Democracy in Deficit: The Political Legacy of Lord Keynes
Money-Financed Deficits and Political Democracy
In Chapter 7, we examined the predicted effects of the Keynesian conversion on political outcomes within a policy-instrument framework that is itself basically Keynesian. We explicitly confined attention to the creation of budget deficits and surpluses for the purpose of macroeconomic management. We paid only secondary attention to the means of financing deficits or the means of disposing of surpluses, save for trying to make explicit the most familiar Keynesian presumption that deficits are financed by the sale of government bonds to citizens and nonbanking firms within the economy, and that budget surpluses are disposed of by the retirement of debt held by these same groups.
As we noted, there has been continuing confusion generated by a stubborn failure to distinguish carefully between genuine public borrowing and money creation. We have tried to make this distinction explicit. The logical next step in the analysis is to consider money creation. Central or national governments, directly or indirectly, possess three means of financing outlays: taxation, borrowing, money issue. The first is eliminated by definition if a deficit is to be created. We have examined the borrowing alternative. We now must look at pure money issue.
Initially, we shall do so within the same basic policy setting utilized in Chapter 7. That is, we shall assume that fiscal adjustments—budgetary management, the creation of deficits or surpluses—provide the primary instruments for the implementation of macroeconomic policy. The analytical model of the preceding chapter is modified only by the assumption concerning the means of financing deficits and of disposing of surpluses. Genuine government borrowing and debt retirement are now replaced by pure money issue and pure money destruction. Furthermore, these offer the only means of changing the supply of money. For purposes of analysis, we initially make the artificial assumption that there exists no independently operative monetary authority. That is to say, the Federal Reserve Board would become, in this model, merely a part of the Treasury.
In the second part of this chapter, we shall shift from the basic Keynesian policy setting toward a monetarist one. This alternative is developed in three sections. In the first, we shall examine the political biases of Keynesian-oriented fiscal policy that is operative alongside a fully effective and wholly independent monetary authority. We shall see what results might be predicted to emerge when we juxtapose a biased fiscal policy and an unbiased monetary policy, where the decision makers for the latter are assumed to be truly benevolent and genuinely wise persons. In the second of the three sections, we drop the independence and wisdom assumptions and replace these by the plausible hypothesis that monetary authorities are, like elected politicians, subjected to both direct and indirect political pressures, and that they need not be all-knowing. Finally, in the last section of the chapter, we shall make an attempt to apply the analyses of both Chapters 7 and 8 to an institutional setting that seems roughly descriptive of the American economy in the late 1970s and early 1980s.
Budget Deficits Financed by Money Creation
In many respects, the economic effects of money-financed deficits are simpler to analyze than those of debt-financed deficits. Since no interest is paid on money, and since a dollar is a dollar regardless of date of issue, money creation, unlike debt creation, involves no future tax liabilities. There is no proposition fully analogous to the Ricardian equivalence theorem which attempts to deny the macroeconomic efficacy of debt-financed deficits.*29 The basic Keynesian proposition should command wider acceptance. The creation of a budget deficit, along with its financing by pure money issue, will increase the rate of spending in the economy.
Assume initially that the government's budget is balanced, with outlays and revenues equal. From this position, current rates of taxation are reduced so as to reduce revenues, with governmental outlays remaining unchanged. Suppose that resulting deficit is financed solely by money creation. In the Keynesian paradigm, the disposable incomes of persons in the economy increase. This will, in turn, increase the rate of spending on goods and services in the private sector. To the extent that output and employment are below, or potentially below, "full-employment" levels, the increase in spending will motivate an increase in real output and in employment. To the extent that the aggregate supply function is upward sloping (the economy is characterized by a Phillips-curve trade-off), the increase in the rate of spending will also drive prices higher. If the aggregate supply function is vertical (the economy is in a post-Phillips setting), the effects will be to increase the rate of monetary spending without any increase in real output and employment.
In any of these economic settings, the substitution effect emphasized earlier with debt-financed deficits will come into play. Persons will sense that publicly supplied goods and services are relatively lower in "price" than they were before the fiscal policy shift. This remains true whether the shift involves a simple tax-rate reduction, an increase in budgetary outlays, or some combination of both. By the first law of economics, persons will "demand" a larger quantity of the goods and services that have been reduced in price. This demand will take the form of pressures brought to bear on elected politicians for expansions in the levels of budgetary outlay. There will be the same public-sector bias from the acceptance of Keynesian economics as that which we previously discussed in the debt-financing case.*30
This public-sector bias is, of course, derivative from the basic prediction that fiscal policy shifts will themselves be biased toward demand-increasing rather than demand-decreasing actions, and for the reasons discussed in Chapter 7. The fundamental bias toward inflation will be, if anything, more severe in a regime in which budgetary unbalance is residually adjusted through changes in the money supply than one in which this is adjusted through changes in public debt. History provides perhaps the best corroboration of this hypothesis. Governments have been more severely restricted in their powers of money creation than in their abilities to borrow. Economic history abounds with evidence to the effect that, when allowed a choice, governments tend to inflate their currencies rather than to impose taxation. A begrudging, and possibly subconscious, recognition of this long-standing principle may have been partially responsible for the early Keynesian emphasis on debt financing rather than on the simpler and more persuasive money financing of deficits, within the confines of the elementary Keynesian settings.
Here, as at many other points in this book, we feel ourselves to be triturating the obvious. To say that there will be an inflationary bias when governments are allowed to create deficits and to finance these with currency is very elementary common sense. It is only some of our colleagues in economics who might deny this principle. They might ask: "Why should governments take action that will cause inflation? Why should citizens support politicians whose actions cause inflation?" To the extent that money-financed deficits generate price increases, the fiscal policy shift can be analyzed as the mere substitution of one form of tax for another. If we remain strictly at the level of analysis that does not consider institutional forms of extracting resources from citizens to be relevant for decisions, there need be no predictable effects of this change in taxation, save for those which might emerge from changes in the distribution of tax shares among persons and groups.
Among all forms of extracting resources, however, inflation is perhaps the most indirect, and it is the one that probably requires the highest degree of sophisticated understanding on the part of the individual. Even to analyze inflation as a form of taxation seems open to serious question when our ultimate purpose is that of understanding human behavior. Governments do not present inflation as a form of tax, as a balancing item in published budget projections or reviews. Governments instead make efforts to attribute the causes of inflation to nongovernmental entities and events—profit-hungry capitalist firms and greedy trade unions, foreign cartels, bad harvest, and the like. If the effects of money issue, in terms of behavioral reactions, should be, in fact, equivalent to those of a tax, there would seem to be no point in all such activities of politicians. Something a bit closer to reality is approximated by the popular references to inflation as the "hidden tax." But the reality itself is much more simple. Elected politicians approve programs of public spending; they impose taxes. If they are not required to balance projected spending with revenues, they will not, because the voting public does not hold them directly responsible for the inflation that their actions necessarily produce.
As noted, however, the institutional model discussed in this part of the chapter is artificial. For purposes of symmetry with the treatment of debt-financed deficits in Chapter 7, it has seemed advisable to look at the consequences of money-financed deficits on the presumption that an independent monetary authority does not exist. If this were at all descriptive of reality, the relationship between deficit creation and inflation might be much more readily perceived by citizens, who might then hold elected politicians to account for irresponsible actions. But it is precisely the existence of a quasi-independent monetary authority, nominally empowered to control the supply of money, that increases the "noise" in the whole system of relationships between fiscal action and changes in the values of the basic macroeconomic variables. This point should become clear in the later discussions in this chapter.
Benevolent and Independent Monetary Authority
In our discussion of debt-financed deficits in Chapter 7, we assumed, more or less implicitly, that monetary policy was purely passive or accommodative and that fiscal policy was the dominant instrument of control or attempted control over rates of total spending in the economy. This seemed to be the appropriate institutional setting for applying public-choice analysis to the Keynesian policy precepts, since this involved using the home turf of the Keynesians themselves. We suggested that the political legacy of Keynes may be summarized in a regime of continuing and apparently mounting budget deficits, inflation, and an expanding public sector.
Those who accept a monetarist paradigm, of almost any variety, may object to this summation. They might acknowledge that the political acceptance of the Keynesian teachings ensures a regime of budget deficits, along with some bias toward public-sector growth. But they would find uncongenial our attribution of inflation to the abandonment of the rule for budget balance. There does exist a monetary authority, and this authority has control powers over the nation's supply of money, quite independently of fiscal action.*31 The Treasury itself cannot strictly turn the printing presses to finance the state's affairs. Within the American institutional setting, it is the central bank, the Federal Reserve Board, that controls the printing press, not the Treasury. Therefore, it might be objected that the linkage between debt-financed deficits and inflation developed in Chapter 7 is too direct, while the linkage between money-financed deficits and inflation treated in the first part of this chapter is based on an analysis that does not incorporate realistic institutional assumptions.
We wish to examine this possible objection in some detail. The monetarists, in their disregard for the impact of alternative institutions on monetary outcomes, have adopted their own version of the "presuppositions of Harvey Road," though with somewhat more justification. Let us assume that there does, in fact, exist a monetary authority, an idealized Federal Reserve Board or central bank, that is totally and completely immune from the pressures of democratic politics. This authority is assumed to be empowered to control the supply of money through the use of any one or any combination of several instruments. The decision makers for this authority are assumed to be both wise and benevolent.
Alongside this monetary authority, the political agencies of the national government tax, borrow, and spend.*32 For the reasons discussed in Chapter 7, we should expect the politically oriented decision makers, freed from the time-honored balanced-budget constraint and attuned to the Keynesian teachings, to generate budget deficits and to finance these by public borrowing. This action will tend to distort the public-sector-private-sector allocation of resources in favor of the former. But there need be no direct linkage between debt-financed deficits and inflation because of the control powers of the monetary authority. To simplify our initial discussion here, we may assume that this authority adopts price-level stability as its overriding policy objective.
What will happen when the budget is unbalanced and new debt to finance the deficit is issued by the central government? The Treasury will be required to enter the market and sell bonds to nonbanking institutions and to individuals. This increase in the supply of bonds will reduce bond prices and increase bond yields. In the short run, interest rates generally will rise, which in turn will reduce the rate of private investment. There will be a bias or distortion in the private-sector allocation of resources as between consumption and capital formation, in favor of the former. If the monetary authority does not adopt an accommodative role here and if it sticks to its declared policy objective, the political legacy of Keynesian economics must be modified to read as follows: a regime of budget deficits, a biased increase in the rate of growth in the public sector, a regime of unduly high interest rates, and a slowdown in the rate of private capital formation.
These effects of deficits will remain in all settings, but they will be dampened considerably in an economy that experiences substantial real growth in output over time. In order to keep the price level stable, additional money will be required. Recognizing this, the monetary authority may find itself able to monetize some share of the public debt that the deficit financing of the government creates. Indeed, if there should be some way of limiting the size of budget deficits to the required rate of increase in the supply of money, a regime of continuing government deficits in these magnitudes might be deemed acceptable. There would, in this case, remain only a slight bias toward public-sector resource use; other political distortions stemming from the Keynesian teachings would be absent. But the very forces at work to create and to expand budget deficits disproportionately would cause the required limits here to be exceeded, with the consequences noted. At best, growth in real output in the economy through time will reduce the impact of the distortions noted.
The independent monetary authority need not, of course, adopt price-level stability as its single policy objective. The decision makers for this authority may accept some Phillips-curve model in the economy, whether or not this is descriptive of reality, and they may choose some explicit trade-off between inflation and unemployment that they think is attainable. Let us say that they select a 5-percent annual rate of price inflation as a maximally acceptable limit. It is evident that this policy will require a higher rate of growth in the money supply than that required for price-level stability, regardless of the rate of growth in real output in the economy. From this, it follows that the monetary authority can absorb a larger proportion of any government deficit, either directly or indirectly, than it could in the first case. An increasing share of the budget deficit can be monetized as the targeted rate of increase in price levels rises. To the extent that the inflation is explicitly selected as a policy objective of the monetary authority, because of some Phillips-curve weighting of conflicting objectives, the responsibility for achieving the intended result belongs squarely on the authority, and not on the fiscal policy accompaniment. The deficits in the latter provide a convenient means of injecting new money into the economy; they do not, in this setting, cause the new money to be injected. The political biases stemming from the acceptance of Keynesian teachings by those who make fiscal policy decisions are equivalent to those outlined above in the price-stability setting.
The Political Environment of Monetary Policy
The inflationary scenario sketched out above provides us with a convenient bridge between an analysis that presumes the existence of a benevolent and wise set of monetary decision makers and an analysis that incorporates institutional influences on those who make monetary decisions. Suppose that a monetary authority possessing legal powers to influence the stock of money exists in nominal independence of electoral politics. The decision makers for this authority are not, however, required to disclose their objectives for policy. We then observe large and increasing budget deficits, financed nominally by borrowing, while, at the same time, we observe an increasing rate of inflation, made possible by comparable increases in the supply of money. What do we conclude from this plausibly and historically descriptive set of facts? Has the monetary authority explicitly allowed the inflation to occur, basing its choices, rightly or wrongly, on some Phillips-curve model of the economy and choosing some inflation as the appropriate price for attaining higher employment? Or has the authority accommodated its own actions to the same political forces that generated the budget deficits?
What does the recent historical evidence suggest? Do larger deficits tend to elicit increases in the stock of money? Or are changes in the stock of money unrelated to the size of budget deficits? Table 8.1 presents in summary form some pertinent evidence regarding this question. The table covers the twenty-eight-year period, 1946-1974, of which the last half, 1961-1974, corresponds essentially to what we have called the "Keynesian period." During the earlier half of this period, there were six years of budget surplus. During five of these years, the rate of growth in the supply of money was quite low, ranging between -1.3 percent and 1.2 percent. Even during the remaining surplus year, 1947, the rate of money growth was a relatively moderate 3.3 percent. During the remaining eight years, the budget was in deficit. During six of these years, the rate of increase in the money stock exceeded the 1.9-percent average rate of increase over the entire fourteen-year period.
An examination of the 1961-1974 period reinforces the thesis that budget deficits are positively related to changes in the stock of money. During this latter period, the average annual increase in the money stock was 4.9 percent, a full three percentage points above the annual average during the preceding interval. A closer examination of this historical record reveals that the Federal Reserve System has responded to budget deficits (surpluses) by increasing (decreasing) its holding of government securities. This pattern obtains for both the 1946-1960 and the 1961-1974 periods. The Federal Reserve, in other words, appears to be a major source for financing budget deficits. The post-Accord experience seems little different from the situation immediately preceding 1951. What is different is simply that the magnitude of budget deficits has become so immense, and with no offsetting periods of surplus. The "facts" suggest that the actions of the Federal Reserve Board have not been independent of the financing needs of the federal government.*33
Our hypothesis is that political pressures also impinge on the decisions of monetary authorities, even if somewhat less directly than on elected politicians, and that the same biases toward demand-increasing policy steps will be present. These pressures would be operative even in a balanced-budget regime, let alone in a post-Keynesian world in which elected politicians seem to have abandoned all pretense to balanced-budget norms. That is to say, even if we could imagine modern governments maintaining strict balance between revenue and spending flows, the monetary authorities would be more likely to support inflationary rates of growth in national money supplies than deflationary rates. Such tendencies would be stronger under fractional reserve banking than under 100-percent reserve banking. Expansions in the monetary base by the monetary authority make possible an expansion in credit by individual banks. To the extent that the national monetary authority reflects the interests of the banking community, a fractional reserve system would seem to be more inflationary than a 100-percent reserve system.
In pre-Keynesian periods, when little or no thought was given to departures from principles of "sound finance" by governments, the inflation-proneness of nationally independent monetary authorities was widely accepted. Economists and philosophers used such predictions as the basis of recommendations for automatically operative monetary systems, in which the unit of money was defined by a fixed quantity of a specific commodity (gold being the best example) and with the effective supply being determined by the forces of the market. Historically, monetary systems based on commodity components seemed to be more stable than independent national systems based on fiduciary issue.
Control features comparable in effect to those operative in a commodity standard are imposed on fiduciary systems by internationally fixed exchange rates among currencies. To the extent that money units of one country must be fixed in value by a specific number of units of money of another country, the monetary authority in any one country is severely constrained in its independent power to choose policy targets for purposes of furthering domestic economic objectives.
But consider the position of a monetary authority in an economy that is largely autonomous. The authority is empowered to issue fiduciary currency and to regulate a banking system based on this currency. The authority may be nominally independent of politics, but pressures will, nonetheless, be brought to bear on its operations. What is important for our purposes is that the indirect pressures on the monetary authorities and the direct pressures on politicians will tend to be mutually reinforcing, and especially so in the direction of increases in money growth rates. A monetary decision maker is in a position only one stage removed from that of the directly elected politician. He will normally have been appointed to office by a politician subject to electoral testing, and he may even serve at the pleasure of the latter. It is scarcely to be expected that persons who are chosen as monetary decision makers will be the sort that are likely to take policy stances sharply contrary to those desired by their political associates, especially since these stances would also run counter to strong public opinion and media pressures.
What incentives does a person with decision-making authority in monetary matters have to hold fast to strict neutrality as between demand-increasing and demand-decreasing actions? Public-choice theory incorporates the basic behavioral hypothesis that persons in political and administrative positions of decision-making power are not, in themselves, much different from the rest of us. They tend to be personal-utility maximizers, and they will be influenced directly by the reward-punishment structure that describes their position in the institutional hierarchy. No monetary decision maker, no central banker, enjoys being hailed as the permanent villain of the piece. He does not relish being held up to the public as responsible for massive unemployment, for widespread poverty, for a housing shortage, for sluggish economic performance, and for whatever else that the uninformed and malicious journalist may throw at him. Why should the monetary bureaucrat expose himself to such uninformed but publicly effective abuse when his own decisions take on all of the characteristics of a genuinely "public good."*34 The monetary decision maker may realize full well that there are "social" gains to be secured from adopting and holding firm against demand-increasing, inflation-generating policies. But these general gains will not be translated into personal rewards that can be enjoyed by the decision maker as a consequence of his policy stance. "Easy money" is also "easy" for the monetary manager; "tight money" is extremely unpleasant for him.
The disproportionate acclaims and criticisms of the public, along with the disproportionate likelihood of support and alienation of political associates, suggest that the utility-maximizing monetary decision maker will behave with a natural bias toward inflation. This bias is enhanced when the institutions of a nominally independent monetary authority are themselves thought to be subject to ultimate control and regulation by elected politicians.*35 Consider the role of the monetary manager who takes a "tight money" position, disregarding the public clamor and disregarding the dismay of his political supporters. He can maintain this position only so long as, and to the extent that, his institutional isolation is protected. His position must be tempered severely if he realizes that the legislative authorities can, if pushed, modify the effective "monetary constitution," by imposing specific regulations or, in the limit, by abolishing the independence of the monetary authority itself. Even the most "public spirited" of monetary bureaucrats may, therefore, find himself forced into patterns of behavior that are biased by the disproportionate political pressures, even if these are wholly indirect.*36
To this point, we have continued to assume that the monetary authority operates with confidence in the accuracy of its predictions about movements in economic aggregates, and that it bases its policy actions on well-established and predictable relationships between these and targeted changes in the economic aggregates. This assumption of omniscience must, of course, be replaced by one of partial ignorance and uncertainty. The decision makers must act without full confidence in their predictions, and on the basis of relationships that are not universally acknowledged to be valid. The effect of this uncertainty is to contribute to the inflationary bias already discussed. In a situation of genuine uncertainty, persons will tend more readily to take those decisions that are responsive to external demands.
Autonomous and nominally independent monetary authorities may be biased toward inflation even in a regime in which fiscal policy is guided by the pre-Keynesian precept of budget balance. The presence of debt-financed budget deficits will, moreover, strengthen the tendencies for monetary expansion. Policy steps will be taken to monetize, directly and/or indirectly, some share of the government debt that the demand-increasing fiscal policy makes necessary. In the face of large and increasing budgetary deficits, the achievement of any specified anti-inflation target might require very high interest rates. But rates at this level may not be politically tolerable. Political and public reactions to the increases in interest rates as well as to the high levels may seem to be as severe as, and possibly more severe than, political and public agitation over inflation itself, at least in some anticipated sense. The monetary authority may be held to be more directly responsible for the level of interest rates than for the rate of inflation. Furthermore, the authority may not anticipate that, in subsequent periods, the expected rate of inflation may drive nominal interest rates even higher. In order to maximize their own utilities, considered over a relatively short time horizon, therefore, the monetary decision makers may try to compromise among conflicting objectives. They will tend to look at interest rates and to try to monetize a portion of deficit-induced debt large enough to keep interest rate changes within tolerable bounds. In the process, they will acquiesce in a rate of monetary growth that causes their anti-inflation targets to be missed.*37
This scenario might offer both a behaviorally realistic but not totally unacceptable policy set in modern political democracy if we could predict stable magnitudes for the relevant variables. If the size of the deficits could be stabilized, or increased only within the limits dictated by the rate of growth in real output, the amount of debt monetization could also be kept within limits, and the rate of inflation could be maintained at some minimal level, to which adjustments could be made over time. There would be some bias toward public-sector allocation, and interest rates would be above noninflationary levels, but they would not be rising over time. Unfortunately, however, the selfsame political forces that might produce the deficit creation-debt monetization-inflationary sequence in the first place will operate to ensure that deficits will continually rise over time. The alleged employment and output stimulation effect of attempted increases in aggregate demand requires increases from previously existing levels. If unemployment and excess capacity seem to be present in the economy, and if political decision makers have been fully converted to the Keynesian policy paradigm, they will be persuaded to increase the size of the budget deficit on precisely the same argument that might have been successful in convincing their political predecessors to inaugurate a regime of unbalanced budgets. When the Keynesian policy paradigm comes to be embedded in an effectively democratic political process, it generates a dynamic of its own that tends to ensure mounting deficits, with predicted consequences. Even if a nominally independent monetary authority should try initially to immunize itself from political pressures, its attempt must come under increasing strain through time. Permanent insulation of an effective monetary authority from politics is not something upon which hopes for rescue should be based.
The corollary of the tendency toward deficits of increasing magnitude over time is the increasing difficulty of securing any reduction in these magnitudes. To a public and to a group of legislators thoroughly converted to textbook Keynesianism, reductions in aggregate spending rates, which might be generated by cutting down on the size of the deficits, will, at any time, cause some increase in unemployment and some cutbacks in real output. Quite apart from the direct and ever-present public-choice reasons that make tax increases and/or expenditure curtailment difficult to achieve, the Keynesian logic offers a strong supporting argument against any such moves for macroeconomic reasons. And in this case, the argument is widely, indeed almost universally, acknowledged to be valid. After a long period of money-financed deficits, growth in the relative size of government, and inflation, any effort on the part of either the budget-making politicians or the monetary authorities to return the national economy toward a regime of balanced budgets, stability in the relative size of the public sector, and price-level stability, will tend to disappoint built-in expectations and will tend to produce the results predicted by the Keynesian models. These embody major costs that are largely concentrated over relatively short periods of time, as against the long-term gains that are promised from the change. Can we really expect ordinary democratic politics to make the difficult decisions required to adopt such a shift of policy? This seems to be the most tragic aspect of the whole Keynesian legacy. A political democracy, once committed to a sequence of Keynesian-motivated money-financed deficits, may find itself incapable of modifying its direction.*38
The American Political Economy, 1976 and Beyond
The discussion and analysis of Chapters 7 and 8 to this point have employed partially abstracted models of political and economic reality for the purpose of generating predictions about the applicability of Keynesian economics in political democracies. The models have surely been "recognizable" in the sense that they have represented somewhat idealized variants of what we observe as existing institutions. In this concluding section, we wish to relate our whole analysis more directly and more specifically to the institutions that describe the American political economy in 1976 and beyond. We wish to apply our analytical models and to make predictions about real-world policy changes.
The developing sequence of cumulatively increasing budget deficits has been noted several times, and we need not review this again here. For better or for worse, fiscal policy since the early 1960s has been driven by the Keynesian precepts, as these are transmitted to, interpreted by, and translated into outcomes by elected politicians. The results are those that public-choice models would have allowed us to predict. The Federal Reserve Board exists in nominal independence of direct political pressure, and it is empowered to control the effective supply of money in the economy. Until 1971, the monetary policy of the board was constrained to an extent by the international system of fixed exchange rates among separate major national currencies. Despite the relatively autonomous position of the American economy, because of its magnitude and because of the relative importance of domestic as opposed to international trading, the fixed-rate constraint did serve as an effective brake on expansionary monetary policies in the 1950s and 1960s. Perhaps even more importantly for purposes of our analysis, the fixed-rate constraint offered a means through which the direct political pressures on the monetary authority could be forestalled. Politicians who might otherwise have attempted to reduce the alleged independence of the Federal Reserve Board were prevented from so doing because of the international reserve dangers that inflation might present, the relevance of which could be demonstrated in simple quantitative terms, the loss of gold reserves.
After 1971, and conclusively after 1973, there has been no such constraint on the actions of the Federal Reserve Board, and indirectly on the actions of those politicians who would reduce the board's nominal independence. As a result, the Federal Reserve Board has become more vulnerable to attempts by elected politicians to regulate its activities with respect to money supply. These attempts were successful up to a point in 1975; since that time, the board has been required to announce specific monetary supply targets to the Congress, something that has never been done before. This political pressure on the independence of the Federal Reserve Board continued in 1976. The House of Representatives, early in 1976, overwhelmingly passed a measure that, if finally enacted into law, would substantially curb even the nominal isolation of the board. The measure in question made the term of the chairman of the board coincide with that of the U.S. president and added so-called "public" members to the boards of the regional Federal Reserve banks. Furthermore, the proposed bill directed the board to adopt the maximum employment objectives as specified in the Full Employment Act of 1946.
These observed events, in conjunction with our basic public-choice analysis, leads us to predict that the Federal Reserve Board will come under increasing and perhaps accelerating pressures for more control by the elected political leaders, and that these pressures will gradually come to be more and more effective. Even if this does not directly occur, the fear of potential political dominance will ensure that the decision makers in the Federal Reserve Board will come increasingly to be influenced by the same political pressures that affect those who determine the basic budgetary outcomes.*39
When we add to this the simple recognition that the Federal Reserve Board is an established bureaucracy, whose members seek to remain secure in their expected perquisites of office, it seems highly unlikely that the Federal Reserve authorities will opt for price-level stability, even as an implicit target for monetary policy. They will accept a rate of inflation as an indirect means of appeasing the political leaders and of assuring them that a share of the newly issued public debt will be monetized. This will, in turn, cause interest rates to rise less rapidly than they might otherwise do in the short term, although the continuing inflationary expectations, which this policy will reinforce, will cause interest rates to remain at high levels over a longer perspective.
This set of predictions may be squared readily with those which have emerged from the more detailed and more sophisticated models that have not incorporated political elements. But our interpretation of the political dynamic of the whole interacting system does not allow us to predict that the American political economy will settle down to some moderate deficit, moderate inflation, moderate unemployment growth path. Our predictions, based on an attempt to analyze the political forces at work in a post-Keynesian age, and after almost two decades of political Keynesianism, must be less sanguine. This is not to rule out the prospect that, for short periods, attempts may be made seriously to reverse what will become increasingly clear as the trend of events. Indeed, the widespread expression of concern about "fiscal responsibility" in 1975 and 1976 may make possible the temporary political viability of some budgetary restrictions, notably toward holding down the introduction of new expenditure programs. But the analysis of the political forces at work suggests to us that such waves of "reaction," if they occur at all, will tend to be short-lived and to be quickly dominated in significance by the underlying secular realities. The episodic attempts by the Nixon administration in both 1969 and 1973 offer examples that may recur, but probably with less frequency. As others have predicted, the political response that seems likely to occur may make things worse rather than better. Political pressures toward direct controls as a means of keeping inflation within bounds may well become overwhelming, despite the near-universal historical record of failure.
As we have indicated elsewhere in this book, we hope that our predictions are in error. We have attempted to present, first of all, our diagnosis of the American political economy in 1976 and beyond, and to make predictions based on this diagnosis. Few can contemplate the predicted results with other than foreboding. In a sense, we are like the physician whose own diagnosis suggests that his patient has cancer; he would be willing, indeed happy, to acknowledge that he has erred in diagnosis and prediction in exchange for the personally satisfying state of observing that his patient is on the road to recovery and, indeed, may not have been so ill as he seemed. Fortunately, this cancer metaphor is only partially applicable. We know that the patient in our case, the American political economy, can be "cured" by self-restorative steps. The question is one of will. Can the American democracy make the necessary reorganizational arrangements in time to forestall the disasters that now seem to be predictable from its observed post-Keynesian dynamic? This offers the subject matter for most of Part III of this book. Before exploring this question, however, we must first consider carefully the basis for the proposition that particular budgetary institutions can influence budgetary outcomes. We do this because this proposition, while common sense to many, is rejected by a number of professional economists.
Notes for this chapter
In an economic environment where an increase in the supply of money causes prices to rise, some rational expectations models may produce something akin to the Ricardian proposition. In this case, there would be no output-employment effects of money-financed deficits, even in the short run. Money-financed deficit creation would, in this model, be a form of current taxation, with no real effects on disposable income and no substitution effect as between public and private goods. These models seem, however, to be even more bizarre in the informational requirements they place on individuals than is the comparable Ricardian model. For instance, they require that the expectations of economic agents are the same as those implied by the solution of the economic model in which they are assumed to exist. Ah, but if only all economists could agree upon a single model! For an exposition by a true believer, of which there are several, see Robert J. Barro, "Rational Expectations and the Role of Monetary Policy," Journal of Monetary Economics 2 (January 1976): 1-32.
One means of eliminating the public-sector bias might involve the institutionalization of Musgrave's analytical separation of the budget into branches. A constitutional rule might require that the allocation budget be kept strictly in balance, while a separate stabilization branch might be empowered to issue new money and distribute it directly to citizens (by helicopter drop or otherwise) on the one hand, and to levy taxes and to destroy the proceeds on the other. The effective operation of such a set of institutions could eliminate the public-sector bias resulting from the "price" effect discussed. The inflationary bias would not, however, be eliminated under such a regime, and, if anything, the political pressures on an independently organized stabilization branch might be even more severe than those present under a consolidated budget. For the original discussion of the analytical basis of the three-branch budget, see R. A. Musgrave, The Theory of Public Finance (New York: McGraw-Hill, 1959).
David Fand, for instance, rejects the suggestion that the supply of money is endogenous, because he interprets such a proposition as signifying an acceptance of the real-bills doctrine. Our perspective on the endogenous character of the money stock as it relates to budget deficits, however, is quite different and is fully consistent with a monetarist perspective. See David I. Fand, "Can the Central Bank Control the Money Stock?" Federal Reserve Bank of St. Louis, Review 52 (January 1970): 12-16.
For simplicity here, we may assume that government must borrow in only one type of security. It cannot, by assumption, change the overall "moneyness" of debt by modifying debt structure.
The proposition that monetary authorities cannot be treated as truly independent of the financial activities of the Treasury, at least when government expenditure and government debt comprise relatively large parts of national income and total credit respectively, is advanced in R. S. Sayers, Central Banking after Bagehot (Oxford: Oxford University Press, 1957), pp. 92-107. Bagehot, by the way, set forth over a century ago (1873) essentially a public-choice-property-rights approach to monetary institutions. See Walter Bagehot, Lombard Street: A Description of the Money Market, 11th ed. (London: Kegan, Paul, Trench, Trubner, 1894 ). The importance of relating inflation to politics has recently been stressed by Thomas Wilson, "The Political Economy of Inflation," Proceedings of the British Academy, vol. 61 (Oxford: Oxford University Press, 1975), pp. 3-25.
Cf. Gordon Tullock, "Public Decisions as Public Goods," Journal of Political Economy 79 (August 1971): 913-918.
E. Ray Canterbery, Economics on a New Frontier (Belmont, Calif.: Wadsworth, 1968), pp. 155-171, explicitly advocates that Federal Reserve nominal independence be replaced by direct political control.
There is some empirical evidence to suggest that the behavior of persons in monetary authorities is explained by hypotheses that have emerged from the theory of bureaucracy. See Keith Acheson and John F. Chant, "The Choice of Monetary Instruments and the Theory of Bureaucracy," Public Choice 12 (Spring 1972): 13-34; and idem, "Bureaucratic Theory and the Choice of Central Bank Goals," Journal of Money, Credit, and Banking 5 (May 1973): 637-655. For a general survey of various efforts to examine positively the conduct of the Federal Reserve authorities, see William P. Yohe, "Federal Reserve Behavior," in William J. Frazer, Jr., ed., Crisis in Economic Theory (Gainesville: University of Florida Press, 1974), pp. 189-200.
Several studies of the link between budget deficits and monetary expansion have treated interest rates as the mediator that creates the link. Budget deficits will tend to depress the price of government securities, thereby placing upward pressure on interest rates. The Federal Reserve, in turn, acts to offset this upward pressure by purchasing government securities. In consequence, monetary expansion takes place. For discussions of this point, see Raymond E. Lombra and Raymond G. Torto, "The Strategy of Monetary Policy," Federal Reserve Bank of Richmond, Monthly Review 61 (September/October 1975): 3-14; and Susan R. Roesch, "The Monetary-Fiscal Mix through Mid-1976," Federal Reserve Bank of St. Louis, Review 57 (August 1975): 2-7.
As Hayek puts it, we may find ourselves caught holding onto a "tiger by the tail." See Friedrich A. Hayek, A Tiger by the Tail (London: Institute of Economic Affairs, 1972).
The revenue collected by government from inflation is quite high, Friedman having estimated it in excess of $25 billion for 1973. Clearly, the forces of government have much to gain from the Federal Reserve's permitting the monetary expansion, so the nominal independence of the Fed should not be allowed to obscure one's understanding of why the expansion takes place under prevailing monetary institutions. The estimate for 1973 is presented in Milton Friedman, Monetary Correction (London: Institute of Economic Affairs, 1974), pp. 14-15. For a more general treatment of revenue received by government from inflation, see Milton Friedman, "Government Revenue from Inflation," Journal of Political Economy 79 (August 1971): 846-856.
End of Notes
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