Democracy in Deficit: The Political Legacy of Lord Keynes

James M. Buchanan.
Buchanan, James M. and Richard E. Wagner
(1919- )
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First Pub. Date
Indianapolis, IN: Liberty Fund, Inc.
Pub. Date
Foreword by Robert D. Tollison.

Chapter 4The Spread of the New Gospel



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.*33 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."*34


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.*35 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.*36 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.*37

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.*38 In 1948, the proposal was elaborated in a more sophisticated form by Milton Friedman.*39 Professional economists attained a "remarkable degree of consensus" in support of the norm of hypothetical budget balance in the late 1940s and early 1950s.*40

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.*41 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.*42


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."*43 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.*44 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.*45 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.

Notes for this chapter

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.

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

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).

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.

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

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.

Milton Friedman, "A Monetary and Fiscal Framework for Economic Stability," American Economic Review 48 (June 1948): 245-264.

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.

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).

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.

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.

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.

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.

End of Notes

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