The Keynesian path to fiscal irresponsibility.

AuthorLee, Dwight R.
PositionEssay

The basic idea behind Keynesian policy for achieving stable economic growth is straightforward, and superficially plausible. When the economy is in a downturn with underutilized resources, Keynesians believe the federal government should increase aggregate demand by increasing deficit spending through some combination of more spending and lower taxes. With the aid of a multiplier effect augmenting the government's increase in aggregate demand, the economy will move back toward full employment. In contrast, they believe that when aggregate demand exceeds the productive capacity of the economy, the federal government can prevent inflationary overheating by reducing demand with a budget surplus generated by some combination of less spending and higher taxes. The resulting decrease in government demand will be augmented by a reverse multiplier effect, which will reduce inflationary pressures by bringing aggregate demand back in line with the economy's productive capacity. As discussed by Keynes and his early followers, there was nothing fiscally irresponsible about such a policy. While the budget would not be balanced on a yearly basis, it would be balanced over time as budget deficits intended to moderate recessions would be offset by budget surpluses used to restrain economic exuberance.

Of course there are problems with Keynesian policy that have to do with the difficulty of forecasting economic trends and making timely fiscal adjustments. These are problems that are widely recognized as troublesome. They are not my concern, however, since I shall argue that even if Keynesian remedies could be implemented in a timely manner, there are other serious problems undermining Keynesian hopes for moderating the decline, duration, and frequency of economic downturns. The first problem is that Keynesian prescriptions are filtered through a political process being driven by many competing agendas, of which balanced economic growth is only one. The second problem is that both Keynesian economics and the political process are almost entirely focused on short-run demand-side concerns while largely ignoring the long-run importance of economic productivity. The result is a political dynamic that has increasingly turned Keynesian economics into a prescription for fiscal irresponsibility that undermines economic growth without pro-rooting economic stability.

Fiscal History before the Great Depression

From 1792 until 1930 the federal budget averaged 3.2 percent of gross domestic product. Peacetime spending (excluding the Civil War and World War I) averaged 2.7 percent of GDP. Over that 139-year period, the federal budget was roughly in balance, with federal deficits occurring in only 38 years. Those deficits occurred almost entirely because of spending increases during wartime or reduced revenues during economic downturns (see Figures 1 and 2). The prevailing view was that such downturns would correct themselves through market adjustments, with increased government spending being neither necessary nor desirable.

That view is certainly supported by economic performance during most of U.S. history. Representative of this performance was the impressive economic growth with low unemployment and increasing real wages in the post-Civil War period, during which the federal budget was either in surplus or balanced for 27 straight years with a surplus in 24 of those years (see Figure 1). In addition to a short and mild recession that started before the Civil War was over, there were two other economic downturns during the 27 years after the Civil War, the longest one starting in 1873. All three downturns recovered in response to market adjustments, with no attempt to shorten it with increased government spending. Despite (or more likely because of) the lack of any Keynesian stimulus, even the duration of the 1873 economic decline was far shorter than the Great Depression of the 1930s. (1) Even with falling tax revenue, the federal budget remained in surplus through the 1873 downturn, with the first post-Civil War budget deficit not occurring until the 1893 downturn, with that deficit caused by a decline in federal revenues, not an increase in government spending. The 1893 decline was a serious depression, though economic recovery took far less time in response to market forces than it did during the Great Depression, when the economy was supposedly being stimulated with unprecedented peacetime federal spending and budget deficits as well as a host of government regulations (see Figure 2).

[FIGURE 1 OMITTED]

An important lesson from this experience, indeed from the entire U.S. experience until the early 1930s, is that while market economies suffer from occasional recessions, they recover and continue growing without the need of increased government spending and budget deficits called for by Keynesian prescriptions.

The fact that market economies self-correct from economic downturns without fiscal stimulus does not imply that federal spending was unimportant to U.S. economic success during the nation's first 140-plus years." (2) The federal budget was spent primarily on such activities as providing national defense, infrastructure, law enforcement, and establishing standards on weights and measures. These activities create an environment that unleashes the power of private enterprise and entrepreneurship to create wealth. But as important as what the federal government did to promote economic success, what it did not do was just as important. It did little to override the decisions of consumers and producers with regulations and spending programs as they pursued their interests in response to market incentives. Government action was limited by the prevailing view that prosperity resulted from people keeping most of their earnings because it is their investments and spending choices that do the most to create productive jobs and general prosperity. The idea that the federal government could promote prosperity by spending more of the nation's wealth would have been widely dismissed as foolish.

[FIGURE 2 OMITTED]

Fiscal History in the Modem Era

A clear divide in U.S. fiscal history took place in the early 1930s. The proximate cause of this divide was the Great Depression, but it can be traced to a shift in the prevailing political ideology that began in the late 1800s with the populist and progressive movements. Those movements were rooted in a growing belief that market economies required the detailed guidance of the federal government. Beginning as a minority view, it became increasingly accepted that only through government regulation of economic decisions and the stimulus of more federal spending and transfers could economic growth be maintained and economic output be distributed fairly. By the 1930s this belief was sufficiently widespread to give political traction to the idea that more government spending (particularly deficit spending) and control over the economy could reverse the economic downturn that became the Great Depression. (3) This view was given intellectual impetus with the 1936 publication of The General Theory of Employment, Interest and Money by John Maynard Keynes, which provided an argument for the use of fiscal policy by central governments to smooth out business cycles. The result was that federal spending expanded and its composition changed.

With the ideological shift, supported by the intellectual acceptance of Keynes's General Theory, politicians found themselves with an excuse to do what most had always wanted to do--take more money from the general public and transfer it to favored groups (or voting blocs). The benefits are invariably less than the costs, but they are visible, readily appreciated, and easily credited to politicians. Predictably, beginning in the 1930s federal spending began increasing as a share of GDP. It was about 4 percent of GDP in 1930, increased during the Great Depression and spiked to a historical high of about 47 percent during World War II. The federal government share of GDP then dropped to about 13 percent in 1948, reached a bumpy plateau in the early 1960s at slightly below to slightly above 20 percent that lasted for over 40 years, and then escalated rapidly in late 2008 to an estimated 25 percent in 2011. (4)

It is not just the growth of total federal spending, however, that deserves attention. As the federal spending has grown, its composition experienced a fundamental change. Except for World War II, the bulk of the growth in federal spending has gone to funding transfers from those...

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