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Last week we examined the anatomy and causes of economic cycles. Today, we look at policy tools targeted at smoothing out the ride.

Booms and busts have been a constant feature of human economic endeavor for as long as commerce has been conducted. But the serious study of how economies operate is a relatively late development, often dated to the seminal work of Adam Smith in 1776. Since that time, conscious effort has been devoted to lengthening the expansions and dampening the inevitable declines. And while opinions vary as to the effectiveness of the particular policy responses developed, it is true that over time the cycles have moderated in intensity on average.

Economics comes from the Greek "oikos" meaning home, and "nomos" or law; that is, the "law of the home" or what makes households and businesses tick. The policy tools that have emerged to influence the behavior of these participants can be broadly classified as either "fiscal" or "monetary" tools.

Fiscal policy regards government taxation and spending. As a general proposition, higher taxes dampen the economy by reducing the disposable income of businesses and households, thereby causing overall spending to decline. This effect manifests throughout the economy, as reduced demand leads to lower employment, savings and investment and therefore declining total output. Conversely, lower taxation puts more dollars in everyone's pocket that find their way back into the bloodstream of the economy and boost output.

Of course, the other side of the equation is government spending. In order to balance budgets, government must spend less when cutting taxes, offsetting the expected increase in private spending. In the 1930s, John Maynard Keynes proposed that governments should actually increase spending while cutting taxes, and deliberately run deficits during soft patches as a direct stimulus for a moribund economy.

Much of Keynesian theory has been superseded, but the basic impulse to practice countercyclical fiscal policy remains a keystone of the US response to recessions. Both Presidents Bush and Obama spearheaded deficit spending plans in efforts to stem the economic slump of 2007-2008.

The fundamental problem here is that few politicians bothered to read the second chapter of Keynes, to wit: governments should raise taxes and run surpluses during expansions to bank up dry powder. Instead, the US national debt has doubled since the end of the last recession to over $22 trillion. We will add another $1 trillion this year alone, during 11th year of the longest expansion ever.

The other major tool is called "monetary policy", pertaining to the supply of money in the economy and its cost (interest rates). While fiscal policy is the purview of Congress and the Executive, monetary policy is conducted by the Federal Reserve, the central banking authority for the US.

The supply of money is an important economic variable: too much in circulation leads to price inflation, while too little chokes off economic growth. The Federal Reserve affects the supply of money through buying and selling government bonds and altering reserve requirements on US banks (how much cash they must keep on hand).

The Fed also influences the level of certain interest rates, which can either promote or retard borrowing for consumption spending and private investment. In theory, lower rates should lead to more investment spending, which stimulates additional growth.

The Federal Reserve adopted a significantly more aggressive stance during the crisis of 2008 by buying massive amounts of bonds and flooding the markets with nearly $4 trillion is cash. This action was also not without controversy, but has established a new precedent for future monetary intervention.

Next week: new challenges to policy tools.

Christopher A. Hopkins, CFA, is a vice president and portfolio manager for Barnett & Co. in Chattanooga

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