Money and Government

As EVERYONE knows, and many deplore, the government has a great deal to do with money. For example, by levying taxes, government takes a substantial cut of the national income. In 1961, federal taxes alone came to $97.9 billion. Tax collections by all governments in the United States $ federal, state, and local – absorbed $143.6 billion, 27.6 percent of the income generated in producing the gross national product. In 1958, the last year for which comparable figures are available, taxes as a proportion of the GNP measured 34 percent in West Germany, 32 percent in France, 31 percent in Sweden, 29 percent in Britain, 28 percent in Italy, 23 percent in Canada, 22 percent in Australia, and 16 percent in Spain.

Government is also a big spender of money. In 1961, all levels of government together spent $149.8 billion, of which $41.2 billion was accounted for by such cash transfer payments as unemployment and veterans’ compensation, pensions under social security, and interest to bondholders. The rest, $108.6 billion, paid for goods and services bought from business, and the wages of civil servants. Of the total volume of goods and services produced by the United States economy, state and local governments together purchased $51.4 billion, or 9.9 percent of the GNP. The federal government purchased $57.2 billion, or 11 percent of the GNP. Eighty-five percent of federal purchases went for national defense. The rest, federal civilian purchases, amounted to $8.5 billion and absorbed 1.8 percent of the civilian output of the economy. Civilian purchases by all levels of government absorbed 12.7 percent of the civilian product, less than in 1939 (13.4 percent) but more than in 1929 (7.5 percent).

it is evident that government is in the money business and in it to stay. How should it conduct that business? What rules should govern its power to issue and borrow and lend money and its power to tax and to spend it? What is the proper budgetary and monetary role of government in a society committed to the proposition that the fundamental goal of economic activity is to cater not to some central authority but to the wants, needs, and whims of individual citizens; a society committed also to organizing production and exchange through more or less competitive markets, based on private property and the incentive of profit?

Any generalization about opinions on such complex issues is subject to counterexample and exception. Nevertheless, I think it is fair to say that, since the late 1930s, there has emerged a sharp split between the views about these matters held by the large majority of the interested public, including businessmen, editorial writers, and politicians, and those held by the predominant majority of professional economists.

Consider, for instance, that favorite chestnut of the stump speaker, the national debt. The popular view is that the national debt is the work of the devil; that the faster it is retired, the better for all of us. Most economists would hold that there is nothing good or bad about the national debt as such, and that debt management, further borrowing, and retiring of debt are instruments to be used, together with spending and taxing, to help achieve such economic goals as high employment, a stable price level, and the desired division of the national output between public and private uses and between consumption and investment.

Or take the related question of interest rates. Some people consider high interest rates and dear money a menace; others vent their anger against cheap money. Most economists would say that exclusive commitment either to cheap money or to dear is wrong. They would argue that government should use its considerable influence on interest rates – an influence it cannot avoid – according to an overall fiscal and monetary strategy designed to achieve the above or similar goals.

Analogous differences separate economists from other people with regard to the proper use of most of the instruments in the fiscal and monetary armory of government: spending, taxes, subsidies. Not that economists agree, for instance, on whether there should be more or less public spending. It is proverbial that they do not. The old story, “Ask two economists a question, and you will get two answers, unless one of them is Mr. Keynes, in which case you will get three,” illustrates a half-truth. However, most of them tend to agree, and to differ with other people, about the broad rules of conduct which should inform the government’s use of these instruments. It is the rules of the game that are at issue.

For illustration, one can do no better than to take the thorny question of balance in the federal budget, an issue of paramount national importance, and the hottest single issue of principle in the area of economic management.

The ideological commitment to budget balance is a powerful force in the land. Does it make sense?

I THINK it safe to infer that most people, if asked their views about the proper rule of conduct for a fiscally responsible government, would answer: “Balance the budget, or, better still, run a surplus and pay off the national debt.” In contrast, a very large majority of economists– including, I would judge, virtually all economists who received their professional graduate training since the late 1930s – hold that whatever may be the case for balance or imbalance in a particular year, the budgetbalance rule is misleading and mischievous, bound to result in gross misallocation of resources.

To be sure, the question of what the level of federal spending and taxing ought to be in a particular year is a matter of legitimate dispute. There is room for technical argument about the exact quantitative effect of budgets on employment, prices, the growth rate, and the like. More important, there would be ground for debate even if economic forecasting were an exact science. Different budgets will have different effects on the balance between private and public use of resources: on the balance between defense and schools, on the one hand, and personal consumables on the other; on consumption today as against investment for consumption in the future; on income distribution – matters which touch on fundamental ethical, social, and political values, about which reasonable men will differ.

The question at issue here, however, is whether the federal budget should be balanced year in and year out as a matter of right. Is budget balance a sound general rule of fiscal conduct?

Anyone who believes, as I do, that it is not – especially if he finds irritating the liturgical quality of the editorial incantations–is tempted to score some debating points. Why, for instance, is annual balance the right rule, not monthly or weekly balance? Or, if it is the impact of government as a whole that matters, why should the federal budget be balanced? Should it not be used to offset surpluses and deficits in state and local budgets? Or – and this is an issue of some importance – why, of the three budgets prepared by the federal government, is the “administrative budget” invariably singled out as the budget to be balanced, considering that it excludes some $25 billion worth of federal trust fund transactions, shows corporate-profit-tax accruals with a halfyear lag, and treats loans as though they were expenditures? The difference is not trivial: in the current fiscal year the administrative budget is expected to be in the red by about $7 billion. The national income accounts budget, which is the most relevant from the point of view of economic impact, will show a deficit of only about $500 million.

But these are debating points. For the true case against balance, one has to probe deeper.

THE CASE AGAINST BUDGET BALANCE

The view that budget balance is a bad guide rests on the following series of propositions (stated in their boldest form):

7. Both inflation, a rise in the general level of prices, and recession, a shortfall in the output of the economy relative to potential output, are bad.

Although it is a question of degree – rapid or sustained inflation and deep or persistent recession are qualitatively more damaging than a slow, intermittent upward creep in prices and short, shallow recessions – the point needs little defense. Inflation results in capricious redistribution of income and wealth, and, in increasing proportion to its speed, will blunt the efficiency of the price system in allocating resources according to consumers’ tastes. Recession, as evidenced by unemployment in excess of 4 percent of the labor force, involves both the personal tragedy of joblessness and the irredeemable waste of valuable goods and services, as reflected in lost wages and profits. As a consequence of the three recessions since 1953, we have squandered, in the form ot idle capacity and idle men, some $180 billion worth of potential output, an amount equal to about one third of the economy’s total output in 1961. And recession, like inflation, leads to arbitrary and damaging changes in the distribution of income. Although everybody except the smart or lucky speculator loses – profit incomes shrink proportionately more than do wage incomes – a large fraction of the loss in wages and salaries is shouldered by the unemployed.

2. If we are not to suffer either appreciable price inflation or recession, total demand for goods and services must be kept in close balance with the growing potential of the economy to produce them.

Total demand for goods and services consists of the sum of personal consumption expenditures, private investment spending for plant, buildings, equipment, and inventory, and government purchases of goods and services.

Potential output is the maximum output the economy is capable of producing at an efficient, businesslike level of operation, with unit costs close to their minima, with plants operating at about 95 percent of rated capacity (not 105 percent), with enough slack to avoid persistent bottlenecks, and with the unemployment rate, which is the best single indicator of slack, at about 3.5 to 4 percent (not 2.9 percent, as in 1953, or 5 to 7 percent, as in 1960-1961).

3. Although a more or less competitive price-market system, based on private property and the incentive of profit, is a potent device for efficiently mediating the allocation of resources among private uses according to consumers’ wants, it is not equipped with an automatic balance wheel which will ensure that total demand will remain in phase with potential output, even if all government budgets are kept in balance and the monetary authorities follow the canons of orthodoxy.

For circumstantial evidence one has only to skim the economic history of capitalist market economies. But, suggestive as it is, the crude evidence about boom and bust is not conclusive. Many argue, for instance, that the fault has lain entirely in clumsy meddling by muddled governments. And, indeed, one cannot deny that only too often government has been the culprit. There is need for better fiscal and monetary performance.

However, the truth that governments have a black record does not imply that if only they went out of business or were restricted to the maintaining of the jails, financed through annually balanced budgets, then the price mechanism would ensure a close match between demand and potential output. There exist powerful built-in forces in a market economy which tend to generate wide, self-aggravating swings in total demand. Even under the most favorable assumptions of perfect competition, with flexible prices and wage rates, the stabilizers built into a wholly private pricemarket system could only guarantee that no situation of recession or depression – or, with a fixed supply of money, of price inflation – could persist indefinitely. It is not at all certain that they would ensure tolerably prompt correction of either an inflationary or a deflationary gap between total demand and potential output.

In a modern context, with the prevalence of market control in both labor and product markets, there simply do not exist automatic private market forces which will keep fluctuations within tolerable limits. The fiscal and monetary powers of government represent the only effective antibody mechanism we possess.

It must not be thought that the apparent invulnerability to serious depression of the United States economy since the war disproves the point. During every one of the post-war recessions we were saved from much more serious trouble by the stabilizing effect of the decline in tax revenues and the increase in social security spending which automatically follow any decline in incomes and rise in unemployment. In 1958, the automatic deficit provided us with a cushion of the order of $7 billion. It is not pleasant to think about what would have happened if we had obeyed the dictates of ideology and attempted to balance the budget by cutting down on spending, or by raising tax rates as did the government in 1932.

4. By appropriate variation of taxes, transfer payments, or its own purchases, and by appropriate supplementary use of credit policy, the federal government can substantially limit the swings in total spending and contain within reasonably narrow bounds – narrower than in the recent past – any gap that may occur between total demand and output, on the one hand, and potential output, on the other. In order to do so, however, the federal budget must either periodically show a large deficit, as well as, periodically, a surplus; or, if deficits are ruled out of order or kept within narrow limits, the absolute level of the budget (purchases and matching taxes) will have to be varied by enormous amounts.

The crude qualitative facts about the workings of fiscal measures are simple. Raising the level of government purchases will add directly to the flow of total demand. If not offset by taxes, it will give rise also to an equal increase in private incomes, and thereby induce a rise in the private component of total demand. The induced increase in private demand, in turn, will further swell private incomes, and hence cause a still further but smaller rise in private demand. The process of expansion is self-limiting, since on each round of the circular flow of spending →output →income →spending, there will be some leakage into private saving or, unless rates are cut, taxes.

A reduction in taxes or an increase in government transfer payments will not in and of itself add to demand. However, it will raise the level of private after-tax income, and hence induce an increase in private demand. Once again, the first-round increase in private demand will further raise private incomes and cause a still further, smaller rise in private demand. Once again, the process of expansion is self-limiting.

None of this bears any analogy to “pump priming,” strictly defined. The notion that a one-shot injection of public spending would suffice to ensure a sustained change in the level of total demand is no part of modern economics. It takes a sustained change in the level of spending or taxing (to a new plateau) to cause a sustained larger change in the level of total demand. The leverage is due to the induced secondary increase in private demand.

There is no need to labor the mechanics. The fact is that a gap between total demand and potential output can be offset by a change in the level of government purchases or transfer payments or taxes, or by some mutually reinforcing or even partly countervailing blend of all three kinds of action, combined with reinforcing or partially countervailing monetary measures. Moreover, unless the different instruments are used to defeat each other, the initial fiscal change need only be some fraction of the gap. The secondary induced effects on private demand will make up the difference.

Does it follow from all this that to eliminate a deflationary shortfall of demand we must have a deficit, that surpluses are not only a good thing but have a restraining effect on total demand, and that balanced budgets are neutral?

If so, the case for deficits in recession and surpluses to fight demand inflation would be both strong and clear. However, it is not quite so. Balanced budgets are not neutral, but have an expansionary effect. The effect on total demand, for instance, of a balanced budget with purchases and taxes (less transfers) at an annual rate of $10 billion will be approximately $10 billion per year. The $10 billion worth of pre-tax income generated by production in response to government orders is all siphoned off by the Treasury, and therefore, private after-tax income and hence private spend ing are not affected. But as long as government purchases and taxes remain at $10 billion a year, total demand will be $10 billion higher than if government spending and taxes were zero.

For the same reason, any balanced change in purchases and taxes will cause total demand to change in the same direction and, approximately, by the same amount. (The economist reader will note that I ignore changes in private spending owing to changes in income distribution, and also the effect on investment of the rate of change in the level of income and of changes in interest rates caused by government finance. Quantitatively, such effects will be too small to alter the qualitative conclusions.)

But if balanced increases in the federal budget will add to total demand, and balanced decreases will compress demand, what remains of the case against balance? Why not do honor to “fiscal responsibility” and fight recessions and inflation by balanced changes in spending and taxes?

There are two related reasons. In order to offset a shortfall in total demand by a balanced rise in purchases and taxes, we should have to increase government purchases by approximately the full amount of the shortfall. In general, the smaller the deficit we allow ourselves in recession, the larger will be the increase in government purchases needed to offset a given deficiency in total demand. And the larger the swings in budget levels, the more resources will have to be shifted back and forth between private and government use, for no better cause than that the alternative would be to shift them back and forth from some use into involuntary nonuse.

There is also a second, deeper reason for not accepting the budget-balance rule. Government budgets are not simply a device for securing harmony between total demand and potential supply. The public budget is the principal means for channeling resources to the national defense and to education, public transportation, public health, and basic research. It is also an important means for combating the pockets of primitive poverty in various parts of the country; for helping the old and the sick; and for ensuring, by education, housing, and public health, a greater equality of opportunity for children of equal ability. When we decide on the level of public spending, we are in effect deciding how much of our resources to allocate to these public tasks and how much to leave for private capital formation and the personal consumption of those better able to help themselves.

Inevitably, opinions will differ about what the balance should be. Inevitably, too, the differences must be compromised by means of political procedures operating through our institutions of representative government. But one thing is plain. The choice should not be made in blind response to variations in total private demand, as it would be if we insist on maintaining the budget in balance.

5. If we responsibly follow modern fiscal doctrine, paying no heed to the balanced-budget rule, we can do much better than we have in the past in avoiding both recession and demand inflation. At the same time we shall be free, within broad limits, to strike whatever balance we desire between public goods and private goods and between current consumption and investment for growth, without foreclosing on questions of income distribution and without in any way weakening our reliance on the price-market system for mediating production and exchange according to private profit and, where private goods are concerned, private choice.

The eminent economist Paul Samuelson has called this doctrine the “neo-classical synthesis” because it combines the deep truths of classical economics, which apply to the scarcity-ridden world of full employment, with what we have learned during the past three decades about recessions and depressions–and inflations. It is perhaps the happiest proposition ever spawned by the “dismal science,” but it is no daydream. As Samuelson put it, the doctrine “springs from careful use of the best modern analyses of economics that scholars here and abroad have over the years been able to attain.”

It is important not to claim too much. Even if we manage our fiscal and monetary instruments with much greater skill and wisdom than we have in the past, many of our economic problems will remain. The modern fiscal doctrine is no cureall. But none of the qualifications and refinements which a fuller discussion would require should be used to conceal its central import. Modern democratic governments can, by reasonably sensible exercise of their traditional fiscal and monetary instruments, sharply limit the excesses of boom and bust. Moreover, they can do so without any undesirable increases in government spending, without recourse to any of the paraphernalia of direct controls which would abort the workings of the price system, and without resort to the socialist medicine of nationalization and government produc tion.

\A/uy is it, then, that modern fiscal and monetary doctrine is so disturbing to many people who think of themselves as conservative? Why do they consider radical and dangerous a doctrine through which we can virtually cure the most serious failures of capitalist institutions by treatment no more harsh than, say, appropriate variation of tax rates and of the supply of money?

Much of the explanation lies in the realm of history and social psychology. One wonders, for instance, to what degree the attitude of the older generation of businessmen reflects an instinctive association, no matter how unjustified, of modern fiscal doctrine with the anti-business flavor of the New Deal.

Some of it, however, involves such matters as inflation and the balance of payments, and a misunderstanding of what we can and cannot expect markets to do for us. It is to these that we now turn.

“WHERE WILL THE MONEY COME FROM?”

The clue to a whole class of objections to deficit spending lies in the perennial question, “Where will the money come from?” It is to evade the issue to point out the obvious – that the government can either borrow money from the public by selling it some IOU’s or manufacture money, if not by the printing press, by the more subtle device of borrowing from the central bank. The question is, should it?

Consider the more radical-sounding method – financing of deficits by selling bonds to the Federal Reserve, thereby increasing the amount of money outstanding. Why do most people consider that a dangerous thing to do?

The standard answer, “Inflation,” raises a crucial issue of definition. If one chooses to define inflation as an increase in the stock of money, then, of course, printing money is tantamount to inflation. But if so, the question, “Why is printing money bad?”, remains unanswered, unless one is satisfied with, “Printing money (inflation) is bad because printing money (inflation) is bad.”

What people really have in mind, of course, is that printing money will cause inflation, defined not as an increase in the money supply but as a rise in the level of prices. There will be “too much money chasing too few goods”–or, more precisely, too much money spending chasing too few goods, and therefore there will have to be a rise in prices and a fall in the value of the currency.

Will it be so? An increase in government spending relative to taxes financed by new or even borrowed money will certainly cause total spending for goods and services to rise. If total spending is thereby made to press against potential output, the effect would indeed be inflationary; there would be a rise in prices. But there is nothing in modern fiscal doctrine which favors increased spending and cutting taxes when total demand is pushing against potential output. The modern prescription is quite the opposite: when demand threatens to outrun potential, contract the supply of money, cut spending, and/or raise taxes (even though the budget is in the black and revenues are rising).

The occasion for cutting taxes relative to spending and expanding the supply of money arises when total demand is substantially less than potential output, and therefore, an increase in total spending is precisely what is wanted in order to draw idle labor and idle plant and machinery into producing useful private or public goods. In other words, the modern prescription calls for the expansion of demand only when the extra spending can be accommodated by drawing idle resources and idle men into useful employment, and when, therefore, the additional demand need not exhaust itself in rising prices.

But will not the increment in money created during recession cause trouble once the economy is approaching full employment? Not if we follow the modern prescription and apply our monetary and fiscal brakes in accordance with the circumstances. When inflation threatens and the need is for keeping total demand in check, the Federal Reserve can supplement restrictive fiscal measures by using open-market operations and its power over the reserve requirements of commercial banks to mop up any excess money and tighten credit.

(To avoid inflation, it would not suffice simply to maintain the supply of money constant. An increase in the money supply is not a necessary condition for inflation to occur, any more than it is a sufficient condition. Total spending for goods and services is not rigidly limited by the stock of money. The rate of turnover of money – the velocity of circulation, so-called–can and does rise, and not a little, during periods of expansion; with bullish prospects for capital gains on securities, and worries about the price level, people will economize on idle cash. Moreover, with a modern fractional-reserve banking system, the central bank has to take action during a boom just to keep the money supply constant. The natural response of our monetary system in the absence of active central-bank policy is to feed any expansion.)

THE PROPER USE OF TAXES

The importance of penetrating the “veil of money” and forcing oneself to think through what the effects of fiscal and monetary measures will be on the demand and supply of real goods and services is perhaps most vividly illustrated by the example of taxes. The economic justification for taxation (as for borrowing) is not, shocking as it may seem, to conserve money by collecting enough of it to finance the government’s expenditures. It is, after all, not money that is scarce as an inescapable fact of nature, but goods and services, and the labor and the managerial and technical skills, the machinery, plant, transport facilities, and raw materials needed to produce those goods and services. And if it is goods and services that we care about and want to conserve, then we must employ taxes not to secure balance between the Treasury’s income and outgo but rather to bring about such changes in private demand as are necessary to ensure that total private plus public demand will neither exceed potential output, causing inflation, nor fall substantially short of potential output, thereby causing wanton waste of resources.

The point is of central importance: the principal purpose of raising taxes is to compress the level of private demand and thereby release resources from private use – not to finance government. For instance, if President Kennedy’s barely balanced administrative budget for fiscal 1963 should turn out to be based on too optimistic a forecast about the rate of expansion of private demand, and if, therefore, revenues during the fiscal year begin to fall short of planned expenditures and the budget begins to show red, then raising tax rates or cutting expenditures in order to eliminate or reduce the deficit would be the wrong thing to do. It would amplify the initial shortfall in total demand; it would shift more resources from private and public use into involuntary idleness. Assuming that it is resources, labor and real capital, that we care about, sensible fiscal policy would call for measures which would make the automatic initial deficit bigger – for increases in spending above the originally planned level and/or a cut in tax rates, as well as easy money.

Conventional fiscal thinking leads to upsidedown economics also in regard to inflation. If, during the 1963 fiscal year, total demand – and hence income, output, and employment – should grow much faster than is now anticipated and the administrative budget begins to show a much larger surplus than is now expected, and, most important, if bottlenecks and widespread price pressures begin to appear, then the appropriate fiscal reaction would not be either to spend the windfall of extra revenue or to give it away in tax cuts. The right policy would involve some mixture of tight money, higher tax rates, and cutbacks in spending – that is, making the budgetary surplus larger.

The moral is plain. If we want to use taxes to help balance the economy, we must be prepared to take active measures to make both deficits (in recessions) and surpluses (during demand inflation) bigger.

WHAT ABOUT THE NATIONAL DEBT?

From reading the editorial pages of some of our newspapers, one might conclude that among our national pastimes, railing against the national debt belongs somewhere between baseball and sex. Yet the economics of the national debt are both straightforward and undramatic:

1. All the reasons why deficits financed by the printing press are inflationary only when undertaken at the wrong time apply a fortiori to deficits financed by borrowing from the public. (The act of borrowing, taken by itself, tends to depress private spending, in that it will reduce bank reserves, cause interest rates to rise, and lead to generally tighter credit. However, the negative effect on private spending will be much smaller than the positive effect when the government spends the money.)

2. Of all our national concerns, the worry that one of these days the ax will fall and we shall have to pay off the entire national debt is perhaps the most groundless. To be sure, each day of every week there will be bondholders who will want to be paid off. If so, they can sell their bonds at the going market price if they are legally “ marketable,” or turn them in if they are not. In this one respect, government bonds are like the bonds of AT&T or any other large private corporation. Of course, in the case of the government, the bonds are secured not by a claim on the profits and assets of a particular corporation but by the fiscal and monetary powers of the United States government. If the government fails to use its fiscal and monetary powers to prevent price inflation, holders of private bonds suffer as well as holders of government bonds.

3. Almost all other analogies between the national debt and private debt or international debt are false. Private debt, or debt owed to foreign governments or individuals, is external. It is owed to others. The national debt is internal. It is owed by Americans to Americans. It does not reflect a claim by others on our resources. There is no external creditor.

4. The total of goods and services available to our children and grandchildren will not be smaller because there will be in existence during their lifetime a national debt, some of which will have been incurred last year or this. They will owe the money to each other. The taxes collected by government from any grandchild Peter to finance interest and repayment will go into the pockets of some grandchild Paul who inherited government bonds. (Anyone who thinks the above reasoning somewhat shady might reflect on the fact that, just as there is no subtraction from the total of goods and services available to us when some of the debt is paid off, there is no net gain of goods and services to a nation and its citizens when the debt is incurred. Increasing the national debt, unlike adding to external debt, does not enable a nation to have more goods and services than it can produce; repaying it, in turn, will not deprive it of any output that it has the resources to produce.)

5.It docs not follow that the national debt is without burden. There is a deadweight loss involved in the transfer of resources, in the form of interest, from taxpayers in general to bondholders. If, therefore, the national debt were to grow much faster than the GNP, there might be cause for concern. However, the facts are reassuring. The ratio of the publicly held federal debt (including debt held by the Federal Reserve Banks and by state and local governments) to the GNP, which was 45 percent in 1939 and rose to 118 percent in 1945, has fallen more or less steadily, to 64 percent by 1952 and 46 percent by 1961. Interest charges in 1961 amounted to 1.5 percent of the national income, as against 2.3 percent in 1946.

“IT DIDN’T WORK IN THE THIRTIES”

Of all the myths which masquerade as solid economic truth, few are more pernicious or false than the proposition that a compensatory fiscal policy was tried during the 1930s and found wanting. The truth is, as anyone who bothers to take a look at the crude quantitative evidence would quickly come to suspect, that it was not tried – at least not until 1940-1942, when it worked like a charm, although then, because of the urgent needs of national defense, we had to overdo it.

The measurement of fiscal impact is a subtle and technical business. It is necessary, for instance, to sort out the discretionary changes which occur when the government changes tax rates or its spending programs from the automatic changes in spending and revenues which occur as a built-in consequence of changes in income and employment. Certainly one cannot tell much by simply looking at deficits. Nonetheless, it is a salutary it slightly misleading fact, in the light of the massive collapse in the level of private demand from $96 billion in 1929 to $48 billion in 1933, that the federal deficit was $2.1 billion in 1931, $1.5 billion in 1932, $1.3 billion in 1933, $2.9 billion in 1934, $3.5 billion in 1936, and $0.2 billion, $2.0 billion, and $2.2 billion, respectively, in 1937, 1938, and 1939. The federal surplus in 1921 was $1.2 billion; the deficit in 1942, $33.2 billion.

Actually, even at a superficial level, the federal performance was rather better than that. If one corrects for the decline in the price level between 1929 and 1933, the federal budget went from a

surplus, as measured in 1961 prices, of $2.4 billion in 1929 to deficits of $4.9 billion in 1931, $3.4 billion in 1933, and (a peak) $8.5 billion in 1936. Even in “real” terms, however, federal deficits were dwarfed by the $65 billion drop in the level of private spending between 1929 and 1933, as measured, once again, in 1961 prices.

Whatever doubts the above figures may raise about the proposition that during the Great Depression the federal government engaged in a compensatory fiscal program of the size which modern doctrine would have called for are confirmed by M.I.T. Professor E. Cary Brown’s rigorous econometric analysis of the quantitative impact of fiscal policy in the 1930s, “Fiscal Policy in the ‘Thirties: A Reappraisal” (American Economic Review, December, 1956). Brown demonstrates that “the federal government’s policies were little more than adequate in most years of the ‘thirties to offset [the] contractive effects of state and local governments . . . the fiscal policy undertaken by all three levels of government was clearly relatively stronger in the ‘thirties than in 1929 in only two years– 1931 and 1936. . . . The primary failure of fiscal policy to be expansive in this period is attributable to the sharp increase in tax structure enacted at all levels of government. . . . The federal Revenue Act of 1932 virtually doubled full employment tax yields.”

It would be easy in the light of present knowledge but unfair to cast all the blame on the Roosevelt Administration. To be sure, there were people who recommended much larger increases in spending, sensing that somehow the old classical rules derived from scarcity were not entirely applicable to a situation where one quarter of the labor force was unemployed and plant and equipment were operating at 50 percent of capacity. Some people even suggested that increased spending need not be accompanied by higher tax rates, that it might be a good idea, rather, to encourage additional private demand by cutting taxes. But it is difficult for a democratic government to violate deeply held rules of “fiscal responsibility,” no matter how wrongheaded. Moreover, there simply did not exist, until the very late thirties, a comprehensive doctrine, factually based on a rational analytical structure, which would have provided a defense against the great many who felt that budget deficits were taking the country to perdition.

COST-PUSH INFLATION

A rather more sophisticated argument against the modern doctrine than any we have yet considered – more sophisticated in its premise, if not in its conclusion – turns on the phenomenon of inflation during recession. Since imperfect competition in many labor and product markets can lead to inflationary wage-price bargains and cause many prices to be flexible only in one direction, up, and since many prices are publicly administered or protected – for example, in transport, power, agriculture – price inflation is not invariably a symptom of demand pressing against potential output. It can occur, as in the 1950s, while markets for both labor and goods are slack.

If the pessimists are right, if labor and management will not exercise restraint at the bargaining table and in setting prices, then no level of total demand will yield both price stability and the full use of our potential. Our monetary and fiscal managers will face a continuing choice between a little faster price creep and a little less output and more unemployment. But whatever line we may wish them to take, the case for a sophisticated, flexible, differentiated fiscal and monetary strategy, and against the balanced-budget rule, stands. The nastier the winds and the tides, the more dangerous it is to tie down the tiller dead center.

There is an important technical point here. If we manage to achieve an average unemployment rate of 4 to 4.5 percent by ranging between 3 percent during booms and 6 percent during recessions. wage rates and prices will rise less than if we achieve the same 4 percent average with variations running from 2.5 percent to 7 or 8 percent. The rate of increase in wage rates during booms is a function not only of the duration of the boom but also of the amount of excess demand in the labor market. On the other hand, any decline in wage rates that occurs during a recession is only marginally sensitive to the amount of excess supplyin the labor market. Having more slack during recessions will not cancel out the effect on wage rates of more excess demand during booms. (In general, when the economy is near full employment, wages and also prices rise more than proportionately as unemployment drops.)

THE BALANCE OF PAYMENTS

There remains the argument that we cannot afford deficits because of the balance of payments. Since rapid expansion of demand will suck in imports and, if it triggers a rise in prices, will make our exports less competitive and imports more attractive, there is good reason to set more modest targets than would be the case if the United States were living in isolation and did not have to maintain a large surplus of exports over imports to cover its international obligations and the outflow of private capital. Balance-of-payments and cost-push considerations certainly help to explain the Kennedy fiscal strategy of cautious expansion, of not trying too quickly to dose the still substantial gap between demand and potential output.

Once again, however, all this has to do with the setting of more or less modest targets for total demand. And once again it strengthens rather than weakens the case for flexible, variegated use of our fiscal and monetary controls to keep total demand growing at the rate which offers the best compromise between the marginally conflicting requirements, on the one hand, of international balance and domestic price stability, and, on the other, of more output and faster growth.

The argument that a deficit – no matter how benign it may be in terms of the price level and our exports and imports, and how desirable in terms of output, employment, and the profitability of the American market for the foreign investor – is too dangerous to tolerate because of its effects on “world psychology” hardly merits comment. The notion that the international financial community, including the large European central banks, will engage in large-scale dumping of dollars, and thereby precipitate a major financial crisis, simply on account of a deficit in the United States administrative budget is preposterous on its face and hardly consistent with the fact of a $7 billion deficit during the current fiscal year. It does not follow, of course, that there is no need for improved international monetary arrangements to make the dollar and the pound less vulnerable to destabilizing speculation.

FEASIBILITY

What about the charge that economic life is too uncertain and complicated for the fiscal and monetary authorities to know what they are doing?

It would be foolish to assert that to operate an effective stabilization policy following modern doctrine is easy. Forecasting is an art, matters of timing and magnitude are delicate, and the machinery of administration and legislation is cumbersome. We cannot and should not try to eliminate all fluctuations or play it too close. Good fiscal doctrine requires that one leave plenty of room for error.

But, in the main, the view that “It cannot be done” is wrong. There is much more regularity to economic life than most people suspect. Damped by the built-in stabilizers, the economy moves slowly and predictably enough for us to keep adjusting our fiscal and monetary controls according to need – unless, of course, we lock them in place. (People who are concerned that delayed responses will make for perverse policy should give strong support to the President’s request for standby authority temporarily to vary income-tax rates by up to five percentage points, subject to congressional veto. Such discretionary authority would be a powerful instrument of “preventive action,” as Walter Lippmann called it. Anyone who doubts its efficacy – or the feasibility of translating modern monetary and fiscal doctrine into responsible policy – would do well to test his views against the remarkable recent Annual Report of the Council of Economic Advisers.)

IRRESPONSIBLE GOVERNMENT?

There is left, of course, the big question: Can a democratic government be trusted to be responsible? Anyone inclined to think not should keep in mind that to abandon the balance-thebudget rule is not to abandon all constraints on government spending. Any increase in spending which will cause total demand to exceed potential output will cause a sharp rise in prices. The faster the growth in government spending, the less occasion will there be for deficits to stimulate private spending, and the more frequent will be the need for surpluses to counter inflation. To claim that relaxing budget balance gives license to government to go on a binge of spending is to assume that the American government will create runaway inflation. Is that likely, given the sensitivity of the electorate to increases in prices? Certainly the stability of the price level during the past year should provide reassurance.

Nevertheless, there is no denying that if we jettison budget balance, we do in effect remove a constraint on government. But is that a sufficient reason for not doing so, for insisting on balance? Surely one must consider what the consequences would be if the restraint is not removed. For make no mistake, the price system, if not supplemented by a fiscal and monetary policy following modern doctrine, provides no protection against largescale unemployment and rapid inflation. Can we afford such failure? How long would the country remain committed to a capitalist orientation?

Money, if used right, is a potent instrument for good. As a social institution, it is indispensable. But a government which tries to operate by rules derived from everyday notions of personal morality will cause the monetary and fiscal mechanism to fail in the task for which it is so superbly fitted – mediating the allocation of resources through private markets to serve our needs for private and public things.

“Money is a good servant but a bad master” – Massinger, 1633.

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