The Consequences of Mr Keynes J. M. BUCHANAN JOHN BURTON R. E. WAGNEI HOBART PAPER 71 Second Impression £1.50 The Consequences of Mr Keynes J. M. BUCHANAN JOHN BURTON R. E. WAGNER S3I»i^H|D0 DO BMW mmmmmm **^nnEQ W^- ^^3^__~~^=Sfed_L____!^^ ;^ HOBART PAPER 78 Second Impression £1.50 INSTITUTE OF ECONOMIC AFFAIRS The Institute was formed in 1957 as a research and educational trust that specialises in the study of markets and pricing systems as technical devices for registering preferences and apportioning resources. Micro-economic analysis forms the kernel of econ­ omics and is relevant and illuminating in both government and private sectors, in collectivist as well as in individualist societies. Where the macro-economic method is used its results are verified and interpreted in the light of micro-economic significance. The Institute's work is assisted by an advisory council which includes: Professor Armen A Alchian Professor Alan T Peacock Professor J M Buchanan G J Ponsonby Colin Clark Professor A R Prest Professor R H Coase Professor H B Rose Professor Malcolm R Fisher George Schwartz Professor T W Hutchison Henry Smith Graham Hutton Professor A A Walters Professor Dennis Lees Professor Jack Wiseman Professor E Victor Morgan Professor B S Yamey The Institute is a company limited by guarantee, controlled by Managing Trustees. It is independent ofany political party or group and financed by sales of publications and by voluntary contributions from individuals, organisations and companies. General Director Ralph Harris Editorial Director Arthur Seldon Deputy Director John B Wood Assistant to Directors Publications Manager Joan Culverwell Michael Solly Librarian Kenneth Smith Hobart Papers published by the Institute are listed on page 94. Details of other publications are available from: THE INSTITUTE OF ECONOMIC AFFAIRS 2 Lord North Street, Westminster, London SWiP 3LB Telephone: 01-799 3745 The Consequences of Mr Keynes An analysis of the misuse of economic theory for political profiteering, with proposals for constitutional disciplines JAMES M. BUCHANAN University Professor of Economics and Director ofthe Center for Study of Public Choice, Virginia Polytechnic Institute, Blacksburg, Virginia RICHARD E. WAGNER Professor of Economics, Virginia Polytechnic Institute and State University JOHN BURTON Principal Lecturer in Economics, Kingston Polytechnic Second Impression Published by THE INSTITUTE OF ECONOMIC AFFAIRS 1978 First published April igy8 Second Impression March 1979 © THE INSTITUTE OF ECONOMIC AFFAIRS, 1978 All rights reserved ISSN 0073-2818 ISBN 0-255 36110-6 Printed in Great Britain by GORON PRO-PRINT CO LTD 6 Marlborough Road, Churchill Industrial Estate, Lancing, Sussex Text set in 'Monotype' Baskerville CONTENTS PREFACE Arthur Seldon 7 THE AUTHORS IO SIGNIFICANCE: The importance of the proposals for the British Reader between pp. 45-46 PART I: DEMOCRACY AND KEYNESIAN CONSTITUTIONS: POLITICAL BIASES AND ECONOMIC CONSEQUENCES I I James M. Buchanan and Richard E. Wagner A. Visions ofthe Economic Order: Classical and Keynesian 13 From Classical stability to Keynesian instability 13 B. The Idealised Environment for Keynesian Economic Policy 14 Keynes's defective assumptions 16 C. Keynesian Presuppositions, Democratic Politics, and Economic Policy 18 Market and political competition: similarities and essential differences 18 Budgets: political gains and losses 19 (i) Budget surpluses and democratic politics 20 (ii) Budget deficits and democratic politics 22 (iii) Keynesian economics in political democracy 23 D. The Destructive, Self-fulfilling Character of the Keynesian Political Biases 24 Hayek's analysis of the impact of inflation 26 E. Conclusion 27 PART II: KEYNES'S LEGACY TO GREAT BRITAIN: 'FOLLY IN A GREAT KINGDOM' 29 John Burton A. Britain's Changing Fiscal History 31 The pre-Keynesian budgetary record 31 The Keynesian budgetary record 33 The displacement hypothesis 35 [3] B. The Pre-Keynesian British Fiscal Constitution 36 The conventions of the fiscal constitution in 19th-century Britain 37 The cohesion and functioning of the British 19th-century fiscal constitution 39 The establishment ofthe balanced-budget rule in 19th-century Britain 41 The pressures towards excessive expenditure and deficit finance in the 19th century 44 C. The Presuppositions of John Maynard Keynes 47 (1) 'The public interest' 47 (2) The philosopher-king hypothesis ofthe British ruling elite 48 (3) The elite's power of persuasion 49 The Bloomsbury View 49 The dentist model of the economic adviser 50 D. The Keynesian British Fiscal Constitution—in Theory 51 (i) Meade 52 (ii) Dalton 53 (iii) Kaldor 54 Conclusion 55 E. The Keynesian British Fiscal Constitution—in Reality 56 Keynesian presuppositions v. Whitehall/ Westminster realpolitik 57 F. The Failure of Remedial Measures 61 Plowden and PESC, 1961: an attempt at reform 61 The crisis measures of 1976 67 A conversion ofthe policy-makers? 69 An evaluation of the prospects 70 The November 1977 'reflation' 72 G. Conclusion: 'Folly in a Great Kingdom' 73 PART III: CONSTITUTIONAL OPTIONS FOR FISCAL CONTROL 77 J. M. Buchanan, J. Burton and R. E. Wagner A. Fatalism v. Reform 79 Force the helmsman to stop fiddling with the tiller? 80 [4] B. Concrete Proposals for the Reform of the British Fiscal-Monetary Constitution 81 i. A combined budget statement 81 2. Re-adopt the balanced-budget principle 81 3. Automatic adjustment towards budget balance 82 4. Orderly transition to full implementation 83 5. Waiver in national emergency 83 6. Conditions for monetary stability 83 C. Unfounded Fears 84 QUESTIONS FOR DISCUSSION 87 FURTHER READING 88 TABLES I. The pre-Keynesian British budgetary record, selected years, 1790-1935 32 II. The Keynesian British budgetary record, annual figures, 1946-76 34 III. The 'hump effect': PESC projections ofthe rate of growth of government expenditure, 1970-71 to 1979-80 65 [5] PREFACE The Hobart Papers are intended to contribute a stream of authoritative, independent and lucid analyses to the under­ standing and application of economics to private and govern­ ment activity. Their characteristic theme has been the optimum use of scarce resources and the extent to which it can best be achieved in markets within an appropriate framework of laws and institutions or, where markets cannot work or have dis­ proportionate defects, by better methods with relative advan­ tages or less decisive defects. Since the alternative to the market is in practice the state, and both are imperfect, the choice between them is made on the judgement of the comparative consequences of market failure and government failure. Markets have to work in an environment of laws and insti­ tutions; laws are made by government, and institutions are largely shaped by it. The most important part of this environ­ ment has long been thought to be in the realm of money and taxes. The provision ofa monetary system to facilitate exchange in the market, the creation of a structure of taxes to finance government with the least possible adverse effect on effort and enterprise, and, not least, matching government income with expenditure in its budget have all been thought to be funda­ mental tasks of government. The purpose of government was thought to be to do what was necessary to help the economic system in which men come together as buyers and sellers to work as smoothly as possible and no more, apart from the direct provision of 'public goods' that could not be supplied in the market. Forty years ago this notion ofthe function of government was contested by J. M. Keynes, who claimed that the economic system required more from government than the creation ofthe framework of laws and institutions because it would settle down into a state in which less than all resources were employed. He taught that government would have to undertake the new function of using its budget to run not only its own activities, but also to maintain the whole economic system in full employment by off-setting its fluctuations with opposite fluctuations in budgetary expansion or contraction of money and credit. He contended that only in this way would it be possible to main­ tain an otherwise freely working economic system in a more or less stable condition without disturbing fluctuations. [7] This diagnosis ofthe working ofthe economic system and the remedy for its supposed instability was questioned from the very beginning by economists whose doubts were not paid much attention,1 perhaps because the Keynesian revolution of 1936 was soon followed by six years of war, by 10 years of recovery from war, and by a further decade in which the Keynesian prescription seemed to have worked in maintaining full em­ ployment, a more or less steady though not spectacular rate of growth, and what now seems to be only very modest inflation. In recent years the Keynesian economic diagnosis has come under increasing criticism and is now accepted by fewer econ­ omists and rejected by more than at any time since its origin. Hobart Paper 78 presents a new critique of Keynes. It is concerned not so much with the accuracy of his economics as with the realism of his politics. Its subject is not whether Keynes was right as a technical economist in establishing the instability and inherent under-employment of the market economy, but whether the instrument he devised to make it stable, budget deficits, could be used by politicians in representative democ­ racy to serve the purpose he intended. Even a technically per­ fect solution devised by economists may be damaging if it exposes them to irresistible importunities and sectional pressures to misuse it. Keynes 'turned the politicians loose' (Part I, p. 27): he gave them the excuse to overspend, overborrow and create money; and they have run amok. This is the critique of Keynesianism made by Professors J. M. Buchanan and Richard E. Wagner ofthe USA in Part I of this Hobart Paper. Their argument is adapted to illuminate the post­ war history of British economic pohcy by John Burton in Part II.