymen often disagree. When inflation reached 10 percent per year in the late 1970s, opinion polls showed that the public viewed inflation as a major economic problem. Yet, as we discussed in Chapter 4, when economists try to identify the social costs of inflation, they can point only to shoeleather costs, menu costs, the costs of a nonindexed tax system, and so on. These costs become large when countries experience hyperinflation, but they seem relatively minor at the moderate rates of inflation experienced in most major economies. Some economists believe that the public confuses inflation with other economic problems that coincide with inflation. For example, growth in productivity and real wages slowed in the 1970s; some laymen might have viewed inflation as the cause of the slowdown in real wages. Yet it is also possible that economists are mistaken: perhaps inflation is in fact very costly, and we have yet to figure out why.

The cost of reducing inflation is a topic on which economists often disagree among themselves. As we discussed in Chapter 13, the standard view—as described by the short-run Phillips curve—is that reducing inflation requires a period of low output and high unemployment. According to this view, the cost of reducing inflation is measured by the sacrifice ratio, which is the number of percentage points of a year’s GDP that must be forgone to reduce inflation by 1 percentage point.

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But some economists think that the cost of reducing inflation can be much smaller than standard estimates of the sacrifice ratio indicate. According to the rational-expectations approach discussed in Chapter 13, if a disinflationary policy is announced in advance and is credible, people will adjust their expectations quickly, so the disinflation need not cause a recession.

Other economists believe that the cost of reducing inflation is much larger than standard estimates of the sacrifice ratio indicate. The theories of hysteresis discussed in Chapter 13 suggest that a recession caused by disinflationary policy could raise the natural rate of unemployment. If so, the cost of reducing inflation is not merely a temporary recession but a persistently higher level of unemployment.

Because the costs of inflation and disinflation remain open to debate, economists sometimes offer conflicting advice to policymakers. Perhaps with further research, we can reach a consensus on the benefits of low inflation and the best way to achieve that goal.

In the 1980s and 1990s, large budget deficits were a primary topic of debate among policymakers in many countries. In Canada, the ratio of federal government debt to GDP tripled from 1973 to 1994—an event unprecedented in peacetime. Although the federal government’s budget has been in surplus for the decade up to 2009, the issue resurfaced with the deep recession of that year, and it will again as the large baby-boom generation reaches retirement age and starts drawing on government benefits for the elderly. As we discussed in Chapter 16, the effect of government budget deficits is a topic about which economists often disagree.

Most of the models in this book, and most economists, take the traditional view of government debt. According to this view, a budget deficit leads to lower national saving, lower investment, and a trade deficit. In the long run, it leads to a smaller steady-state capital stock and a larger foreign debt. Those who hold the traditional view conclude that budget deficits place a burden on future generations.

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Yet not all economists agree with this assessment. Advocates of the Ricardian view of government debt are skeptical. They stress that a budget deficit merely represents a substitution of future taxes for current taxes. As long as consumers are forward-looking, as the theories of consumption presented in Chapter 17 assume, they will save today to meet their or their children’s future tax liability. These economists believe that budget deficits have only a minor effect on the economy. They believe that the government’s spending decisions matter, but whether that spending is financed by taxation or by selling government bonds is of secondary importance.

Still other economists believe that the budget deficit is an imperfect measure of fiscal policy. Although the government’s choices regarding taxes and spending have great influence on the welfare of different generations, many of these choices are not reflected in the size of the government debt. The level of public pension benefits and contributions, for instance, determines the welfare of the elder beneficiaries versus the working-age taxpayers, but measures of the budget deficit do not reflect this policy choice. According to some economists, we should stop focusing on the government’s current budget deficit and the associated level of debt, and concentrate instead on the longer-term generational impacts of fiscal policy.

Recent events have focused renewed attention on the possibility of government default. In the eighteenth century, Alexander Hamilton argued successfully that the U.S. federal government should always honour its debts. But in 2011 many European nations were struggling to do just that, and it looked likely that Greece and perhaps other countries would default. In August of that year, Standard and Poor’s reduced its credit rating on U.S. bonds below the top AAA level, suggesting that Alexander Hamilton’s rule might someday be violated even in the United States. The concern is that as the large baby-boom generation reaches retirement age and starts drawing on social programs for the elderly, the government will not have addressed how to finance these commitments. The U.S. political system is divided about what should be done to put the government back on a financially sustainable path. In particular, the political dysfunction stems from divisions over how much of the fiscal adjustment should come from higher tax revenue and how much should come from reduced government spending. Given the importance of economic developments in the United States for our country, Canadians will be watching this intense debate with interest.