Democracy in Deficit: The Political Legacy of Lord Keynes
Assessing the Damages
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:
Our success has come in two fields: one in macro-economics and employment policy.... Our success ... can be visualized very easily if we simply contrast the twenty years after the First World War, in which we had the Great Depression and an international situation which ended in Hitler and the disaster of the Second World War, with the twenty years after the Second World War, in which we had no Great Depression, merely a few little ones, and the United States had the longest period of sustained high employment and growth in its history.... Not all of this is due to economics, but some of it is, and even if only a small part of it is, the rate of return on the investment in economics must be enormous. The investment has really been very small and the returns, if we measure them by the cost of the depressions which we have not had, could easily run into a trillion dollars. On quite reasonable assumptions, therefore, the rate of return on economics has been on the order of tens of thousands of percent in the period since the end of World War II. It is no wonder that we find economists at the top of the salary scale!*46
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.*47 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.*48
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.*49
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.*50
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.*51
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.*52 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.*53 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
there is no subtler, no surer means of overturning the existing basis of Society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.*54
Joseph A. Schumpeter remarked that
perennial inflationary pressure can play an important part in the eventual conquest of the private-enterprise system by the bureaucracy—the resultant frictions and deadlock being attributed to private enterprise and used as argument for further restrictions and regulation.*55
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.*56 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.*57 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.*58
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.*59
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.*60 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.*61
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.*62 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.*63
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.*64
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.*65
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.*66
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.*67
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.*68 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.*69 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.*70 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.*71
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.
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.*72
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.*73
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.*74 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,*75 has severed one of the constraints on internal monetary expansion.*76 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
what went wrong was not Keynes' schemes. It was his optimism about politics, politicians, employers and trade unionists.... Keynes would have been the foremost to denounce such behaviour as the doom of democracy.*77
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?
Notes for this chapter
Kenneth E. Boulding, Economics as a Science (New York: McGraw-Hill, 1970), p. 151.
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.
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.
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).
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).
See the analysis in Reuben A. Kessel and Armen A. Alchian, "The Effects of Inflation," Journal of Political Economy 70 (December 1962): 521-537.
See Phillip Cagan, The Hydra-Headed Monster: The Problem of Inflation in the United States (Washington: American Enterprise Institute, 1974).
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.
John Maynard Keynes, The Economic Consequences of the Peace (New York: Harcourt, Brace, 1920), p. 236.
Joseph A. Schumpeter, Capitalism, Socialism, and Democracy, 3rd ed. (New York: Harper and Row, 1950), p. 424.
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.
For an elaboration of these and related issues, see David Meiselman, "More Inflation, More Unemployment," Tax Review 37 (January 1976): 1-4.
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.
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.
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).
For a general discussion of this point, see William H. Peterson, "The Impact of Inflation on Management Decisions," Freeman 25 (July 1975): 399-411.
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).
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.
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.
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.
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.
Colin Clark, "Public Finance and Changes in the Value of Money," Economic Journal 55 (December 1945): 371-389.
Harry G. Johnson, "Living with Inflation," Banker 125 (August 1975): 863-864.
See Graham Hutton, "Taxation and Inflation," Banker 125 (December 1975): 1493-1499.
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.
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.
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.
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).
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.
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.
Graham Hutton, What Killed Prosperity in Every State from Ancient Rome to the Present (Philadelphia: Chilton Book, 1960), p. 96.
End of Notes
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