This PDF is a selection from an out-of-print volume from the National Bureau of Economic Research Volume Title: The Defining Moment: The Great Depression and the American Economy in the Twentieth Century Volume Author/Editor: Michael D. Bordo, Claudia Goldin and Eugene N. White, editors Volume Publisher: University of Chicago Press Volume ISBN: 0-226-06589-8 Volume URL: http://www.nber.org/books/bord98-1 Publication Date: January 1998 Chapter Title: Fiscal Policy in the Shadow of the Great Depression Chapter Author: J. Bradford DeLong Chapter URL: http://www.nber.org/chapters/c6888 Chapter pages in book: (p. 67 - 86) 2 Fiscal Policy in the Shadow of the Great Depression J. Bradford De Long Before the Great Depression the U.S. government did not have a fiscal policy, at least not in the sense that economists have meant for the past two genera- tions. The government did not attempt to tune its deficit or surplus to achieve the goal of full employment or low inflation. This is not to say that the federal budget was typically in balance. The federal government did borrow, and bor- row on a very large scale in wartime: a typical pre-World War I1 war would end with total federal debt equal to some three-tenths of a year’s national product. But after a typical war was over the debt would rapidly be redeemed: the War of 1812 debt had been paid off by the 1830s. The Mexican War debt had been extinguished by the early 1850s. The enormous Civil War debt and the less enormous Spanish-American War debt had been extinguished by the eve of World War I. Thus U.S. “fiscal policy” before the Great Depression was simple: the federal government borrowed what it could during wartime. It strove thereafter to run peacetime surpluses to reduce the ratio of debt to na- tional product. All this changed with the Great Depression. The first depression-era federal deficits were involuntary: both Herbert Hoo- ver and (in his first term at least) Franklin Roosevelt tried to achieve balanced budgets. But they each failed to find politically feasible policies that could pass the Congress and would balance the budget. Later depression-era federal deficits were more voluntary: the government came to make a virtue out of necessity and to trumpet the potential macroeconomic benefits of a depression J. Bradford De Long is associate professor of economics at the University of California, Berke- ley, a research associate of the National Bureau of Economic Research, and a visiting scholar at the Federal Reserve Bank of San Francisco. The author thanks the National Science Foundation and the Alfred P. Sloan Foundation for financial support. He also thanks John Auten, Robert Barsky, Bany Eichengreen, Claudia Goldin, Richard Grossman, Robert Hall, Chris Hanes, Chad Jones, Lars Jonung, Greg Mankiw, Alicia Munnell, Charles Schultze, Andrei Shleifer, Larry Summers, Richard Sutch, Robert Waldmann, David Wilcox, Eugene White, and especially Michael Bordo for helpful discussions. 67 68 J. Bradford De Long deficit. Thus the US. government abandoned the principle that the only good peacetime budget was a balanced budget. And the depression-era deficits were continued and vastly expanded during World War 11. The shadow cast by the Great Depression prevented a return to the prede- pression principle of budget balance after World War 11: the political economic folk wisdom, not completely wrong, was that addiction to budget balance had deepened the depression. But what was to replace the predepression commit- ment to peacetime balance as an operational goal? For the first generation or so after World War 11, economists’ and politicians’ views appeared to be converging on a possible consensus, a position that had been set out by the Committee on Economic Development (CED) under the intellectual leadership of future Nixon-era Council of Economic Advisers (CEA) chair Herbert Stein.’ The CED position was to set tax rates and expenditure programs so that the budget would be in surplus or in balance at high employment (whichever was desired) but to leave unhindered the operation of the “automatic stabilizers” set in motion as recession causes revenues to fall, spending to rise, and the budget to swing into deficit. These automatic stabilizers take effect within a single calendar quarter, as claims for unemployment insurance and food stamps are filed and as tax withholdings are received (or not received) by the Federal Reserve system. They reduce the sensitivity of aggregate demand to shifts in autonomous spending or monetary velocity, thus diminishing the mag- nitude of cyclical fluctuations. And they operate much more quickly than dis- cretionary fiscal policies or shifts in monetary policy can-thus they are an irreplaceable tool of macroeconomic management. But neither Herbert Stein’s nor any other principle managed to become the basis of an enduring consensus. And no logic can be seen in the pattern of U.S. fiscal policy across decades: whatever logic might have been seen vanished with the emergence of long-term “structural” deficits during the 1980s under Ronald Reagan’s presidency, and with the appearance of very long term projec- tions of large deficits as a social insurance system designed before 1973 col- lided with slower real revenue after the 1973 beginning of the productivity slowdown (see Auerbach 1994). This paper traces, first, the breakdown of the predepression consensus on fiscal rectitude under the pressure of the depression. It then considers the shadow cast by the memory of the depression on post-World War I1 fiscal policy, as economists, bureaucrats, and politicians struggled to learn the right lessons from the depression. It concludes on a note of pessimism: pressures on the US. fiscal balance are strong, political understanding of the benefits of alternative policies are weak, and the attention span of the political system is short. Even though the consen- 1. Stein’s The Fiscal Revolution in America: Policy in Pursuit of Reality was and remains a classic. 69 Fiscal Policy in the Shadow of the Great Depression sus of economists has provided and will continue to provide good advice, fiscal policy in the future is likely to display a similar lack of logic and have similar damaging effects on the economy as in the recent past. 2.1 Predepression Fiscal Policy 2.1.1 Peacetime Surpluses Before the Great Depression, the idea that the government should tune its fiscal policy to control and moderate the business cycle was far from the center of political and economic discourse. The government did borrow, but its bor- rowings were confined to wartime. Wartime borrowings were large relative to the size of the economy: wars are very expensive. The Revolutionary War debt assumed by Treasury Secretary Alexander Hamilton amounted to perhaps one- fifth of the then-United States’ annual national product. The Civil War debt accumulated under Treasury Secretary Salmon Chase and the World War I debt borrowed under Treasury Secretary William G. McAdoo each amounted to roughly three-tenths of annual national product (see fig. 2.1). But after the wars were over, the debt invariably shrank as a share of national product. Some of the debt was retired by budget surpluses. The remaining debt, constant in nominal terms, shrank relative to GDP because of real per capita income growth, population growth, and inflation. The Revolutionary War debt (both that issued under the Articles of Confed- eration and that assumed from the states on Hamilton’s initiative) had been reduced from roughly 20 to perhaps 5 percent of national product by the eve of the War of 1812. The War of 18 12 debt was steadily reduced throughout the 120% , 100% 80% 40% 20% 0% 1790 1820 1850 1880 1910 1940 1970 Fig. 2.1 Federal debt as a share of national product Sources: U.S. Bureau of the Census (1975) and CEA (1996). 70 J. Bradford De Long 5% 0% -5% -1 0% -1 5% -20% -25% 1870 1890 1910 1930 1950 1970 1990 Fig. 2.2 Budget surplus (or deficit) as a share of national product Sources: U.S. Bureau of the Census (1975) and CEA (1996). 1820s, and President Andrew Jackson paid off virtually the entire national debt in the 1830s. The small debt run up during the Mexican War was similarly erased by the end of the 1850s. The large Civil War debt and the small (relative to national product) Spanish-American War debt were similarly paid off over the decades: the ratio of federal debt to national product was less than 3 percent on the eve of World War I. The pattern was the same after World War I. The decade of the 1920s saw a near halving of the federal debt as a share of national product. Before the Great Depression there were peacetime decades-the 192Os, the 1880s, and the 1820s-in which the nominal federal budget was in surplus to the extent of 2 percent of national product or so. There were peacetime decades in which the nominal federal budget was in rough balance, and in which the growth of per capita income, the growth of population, and (usually) the slow progress of inflation reduced the relative size of the debt measured as a share of national product. There were no peacetime decades in which the federal budget was in more than trivial deficit (see fig. 2.2). 2.1.2 Ideologies and Doctrines The rationale for the predepression consensus against countercyclical fiscal policy had at least five facets. First came a fear of the impact of large federal debts on the economic health of the country. A large debt meant large interest payments to service the debt.