Government's Role in the Economy

Government's Role in the Economy

From the U.S. Department of State

While consumers and producers make most decisions that mold the economy, government activities have a powerful effect on the U.S. economy in at least four areas.

Stabilization and Growth. Perhaps most importantly, the federal government guides the overall pace of economic activity, attempting to maintain steady growth, high levels of employment, and price stability. By adjusting spending and tax rates (fiscal policy) or managing the money supply and controlling the use of credit (monetary policy), it can slow down or speed up the economy's rate of growth -- in the process, affecting the level of prices and employment.

For many years following the Great Depression of the 1930s, recessions -- periods of slow economic growth and high unemployment -- were viewed as the greatest of economic threats. When the danger of recession appeared most serious, government sought to strengthen the economy by spending heavily itself or cutting taxes so that consumers would spend more, and by fostering rapid growth in the money supply, which also encouraged more spending. In the 1970s, major price increases, particularly for energy, created a strong fear of inflation -- increases in the overall level of prices. As a result, government leaders came to concentrate more on controlling inflation than on combating recession by limiting spending, resisting tax cuts, and reining in growth in the money supply.

Ideas about the best tools for stabilizing the economy changed substantially between the 1960s and the 1990s. In the 1960s, government had great faith in fiscal policy -- manipulation of government revenues to influence the economy. Since spending and taxes are controlled by the president and the Congress, these elected officials played a leading role in directing the economy. A period of high inflation, high unemployment, and huge government deficits weakened confidence in fiscal policy as a tool for regulating the overall pace of economic activity. Instead, monetary policy -- controlling the nation's money supply through such devices as interest rates -- assumed growing prominence. Monetary policy is directed by the nation's central bank, known as the Federal Reserve Board, with considerable independence from the president and the Congress.

Regulation and Control. The U.S. federal government regulates private enterprise in numerous ways. Regulation falls into two general categories. Economic regulation seeks, either directly or indirectly, to control prices. Traditionally, the government has sought to prevent monopolies such as electric utilities from raising prices beyond the level that would ensure them reasonable profits. At times, the government has extended economic control to other kinds of industries as well. In the years following the Great Depression, it devised a complex system to stabilize prices for agricultural goods, which tend to fluctuate wildly in response to rapidly changing supply and demand. A number of other industries -- trucking and, later, airlines -- successfully sought regulation themselves to limit what they considered harmful price-cutting.
Another form of economic regulation, antitrust law, seeks to strengthen market forces so that direct regulation is unnecessary. The government -- and, sometimes, private parties -- have used antitrust law to prohibit practices or mergers that would unduly limit competition.

Government also exercises control over private companies to achieve social goals, such as protecting the public's health and safety or maintaining a clean and healthy environment. The U.S. Food and Drug Administration bans harmful drugs, for example; the Occupational Safety and Health Administration protects workers from hazards they may encounter in their jobs; and the Environmental Protection Agency seeks to control water and air pollution.

American attitudes about regulation changed substantially during the final three decades of the 20th century. Beginning in the 1970s, policy-makers grew increasingly concerned that economic regulation protected inefficient companies at the expense of consumers in industries such as airlines and trucking. At the same time, technological changes spawned new competitors in some industries, such as telecommunications, that once were considered natural monopolies. Both developments led to a succession of laws easing regulation.

While leaders of both political parties generally favored economic deregulation during the 1970s, 1980s, and 1990s, there was less agreement concerning regulations designed to achieve social goals. Social regulation had assumed growing importance in the years following the Depression and World War II, and again in the 1960s and 1970s. But during the presidency of Ronald Reagan in the 1980s, the government relaxed rules to protect workers, consumers, and the environment, arguing that regulation interfered with free enterprise, increased the costs of doing business, and thus contributed to inflation. Still, many Americans continued to voice concerns about specific events or trends, prompting the government to issue new regulations in some areas, including environmental protection.

Some citizens, meanwhile, have turned to the courts when they feel their elected officials are not addressing certain issues quickly or strongly enough. For instance, in the 1990s, individuals, and eventually government itself, sued tobacco companies over the health risks of cigarette smoking. A large financial settlement provided states with long-term payments to cover medical costs to treat smoking-related illnesses.

Direct Services. Each level of government provides many direct services. The federal government, for example, is responsible for national defense, backs research that often leads to the development of new products, conducts space exploration, and runs numerous programs designed to help workers develop workplace skills and find jobs. Government spending has a significant effect on local and regional economies -- and even on the overall pace of economic activity.

State governments, meanwhile, are responsible for the construction and maintenance of most highways. State, county, or city governments play the leading role in financing and operating public schools. Local governments are primarily responsible for police and fire protection. Government spending in each of these areas can also affect local and regional economies, although federal decisions generally have the greatest economic impact.

Overall, federal, state, and local spending accounted for almost 18 percent of gross domestic product in 1997.

Direct Assistance. Government also provides many kinds of help to businesses and individuals. It offers low-interest loans and technical assistance to small businesses, and it provides loans to help students attend college. Government-sponsored enterprises buy home mortgages from lenders and turn them into securities that can be bought and sold by investors, thereby encouraging home lending. Government also actively promotes exports and seeks to prevent foreign countries from maintaining trade barriers that restrict imports.

Government supports individuals who cannot adequately care for themselves. Social Security, which is financed by a tax on employers and employees, accounts for the largest portion of Americans' retirement income. The Medicare program pays for many of the medical costs of the elderly. The Medicaid program finances medical care for low-income families. In many states, government maintains institutions for the mentally ill or people with severe disabilities. The federal government provides Food Stamps to help poor families obtain food, and the federal and state governments jointly provide welfare grants to support low-income parents with children.

Many of these programs, including Social Security, trace their roots to the "New Deal" programs of Franklin D. Roosevelt, who served as the U.S. president from 1933 to 1945. Key to Roosevelt's reforms was a belief that poverty usually resulted from social and economic causes rather than from failed personal morals. This view repudiated a common notion whose roots lay in New England Puritanism that success was a sign of God's favor and failure a sign of God's displeasure. This was an important transformation in American social and economic thought. Even today, however, echoes of the older notions are still heard in debates around certain issues, especially welfare.

Many other assistance programs for individuals and families, including Medicare and Medicaid, were begun in the 1960s during President Lyndon Johnson's (1963-1969) "War on Poverty." Although some of these programs encountered financial difficulties in the 1990s and various reforms were proposed, they continued to have strong support from both of the United States' major political parties. Critics argued, however, that providing welfare to unemployed but healthy individuals actually created dependency rather than solving problems. Welfare reform legislation enacted in 1996 under President Bill Clinton (1993-2001) requires people to work as a condition of receiving benefits and imposes limits on how long individuals may receive payments.


Americans are proud of their economic system, believing it provides opportunities for all citizens to have good lives. Their faith is clouded, however, by the fact that poverty persists in many parts of the country. Government anti-poverty efforts have made some progress but have not eradicated the problem. Similarly, periods of strong economic growth, which bring more jobs and higher wages, have helped reduce poverty but have not eliminated it entirely.
The federal government defines a minimum amount of income necessary for basic maintenance of a family of four. This amount may fluctuate depending on the cost of living and the location of the family. In 1998, a family of four with an annual income below $16,530 was classified as living in poverty.

The percentage of people living below the poverty level dropped from 22.4 percent in 1959 to 11.4 percent in 1978. But since then, it has fluctuated in a fairly narrow range. In 1998, it stood at 12.7 percent.

What is more, the overall figures mask much more severe pockets of poverty. In 1998, more than one-quarter of all African-Americans (26.1 percent) lived in poverty; though distressingly high, that figure did represent an improvement from 1979, when 31 percent of blacks were officially classified as poor, and it was the lowest poverty rate for this group since 1959. Families headed by single mothers are particularly susceptible to poverty. Partly as a result of this phenomenon, almost one in five children (18.9 percent) was poor in 1997. The poverty rate was 36.7 percent among African-American children and 34.4 percent among Hispanic children.

Some analysts have suggested that the official poverty figures overstate the real extent of poverty because they measure only cash income and exclude certain government assistance programs such as Food Stamps, health care, and public housing. Others point out, however, that these programs rarely cover all of a family's food or health care needs and that there is a shortage of public housing. Some argue that even families whose incomes are above the official poverty level sometimes go hungry, skimping on food to pay for such things as housing, medical care, and clothing. Still others point out that people at the poverty level sometimes receive cash income from casual work and in the "underground" sector of the economy, which is never recorded in official statistics.

In any event, it is clear that the American economic system does not apportion its rewards equally. In 1997, the wealthiest one-fifth of American families accounted for 47.2 percent of the nation's income, according to the Economic Policy Institute, a Washington-based research organization. In contrast, the poorest one-fifth earned just 4.2 percent of the nation's income, and the poorest 40 percent accounted for only 14 percent of income.

Despite the generally prosperous American economy as a whole, concerns about inequality continued during the 1980s and 1990s. Increasing global competition threatened workers in many traditional manufacturing industries, and their wages stagnated. At the same time, the federal government edged away from tax policies that sought to favor lower-income families at the expense of wealthier ones, and it also cut spending on a number of domestic social programs intended to help the disadvantaged. Meanwhile, wealthier families reaped most of the gains from the booming stock market.

In the late 1990s, there were some signs these patterns were reversing, as wage gains accelerated -- especially among poorer workers. But at the end of the decade, it was still too early to determine whether this trend would continue.

The U.S. government grew substantially beginning with President Franklin Roosevelt's administration. In an attempt to end the unemployment and misery of the Great Depression, Roosevelt's New Deal created many new federal programs and expanded many existing ones. The rise of the United States as the world's major military power during and after World War II also fueled government growth. The growth of urban and suburban areas in the postwar period made expanded public services more feasible. Greater educational expectations led to significant government investment in schools and colleges. An enormous national push for scientific and technological advances spawned new agencies and substantial public investment in fields ranging from space exploration to health care in the 1960s. And the growing dependence of many Americans on medical and retirement programs that had not existed at the dawn of the 20th century swelled federal spending further.
While many Americans think that the federal government in Washington has ballooned out of hand, employment figures indicate that this has not been the case. There has been significant growth in government employment, but most of this has been at the state and local levels. From 1960 to 1990, the number of state and local government employees increased from 6.4 million to 15.2 million, while the number of civilian federal employees rose only slightly, from 2.4 million to 3 million. Cutbacks at the federal level saw the federal labor force drop to 2.7 million by 1998, but employment by state and local governments more than offset that decline, reaching almost 16 million in 1998. (The number of Americans in the military declined from almost 3.6 million in 1968, when the United States was embroiled in the war in Vietnam, to 1.4 million in 1998.)

The rising costs of taxes to pay for expanded government services, as well as the general American distaste for "big government" and increasingly powerful public employee unions, led many policy-makers in the 1970s, 1980s, and 1990s to question whether government is the most efficient provider of needed services. A new word -- "privatization" -- was coined and quickly gained acceptance worldwide to describe the practice of turning certain government functions over to the private sector.

In the United States, privatization has occurred primarily at the municipal and regional levels. Major U.S. cities such as New York, Los Angeles, Philadelphia, Dallas, and Phoenix began to employ private companies or nonprofit organizations to perform a wide variety of activities previously performed by the municipalities themselves, ranging from streetlight repair to solid-waste disposal and from data processing to management of prisons. Some federal agencies, meanwhile, sought to operate more like private enterprises; the United States Postal Service, for instance, largely supports itself from its own revenues rather than relying on general tax dollars.

Privatization of public services remains controversial, however. While advocates insist that it reduces costs and increases productivity, others argue the opposite, noting that private contractors need to make a profit and asserting that they are not necessarily being more productive. Public sector unions, not surprisingly, adamantly oppose most privatization proposals. They contend that private contractors in some cases have submitted very low bids in order to win contracts, but later raised prices substantially. Advocates counter that privatization can be effective if it introduces competition. Sometimes the spur of threatened privatization may even encourage local government workers to become more efficient.

As debates over regulation, government spending, and welfare reform all demonstrate, the proper role of government in the nation's economy remains a hot topic for debate more than 200 years after the United States became an independent nation.