Evolving Attitudes toward the Federal Deficit, 1953-2006

"Macroeconomic policy in the 1960s: the causes and consequences of a mistaken revolution"
Christina D. Romer, University of California, Berkeley (September 2007)

The conventional wisdom for students of economics is that, after 1944, the developed economies of North America and Western Europe embraced Keynesian economics: the presumption of full employment was abandoned in economic analysis, as was the idea that "supply creates its own demand." This generally prevailed until the late 1970s, when it was succeeded by monetarism (to 1986) and then Real Business Cycle (RBC) theory, now called Dynamic Stochastic General Equilibrium (DSGE) and very much in vogue in the profession.

Continuing my summary of the conventional wisdom, the notion goes that the period of Keynesian dominance in the USA (at least) was accompanied by heavy reliance on fiscal policy. After 1981, for example, the effect of monetarist policy and massive tax cuts led to a staggering deficit in the federal budget (graph) utterly surpassing anything before or since.¹  Despite the anathemas pronounced against Keynes, most policy ideas are highly distorted versions of Keynesian: the White House typically insists on stimulus packages (now during expansions, to prevent a recession) or else tax cuts (either on ideological grounds or to further stimulate the economy.  Economists have roundly denounced the idea of fiscal policy, but there are still lot of them applauding deregulation and tax cuts
"to create jobs."

One challenge here is that Keynes died in 1946, unable to comment thereafter on the quality of implementation of his ideas.  Academic interpretation of his General Theory was influenced by John Hicks and Alvin Hansen, who developed the IS-LM model used for teaching macroeconomics until quite recently.  Meanwhile, some really good enhancements to the theory, such as the work of A.W. Phillips, were misrepresented by polemicists against Keynesianism (and oversimplified by practitioners).²

I also feel the need to introduce another historical figure, the journalist Abba P. Lerner. Lerner's relevant views were outlined in a short tract, Functional Finance (1943) in which he argued that the true insights of Keynes were far more profound than his disciples were letting on.  In effect, he argued that Keynes had failed to realize the full implications of his own ideas.

Lerner (1943), p.3: The central idea is that government fiscal policy, its spending and taxing, its borrowing and repayment of loans, its issue of new money and its withdrawal of money, shall all be undertaken with an eye only to the results of these actions on the economy and not to any established traditional doctrine about what is sound or unsound.

The rest of his ideas follow in the same mold.  Anyone reading Functional Finance will see in it the modern lack of concern for deficit spending or sound money policies.  Lerner is merely concerned with the consequences of tax increases and spending increases on inflation or employment levels.

We now turn to Christina Romer's paper, which is a frontal assault on Abba Lerner.  At first, her paper looks as though it is going to appeal to tradition: she dwells on the fact that, until 1962, the Federal Reserve and the budgetary planners in the White House and Congress took deficits seriously, whereas Kennedy and Johnson did not: for shame!

Romer (2007), p.10: However, the changing attitude toward fiscal discipline seemed to go even further than this. Whereas balancing the budget and retiring the public debt was an objective good for Truman and beneficial to growth for Eisenhower, it seems to have become almost superfluous for policymakers in the 1960s. Indeed, it is nearly impossible to find references in the Economic Reports or Budget Messages of the 1960s to a long-run goal of budget balance. The one exception is the 1963 Economic Report which stated: “The problem is to maintain a relationship between the deficits and surpluses of the various sectors that will permit this balance to be reached at a satisfactory level of economic activity – and without a prolonged succession of government deficits” (p. 74). But even here, it seems clear that maintaining full employment is the key concern, and the commitment to long-run balance feels vague and half-hearted. 

Presidents Kennedy through Ford embraced the idea that tax cuts would pay for themselves by enhanced economic growth, which did not happen (although tax cuts were on very high top marginal rates).

Prof. Romer also applies the same criticism to monetary policy; she analyzes monetary expansion in accordance with the Volcker-Greenspan-Bernanke monetary rule (p.14) and finds it unacceptably lax.

Romer (2007), p.16: The consequences of the economic beliefs and the resulting policy actions in the 1960s and 1970s are well known. Inflation, which was close to 1% at the start of the Kennedy administration in 1961, rose steadily over the decade, ending at over 5%. It then rose even more dramatically in the 1970s. While the effect of the oil price shocks in 1974 and 1978 are quite obvious, modern scholars, such as DeLong (1997) and Barsky and Kilian (2001), have been convincing that monetary expansion and loose policy more generally were the key source of the inflation in these decades. The expansionary bias in both monetary and fiscal policy led to rates of inflation unheard of in peacetime. 

Romer praises Ronald Reagan and Marty Feldstein's stated views that a balanced budget was a long term good, but mysteriously ignores the cynical political exploitation of this view.  It's as if she overlooked the ideological basis of the Conservative Movement, that it was redeemed through faith in sound finance (rather than works--something that would be left to the infidel Clinton to perform).

The main points of her essay are startlingly unsubstantiated. She claims that deficits do have an effect on well-being, but she doesn't explain why or cite conditions that determine when deficits become dangerous (pp. 25-27).  She ignores the ideological convictions and priors of the administrations that submit budgets, as if budget decisions are made by schools of economists, and she cites little more than a hunch that the Great Moderation happened because Fed policies were sound (p.20).  In fact, she speaks approvingly of the new policies, when deficit spending has become far worse than it was in the 1960s. 

Christina Romer may well have a compelling argument for believing that functional finance is the culprit (FWIW, she never mentions the phrase, alluding instead to a James M. Buchanan book that excoriates John M. Keynes). But this paper is not convincing, and I remain convinced that the contents of budget priorities, rather than functional finance, are at the heart of America's financial issues.

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NOTES

1.  One point bears noting: the period 1983-1990 (the recovery phase) featured an aggregate real GDP growth of 38%; that of 1991-2000, 43%.  During the first period, the total public debt grew from 33% of GDP to 53%, while during the second period, it started at 57%, rose to 64% (1994), then declined back to 54%.   In other words, in the 1980s, the rather large expansion of the economy was propelled by an unsustainable and unwholesome explosion of expansionary deficits; in the 1990s, the larger expansion of the economy was accompanied by a net contraction of public debt.
   
   This point must never be forgotten: it's pretty easy to have an impressive economic showing when you allow chronic deficits of  >3% of GDP.  Reducing the deficit and growing the economy is a much more impressive feat.  
2. Phillips is usually accused of positing a simplistic relationship between the rate of inflation and the rate of unemployment.  See A.W. Phillips, "The Relation between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1861-1957" Economica, New Series, Vol. 25, No. 100 (Nov., 1958), pp. 283-299