So what was really happening under the guise of “enlightened” counter-cyclical fiscal policy is that deficit finance was on the cusp of becoming a permanent way of life. Washington did not yet succumb to Keynesian stimulus in 1953–1954, but only on account of the old-fashioned views of Ike and his doughty treasury secretary.
In fact, Eisenhower’s own mind was deeply conflicted on the issue of business cycle stabilization. Possessed with a well-honed sense of history, Eisenhower was keenly aware that as the first Republican president since Hoover it was imperative that a severe economic downturn not occur on his watch. Consequently, he scrutinized the economic data flow intently for any sign of a free-fall and was frequently rattled by Burns’ worry-wart proclivities.
Moreover, some of the outside advice coming to the White House on economic matters was as misdirected as that emanating from Arthur Burns. Leading elements of Big Business represented by the Committee for Economic Development (CED) and many business-oriented Republican economists were already embracing a “Keynesian lite” version of counter-cyclical policy.
While eschewing the cruder types of pump priming such as public works, their theory seemed to be that deft adjustments of tax measures and retiming of already approved spending could iron out the kinks in the business cycle. Timely preventative action, as it were, would preclude another downward spiral into depression.
To be sure, these incipient business-friendly central planners did not usually embrace hard-core Keynesian postulates about the structural defects of capitalism which made countercyclical policy necessary in the first place. In fact, the Keynesian lite advocates seemed to have no particular theory of the business cycle at all.
They appeared to simply assume that the Great Depression was proof enough that the US economy was prone to violent self-fueling contractions. The federal government, therefore, needed to stand at the ready with fiscal fire hose and ladder to forestall even a hint of recurrence.
The Great Depression, however, was not the product of a fragile business cycle prone to easy recurrence. As has been seen, it was the result of the unique set of historical developments that had virtually no chance of repetition in the postwar world of the 1950s.
These unique historical antecedents to world depression included the 1920s overhang of heavy war debts and reparations; the massive currency inflation and trade and production dislocations from the Great War; the failed 1920s attempt by the major nations to recreate a workable trade and monetary system under the flawed gold exchange standard; and the Wall Street–financed export boom which brought an artificial global expansion during 1925–1929, followed by a violent collapse of commodity prices and trade volumes after the Wall Street crash.
None of this remotely pertained to the postwar world where the US economy benefited enormously from the revival of global trade and capital flows and from the dramatic repair of domestic balance sheets under the Second World War command economy. There was no monster lurking under the nation’s macroeconomic bed. The “fresh start” US economy of the 1950s was not about to relapse into another great depression.
PROFESSOR HELLER’S BAD ADVICE:
THE SPECTER OF THE NEW ECONOMICS
Still, with public memories of the depression hardships still fresh, politicians of both parties were quick to embrace “counter-cyclical” fiscal policy as a convenient hall pass from the discipline of the old-time balanced budget religion. And waiting in the wings to justify that propensity was an even more virulent form of the Keynesian fallacy which became known as the “new economics.”
It held that not only was countercyclical fiscal policy needed to forestall another depression, but that it could also actually “fine-tune” the recovery phase of the business cycle. Enlightened economic management would thereby squeeze every last dollar of “potential” GDP out of the American economy.
The leading apostle of the new economics, and the future chairman of the Kennedy administration’s Council of Economic Advisors, was Professor Walter Heller. Appearing before the Joint Economic Committee in January 1955, he was not loath to offer some advice on how to goose the recovery that started in mid-1954.
“I feel we are in a period where deficits are constructive,” he opined, and then further suggested that “Federal deficits are likely to provoke a higher production response than a higher price response.”
The data, however, underscore the ludicrous perfectionism lurking in the new economics. Without any fiscal stimulus at all, real GDP had expanded at a 4.6 percent rate in the third quarter of 1954 and at an 8.3 percent annual rate in the fourth quarter—outcomes which had already occurred before Heller’s testimony.
Moreover, even as Heller lectured Congress on how to make things better in early 1955, the US economy was already striding at full gallop. Real GDP expanded at an astonishing 12 percent rate in the first quarter and by about 7 percent and 5 percent in the second and third quarters of 1955, respectively.
In fact, at the time of Heller’s testimony on how to improve the nation’s growth performance, the US economy was at the midpoint of a five-quarter growth spurt which averaged 7.5 percent per annum. This was the highest five quarter rate in modern American history!
In short, there was no case whatsoever for deficit-financed fiscal stimulus in early 1955. Yet the pretentious professor from the University of Minnesota could not leave well enough alone nor permit the free market economy to generate growth consistent with the private choices and actions of the American people.
Heller also got it completely wrong on inflation. At the time of his testimony, the Korean War inflation had been successfully extinguished by the Fed’s 1953–1954 tightening cycle, and the year-over-year CPI was close to zero.
By June 1956, however, consumer prices were 2 percent higher than the prior year and by March 1957 the twelve-month CPI was climbing at nearly a 4 percent rate. So there had indeed been a “higher price response,” which Heller said wouldn’t happen, and it occurred even without the extra stimulus he did advocate in January 1955.
This worrisome inflationary trend, in turn, reflected the Fed’s error in allowing bank credit to expand too rapidly during the recovery, thereby fueling an overheated business expansion and a new outbreak of rising prices and wages. Under these circumstances, obviously, the last thing the central bank needed was Heller’s recipe of expanded government borrowing, which would have compounded the overheated credit cycle that it was already having difficulty keeping in check.
THE RISE OF THE FULL-EMPLOYMENT BUDGET; EXECUTIONER OF THE OLD TIME FISCAL RELIGION
Professor Walter Heller was not the first economist to issue a mistaken forecast. Yet at its heart was an insidious economic doctrine that would push fiscal policy into massive systemic error during the 1960s. There had been room to stimulate growth without inflation because by Professor Heller’s lights “our rate of production is running some $20 billion short of our potential, maybe more.”
In other words, Heller and the new economists had a math model of the economy that told them whether the bathtub of potential GDP was full up to the rim. And if it was not, the model computed the precise quantity of incremental output that could be safely achieved by means of a further shot of “demand stimulus.”
At the time Heller testified, the nominal GDP was running at a $400 billion rate, so based on his public statement the implied potential GDP was $420 billion. Yet exactly how did Professor Heller know that the approximate 15 million farms, mines, factories, and service firms then operating in America were collectively capable of 5 percent more output without additional investment, inflationary pressures, or other dislocations?
The answer was both simple and laughably primitive by the lights of subsequent history. Potential output, it seems, was a function of “full employment,” which Heller deemed to be achieved when unemployment was pushed down to 4 percent of the labor force.
During the prior year, actual unemployment had been about 5.5 percent, meaning that the 64 million strong US labor force at the
time was allegedly capable of generating one and a half percentage points of additional employment. As a computational matter, that amounted to about a million more jobs. And at an average implied output of $20,000 per job, these additional employees would generate $20 billion of extra GDP.
It is hard to say which part of the Heller equation has proved the more specious. During the period since 1950, his 4 percent unemployment target was sustained only during the wars in Korea and Vietnam, when 3.5 million working-age men were under arms. And in both cases the associated red-hot war economy led to a subsequent inflationary blow-off.
So there exists no evidence from peacetime, either before then or since, that an unemployment rate of 4 percent or below is permanently sustainable on a noninflationary basis. Indeed, it was evident from wartime episodes of ultra-low unemployment that serious bottlenecks and disruption invariably occur when key sectors of the national economy become overheated, and that allowance must be made for the frictional unemployment inherent in a dynamic capitalist economy with generally uninhibited labor and capital mobility.
The proof is in the pudding. The US unemployment rate has averaged not 4 percent, but 6 percent during the approximate six hundred months which have elapsed since 1954, exclusive of the four-year Vietnam peak. Average unemployment has thus been about 50 percent greater than the full-employment target postulated by the new economics. In fact, the unemployment rate over this period has reached Professor Heller’s 4 percent target only once every thirty months.
That’s a pretty decisive trend reflecting the entire range of real-world disturbances which have impacted the American economy. These include external commodity shocks, droughts and floods, housing boom and bust cycles, the rise and fall of major industries, foreign trade disruptions, and much more.
And that was only one of the errors. Average output per employee in 1954 had been only about $7,000. Heller’s math model assumed a figure three times that level, meaning that even if filling the macroeconomic bathtub to the rim was an appropriate fiscal policy objective, Heller had vastly exaggerated the scope for additional output, if there was any at all.
At the end of the day, the deeper fault of the new economics was not merely its lack of clairvoyance about the empirical limits of full employment. Its far more onerous sin was encouraging congressional politicians to even entertain the notion that Washington could steer the vast American economy along a path of frictionless perfection, and that this could be accomplished with the blunt instrument of the federal budget.
Indeed, in the fullness of time it became evident that this proposition was upside down: the real structural “imperfection” lay with the state, not the capitalist economy. The inability of capitalism to hew rigidly to the path of full employment was trifling compared to Washington’s utter failure to maintain even a semblance of budgetary discipline and honest fiscal reckoning, once the balanced budget rule was jettisoned.
After the new economics was enshrined as official policy in the 1962 “Economic Report of the President,” it did not take the newly empowered professoriate long to corrupt the very language of fiscal discourse. Politicians had once rightly feared budget deficits. Plain old budgetary red ink, however, was now rechristened as a “full-employment surplus.”
This new formulation was obviously designed to ameliorate recidivist deficit spending fears still held by unenlightened politicians. But its actual import was far more pernicious. By the lights of the new economics, these fanciful full-employment “surpluses” were held to actually harm the macroeconomy because they purportedly restricted aggregate demand. So the cure was to eliminate the full-employment surplus by means of tax cuts or spending increases. Stated differently, the professors invited the politicians to make the actual cash deficit even bigger.
EISENHOWER STAYS THE COURSE
AND DELIVERS FISCAL BALANCE
Fortunately, Eisenhower was having nothing to do with either the Keynesian lite or Professor Heller’s full-monty version embraced by such leading lights as Democratic senators Paul Douglas and Hubert Humphrey. By keeping a firm rein on spending, the Eisenhower administration was able to deliver a budget surplus in fiscal 1956 and 1957, and to propose a balanced budget plan for each of the remaining four budgets during Ike’s tenure.
The federal budget did swing back to deficits when the automatic stabilizers kicked in during the short but steep recession of 1957–1958. The notable result of this temporary setback, however, was that Eisenhower again refused to embrace countercyclical tax cuts or spending increases to combat the recession, thereby hewing to his long-term fiscal goals.
Furthermore, after the rebound got under way in mid-1958, Ike personally led a full-court press to convert the $13 billion recession deficit into a surplus the very next year. This determined presidential campaign for a balanced budget even included a threat to call a special session of Congress to raise taxes if his spending vetoes were not upheld.
Eisenhower did, in fact, achieve a small surplus in fiscal 1960. Not only was this a testament to his resolute fiscal leadership but, more importantly, it was a stunning repudiation of the Keynesian professoriate. In complete violation of their vaunted math model, Ike’s deficit-cutting actions increased the alleged “full-employment surplus” by 2.5 percentage points of GDP between fiscal 1959 and 1960. This swing would have computed to $400 billion in today’s economy and was supposed to unleash a bogeyman called “fiscal drag” that would send the economy plummeting back into deep recession.
Yet the bogeyman of “fiscal drag” turned out to be just that: an academic postulate not born out in the real world. During the three-year period from the recession bottom in the second quarter of 1958 through the second quarter of 1961, in fact, real GDP expanded at a 4.2 percent annual rate.
To be sure, during those twelve quarters of solid recovery, the headline rate of annualized GDP change varied widely by quarter, ranging from an 11 percent gain to a 5 percent decline. But those swings were entirely due to inventory fluctuations. With only a few brief exceptions, business investment, consumer spending, and private incomes expanded strongly quarter after quarter throughout the period.
By the time of the 1960 campaign, however, proponents of the new economics were jawing loudly against Ike’s “Neanderthal” fiscal policy because reported GDP had temporarily slowed. Within months, of course, the spurious nature of these charges became evident when the US economy reaccelerated, expanding at an 8 percent annual rate by the second quarter of 1961.
And this rebound most assuredly reflected the economy’s preexisting natural momentum. There simply wasn’t any identifiable economic policy initiative launched by the time the Bay of Pigs invasion of Cuba ensnared the Kennedy administration during its first hundred days in office.
The truth is that the Keynesian professors had been essentially tilting at economic windmills during the 1960 campaign. Their evidence that the economy was lagging turned out to represent mainly short-term fluctuations in the inventory component of GDP.
Reported real GDP growth averaged only 0.8 percent during the four quarters of 1960, but it clocked in at a far more respectable 2.6 percent quarterly average after inventory change is backed out of the headline number. Thus, the Keynesian professoriate’s full-throated attack on Eisenhower’s circumspect fiscal policy implied that Washington’s macroeconomic job description extended all the way to ironing out even the economy’s short-run inventory oscillations. The patent absurdity of this proposition would soon be made abundantly clear by the disastrous experiments in “fiscal fine tuning” undertaken in the 1960s and 1970s.
In any event, the turning point which would usher in these calamities had clearly been reached. Kennedy, the winner of the 1960 presidential election, would install Professor Heller and his pretentious gang of Keynesian professors at the seat of power. Worse still, Nixon, who lost the election, would harbor an eternal grudge, blaming the fiscal orthodoxy of Ike and the sound money stand of William McChesney Martin for his defeat.
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HOW IKE’S FISCAL RECTITUDE
REINFORCED SOUND MONEY
That Eisenhower’s reign of old-fashioned fiscal discipline was crucial to the preservation of sound money cannot be gainsaid. This would become fully evident within the next decade when deficit-wielding politicians on both ends of Pennsylvania Avenue took to demanding that the Fed “accommodate” their fiscal stimulus sprees.
Indeed, when Keynesian fiscal activism became firmly entrenched in Washington, William McChesney Martin’s style of resolute monetary discipline was destined to vanish. This development, in turn, doomed the rickety structure of the Bretton Woods gold standard.
Eisenhower’s budgetary success, in turn, rested upon what amounts to heresy in the modern Republican Party. Owing to his unwillingness to completely dismantle Truman’s war taxes until the budget was balanced first, Ike made only limited progress lowering the tax burden. From a peak level of 19 percent reached under Truman’s war taxes, federal receipts were reduced to slightly under 18 percent. At the same time, Ike reduced outlays by two full percentage points of GDP by dint of the defense retrenchment and firm opposition to new or expanded domestic programs.
The nation’s fiscal accounts were thus wrestled into reasonable balance at about 18 percent of GDP on both sides of the ledger during Eisenhower’s final budgets. This outcome was the embodiment of the old-fashioned notion that taxes must be imposed to pay the government’s bills when the avenues for spending control have been exhausted.
Indeed, this testament to fiscal orthodoxy could not have been achieved without purposeful embrace of the inherited Truman tax régime by a Republican White House. And notwithstanding strong pressure from its own rank and file to repeal them.
Given several surplus years and limited “automatic stabilizer” deficits during the recession years, the cumulative deficit in Eisenhower’s eight years was minuscule. Total deficits amounted to just $15 billion, or 0.4 percent of GDP. This salutary fiscal outcome has not been even remotely approached by any administration since then.
The Great Deformation Page 32
