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The Collected Works of James M. Buchanan volume 8 Democracy in De®cit James M. Buchanan and Richard E. Wagner, Big Sky, Montana The Collected Works of James M. Buchanan volume 8 Democracy in De®cit The Political Legacy of Lord Keynes James M. Buchanan and Richard E. Wagner liberty fund Indianapolis This book is published by Liberty Fund, Inc., a foundation established to encourage study of the ideal of a society of free and responsible individuals. The cuneiform inscription that serves as our logo and as the design motif for our endpapers is the earliest-known written appearance of the word ``freedom'' (amagi), or ``liberty.'' It is taken from a clay document written about 2300 b.c. in the Sumerian city-state of Lagash. Foreword and coauthor note q 2000 by Liberty Fund, Inc. Democracy in De®cit: The Political Legacy of Lord Keynes q 1977 by Academic Press, Inc. All rights reserved Printed in the United States of America 04 03 02 01 00 c 54321 04 03 02 01 00 p 54321 Library of Congress Cataloging-in-Publication Data Buchanan, James M. Democracy in de®cit : the political legacy of Lord Keynes / James M. Buchanan and Richard E. Wagner. p. cm. Ð (The collected works of James M. Buchanan ; v. 8) Originally published : New York : Academic Press. c1977. With a new foreword. Includes bibliographical references and index. isbn 0-86597-227-3 (hc : alk. paper). Ð isbn 0-86597-228-1 (pbk : alk. paper) 1. United StatesÐEconomic policy. 2. Fiscal policyÐUnited States. 3. Keynesian economics. I. Wagner, Richard E. II. Title. III. Series: Buchanan, James M. Works. 1999 ; v. 8. hc106.6b74 2000 330.973809Ðdc21 99-24064 liberty fund, inc. 8335 Allison Pointe Trail, Suite 300 Indianapolis, IN 46250-1684 Contents Foreword xi Preface xvii Acknowledgments xxi I. What Happened? 1. What Hath Keynes Wrought? 3 The Political Economy 4 A Review of the Record 5 The Theory of Public Choice 7 Fiscal and Monetary Reform 8 2. The Old-Time Fiscal Religion 10 Classical Fiscal Principle 10 Fiscal Practice in Pre-Keynesian Times 13 Balanced Budgets, Debt Burdens, and Fiscal Responsibility 16 Fiscal Principles and Keynesian Economic Theory 21 The Fiscal Constitution 23 3. First, the Academic Scribblers 25 ``Classical Economics,'' a Construction in Straw? 26 The Birth of Macroeconomics 29 The New Role for the State 31 The Scorn for Budget Balance 32 The New Precepts for Fiscal Policy 33 Budget De®cits, Public Debt, and Money Creation 34 The Dreams of Camelot 37 viii Contents 4. The Spread of the New Gospel 38 Introduction 38 Passive Imbalance 38 Built-in Flexibility 41 Hypothetical Budget Balance 42 Monetary Policy and In¯ation 43 The Rhetoric and the Reality of the Fifties 45 Fiscal Drag 47 The Reluctant Politician 49 Political Keynesianism: The Tax Cut of 1964 50 Economists, Politicians, and the Public 52 Functional Finance and Hypothetical Budget Balance 53 5. Assessing the Damages 56 Introduction 56 The Summary Record 57 Budget De®cits, Monetary Institutions, and In¯ation 59 In¯ation: Anticipated and Unanticipated 61 Why Worry about In¯ation? 62 In¯ation, Budget De®cits, and Capital Investment 66 The Bloated Public Sector 71 International Consequences 73 Tragedy, Not Triumph 75 II. What Went Wrong? 6. The Presuppositions of Harvey Road 79 Introduction 79 The Presuppositions of Harvey Road 80 The Economic Environment of the ``General Theory'' 83 Strings Can Be Pulled 85 The Great Phillips Trade-off 87 Post-Keynes, Post-Phillips 90 Reform through National Economic Planning 92 Contents ix 7. Keynesian Economics in Democratic Politics 95 Introduction 95 Budgetary Management in an Unstable Economy 96 Taxing, Spending, and Political Competition 98 Unbalanced Budgets, Democratic Politics, and Keynesian Biases 101 De®cit Finance and Public-Sector Bias 106 8. Money-Financed De®cits and Political Democracy 110 Introduction 110 Budget De®cits Financed by Money Creation 111 Benevolent and Independent Monetary Authority 114 The Political Environment of Monetary Policy 117 The American Political Economy, 1976 and Beyond 125 9. Institutional Constraints and Political Choice 129 Introduction 129 The Public Economy and the Private 130 Fiscal Perception and Tax Institutions 131 Debt-Financed Budget De®cits 138 Money-Financed Budget De®cits 147 Institutions Matter 149 III. What Can Be Done? 10. Alternative Budgetary Rules 153 Budget Balance over the Cycle 154 Built-in Flexibility 155 Budget Balance at Full Employment 157 The Budget Reform Act of 1974 162 Short-Term Politics for Long-Term Objectives 164 11. What about Full Employment? 167 Introduction 167 Current Unemployment and the Quandary of Policy 167 x Contents The Keynesian Theory of Employment 170 The In¯ation-Unemployment Trade-off 172 The In¯ation-Unemployment Spiral 174 Biting the Bullet 177 So, What about Full Employment? 178 12. A Return to Fiscal Principle 180 The Thrill Is Gone 180 The Case for Constitutional Norms 182 The Case for Budget Balance 183 Fiscal Decisions under Budget Balance 184 Tax Rates and Spending Rates as Residual Budget Adjustors 185 A Speci®c Proposal 187 Debt Retirement and Budget Surplus 189 In Summation 190 Author Index 195 Subject Index 197 Foreword Democracy in De®cit, by James M. Buchanan and Richard E. Wagner, repre- sents one of the ®rst comprehensive attempts to apply the basic principles of public choice analysis to macroeconomic theory and policy.1 Until the 1970s, macroeconomics was devoid of any behavioral content with respect to its treatment of government. Government was simply treated as an exogenous force (G¢ ), which behaved in the way prescribed by a given macroeconomic theory. In this approach, government invariably acted in the public interest as perceived by the host theory. Both the so-called Keynesian and monetarist approaches were beset by this problem, although it was the inherent contra- dictions of the Keynesian theory that attracted the attention of Buchanan and Wagner. Democracy in De®cit led the way in economics in endogenizing the role of government in discussions of macroeconomic theory and policy. The central purpose of the book was to examine the simple precepts of Keynesian eco- nomics through the lens of public choice theory. The basic discovery was that Keynesian economics had a bias toward de®cits in terms of political self- interest. That is, at the margin politicians preferred easy choices to hard ones, and this meant lower taxes and higher spending. Thus, whatever the merits of Keynesian economics in using government ®scal policy to ``balance'' the forces of in¯ation and de¯ation and employment and unemployment in an economy, its application in a democratic setting had severe problems of in- centive compatibility; that is, there was a bias toward de®cit ®nance. And, of course, there is no need to reiterate here the evidence in the United States 1. James M. Buchanan and Richard E. Wagner, Democracy in De®cit: The Political Leg- acy of Lord Keynes (New York: Academic Press, 1977), volume 8 in the series. xi xii Foreword and elsewhere for the correctness of the Buchanan insight on Keynesian eco- nomics. It is all too apparent that the thesis of this book has been borne out. Democracy in De®cit led the way to modern work on political business cy- cles and the incorporation of public choice considerations into macroeco- nomic theory. For example, there is a literature today that discusses the issue of the time consistency of economic policy. Does a conservative incumbent who cannot stand for reelection run a de®cit in order to control spending by a liberal successor? One can easily see the hand of Buchanan in such con- structions. In this example, term limits (a public choice phenomenon) are at the center of a macroeconomic model. Moreover, monetarism has not escaped the inspection of public choice analysis. Buchanan and others have pioneered work on the behavior of ®at money monopolists. This public choice work stands in stark contrast to earlier work by Keynesians and monetarists who supposed that economists stood outside and above politics and offered advice to politicians and central banks that would be automatically adopted. Otherwise, policymakers were misguided or uninformed. If they knew the right thing, they would do the right thing. This approach to macroeconomics is now largely dead, thanks to books like Democracy in De®cit. Today, the age-old adage that incentives matter is heeded by macroeconomists, and it is recognized that political in- centiveÐnot the ivory tower advice of economistsÐdrives macroeconomic events. Democracy in De®cit is also closely related to Buchanan's interest in ®scal and monetary rules to guide long-run policy in macroeconomics. Such rules are needed to overcome the short-run political incentives analyzed in this book and to provide a stable basis for long-run economic growth. Buchanan's lifelong dedication to the goal of a balanced budget amendment to the United States Constitution and to a regime of monetary rules rather than central bank discretion can be seen in this light. The real alternative to ®scal and monetary rules is, after all, not the per- fection of economic policy in some economic theorist's dream. It is what the rough and tumble of ordinary politics produces. The problem is to ®nd a feasible solution to long-run economic stability and growth. Viewed in this way, there is really no con¯ict between rules and discretion, and, thanks in part to Buchanan's insistence on this point, the world today seems poised to Foreword xiii have more rule-based economic institutions. Democracy in De®cit is but one of Buchanan's many intellectual efforts toward this end. Robert D. Tollison University of Mississippi 1998 Richard E.

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