The Library of Economics and Liberty
Democracy in Deficit: The Political Legacy of Lord Keynes, continued ...
By James M. Buchanan and Richard E. Wagner
Part III. What Can Be Done?
Chapter 10 Alternative Budgetary Rules
Budget Balance over the Cycle
The principle that the government’s budget should be balanced over the course of the business cycle represented an effort to bridge the gulf that appeared to separate the Keynesian precept of functional finance from the classical precept of an annually balanced budget.
Budget balance over the cycle appeared to retain an ultimate balancing of revenues and outlays, of costs and benefits, which is the essential feature of the strict budget-balance concept.
The old-fashioned rule was to be modified only in the accounting period over which the balancing criterion was to be applied; the period was lengthened from the arbitrary accounting year to that which described the full sequence of the business cycle.
It appeared that this would allow for the discretionary use of the budget for purposes of countercyclical macroeconomic management.
The modified old-fashioned rule and the new Keynesian use of the budget looked to be fully harmonious.
This apparent reconciliation of these two sets of budgetary principles would possibly have been successful if, in fact, business cycles were somehow known to be regular in their amplitude and time sequence and, in addition, were known to exist exogenous to economic policy.
In this situation, and only in this situation, business activity would rise and fall with a regular and predictable rhythm.
Budget deficits and surpluses could be applied symmetrically, and the amplitude of the fluctuations could be diminished.
The deficits and surpluses would cancel out over the entire cycle, and yet macroeconomic management would smooth out both the peaks and the troughs of economic activity.
When business cycles occur in a predictable pattern of regular oscillations and when political constraints on budgetary policy are ignored, the principle of a balanced budget over the cycle seems to bridge the gulf that otherwise would seem to separate the classical and the Keynesian prescriptions.
Even if the underlying oscillations in economic activity were known to be regular and exogenous, this budgetary rule would probably be applied asymmetrically in a democratic setting, for reasons we have already developed in Chapter 7.
Once the irregularity and subsequent nonpredictability of cycles are acknowledged, this political bias would become even stronger.
However, in a setting in which cyclical swings are known to be regular, the presence of a cumulative budget deficit over the whole cycle would offer a clear and unambiguous indicator that the balancing rule had been violated.
Knowledge that such a criterion might be present would itself act as a constraint on irresponsible budgetary behavior.
When cycles are irregular, however, the rule for a cyclically balanced budget and that for functional finance are inconsistent, quite independent of political bias in application.
One has to give way to the other.
Either the cyclically balanced budget must be pursued at the expense of functional finance, or functional finance must take precedence over the norm of a cyclically balanced budget.
The irregularity of cycles undermines the bridge between the two norms and, therefore, negates the possibility that the rule of budget balance over the cycle could serve as an effective substitute for the constitutional constraint of budget balance within the accounting period.
The principle of a balanced budget over the cycle, which acknowledged the necessity for budgetary manipulation to achieve common stabilization objectives, had a relatively short existence in the arsenal of fiscal weapons.
A line of argument soon surfaced to suggest that prevailing budgetary-fiscal institutions operated automatically to stabilize the aggregate level of economic activity.
This idea of built-in flexibility shifted the focus from the need for discretionary fiscal manipulation to the prospects for institutional adjustments that would ensure automatic fiscal reactions in the direction of desired objectives.
TO BE CONTINUED ...
THE POLITICAL LEGACY OF LORD KEYNES
Re: THE POLITICAL LEGACY OF LORD KEYNES
The Library of Economics and Liberty
Democracy in Deficit: The Political Legacy of Lord Keynes, continued ...
By James M. Buchanan and Richard E. Wagner
Part III. What Can Be Done?
Chapter 10 Alternative Budgetary Rules, continued ...
Built-in Flexibility
As our narrative in earlier chapters has shown, one of the first steps on the way to full-fledged Keynesian budgetary management was the recognition that attempts to maintain strict budget balance during periods of economic distress might accentuate depression and, in turn, worsen rather than improve the prospects of budget balance.
It was noted that the deficits of the early depression years of the 1930s were due to the simultaneous fall in tax revenues and the increase in relief outlays, and that these deficits themselves were forces leading toward recovery.
Before the 1930s, when strictly classical principles were dominant, such “built-in flexibility” was considered to be an undesirable property of a fiscal system.
Instability in revenues and outlays was something to be avoided, since this made the task of balancing the budget more difficult.
With the deficits of the Great Depression, however, there came to be increasing awareness that such instability was desirable in itself.
Macroeconomic considerations began to emerge, and built-in flexibility was adjudged to moderate fluctuations in aggregate economic activity. 60
Once these side effects of budgetary unbalance were fully recognized to be desirable, a natural extension, and especially to those economists who had accepted the then new Keynesian paradigm, was to propose structural changes in the budget that would increase the macroeconomic adjustments, that would increase the built-in flexibility.
That is to say, Keynesian-inspired norms for both the taxing and the spending structure appeared alongside the traditional norms which were derivative from considerations internal to the fiscal system rather than external.
Proposals for tax reform came to be evaluated against macroeconomic criteria, for their effects on real income and employment, over and above those familiar criteria of “justice,” “equity,” “convenience,” “certainty,” and others.
In some cases, the macroeconomic criteria achieved dominance in the economists’ lexicon.
Similar changes occurred in the analysis of spending.
Macroeconomic arguments, based on Keynesian economics, came to be advanced for the acceleration of welfare and relief types of budgetary outlay.
In their early phases, however, the policy implications of these arguments for built-in flexibility were confined to structural features on both the revenue and spending sides of the fiscal account.
There was nothing here that offered a norm or criterion for the state of budget balance or imbalance.
In one sense, the discovery of built-in flexibility, both in its positive and in its normative aspect, was supplemental to the accompanying discussion of alternatives to the balanced-budget rule.
TO BE CONTINUED ...
Democracy in Deficit: The Political Legacy of Lord Keynes, continued ...
By James M. Buchanan and Richard E. Wagner
Part III. What Can Be Done?
Chapter 10 Alternative Budgetary Rules, continued ...
Built-in Flexibility
As our narrative in earlier chapters has shown, one of the first steps on the way to full-fledged Keynesian budgetary management was the recognition that attempts to maintain strict budget balance during periods of economic distress might accentuate depression and, in turn, worsen rather than improve the prospects of budget balance.
It was noted that the deficits of the early depression years of the 1930s were due to the simultaneous fall in tax revenues and the increase in relief outlays, and that these deficits themselves were forces leading toward recovery.
Before the 1930s, when strictly classical principles were dominant, such “built-in flexibility” was considered to be an undesirable property of a fiscal system.
Instability in revenues and outlays was something to be avoided, since this made the task of balancing the budget more difficult.
With the deficits of the Great Depression, however, there came to be increasing awareness that such instability was desirable in itself.
Macroeconomic considerations began to emerge, and built-in flexibility was adjudged to moderate fluctuations in aggregate economic activity. 60
Once these side effects of budgetary unbalance were fully recognized to be desirable, a natural extension, and especially to those economists who had accepted the then new Keynesian paradigm, was to propose structural changes in the budget that would increase the macroeconomic adjustments, that would increase the built-in flexibility.
That is to say, Keynesian-inspired norms for both the taxing and the spending structure appeared alongside the traditional norms which were derivative from considerations internal to the fiscal system rather than external.
Proposals for tax reform came to be evaluated against macroeconomic criteria, for their effects on real income and employment, over and above those familiar criteria of “justice,” “equity,” “convenience,” “certainty,” and others.
In some cases, the macroeconomic criteria achieved dominance in the economists’ lexicon.
Similar changes occurred in the analysis of spending.
Macroeconomic arguments, based on Keynesian economics, came to be advanced for the acceleration of welfare and relief types of budgetary outlay.
In their early phases, however, the policy implications of these arguments for built-in flexibility were confined to structural features on both the revenue and spending sides of the fiscal account.
There was nothing here that offered a norm or criterion for the state of budget balance or imbalance.
In one sense, the discovery of built-in flexibility, both in its positive and in its normative aspect, was supplemental to the accompanying discussion of alternatives to the balanced-budget rule.
TO BE CONTINUED ...
Re: THE POLITICAL LEGACY OF LORD KEYNES
The Library of Economics and Liberty
Democracy in Deficit: The Political Legacy of Lord Keynes, continued ...
By James M. Buchanan and Richard E. Wagner
Part III. What Can Be Done?
Chapter 10 Alternative Budgetary Rules, continued ...
Budget Balance at Full Employment
The incorporation of the structural norms for built-in flexibility provided almost a natural lead-in to an alternative to that of the annually balanced budget.
This alternative is the principle of budget balance at full employment, or, as it has come to be known in the 1960s and 1970s, budget balance at high employment.
Once it came to be recognized that the budget deficits that emerged passively during periods of economic recession exerted desired pressures toward recovery, it was but a small step to the recognition that the recovery itself exerted a simultaneous effect on the size of the deficits.
From this, it followed that the expansiveness or the restrictiveness of fiscal policy might be measured, not by looking at the generation of surpluses or deficits in any current-period setting, but by predictions of the effects that would emerge in a hypothetically postulated setting of full employment. 61
In the Keynesian economic environment, if the economy is operating at full employment, there is no Keynesian-inspired reason for departure from budget balance.
The norm should become, therefore, that of setting revenues and expenditures such that the two sides of the budget will come into balance if the full-employment level of income should be achieved.
Under the operation of this norm, and because of the built-in flexibility, surpluses would automatically be created in all settings in which demand pressures are excessive.
This alternative rule seems to incorporate both the norms for Keynesian budgetary management and the classical principle of balancing revenues against spending.
In particular, the fiscal choice process, in the Wicksellian emphasis, seems to be balanced here in that new programs of spending proposed would be weighed against the tax costs of these programs, at full-employment income.
The analytical basis of the budget-balance-at-full-employment rule is starkly simple.
Assume, for purposes of argument here, that federal budget outlays are currently at an annual rate of $400 billion, and that tax collections are at the annual rate of $350 billion.
In current account terms, there is a budget deficit of $50 billion on an annualized basis.
Suppose, however, that the economic situation is also characterized by an unemployment rate of 7 percent, clearly adjudged to be a less-than-full-employment rate.
Now assume further that it is predicted that a fall in the unemployment rate (i.e., an increase in real income and employment) acts both to increase tax collections (because of the increase in income) and to reduce somewhat the rate of federal spending (on unemployment compensation, on food stamps, on relief payments).
Let us say that it is predicted that a 2-percent shift in the unemployment rate, to 5 percent, will increase tax revenues to $390 billion and will cut spending to $390 billion.
The $50 billion budget deficit, now observed, would vanish and the budget would be in balance.
But what if “full employment” is defined to be 4 percent?
The budget would have reached balance at the 5-percent unemployment rate.
If unemployment should be reduced to 4 percent, further operation of the built-in stabilizers would generate total revenues at a predicted $410 billion rate, and outlays would be predicted to fall to $385 billion.
Hence, at the defined full-employment rate of 4 percent, the federal budget would be in surplus, not in deficit.
The initially observed $50 billion shortfall in revenues behind outlays would actually be indicative of a “full-employment surplus.”
Politicians, the public, and the professors might then talk themselves into thinking that a fully responsible fiscal policy would require increasing the observed deficit.
“Full-employment surplus,” a phrase that became prominent in the Economic Report of the President’s Council of Economic Advisers after 1962, is the difference between anticipated federal revenues and federal government outlays or expenditures that are projected at some arbitrarily designated level of employment and income. 62
As early as 1947, the Committee for Economic Development proposed that the federal budget should be arranged so that a $3 billion surplus would emerge at an unemployment rate of 4 percent. 63
This particular projection also yielded a balanced budget at an unemployment rate of 6 percent.
In this framework, any given budget is considered to be expansive if the full-employment surplus is negative, and contractionary if this full-employment surplus is positive.
The larger the surplus, the more restrictive the budget structure is considered, regardless of the fact that actual budget may be running a substantial deficit.
Similarly, the more negative the full-employment surplus, the more expansive the budget is considered, regardless of the actual, contemporaneous relation between taxes and expenditures.
The conception of budget balance at full employment has wide support, and, as a norm, it might appear to be a reasonable compromise between the old-time fiscal religion and the Keynesian precepts.
The implied norms for budget balance at full employment seem to meet minimal classical requirements while allowing functional finance to operate.
This service to two masters might be pardonable if the principle should be able to achieve its logical promise in practice.
But it should be clear that this promise will not likely be met.
Politically, what appears to be a vehicle to promote fiscal responsibility may become little more than an excuse for the budgetary license.
Quite apart from the political implications, however, the whole conception is deceptive in its unacknowledged dependence on the existence of the presumed economic environment of the 1930s.
We shall initially examine the possible application of this principle independently of the political- or public-choice biases that emerge in exaggerated form under its influence.
To do so, we may assume that democratic political pressures exert no influence on fiscal decisions, which are made exclusively by “wise” persons in Washington.
This is, of course, a wholly unrealistic setting for fiscal policy choices, but it helpfully allows us to isolate the fundamental economic implications of this proposed alternative rule for budget making.
The rule is deceptive because it tends to conceal the implicit assumption about the state or condition of the economy that it contains.
This is that the national economy resembles the economy of the early Keynesian models.
In these, as we have previously noted, “full-employment income” is sharply and clearly defined; expansions in total spending exclusively affect real output and employment until this level of income is attained; there is no upward pressure on prices.
These naive models have substantially disappeared from sophisticated economic discourse, but it is perhaps a mark of the distance between the realm of ideas and that of practice that these naive models seem to persist beneath the surface of most current discussions of the full-employment surplus.
In earlier chapters, we traced the history of the changes in economists’ attitudes as these naive models were replaced by those that embodied the Phillips-curve sort of trade-off between unemployment and inflation.
A specific definition for “full-employment income” does not emerge from the trade-off models, and macroeconomic policy of any kind requires the selection of some point on a curve which is seen as continuous, with no kinks or corners.
But what does this do to the rule for budget balance at full employment?
The dilemma has, of course, been recognized, and attempts have been made to rescue the efficacy of the widely accepted principle for fiscal “responsibility” by specifying some combined unemployment-inflation targets.
These have ranged from the more restrictive norm of “budget balance at that level of income and employment that can be achieved without inflation” to the norm that simply defines an employment target, say 4-percent unemployment, and disregards the potential inflationary consequences.
What is relevant for our purposes is that any such combination of targeted levels of unemployment and inflation reflects an explicit selection of an arbitrary point along an alleged inflation-unemployment trade-off curve.
As such, there is no demonstrably unique point that dominates all others, and reasonable persons may differ concerning the relative weights to be assigned to the two conflicting objectives, increased employment and reduced inflation.
Assignment of the decisions to “wise” persons will in no way remove the necessity of establishing some weights.
Economists in increasing numbers have gone beyond even the simplistic trade-off models, however, and it is now widely acknowledged that a Phillips curve, even if one exists, will shift through time as expectations are modified.
What does this do for the potential applicability of the “budget balance at full employment” rule?
Suppose, for example, that a combination of a 4-percent unemployment rate and a 4-percent rate of inflation is selected as the objective for policy, as the economic setting for which an attempt would be made to bring federal government revenues and outlays into balance.
Suppose, further, that this combination does, in fact, describe a possible position for the economy at the time the target is selected, say, in 1977.
Let us say that budgetary plans for 1978 and 1979 are then made on the basis of this target, and budgetary authorities rearrange institutions of taxing and spending to this end (such decisions are now made, we assume, by the bureaucrats appointed by the wise persons).
But this whole procedure, to be at all workable, depends on the stability of the presumed Phillips curve, on the attainability of the 4-4 points.
Suppose, however, that, by the time the budgetary adjustments take effect, by 1979, the Phillips curve has shifted, and the rate of inflation that will emerge at a 4-percent unemployment rate is 6 percent, rather than the 4 percent incorporated in the plans.
The emptiness of the proposed norm for budgetary management becomes apparent. 64
At the extreme other end of the spectrum from the early naive Keynesian models in which a full-employment level of income is sharply defined is the model that denies the existence of any trade-off and that embodies a “natural rate” of unemployment, which cannot be permanently modified by shifts in the rate of aggregate spending. 65
If this model should, in fact, describe empirical reality, while, at the same time, the “budget balance at full employment” norm is pursued, either in its pristine form or in some Phillips-curve variant, the avenue is opened for a regime of continuous budget deficits which would be wholly ineffective in achieving the macroeconomic objectives for which they are created.
To this point, we have ignored what is perhaps the most important limitation on the operation of the alternative budgetary rule, which calls for balance at full-employment income.
This is the extreme vulnerability of the rule in a political setting where fiscal decisions are made, not by wise persons immune from constituency pressures, but by ordinary politicians who are responsive to demands of the voting public.
The directional biases toward budgetary expansion and toward deficit financing that we have discussed in Chapter 7 are exaggerated under any attempt to apply the alternative rule for budgetary management.
The predictions made about the employment-increasing potential of budget deficits are likely to be unduly unrealistic on the optimistic side, while, at the same time, the inflation-producing results of these deficits are likely to be discounted.
The targeted combinations of unemployment and inflation rates that emerge from the choices of politicians are quite likely to lie off of the short-run Phillips curve for the economy rather than on it.
Even if a point is selected that lies on the relevant curve, the relative weight given to the employment objective is likely to be high relative to that accorded to monetary stability.
Quite apart from biases in the selection of targets, however, the proposed rule is politically open to abuse because of the absence of any feedback constraint on error stemming from overoptimistic projections.
Both the annually balanced budget and the balanced budget over the cycle contain some benchmarks that make it possible for citizens and politicians to judge whether the stated principle is being adhered to or being violated.
Error becomes visible for all to see.
No such possibility exists with the modern fiscal norm — ”budget balance at full employment.”
There simply is no way that actual budgetary performance can be evaluated with a view to determine whether the rule is or is not being followed.
A large current deficit can quite readily be passed off as actually reflecting a restrictive fiscal policy.
And there is no way that this allegation can be tested, because the idealized conditions that would be required for a test will never exist, and could never exist.
TO BE CONTINUED ...
Democracy in Deficit: The Political Legacy of Lord Keynes, continued ...
By James M. Buchanan and Richard E. Wagner
Part III. What Can Be Done?
Chapter 10 Alternative Budgetary Rules, continued ...
Budget Balance at Full Employment
The incorporation of the structural norms for built-in flexibility provided almost a natural lead-in to an alternative to that of the annually balanced budget.
This alternative is the principle of budget balance at full employment, or, as it has come to be known in the 1960s and 1970s, budget balance at high employment.
Once it came to be recognized that the budget deficits that emerged passively during periods of economic recession exerted desired pressures toward recovery, it was but a small step to the recognition that the recovery itself exerted a simultaneous effect on the size of the deficits.
From this, it followed that the expansiveness or the restrictiveness of fiscal policy might be measured, not by looking at the generation of surpluses or deficits in any current-period setting, but by predictions of the effects that would emerge in a hypothetically postulated setting of full employment. 61
In the Keynesian economic environment, if the economy is operating at full employment, there is no Keynesian-inspired reason for departure from budget balance.
The norm should become, therefore, that of setting revenues and expenditures such that the two sides of the budget will come into balance if the full-employment level of income should be achieved.
Under the operation of this norm, and because of the built-in flexibility, surpluses would automatically be created in all settings in which demand pressures are excessive.
This alternative rule seems to incorporate both the norms for Keynesian budgetary management and the classical principle of balancing revenues against spending.
In particular, the fiscal choice process, in the Wicksellian emphasis, seems to be balanced here in that new programs of spending proposed would be weighed against the tax costs of these programs, at full-employment income.
The analytical basis of the budget-balance-at-full-employment rule is starkly simple.
Assume, for purposes of argument here, that federal budget outlays are currently at an annual rate of $400 billion, and that tax collections are at the annual rate of $350 billion.
In current account terms, there is a budget deficit of $50 billion on an annualized basis.
Suppose, however, that the economic situation is also characterized by an unemployment rate of 7 percent, clearly adjudged to be a less-than-full-employment rate.
Now assume further that it is predicted that a fall in the unemployment rate (i.e., an increase in real income and employment) acts both to increase tax collections (because of the increase in income) and to reduce somewhat the rate of federal spending (on unemployment compensation, on food stamps, on relief payments).
Let us say that it is predicted that a 2-percent shift in the unemployment rate, to 5 percent, will increase tax revenues to $390 billion and will cut spending to $390 billion.
The $50 billion budget deficit, now observed, would vanish and the budget would be in balance.
But what if “full employment” is defined to be 4 percent?
The budget would have reached balance at the 5-percent unemployment rate.
If unemployment should be reduced to 4 percent, further operation of the built-in stabilizers would generate total revenues at a predicted $410 billion rate, and outlays would be predicted to fall to $385 billion.
Hence, at the defined full-employment rate of 4 percent, the federal budget would be in surplus, not in deficit.
The initially observed $50 billion shortfall in revenues behind outlays would actually be indicative of a “full-employment surplus.”
Politicians, the public, and the professors might then talk themselves into thinking that a fully responsible fiscal policy would require increasing the observed deficit.
“Full-employment surplus,” a phrase that became prominent in the Economic Report of the President’s Council of Economic Advisers after 1962, is the difference between anticipated federal revenues and federal government outlays or expenditures that are projected at some arbitrarily designated level of employment and income. 62
As early as 1947, the Committee for Economic Development proposed that the federal budget should be arranged so that a $3 billion surplus would emerge at an unemployment rate of 4 percent. 63
This particular projection also yielded a balanced budget at an unemployment rate of 6 percent.
In this framework, any given budget is considered to be expansive if the full-employment surplus is negative, and contractionary if this full-employment surplus is positive.
The larger the surplus, the more restrictive the budget structure is considered, regardless of the fact that actual budget may be running a substantial deficit.
Similarly, the more negative the full-employment surplus, the more expansive the budget is considered, regardless of the actual, contemporaneous relation between taxes and expenditures.
The conception of budget balance at full employment has wide support, and, as a norm, it might appear to be a reasonable compromise between the old-time fiscal religion and the Keynesian precepts.
The implied norms for budget balance at full employment seem to meet minimal classical requirements while allowing functional finance to operate.
This service to two masters might be pardonable if the principle should be able to achieve its logical promise in practice.
But it should be clear that this promise will not likely be met.
Politically, what appears to be a vehicle to promote fiscal responsibility may become little more than an excuse for the budgetary license.
Quite apart from the political implications, however, the whole conception is deceptive in its unacknowledged dependence on the existence of the presumed economic environment of the 1930s.
We shall initially examine the possible application of this principle independently of the political- or public-choice biases that emerge in exaggerated form under its influence.
To do so, we may assume that democratic political pressures exert no influence on fiscal decisions, which are made exclusively by “wise” persons in Washington.
This is, of course, a wholly unrealistic setting for fiscal policy choices, but it helpfully allows us to isolate the fundamental economic implications of this proposed alternative rule for budget making.
The rule is deceptive because it tends to conceal the implicit assumption about the state or condition of the economy that it contains.
This is that the national economy resembles the economy of the early Keynesian models.
In these, as we have previously noted, “full-employment income” is sharply and clearly defined; expansions in total spending exclusively affect real output and employment until this level of income is attained; there is no upward pressure on prices.
These naive models have substantially disappeared from sophisticated economic discourse, but it is perhaps a mark of the distance between the realm of ideas and that of practice that these naive models seem to persist beneath the surface of most current discussions of the full-employment surplus.
In earlier chapters, we traced the history of the changes in economists’ attitudes as these naive models were replaced by those that embodied the Phillips-curve sort of trade-off between unemployment and inflation.
A specific definition for “full-employment income” does not emerge from the trade-off models, and macroeconomic policy of any kind requires the selection of some point on a curve which is seen as continuous, with no kinks or corners.
But what does this do to the rule for budget balance at full employment?
The dilemma has, of course, been recognized, and attempts have been made to rescue the efficacy of the widely accepted principle for fiscal “responsibility” by specifying some combined unemployment-inflation targets.
These have ranged from the more restrictive norm of “budget balance at that level of income and employment that can be achieved without inflation” to the norm that simply defines an employment target, say 4-percent unemployment, and disregards the potential inflationary consequences.
What is relevant for our purposes is that any such combination of targeted levels of unemployment and inflation reflects an explicit selection of an arbitrary point along an alleged inflation-unemployment trade-off curve.
As such, there is no demonstrably unique point that dominates all others, and reasonable persons may differ concerning the relative weights to be assigned to the two conflicting objectives, increased employment and reduced inflation.
Assignment of the decisions to “wise” persons will in no way remove the necessity of establishing some weights.
Economists in increasing numbers have gone beyond even the simplistic trade-off models, however, and it is now widely acknowledged that a Phillips curve, even if one exists, will shift through time as expectations are modified.
What does this do for the potential applicability of the “budget balance at full employment” rule?
Suppose, for example, that a combination of a 4-percent unemployment rate and a 4-percent rate of inflation is selected as the objective for policy, as the economic setting for which an attempt would be made to bring federal government revenues and outlays into balance.
Suppose, further, that this combination does, in fact, describe a possible position for the economy at the time the target is selected, say, in 1977.
Let us say that budgetary plans for 1978 and 1979 are then made on the basis of this target, and budgetary authorities rearrange institutions of taxing and spending to this end (such decisions are now made, we assume, by the bureaucrats appointed by the wise persons).
But this whole procedure, to be at all workable, depends on the stability of the presumed Phillips curve, on the attainability of the 4-4 points.
Suppose, however, that, by the time the budgetary adjustments take effect, by 1979, the Phillips curve has shifted, and the rate of inflation that will emerge at a 4-percent unemployment rate is 6 percent, rather than the 4 percent incorporated in the plans.
The emptiness of the proposed norm for budgetary management becomes apparent. 64
At the extreme other end of the spectrum from the early naive Keynesian models in which a full-employment level of income is sharply defined is the model that denies the existence of any trade-off and that embodies a “natural rate” of unemployment, which cannot be permanently modified by shifts in the rate of aggregate spending. 65
If this model should, in fact, describe empirical reality, while, at the same time, the “budget balance at full employment” norm is pursued, either in its pristine form or in some Phillips-curve variant, the avenue is opened for a regime of continuous budget deficits which would be wholly ineffective in achieving the macroeconomic objectives for which they are created.
To this point, we have ignored what is perhaps the most important limitation on the operation of the alternative budgetary rule, which calls for balance at full-employment income.
This is the extreme vulnerability of the rule in a political setting where fiscal decisions are made, not by wise persons immune from constituency pressures, but by ordinary politicians who are responsive to demands of the voting public.
The directional biases toward budgetary expansion and toward deficit financing that we have discussed in Chapter 7 are exaggerated under any attempt to apply the alternative rule for budgetary management.
The predictions made about the employment-increasing potential of budget deficits are likely to be unduly unrealistic on the optimistic side, while, at the same time, the inflation-producing results of these deficits are likely to be discounted.
The targeted combinations of unemployment and inflation rates that emerge from the choices of politicians are quite likely to lie off of the short-run Phillips curve for the economy rather than on it.
Even if a point is selected that lies on the relevant curve, the relative weight given to the employment objective is likely to be high relative to that accorded to monetary stability.
Quite apart from biases in the selection of targets, however, the proposed rule is politically open to abuse because of the absence of any feedback constraint on error stemming from overoptimistic projections.
Both the annually balanced budget and the balanced budget over the cycle contain some benchmarks that make it possible for citizens and politicians to judge whether the stated principle is being adhered to or being violated.
Error becomes visible for all to see.
No such possibility exists with the modern fiscal norm — ”budget balance at full employment.”
There simply is no way that actual budgetary performance can be evaluated with a view to determine whether the rule is or is not being followed.
A large current deficit can quite readily be passed off as actually reflecting a restrictive fiscal policy.
And there is no way that this allegation can be tested, because the idealized conditions that would be required for a test will never exist, and could never exist.
TO BE CONTINUED ...
Re: THE POLITICAL LEGACY OF LORD KEYNES
The Library of Economics and Liberty
Democracy in Deficit: The Political Legacy of Lord Keynes, continued ...
By James M. Buchanan and Richard E. Wagner
Part III. What Can Be Done?
Chapter 10 Alternative Budgetary Rules, continued ...
The Budget Reform Act of 1974
The Congressional Budget and Impoundment Control Act of 1974 has been described by U.S. News & World Report as “a revolutionary budget reform intended to give Congress a tighter grip on the nation’s purse strings….”
The passage of this act indicates that the elements of the Keynesian modification of our fiscal constitution have not gone wholly unrecognized.
Such recognition that some things are awry with our fiscal conduct is an essential prerequisite to reversing the tendencies of the past generation.
The act itself, however, is unlikely to be the revolutionary reform that U.S. News & World Report suggested.
The Budget Reform Act emerged from a recognition that previous budgetary procedures generated a bias toward spending and budget deficits.
The total amount of spending emerged as the product of many individual appropriations decisions.
No decision was ever made as to the total amount of public expenditure.
Moreover, decisions regarding taxation were made independently of decisions regarding expenditure.
A decision to increase expenditure could be made in isolation from decisions about whether that expenditure should be financed by increased taxation, by issuance of public debt, or by reduced expenditure for other services.
It increasingly came to be recognized that such institutional practices created biases toward public spending and budget deficits.
This growing recognition inspired and informed the Budget Reform Act of 1974. 66
A Budget Committee was created for each house, and these committees were given the task of setting overall targets for revenues, expenditures, and the resulting deficit or surplus.
As well as setting a target for the overall level of expenditure, these committees were supposed to apportion this amount among sixteen functional categories of public expenditure.
A Congressional Budget Office was created to assist in this process, as well as to make five-year projections.
These projections were designed to help gauge the future impact of present decisions.
Under the previous setting for budgetary choice, programs would often be created with small initial expenditure requirements, but would soon undergo an explosive growth in spending requirements.
The fiscal year was changed to start on 1 October, rather than on 1 July.
Accordingly, fiscal 1977 began on 1 October 1976, instead of 1 July 1976, as it would have done previously.
By 15 May preceding the start of the new fiscal year, Congress is required to have passed its first concurrent resolution.
This resolution contains tentative targets for outlays and revenues, as well as for such residually determined magnitudes as the budget deficit or surplus and the amount of national debt.
Furthermore, this target amount for total outlay is apportioned among the sixteen functional categories.
After the passage of this first concurrent resolution, the former congressional procedures take effect.
Separate committees examined the various proposals for appropriations and revenues, with these various examinations being conducted in light of the first concurrent resolution.
By late September, Congress is required to have passed the second concurrent resolution, with the fiscal year then starting on 1 October.
This second resolution is supposed to resolve any discrepancies that arise between the first resolution and the decisions that were made subsequently.
The Budget Reform Act is not the first attempt at instituting a comprehensive process of budget review.
The Legislative Reorganization Act of 1946 also attempted to impose a congressional assessment of the entire budget.
That legislation established a joint committee of the Senate and House that would determine an appropriation ceiling, the intention being that this ceiling would control the growth in expenditure.
Only in 1949, however, did Congress manage to establish such a ceiling.
And it promptly ignored that ceiling by approving appropriations that exceeded the ceiling by more than $6 billion.
Until 1974, there were no further attempts at overall congressional control of the budget.
It is, of course, always possible that the 1974 act will prove to be more successful than the 1946 act.
The act itself, however, does nothing to curb deficit spending.
Rather, it merely requires that the projected level of the deficit be made explicit. 67
Moreover, any divergence of the second concurrent resolution from the first is likely to be in the direction of larger spending and larger deficits.
It is unlikely indeed that the appropriations committees would generate projected outlays below the targets set in the first concurrent resolution.
Any discrepancies would almost certainly be in the direction of increased appropriations.
It is also unlikely that the second concurrent resolution would simply disallow all of these resulting discrepancies.
While some may be disallowed, the second resolution is also likely to set higher expenditure levels, along with larger deficits.
The most reasonable assessment of the Budget Reform Act seems to be, as Lenin might have put it: “Expenditure ceilings, like pie crusts, are meant to be broken.”
TO BE CONTINUED ...
Democracy in Deficit: The Political Legacy of Lord Keynes, continued ...
By James M. Buchanan and Richard E. Wagner
Part III. What Can Be Done?
Chapter 10 Alternative Budgetary Rules, continued ...
The Budget Reform Act of 1974
The Congressional Budget and Impoundment Control Act of 1974 has been described by U.S. News & World Report as “a revolutionary budget reform intended to give Congress a tighter grip on the nation’s purse strings….”
The passage of this act indicates that the elements of the Keynesian modification of our fiscal constitution have not gone wholly unrecognized.
Such recognition that some things are awry with our fiscal conduct is an essential prerequisite to reversing the tendencies of the past generation.
The act itself, however, is unlikely to be the revolutionary reform that U.S. News & World Report suggested.
The Budget Reform Act emerged from a recognition that previous budgetary procedures generated a bias toward spending and budget deficits.
The total amount of spending emerged as the product of many individual appropriations decisions.
No decision was ever made as to the total amount of public expenditure.
Moreover, decisions regarding taxation were made independently of decisions regarding expenditure.
A decision to increase expenditure could be made in isolation from decisions about whether that expenditure should be financed by increased taxation, by issuance of public debt, or by reduced expenditure for other services.
It increasingly came to be recognized that such institutional practices created biases toward public spending and budget deficits.
This growing recognition inspired and informed the Budget Reform Act of 1974. 66
A Budget Committee was created for each house, and these committees were given the task of setting overall targets for revenues, expenditures, and the resulting deficit or surplus.
As well as setting a target for the overall level of expenditure, these committees were supposed to apportion this amount among sixteen functional categories of public expenditure.
A Congressional Budget Office was created to assist in this process, as well as to make five-year projections.
These projections were designed to help gauge the future impact of present decisions.
Under the previous setting for budgetary choice, programs would often be created with small initial expenditure requirements, but would soon undergo an explosive growth in spending requirements.
The fiscal year was changed to start on 1 October, rather than on 1 July.
Accordingly, fiscal 1977 began on 1 October 1976, instead of 1 July 1976, as it would have done previously.
By 15 May preceding the start of the new fiscal year, Congress is required to have passed its first concurrent resolution.
This resolution contains tentative targets for outlays and revenues, as well as for such residually determined magnitudes as the budget deficit or surplus and the amount of national debt.
Furthermore, this target amount for total outlay is apportioned among the sixteen functional categories.
After the passage of this first concurrent resolution, the former congressional procedures take effect.
Separate committees examined the various proposals for appropriations and revenues, with these various examinations being conducted in light of the first concurrent resolution.
By late September, Congress is required to have passed the second concurrent resolution, with the fiscal year then starting on 1 October.
This second resolution is supposed to resolve any discrepancies that arise between the first resolution and the decisions that were made subsequently.
The Budget Reform Act is not the first attempt at instituting a comprehensive process of budget review.
The Legislative Reorganization Act of 1946 also attempted to impose a congressional assessment of the entire budget.
That legislation established a joint committee of the Senate and House that would determine an appropriation ceiling, the intention being that this ceiling would control the growth in expenditure.
Only in 1949, however, did Congress manage to establish such a ceiling.
And it promptly ignored that ceiling by approving appropriations that exceeded the ceiling by more than $6 billion.
Until 1974, there were no further attempts at overall congressional control of the budget.
It is, of course, always possible that the 1974 act will prove to be more successful than the 1946 act.
The act itself, however, does nothing to curb deficit spending.
Rather, it merely requires that the projected level of the deficit be made explicit. 67
Moreover, any divergence of the second concurrent resolution from the first is likely to be in the direction of larger spending and larger deficits.
It is unlikely indeed that the appropriations committees would generate projected outlays below the targets set in the first concurrent resolution.
Any discrepancies would almost certainly be in the direction of increased appropriations.
It is also unlikely that the second concurrent resolution would simply disallow all of these resulting discrepancies.
While some may be disallowed, the second resolution is also likely to set higher expenditure levels, along with larger deficits.
The most reasonable assessment of the Budget Reform Act seems to be, as Lenin might have put it: “Expenditure ceilings, like pie crusts, are meant to be broken.”
TO BE CONTINUED ...
Re: THE POLITICAL LEGACY OF LORD KEYNES
The Library of Economics and Liberty
Democracy in Deficit: The Political Legacy of Lord Keynes, continued ...
By James M. Buchanan and Richard E. Wagner
Part III. What Can Be Done?
Chapter 10 Alternative Budgetary Rules, concluded ...
Short-Term Politics for Long-Term Objectives
Since the Keynesian destruction of the balanced-budget principle, we have witnessed a parade of alternative principles, all pretending to function as constraints on budgetary excesses.
To date, none of these alternatives have been successful in this regard.
Budgets continually become ever more bloated, and we have now become accustomed to thinking of a 2- or 3-percent inflation as an objective we might possibly attain once again in the dim future.
One now hears little about price stability, and the pace of the extension of bureaucratic controls is still quickening.
The complex rules and principles that have been advanced over the past generation have given an illusion of control.
They appear to mitigate the apparent disparity between common-sense notions of responsible fiscal behavior and the widely sensed irresponsibility of present budgetary outcomes.
These complex rules suggest that the appearance of irresponsibility is illusory, and that such observed budgetary behavior is really necessary to fulfill the precepts of fiscal responsibility.
These arguments say we must travel the deficits road to surplus (or balance).
Since our political conversion to Keynesianism during the Kennedy administration, we have been told that deficits today will stimulate the economy into producing full-employment surpluses tomorrow.
Only tomorrow never seems to come.
Deficits have become ever more firmly ensconced as a way of life, and the imminency of surpluses has receded — once we were told that it would take only a few years before the federal budget would be in surplus, but the number of years lengthens as the size of the deficits grows.
Can any honest person realistically predict balance in the federal budget? 68
Such complex budgetary rules as “balance at full employment” serve to rationalize budgetary irresponsibility by playing upon the sense that the present is unique and involves special circumstances, and that once these circumstances have been dealt with, we can revert to the rules applicable to “normal” settings.
This is like the alcoholic who has some sense that all is not well with his conduct of his life, and who resolves to get hold of himself once the particular tensions he currently finds unbearable have passed him by.
Only each day, week, or month presents a fresh set of tensions, unusual circumstances, and special conditions, so “normalcy” never returns, for either the alcoholic or the Keynesian political economy.
We have been witnessing the political working out of a conflict familiar to all of us, that between short-term and long-term considerations.
We all recognize that the fixation on some long-term objective or goal is necessary to provide a disciplinary base for judging short-term choices.
But if that long-term objective is not fixed in mind, or if it is permitted to be swamped by momentary, short-term considerations, the result almost surely will produce a drift in directions far removed from those that would be considered desirable.
Politicians themselves have, for the most part, short time horizons.
For most of them, each election presents a critical point, and the primary problem they face is getting past this hurdle.
“Tis better to run away today to be around to fight again another day” might well be the motto.
This is not to say that politicians never look beyond the next election in choosing courses of action, but only that such short-term considerations dominate the actions of most of them.
Such features are, of course, an inherent and necessary attribute of a democracy.
But when this necessary attribute is mixed with a fiscal constitution that does not restrain the ordinary spending and deficit-creating proclivities, the result portends disaster.
We do not suggest that we relinquish political and public control of our affairs, but only that politicians be placed once again in an effective constitutional framework in which budgetary manipulation for purposes of enhancing short-run political survival is more tightly restrained, thereby giving fuller scope to the working of the long-term forces that are so necessary for the smooth functioning of our economic order.
Just as an alcoholic might embrace Alcoholics Anonymous, so might a nation drunk on deficits and gorged with government embrace a balanced budget and monetary stability.
59. The seminal exposition of functional finance is Abba P. Lerner, “Functional Finance and the Federal Debt,” Social Research 10 (February 1943): 38-51.
60. See Herbert Stein, The Fiscal Revolution in America (Chicago: University of Chicago Press, 1969), pp. 187-190, for a discussion of the change in attitudes toward built-in flexibility which took place during the 1930s.
61. See Stein, pp. 127-128, for a discussion of the emergence of this idea.
62. For a description of the technique used to estimate full-employment surplus, see Keith Carlson, “Estimates of the High-Employment Budget, 1947-1967,” Federal Reserve Board of St. Louis, Review 49 (June 1967): 6-14.
63. Taxes and the Budget: A Program for Prosperity in a Free Economy (New York: Committee for Economic Development, 1947). See also Walter W. Heller, “CED’s Stabilizing Budget Policy after Ten Years,” American Economic Review 47 (September 1957): 634-651.
64. In an argument related to our point here, Lucas has cast doubt upon the ability to use the parameters of econometric models for evaluating alternative public policies. The reason is that the selection of a policy will itself modify the actions of economic agents, thereby altering the behavior implied by the estimated parameters and vitiating the conclusions of the econometric model. See Robert E. Lucas, Jr., “Econometric Policy Evaluation: A Critique,” in Karl Brunner and Allan H. Meltzer, eds., The Phillips Curve and Labor Markets (Amsterdam: North-Holland, 1976), pp. 19-46.
65. For a discussion, see Milton Friedman, “The Role of Monetary Policy,” American Economic Review 58 (March 1968): 1-17.
66. For a description and discussion of the act, see Committee for Economic Development, The New Congressional Budget Process and the Economy (New York: Committee for Economic Development, 1975); and Jesse Burkhead and Charles Knerr, “Congressional Budget Reform: New Decision Structures” (Paper presented at a conference, “Federal Fiscal Responsibility,” March 1976), to be published in a volume of proceedings.
67. Some economists have suggested that the Keynesian-oriented staff of the Congressional Budget Office, created under the 1974 act, may exert a direct influence toward larger deficits rather than toward smaller. Comments by Beryl Sprinkel to this effect were reported in the Washington Post, 5 May 1976, p. D9.
68. The conventional journalistic wisdom on economists’ views on budget balance was expressed in Time‘s report on the economic advisers to the 1976 presidential contenders. The account stated that “Martin Anderson is one of the few economists who still believe that a literally balanced federal budget is possible” (Time, 26 April 1976, p. 54). While we should acknowledge that relatively few of our professional colleagues would now believe that budget balance is desirable, we should indeed be surprised to learn that few consider balance to be possible, unless, of course, the political constraints that we emphasize are incorporated into the prediction.
TO BE CONTINUED ...
Democracy in Deficit: The Political Legacy of Lord Keynes, continued ...
By James M. Buchanan and Richard E. Wagner
Part III. What Can Be Done?
Chapter 10 Alternative Budgetary Rules, concluded ...
Short-Term Politics for Long-Term Objectives
Since the Keynesian destruction of the balanced-budget principle, we have witnessed a parade of alternative principles, all pretending to function as constraints on budgetary excesses.
To date, none of these alternatives have been successful in this regard.
Budgets continually become ever more bloated, and we have now become accustomed to thinking of a 2- or 3-percent inflation as an objective we might possibly attain once again in the dim future.
One now hears little about price stability, and the pace of the extension of bureaucratic controls is still quickening.
The complex rules and principles that have been advanced over the past generation have given an illusion of control.
They appear to mitigate the apparent disparity between common-sense notions of responsible fiscal behavior and the widely sensed irresponsibility of present budgetary outcomes.
These complex rules suggest that the appearance of irresponsibility is illusory, and that such observed budgetary behavior is really necessary to fulfill the precepts of fiscal responsibility.
These arguments say we must travel the deficits road to surplus (or balance).
Since our political conversion to Keynesianism during the Kennedy administration, we have been told that deficits today will stimulate the economy into producing full-employment surpluses tomorrow.
Only tomorrow never seems to come.
Deficits have become ever more firmly ensconced as a way of life, and the imminency of surpluses has receded — once we were told that it would take only a few years before the federal budget would be in surplus, but the number of years lengthens as the size of the deficits grows.
Can any honest person realistically predict balance in the federal budget? 68
Such complex budgetary rules as “balance at full employment” serve to rationalize budgetary irresponsibility by playing upon the sense that the present is unique and involves special circumstances, and that once these circumstances have been dealt with, we can revert to the rules applicable to “normal” settings.
This is like the alcoholic who has some sense that all is not well with his conduct of his life, and who resolves to get hold of himself once the particular tensions he currently finds unbearable have passed him by.
Only each day, week, or month presents a fresh set of tensions, unusual circumstances, and special conditions, so “normalcy” never returns, for either the alcoholic or the Keynesian political economy.
We have been witnessing the political working out of a conflict familiar to all of us, that between short-term and long-term considerations.
We all recognize that the fixation on some long-term objective or goal is necessary to provide a disciplinary base for judging short-term choices.
But if that long-term objective is not fixed in mind, or if it is permitted to be swamped by momentary, short-term considerations, the result almost surely will produce a drift in directions far removed from those that would be considered desirable.
Politicians themselves have, for the most part, short time horizons.
For most of them, each election presents a critical point, and the primary problem they face is getting past this hurdle.
“Tis better to run away today to be around to fight again another day” might well be the motto.
This is not to say that politicians never look beyond the next election in choosing courses of action, but only that such short-term considerations dominate the actions of most of them.
Such features are, of course, an inherent and necessary attribute of a democracy.
But when this necessary attribute is mixed with a fiscal constitution that does not restrain the ordinary spending and deficit-creating proclivities, the result portends disaster.
We do not suggest that we relinquish political and public control of our affairs, but only that politicians be placed once again in an effective constitutional framework in which budgetary manipulation for purposes of enhancing short-run political survival is more tightly restrained, thereby giving fuller scope to the working of the long-term forces that are so necessary for the smooth functioning of our economic order.
Just as an alcoholic might embrace Alcoholics Anonymous, so might a nation drunk on deficits and gorged with government embrace a balanced budget and monetary stability.
59. The seminal exposition of functional finance is Abba P. Lerner, “Functional Finance and the Federal Debt,” Social Research 10 (February 1943): 38-51.
60. See Herbert Stein, The Fiscal Revolution in America (Chicago: University of Chicago Press, 1969), pp. 187-190, for a discussion of the change in attitudes toward built-in flexibility which took place during the 1930s.
61. See Stein, pp. 127-128, for a discussion of the emergence of this idea.
62. For a description of the technique used to estimate full-employment surplus, see Keith Carlson, “Estimates of the High-Employment Budget, 1947-1967,” Federal Reserve Board of St. Louis, Review 49 (June 1967): 6-14.
63. Taxes and the Budget: A Program for Prosperity in a Free Economy (New York: Committee for Economic Development, 1947). See also Walter W. Heller, “CED’s Stabilizing Budget Policy after Ten Years,” American Economic Review 47 (September 1957): 634-651.
64. In an argument related to our point here, Lucas has cast doubt upon the ability to use the parameters of econometric models for evaluating alternative public policies. The reason is that the selection of a policy will itself modify the actions of economic agents, thereby altering the behavior implied by the estimated parameters and vitiating the conclusions of the econometric model. See Robert E. Lucas, Jr., “Econometric Policy Evaluation: A Critique,” in Karl Brunner and Allan H. Meltzer, eds., The Phillips Curve and Labor Markets (Amsterdam: North-Holland, 1976), pp. 19-46.
65. For a discussion, see Milton Friedman, “The Role of Monetary Policy,” American Economic Review 58 (March 1968): 1-17.
66. For a description and discussion of the act, see Committee for Economic Development, The New Congressional Budget Process and the Economy (New York: Committee for Economic Development, 1975); and Jesse Burkhead and Charles Knerr, “Congressional Budget Reform: New Decision Structures” (Paper presented at a conference, “Federal Fiscal Responsibility,” March 1976), to be published in a volume of proceedings.
67. Some economists have suggested that the Keynesian-oriented staff of the Congressional Budget Office, created under the 1974 act, may exert a direct influence toward larger deficits rather than toward smaller. Comments by Beryl Sprinkel to this effect were reported in the Washington Post, 5 May 1976, p. D9.
68. The conventional journalistic wisdom on economists’ views on budget balance was expressed in Time‘s report on the economic advisers to the 1976 presidential contenders. The account stated that “Martin Anderson is one of the few economists who still believe that a literally balanced federal budget is possible” (Time, 26 April 1976, p. 54). While we should acknowledge that relatively few of our professional colleagues would now believe that budget balance is desirable, we should indeed be surprised to learn that few consider balance to be possible, unless, of course, the political constraints that we emphasize are incorporated into the prediction.
TO BE CONTINUED ...
Re: THE POLITICAL LEGACY OF LORD KEYNES
The Library of Economics and Liberty
Democracy in Deficit: The Political Legacy of Lord Keynes, continued ...
By James M. Buchanan and Richard E. Wagner
Part III. What Can Be Done?
Chapter 11 - What about Full Employment?
Introduction
Much of our argument in this book may find widespread acceptance.
But many who find our diagnosis persuasive may reject our implicit prescription of a return to the old-fashioned norms of fiscal conduct.
The fiscal policy clock cannot simply be turned back, and, since the Employment Act of 1946, the United States has been committed to pursuing policies that promote full employment.
Those who accept our diagnosis but who balk at our implied remedy are likely to ask, “What about full employment?”
The old-fashioned medicine might have been fine for the pre-Keynesian era, but the complex economic and political setting of the modern world may seem to dictate the administration of more potent Keynesian-like elixir.
Can we really do other than pursue activist fiscal policies until the economy gets on and stays on its potential growth path?
Perhaps then, and only then, we might return to something resembling the rules.
TO BE CONTINUED ...
Democracy in Deficit: The Political Legacy of Lord Keynes, continued ...
By James M. Buchanan and Richard E. Wagner
Part III. What Can Be Done?
Chapter 11 - What about Full Employment?
Introduction
Much of our argument in this book may find widespread acceptance.
But many who find our diagnosis persuasive may reject our implicit prescription of a return to the old-fashioned norms of fiscal conduct.
The fiscal policy clock cannot simply be turned back, and, since the Employment Act of 1946, the United States has been committed to pursuing policies that promote full employment.
Those who accept our diagnosis but who balk at our implied remedy are likely to ask, “What about full employment?”
The old-fashioned medicine might have been fine for the pre-Keynesian era, but the complex economic and political setting of the modern world may seem to dictate the administration of more potent Keynesian-like elixir.
Can we really do other than pursue activist fiscal policies until the economy gets on and stays on its potential growth path?
Perhaps then, and only then, we might return to something resembling the rules.
TO BE CONTINUED ...
Re: THE POLITICAL LEGACY OF LORD KEYNES
The Library of Economics and Liberty
Democracy in Deficit: The Political Legacy of Lord Keynes, continued ...
By James M. Buchanan and Richard E. Wagner
Part III. What Can Be Done?
Chapter 11 - What about Full Employment?, continued ...
Current Unemployment and the Quandary of Policy
With the passage of the Employment Act of 1946, Congress declared that it was the policy and responsibility of the Federal Government … to coordinate and utilize all its plans, functions, and resources for the purpose of creating and maintaining … conditions under which there will be afforded useful employment for those able, willing, and seeking to work.
The Council of Economic Advisers was created to assist in the implementation of this act.
Just what constitutes “full employment” was not defined in the act, and, moreover, it is an inherently unobservable variable.
Despite this necessary imprecision in definition, the Employment Act is exceedingly significant, for with its enactment, the Congress sanctified the principal thrust of the Keynesian analysis.
By implication, the free enterprise economy was officially conceived to be unstable; it became the task of government to act as a balance wheel to promote stability and growth.
The Employment Act mandated that the government practice compensatory policy so as to promote full employment.
Whenever employment declined below that level defined to be “full employment,” government seemed legally to be required to undertake expansive budgetary and/or monetary policy. 69
But what is full employment?
The Keynesian economists have never been precisely clear on this question, and their acceptable targets have been moved progressively downward through time.
In the 1962 Report of the Council of Economic Advisers, full employment was officially defined to be present when there was a 4-percent measured rate of unemployment. 70
This was, however, taken to be only some interim rate, with the long-run objective rate considerably lower.
The much-discussed Humphrey-Hawkins bill in 1976 set out a 3-percent target rate, to be attained within four years.
Historically, however, unemployment in the United States has only infrequently, and then only temporarily, fallen below 4 percent.
During the sixty-three-year period after the creation of the Federal Reserve System, the period 1913-1975, there were only twenty years in which unemployment averaged 4 percent or less.
Ten of these years — 1918, 1943-1945, 1951-1953, and 1966-1968 — occurred during periods when the United States was at war, although the mobilization was not so intense in the latter two periods as it was in the former two.
The normal rate of unemployment, though unmeasurable, would appear to lie somewhat above 4 percent.
During the fifteen-year period 1946-1960, a period that included both moderate mobilization and moderate recession, as well as predating the full Keynesian conversion of our politicians, unemployment averaged 4.5 percent.
Even if we could make the heroic assumption that the institutional-structural features affecting employment have remained invariant over the long periods noted, it would seem clear that the “normal” rate of unemployment lies considerably above 4 percent.
And, of course, it would be illegitimate to make such an assumption of invariance through time.
Both demographic shifts within the labor force (toward younger and female workers) and policy changes (unemployment compensation, extended minimum wage coverage, increases in welfare payments and retirement support) have had the effect of increasing the level of unemployment that would be consistent with any specified rate of inflation. 71
A national economic policy targeted to achieve, say, a 4-percent rate of unemployment is likely to be inflationary on the one hand and unattainable on the other, especially in the long run, at least in the absence of corrective policies aimed at structural features of labor markets.
Efforts to attain such a rate of measured unemployment would probably generate increasing rates of inflation, with little demonstrable effects on employment itself. 72
Since 1964, when we entered the Great Society stage of our national history, we have lived through a period in which federal budget deficits have been increasing rapidly, along with explosive growth in the size of government.
In the early years of this period, 1964-1969, unemployment fell steadily, along with continuing inflation.
Taken alone, this mid-1960s experience might suggest a changing trade-off between inflation and unemployment.
But economic life is not so simple.
Inflation may reduce unemployment for a time, but it also distorts the structure of the economy in the process.
Such structural distortions may, in turn, require an increase in unemployment before the economy can make the readjustments that are necessary to dissipate the distortions.
This day of reckoning can be postponed only through ever-increasing inflation, or through the replacement of the free economy by a command economy, one in which direct controls are imposed.
In the years after 1969, unemployment increased along with inflation, and the accelerated unemployment experienced in the recession of 1974-1975 attests to the difficulty of slowing down a rate of inflation once started.
The combination of substantial unemployment and inflation creates a quandary for economic policy.
The Employment Act of 1946 seems to commit the nation to public policies designed to promote full employment.
In the simplistic Keynesian theory of economic process (and the Employment Act implied an acceptance of this Keynesian theory), total employment varies directly with the volume of total spending.
The mere presence of unemployment provides a signal for expansionary policies that increase aggregate or total spending in the economy.
Inflation, by contrast, can be alleviated only through contractionary policies that reduce aggregate spending.
Unemployment calls for expansion, while inflation calls for contraction.
This is the quandary, pure and simple.
TO BE CONTINUED ...
Democracy in Deficit: The Political Legacy of Lord Keynes, continued ...
By James M. Buchanan and Richard E. Wagner
Part III. What Can Be Done?
Chapter 11 - What about Full Employment?, continued ...
Current Unemployment and the Quandary of Policy
With the passage of the Employment Act of 1946, Congress declared that it was the policy and responsibility of the Federal Government … to coordinate and utilize all its plans, functions, and resources for the purpose of creating and maintaining … conditions under which there will be afforded useful employment for those able, willing, and seeking to work.
The Council of Economic Advisers was created to assist in the implementation of this act.
Just what constitutes “full employment” was not defined in the act, and, moreover, it is an inherently unobservable variable.
Despite this necessary imprecision in definition, the Employment Act is exceedingly significant, for with its enactment, the Congress sanctified the principal thrust of the Keynesian analysis.
By implication, the free enterprise economy was officially conceived to be unstable; it became the task of government to act as a balance wheel to promote stability and growth.
The Employment Act mandated that the government practice compensatory policy so as to promote full employment.
Whenever employment declined below that level defined to be “full employment,” government seemed legally to be required to undertake expansive budgetary and/or monetary policy. 69
But what is full employment?
The Keynesian economists have never been precisely clear on this question, and their acceptable targets have been moved progressively downward through time.
In the 1962 Report of the Council of Economic Advisers, full employment was officially defined to be present when there was a 4-percent measured rate of unemployment. 70
This was, however, taken to be only some interim rate, with the long-run objective rate considerably lower.
The much-discussed Humphrey-Hawkins bill in 1976 set out a 3-percent target rate, to be attained within four years.
Historically, however, unemployment in the United States has only infrequently, and then only temporarily, fallen below 4 percent.
During the sixty-three-year period after the creation of the Federal Reserve System, the period 1913-1975, there were only twenty years in which unemployment averaged 4 percent or less.
Ten of these years — 1918, 1943-1945, 1951-1953, and 1966-1968 — occurred during periods when the United States was at war, although the mobilization was not so intense in the latter two periods as it was in the former two.
The normal rate of unemployment, though unmeasurable, would appear to lie somewhat above 4 percent.
During the fifteen-year period 1946-1960, a period that included both moderate mobilization and moderate recession, as well as predating the full Keynesian conversion of our politicians, unemployment averaged 4.5 percent.
Even if we could make the heroic assumption that the institutional-structural features affecting employment have remained invariant over the long periods noted, it would seem clear that the “normal” rate of unemployment lies considerably above 4 percent.
And, of course, it would be illegitimate to make such an assumption of invariance through time.
Both demographic shifts within the labor force (toward younger and female workers) and policy changes (unemployment compensation, extended minimum wage coverage, increases in welfare payments and retirement support) have had the effect of increasing the level of unemployment that would be consistent with any specified rate of inflation. 71
A national economic policy targeted to achieve, say, a 4-percent rate of unemployment is likely to be inflationary on the one hand and unattainable on the other, especially in the long run, at least in the absence of corrective policies aimed at structural features of labor markets.
Efforts to attain such a rate of measured unemployment would probably generate increasing rates of inflation, with little demonstrable effects on employment itself. 72
Since 1964, when we entered the Great Society stage of our national history, we have lived through a period in which federal budget deficits have been increasing rapidly, along with explosive growth in the size of government.
In the early years of this period, 1964-1969, unemployment fell steadily, along with continuing inflation.
Taken alone, this mid-1960s experience might suggest a changing trade-off between inflation and unemployment.
But economic life is not so simple.
Inflation may reduce unemployment for a time, but it also distorts the structure of the economy in the process.
Such structural distortions may, in turn, require an increase in unemployment before the economy can make the readjustments that are necessary to dissipate the distortions.
This day of reckoning can be postponed only through ever-increasing inflation, or through the replacement of the free economy by a command economy, one in which direct controls are imposed.
In the years after 1969, unemployment increased along with inflation, and the accelerated unemployment experienced in the recession of 1974-1975 attests to the difficulty of slowing down a rate of inflation once started.
The combination of substantial unemployment and inflation creates a quandary for economic policy.
The Employment Act of 1946 seems to commit the nation to public policies designed to promote full employment.
In the simplistic Keynesian theory of economic process (and the Employment Act implied an acceptance of this Keynesian theory), total employment varies directly with the volume of total spending.
The mere presence of unemployment provides a signal for expansionary policies that increase aggregate or total spending in the economy.
Inflation, by contrast, can be alleviated only through contractionary policies that reduce aggregate spending.
Unemployment calls for expansion, while inflation calls for contraction.
This is the quandary, pure and simple.
TO BE CONTINUED ...
Re: THE POLITICAL LEGACY OF LORD KEYNES
The Library of Economics and Liberty
Democracy in Deficit: The Political Legacy of Lord Keynes, continued ...
By James M. Buchanan and Richard E. Wagner
Part III. What Can Be Done?
Chapter 11 - What about Full Employment?, continued ...
The Keynesian Theory of Employment
It will be useful again to summarize the basic Keynesian theory of economic policy that allegedly supports the politically dominant policy paradigm.
If some such extraordinary and exogenous force or event, a collapse of the banking-monetary structure, a revaluation of the national currency at some disequilibrium level, or a major physical catastrophe, has generated a reduction in the aggregate demand for goods and services in the economy, a reduction that has dramatically modified business expectations, output and employment will have been reduced, possibly along with prices and wages, although the latter response may lag behind the former.
In this setting, an explicit program of expanding aggregate spending in the economy through fiscal measures (the efficacy of monetary policy may be temporarily reduced by the existence of excess liquidity) will modify business expectations and will succeed in expanding the total volume of spending relative to total labor costs (and, to employers, this will amount to a reduction in real wages as a share of product prices).
As a result, output and employment will expand, possibly along with some increase in prices, although the latter may again lag behind the former.
This summarizes our understanding of the theory of macroeconomic policy, as presented by Keynes himself, with the one exception that he falsely proclaimed it to be a general theory, presumably applicable to economic environments in which no extraordinary event has occurred at all, environments that are not remotely akin to those of the depressed 1930s.
It seems quite likely that Keynes, always willing to change his mind, would have quickly abandoned these claims to generality had he lived into the years following World War II.
But his followers, the Keynesians who became his disciples charged with spreading the gospel, made a simplistic extension of the basic model to economic environments for which the whole “theory” is clearly inapplicable.
If, instead of some extraordinary and exogenous event that has literally plunged the economy into a depressed state, financially and psychologically, endogenous structural features of the market (including governmentally enforced regulations and restrictions) have generated a level of unemployment (say, 5, 6, 7, or even 8 percent) that is deemed “unacceptable” against some arbitrarily chosen standard (with, say, a 3-percent or a 4-percent target), the policy norm derived from the Keynesian model may not be at all appropriate.
In such a setting, the Keynesians would have us apply essentially the same expansionary tools as those applied in the extraordinarily depressed economy.
Aggregate spending “should” be expanded so as to increase the level of employment.
And, as we have noted, the Keynesians did succeed in convincing the politicians to this effect.
When this falsely applied theory of policy is appended to an apparent legislative mandate for the achievement of “full employment,” a mandate that was, itself, a product of depression mentality, the policy prescriptions become straightforward.
When unemployment exists, for any reason, the stream of spending must be increased.
Conversely, any policy that reduces aggregate spending must increase unemployment.
Unfortunately, this states all too perfectly the macroeconomic policy paradigm of modern democracy.
Any politicians who want to appear responsive to the needs of the unemployed must support expansionary fiscal measures. 73
(The parade of presidential hopefuls in 1976 who mouthed the simplest of Keynesian propositions should, in itself, offer substantive proof for the central argument of this book.)
Only some misanthropic capitalist or his lackey would suggest that the unemployment observed in the 1970s may not be much reduced by further increases in total spending, that such reductions that could be achieved might be short-lived, and that these could be secured only at the expense of accelerated inflation.
Herein lies what may properly be considered our national economic-political tragedy, one that finds its origins in ideas that were both imperfectly understood and inappropriately applied. 74
Having entered the realm of political discourse, however, these ideas cannot be readily exorcised by the empirical findings of the academic economists.
TO BE CONTINUED ...
Democracy in Deficit: The Political Legacy of Lord Keynes, continued ...
By James M. Buchanan and Richard E. Wagner
Part III. What Can Be Done?
Chapter 11 - What about Full Employment?, continued ...
The Keynesian Theory of Employment
It will be useful again to summarize the basic Keynesian theory of economic policy that allegedly supports the politically dominant policy paradigm.
If some such extraordinary and exogenous force or event, a collapse of the banking-monetary structure, a revaluation of the national currency at some disequilibrium level, or a major physical catastrophe, has generated a reduction in the aggregate demand for goods and services in the economy, a reduction that has dramatically modified business expectations, output and employment will have been reduced, possibly along with prices and wages, although the latter response may lag behind the former.
In this setting, an explicit program of expanding aggregate spending in the economy through fiscal measures (the efficacy of monetary policy may be temporarily reduced by the existence of excess liquidity) will modify business expectations and will succeed in expanding the total volume of spending relative to total labor costs (and, to employers, this will amount to a reduction in real wages as a share of product prices).
As a result, output and employment will expand, possibly along with some increase in prices, although the latter may again lag behind the former.
This summarizes our understanding of the theory of macroeconomic policy, as presented by Keynes himself, with the one exception that he falsely proclaimed it to be a general theory, presumably applicable to economic environments in which no extraordinary event has occurred at all, environments that are not remotely akin to those of the depressed 1930s.
It seems quite likely that Keynes, always willing to change his mind, would have quickly abandoned these claims to generality had he lived into the years following World War II.
But his followers, the Keynesians who became his disciples charged with spreading the gospel, made a simplistic extension of the basic model to economic environments for which the whole “theory” is clearly inapplicable.
If, instead of some extraordinary and exogenous event that has literally plunged the economy into a depressed state, financially and psychologically, endogenous structural features of the market (including governmentally enforced regulations and restrictions) have generated a level of unemployment (say, 5, 6, 7, or even 8 percent) that is deemed “unacceptable” against some arbitrarily chosen standard (with, say, a 3-percent or a 4-percent target), the policy norm derived from the Keynesian model may not be at all appropriate.
In such a setting, the Keynesians would have us apply essentially the same expansionary tools as those applied in the extraordinarily depressed economy.
Aggregate spending “should” be expanded so as to increase the level of employment.
And, as we have noted, the Keynesians did succeed in convincing the politicians to this effect.
When this falsely applied theory of policy is appended to an apparent legislative mandate for the achievement of “full employment,” a mandate that was, itself, a product of depression mentality, the policy prescriptions become straightforward.
When unemployment exists, for any reason, the stream of spending must be increased.
Conversely, any policy that reduces aggregate spending must increase unemployment.
Unfortunately, this states all too perfectly the macroeconomic policy paradigm of modern democracy.
Any politicians who want to appear responsive to the needs of the unemployed must support expansionary fiscal measures. 73
(The parade of presidential hopefuls in 1976 who mouthed the simplest of Keynesian propositions should, in itself, offer substantive proof for the central argument of this book.)
Only some misanthropic capitalist or his lackey would suggest that the unemployment observed in the 1970s may not be much reduced by further increases in total spending, that such reductions that could be achieved might be short-lived, and that these could be secured only at the expense of accelerated inflation.
Herein lies what may properly be considered our national economic-political tragedy, one that finds its origins in ideas that were both imperfectly understood and inappropriately applied. 74
Having entered the realm of political discourse, however, these ideas cannot be readily exorcised by the empirical findings of the academic economists.
TO BE CONTINUED ...
Re: THE POLITICAL LEGACY OF LORD KEYNES
The Library of Economics and Liberty
Democracy in Deficit: The Political Legacy of Lord Keynes, continued ...
By James M. Buchanan and Richard E. Wagner
Part III. What Can Be Done?
Chapter 11 - What about Full Employment?, continued ...
The Inflation-Unemployment Trade-off
In its early textbook formulations, although not in Keynes’ own work, the Keynesian theory of macroeconomic management posited a categorical distinction between the conditions under which expansionary policies would be inflationary and the conditions under which they would generate noninflationary increases in employment and output.
Up to a certain level of employment, expansionary policies would elicit increases in employment and output, but without increasing prices.
Beyond that level of employment, expansionary policies would increase prices, but without increasing employment and output.
It was always recognized that this view was but a simplified representation, though one that captured adequately the central features of the phenomena under examination.
By the late 1950s, this simplistic view gave way to the widespread realization that acceptably full employment and stability in the value of money might be inconsistent.
In an economy with strong labor unions and/or governmental wage floors, both full employment and a stable price level were not likely to be achieved; some trade-off was necessary.
If unemployment was to be reduced to tolerable levels, increasing prices might have to be tolerated.
The empirical basis of this trade-off was the so-called “Phillips curve,” and the inflation-unemployment relationship became the focal point of almost all discussions of macroeconomic policy after the late 1950s. 75
Inflation and unemployment became matters of political choice, and a politician who assigned weight to stability in the purchasing power of money was automatically branded by popular opinion as someone who favored higher rates of unemployment, as someone who would deliberately create food-stamp lines.
Like the simplistic Keynesian theory of employment, the inflation-unemployment trade-off possessed a striking attention-arresting power.
This trade-off came to dominate the images people formed as to the nature of reality, and democratic politics conformed to this image.
When this is combined with the view that inflation is a problem not nearly so severe as unemployment, the inflationary bias becomes transparent.
What decent politician could countenance greater unemployment simply to attain price-level stability?
By the late 1960s, the foundations of the inflation-unemployment trade-off began to erode, in the minds of academicians, though not in the minds of citizens and politicians.
The Phillips curve, it came to be realized, described only a short-run, not a long-run, trade-off. 76
Expansions in aggregate demand, accompanied by some inflation, could reduce unemployment in the short run, but only because the inflationary effects were not fully anticipated.
Once the predictable effects of inflation on real wages came to be understood, permanent structural features of the economy would reassert themselves.
As expectations came to be adjusted to inflation, unemployment would rise to roughly the level determined by these structural features.
The price level would, of course, be higher because of the expanded monetary spending, but there would be no permanent increase in employment.
A permanent increase in prices would be the cost of, at best, a temporary and short-lived reduction in unemployment.
The idea that the inflation-unemployment trade-off can be exploited only in the short run, not in the long run, embodies the notion of a “natural rate” of employment.
This natural rate of unemployment corresponds to full employment in the classical, non-Keynesian analytical framework. 77
Unemployment can be reduced below this natural rate only by a continually accelerating inflation.
If, for instance, a 4-percent rate of unemployment is accepted as an objective of macroeconomic policy, and if the natural rate of unemployment lies above 4 percent, say in the vicinity of 5 percent, pursuit of the standard policies of Keynesian management will produce a continually accelerating inflation in pursuit of this unattainable objective.
TO BE CONTINUED ...
Democracy in Deficit: The Political Legacy of Lord Keynes, continued ...
By James M. Buchanan and Richard E. Wagner
Part III. What Can Be Done?
Chapter 11 - What about Full Employment?, continued ...
The Inflation-Unemployment Trade-off
In its early textbook formulations, although not in Keynes’ own work, the Keynesian theory of macroeconomic management posited a categorical distinction between the conditions under which expansionary policies would be inflationary and the conditions under which they would generate noninflationary increases in employment and output.
Up to a certain level of employment, expansionary policies would elicit increases in employment and output, but without increasing prices.
Beyond that level of employment, expansionary policies would increase prices, but without increasing employment and output.
It was always recognized that this view was but a simplified representation, though one that captured adequately the central features of the phenomena under examination.
By the late 1950s, this simplistic view gave way to the widespread realization that acceptably full employment and stability in the value of money might be inconsistent.
In an economy with strong labor unions and/or governmental wage floors, both full employment and a stable price level were not likely to be achieved; some trade-off was necessary.
If unemployment was to be reduced to tolerable levels, increasing prices might have to be tolerated.
The empirical basis of this trade-off was the so-called “Phillips curve,” and the inflation-unemployment relationship became the focal point of almost all discussions of macroeconomic policy after the late 1950s. 75
Inflation and unemployment became matters of political choice, and a politician who assigned weight to stability in the purchasing power of money was automatically branded by popular opinion as someone who favored higher rates of unemployment, as someone who would deliberately create food-stamp lines.
Like the simplistic Keynesian theory of employment, the inflation-unemployment trade-off possessed a striking attention-arresting power.
This trade-off came to dominate the images people formed as to the nature of reality, and democratic politics conformed to this image.
When this is combined with the view that inflation is a problem not nearly so severe as unemployment, the inflationary bias becomes transparent.
What decent politician could countenance greater unemployment simply to attain price-level stability?
By the late 1960s, the foundations of the inflation-unemployment trade-off began to erode, in the minds of academicians, though not in the minds of citizens and politicians.
The Phillips curve, it came to be realized, described only a short-run, not a long-run, trade-off. 76
Expansions in aggregate demand, accompanied by some inflation, could reduce unemployment in the short run, but only because the inflationary effects were not fully anticipated.
Once the predictable effects of inflation on real wages came to be understood, permanent structural features of the economy would reassert themselves.
As expectations came to be adjusted to inflation, unemployment would rise to roughly the level determined by these structural features.
The price level would, of course, be higher because of the expanded monetary spending, but there would be no permanent increase in employment.
A permanent increase in prices would be the cost of, at best, a temporary and short-lived reduction in unemployment.
The idea that the inflation-unemployment trade-off can be exploited only in the short run, not in the long run, embodies the notion of a “natural rate” of employment.
This natural rate of unemployment corresponds to full employment in the classical, non-Keynesian analytical framework. 77
Unemployment can be reduced below this natural rate only by a continually accelerating inflation.
If, for instance, a 4-percent rate of unemployment is accepted as an objective of macroeconomic policy, and if the natural rate of unemployment lies above 4 percent, say in the vicinity of 5 percent, pursuit of the standard policies of Keynesian management will produce a continually accelerating inflation in pursuit of this unattainable objective.
TO BE CONTINUED ...
Re: THE POLITICAL LEGACY OF LORD KEYNES
The Library of Economics and Liberty
Democracy in Deficit: The Political Legacy of Lord Keynes, continued ...
By James M. Buchanan and Richard E. Wagner
Part III. What Can Be Done?
Chapter 11 - What about Full Employment?, continued ...
The Inflation-Unemployment Spiral
This has come increasingly to be recognized by economists, and much of the earlier academic support for expansionary fiscal-monetary policies based on the alleged Phillips-curve trade-off has disappeared.
Politically, however, the arguments proceed unchecked, and it seems highly unlikely that elected politicians can adhere to the discipline that would be required to escape from the inflationary spiral.
The experience with the recession of 1974-1975 offered a test.
Why was the American economy characterized by “stagflation” in 1974 and 1975?
Unemployment seemed clearly to be above any plausible “natural rate,” while, at the same time, the price level continued to rise.
There are two complementary parts of an explanation for this phenomenon.
The double-digit inflation set off by the fiscal-monetary excesses of 1972 and 1973 set in motion fears of explosive hyperinflation; this caused the monetary authorities to decelerate the rate of monetary expansion.
But, because of built-in expectations of the public concerning the continuance of accelerating rates of inflation, any deceleration in the rate of monetary expansion had an effect essentially the same as an actual reduction in aggregate demand would produce in a setting of monetary stability.
The responses of business firms and consumers brought about reductions in output and employment, though upward pressures on prices were maintained, both because of lagged effects and because the deceleration was still within a range that allowed for continued inflation.
Unemployment moved upward to levels that were probably well above the sustainable natural rate, given the structural features of the United States’ economy.
“Stagflation” could, therefore, be explained in this way, even if we should leave out of account the internal allocative distortions that long-continued inflation itself produced or might have produced.
Once we allow for such distortions, any attempt to decelerate the rate of monetary expansion will generate more pronounced output and employment responses, with the magnitude of these being related directly to the length of the inflationary period.
It is this second part of the overall explanation of “stagflation” that gives rise to the view that continued inflation, in itself, must be a direct cause of greater unemployment in any future period when any deceleration in the rate of inflation takes place.
Inflation has two effects.
One effect is to lower real wages; this was Keynes’ thesis, and it is this effect that is recognized by those who argue that, once inflation is fully anticipated, the rate of unemployment cannot be permanently reduced below its natural level.
This effect gives the customary result of a short-run trade-off between inflation and unemployment, while any such trade-off is absent in the long run.
The other effect is a possible general disruption of the working of the market economy, reflected in the reallocations of resources that take place in response to the inflation-caused short-run shifts in relative prices, as well as in the reallocations that result in response to the increase in the rate of mistakes owing to the increased difficulty of rational economic calculation.
As these allocative distortions become more important, a policy shift away from accelerating inflation both will generate a temporary increase in unemployment above the natural rate and will alter the length of time required to return to the natural rate.
If the economy is to “recover” from the Keynesian-inspired inflationary spree, the recovery phase will necessarily involve unemployment above the natural rate, and this phase can be regarded as the “price” of the mistakes of the past.
Suppose, however, that a government necessarily subject to Keynesian pressures, and faced with an observed rise in unemployment above what seems to be the natural rate, does not carry through its anti-inflation commitment and decides instead to stimulate aggregate demand once again.
This stimulatory policy unleashes two opposing forces.
The temporary fall in the real-wage rate may reduce unemployment somewhat.
But the removal of the allocative distortions is postponed and still further distortions are encouraged, which will, in turn, make a subsequent policy of retaining monetary stability more difficult.
If, on the other hand, an anti-inflation policy is carried through, and a rate of unemployment in excess of the natural rate is tolerated for a sufficient time, the economy will eventually “recover” in the sense that the rate of unemployment consistent with basic structural features will be attained.
But if the day of reckoning is postponed through periodic injections of Keynesian stimulation, an inflation-unemployment spiral can develop.
New doses of inflation may initially stimulate employment, but they will also increase the volume of mistaken, unsustainable economic decisions.
The misallocations that stem from such errors will, in turn, generate reallocative unemployment.
Should the economy be shocked with still a further dose of Keynesian expansionary medicine rather than being permitted gradually to adjust to its natural equilibrium, some short-run reduction in unemployment may take place once again.
But additional mistakes, resource misallocations, will be again injected into the economy, and the rectification of these mistakes will, in turn, generate additional unemployment.
In this way, a spiral of inflation and unemployment can result from Keynesian prescriptions.
Inflation creates allocative mistakes, and these mistakes cannot be rectified costlessly.
There are readjustment costs that simply must be borne before the economy can return to normal. 78
The day of reckoning can only be postponed, not forgiven, and the longer it is postponed, the more frightful the eventual day of reckoning becomes.
TO BE CONTINUED ...
Democracy in Deficit: The Political Legacy of Lord Keynes, continued ...
By James M. Buchanan and Richard E. Wagner
Part III. What Can Be Done?
Chapter 11 - What about Full Employment?, continued ...
The Inflation-Unemployment Spiral
This has come increasingly to be recognized by economists, and much of the earlier academic support for expansionary fiscal-monetary policies based on the alleged Phillips-curve trade-off has disappeared.
Politically, however, the arguments proceed unchecked, and it seems highly unlikely that elected politicians can adhere to the discipline that would be required to escape from the inflationary spiral.
The experience with the recession of 1974-1975 offered a test.
Why was the American economy characterized by “stagflation” in 1974 and 1975?
Unemployment seemed clearly to be above any plausible “natural rate,” while, at the same time, the price level continued to rise.
There are two complementary parts of an explanation for this phenomenon.
The double-digit inflation set off by the fiscal-monetary excesses of 1972 and 1973 set in motion fears of explosive hyperinflation; this caused the monetary authorities to decelerate the rate of monetary expansion.
But, because of built-in expectations of the public concerning the continuance of accelerating rates of inflation, any deceleration in the rate of monetary expansion had an effect essentially the same as an actual reduction in aggregate demand would produce in a setting of monetary stability.
The responses of business firms and consumers brought about reductions in output and employment, though upward pressures on prices were maintained, both because of lagged effects and because the deceleration was still within a range that allowed for continued inflation.
Unemployment moved upward to levels that were probably well above the sustainable natural rate, given the structural features of the United States’ economy.
“Stagflation” could, therefore, be explained in this way, even if we should leave out of account the internal allocative distortions that long-continued inflation itself produced or might have produced.
Once we allow for such distortions, any attempt to decelerate the rate of monetary expansion will generate more pronounced output and employment responses, with the magnitude of these being related directly to the length of the inflationary period.
It is this second part of the overall explanation of “stagflation” that gives rise to the view that continued inflation, in itself, must be a direct cause of greater unemployment in any future period when any deceleration in the rate of inflation takes place.
Inflation has two effects.
One effect is to lower real wages; this was Keynes’ thesis, and it is this effect that is recognized by those who argue that, once inflation is fully anticipated, the rate of unemployment cannot be permanently reduced below its natural level.
This effect gives the customary result of a short-run trade-off between inflation and unemployment, while any such trade-off is absent in the long run.
The other effect is a possible general disruption of the working of the market economy, reflected in the reallocations of resources that take place in response to the inflation-caused short-run shifts in relative prices, as well as in the reallocations that result in response to the increase in the rate of mistakes owing to the increased difficulty of rational economic calculation.
As these allocative distortions become more important, a policy shift away from accelerating inflation both will generate a temporary increase in unemployment above the natural rate and will alter the length of time required to return to the natural rate.
If the economy is to “recover” from the Keynesian-inspired inflationary spree, the recovery phase will necessarily involve unemployment above the natural rate, and this phase can be regarded as the “price” of the mistakes of the past.
Suppose, however, that a government necessarily subject to Keynesian pressures, and faced with an observed rise in unemployment above what seems to be the natural rate, does not carry through its anti-inflation commitment and decides instead to stimulate aggregate demand once again.
This stimulatory policy unleashes two opposing forces.
The temporary fall in the real-wage rate may reduce unemployment somewhat.
But the removal of the allocative distortions is postponed and still further distortions are encouraged, which will, in turn, make a subsequent policy of retaining monetary stability more difficult.
If, on the other hand, an anti-inflation policy is carried through, and a rate of unemployment in excess of the natural rate is tolerated for a sufficient time, the economy will eventually “recover” in the sense that the rate of unemployment consistent with basic structural features will be attained.
But if the day of reckoning is postponed through periodic injections of Keynesian stimulation, an inflation-unemployment spiral can develop.
New doses of inflation may initially stimulate employment, but they will also increase the volume of mistaken, unsustainable economic decisions.
The misallocations that stem from such errors will, in turn, generate reallocative unemployment.
Should the economy be shocked with still a further dose of Keynesian expansionary medicine rather than being permitted gradually to adjust to its natural equilibrium, some short-run reduction in unemployment may take place once again.
But additional mistakes, resource misallocations, will be again injected into the economy, and the rectification of these mistakes will, in turn, generate additional unemployment.
In this way, a spiral of inflation and unemployment can result from Keynesian prescriptions.
Inflation creates allocative mistakes, and these mistakes cannot be rectified costlessly.
There are readjustment costs that simply must be borne before the economy can return to normal. 78
The day of reckoning can only be postponed, not forgiven, and the longer it is postponed, the more frightful the eventual day of reckoning becomes.
TO BE CONTINUED ...