Democracy in Deficit: The Political Legacy of Lord Keynes
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."*22 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.*23
"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.*24
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.*25
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.*26 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.*27
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.*28 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.*29 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.*30
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.*31 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.*32 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?
Notes for this chapter
John Maynard Keynes, The General Theory of Employment, Interest, and Money (New York: Harcourt, Brace, 1936), p. vi.
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.
For a recent, careful restatement of this position, see W. H. Hutt, A Rehabilitation of Say's Law (Athens: Ohio University Press, 1974).
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.
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.
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.
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.
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.
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.
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.
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.
End of Notes
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