The Online Library of Liberty

A project of Liberty Fund, Inc.

• Foreword
• Richard E. Wagner
• Preface
• Acknowledgments
• Part One: What Happened?
• 1.: What Hath Keynes Wrought?
• 2.: The Old-time Fiscal Religion
• 3.: First, the Academic Scribblers
• 4.: The Spread of the New Gospel
• 5.: Assessing the Damages
• Part Two: What Went Wrong?
• 6.: The Presuppositions of Harvey Road
• 7.: Keynesian Economics In Democratic Politics
• 8.: Money-financed Deficits and Political Democracy
• 9.: Institutional Constraints and Political Choice
• Part Three: What Can Be Done?
• 10.: Alternative Budgetary Rules
• 11.: What About Full Employment?
• 12.: A Return to Fiscal Principle

PART ONE

What Happened?

1.

What Hath Keynes Wrought?

In the year (1776) of the American Declaration of Independence, Adam Smith observed that “What is prudence in the conduct of every private family, can scarce be folly in that of a great kingdom.” Until the advent of the “Keynesian revolution” in the middle years of this century, the fiscal conduct of the American Republic was informed by this Smithian principle of fiscal responsibility: Government should not spend without imposing taxes; and government should not place future generations in bondage by deficit financing of public outlays designed to provide temporary and short-lived benefits.

With the completion of the Keynesian revolution, these time-tested principles of fiscal responsibility were consigned to the heap of superstitious nostrums that once stifled enlightened political-fiscal activism. Keynesianism stood the Smithian analogy on its head. The stress was placed on the differences rather than the similarities between a family and the state, and notably with respect to principles of prudent fiscal conduct. The state was no longer to be conceived in the image of the family, and the rules of prudent fiscal conduct differed dramatically as between the two institutions. The message of Keynesianism might be summarized as: What is folly in the conduct of a private family may be prudence in the conduct of the affairs of a great nation.

“We are all Keynesians now.” This was a familiar statement in the 1960s, attributed even to the likes of Milton Friedman among the academicians and to Richard Nixon among the politicians. Yet it takes no scientific talent to observe that ours is not an economic paradise. During the post-Keynesian, post-1960 era, we have labored under continuing and increasing budget deficits, a rapidly growing governmental sector, high unemployment, apparently permanent and perhaps increasing inflation, and accompanying disenchantment with the American sociopolitical order.

This is not as it was supposed to be. After Walter Heller’s finest hours in 1963, fiscal wisdom was to have finally triumphed over fiscal folly. The national economy was to have settled down on or near its steady growth potential, onward and upward toward better things, public and private. The spirit of optimism was indeed contagious, so much so that economic productivity and growth, the announced objectives for the post-Sputnik, post-Eisenhower years, were soon abandoned, to be replaced by the redistributionist zeal of Lyndon Johnson’s “Great Society” and by the no-growth implications of Ralph Nader, the Sierra Club, Common Cause, and Edmund Muskie’s Environmental Protection Agency. Having mastered the management of the national economy, the policy planners were to have moved on to quality-of-life issues. The “Great Society” was to become real.

What happened? Why does Camelot lie in ruin? Viet Nam and Watergate cannot explain everything forever. Intellectual error of monumental proportion has been made, and not exclusively by the ordinary politicians. Error also lies squarely with the economists.

The academic scribbler of the past who must bear substantial responsibility is Lord Keynes himself, whose ideas were uncritically accepted by American establishment economists. The mounting historical evidence of the effects of these ideas cannot continue to be ignored. Keynesian economics has turned the politicians loose; it has destroyed the effective constraint on politicians’ ordinary appetites. Armed with the Keynesian message, politicians can spend and spend without the apparent necessity to tax. “Democracy in deficit” is descriptive, both of our economic plight and of the subject matter for this book.

The Political Economy

This book is an essay in political economy rather than in economic theory. Our focus is upon the political institutions through which economic policy must be implemented, policy which is, itself, ultimately derived from theory, good or bad. And central to our argument is the principle that the criteria for good theory are necessarily related to the political institutions of the society. The ideal normative theory of economic management for an authoritarian regime may fail completely for a regime that embodies participation by those who are to be managed. This necessary linkage or interdependence between the basic political structure of society and the economic theory of policy has never been properly recognized by economists, despite its elementary logic and its overwhelming empirical apparency.

Our critique of Keynesianism is concentrated on its political presuppositions, not on its internal theoretical structure. It is as if someone tried to make a jet engine operate by using the theory of the piston-driven machine. Nothing need be wrong with the theory save that it is wholly misapplied. This allows us largely but not completely to circumvent the troublesome and sometimes complex analyses in modern macroeconomic and monetary theory. This does not imply, however, that the applicable theory, that which is fully appropriate to the political institutions of a functioning democratic society, is simple and straightforward or, indeed, that this theory has been fully developed. Our discussion provides the setting within which such a theory might be pursued, and our plea is for economists to begin to think in terms of the political structure that we observe. But before this step can be taken, we must somehow reach agreement on the elements of the political decision process, on the model for policy making, to which any theory of policy is to be applied.

At this point, values cannot be left aside. If the Keynesian policy precepts for national economic management have failed, there are two ways of reacting. We may place the blame squarely on the vagaries of democratic politics, and propose that democratic decision making be replaced by more authoritarian rule. Or, alternatively, we can reject the applicability of the policy precepts in democratic structure, and try to invent and apply policy principles that are consistent with such structure. We choose the latter.1 Our values dictate the democratic decision-making institutions should be maintained and that, to this end, inapplicable economic theories should be discarded as is necessary. If we observe democracy in deficit, we wish to repair the “deficit” part of this description, not to discard the “democracy” element.

A Review of the Record

We challenge the Keynesian theory of economic policy in this book. Our challenge will stand or fall upon the ability of our argument to persuade. There are two strings to our bow. We must first review both the pre-Keynesian and the post-Keynesian record. Forty years of history offers us a basis for at least preliminary assessment. We shall look carefully at the fiscal activities of the United States government before the Great Depression of the 1930s, before the publication of Keynes’ General Theory.2 The simple facts of budget balance or imbalance are important here, and these will not be neglected in the discussion of Chapter 2. More importantly for our purposes, however, we must try to determine the “principles” for budget making that informed the political decision makers. What precepts for “fiscal responsibility” were implicit in their behavior? How influential was the simple analogy between the individual and the government financial account? How did the balanced-budget norm act to constrain spending proclivities of politicians and parties?

There was no full-blown Keynesian “revolution” in the 1930s. The American acceptance of Keynesian ideas proceeded step by step from the Harvard economists, to economists in general, to the journalists, and, finally, to the politicians in power. This gradual spread of Keynesian notions, as well as the accompanying demise of the old-fashioned principles for financial responsibility, is documented in Chapters 3 and 4. The Keynesian brigades first had to storm the halls of ivy, for only then would they have a base from which to capture the minds of the public and the halls of Congress. Chapter 3 documents the triumph of Keynesianism throughout the groves of academe, while Chapter 4 describes the infusion of Keynesianism into the general consciousness of the body politic—its emergence as an element of our general cultural climate.

Even if our review of the historical record is convincing, no case is established for raising the alarm. What is of such great moment if elected politicians do respond to the Keynesian messages in somewhat biased manner? What is there about budget deficits to arouse concern? How can the burden of debt be passed along to our grandchildren? Is inflation the monster that it is sometimes claimed to be? Why not learn to live with it, especially if unemployment can be kept within bounds? If Keynesian economics has and can secure high-level employment, why not give it the highest marks, even when recognizing its by-product generation of inflation and relatively expanding government? These are the questions that require serious analysis and discussion, because these are the questions that most economists would ask of us; they are explored in Chapter 5.

The Theory of Public Choice

Our second instrument of persuasion is a theory for decision making in democracy, a theory of public choice, which was so long neglected by economists. This is developed in Chapters 6 through 9. Keynes was not a democrat, but, rather, looked upon himself as a potential member of an enlightened ruling elite. Political institutions were largely irrelevant for the formulation of his policy presumptions. The application of the Keynesian precepts within a working political democracy, however, would often require politicians to undertake actions that would reduce their prospects for survival. Should we then be surprised that the Keynesian democratic political institutions will produce policy responses contrary to those that would be forthcoming from some idealized application of the norms in the absence of political feedback?

In Chapter 7, it is shown that ordinary political representatives in positions of either legislative or executive authority will behave quite differently when confronted with taxing and spending alternatives than would their benevolently despotic counterparts, those whom Keynes viewed as making policy, whose behavior is examined in Chapter 6. In Chapter 8, the analysis of Chapter 7 is extended to the behavior of monetary authorities, and monetary decisions are considered as endogenous rather than as exogenous variables.

A crucial feature of our argument is the ability of political and fiscal institutions to influence the outcomes of political processes, a subject that we explore in Chapter 9. Institutions matter in our analysis. While this position is generally accepted by those who call themselves “Keynesians,” it is disputed by many of those who consider themselves “anti-” or “non-Keynesians.” These latter analysts argue that institutions are generally irrelevant. With respect to institutions, we are like the Keynesians, for we do not let an infatuation with abstract models destroy our sense of reality. Instead, we accept the proposition that institutions, like ideas, have consequences that are not at all obvious at the time of their inception, a point that Richard Weaver noted so memorably.3 At the same time, however, our view of the nature of a free-enterprise economic order is distinctly non-Keynesian, although “Keynesianism” must to some extent be distinguished from the “economics of Keynes.”4

The theory of public choice discussed in Chapters 6-9 is not at all complex, and it offers satisfactory explanations of the post-Keynesian fiscal record. The Keynesian defense must be, however, that the theory is indeed too simplistic, that politicians can and will behave differently from the predictions of the theory. We do not, of course, rule out the ability of politicians, intelligent persons all, to learn the Keynesian lessons. But will the voters-citizens, who determine who their political representatives will be, accept the proffered wisdom? This is a tougher question, and the familiar call for more economic education of the public has long since become a tiresome relic. The Keynesian who relies on a more sophisticated electorate to reverse the accumulating record leans on a frail reed.

Fiscal and Monetary Reform

In the last three chapters of the book, we return to what may be considered the main theme. Even the ardent Keynesians recognized, quite early, that some replacement for the fiscal rule of balanced budgets might be required as guidance for even the enlightened politicians. In Chapter 10, we examine the alternative rules for fiscal responsibility that have been advanced and used in the discussion of fiscal and budgetary policy. These include the rule for budget balance over the business cycle, and, more importantly, the rule for budget balance at full employment which continues to inform the official economic pronouncements from Washington, even if it is largely disregarded in practice.

Chapter 11 represents our response to what will seem to many to be our most vulnerable point. What about unemployment? Our criticism of the implications of the Keynesian teachings may be widely accepted, up to a point. But how are we to respond to the argument that the maintenance of high-level employment is the overriding objective for national economic policy, and that only the Keynesian teachings offer resolution? These questions inform this chapter, in which we question the foundations of such prevalent attitudes.

Chapter 12 offers our own substantive proposals for fiscal and monetary reform. Our emphasis here is on the necessity that the reforms introduced be treated as genuine constitutional measures, rules that are designed to constrain the short-run expedient behavior of politicians. Our emphasis here is in the long-range nature of reform, rather than on the details of particular proposals. To avoid charges of incompleteness and omission, however, we advance explicit suggestions for constitutional change, and notably for the adoption of a constitutional amendment requiring budget balance.

2.

The Old-Time Fiscal Religion

Classical Fiscal Principle

The history of both fiscal principle and fiscal practice may reasonably be divided into pre- and post-Keynesian periods. The Keynesian breakpoint is stressed concisely by Hugh Dalton, the textbook writer whose own political career was notoriously brief. In the post-Keynesian editions of his Principles of Public Finance, Dalton said:

In this chapter, we shall examine briefly the pre-Keynesian history, in terms of both the articulation of fiscal principle and the implementation of fiscal practice. As noted at the beginning of Chapter 1, the pre-Keynesian or “classical” principles can perhaps best be summarized in the analogy between the state and the family. Prudent financial conduct by the government was conceived in basically the same image as that by the family or the firm. Frugality, not profligacy, was accepted as the cardinal virtue, and this norm assumed practical shape in the widely shared principle that public budgets should be in balance, if not in surplus, and that deficits were to be tolerated only in extraordinary circumstances. Substantial and continuing deficits were interpreted as the mark of fiscal folly. Principles of sound business practice were also held relevant to the fiscal affairs of government. When capital expenditures were financed by debt, sinking funds for amortization were to be established and maintained. The substantial attention paid to the use and operation of sinking funds in the fiscal literature during the whole pre-Keynesian era attests to the strength with which these basic classical principles were held.2

Textbooks and treatises embodied the noncontroverted principle that public budgets should be in balance. C. F. Bastable, one of the leading public-finance scholars of the late nineteenth and early twentieth centuries, in commenting on “The Relation of Expenditure and Receipts,” suggested that

Bastable recognized the possibility of extenuating circumstances, which led him to modify his statement of the principle of budget balance by stating:

Classical or pre-Keynesian fiscal principles, in other words, supported a budget surplus during normal times so as to provide a cushion for more troublesome periods. And similar statements can be found throughout the pre-Keynesian fiscal literature.5

Aside from the simple, and basically intuitive, analogy drawn between governments and individuals and business firms, these rules for “sound finance” were reinforced by two distinct analytical principles, only one of which was made explicit in the economic policy analysis of the period. The dominant principle (one that was expressed clearly by Adam Smith and incorporated into the theory of economic policy) was that resort to debt finance by government provided evidence of public profligacy, and, furthermore, a form of profligacy that imposed fiscal burdens on subsequent taxpayers. Put starkly, debt finance enabled people living currently to enrich themselves at the expense of people living in the future. These notions about debt finance, which were undermined by the Keynesian revolution, reinforced adherence to a balanced-budget principle of fiscal conduct. We shall describe these principles of debt finance and debt burden more carefully in a subsequent section of this chapter.

A second analytical principle emerged more than a century after Smith’s Wealth of Nations, and it was not explicitly incorporated into the norms for policy. But it may have been implicitly recognized. It is important because it reinforces the classical principles from a different and essentially political or public-choice perspective. In 1896, Knut Wicksell noted that an individual could make an informed, rational assessment of various proposals for public expenditure only if he were confronted with a tax bill at the same time.6 Moreover, to facilitate such comparison, Wicksell suggested that the total costs of any proposed expenditure program should be apportioned among the individual members of the political community. These were among the institutional features that he thought necessary to make reasonably efficient fiscal decisions in a democracy. Effective democratic government requires institutional arrangements that force citizens to take account of the costs of government as well as the benefits, and to do so simultaneously. The Wicksellian emphasis was on making political decisions more efficient, on ensuring that costs be properly weighed against benefits. A norm of balancing the fiscal decision or choice process, if not a formal balancing of the budget, emerges directly from the Wicksellian analysis.

Fiscal Practice in Pre-Keynesian Times

Pre-Keynesian fiscal practice was clearly informed by the classical notions of fiscal responsibility, as an examination of the record will show.7 This fiscal history was not one of a rigidly balanced budget defined on an annual accounting basis. There were considerable year-to-year fluctuations in receipts, in expenditures, and in the resulting surplus or deficit. Nonetheless, a pattern is clearly discernible: Deficits emerged primarily during periods of war; budgets normally produced surpluses during peacetime, and these surpluses were used to retire the debt created during war emergencies.8

The years immediately following the establishment of the American Republic in 1789 were turbulent. There was war with the Indians in the Northwest; the Whiskey Rebellion erupted; and relations with England were deteriorating and fears of war were strong. Federal government budgets were generally in deficit during this period, and by 1795 the gross national debt was $83.8 million. But by 1811 this total had been reduced nearly by half, to $45.2 million. And during the sixteen years of this 1795-1811 period, there were fourteen years of surplus and two years of a deficit. Moreover, the surpluses tended to be relatively large, averaging in the vicinity of $2.5 million in federal budgets with total expenditures that averaged around $8 million.

The War of 1812 brought forth a new sequence of budget deficits that lasted through 1815. The cumulative deficit over this four-year period slightly exceeded $65 million, which was more than one-half of the cumulative public expenditure during this same period. Once again, however, the gross national debt of $127 million at the end of 1815 was steadily reduced during the subsequent two decades. In the twenty-one years from 1816 through 1836, there were eighteen years of surplus, and the gross debt had fallen to $337,000 by the end of 1836.

John W. Kearny, writing in 1887 on the fiscal history of the 1789-1835 period, reflected the sentiment that the retirement of public debt was an important political issue at that time. The primary vehicle for accomplishing this policy of debt retirement was the Sinking-Fund Act of 1795, as amended in 1802. Under these acts, substantial revenues were earmarked and set aside for debt retirement. Kearny’s assessment of the 1795 act expresses clearly the attitude toward deficit finance and public debt that prevailed:

The depression that followed the Panic of 1837 lasted throughout the administration of Martin Van Buren and halfway through the administration of William Henry Harrison and John Tyler, terminating only in 1843. This depression seems clearly to have been the most severe of the nineteenth century and has been described as “one of the longest periods of sustained contraction in the nation’s history, rivaled only by the downswing of 1929-33.”10 During this seven-year period of economic stress, there were six years of deficit, and the national debt had soared to $32.7 million by the end of 1843.

Once again, as stability returned, the normal pattern of affairs was resumed. Three consecutive surpluses were run, reducing the national debt to $15.6 million by the end of 1846. With the advent of the Mexican-American War, deficits emerged again during 1847-1849, and the gross debt climbed to $63.5 million by the end of 1849. Eight years of surplus then ensued, followed by two years of deficit, and then the Civil War. By the end of 1865, the gross public debt of the United States government had increased dramatically to $2.7 billion.

Once hostilities ceased, however, twenty-eight consecutive years of budget surplus resulted. By the end of 1893, the gross debt had been reduced by two-thirds, to $961 million. The rate of reduction of outstanding debt was substantial, with approximately one-quarter of public expenditure during this period being devoted to debt amortization. Deficits emerged in 1894 and 1895, and, later in the decade, the Spanish-American War brought forth four additional years of deficit. By the end of 1899, the gross national debt stood at $1.4 billion.

The years prior to World War I were a mixture of surplus and deficit, with a slight tendency toward surplus serving to reduce the debt to $1.2 billion by the end of 1916. World War I brought three years of deficit, and the national debt stood at $25.5 billion by the end of 1918. There then followed eleven consecutive years of surplus, which reduced the national debt to $16.2 billion by 1930. The Great Depression and World War II then combined to produce sixteen consecutive years of deficit, after which the gross national debt stood at $169.4 billion in 1946.

Until 1946, then, the story of our fiscal practice was largely a consistent one, with budget surpluses being the normal rule, and with deficits emerging primarily during periods of war and severe depression. The history of fiscal practice coincided with a theory of debt finance that held that resort to debt issue provided a means of reducing present burdens in exchange for the obligation to take on greater burdens in the future. It was only during some such extraordinary event as a war or a major depression that debt finance seemed to be justified.

While the history of our fiscal practice did not change through 1946, fiscal theory began to change during the 1930s. One of the elements of this change was the emerging dominance of a theory of the burden of public debt that had been widely discredited. The classical theory of public debt, which we shall describe more fully in the next section, suggests that debt issue is a means by which present taxpayers can shift part of the cost of government on the shoulders of taxpayers in future periods. The competing theory of public debt, which had been variously suggested by earlier writers, was embraced anew by Keynesian economists, so much so that it quickly became the orthodox one, and well may be called the “Keynesian” theory of public debt. This theory explicitly denies that debt finance places any burden on future taxpayers. It suggests instead that citizens who live during the period when public expenditures are made always and necessarily bear the cost of public services, regardless of whether those services are financed through taxation or through debt creation. This shift in ideas on public debt was, in turn, vital in securing acquiescence to deficit financing. There was no longer any reason for opposing deficit financing on basically moral grounds. This Keynesian theory of debt burden, however, is a topic to be covered in the next chapter; the task at hand is to examine briefly the Smithian or classical theory.

Balanced Budgets, Debt Burdens, and Fiscal Responsibility

Pre-Keynesian debt theory held that there is one fundamental difference between tax finance and debt finance that is obscured by the Keynesians. In the pre-Keynesian view, a choice between tax finance and debt finance is a choice of the timing of the payments for public expenditure. Tax finance places the burden of payment squarely upon those members of the political community during the period when the expenditure decision is made. Debt finance, on the other hand, postpones payment until interest and amortization payments on debt come due. Debt finance enables those people living at the time of fiscal decision to shift payment onto those living in later periods, which may, of course, be the same group, especially if the period over which the debt is amortized is short.

In earlier works, we have offered an analytical defense of the classical theory of public debt, and especially as it is compared with its putative Keynesian replacement.11 We shall not, at this point, repeat details of other works. Nonetheless, a summary analysis of the basic classical theory will be helpful, since the broad acceptance of this theory by the public and by the politicians was surely a significant element in cementing and reinforcing the private-public finance analogy.

What happens when a government borrows? Before this question may be answered, we must specify both the fiscal setting that is assumed to be present and the alternative courses of action that might be followed. The purpose of borrowing is, presumably, to finance public spending. It seems, therefore, appropriate to assume that a provisional decision has been made to spend public funds. Having made this decision, the question reduces to one of choice among alternative means of financing. There are only three possibilities: (1) taxation, (2) public borrowing or debt issue, and (3) money creation. We shall, at this point, leave money creation out of account, because the Keynesian attack was launched on the classical theory of public borrowing, not upon the traditionally accepted theory of the effects of money creation. The theory of public debt reduces to a comparison between the effects of taxation and public debt issue, on the assumption that the public spending is fixed. The question becomes: When a government borrows, what happens that does not happen when it finances the same outlay through current taxation?

With borrowing, the command over real resources, over purchasing power, is surrendered voluntarily to government by those who purchase the bonds sold by the government, in a private set of choices independent of the political process. This is simply an ordinary exchange. Those who purchase these claims are not purchasing or paying for the benefits that are promised by the government outlays. They are simply paying for the obligations on the part of the government to provide them with an interest return in future periods and to amortize the principal on some determinate schedule. (This extremely simple point, the heart of the whole classical theory of public debt, is the source of major intellectual confusion.) These bond purchasers are the only persons in the community who give up or sacrifice commands over current resource use, who give up private investment or consumption prospects, in order that the government may obtain command over the resources which the budgetary outlays indicate to be desirable.

But if this sacrifice of purchasing power is made through a set of voluntary exchanges for bonds, who is really “purchasing,” and by implication “paying for,” the benefits that the budgetary outlays promise to provide? The ultimate “purchasers” of such benefits, under the public debt as under the taxation alternative, are all the members of the political community, at least as these are represented through the standard political decision-making process. A decision to “purchase” these benefits is presumably made via the political rules and institutions in being. But who “pays for” these benefits? Who suffers private costs which may then be balanced off against the private benefits offered by the publicly supplied services? Under taxation, these costs are imposed directly on the citizens, as determined by the existing rules for tax or cost sharing. Under public borrowing, by contrast, these costs are not imposed currently, during the budgetary period when the outlays are made. Instead, these costs are postponed or put off until later periods when interest and amortization payments come due. This elementary proposition applies to public borrowing in precisely the same way that it applies to private borrowing; the classical analogy between private and public finance seems to hold without qualification.

Indeed, the whole purpose of borrowing, private or public, should be to facilitate an expansion of outlay by putting off the necessity for meeting the costs. The basic institution of debt is designed to modify the time sequence between outlay and payment. As such, and again for both the private and the public borrower, there is no general normative rule against borrowing as opposed to current financing, and especially with respect to capital outlays. There is nothing in the classical theory of public debt that allows us to condemn government borrowing at all times and places.

Both for the family or firm and for the government, there exist norms for financial responsibility, for prudent fiscal conduct. Resort to borrowing, to debt issue, should be limited to those situations in which spending needs are “bunched” in time, owing either to such extraordinary circumstances as natural emergencies or disasters or to the lumpy requirements of a capital investment program. In either case, borrowing should be accompanied by a scheduled program of amortization. When debt is incurred because of the investment of funds in capital creation, amortization should be scheduled to coincide with the useful or productive life of the capital assets. Guided by this principle of fiscal responsibility, a government may, for example, incur public debts to construct a road or highway network, provided that these debts are scheduled for amortization over the years during which the network is anticipated to yield benefits or returns to the citizens of the political community. Such considerations as these provide the source for separating current and capital budgets in the accounts of governments, with the implication that principles of financing may differ as the type of outlay differs. These norms incorporate the notion that only the prospect of benefits in periods subsequent to the outlay makes legitimate the postponing or putting off of the costs of this outlay. There is nothing in this classically familiar argument, however, that suggests that the costs will somehow disappear because the benefits accrue in later periods, an absurd distortion that some of the more extreme Keynesian arguments would seem to introduce.

The classical rules for responsible borrowing, public or private, are clear enough, but the public-finance-private-finance analogy may break down when the effects of irresponsible or imprudent financial conduct are analyzed. The dangers of irresponsible borrowing seem greater for governments than for private families or firms. For this reason, more stringent constraints may need to be placed on public than on private debt issue. The difference lies in the specification and identification of the liability or obligation incurred under debt financing in the two cases. If an individual borrows, he incurs a personal liability. The creditor holds a claim against the assets of the person who initially makes the decision to borrow, and the borrower cannot readily shift his liability to others. There are few willing recipients of liabilities. If the borrower dies, the creditor has a claim against his estate.

Compare this with the situation of an individual who is a citizen in a political community whose governmental units borrow to finance current outlay. At the time of the borrowing decision, the individual citizen is not assigned a specific and determinate share of the fiscal liability that the public debt represents. He may, of course, sense that some such liability exists for the whole community, but there is no identifiable claim created against his privately owned assets. The obligations are those of the political community, generally considered, rather than those of identified members of the community. If, then, a person can succeed in escaping what might be considered his “fair” share of the liability by some change in the tax-share structure, or by some shift in the membership of the community through migration, or merely by growth in the domestic population, he will not behave as if the public debt is equivalent to private debt.

Because of this difference in the specification and identification of liability in private and public debt, we should predict that persons will be somewhat less prudent in issuing the latter than the former. That is to say, the pressures brought to bear on governmental decision makers to constrain irresponsible borrowing may not be comparable to those that the analogous private borrower would incorporate within his own behavioral calculus. The relative absence of such public or voter constraints might lead elected politicians, those who explicitly make spending, taxing, and borrowing decisions for governments, to borrow even when the conditions for responsible debt issues are not present. It is in recognition of such proclivities that classical principles of public fiscal responsibility incorporate explicit limits on resort to borrowing as a financing alternative, and which also dictate that sinking funds or other comparable provisions be made for amortization of loans at the time of any initial spending-borrowing commitment.12

Without some such constraints, the classical theory embodies the prediction of a political scenario with cumulatively increasing public debt, unaccompanied by comparable values in accumulating public assets, a debt which, quite literally, places a mortgage claim against the future income of the productive members of the political community. As new generations of voters-taxpayers appear, they would, under this scenario, face fiscal burdens that owe their origins exclusively to the profligacy of their forebears. To the extent that citizens, and the politicians who act for them in making fiscal choices, regard members of future generations as lineal extensions of their own lives, the implicit fears of overextended public credit might never be realized. But for the reasons noted above, classical precepts suggest that dependence could not be placed on such potential concern for taxpayers in future periods. The effective time horizon, both for members of the voting public and for the elected politicians alike, seems likely to be short, an implicit presumption of the whole classical construction.

This is not, of course, to deny that the effects on taxpayers in later budgetary periods do not serve, and cannot serve, as constraints on public borrowing. So long as decision makers act on the knowledge that debt issue does, in fact, shift the cost of outlay forward in time, some limit is placed on irresponsible behavior. That is to say, even in the absence of classically inspired institutional constraints on public debt, a generalized public acceptance of the classical theory of public debt would, in itself, exert an important inhibiting effect. It is in this context that the putative replacement of the classical theory by the Keynesian theory can best be evaluated. The latter denies that debt finance implements an intertemporal shift of realized burden or cost of outlay, quite apart from the question as to the possible desirability or undesirability of this method of financing. The existence of opportunities for cumulative political profligacy is viewed as impossible; there are no necessarily adverse consequences for future taxpayers. The selling of the Keynesian theory of debt burden, which we shall examine in the next chapter, was a necessary first step in bringing about a democracy in deficit.

Fiscal Principles and Keynesian Economic Theory

There was a genuine “Keynesian revolution” in fiscal principles, the effects of which we attempt to chronicle in this book. But we should not overlook the fact that this fiscal revolution was embedded within the more comprehensive Keynesian theory of economic process. As Chapters 3 and 4 will discuss in some detail, there was a shift in the vision or paradigm for the operation of the whole economy. Without this, there would have been no need for the revolutionary shift in attitudes about fiscal precepts.

This is illustrated in the competing theories of public debt, noted above. Analyses of the effects of public debt closely similar to those associated with those advanced under Keynesian banners had been advanced long before the 1930s and in various countries and by various writers.13 These attacks on the classical theory were never fully effective in capturing the minds of economists, because they were not accompanied by a shift away from the underlying paradigm of neoclassical economics. A nonclassical theory of public debt superimposed on an essentially classical theory of economic process could, at best, have been relevant for government budget making. But the nonclassical theory of public debt advanced by the Keynesians was superimposed on the nonclassical theory of economic process, a theory which, in its normative application, elevated deficit financing to a central role. A change in the effective fiscal constitution implied not only a release of politicians from the constraining influences that prevented approval of larger debt-financed public budgets, but also a means for securing the more important macroeconomic objectives of increased real income and employment.14 To be sure, it was recognized that deficit financing might also increase governmental outlays, possibly an objective in itself, but the strictly Keynesian emphasis was on the effects on the economy rather than on the probable size of the budget as such. And it was this instrumental value of budget deficits, and by implication of public debt, that led economists to endorse, often enthusiastically and without careful analysis, theoretical constructions that would have been held untenable if examined independently and on their own.

There is, of course, no necessary relationship between the theory of public debt and the theory of economic process. A sophisticated analysis can incorporate a strictly classical theory of public debt into a predominantly Keynesian theory of income and employment. Or, conversely, a modern non-Keynesian monetarist could possibly accept the no-transfer or Keynesian theory of debt burden. The same could scarcely be said for fiscal principles, considered in total. The old-time fiscal religion, that which incorporates both the classical theory of debt and the precept which calls for budget balance, could not readily be complementary to an analysis of the economic process and policy that is fully Keynesian. In terms of intellectual history, it was the acceptance of Keynesian economic theory which produced the revolution in ideas about fiscal principles and practice, rather than the reverse.

The Fiscal Constitution

Whether they are incorporated formally in some legally binding and explicitly constitutional document or merely in a set of customary, traditional, and widely accepted precepts, we can describe the prevailing rules guiding fiscal choice as a “fiscal constitution.” As we have noted, thoughout the pre-Keynesian era, the effective fiscal constitution was based on the central principle that public finance and private finance are analogous, and that the norms for prudent conduct are similar. Barring extraordinary circumstances, public expenditures were supposed to be financed by taxation, just as private spending was supposed to be financed from income.

The pre-Keynesian or classical fiscal constitution was not written in any formal set of rules. It was, nonetheless, almost universally accepted.15 And its importance lay in its influence in constraining the profligacy of all persons, members of the public along with the politicians who acted for them. Because expenditures were expected to be financed from taxation, there was less temptation for dominant political coalitions to use the political process to implement direct income transfers among groups. Once the expenditure-taxation nexus was broken, however, the opportunities for such income transfers were increased. Harry G. Johnson, for instance, has advanced the thesis that the modern tendency toward ever-increasing budget deficits results from such redistributional games. Governments increasingly enact public expenditure programs that confer benefits on special segments of the population, with the cost borne by taxpayers generally. Many such programs might not be financed in the face of strenuous taxpayer resistance, but might well secure acceptance under debt finance. The hostility to the expenditure programs is reduced in this way, and budgets rise; intergroup income transfers multiply.16

Few could quarrel with the simple thesis that the effective fiscal constitution in the United States was transformed by Keynesian economics. The old-time fiscal religion is no more. But, one might reasonably ask, “so what?” The destruction of the classical principles of fiscal policy was to have made possible major gains in overall economic performance. If so, we should not mourn the passing of such outmoded principles.

Keynesianism offered the promise of replacing the old with a better, more efficient fiscal constitution. By using government to control aggregate macroeconomic variables, cyclical fluctuations in economic activity were to be damped; the economy was to have both less unemployment and less inflation. If interpreted as prediction, the Keynesian promise has not been kept. The economy of the 1970s has not performed satisfactorily, despite the Keynesian-inspired direction of policy.

3.

First, the Academic Scribblers

John Maynard Keynes was a speculator, in ideas as well as in foreign currencies, and his speculation was scarcely idle. He held an arrogant confidence in the ideas that he adopted, at least while he held them, along with a disdain for the virtues of temporal consistency. His objective, with The General Theory of Employment, Interest, and Money (1936), was to secure a permanent shift in the policies of governments, and he recognized that the conversion of the academic scribblers, in this case the economists, was a necessary first step. “It is my fellow economists, not the general public, whom I must convince.”1 In the economic disorder of the Great Depression, there were many persons—politicians, scholars, publicists—in America and elsewhere, who advanced policy proposals akin to those that were to be called “Keynesian.” But it was Keynes, and Keynes alone, who captured the minds of the economists (or most of them) by changing their vision of the economic process.

Without Keynes, government budgets would have become unbalanced, as they did before Keynes, during periods of depression and war. Without Keynes, governments would have varied the rate of money creation over time and place, with bad and good consequences. Without Keynes, World War II would have happened, and the economies of Western democracies would have been pulled out of the lingering stagnation of the 1930s. Without Keynes, substantially full employment and an accompanying inflationary threat would have described the postwar years. But these events of history would have been conceived and described differently, then and now, without the towering Keynesian presence. Without Keynes, the proclivities of ordinary politicians would have been held in check more adequately in the 1960s and 1970s. Without Keynes, modern budgets would not be quite so bloated, with the threat of more to come, and inflation would not be the clear and present danger to the free society that it has surely now become. The legacy or heritage of Lord Keynes is the putative intellectual legitimacy provided to the natural and predictable political biases toward deficit spending, inflation, and the growth of government.

Our objective in this chapter is to examine the Keynesian impact on the ideas of economists, on the “Keynesian revolution” in economic theory and policy as discussed within the ivied walls of academia. By necessity as well as intent, our treatment will be general and without detail, since our purpose is not that of offering a contribution to intellectual or scientific history, but, rather, that of providing an essential element in any understanding of the ultimate political consequences of Keynesian ideas.1

“Classical Economics,” a Construction in Straw?

Keynes set out to change the way that economists looked at the national economy. A first step was the construction of a convenient and vulnerable target, which emerged as the “classical economists,” who were only partially identified but who were, in fact, somewhat provincially located in England. With scarcely a sidewise glance at the institutional prerequisites, Keynes aimed directly at the jugular of the targeted model, the self-equilibrating mechanism of the market economy. In the Keynesian description, the classical economist remained steadfast in his vision of a stable economy that contained within it self-adjusting reactions to exogenous shocks, reactions that would ensure that the economy as a whole, as well as in its particular sectors, would return toward a determinate set of equilibrium values. Furthermore, these values were determinate at plausibly desired levels. Following Ricardo and rejecting Malthus, the classical economists denied the prospects of a general glut on markets.2

It is not within our purpose here to discuss the methodological or the analytical validity of the Keynesian argument against its allegedly classical opposition. We shall not attempt to discuss our own interpretation of just what pre-Keynesian economics actually was. The attack was launched, not upon that which might have existed, but upon an explicitly defined variant, which may or may not have been caricature. And the facts of intellectual history attest to the success of the venture. Economists of the twentieth century’s middle decades conceived “classical economics” in the image conjured for them by Keynes, and they interpret the “revolution” as the shift away from that image. This is all that need concern us here.

In this image, “classical economics” embodied the presumption that there existed built-in equilibrating forces which ensured that a capitalistic economy would generate continuing prosperity and high-level employment. Exogenous shocks might, of course, occur, but these would trigger reactions that would quickly, and surely, tend to restore overall equilibrium at high-employment levels. Such an image seemed counter to the observed facts of the 1920s in Britain and of the 1930s almost everywhere. National economies seemed to be floundering, not prospering, and unemployment seemed to be both pervasive and permanent.

Keynes boldly challenged the basic classical paradigm of his construction. He denied the very existence of the self-equilibrating forces of the capitalist economy. He rejected the extension of the Marshallian conception of particular market equilibrium to the economy as a whole, and to the aggregates that might be introduced to describe it. A national economy might attain “equilibrium,” but there need be no assurance that the automatic forces of the market would produce acceptably high and growing real output and high-level employment.4

Again we need not and shall not trace out the essential Keynesian argument, in any of its many variants, and there would be little that we might add to the still-burgeoning literature of critical reinterpretation and analysis. What is important for us is the observed intellectual success of the central Keynesian challenge. From the early 1940s, most professionally trained economists looked at “the economy” differently from the way they might have looked at the selfsame phenomenon in the early 1920s or early 1930s. In a general sense of the phrase, a paradigm shift took place.

Before Keynes, economists of almost all persuasions implicitly measured the social productivity of their own efforts by the potential gains in allocative efficiency which might be forthcoming upon the rational incorporation of economists’ continuing institutional criticisms of political reality. How much increase in social value might be generated by a shift of resources from this to that use? Keynes sought to change, and succeeded in changing, this role for economists. Allocative efficiency, as a meaningful and desirable social objective, was not rejected. Instead, it was simply relegated to a second level of importance by comparison with the “pure efficiency” that was promised by an increase in the sheer volume of employment itself. It is little wonder that economists became excited about their greatly enhanced role and that they came to see themselves as new persons of standing.

Once converted, economists could have readily been predicted to allow Keynes the role of pied piper. But how were they to be converted? They had to be convinced that the economic disaster of the Great Depression was something more than the consequence of specific mistakes in monetary policy, and that correction required more than temporary measures. Keynes accomplished this aspect of the conversion by presenting a general theory of the aggregative economic process, one that appeared to explain the events of the 1930s as one possible natural outcome of market interaction rather than as an aberrant result produced by policy lapses.5 In this general theory, there is no direct linkage between the overall or aggregate level of output and employment that would be determined by the attainment of equilibrium in labor and money markets and that level of output and employment that might be objectively considered desirable. In the actual equilibrium attained through the workings of the market process, persons might find themselves involuntarily unemployed, and they could not increase the overall level of employment by offers to work for lowered money wages. Nor could central bankers ensure a return to prosperity by the simple easing of money and credit markets. Under certain conditions, these actions could not reduce interest rates and, through this, increase the rate of capital investment. To shock the system out of its possible locked-in position, exogenous forces would have to be introduced, in the form of deficit spending by government.

The Birth of Macroeconomics

As if in one fell swoop, a new and exciting half-discipline was appended to the classical tradition. Macroeconomics was born almost full-blown from the Keynesian impact. To the conventional theory of resource allocation, now to be labeled “microeconomics,” the new theory of employment was added, and labeled “macroeconomics.” The professional economist, henceforward, would have to be trained in the understanding not only of the theory of the market process, but also the theory of aggregative economics, that theory from which predictions might be made about levels of employment and output. Even those who remained skeptical of the whole Keynesian edifice felt compelled to become expert in the manipulation of the conceptual models. And perhaps most importantly for our history, textbook writers responded by introducing simplistic Keynesian constructions into the elementary textbooks. Paul Samuelson’s Economics (1948) swept the field, almost from its initial appearance early after the end of World War II. Other textbooks soon followed, and almost all were similar in their dichotomous presentation of subject matter. Courses were organized into two parts, microeconomics and macroeconomics, with relatively little concern about possible bridges between these sometimes disparate halves of the discipline.

Each part of the modified discipline carried with it implicit norms for social policy. Microeconomics, the rechristened traditional price theory, implicitly elevates allocative efficiency to a position as the dominant norm, and applications of theory here have usually involved demonstrations of the efficiency-producing or efficiency-retarding properties of particular institutional arrangements. Macroeconomics, the Keynesian consequence, elevates high-level output and employment to its position of normative dominance, with little or no indicated regard to the efficiency with which resources are utilized. There are, however, significant differences in the implications of these policy norms as between micro- and macroeconomics. In the former, the underlying ideal or optimum structure, toward which policy steps should legitimately be aimed, is a well-functioning regime of markets. At an analytical level, demonstrations that “markets fail” under certain conditions are taken to suggest that correctives will “make markets work” or, if this is impossible, will substitute regulation for markets, with the norm for regulation itself being that of duplicating market results. Equally, if not more, important are the demonstrations that markets fail because of unnecessary and inefficient political control and regulation, with the implication that removal and/or reduction of control itself will generate desired results. In summary, the policy implications of microeconomics are not themselves overtly interventionist and, if anything, probably tend toward the anti-interventionist pole.

The contrast with macroeconomics in this respect is striking. There is nothing akin to the “well-functioning market” which will produce optimally preferred results, no matter how well embedded in legal and institutional structure. Indeed, the central thrust of the Keynesian message is precisely to deny the existence of such an underlying ideal. “The economy,” in the Keynesian paradigm, is afloat without a rudder, and its own internal forces, if left to themselves, are as likely to ground the system on the rocks of deep depression as they are to steer it toward the narrow channels of prosperity. Once this model for an economy is accepted to be analytically descriptive, even if major quibbles over details of interpretation persist, the overall direction of the economy by governmental or political control becomes almost morally imperative. There is a necessary interventionist bias which stems from the analytical basis of macroeconomics, a bias that is inherent in the paradigm itself and which need not be at all related to the ideological persuasion of the economist practitioner.

The New Role for the State

The Keynesian capture of the economists, therefore, carried with it a dramatically modified role for the state in their vision of the world. In this new vision, the state was obliged to take affirmative action toward ensuring that the national economy would remain prosperous, action which could, however, be taken with clearly defined objectives in view. Furthermore, in the initial surges of enthusiasm, few questions of conflict among objectives seemed to present themselves. Who could reject the desirability of high-level output and employment? Politicians responded quickly, and the effective “economic constitution” was changed to embody an explicit commitment of governmental responsibility for full employment. The Full Employment Act became law in the United States in 1946. The President’s Council of Economic Advisers was created, reflecting the political recognition of the enhanced role of the economists and of economic theory after Keynes.6

The idealized scenario for the then “New Economics” was relatively straightforward. Economists were required first to make forecasts about the short- and medium-term movements in the appropriate aggregates—consumption, investment, public spending, and foreign trade. These forecasts were then to be fed into the suitably constructed model for the working of the national economy. Out of this, there was to emerge a prediction about equilibrium levels of output and employment. This prediction was then to be matched against desired or targeted values. If a shortfall seemed likely, further estimation was to be made about the required magnitude of adjustment. This result was then to be communicated to the decision makers, who would, presumably, respond by manipulating the government budget to accommodate the required changes.

This scenario, as sketched, encountered rough going early on when the immediate post-World War II forecasts proved so demonstrably in error.7 Almost from the onset of attempts to put Keynesian economics into practice, conflicts between the employment and the price-level objectives appeared, dousing the early enthusiasm for the economists’ new Jerusalem. Nonetheless, there was no backtracking on the fundamental reassignment of functions. The responsibility for maintaining prosperity remained squarely on the shoulders of government. Stabilization policy occupied the minds and hearts of economists, even amidst the developing evidence of broad forecasting error, and despite the sharpening analytical criticism of the basic Keynesian structure. The newly acquired faith in macroeconomic policy tools was, in fact, maintained by the political lags in implementation. While textbooks spread the simple Keynesian precepts, and while learned academicians debated sophisticated points in logical analysis, the politics of policy proceeded much as before the revolution, enabling economists to blame government for observed stabilization failures. The recessions of the 1950s, even if mild by prewar standards, were held to reflect failures of political response. Economists in the academy were preparing the groundwork for the New Frontier, when Keynesian ideas shifted beyond the sanctuaries to capture the minds and hearts of ordinary politicians and the public.

The Scorn for Budget Balance

The old-time fiscal religion, which we have previously discussed in Chapter 2, was not easy to dislodge. Before the Keynesian challenge, an effective “fiscal constitution” did exist, even if this was not embodied in a written document. This “constitution” included the precept for budget balance, and this rule served as an important constraint on the natural proclivities of politicians. The economists who had absorbed the Keynesian teachings were faced with the challenge of persuading political leaders and the public at large that the old-time fiscal religion was irrelevant in the modern setting. As a sacrosanct principle, budget balance had to be uprooted. Prosperity in the national economy, not any particular rule or state of the government’s budget, was promoted as the overriding policy objective. And if the achievement and the maintenance of prosperity required deliberate creation of budget deficits, who should be concerned? Deficits in the government budget, said the Keynesians, were indeed small prices to pay for the blessings of high employment.

A new mythology was born. Since there was no particular virtue in budget balance, per se, there was no particular vice in budget unbalance, per se. The lesson was clear: Budget balance did not matter. There was apparently no normative relationship, even in some remote conceptual sense, between the two sides of the government’s fiscal account. The government was different from the individual. The Keynesian-oriented textbooks hammered home this message to a continuing sequence of student cohort groups. Is there any wonder that, eventually, the message would be heeded?

The New Precepts for Fiscal Policy

The new rules that were to guide fiscal policy were simple. Budget deficits were to be created when aggregate demand threatened to fall short of that level required to maintain full employment. Conversely, and symmetrically, budget surpluses were to be created when aggregate demand threatened to exceed full-employment targets, generating price inflation. A balanced budget would rationally emerge only when aggregate demand was predicted to be just sufficient to generate full employment without exerting inflationary pressures on prices. Otherwise, unbalanced budgets would be required. In this pure regime of functional finance, a regime in which the government’s budget was to be used, and used rationally, as the primary instrument for stabilization, budget deficits or budget surpluses might emerge over some cumulative multiperiod sequence. Those who were most explicit in their advocacy of such a regime expressed little or no concern for the direction of budget unbalance over time.8 In the wake of the experience of the Great Depression, however, the emphasis was placed on the possible need for a continuing sequence of deficits. The potential application of the new fiscal principles in threatened inflationary periods was discussed largely in hypothetical terms, appended to lend analytical symmetry to the policy models.

Budget Deficits, Public Debt, and Money Creation

The deliberate creation of budget deficits—the explicit decision to spend and not to tax—was the feature of Keynesian policy that ran most squarely in the face of traditional and time-honored norms for fiscal responsibility. But there was no alternative for the Keynesian convert. To increase aggregate demand, total spending in the economy must be increased, and this could only be guaranteed if the private-spending offsets of tax increase could be avoided or swamped. New net spending must emerge, and the creation of budget deficits offered the only apparent escape from economic stagnation.9

If, however, the flow of spending was to be increased in this manner, the problem of financing deficits necessarily arose. And at this point, the policy advocate encountered two separate and subsidiary norms in the previously existing “constitution.” Deficits could be financed in only one of two ways, either through government borrowing (the issue of public debt) or through the explicit creation of money (available only to central government). But public debt, in the classical theory of public finance, transfers burdens onto the shoulders of future generations. And money creation was associated, historically, with governmental corruption along with the dangers of inflation.

Retrospectively, it remains somewhat surprising that the Keynesians, or most of them, chose to challenge the debt-burden argument of classical public-finance theory rather than the money-creation alternative. (By so doing, quite unnecessary intellectual confusion was introduced into an important area of economic theory, confusion that had not, even as late as 1976, been fully eliminated.) Within the strict assumptions of the Keynesian model, and in the deficient-demand setting, the opportunity cost of additional governmental spending is genuinely zero. From this, it follows directly that the creation of money to finance the required deficit involves no net cost; there is no danger of price inflation. In the absence of political-institutional constraints, therefore, the idealized Keynesian policy package for escape from such economic situations is the explicit creation of budget deficits along with the financing of these by pure money issue.

In such a context, any resort to public debt issue, to public borrowing, is a necessary second-best. Why should the government offer any interest return at all to potential lenders of funds, to the purchasers of government debt instruments, when the alternative of printing money at negligible real cost and at zero interest is available? Regardless of the temporal location of the burden of servicing and amortizing public debt, there is no supportable argument for public borrowing in the setting of deficient demand. In trying to work out a supporting argument here, the Keynesian economists were confused, even on their own terms.

Because they unreasonably assumed that deficits were to be financed by public borrowing rather than by money creation, the Keynesian advocates felt themselves obliged to reduce the sting of the argument concerning the temporal transfer of cost or burden.10 To accomplish this, they revived in sophisticated form the distinction between the norms for private, personal financial integrity and those for public, governmental financial responsibility. Budget balance did matter for an individual or family; budget balance did not matter for a government. Borrowing for an individual offered a means of postponing payment, of putting off the costs of current spending, which might or might not be desirable. For government, however, there was no such temporal transfer. It was held to be impossible to implement a transfer of cost or burden through time because government included all members of the community, and, so long as public debt was internally owned, “we owe it to ourselves.” Debtors and creditors were mutually canceling; hence, in the macroeconomic context, the society could never be “in debt” in any way comparable to that situation in which a person, a family, a firm, a local government, or even a central government that had borrowed from foreigners might find itself.

This argument was deceptively attractive. It did much to remove the charge of fiscal irresponsibility from the deficit-creation position. Politicians and the public might hold fast to the classical theory, in its vulgar or its sophisticated variant, but so long as professional economists could be found to present the plausible counterargument, this flank of the Keynesian intellectual position was amply protected, or so it seemed.

The “new orthodoxy” of public debt stood almost unchallenged among economists during the 1940s and 1950s, despite its glaring logical contradictions.11 The Keynesian advocates failed to see that, if their theory of debt burden is correct, the benefits of public spending are always available without cost merely by resort to borrowing, and without regard to the phase of the economic cycle. If there is no transfer of cost onto taxpayers in future periods (whether these be the same or different from current taxpayers), and if bond purchasers voluntarily transfer funds to government in exchange for promises of future interest and amortization payments, there is no cost to anyone in society at the time public spending is carried out. Only the benefits of such spending remain. The economic analogue to the perpetual motion machine would have been found.

A central confusion in the whole Keynesian argument lay in its failure to bring policy alternatives down to the level of choices confronted by individual citizens, or confronted for them by their political representatives, and, in turn, to predict the effects of these alternatives on the utilities of individuals. It proved difficult to get at, and to correct, this fundamental confusion because of careless and sloppy usage of institutional description. The Keynesian economist rarely made the careful distinction between money creation and public debt issue that is required as the first step toward logical clarity. Linguistically, he often referred to what amounts to disguised money creation as “public debt,” notably in his classification of government “borrowing” from the banking system. He tended to equate the whole defense of deficit financing with his defense of public debt, as a financing instrument, when, as noted above, this need not have been done at all. On his own grounds, the Keynesian economist could have made a much more effective case for deficit financing by direct money creation. Had he done so, perhaps the transmission of his message to the politicians and to the public would have contained within it much stronger built-in safeguards. It is indeed interesting to speculate what might have happened in the post-Keynesian world of fiscal policy if the financing of budget deficits had been restricted to money issue, and if this means of financing had been explicitly acknowledged by all parties.

The Dreams of Camelot

But such was not to be. The Keynesian economists were able to remain within their ivory towers during the 1950s, secure in their own untested confusions and willingly assessing blame upon the mossback attitudes of politicians and the public. In the early 1960s, for a few months in history, all their dreams seemed to become potentially realizable. The “New Economics” had finally moved beyond the elementary textbooks and beyond the halls of the academy. The enlightened would rule the world, or at least the economic aspects of it. But such dreams of Camelot, in economic policy as in other areas, were dashed against the hard realities of democratic politics. Institutional constraints, which seem so commonplace to the observer of the 1970s, were simply overlooked by the Keynesian economists until these emerged so quickly in the 1960s. They faced the rude awakening to the simple fact that their whole analytical structure, its strengths and its weaknesses, had been constructed and elaborated in almost total disregard for the institutional world where decisions are and must be made. The political history of economic policy for the 1960s and 1970s, which we shall trace further in Chapter 4, is not a happy one. Can we seriously absolve the academic scribblers from their own share of blame?

4.

The Spread of the New Gospel

Introduction

Economists do not control political history, despite their desires and dreams. Our narrative summary of the Keynesian revolution cannot, therefore, be limited to the conversion of the economists. We must look at the spreading of the Keynesian gospel to the public, and especially to the political decision makers, if we are to make sense of the situation that we confront in the late 1970s and the 1980s. The old-time fiscal religion was surprisingly strong. The effective fiscal constitution was not amended at one fell swoop, and not without some struggle. But ultimately it did give way; its precepts lost their power of persuasion. The Keynesian revolution began in the classroom and was nurtured there, but ultimately it invaded the citadels of power. The ideas of the Cambridge academic scribbler did modify, and profoundly, the actions of politicians, and with precisely the sort of time lag that Keynes himself noted in the very last paragraph of his book. Since the early 1960s, politicians have become at least half Keynesians, or they have done so in sufficient number to ensure that budget policy proceeds from a half-Keynesian paradigm. We shall discuss the attitudes of modern politicians at length, but we must first complete our narrative.

Passive Imbalance

Budget deficits may emerge either as a result of deliberate decisions to spend beyond ordinary revenue constraints or because established flows of spending and taxing react differently to shifts in the aggregate bases of an economy. We may refer to these as “active” and “passive” deficits, respectively. One of the first effects of the Great Depression of the 1930s, which dramatically reduced income, output, and employment in the American economy, was the generation of a deficit in the federal government’s budget. From a position of comfortable surplus in 1929, the budget became unbalanced in calendar 1930, largely owing to the dramatic reduction in tax revenues. This revenue shortfall, plus the increase in transfer programs, created an even larger deficit for 1931.

The old-time fiscal religion, which embodied the analogy between private and public finance, dictated revenue-increasing and spending-decreasing actions as countermeasures to the emergence of passive budget deficits. These precepts were dominant in 1932 when, in reaction to the deficits of the two preceding calendar years, along with prospects for even larger deficits, federal taxes were increased substantially.1 Even this tax increase was apparently not sufficient to stifle political criticism; Franklin D. Roosevelt based his electoral campaign of 1932 on a balanced-budget commitment, and he severely criticized Herbert Hoover for the fiscal irresponsibility that the budget deficits reflected. In a radio address in July 1932, for instance, Roosevelt said, “Let us have the courage to stop borrowing to meet continuing deficits.... Revenues must cover expenditures by one means or another. Any government, like any family, can, for a year, spend a little more than it earns. But you and I know that a continuation of that habit means the poorhouse.”2

The first task for the economists, even in these years before the publication of Keynes’ book, seemed to be clear. They tried, or at least many of them did, to convince President Roosevelt, along with other political leaders, that the emerging budget deficits, passively and indirectly created, gave no cause for alarm, and that tax increases and spending cuts could only be counterproductive in the general restoration of prosperity.3 Once in office, President Roosevelt soon found that, regardless of the old-fashioned precepts discussed in his campaign, expansions in spending programs were politically popular, while tax increases were not. So long as the traditional rules were not widely violated, so long as the times could genuinely be judged extraordinary, and so long as there were economists around to offer plausible reasons for allowing the emerging deficits to go undisturbed, political decision makers were ready to oblige, even if they continued to pay lip service to the old-time principles.

Even before 1936, therefore, the first step on the road toward political implementation of the full Keynesian message was accomplished. During periods of economic distress, when the maintenance of budget balance required explicit action toward increasing taxes and/or reducing governmental outlays, the political weakness inherent in the traditional fiscal constitution was exposed, and the norms were violated with little observable consequence. Until Keynes presented his “General Theory,” however, these policy actions (or inactions) were not embedded in a normative analytical framework that elevated the budget itself to a dominant instrumental role in maintaining prosperity. The basic Keynesian innovation lay precisely in such explicit use of the budget for this purpose, one that had scarcely been dreamed of in any pre-Keynesian philosophy.4 As we have noted, many economists readily accepted the new religion. But the conversion of the politicians encountered unpredicted obstacles.

In the euphoria of victory in World War II, and flush with the observed faith of economists in their new prophet, the Full Employment Act of 1946 became law. Despite the vagueness of its objectives, this act seemed to reflect an acceptance of governmental responsibility for the maintenance of economic prosperity, and it seemed also to offer economists an opportunity to demonstrate their greatly enhanced social productivity. Early expectations were rudely shattered, however, by the abject failure of the Keynesian economic forecasters in the immediate postwar years. The initial bloom of Keynesian hopes faded, and politicians and the public adopted a cautious wait-and-see attitude toward macroeconomic policy planning.

Built-in Flexibility

The late 1940s saw many of the Keynesian economists licking their wounds, resting content with the exposition of the Keynesian message in the elementary textbooks, and taking initial steps toward consolidating the territory staked out in the 1930s. The apparent coolness of the politicians toward the active creation of budget deficits, along with the economists’ own forecasting limits, suggested that more effective use might be made of the observed political acquiescence to passive imbalance. Even if budget deficits could not be, or would not be, created explicitly for the attainment of desired macroeconomic objectives, the two sides of the budget might be evaluated, at least in part, according to their by-product effects in furthering these objectives. If the politicians could be brought to this level of economic sophistication, a second major step toward the Keynesian policy mecca would have been taken. The initial assurance against reactions toward curing passive imbalance would now be supplemented by political recognition that the budget deficit, in itself, worked as a major element toward restoring prosperity. For the politicians to deplore the fiscal irresponsibility reflected in observed deficits while passively accepting these and foregoing counterproductive fiscal measures was one thing; for these same politicians to recognize that the observed deficits themselves offered one means of returning the economy toward desired output and employment levels was quite another.

Once the emergence of deficits came to be viewed as a corrective force, and once alternative budgets came to be evaluated by the strength of the corrective potential, only a minor shift in attitude was required to incorporate such potential in the objectives for budget making itself. The economists quickly inserted “built-in flexibility” as a norm for both the taxing and spending sides of the fiscal account. Other things equal, taxes “should” be levied so as to ensure wide variations in revenue over the business cycle, variations that carry the same sign as those in the underlying economic aggregates, and which are disproportionately larger than the latter. Similarly, for the other side of the budget, spending programs, and notably transfers, “should” be arranged so that variations over the cycle are of the opposing sign to those in the underlying economic aggregates and, ideally, of disproportionate magnitude. These post-Keynesian norms for the internal structure of budget making offered support to those political pressures which would ordinarily support progressive taxation of personal incomes, along with the taxation of corporate income and/or profits, and, on the spending side, the initiation or increase of welfare-type transfers.5

Hypothetical Budget Balance

Even with passive imbalance accepted, however, and even with built-in flexibility accorded some place in an array of fiscal norms, a major step in the political conversion to Keynesian economics remained to be accomplished. Balance or imbalance in the budget was still related to income, output, and employment only in some ex post sense. The specific relationship between budget balance, per se, and the level of national income was not developed in the early discussions among the fiscal policy economists and surely not in the thinking of political leaders. In its early formulations, Keynesian fiscal policy involved the deliberate usage of the budget to achieve desired levels of income and employment, the use of “functional finance,” without regard to the question of balance or imbalance. And, indeed, much of the early discussion implied that a regime of permanent and continuing budget deficits would be required to ensure economic prosperity.

As the predictions of events for 1946 and 1947 turned sour, however, and as inflation rather than stagnation appeared as an unanticipated problem for the American economy, the question of budget balance more or less naturally presented itself. Even the most ardent Keynesian could not legitimately support the creation of budget deficits in periods of full employment and high national income. In other words, the budget “should” attain balance once the macroeconomic objectives desired are attained. This conclusion provided, in its turn, a norm for directly relating the degree of balance or imbalance in the government’s budget to the underlying state of the economy.

The limitations on forecasting ability, along with the political-institutional constraints on discretionary budgetary adjustments, turned attention to built-in flexibility. It was suggested that, with such flexibility, the Keynesian policy norms could be applied even in the restrictive setting of passive imbalance. If political decision makers either would not or could not manipulate the two sides of the budget so as to further output and employment objectives directly, the Keynesian precepts still might prove of value in determining long-range targets for budget planning. The economists still might have something to offer. When should the government’s budget be balanced? When should planned rates of outlay be fully covered by anticipated revenue streams? The post-Keynesians had clear answers. Both the expenditure and the tax side of the budget should be arranged, on a quasipermanent basis, so that overall balance would be achieved if and when certain output and employment objectives were attained.

Budget balance at some hypothetical level of national income, as opposed to any balance between observed revenue and spending flows, became the norm for quasipermanent changes in taxes and expenditures. Proposals for implementing this notion of hypothetical budget balance were specifically made in 1947 by the Committee for Economic Development.6 In 1948, the proposal was elaborated in a more sophisticated form by Milton Friedman.7 Professional economists attained a “remarkable degree of consensus” in support of the norm of hypothetical budget balance in the late 1940s and early 1950s.8

Monetary Policy and Inflation

The economists’ discussions of built-in flexibility and of budget balance at some hypothetical level of national income stemmed from two separate sources. The first, as noted above, was the recognition that discretionary budget management simply was not within the spirit of the times. The second, and equally important, source of the newfound emphasis lay in the dramatically modified historical setting. Keynesian economics, and the policy precepts it embodied, was developed almost exclusively in application to a depressed national economy, with high unemployment, excess industrial capacity, and little or no upward pressures on prices. But the years after World War II were, by contrast, years of rapidly increasing output, near full employment, and inflationary movements in prices.

The Keynesian elevation of the budget to its position as the dominant instrument for macroeconomic policy, along with the parallel relegation of monetary policy to a subsidiary role, was based, in large part, on the alleged presence of a liquidity trap during periods of deep depression. The basic model was asymmetrical, however, for nothing in Keynesian analysis suggested that monetary controls could not be effectively applied to dampen inflationary threats. Properly interpreted, Keynesian analysis does not imply that money does not matter; it implies that money matters asymmetrically. High interest rates offer, in this analysis, one means of choking off an inflationary boom. But this policy instrument need not be dusted off and utilized if, in fact, fiscal policy precepts are adhered to, in boom times as well as bust.

Immediately after World War II, the Keynesian economists came close to convincing the Truman-era politicians that a permanent regime of low interest rates, of “easy money,” could at long last be realized. But the fiscal counterpart to such an “easy money” regime, one that required the accumulation of budgetary surpluses, did not readily come into being. As the inflationary threat seemed to worsen, money and monetary control were rediscovered in practice in 1951, along with the incorporation of a policy asymmetry into the discussions and the textbooks of the time. “You can’t push on a string”—this analogy suggested that monetary policy was an appropriate instrument for restricting total spending but inappropriate for expanding it.

This one-sided incorporation of monetary policy instruments makes difficult our attempt to trace the conversion of politicians to Keynesian ideas. Without the dramatic shift in the potential for monetary policy that came with the Treasury-Federal Reserve Accord in 1951, we might simply look at the record for the Eisenhower years to determine the extent to which the Keynesian fiscal policy precepts were honored. But the shift did occur, and there need have been nothing specifically “non-Keynesian” about using the policy instruments asymmetrically over the cycle. A regime with alternating periods of “easy budgets and tight money” suggested a way station between the rhetoric of the old-time fiscal religion and the Keynesian spree of the 1960s and 1970s.

The Rhetoric and the Reality of the Fifties

How are we to classify the Eisenhower years? Did the fiscal politics of the 1950s fully reflect Keynesian teachings? Politically, should we call these years “pre-Keynesian” or “post-Keynesian”?

The answers must be ambiguous for several reasons. The relatively mild swings in the business cycle offered us no definitive test of political will. There is nothing in the historical record that demonstrates a political willingness to use the budget actively as an instrument for securing and maintaining high-level employment and output. On the other hand, the record does show a willingness to acquiesce in passive budget imbalance, along with repeated commitments for explicit utilization of budgetary instruments in the event of serious economic decline. The political economics of the Eisenhower years was clearly not that of the 1960s, which we can definitely label as “post-Keynesian,” but it was far from the economics of the 1920s.

Much of the rhetoric was pre-Keynesian, both with specific reference to budget balance and with reference to other macroeconomic concerns. The conflict between the high-employment and price-level objectives, a conflict that was obscured in the Great Depression only to surface with a vengeance in the late 1940s, divided the most ardent Keynesians and their opponents. The former, almost without exception, tended to place high employment at the top of their priority listing, and to neglect the dangers of inflation. Those who were most reluctant to embrace Keynesian policy norms took the opposing stance and indicated a willingness to accept lower levels of employment in exchange for a more secure throttle on inflation. The Eisenhower administration came into office with an expressed purpose of doing something about the inflation of the postwar years, and also about a parallel policy target, the growth in the rate of federal spending. A modified trade-off among macroeconomic objectives, quite apart from an acceptance and understanding of the Keynesian policy instruments, would have been sufficient to explain the observed behavior of the Eisenhower political leaders. That is to say, the politicians of the 1950s, on the basis of their observed actions alone, cannot be found guilty of pre-Keynesian ignorance. They were, of course, sharply criticized by the “Keynesians”; but this criticism was centered more on the acknowledged value trade-off between the inflation and unemployment targets than the use or misuse of the policy instruments.

At a different level of assessment, however, we must look at the analytical presuppositions of these decision makers. Did they acknowledge the existence of the trade-off between employment and inflation, the trade-off that was almost universally accepted and widely discussed by the economists of the decade? Was the Eisenhower economic policy based on an explicit willingness to tolerate somewhat higher rates of unemployment than might have been possible in exchange for a somewhat more stable level of prices? If the evidence suggests an affirmative answer, we may say that the political conversion to Keynesian economics was instrumentally completed. We are, of course, economists, and it is all too easy to interpret and to explain the events of history “as if” the results emerge from economists’ models. It is especially tempting to explain the macroeconomics of the 1950s in such terms and to say that the Eisenhower political leaders were dominated by a fear of inflation while remaining relatively unconcerned about unemployment.

If we look again at the rhetoric of the 1950s, along with the reality, however, and if we try to do so without wearing the economists’ blinders, the label “pre-Keynesian” fits the Eisenhower politicians better than does its opposite. The paradigm of the decade was that of an economic system that is inherently stable, provided that taxes are not onerously high and government spending is not out of bounds, and provided that the central bank carries out its appropriate monetary role. There was no political inclination to use the federal budget for achieving some hypothetical and targeted rate of growth in national income. The economics of George Humphrey and Robert Anderson was little different from that of Andrew Mellon, thirty years before.9 The economics of the economists was, of course, dramatically different. In the 1920s, there was no overt policy conflict between the economists and the politicians of their time. By contrast, the 1950s were years of developing tension between the economists-intellectuals and their political peers, with the Keynesian economists unceasingly berating the effective decision makers for their failure to have learned the Keynesian lessons, for their reactionary adherence to outmoded principles of fiscal rectitude. This discourse laid the groundwork for the policy shift of the 1960s.

But, as noted earlier, there were major differences between the 1920s and the 1950s. Passive deficits were accepted, even if there was extreme reluctance to utilize the budget actively to combat what proved to be relatively mild swings in the aggregate economy. The built-in flexibility embodied in the federal government’s budget was both acknowledged and allowed to work. Furthermore, despite the rhetoric that called for the accumulation of budget surpluses during periods of economic recovery, little or no action was taken to ensure that sizeable surpluses did, in fact, occur. The promised increased flow of revenues was matched by commitments for new spending, and the Eisenhower leadership did not effectively forestall this. Public debt was not reduced in any way remotely comparable to the previous postwar periods.

Fiscal Drag

The Eisenhower administration was most severely criticized for its failure to pursue an active fiscal policy during and after the 1958 recession. Political pressures for quick tax reduction were contained in 1958, with the assistance of Democratic leaders in Congress, and attempts were made to convert the massive $12 billion passive deficit of that year into budget surpluses for the recovery years, 1959 and 1960. The rate of growth in federal spending was held down, and a relatively quick turnaround in the impact of the budget on the national economy was achieved, in the face of continuing high levels of unemployment.

It was during these last months of the Eisenhower administration that the notion or concept of “fiscal drag” emerged in the policy discourse of economists, based on an extension and elaboration of the norm for budget balance at some hypothetically defined level of national income and incorporating the recognition that income grows through time. The Eisenhower budgetary policy for the recovery years of 1959 and 1960 was sharply criticized for its apparent concentration on observed rather than potential flows of revenues and outlays. By defining a target “high-employment” level of national income on a projected normal growth path, and then by projecting and estimating the tax revenues and government outlays that would be forthcoming under existing programs at that level of income, a test for hypothetical budget balance could be made. Preliminary tests suggested that the Eisenhower budgetary policies for those years would have generated a surplus at the targeted high-employment level of income. That is to say, although actually observed flows of revenues and outlays need not have indicated a budget surplus, such a surplus would indeed have been created if national income had been generated at the higher and more desired level. However, since observed national income was below this target level, and because the potential for the surplus was already incorporated in the tax-spending structure, the budget instrument itself worked against the prospect that the target level of national income could ever be attained at all. This result seemed to follow directly from the recognition that the budget itself was an important determinant of national income. Before the targeted level of income could be reached, the budget itself would begin to exert a depressing influence on aggregate demand. This “fiscal drag” was something to be avoided.10

From this analysis follows the budgetary precept that runs so strongly counter to ordinary common sense. During a period of economic recovery, the deliberate creation of a budget deficit, or the creation of a larger deficit than might already exist, offers a means of securing the achievement of budget surplus at high-employment income. We shall discuss this argument further at a later point. But here we note only that this was the prevailing wisdom among the enlightened economists on the Washington scene in 1960; this, plus the relatively sluggish recovery itself, provided the setting for the politics and the economics of Kennedy’s New Frontier.

The Reluctant Politician

In one of his more exuberant moments, President Kennedy may have called himself a Berliner; but during the early months of his administration, he could scarcely have called himself a Keynesian. As Herbert Stein suggested, “Kennedy’s fiscal thinking was conventional. He believed in budget-balancing. While he was aware of circumstances in which the budget could not or should not be balanced, he preferred a balanced budget, being in this respect like most other people but unlike modern economists.”11 But President Kennedy’s economic advisers were, to a man, solidly Keynesian, in both the instrumental and the valuational meaning of this term. They were willing to recommend the usage of the full array of budgetary instruments to secure high employment and economic growth, and they were relatively unconcerned about the inflationary danger that such policies might produce. The trade-off between employment and inflation was explicitly incorporated in their models of economic process, and they were willing to accept the relatively limited inflation that these models seemed to suggest as the price for higher employment.

But these advisers were also Galbraithian, in that they preferred to increase demand through expansions in federal spending rather than through tax reductions. Furthermore, they were strongly supportive of “easy money,” a policy of low interest rates designed to stimulate domestic investment. These patterns of adjustment were closely attuned with the standard political pressures upon the Democratic administration. Hence, in 1961 and early 1962, there was little or no discussion of tax reduction, despite the continuing sluggishness of the national economy, sluggishness that was still blamed on the follies of the previous Eisenhower leadership. Balance-of-payments difficulties prevented the adoption of the monetary policy that the Keynesians desired, and dramatic proposals for large increases in federal spending would surely have run squarely in the face of congressional opposition, a fact that President Kennedy fully recognized. Stimulation of the economy was, therefore, limited in total, despite the arguments of the president’s advisers.

Political Keynesianism: The Tax Cut of 1964

The principles of the old-fashioned fiscal religion did not remain inviolate up until the early 1960s only to collapse under the renewed onslaught of the modern economists. The foundations had been eroded, gradually and inexorably, since the conversion of the economists in the 1940s. And the political resistance to an activist fiscal policy was steadily weakened throughout the 1950s, despite much rhetoric to the contrary. But if a single event must be chosen to mark the full political acceptance of the Keynesian policy gospel, the tax cut of 1964 stands alone. Initially discussed in 1962, actively proposed and debated throughout 1963, and finally enacted in early 1964, this tax reduction demonstrated that political decision makers could act, and did act, to use the federal budget in an effort to achieve a hypothetical target for national income. Tax rates were reduced, and substantially so, despite the presence of an existing budget deficit, and despite the absence of economic recession. The argument for this unprecedented step was almost purely Keynesian. There was little recourse to the Mellon-Taft-Humphrey view that lowered tax rates, whenever and however implemented, offered the sure path to prosperity. Instead, taxes were to be reduced because national income was not being generated at a level that was potentially attainable, given the resource capacities of the nation. The economy was growing, but not nearly fast enough, and the increased deficit resulting from the tax cut was to be the instrument that moved the economy to its growth path. There was no parallel reformist argument for expenditure increase, and the tax reduction in itself was not wildly redistributionist. The objective was clean and simple: the restoration of the national economy to its full growth potential.

Should we not have predicted that the economists would be highly pleased in their newly established positions? The “New Economics” had, at long last, arrived; the politicians had finally been converted; the Keynesian revolution had become reality; its principles were henceforward to be enshrined in the conventional political wisdom. These were truly the economists’ halcyon days.

But days they were, or perhaps months. How can they (we) have been so naive? This question must have emerged to plague those who were most enthusiastic, and it must have done so soon after 1965. Could the fiscal politics of the next decade, 1965-1975, and beyond, not have been foreseen, predicted, and possibly forestalled? Or did the economists in Camelot dream of a future in which democratic fiscal politics were to be replaced, once and for all, by the fiscal gospel of Lord Keynes, as amended? We shall discuss such questions in depth, but for now we emphasize only the results of this conversion of the politicians to the Keynesian norms. As we have pointed out, this conversion was a gradual one, extending over the several decades, but 1964-1965 offers the historical watershed. Before this date, the fiscal politics of America was at least partially “pre-Keynesian” in both rhetoric and reality. After 1965, the fiscal politics became definitely “post-Keynesian” in reality, although elements of the old-time religion remained in the political argument.

The results are on record for all to see. After 1964, the United States embarked on a course of fiscal irresponsibility matched by no other period in its two-century history. A record-setting deficit of $25 billion in 1968 generated a temporary obeisance to the old-fashioned verities in 1969, the first Nixon year. But following this, the federal government’s budget swept onward and upward toward explosive heights, financed increasingly and disproportionately by deficits. Deficits of more than $23 billion were recorded in each of the 1971 and 1972 fiscal years. This provided the setting for Nixon’s putative 1974 “battle of the budget,” his last pre-Watergate scandal effort to bring spending into line with revenues. Fiscal 1973 saw the deficit reduced to plausibly acceptable limits, only to become dangerously large in fiscal 1975 and 1976, when a two-year deficit of more than $100 billion was accumulated. Who can look into our fiscal future without trepidation, regardless of his own political or ideological persuasion?

The mystery lies not in the facts of the fiscal record, but in the failure of social scientists, and economists in particular, to predict the results of the eclipse of the old rules for fiscal responsibility. Once democratically elected politicians, and behind them their constituents in the voting public, were finally convinced that budget balance carried little or no normative weight, what was there left to restrain the ever-present spending pressures? The results are, and should have been, predictable at the most naive level of behavioral analysis. We shall examine this failure of prediction in Part II, but the facts suggest that the naive analysis would have been applicable. After the 1964 tax reduction, the “price” of public goods and services seemed lower. Should we not have foreseen efforts to “purchase” larger quantities? Should we not have predicted the Great Society-Viet Nam spending explosion of the late 1960s?

Economists, Politicians, and the Public

The Keynesian economists are ready with responses to such questions. They fall back on the symmetrical applicability of the basic Keynesian policy precepts, and they lay the fiscal-monetary irresponsibility squarely on the politicians. If the political decision makers of the 1960s and 1970s, exemplified particularly in Lyndon Johnson and Richard Nixon (both of whom remain forever villains in the liberal intellectuals’ lexicon), had listened to the advice of their economist advisers, as did their counterparts in Camelot, the economic disasters need not have emerged. After all, or so the argument of the Keynesian economists proceeds, the precepts are wholly symmetrical. Budget surpluses may be desired at certain times. Enlightened political leadership would have imposed higher taxes after 1965, as their economist advisers recommended, and efforts would have been made to hold down rates of growth in federal domestic spending to offset Viet Nam outlays.

In such attempts to evade their own share of the responsibility for the post-1965 fiscal history, the economists rarely note the politician’s place in a democratic society. From Roosevelt’s New Deal onward, elected politicians have lived with the demonstrated relationship between favorable election returns and expansion in public spending programs. Can anyone seriously expect the ordinary persons who are elected to office to act differently from the rest of us? The only effective constraint on the spending proclivities of elected politicians from the 1930s onward has been the heritage of our historical “fiscal constitution,” a set of rules that did include the balancing of outlays with revenues. But once this constraint was eliminated, why should the elected politician behave differently from the way we have observed him to behave after 1965? Could we have expected the president and the Congress, Democratic or Republican, to propose and to enact significant tax-rate increases during a period of economic prosperity? In Camelot, the politicians followed the economists’ advice because such advice coincided directly with the naturally emergent political pressures. Why did the economists fail to see that a setting in which the appropriate Keynesian policy would run directly counter to these natural pressures might generate quite different results?

Functional Finance and Hypothetical Budget Balance

In retrospect, it may be argued that damage was done to the basic Keynesian cause by the attempts to provide substitutes for the balanced-budget rule, and most notably by the rule that the government’s budget “should” be balanced at some hypothetical level of national income, a level that describes full capacity or full-employment output. In the pristine simplicity of their early formulation, most clearly exposited by Abba Lerner, the Keynesian policy precepts contained no substitute for the balanced budget. Functional finance required no such rule at all; taxes were to be levied, not for the purpose of financing public outlays, but for the sole purpose of forestalling and preventing inflation.12 It is indeed interesting to speculate on “what might have been” had the Keynesian economists followed Lerner’s lead. The “education” of political leaders, and ultimately of the public, would have been quite different. The principles for policy would have been much simpler, and it is scarcely beyond the realm of plausibility to suggest that the required lessons might have been learned, that a politically viable regime of responsible functional finance might have emerged.

But such was not to be. Even the Keynesian economists seemed unwilling to jettison the time-honored notion that the extension and the makeup of the public sector, of governmental outlays, must somehow be related to the willingness of persons to pay for public goods and services, as expressed indirectly through the activities of legislatures in imposing taxes. But how was this tie-in between the two sides of the fiscal account to be reconciled with the basic Keynesian thrust which called for the abandonment of the balanced-budget rule? We have already traced the developments that reflected this tension, from the initial acquiescence in passive imbalance on the presupposition that balance would somehow be achieved over the business cycle, to the more sophisticated notion that a rule of budget balance might be restored, but balance this time at some hypothetically determined level of national income. But we must now look somewhat more closely and carefully at the burden that this new norm places on the political decision maker. He is told by his economists that budget balance at high employment is desirable, and that both outlay and revenue adjustments should be made on the “as if” assumption that the targeted level of income is generated. Once this exercise is completed, he is told, he may then acquiesce in the deficits or surpluses produced by the flow of economic events secure in the knowledge that all is well. This is a deceptively attractive scenario until we recognize that it offers an open-ended invitation to strictly judgmental decisions on what is, in fact, “high-employment” income. Furthermore, it tends to “build in” a presumed trade-off between unemployment and inflation, which may or may not exist.

What is the hypothetical level of income to be chosen for budget balance?—or, if desired, for some overbalance? There may be no uniquely determined level of high-employment income, and economists will surely continue to argue about the degree and extent of genuinely structural unemployment that might be present at any time. Additional definitiveness might be introduced by stipulating that the target income is that which could be generated without inflation. But, if structural unemployment is pervasive, this sort of budgetary norm may suggest balance between revenues and outlays in the face of observed rates of unemployment that are higher than those considered to be politically acceptable. In such a setting, imagine the pressures on the politicians who attempt to justify the absence of a budget deficit, after forty years of the Keynesian teachings.

An additional difficulty arises in the division of responsibility between the fiscal and monetary instruments. With the budget-balance-at-hypothetical-income norm, the tendency may be to place the restrictive burden on the monetary authorities and instruments while adding to this burden by the manipulation of budgetary-fiscal instruments applied to unattainable targets. Consider, for example, the setting in 1975, when we observed both unemployment and inflation rates of roughly 8 percent. The balance-at-hypothetical-income norm could have been, and indeed was, used by economists and politicians to justify the budget deficits observed in that year, and to argue for increases in these deficits. The inflation was, in turn, “explained” either by structural elements (administered prices) or by the failures of the monetary authorities to restrain demand. In this latter sense, the monetarists tended to support the Keynesians indirectly because of their emphasis on the purely monetary sources of inflation. This emphasis allows the politicians to expand the budget deficit in putative adherence to the balance-at-high-employment norm, bloating the size of the public sector in the process. To the extent that the responsibility for inflation can be placed on the monetary authorities, the restrictive role for fiscal policy is politically weakened regardless of the budgetary norm that is accepted.13 Neither the monetarists nor the Keynesians can have it both ways. “Easy money” cannot explain inflation and “fiscal drag” unemployment. Yet this is precisely the explanation mix that was translated directly into policy in 1975, generating the tax-reduction pressures on the one hand and the relatively mixed monetary policy actions on the other.

5.

Assessing the Damages

Introduction

We have traced the intrusion of the Keynesian paradigm into our national economic and political environment. We have suggested that the effect is a regime of deficits, inflation, and growing government. But is this necessarily an undesirable outcome? Many economists would claim that the Keynesian legacy embodies an improvement in the quality of economic policy. Deficits, they would argue, are useful and even necessary instruments that may be required for macroeconomic management. Inflation, they would suggest, may be but a small and necessary price to pay for the alleviation of unemployment. Moreover, the growth of government is in some respects not a bane but a blessing, for it improves the potential efficacy of macroeconomic policy. The modern Keynesian must argue that the performance of the economy has been demonstrably improved since the political adoption of the New Economics. Because the effective decision makers have been schooled in the Keynesian principles, the economy should function better, it should be kept within stable bounds, bounds that might be exceeded in the absence of such understanding. Even so late as 1970, Kenneth E. Boulding, himself no doctrinaire Keynesian, declared:

We cannot, of course, deny that the Keynesian conversion has had substantial effects upon our economic order. We do suggest, however, that these effects may not have been wholly constructive. Keynesianism is not the boon its apologists claim, and, unfortunately, it can scarcely be described as nothing more than a minor nuisance. Sober assessment suggests that, politically, Keynesianism may represent a substantial disease, one that can, over the long run, prove fatal for a functioning democracy. Our purpose in this chapter is to assess the damages, to examine in some detail the costs that Keynesianism, in a politically realistic setting, has imposed and seems likely to impose should it remain dominant in future years.

The Summary Record

Budget deficits, inflation, and an accelerating growth in the relative size of government—these have become characteristic features of the American political economy in the post-Keynesian era. The facts, some of which we cite below, are available for all to see. Disagreement may arise, not over the record itself, but over the relationship between the record and the influence of Keynesian ideas on political decisions. Once again we should emphasize that we do not attribute everything to the Keynesian revolution; and surely there are non-Keynesian forces behind both the persistent inflationary pressures of the postwar era and the accelerating size of the public sector. Our claim is the more modest one that at least some of the record we observe can be “explained” by the impact of the Keynesian influence.

During the 1961-1976 period, there was but one year of federal budget surplus lost among fifteen years of deficit, with a cumulative deficit that exceeded $230 billion and with a return to budget balance looming nowhere on the horizon. Public spending—at all governmental levels, federal, state, and local—in the United States amounted to 32.8 percent of national income in 1960; this proportion had increased to 43.4 percent by 1975.2 Moreover, since the 1964 tax reduction, increases in governmental spending have absorbed nearly 50 percent of increases in national income. And during this period of supposedly enlightened economic management, consumer prices increased by almost 90 percent.

This Keynesian period contrasts sharply with the transitional years 1947-1960. During this latter period, there were seven years of deficit and seven years of surplus. Deficits totaled some $31 billion, but these were practically matched by the surpluses that totaled $30 billion. This overall budget balance becomes even more striking when it is recalled that the period included the Korean War. Consumer prices increased by 32 percent, an inflationary tendency not found in most previous peacetime periods, but still a low rate when compared with experience since the full-fledged acceptance of Keynesianism. And even this 32-percent figure exaggerates the nature of the inflationary pressures during this transition period, for fully one-half of the total rise in prices occurred during just two years, 1948 and 1951. In other words, the normal rate of price rise during this period was about 1 percent annually.3

Budget Deficits, Monetary Institutions, and Inflation

The budget deficits that emerged from the Keynesian revision of the fiscal constitution injected an inflationary bias into the economic order. Empirically, the deficit-inflation nexus is strong and is widely acknowledged in popular discussion. Yet there are economists who would deny that deficits are inflationary. It is important that we make clear our position on this issue.

Monetarists, or at least most of them, would deny that deficit spending in itself is inflationary. They concentrate their fire, and they suggest that inflation results and can result only from an increase in the supply of money relative to the supply of goods. It is increases in the supply of money, not budget deficits, that cause or bring about inflation. We do not deny this monetarist logic. We do suggest, however, that it is reasonable to describe inflation as one consequence of budget deficits, and hence, indirectly, as a consequence of the Keynesian conversion.4

In the customary monetarist framework, the supply of money is treated as an exogenous variable, one determined by the monetary authorities. That is to say, the supply of money is viewed as being inelastic with respect to budget deficits. We do not deny that monetary institutions could be created in which the supply of money was indeed deficit invariant. We do deny, however, that existing monetary institutions are unresponsive to deficits. Simply because one might imagine a setting in which the supply of money is invariant to budget deficits or surpluses does not mean that actual institutions operate in this manner.

As we explore more fully in Chapter 8, existing political and monetary institutions operate to make the supply of money increase in response to budget imbalance. Within our prevailing institutional setting, budget deficits will tend to bring about monetary expansion. Therefore, it is appropriate to claim that budget deficits are inflationary, for such a claim is in fact simply a prediction about the response of our monetary institutions. While it seems entirely reasonable to link inflation more or less directly to budget deficits, this linkage need not imply a rejection of the insights of monetarism in favor of those of fiscalism. On the contrary, it affirms them, but goes further in that it makes a prediction as to the response of contemporary monetary institutions.5

Inflation: Anticipated and Unanticipated

The economic literature on inflation makes much of the distinction between anticipated inflation and unanticipated inflation. This distinction, which is as seductive in its appearance as it is misleading in its message, has had much to do with creating the belief that inflation gives little cause for alarm, a belief that is erroneous in its cognitive foundations.

An unanticipated inflation catches people by surprise, whereas an anticipated inflation catches no one off guard. In the former case, the supply of money expands unexpectedly, driving prices upward. Since people do not know in advance that inflation is imminent and to what extent, they cannot account for it in their long-term contractual arrangements. If inflation is fully anticipated, however, people know in advance that the supply of money will be expanding and that the price level will be rising at a predictable rate. This knowledge enables them to account for the future rise in prices in undertaking their various activities. If price stability should be expected, a person might lend $100 today in exchange for $110 in one year, reflecting a 10-percent annual rate of return on the investment. But suppose that such a contract is made, and the lender finds that the price level rises by 10 percent; the $110 he receives at the end of the year will enable him to buy only what he could have purchased with the initial $100 one year earlier. The unanticipated inflation would have, in this case, reduced his real rate of return to zero. If, however, the potential lender should have anticipated that prices would rise by 10 percent annually, he would have lent only in exchange for the promise of a return of $121 after one year. Only under such an agreement would he expect to get back the initial purchasing power plus a 10-percent return on the investment. As this simple example shows, unanticipated inflation transfers wealth from people who are net monetary creditors to people who are net monetary debtors. With a fully anticipated inflation, by contrast, these transfers could not take place.6

A fully anticipated inflation would seem to create some minor irritations—frequent changes in vending machines and more resort to long division—but little else. The idealized analytical construction for anticipated inflation allows everyone to know with certainty that prices will rise at some specified annual rate. From this, it follows that the nominal terms of contracts will be adjusted to incorporate the predicted reduction in the real value of the unit of account in terms of which payment is specified. This type of inflationary regime is one of perfect predictability. All persons come to hold the same view as to the future course of prices. There is no uncertainty as to the real value of the unit of account five, ten, or twenty years hence. Economic life is essentially no different from what it would be if the price level were stable.

While the construction of a perfectly anticipated inflation is not descriptive in reality, it does isolate elements that help in explaining behavior. Individuals do learn, and they will try to alter the nominal terms of long-period contracts as they come to feel differently about future inflationary prospects. Continued experience with unanticipated inflation surely leads to some anticipation of inflation. But this is not at all the same thing as the anticipation of that rate of inflation which will, in fact, take place. To an important extent, inflation is always, and must be, unanticipated. We do not possess the automatic stability properties of a barter economy, of which the construct of a fully anticipated inflation is one particular form, but possess instead the uncertainties inherent in a truly monetary economy, although alternative monetary institutions may mollify or intensify these uncertainties. Unlike a stylized anticipated inflation, inflation in real life must increase the uncertainty that people hold about the future.

Why Worry about Inflation?

Commonplace in much economic literature is the notion that the dangers of inflation perceived by the general public are grossly exaggerated. Few economists would follow Cagan in describing inflation as a monster, a hydra-headed one at that.7 Many economists have treated inflation as a comparatively trivial problem, something that is regarded as making rational calculation a bit more difficult, but not much else. The most substantial cost of inflation, according to this literature, is the excess burden that results from the inflation tax on money balances. Under inflation, people hold a smaller stock of real balances than they would hold under price stability or deflation. The loss of utility resulting from this smaller stock is the cost of inflation.8 The size of this loss will, under plausible circumstances, be quite small, much on the order of the small estimates of the welfare loss from monopoly.

This view seems to us to be in error. Inflation is likely to be far more costly than simple considerations of welfare loss suggest. Several noted economists have recognized the significance of inflation for the long-run character of our economic order. John Maynard Keynes, in whose name the present inflationary thrust is often legitimatized, observed that

Joseph A. Schumpeter remarked that

The standard economic analysis of inflation rests upon the assumption, as inadmissible as it is conventional, that inflation does not disturb the underlying institutional framework.11 Inflation, it is assumed, sets in motion no forces that operate to change the very character of the economic system. If the possibility of such institutional adaptation is precluded by the choice of analytical framework, it is no wonder that inflation is viewed as insubstantial. Once the ability of inflation to modify the institutional framework of the economic order is recognized, inflation does not appear to be quite so benign.

Inflation generates a shift in the relative rates of return that persons can secure from alternative types of activities. The distribution of effort among activities or opportunities will differ as between an inflationary and a noninflationary environment. As inflation sets in, the returns to directly productive activity fall relative to the returns from efforts devoted to securing private gains from successful adjustments to inflation per se.12 The returns to such activities as developing new drugs, for instance, will decline relative to the returns to such activities as forecasting future price trends and developing accounting techniques that serve to reduce tax liability. The inflation itself is responsible for making the latter sorts of activity profitable ones. In a noninflationary environment, however, such uses would be unnecessary, and the resources could take up alternative employments.

Over and above the direct distortions among earning opportunities that it generates, inflation alters the economy’s basic structure of production and disturbs the functioning of markets. Shifts in relative prices are generated which, in turn, alter patterns of resource use. Additionally, inflation injects uncertainty and misinformation into the functioning market structure. Intertemporal planning becomes more difficult, and accounting systems, whose informational value rests primarily on a regime of predictable value of the monetary unit, tend to mislead and to offer distorted signals. As a result, a variety of decisions are made which cannot be self-validating in the long run. Resources will be directed into areas where their continued employment cannot be maintained because the pattern of consumer demand will prove inconsistent with the anticipated pattern of production. Mistakes will come increasingly to plague the decisions of business firms and consumers.13

The most substantial dangers from inflation come into view, however, only when we consider the interplay between economic and political forces. As Keynes noted, individual citizens will at best understand the sources and consequences of inflation only imperfectly—first appearances will to some extent be confounded with ultimate reality. Because of this informational phenomenon, inflation will tend to generate misplaced blame for the economic disorder that results. This makes the inflationary consequences of the Keynesian conversion a serious matter, not a second-order by-product to be dismissed lightly.

For reasons we examine in Chapter 9, inflation, at least as it manifests itself under prevailing monetary institutions, obscures the information signals that citizens receive concerning the sources of decline in their real income. As it appears to them, their real income declines not because the government collects more real taxes but because private firms charge higher prices for their products. In consequence, the political pressures emerging from inflation would tend to take the form of suggested direct restraints on the prices charged by business firms, as opposed to widespread public clamor for restraints on “prices” exacted by government.14

To see beyond this institutional veil, and to discern that the higher prices of products sold by private business firms are really only a manifestation of higher taxes collected by government, would take considerable effort and skill. The generally undistinguished responses to tests of economic principles that are administered to past economics students cast doubt upon the likelihood that inflation will be viewed simply as an alternative form of taxation. That professional economists would differ sharply among themselves in this matter would seem to cinch the point.

These matters of necessarily incomplete knowledge are compounded by the differential incentives to invest in the attainment of different types of knowledge. Someone who more correctly anticipates the rate of inflation will generally fare better than someone who does not. Relatedly, inflation always presents opportunities for profit through actions designed to exploit the various discrepancies that inflation invariably produces. An individual’s own actions, in other words, will directly and immediately influence his net worth, so there is an incentive for him to invest in securing relevant knowledge. But there are no comparable incentives for an individual to invest resources in an attempt to understand the cause of inflation. To an individual, there is no economic value in knowing whether the source of his loss in real income is the higher prices charged by business firms or the “counterfeiting” of the government.15 The citizen cannot trade directly upon knowledge. Only as a majority of citizens come to see inflation in the same way, thereby creating the conditions favorable to a change in governmental policy, will the investment in knowledge come to possess any payoff.

Informationally, then, inflation is likely to be misperceived, at least under present monetary institutions. Individuals are unlikely to see clearly through the institutional veils. Additionally, however, the incentives that exist are such that it is worth very little to persons to discern the correct interpretation of inflation. Unlike the situation with respect to ordinary market choice, there is very little payoff to discerning the truth. These two features reinforce one another to produce a misplaced blame for inflation.

It is the business firms and labor unions that are viewed as being the source of the loss of real income. From this, it follows that controls placed on wages and prices become a popular political response to the frustrations of inflation, especially as the inflation continues and its rate accelerates. The costs of controls, both in terms of economic value and in terms of restrictions on personal liberty, should, therefore, be reckoned as major components of the inclusive costs of inflation.

Inflation, Budget Deficits, and Capital Investment

We do not need to become full-blown Hegelians to entertain the general notion of zeitgeist, a “spirit of the times.” Such a spirit seems at work in the 1960s and 1970s, and is evidenced by what appears as a generalized erosion in public and private manners, increasingly liberalized attitudes toward sexual activities, a declining vitality of the Puritan work ethic, deterioration in product quality, explosion of the welfare rolls, widespread corruption in both the private and the governmental sector, and, finally, observed increases in the alienation of voters from the political process. We do not, of course, attribute all or even the major share of these to the Keynesian conversion of the public and the politicians. But who can deny that inflation, itself one consequence of that conversion, plays some role in reinforcing several of the observed behavior patterns. Inflation destroys expectations and creates uncertainty; it increases the sense of felt injustice and causes alienation. It prompts behavioral responses that reflect a generalized shortening of time horizons. “Enjoy, enjoy”—the imperative of our time—becomes a rational response in a setting where tomorrow remains insecure and where the plans made yesterday seem to have been made in folly.16

As we have noted, inflation in itself introduces and/or reinforces an antibusiness or anticapitalist bias in public attitudes, a bias stemming from the misplaced blame for the observed erosion in the purchasing power of money and the accompanying fall in the value of accumulated monetary claims. This bias may, in its turn, be influential in providing support to political attempts at imposing direct controls, with all the costs that these embody, both in terms of measured economic efficiency and in terms of restrictions on personal liberty. Even if direct controls are not imposed, however, inflation may lend support for less direct measures that discriminate against the business sector, and notably against private investment. In a period of continuing and possibly accelerating inflation, tax changes are likely to be made that adjust, to some extent, the inflation-induced shifts in private, personal liabilities. But political support for comparable adjustments in business or corporate taxation—adjustment for nominal inventory profits, for shifts in values of depreciable assets, and so on—is not likely to emerge as a dominant force. Taxes on business are, therefore, quite likely to become more penalizing to private investment during periods of inflation.

Standard accounting conventions have developed largely in a noninflationary environment, and the information that such techniques convey regarding managerial decisions becomes less accurate when inflation erupts.17 Business profits become overstated, owing both to the presence of phantom inventory profits and to the underdepreciation of plant and equipment. In an inflationary setting, depreciation charges on old assets will be insufficient to allow for adequate replacement. An asset valued at $10 million might, after a decade of inflation, cost $20 million to replace. Since allowable depreciation charges would be limited to $10 million, only one-half of the asset could be replaced without dipping into new supplies of saving. Under FIFO accounting procedures, moreover, “profits” will also be attributed to the replacement of old inventory by new.18

The overstatement of business profits is as striking in its size as it is disturbing in its consequences. In nominal terms, post-tax earnings of nonfinancial corporations rose from $38 billion in 1965 to $65 billion in 1974. This 71-percent increase kept pace with inflation during this period, which might convey the impression that real earnings had at least remained constant. The elimination of underdepreciation and phantom inventory profits, however, yields post-tax earnings in 1974 of only $20 billion, nearly a 50-percent decline over this ten-year period. The payment of taxes on what are fictive profits brought about an increase in effective tax rates on corporations of more than 50 percent. A tax rate of 43 percent in 1965 became an effective rate of 69 percent in 1974.19

In addition to the consumption of capital that operates indirectly through the ability of inflation to impose taxes on fictive profits, budget deficits may directly retard capital formation as well. The deficit financing of public outlays may “crowd out” private investment, with the predicted result that the rate of capital formation in the economy is significantly reduced over time. The expansion in public borrowing to finance the budget deficit represents an increased demand for loanable funds. While a subsequent rise in interest rates may elicit some increase in the amount of total saving in the economy, the residual amount of saving available to meet the private-sector demands for loanable funds will fall. Utilization of savings by government to finance its deficit will crowd out utilization of savings for private investment.20

To illustrate, suppose that, under balanced-budget conditions, $90 billion would be saved, all of which would then be available to private borrowers, to investors. Now suppose that the government runs a $70 billion deficit. Let us say that the resulting rise in the rate of interest would be sufficient to increase private saving by $10 billion, raising total saving to $100 billion. Of this $100 billion, however, government would absorb $70 billion to finance its deficit. This would leave only $30 billion for private investors. The nonmonetized deficit would have reduced the rate of private capital formation by 67 percent below that rate which would have been forthcoming in the absence of the budget deficit. The deficit would, in this example, have crowded out $60 billion of private investment.

The $70 billion borrowed by government could, of course, also be used for capital investment, either directly on public investment projects or indirectly in the form of subsidies to the creation of private capital. To the extent that this happens, a crowding-out effect in the aggregate would be mitigated, although the public-private investment mix would be shifted, raising questions about the comparative productivity of public and private investment. In the modern political climate, however, the funds secured through public borrowing would probably be utilized largely for the financing of budgetary shortfalls, with the lion’s share of outlay being made on consumption, directly or indirectly. Transfer payments grew more rapidly than any other component of the federal budget after the early 1960s. The crowding out that would actually occur, then, would be one in which private capital investment was replaced by increased consumption, mostly through transfer payments: Ploughs, generating plants, and fertilizer would be sacrificed for TV dinners purchased by food stamps.

By diverting personal saving from investment to consumption, our capital stock is reduced. The economy will come to be confronted by a “capital shortage.” A fiscally induced stimulation of consumption spending would attract resources from higher-order activities to lower-order activities. The structure of production would be modified, and the economy’s capital stock might shrink. This process ultimately would reduce rather than increase the volume of consumption services that the economy could provide at a sustained rate. The maintenance of a higher level of consumption over a short period could be accomplished only at the expense of a depreciation of the nation’s capital stock. In this scenario, we should be gradually reducing the rate of increase in our capital stock. As a rich nation, we could perhaps sustain this process beyond the limited time horizons of most politicians, but an ultimate reckoning would have to take place.21

These issues of capital shortage, and the debate that has taken place over them, serve once again to illustrate the importance of developing an appropriate interpretation of the nature of the economic process. Those who dispute the claim that we are suffering from capital shortage, from a shrinkage of our capital stock, point to the existence of underutilized plant and equipment as evidence in support of their position. The cereal manufacturer who possesses excess capacity, it is suggested, can hardly be said to be suffering from a shortage of capital. What is wrong, rather, is a deficiency of consumption—a surplus of capital, in effect.

The real problem, however, may be a shortage of such complementary capital as wheat, fertilizer, tractors, machine tools, or ovens, all of which, and many more, must cooperate in the production of cereal. A modification of the structure of production may generate some underutilization of capital. And it seems possible that full utilization cannot be restored until the complementary capital is replenished. But such restoration requires additional saving. The further stimulation of consumption, however, would shrink the capital stock still further, and this shift of the structure of production might make matters even worse. The presence of underutilized capital may be an indication of a shortage of complementary capital, not a surplus of the specific capital itself.22

The Bloated Public Sector

Permanent budget deficits, inflation, and an expanding and disproportionately large public sector are all part of a package. They are all attributable, at least in part, to the interventionist bias created by Keynesian economics. Deficits and inflation are related to the growth of government in a reciprocal fashion. Deficits and inflation contribute to the growth of government, while the growth of government itself generates inflationary pressures.

Colin Clark once advanced the thesis that, once government’s share in national income exceeds 25 percent, strong inflationary pressures will emerge.23 Much of the ensuing critical discussion concentrated on Clark’s specific mention of 25 percent as the critical limit to the relative size of government. Widely proclaimed refutations of Clark’s thesis were reported by Keynesian interventionists as government’s share seemed to inch beyond 25 percent without the simultaneous occurrence of strong inflationary pressures. Lost amid these shouts was Clark’s general principle that there exists a positive relation between the relative size of government and the strength of inflationary pressures. This thesis of a positive relation between the size of government and the rate of inflation can be supported from two distinct and complementary perspectives, as we have already indicated.

Harry G. Johnson has supported Clark’s thesis by arguing that deficit spending and the resulting inflation have made possible the increasing size of the public sector.24 We shall examine the general reasons for this in Chapter 7. Johnson suggests that taxpayers would not support the present apparatus of the welfare state if they were taxed directly for all of its activities. Deficit spending and inflationary finance tend to alleviate the intensity of taxpayer resistance, ensuring a relative expansion in the size of public budgets. Inflationary finance becomes a means of securing public acquiescence in larger public budgets.

This knowledge-reducing property of inflation is reinforced in a revenue structure that rests on a progressive tax system. In a narrow sense, inflation is a tax on money balances. In addition, however, inflation brings about increases in the real rates of other taxes. Under a progressive income tax, for instance, tax liability will rise more rapidly than income. For the United States personal income tax, considered in its entirety, estimates prepared from data and rate schedules in the early 1970s suggested that a 10-percent rate of general inflation would generate roughly a 15-percent increase in federal tax collections.

While inflationary finance may stimulate public spending, it is also possible for public spending to create inflation. To the extent that resources utilized by government are less productive than resources utilized by the private sector, a shift toward a larger public sector reduces the overall productivity in the economy. In this sense, an increasing relative size of the public sector, measured by an increasing share of national income represented by public spending, becomes equivalent to a reduction in the overall productivity of resources in the economy.25 Unless the rate of growth in the supply of money is correspondingly adjusted downward, the public-sector growth must itself be inflationary. Therefore, the growth of public spending may induce inflation at the same time that the inflationary financing of governmental activities lowers taxpayer resistance to further increases in public spending.26

An increasingly disproportionate public sector, quite apart from its inflationary consequences, carries with it the familiar, but always important, implications for individual liberty. The governmental bureaucracy, at least indirectly supported by the biased, if well-intentioned, notions of Keynesian origin, comes to have a momentum and a power of its own. Keynesian norms may suggest, rightly or wrongly, an expansion in aggregate public spending. But aggregates are made up of component parts; an expansion in overall budget size is reflected in increases in particular spending programs, each one of which will quickly come to develop its own beneficiary constituency, within both the bureaucracy itself and the clientele groups being served. To justify its continued existence, the particular bureaucracy of each spending program must increase the apparent “needs” for the services it supplies. Too often these activities by bureaucrats take the form of increasingly costly intrusions into the lives of ordinary citizens, and especially in their capacities as business decision makers.

International Consequences

Our purpose in this chapter is to offer an assessment of the damages to our economic-political order that may have been produced by the Keynesian conversion. Such an assessment should include some reference to international consequences, although these are, to an extent, mitigated by the simultaneous influences at work in the political structures of almost all of the nations of the West.

Under the traditional gold standard, approximately realized before World War I, a national economy could not operate independently so as to control its domestic price level. If a nation tried to finance budget deficits through inflationary credit expansion, the international demand for its output would fall. The ensuing gold drainage would reduce the nation’s money stock, thereby depressing the nation’s price level. Public debt could not be effectively monetized under the gold standard. During the period when the United States was on a gold standard, there were annual fluctuations in prices, but changes in one direction tended to be followed by changes in the opposite direction, yielding long-run price stability in the process.27

Although much less direct in its impact, the same basic relationship was at work under the less restrictive gold-reserve standard of the years between World War II and the 1970s. Public debt could be monetized in the short run, but the resulting inflation would depress the demand for exports. Balance-of-payments deficits would arise. In the short run, such deficits need have no impact upon the domestic money stock. Eventually, however, deficits would cumulate to the point at which contractions in the domestic money supply would become necessary.28

The international monetary system changed dramatically in the 1970s when a regime of floating exchange rates replaced that of fixed rates. This change was hailed, by Keynesian and non-Keynesian economists alike, as a desirable step which would finally allow a single nation to act independently in macroeconomic policy. Under free exchange rates, a nation can control its domestic money supply unless the government tries to control fluctuations in its own exchange rate, in which case it necessarily relinquishes some of this control.29 Inflationary policies no longer call forth, either immediately or imminently, a corrective reduction in the domestic money supply. The exchange rate now adjusts automatically to maintain equilibrium in the balance of payments. Debt can be monetized without the necessity ultimately of reversing the process. This shift in the form of international monetary arrangements, while strengthening the ability of a nation to control its monetary policies,30 has severed one of the constraints on internal monetary expansion.31 It does not seem to be entirely a coincidence that deficit spending and inflation have intensified since the shift to free exchange rates. It is possible, of course, that continually falling values of a nation’s currency will operate as an effective restraint on domestic monetary expansion. Only time will tell.

Tragedy, Not Triumph

A regime of permanent budget deficits, inflation, and an increasing public-sector share of national income—these seem to us to be the consequences of the application of Keynesian precepts in American democracy. Increasingly, these consequences are coming to be recognized as signals of disease rather than of the robust health that Keynesianism seemed to offer. Graham Hutton has suggested that

The juxtaposition of Keynesian policy prescriptions and political democracy creates an unstable mixture. The economic order seems to become more, rather than less, fragile—coming to resemble a house of cards. A nation’s response to such situations is always problematical. It is always easy to assess history from the perspective of hindsight. But the wisdom of hindsight would rarely permit nations and civilizations to deteriorate. Without the benefit of hindsight, we cannot foretell the future. We can, however, try to diagnose our present difficulties, point out possible paths of escape, and explain the dangers that lurk before us.

The ultimate danger in such situations as that which we are coming to confront, one that has been confirmed historically all too frequently, is that we will come to see our salvation as residing in the use of power. Power is always sought to promote the good, of course, never the bad. We are being bombarded with increasing intensity with calls for incomes policies, price and wage controls, national planning, and the like. Each of these aims to achieve its objectives by the imposition of new restrictions on the freedom of individuals. Will our own version of “national socialism” be the ultimate damage wrought by the Keynesian conversion?

[2. ]For a formulation of this choice alternative in a British context, see Robin Pringle, “Britain Hesitates before an Ineluctable Choice,” Banker 125 (May 1975): 493-496.

[3. ]John Maynard Keynes, The General Theory of Employment, Interest, and Money (New York: Harcourt, Brace, 1936).

[4. ]See Richard M. Weaver, Ideas Have Consequences (Chicago: University of Chicago Press, 1948).

[5. ]See Axel Leijonhufvud, On Keynesian Economics and the Economics of Keynes (London: Oxford University Press, 1968); and G. L. S. Shackle, “Keynes and Today’s Establishment in Economic Theory: A View,” Journal of Economic Literature 11 (June 1973): 516-519. A somewhat different perspective is presented in Leland B. Yeager, “The Keynesian Diversion,” Western Economic Journal 11 (June 1973): 150-163.

[6. ]Hugh Dalton, Principles of Public Finance, 4th ed. (London: Routledge and Kegan Paul, 1954), p. 221.

[7. ]For a thorough examination of these classical principles and how they functioned as an unwritten constitutional constraint during the pre-Keynesian era, see William Breit, “Starving the Leviathan: Balanced Budget Prescriptions before Keynes” (Paper presented at the Conference on Federal Fiscal Responsibility, March 1976), to be published in a conference volume.

[8. ]C. F. Bastable, Public Finance, 3rd ed. (London: Macmillan, 1903), p. 611.

[9. ]Ibid.

[10. ]For a survey of the balanced-budget principle, see Jesse Burkhead, “The Balanced Budget,” Quarterly Journal of Economics 68 (May 1954): 191-216.

[11. ]Knut Wicksell, Finanztheoretische Untersuchungen (Jena: Gustav Fischer, 1896). Translated as “A New Principle of Just Taxation” in R. A. Musgrave and A. T. Peacock, eds., Classics in the Theory of Public Finance (London: Macmillan, 1958), pp. 72-118.

[12. ]Numerical details by year can be found in the “Statistical Appendix” to the Annual Report of the Secretary of the Treasury on the State of the Finances (Washington: U.S. Government Printing Office, 1976).

[13. ]For a survey of our budgetary history through 1958, see Lewis H. Kimmel, Federal Budget and Fiscal Policy, 1789-1958 (Washington: Brookings Institution, 1959).

[14. ]John W. Kearny, Sketch of American Finances, 1789-1835 (1887; reprint ed., New York: Greenwood Press, 1968), pp. 43-44.

[15. ]Lance E. Davis, Jonathan R. T. Hughes, and Duncan M. McDougall, American Economic History, rev. ed. (Homewood, Ill.: Richard D. Irwin, 1965), p. 420. See also Reginald C. McGrane, The Panic of 1837 (New York: Russell and Russell, 1965).

[16. ]See James M. Buchanan, Public Principles of Public Debt (Homewood, Ill.: Richard D. Irwin, 1958); and James M. Buchanan and Richard E. Wagner, Public Debt in a Democratic Society (Washington: American Enterprise Institute, 1967).

[17. ]For an analysis of the possibilities for debt abuse within a political democracy, see James M. Buchanan, Public Finance in Democratic Process (Chapel Hill: University of North Carolina Press, 1967), pp. 256-266; and Richard E. Wagner, “Optimality in Local Debt Limitation,” National Tax Journal 23 (September 1970): 297-305.

[18. ]For a summary of the literature, see Buchanan, Public Principles of Public Debt, pp. 16-20.

[19. ]For examinations of this categorical shift in the scope of fiscal policy during the 1930s, see Ursula K. Hicks, British Public Finances: Their Structure and Development, 1880-1952 (London: Oxford University Press, 1954); and Lawrence C. Pierce, The Politics of Fiscal Policy Formation (Pacific Palisades, Calif.: Goodyear, 1971). With reference to Great Britain, Hicks noted:

Fiscal policy in the sense of a purposeful marshalling of the armoury of public finance in order to influence the level of incomes cannot be said to have been recognized as an art before the middle or late 1930s. Up to that time considerations of public finance ran in terms only of the effects of individual taxes and outlays, on particular aspects of economic life, without regard to the total effect. [p. 140] With reference to the United States, Pierce observed: Until the late 1930s, the role of the government budget was limited to providing public services, raising taxes to pay for them, and, less often, influencing the distribution of income among regions and individuals. It is only since the late 1930s that economists and political leaders have come to believe that they can also use the federal budget to help avoid most of the economic ills associated with high levels of unemployment, price inflation, and economic stagnation. [p. 1]

[20. ]See Breit.

[21. ]Harry G. Johnson, “Living with Inflation,” Banker 125 (August 1975): 863-864.

[22. ]John Maynard Keynes, The General Theory of Employment, Interest, and Money (New York: Harcourt, Brace, 1936), p. vi.

[23. ]In various works, Professor Axel Leijonhufvud of UCLA has examined the impact of Keynesian ideas on economists in some detail. We are indebted to his insights here, which supplement our much less comprehensive examination of the intellectual history.

Robert Skidelsky, “Keynes and the Revolt against the Victorians,” Spectator, 1 May 1976, pp. 14-16, contrasts the Keynesian and the Victorian world views. While the Victorian emphasis was on a goal-directed life, the Keynesian emphasis stressed living in the present. Keynes’ assault on saving and thrift is one consequence of this shift in Weltanschauung.

[24. ]For a recent, careful restatement of this position, see W. H. Hutt, A Rehabilitation of Say’s Law (Athens: Ohio University Press, 1974).

[25. ]See Axel Leijonhufvud, “Effective Demand Failures,” Swedish Journal of Economics 75 (March 1973): 27-48, for a description of these two alternative paradigms and a discussion of how they influence the economist’s analytical perspective.

[26. ]One important element in the articulation of this Keynesian position was the presence of persistently high unemployment throughout the 1930s. Such a record seemed to vitiate the classical belief in a self-adjusting economy. This entire record, it now turns out, is false, for substantial numbers (2-3.5 million) of governmental employees were counted as being unemployed. When a correct accounting is made for such persons, the pattern changes starkly to one of a rapid and continuous reduction in unemployment from 1932 until the recession of 1937-1938, which itself resulted from the Federal Reserve’s doubling of reserve requirements between August 1936 and May 1937. This piece of detective work is due to Michael R. Darby, “Three-and-a-Half Million U.S. Employees Have Been Mislaid: Or, an Explanation of Unemployment, 1934-1941,” Journal of Political Economy 84 (February 1976): 1-16.

[27. ]Stephen K. Bailey, Congress Makes a Law (New York: Columbia University Press, 1950), is the standard legislative history of the enactment of the Employment Act of 1946.

[28. ]Such forecasts include S. Morris Livingston, “Forecasting Postwar Demand,” Econometrica 13 (January 1945): 15-24; Richard A. Musgrave, “Alternative Budget Policies for Full Employment,” American Economic Review 35 (June 1945): 387-400; National Planning Association, National Budgets for Full Employment (Washington: National Planning Association, 1945); and Arthur Smithies, “Forecasting Postwar Demand,” Econometrica 13 (January 1945): 1-14. Such postwar forecasts were criticized in Albert G. Hart, ” ’Model-Building’ and Fiscal Policy,” American Economic Review 35 (September 1945): 531-558.

[29. ]The clearest exposition of a position that was widely shared is found in Abba P. Lerner, The Economics of Control (New York: Macmillan, 1944), pp. 285-322.

[30. ]For completeness, we should note here that the Keynesian theory of policy, as developed in the 1940s and 1950s, included the balanced-budget multiplier. Aggregate spending in the economy might be increased by an increase in government outlays, even if budget balance is strictly maintained, because of the fact that the increased tax revenues would be drawn, in part, from private savings. The standard exposition of this proposition is William J. Baumol and Maurice H. Peston, “More on the Multiplier Effects of a Balanced Budget,” American Economic Review 45 (March 1955): 140-148.

[31. ]Richard A. Musgrave, in reviewing Alvin Hansen’s role in the selling of Keynesianism in the 1940s, acknowledged the pivotal position occupied by the classical theory of public debt when he wrote: “The battle for full employment had to be continued, and the counteroffensive, built around the alleged dangers of a rising public debt, had to be met.” See Musgrave’s contribution to the symposium on Alvin H. Hansen: “Caring for the Real Problems,” Quarterly Journal of Economics 90 (February 1976): 5.

[32. ]The “new orthodoxy” was first challenged explicitly by James M. Buchanan in 1958. In his book, Public Principles of Public Debt (Homewood, Ill.: Richard D. Irwin, 1958), Buchanan specifically refuted the three main elements of the Keynesian theory, and he argued that, in its essentials, the pre-Keynesian classical theory of public debt was correct. Buchanan’s thesis was widely challenged and a lively debate among economists took place in the early 1960s. Many of the contributions are included in James M. Ferguson, ed., Public Debt and Future Generations (Chapel Hill: University of North Carolina Press, 1964). For a summary treatment, see James M. Buchanan and Richard E. Wagner, Public Debt in a Democratic Society (Washington: American Enterprise Institute, 1967). Buchanan sought to place elements of the debt-burden discussion in a broader framework of economic theory in his book, Cost and Choice (Chicago: Markham, 1968). For a later paper that places the debt-burden discussion in a cost-theory perspective, see E. G. West, “Public Debt Burden and Cost Theory,” Economic Inquiry 13 (June 1975): 179-190.

[33. ]For a general discussion of fiscal policy in the 1930s, with an emphasis on the effects of the tax increase of 1932, see E. C. Brown, “Fiscal Policy in the Thirties: A Reappraisal,” American Economic Review 46 (December 1956): 857-879.

[34. ]Cited in Fredrick C. Mosher and Orville F. Poland, The Costs of American Government (New York: Dodd, Mead, 1964), p. 73.

[35. ]For a discussion of the attitudes of American economists in the early 1930s, particularly those associated with the University of Chicago, see J. Ronnie Davis, The New Economics and the Old Economists (Ames: Iowa State University Press, 1971).

[36. ]Gottfried Haberler observed, with reference to Keynes, that “no ’classical’ economist had propagated the case for easy money and deficit spending with the same energy, persuasiveness, and enthusiasm as Keynes, and with the seemingly general theoretical underpinning, and that many orthodox economists rejected these policies outright.” See Haberler’s contribution to the symposium on Alvin H. Hansen: “Some Reminiscences,” Quarterly Journal of Economics 90 (February 1976): 11.

[37. ]For an early analysis, see Richard A. Musgrave and Merton H. Miller, “Built-in Flexibility,” American Economic Review 38 (March 1948): 122-128.

[38. ]Committee for Economic Development, Taxes and the Budget: A Program for Prosperity in a Free Economy (New York: Committee for Economic Development, 1947). This proposal, along with the intellectual antecedents, is discussed in Walter W. Heller, “CED’s Stabilizing Budget Policy after Ten Years,” American Economic Review 47 (September 1957): 634-651.

[39. ]Milton Friedman, “A Monetary and Fiscal Framework for Economic Stability,” American Economic Review 48 (June 1948): 245-264.

[40. ]For a summary discussion, see Heller. It should be noted that Heller distinguished between a “tranquilizing budget policy” and a “stabilizing budget policy,” and threw his support to the latter.

[41. ]In his book, Taxation: The People’s Business (New York: Macmillan, 1924), Mellon not only noted that “the government is just a business, and can and should be run on business principles ...” (p. 17), but also remarked approvingly that “since the war two guiding principles have dominated the financial policy of the Government. One is the balancing of the budget, and the other is the payment of the public debt. Both are in line with the fundamental policy of the Government since its beginning” (p. 25).

[42. ]The interest in revenue sharing that surfaced in the early 1960s was, at that time, sparked in part by a desire to offset fiscal drag. Rather than cutting taxes to avoid fiscal drag, it was proposed that revenues be transferred to state and local governments. For references to what, at the time, was referred to as the “Heller-Pechman proposal,” see Walter W. Heller, “Strengthening the Fiscal Base of Our Federalism,” in New Dimensions of Political Economy (Cambridge: Harvard University Press, 1966), pp. 117-172; and Joseph A. Pechman, “Financing State and Local Government,” in Proceedings of a Symposium on Federal Taxation (New York: American Bankers Association, 1965), pp. 71-85.

[43. ]Herbert Stein, The Fiscal Revolution in America (Chicago: University of Chicago Press, 1969), p. 375. We should acknowledge our indebtedness to Stein’s careful and complete history of fiscal policy over the whole post-Keynesian period before the late 1960s. Our interpretation differs from that advanced by Stein largely in the fact that we have had an additional decade in which to evaluate the record, the events of which have done much to reduce the faith of economists, regardless of their ideological persuasion, in the basic Keynesian precepts.

[44. ]Abba P. Lerner, “Functional Finance and the Federal Debt,” Social Research 10 (February 1943): 38-51; and idem, The Economics of Control (New York: Macmillan, 1944), pp. 285-322.

[45. ]Henry C. Wallich, an economist as well as a member of the Federal Reserve Board, has fully recognized this effect of monetarist prescriptions. He stated: “Increasingly, monetarist prescriptions play a role in political discussions.... The elected representatives of the people have discerned the attraction of monetarist doctrine because it plays down the effects of fiscal policy. Deficits can do no major damage so long as the central bank does its job right.” Wallich then goes on to suggest that the monetary authorities, “for the same reason, have tended to preserve a degree of faith in Keynesianism.” Citations are from Henry C. Wallich, “From Multiplier to Quantity Theory,” preliminary mimeographed paper, 23 May 1975.

[46. ]Kenneth E. Boulding, Economics as a Science (New York: McGraw-Hill, 1970), p. 151.

[47. ]We cannot attribute the increase in state and local government spending over this period directly to the abandonment of the balanced-budget norm, since these units lack powers of money creation and, hence, are effectively constrained by something akin to the old-fashioned fiscal principles. Even here, however, it could be argued that the release of spending proclivities at the federal level may have influenced the whole political attitude toward public spending. Furthermore, much of the observed increase in state-local spending is attributable to federal inducements via matching grants and to federal mandates, legislative, administrative, and judicial.

Along these lines, one might point out that state and local expenditures have actually been increasing relative to federal expenditures since 1960. In 1960, state and local expenditures were 53.5 percent of federal expenditures, but by 1975 this percentage had risen to 62.3 percent. For these data, see the Economic Report of the President (Washington: U.S. Government Printing Office, 1976), pp. 249-251. The growth of government, it would appear, has been especially rapid among the lower levels of government.

Such data, however, are exceedingly misleading, for they attribute to state and local governments those expenditures that were financed by grants from the federal government. Such grants totaled $6.9 billion in 1960, and had swollen to $48.3 billion in 1975. Removing such grants from the figures for state and local expenditures changes the interpretation considerably. State and local expenditures are now seen to be 46.1 percent of federal expenditure in 1960, increasing only to 48.8 percent in 1975. Moreover, federal grants customarily are offered on a matching basis, which generally stimulates additional state and local expenditure. This portion of expenditure that is a result of the stimulating input of federal grants should also properly be attributed to the federal government. If it is assumed that each dollar of federal grant stimulates state and local spending by 20¢, state and local spending as a percentage of federal spending was practically stable over the 1960-1975 period, rising only from 43.9 percent to 44.8 percent. The figure of a 20-percent rate of stimulation is consistent with that found in Edward M. Gramlich, “Alternative Federal Policies for Stimulating State and Local Expenditures: A Comparison of Their Effects,” National Tax Journal 21 (June 1968): 119-129.

[48. ]That the Truman-Eisenhower years were indeed transitional becomes apparent once it is recalled that such a period previously would have been accompanied by a cumulative budget surplus, with the surplus used to retire public debt. The decade following World War I, 1920-1929, for instance, saw ten consecutive surpluses, with the total surplus exceeding $7.6 billion. This surplus made possible a 30-percent reduction in the national debt. Prices were generally stable, but with a slight downward drift. Prices did fall sharply during the contraction of 1920-1921, but were stable thereafter. Wholesale prices fell by nearly 40 percent between 1920 and 1921, while consumer prices fell by a little over 10 percent. From then on, approximate stability reigned: Wholesale prices fell by slightly less than 3 percent during the remainder of the decade, while consumer prices declined by slightly over 4 percent. Moreover, the share of government in the economy actually declined, falling from 14.7 percent in 1922 (figures for 1920 are not available) to 11.9 percent in 1929.

[49. ]David Laidler and Michael Parkin advance a similar position when they observe: “It is central to modern work on the role of the government budget constraint in the money supply process that an expansionary fiscal policy met by borrowing from the central bank will result in sustained monetary expansion.... In the light of this work the question as to whether monetary expansion is a unique ’cause’ of inflation seems to us to be one mainly of semantics” (“Inflation: A Survey,” Economic Journal 85 [December 1975]: 796).

[50. ]The massive cumulative deficit since 1960 has been accompanied by a substantial shortening of the maturity structure of marketable issues of national debt. In 1960, 39.8 percent of such debt was scheduled to mature within one year. By 1975, this figure had expanded to 55 percent. While 12.8 percent of such debt had a maturity date of ten years or longer in 1960, this figure had shrunk to 6.8 percent in 1975. This shortening of the maturity structure reinforced the outright monetization of budget deficits that occurred during this period (Source: Federal Reserve Bulletin ).

[51. ]See the analysis in Reuben A. Kessel and Armen A. Alchian, “The Effects of Inflation,” Journal of Political Economy 70 (December 1962): 521-537.

[52. ]See Phillip Cagan, The Hydra-Headed Monster: The Problem of Inflation in the United States (Washington: American Enterprise Institute, 1974).

[53. ]See, for instance, Martin J. Bailey, “The Welfare Cost of Inflationary Finance,” Journal of Political Economy 64 (April 1956): 93-110; and Alvin L. Marty, “Growth and the Welfare Cost of Inflationary Finance,” Journal of Political Economy 75 (February 1967): 71-76.

[54. ]John Maynard Keynes, The Economic Consequences of the Peace (New York: Harcourt, Brace, 1920), p. 236.

[55. ]Joseph A. Schumpeter, Capitalism, Socialism, and Democracy, 3rd ed. (New York: Harper and Row, 1950), p. 424.

[56. ]On this point, see Axel Leijonhufvud’s careful, contrary-to-conventional-wisdom analysis of inflation from this institutionalist perspective, “Costs and Consequences of Inflation,” manuscript, May 1975.

[57. ]See ibid.

[58. ]For an elaboration of these and related issues, see David Meiselman, “More Inflation, More Unemployment,” Tax Review 37 (January 1976): 1-4.

[59. ]This point suggests the hypothesis that democracies will impose controls on private producers more rapidly and profusely under inflationary conditions than under conditions of price-level stability. Casual empiricism surely supports this hypothesis, but more sophisticated testing would be helpful.

[60. ]An anticipation of future rates of inflation can be formed without a correct understanding as to why the inflation is taking place. A long-term historical experience in which prices rise by roughly 10 percent annually will come to inform the nominal terms of trade, regardless of what particular explanation individuals may happen to attribute to the observed inflationary pressures.

[61. ]Wilhelm Röpke recognized this consequence of inflation when he remarked: “Inflation, and the spirit which nourishes it and accepts it, is merely the monetary aspect of the general decay of law and of respect for law. It requires no special astuteness to realize that the vanishing respect for property is very intimately related to the numbing of respect for the integrity of money and its value. In fact, laxity about property and laxity about money are very closely bound up together; in both cases what is firm, durable, earned, secured and designed for continuity gives place to what is fragile, fugitive, fleeting, unsure and ephemeral. And that is not the kind of foundation on which the free society can long remain standing” (Welfare, Freedom and Inflation [Tuscaloosa: University of Alabama Press, 1964], p. 70).

[62. ]For a general discussion of this point, see William H. Peterson, “The Impact of Inflation on Management Decisions,” Freeman 25 (July 1975): 399-411.

[63. ]The switch from FIFO to LIFO methods of inventory valuation, which has been taking place in recent years, is one particular attempt to deal with the reduced accuracy of accounting information in an inflationary environment. For a careful examination of this problem, see George Terborgh, Inflation and Profits (New York: Machinery and Allied Products Institute, 1974).

[64. ]These figures are reported in Reginald H. Jones, “Tax Changes Can Help Close Capital Gap,” Tax Review 36 (July 1975): 29-32. See also Norman B. Ture, “Capital Needs, Profits, and Inflation,” Tax Review 36 (January 1975): 1-4; and C. Lowell Harriss, “Tax Fundamentals for Economic Progress,” Tax Review 36 (April 1975): 13-16.

[65. ]This proposition about “crowding out” is surveyed in Keith M. Carlson and Roger W. Spencer, “Crowding Out and Its Critics,” Federal Reserve Bank of St. Louis, Review 57 (December 1975): 2-17.

[66. ]Some comparative figures released by the U.S. Treasury Department are instructive in this respect. During the 1963-1970 period covered by the study, the share of national output that was devoted to additions to the capital stock was considerably less in the United States than in several of the relatively progressive industrialized nations. Our rate of capital investment was 13.6 percent. This rate was 17.4 percent in Canada, 18.2 percent in France, 20 percent in West Germany, and 29 percent in Japan.

[67. ]In this and the immediately preceding paragraphs, we have introduced, all too briefly, elements of the so-called “Austrian theory” of the cycle. We feel that the emphasis on the structural maladjustments that can result from monetary disturbances is an important insight, especially in the political context we have been describing. At the same time, however, we retain essentially a monetarist interpretation of such a phenomenon as the Great Depression, as well as a belief in the usefulness of aggregate demand stimulation under such circumstances. The forces of secondary deflation that operate under rigid wages and prices seem to us to overwhelm those real maladjustments that are those of the primary depression itself. Our position on the relation between the Austrian and monetarist interpretations is quite similar to that found in Gottfried Haberler, The World Economy, Money, and the Great Depression, 1919-1939 (Washington: American Enterprise Institute, 1976), pp. 21-44.

[68. ]Colin Clark, “Public Finance and Changes in the Value of Money,” Economic Journal 55 (December 1945): 371-389.

[69. ]Harry G. Johnson, “Living with Inflation,” Banker 125 (August 1975): 863-864.

[70. ]See Graham Hutton, “Taxation and Inflation,” Banker 125 (December 1975): 1493-1499.

[71. ]In recent years, an expanding body of thought, both conceptual and empirical, has been developing in support of the proposition that, at the prevailing margins of choice, resources employed in the public sector are less efficient than resources employed in the private sector. For a sample of this literature, see William A. Niskanen, Bureaucracy and Representative Government (Chicago: Aldine, 1971); Thomas E. Borcherding, ed., Budgets and Bureaucrats (Durham, N.C.: Duke University Press, 1976); Roger Ahlbrandt, “Efficiency in the Provision of Fire Services,” Public Choice 16 (Fall 1973): 1-16; David G. Davies, “The Efficiency of Private versus Public Firms: The Case of Australia’s Trio Airlines,” Journal of Law and Economics 14 (April 1971): 144-165; William A. Niskanen, “Bureaucracy and the Interests of Bureaucrats,” Journal of Law and Economics 18 (December 1975): 617-643; and Richard E. Wagner and Warren E. Weber, “Competition, Monopoly, and the Organization of Government in Metropolitan Areas,” Journal of Law and Economics 18 (December 1975): 661-684.

[72. ]For a description and analysis of our movement from a gold standard to a fiduciary standard, see Benjamin Klein, “Our New Monetary Standard: The Measurement and Effects of Price Uncertainty, 1880-1973,” Economic Inquiry 13 (December 1975): 461-484.

[73. ]Haberler suggests that, if there is uniform resistance to deflation, a balance of payments disequilibrium may be resolved through inflation in surplus countries, rather than through deflation in deficit countries. Gottfried Haberler, “The Future of the International Monetary System,” Zeitschrift für Nationalökonomie 34, no. 3-4 (1974): 387-396.

[74. ]For an examination of the relation between the international monetary system and domestic monetary policy, see Harry G. Johnson, Inflation and the Monetarist Controversy (Amsterdam: North-Holland, 1972).

[75. ]David Fand has discussed in some detail the relationship between the shift to floating rates and the prospects for inflation. He argues that the excess reserves produced by the shift tended to be inflationary in the transitional period but that the enhanced control of the national monetary authorities should lead to less inflation over a longer term. In this analysis, Fand neglects the possible increased vulnerability of national monetary authorities to domestic political pressures, a point that we discuss in Chapter 8. See David I. Fand, “World Reserves and World Inflation,” Banca Nazionale del Lavoro Quarterly Review 115 (December 1975): 3-25.

[76. ]Recognizing this relationship does not necessarily imply the superiority of a fixed exchange-rate system. The choice between a floating and a fixed system rests, finally, on predictions about the operation of domestic decision makers on the one hand and foreign decision makers, in the aggregate, on the other. Floating rates provide protection against exogenous foreign influences on the domestic economy. But, at the same time, they make the economy considerably more vulnerable to unwise manipulation by domestic politicians.

[77. ]Graham Hutton, What Killed Prosperity in Every State from Ancient Rome to the Present (Philadelphia: Chilton Book, 1960), p. 96.