The president has delivered his budget to Congress. Though Congress can be expected to weigh in with much overblown rhetoric, the appropriation bills it passes probably won’t differ much from the president’s proposal.
Whatever the exact outcome, one thing is clear: No school of economic thought supports the current practice of increasing the national debt, year after year. Only history will tell whether it is economists or the U.S. government that is wrong.
Let’s start with a brief review. From the late 1700s to the 1930s, economists generally thought that governments should be prudent, spending only what they brought in from taxes and going into debt only in emergencies.
In 1936, John Maynard Keynes proposed an alternate view in his “General Theory of Employment, Interest and Money.” Keynes argued that governments could and should intervene to stabilize economies. If inflation threatened, a government should cut spending, raise taxes and crimp the money supply to raise interest rates. To fight a recession it should increase spending, cut taxes, and boost the money supply to lower interest rates. The object of all this was to change the economy’s overall demand for goods and services.
Following such policies, a government might run budget deficits when the economy was slow, but surpluses when the economy was good. Keynes never argued, however, for incurring larger and larger debts.
By the 1950s and 1960s, Keynesian demand manipulation dominated the policies of many countries, including the United States.
The high unemployment and inflation of the 1970s forced some rethinking. Some economists saw cause and effect between Keynesian policies and stagflation. The economic problems of the 1970s did not occur despite government policies, but precisely because of those policies.
Three sets of economists criticized Keynes. Monetarists, led by Milton Friedman, argued that trying to manage the economy by varying taxes, spending and the money supply was harmful.
The money supply was important. Central banks like the U.S. Federal Reserve increase the money supply as fast as the economy itself grew over the long run. After that, government should keep its dirty mitts off the economy, the monetarists said. Deficit spending was bad. Increasing national debt was bad.
A second school of thought, “rational expectations,” included many economists who had been Keynesians but came to believe that his ideas were wrong. They argued that households and businesses react to Keynesian policies in rational, self-protecting ways. The sum of such reactions across an economy counters the effects of Keynesian policies, rendering them ineffective.
In terms of practical policies, the rational expectationists generally agreed with the monetarists: Alternately stomping economic gas and brake pedals is bad. Let the money supply grow at a steady rate, keep government’s role in the economy minimal and avoid deficit spending.
The third group, supply-side economists, lacked the elegant mathematics of the rational expectationists and never had the academic clout of other critics. But they did catch the ear of politicians. They argued that Keynesians erred in their emphasis on manipulating demand. It was better to focus on the supply side of the economy, they said, implementing longer-run policies to foster savings and investment. We should reduce high marginal income tax rates on the wealthy, because they were most likely to save and invest more if favored with lower taxes. We should reduce taxes on dividends and interest for the same reason. Switching to a national value-added or sales tax would discourage consumption and increase savings and investment.
Both Keynesians and supply-siders thus favored certain tax cuts. Keynesians supported short-term ones to fight recessions. Supply-siders wanted lower taxes to spur investment.
But neither group argued that running up the national debt, year after year, was a good idea. Keynesians thought that budget surpluses during booms should balance deficits during busts. Supply-siders thought that changing who and what we tax would foster economic growth that would, over time, increase government revenue. But neither group saw any benefit to large perennial deficits.
Yet we run deficits year after year and the economy is doing OK — we have rising output, high employment and low inflation. Perhaps the economists are wrong. For decades, aeronautical engineers could not explain why bumblebees managed to fly, but fly they certainly did. Perhaps in 20 years, brighter economists will understand something that current ones do not.
Or perhaps economists are right after all. Perhaps the economy is OK only because oil-exporting countries and Asian central banks are willing to lend us a lot of money cheaply, temporarily staving off the results of excess borrowing.
Our grandchildren will know the answer. Perhaps they will be grateful for our current profligacy. And perhaps they won’t.
© 2007 Edward Lotterman
Chanarambie Consulting, Inc.