The Inevitability of Government Growth 9780231894609

Table of contents :
Contents
Tables
Introduction
Acknowledgments
1. The Perils of Fettered Government Expenditures
2. The Atrophy of Net Investment and Some Consequences for the U.S. Mixed Economy
3. Perspectives on the Forty-sixth Anniversary of the U.S. Mixed Economy
4. Budget Deficits and the Quality of Presidential Administrations: 1789–1960
5A. The Princess and the Pea; or the Alleged Vietnam War Origins of the Current Inflation
5B. The Alleged Vietnam War Origins of the Current Inflation: A Comment
5C. Demonstrating the Undemonstrable: A Reply to Garrison and Mayhew
6. Stagnation – Performance and Policy: A Comparison of the Depression Decade with 1973–1984
7. Can the Good Performance of the 1960s Be Repeated in the 1980s?
8. Real Public Sector Employment Growth, Wagner’s Law, and Economic Growth in the United States
9. Why Has the United States Operated Below Potential Since World War II?
10. International Dimensions of a High Growth Rate
11. The Inevitability of Government Growth
Name Index
Subject Index

Citation preview

T H E INEVITABILITY OF G O V E R N M E N T GROWTH

The Inevitability of Government Growth HAROLD G. V A T T E R

AND

J O H N F. WALKER

Columbia University Press

New York

Columbia University Press New York Oxford Copyright © 1990 C o l u m b i a University Press All rights reserved Library of Congress Calaloging-in-Publication

Data

Vatter, Harold G. The inevitability of g o v e r n m e n t g r o w t h / Harold G. Vatter and J o h n F. Walker, p. cm. Includes bibliographical references a n d index. ISBN 0-231-07020-9 I. U n e m p l o y m e n t — United S t a t e s — E f f e c t of inflation on. 2. Mixed economy — United States. 3. Budget deficits — United States. 4. United S t a t e s — E c o n o m i c c o n d i t i o n s — 1 9 4 5 - 5. United States— Economic policy. I. Walker, J o h n F. II Title. HD5724.V38 1990 339.5*0973 — dc20 90-40164 CIP Casebound editions of C o l u m b i a University Press books are S m v t h - s e w n a n d printed on p e r m a n e n t a n d d u r a b l e acid-free p a p e r

Printed in the United S t a t e s of America c 10 9 8 7 6 5 4 3 2 1

To Robert Eisner, preeminent defender of humanism's union with economic science

CONTENTS

CONTENTS Tables Introduction Acknowledgments 1. 2. 3. 4. 5A. SB. SC. 6. 7. 8. 9. 10. 11.

The Perils of Fettered Government Expenditures The Atrophy of Net Investment and Some Consequences for the U.S. Mixed Economy Perspectives on the Forty-sixth Anniversary of the U.S. Mixed Economy Budget Deficits and the Quality of Presidential Administrations: 1789-1960 The Princess and the Pea; or the Alleged Vietnam War Origins of the Current Inflation A Comment by Charles B. Garrison and Anne Mayhew

ix xiii xix l 6 23 62 70 82

Demonstrating the Undemonstrable: A Reply to Garrison and M a y h e w Stagnation — Performance and Policy: A Comparison of the Depression Decade with 1973-1984 Can the Good Performance of the 1960s Be Repeated in the 1980s? Real Public Sector Employment Growth, Wagner's Law, and Economic Growth in the United States Why Has the United States Operated Below Potential Since W o r l d W a r II? International Dimensions of a High Growth Rate The Inevitability of Government Growth

153 173 202

Name Index Subject Index

291 295

94 105 120 130

vii

TABLES

Table 3.1 Table 3.2

Table 3.3

Table 3.4

Table 5.1 Table 5.2 Table 5.3

Table 5.4 Table 5.5 Table 5.6 Table 5.7 Table 5.8 Table 5.9

Percentage Shares for Three Major Expenditure Flows, Selected Periods, 1869-1888 to 1970-1977 Government Domestic Civilian Outlays in Constant (1972) Dollars as Percentage of Constant Dollar Nonrecession G N P for Selected Years, 1929-1977 Government Civilian Employment as Percentage of Civilian Labor Force, Selected Years, 1929-1977 Government Outlays, Including Net Transfers, as a Percentage of Gross Domestic Product: Selected Mixed Economies, Current Prices, Selected Years, 1960-1976 Estimates of Beginning Date of Inflation Defects and Surpluses for a Five-Year Period Annual Percentage Increases in Selected Money Aggregates, December to December, Calendar Years 1963-1970 Quarterly Price Changes and Federal Shares of GNP Economic Impact of the Federal Government During T w o Wars Economic Conditions Prior to T w o Wars Inflation During T w o Wars Labor Market Conditions During the Vietnam War Four Estimates of the Relative G N P Gap, 1950-1954 (Gap in Percent of Potential G N P )

25

28

32

42 72 75

76 79 84 85 87 90 101 ix

X Tables Table 6.1 Table 6.2 Table 7.1 Table 7.2 Table 7.3 Table 8.1

Table 8.2A Table 8.2B Table 9.1

Table 9.2

Table 10.1

Table 10.2 Table 10.3 Table 10.4

Table 10.5 Table 11.1 Table 11.2

Real Annual Percentage Rates of Change, Selected Critical Spending Streams Comparison of Policy Tax and Income Tax, 1969-1985 (in Billions of 1972 Dollars) Change in Total Spending, Selected Categories, 1962-1969 (Current Dollars) Selected Input Contributions to Growth of Total Output, 1964-1969 Investment and the Sources and Uses of Funds by Nonfinancial Corporations Comparative Annual Growth Rates, All Civilian Employees, and FTE Civilian Employees, Public and Private, Selected Periods, 1929-1979 (Percent per Year) Government Civilian Employment, Federal, State, and Local, Decadal, 1929-1979 All-Government Civilian Plus Military Employment, Decadal, 1929-1979 Predicted and Actual Annual Percentage Changes in Real GNP, Federal Purchases, and Nonresidential Fixed Investment from the Council of Economic Advisers Annual Percentage Changes in Government Purchases, GNP, Gross Investment, Civilian Labor Force, Capital Stock, and Output-Input Ratios (1948-1985 and Selected Subperiods) Projections of Major Real Spending Streams, Slow-Growth and High-Growth Assumptions, and Projected High-Growth Savings/Investment Balances, 1987-2007 (Billions of 1982 Dollars) Real Interest Rate Calculation (in Percent) Average of Monthly Rates Real Interest Rate, the Two Quarters Preceding Cycle Peaks Real Interest Rates, the Value of the Dollar, Real Exports, and Real Imports (Compound Annual Rates of Change) The Real Interest Rate and the Budget and Trade Deficits (in Percent) Government Civilian Employment, Selected Years, 1950-1987 (Thousands) Average Annual Compound Percentage Growth

108 118 121 121 125

134 136 138

164

166

177 194 196

197 198 203

Table 11.3 Table 11.4 Table 11.5

Rates, G N P and Government Purchases (1982 Dollars) Adults Under Correctional Supervision (Thousands) U.S. District Court Criminal Defendants Imprisoned Nations Owning Oil Companies

INTRODUCTION

The mixed economy era of big government has demonstrated that the time-honored early Marxist forecast of the "final stage of c a p i t a l i s m " was poorly estimated. The great theoretical sire of the mixed economy, J o h n Maynard Keynes, correctly specified that large public spending could compensate for the long-run slowdown in total demand due to declining private investment. Keynes' prescription for thus bolstering aggregate demand has been more or less realized in most advanced capitalistic economies. Yet conservatives, opposed to both Marx and to Keynes' big public spending recommendation, point with pride to the economic growth record in the United S t a t e s and elsewhere in the decades since the Great Depression of the 1930s. To try to escape from this inconsistency the conservatives allege that the growth achievements have been racked up by the tattered remnants of private market forces bravely functioning in spite of burdensome government intervention. The great contemporary controversies surrounding the ramifications of this proposition are the essential subject m a t t e r of the writings in this work. We emphasize, in contradistinction to the orthodox proposition, that powerful preKeynesian types of policy influences have substantially hindered if not sabotaged the mixed economy's assumption of government responsibility for sustained high employment. Whatever actual economic growth we have enjoyed has been largely attributable to rising public demand. This general theme will readily emerge even from some of the specific, narrower matters treated in certain of the chapters. For example, the survey of able versus incompetent presidents invokes the criterion of public budget deficits. There is a close policy connection between budget deficits and public versus private spending. xiii

xiv

Introduction

The contemporary era of big government, which is global in scope, expresses a deep-rooted and overwhelming community consensus. Chapter 3 offers support for this interpretation of the mixed economy's historical origins. Moreover, the consensus has harvested the ever-expanding democratic and humanistic values that run deep in Western culture. Furthermore, those historically ascending values have increasingly tended to discard the individualistic and laissez-faire trappings more appropriate to an earlier epoch. The hallmarks of the mixed economy consensus are its strong reliance upon collective solutions and its rejection of the classical opinion that government was "unproductive." But the inheritance of pre-Keynesian political and ideological orthodoxy retains today an almost incredible virulence, particularly in the rugged, anti-government culture of the United States. It is partly in consequence of this fact that our presentations regarding the necessity for a Keynesian-type growth policy possess a polemic coloration. We trust the reader will enjoy this element in some of the essays as much as we did in the making of them. The statistical groundwork for government growth in the U.S. mixed economy is laid in chapter 8 on Wagner's Law. Adolf Wagner's nineteenth-century empirical forecast that government would increase its relative share in a modern industrial society is abundantly supported by the facts of history. The essay shows this for the years ending with the decade of the 1970s, using government civilian employment as a basic criterion—a clear-cut real measure which avoids doubts that could arise both from long-run vicissitudes in measured money income or price deflators and from controversy over the inclusion of public transfer payments. However, while the lines of reason we advance for the irreversibility of the mixed economy and the hopelessness of privatization may be convincing enough, we are not persuaded that one can extrapolate into the long-run future the relative public employment growth that has occurred during the first three quarters of the twentieth century. If we cannot, then does Wagner's Law have any future? Our answer to that question is in the affirmative; but the Law will undergo a transformation. We accordingly hypothesize that the 1980s marks a transition to a new form of the Law. In its new guise, a longrun increase in government guidance of the economy will become the dominant pattern. And that expansion in public intrusive guidance will be superimposed upon a public spending rate that must at least equal society's targeted growth rate for GNP. These propositions are

Introduction

xv

fully p r o p o u n d e d a n d s u p p o r t e d in the final c h a p t e r on the inevitability of g o v e r n m e n t g r o w t h . Acknowledgment of the a b s o l u t e necessity for rising p u b l i c expend i t u r e s if the economy is to grow at a satisfactory pace is a conviction a r r i v e d at in one sense by default. T h e r e are only t w o strategic domestic s p e n d i n g s t r e a m s that can possibly drive the g r o w t h process onw a r d . One is g o v e r n m e n t purchases, the o t h e r is p r i v a t e i n v e s t m e n t , p a r t i c u l a r l y s p e n d i n g on producers' d u r a b l e e q u i p m e n t (PDE). The r e a d e r will note that in o u r c h a p t e r "Can the Good Perform a n c e of the 1960s Be Repeated in the 1980s?" we p r e d i c t e d that if t h e r e w e r e to be a large increase in g o v e r n m e n t s p e n d i n g in the 1980s, there would likely be a robust expansion in real GNP. As the 1980s have d r a w n to a close, we observe t h e r e w a s a large rise in governm e n t spending, a n d it was indeed linked with a vigorous increase in the real G N P rate, as predicted. Investment is the darling of the a n t i - g o v e r n m e n t traditionalists. But its very technological successes have forced it to default on its developmental spending obligations. Conventional pundits have failed to notice this. The fact is that by the late t w e n t i e t h c e n t u r y in o u r capital-rich economy, PDE investment i n c r e m e n t s h a v e b e c o m e too small a n d inconstant, too d e p e n d e n t on expected o t h e r s p e n d i n g , a n d too productive of new capacity to be the a u t o n o m o u s engine of econ o m i c development that it was in the nineteenth c e n t u r y . Moreover, PDE's productivity-raising, supply-side role in g r o w t h h a s been both a u g m e n t e d a n d substantially s u p p l a n t e d by o t h e r sources, such as public a n d nonprofit education i n p u t s ( h u m a n capital). O u r a r g u m e n t on this crucial historical t r a n s f o r m a t i o n is thoroughly spelled out in several places in this v o l u m e . Quite s t a r t l i n g statistical evidence on the d e m a n d aspect of the t r a n s f o r m a t i o n will be found in the c h a p t e r on the e c o n o m y ' s shortfall below its potential since World W a r II. There it is s h o w n , for e x a m p l e , t h a t the a n n u a l growth r a t e of real PDE investment exhibited no connection at all with the drastic fall in the G N P r a t e between the t w o long periods 1948-1968 and 1968-1985. In s h a r p c o n t r a s t , a very clear connection existed between the d r o p in the g o v e r n m e n t p u r c h a s e s r a t e and the GNP drop. Much a l a r m h a s been sounded over the p r o d u c t i v i t y s l o w d o w n in the United States since the early 1970s. U n f o r t u n a t e l y , the productivity analysts are all supply-siders, just like the e s t i m a t o r s of potential o u t p u t . They have on blinders for, as we show a n d as all good economists know, there is a d e m a n d side to productivity: the n u m e r a t o r of the o u t p u t / l a b o r expression, for e x a m p l e , is p a r t l y — a n d we believe

xvi Introduction mainly—a function of total demand. It is precisely this demand influence that has withered during the slowdown years. If one speaks of public spending and associated high growth rates, it will of course be insisted by critics that something must also be said about the government's budget policy, the federal debt, and inflation. (We can at last comfortably avoid treating monetary policy, now that the Federal Reserve's chairman has granted what we have long known, namely that we cannot delineate the category "money," and there is no connection "at present" between an indefinable "money supply," growth, and inflation anyway.) Our treatment of these matters is admittedly brief. However, we emphasize that combating inflationary prospects by noninflationary unemployment rate targets and deliberately contrived stagnation produces terrible human costs. If we did not systematically sweep those lost output costs under the rug, then the well-touted costs of inflation, as well as the costs of an incomes policy to control inflation, could be more fairly and competently appraised. As for budget deficits, there is much reason to say, "Damn the deficits, full speed ahead." With some strong growth medicine, adm i n i s t e r e d by tax-financed spending increases, the economy will outgrow real deficits. Furthermore, the large interest payments on the federal debt are somebody's income, received overwhelmingly by Americans who on the average help raise the savings ratio. What they spend pleases demand managers and what they save pleases the orthodox investment engineers. In recent years presidents, most state legislatures, and the United States Senate have called for a constitutional amendment to require an annually balanced budget. Such a proposal confuses an accounting anomaly with a serious symptom of malaise in the economy and in government policy. As a sort of preface to the discussion of this confusion, we take a poke in chapter 4 on the budget at presidential records regarding federal budgets compared with presidential reputations. In the view of an impressive consensus of historians, the only presidents who consistently followed a de facto balanced budget rule were the very worst on record. Our present political leaders are by implication praising the performance of Millard Fillmore, U. S. Grant, and Warren G. Harding, and disapproving Washington, Jefferson, Lincoln, the two Roosevelts, and every president since World War II (including Ronald Reagan, of course). Chapter 1, "The Perils of Fettered Government Expenditures," reminds us that a large and growing national debt is central to much of

Introduction

xvii

modern economic life. For example, we use two main routes designed to control the total level of economic activity: monetary policy and fiscal policy. The Federal Reserve strives to control money supply increases and short-period GNP by buying portions of the marketable national debt from the private sector. This means that the private sector must continously replenish its holdings of treasury securities. A balanced budget rule would eliminate this replenishment option and soon produce a public debt entirely owned by the Federal Reserve. A new monetary control mechanism would have to be invented. As for fiscal policy, Congress and the Executive have the power, for example, to increase GNP by cutting taxes and/or increasing government expenditures. A balanced budget rule would make fiscal policy illegal. It is small wonder that a majority of even the conservatively composed American Economic Association membership is opposed to such a rule. Not only the private sector, but most state and local governments prefer to hold their short-term financial transactions balances in national debt instruments. Short-term government securities pay interest, are exchangeable for money at certain rates, and are the safest investment known. A balanced budget rule would quickly reduce the availability of short-run, completely safe, paying assets. Thus, both government and private persons would receive less by not having access to safe federal paper or get more at the sacrifice of taking riskier private paper. In short, the balanced budget rule would increase risk and/or decrease returns. High employment is not enough. The proper policy target is high growth along with maximum employment. Only both objectives yield the desirable productivity results. We had moderately high employment in the mid-1980s in conjunction with growth far below potential. That is why the productivity performance was poor. It is revealing that the orthodox pundits ignore the growth shortfall and tremble at the low unemployment rate—even as they lament the poor productivity record (except in manufacturing, when mentioned). The revelation resides in the fact that these orthodox spokespersons abhor above all what they think is the greatest of all threats—inflation (more than 4 percent inflation is inflation). Do they also tremble at the suspicion that elimination of the growth shortfall would require a vigorous rise in public expenditures? The hub of the matter, as shown in this collection, is that inflation phobia accepts the sacrifice of almost any otherwise desirable objective—high employment, growth at potential, a good productivity record.

xviii

Introduction

To say "high employment is not enough," that is to speak up for better productivity performance as well, means to put inflation in a more subordinate place. There are two possible treatments for inflation. One is to ignore it. The other is to control it. Ignoring it is impermissible. Steps to control it cause a furor about an alleged loss of " f r e e d o m " to public price controllers. That may well be. But we all support freedom in o u r own way. Thus it is perfectly appropriate for these essays to point out that deliberately engineered stagnation, designed as an anti-inflationary program, may be viewed as a loss of freedom to public-job destroyers and a crime against a needful world. The conviction that history and veracity are on your side is small comfort if the vital message is unnoticed. Publication of our writings in one collection will hopefully bring o u r growth analysis to a wider public than scattered pieces in largely scholarly periodicals could accomplish. If successful in this respect, we venture the further hope that some will be persuaded and others will make constructive criticisms. But in the last analysis the overriding hope is for a more h u m a n e public growth policy.

ACKNOWLEDGMENTS

These essays have benefited enormously from the critical assistance of many professional colleagues and friends over some years of gestation and creation. We therefore welcome this opportunity to express publicly our appreciation for that assistance to Dieter Biehl, Stuart Bruchey, Paul Davidson, Richard M. Davis, Les Fishman, Robert Heilbroner, Lawrence Mansfield, Morris D. Morris, Arthur Neal, the late Irving Richter, Charles Schultze, Jack Thorkelson, Terry Vatter, and Helen Youngelson-Neal. We are grateful to Joy Spalding for her initial suggestion that we put together a collection of o u r publications. We are especially indebted to Kate Wittenberg for her unstinting editorial support. John Walker w a n t s to thank Pat Walker for loving support. Finally, we wish to acknowledge the careful and laborious production work generously provided by Marcia Tate, Rosa Housman, and Rita Beemer.

xix

T H E I N E V I T A B I L I T Y OF G O V E R N M E N T G R O W T H

CHAPTER 1

The Perils of Fettered Government Expenditures H A R O L D G . VATTER J O H N F. WALKER

One gets the impression that a very large segment of the U.S. population in 1978 favors an annually balanced federal budget and a rather severe restriction upon the growth of total government expenditures. Perhaps the most frequently suggested form of spending restraint is a ceiling set by the rate of growth of personal income. With respect to the insistence upon a balanced budget, the implication is that the federal debt would cease to grow (or perhaps would decrease). However, a large and growing national debt is a necessary part of the government's policies to control the economy without detailed direct controls over business and labor. We can make the economy expand by fiscal policy—for example, by cutting taxes and leaving government spending constant. This enables the recipients of tax cuts—businesses and individuals—to spend more and thus increase the GNP, but it also increases the national debt. This has been the logic behind most recent U.S. government tax cuts. It has the interesting characteristic of financing private sector expansion through increasing public sector debt. The other principal economic control is monetary policy. The Federal Reserve Bank controls the quantity of money through open market operations, that is, the buying and selling of national debt instruments. To increase money in the economy, a necessary part of economic growth, the Federal Reserve buys debt from the other parts of the economy and pays for it with newly created money, which is multiplied by the banks into larger amounts of money. Since the long-run goal of society is continued increases in the Reprinted with permission of publisher, M. E. Sharpe, Inc. 80 Business Park Drive, New York, N.Y., 10504 USA, from the January/February 1979 issue of Challenge.

1

2 The Perils of Fettered Government Expenditures GNP, the long-run policy of the Federal Reserve is continued accumulation of its national debt holdings. This is a well-established pattern of its behavior. In 1950 the Federal Reserve's holdings of the national debt were $20.8 billion, which was 8 percent of the total debt. By 1977 its holdings were $104.7 billion—15 percent of the total. With a limitation preventing increases in the national debt, the Federal Reserve would soon own most of it and would have to find another tool for controlling the supply of money. Any other tool would probably involve radical change in the way the system operates, with either substantial increases in the power of the central government or the likelihood of depression. To continue open market operations without an increasing national debt would require the Federal Reserve to buy and sell common stocks and private corporate bonds, for the New York Stock Exchange is the only organized market that is equipped to handle the volume of business the Fed needs. It seems unlikely that people like William Simon want a branch of the government to be the largest owner of all the major corporations. So he must have some other system of monetary control in mind when he proposes no further increases in debt. The national debt is intensively used by the American business community. National debt provides business with an absolutely secure investment that pays interest. Most corporate treasurers are active traders of treasury bills. The interest on those bills minus the costs of the corporate treasurers' offices often contributes a large fraction of corporate income. So the end of growth in the national debt means a reduction in the profitability of corporations or an increase in their risks as they switch to commercial paper and other less secure short- and long-term financial investments. State and local governments also earn substantial sums on treasury securities. Most observers agree that the property tax receipts for a year should not be put at risk by any local government. So in many states the law prohibits the investment of public funds in any other security. Therefore, an end to increases or an absolute reduction in the national debt implies either a reduction in local government services or an increase in local taxes. Hence, cessation in the growth of the national debt would severely limit the use of both fiscal and monetary policy and would increase the riskiness of society's total financial portfolio. That is, the likelihood of financial panic would be increased, and most of the government's tools for dealing with it would be severely weakened. If the

The Perils of Fettered Government Expenditures

3

advice of the current antigovernment element is heeded, Americans are likely to be forced at great cost to relearn the lessons of the 1930s. With respect to proposed restraints upon the growth of government expenditures to, say, the growth rate of personal income, it should be immediately noted that personal income grows over the long run at roughly the same rate as GNP. This fact, together with the apparent drift of the current social consensus, suggests restriction upon the growth of government expenditure over the long run to a rate no greater than that for total production. A century ago the G e r m a n economist Adolph Wagner observed that the share of the economy going to the government grew as the economy grew. He further asserted that the trend he had observed by the 1870s could be expected to continue indefinitely into the future. This assertion has come to be known as Wagner's Law. So far there are no economically developed societies that have failed to follow the path predicted by Wagner. It is thus clear that the anti-growth-in-government people are radical. For they propose to break a trend in the economy that goes back more than a century and encompasses most or all of the expansion of capitalism in Europe and America. The question raised here is: Could the U.S. economy continue to grow at its customary long-run pace of about 3.7 percent a year if total government expenditures failed to grow at a faster pace? The first step in providing an estimated answer to this hypothetical question is to glance at the long-period record. We shall proceed in price-deflated, or real, terms. We also confine ourselves to the period of the so-called "mixed economy" (since the 1930s or 1940s) because we assume the question has to do with constraining (rather than dismantling) the contemporary economic regime of large public budgets, social security, transfer payments, etc. The record shows that over the last four decades, ignoring the exceptional experience of World War II, government expenditures have grown notably faster than total expenditures (total production, or GNP). For example, f r o m 1948 through 1977, total real government expenditures have risen at an a n n u a l c o m p o u n d rate of more than 4 percent, whereas real GNP increased at only 3.5 percent. It is presumed that current proposals for restraint would arrest this trend relationship. But total demand, ignoring for simplicity the behavior of the export-import pattern, consists of private household spending (C), business investment spending (I), and government spending (G). Under the mixed economy, the growth of total d e m a n d sufficient to assure a long-run output growth of about 3.7 percent a year has occurred by

4 The Perils of Fettered Government

Expenditures

m e a n s of a roughly constant gross investment share of GNP and a rising G share financed partly by deficits, which absorbed the excess private saving that business did not want for investment. It cannot be stressed too much that the constant investment share has generated sufficient capital capacity growth to provide for the historically typical 3.7 percent GNP growth. The latter rate obtained for decades prior to the emergence of the mixed economy in the 1930s. Over the long pull, however, a billion dollars of fixed business investment of constant purchasing power has been associated with ever more capacity to produce. This long-run productivity trend forestalls the possibility of getting much if any stimulus from the d e m a n d side by transferring spending streams from G to I. Thus, all the contemporary emphasis in public policy discussion upon stimulating more investment d e m a n d , while it might, if implemented, provide a brief boost to output expansion, is actually chasing a lingering nineteenthcentury rainbow. In the longer run, the massive capacity effects would overwhelm the expenditure-generating effects, excess capacity would develop, and profitability on new investment would fall. These effects would f r u s t r a t e the attempt to get growth by stimulating investment spending at the expense of G growth. Put simply, increasing investment increases both the capacity to produce o u t p u t and the income to buy it. But investment usually produces more capacity than spending does. Too much is saved. Indeed, it is the ceiling on I set by rising productivity that has necessitated government deficits. Such deficits have provided growthpermitting offsets to some of society's huge savings that were not offset by private investment. Hence, to try to grow at customary rates without deficits and an increase in debt is impossible. An absolute and/or relative reduction in G, and equivalently in taxes, would, of course, induce some compensating rise in private consumption. But people save part of their increased income, so C goes u p less than G goes down. Every class in the principles of economics learns that equal cuts in government spending and taxes reduce GNP, instead of raising it. The current attack upon government spending typically fails to address itself to the civilian-military composition of the federal budget. But it seems probable that the brunt of any reductions would fall upon the federal civilian, and of course the civilian state and local, spending. This means essentially a reduction in public payrolls, as is already evident in actions currently being taken on the state and local level. It is doubtful that the marginal or average propensity to spend on

The Perils of Fettered Government Expenditures

5

consumer goods by the community at large is as high as it is for government employees, since they have better job security a n d pensions and thus less need to save. Hence, a transfer of income from government employees to the community at large, ignoring the possible additional income-distributive effects, would probably not raise society's propensity to consume privately. If anything, it would in all likelihood lower it. But even if the income, employment, and spending effects were such that private consumption rose in the short run to compensate fully for an absolute or relative reduction in G, the long-run effect upon the growth of the economy would be depressive. Indeed, it would generate stagnation. The reasons are twofold. First, private consumption depends upon income growth and has never shown a long-run tendency to rise faster than income. So why should it suddenly change now? We can see no reason to expect such a remarkable change in the behavior of consumers. Second, any substantial reduction in G would remove from the stream of aggregate demand the one significant, dynamic, leading expenditure flow that has for practically the whole of the twentieth century assured sufficient demand stimulus to induce and w a r r a n t a 3.7 percent growth of productive capacity. Obliteration of this demand stimulant, tying it for example to a 3.7 percent growth rate, would leave no m a j o r known demand flow that would perform the dynamic growth role that private investment spending provided in the nineteenth century. Hence, the current " m o v e m e n t " of the Simons, Greenspans, and the National Free Enterprise Day proponents to so limit the growth of government is advancing a prescription for economic stagnation.

CHAPTER 2

The Atrophy of Net Investment and Some Consequences for the U.S. Mixed Economy HAROLD G. VATTER

In this last half of the twentieth century, the United States is experiencing the continuation of a long-term trend that resembles a modified version of John Stuart Mill's stationary state. In that state of the economy, net tangible business investment approximated zero. The data pertinent to this timely proposition, to be presented to the extent practicable below, reveal that over the long run, from the late nineteenth century to the present (beginning probably in the 1920s), there has been a dramatic drop in the share of net fixed business nonresidential investment in net total product. Indeed, the share of this historically and theoretically strategic private investment category has now become so small that it seems pressingly appropriate for us 1) to examine whether this share decline helps explain some of the puzzling and controversial phenomena characterizing the post-World War II economic evolution of the U.S. mixed economy and 2) to explore the possible implications of a heuristic model in which the share approximates zero.

THE MODEL

There are several prominent features of the closed economy growth model of atrophying net tangible investment. The growth role of net private investment, as measured in national income and private business accounting, has become almost inconsequential. This condition, as with Mill's stationary state, is nonetheless compatible with increases in total factor productivity, since replacement investment can Reprinted from Journal of Economic Issues (March 1982), pp. 237-253. by special permission of the copyright holder, the Association for Evolutionary Economics.

6

The Atrophy of Net Investment

7

and does embody technical progress. Indeed, Mill's recognition has become greatly strengthened and amplified by the enormous increase (as Edward Denison, John Kendrick, and others have shown) in the productivity-raising influence of "intangible" human capital and research and development outlays by both government and private enterprise. Consequently, the ratio of output to fixed capital, a partial productivity relationship, has historically risen. In short, over the long span it has required ever less additions of fixed investment to get an additional billion dollars of real output or capacity. Meanwhile, the proportion of replacement to gross fixed investment has historically drifted upward. Thus, replacement investment, approaching gross investment in magnitude, is presently getting closer and closer to becoming the exclusive carrier of technical progress, insofar as such progress is embodied in fixed business capital. On the level of the representative individual enterprise, the withering away of net fixed investment spells approaching termination of the historic and deeply rooted raison d'etre of the nonfinancial firm: accumulation of capital. In consequence, undistributed accounting profits, if not taxed away, would lack the traditional offsets, at least in a closed economy. What this means if foreign investment offsets are possible is briefly explored, although it is not strictly contained in the model. The analysis employs the standard concepts used in business accounting and in the national income and product accounts, using constant dollar magnitudes. In the absence of better data, replacement investment, lT, is assumed equal to capital consumption allowances, or depreciation, with capital consumption adjustment in the more contemporary data. Gross tangible fixed nonresidential investment, Ig, equals Ir plus net investment, /„. The capital stock, K, is of course only tangible fixed nonresidential business capital (structures and producers' durable equipment). Some rearranging and pigeonholing is done. Thus, housing investment is implicitly allocated to personal consumption expenditures, C. Inventory investment is ignored as inconsequential in such a long-run growth analysis. Since the analysis proceeds in its essentials in terms of a closed economy, net exports are also ignored; an export growth model would hardly be appropriate to U.S. economic evolution over the last century; however, net exports are discussed briefly in connection with the matter of offsets to net business savings.

8 The Atrophy of Net Investment

EMPIRICAL SUPPORT T o v i e w the actual long-run pattern, averages for quarter century periods were developed: 1875-1900 and 1949-1974. The following are the estimates of these averages for the two time spans 1 :

Net fixed investment as % N N P Gross fixed investment as % N N P Capital consumption as % gross investment Net investment as % gross investment Annual compound rate of N N P growth Derived average value of ratio of net stock of fixed capital to N N P

1875-1900

1949-1974

6.0 15.0

3.0 10.0

61.0 39.0

70.0 30.0

4.6

3.5

1.30

0.86

There was no apparent trend in the data, from the sources used, in the later period in either the investment-to-NNP (net national product) ratio or the capital-to-NNP ratio. 2 In the earlier period, the Kuznets data show distinct movements behind the averages shown in the tabulation above. The /„/NNP ratio rose substantially from an average of 5.1 percent in the first half of the 1875-1900 time span to 6.9 in the second half. The average /g/NNP ratio also increased, from 13.4 to 17 percent. As would be expected, the derived ratio of the stock of fixed capital, K, to N N P also rose, averaging 1.11 for 1875-1887 and 1.50 for 1888-1900. This increase in £ / N N P yields a large annual growth rate for K of 5.8 percent, which may be compared with the rate of 5.4 percent implied in Kuznets' series (1946:228) on fixed capital stock between 1879 and 1899.3 A rise in the capital-to-output ratio in the late nineteenth century, and its cessation and subsequent fall beginning early in the twentieth century, has been widely noted (for example, R a y m o n d Goldsmith (1952:307) and Robert Gallman (1960:36-39; 1972:33-35). 4 Using a more comprehensive definition of capital than that employed here, Gallman's indexes (1972: 34) of real capital and N N P imply a steady decennial fall in the output-to-capital ratio from an average of .65 in 1870-1880 to a nadir of .41 in 1910-1920, followed by a continuous decennial rise to an average of .57 in 1950— 1960. Calculations for the 1920s, based upon Kuznets' data (1961) indicate that for the /„/NNP ratio, by far the greater part of the dramatic

The Atrophy of Net Investment

9

fall shown in the tabulation above had already occurred by that decade. 5 Something very significant in the structure and functioning of the U.S. economy must have happened in the quarter century preceding the mid-1920s, together with the two interwar decades, something certainly challenging to the historical investigator. Most specifically, there was apparently a massive alteration in the operation of the fixed capital mechanism. 6 The quantitative estimates shown here could no doubt be refined, but the enormous changes they show are unassailable in the light of the data available to us today. It may be argued that we are observing here a very long cycle of some sort, with a contraction phase of (at least) sixty years (19151975). While many things are possible, such a hypothesis does not seem at all plausible. First, data observations spanning hundreds of years would be required to substantiate such a speculation empirically. Second, we have no doctrinal sanction for a cycle of that duration. Third, we do have appropriate doctrinal sanction in the form of the secular stationary state with zero net investment. Fourth, there is no theoretical argument in behalf of the notion that the downward drift of the investment ratio must necessarily reverse itself. It might be surmised that with the marginal output-to-capital ratio secularly rising, there should be such a reversal. But this is not likely to happen so long as property's relative share continues to fall, the ratio of gross property income to the value of the stock of tangible fixed capital continues to be sustained, and technological progress more or less maintains the rate of output growth. Fifth, the chief determinants of persistent capital-saving innovations, that is, the growth of applied knowledge and human capital investment, seem to be abiding features of our culture that can reasonably be expected to maintain their puissance. Hence, the possibility of a very long cycle in the net investment ratio is set aside in this discussion. The changes shown in the tabular presentation above are impressively consistent with major propositions stated in the outline of the argument and the model projected here. The share of net investment in net output contemporaneously has been only half of what it was in the early period. Gross fixed investment has become two thirds of its level relative to NNP as compared with the end of the nineteenth century. Replacement investment, assumed here to be approximately equal to capital consumption allowances (CCA), has absorbed ever more of the gross, with the net correspondingly falling to less than one third of all gross fixed investment, partly because of a shift in the composition of fixed investment from structures to producers' durable

10 The Atrophy of Net Investment equipment (PDE). These changes may or may not have contributed significantly to the substantial drop in the rate of output growth. But it is perfectly clear that the output-to-capital ratio for the whole economy has jumped upward, specifically from .77 to 1.16 over the two long periods shown here.7 Thus, the adjustment to the decline in the growth rate of N N P was associated with approximately a 50 percent rise in the NNP/K ratio and an equiproportional fall in the net investment ratio. Net fixed investment has atrophied relatively, and fixed capital has become more "productive." In prosperous 1929, a constant dollar of investment in the net stock of nonresidential plant and equipment produced 89 cents of real net product; in prosperous 1966, with the capacity utilization rate in manufacturing at close to the normal full use level of 91 percent, a constant dollar of plant and equipment produced $1.44 of real net national product. 8 Such a long-run rise in what amounts to the minimum of the incremental output-to-capital ratio was certainly a remarkable productivity achievement. In the important manufacturing sector, the calculated ratio of the output index to the real net value of fixed capital (the capacity-tovalue ratio) jumped from 437 in 1950 to 643 in 1977.9 Alternatively put, manufacturing output, at roughly comparable capacity utilization rates, rose over that period at an estimated annual rate of almost 4.2 percent, while the net stock of plant and equipment rose only 2.7 percent a year. Denison, among others, has attempted to show that the historic rise in tangible capital productivity, along with so-called total factor productivity (with factor defined in terms of the traditional triology of labor, capital, and land), has been due to input quality improvement, advance of knowledge, education and other human capital investment, and so forth. 10 These "residual" productivity-raising influences could well operate, with public science and technology policy as handmaiden, indefinitely and free of diminishing returns barriers. One model of the natural growth path of the U.S. economy estimates the net investment ratio in 1990—2000 to be 30 percent lower than it was on the average during 1955-1973 (with no change in the gross ratio). But the rates of advance of man-hour productivity and of technical progress are maintained from 1968-1973 to 1992-2000 (Coen and Hickman, May 1980). Application of the pertinent data to a Cobb-Douglas aggregate production function for the period 1949-1978 suggests that capital stock growth through net fixed investment made an imputed contribution of about .9 of a percentage point to the 3.5 percent annual gross

The Atrophy of Net Investment

11

private product g r o w t h . " Thus, potential output growth at about 3 percent a year is already within reach in the absence of any net fixed investment. While quality improvement in capital goods (embodied technical progress) has no doubt been one way in which total factor productivity has been increased, such productivity effects, as Denison notes (March 1964), cannot over the long run ordinarily be ascribed to high rates of gross investment, and therefore neither can they be ascribed to high ratios of net to total investment. He postulates, no doubt quite correctly in the general case, that for both industries a n d firms "any reasonable a m o u n t of gross investment will already provide for taking up those investment opportunities" (ibid., p. 92) in which capital goods quality improvement, concomitant profitability, and (in my terminology) the ratio of marginal capacity to value are high.

IMPLICATIONS

The secular fall in the //NNP ratio is due overwhelmingly to developments in the private economic and education sectors, r a t h e r than to government policies inimical to investment. The plausibility of this interpretation is supported by the fact that the decline had already begun by the noninterventionist 1920s. Furthermore, the fact that gross fixed tangible investment in ratio to GPP (gross private product) during the interventionist era after World War II was at least as high as it was in the preinterventionist 1920s is inconsistent with the suppressive-government hypothesis. In the same vein, the "tax s t a t e " has apparently interfered remarkably little with gross business aftertax savings and has thus sustained the gross rate of return on tangible fixed capital at rates comparing favorably with the noninterventionist conditions of the 1920s. Furthermore, the secular rise in the capacity/ capital proportion has meant that at the net investment ratio levels obtaining under government intervention, the associated capacity creation is fully adequate to provide for a growth potential closely approximating that actually achieved ever since World War I. In view of the long-run falling trend of net investment, together with its modest and declining imputed contribution to output growth, and keeping in mind the secular rise of the imputed contribution of productivity-raising residual influences, some implications and associated policy problems of a growth model approaching zero net fixed investment are now briefly explored. The assumption of zero net investment is largely heuristic, but it

12 The Atrophy of Net Investment may nonetheless be pertinent at this juncture in history because we would expect its approach to inaugurate some related economic phenomena (and attendant policy problems) long before the zero point were reached. For example, we would expect capital-to-labor ratios to rise at decreasing rates and/or rates that fall below capacity-tolabor or output-to-labor ratios (if net investment were zero, capitalto-labor ratios, with rising employment, would fall). While post-World War II data do not reveal such trend relationships for the total private economy, there is some evidence of them in manufacturing. In that sector, from 1950 to 1978 the capital-to-labor ratio rose only 62 percent, whereas the capacity-to-labor ratio increased about 140 percent. 12 It would be pointless to aver that the net investment rate is in fact tending toward exactly zero. It may be tending toward a very low positive rate that is lower than the actual contemporary level, or some negative rate, or a rate fluctuating around zero. A heuristic rate of zero is simply a convenient one for the purpose of exploring in sharper, and hence more clarifying, form the long-run implications for growth and the government budget of the past trend extrapolated. It is quite possible to extract those implications, and some of them are covered in this discussion, but in a measure not so sheer, from the actual low contemporary levels of the net investment rate.

THE " C + Q " E C O N O M Y

Mill's formal model of the stationary state was, when viewed from the aggregate expenditures standpoint, a laissez faire "C + I" domestic economy with minimum government. Taking that aggregate as GNP, only two expenditure streams exhaust the total output: private household consumption and replacement investment. Gross investment equals replacement investment (including "modernization" investment). The threat of such an ominous economic condition can be viewed as a partial explanation for the insertion at a certain point in history of a newly growing, "Keynesian" spending stream of government expenditures. Certainly, this was the objective of the Keynes-Hansen advocacy of more G (government purchases of goods and services) in the long run: a necessity to avoid laissez faire stagnation. It is at any rate a congenial fact, as is well known, that beginning with the Great Depression the composition of aggregate domestic expenditures did change, such that laissez faire's C + I became 1 3

The Atrophy of Net Investment

13

G N P = C + / + G. Almost a half century of this mixed economy pattern has unfolded in the United States. In the course of that process, G has been the most rapidly g r o w i n g stream of expenditures. 1 4 That relative g r o w t h has been at the expense of a relatively falling ( " p r i v a t e " ) C. Converting this to net flows, w e have for this first phase in the evolution of the m i x e d economy N N P = C + /„ + G with /„ down to an average of about 3 percent of the total. 15 For all practical purposes, w e can refer to the approach of a mature, mixed domestic economy in which N N P = C + G. This expression has the advantage that it highlights not only the longrun atrophy of /„ but also the essential and dynamic long-run g r o w t h role of G. It makes the growth of big G over the past decades a quite rational, because necessitous, phenomenon in the context of a society c o m m i t t e d to high e m p l o y m e n t and the associated growth of total production. When conjoined with recognition of the supply side changes that have wrought a long-run rise in the output-to-capital ratio, the expression also conduces to an appraisal of current efforts purportedly designed to augment /„. Certain contemporary policy conflicts may thus be viewed as reflecting a struggle between /„ and G. Specifically, a great effort is allegedly being exerted, more powerful than is customary, to shift the composition of expenditures and output f r o m G to /„,16 In terms of the present discussion, this effort is seen as an attempt to arrest/reverse the historical trend toward the atrophy of /„ and its attendant replacement with G. 17 Such a shift might appear to be feasible enough, the political consensus permitting, from the expenditure side. But from the supply side, as w e learned f r o m the seminal contributions of Evsey D o m a r and R o y Harrod, things might be much more recalcitrant than suspected, and despite the apparent aroused interest in that side of the economy, there has been little if any examination of the relevant long-run changes examined here. T h e attempt to invest more at the expense of decreasing G could conceivably leave aggregate demand untouched w h i l e at the same time augmenting productive capacity. 1 8 Such a policy could not, of course, be effectuated. It has been shown above that at contemporary

14 The Atrophy of Net Investment capacity/capital levels the augmentation of capacity associated with an additional average $1 billion of net fixed investment is substantially larger than the investment outlay. It would be extremely perilous to try to arrest for long the growth of G (Vatter and Walker 1979). INTANGIBLE INVESTMENT

The work of Theodore Schultz, Denison, Kendrick, Fritz Machlup, and others strongly implies that concentration on augmenting the capital-saving, productivity-raising "residual" factors is the appropriate public and private policy emphasis. Policy concentration currently appears rather to be on augmenting fixed business investment. 19 In the light of the historical records as interpreted here, this latter emphasis represents a dream of returning, in this respect also, to a laissez-faire world in which net fixed investment was relatively growing and was twice the relative magnitude it has exhibited for a half century. Also in that world the residual influences on the growth of potential output were only a little over half what they are today. 20 Is such a reversal feasible? Let us devote now a bit more attention to the savings-investment aspect of the heuristic assumption of zero net investment. If large accounting profits persisted in the absence of opportunities for net real domestic (or foreign) investment offsets, the enterprise system would confront a serious dilemma. From a classical business accounting standpoint, profitability was an increase in net worth or in total assets. For the nonfinancial enterprise particularly, this typically took the form of an increase in some conventionally measured plant and equipment value magnitude. 21 But in the present zero net investment model the real value of the total capital stock would be constant through time. Only aggregate capacity would expand. Some firms could expand both assets (and capacity) at the expense of others, but the macro limits would set ceilings on the net total effects of such jockeying for position. We have no familiarity with a business system devoted to the generation of ever larger net savings out of maximized profits but at the same time lacking any real fixed asset growth. 22 Of course, we have some familiarity with the general notion of insufficient investment opportunities: It is the long-run "Keynesian dilemma." It has been argued that private outlays for productivity-raising intangible factors, such as research and development, are investment, and since they have been secularly rising relative to total product, they may be viewed as compensating for relatively declining business

The Atrophy of Net Investment fixed

tangible i n v e s t m e n t . W h i l e f r o m an e c o n o m i c point of

15 view

research and d e v e l o p m e n t and similar outlays should indeed be treated like i n v e s t m e n t , business enterprise does not d o so. It is the business v i e w p o i n t and t r e a t m e n t of such outlays that are i m p o r t a n t f r o m the standpoint of the f u n c t i o n i n g of the enterprise system, and that is the e m p h a s i s here. T h e s e p r i v a t e outlays are costed b y business in the i n c o m e statement. " T h e business c o r p o r a t i o n , p a y i n g f o r its o w n research, w i l l not c a p i t a l i z e this outlay (as an asset on its books) but w i l l expense it (as a cost of p r o d u c t i o n ) . . . . T h e research w i l l . . . be r e g a r d e d as a current c o s t " ( M a c h l u p 1972: 186). 23 H e n c e , the putat i v e " f l o w of i n t a n g i b l e s " is not, f r o m the standpoint of the functioning of the business system, an investment outlet for savings.

CAPrTAL EXPORT U p to this point, c a p i t a l export has been ignored as inconsequential to the basic a r g u m e n t . Is this assumption w a r r a n t e d ? Is capital export a possibly significant offset f o r business net i n c o m e that

firms

are not w i l l i n g to a l l o c a t e to net d o m e s t i c investment? T h e r e can b e no doubt that f o r e i g n investment has historically p r o v i d e d a gross outlet f o r business savings that cannot be remuneratively p l a c e d in the h o m e market. H o w e v e r , f o r e i g n investment also y i e l d s i n c o m e f r o m a b r o a d , and this p r o p e r t y i n c o m e in turn, other things equal, adds to business savings (the p r o p e n s i t y to c o n s u m e out of such i n v e s t m e n t i n c o m e is p r o b a b l y v e r y l o w ) . N o w , the record shows that f o r about three decades after W o r l d W a r II the g r o w i n g net n e w p r i v a t e business long-term capital e x p o r t w a s , until the late 1970s, about m a t c h e d b y the g r o w i n g v o l u m e of net p r i v a t e investment i n c o m e r e c e i v a b l e f r o m a b r o a d . (In the late 1970s, as the stock of f o r e i g n assets h e l d b y A m e r i c a n s — o v e r w h e l m i n g l y business corp o r a t i o n s — c o n t i n u e d to mount, net investment i n c o m e c a m e to exc e e d b y f a r the net o u t f l o w of n e w long-term loans to foreigners.) Consequently, the relevant international transactions did not, for about a q u a r t e r c e n t u r y , m u c h alter the m a g n i t u d e of annual business savings seeking p r o f i t a b l e d o m e s t i c investment offsets. But continuation in the future of the b u i l d u p of f o r e i g n assets held by U.S. c o r p o r a t i o n s w o u l d likely a u g m e n t the excess of net investment i n c o m e o v e r the net v o l u m e of n e w long-term loans. This mature-creditor pattern would, of course, e x a c e r b a t e , in the absence of net investment outlets, the savings-investment p r o b l e m at h o m e . H e n c e , on the basis of latetwentieth-century e x p e r i e n c e , the ( c o n s e r v a t i v e ) assumption seems w a r r a n t e d that f o r e i g n capital e x p o r t can be e x c l u d e d f r o m a discus-

16 The Atrophy of Net Investment sion of the empirically probable implications of a zero net investment model. P O S m V E SAVINGS WITH ZERO INVESTMENT

How then can long-run stagnation be avoided if net investment approaches zero? A likely way out, other than some kind of major institutional upheaval, would be possible through a significant extension of the mixed economy pattern. For this reason, in what follows, comparisons are drawn continuously between the zero net investment model and actual economic trends. Such a model, assuming constant prices, might have the following characteristics. Assume firms continued to retain some profits rather than have them all taxed away to finance balanced public budgets. A constant volume of untaxed profits, together with a stock of fixed capital of unchanging value, would ensure an invariable rate of profit on that stock. However, with absolutely rising government deficits and public debt, a constant rate of interest on that debt would mean that property income (profits plus government interest received) relative to property (fixed capital stock plus public debt securities) would fall in the long run. And property income, thus narrowly defined, relative to growing N N P , would also fall. This is to be expected since the lower rate, government-interest component would be a rising share of property income. To sketch in the remaining relevant macro magnitudes is simple enough. NNP, G, and C (including housing construction) and taxes would all increase at the same rate.24 Then net private savings would equal the deficit in each period, and both would grow at the same rate as NNP, and so forth. The resulting significant long-run ratio trends, not yet mentioned, would be: public debt to NNP, falling; government interest to N N P , falling. Four of the ratio trends in this scenario closely resemble the postWorld War II patterns in the U.S. mixed economy. In ratio to N N P they are: consumption plus residential construction, all government spending in the NIPA (national income and product accounts),25 all public debt, and all taxes for general revenue. Thus in these important respects the scenario is quite "realistic." Government interest paid on public debt has, however, been rising, along with the upward drift of all nominal interest rates. Between 1950 and 1979, for example, government nominal interests paid out rose 826 percent, whereas nominal public debt rose only 244 percent.

The Atrophy of Net Investment

17

These disparate increases in an inflationary context would not, however, appear necessarily to cast doubt upon a fixed rate of yield in the constant price model envisioned here. Fixed nominal yields on municipals and railroad bonds for long periods, for example, were characteristic before 1929. With respect to measured corporate after-tax profits in ratio to the value of net stocks of fixed capital, the post-World War II trend, as is well known, has been downward. In contrast, the zero net investment model envisions a constant r a t e — a condition that would presumably be viewed by business more favorably than the experience of recent decades. The constant ratios of deficits to NNP and to G, together with a falling public debt to NNP, would also appear somewhat benign in view of traditional business hostility to these alleged evidences of interference with the "free market." In the same vein, the constancy of the proportion of government purchases to total net product would continue to arrest, in that respect, the process of transferring decisions over the disposition of resources to government. What might seem inimical in the model to the feasibility of continuation of the operation of the business system is the relative decline in the property income share (as narrowly defined). Perhaps the most appropriate comment on this aspect is to recall that such a trend has apparently been mildly in effect for many decades—indeed, long before the mixed economy arrived on the scene. CONCLUSION

The zero net investment model is in many respects not too different from the economy that has in fact already evolved in the United States and elsewhere in the capitalistic mixed systems. Indeed, from an alternate perspective, a major implication of the model of net fixed investment atrophy is that the gradual attrition of such investment in the context of a large annual flow of net savings primarily out of property incomes has necessitated the persistence of government defi c i t s — the "Keynesian solution" to the "Keynesian dilemma." Despite all the clamor against deficits from the 1930s to the present, and despite presidential wishful thinking about the 1980s, large deficits will undoubtedly persist if output is to grow. This is why, in the national income and product accounts, for the whole period 19481980, total government deficits of $259 billion exceeded total surpluses of $66 billion by a factor of about four. The government deficit solution provides, therefore, the clue to an explanation of the savingsinvestment dilemma that gave rise to it.

18 The Atrophy of Net Investment In this connection, note that the " t a x state" after World War II siphoned off from nonfinancial corporate pretax profits r a t h e r less than one half the total, on the average, for financing part of G. This left for retention, together with capital consumption allowances and a d j u s t m e n t (gross internal cash flow), sums approximately sufficient to match, or "finance," gross domestic fixed investment, on the average, from 1948 through 1977! (Is this already an "economic law" of the mixed economy?) If about half of the nonfinancial corporate pretax profits had not been taxed away but left in the hands of those corporations, with G falling equally, could they have invested them in more plant and equipment? No. GNP could hardly have been much, if any, larger, yet business was already creating fixed capital and its associated capacity at just about the rate that the given GNP growth rate could absorb without generating more income-depressing excess capacity. There are, of course, alternative arguments as to why private investment is inadequate in some sense, for example, government "crowding o u t " through debt-financed government expenditures, and an alleged long-run fall in the rate of private saving ("shortage of savings"). However, even if the latter were true, a not yet established fact, it is noteworthy that a survey of government in relation to capital formation concludes that "even those who are determined non-Keynesians cannot be excused by the strength of their convictions from providing more empirical evidence that an increase in the national saving rate will . . . result in higher investment under current circumstances" (Von Furstenberg and Malkiel, September 1977). Furthermore, "it may be impossible to achieve full employment without continued deficits. A more expansionary monetary policy and a more restrictive fiscal policy may help raise the national saving rate, but substantial deficits may still be called for under present conditions" [ibid.]. The writers seem to be intuitively on the right track, but "present conditions" and "current circumstances" are not explained; the thesis advanced here does provide an explanation, and one that has good empirical support. In other words, the old bogey of exhausted private net investment opportunities and attendant stagnation seems to be very much alive behind the scenes in the contemporary U.S. mixed economy. And this is so mainly because of the secular rise in the capacity-to-capital ratio and the productivity-raising effects of the knowledge revolution. Not only Alvin Hansen, but also Joseph Schumpeter scores: laissez faire " i n t a c t " capitalism killed itself off by virtue of its productivity achievements. However, the productivity advances, although accom-

The Atrophy of Net Investment

19

plished by business, cannot by any means be entirely attributed to Schumpeter's private entrepreneurial innovation, for much if not most of the knowledge revolution e m b o d i e d in those advances

involved

public education and government-supported research and development.

NOTES 1. The relevant late nineteenth-century data may be found in Simon Kuznets' classic study for the National Bureau of Economic Research. S. Kuznets, Capital in the American Economy (Princeton, N.J.: Princeton University Press, 1961), pp. 563-596. All calculations are from his constant (1929 prices) time series, which are five-year moving averages. The fixed private nonresidential investment series was constructed by adding his producers' durable equipment ( P D E ) estimates to his " o t h e r " construction series. Kuznets has capital consumption allowances (CCA) segregated for both these investment components. N N P is his Variant III. The capital/NNP ratio was derived by using the Harrod-Domar expression: I/NNP ^ ^ ^ p = N N P growth rate = capital stock growth rate. The N N P growth rate for 1869-1901 may be found in the growth triangles in U.S. Department of Commerce, Long-Term Economic Growth, 1860-1970 (Washington, D.C.: GPO, June 1973). The derivation of the post-World War II estimates, while requiring much effort, was straightforward enough. The immediate postwar years were omitted to exclude the influence of the abnormal "catching u p " spurt in net investment at that time. The U.S. Department of Commerce, The National Income and Product Accounts of the United States, 1929-1974 (Washington, D.C.: GPO, 1977), pp. 26-27, 164-165 contains the necessary constant dollar time series, 1929-1974, for N N P , gross and net business tangible nonresidential investment, and capital consumption allowances with capital consumption adjustment. It was easy to check some of these data with other sources, such as the Economic Reports of the President, Survey of Current Business, and so forth. N o significant differences emerged from such checks. I have rounded the results of my processing of the data. For example, the average net investment/NNP ratio in constant dollars was .0312, in current dollars .0314. Estimates for the last half of the 1970s did not change the approximate .03 average for this ratio (for example, in current dollars, applying the Conference Board Road Map 1980 estimate of net to gross investment for the whole of the 1970s of 24.9 percent yields for 1975-1979 an average of .0299). The N N P growth rate may be calculated from any number of sources. The derived estimate of the fixed capital/NNP ratio was checked against John C. Musgrave's estimates of the constant (1972) dollar valuation of the aggregate net stocks of fixed nonresidential business capital, a series ending

20 The Atrophy of Net Investment in 1975. J. Musgrave, "Fixed Nonresidential Business and Residential Capital in the United States, 1925-1975," Survey of Current Business (April 1976), p. 49. The result was an average ratio of .79 for the whole period 1949-1974. Such a lower ratio would pull down the net investment/NNP ratio to .028, an inconsequential difference, which suggests that .03 is within reasonable bounds. 2. Regarding the latter, Musgrave's net stocks grow at 4 percent a year, 1948-1975 (see also Economic Report of the President, January 1981, p. 71), which would give a distinct upward trend to the capital/output ratio. His gross stocks grow at about the same rate as N N P , however. In another study, John W. Kendrick found the real gross fixed capital stock in the business sector growing at only 3 percent, with gross business product growing at 3.9 percent, a distinct drop in capital/output. John W. Kendrick, The National Wealth of the United States (New York: Conference Board, 1976), p. 38. Edward Denison's index of a weighted average of gross and net stocks, 1949-1974, grows at an annual rate of 3.54 percent. Edward F. Denison, Accounting for Slower Economic Growth (Washington, D.C.: Brookings Institution, 1979), p. 51. 3. See also Simon Kuznets, "Long-Term Changes in the National Income of the United States of America since 1870," in Simon Kuznets, ed., Income and Wealth of the United States: Trends and Structure (Cambridge, England: Bowes & Bowes, 1952), pp. 127-128. 4. Goldsmith's estimates are from table 1, and columns (10) and (11) are summed, panel C. Raymond Goldsmith, "Growth of Reproducible Wealth of the United States of America from 1805 to 1950," in Kuznets, Income and Wealth, 1952. Gallman's cited estimates are from Robert Gallman, "The Pace and Pattern of American Economic Growth," in Lance E. Davis et al., eds., American Economic Growth (New York: Harper & Row, 1972), p. 34. 5. The data are for 1922-1927. See note 1 for sources of the tabulation. With a 3.5 percent annual N N P growth rate, the average K/NNP in the 1920s is .95. 6. For example, Kuznets' 1961 constant-dollar, five-year moving average of gross business fixed investment hovered between $7 and $8 billion over the seventeen years from 1904 to 1921 (see U.S. Department of Commerce, LongTerm Economic Growth, Series A29, 1973, pp. 186-187)! 7. If the 1887-1900 average for NNP/K of two thirds is taken as the base for comparison, the upward jump is, of course, even greater. 8. Stock estimates, in 1972 dollars, are from Denison, 1979, p. 51; and real N N P is calculated from N N P series in the Economic Report of the President (January 1981, p. 252), deflated by the 1972 G N P deflator therein. 9. The production index and the capacity utilization rates are from Economic Report of the President (January 1981, pp. 278, 281). Five-year averages centered upon the stipulated years are used. The stock data, in 1972 dollars, are from Statistical Abstract (1977, p. 797; and 1979, p. 801). 10. It has been contended by some that the secular drift in the capital/ output ratio may be attributed to intersectoral shifts, for example, the alleged rise of the private service sector, which should have a low capital/output ratio.

The Atrophy

of Net Investment

21

However, after examining this hypothesis, Kuznets concluded that, in most cases, including the American, "the evidence . . . extends little support to the hope that long-term trends in country-wide capital-output ratios can be explained by secular shifts in the weights of the several sectors" (Capital in the American Economy, p. 48). 11. Denison estimated that fixed business capital a n d inventories contributed only 15 percent to the growth of national income originating in nonresidential business, 1948-1973. Edward F. Denison, "The Contribution of Capital to Economic G r o w t h , " American Economic Review (May 1980), 70:220. 12. Capital is the real net stock of fixed nonresidential capital in manufacturing (Musgrave, April 1976; and Statistical Abstract, [1979, p. 801]). Labor is wage and salary workers in manufacturing establishments (Economic Report of the President, J a n u a r y 1981, p. 273), three-year averages centered on 1950 and 1978. Capacity is taken from Statistical Abstract (1979, p. 799). 13. Recall that residential construction is here allocated to C, inventory investment is ignored, and the economy is closed. This keeps I as domestic fixed business investment. 14. Until the early 1970s; in that decade G's growth sharply decelerated as did GNP growth. Indeed, in that decade of slow economic growth, G's rise was slower than all the other m a j o r spending streams. As is well known, real federal purchases were lower in 1979 than they were in 1962. 15. This is about $70 billion at 1980 levels of NNP (current prices), which would be about 24 percent of actual gross fixed nonresidential investment in that year. 16. And also, incidentally, from C to /„. 17. It is, of course, possible that what is intended, and/or will be accomplished, is simply a shift within a growing G from civilian to military. 18. If $40 billion had been cut from G in 1978, with no decrease in taxes, and the entire a m o u n t miraculously transferred unscathed to fixed investment, G would have fallen by about 9 percent, Ig risen by about 17 percent, and /„ by 72 percent! Useful fantasizing. 19. See Denison's demolishing critique of this policy emphasis (May 1980, pp. 221-222). 20. My calculations show the residual accounts for more than 55 percent of output growth in a Cobb-Douglas aggregate production function for the period 1949-1978. For comparison, see the estimates in Vatter, which yield a residual of 31 percent for the period of 1870-1910. Harold G. Vatter, The Drive to Industrial Maturity (Westport, Conn.: Greenwood Press, 1975), p. 330. 21. Of course, net internal funds do not find offsets exclusively in net fixed investment, but they undoubtedly do for the most part. It is unlikely to be an accident that the ratio of gross retained internal funds to gross fixed investment annually for the domestic operations of nonfinancial corporations in the United States averaged 98.8 percent from 1948 through 1977. See Machinery and Allied Products Institute, Capital Goods Review (September 1977). 22. On the m a c r o level, it would not make any difference to the a r g u m e n t in the unlikely event that all profits were paid out in dividends; the particular

22 The Atrophy of Net Investment possessor of profit income is irrelevant to the matter of investment offsets for net savings, although somewhat less might be saved if all profits were converted into dividends. 23. The firm expenses such outlay for good reason: it has no idea how much of the putative stock of intangibles is really its own. For a national income accountant the problem is different; it is not who captures the claim on the asset but how to isolate and capture the proper magnitude. The more important public outlays for productivity-raising intangibles are also, as such, obviously not a private offset to private savings. 24. These taxes exclude taxes to finance an assumed equivalent volume of public transfer payments. 25. In 1971 dollars for these two; current dollars for the following two. The actual G/NNP ratio in 1972 dollars reached 21.8 percent in 1939 and was approximately the same forty years later (it had peaked in 1968 at 27 percent).

REFERENCES Coen, Robert M., and Bert G. Hickman. "Investment and Growth in an Econometric Model of the United States." American Economic Review (May 1980), 70:217. Denison, Edward F. " T h e Unimportance of the Embodied Question." American Economic Review (March 1964), 54:90-93. Gallman, Robert. "Commodity Output, 1839-1899." In National Bureau of Economic Research, Trends in the American Economy in the Nineteenth Century, pp. 36-39. Princeton, N.J.: Princeton University Press, 1960. Kuznets, Simon. National Product since 1869. New York: National Bureau of Economic Research, 1946. Kuznets, Simon. "Quantitative Aspects of the Economic Growth of Nations: Long-Term Trends in Capital Formation Proportions." Economic Development and Cultural Change (July 1961), 9. Machlup, Fritz. The Production and Distribution of Knowledge in the United States. Princeton, N.J.: Princeton University Press, 1972. U.S. Department of Commerce, Bureau of the Census. Statistical

Abstract

of

the United States. Washington, D.C.: GPO, various years. Vatter, Harold G., and John F. Walker. " T h e Perils of Fettered Government Expenditures." Challenge (January-February 1979). Von Furstenberg, George M., and Burton G. Malkiel. " T h e Government and Capital Formation: A Survey of Recent Issues." Journal of Economic Literature (September 1977), 15:867.

CHAPTER 3

Perspectives on the Forty-sixth of the U.S. Mixed Economy

Anniversary

H A R O L D G. VATTER

All mixed economies exhibit a great relative shift from private to social expenditure. While Britain, Sweden, and perhaps some other European countries may be said to have experienced a somewhat longer transition period between laissez faire and the mixed economy, particularly with respect to this social welfare activity, a remarkable feature of the American experience was its precipitous character. 1 The abrupt transformation of the 1930s during the Great Depression in the United States helps legitimize the conception that the interventionist regime represented a distinct new era in the relations between government and the economy, as well as between government and society. The essence is, of course, the rise in the importance of government in the economy. The use of term " e r a " is designed to denote the decisive and viable character of the transformation from laissez faire capitalism. Also, the concept of an era in history stimulates the detection of significant distinguishing and differentiating features. Further, discovery of those features in turn leads us to a study of how they are presently evolving and where they may be leading. Gradualists may object to such periodization into eras and point to the existence of certain continuities with government intervention under laissez faire. Let me try to dispose of one aspect of this objective quickly and at the outset of my discussion. Except possibly for the mere "custodial" care for a small minority 2 among the poor, I do not wish to assert that the laissez faire era in the United States involved a "night watchman" arrangement. That is a straw man. Under the nineteenth-century U.S. laissez-faire conditions, as elsewhere, Reprinted f r o m Explorations in Economic of the copyright holder, the Academic Press.

History

16(1979), pp. 297-330, with permission

23

24 Perspectives on the U.S. Mixed Economy economic functions performed by government at its several levels exceed w h a t may be considered the minimal: government afforded protection and stimulus to capital formation and participated in a wide range of activities, although always in an economy t h a t was predominantly laissez faire in ideology and in practice, a n d that became more a u t o n o m o u s about the middle of the (nineteenth) century. 3 The laissez faire and mixed-economy stages are historically relativistic delineations in the evolution of government's role. And there is, of course, no rigidity implied in dating the beginning of the latter era in the United States with the inauguration of Franklin D. Roosevelt (FDR) in 1933.

HALLMARKS

Thus the old continues, a d a p t s , and even grows within the new framework. For example, government regulatory activities in the United States, some inaugurated with the founding of the Republic, when r e m n a n t s of mercantilist views were still widespread, have proliferated during the mixed-economy era. But the latter exhibits certain distinguishing economic (and social) hallmarks, most of which not only are widely acknowledged but also are found, significantly enough, in c o m m o n with interventionist regimes in other advanced capitalist countries. The more obvious ones, including a n u m b e r that cannot be treated here, include the f u n d a m e n t a l one of discarding the concept of "society as a n a d j u n c t of the m a r k e t , " 4 a trend t o w a r d some type of social planning (e.g., French indicative planning), persistent net public budget deficits with resultant large and rising public debt in the long run, a n absolute and relative j u m p in government expenditures and transfer p a y m e n t s to persons, the extension of the income tax, a vast socialization of material security for the individual, a distinct drop in the relative importance of " p r i v a t e " consumption, 5 a dampening of the economic cycle, and a secular rise in general prices. 6 By " g o v e r n m e n t " in the U.S. case I mean federal, state, and local combined, unless otherwise specified. The expenditure criteria referred to, however, inadequate in some vital respects, are, I believe, generally superior to the criterion of public employment for present purposes, especially because the growth of government e m p l o y m e n t does not properly reflect the vast increase in public transfers. Nevertheless, it is necessary to look briefly at the public e m p l o y m e n t trends. In stressing expenditure criteria it is not

Perspectives on the U.S. Mixed Economy 25 intended that the numerous other ways, such as tax favoritism and various indirect and subsidy-like programs, contemporaneously employed to influence the "private" sector, be ignored entirely. Many of these, incidentally, are in substance if not in form, carryovers from the laissez faire era. Import restrictions are illustrative of the category. Government has always to some degree fostered economic development or helped remove barriers to such development (Spengler 1959:357). On the other hand, on the federal level the antipoverty, income-security, and welfare element is comparatively new to the mixed-economy era. An example is the federal m i n i m u m wage—a program also not reflected in public expenditures. Documentation of the massive, sudden, and lasting departure in the United States from the laissez-faire past is readily found. Kuznets' estimates of percentage shares for all government purchases in GNP at current prices are shown in table 3.1, with the last row in brackets added from Department of Commerce data. The persistence of the new high and rising relative level of government expenditures after the 1920s is clearly evident. Government outlays exclusive of transfers drift very gradually upward through the period ending with laissez faire 1928, the proportion rising at an annual compound rate of only about 0.7 percent. If they had continued to rise at the same rate through 1969, they would have amounted to only 7.1 percent of GNP. The indications are that, at least from 1900 to 1929, the entire rise was due to state and local expenditure increases. 7 Expenditure estiTABLE 3-1. Percentage Shares for Three Major Expenditure Flows, Selected Periods, 1869-1888 to 1970-1977

Period

Private consumption

Government outlays

Gross domestic capital formation

1869-1888 1889-1908 1909-1928 1946-1955 1950-1959 (1970-1977

76.7 73.6 74.7 66.4 63.7 63.2

3.6 4.4 4.9 15.4 17.9 21.6

20.6 21.4 18.4 17.3 17.9 14.9]

Sources: Kuznets (1966, p. 237, Table 5.3). Kuznets' table also indicates that the jump in government shares occurred after the 1920s in the United Kingdom, Germany, Italy, Norway, and Sweden. Prior to and incuding the 1920s, the rise in the share was steady and persistent. The last row in brackets is calculated from the Economic Report of the President (January 1979, p. 183, Table B-1).

26 Perspectives on the U.S. Mixed Economy mates suggest that Wagner's law failed to operate for the federal level from the late nineteenth century to 1929.8 The mild upward drift in the ratios for the combined levels through the 1920s can no doubt be attributed to a considerable number of influences, such as possibly urbanization (last quarter of nineteenth century), demographic changes, technological advance, and income-elastic demand for public services. The list is long and is ably compiled, for example, by the Swedish social scientist Daniel Tarschys (1975:9-31). The sharp relative drop in "private" consumption shown above in the Kuznets and the 1970s' data occurred after the 1920s. Current estimates show personal consumption expenditures in 1929 were about 75 percent of GNP, the same as Kuznets' average for 1909-1928. In prosperous 1973 (4.9 percent unemployment), private consumption, excluding residential construction, was only 62 percent of GNP. Relatively growing public transfers to persons and relatively growing government payrolls tended to sustain private personal consumption. The gross capital formation ratios in the Kuznets series, which include residential construction, show a sharp decrease of 14 percent after 1889-1908, with a plateau following that distinct drop and beginning in laissez faire ¡909-1928, not mixed economy 1946-1955.9 These lower gross investment spending ratios seem but slightly reduced after the emergence of the mixed economy—up to the 1970s at least. Viewed from the supply side and in current price terms, gross investment therefore accommodated for a protracted period the continued secular growth of total product with but slight adjustment, so far at any rate, to its changed institutional environment. Viewed from the demand side, the gross propensity to invest, as contrasted with the propensity to consume, exhibited no sharp discontinuity after the first decades of the twentieth century in the structure of social preferences as expressed by broad expenditure category. The great shift in revealed preferences was from private to public "consumption" — including in the latter, of course, the social "consumption" of military goods and services.10 Unweighted, taxonomic treatments of government's rise, like Tarschys', however competently comprehensive, fail to discover the most vital explanatory factors that highlight the demise of laissez faire and distinguish the mixed economy as a new era. To get at that, it would appear that one must at the very outset note the striking discontinuity in the relevant statistical trends." Table 3.2 is designed, among other purposes, to reveal this discontinuity. It shows that the jump in public spending occurred before that shown in the Kuznets series, namely, in the 1930s. It also shows

Perspectives on the U.S. Mixed Economy 27 that the j u m p in that New Deal decade was almost entirely attributable to a 90 percent rise in the federal government's spending viewed as a percentage of GNP. No comparable phenomenon can be found in any previous peacetime decade series, and hence, the dating of the inauguration of the mixed system is unquestionable. Table 3.2 is the basic table for showing what happened to governments' economic importance when the United States entered upon the mixed-economy era. It estimates the percentage that real government outlays for domestic programs represent in real GNPs that are standardized for a 5 percent "nonrecession" unemployment rate. Thus the percentages are not seriously affected by cyclical influences emanating from the GNP, or denominator, side. 12 Also, while military and international affairs' expenditures have been of overwhelming importance to the federal outlays in the U.S. case, their elimination to isolate domestic program expenditures not only yields a less episodic series but also gives a clearer picture of the strength of the deeprooted internal wellsprings generating and sustaining the interventionist system. The significance of international comparisons is likewise thereby enhanced. Real magnitudes are presented in table 3.2 in order to avoid the possible misrepresentation (exaggeration of government spending rise) stemming from the greater secular increase in prices of government purchases of goods a n d services than in the GNP deflator. This is of course a statistically built-in feature of the government deflators largely by virtue of the use of input prices (wages and salaries of government employees) instead of output prices as used for the private sector component of the GNP deflator. While the assumption that government productivity does not rise may well be quite incorrect, it is perhaps better to lean toward the conservative side and not run the risk of exagerating the relative rise in the importance of public domestic spending. This will not, however, be feasible, because of d a t a limitations, in making the international comparisons in table 3.4. Current magnitudes are not to be ignored, in any case, for they do represent how the community decides to allocate its pecuniary resources. Since table 3.2 applies the federal price deflator to federal transfers to persons and grants-in-aid to the state and local (S&L) governments, both included here in federal outlays, there is again a bias on the conservative side. The GNP or personal consumption deflator should properly be applied to these transfers, as well as to the imputed but inestimable portion of federal grants that become S&L transfers to persons. Similarly, the latter governments make inestimable transfers

28 Perspectives on the U.S. Mixed Economy TABLE 3-2. Government Domestic Civilian Outlays in Constant (1972) Dollars as Percentage of Constant Dollar Nonrecession G N P for Selected Years, 1929-1977

Year 1929 1939 1949 1955 1960 1965 1970 1975 1977

Nonrecession G N P (billion dollars) 298.4 365.9 495.3 618.2 738.3 877.3 1044.2 1248.9 1405.3

Federal outlays (billion dollars) 9.3 21.6 45.2 51.7 73.8 97.3 113.6 176.9 205.0

Federal/GNP

(%) 3.1 5.9 9.1 8.4 10.0 11.1 10.9 14.2 14.6

Sources and Methods: The basic conceptual framework comes from Owen and Schultze (1976, p. 323, Table 8-2). Estimates therein pertain to the years 1955-1977, and I made computations as similar to them as possible for 1929-1949. This source chapter is written by Schultze. His conceptual framework seems appropriate also for my analytical needs. Schultze develops a series for nonrecession GNP that assumes 5% unemployment. He takes total federal outlays, which include transfer payments, net interest on public debt, and grants-in-aid to state and local governments. Minor adjustments to these for Vietnam War costs (1970) and recession-related outlays in certain years yield his "baseline budget." From this he subtracts outlays on national defense and international affairs to get total outlays on domestic programs, the series we want. From my 1929 nonrecession GNP I had to reduce the actual total of 103.4 billion to 98.1 billion to correct for the unemployment rate, which was only 3.2%. There were no recession-related outlays that year. For 1939 there were such outlays: 2.9 billion, the sum of outlays for relief and public works during the fiscal year 1940 (see Studenski and Krooss, 1963, p. 406, Table 69). Nonrecession GNP was 104.2 billion. For 1949 recession-related outlays were 3.4 billion, the government unemployment insurance benefits entering into personal income (U.S. Department of Commerce, 1977, p. 66, Table 2.1, line 17), plus public works expenditures for that calendar year

to persons out of their own revenues, and the S&L price deflator should properly not, as I have done, be applied to that component. This defect likewise tends to understate the increase in the relative importance of S&L government spending over time. 13 Table 3.2 contains much that is of interest in any attempt to understand the development of the mixed economy, not only dating its emergence, as noted, but also showing that it has been federal spending relative to GNP that has experienced both the initial j u m p after 1929 and the secular rise, not S&L spending (when S&L spending is

Perspectives on the U.S. Mixed Economy

T A B L E 3-2.

(cont.)

S&L outlays (billion dollars) 34.9 42.0 47.4 62.3 76.2 98.3 122.1 135.7 134.1

29

S & IV GNP

All Government/GNP

(%)

(%)

11.4 11.5 9.6 10.1 10.3 11.2 11.7 10.9 9.5

14.5 17.4 18.7 18.5 20.3 22.3 22.6 25.1 24.1

(Studenski and Krooss, 1963, p. 463, Table 90). Nonrecession G N P for 1949 was 260.5 billion. The data for outlays on national defense and foreign affairs are from Historical Statistics (Part 2, p. 1115 Series Y 467 and 468, for 1929 and 1939); for 1949 they are from the Tax Foundation (1975, p. 80). For all other years Schultze's figures are used. For state and local outlays all computations are my own. I took S & L totals, like the federal totals, from the Economic Report of the President (January 1979, p. 267), hereafter designated "ERP". From this, I subtracted grants-in-aid from the federal government in order to avoid double counting when S & L is added to the federal to get the last column in the table. Also, we want to know the magnitude of the S & L role from own revenue sources. The grants-in-aid series for 1949 to 1977 is from E R P . But for 1929 and 1939 it was necessary to average from available series (Tax Foundation, 1975, p. 133) —for 1929, the rounded average of 1927 and 1932, and for 1939 the average of 1938 and 1940. Fortunately, the magnitudes for 1927 and 1932 were very small, averaging only 200 million in a S & L total of 7.66 billion. Appropriate price deflators in 1972 dollars were taken from E R P (January 1979, pp. 186-187). I am skeptical of the applicability of the federal price deflator to the transfer payments and, to a lesser degree, the grants-in-aid components of the federal totals. The effect of using it is, I believe, to understate the rise of real federal outlays.

defined, as here, to exclude federal grants-in-aid). Consequently the u p w a r d trend in the all-government proportion has been due entirely to the federal share rise. Such a striking shift suggests a notable, m a j o r t r a n s f o r m a t i o n in the political consensus. We also observe f r o m table 3.2 that the federal percentage j u m p e d u p w a r d again significantly in the 1940s. The rise b e c a m e m o r e gradual d u r i n g the ensuing two decades. The 1970s, on the o t h e r h a n d , a p p a r e n t l y b r o u g h t a n o t h e r s h a r p increase, although the full record for the d e c a d e r e m a i n s to be seen. In general, the e s t i m a t e s reveal

30 Perspectives on the U.S. Mixed Economy that the New Deal did not institute a once-for-all j u m p in the comparative importance of government spending. The level of the federal percentages, as calculated, while far below the S&L level in laissez faire 1929, had approximately caught up with the latter in the ensuing, tumultuous twenty years (not by the end of the New Deal in 1939). After a two-decade interlude of approximate equality in the percentages accounted for by the federal and the S&L governments, the 1970s apparently indicated another distinct relative rise in the former, carrying the federal proportion well above the latter. That relative rise can be attributed chiefly to a very large absolute and relative increase in the sum of federal transfers plus grants-in-aid in the 1970s—prominent features in the development of the mixed economy. The first aspect of table 3.2 that is very much worth noting, although it has more to do with prospects than hallmarks, is that the proportions for all government do not indicate that the long-run rise in the government's place in aggregate spending has terminated. Of course, the table conceals the composition of public spending as between purchases and transfers to persons and to lower government levels. But this significant hallmark has just been noted: The secular rise in all governments' spending importance is almost entirely due to the burgeoning transfers and grants, with transfers outweighing grants by 2.5 to 3 to 1. Thus, income security and health payments, in cash and in kind, have been the emphasis in civilian expenditure growth, doubling from one fifth of federal current dollar budget outlays in 1960 to more than 40 percent in the late 1970s (Statistical Abstract 1978:260, no. 422). Despite the very large role of military spending in federal government purchases in the U.S. mixed economy, much larger than has been typical of the European cases, after the Korean War such spending declined from 86 percent to 65 percent in 1977 (current dollars). Thus, even ignoring transfers and grants, some more leeway was consequently permitted for the expansion of domestic social expenditures, a development more resembling the European model, but not evident in table 3.2. In seeking hallmarks it is revealing to examine briefly and compare with table 3.2 another "real" set of data, that on public employment. These data are presented in table 3.3. Here I relate the long-run trends in federal, civilian, and S&L noneducational employment to trends in the total civilian labor force. Table 3.3 shows a distinct u p w a r d secular trend for almost a half century of the mixed economy in the ratio of all public civilian full-

Perspectives on the U.S. Mixed Economy

31

time equivalent (FTE) employment to the civilian labor force. This was not new under the mixed system, for the ratio had risen secularly much earlier, e.g., from 1900 to 1929,14 for all the federal and S&L components. However, the entire jump in the federal percentage, which is very great, is complete by the end of the 1940s. There was a once-for-all rise in relative federal employment. There was no "burgeoning federal civilian bureaucracy," as indicated by employment, in the mixed economy after 1949.15 Since World War II it was the S&L government that increasingly administered the interventionist regime, for only those governments exhibited and accounted for the relative growth in public employment during the most recent three decades of economic history. Hence the mixed economy brought about a cessation after World War II in the historical relative increase of federal employment as compared with the total civilian labor force. In comparing table 3.2 with table 3.3, it will be observed that both the spending proportions and the employment proportions for all government show a rising secular trend, with no clear indication of a termination of either trend. Although 1977 shows a turndown in both spending and employment proportions, the argument that follows will make it clear that this is probably a very short-term phenomenon. But the trend in the relative importance of S&L versus federal employment is in sharp contrast to the trend in spending proportions, particularly after World War II. Two hallmarks of the U.S. mixed system are embedded in this contrast when taken in conjunction with the fact that the secular rise in government's spending importance is almost entirely due to growing public transfers to persons and federal grants-in-aid to the S&L levels of government. The first hallmark is that the overall relative growth of federal spending concealed two facets of its fiscal policy, i.e., the transfer of cash to individuals to spend as they wished and the transfer of federal revenues to the S&L governments for their dispensation. The second hallmark, as previously noted, is that S&L employees have been endowed with the chief responsibility for administering the employed public element in economic life. Both hallmarks are deeply rooted in the American cultural past. The first expresses a traditional American proclivity for heavy reliance on individual private decision making. The second expresses a traditional "Jcffersonian" bias in favor of local as against federal government administration. Better examples of the mixture of continuity and discontinuity in history could scarcely be found.

32 Perspectives on the U.S. Mixed Economy TABLE 3-3. Government Civilian Employment as Percentage of Civilian Labor Force, Selected Years, 1929-1977

Year

Federal civilian employment (000)

1929 1939 1949 1955 1960 1965 1970 1975 1977

533 722 1175 1159 1329 1439 1687 1800 1817

Federal as percent of civilian labor force 1.08 1.31 1.92 1.78 1.91 1.93 2.04 1.94 1.87

S&L noneducation employment (000) 1275 1636 2103 2552 3036 3600 4275 5214 5392

Sources and Methods: The federal series is the standard civilian FTE total minus Department of Defense "civilian" employees. The source is the U.S. Bureau of Labor Statistics (1977), and the monthly issues of the same volume sets for February 1977, p. 61 and December 1978, p. 59. The State and Local series is from the Tax Foundation (1977 ed., p. 24), and Statistical Abstract (1978, p. 318, No. 507). This series is also in full time equivalents. The reason for omitting DOD employees from the federal series is because they obviously have no direct connection with the mixed

ORIGINS

One important inference that I think can be drawn from the emphasis in the present discussion upon the discontinuous expenditure pattern is that the influence of vested interests—tax collectors, lenders to the public treasuries, and the government bureaucracy—in the early 1930s cannot possibly explain the sudden inception of the U.S. mixed economy in the 1930s. The first two groups not only were of inconsequential influence but also were dominated by classical, laissez faire, "ideological—cognitive" precepts (to use Tarschys' term), and they generally acted to restrain the rise of government as represented in the New Deal. The public bureaucracy inherited from the laissez faire era was too small to even begin to explain the sudden j u m p in government civilian intervention. Moreover, the bulk of the bureaucracy was state and local, while expansion was initially, as has been shown, heavily concentrated at the federal level. 16 Total federal civilian employment in 1933 was about 600,000 of which some 100,000 were in the defense establishment. Only about 70,000 civilian employees were located in Washington, D.C. (Historical Statistics, part 2, p. 1102.)

Perspectives

TABLE 3-3.

on the U.S.

Mixed

Economy

33

(cont.) S&L

All g o v e r n m e n t

a s percent of civilian labor force

a s percent of civilian labor force

2.59 2.96 3.43 3.92 4.36 4.84 5.17 5.63 5.54

3.67 4.27 5.35 5.70 6.27 6.77 7.21 7.57 7.41

economy's domestic governmental programmatic role (they of course underwrite total employment). The omission of S & L educational employment is designed chiefly to eliminate postwar "baby boom" effects. This omission is admittedly more controversial. However, public education's share of total S & L employment, 46% in 1929, had risen to only 4 9 % in 1977, so its inclusion would have little effect on the trend.

Let me suggest, therefore, that a combination of historical and domestic socioeconomic changes, organizational and institutional changes, and a violent shift in public preferences can explain for the most part the emergence of the new interventionist regime in the United States. In all this, I emphasize domestic aspects because I reject the theory that the U.S. Depression was internationally generated. A single factor was the primary, immediate, socioeconomic determinant: mass unemployment. 17 That defect in the functioning of the private market system, one that plagued Northwest Europe throughout the 1920s, had already been pinpointed by the insightful Keynes in 1926 as spelling the end of laissez faire (Keynes 1952: 312— 322). But evolving market defects, classed here under the rubric of socioeconomic changes, are partly in the eye of the beholder. It was perceived defects that counted. Public perceptions underwent a substantial structural change. These perceptions acknowledged, with FDR, that "the necessitous man is not free." They recognized that equality of access, even where such obtained, was not the same as equality of outcome (Titmuss 1968:196). This change introduces Tarschys' "ideological-cognitive" influence

34 Perspectives on the U.S. M ixed Economy in the form of a sudden public preference (demand) for action—by the federal government—to correct a long-standing flaw in the private market system. The a t t e m p t was first made, from 1930 to 1933, to induce the state and local governments to assume the main responsibility for what appeared as a recovery task. But their own fiscal resources soon proved inadequate, after frequently heroic efforts that carried some of them to the threshold of insolvency, to cope with the inundating task. In many cases they behaved with cyclical perversity, resorting to retrenchment like private business firms. The flaw in the private market appeared at the time to be cyclical and temporary; it was not perceived as in any significant sense a permanent problem. 1 8 Hence the federal government actions accordingly initiated in this first phase of the mixed-economy's history did not a p p e a r at the time as a necessarily lasting program. However, the Employment Act of 1946 reflected a new, transformed outlook and did prophetically initiate a lasting public commitment to high employment. At this point the question arises, why did not earlier severe, cyclical depressions elicit the transformations in the "ideological-cognitive" and political spheres that occurred in the 1930s? The answer can only be sketched here, but I suggest that it may be found primarily in certain organizational and institutional developments that were themselves forms of response to historical changes in the underlying structure and operation of socioeconomic relationships. Those historical changes had gradually been laying the basis for a different social response. They included, for example, the end of the agricultural frontier and the continuing reduction in the farm population (absolute after 1916), the urbanization process, the maturation of the spread of private market administration, the formation of a large professional class, the formation of a very large and rapidly growing industrial and commercial wage-earning s t r a t u m , the dilution of craft labor skills, the end of job competition from immigration, the growing cultural homogenization of the wage-labor force, and the steady enlargement of the proportion of elderly in the population. These are all well known, and I am only propounding their relevance here. On the organizational and institutional side, coordinate developments were also preparing the ground for the forthcoming transformations. Labor unionism, however programatically limited, was becoming an established institution. In a larger sense this contributed to the acceptance, through a demonstration effect, by wage earners in general, both employed and unemployed, of the legitimacy of organization to achieve rightful aims (this belief later burst forth in the form of the militant unemployed organizations and then the Congress of Industrial Organizations [CIO]). Meanwhile, the long-established tra-

Perspectives on the U.S. Mixed Economy 35 dition of farm organization, buttressed by a combination of populism and what Douglass North has called a keen feeling of deteriorating status, was kept alive and active by the end of agriculture's "golden age" and the depressed state of farming in the 1920s. Similarly, the progressive and humanist traditions in American culture had been gaining influence with the urban middle class, particularly the professional stratum—Joseph Schumpeter's "hostile intellectuals"—and this was expressed in the gradual extension of both social welfare activism and progressive politics. 19 These are some of the more relevant antecedents to the explosive developments of the 1930s. All of them were, however, sufficiently deeply rooted to abide long past the events of that historic decade. Similar developments unfolded in many European nations. I am tempted to add one further point on the subjective, ideological aspect of depression-promoted transformations. That has to do with the public's image of business leadership. The competence of that leadership to pilot the economic ship of state had been oversold, especially in the 1920s, and when the catastrophe struck in the 1930s the image was almost demolished. The demolition squad was enlarged to include many more than merely the hostile intellectuals of the insightful Schumpeter. Social Darwinism died. The corporate establishment was henceforth put on the defensive. The interpretation thus advanced here is that the call for federal government action in the 1930s was the crystallization of a set of social preference functions whose gestation period reached far back into at least the late nineteenth century. In general, that function was rooted in the progressive, egalitarian, and humanist traditions, as well as in the development of democratic, agrarian-populist, and labor consciousness during the preceding decades of government irresponsibility toward help to the lower and middle-income groups. But the formation and solidification of the new interventionist consensus was, I suggest, a massive, decisive, and nonpragmatic upheaval. The analysis of socioeconomic origins need not terminate with reference to matters as perceived by the participants in the 1930s. If the perceived socioeconomic problem complex was merely temporary and cyclical, as then believed, mixed economies might come and go. But they abide. And while the aggrandizing propensities of bureaucratic suppliers of government services are not likely to be completely washed out by the business-fostered bias in favor of privately produced goods and the persistence of powerful laissez faire fiscal precepts among the population, I doubt they can explain much of the continued existence of large and growing interventionism. In the American case the federal element in total government out-

36 Perspectives on the U.S. Mixed Economy lays, "G," has been sustained chiefly by the military budget, which averaged almost four times the nonmilitary total in the decades following World War II. But the growth of U.S. federal transfers and the expansion of all government expenditures, including transfers in other less militarily oriented mixed economies, e.g.. West Germany and the smaller Western European economies, imply that the big budgets would persist in the United States even should peace and détente break out. There is great variation among the North Atlantic mixed economies in their ratios of military expenditures to GNP despite more similar proportions in their total G to GNP. The civilian/military proportions making up total G are not, therefore, very significant for the trends emphasized in the present discussion. That is why the data in tables 3.2 and 3.3 are confined to civilian magnitudes. Hence, the usual méthodologie imperative to look for long-run factors among the socioeconomic origins of the mixed U.S. economy is buttressed by the fact of the continued existence of interventionist arrangements in other highly developed economies for so protracted a period of time. Historians of economic evolution and of economic doctrines are well aware of the fact that questions regarding long-run influences were posed and answers advanced during the Great Depression years. Schumpeter, for example, argued that there were long-run institutional, social, and ideological trends inimical to the continuation of "intact," laissez faire capitalism. But he denied the existence of substantive flaws in the capitalist growth engine itself and also denied that the severity and long duration of the great depression reflected any forces making for secular retardation. Other theorists, with whom Schumpeter joined on some points, explained the Depression's severity and duration in terms of postWorld War I international disequilibrium, unusual overexpansion in the 1920s, and the destruction of business' animal spirits by the "welfare state." But it appropriately fell to America's leading Keynesian to develop a long-run hypothesis linking the cyclical depression with secular retardation in the private-market growth mechanism. Alvin Hansen extracted the long-run insights of Keynes; passed over Keynes' formal, instantaneous model of underemployment equilibrium; drew heavily upon John Stuart Mill's version of the classical stationary state; and rooted his resulting stagnation thesis in empirical material from U.S. economic history. I believe we can find much of explanatory value regarding both the economic origins and the continuation of the U.S. mixed economy in certain, although not all, of the elements of Hansen's hypothesis. The hypothesis referred to a laissez faire, not a mixed, capitalism.

Perspectives on the U.S. Mixed Economy

37

For Hansen, stagnation was the problem generated by the market system in the absence of any significant countervailing, Keynesiantype intervention by government. He viewed and urged precisely such demand-sustaining intervention as the proper solution to the stagnation dilemma that the economic system's evolution had already evinced in Europe well before 1930. This distinction has been ignored by most eminent economists and economic historians, w h o have ignorantly a t t e m p t e d to refute Hansen's thesis with the record of GNP growth under the post-World War II interventionist regime in the United States. Certainly there are competing explanations, and they, like the whole set of questions that gave rise to them, have been pretty much shelved in recent times. But there is much continuity in history, a n d I think, therefore, these matters should not, and indeed cannot, be shelved. The fact of continuity strongly suggests that origins, continuation, and future prospects of the mixed economy are to be analytically connected. And it seems to me that some sort of secular retardation hypothesis addressed to laissez faire capitalism does a better job than any competitor of explaining the viability of interventionism. I think the element with by far the highest yield for the American case in Hansen's doctrine is the notion of capital-saving innovations. We know, of course, that "technologically disembodied" capital goods alone can conceivably account for only a very modest portion of the secular rise in output and labor productivity, and very much less of the trend in total factor productivity. Still, the concept of capitalsaving technological advance, in which capital goods embody some of the advance in knowledge, etc., points directly, as in Harrod's later use of the term, to the historical rise in the output/capital ratio. I prefer to call this the capacity/capital ratio, and there can be no doubt any more that the trend of that ratio, with respect to fixed nonresidential business capital, is u p w a r d in the United States, normally at a rate in the neighborhood of almost 1 percent per year compounded. This is not exclusively or even primarily a capital productivity phenomenon but essentially the end product of all the embodied and disembodied effort that can be applied to the worthy cause of productivity rise. The end result is relatively ever less net additions to the stock of fixed business capital, ever less net fixed investment, to achieve our customary capacity growth rate of between 3.5 and 3.75 percent per year. 20 If we extract residential construction, inventory investment, and net foreign investment from gross capital formation, we have left the growth-strategic category for an appropriate closed-economy model

38 Perspectives on the U.S. Mixed Economy of a capitalistic economy: domestic nonresidential business fixed investment. The net investment component of the gross has been drifting downward until it has averaged in the post-World War II period rather less than 3 percent of NNP (net national product). My presumption is that this decline is primarily due to the secularly rising capacity effects of a constant dollar of gross investment outlays. In other words, in the absence of government support for the maintenance of aggregate demand, the private economy would approach ever more closely the Mill-Keynes-Hansen stationary state, with the marginal efficiency of net investment approximately zero. This trend was already under way in the 1920s but was registered in acute form only in the 1930s. In both the Millian and the contemporary KeynesHansen stationary laissez faire state, as well as in the mixed economy, technical progress can be expected to continue and capacity to rise secularly even though gross investment is approaching replacement investment. The European mixed economies, while also experiencing the breakdown of Say's law (long run) since World War I, have not yet, in all probability, come nearly as close to net fixed investment atrophy as the United States, because they have much lower capital/labor ratios and total factor productivity levels that are substantially below the American. 21 In terms of spending streams, the much higher average and incremental capacity/capital ratios in the United States than in Europe accentuate the greater underlying need in the former for government direct purchase, public transfers to sustain "private" consumption, or, if possible, increases in net exports. All this means, in terms of NNP in the U.S. case, that since the net investment component is slowly vanishing, the economy is heading for a world in which NNP is no longer C plus net I plus G but rather simply C plus G, assuming a closed-economy model. The history of the mixed economy in the United States has mirrored the Keynes— Hansen image: the relative displacement of net I by G.22 While gross fixed I has so far stubbornly held at about 10 percent of GNP, it must one day begin to fall proportionately if past upward trends in the capacity/capital ratio continue—and I see no reason why they should not. The rate of rise might even increase as the international productivity competition intensifies. Thus, with C a function of income growth, only a rising G can continue to sustain aggregate demand, as it has for three quarters of a century, sufficiently to match the growth of capacity. These comments outline only the economic reasons why a new set of relationships between government and the economy, which began

Perspectives on the U.S. Mixed Economy 39 with a cyclical recovery target in 1933, and which failed to get full employment until deficit-financed G was made big enough by war, became transformed into a permanent growth requirement after World War II. The elasticity assumptions should be noted here: The demand for the output of private fixed investment is income inelastic, whereas spending by government is income elastic. A continuing upward shift in public preference for collective goods, when taken together with the social provision of income security through public transfers, not all of them new by any means, marked the post-World War II phase of the mixed-economy's history in the United States and elsewhere. These developments were stimulated everywhere by demands for more outlays and regulation to correct previously perceived market failures and by the emanation of several newly perceived defects, mostly having to do with externalities, in the operation of the private market. 2 3 The resulting upward shift in the public's demand for intervention greatly reinforced the then well-established recognition of the need for a large, usually in part deficit-financed, G to sustain economic growth. The "intermediate-position radical" (i.e., conservative) James E. Meade (1975:122) distinguished certain almost devastating sets of reasons for the failure of the market to yield "the most efficient use of society's resources": it cannot cope fully with the uncertainties of the future, it cannot give the correct guidance for structural changes in the economy; and it overlooks many social costs and benefits which escape its calculus. To a smaller or greater degree the inadequacies pervade practically all economic activities. A more specific enumeration of the largely post-World War II market failures would include the cumulation of external diseconomies and disutilities, private underinvestment in research and development (R&D); the market's neglect of h u m a n capital investment; environmental decay; urban damage to the quality of life; the inability of the uninformed family (!) to generate an o p t i m u m population; the incapacity of the market system if left alone to coordinate domestic performance with changes in the balance of payments; distributive inequity and the persistence of poverty; the administration of market behavior by large organizations rather than the shaping of such behavior by atomistically competitive decisions; the related tendency of the market to undermine the achievement of certain social policy goals, such as stable prices 2 4 ; and the incapacity of the market to

40 Perspectives on the U.S. Mixed Economy provide adequate health services and new housing for the lowerincome strata. While the probable cessation of growth remained the major, recognized threat that underlay the mixed economy's raison d etre, society's increasing concern with an ever-expanding package of perceived derangements required the placement of proportionately ever more resources and authority at the disposal of the state or, alternatively expressed, the funneling of proportionately more of the controls over resources through public channels. These newly discovered or emphasized defects were viewed by the important decision-making segments of the public as greater than any expected defects associated with the placement of corrective responsibility upon the shoulder of government. Consequently, the trend toward planning has continued, and supply management has necessarily begun more and more to share the stage with demand management. It may well be that the absolutely growing contingent of public employees associated with the interventionist regime added a modest new demand influence making for the future expansion of that regime. But if these same deficiencies were not also perceived by large segments of the whole population, it seems doubtful that the attention given by government to correcting them would be anything like as great as that which has actually occurred. What we are witnessing contemporaneously is apparently a new, widespread, and deep-rooted upsurge in both the awareness of market failures and the demand for social treatment of those newly perceived or newly highlighted ailments. Public policy is no longer viewed as a mere "ad hoc appendage to economic growth" (Titmuss 1968:164).

IRREVERSIBILITY

The eminent British economist Thomas Balogh has noted that the attack upon John Kenneth Galbraith's " A g e of Uncertainty" on BBC by Milton Friedman and Sir Keith Joseph "implied that only unemployment, the dismantling of the Welfare State, and denationalization could 'save Britain' " (Balogh 1977). The nationalization issue has never been important in the United States, but mass unemployment and the "welfare state" have. Friedman and the other laissez faires may be interpreted to call essentially for a return to pre-1929 conditions with respect to what they regard as cyclical unemployment, the "grants economy," and other public welfare programs. For them private business investment, infinitely encouraged, could always take

Perspectives on the U.S. Mixed Economy 41 care of the growth problem. 2 5 Paul Samuelson demurs: "even reactionaries don't want to go back to the old system" (Challenge, March/ April 1977). Even Friedman has commented that he has no great confidence in his chances for success in bringing about a return to the old order (Challenge, March/April 1977:6). Nevertheless, the continued resistance to expansion of public civilian programs, the groundswell of criticism of government regulation, and the controversy over the extent of dismantling desired or expected by the laissez faire advocates keep alive the basic question of the viability of the mixed system. And the increasingly widespread conviction that inflation is endemic to that system has further reinforced the system's opponents. Furthermore, few influences are so destructive of a social-policy construct as its faint-hearted implementation, a disease plaguing the peacetime mixed economy in the United States since its inception because of the hostility to big government and the associated traditional belief that government is "unproductive." However, there are good reasons for Samuelson to declare, 2 6 "After the New Deal, American economic life was never again the same. We had converged with Western Europe to the mixed economy." Such judgment cannot, of course, be proved; it can only be endowed with historical plausibility. I have tried to show some of the main historical changes that give credence to such a judgment: in sum, the gradual breakdown in the long-run functioning of Say's law, stemming from increasingly insufficient net fixed investment demand offsets to net private savings, with attendant secular unemployment in the absence of corrective government action; and the evolution of a number of lasting structural, institutional, and organizational changes in the economy and in society that gave rise to a massive and p e r m a n e n t reorientation of public attitude involving a heightened intolerance of more and more newly perceived private market defects and a heightened preference for government intervention to correct those perceived defects, as well as to provide substitute and supplementary public goods. The credence these factors lend to Samuelson's judgment is at the same time cogent evidence that the mixed economy is both viable and irreversible. The international character of the mixed system further attests to its viability and irreversibility and underscores the notion that the new arrangements constituted an era in the evolution of twentiethcentury capitalism. This era is characterized economically as having capitalist systems that exhibit high savings flows and high income per capita, are rich in business fixed capital, enjoy historically high capacity/capital ratios, and experience a secular retardation in satis-

42 Perspectives on the U.S. Mixed Economy factorily remunerative net fixed investment opportunities. The North Atlantic economies have all experienced these conditions in varying degree and for some decades have not been able to function as merely "C + I" systems. Aggregate private demand has long been insufficient to afford a high employment growth rate, even with declining population growth and the shortening of the workweek. The post-World War II investment spurt in European countries may be viewed as a transitory phase of attaining higher capital/labor and capacity/capital ratios until productivity achievements destroy the feasibility of further net investment—all under the favorable stimulus from growing public expenditures and support of private demand from transfer payments, subsidies, selective tax expenditures, etc. Maddison (1964:103-104) has noted that in the course of the 1950s government expenditures on goods and services in money terms increased faster than private demand in the United States and Canada and in all European countries except Germany. Table 3.4, showing a Table 3-4. Government Outlays, Including Net Transfers as a Percentage of Gross Domestic Product: Selected Mixed Economies, Current Prices, Selected Years, 1960-1976

United States United Kingdom West Germany France Belgium Denmark Sweden Canada

1960

1965

1969

1973

1976

25.3 27.4 20.7 16.0 16.7 18.9 30.1 19.5

25.8 29.2 23.1 16.0 19.2 23.4 36.5 24.2

29.1 32.5 24.9 16.9 20.8 26.9 41.9 31.3

29.5 32.2 31.5 19.0 24.3 37.7 42.7 31.9

32.3 38.1 32.3 22.1 26.9 37.1 49.4 33.3

Excluding Transfers United States United Kingdom West Germany France Belgium Denmark Sweden Canada

19.9 18.5 13.7 13.1 13.2 13.2 17.3 15.5

20.3 19.1 15.6 12.9 13.7 15.8 19.7 17.2

22.3 20.0 16.0 12.6 14.4 18.7 23.0 20.2

20.8 20.8 18.4 14.4 15.4 22.6 25.9 21.1

21.4 24.5 20.7 16.2 17.8 25.4 28.6 22.7

Source: United Nations, Yearbook of National Account Statistics, 1977, Vol. I, Individual Country Data (New York: United Nations, 1978), except United States, source for which is various issues of the Economic Report of the President.

Perspectives on the U.S. Mixed Economy 43 representative group for which current money unit data are available, carries forward those developments from 1960. The whole period thus encompasses a quarter century following the jump in government's role in the North Atlantic World during the preceding two decades or more. Both the upper panel of table 3.4 (which includes transfers) and the lower panel (which excludes transfers) show the higher level of government participation, as well as the same rising trends in all the selected cases, including West Germany. Lieberman (1977:xv-xvi), in his study of European mixed economies since World War II, concludes that two important trends run through the economic history of postwar Europe. In the West, state intervention in economic life became stronger over time and national planning eventually became an inherent feature of post-1945 European capitalism. . . . Although the extent of state intervention differed in the various economies of Western Europe, it grew over time. . . . Together with an expanding public sector, public investment, both in absolute terms and as a proportion of total investment, grew in all countries. The North American experience of intervention is not essentially different from the European. The new era is global; the United States is a part of it. And eras may terminate, but they do not reverse themselves. But there is one contrast in the case of the United States that should be noticed. The bottom panel table 3.4 shows that only the United States has failed to exhibit, for the selected dates, a clear increase in the government share when transfers are excluded. 27 Unlike many European societies that have more of a predilection for direct nonmarket approaches, the United States is more reluctant to shift away from the use of the private market toward public administration of resources. Through a heavy dependence upon public transfers to persons in the United States, a somewhat greater reliance upon the private market is achieved. Only Belgium and Canada showed a similar rise, 1960-1976. The new era has itself experienced important changes, of which the burgeoning public transfers, the emergence of stagflation, and the spread of planning are only three prominent features. The veritable mountain of newly accumulated defects in the operation of the "free market'' that over the decades has produced the changing social consensus favorable to further collective solutions attests to the fact that

44 Perspectives on the U.S. Mixed Economy the public image of the market alternative to government intervention is, when seen in the whole, vastly more defiled than most of us may realize. 28 Outside of certain courses in economic theory and the pages of propaganda organs, few would accept Friedman's (1977:11) romantic and archaic description of the market as a finely ordered and effectively tuned system, one which arises out of men's individually motivated actions, yet is not deliberately created by men . . . a system which enables the dispersed knowledge and skill of millions of people to be coordinated for a common purpose. Aside from the teleological appurtenance contained in this statement, it is doubtful that either sophisticates or the lay public subscribe to this Smithian conception of the actual market alternative to admittedly bureaucratic, social decision-making through the governmental process. It is coming to be realized even by conventional social theorists that the only proper uses of the competitive market model are either heuristic or normative. The emergence of the mixed system was connected with a vast social upheaval in thinking, a revolution of ideas that rejected the recurrent proclivity of the "finely ordered and effectively tuned" market system to generate full employment only during cyclical peak zones, chronic unemployment through most of the cycle, and mass unemployment in cyclical trough zones. Concomitantly, the public image of the leading business guardians of the latter system, now corporate executives rather than the entrepreneurowners of the romantic American tradition, so widely respected prior to the stock market crash and the ensuing grim years of collapse, became very badly tarnished. Since those particularly troubled times an especially dysfunctional aspect of the private market system matured. I refer to the grave, ubiquitous, and powerful monopolistic elements in the market and its institutional setting that accompanied the evolving organizational revolution during the whole twentieth century. There is no need to elaborate here the finally firmly established conception of administered private markets, to the study of which Means devoted the better years of a lifetime. 29 That conception has in fact largely and properly supplanted the Smithian atomistic-market conception in the ranks of contemporary corporate executives, labor organizations, farm associations, trade associations, government bureaucrats, and the lay public— indeed by almost every organizational practitioner who, in contrast to certain academicians, needs to value relevance over rigor. 30 The Smithian view was that monopolistic administration was chiefly

Perspectives on the U.S. Mixed Economy

45

a creation of the (mercantilist) state; the modern view inclines toward the belief that is, with notable exception, a creation of advanced technology in the context of business maximization goals. Of course, in contemporary capitalism there also developed monopolistic administration by the state, e.g., through public regulation and the cartelization of agriculture. The spread of private-market administration no doubt contributed mightily to the permanency of laissez faire's defeat. In the contemporary American system, when Washington presidential administrations, rejecting in horror the imperatives of a general and formal incomes policy, appeal to the vital private decision-making centers for wage-price restraints, they inevitably invoke the cooperation of the great private administrative organizations that rule the bulk of market behavior and market results. Oh! If only those organizations were as administratively advanced and disciplined as their Swedish counterparts! The very erosion of the more individualized private decision-making nexus, formerly believed to function in a manner tantamount to natural law, by large private administrative collectives, has ever more firmly embedded and fixed upon the body politic the pattern of socially constructed decisions channeled through government. An increasingly cynical public has accordingly crossed another threshold and shed its confidence in the social optimality of market decisions by the corporate bureaucracy, as well as by other private vestedinterest groups. The attendant turn to government is all the more impressive because it has persisted and gained momentum in the face of a long tradition of cynicism regarding both politics and politicians. Big government has steadily enhanced its prestigious status as a wellestablished lesser evil. In striking the balance between private and public allocation, the issues have come to be posed, not as controls or no controls, but public versus private controls (Reagan 1963:188, 189). The process of augmenting interventionism after World War II has derived much of its strength from the fact that the private enterprise bureaucracies, big and small, have themselves, with their own piecemeal efforts, helped to build the gerrymandered governmental structure and policy. Calvin B. Hoover, a brilliant but "practical" economist whose contributions to the field of political economy are still sadly neglected by theorists and practitioners in that field, almost two decades ago called attention to the conservative acquiescence in the mixed economy (1961, ch. 9). If he had been writing in the late 1970s he no doubt would have referred to the full cooperation of the corpo-

46 Perspectives on the U.S. Mixed Economy rate business element in the essentials of that system. Only the backward elements in small-town chambers of commerce and some of the petit bourgeoisie within the business community have continued to yearn seriously for a return to the "free m a r k e t " (for others). Most of what appears to be opposition to government intervention is either hindrance-avoiding or jockeying for stronger positions in the continuous struggle in the public arena with other pressure groups. Why should the business stratum not support some or other form of the mixed economy? The government's commitment to maximum employment and purchasing power in the Employment Act was a commitment to underwrite aggregate business receipts and to ensure the aggregate profitability of the enterprise complex. Corporate aftertax profits in ratio to the corporate net stock of fixed nonresidential capital for fourteen representative nonrecession years between 1950 and 1973 averaged 11.9 percent, only moderately less than the profitbloated 1929 rate of 13 percent. 31 The economic cycle, the major aggregate source of business uncertainty in the historical past, and a major empirical basis for a prominent theory of profits, has been distinctly dampened under the mixed arrangements. The much-maligned public deficits provided business (and households) with a vast new influx of riskless securities for their asset portfolios. Banks hardly ever failed, there were no more runs on banks, and the rate of general business failures was drastically reduced to historic lows. The rate of economic growth under the mixed economy has been as high as or higher under twentieth-century laissez faire. With such enormous vested interests, the powerful business stratum has to be solidly behind continuation of the new firmly established interventionist regime. Although he is not historically oriented in his almost classic work on welfare economics, Baumol (1969:52, 53) has contributed importantly to the theory of the mixed economy's later phase of development and to the explanation for its viability and irreversibility by his attempt to "base an economic theory of the state on an extension of the external economies argument." While this approach loads a great deal onto what he calls the "generalized" concept of externalities, 3 2 a sympathetically broad construction of the term would clearly encompass most of the controversial postwar "defect" phenomena listed earlier. Many of the matters that I have presented as evolving defects of the market in the second phase of the mixed-economy's evolution could easily be translated as socially adverse externalities, net diseconomies, or disutilities. It is well known that, even if the organizational revolution and the insinuation of monopoly elements into the market had never occurred, and even therefore if the market

Perspectives on the U.S. Mixed Economy 47 system had been the atomistically competitive phenomenon so dear to economic orthodoxy, it nevertheless would have had an enormous capacity to generate externalities. And neither competitive theory nor the market in operation was ever concerned to rectify the individual and social disutilities of the skewed distribution of income and wealth. The externalities always existed, like the economic cycle of employment. But the capacity of the market to create net adverse externalities, many of which were devastatingly cumulative, accelerated over time. 33 This acceleration fed in particular upon the combination of population and output growth. Pollution grows exponentially. But of course in the last analysis, a threshold was crossed; the associated defects in the private economy had to be perceived as such by a more aware public before a call for correction through collective action by more government intervention could be sounded. The perception was initially quite disorganized and haphazard, but the associated public ferment and agitation became ever more widespread. Thus the postwar movements demanding antiexternality intervention of one sort or another included ecologists, conservationists, environmentalists, population restrictionists, blacks, women, the elderly, youth, business, farmers, labor, the poor, the state and local governments, the ill, the handicapped, the disabled, the untrained, the unemployed, veterans, and bond holders. This partial list shows that almost everybody had acquired some stake in more intervention. 34 Looked at programmatically and on the federal level alone, three types of civilian programs account for almost nine tenths of the growth in the ratio of domestic civilian expenditures to GNP between the mid-1950s and 1977.35 These were (1) individual payment programs, e.g., retirement, disability, unemployment, and low-income assistance payments to individuals (about two thirds of the growth); (2) physical investment and subsidies, e.g., farm subsidies, interstate highways, water resource projects, space exploration (largely military in purpose), mass transit, environmental control, and energy investment; and (3) social investment and services, e.g., support for health care, education, manpower training, social services, and community development. Also, the inflation-connected rise in interest rates very much increased as a proportion of the GNP and the interest costs of the relatively declining public debt. The deep social roots of these income security and antiexternality programs, and the rising expenditure under them, attest to the enduring character of the interventionist system. For example, note that expenditure growth came largely from extended coverage and new programs affecting many millions. But intervention also succeeded in creating a positive image for

48 Perspectives on the U.S. Mixed Economy itself. It came to be accepted, rightly or wrongly, that the numerous civilian governmental programs could contribute significantly to the correction of perceived economic ills and to the provisions of services neglected or inadequately supplied by the market, particularly the social services. Dampening the economic cycle, the minimum wage, social security, the mitigation of intergroup conflict, money and inkind transfers, and a multitude of other subsidies, direct and indirect, are cases in point. The high degree of public acceptance ultimately achieved by these programs is also demonstrated by the extent to which interventionism has pushed outward the aggregate tax constraint. Who in the 1920s would have dreamed that Americans would tolerate a total tax bill amounting to 31 percent of GNP? Despite Galbraith's proper alarm over the starved public-civilian sector, the secular rise in per capita personal income under the mixed economy has been most favorable for underpinning its continuation: The long-run income elasticity of the supply of tax monies, like the demand for public services, is substantially greater than unity.36 And it has proved more elastic under interventionism than it was under laissez faire. The "extractive capability" of the contemporary politico-economic arrangement has confounded its opponents.37 It was noted above in the discussion of origins that the growth of the public bureaucracy under the mixed system no doubt itself contributed only modestly to fastening that system upon society. It needs to be added, however, that in the United States the whole federalstate-local hierarchy was increasingly mobilized to help accomplish this effect through the institution of large-scale revenue sharing. This gave the state and local governments a growing vested interest in the augmentation of federal revenues, partly transforming the view of such revenues form competing substitute to complement, and it also increased their willingness to spend (Tarschys 1975:25). FUTURE PROSPECTS Certainly economic historians can probably better than most groups assume a responsibility to anticipate the future. Historians above all can wholeheartedly subscribe to the maxim that "what is past is prologue." It is noteworthy that a president of the American Economic Association, in an address critical of the profession,38 strongly recommended that economists concern themselves with such questions as "what combinations of pressures have caused this extension of government intervention; what forces will extend it further, what

Perspectives on the U.S. Mixed Economy 49 forms will such intervention take." I propose to accept this suggestion and deal briefly with some of the future aspects of the mixed economy as I perceive them. I can only sketch in the outlines here. What follows is not, of course, a matter of advocacy but of forecast, based on the tendencies of the earlier parts of this century. There has been much conjecture about whether the enlargement of governments' role has attained its maximum or indeed become overextended. This was a focal point in much of the discussion of the history of the welfare state at the 1978 meetings of the International Economic History Association. For the United States, I think the top panel of table 3.4 is very much worth studying. For example, the percentage increase in the ratios in that panel for the United States was the smallest of all the mixed economies shown, although, to be sure, the U.S. level at the beginning of the period was already comparatively high. While the differences in levels of the ratios of government outlays to GNP among countries in 1976 may well be due in part to conceptual and other differences in the compilation of the statistics, they no doubt chiefly reflect broad differences in the extent of the development of government's role in the economy. But the wide gaps in levels suggest it would be very difficult to determine the optimum or equilibrium level of the ratio for any country over time. This is the essential point. One study of the welfare state employs the distinction between the social security state having a minimum safety net below which no one could fall but above which one must climb on one's own efforts, and the most advanced mixed economy, the social welfare state, in which the full range of human services are available to all as a matter of right, and markets are confined to limited resource allocation functions and the registration of certain consumer preferences (Campbell, December 1978). Thus Sweden approaches the social welfare state and the United States the social security state. There is an enormous gap between the 1976 U.S. ratio of total government outlays to GNP, 32.3 percent, and the average of 41.5 percent for Sweden, the United Kingdom, and Denmark in table 3.4. Hence, it would seem reasonable to conclude, allowing for cultural differences, that the United States in the 1970s had not necessarily reached an equilibrium ratio, although no one could say whether it could muster the social consensus required for an advanced mixed economy on the Swedish, Danish, or U.K. model. In any case, we cannot with confidence conclude that the growth of government has attained its maximum. As indicated earlier, under the mixed economy of the future

50 Perspectives on the U.S. Mixed Economy NNP=C+G as net investment approaches complete atrophy. 39 All G will probably continue to rise moderately relative to C and to N N P as the socialization of material security proceeds (or possibly, the military budget grows relatively). It is the long-run direction in which the economy moved between 1929 and 1968.40 The problems of adjusting to it, as well as public resistance to it, explain, I believe, many of the policy controversies of recent times. Assuming the continued public commitment to high employment growth, the persistence of existing property relationships, and comparative stability of property's income share or of the rate of return on fixed assets, ex ante net savings (especially retained profits) would continue to exceed ex ante net investment, and therefore there would have to be chronic government deficits, unless the entire excess were taxed to finance G plus public transfers. The latter would require a fundamental upheaval in the social balance, an eventuality I am not anticipating here.41 If the latter change were to occur, however, it would be difficult to view the associated institutional arrangements as capitalism in any historically rooted sense, particularly because then retained after-tax business profits would be zero. Property incomes might accrue to private individuals, but the accrual would be an empty shell, for their disposition would be in the hands of the government. As Hale (1976:36) once put it, "what is left of private property if it is stripped of that which primarily gives it meaning to an owner, its income yield?" I think it is therefore much more plausible to envision the forseeable future as a capitalism in which all household saving is social saving (taxed away to finance, e.g., social services) than as a "capitalism" in which all net business saving (retained profits) is socialized. Even if the augmented tax revenues were financing military goods and services, I doubt such a program would be palatably "capitalistic." The implication of all this points to a much-modified capitalistic future with increased planning and further socialization of demand. Such a scenario would seem to be in accord with the worst fears of the ultraconservatives regarding Schumpeter's "march into socialism." However, it would clearly not be socialism, for in such a mixed system incomes accruing to property could still persist, household consumption could remain quasi-private, and business firms would have an alternative to fixed real-asset accumulation in the form of even greater holdings of government obligations than obtains at present.42

Perspectives on the U.S. Mixed Economy 51 But as every economist knows, there are two blades to the Marshallian demand-and-supply scissors. The mixed economy has of necessity already moved, albeit haphazardly, toward the socialization (government planning) of supply, for reasons described under Origins. The farm program; the expanded public utility regulation; the emergence of technology support and assessment by government; the extensive system of subsidies, including investment inducements; the military budget; and federal involvement with manpower, materials, and energy supplies are all prominent illustrations. I would like, however, to focus on something more drastically impending that will also greatly accelerate the trend toward government supply management. I refer to inflation control, or incomes policy. Since high employment policy stimulates both demand-pull and administered price-push inflation, and inflation cannot be counted on to stay within moderate limits, the growth-successful mixed economy faces a well-known dilemma. Alternatively and better put, price-push may be viewed as the expression of an ever more intense and sophisticated jungle warfare between economic blocs, driven in large part by the reality of the money illusion and continually jockeying for stronger relative positions. 43 The monetary authorities are coordinate^ pressured to validate the administered price increases, and this cumulative process, buttressed by the spread of indexing, accelerates the inflation, which in turn exacerbates the jungle warfare. But "the American people will not take a rapid shrinkage of the purchasing power of money complacently at any time in the foreseeable future" (Okun 1975:33). Sooner or later inflation will increase and it will be decided that this warfare, like that between nations, 44 labor and management, farmers and nonfarmers, public utilities and consumers, polluters and environmentalists, will best be transferred to the public arena. Among other aspects of such a course, it is the "civilized" way to handle such conflicts. In the public arena, proposed price increases to try to better one's relative economic position will be subjected to cost-benefit analyses and impact studies—a much more temperate way to conduct the parochial struggle, a procedure that has characterized much of the mixed-economy's history. Indeed, the mixed economy itself may be interpreted as both expression and attempted resolution of intergroup conflict. " A society must become a welfare state to the extent necessary to prevent disintegration and conflict over the question of distributive justice" (Peterson 1960:107). Incomes policy, which even Myrdal (1960:117) has called "a type of particularly obnoxious direct state intervention," means relinquishment of the "freedom" to conduct price warfare privately and

52 Perspectives on the U.S. Mixed Economy the substitution of publicly administered general wage and price controls. However unpalatable, the latter, applied at least to the great administered market sectors, are probably inevitable. In this connection it is significant that in late 1977 two ideologically widely divergent economists of eminence both proposed de facto incomes policies in the guise of nongeneral techniques, Arthur Okun with the carrot of tax relief for price = wage restraint, Henry Wallich with the club of tax penalties for employers who give "excessive" wage (and consequent price) increases (Challenge, November/December 1977:13, 40, 42). The latter acknowledged that his proposal would be a kind of incomes policy. But both plans would require the comprehensive policing of prices, costs, and wages. The adoption of an incomes policy requires governmental intrusion into the hitherto sacrosanct region of price administration, the terms u p o n which more or less of particular goods and services will be supplied. However painful, it must and will come in some form, and as it does it will vastly extend and rationalize the planning of the economy by government. It is indicative of the trend that more and more prominent economists anticipate this eventuality. 4 5 Thus the long-run future trend of the mixed economy promises to be an even richer mixture of the public components. However, Heilbroner (1976), w h o has forecast that "national economic planning will arrive when businessmen demand it, and demand it they will, to save the capitalist system," anticipates that the "remarkable administrative mechan i s m " of the market will be leaned upon heavily in the planned system. 4 6 I think Heilbroner may be trying to sweeten painful forthcoming developments, making the process of "creeping planning" more acceptable. Or, more graciously put, he may be said to be referring to the "transition" to more extensive economic and social planning. On the other hand, the mixed a r r a n g e m e n t s will no doubt rely to some extent upon market-type signaling devices, less "heavily" t h a n Heilbroner anticipates. The full truth about the future shape of the mixed economy probably would be quite unacceptable to the social consensus of the first half century of interventionism. But m u c h of the mixed-economy pattern, especially after the New Deal, evolved in bits and pieces, a piecemeal process that m a d e extension of intervention unsteady and faltering but acceptable. Currently, the internationally lagging United States is in the process of working out one m a j o r piece in the health field. The New Dealer Gardiner Means (March 1969:31), sire of the theory of administered pricing, has also cautiously outlined the contours of the forthcoming transition period:

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53

I envisage a system in which fine tuning of aggregate demand, principally through monetary policy, will remain a high level of employment of both men and machine; in which administrative inflation will be under practical control through advisory planning, wage-price guidelines and perhaps specific controls for strategic commodities; in which an external balance of payments will be maintained through exchange rates which are relatively fixed for short periods of time, but gradually change to correct fundamental imbalances; in which business decisions (as well as those of government) on the allocation of resources will be brought into closer relation to the public interest through advisory planning and clarification of what constitutes economic performance; and a complete system of government measures to support incomes of the disadvantaged at an acceptable minimum level, while above this level inequities are kept to a minimum through better operation of the economy and through the continued use of taxation. In any case, the so-called dilemma of stagflation will thus be resolved, even though that resolution may well bring more prominently to the forefront what has already clearly become the central political problem of the twentieth c e n t u r y — h o w to keep growing bureaucracies democratic. The deeper penetration of the state into the sphere of supply w i l l not mean the end of demand management, which some, confronting the stagflation dilemma, have heralded as the end of the age of Keynes. Demand management to ensure the adequate growth rate of aggregate demand will be absolutely necessary for the reasons stated previously. The failure of the more or less discretionary demand management to ensure high employment growth without excessive inflation in the past is the end of the age of Keynes only in the sense that demand management assumed prices were competitively determined and lived with private net business fixed investment that was deceptively still moderately above zero. Furthermore, Keynes and most of his followers did not perceive the approach of zero net investment and therefore did not realize that this meant the virtual end of certain vital aspects of capitalism as w e have known it. 47 Also, the forthcoming phase of much more nearly comprehensive supply management will raise the levels of intervention to a point that without doubt would have undermined Keynes' comfortable belief that execution of his policies would still leave " a wide field for the exercise of private initiative and responsibility. . . preserving efficiency and f r e e d o m "

54 Perspectives on the U.S. M ixed Economy (1936:378, 380-381). And by w a y of coda, this anticipated evolution will certainly bring the end of the simplistic "neoclassical synthesis" of academic economics. It follows that it is extremely unlikely that the Keynesianism of more or less discretionary demand management and chronic deficits is dead. As Worswick (January 1977:12) has emphasized, the mixed economy for the foreseeable future will still have to earmark demand management to keep down unemployment. It is simply not sufficient, however; indeed it is perverse, if used alone, for controlling inflation. Hence, Worswick draws the same conclusion, without d r a w i n g out the enlarged planning implications presented here, that " s o m e form of incomes policy is needed as a permanent support to demand management in maintaining full employment." W h a t is " n e e d e d " will undoubtedly be affected. But the resultant will gradually bring the protracted first phase of the mixed economy to an end and introduce a new phase marked by comprehensive supply management and its coordination with continued demand management.

NOTES 1. Some of the major relevant economic changes in the gestation years of the European mixed economies are well presented and analyzed in I. Svennilson, Growth and Stagnation in the European Economy (Geneva: United Nations Economic Commission for Europe, 1954). 2. The phrase is from R. Titmuss, Commitment to Welfare (New York: Pantheon, 1968), p. 154. 3. J. J. Spengler, "The State and Economic Growth: Summary and Interpretation," in H. G. J. Aitken, ed., The State and Economic Growth (New York: Social Science Research Council, 1959), p. 355. Here "autonomous" means resource disposal decisions by nonpolitical agencies. 4. This insightful phrase is apparently that of A. V. Dicey, referred to in Titmuss, Commitment to Welfare, p. 189. 5. Very little spending in private, in the traditional sense, under the mixed economy; practically all spending is affected directly, or a step removed, by the public budget. Both public transfers to persons and public payrolls have bolstered the officially reported personal consumption expenditures. The mixed economy vastly accelerated the liquidation of the public-private dichotomy. Hence the rebirth of "political economy." 6. This is not quite differentiating in the U.S. case, because prices rose under laissez faire after 1896. But then, the rise is cyclically immune under the mixed system: inflation exhibits a ratchet pattern, and the causes may well be at least partly new. 7. Fabricant's estimates for all federal outlays, including military, when related to Kendrick's GNP estimates, both in current dollars, show the following percentages for the former's selected years: 1900, 2.8; 1903, 2.6; 1913,

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55

2.4; 1923, 2.9; 1929, 2.8. For 1939 the percentage is 9.8, and for 1949 it is 14.0. J. W. Kendrick, Productivity Trends in the United States (Princeton, N_J.: Princeton University Press, 1961), pp. 296, 297; S. Fabricant, The Trend of Government Activity in the United States since 1900 (New York: National Bureau of Economic Research, 1952), pp. 242-243; and U.S. Department of Commerce, Long-Term Economic Growth, 1860-1970 (Washington, D.C.; GPO, June 1973), Series A7, pp. 182, 183. 8. It was Adolph Wagner's hypothesis that as per capita income increases over the long run in modern industrial economies, the public sector will grow as a proportion of total economic activity. 9. Although the low levels of the omitted 1930s were indicative of the longrun trend, they were not typical of it. 10. Some of this public consumption included, of course, producers' goods in the generic sense. There is no need to enter into this classification controversy here. 11. The interpretation presented here, that the 1930s exhibited a discontinuity in the evolution of government's role, violates the gradualist interpretation of the process as represented in Wagner's Law. For a competent explication of the gradualist view of the U.S. experience, see F. C. Mosher and O. F. Poland, The Costs of American Governments (New York: Dodd, Mead, 1964), p. 23. These writers' bias shows in their selection of the three years, 1927, 1932, and 1938, for portraying the "peacetime" secular rise in public expenditures. The year 1932, they grant, is "somewhat deceiving." By using it as a terminal and initial year for calculating trends, they get, for example, public outlays rising at 3.8 percent per year over 1902-1932, and 4.4 percent over 19321962, and decide the former rate was "very nearly as high" as the latter (p. 23). However, in a footnote on the same page they call attention to the much greater rate discrepancy if 1927 is chosen: 3.3 vs. 4.7 percent. I obviously prefer this, since I employ the contrast: Laissez faire vs. mixed economy. In fairness to Mosher and Poland, note that they aver, in their last chapter, "There can be no doubt that the role and responsibilities of governments in the United States have changed fundamentally since the 1920s" (p. 147). 12. Cyclical changes influence the level of government spending, whether the economy be in high gear or contraction. Adjustments are made, however, in the Schultze technique only for outlays to counter recession, and I also embrace this defect. 13. For example, ail real S&L transfers, using the GNP deflator, rose from 10 percent of real S&L outlays (table 3.1) in 1955 to 15.7 percent in 1977, a 57 percent increase. But using the S&L deflator yields S&L transfers that are 12.7 percent of real S&L outlays in 1955 and 14.9 percent in 1977, a mere 17 percent rise. 14. See Fabricant, Trend of Government Activity, appendix B, for government employment. 15. This is consistent with the comparative constancy of federal civilian purchases of goods and services after World War II. 16. Except for state nonschool employees.

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17. Reagan classifies the explanations for "expanding governmental activity" under the headings circumstantial development (e.g., industrialization, urbanization), increased knowledge of how the economy functions, and changing community values. M. Reagan, The Managed Economy (London: Oxford University Press, 1963), p. 161. On my interpretation of his discussion he, unlike Tarschys and I, tends to neglect organizational and institutional changes in this classification. His changing community values corresponds roughly, I think, to my public preference functions (and Tarschy's ideological-cognitive level). I tend to denigrate the power of increased knowledge; while no doubt an influence, I think Reagan much overemphasizes it. However, Reagan's discussion of the influence of the Great Depression, particularly his asserted link between it and income protection programs, is close to my discontinuity emphasis. 18. Economic orthodoxy denies even today that it was in significant part a result of long-run, evolutionary changes. 19. Reagan's treatment of these developments is impressive (The Managed Economy, pp. 165-168, passim). 20. There is much evidence of this trend. Perhaps one set of estimates by Kuznets will suffice here. S. Kuznets, Capital in the American Economy (Princeton, N.J.: Princeton University Press, 1961), pp. 96, 97, table 9. He concludes, on the basis of decadal averages, that the share of total net capital formation in NNP peaked at 13.2 percent in the decade 1889-1898, fell to 10.7 percent in the "boom" of the 1920s, and dropped again drastically to 6.0 percent in the decade 1946-1955. 21. See A. Maddison, Economic Growth in the West (New York: Twentieth Century Fund, 1964), pp. 19-20, 81-82; and E. F. Denison, Why Growth Rates Differ (Washington, D.C.: Brookings Institution, 1967), p. 170, tables 12, 13. 22. And a relative decline in C. I assume consumption in the long run is a function of income. I use a closed economy model for simplicity. Housing construction is by implication included under C, and inventory investment ignored. There is an earlier attempt at elaboration of this thesis in H. Vatter, "Capitalism without Accumulation," Journal of Economic Issues (March 1969), 3(1):I10-125. 23. I use the terms "failure," "defect," and "flaw" interchangeably to include not only failures often referred to by welfare economists, that obtain even in a stationary, perfectly competitive, errorless market system, but "real world" failures. See F. M. Bator, "The Anatomy of Market Failure," Quarterly Journal of Economics (August 1958), 72(3):351-352. 24. On this point, see the stimulating discussion in Challenge (November/ December 1977), "The Great Stagflation Swamp," 20(5):6-13. 25. But there is no point in reasoning that large government spending discouraged or crowded out private investment, for the actual average amount invested by business installed all the long-run capacity that a customary GNP growth rate of 3.6 percent per year could tolerate without generating a depressing excess. Can anyone imagine substantial substitution of investment in productive capacity for a larger portion of the military budget? Who would

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buy the output of the increased capacity if it were operated at standard rates? "Investment for further investment" will not do, for capacity always rises faster than the increase in value of the net stock. 26. P. Samuelson, Economics, 10th ed. (New York: McGraw-Hill, 1976), p. 867. In the eighth edition, Samuelson had said "permanently changed" instead of "never again the same" (p. 818). 27. See note 40 showing all G as a percentage of GNP for selected years, 1929-1978. 28. We are all aware, of course, that strictly speaking, there is no homogeneous "public." Indeed, my emphasis is on its heterogeneity. When the term is used here it is a handy proxy for the significant, relevant sectors of the involved public. 29. G. Means' initial projection of the administered price concept was in a report to the Secretary of Agriculture, "Industrial Prices and Their Relative Flexibility," 74th Cong., 1st Sess., Sen Doc. No. 13, 1935. See also, more recently G. Means, "Inflation and Unemployment," in J. Blair, ed., The Roots of Inflation (New York: B. Franklin, 1975), pp. 1-15. 30. The relevance-rigor contrast is the refreshing central theme of Gordon's presidential address at the December 1975 meetings of the American Economic Association. R. A. Gordon, "Rigor and Relevance in a Changing Institutional Setting," American Economic Review (March 1976), 66(1): 1-14. 31. After-tax corporate profits were taken from U.S. Department of Commerce, The National Income and Product Accounts of the United States, 1929— 74 (Washington, D.C.: GPO, 1977), pp. 250-251, table 6.21, line 1. Net stocks of fixed nonresidential capital were taken from J. C. Musgrave, "Fixed Nonresidential Business and Residential Capital in the United States, 1925-75," Survey of Current Business (April 1976), p. 47, table 2. All data were in current dollars. Aid in the selection of years, i.e., 1950-1952, 1955, 1956, 1959, 1962, 1963, 1965-1968, 1973, was derived from the Conference Board (March 1978). 32. For example, many of us would hesitate to subsume income distribution and unemployment under externalities (Baumol refers to diseconomies). 33. Baumol notes, for example, the cumulatively dysfunctional and costly process of urban blight leading to the middle-class flight to the suburbs. This passage contains the lapidary phrase "deterioration . . . feeding remorselessly upon itself." W. J. Baumol, Welfare Economics and the Theory of the State (Cambridge, Mass.: Harvard University Press, 1969), pp. 37-38. 34. A somewhat unusually frank expression of vested interest was the statement by Syracuse mayor Lee Alexander, president of the U.S. Conference of Mayors, on January 25, 1978: "You cannot develop a national urban policy while cutting back on the federal government's share of the GNP. You have to spend more money. . . . Mayors all over the country are alarmed. If the president adheres to this policy we will not have full employment, we will not have national health insurance." The reference was to President Carter's fiscal

58

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1979 budget of one-half trillion dollars. Reported in the Portland Oregonian, J a n u a r y 26, 1978; AP dispatch by J o n a t h a n Wolman. 35. For the immediately following I rely heavily upon Owen and Schultze. H. Owen a n d C. L. Schultze, eds., Setting National Priorities: The Next Ten Years (Washington, D.C.: Brookings Institution, 1976), pp. 334-346. 36. See, e.g., D. Tarschys, "The Growth of Public Expenditures: Nine Modes of Explanation," Scandinavian Political Studies (October 1975), p. 24. 37. While I a m not addressing myself here to the distributive aspects of the total tax system, it may be noted that in the United States at least there a p p e a r s to have been a drift toward increasing regressivity. The federal tax system, formerly the stronghold of progressivity in an otherwise regressive structure, moved after World War II more a n d more toward reliance on the regressive social security tax a n d away from the corporate income tax as proportionate sources of total tax revenues. 38. Gordon, "Rigor and Relevance," p. 12. Some economists have, of course, dealt with these questions. There is a high-quality treatment in Reagan, The Managed Economy, which has a long section on "The Political Economy of the Future." But the discussion therein is of the nature of recommendations, not forecasts. 39. This limiting case ignores the possibility of negative net fixed investment, but such a model could easily be worked into the one being projected here. 40. All G (excluding transfers) as a percentage of actual GNP grew as follows.

1929 1939 1949 1955 1960 1965 1968 1970 1975 1977 1978

Current Dollars

1972 Dollars

8.5 14.9 14.9 18.8 19.8 20.1 22.9 22.3 22.1 20.9 20.6

13.0 19.7 19.6 23.0 23.5 22.6 24.6 23.3 21.8 20.2 19.9

It will be noted that policy moved in the direction of a shift away from G after 1968. It is difficult to believe that GNP growth could be sustained under such conditions. In any case, the shift entailed an accompanying shift u p w a r d in the comparative importance of personal " p r i v a t e " consumption expenditures. It will be recalled I have noted that a basic policy of the U.S. mixed economy has been to underwrite such consumption by rapidly rising federal public transfers to persons. The shifting balance between C and G was strongly against C until 1968. But transfers apparently could make C a dynamic expansion stimulus for a time.

Perspectives

on the U.S. Mixed Economy

59

41. As is well known, a balanced budget expansion in net national product, as envisioned here, would for a single country acting alone produce a disequilibrating deterioration in its balance of payments that could frustrate its attempt to increase total product in this manner. The reason is that imports would rise more than exports for the one country. The international planning implication, or requirement, is clear. Since for the world as a whole there is no "imports minus exports" term, in the macro equations of each and every country this term in effect drops out because with, and only with, the same planning policy everywhere exports would rise equally with imports for all. (For a discussion see W . Eltis, " T h e Failure of the Keynesian Conventional W i s d o m , " Lloyds Bank Review [October 1976], 122, pp. 1 - 8 , but especially p. 7). International planning will have to be developed to make national planning successful. Recognition of this is acknowledged in the many new international agencies (planning always begins with money—e.g., the I M F ) created after World War II. The following would have been an unthinkable assertion a half-century ago: " T h e (Carter) administration's view is that none of the capitalist world's major trading nations . . . has a right to accumulate a large current-accounts surplus" (Associated Press, reported in the Portland Oregonian, December 12, 1977). The necessity for an internationally planned mixed economy has become widely acknowledged. For example, the Brookings Bulletin (1976), 13(1):7, in reviewing The World Economy in Transition, a tripartite report by seventeen economists from the European Community, Japan, and North America (September 1975), comments and quotes as follows: "Economic interdependence demands closer coordination in the management of domestic policies. 'There will be no general expansion if each country remains passive and waits for expansion in other countries to provide an export-led recovery for themselves. Moreover, once a strong upswing is on the way, governments may have to coordinate policies so as to avoid the excesses of another uncontrolled boom like that of 1972-73.' " I am accepting the premise of President Paul A. Volcker of the Federal Reserve Bank of N e w York ( F R B N Y ) that "the underlying pressures toward integration and interdependence (in the world economy) are growing stronger, not w e a k e r " ( F R B N Y , Quarterly Review, Winter 1978-1979, p. 2). However troublesome the effort, the world is moving toward a new international economic order of some sort. W e should not expect to see such a novel pattern of management emerge quickly or without great frictions and tensions. 42. In the 1970s West German investors were pouring funds into the U.S. economy, apparently because they believed it to be a haven, not only of profitability, but of long-run stability. The New York Times feature writer John Vinocur, after studying German investor attitudes with respect to this capital export flow, pointed out that these investors viewed the United States as "an arch-conservative country, committed to a kind of Darwinistic capitalism that will protect private enterprise to the last cartridge" (Portland Oregonian, January 22, 1978, p. A15). 43. For a penetrating presentation of this view of the inflationary process, see M. Panic, " T h e Inevitable Inflation," Lloyds Bank Review (July 1976), 121:1-15. Myrdal has argued persuasively that in this struggle persons acting

60 Perspectives on the U.S. Mixed

Economy

as producers are typically more powerful than persons acting as consumers, and this is today the accepted view in the theory of choice. G. Myrdal, Beyond the Welfare State (New Haven, Conn.: Yale University Press, 1960), pp. 114— 117, passim. 44. In his keynote speech before the December 1977 AFL-CIO National Convention, President George Meany termed foreign trade "a guerilla warfare of economics," and his protective proposals bore him out (Associated Press dispatch in Portland Oregonian, December 9, 1977, p. A8). 45. See, e.g., Nobel Laureate Wassily Leontieff, "National Economic Planning: Methods and Problems," Challenge (July/August 1976). 46. I cannot discuss here the character and techniques of future planning. Most of us would no doubt hope, with Reagan, that it would in general take the form of inducements rather than directives. See Reagan, The Managed Economy, p. 252. 47. See the insightful discussion of this interpretation by Hale. E. E. Hale, "Some Implications of Keynes' General Theory of Employment, Interest and Money," Review of Radical Political Economics (1976), 8(4):35-37, passim.

REFERENCES Balogh, T. "Review of John Kenneth Galbraith's Age of Uncertainty." Journal of Economic Literature (September 1977), 15(3):934. Blair, J., ed. The Roots of Inflation. New York: B. Franklin, 1975. Campbell, G. R. "Review of N. Furniss and T. Tilton, The Case for the Welfare State." Journal of Economic Issues (December 1978), 12(4):958-960. Friedman, M. "Adam Smith's Relevance for Today." Challenge (March/April 1977), p. 6. Heilbroner, R. "The American Plan." New York Times Magazine (January 25, 1976), p. 40. Hoover, C. B. The Economy, Liberty and the State. New York: Doubleday, 1961. Keynes, J. M. The General Theory of Employment, Interest and Money. London: Macmillan & Co., 1936. Keynes, J. M. "The End of Laissez-faire." In Keynes, J. M., Essays in Persuasion. London: Rupert Hart-Davis, 1952. Kuznets, S. Modern Economic Growth. New Haven, Conn.: Yale University Press, 1966. Lieberman, S. The Growth of European Mixed Economies. New York: Schenkman-Wiley, 1977. Meade, J. E. The Intelligent Radical's Guide to Economic Policy. London: Allen & Unwin, 1975. Means, G. C. "The Problems and Prospects of Collective Capitalism." Journal of Economic Issues (March 1969) 3(1):31. Okun, A. M. "What's Wrong with the U.S. Economy? Diagnosis and Prescription." Economics and Business (1975), 15(2):33.

Perspectives

on the U.S. Mixed Economy

61

Peterson, W. C. The Welfare State in France. Lincoln: University of Nebraska press, 1960. Schultze, C. L. "Federal Spending: Past, Present, and Future." In H. Owen and C. L. Schultze, eds., Setting National Priorities. Studenski, P., and H. E. Krooss. Financial History of the United States. New York: McGraw-Hill, 1963. Tax Foundation. Facts and Figures on Government Finance. New York: Tax Foundation, 1975. United Nations. Yearbook of National Accounts Statistics, 1977, vol. 1. New York: United Nations, 1978. U.S. Council of Economic Advisers. Economic Report of the President. Washington, D.C.: GPO, various editions. U.S. Department of Commerce. Historical Statistics of the United States, Colonial Times to 1970, parts 1 and 2. Washington, D.C.: GPO, 1975. U.S. Department of Commerce. Statistical Abstract of the United States. Washington, D.C.: GPO, various editions. Worswick, G. D. N. "The End of Demand Management?" Lloyds Bank Review (1977), 123:12.

CHAPTER 4

Budget Deficits and the Quality of Presidential Administrations: 1789—1960 JOHN F. WALKER

In recent months thirty American state legislatures have passed resolutions calling for a constitutional convention to meet and amend the Constitution to require annually balanced federal budgets. Committees of the Congress are considering referring such an amendment directly to the legislatures. At least part of the pressure on Congress is the threat of a constitutional convention. Many federal-level politicians think that the economic losses involved in annually balanced budgets are not as great as the political, social, and civil rights losses that a new constitutional convention would impose on the country.1 Economists have not paid any serious attention to the criteria of an annually balanced budget since the Keynesian revolution. The most nearly complete statement of the role of the budget in a Keynesian system is in Lerner's Economics of Control:2 The only reason for abiding by any principle of balancing the budget is that there is a strong prejudice in favor of such a procedure on the part of businessmen who think of the government as a business just like their own and on the part of a large section of the population in a capitalist society in whom the businessmen have been able to instill their own ideology. In a controlled economy, where a great part or even the greater part of the economy is run by businessmen, these prejudices are important and should be respected if possible. They are not more important than maintaining full employment or achieving the optimum use of resources or preventing inflation, and these objectives cannot be sacrificed to the businessman's feeling that the government should abide by "sound business principles." Reprinted with permission from Western Tax Review (January 1981), pp. 132-141.

62

Budget Deficits and Presidential Administrations

63

But if there is any way in which the budget can be balanced without giving up full employment and the optimum use of resources and without incurring inflation, it should be given the fullest consideration. The most intense post-Keynesian debate on the effect of budget deficits is the argument touched off by Buchanan, 3 who argued that the burden of the debt could be transferred to future generations. Many journal articles ensued, agreeing, disagreeing, correcting, and amending. Most participants in the argument agreed it was relevant only for the case of a fully employed, that is, non-Keynesian economy. 4 Those who agree that debt burdens can exist and be transferred to future generations have developed a set of criteria to judge whether such a burden creation and transfer is good or not. Debt finance of government creates a burden principally if the project financed produces a future income stream that is less than the income stream that we would get from leaving the resources in private hands or taking them through taxes. That is, to know whether debt finance has burdened the system we need to know what public projects the debt financed, what private projects the debt replaced, and their relative social productivities. There is little evidence on this question so there is little evidence on burden from debt. We seem to have a system where the politicians are willing to make substantial political sacrifices to establish an economic principle that the economists do not take seriously. In this chapter I show that the principle of the balanced budget is no more politically useful than it is economically useful. One of the principal problems for economists studying the government is the lack of a normative theory of government. The traditional microeconomic general equilibrium is generated first by assuming there is no government. Then adding a government that enforces property rights and contracts and manipulates lump-sum taxes and bounties forces all relevant functions to have a proper slope. 5 We have no idea how to implement or measure most of the things welfare economics demands. The Keynesians have provided a simple measurable set of public goals: full employment and high output. But they have not successfully wrestled with the welfare economists' observation that some full employment points are better than other full employment points, and output is higher in some cases of unemployment than in certain cases of full employment. All of this is even more obscure in the world of the second best. So what is good government? Economic theory has

64 Budget Deficits and Presidential

Administrations

never been clear on that point. I take a simplistic delphic approach to that question. I a s s u m e that good government has occurred in the United States in those periods when eminent American historians say we have had high-quality presidents in office. Arthur M. Schlesinger, Sr., twice published the results of surveys of prominent historians on the quality of American presidents. 6 The first survey, published in 1949, and the second, in 1962, are nearly identical in the rank order of presidents. I use Schlesinger's presidential ranking as a proxy for the quality of government, in the terms of the various presidents. Schlesinger's 1962 rankings are: Great: Near Great:

Average:

Below Average:

Failure:

1. Lincoln 4. Wilson

2. Washington 5. Jefferson

6. Jackson 9. T r u m a n

7. T. Roosevelt 10. J. Adams

8. Polk 11. Cleveland

13. 16. 19. 22.

14. 17. 20. 23.

12. 15. 18. 21.

Madison McKinley Monroe Arthur

J. Q. Adams Taft Hoover Eisenhower

24. Taylor 27. Coolidge

25. Tyler 28. Pierce

30. Grant

31. Harding

3. F. D. Roosevelt

Hayes Van Buren B. Harrison A. Johnson

26. Fillmore 29. Buchanan

Unfortunately, Schlesinger never explains how the ballots were written or how the votes were converted to numerical rankings. He does explain that W. H. Harrison and J. A. Garfield were omitted because neither served long enough to affect anything. The word budget has so many different meanings in economics, politics, and society generally that it would be remarkable if any two people were to use the word the same way. When one is crossing discipline lines, as from economics to politics, confusion is most likely. In American law the budget has meant the proposal of the president to the Congress submitted every January. But the government has also reported quarterly the actual annual rates of taxing, spending, and borrowing on both an accrual and a receipt and disbursement basis. These are called budget figures. It is never the case that w h a t the government is doing is the same as what the president proposed months or years earlier.

Budget Deficits and Presidential Administrations

65

I refer to the actual taxing, spending, a n d borrowing of the U.S. government for each calendar year from 1791 to 1841 as the budget for that year and the actual taxing, spending, and borrowing for each fiscal year from 1842 to 1960 as the budget for that year. For 1789-90 the data are biennial. These data are reported in the Historical Statistics of the United States.1 Budgeting was actually adopted by the United States in 1922. Budgets for earlier years are the invention of modern minds. The modern sense of a budget as a proposed plan of taxing, borrowing, and spending presented by a chief executive to a legislature first appears in England in 1820. So to refer to the American budget of 1795 is to use ideas of public behavior that were unknown then. The actual budget behavior of the United States government is never controlled exclusively by the president. It is jointly controlled by the president and the Congress. This presents a dating problem. Since 1842 the United States has used a fiscal year. From 1842 through 1960 fiscal years ended on June 30. But from 1842 until 1933 presidents took office on March 4. There was no way that President Grover Cleveland, who was sworn in on March 4, 1885, could affect the budget for fiscal 1885, which ended 118 days after inauguration. So I assume a president is responsible for the budget the year he leaves office and not responsible for the budget the year he takes office. 8 This assumption holds from the Jefferson administration forward. Under Washington a n d Adams the Congress had gone into session shortly after the new president's inauguration. But Jefferson took office March 4, 1801. Obviously Jefferson could not affect the taxing, spending, and borrowing of 1801. It must have followed the p a t h set by John Adams and his Congress a year earlier. This peculiar p a t t e r n , where the new Congress does not convene until thirteen months after their election, continued until 1837, when they began to have short congressional sessions in the fall and long ones from January to about May. Consequently, I can say that the American presidents have never been able to affect what I call the budget for at least a year after taking office. Although the early presidents could not have used the (as yet) uninvented idea of a national budget, they did have the idea of an offbudget transaction. The Louisiana Purchase was financed by a special debt issue. Those bonds were issued in a period when the Historical Statistics of the United States show continuous a n n u a l surpluses. But the surpluses were not large enough to cover the bonds issued. 9 I have no idea w h e t h e r there are other cases of large off-budget debt transactions or not.

66 Budget Deficits and Presidential

Administrations

I have contrasted the historians' rankings of the presidents to the budget behavior for the years the presidents could have influenced. Since different presidents affected different periods, varying from twelve years for Franklin Roosevelt to one year for Zachary Taylor, a simple contrast of number of deficits to rank is misleading. So I have averaged the percentage of budgets a president could affect that were deficits to the historians' ranking of the presidents. The scatter appears as figure 4.1. A simple linear regression of the points gets Rank = 2 0 . 0 7 - 11.13 (percentage of budgets in deficit) R 2 = .1747 Not surprisingly, budget behavior explains very little of the ranking or status of presidents. Figure 4.1 shows that deficits are somewhat more prevalent in the budgets of better presidents and less prevalent in the budgets of poorer presidents. The pattern is: Figure 4.1

30"-

25 I

20 f C a)

CE

•

15 -

•

10

_i

20

i

40

i

60

i

80

Percent of a president's budgets in deficit

T

100

Budget Deficits and Presidential Administrations

% of Budgets in Deficit

Great

Near Great

Average

Below Average

Failure

.38

.60

.63

.71

1.00

67

There seems to be a slight positive association between quality of president and proportion of his budgets in deficit. Even more striking is to look at the presidents who consistently balanced their budgets. Their names and ranks are: % of Class J . Q. Adams R. B. Hayes B. Harrison C. A. Arthur A. Johnson Z. Taylor M. Fillmore C. Coolidge F. Pierce U. S . Grant W. G. Harding

13 14 20 21 23 24 26 27 28 30 31

Average

42%

Below Average

66%

Failures

100%

The rule of an annually balanced budget in all times except special crises is an excellent selector of the very worst in presidents. It is, of course, the rule that many politicians now espouse. It may be that politicians see balanced budgets as one of the criteria people use in deciding whether to reelect an incumbent president. But again the data do not support the hypothesis. F r o m 1789 through 1956 there were twenty-one presidential elections in which an incumbent tried to succeed himself. In fifteen cases the incumbent was reelected. Of the fifteen successful incumbents, only three (20 percent) — J a c k s o n , Coolidge, and G r a n t — w e r e consistent budget balancers in their first term. (It is four if Jefferson's financing of the Louisiana Purchase is ignored.) However, of the six unsuccessful incumbents, two (33 p e r c e n t ) — J . Q. Adams and Cleveland—were consistent budget balancers. Obviously annually balanced budgets have not been the royal road to reelection for incumbent presidents. Why politicians think annually balanced budgets are good I do not know. I have, however, shown that annually balanced budgets do not select for either good presidents or successful, that is, reelectable presidents. In my survey of federal budget deficits several points b e c a m e clear that are often denied by popular commentators on the budget.

68 Budget Deficits and Presidential Administrations First, deficits are common through American history. They occur under liberals and conservatives, good presidents and bad, and deficits are becoming more prevalent.

Budget Years 1792-1824 1825-1865 1866-1893 1894-1930 1931-1976 Total

No. of Budgets

No. of Deficits

Deficits/ No. of Budgets

33 41 28 37 46

12 17 0 17 38

.364 .415 .000 .459 .826

185

84

.454

There is one long period of consistently balanced budgets—the post—Civil War conservative Republican era. Except for the postCivil War period and the current one, about 40-50 percent of the budgets have been deficits, which is also the proportion of deficits in the total. Clearly the Depression of the 1930s and the post-Keynesian era have experienced a much higher proportion of deficits. Average (Deficit!Expenditure) * 12 17 0 17 16 22

deficit deficit deficit deficit deficit deficit

years years years years years years

between between between between between between

1792 1825 1866 1894 1931 1947

and and and and and and

1824 1865 1893 1930 1946 1976

.296 .408 .000 .171 .442 .066

' T h e s e averages are calculated by taking the ratio of each year's deficit to that year's total federal expenditures. Then the ratios are averaged. This avoids the problem that the larger annual budgets of later years w o u l d dominate the computation if total deficits w e r e divided by total expenditures.

Another change in the pattern of deficits occurred with the end of the Second World War. Deficits, although less prevalent in earlier eras, financed a larger proportion of total federal spending in those years when they were used than they have since World War II. It is often argued that we need a restriction on deficits to achieve a restriction on federal spending. Since modern deficits finance only a small proportion of modern spending, deficit limits will have little or no effect on the level of federal spending. However, if Jefferson had

Budget Deficits and Presidential

Administrations

69

faced a deficit limit he quite possibly could not have purchased Louisiana.

CONCLUSIONS

The " d i s c i p l i n e " of an annually balanced budget, although popular in public discussion, is not a part of American fiscal history. If the rule is used to evaluate presidential administrations after the fact, we find that those presidents w h o were consistent budget balancers were inferior presidents. Deficits have been common in most periods of American history and have become more common since 1931. But since the Second World War, deficits have made up only a small fraction of federal revenues in deficit years, whereas they made up a substantial fraction of total federal revenues in deficit years before the war. Finally, most economists have agreed that deficits in periods of unemployment are not a serious threat to the economy. And where deficits do pose a problem, it is usually because of the use of the revenue, not how it is raised. This we have not managed to teach the politicians, so they continue to impose their idea of what our ideas are on us, to the peril of both groups.

NOTES 1. Lee Byrd, "Panel Backs Constitutional Amendment for Balanced Budget," Oregonian (December 20, 1979), p. A10. 2. Abba Lerner, Economics of Control, (New York: Macmillan, 1944), p. 319. 3. James M. Buchanan, Public Principles of Public Debt, (Homewood, 111.: Richard D. Irwin, 1958). 4. James Tobin, "The Burden of the Public Debt: A Review Article," Journal of Finance (December 1965,), pp. 679-683. 5. J. de V. Graaff, Theoretical Welfare Economics (Cambridge, England: Cambridge University Press, 1963). 6. Arthur M. Schlesinger, Sr., Paths to the Present (New York: Macmillan, 1949); Arthur M. Schlesinger, Sr., "Our Presidents and Rating by Seventy-five Historians," New York Times Magazine (July 29, 1962), pp. 12-14. 7. Historical Statistics of the United States, Part 2 (Washington, D.C.: U.S. Department of Commerce, 1975). 8. United States Statutes at Large, vol. 16 (Boston: Charles C. Little and Brown, 1845-1848). 9. Harvey E. Fisk, Our Public Debt (New York: Bankers Trust Company, 1919), pp. 8-14.

CHAPTER 5A

The Princess and the Pea; or the Alleged Vietnam War Origins of the Current Inflation J O H N F. W A L K E R H A R O L D G. VATTER

The Report of the Council of Economic Advisers for 1981 says, "The first jump in the underlying inflation rate came during the Vietnam War, when a large rise in both military expenditures and outlays for Great Society programs was financed for several years without a tax increase. This led to a very large federal budget deficit superimposed on an economy operating at a high level. The result was a classic example of excess demand over excess supply." 1 Nearly identical arguments can be found in the writings of economists of many different perspectives, including the monetarist Raburn Williams, the Keynesian Arthur Okun, and the eclectic Paul Samuelson.2 We argue that most of the facts asserted in the conventional wisdom regarding the alleged Vietnam War origins of the current inflationary period are wrong. During the period of escalation taxes rose, spending on other federal programs fell, and changes in Federal Reserve holdings of federal debt were about the same as those of the years immediately before the escalation. Several important points about the escalation are ignored by most commentators on the war origins of the inflation. They include: that the escalation was of short duration, that it was of small magnitude, and that there is no statistically valid evidence of inflation during the period of the escalation. We measure economic escalation as increases in the percentage of gross national product (GNP) going to defense. This is roughly consistent with the conventional wisdom " I f more guns, then less butter," or "Inflation when at full employment," implied in the citation above. Reprinted from Journal of Economic Issues (June 1982), pp. 597-607, by special permission of the copyright holder, the Association for Evolutionary Economics.

70

Alleged Vietnam War Origins of the Current Inflation 71 By this measure the escalation was confined to the two calendar years 1966 and 1967 when calendar year data are used, or the seven quarters 1965jv to 1967 ii when using quarterly data. During most of the years of the war, defense as a proportion of our available production was declining. The first combat casualty was in December 1962.3 That year defense was 9.1 percent of GNP; it then fell steadily until 1965 when it was 7.2 percent of GNP. Then it rose to this historically low level (in a Cold War sense) of 9 percent in 1967. From 1967 to the end of combat in 1973, defense as a percent of GNP fell continuously until it reached 5.6 percent. We ended the war with defense taking about the same share of our output that it had taken in the years before the Korean War but much less than at any time since 1951. In any long-run sense the Vietnam War period was a period of deescalation in the share of American output going to the military. Did this tiny escalation in the midst of a secular deescalation cause an inflation that lasted longer than any other postwar inflation in U.S. history? If so, it could not have been measured during the period the escalation occurred. Armen Alchian and William Allen have observed: The U.S. Bureau of Labor Statistics each month publishes a Consumer Price Index as an approximation to the cost of living of the ordinary middle income family. . . . Because of sampling, quality changes, purchase-pattern shifts, to name a few factors, the index is an approximation. Yet a change of over two to four percent in one year in that index could occur only if there really were a change in the general cost of living; this leeway of 2 or 3 percent reflects the margin of error of range of effects of fluctuations of the other pertinent elements. 4 This point is reinforced by Triplett's recent measurements of sources of error in the price index. 5 He found that different measurements of housing costs alone changed the annual inflation rate for 1980 by 2.3 percentage points. With Alchian and Allen's 3 percent range of uncertainty, there is no inflation during the escalation, since the highest year-to-year price increases are 2.9 percent from 1965 to 1966 and again from 1966 to 1967. Every year since then prices have increased by more than 3 percent. There were two quarters during the escalation when prices rose at a seasonally adjusted annual rate of more than 3 percent a year, 1966ii lii . But they were followed by two quarters of measured inflation well below 3 percent. Wholesale prices were actually falling in 1966¡v and 1967j and 1967U,. It seems reasonable to conclude that in a fiscal policy sense the

72 Alleged Vietnam War Origins of the Current Inflation escalation may have contributed to the inflation of 1968, but we argue that most of the next thirteen years of inflation cannot be blamed on the weak reed of a tiny two-year escalation. A surprising number of economists date the origins of the current inflation either before the escalation occurred or before the price indexes unambiguously signaled inflation in 1968. Some of them are included in table 5.1. 6 This group includes radicals, conservatives, eclectics, federal agencies, and private foundations, but no consensus. Well-trained people looking at a time series chose to notice breaks in a trend where levels were so low that all numbers were less than the limits of the probable error in the numbers. If we accept that there is an error in the price indices and that the probable magnitude of that error is about that stated by Alchian and Allen, then the inflation cannot be shown to have started before 1968. Even then the identification of inflation is tenuous if we use the wholesale price index, which was rising at a mere 1.57 percent annual rate for the middle two quarters of 1968 and rose by only 2.5 percent for the year. Although inflation could not be shown empirically in the period of escalation, it was predicted theoretically. The Council of Economic Advisers in its Annual Report for 1966 reported that the interim unemployment rate goal of 4 percent had been met and "the economy can operate efficiently at lower rates (of unemployment)." 7 But it also observed, "with the economy now approaching full utilization of its resources, the risk of price T A B L E 5.1 Estimates of Beginning Date of Inflation

Observer P. A. Samuelson Council of Economic Advisors B. Friedman H.T.Shapiro Committee for Economic Development G. Haberler Council of Economic Advisors E. K. Hunt & H. J. Sherman P. Cagan

Reported first year of inflation

Measured percent rate of change of Consumer Price Index over previous year

1965

1.7

1965 1964 1966

1.7 1.3 2.9

mid-1965 1965

2.8 1.7

late 1965 1967 1965

2.5 2.9 1.7

Alleged Vietnam War Origins of the Current Inflation 73 increases becomes greater." 8 These comments were published in January 1966 and so must have been written during the first quarter of the escalation. Clearly, in 1966 we are dealing with the KennedyJohnson long cyclical expansion. Such thinking combined with the war escalation would normally induce tax increases to offset the inflationary pressures. In fact such tax increases did occur. Federal taxes as a percent of GNP were at a secular low of 17.7 in 1965^ and defense spending as a percent of GNP was also at a secular low of 7.1. Four quarters later federal taxes' share of GNP had increased 1.2 percentage points while defense expenditures' share of GNP had increased 0.7 percentage point. Obviously the first year of escalation was overfinanced by tax increases. We did go for more guns by trying to reduce butter. For the five quarters 1966^ through 1967^, federal taxes as a percent of GNP remained constant while defense expenditures continued to rise, from 7.8 to 9.0 percent of GNP. That is the only period during which it can be said that we tried for guns and butter together. It is a very paradoxical escalation period, including two consecutive quarters of declining rates of increase in retail prices and two consecutive quarters of negative rates of change in wholesale prices and the famous minirecession, when real GNP actually fell from 1966 iv to 1967;. In 1967¡ii, the first quarter after the escalation, taxes as a percent of GNP jumped to 20.6 and continued rising to a peak of 21.0 in 1968^. So there were two tax increases associated with the stepped-up war. One was coterminous with the first year of escalation. It consisted of the automatic tax increase implicit in a progressive tax system and rising income and of increases in social insurance taxes faster than increases in social insurance benefits. The second tax increase, which took effect at the end of the escalation, was a discretionary increase in rates aimed at the inflationary problem. Given the pattern of movement of wholesale and retail prices in the two years before 1967 ii( it is hard to imagine an antiinflation tax increase taking effect any sooner. The Consumer Price Index (CPI) reported quarterly at annual rates from 1967 j through 1967 ¡¡i went up 122, 3.24, and 4.17 percent, respectively, which looks like the beginning of an inflation, and in 1967^ federal taxes increased substantially. But a very similar price pattern occurred the previous year when the CPI quarterly at annual rates from 1966 j to 1966^ went up 239, and 3.32, and 4.01 percent, respectively. Even without a tax increase, the next two quarters were 2.09 and 1.22. For calendar year 1969, federal taxes as a percent of GNP were the highest for the whole post-World War II period.

74 Alleged Vietnam War Origins of the Current Inflation In the escalation period the federal government not only increased taxes, which should have lowered private demand, but it also lowered the share of GNP it took for all other federal purposes from 2.6 percent in calendar 1965 to 2.4 percent in calendar 1967. Two tenths of a percent of GNP does not look like much, but it is a 7.7 percent fall in the share of GNP going to other federal purposes. So there were more guns financed by fewer national parks. A look at other wars may be useful. In World War II, escalation of resources steered toward defense peaked in 1943, when defense took 41.5 percent of GNP. Stable prices were achieved by 1949, six years later. In the Korean War, defense's share of GNP peaked in 1953 at 13.3. Stable prices were achieved the same year. Vietnam War escalation ended in 1967, the last year annual rates of inflation were below 3 percent. We have not had stable (less than 3 percent annual increase) prices in any of the fourteen years since then. Thus, the escalation of the defense sector of our economy for the Vietnam War was small and short. Taxes did rise along with defense spending except for a five-quarter period from 1966 (i to 1967^. Other federal spending's share of GNP was cut back to help finance the war escalation. Although inflation could theoretically be expected in a period like 1966-67, the price indices did not convincingly demonstrate inflation until 1968. Many major commentators on inflation in that period chose to say it started before the price indices confidently show that it started. The notion that the price rises of the mid-1960s should be viewed as primarily a Vietnam War phenomenon relies heavily on the increase in federal budget deficits, according to some views. Such a view immediately flies in the face of the historical record, which shows no demonstrable connection between deficits and inflation (William Niskanen has concurred), with or without varying time lags. Nevertheless, in view of the current popularity of this belief, we shall glance at the budgetary record and the possibly connected money stock changes for the period of the Vietnam escalation. We reject the use of the unified budget for this purpose, not because we fear the case it seems to make by virtue of its big peak deficit as late as fiscal 1968, but because the consensus of economists is clear that the National Income and Product Accounts (NIPA) budget is the proper one for analysis of the budget impact on the economy. 9 The record of deficits and surpluses for the appropriate calendar years, in billions of dollars, is set forth in table 5.2. 10 One who was carelessly enamored of common-sense observations might immediately wonder what the shouting was all about, in view

Alleged Vietnam War Origins of the Current Inflation 75

of the fact that this peak calendar year deficit was a mere 1.7 percent of 1967 GNP. Furthermore, it was preceded by a deficit that was minuscule and followed by a drastic drop to a level that was seven tenths of one percent of 1968 GNP. A heavy burden indeed for a modest prime mover! But the more technically minded defenders of the orthodox label would of course turn to a presumed marginal role of the 1967 calendar year deficit, and the monetarists would and do turn to presumed quantity-of-money connections with the deficit on one end of the causative chain and the alleged price effects of that money on the other end." So that must be investigated. But note that we all agree that the price effects of such hypothesized deficits-money connection would be lagged. We presume that the double lag, from deficit to money supply and from money supply to prices, would come to the surface, on a calendar year basis, certainly no sooner than 1968. Experts are uncertain about that length of these lags. 12 Hence, for the budgeteers-monetarists the 5.8 percent rise in the CPI over the two years 1965-67 cannot be a part of the so-called Vietnam War inflation, any more than the 1.7 percent price rise from 1964 to 1965 can be. The only escape from this conclusion would be to introduce pre1968 "expectations," the last, nontestable, subjective refuge of the analytically trapped. We will not venture into that realm here. The changes in the most pertinent monetary aggregates are present in table 5.3. The changes are for calendar years from December to December. In examining the table it should be borne in mind that the one-year jump in the federal budget deficit was calendar 1967. It will be seen that in 1967 the volume of federal securities, comprising the overwhelming bulk of reserve bank credit, also rose notably, by 11.6 percent. The rise amounted to $5.1 billion, but it was dampened by an increase of only $4.4 billion in the total amount of reserve bank TABLE 5.2. Defects and Surpluses for a Five-Year Period

1965 1966 1967 1968 1969

National income and product accounts budget

Full employment budget

.5 -1.8 -13.2 -5.8 8.5

1.0 -3.6 -10.5 -6.0 11.7

76 Alleged Vietnam War Origins of the Current Inflation credit. Significantly, the federal reserve holdings of government securities rose by only $3.6 billion in the ensuing year, a drop in the rate of increase to 7.4 percent. The increase in security holdings does not seem to suggest a large effect from the budget deficit of 1967. The proportionate rises of such holdings in the years 1963-64 and 1964-65 were almost as large as that for 1967, years during which the budget had a small deficit and a negligible surplus, respectively. In general, the security holdings record does not indicate important responses to the Vietnam War during 1967 and 1968. Indeed, the average of percentage increases for 1966-67 to 1968-69 is less than the average for 1962-63 to 1964-65 (the 1962-63 increase was 10.4 percent). Finally, it should be observed that for both 1967-68 and 1968-69 the proportionate rise in total reserve bank credit was significantly greater than the rise in security holdings. This fact tends to remove much of the onus from the two years of noteworthy budget deficits (1967 and to a lesser amount, 1968) when dealing with the behavior of the monetary base and the money stock during the last two year-to-year changes portrayed in table 5.3. The record of increases in the monetary base, with only one moderate episodic j u m p — i n 1967-68—likewise contributes little or nothing to our understanding of possible connections between it and either the regularity of the concomitant yearly price increases then occurTABLE 5-3 Annual Percentage Increases in Selected Monetary Aggregates, December to December, Calendar Years 1963-1970

December

Total reserve bank credit

U.S. government securities held by Federal Reserve banks

Monetary base

Money supply (M1)

Money supply (M2)

1963-64 1964-65 1965-66 1966-67 1967-68 1968-69 1969-70

9.0 10.0 6.8 9.4 10.3 13.3 4.1

10.1 10.2 7.1 11.6 7.4 9.5 7.3

5.2 5.5 5.4 5.7 8.1 5.0 5.7

4.6 4.7 2.6 6.6 8.1 3.2 5.1

7.0 8.8 5.6 10.0 9.5 2.4 7.9

Source: Economic Report of the President, 1980, Tables B-58, B-63. Percentages calculated.

Alleged Vietnam War Origins of the Current Inflation 77 ring or the timing and pattern of money supply changes. At best, it could be said that its j u m p in 1968 had a lagged relation to the 1967 j u m p in the federal budget. But both M, and M2 jumped a year before—which was a year later than most of the aforementioned economic authorities proclaimed the first year of inflation. The "credit c r u n c h " of 1966 is cause for hardly a ripple in the monetary base series. Both M t and M 2 exhibit a two-year period of notable percentage increases. Yet the increases commence in 1967, the same year as the j u m p in both the budget deficit and federal reserve security holdings; a time lag should certainly be expected here. It would seem more plausible to view the money stock rise in 1967 as mainly a response to the fact that " m o n e t a r y policy had turned expansionary, in order to help cushion the inventory adjustment, and to assist actively in the recovery of homebuilding," a policy that "remained easy until very late in the year." 1 3 The s h a r p u p t u r n of 4.2 percent in the CPI for 1968 must be the one and only candidate to w a r r a n t the notion of a budget-linked Vietnam War inflation. 1 4 That notion would connect the 13.2 billion deficit of 1967 with the 11.6 percent rise in the U.S. government securities held by the reserve banks in the same year, together with the increase in the money supply in 1967 and 1968. 15 We do not take issue with an interpreter who, relying upon these hypothetical connections, chooses to identify the price rise of 1968 as partly a war-related phenomenon. However, that interpreter would also have to deal with such production supply side facts as a 5.6 percent increase in the apparel commodities component and a 5.7 percent rise in all-services-lessrent component of the CPI—elements having only a remote connection with the war. But we do contend that the w a r cannot be significantly responsible for the u p w a r d turn of prices before 1968 or for the accelerated upward price trend after 1968. The "Vietnam War inflation," at best, was essentially concentrated in one year. Both monetary and fiscal analyses come to this s a m e conclusion. It is not o u r responsibility to present here an alternative explanation of the measured u p w a r d movement in the CPI from 1.7 percent in 1965-65 to 2.9 percent in 1965-66. However, assuming that movement is statistically significant, as the profession appears to think, we are curious about economists' neglect of the likely role of the s h a r p rises in such components of the index as food, medical, and other services, the 12.4 percent advance in interest costs on new home mortgages, a n d the 6 percent j u m p in average hourly labor compen-

TABLE 5-4 Quarterly Price Changes and Federal Shares of GNP Prices, quarterly changes at annual rates

Federal government shares Federal nonDefense defense expenditures/ expenditures/ GNP, % GNP, %

Federal receipts NIPA basis/ GNP, %

Consumer Price Index

Wholesale Price Index

Year

%A

%A

1964Ì ii iii iv

0.43 1.30 1.29 1.72

0.42 -1.27 2.54 0.00

8.0 7.8 7.6 7.4

2.6 2.6 2.5 2.6

18.5 17.7 17.9 18.1

1965Ì ii iii iv

0.43 4.27 0.42 2.53

1.26 5.86 0.83 4.12

7.1 7.1 7.1 7.4

2.5 2.6 2.6 2.6

18.5 18.3 17.7 17.8

1966Ì ii iii iv

2.39 3.32 4.01 2.09

4.89 1.21 4.42 -3.57

7.5 7.8 8.3 8.4

2.5 2.5 2.5 2.4

18.6 18.9 18.9 18.9

1967i ii iii iv

1.22 3.24 4.17 3.74

-0.80 2.41 -0.40 2.80

8.9 9.0 8.6 9.0

2.5 2.4 2.4 2.5

18.9 18.8 20.6 20.6

1968Ì ii iii iv

4.72 4.67 4.23 4.95

5.16 1.57 1.56 2.72

9.1 9.0 8.7 8.7

2.4 2.5 2.5 2.4

20.8 21.0 20.8 20.7

1969Î ii iii iv

6.02 6.30 5.46 6.12

6.95 5.31 1.12 5.60

8.2 8.1 8.1 8.1

2.4 2.3 2.2 2.2

20.0 21.4 20.7 20.7

1970Ì ii iii iv

5.79 6.43 4.19 5.56

4.87 1.83 2.19 0.00

7.9 7.5 7.3 7.3

2.3 2.3 2.2 2.2

20.0 19.9 19.2 19.0

Source: Business Statistics, 21st ed. (Washington: U.S. Government Printing Office, March 1978).

Alleged Vietnam War Origins of the Current Inflation

79

sation in the dominant nonfarm business sector (annual basis). 16 The latter increased unit labor costs by 3.5 percent in 1966. As a wellknown, m a j o r "underlying determinant of prices" subject to almost no lag in pass-through to prices, we think such a unit labor cost increase, together with the jump in the aforementioned components, might be quite sufficient to explain the 1966 movement in the CPI. 17 (Incidentally, unit labor costs rose 3.6 percent in 1967 and mounted unremittingly thereafter.) The slowdown in the labor productivity rise as the Kennedy-Johnson expansion approached full employment, in the context of an unceasing upward trend of compensation per hour culminating in its 1966 escalation, seems to us to attest clearly to the most traditional kind of " c i v i l i a n " prosperity b e h a v i o r — w i t h appropriate implications for prices in both 1966 and 1967. Why this alternative explanatory path has been neglected is even farther beyond the objectives of this analysis. However, the matter is, among other things, something of a challenge in its ideological aspect. W e wonder, for example, whether the desire to link inflation with unbalanced (deficit) federal budgets and even moderate increases in federal spending has come to assume the magnitude of an ideological craze, despite the spate of econometric work dispelling such a link, certainly with respect to the deficits. Doctrine has been known to reflect policy bias, a connection from which w e do not ourselves purport to be disengaged. However, one job of economists is to marshall the relevant evidence, including neglected evidence, especially whenever prevailing belief systems relying on slim empirical support appear to be all too easily accepted (table 5.4). It would d o the profession and the society some good if economists would use their tools to analyze the Vietnam War in a vein similar to this chapter's. W e find the war to be an economically trivial event in the macroeconomic statistics. Yet we recognize the significant strains it produced on American society and the staggering economic and social strains it produced for Vietnamese society. What would it be like if we really escalated the share of our resources going to defense? NOTES 1. Council of Economic Advisers, Annual Report for 1981 (Washington, D.C.: GPO, 1981), p. 36. 2. Rabum M. Williams, inflation! (Arlington Heights, 111.: AHM Publishing, 1980), pp. 29-35; Arthur M. Okun, The Political Economy of Prosperity (New York: Norton, 1970), pp. 73—79; Paul A. Samuelson, Economics, 11th ed. (New York: McGraw-Hill, 1980), p. 775.

80 Alleged Vietnam

War Origins

of the Current

Inflation

3. Luman H. Long, ed.. The 1971 World Almanac ( N e w York: Newspaper Enterprise Association, 1971), p. 34. 4. Armen A. Alchian and William R. Allen, University Economics, 3d ed. (Belmont, Calif.: Wadsworth, 1971), p. 713. 5. Jack E. Triplett, "Reconciling the CPI and the PCE Deflator," Monthly Labor Review (1981), 104:8. 6. Samuelson, Economics, 11th ed., pp. 242, 775; Council of Economic Advisers, "Inflation Alert" (August 17, 1970), p. II 17; Benjamin Friedman, Inflation, World Wide Disaster (Boston: Houghton Mifflin, 1973), p. 228; Harold T. Shapiro, "Inflation in the United States," in Lawrence B. Krause and Walter S. Salant, eds., Worldwide Inflation (Washington, D.C.: Brookings Institution, 1977), p. 278; Committee for Economic Development, National Economy and the Vietnam War ( N e w York: Committee for Economic Development, April 1968), p. 23; Gottfried Haberler, Inflation, Its Causes and Cures (Washington, D.C.: American Enterprise Institute, July 1966), p. 2; Council of Economic Advisers, Annual Report for 1967 (Washington, D.C.: GPO, 1967), p. 37; E. K . Hunt and Howard J. Sherman, Economics: An Introduction to Traditional and Radical Views ( N e w York: Harper and Row, 1972), p. 343; Phillip Cagan, The Hydra Headed Monster (Washington, D.C.: American Enterprise Institute, October 1974), p. 2. 7. Council of Economic Advisers, Annual D.C.: GPO, 1966), p. 75.

Report for 1966 (Washington,

8. Ibid., p. 87. 9. This is the route taken by Williams, Inflation!, U.S. congress, Joint Economic Committee, Economic (Washington, D.C.: GPO, January 1962), p. 77.

p. 29; see for example, Report of the President

10. Economic Report of the President, January 1980, pp. 288, 289; February 1971, p. 73, table 25. 11. The income velocity of M t was quite stable around an average of 4.32 over the calendar years 1966-1969. 12. " T h e inflationary effects of overly rapid money growth are not felt immediately. In fact, evidence suggests that money does not begin to impact prices until nearly one year later and continues to be felt in the following year. This widely referred to as the 'lagged effect' of monetary policy on inflation." Federal Reserve Bank of Atlanta, Economic Review (January/ February 1980), p. 15. Another monetary theorist found that changes in the inflation rate responded to changes in money growth with an average lag of two years in the post-Korean War period; Robert E. Weintraub, "Monetary Policy and Economic Performance, Summer 1976-November 1980: An Overv i e w , " Federal Reserve Bank of Richmond, Economic Review (July/August 1981):13. 13. Economic Report of the President, February 1968, pp. 76-78. 14. Producer prices of industrial commodities rose only 2.5 percent in 1968, the G N P deflator by 4.5 percent. 15. The Economic Report of the President for January 1969 says, "Growth of the money supply in the second quarter of 1968 was at an annual rate of 9

Alleged Vietnam

War Origins of the Current Inflation

81

percent. The reasons for this acceleration — to a rate almost double the growth in the preceding q u a r t e r — a r e not fully a p p a r e n t " (p. 92). 16. Economic Report of the President, February 1968, p. 112. With respect to wholesale prices in this period, see Economic Report of the President, January 1967, p. 74. 17. See, for example, Mark A. Wasserman and Shirley N. Watt, "The Economy in 1980," Federal Reserve Bulletin (January 1981):1.

CHAPTER 5B

The Alleged Vietnam War Origins of the Current Inflation: A Comment CHARLES B . GARRISON A N N E MAYHEW University of Tennessee

John F. Walker and Harold G. Vatter conclude that the Vietnam War was the cause neither of the inflation during the period of the war's escalation (roughly 1966 to 1968) nor of the post-1968 inflation that extended into the 1970s. They support this contention by arguing (1) that in comparison with other wars, such as the Korean War, the escalation was "tiny"; (2) that the escalation in its first year was offset by tax increases (and in fact was "overfinanced" by rising tax collections); (3) that the inflation that occurred during the period of escalation was small and essentially confined to one year (1968); and (4) that the inflation could not be blamed on the war, anyway, because such a link must rely heavily on an inflation theory that assigns a causal role to budget deficits, a view that "flies in the face of the historical record, which shows no demonstrable connection between deficits and inflation." Walker and Vatter further support this last point by arguing that the movement of prices in 1966 and 1967, rather than defense-related, was a consequence of traditional "civilian" prosperity behavior (characterized by rising labor compensation costs and jumps in such nondefense components of the price indexes as apparel and services). They conclude that an "alternative explanatory path" should be explored to identify the causes of the initial jump in inflation in the late 1960s and its continuation into the 1970s. While we share Walker and Vatter's skepticism that the inflation of the 1970s was exclusively a legacy of the Vietnam War, we nevertheless conclude that they have grossly underestimated the war's contribution. In this comment we pursue the line of thought they suggest Reprinted from Journal of Economic Issues (March 1983, pp. 175-186, by special permission of the copyright holder, the Association for Evolutionary Economics.

82

A Comment by Charles Garrison and Anne Mayhew 8 3 and compare the Vietnam era escalation with that of the Korean W a r . Contrary to Walker and Vatter, however, we show (by using a more appropriate measure of the fiscal impact of w a r ) that the Vietnam escalation was of a magnitude comparable to that of the Korean W a r and accordingly must bear a m a j o r share of the responsibility for the ensuing inflation. Comparison with the Korean W a r enables us also to investigate a particularly intriguing implication of the WalkerVatter analysis: that the government's tax and nondefense expenditure fiscal policies during the Vietnam era were proper and well timed and tended to reduce aggregate nondefense demand, thereby stabilizing the economy. W e find the opposite (again by employing more appropriate measures of fiscal impact): fiscal policy was inadequate and ill timed, thereby contributing to an insidious cumulative buildup of inflation that became extremely difficult and costly to eradicate once appropriate measures w e r e (belatedly) taken. Indeed, the ineptness of policy becomes especially glaring when compared with the Korean W a r experience. During the Korean War both tax and wageprice policies contributed to a containment of inflationary pressures so that the inflation was confined to a one-year period. W e provide in the next section a discussion of our measures of the fiscal impact of the t w o wars and a comparison of the economic policies pursued during the t w o periods. In the third section we consider the channels through which defense spending and deficits can result in inflation.

A COMPARISON OF TWO WARS Walker and Vatter base their contention that the Vietnam W a r was "an economically trivial e v e n t " partly on the fact that their measure of escalation, the percent of G N P going to defense, rose relatively little during the Vietnam era, from 7.2 percent in 1965 to 9.0 percent in 1967. By w a y of comparison, this ratio rose from 5.0 to 13.2 percent during the Korean W a r . Walker and Vatter date the Vietnam escalation as beginning in 1965iv and continuing through 1967; they thus characterize the escalation as " s m a l l " and "short." They further observe that the impact of the military escalation was softened by t w o tax increases: " O n e was coterminous with the first year of escalation. It consisted of the automatic tax increase implicit in a progressive tax system (when income rises). . . . The second tax increase, which took effect at the end of the escalation (the 1968 surtax), was a discretionary increase in rates." Walker and Vatter thus argue that the increase in defense expenditures was relatively minor and that the ensuing inflationary pressures were offset by wise and timely stabilizing pol-

84 A Comment by Charles Garrison and Anne Mayhew TABLE 5-5. Economic Impact of the Federal Government During Two Wars

A.

Korean War

Vietnam War

27.6 26.1 (a)

14.4 9.2 3.1

1950iv

1968iii

1

11

-4.2 -15.1 (a)

-5.5 -10.7 -1.7

1951 i

1971m

2

23

Magnitude of Escalation Increase in Defense Expenditures (in billions of 1972$) During first year During second year During third year

B. Tax Increase Date Imposed Quarters elapsed between initial escalation and imposition of tax increase C. Net Fiscal Impact Change in High-Employment Budget Surplus (in billions of 1972 $) During first year During second year During third year D. Wage and Price Controls Date Imposed Quarters elapsed between initial escalation and imposition of controls

(a) Not calculated; duration of the Korean War escalation is estimated as only two years. Sources: Survey of Current Business, April 1982, and U.S. Department of Commerce, Bureau of Economic Analysis.

icy in the form of tax increases. They voice their approval of economic policy during the Vietnam era by contending that "it is hard to imagine an anti-inflation tax increase taking effect any sooner." A more nearly comprehensive comparison of the Vietnam War with the Korean War than that provided by Walker and Vatter is needed to judge the economic importance of the Vietnam escalation. We present such a comparison in tables 5.5 and 5.6. Part A of table 5.5

A Comment by Charles Garrison and Anne Mayhew 85 TABLE 5-6. Economic Conditions Prior to Two Wars

Date of initial escalation Conditions one quarter prior to escalation A.

1950iii

1965iv

525.1 547.6 22.5

932.3 931.8 -0.5

2

19

5.6

4.4

4.0

4.4

1.1

2.0

Labor Market Unemployment rate (%) High-employmnent unemployment rate

C.

Vietnam War

Output Real G N P (in 1 9 7 2 $ ) Potential Real G N P Real G N P Gap Length of expansion since preceding recession trough (quarters)

B.

Korean War

Inflation Rate of inflation since preceding recession trough (%)

Source: Survey of Current Business, November 1980, p. 17.

shows that the Korean escalation was indeed larger that its Vietnam counterpart, but this turns out to be illusory, at least for the first year of escalation. In table 5.6 we summarize the conditions existing in the nation's economy at the beginning of the two escalations. The difference is striking: the first year of the Korean escalation was partly accommodated by an economy with considerable excess capacity, whereas the Vietnam War began when the economy was already at full employment. This is because in 1950 the economy had just begun recovering from the recession of 1949, whereas in late 1965 the economy had been expanding since 1961, with especially strong growth in 1964 and 1965. If one deducts the amount of excess capacity (the GNP gap) from the amount of the defense spending increase, one can estimate a measure of "excess aggregate demand." This calculation yields an excess demand of $5.1 billion in the first year of the Korean escalation versus $14.9 billion for the first year of the Vietnam escalation

86 A Comment by Charles Garrison and Anne Mayhew (both in 1972 dollars)! The Walker-Vatter approach of emphasizing the relatively small increase in the percentage of GNP going to defense is thus seriously lacking as a measure of the economic impact of the Vietnam escalation. But Walker and Vatter contend that the excess demand in the first year of the Vietnam escalation was mitigated by a tax increase; what of this argument? In comparison with tax policy during the corresponding period of the Korean War, we find that the tax increase was rather anemic and amounted only to an automatic response of tax revenues as nominal G N P rose. Indeed, personal income tax rates during 1966 were still low, owing to the 1964 Kennedy-Johnson tax cut. (In 1963, prior to the tax cut, personal income tax collections amounted to 13.1 percent of adjusted gross income; this percentage fell to 11.5 for 1965 and had risen only to 12.0 by 1966 [U.S. Treasury Department 1963, 1965, 1966].1 Compared with 1963, this means that disposable personal income's share of G N P in real terms was high in 1966 (65.7 percent compared with 65.1 percent in 1963) and that consumer demand accordingly remained strong. In contrast, the government pursued a truly restrictive tax policy in 1950 by raising tax rates in the fourth quarter of that year, only one quarter after the war began. 2 The results were that (1) disposable personal income as a percent of G N P fell rather sharply, from 68.4 percent in 1949 to 64.3 in 1951 and 63.8 in 1952, and (2) consumer expenditures as a percent of G N P declined from 64.9 in 1949 to 59.0 in 1951 and 58.3 in 1952. Tax policy in the Vietnam era appears poor indeed when one recalls that Congress did not enact a discretionary increase in tax rates until 1968 ¡¡¡, almost three years after the escalation began (see part B of table 5.5).3 Thus Walker and Vatter are led astray by their assumption that increased tax revenue caused by growth of the tax base is essentially the same as a tax increase. But to qualify as a tax increase that will reduce inflationary pressure, a tax action must reduce private demand. The increase in tax rates during the Korean War obviously qualifies: the negative effect on disposable personal income tended to depress consumer demand. On the other hand, by this criterion there was no tax increase during the first eleven quarters of the Vietnam War. Meanwhile inflation gradually built up, as shown in table 5.7. A measure of net fiscal impact, the change in the high-employment budget surplus, is useful in supporting our point regarding tax policy. As shown in part C of table 5.5, this budget measure yields a cumulative stimulus of only $19.3 billion during the two years of the Korean War escalation, as compared with a cumulative defense buildup of

A Comment by Charles Garrison and Anne Mayhew 87 $53.7 billion. Thus the remaining $34.4 billion of the expenditure increase, or 64.1 percent, m a y be considered to have been financed by the tax increase (and other fiscal stringencies). In contrast, the first two years of the Vietnam era produced a cumulative net stimulus of $16.2 billion and a defense buildup of $23.6 billion. Thus only $7.4 billion, or 31.4 percent, of the defense expenditure increase can be said to have been financed by offsetting fiscal restriction. The second policy area in which the Vietnam War differs sharply from the Korean War is that of wage and price controls. Fairly comprehensive controls were instituted only two q u a r t e r s after the initial Korean escalation, in the first q u a r t e r of 1951 (see part D of table 5.5). 4 It appears that the controls, in combination with the restrictive influence of the increase in tax rates, helped to contain inflation to a relatively brief flareup, after which prices were impressively stable despite the continuing high level of defense expenditures in the Cold War era. We consider this price behavior to be a m a j o r difference between the Vietnam era and the Korean War era. Wage and price controls were not instituted for almost six years after the Vietnam escalation began. Given that a discretionary tax increase was not enacted for almost three years, it is not surprising that the Vietnam inflation was not contained to a relatively brief period as was the case TABLE 5-7. Inflation During Two Wars Period3

Korean War

Vietnam War

Annual rate of change, GNP deflator (%) First year of escalation Second year Third year*' Fourth year*3

8.5 0.7 2.3 1.4

3.2 2.9 4.7 5.4

a

Rates of inflation are calculated from the beginning quarter of escalation. The Korean War escalation began in 1950iii; inflation during the first year thus is calculated as the percentage change in the deflator from 1950ii to 1951 it, during the second year as the percentage change from 1951 ii to 1952ii, and so on. Similarly, inflation during the first year of the Vietnam War is calculated as the rate from 1965iii to 1966iii, and so on. b

The Korean War lasted for only two years. However, the high level of defense expenditures continued during the ensuing Cold War period, and accordingly defenserelated aggregate demand remained at a very high level. Source: U.S. Department of Commerce.

88 A Comment by Charles Garrison and Anne Mayhew in the Korean W a r but was allowed gradually to cumulate (see table 5.7). The result w a s that not even the recession of 1970 was able to reduce significantly the rate of inflation. Our v i e w that controls played a major role in confining the Korean W a r inflation to a one-year period is supported by Phillips curve analysis. A curve constructed for the decade 1950—59 has the expected slope (the lower the rate of unemployment, the higher the rate of inflation), and the actual observations for most years lie close to the fitted curve. The only exceptions are for the period 1952^—1953 i v , when the inflation rates were well below those compatible with the very low unemployment rates that prevailed during the period.

DEFENSE, DEFICITS, AND INFLATION H a v i n g failed to find a direct link between Vietnam defense expenditures and inflation, Walker and Vatter consider an indirect mechanism whereby a government deficit might cause an increase in the quantity of money and, through this monetary channel, cause an increase in inflation. This v i e w of the w a y in which government deficits affect economic activity appears to be quite popular 5 and relies on a connection between a budget deficit and the volume of government securities held by Federal Reserve banks. Thus inflation is held to be at root a monetary phenomenon, and a fiscal stimulus (an increase in the deficit) is held to have no inflationary effects if only the Federal Reserve could resist pressures to monetize the budget deficit. Although it is not always stated explicitly, this doctrine asserts that pure fiscal actions have no effects whatever on aggregate demand; deficits then are incapable of increasing output, employment, or prices through demand channels unless accompanied by an increase in money growth. Walker and Vatter, pursuing this alleged transmission mechanism, find only one year in the Vietnam e r a — 1 9 6 7 — i n which Federal Reserve holdings of government securities increased significantly. They then concede that the 1967 government deficit could be connected to the increase in the money supply in 1967 and 1968. However, they conclude that because of time lags, prices could be affected "certainly no sooner than 1968." Although themselves apparently skeptical of this deficits-to-money-to-inflation transmission process, they then concede that the price rise of 1968 could be partly w a r related (but not the earlier increase of prices in 1966 or 1967, nor, for that matter, the post-1968 rise of prices, since the rate of increase of Federal Reserve holdings of government securities tended to fall after 1967).

A Comment by Charles Garrison and Anne Mayhew 89 Despite the fact that the war effort dragged on for a total of about seven years (1966 through 1972), this analysis has the rather neat effect of confining the war-related inflation to a single year! Walker and Vatter buttress this conclusion by observing that the inflation in the pre- and post-1968 years of the Vietnam era was characterized by increases in such nondefense components of the price index as food and services and an increase in labor compensation per hour. (Even in 1968, they point out, such nondefense components as apparel and all services-less-rent accounted for much of the price increase.) They find this behavior to be evidence of inflation induced by "civilian prosperity"—not by defense expenditures. They then wonder why this "alternative explanatory p a t h " has been neglected. We reject the notion that just because an inflation affects nondefense items the inflation cannot be war related. An excess-demand induced inflation can be caused by an increase in defense spending or an increase in private spending. Either type of spending increase causes output to rise, employment to increase, labor markets to become tight, and the rate of increase in labor compensation per hour to rise. In most industries, because labor is the major cost of production and because prices reflect a markup over labor cost, firms react to an increase in compensation by raising prices, that is, by "passing through" the increase in labor cost. 6 It is thus not surprising that an inflation may be rooted in a military escalation and yet manifested in price increases in a wide variety of goods and services; no "alternative explanation" for this result need be sought. In this regard note that during the Korean War inflation, the price indexes for a number of nondefense categories, including consumer nondurables and the index of labor compensation, rose more rapidly than the GNP deflator did; this obviously does not mean that the inflation was not war related. We also cannot accept the contention that the only channel by which the Vietnam War affected prices was the deficit-money-supplyprices mechanism. As emphasized in our tables 5.5 and 5.6, we find strong fiscal stimulus from the outset of the escalation; the result was that labor markets became tight very early in the war and remained so for four full years! As we show in table 5.8, employee compensation responded by increasing at rates well in excess of productivity gains, resulting in the gradual increase of inflation rates in the period 1966 through 1969. It will be observed that this scenario does not require the extremely long lag posited by Walker and Vatter; rather, it assigns responsibility for the entire inflation of 1966-69 to excess demand.

90 A Comment by Charles Garrison and Anne Mayhew Since we assign major responsibility for the excess demand to the fiscal stimulus associated with the war effort, we also find that the war is responsible for the entire inflation of the four-year period (not just for the single year 1968). This last statement needs to be qualified. It is possible in principle that despite the fiscal stimulus of the Vietnam War effort, excess demand could have been avoided by suitably restrictive monetary policy. As is fairly well known, the Federal Reserve attempted just that in the second half of 1966, reducing the rate of money growth despite the rising deficit. The Fed, however, soon retired from the inflation-fighting arena, perhaps because it became apparent that the lack of help from fiscal policy insured that the adverse consequences of the restrictive monetary stance would be confined to highly visible interest-sensitive components of output, especially residential construction. In this sense it may be said that the excessive fiscal stimulus contributed also to excessive money growth. But how can this analysis explain the stubbornly high rates of inflation in 1970 and 1971, when recession had set in as a result of a switch to restrictive fiscal and monetary policies? After all, those two years were characterized by rising unemployment and a resulting slack in labor markets. But table 5.8 reveals also that employee compensation continued to grow at high rates during those years. We attribute this result to the gradual nature of wage rate response to labor market conditions. Indeed, it appears that as a result of the TABLE 5-8. Labor Market Conditions During the Vietnam War

Unemployment rate

Annual rate of change Worker Output compensation per hour

Pre-War Period Average 1964-65

4.8

4.7

4.5

War Period 1966 1967 1968 1969 1970 1971

3.8 3.8 3.6 3.5 4.9 5.9

7.1 5.6 7.6 7.0 7.1 6.6

3.3 2.2 3.3 0.4

Source: Economic Report of the President,

1981.

0.8

3.2

A Comment by Charles Garrison and Anne Mayhew 91 prolonged inflation of the 1966-69 period, the Phillips curve shifted upward as agents incorporated a high expected inflation rate into their w a g e and price behavior. W e constructed a Phillips curve for the period 1970-73 and found that it lies well above a curve for the period 1960—69; that is, after 1969 a given unemployment rate was consistent w i t h a higher inflation rate than was the case prior to 1969. Thus, we find that even the inflation of 1970-71, because of the inertia built into the wage-price process, must be attributed to the war. Further, the less favorable tradeoff reflected in the higher Phillips curve for the entire period 1970-73 must be attributed to the w a r . What of the worsening inflation during the remainder of the 1970s? At this point we would agree with Walker and Vatter that the culpability of the Vietnam War is limited. Pursual of the Phillips curve analysis leads us to the observation that the curve shifted upward again in 1974, but this shift, and the rising inflation of that year, apparently were mainly a result of agricultural and energy supply shocks. The role of the war at this point must be limited to the conjecture that the economy would have been better able to accommodate the supply shocks if it had not lost the favorable Phillips curve tradeoff of the mid-1960s. In particular, the economy might have avoided the entire 1970s syndrome of a boom-and-burst economy as monetary and fiscal policy alternated between an effort to fight inflation and an effort to fight unemployment.

CONCLUSION Walker and Vatter argue that the Vietnam escalation was sufficiently small and fiscal policy sufficiently restrictive to eliminate the Vietnam W a r from any list of m a j o r causes of the inflation of the late 1960s and 1970s. However, w e conclude that one must consider a failure to offset the impact of the increased defense expenditure in an already fully employed economy to have led to the inflation of the late 1960s and to have contributed to the continuing inflation of the 1970s. Although the Vietnam escalation was smaller than the Korean W a r build up of defense expenditures, it was much larger relative to the economy's existing excess capacity, especially in its early stage. Further, the Vietnam era policy was strikingly inept as compared with policy in 1950-52. The Truman administration recognized the inflationary dangers of an increase in defense expenditure even in an economy operating at less than full employment and moved quickly to increase tax rates and to limit consumer expenditure through direct controls on credit. The administration was aware that further

9 2 A Comment by Charles Garrison and Anne Mayhew increases in income that would follow from the increase in defense expenditure would lead to further increases in the prices of consumer goods, as well as to increases in the prices of defense goods, and that consumer demand needed to be reduced. Quite properly, Truman did not disassociate an inflation resulting from "civilian prosperity" from the increased government expenditure that was contributing to the prosperity. Fortunately Congress accepted the Truman proposals. The Truman administration also moved quickly to impose seriously administered wage and price controls when it became obvious that the Korean conflict would not end quickly. The slower rate of wage increases and of inflation in 1951 and 1952 was surely due in large measure to these controls. Walker and Vatter end their article by asking, "what would it be like if we really escalated the share of our resources going to defense?" We answer that if the policies of 1950—52 were used, such escalation would not lead to rapid inflation. We also reply that even a relatively small escalation can lead to sustained inflation if it occurs in a fully employed economy and is accompanied by inept fiscal policy. That, we conclude, is what happened in the Vietnam period. NOTES 1. Reduction in the percentage of income paid as income taxes had been even greater for a given income class. For example, for those with incomes below $8,000, the percentage fell from 9.1 in 1963 to 7.5 in 1966. 2. The speed with which President Truman and Congress reacted to the change in economic conditions resulting from the outbreak of the Korean War is impressive. When South Korea was invaded in June 1950, Congress was considering a bill to reduce taxes. In The Midyear Economic Report of the President, issued in July, Truman noted: "Since I made tax recommendations to the Congress in January, the situation has changed drastically. There is now no need to reduce any taxes to stimulate business recovery. That recovery even before the development in Korea was more vigorous than most expected, and increased military spending will now accelerate this trend. . . . Substantial tax increases now are called for by the requirements of sound budget policy and by the threat of inflation." The Midyear Economic Report of the President, ¡950 (Washington, D.C.: GPO, 1950), p. 10. Truman asked that the bill before Congress be revised to provide for an increase in individual income tax rates and in corporate tax rates. These tax increases were enacted in September, and in January of 1951 Congress made an excess profits tax retroactive to July 1, 1950. In addition, Congress reinstated the power of the Federal Reserve Board to regulate consumer credit and gave it the power to regulate mortgage credit. 3. Shares of G N P are calculated from data in Economic Report of the

A Comment

by Charles Garrison and Anne Mayhew

93

President, 1982, and are in real terms. Note that, in calculating consumption expenditures and disposable income as a percentage of GNP, the percentages differ somewhat depending on whether nominal or real values are used. This is because the implicit price deflator for consumption expenditures was larger than that for GNP during the periods considered. The conclusion, however, is not affected; disposable income's share of GNP declined significantly during the Korean War but did not fall during 1966 and 1967. That is, consumer spending power was not reduced during the crucial early years of the Vietnam War. 4. In September 1950, Congress passed the Defense Production Act, which gave the president authority to stabilize wages and prices. The entry of China into the conflict in November and the rapid rise of prices led President Truman to declare a national emergency in December and so to begin the establishment of the wage and price control mechanism. In late January a general wage and price freeze went into effect. Over the next two years the administration exercised control over a wide range of prices and wages. The seriousness of these controls and the contrast with the controls of 1971-1974 is documented by Hugh Rockoff, who has suggested that the size of the bureaucracy administering controls is a measure of the pervasiveness of controls. Hugh Rockoff, "Price and Wage Controls in Four Wartime Periods," Journal of Economic History (June 1981), 41:381-401. By this measure, we have calculated that expenditures by primary and related control agencies during the Korean War period (1951 and 1952) in real terms were 1.6 times labor cost mechanism; Arthur Okun, Prices and Quantities: A Macroeconomic Analysis (Washington, D.C.: Brookings Institution, 1981). The process is the same, however greater than during the Vietnam War controls period embracing Phase 2 and Phase 3. As a percent of GNP, they were about four times greater than during Phase 2 and Phase 3. 5. See, for example, Scott E. Hein, "Deficits and Inflation," Review, Federal Reserve Bank of St. Louis (March 1981), 63:3-10; and P. Giffen, J. Macomber, and R. Berry, "An Empirical Examination of Current Inflation and Deficit Spending," Journal of Post Keynesian Economics (Fall 1981), 4:63-67. 6. For a recent treatment of this process of "gradual price adjustment," see Robert J. Gordon, "Output Fluctuations and Gradual Price Adjustment," Journal of Economic Literature (June 1981), 19:493-530.

CHAPTER S C

Demonstrating the Undemonstrable: A Reply to Garrison and Mayhew J O H N F . WALKER HAROLD G. VATTER

Professors Charles B. Garrison and Anne Mayhew have read closely "The Alleged Vietnam War Origins of the Current Inflation." Such behavior is flattering to authors and we thank them for it. Unfortunately we can agree with very little of their discussion.' In our analysis of the alleged Vietnam War inflation we were in the favored position of advancing the null hypothesis: The main data failed to support the hypothesis of a war-created break in the price trend as almost universally embraced by the profession. Garrison and Mayhew attempt a rebuttal that unfortunately entails a much more difficult task of demonstrating that a particular inflation theory (warinduced excess aggregate demand) explains a break in the price trend. (Their timing of the break is cannily unspecified.) We say "unfortunately" for them because the defense of such a particular hypothesis forces them to support what is in their view almost a decade of continuous inflation with very small variations in very weak data. We, on the other hand, have merely to say that those poor materials cannot be used to fashion a convincing explanation. Our general adverse response to the Garrison-Mayhew comment will be centered on what we believe to be their misuse of shaky data, but first let us project three points regarding their approach to the pre- and post-escalation periods. Garrison and Mayhew seem more concerned in much of their paper with the imperfect macroeconomic policy of the Johnson administration than with anything we had to say. While we did not generally defend any public policy in our paper we did wrestle with the recogReprinted f r o m Journal of Economic Issues (March 1983), pp. 186-195, by special permission of the copyright holder, the Association for Evolutionary Economics.

94

Demonstrating the Undemonstrable 95 nition lag, an important theoretical problem that bedevils policymakers. We point out that the Consumer Price Index (CPI) reports quarterly at annual rates for the first three quarters of 1966 were 2.39, 3.32, and 4.01, which looks like the beginning of an inflation. But, the next two quarters the numbers were 2.09 and 1.22, which looks like the end of an inflation. The first three quarters of 1967 produced numbers nearly identical to the first three quarters of 1966: the 1967 CPI numbers are 1.22, 3.24, and 4.17. 2 We can see no way that a government noting that the first set did not produce inflation could know that the second set would. We also quote the Council of Economic Advisers, which assured the country that the government would try to create inflation: "The Council of Economic Advisers in its Annual Report for 1966 reported that the interim unemployment rate goal of 4 percent had been met and the economy can operate efficiently at lower rates (of unemployment). But, it also observed, with the economy now approaching full utilization of its resources, the risk of price increases becomes greater." 3 In a Phillips curve analysis, which is Garrison and Mayhew's method, this statement can be interpreted to mean fiscal and monetary policy will be used to increase demand until inflation is produced. So the government's policy was to produce inflation in the late 1960s. That policy was based, not on war, but on a desire to lower unemployment and test the technical characteristics of the system. This approach makes the war irrelevant. If the demand increase had not been for war it would have been for something else. On the same page of our article we noted that taxes as a percentage of GNP rose by more than defense as a percentage of GNP in the first year of the escalation. Garrison and Mayhew, in referring to this point, say, "Thus Walker and Vatter are led astray by their assumption that increased tax revenue caused by growth of the tax base is essentially the same as a tax increase. But, to qualify as a tax increase that will reduce inflationary pressure, a tax action must reduce private d e m a n d . " 4 We pointed out that the increase in taxes in the first year of the escalation (1965 iv to 1966iv) was of two parts. First, there was an increase in social insurance taxes that was greater than the increase in social insurance benefits. Such a tax increase is unequivocally antiinflationary. The other part of the tax increase in that period is the built-in stabilizer element of a progressive tax system. It is not antiinflationary relative to a tax rate increase for the same taxes. But it does dampen the increase in private demand and is antiinflationary

96 Demonstrating the Undemonstrable relative to other types of tax systems or laissez faire. Their statement that "there was no tax increase during the first eleven quarters of the Vietnam W a r " cannot be demonstrated if the beginning of the w a r is dated at 1965 iv . Furthermore, as we have shown above, there is little convincing evidence of the beginnings of an inflation and some convincing evidence that the government was seeking inflation in that period. Neither the price data nor the policy statements can be assigned unambiguously to the war. A second preliminary point regarding the Garrison-Mayhew approach involves their use of the GNP gap. If, as they say, excess capacity was so helpful in instigating the economic effects of the Korean buildup as compared with Vietnam, why did the GNP deflator in the former case rise 8.5 percent in the "first year of escalation" (Garrison and Mayhew, table 5.7), but in the corresponding Vietnam case only 3.2 percent? Failure to treat this is remarkable in itself. But we wish to look into the contrasting price behavior for an additional reason, that is, its relevance for the decision to institute, or not institute, wage and price controls. The details are as follows. On January 15, 1951, in the sixth month of the "first year of escalation" in the Korean War, the CPI was 181.5, already 6.64 percent above its preescalation level of 170.2 in June 1950. 5 In striking contrast, as of March 1966, the CPI at 112.0 was only 1.6 percent above its "preescalation" level of 110.2 six months earlier in September 1965. As late as December 1966, it was still only 4.01 percent above September 1965.6 It was not until the last q u a r t e r of 1967 that the index reached 6.64 percent above September 1965— that is, after a lapse of two years. While we are by no means unsympathetic to the institution of wage and price controls, particularly in w a r time, and have no need to defend federal economic policy during the Vietnam War, apparently we can, nevertheless, much more readily than Garrison and Mayhew, comprehend the greater political barriers to the institution of wage and price controls in the case of the Vietnam War precisely because of this sluggish upward drift of the official price index in that case as compared with the final months of 1951. As late as early 1967, the government thought inflationary pressures were abating: The advance of price has already begun to slow. Wholesale prices in December were below their levels of August. The more moderate pace of economic advance now underway, which the policies I a m recommending are designed to maintain, should further diminish inflationary pressures.

Demonstrating the Undemonstrable 97 W e cannot rescind all of last year's increases in costs, some of which are still spreading through our structure of prices. Price stability cannot be restored overnight. But w e will be making good progress toward price stability this year. 7 A third and final preliminary point prefacing our central theme has to do with Garrison and Mayhew's treatment of the inflation beginning with 1968. T o attribute the inflation from 1968 through 1973 overwhelmingly, as they do, to the Vietnam escalation and deescalation, in v i e w of the number of professionally acknowledged competing hypotheses, is nothing short of an elementary statistical error. It is quite possible to entertain for this period cost-push, administered price, monetarist, deficit-monetarist, or bottleneck hypotheses, as well as excessive total demand. T o assert that any one of these is uniquely correct is the rashest of enterprises, for among other things it requires a much higher order of data quality than exists. Our position is that the data do not uniquely and definitively support any one of the standard theories or their subsets. And the farther away we get from 1966-68, the more tenuous the Vietnam attribution becomes. T o assert such attribution is a post hoc ergo propter hoc fallacy entailing the most difficult notion that big political events necessarily generate big economic events. The first third of our original discussion was a description of various datings of the origins of the Vietnam War inflation, contrasted with the annual inflation rate measured for each claimed initial date. Some scholars say the inflation began as early as 1964, when the annual increase in the CPI was 1.3 percent. Others say it began as late as 1967, when the annual CPI rate was 2.9 percent. W e then point out that the error term in the CPI is about 3 percentage points. Consequently, the existence of inflation in the period 19641967 cannot be demonstrated. Somehow Garrison and M a y h e w know that there was inflation in 1966 and 1967. They refer to the "earlier increase of prices in 1966 and 1967/' 8 and to the "entire inflation of 1966—69,"9 but they nowhere explain h o w they came to know that the first year of the inflation is 1966. Only one of the nine scholars we cited use that year. Of course w e are arguing that those scholars were collectively uncertain in their dating, but Garrison and Mayhew should at least try to explain their nonstandard date or why our statistical criticism is irrelevant. They do neither. They simply assert a nonmeasurable fact that is not generally accepted by scholars. Much of their discussion of the escalation exhibits this same substitution of obiter dicta for careful measurement and analysis, an escape

98 Demonstrating the Undemonstrable route for which we have some sympathy. We measured the escalation as an increase in the percentage of GNP going to defense. It has several obvious flaws but it gets at the point that escalation for the economy is substantially smaller and shorter than escalation related to the number of forces in Southeast Asia, which is often used in political sources. The consequence of the former is inherent in our post-Korean War policy of maintaining a large standing armed force. Such a policy makes possible substantial military action by using the standing forces and equipment with little effect on current domestic economic activity. Garrison and Mayhew cite our definition of escalation as "the percent of GNP going to defense, [which] rose relatively little during the Vietnam era, from 7.2 percent in 1965 to 9.0 percent in 1967. By way of comparison, this ratio rose from 5.0 to 13.2 percent during the Korean War. Walker and Vatter date the Vietnam escalation as beginning in 1965iv and continuing through 1967." 10 This citation mixes our two definitions, which are, "the escalation was confined to the two calendar years 1966 and 1967 when using calendar year data, or the seven quarters 1965iv to 1967^ when using quarterly d a t a . " " This odd mixing causes the escalation to appear substantially bigger than it was. Saying 1965iv through 1967 implies nine quarters instead of seven. If they had mixed the quote the other way it would say 1966 through 1967^, which implies six quarters. This sort of cavalier use of data, which as we shall see is pervasive in their critique, is one of our principal concerns. Garrison and Mayhew accept our dating for the beginning of the escalation in the sense that they use it in their table 5.6.12 But in table 5.7 they refer to a third and fourth year of escalation. Such years do not exist for our definition of escalation, so they must be using some other definition of escalation. But they do not otherwise say what their definition of escalation is. If our inference is correct and they accept our beginning date, then their ending date is 1967jv. But by then, defense as a percent of GNP had been falling for at least seven quarters, which does not imply escalation to us. We clearly point out that the escalation was actually a short-term small break in a secular trend: defense as a percent of GNP declines from 1953 through 1979. Again our very title implies some long-term thinking. We presented a chapter relating current inflation to war escalation that ended more than fourteen years before the chapter was written. Certainly some ability to recover from small short-term shifts in share of resources must exist in market economies. If not they would

Demonstrating the Undemonstrable

99

have torn themselves apart years ago. State and local governments' share of GNP has increased steadily f r o m 5.5 to 12.8 percent between 1947 and 1980. Yet few serious people b l a m e the inflation on them. Garrison and Mayhew bear a much greater b u r d e n of proof than we do. We did not explain the inflation of the last decade or so. We argued that a popular explanation of the origins of that inflatioin was not enough to explain almost fifteen years of continuous inflation. We accepted that it may explain part of the inflation of 1968 a n d noted that much larger escalations in other wars had not produced such subsequent lengthy inflations. Garrison and Mayhew read the record to say that the Korean War escalation relative to excess capacity in the economy was smaller than the Vietnam War escalation relative to the excess capacity in the economy. That fact combined with price controls limited the Korean War inflation to one year. But it is the conventional wisdom of our profession and the experience of the World War II and the NixonVietnam price controls that when the controls are removed inflation appears. Another c o m m o n explanation of no inflation after the Korean War is the recession of 1954. But we are in the midst of the fourth recession since the Vietnam escalation. The 1969 recession was just six q u a r t e r s after the end of that escalation. Recessions did not stop the "Vietnam inflation," the Nixon price controls did not stop the "Vietnam inflation." What will? We don't know. Garrison and Mayhew assert that our small escalation is misspecified because we do not use the high employment budget surplus. In fact we did report the full employment budget surpluses a n d deficits for 1965-1969. It is exactly the s a m e budget except for a variation in the assumed full employment rate. We show that the pattern a n d magnitudes of federal surpluses and deficits in the national income and product account deficit that we use and in the full employment budget are substantially the same. However, they are, of course, correct that the high employment and full employment budgets are designed to compare the degree of expansiveness or contractiveness of fiscal policies. Unfortunately the idea is to contrast several policies for the same year. But that is not what they do. They contrast absolute a m o u n t s of constant dollar high employment budget surpluses a decade and a half a p a r t ! Twenty years ago Michael Levy pointed out the pitfalls of such a procedure: The fiscal impact of alternative budget programs for a given fiscal year can be compared by m e a n s of the absolute size of the

100 Demonstrating the Undemonstrable full employment budget surplus. However, when the budget structures under consideration relate to different fiscal years, a comparison of the absolute size of their respective full employment budget surpluses is not a particularly a p p r o p r i a t e measure of the relative impact on the economy, because full employment GNP (and in most cases actual GNP, too) has increased during the intervening period. Instead, the relative full employment budget surplus should be used, that is, the full employment budget surplus expressed as a percentage of full employment GNP. However, even this relative surplus will not be a proper measure of discretionary changes in budget structure over time. Growing full employment GNP, through its effect on the built-in stabilizers, will boost government revenues f r o m year to year. As a result, in the absence of any changes in government spending or the tax structure, both the absolute and relative full employment budget surplus would increase from year to year. 1 3 Simply, high employment budget surpluses cannot be summed, cannot be used to contrast separate years unless converted to relative surpluses or deficits, and even then are meaningless unless the effect of the built-in stabilizers is identical in the two years. Garrison and Mayhew use only absolute values of the deficits, which they sum, and then use the summed deficits to contrast very widely separated years where the probability of identical built-in stabilizer effects is unknown. Their report on the relative expansiveness of the early Vietn a m and Korean War budgets is therefore meaningless. Garrison and Mayhew use as their source for Tables 5.5 and 5.6, wherein they contrast Korean and Vietnam War budget behaviors, two articles by Frank deLeeuw and others in the Survey of Current Business. Both articles present revisions of the high employment budget, but neither article presents any data f r o m the period of the Korean War! 1 4 We do not know where they got their data, but they did not get it where they say they got i t — w h i c h is very bad research procedure. We have tried to find their Korean d a t a . To make the case they want to make it is necessary to have a good measure of potential GNP that can then be contrasted to actual GNP for the same period. Potential GNP minus actual GNP divided by potential GNP gives a measure of excess GNP capacity in the economy. Levy calls it the relative GNP gap. Table 5.9 shows what we found. It presents several estimates of the potential gap for the period of the Korean escalation. The Korean War began in June 1950 a n d ended in July 1953. With

Demonstrating

the Undemonstrable

101

Knowles's estimates the Korean War began with an economy working at or above its capacity, but the Okun estimates indicate there was some excess capacity that could help support a war. All estimates except Denison's indicate the economy operated above its potential for more than the full three years of the war. The relative gap is biggest in the third year of the war, when Garrison and Mayhew and Walker and Vatter say there was no escalation. Any review of these numbers makes it clear that the errors in potential GNP gaps are sufficient to make fine distinctions between pairs of them unconvincing. Incidentally, the economic managers of the time thought there was no excess capacity in 1950. In some respects, it will be harder to convert to defense production than it was in 1940. Then, there were idle plants and men and materials which could be channeled into the defense effort. Since our economy has recently been running full blast, the defense program will have to pull men and materials, as well as plants, away from existing peacetime uses. 15 TABLE 5.9. Four Estimates of the Relative GNP Gap, 1950-54 (Gap in Percent of Potential GNP) 1954 dollars Year

Quarter

Knowles

1950

1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4 1

2.3 0.2 -3.2 -4.0 -3.8 -4.6 -5.5 -4.5 -4.4 -3.2 -3.1 -4.9 -5.7 -5.8 -3.9 -1.1 0.8

1951

1952

1953

1954

Estimator Okun C.E.A. 7.13 5.16 2.19 0.32 -1.63 -2.63 -2.29 -1.96 -2.97 -2.97 -2.29 -3.99 -4.34 -4.69 -4.34 -0.97 3.70

4.42 2.53 -0.65 -1.41 -1.06 -1.77 -2.55 -1.64 -1.33 -0.17 -0.06 -1.71 -2.47 -2.56 -0.65 2.12 3.92

Denison 4.18 3.38 -0.71 -1.41 -0.97 -1.61 -2.30 -1.31 -0.92 0.31 0.54 -1.03 -1.68 -1.69 0.00 2.33 3.89

Source: Michael E. Levy, Fiscal Policy Cycles and Growth (New York: National Industrial Conference Board, 1963), p. 124.

102 Demonstrating the Undemonstrable Again, one of our principal themes is not what is known but what cannot be known because sufficiently good data to prove a case do not exist. In making the case that the Vietnam War escalation produced problems that extend into the 1970s, Garrison and Mayhew cite but do not report the details of some Phillips curves they have measured, one for the period 1970-73 and another for the period 1960-69.16 They do not say whether the data they used were annual or quarterly, whether wages or prices were on the ordinate, which index number was used, or any of dozens of other pertinent facts necessary to a reproducible experiment. But they assert that it helped convince them that delayed responses of wages to prices caused the Phillips curve to shift to the right, making all inflation choices worse than they had been before the war. The literature on the Phillips curve is enormous. The review article in the Journal of Economic Literature cites 228 different studies 17 and concludes that " i t is well known that the data produce loops. Thus the economy is never on the Phillips curve, except for that instant when the loops cross the curve. What then does the Phillips curve describe? Clearly, a more adequate theoretical explanation is needed before the relationship can be adequately understood." 18 It goes on to say that "there appears to be no long run trade-off between inflation and unemployment. In the absence of disturbances, the economy will settle down to a natural rate of unemployment. . . . Real economic disturbances may change the natural rate." 1 9 Robert Barro provides an example of a real economic disturbance changing the natural rate of unemployment. A real economic disturbance is of course an institutional change in this case: The explanation of behavior in 1970 is complicated since it hinges on the treatment of the switch to the lottery draft as equivalent, in terms of unemployment effects, to a removal of conscription. The assumption that the military variable was zero from 1970 on implies a natural rate since 1970 of 6 to 6.5 percent (depending on the value of the M I N W variable)—an increase of 1.5 to 2 percentage points from the 4.4 percent value for 1969.20 Barro's shift in the "natural" unemployment rate occurs at the same point in time as Garrison and Mayhew's shift in the Phillips curve. This shows that their position that the shift is caused by the escalation is not demonstrated, and until improved theory and data are available it is not demonstrable. The draft was repealed, not during the escalation, but rather during the political reaction to the social and economic horrors associated with the war, which came well after

Demonstrating the Undemonslrable

103

the escalation. So if the Garrison-Mayhew position that the Phillips tradeoff got worse in 1970 and the Barro position that it was the draft repeal that caused the worsening is correct, then deescalation, not escalation, caused the inflation of the early 1970s. The implied cure to such an inflation is to reinstitute the draft, an answer that presumably none of us want. W e had hoped that one of the effects of our chapter would be that some members of the profession would begin to exercise more care in the use of highly refined economic data. The error terms for most economic statistics are not even published. But we know they are large. Unfortunately Garrison and Mayhew did not get the message. S o they have said with some certainty several things that cannot be demonstrated. They are in prestigious company there. Our chapter attributed similar errors to eminent institutions like the Committee for Economic Development, Council of Economic Advisers, and Paul A. Samuelson. Finally, the last t w o paragraphs of our chapter were an observation that the w a r was economically trivial as a macroeconomic event, even though it produced innumerable and enormous political and social horrors for the United States, and political, social, and economic horrors for all of Indo-China. W e raised the question, " W h a t would it be like if w e really escalated the share of our resources going to defense?" The answers we hoped to attract were studies on the capacity of the country to make w a r and the implications for mankind of using that capacity. Thfe answer w e got from Garrison and M a y h e w was that if w e had had better fiscal and price policies in 1966 and 1967 we would not have had the inflation of the 1970s. So let us now end with a whimper. The Economic Report of the President, 1982 projects an increase in defense as a percent of G N P for the period 1981-87 that is almost as big as the increase during the Vietnam War. 2 1 But the period of escalation is longer so the effect on the economy will be less. However, the capacity to destroy mankind or several small countries will be bigger because the G N P is bigger. The profession needs to tell the nation that the economic barrier to war, its appalling economic costs, has been destroyed by the enormous size of our economy. Consequently, we had better erect stronger political and social barriers or w e will have more war.

NOTES 1. Charles B. Garrison and Anne Mayhew, "The Alleged Vietnam War Origins of the Current Inflation," Journal of Economic Issues (March 1983), 17:175-186.

104 Demonstrating

the

Undemonstrable

2. John F. Walker and Harold G. Vatter, " T h e Princess and the Pea; or, the Alleged Vietnam War Origins of the Current Inflation," Journal of Economic Issues (June 1982), 16:600-601. 3. Ibid. 4. Garrison and Mayhew, " T h e Alleged Origins," p. 179. 5. Economic Report of the President (Washington, D.C.: GPO, January 1953), p. 190, Table B-24. 6. Economic p. 262.

Report of the President (Washington, D.C.: GPO, January 1967),

7. Ibid., p. 7. 8. Garrison and Mayhew, " T h e Alleged Origins," p. 181. 9. Ibid., p. 182. 10. Ibid., p. 176. 11. Walker and Vatter, " T h e Princess and the Pea," p. 598. 12. Garrison and Mayhew, " T h e Alleged Origins," p. 178. 13. Michael E. Levy, Fiscal Policy Cycles and Growth ( N e w York: National Industrial Conference Board, 1963), p. 22. 14. Frank deLeeuw et al., " T h e High Employment Budget: New Estimates, 1955-80," Survey of Current Business (November 1980), 60:13-43; Frank deLeeuw and Thomas M. Holloway, " T h e High Employment Budget: Revised Estimates and Automatic Inflation Effects," Suurvey of Current Business (April 1982), 62:21-33. 15. Economic Report of the President (Washington, D.C.: GPO, January 1951), cited in Reuben E. Siesinger, ed., National Economic Policy: The Presidential Reports (Princeton, N J . : D. Van Nostrand, 1968), p. 26. 16. Garrison and Mayhew, " T h e Alleged Origins," p. 180. 17. Anthony M. Santomero and John T. Seater, "The Inflation-Unemployment Trade-off: A Critique of the Literature," Journal of Economic Literature (June 1978), 16:533-544. 18. Ibid. 19. Ibid., p. 533. 20. Robert J. Barro, "Unanticipated Money Growth and Unemployment in the United States," American Economic Review (March 1977), 69:113. 21. Economic Report of the President (Washington, D.C.: GPO, February, 1982), pp. 83-88.

CHAPTER 6

Stagnation—Performance and Policy: A Comparison of the Depression Decade with 1973-1984 J O H N F. W A L K E R HAROLD G. VATTER

This is a discussion of long-run growth prospects in a historical context. We attempt to synthesize the following hypotheses: (1) the U.S. private economy, which was approaching secular stagnation in the 1930s, is again stagnating; (2) the persistence of mass unemployment from 1930 through 1941 was due to the failure of private sector spending streams to grow sufficiently and of the civilian New Deal to administer sufficient stimulatory Keynesian medicine; (3) stagnation was overcome (a) by wartime spending and (b) by, in the postwar decades and going on until the early 1970s, the growth of local and state government spending, which largely offset slowing growth rates of spending in the private sector; (4) the slowing of all government spending in the 1970s has aggravated the chronic shortfall of actual GNP below potential GNP; (5) it is illusory to rely on private spending or fixed business investment to assure growth at full employment; and (6) in the 1980s, only a reapplication of strong Keynesian medicine plus an incomes policy can bring the economy up to, and maintain high employment during, a noninflationary growth trend. Our task is to integrate and endow these hypotheses with empirical and theoretical plausibility. Hypotheses (2) and (3a) are now generally accepted and empirically confirmed.

THE SETTING

The institutional and economic setting in the mid-1980s is rather different from that in the mid-1930s. We need to note the pertinent Reprinted with permission of publisher, M. E. Sharpe, Inc., 80 Business Park Drive, Armonk. N.Y., 10504 USA from Journal of Post Keynesian Economics, Summer 1986, pp. 515530.

105

106 Stagnation—Performance and Policy differences in order to determine whether they make the tasks of recovery and growth essentially similar in the two periods. One contrast is the existence of a well-established mixed economy today. Because of this, postwar economic contractions have bottomed out at a much higher level of activity than was the case under the preWorld War II laissez-faire regime. A second contrast between the 1930s and the 1980s has to do with the condition of the infrastructure. In the 1930s the infrastructure was in comparatively good condition, thanks to the newness and good maintenance levels inherited from the prosperous 1920s. Today the infrastructure so essential to operation of the market is in a serious state of inadequacy due to postponed maintenance, replacement, and expansion. A third contrast has to do with the differing extent of environmental damage and the attendant costs. In the 1930s the damage was less extensive, the threat to the socioeconomic fabric was much less menacing, and spending on such real outputs as healthy air and water was less recognized as an employment-generating social investment. A fourth contrast between the 1930s and the 1980s resides in the heritage of price trends. Prices had drifted upward gently from 1896 to World War I and were remarkably stable in the decade of the 1920s following wartime inflation. Then came the drastic price collapse from 1929 to 1933. It is small wonder that the Roosevelt administration devoted itself to "reflation." While the 1980s could tolerate some inflation, the background of inflation from 1974 to 1982 makes it highly likely that major steps will be taken to restrain price increases. A fifth contrast may be found in the declining relative importance of the farm sector. The enormous exodus of human resources from agriculture has endowed us with a large constellation of nonfarm sectors that exhibit contrastingly higher income demand elasticities. This bodes well for the momentum of a recovery today. A sixth contrast is the absence of a large surplus population in agriculture in the 1980s. Therefore, great increases in labor available for nonfarm industries cannot be derived from the farm areas as they had been for most of the preceding 150 years. However, the United States did have a surge in the labor force participation rate of women and in new workers resulting from the baby boom, boosting employment potentials in the last fifteen years. If the nation had fully utilized these " n e w " inputs, the economy would have boomed. Unfortunately, the boom was in unemployment rates.

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THE HISTORICAL RECORD

Bearing these comparisons in mind, our focus will be on long-run private domestic investment (I) and public spending (G). Unfortunately, these two categories are often assumed to be substitutes: the more G the less /, and vice versa. This is a tragic illusion; economic history shows the two are essentially complements rather than substitutes. But the complementarity is unidirectional: investment will respond to increased government spending, not vice versa—although increased public spending has been a policy response to a decrease in investment. The belief that there is in the long run a likely substitution in the direction of more investment in response to less public spending, now enjoying an ideological resurgence, is not consistent with the record. Table 6.1 shows that between 1950-1973 and 1973-1984 the annual rate of growth of government spending collapsed from 4.21 to 1.63. Fixed business investment, despite massive public encouragement, also fell from 4.30 to 3.80. With the growth rate of two major components falling it is not surprising that the growth rate of GNP itself fell from 3.78 to 2.33. Today, every time the rate of expansion of GNP exceeds lowered long-run growth expectations the government and its economic advisers declare the economy is well and getting better. But that expansion has not overcome the chronic stagnation within which it occurred. As table 6.1 shows, such performance is nothing new: the expansion from 1933 to 1937 was most robust, but stagnation persisted from 1929 through 1940, the eve of the "Keynesian" war economy. The N e w Deal had little if anything to do with the timing of the lower turning point of the cycle in 1933. The upturn from a bottom supported by the Hoover deficits was significantly aided by a rise in total real gross fixed nonresidential investment. The producers' durable equipment component (PDE) of capital formation surmounted the depressing influence of huge excess capacity, turning up a year prior to the GNP nadir, largely in order to effect cost reductions and some desperately needed replacement even in the context of a continuing absolute drawing down of the real gross equipment stock that lasted until 1939. The mere approach to 1929 levels for the value of the PDE stock brought with it major improvements in the output capacity associated with that stock (and its cooperating factors). To illustrate, in 1940, real G N P was 9 percent above its 1929 level, whereas the PDE

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stock value was only 88 percent of the 1929 level. The output/capitalstock ratio had risen sharply to 2.08 from 1929's 1.68. In 1941 the output/capital ratio, reflecting a small rise in the stock value and a big rise in GNP, stood at 2.34! Thus, capital-saving innovations embodied in the decade's gross PDE investment had significantly raised the capacity/capital ratio for PDE in the Depression decade. Accordingly gross PDE spending for TABLE 6-1. Real Annual Percentage Rates of Change, Selected Critical Spending Streams

1920 to 1929*

Pertinent time periods 1929 1933 1950 to to to 1937 1940 1973

1973 to 1984

0.79

9.51

3.78

2.33

-0.34 -6.56 -3.34 -0.83

29.61 20.42 25.59 32.75

4.66 3.77 4.30 3.22

4.62 2.01 3.80 0.00

Public Spending and Investment NA NA Federal Nondefense NA NA Federal Defense NA 12.94 Total Federal NA 1.19 State and Local Government Total Government 4. 81 ; 3.33 2.86

NA NA 16.25 2.89 6.82

Gross National Product Gross Private Investment Producers Durable Equipment Nonresidential Structures Total Fixed Business Investment Nonfarm Housing Construction

5.08 6.38 5.73 9.28

NA NA 3.12 5.04 4.21

1.69 2.50 2.27 1.21 1.63

Source: Data calculations: Economic Report of the President, January 1964 and February 1985. Note: For the private investment series, 3-year averages were used, centered upon the initial and terminal years shown, in order to assure a more accurate representation of the trend. Thus 1984 is a 3-year average employing the 1985 second quarter estimates (at annual rates) to represent the third year. See U.S. Department of Commerce, Survey of Current Business, August 1985, 65 (8) p. 5, Table 1.1 -1.2. "For 1920-29, calculations are from R.A. Gordon, Business Fluctuations, 2nd ed. (New York: Harper & Bros., 1961), p. 407, Table 23. Three-year averages surrounding 1920 are calculated for all the investment series, but the single year 1929 is used for the terminal date. Total government spending for 1920-29 (in 1929 prices) is from John W. Kendrick, Productivity Trends in the United States (Princeton: Princeton University Press, 1961), p. 294, Table A-lla. The larger rate is for 1920-29; the smaller is for 1921-29. NA = not available.

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the period was severely constrained by the large capacity increases that replacement equipment generated. The rising productivity of P D E investment during the Great Depression contributed in part to the "vanishing investment opportunities" encountered by the private sector. But it was capital formation in business structures upon which vanishing investment opportunities w e r e overwhelmingly centered. This long-lived component of fixed investment possessed a gross real stock value (1972 dollars) of $447 billion in 1929. T w e l v e years later the stock value was down to $423 billion and it continued to fall during the w a r . The 1929 real dollar value for the gross stock was not reached again until 1952.1 This quarter-century zero real growth record reflected a very long-run trend of secular retardation going back into the nineteenth century. The poor growth performance of investment in structures was inhibited not only by the postponability of long-lived capital outlays but also by this retardation of secular trend. Here was the truly anemic component of gross fixed investment in the 1930s, a still large stagnating component that held down total investment to decadal " p e a k s " far below 1929. The capacity/capital effects for structures between 1929 and 1941 were as dramatic as those for PDE. For example, the gross GNP/ capital-structures ratios rose from .70 in 1929 to .94 in 1941. Housing did recover in the 1930s though not with sufficient v i g o r to exceed replacement needs and/or to overcome investment weakness elsewhere. The net constant-dollar stock of residential capital in 1941 was the same as it had been in 1932.2 The depression-stagnation investment malaise w a s pervasive. After W o r l d W a r I I in the political context of big and expanding government, public budget deficits, the spread of social regulation, and the explosion of federal welfare transfers, the real gross stock of PDE and private nonresidential business structures exhibited growth rates that compare favorably with the prewar laissez faire period and were quite adequate to accommodate a real G N P growth pretty much on twentieth-century trend at about 3.5 percent. W e must emphasize the lackluster support for the economy and for investment that was provided by the public sector during the years of anemic recovery in the 1930s. The all-government national income and product accounts deficits for 1934-1936, then viewed as shockingly high, averaged only about 3.4 percent of current dollar G N P ; and E. Cary Brown has shown that the all-government full employment deficits were inconsequential. 3

110 Stagnation—Performance and Policy As the N e w Deal groped its confused way toward the Keynesian solution to underutilized resources, it created a new kind of leading sector, one that represented a nonmarket, socially arrived-at, deliberated consensus. Such a leading sector, government spending and employment, differed from the leading sectors in the market economy under laissez faire because of its quasi-planned character. There had been leading sectors in the private market growth process before the Great Depression—canals, railroads, motor vehicles, for example—"great new industry" leaders selected by economic historians. Each was in significant part publicly financed and encouraged. Government, and in particular state and local government, was the leading sector in the U.S. economy after World War II. In the decades during which all-government spending performed the leading sector role, i.e., from about 1950 to the mid-1970s, its real annual compound growth rate was approximately 5 percent. This means counterfactually that, in the absence of such differentially high government growth, the economy would have exhibited much more severe chronic stagnation than it actually did. The principal changes from the 1950-1973 period to the 19731984 period are massive reductions in the rate of growth in the heavily publicly subsidized nonfarm housing construction sector and the state and local government sector. Housing was substantially financed by FHA and VA loan props and the restriction of savings and loan association portfolios to real estate. As the national government weakened these props it weakened housing investment. As the less-governmentis-better movement swept state and local government, their rates of growth fell below those of the economy. This did release growing resources for use elsewhere, but it did not produce advances in the rate of increase in private investment spending. So, many of the released resources became unemployed.

DELIBERATE STAGNATION

It is because of the theoretically informed social discretion represented in the public leading sector that we have defined the recent mixed-economy stagnation as different from the underutilization (stagnation) of resources before World War II. The modern mixed economy is deliberately fostering avoidable stagnation. The standard postwar rationale for the mixed economy is that, to the extent the private economy contributes to growth, all well and good, but insofar as the market yields a socially unsatisfactory result,

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then some level of public spending and employment must intervene. Since World War II the market has been inadequate and government has had to expand. In doing so, public policy has built upon the groundwork laid down long ago by the New Deal. This view has, however, recently lost favor. DECLINING GROWTH ROLE O F FIXED INVESTMENT DUE T O CAPTTALSAVINQ INNOVATIONS AND HUMAN CAPITAL INVESTMENT

The heart of the Hansen stagnation thesis was the presumption of vanishing private investment opportunities. In the absence of large and rapidly growing public expenditures, this would generate a shortfall of actual below-potential GNP, which is stagnation. With Keynes, the source of this eventuality was classical long-run diminishing returns in a capital-rich economy. With Hansen it was partly diminishing returns but also capital-saving innovations, and it is this latter phenomenon and its larger implications that we wish to stress. Historically, technology has moved from capital-absorbing innovations to capital-conserving innovations. This reversal, which secularly reduces the accelerator coefficients, is expressed for tangible capital in the empirically demonstrated upward drift, at least until the mid 1960s, in the business output/fixed-capital ratio or capacity/ fixed-capital ratio. 4 Peter L. Bernstein finds that for the manufacturing sector the capacity/capital-stock ratio rises significantly from 1948 to the mid-1970s. 5 He also argues persuasively that the official estimates of the fixed capital stock in the economy overstate the increase in its aggregate worth—which if correct would understate the rise in the output/capital and capacity/capital ratios. The trend is also supported by a development not anticipated by Hansen, that is, by the ever greater share of increase attributable to human capital and the advance of knowledge. The secular rise in the output/capital ratio means that it takes ever less real fixed investment to achieve a given increase in capacity output. Policy efforts to raise the net fixed investment ratio above the sustainable equilibrium proportion could only generate more excess capacity. This, in turn, would, via new knowledge embodiment, raise the capacity/capital proportion and thus further enhance capital's contribution to the growth of total factor productivity, the progress of potential supply, and the full employment equilibrium rate of required total demand increase. However, the multiplier support extended to demand growth by such a rise in the investment ratio, whatever the magnitude of such support might be initially, would of

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course lose its efficacy as the investment increment ended. If the new, higher ratio were sustained, the accompanying capacity buildup would continue, with capacity growing faster than the value of the stock.6 The arrested expansion of the 1920s is a striking example of this. In that decade there was a sustained high-level gross fixed investment rate, but after mid-decade no further investment increments occurred. Hence there were no investment multipliers. Capacity piled up and no other spending stream, such as government, rose to provide an equivalent aggregate demand expansion. Capacity became, therefore, excessive, and deceleration of the economy followed. This nexus of growth processes may be further illustrated with more contemporary data. The actual average net fixed capital investment ratio (net investment to G N P ) since World War II has averaged a very modest .0302, noticeably below its 1929 level of .0371. The postwar ratio is stable. Given the actual long-run G N P annual growth rate of .035, the Harrod-Domar expression yields a capital/output ratio of .863, a figure not far from a calculated capital/GNP based on Musgrave's net fixed capital stock for 1979 of .802 (using a three-year average for real GNP). Musgrave's estimates yield a net capital/GNP for 1929 of 1.09. Hence, a fall of at least one fifth in the actual capital/ G N P over that period was effected despite the considerably lower net fixed investment ratio. It has been estimated that the multiplier coefficient itself has evinced a long-run decline because consumers, owing to consumer credit growth, have been less restrained by liquidity considerations in the postwar period. A further cause could be the automatic stabilizing effect of the federal budget. 7 Such a trend can only have a growthretarding impact as it interacts with the robust capacity effects of a steady, sustained fixed investment rate.

POLICY IMPLICATIONS

Given this conflict, society should choose some investment/GNP ratio. If it is larger than the current ratio we will get multiplier effects as we move to the chosen level. But once the level is achieved, the demand-creating multipliers disappear since investment's relative growth stops. But capacity continues to grow. To buy the output of the increasing capacity we must institute noninvestment demand stimulation. Through such a combination total demand and potential capacity can move forward together. Investment stimulation alone will work only if the investment/GNP ratio can rise continuously. The required amount of noninvestment demand stimulation is larger, the higher the chosen investment/GNP ratio.

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A c o n t i n u a t i o n of the c o n t e m p o r a r y secular rise in the capacity/ c a p i t a l r a t i o c o m m a n d s a secular fall in the e q u i l i b r i u m p r o p o r t i o n of total o u t p u t t h a t c a n be allocated to net fixed i n v e s t m e n t . It is in this respect that the rising productivity of tangible c a p i t a l could be said to g r a d u a l l y a n d inexorably dispel net i n v e s t m e n t o p p o r t u n i t i e s . The N e w Deal's r e l u c t a n t " p u m p - p r i m i n g " deficit e x p e n d i t u r e s implied reliance on the p r e s u m p t i o n that p r i v a t e i n v e s t m e n t w a s the p r i m e m o v e r of both recovery a n d g r o w t h . The secular fall in the net investment r a t i o is i n c o m p a t i b l e w i t h this p u m p - p r i m i n g view a n d the c o n t e m p o r a r y policy e m p h a s i s u p o n m o r e fixed i n v e s t m e n t . We say " c o n t e m p o r a r y " because the exhortations of professional e c o n o m i s t s f r o m Rivlin to Feldstein to fly f r o m deficit-financed p u b l i c e x p e n d i t u r e s to debt-financed p r i v a t e investm e n t as a w a y of a s s u r i n g long-term e c o n o m i c g r o w t h invoke reliance on the s a m e p u m p - p r i m i n g p r e s u m p t i o n . E c o n o m i s t s w h o assert t h a t i n v e s t m e n t can be a leading sector should be labeled " i n v e s t m e n t e n g i n e e r s . " But even i n v e s t m e n t engineers find that i n v e s t m e n t works as a leading sector only if a p p r o p r i a t e public (tax-subsidy) policy is a d o p t e d . Ultimately, then, we all agree that g o v e r n m e n t induces investment. The d w i n d l i n g of t h e net fixed investment r a t i o a n d the secular c o n s t a n c y of the gross fixed investment r a t i o at a b o u t 10 percent of G N P c o n t r i b u t e s to s t a g n a t i o n . The connection b e t w e e n i n v e s t m e n t limits a n d s t a g n a t i o n resides in the c o m b i n a t i o n of a declining net i n v e s t m e n t ratio, a w a n i n g m u l t i p l i e r coefficient, a n d a rising capacity/capital p r o p o r t i o n . Net capital f o r m a t i o n c a n n o t m e e t K u z n e t s ' t w o basic r e q u i r e m e n t s for a leading sector w h e n viewed f r o m the d e m a n d side: the sector m u s t be large a n d m u s t be growing significantly faster t h a n the total. As for gross fixed i n v e s t m e n t , the m a g n i t u d e at 10 percent of G N P is potentially large e n o u g h to g e n e r a t e larger a b s o l u t e m u l t i p l i e r effects. But since its t r e n d r a t e of g r o w t h is n o higher t h a n that for total d e m a n d , it fails to meet the second r e q u i r e m e n t for leading sector. Looking a t the s u p p l y side of gross i n v e s t m e n t , we see that the d o m i n a n t r e p l a c e m e n t c o m p o n e n t (about 7 0 - 7 5 percent of gross) is the chief g e n e r a t o r of the p r o d u c t i v i t y a n d c a p a c i t y effects t h a t overw h e l m the m u l t i p l i e r s . The induced, as distinguished f r o m the costcutting, e l e m e n t in t h e gross is of course by its n a t u r e a function of rising expected d e m a n d . Rising expected d e m a n d is not likely to e m a n a t e f r o m a u t o n o m o u s cost-cutting i n v e s t m e n t . The o r t h o d o x reliance, d r a w n f r o m a n earlier era, u p o n " i n v e s t m e n t for f u r t h e r inv e s t m e n t " — s e l f - r e i n f o r c i n g c a p i t a l f o r m a t i o n g r o w t h — i s a delusion.

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Every president from Eisenhower to Reagan advocated cuts in taxes on business as a device to induce more investment. The business community continues to argue that the quantity and location of investment is significantly affected by taxes. State legislatures are fighting to attract business with tax cuts. The federal government, the state governments, and a large fraction of the business community argue that taxes are a major determinant of business investment policy. This conventional viewpoint acknowledges that investment is a social policy variable, significantly determined by government tax and spending policies. The unorthodox conclusion from all this is that fixed tangible capital formation in the contemporary era of remarkable capital productivity achievements will, only through the prod of government supply-side stimulus and, more importantly, through some other leading expenditure sector(s), help raise and maintain actual long-run GNP growth to the level of potential. These interpretations call for the identification of two distinct types of stagnation. The first is Hansen's, or "natural," laissez-faire stagnation, caused by the private market forces he referred to. These factors pose a permanent dilemma for advanced, capital-rich market societies. The second kind of stagnation exists in recent decades and is completely avoidable and yet purposeful. Purposeful stagnation occurs when a government in the service of some particular policy goal, such as disciplining the labor force to cure inflation, deliberately slows the growth rate and consequently increases the unemployment rate. Classical stagnationists describe stagnation as a long-run phenomenon, that is, a continual, probably increasing, tendency for the private economy under laissez faire to perform well below its potential. The sine qua non of stagnation in the private economy was the Great Depression, roughly 1930-1940. Hansen wrote, "And, indeed, unless fairly drastic action is taken [italics ours], there is a serious danger that we may move sidewise in the United States or even slip down gradually over the next few years. Measured against the attainable growth of G N P of which w e are capable, such an experience would indeed be a form of stagnation." 8 Samuelson describes the period Hansen was forecasting as the "Eisenhower Stagnation," roughly 1954—60.9 Most of the recent stagflation treatises date the new stagnation as beginning somewhere between 1969 and 1973 and continuing to this date. Therefore, orthodox economists acknowledge we have stagnated in 1929-1940, 19541960 and 1969 to date. On these premises the U.S. economy has been stagnating almost 60 percent of the time since 1929.

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and Policy 115

Hence, for the half century ending in 1983, there have been only ten years (ignoring World War II and conversion) in which actual GNP has equaled or exceeded potential. Those ten years have been noteworthy for the presence of expansionary government. Unfortunately, most of the expansion was war-laden. Three of those years (1950-52) were during the Korean War; five of them were during the Vietnam War, which overlapped the activist, Kennedy-Johnson, Keynesian, civilian expansionist regimes. Without the strong pull from government demand, over the last half century the civilian economy has achieved its potential only in 1956 and 1973. Even those two years, on the basis of the utilization of h u m a n resources (unemployment) criterion, were significantly inferior to 1929. If stagnation is a fifty-year trend, then pursuing short-run inflation-unemployment tradeoffs to stop inflation through government budget restraint only exacerbates the long-run shortfall problem. Regarding the more recent years, there appears to be a turning point in 1969. With the exception of 1973, all years are below GNP potential and they exhibit a distinct and sharp downward trend. The decade of the 1970s thus reveals the face of long-run stagnation, unleashed by the demise of the state and local stimulus together with the failure of the federal government to compensate for this demise. Despite the favorable PDE record of the 1970s, it was a generally stagnant period. The chief dampening influence on the economic performance of the 1970s was the slowdown in growth of what had been the leading expenditures sector after World War II: state and local government. Real spending for goods and services by that large sector had grown at a yearly compound rate of 5.38 percent from 1949 to 1969. But from 1970 to 1980 it grew at only 2.39 percent a year. The element that did boost total output in the 1970s was the combination of PDE growth and net export expansion, which together rose from 7 to 11 percent of GNP and grew at an annual rate of 8.48 percent. Still, without the state and local government stimulus, the PDE investment groundswell turned out to be a prescription for excess capacity. Imports as a share of output have significantly increased since 1960. Some of the imports are PDE. Although some domestic sales are lost to foreign producers, demand for domestic PDE did not fall from 1950-1973 to 1973-1984. So total demand for capacity-creating investment goods is understated in table 6.1. Imported capital goods increase capital stock and domestic capacity while dampening the increase in d e m a n d for output of domestic industries.

116 Stagnation—Performance

and Policy

THE ECONOMIC WASTE OF DELIBERATE STAGNATION For the first four years of the 1980s, one can calculate what real G N P with a 3.5 percent annual growth rate would have been after 1979. Comparison with the actual yields a shortfall every year, and the cumulative total of that shortfall for the four years is $444 billion of unrealized potential (waste). It is, of course, true that throughout the entire industrial phase of U.S. economic history the system has operated below its potential, with full employment obtaining only in brief spans surrounding cyclical peaks. In referring to stagnation during the recent decades, w e are infusing the shortfall below potential with a historically different and quite shocking significance: now when we operate below our capability we do so on purpose. This is occurring because the macroeconomic theoretical revolution provided us with a set of macroeconomic tools, together with coordinate policy precepts, that make it entirely feasible for us to maximize G N P growth and minimize unemployment.

CONCLUSIONS REGARDING POLICIES TO ESCAPE THE GROWTH MALAISE It is an atavistic illusion today, as it was in the 1930s, to believe that sustained net private fixed investment, in a small government milieu, can guide domestic G N P along a high-employment long-run growth path. It is too small and too much induced—induced by expectations of prolonged increase in final demand together with favorable tax, public expenditures, and subsidies. Autonomous, productivity-raising business fixed investment is substantially a replacement phenomenon. The net fixed investment stream has for decades been primarily a function of final sales and secondarily of government inducements from the supply side. As a policy matter, hardly anyone objects to continuation of supply-side inducements in some form. But growth policy must primarily rely upon other, final demand inducements. W e know that consumption cannot lead the growth process and in the long run export growth without import growth is impossible unless we and our trading partners are willing to run sustained imbalances of payments, which is very unlikely. If export growth is matched by import growth, there is no net stimulus. Only in a bouyant publicspending milieu will gross fixed investment perform at its traditional rate of some 10 percent of G N P . At this rate capital modernization, embodying quality improvement and the advances in applied knowledge, will make an appropriate contribution to productivity rise. But only a sustained rise in the net income-generating expenditures

Stagnation—Performance

and Policy 117

of government can overcome the contemporary malaise. This means that a substantial j u m p in the already large federal deficit is necessary to induce a recovery to sustained high employment, followed by a leveling off of the deficit as a result of the consequent expansion in the national income. Fortunately, the government is now so large relative to total economic activity that to boost the economy it does not have to perpetuate a percentage increase in its budget a n d its deficit nearly as large as was required in the 1930s, when the budget was a much smaller proportion of GNP. Our pure theory of secular stagnation and antistagnation policy in the U.S. economy builds upon Hansen, the long-run Keynesian, and Keynes himself, the former for the basic explanation of the growth malaise, the latter for the primary explanation of what is the appropriate policy. Indeed it is Keynesian policy that has kept stagnation within tolerable limits for a half century. It is true that these theories do not cope any better than their neoclassical predecessors with the chronic inflationary pressures that have latterly come to beset the system. We have a prescription for that, but we are not strongly concerned with it here—except to stress that the alternative prescription of deliberately fostering wasted resources is in our value framework too antieconomic to accept. There is no other route if we truly wish to escape stagnation and large, chronic unemployment. The New Deal saw this and embraced the inevitable. But it was reluctant rather than bold about it, and its full-employment deficits were pitifully small. The New Deal did have to wrestle with a powerful bias in society against budget deficits, but the economic crisis of the 1930s created an atmosphere of desperation that made a fiscal rebellion feasible. While the rise in employment and output attendant upon a large increase in public expenditure will tend to inhibit the concomitant inflationary potential, we could not rely upon this output surge, together with the subsequent weak fiscal drag, to fully stifle the inflationary pressure. Although some price rise is certainly tolerable, it may be necessary to move in a direction even more terrifying to the traditionalists than the bigger deficit route—some form of incomes policy for a protracted period. Such would be required all the more as the economy got closer to its high-employment growth path. This is not as radical as it sounds since a deliberate policy of stagnation is a form of incomes policy that keeps wages and prices in line via slack markets—but the social costs of this incomes policy are tremendous. Perpetuation of an enlightened incomes policy could avoid the enormous losses of output that the United States has suffered over the recent decade-and-a-half as it has attempted to fight inflation with

118 Stagnation—Performance

and

Policy

c h r o n i c a l l y r e d u c e d o u t p u t a n d t h e h i g h h u m a n c o s t s of e x c e s s i v e u n e m p l o y m e n t . Public policies to reduce output have been a mons t r o u s t a x o n s o c i e t y ( w h i c h w o u l d b e richer w i t h o u t t h e p o l i c y ) . For e x a m p l e , a s t a b l e 6.2 s h o w s , in t h e R e a g a n y ea rs 1 9 8 2 - 8 5 the e n o r m o u s c u m u l a t i v e p o l i c y c o s t ( t a x ) o f d e l i b e r a t e s t a g n a t i o n is $ 1 4 8 . 1

TABLE 6-2. Comparison of Policy Tax and Income Tax, 1969-1985 (in billions of 1972 dollars)

Year

Actual GNP

Potential GNP

Policy tax (potential minus actual GNP

1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985ii

1087.6 1085.6 1122.4 1185.9 1254.3 1246.3 1231.6 1298.2 1369.7 1438.6 1479.4 1474.0 1502.6 1478.4 1534.7 1639.0 1671.3

1069.6 1107.1 1145.8 1185.9 1227.4 1270.4 1314.8 1360.8 1408.5 1457.8 1508.8 1561.6 1616.3 1672.8 1731.4 1792.0 1854.7

(18.0) 21.5 23.4 0.0 (26.9) 24.1 83.2 62.6 38.8 19.2 29.4 87.6 113.7 194.4 196.7 153.0 183.4

Sources: Actual GNP: Economic

Current Business, Statistics,

Report of the President,

Net federal individual income tax receipts 98.7 97.7 89.4 94.7 97.7 102.2 97.7 99.9 113.2 121.4 134.1 136.4 147.0 144.5 135.3 134.4 165.2

1985, p. 234, and Survey of

September 1985, p. 5; individual income taxes:

1982, p. 67 and Survey of Current Business,

Business

September 1985, p. 514.

Notes: Potential GNP is calculated by assuming actual GNP equals potential GNP in 1972 and calculating the other years assuming a 3.5 percent real annual growth rate, which is the twentieth century trend rate. In 1972 the unemployment rate was 5.5 percent, which falls between the experience of the 1960s where the average annual unemployment rate was 4.65 percent and there was little or no stagnation, and the 1970s, when the average annual unemployment rate was 6.1 percent and there was substantial stagnation. Therefore, our assumed normal may include some stagnation. Net federal individual income tax collections were deflated using the personal consumption expenditure deflator to get real 1972 tax dollars to compare to the real GNP figures. Parentheses indicate negative values.

Stagnation—Performance

and Policy

119

billion (in 1972 dollars) larger than the cumulative total revenues from individual income taxes. This misguided, deliberate stagnation policy tax is therefore the highest tax society has paid in recent years. Of course the output lost because of b a d macro policy is lost to all sectors of society forever. The income tax is a loss to the private sector and a gain to the public sector. In some cases, an increase in income taxes can be a benefit to the private sector if the funds are then spent for public services that are more valuable than the private services foregone, or if the funds are held to eliminate inflation. Increase in the "deliberate stagnation policy" tax benefits no sector of the economy. It is pure waste.

NOTES 1. John W. Kendrick, Kyu Sik Lee, and Jean Lomask, The National Wealth of the United States (New York: Conference Board, 1976). 2. John C. Musgrave, "Fixed Capital Stock in the United States: Revised Estimates," Survey of Current Business (February 1981), pp. 57-68. 3. E. Cary Brown, "Fiscal Policy in the Thirties: A Reappraisal," American Economic Review (December 1956), 46:857-879. 4. Harold G. Vatter, "The Atrophy of Net Investment and Some Consequences for the U.S. Mixed Economy," Journal of Economic Issues (March 1982), 41:237-253. 5. Peter L. Bernstein, "Capital Stock and Management Decisions," Journal of Post Keynesian Economics (Fall 1983), 6(l):20-38. 6. A prominent illustration of a rise in capacity/stock is found in the manufacturing sector, in which the capacity index between 1950 and 1983 increased 4 percent a year while the constant dollar net stock value rose only 0.78 percent a year. See Musgrave, "Fixed Capital Stock," and U.S. Department of Commerce, Bureau of the Census, Statistical Abstract (Washington, D C.: GPO, 1958), pp. 525, 757. 7. Schultze draws on De Long and Summers for these points. Charles L. Schultze, "Phillips Curves, Price Expectations and Other Macroeconomic Phenomena in the United States: A 90-Year History," paper presented at National Bureau of Economic Research Conference on the Business Cycle, available as Harvard Institute for Economic Research Discussion Paper no. 1077, August 1984. 8. Alvin H. Hansen, "The Stagnation Thesis," in A. Smithies and J. K. Butters, eds.. Readings in Fiscal Policy (Homewood, 111.: Richard D. Irwin, for the American Economic Association, 1955). 9. Paul A. Samuelson, Economics, 11th ed. (New York: McGraw-Hill, 1980).

CHAPTER 7

Can the Good Performance of the 1960s Be Repeated in the 1980s? HAROLD G. VATTER J O H N F . WALKER

To the question of this discussion. Can the U.S. economy in the 1980s, if it hurries, equal the good economic performance of the 1960s, our answer is: Probably yes, if. . . . The reasons for this prognosis are outlined herein. Performance in the 1960s was not in all major respects good. On the other hand, the expansion from 1961 through 1969 was in its entirety a "prosperity without parallel in our history." 1 From 1959 to 1969 the upward price drift was quite moderate—for example, 2.32 percent a year for the CPI. Total civilian employment rose 2.24 percent, and hours of all persons in the nonfarm business sector 2.27 percent, from 1962 to 1969. Research and development outlays in ratio to GNP were historically high. 2 The decrease in the unemployment rate and the improvement in material welfare are gains that can only hint at numerous additional achievements unrecountable here. We confidently project the 1960s as a model whose broad contours the United States would do well to emulate in the remaining years of the 1980s. A selective look at the 1960s, from the cyclical recovery year 1962 to the end, viewed from the demand side, is shown in table 7.1. Two expenditure streams, of approximately equal size (other than transfers), stand out prominently as leading the growth in aggregate demand: state and local government (S & L) and nonresidential business fixed investment. The great bulk of business fixed investment was then, as it typically is, induced by expected sales increase. But in the 1960s, federal supply-side inducements also encouraged investReprinted from Journal of Economic Issues (June 1983), pp. 369-378, by special permission of the copyright holder, the Association for Evolutionary Economics.

120

TABLE 7-1. Change in Total Spending, Selected Categories, 1962-1969 (current dollars) Expenditures ($ billions) Category GNP Personal consumption Business plant and equipment Residential construction • Federal non-defense National defense State and local government [Federal grants to S & L governments] [Federal transfers to persons]

1962

1969

565.0 355.2 52.2 27.0 12.7 51.1 54.3 8.0 25.6

944.0 581.8 101.3 38.2 21.2 76.3 111.2 20.3 50.6

Percent change 67.1 63.8 94.1 41.5 66.9 49.3 104.8 153.8 97.7

Source: Calculated from data in Economic Report of the President (Washington, D.C.: U.S. Government Printing Office, February 1982), passim. 'Three-year averages centered on the selected dates for this volatile component yield an increase of 90 percent.

TABLE 7-2. Selected Input Contributions to Growth of Total Output, 1964-69 Total factor input labor employment hours age/sex composition education unallocated capital of which nonresidential structures and equipment Output per unit of input of which advances in knowledge & n.e.c. improved resource allocation economies of scale

3.08 2.28 2.36 -0.26 -0.29 0.37 0.10 0.80

0.42 1.37 1.02 0.35 0.43

Source: Edward F. Denison, Accounting for Slower Economic Growth (Washington: Brookings, 1979).

122 Can the Good Performance of the 1960s Be Repeated in the 1980s? ment: the investment tax credit of 1962, the liberalization of tax depreciation guidelines, low long-term interest rates, the tax cut for corporations, and the reduction of the top individual tax rates from 91 to 70 percent. 3 We maintain that the stimulus to rising total demand coming from the expansion of S & L spending, when conjoined with rapid fixed investment expansion stemming from the same source and supplyside incentives, made such investment increases complementary with S & L spending increases—not, as with Reaganomics, a substitute for government spending. The concrescence of S & L and fixed-investment spending was the heart of the expansion. And the former was heavily underwritten by the great rise in federal grants-in-aid (shown bracketed in table 7.1). The amount of these grants given the S & L governments fortunately accelerated after 1965 and bolstered the S & L expenditures growth after the investment boom had peaked in 1966. It will be observed that the military budget, a weak provider of employment, was a lagging expenditure category, as compared with both GNP expansion and federal nondefense outlays. Edward Denison provides us with one picture of how the 1960s grew as viewed from the production side. Unfortunately, his estimates break at 1964: they treat the whole decade 1953-1964 followed by the half decade 1964-69. We present, in tabular form, his estimated positive contributions to the 4.45 percent per year rise in national income, in percentage points (table 7.2). The relationships among the numbers in this tabulation broadly represent the economy for the whole period after World War II and can be expected to hold generally for the 1980s—given the appropriate public and private policy setting. 4 We consider the following relevant for the 1980s. First, labor input, which is at a very high rate, is an important factor in this decade's economic performance. Employment of wage and salary workers in nonagricultural establishments increased at the phenomenal rate of 3.85 percent a year (it was also unusually high at 2.48 percent, 1970-1980). All civilian employment rose 2.36 percent annually in the five years 1964-69. This is far above the likely rise, based on labor force projections, of between 1 and 1.5 percent for the total labor force in the 1980s. Data Resources, Inc. has estimated total employment growth from 1980 to 1989 at an annual rate of 1.7 percent. While this bodes well for the course of the capital/labor ratio, it is perilously low if most of the 10 percent of the labor force officially unemployed are, in addition to labor force additions, also to be reemployed. 5 If employment were to increase at an annual rate of 2

Can the Good Performance of the 1960s Be Repeated in the 1980s? 123 percent, then GNP would need to grow at least 3.5 percent a year for a very modest annual "labor productivity" increase of 1.5 percent. Such a G N P requirement, however, is at least half a percentage point below the actual for 1960-1970. Second, fixed capital input, the capital stock in place,6 limped along with about a 9 percent contribution (the same for the whole period 1948-1973) to the increase in output, in 1964-69. This occurred in the context of a vigorous annual real increase in gross fixed business nonresidential investment of 7.15 percent. Third, Denison maintains, and we concur, that the advance of knowledge is the biggest reason for the long-run growth of total factor productivity. If we add this incorporation of new knowledge (about 1.02) into the productive process to worker education improvement (.37) we get 1.39 percentage points, or the source for about 31 percent of national income growth. Intangible capital as proportion of total gross domestic wealth jumped from 31 to 39 percent from 1957 to 1969.7 The policy implications of this are that growth policy demands an emphasis on education, worker training, and civilian research and development. A heavy emphasis in the 1980s on business fixed investment, with the investment ratio in the past on trend, could well be misplaced—especially if it is not industry specific. Fourth, improved resource allocation, equal to about 8 percent of all expansion sources, consisted mainly of the shift of workers from farming, a determinant that will be absent in the 1980s because that process has virtually exhausted itself. Fifth, economies of scale accounted for almost 10 percent of total sources of output expansion. With normal expansion of markets, "the business economy of the United States operates under increasing returns to scale." 8 The basic institutional setting, characteristics, and broad expansion prospects of the U.S. economy in 1982 were much the same as they were in 1962. The differences are largely ones of degree. In the context of such differences, the economy has, however, entered the 1980s with a background of stagflation and inflation, twin threats to the American policy consensus. The professed goals of federal policy in the 1980s seem basically the same as they were in the 1960s. In its first economic report the Kennedy administration announced its "Goals of Economic Policy": " ( 1 ) The achievement of full employment and sustained prosperity without inflation, (2) the acceleration of economic growth, (3) the extension of equality of opportunity, and (4) the restoration of balance of payments equilibrium." 9 These goals are partially repeated and ominously changed by the

124 Can the Good Performance of the 1960s Be Repeated in the 1980s? Reagan a d m i n i s t r a t i o n in its first economic report, which said, "The general objectives of this act (the Full Employment and Balanced Growth Act of 1978)—and those of the Administration—are to achieve full employment, growth in productivity, price stability, and a reduced share of governmental spending in the nation's o u t p u t . " 1 0 John F. Kennedy a n d Ronald Reagan agree that the economy should achieve full employment without inflation. Kennedy's full employment a n d accelerated growth is logically the same as Reagan's full e m p l o y m e n t with growth in productivity. Reagan ignores equality of opportunity, since it is not consistent with a sharply skewed distribution of wealth or income. Not surprisingly, the Reagan administration, with its desire to make the government smaller, deemphasizes equality of opportunity programs, which tend to increase the size of gross government relative to GNP. The explicit goal of a bigger GNP with a smaller governmental share assumes that Wagner's Law can be repealed. We know of no evidence that such a thing can be done. There is massive evidence that such a thing has never been done if one includes transfers as part of government expenditures. 1 1 However, to date the Reagan administration, with the exception of supply-side, investment tax-subsidy coddling, would serve these goals with policies very different from, and generally opposite to, the policies of the Kennedy-Johnson period. While we do not maintain that public economic policy should be in all m a j o r respects the same as in the 1960s, neither do we believe we can come up with a good sixtieslike performance with policy as contrary to that of Kennedy-Johnson as is Reagan's. The Reagan administration seems to think that its tax policy changes are qualitatively different from those of recent administrations: "This tax policy is a s h a r p break f r o m the policies of the recent past." 1 2 It goes on to assert that the key to its policy is a long-run perspective. 1 3 Taxes on high-income individuals and corporations have been lowered regularly by both Republicans and Democrats since the end of the Korean War. The top marginal rate in the individual income tax was 92 percent for most of the 1950s, fell to 77 percent in 1964, to 70 percent in the 1970s and to 50 percent in the 1980s. 14 Over the same period the average rate of income tax paid by persons earning more t h a n $100,000 per year has steadily declined from 53.4 percent in 1952 to 37.9 percent in 1979. 15 The few (and temporary) tax increases in the 1950-1980 period clearly were associated with fighting the Vietnam War and its associated inflation. 1 6 So we already have had a long-run a t t e m p t to increase investment

Can the Good Performance of the 1960s Be Repeated in the 1980s? 125 and saving through tax policy changes remarkably similar to those advocated by President Reagan. Accelerated depreciation, corporate and personal income tax rate cuts, a n d increasingly generous IRA and Keogh plan provisions make u p most of the Reagan tax policy. All of these programs were pioneered and expanded by earlier administrations. Thirty years of continuously cutting the taxes of high-income groups to increase investment and economic growth has done very little for investment, which in the aggregate seems relatively invariant to such taxation. Nor does investment seem to explain growth. 1 7 However, these tax cuts have increased the sources of funds for nonfinancial nonfarm corporations. No recent American government has wrestled with the problem that giving more f u n d s to business does not guarantee that they will do anything socially productive with these funds. Table 7.3 illustrates this dilemma. The set of nonfinancial nonfarm corporations are increasingly becoming financial intermediaries. Increasing shares of the funds they raise and the funds they "invest" create debt rather than real assets. If we are to rely on the corporate sector as an agent of economic development through tax cut-financed investments, we need some mechanism to induce the beneficiaries to use the funds in socially desired ways. Without such a mechanism there is additional reason to doubt real investment can be a leading sector. But this is an a r g u m e n t for more government controls on business investment and possibly more serious enforcement of the separation TABLE 7 . 3 . Investment and the Sources and Uses of Funds By Nonfinancial Corporations

Internally generated funds/

All nonfinancial nonfarm corporations' percent of total source of funds used

Average for the years

Investment/ GNP

All sources of funds

Capital expenditures

Increase in financial assets

1950-60 1960-70 1970-80

16.1 15.3 15.8

66.1 64.1 60.4

74.7 69.3 64.3

20.0 20.5 26.6

Source: Economic Report of the President (Washington, D.C.: U.S. Government Printing Office, February 1982), pp. 233, 334.

126 Can the Good Performance of the 1960s Be Repeated in the 1980s? of real and financial enterprise built into the national banking regulations. The current policy is to go the other way. 18 In their general outline and thrust the tax changes proposed for the 1980s are the same as the policies of the 1960s and 1970s. And the argument that the economy has been stunted and distorted by excessive increases in taxes on corporations and high-income individuals is specious, since those groups got most of the tax cuts of the last thirty years. The big tax increases have been social insurance taxes and the predominantly regressive S & L taxes. Since postwar tax policy was essentially the same for good decades and bad under Republicans and Democrats, tax policy cannot explain why the economy in the 1960s exhibited better economic performance than in the 1950s or 1970s. We believe the key to understanding the success of the 1960s, to the extent it is budget policy, is in expenditure policy. In the 1960s, the government committed itself to do more. It cut taxes and increased public works. It increasingly interposed itself in all our lives to prevent prejudice and force more nearly equal treatment for various culturally disparaged groups. It committed itself to full medical care for all older citizens. It substantially increased society's commitment to the environment. It undertook to significantly improve S & L government services by a massive increase in grants-in-aid, without which it is unlikely that S & L governments would have increased nearly as much as they did. Government outlays were the economy's leading expenditure stream in the 1960s, with federally aided S & Ls the fastest growing—a 138 percent rise in current dollars 1960-69, compared with an 86 percent rise for GNP. Federal outlays rose 102 percent as they increasingly subsidized the S & L through grants-in-aid. Business fixed investment was induced primarily by the government spending stimulus to expand in tandem—109 percent. The tax system at that time consequently brought in a 113 percent rise in all government receipts, making it possible to finance the large expansion in expenditures without big unified budget deficits. With high-employment public budgets displaying minimal surpluses and deficits, it was expenditure growth that carried the economy upward in the 1960s. Unfortunately, the Reagan administration seems determined to reduce state and local governments by reducing federal transfers to them. 19 We share Lester Thurow's conviction about 1982-83 that "without a governmental yank, this recession is not going to end." 2 0 In the longer perspective, without a governmental yank entailing very large

Can the Good Performance of the 1960s Be Repeated in the 1980s? 127 deficits, the economy will not grow in the 1980s. There is no other candidate for the job of leading expenditure stream. We know neither household consumption nor net foreign investment can do the job. Nor can business fixed investment, for such investment is so highly productive today that it generates capacity increases that outrun its multiplier effects. Without anticipated sales increases, such fixed investment as might occur "autonomously" would be largely replacement investment that could also readily raise capacity and labor productivity, with the latter tending to reduce employment. Residential construction might outperform the 1960s, especially if the government instituted an FHA for the growing elderly cohort. Of course, that's increasing government intervention again. That leaves government. The federal deficit, now slated to be about 5 percent of GNP in fiscal 1983, about a percentage point higher than in 1934 and 1936, will have to rise substantially to get the aggregate spending that will produce the increase in tax receipts that will subsequently begin to cut it down. Incidentally, in " p o o r Japan," in 1981 the deficit was one third of the central government budget; it was only about 10 percent in the United States! 21 On the expenditure criterion government will unquestionably have to get bigger. It may begin to approach the relative size of government in some European mixed economies. Of course, the federal government's exhaustive expenditures in 1981 were only 7.8 percent of GNP, whereas in 1961 they were 10.9 percent of GNP, a 28 percent drop! So the current cry from Washington about growing big government is historically false. Still, it is bigger if w e add the welfare elements, that is, the social transfers. Hence the present administration's demands for reduction in the size of government clearly emerge as demands for cutting the welfare segment (even as the military segment is planned to grow). With Kennedy-Johnson it was the welfare increases that were called for and executed. It is precisely to those welfare expenditures that we must turn to discover the wellsprings of GNP expansion in the 1960s. In the 1960s, "America in Ruins" referred to welfare, poverty, education, and the social infrastructure. 22 At the time, these civilian areas stood out as John Kenneth Galbraith's "starved public sector," and they were attended to, along with "supply-side" support, after a fashion. At the beginning of the 1980s the administration denies these areas and places them fiscally under attack. Indeed, welfare and the social infrastructure, without which private enterprise will be a shambles, already are at the crisis threshold. Consider the dependent population. When the baby boom struck the public schools in the

128 Can the Good Performance

of the 1960s Be Repeated in the 1980s?

1960s, no one questioned public support of these children. And so those children supplied the economy with an enormous increase in the demand for public services and their supply. So it can be with the gerontological boom: if w e view taking care of our parents as an opportunity, just as with the baby boom, then w e will also finance the facilities they need. In each case workers are coerced to do their moral duty. The only tested alternative would be an explosion of military outlays with their relatively weak employment effects. 23 Our proposed increases in public expenditures will create demandpull inflation reinforced by cost-push. T o tame the accompanying inflationary forces w e will have to institute, like Switzerland, general wage, price, and interest rate controls or complete indexation for a protracted time. If controls are instituted, we agree with Gar Alperovitz and Jeff Faux that they must be accompanied by special attention to certain key sectors: energy, food, health care, and the housing supply. 24 Throughout the noninflationary 1960s, monetarists attacked a policy that saw money stock increases lagging behind output (1961-65), and just about matching it (1964-68). But w e approve such a conservative behavior for money for the 1980s. Unfortunately, monetarists have had a large say in policy since 1969, which period includes the worst peacetime inflation in our history. We recommend giving the Council of Economic Advisers back to the Keynesians and the Fed to the like of Marriner Eccles and William McChesney Martin. In conclusion, we concur with most modern theorists who have emphasized the psychological elements in the economy. If we think with Herbert Hoover and Reagan that we cannot afford to employ the unemployed, feed our parents, reconstruct the infrastructure, and bring the blessings of liberty to our children, then we will act to fulfill that prophecy. However, if we see the task of the 1980s as a relatively moderate extension of the established trends of this economically successful century, then we will act decently, spend generously, and get rich. NOTES 1. Economic Report of the President (Washington, D.C.: GPO, January 1969), p. 4. 2. U.S. Congress, Joint Economic Committee, Subcommittee on Economic Growth, Economic Growth and Total Capital Formation, 94th Cong., 2d Sess., February 18, 1976, p. 4. 3. See Walter Heller, "Kennedy's Supply-Side Economics," Challenge ( M a y June 1981), 24:14-18.

Can the Good Performance of the 1960s Be Repeated in the 1980s? 129 4. See David W. Benson and V. Vance Roley, "Business Fixed Investment in the 1980s: Prospective Needs and Policy Alternatives," Federal Reserve Bank of Kansas City, Economic Review (February 1981), pp. 3-16, especially table 1. 5. With a civilian labor force of about 111 million in late 1982, even with a "natural" unemployment rate of 4 percent there would still be 6Vi million unemployed to be hired. 6. Edward F. Denison, Accounting for Slower Economic Growth (Washington, D.C.: Brookings Institution, 1979), p. 50. 7. Congress, Joint Economic Committee, Economic Growth and Total Capital Formation, p. 10. 8. Ibid., p. 78. 9. Economic Report of the President, 1962, pp. 7 - 8 . 10. Economic Report of the President, 1982, p. 213. 11. Morris Beck, "Public Sector Growth: A Real Perspective," Public Finance (1979), 34:313-343. 12. Economic Report of the President, 1982, p. 109. 13. Ibid. 14. Facts and Figures in Government Finance (New York: Tax Foundation, 1979), p. 103. 15. Ibid., p. 107. 16. John Walker and Harold G. Vatter, "The Princess and the Pea: or the Alleged Vietnam Origins of the Current Inflation," Journal of Economic Issues (June 1982), 16:597-607; John Walker and Harold G. Vatter, "Demonstrating the Undemonstrable," Jowrwa/ of Economic Issues (March 1983), 17:186-195. 17. Harold G. Vatter, "Capitalism without Accumulation," Journal of Economic Issues (March 1969), 3:110-135; Harold G. Vatter, "The Atrophy of Net Investment and Some Consequences for the U.S. Mixed Economy," Journal of Economic Issues (March 1982), 16:237-253. 18. Economic Report of the President, 1982, chapter 6. 19. Ibid., p. 92. 20. Lester Thurow, "The Cost of Unemployment," Newsweek (October 4, 1982), p. 70. 21. "How Japan Does It," Time (March 30, 1981), p. 60. 22. Pat Choate and Susan Waler, America in Ruins (Washington, D.C.: Council of State Planning Agencies, 1981). 23. D. E. Anderson, "Study Ties Defense, Job Losses," Oregonian (October 25, 1982), p. 1. 24. See their "Controls and the Basic Necessities," Challenge (May-June 1980), pp. 21-29.

CHAPTER 8

Real Public Sector Employment Growth, Wagner's Law, and Economic Growth in the United States H A R O L D G. J O H N F.

VATTER

WALKER

The question of the size of the government sector has become a pressing socioeconomic and political issue in contemporary times. In a number of fields within economics, notably public finance, economic growth, and economic history, attempts to determine the optimum level of government participation and to test the empirical validity of Wagner's Law reflect an awakened concern with the size of the public sector. Further, the size issue has been currently endowed with a new urgency by the efforts in Washington and London to arrest and even reverse the long-run growth of the interventionist component of the post-World War II mixed economy. Almost all of the recent work on the size of the government sector has proceeded in terms of pecuniary measures such as nominal or deflated public expenditures in ratio to gross national product (GNP) or gross domestic product (GDP). We are indebted particularly to Morris Beck for a scholarly effort to determine the real size of the government sector in a number of industrially advanced mixed economies. 1 Richard and Peggy Musgrave have noted, however, that undeflated expenditure magnitudes reflect economic choices in their own way just as well as deflated measures: that no single perspective has a monopoly on the "real." 2 Appraisal of the size of the government sector from differing perspectives can contribute to the shaping of choices themselves, as John Kenneth Galbraith pointed out long ago when he viewed with alarm the "starved public sector." Such appraisal should include examination of the amount of " r e a l " resources absorbed in government activThe article is reproduced here with the permission of the original publishers, Foundation Journal Public Finance, The Hague. The paper was originally published in Public Finance! Finances Publiques (1986), 41:116-138.

130

Real Public Sector Employment Growth 131 ity. Furthermore, any adequate grasp of the growth role of government in the economy as a whole must include an analysis that proceeds in real terms, however measured. The Musgrave estimates of the federal government's constant dollar gross stock of fixed capital (equipment and structures) show that its magnitude jumped from 2.4 percent of all private fixed nonresidential gross capital stock in 1929 to 13.5 percent in 1949, but thereafter fell steadily to only 8.8 percent in 1979.3 This is hardly in accord either with the constancy of federal employment relative to the total civilian labor force after 1949 or with the many pecuniary measures of federal government growth after 1949. Furthermore, the federal percentage j u m p from 1929 to 1949 reflects in large part the special circumstance that the private capital stock grew only 7 percent in that twenty years. If we turn to the state and local stock, the trend record is similar: the percentage is 25 in 1929, j u m p s to 41 in 1939, and rises only to 44 in the next four decades. This conflicts with everything we know about the rise in the relative importance of state and local government, on any measure, after World War II. We conclude, therefore, that the use of the public capital stock is an inappropriate criterion for appraising either the relative growth of government or Wagner's Law. This paper is concerned with the United States and appraises the growth of government therein, particularly since 1929, using employment mainly, but not exclusively, as the measure. It is thus concerned with the long-run record of real h u m a n resources engaged. The federal and the state and local (S & L) levels are also disaggregated. The appraisal furthermore treats the size and character of the government sector as it impinges on economic growth. If we are interested in Wagner's Law, or whether government is getting "too big," or whether government has been a leading, lagging, or neutral sector in the economic growth process, public employment may be by far the most appropriate measure available. Such concerns provide the focus for what we do here. Despite the commendable work of Beck a n d others on real public sector growth, an expenditure approach is seriously flawed in its capacity to show trends in absolute, and even relative, real resource absorption. This is readily acknowledged by Beck et al. All-government expenditure and purchase totals suffer from the distressing effort to form a single separate package out of the federal and the S & L totals and then to sum the two into one aggregate encompassing 1) purchases, mostly of goods, from the private sector; 2) purchases of the services of government employees; and 3) transfer payments to

132 Real Public Sector Employment Growth persons, net grants in aid from the federal to the S & L governments, and net interest paid. What such a heroic summation process can show, and what it signifies regarding impact, is not easy to discern. The procedure is beset with much more precarious pitfalls than GNP calculation because there is only a handful of components. Furthermore, conversion from nominal to real expenditure aggregates requires selection of the appropriate deflator. A word of our own on this seems in order. Aside from the standard price index number construction problems, the calculators of price indexes do not regularly report all of the sources of error in their numbers and the estimated magnitudes of the total error. For example, it has been shown that the old CPI could be changed 3 percentage points for one year by redefining the measurement of housing costs; hence the CPI has been redefined. If there is systematic error in government purchase and expenditure price indexes, then real comparisons will overstate (understate) the size of government if the price index understates (overstates). If errors oscillate, then what appears to be growth (shrinkage) may in reality be shrinkage (growth). Without regular annual reports on the total error in the indices, overstatements, understatements, and misstatements of the magnitude of real growth of government cannot be known from dollar data. One difficulty would arise from the selection of a deflator for government purchases of goods. When the government contracts to purchase 800 fighters at $17 million apiece, no reasonable person believes this stipulates that the government will either buy 800 fighters or pay $17 million apiece for however many it eventually buys. To describe correctly the prices government pays and the quantities it receives, we need the actual payments made. Unfortunately, for major military durable contracts and public works that means the public prices are incalculable for many years after the purchase decision is made. This may readily be appreciated with regard to the important element of military goods, for which no reasonable deflator can be constructed. Again with respect to labor services, there is a 14-percentage point difference between two sources, the government services purchases deflator (United States, Department of Commerce) and the annual government employee earnings deflator. 4 To deflate the heterogeneous all-government expenditures collection, to say nothing of disaggregated levels of government, is thus a heroic task much in need of alternative perspectives such as ours. The employment perspective is favored by good data. Government employees handle goods purchases, acquire and dispense funds, uti-

Real Public Sector Employment Growth 133 lize the stocks of government capital goods, provide direct services to the private sector and to other public agencies, monitor the behavior of a large fraction of businesses and households, and administer the flows of cash and in-kind transfers. While we do not have good inputhours figures, we at least have good estimates of the numbers of persons engaged. And they are by definition in "real" terms. They can be disaggregated. Furthermore, there is no duplication, as there is in the case of intergovernmental transfers, between federal and S & L. We can compare such government employment data with the corresponding (real) labor force or employment totals in the rest of the economy to get a picture of the importance of government activity over time. Technically viewed, there is a bias due to our inclusion of government employees in the total civilian labor force. 5 But to say that those who work for government are not a part of the resources of society (our notion of the labor force) is to say that government itself is not a part of society. We reject this notion. Inclusion of government workers in the denominator of our percentages merely lowers their level. More important for analytical purposes, it understates the comparative growth rates of government's share of the labor force; exclusion would strengthen our trend data and our interpretations. Professor Thomas E. Borcherding has also suggested that employment is a good criterion for the measurement of government size. 6 Furthermore, his estimates of total public civilian employment in ratio to his fulltime equivalent (FTE) labor force show levels and trend approximating ours, althouth his levels run rather higher, probably because of his FTE labor force estimates. Table 8.1 shows that growth rates for both public and private employees, using either all workers (state and local, and federal) or FTE workers, are essentially similar. Furthermore, the all-government civilian FTE rates exceed the private FTE annual percentage growth rates in every period of time. Because education on the S & L level was strongly influenced by the nonsecular baby boom, it seems proper for some purposes, particularly the very long run trend, to remove S & L employment devoted to education activity. But for other purposes, such as intermediateperiod empirical growth analysis, we include education employment. Fortunately, for many years the Tax Foundation has conveniently disaggregated S & L education from other S & L employees. We think isolation of the civilian component of federal employment is desirable. For the concerns of this chapter we therefore remove the military component of federal employment by deleting the armed forces. This approach follows the design of Clemens-August Andreae

134 Real Public Sector Employment Growth TABLE 8-1. Comparative Annual Growth Rates, All Civilian Employees, and FTE Civilian Employees Public and Private, Selected Periods, 1929-1979 (Percent per year)

Period

All S&L including education

S&L excluding education FTE

All federal

1929-79 1949-79 1969-79

3.34 4.08 3.33

3.15 3.84 3.13

3.27 1.08 -0.60

Sources: Rates calculated from data as follows: federal civilian employees (including DOD workers), Historical Statistics of the United States, Part 2, p. 1102, Series Y308 and Tax Foundation, Facts and Figures on Government Finance, 1981, p. 27; S & L employees, Historical Statistics, Part 2, p. 1104, Series Y332, all private industries, civilian employment: using 3-year averages after 1929, all government civilian

in his analysis of government payrolls in West Germany. 7 We additionally delete civilian employees of the Department of Defense (DOD) since such employees are presumed to be functionally connected with the noncivilian work of the federal government. There are, of course, some other federal employees, e.g., those related to space research, some international affairs, and intelligence, that might also be classified as militarily engaged, but they are a comparatively small proportion of the total, and they are difficult to clearly identify. Hence, we simply take out the large contingent in the DOD (almost a million in 1980). Of course, our exclusion of federal military employment should not blind us to the fact that the federal government has maintained a high plateau in this category ever since the onset of the Cold War. In 1970, the Postmaster General was removed from the cabinet and made an appointee of the board of directors of the U.S. Postal Service, Inc. To our mind this hocus pocus of Nixon's in no way changes the status of postal workers from public to private. We are aware that at least some other nominally private employees are actually federal staff. The people at Sandia Labs who designed our nuclear devices and the people at Lockheed's "skunk works" who designed the SR-71 are unequivocally federal workers in federal arsenals, not private employees. Unfortunately we have no source to tell us how many putatively private concerns are actually federal agencies. So we ignore the problem, which in this context means we assume it is a small problem. Neither the literature of economic theory nor of public finance has

Real Public Sector Employment Growth 135

TABLE 8-1. (coni.)

Federal total

All government FTE

Private total

Private FTE

3.28 1.24 0.00

3.18 3.12 2.38

1.23 1.51 2.36

1.56 1.91 2.10

employment from Historical Statistics, Part 2, pp. 1102,1104, Series Y308, Y332 and Statistical Abstract, 1985, p. 410, No. 688, is subtracted from averages of total civilian employment in Economic Report of the President, February 1985, p. 266, Table B-29; all FTE columns, Facts and Figures, iibid., p. 26.

managed to produce a generally accepted list of the proper functions of government. Each country has adopted some mix of private and public industries. There is much discussion about privatization of public agencies, particularly in the United States and the United Kingdom. Privatization changes the previously accepted evolution of the scope of government in each economy to accept a new smaller government definition. The "excess" government agencies are then sold to the private sector. Obviously, this only works with public agencies that have a substantial independent revenue generation potential. As The Economist has observed, "The debate in America is more theoretical than real since the government owns few business enterprises." 8 Using Heller and Tait's data we have calcualted that nonfinancial public enterprise employees in the high per capita income countries averages 4.06 percent of nonagricultural sector employment, while in the United States it is 0.71 percent. 9 Consequently, such changes have almost no effect on our data, although a similar study covering the United Kingdom would clearly have to wrestle with the effects of privatization and its predecessor, nationalization. The decision to remove the military from federal employment stems from the arguable assumption that military employment (armed forces plus DOD) reflects primarily international policy as distinguished from the social consensus regarding how best to conduct the affairs of the domestic economy. It is domestic policy with which we are concerned. While the military certainly affects the size, and therefore the growth impact, of the federal government, it is a component that is

136 Real Public Sector Employment Growth T A B L E 8 - 2 A . Government Civilian Employment, Federal, State and Local, Decadal, 1 9 2 9 - 7 9

Y e a r or decade 1929 1939 1929-39 1949 1939-49 1959 1949-59 1969 1959-1969 1979 1969-79 1929-79 1949-79

Federal employment (000)

Percent of civilian labor force

S&L employment excluding including education education (000) (000)

477 758

.97 1.37

1389 1797

2532 3090

1222

1.99

2328

3948

1305

1.91

3180

5850

1734

2.15

4528

9444

1916

1.83

6370

13102

Sources: See Sources for Table 8-1.

largely nondiscretionary so far as domestic policy goals (other than short-run stabilization) are concerned. Since the onset of the Cold War after World War II, defense employment (armed services plus DOD) has of course been very large (see table 8.2B). If it were added to total civilian government employees including S & L education in the peak decadal year 1969, for example, it was 4.8 million persons, as table 8.2B shows, total public employment would sum to almost 16 million, or about 20 percent of the civilian labor force (instead of the 13.85 percent shown for civilian government in table 8.2A). The steady enlargement of defense employment up to the 1970s sustained all public employment's large lead in annual growth rates over civilian labor force rates. For example, while the civilian labor force rose only 1.39 percent a year, all public employment increased 3.74 percent a year from 1949 to 1969. However, military employment fell drastically between 1969 and 1979: from 4.8 million to about 3 million. The result was a drastic cut in the growth rate of all public employees, reducing it to about 1.2 percent a year—the first decade in which the aggregate public, so defined, dropped below the rate for the (exceptionally large) advance in the

Real Public Sector Employment

Growth

137

T A B L E 8-2A. (cont.) Percent civilian labor force including education

5.15 5.59 6.44 8.56 11.70 12.48

Annual growth rate (percent) S&L excluding education

S&L including education

4.76

2.61

2.01

4.89

2.62

2.48

0.66

3.17

4.01

2.88

3.60

4.91

0.88 2.80 1.47

3.47 3.09 3.41

3.33 3.34 4.08

Federal

civilian labor force rate. But this only highlights the inexorable expansion of civilian public employment, which even in that decade rose faster than the civilian labor force (table 8.2A). The basic data for all-government civilian employment, as we conceive it, and defined either to exclude or to include S & L educational employment, are presented in table 8.2A. They show that (1) Wagner's Law remains empirically supported through the 1970s; the ratio of government employees to the total civilian labor force, either excluding or including S & L educational employment, increases over the half century shown; (2) compared with the total economy as represented by the civilian labor force, S & L employment alone has become a "large" factor, amounting to from 6 percent to more than 8 percent already at the end of the World War II decade; (3) since government employment has been both large and relatively growing, it would appear to be a candidate for a leading sector in the growth process as specified by Simon Kuznets. 10 We deal with this matter in more detail below. We do not have to rely on deflated transfer payments, as Beck does for example, to demonstrate the continuing relative growth of total

138 Real Public Sector Employment Growth government's real size. Of course, government employees were engaged in circulating cash and inkind transfer payments. Such bookkeeping operations may add to the number of employees. However, as a measure of government size, it seems implausible that those employees were adding anything like the percentage to public employment that transfer payments were adding to total public expenditures. For example, the rise of $193 billion of federal cash transfers to persons between 1955 and 1979 was equal to 44 percent of the total current dollar rise in all federal expenditures, but the associated increase of 120.3 thousand employees of the department of Health, Education, and Welfare (HEW), partly engaged in dispensing transfers, was only 17 percent of the increase in total federal civilian employment (as we have defined it). This contrast between the demonstration of government real relative growth on the employment criterion and no growth on the expenTABLE 8-2B. All-Government Civilian Plus Military Employment, Decadal, 1929-79

Military employment

Year or Decade 1929 1939 1929-39 1949 1939-1949 1959 1949-59 1969 1959-69 1979 1969-79 1929-79 1949-79 1949-69

Military plus total gov't. civilian including S&L education (000)

Civilian employees of Department of Defense (000)

Total military (000)

255 335

103 196

358 531

3,367 4,379

1,615

880

2,495

7,665

2,504

1,078

3,582

10,738

3,460

1,342

4,802

15,980

2,014

960

2,974

17,992

Armed forces (000)

Sources: Armed Forces: Military personnel on active duty, Historical Statistics, p. 1141, Series Y904 and Statistical Abstract, 1985, p. 34, No. 567. Department of

Real Public Sector Employment

Growth 139

d i t u r e criterion if t r a n s f e r outlays be excluded has implications for speculation r e g a r d i n g a n y possible trend in the extent of government c o n t r a c t i n g out. C o n t r a c t i n g out m a i n t a i n s e x p e n d i t u r e s while res t r a i n i n g the g r o w t h in public e m p l o y m e n t . Using e x p e n d i t u r e criteria, if c o n t r a c t i n g out had a falling trend, then stable relative public exhaustive e x p e n d i t u r e s (Beck's findings) can be reconciled with rising relative p u b l i c e m p l o y m e n t . " Rising relative public e m p l o y m e n t with c o n s t a n t relative public exhaustive expenditures could be reconciled by a falling relative public wage bill. But both federal a n d s t a t e a n d local average a n n u a l earnings per employee have been rising a t a b o u t the s a m e r a t e as private average a n n u a l earnings per e m p l o y e e since 1949. 12 These results seem contrary to prevailing expert speculation. Even in the face of rising contracting out Heller and Tait found: " T o t a l g o v e r n m e n t e m p l o y m e n t per c a p i t a tends to increase as p e r c a p i t a i n c o m e rises, thus supporting the validity of the

TABLE 8-2B.

(cont.) Gov't military plus civilian, percent civilian labor force 6.85 7.93 12.51 15.71 19.79 17.14

Annual growth rate (percent) All gov't. including Total military military

4.02

2.66

16.73

5.76

3.69

3.43

2.97

4.06

-4.68 4.33 0.59 3.33

1.19 3.41 2.89 3.74

Defense: Historical Statistics, p. 1102, Series Y313 and Statistical Abstract, 1980, p. 281, No. 472. Other columns: sources for Table 8-2A.

140 Real Public Sector Employment Growth alternative test of Wagner's law presented in this study. This is a particularly strong result when one considers that the expansion of the public sector in some developed countries has taken the form of transfers and the contracting out of services rather than through the provision of direct employment." 1 3 Further research would appear to be in order. We spoke of empirical support for Wagner's Law, but in so doing we do not necessarily subscribe exclusively to Wagner's reasons. Indeed, we would hypothesize that Wagner did not anticipate what we believe to be the chief reason for the growth of government in the mixed-economy era, i.e., the assumption of state responsibility for the overall performance of the economy in the context of the exhaustion of sufficient investment opportunities to provide a satisfactory growth rate. The value judgment that government has gotten too big relative to the economy has produced a number of different attacks on Wagner's Law. For example, some forecasters anticipate a decline in the ratio of government expenditures to GNP. 14 Peacock and Wiseman, referring to their own Great Britain, predict a likely constancy or a decline in that ratio. 15 Clark long ago anticipated that any society whose government accounted for more than 25 percent of total output would unendingly inflate. 16 Bacon and Eltis represent a revival of Clark in that they argue, for the British case, that absolute government growth implies a diminution in the aggregate of private income and spending, and particularly of private investment spending. 17 This view is, in contemporary hands, congenial with that which Biehl has termed the "super-consumer" approach, according to which " . . . the benefits from public consumption do not enter the social welfare function . . . the (private) economy becomes the poorer, the larger the state's budget. Public expenditures are equivalent with wastage of resources." 18 On the issue of the sources of relative government growth, Edward Gramlich's review of three of the standard theories shows persuasively that the productivity disparity hypothesis and the real expenditure theories (bureaucratic growth and voter influences) are poorly supported by the evidence assembled so far. 19 We concur. But Gramlich is sympathetic to a number of studies advancing a third notion that there may be an element of rent in public sector wages due to the differential in the strength of public employee unions and voting efforts. Even if true, such an argument is relevant to an examination of Wagner's Law only if it can be shown that the rent element of public remuneration is greater than that in the private sector. Unfor-

Real Public Sector Employment

Growth

141

tunately, no evidence on this comparison is presented. We cannot, therefore, accept the third of the standard theories as examined by Gramlich. However, this relative compensation theory is noted and treated in another paper in the same volume by Joseph F. Quinn. 20 He concludes from U.S. data that both average earnings and pensions are higher for public-sector than for private-sector employees. The implication from this is that higher remuneration in public employment will expand the demand for such jobs by suppliers of labor at a rate exceeding the growth of private employment. A further functionally essential implication is that such job demand will influence government employers to shift their long-run demand schedules for labor to the right faster than private schedules are shifted. But the movement of labor's supply schedule from a low-compensation sector to a higher one is not a guarantee that the potential migrants will be hired. Witness the masses of unemployed in Third World metropolises—people who have left the low-income agrarian sectors for the higher average income in the urban sectors. In the historical migrations in U.S. experience, both from overseas and out of farming, employment accompanied the migrations only because the growth of autonomous labor demand in the United States, particularly in the rapidly industrializing and urbanizing sectors, was sufficient. This argument requires the growth of government labor demand to be functionally related to labor supply (this must be demonstrated). But it is not. Until it is demonstrated, it is more reasonable to presume that public labor demand growth is not partially induced by the labor supply. The autonomy of government in this respect is an institutional restraint, or entry barrier, making public and private occupations noncompeting groups. The argument that citizens as labor suppliers demanded higher paying government jobs in preference to lower paying private jobs and that government consequently supplies those jobs also implies an open-ended fiscal policy. But Morris Beck has shown that in exhaustive expenditure terms government stopped expanding more than a decade ago. Thus it is impossible for government to both take more of the labor force and pay it at higher rates, since that would require an increasing share of total financial resources, on the assumption that the wage share of exhaustive expenditures is relatively constant. In these theories, demand and supply are not independent, which is a necessary condition for microeconomic analysis. Using such analysis, while assuming its necessary conditions do not exist, has very little meaning.

142 Real Public Sector Employment

Growth

Interpretation of the government employment, Ng, trend involves the question w h e t h e r the 1970s suggest a long-run slowdown or cessation in relative government employment growth, a suggestion that m a y at first glance a p p e a r to receive support from the very slight rise in that decade of the ratio of Ng to the total labor force, Lc. However, 1979 is but moderately below trend and substantially above the 1950s. Hence, it would be risky to speculate that the 1970s presage a secular slowdown. It needs to be recalled that the growth of N g is being compared with the second highest growth rate of Lc—a whopping 2.66 percent a y e a r — f o r any decade since 1929. In contrast, possible reductions in the relative growth of public employment in the 1980s, presaged by policies instituted during the Reagan presidency, will occur in the context of very low labor growth projections. It is i m p o r t a n t to remember that Wagner's Law is a long-run phenomenon. Our d a t a show Ng rising more rapidly than Lc through 1979. If the data are correct no one can show the end of Wagner's Law until a long-run series of n u m b e r s is available. That cannot happen before the 1990s and in a good statistical probability sense could not be shown even then. As for the growth role of government, it should be observed that NK exceeded 5 percent of its pertinent referent, Lc, by 1949, and at a range between 8 percent and 14 percent after 1969, government had unquestionably risen far above the level ordinarily considered necessary to become a candidate for a leading growth sector. Over the long pull from 1929 to 1979, government employment grew at roughly twice the rate of the total civilian labor force. Hence, it may be concluded that a drastic cut in the growth rate of government could seriously u n d e r m i n e this historic stimulus that the economy has enjoyed for half a century. Given the community's propensities to populate, spend, save, and invest, together with its chosen labor market participation rate, government absorption through its civilian employment growth of a large portion of the annual increment to the labor force has significantly contributed to preventing the emergence of a "reserve a r m y of unemployed" with its attendant retardation of production growth. This statement implies, of course, our doubts respecting the presumption of a counterfactual hypothesis that in the absence of large government underwriting of aggregate employment there might have been since World War II a more or less equivalent provision of employment by the private sector. To be a leading element in the growth process a sector must be not only large but also grow faster than the total economy. It must also exhibit a substantial degree of independent motive power. 2 1

Real Public Sector Employment Growth 143 Government growth in the United States, and in most other advanced industrial economies, has met these criteria for a leading sector. The growth of the public sector obviously fits the first two criteria. The third one listed is, of course, the hardest to demonstrate. But the evidence for it, which we present herewith, seems reasonably clear cut. Specific autonomous social phenomena can explain the accelerated pace of government activity in the twentieth century. For one thing, as American society urbanized, the more densely populated, nonagrarian public raised new and additional d e m a n d s for a wide variety of practical governmental services. Furthermore, the enlarging insistence by a democratic polity upon both literacy and a more full-bodied life inspired the public school movement and the consequent proliferation of education. We all recognize the enormous impact of the baby boom on the public schools after World War II. Higher education expanded, albeit more slowly, before the Great Depression, in response primarily to the challenge presented by the increasing technical complexity of an industrializing society. For example, the Federal Land Grant University-County Agent program is a very successful federal project to use state agencies to increase useful business technology beginning in 1862. After World War II, there was an upsurge of democratic aspirations that became strongly focused on public higher education. Thus it was no accident that there was a veritable explosion of public college, university, and community college education facilities. The assumption by the federal government of responsibility for m a x i m u m employment and purchasing power did not occur before the Great Depression despite a long record of prosperity/depression. It required the crystallization of a new social consensus in the 1930s to elicit the a p p e a r a n c e of that policy. Because of that evolving consensus, almost everyone subsequently came to accept the Keynesian proposition that the federal government can a n d should independently influence the economy's performance. Finally, the establishment of a social insurance system, together with the immense expansion of the social transfer payment—indeed, the welfare state itself— attest at once to the emergence of a new sociopolitical ethic uniquely reflecting the sway of an historically affluent society. We believe these notions are fully consistent with Wagner's: 2 2 All earlier a t t e m p t s to lay down absolute figures of expenditure or to define an u p p e r limit of its [the state's] proportion to national income, have always miscarried. These a t t e m p t s are

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based on a false, superficial, and mechanical conception of the relationship of the State to the national economy, instead of on a proper organic view. It must be emphasized that in considering the absolute and relative level of expenditure for any public service, neither its costs nor its value alone must be taken into account, but both together. Neither purely political considerations deriving from the nature of the State, nor purely and exclusively private economic considerations must be allowed decisive weight. The following may be taken as a rule: State expenditure may be higher, in absolute terms and as a percentage of national income, in proportion as the immediate economic value (taken in the widest sense) of a public service is greater, its contribution to general productivity greater as well as the " f r e e " national income (i.e., in Roscher's sense that part of national income which is left after the satisfaction of the people's essential material needs), and finally, in proportion as the part of state revenue derived from sources other than taxation, i.e., from the state's private business activities, is larger. We note that Professor Borcherding has redefined Wagner's Law to mean the income elasticity of demand for public service. 23 (Diba). It seems to us that Borcherding's applications of the narrow focus of price theory to government are just what Wagner criticized. Using all government in the numerator of an income elasticity calculation makes no microeconomic sense. Government is a very large and heterogeneous bundle of goods and services. Unlike the bundle of close substitute private products in an Engel curve, most government services, such as defense, preserving the environment, income security, education, and the postal service are not close substitutes. Thus some of the broad service categories (to say nothing of their components) m a y be quite income responsive while others are not. Furthermore, Marshall's classic concept of elasticity is a short-run, comparative-static notion. Wagner's Law refers to patterns evolving over the very long run. It is most improper to do ceteris paribus analysis over such a long-run span. We do not, therefore, find the widespread application of the income elasticity concept appropriate for the analysis of government's relative long-run growth. In summary, the development of our modern industrial nation has been accompanied by a proliferation of socially expressed d e m a n d s for public solutions to broad h u m a n problems. These demands and their solutions, while typically shot through with economic content,

Real Public Sector Employment Growth 145 have nonetheless played an exogenous role vis-à-vis the operation of the private market system. Hence, government has been able to act as balancing wheel in the intermediate time period and growth stimulator in the longer run. Beck's ratio of real total government expenditure (including transfers and interest payments) to real GDP is about 29 percent for 1977.24 His expenditures include the military outlays. A calculation of the military plus total civilian public employment, inclusive of S & L education, yields 17,520,000 persons for 1977. This figure, comparable to Beck's, was 17.7 percent of the civilian labor force. Since the chief reason for the expansion of all civilian government, looked at from the pecuniary viewpoint, was the growth of transfers, it should be no surprise that public employment, which scarcely responds to transfer payment increase, reveals a much lesser rise in the relative importance of government. Our aggregate ratio of government to total employment is still far below the figure for all-government involvement based on pecuniary criteria. On the other hand, if only government purchases be considered, Beck's ratio to real GDP plummets to only 13.4 percent, and the use of the employment criterion as measure of level gives a notably larger importance to government in the economy, i.e., suggests that the government sector is labor intensive. Our measurements of the relative size of government using employment indicate that government (excluding transfers) is bigger than Beck's results, and including transfers, is smaller than Beck's results. So intuitively our results on the relative size of government are reasonable and conform with the results of his more extensive study. However, we find direct government command over the labor force, and hence the economy continues to grow, which Beck finds only indirectly through transfer increases. Furthermore, our more simply constituted real magnitudes avoid the equivocation that Beck's measures contain. In this respect, with our proportions falling between his with-vs.-without transfers, we in a sense protect Beck's and Wagner's growing-government conclusion against the possible criticism that only transfers sustain the larger government share. We conclude Wagner's Law is more robust than Beck indicates. And we reiterate, government continues to be a leading sector in Kuznet's terms. There is, of course, the counterposition that reduction of the relative, or even the absolute, size of the public can stimulate private sector development. This position has been advanced in the form of a number of variants by Borcherding, Friedman, Niskanen, and others purporting to deal with the optimal size of the public sector. Niska-

146 Real Public Sector Employment Growth nen, for example, supports the older classical view that government growth may have slowed private-sector development. 2 5 We see several reasons for skepticism regarding this counterposition. In the first place, it fails to appreciate the historical origins and development of the modern mixed economy, i.e., the chronic, socially unacceptable performance of the unalloyed private-market system. Secondly, because of the continued expansion of the government sector, it has been empirically impossible to show, in the case of any Western mixed economy, that the performance defects have been corrected through the initiative of the business system itself over the course of more than a half century. Indeed, a host of additional market-connected disabilities on both the national and international levels have arisen as time passed. In the third place, since the mid-1970s there has been a slowing down of government growth in the United States, as our employment data demonstrate. Yet the private sector accompaniment of this slowdown has been not quickening of its growth and productivity behavior, but economic stagnation. 2 6 And the best private-sector growth performance since World War II (1962—1973) was accompanied by the great boom in state and local government employment. In the fourth place, the contention that arresting government advance under contemporary institutional conditions can stimulate a sustained, socially acceptable, private-sector advance requires the construction of an aggregate counterfactual model. Such a model has not been constructed. Piecemeal theorizing about recent particular deregulations and marginal tax or transfer changes is certainly no substitute for such a counterfactual macro model. As for actual piecemeal experiments with governmental withdrawal, for example, by the supply siders under Presidents Carter and Reagan, these have been accompanied since 1980 by such Keynesian-type federal measures as burgeoning deficits and military outlays that the small contractive experiments have been overwhelmed. The legitimate search for an optimally sized public sector in each country should not be a foil for expressing a private sector, laissez faire bias. In any case, little progress has been made toward the determination of such an equilibrium. Arguments that increased resources going to the state implies decreased resources going to the private sector are incorrect analogies from movements along the production-possibilities frontier in a fully employed economy. But, full employment is rare in contemporary capitalistic economies, and the "guns-or-butter" tradeoff is generated on the assumption of no time change. Wagner's Law is about change

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over long-run time. Unless a generally accepted time-variable welfare economics is developed, such arguments have no theoretical base. We now turn to disaggregation of the all-government civilian employment totals, using the breakdown federal vs. S & L. Table 8.2A provides the essential data. The contrasting record of the two levels of government is most striking and informative. Both levels of government contribute to the long-run rise in the relative importance of public employment in the 1930s, but only the fast-growing federal government leads in the 1940s. Thereafter, the federal government's position in the total labor force remains fixed, without any discernible trend. But S & L employment, on a decadal basis, continues its trend of rising relative importance for the entire half century that begins in the Great Depression. In other words, the rise in all-government's comparative importance after World War II is entirely due to the growth of the state and local governments, and the importance of federal civilian employment in total public civilian employment declines from rather more than half of S & L employment (excluding education) in 1949 to less than one third in 1979. Including education in S & L employment involves a fall of the federal share of total civilian government employment from less than a third to only 15 percent over the same period. A "new federalism" directed toward transferring government activity from the federal to the state and local levels of operation (if not financing) would not be at all new but would only accentuate a decentralization trend that has long been taking place in terms of real labor resources committed. The administration of the contemporary mixed economy has thus long been overwhelmingly and increasingly in the hands of the "grass roots" employee echelons. This is consistent with what Wallace E. Oates found for expenditures in a number of advanced countries over the period 1950-1970. 27 The process of decentralization after World War II is similarly reflected in pecuniary criteria. For example, with respect to civilian expenditures, in current dollars S & L purchases of goods and services increased from 150 percent of federal nondefense outlays in 1949 to 442 percent in 1979. Even if S & L purchases from their own revenue sources (i.e., excluding grants-in-aid from the federal government) be used for the comparison, the S & L expenditures rose sharply from 119 percent of federal nonmilitary outlays for goods and services in 1949 to 299 percent in 1979. If all federal purchases, including national defense, are related to all S & L purchases, decentralization is still the pattern: S & L/federal is 88 percent in 1949, 182 percent in

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1979, and the rise is still striking when the trend is calculated from S & L o w n revenue sources. In terms of civilian real expenditures for "collective consumption," or government purchases of goods and services, in 1979 the federal government total was about one fifth the S & L purchases of goods and services. But federal civilian employment in that year (excluding D O D ) was only about 15 percent of S & L employment (including education). This would seem to be a sensible comparison. It might suggest that the federal government was doing more (purchases) with less labor than the S & L governments. However, federal purchases of services were substantially enlarged compared with S & L purchases by the fact that the average annual nominal earnings per federal e m p l o y e e were 40 percent higher than S & L (including education) average earnings (Tax Foundation [1981, p. 26]), and real earnings w e r e 44 percent higher. More " n e w f e d e r a l i s m " would entail a sectoral shift to lower w a g e public employment, a shift that w o u l d reduce real all-government collective consumption in pecuniary terms even if the number of government employees were not decreased.

CONCLUSION W e have shown, using direct real measures, that Wagner's L a w still holds. Government has continued to grow faster than the private sector right up to the end of the 1970s. W e find real direct government c o m m a n d over resources continues to rise, whereas Beck, as noted above, finds that government command over resources rises only if transfers are included. 28 Also, government has g r o w n to a sufficient size and is driven by sufficiently market-independent forces to qualify as a leading sector as defined by Kuznets. For the last thirty years most of the lead has been carried by S & L. Consequently proposals by the current federal administration to increase the relative responsibility of that sector would simply enshrine in policy an existing long-term trend. The fact that it was not federal but S & L employment (or spending) that led the economy's growth after W o r l d W a r II must be related to the singular commitment of the federal government in 1946 to maintain m a x i m u m employment and purchasing power, i.e., to economic growth. W e see these two facts as quite consistent because w e interpret the Employment Act and its revisions in the HumphreyHawkins Act to have placed final responsibility for high e m p l o y m e n t on the federal government. Thus, if other large sectors, private or public, advanced sufficiently fast to assure satisfactory total growth,

Real Public Sector Employment Growth 149 then the goal of the Act would be achieved without a great relative increase in the federal sector. We have seen that the S & L governments shouldered the employment-creating task, to be sure partly with federal financial assistance through grants-in-aid and through a very large federal expenditure response to the educational impetus emanating from the baby boom. If the S & L governments had not played the growth leadership role that they did, and if no large private sector had emerged to play such a role, then the objectives of the Employment Act, if taken seriously, would necessarily have been achieved by an appropriate rise in the federal share of the economy. Thus, although the federal government's share of total civilian employment has not increased since the second world war, that does not imply the abnegation of federal responsibility for the level of employment. Most recent administrations have specifically accepted this responsibility. It is probably most evident in the recommendation of every administration from Eisenhower to date that taxes be cut to encourage investment. Literally every president has accepted the simple view that increased investment would produce more jobs and lower unemployment rates. That David Ricardo had proved such a notion to be not necessarily true seems to have escaped presidential advisers. Anyone aware of the birth rates from 1948 to 1960 could have predicted the startling increase in state and local government employment in the country from 1954 to 1961. There was no way to educate the children without greatly increasing the level of government traditionally responsible for primary and secondary education. A competent federal government seeing such a development would recognize that state and local government would be for a substantial time a major force increasing employment. It could then use its energies better in areas other than employment creation, such as helping to finance precisely the inevitable explosion of school children and teachers. This is exactly what happened. As the fiscal pressures on school programs at all levels grew, so did federal aid to such programs. As the school systems finally reached a size capable of handling the baby boom and those babies showed their sterility, some federal officials and advisers recognized a major prop to employment was gone and began to discuss using the federal government as an employer of last resort. Such proposals were rejected by the conservative governments of the 1970s and 1980s. But they did accept the tax cut, investment subsidies, and related employment-increasing schemes. They preached that such schemes would indeed increase employment. For years the

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federal government declared that it was responsible for total employment and had policies that would keep unemployment low. It then activated those "political cycle" policies, and presidents campaigned on their success. Hence the federal government must either be found responsible for total employment or be found benighted. These are the reasons why we add a fourth explanation to Wagner's three chief explanations for relative government growth. Wagner's recognition of (1) increased public administration and regulation, (2) the expansion of cultural and welfare functions, and even (3) state intervention to control monopoly, are no doubt operative factors in the long-run career of modern governments. But it would be stretching Wagner's " w e l f a r e " factor implausibly to try to include in it mixed-economy's c o m m i t m e n t to m a x i m u m employment and purchasing power. While consistent with Wagner's factor, we consider this historically new c o m m i t m e n t to use government to assure satisfactory performance of the economy to be the m a j o r contemporary influence that guarantees the empirical validity of Wagner's forecast. The assumption of u l t i m a t e public responsibility for the economy's stability and growth performance does not fit neatly into the s t a n d a r d procedural classification into sources and impact of government growth. 2 9 We do not, however, view this as a methodological p r o b l e m . It is necessary simply to understand that the public's d e m a n d for the government to assume such a responsibility ("source") has operationally meant over the last half century or so that government has been the leading sector in the U.S. economy's developmental performance ("impact"). The data we have marshaled showing the historical allocation of the U.S. labor force since 1929 are entirely consistent with this view of the integration of source and impact. In our study of the connection between government and economic growth we have used employment as the proxy to measure the relative size of government. Others use expenditures or revenues as proxy. Our proxy shows well the relative increase in government a n d is consistent with our hypothesis that government has decisively influenced the economy's growth record. Focusing on economic growth implications, we further find that state and local employment fits Kuznets' criteria for a leading sector in the U.S. economy. We note that many states are attempting to limit their growth to the growth of local income. However, if successful, such schemes will destroy the economy's leading sector. We know of no evidence that destroying one leading sector causes another one to appear.

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NOTES 1. M. Beck, "Public Sector G r o w t h : A Real Perspective," Public Finance/ Finances Publiques (1979), 34(3):313-356. 2. R i c h a r d A. Musgrave a n d Peggy B. Musgrave, Public Finance in Theory and Practice, 3d ed. (New York: McGraw-Hill, 1980), p p . 1 4 7 - 1 4 8 . 3. J o h n C. Musgrave, " G o v e r n m e n t - O w n e d Fixed Capital in the United States, 1925-79," Survey of Current Business (1980), 60(3):36; J o h n C. Musgrave, "Fixed Capital Stock in the United States: Revised E s t i m a t e s , " Survey of Current Business (1981), 61(2):59. 4. U.S. D e p a r t m e n t of C o m m e r c e , B u r e a u of E c o n o m i c Analysis, The National Income and Product Accounts of the United States, 1929-74: Statistical Tables, Supplement to SCB (Washington, D.C.: GPO, 1977), p p . 2 7 2 - 2 7 3 ; Tax F o u n d a t i o n , Facts and Figures on Government Finance (New York: Tax Found a t i o n , 1981), p. 26. 5. S u b r a h m a n y a m G a n t i a n d B h a r a t R. Kolluri, " W a g n e r ' s Law of Public E x p e n d i t u r e s : S o m e Efficient Results for the United S t a t e s , " Public Finances/ Finances Publiques (1979), 34(2):226. 6. T h o m a s E. Borcherding, "One H u n d r e d Years of Public Spending, 18701970," in T h o m a s E. Borcherding, ed., Budgets and Bureaucrats (Durham, N.C.: Duke University Press, 1977), p p . 1 9 - 4 4 . 7. Clemens-August Andreae, " T e n d e n c i e s in the Development of Personnel Outlays," in Horst Claus R e c k t e n w a l d , ed., Secular Trends of the Public Sector (Paris: Editions Cujas, 1978), pp. 1 1 - 1 8 . 8. The Economist (1985), " P r i v a t i s a t i o n : E v e r y b o d y ' s Doing It Differently," 297 (7425/7426):71 - 8 6 . 9. Peter S. Heller a n d Alan A. Tait, Government Employment and Pay: Some International Comparisons (1984), I n t e r n a t i o n a l M o n e t a r y F u n d Occasional Paper no. 24, p. 42. 10. S i m o n Kuznets, Economic Growth and Structure (New York: N o r t o n , 1965), p p . 2 1 7 - 2 2 1 . 11. Borcherding, " O n e H u n d r e d Years," p p . 1 9 - 4 4 . 12. Tax F o u n d a t i o n , Facts and Figures on Government Finance (New York: Tax F o u n d a t i o n , 1977), p. 24. 13. Heller a n d Tait, Government Employment and Pay, p. 35. 14. Otto Eckstein, Trends in Public Expenditure in the Next Decade, cited in Alan T. Peacock a n d J a c k W i s e m a n , The Growth of Public Expenditure in the United Kingdom (Princeton, N.J.: Princeton University Press, 1961), p. 147. 15. Peacock a n d W i s e m a n , The Growth of Public Expenditure in the United Kingdom. 16. Colin Clark, " P u b l i c Finance a n d Changes in the Value of Money," Economic Journal (1945), 45(4):371 - 3 8 9 . 17. R. Bacon a n d W. Eltis, Britain's Economic Problem: Too Few Producers (New York: St. M a r t i n ' s Press, 1976), p p . 9 2 - 1 1 6 . 18. Dieter Biehl, " B u d g e t E q u i l i b r i u m in the Long a n d the S h o r t R u n , " in

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Horst Claus Recktenwald, ed., Secular Trends of the Public Sector (Paris: Editions Cujas. 1978), pp. 175-189. 19. E d w a r d M. Grämlich, "Models of Excessive Government Spending: Do the Facts Support the Theories?," in Robert H. Haveman, ed., Public Finance and Public Employment (Detroit: Wayne State University Press, 1982), pp. 289-308. 20. Joseph F. Quinn, "Compensation in the Public Sector: The Importance of Pensions," in Robert H. Haveman, ed., Public Finance and Public Employment (Detroit: Wayne State University Press, 1982), pp. 227-244. 21. Kuznets, Economic Growth and Structure, pp. 220-221. 22. Adolf Wagner, "Three Extracts on Public Finance," in R. A. Musgrave and Alan T. Peacock, eds., Classics in the Theory of Public Finance (London: Macmillan, 1958), pp. 1 - 1 5 . 23. Thomas E. Borcherding, "The Sources of Growth of Public Expenditures," in Thomas E. Borcherding, ed., Budgets and Bureaucrats (Durham, N.C.: Duke University Press, 1977), pp. 45-70; Bahzad T. Diba, "Note on Public Sector Growth: A Real Perspective," Public Finances!Finances Publiques (1982), 37(1): 114-118. 24. Beck, "Public Sector Growth," p. 317. 25. William A. Niskanen, "The Growth of Government a n d the Growth of the Economy," in Dieter Biehl, Karl W. Roskamp, and Wolfgang F. Stolper, eds., Public Finance and Economic Growth (Detroit: Wayne State University Press, 1983), pp. 1 - 1 3 . 26. John F. Walker and Harold G. Vatter, "Stagnation: Performance and Policy: A Comparison of the Depression Decade with 1973-84," Journal of Post Keynesian Economics ( S u m m e r 1986) 515-535. 27. Wallace E. Oates, "The Changing Structure of Intergovernmental Fiscal Relations," in Horst Claus Recktenwald, ed., Secular Trends of the Public Sector (Paris: Editions Cujas, 1978), p. 156. 28. Beck, "Public Sector Growth," p. 314. 29. Robert H. Haveman a n d Victor Halberstadt, "Public Finance a n d Public Employment: An Introduction," in Robert H. Haveman, ed., Public Finance and Public Employment (Detroit: Wayne State University Press, 1982), p. 4.

CHAPTER 9

Why Has the United States Operated Below Potential Since World War II? J O H N F . WALKER HAROLD G. VATTER The truth, the central stupendous truth about developed economies today is, that they can have—in anything but the shortest run — the kind and scale of resources they decide to have. . . . It is no longer resources that limit decisions. It is the decision that makes the resources. This is the f u n d a m e n t a l , revolutionary c h a n g e — p e r h a p s the most revolutionary mankind has ever known. — U Thant, 1962

If a trend line of real GNP were drawn through the higher years surrounding the peaks of cycles in the laissez faire era from 1869 to 1929, the values for those years may be interpreted to show the economy's potential long-run performance. Such a graph would also reveal that most of the time the system operated below its potential thus defined. That cyclical shortfall was traditionally viewed as the inevitable and uncontrollable price of progress. From the Keynesian revolution we learned that we do not have to pay that price. Yet under the post-1929 mixed economy the price is still exacted, because we have permitted and even encouraged it. In the present era of government intervention the market has continued to exhibit its inherent cyclical impulses. So the problem of the cyclical shortfall abides. However, the existence of a large and stable public sector, together with new built-in stabilizers, has substantially reduced cyclical amplitudes since World War II. Therefore, from a policy standpoint what is more important today is the achievement of a robust trend potential. This we have not enjoyed for most of the time, and its lack is the focus of our analysis. Keynes in the General Theory unfortunately addressed only the cyclical shortfall. In that static formal model we find no explicit theory of economic growth. On the policy level Keynes was a pump Reprinted with permission of publisher, M. E. Sharpe, Inc., 80 Business Park Drive, Arn o n k , N.Y., 10504 USA, from Journal of Post Keynesian Economics (Spring 1989), pp. 327-346.

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154 Why Has the U.S. Operated Below Potential Since World War II? p r i m e r with implicit, classical faith in the efficacy of both the cyclical expansion and the growth role of private investment. Hansen projected, however, a theory that emphasized the euthanasia of the role of private investment as an engine of economic growth. For him the trend rate of potential GNP itself was therefore threatened by a factor that was inherent in an advanced market economy. By showing that in a capital-rich economy, business fixed investment was reduced to a demand-dependent variable that was also killing itself in part by its own productivity enhancement, Hansen's long-run model completed the dismantling of Say's Law. Demand for physical capital creates its own total supply and sectoral composition, short run and long run, in that model. Both the output growth trend and the cyclical shortfall below it after Hansen could be seen as dependent on (expected) spending. To do full justice to Keynes and his remarkable contemporary relevance, we must go beyond the General Theory's formal model and acknowledge his profound insights into the endogenous f u n d a m e n t a l s that shape the long-run career of advanced capitalism. Some of these are to be found in his famous and strikingly prescient Galton lecture on the consequences of a declining population (Keynes 1937:17). Keynes therein spelled out his expectations regarding the "diminishing importance of capital accumulation." His reasoning included reference to the development of capital-saving innovations, although the paucity of data prevented him from ascribing a weight to them. 1 Furthermore, Keynes stressed that, given the contractive influence of declining population, the trend growth rate of output and capital will be strategically determined by demand a n d the public policies influencing that demand: "With a stationary population we shall . . . be absolutely dependent for the maintenance of prosperity and civil peace on policies of increasing consumption by a more equal distribution of incomes and of forcing down the rate of interest" (p. 17). In other words, the " n a t u r a l " trend rate of growth is not natural but is a policy variable, and sustained high growth in a capital-rich market economy requires a high spending rate on noninvestment goods to compensate for what Keynes believed to be the inhibiting influences of a declining population rate on the demand for capital goods and the ever smaller magnitude of tangible investment requirements partly due to capital-saving innovations. 2 Citation of these Keynes-Hansen contributions brings us very much u p to date. We can pick up the line of reasoning in terms of the Harrod-Domar basic growth statement and delineate two broad historic growth periods in the United States since the Civil War. We term

Why Has the U.S. Operated Below Potential Since World War II? 155

them laissez faire up to the Great Depression of the 1930s, followed by the mixed economy. The first era was marked by a still high but falling population rate, a high output growth rate, vigorous tangible capital stock building, and a relatively low average output/capital ratio. The contemporary mixed economy has a low and falling population rate, a slower actual output growth trend, a historically very large fixed capital stock, a lowered ratio of investment to output, and a much higher average output/capital ratio. Additionally, the mixed economy experiences a greatly augmented productivity role for its now large stock of human capital and other "residual" factors. THE POTENTIAL GROWTH RATE

Our emphasis, like Keynes', on the primary role of demand in the determination of the actual growth rate also elevates demand to the position of primary influence in the determination of the potential growth rate. We proceed with this line of reasoning, first by reference to tangible capital in relation to growth in the mixed economy of "diminished capital accumulation" compared with the earlier laissez faire market system. It is firmly established by all the empirical work on this subject that the real net investment ratio (net private fixed tangible business investment as a proportion of real net national product [NNPJ) has averaged since World War II much less than it was in the upward trending late nineteenth and early twentieth century. 3 Consistent with that trend, the capital/output ratio (stock of fixed capital as a proportion of output) has, after rising in the nineteenth century, fallen in the twentieth. 4 We prefer at this point in our discussion to use (net) output/capital, however, because it expresses "capital productivity" and fits the Domar growth expression, g' = I/QxQ/K. The real net output/capital ratio has averaged since World War II at least a third higher than it was before 1914.5 All this is consistent, not only with what we know about structural shifts within the economy, but also with the Keynes-Hansen concept of advancing capital-saving technology, a notion much enhanced by the work of Denison and others on the rising importance of human capital in the determination of output growth from the supply side. The rising output/capital secular trend has occurred despite the slower output growth trend in the twentieth century compared with the nineteenth. Since World War II the historically high ratio was roughly constant for a quarter century until the post-1973 period of

156 Why Has the U.S. Operated Below Potential Since World War II? growth slowdown and government-stimulated investment pulled the level down. These higher average and marginal output/capital ratios in contemporary times are synonymous with a supply-side diminution of the amount of fixed capital stock additions required to get a given output (or capacity) increase. But stock additions are investment. Therefore, the accompanying diminution in supply-side investment requirements has also weakened the influence of investment as a demand stimulant. This demand effect is of course precisely what Domar was getting at when he showed that only additions to investment have multipliers while a constant investment rate adds dangerously to capacity. Domar's theory was Keynesian, even though he caught the glaring gap in Keynesian theory regarding the capacity effects of net investment: he insisted that his growth equation required expenditure increase from sources outside the investment stream in order to get balanced growth. In the absence of a sufficient "outside" source, output rise would fall behind capital, and therefore, capacity would increase. Excess capacity would result, leading to a drop in investment and consequent falling output and income. Unfortunately, U.S. public policy has not heeded this model of growth and growth policy. It has rather continued since World War II to rely upon the nineteenth-century precept that investment creates its own demand. Along with this outmoded "principle," government policy has insisted that public spending is unproductive and must be curtailed. In this hoary perspective (reborn under the contemporary "public choice" rubric) investment is a competing, superior, and all too often suppressed substitute for "bureaucratically determined" government expenditures. Furthermore, with intensification of the inflation problem (primarily energy, housing, food and medical care price explosions in the 1970s), the conventional antiinflation policy of deliberately engineered unemployment became preeminently accepted. Finally, the argument that financing public spending increases with deficits would crowd out borrowing for the sacred private investment cow intensified the government restraint impulse. Expansion and growth were thereby subjected to a double-barreled attack. The predominance for most of the time of this misguided policy package kept U.S. output growth below potential during the greater part of the postwar era. To pinpoint that potential as a primarily demand-determined magnitude, we turn to the experience of the 1960s.6 That decade, sitting astride the middle passage of the postwar era, exhibited the best sustained performance for the entire four decades.

Why Has the U.S. Operated Below Potential Since World War II? 157 The 1960s from 1962 to 1969 produced an a n n u a l rise in real N N P of 4.35 percent and a GNP rise of 4.50 percent. It produced five consecutive years out of the seven non-Korean years during the entire period 1948-1986 in which the capacity utilization rate was equal to or greater than 87 percent. Significantly, the huge real government purchases rose strongly through 1968 at an annual rate of 4 percent. 7 Hence we view that decade as exhibiting the contemporary economy's best demand-guided potential growth rate. But there are, of course, supply constraints. Nevertheless, we believe that setting potential d e m a n d at approximately the 1962-69 rate did not and would not ordinarily unduly press against the economy's supply ceiling. The capacity utilization rate, for example, averaged 86.6 percent over those years, and only once got as high as 91 percent. Such an average rate would not be considered excessive by most CEOs, and we know of no theoretical persuasion that would judge it to be inordinately high. Our recommendation of the 1960s as a model to imitate in economic policy is even consistent with the popular notion of a nonaccelerating inflation rate of unemployment, or NAIRU. The rate of inflation was both the most steady (lowest variance over a five-year period) and the lowest level of the postwar period in the first half of the 1960s. In J a n u a r y 1962 the government announced an interim target unemployment rate of 4.0 percent, which was first achieved in December 1965. In the 1966 Economic Report of the President the target rate of unemployment was lowered to 3.5 and an extensive discussion of the consequent possibility of inflation was presented. All reasonable readings of the d a t a say there was no inflation from 1960 to 1965. (The year-to-year percentage changes in the CPI for those years were: 1.6, 1.0, 1.1, 1.2, 1.3, and 1.7). From 1965 to 1969 the rate did rise moderately. We conclude that in those years the NAIRU was about 4 percent because until the unemployment rate fell below 4 percent, prices were extraordinarily stable. In our j u d g m e n t the mild inflation from 1965 to 1969 was worth it because it was accompanied by very robust rates of real economic growth. We should remind ourselves that as total spending expands, investment and the capital stock typically respond. In the 1960s the rate of growth of the stock, the average of the gross stock a n d the net stock, kept pace with output growth. 8 As the output rate recovered during the first years of the decade, the capacity utilization rate increased rapidly. In the later years the stock increased rapidly. At no point during the decade did a general shortage of stock significantly limit expansion. Output and stock grew at about the same rate during the decade. Thus, rapid government spending increase augmented the

158 Why Has the U.S. Operated Below Potential Since World War II? income that stimulated and helped finance the investment rise. Government spending a n d investment were complements, not substitutes. The civilian unemployment rate in the sixties described a pattern similar to the capacity utilization rate. Averaging 4.8 percent between 1960 and 1969, it averaged 6 percent in the first two years, then fell gradually and averaged 3.6 percent in the last four years of the decade. That labor supply constraints were not coercive may be seen by a comparison of the 1960s with the ensuing decade of slow growth and high unemployment rates (annual expansion rates, in percent):

1962-1969 1969-1979

Hours of All Persons, Business Sector

Total Civilian Employment

1.72 1.61

2.24 2.41

The differences in the two periods, one of high expansion, the second of sluggish performance, are insufficient to suggest that the use of the 1960s as potential needs to be questioned because of labor supply limitations. 9 The lack of labor constraint upon the output growth rate, or alternatively put, the lack of dependence of output growth on the labor input rate, is shown by the almost wild rate differences in the two during the postwar era. Take, for example, the annual percentage rates of growth for the following three periods:

1948-1963 1962-1973 1973-1985

Real Gross Domestic Business Product

Hours of All Persons, Business Sector

3.64 3.94 2.59

.21 1.46 1.55

In the first two periods the output rate was similar, but the labor input rate in the second period was seven times that in the first period. In the last two periods the output rates were strikingly different, but the labor input rates were quite close. And relationships between the growth rate of labor hours worked and the labor force growth rate are also disconnected for many reasons, particularly because of variations in the unemployment rate and the demand for labor. A declining rate of population growth does not, within the relevant range, limit potential output. The period 1962-1973 again shows the feasibility of a 4 percent potential output rate. This was approximately accomplished in those

Why Has the U.S. Operated Below Potential Since World War II? 159 years with a labor input rate of increase of only 1.5 percent a year. Since almost the same output rate was achieved with an input growth of only .21 in 1948-1963 we should be able to achieve 4 percent output growth with labor input growths of well less than 1.5 percent. T o argue otherwise is to argue the past was better at organizing production than the present or the future is. Labor is, however, more than a supply factor in the trend potential. Labor utilization is also a policy target determined by the strength of what the Cornwalls have aptly called "the demand for full employment (Cornwall and Cornwall 1987:789). We conclude that the potential trend rate of growth of real output for the postwar era was about 4 percent a year, essentially the same as the actual during late nineteenth-century laissez faire. As is well known, the actual rate for the whole period 1948-1985 fell far short of this; i.e., it was about 3.26 for G N P and slightly less for NNP. 1 0 The actual magnitudes of the Domar variables, defined net of course, during 1962-69 were: investment ratio, I I Q = .0398 output/capital ratio, Q/K= 1.08 N N P annual rate = .043 For a conservative statement of the potential, using 4 percent for N N P growth, the economy could achieve such an output target with the same output/capital ratio it averaged in the 1960s and an investment ratio equal to the average for 1962-69 and 1949-1954, i.e., about .037. The fact that such an investment ratio is slightly above the .035 actually achieved for the entire postwar period by no means implies dependence on investment growth for sufficient aggregate demand growth. The latter requirement must be met through a high rate of autonomous public expenditure growth.

S U B P E R I O D S OF THE P O S T W A R ERA

We speak of performance chronically below potential. Only a few oddballs question the empirical correctness of this for the 1973-1986 period (Maddison 1987:649). We certainly do not. But 1948-1973 is more complicated to interpret. Angus Maddison refers to it as "the postwar golden a g e " (ibid.). It may have been for Japan and certain European countries. W e think it was not for the United States. Before the "golden sixties" the performance of the economy was mediocre. Between 1949 and 1961 the annual N N P rise was a modest 3.45 percent. The average capacity utilization rate was a little more

160 Why Has the U.S. Operated Below Potential Since World War II? than a lowly 82 percent, and the average civilian unemployment rate was about 5 percent. The average of the gross/net fixed capital stock grew at only 3 percent a year, reflecting a lackadaisical fixed investment response. There is more to it than the whole period 1949-1961 reveals, however. Closer scrutiny shows that 1949—1954 was quite robust, whereas 1954-1962 was quite stagnant. In the former period, N N P rose at the unusually high rate of about 5 percent a year, whereas in the latter span it increased at only 2.7 percent annually. The chief reason for the high N N P rate during 1949-1953 was, of course, the federal Korean War expenditures. For the whole period 1949-1954, real total government spending increased at an annual rate of almost 11 percent. Of course, with unemployment in 1952 and 1953 less than 3 percent, real N N P could not respond to increased spending, because supply constrained the economy for the only time in the thirty-seven years reviewed. During the "Eisenhower stagnation," 1954-1962," total real government expenditures growth dropped to 2.17 percent a year, and the average gross/net fixed capital stock rose annually by only 2.86 percent. Neither the investment nor the stock record suggests any continuation of "postwar rebuilding." The average civilian unemployment rate was 5.4 percent and trending upward through 1961. Performance was therefore substantially below any reasonable definition of potential. Those eight years showed how poorly the contemporary economy operates under restricted government spending growth. What creates the appearance of golden years for the entire period 1949-1973 is the Korean War impact and the truly golden sixties, 1962-69. After 1968, expansion of the economy's autonomous leading sector—government—collapsed. As a result, chronic stagnation began to reappear. For example, the rate of N N P expansion from 1969 to 1973 was only 3 percent yearly.

THE STRATEGIC ROLE OF DEMAND

A long list of first-class macroeconomic theorists have argued for more than 150 years that demand, as shaped by autonomous government, and not supply constraint, is the principal determinant of economic growth in market economies. Malthus argued that the government should maintain the Corn Laws to shift the resulting surplus to the landlords who would spend it and lead the economy to investment in industries producing the goods demanded. The supply-sider Ricardo argued that the repeal of the Corn Laws would transfer funds to the capitalists, who would then spend them on investment goods.

Why Has the U.S. Operated Below Potential Since World War II? 161 Both believed that government would choose the policies that led to the investment outlays that produced growth. In a similar debate today many economists are arguing that the government has arrogated to itself the Malthusian landlords' role, through its large budget. They argue that to increase economic growth we must rearrange our institutions to take resources away from the government and give them to the capitalists who will then invest and make the economy grow. We have called them "investment engineers" (Walker and Vatter 1986:523). The investment engineers ignore the major work done on the declining role of investment in the economy by Keynes, Hansen, Harrod, Domar, Eisner, Denison, Solow, and many others. The investment dilemma is perhaps most clearly stated by Domar. He fully analyzed the model we call Harrod-Domar, which was anticipated by Keynes and appears in his Galton lecture delivered to the Eugenics Society in 1937, to which we have referred above. In that model all net investment raises the capacity to supply, but only increases in net investment raise the capacity to demand. Real net fixed nonresidential investment has been positive every year from 1948 through 1986. But only once has the rate of change of net fixed investment been positive for as many as five consecutive years. In fourteen of these years the level of net investment was below the previous year. In many years gross investment increases were small and consequent demand increases were small, even though total capacity increases were large. The reverse case, where the change in demand from the change in investment times the multiplier exceeded the change in supply potential brought about by the new level of investment, did not in all likelihood occur. If the marginal propensity to save and the incremental output/ capital ratio shifted in remarkably fortuitous ways, it would be possible for investment-stimulated demand to grow at the various annual rates necessary to equal the annual increases in supply capacity. But of course they did not. With a higher output/capital ratio, any increment to the stock of capital increases the capacity to supply by a greater amount than the older investments did when it was lower. Increased rates of growth of potential supply from shifts to higher output/capital ratios can be balanced by increased investment additions or higher multipliers. We have not in fact had higher rates of investment increase, yet the investment engineers keep calling for higher savings rates, which imply a higher marginal propensity to save, which in turn implies a lower multiplier. The investment engineers cannot have it both ways. Hansen had capital-saving innovation (a rising output/capital ra-

162 Why Has the U.S. Operated Below Potential Since World War II? tio) as one of his explanations for the laissez faire secular stagnation he saw in the 1930s a n d fought against after the w a r . We are again in a period of stagnation. His student, Domar, clearly and completely eliminated with superb logic the simple-minded Ricardianism of the investment engineers. Small a m o u n t s of investment produce large a m o u n t s of productive capacity and the change in investment may not exist at all. In such a case there is no new d e m a n d for the enlarged capacity. Or the addition may be small and thus produce a new d e m a n d capacity smaller than the new supply capacity. Hence depressing excess capacity is produced. The more excess capacity we produce, the less likely we are to get the large percentage increases in investment that we need to produce the d e m a n d to buy the output of the past investments and any new ones we undertake. In 1947 Domar observed, "Indeed, it is difficult enough to keep investment at some reasonably high level year after year, but the requirement that it always be rising is not likely to be met for any considerable t i m e " (1957:99). Domar's student Eisner, studying the question of what determines investment, found that it was demand. "Once increases in d e m a n d and the consequent pressure of demand on capacity are recognized as a m a j o r and decisive determinant of business investment, the way is clear to achieving a rate of investment and a general level of prosperity in the latter half of this decade (the 1960s) far exceeding anything we have known and most of what we have imagined in the p a s t " (Eisner 1964:11-12). Few forecasts have been more accurate. Unfortunately, since the end of the 1960s the government and its economic advisers have been obsessed with the notion of making the economy grow rapidly by cutting business taxes to free resources for investment and cutting government spending to further free resources, which they assume investors will then take up. We have surveyed every Economic Report of the President from 1970 to 1987. Almost all of them call for federal action to expand the economy through tax cuts with almost no increase in government spending. Since passage of the Humphrey-Hawkins Act the president has been required to forecast the increase in government spending as a percentage of the economy each year. These forecasts almost always predict an increase in government spending that is less than the increase in the GNP. Yet Wagner's Law, u p to the present, is one of the strongest relationships in all modern economies. From 1979 to date, in compliance with a directive of the Humphrey-Hawkins Act, the Annual Report of the Council of Economic Advisers has included estimates of the growth of real GNP and several

Why Has the U.S. Operated Below Potential Since World War II? 163 of its components for the year following the issuance of the Report. It is issued in J a n u a r y of the year a n d forecasts the growth from the fourth q u a r t e r of the preceding year to the fourth q u a r t e r of the year of the Report. For the Reports from 1979 to date the data have been presented in virtually identical form, so we can see the shape of the expectations of the president and his economic advisers. Part of these d a t a are summarized in table 9.1 The average prediction in this period is for a slow growth in gove r n m e n t spending, a rapid growth in investment, a n d a well below historical average growth in GNP. This could be called expected stagnation. The expected stagnation was chronically overachieved. We grew even more slowly than the grim predictions. The advisers obviously expected fixed nonresidential investment to be a leading sector. It was not. Such growth as we got was led by the unexpected growth in federal government purchases. On average in this period both the Carter and Reagan administrations were big spenders! Since there was historically high unemployment of labor and low utilization of capital in this period, crowding out of investment by government could not occur. Hence, if the large increases in federal purchases had not occurred, the GNP growth would have been even less by the a m o u n t of the lost federal purchases plus the lost investment induced by the lost federal purchases a n d the lost consumption of the employees whose income those federal purchases represented. The Council predicted government spending growth of 1.1 percent a year; the government achieved 5.1 percent. Without the big increase in government purchases, actual stagnation would have been even worse than it was. In table 9.2 the average annual growth rate of the GNP and of government purchases, together with net fixed nonresidential investment for 1948 to 1985, and for five subperiods. The subperiods are chosen by the behavior of government spending. Table 9.2 contains much of the empirical evidence pertinent to the analysis in this chapter. The periodization is, of course, based on that analysis. Thus, the periods are delineated by the rate of change of government purchases of goods and services a n d the relatively high or low level of G in every year of the period. The chosen periods are all periods in which the average annual growth of government purchases is either greater than 3.5 percent or less than 3.5 percent, and the period is at least three years long (except 1984—86). We find that when the rate of government purchases is vigorously

164 Why Has the U.S. Operated Below Potential Since World War II? expanding, GNP growth is relatively robust. When the government purchases rate is sluggish, so is the GNP rate. This connection fits well our central thesis. We find that rates of taxation (relative to GNP) move very slowly. This is not consistent with the startling differences in the growth of GNP. When the relative growth of the rates is negative, GNP grows more slowly. The tax and spending relatives suggest that when the government taxes and spends, the society gets richer. When tax rates and spending slows, society gains less. We are aware that many will at once accuse us of neglecting the role of business investment. Table 9.2 reveals conclusively why we do indeed denigrate its widely alleged impact. Investment in fixed nonresidential structures for the whole postwar era grew notably less rapidly than either government purchases or GNP. But in the first long-run subperiod of rapidly expanding G and GNP, 1948-1968, it similarly exhibited a relatively high rate of growth. It is not hypothesized here that the good performance for structures is overwhelmingly a demand-induced phenomenon, for there was no doubt much postwar rebuilding; the value of the stock of structures, for example, did not reach its 1930 secular high until 1955-56. The secularly desired output-structures ratio was apparently reached around the mid-1960s, and the sluggish GNP rate after the 1960s set the pace for the structures investment rate. TABLE 9-1. Predicted and Actual Annual Percentage Changes in Real GNP, Federal Purchases, and Nonresidential Fixed Investment from the Council of Economic Advisors

Year 1979' 1980* 1981* 1982* 1983 1984 1985 1986 average •Average of range.

GNP actual predicted 2.25 -1.0 1.75 3.0 3.1 4.5 4.0 4.0 2.7

0.8 -0.3 0.7 -1.2 6.1 5.6 2.5 2.2 2.0

Federal purchases predicted actual 1.0 3.25 3.25 -1.5 1.2 3.7 2.2 -4.0 1.1

1.1 4.7 6.6 6.6 -6.0 14.2 11.8 1.8 5.1

Why Has the U.S. Operated Below Potential Since World War II? 165 Gross investment in fixed nonresidential equipment (PDE) outpaced both the GNP and structures investment rates for the whole postwar period and in both of our long subperiods. The same is true of the stock growth record. The PDE investment and stock series advanced like a juggernaut, quite independently of what was happening to GNP. Indeed, both the high flow and the stock rates exhibit no response to the GNP growth slowdown during 1968-1985. Nor, compared with that sluggish GNP period, do they show greater performance during the faster growth years, 1948-1968. From this we d r a w the significant conclusion that GNP growth in the postwar era was not in any significant sense determined by the robust performance of PDE investment spending. It is likely that the PDE performance was determined overwhelmingly by supply-side factors such as m a j o r innovations and public policy stimuli. When the PDE record is related to total private production, a remarkable fall in the partial productivity ratio emerges. The fall is particularly d r a m a t i c in the excessively stagnant years of economic growth, 1968-1983. We do not attempt here to explain this economically " i r r a t i o n a l " behavior. We do emphasize again that it shows the incapacity of a high rate of PDE investment to control output behavior. Indeed, the relationship must be considered quite perverse by an investment engineer. The table shows that, with the possible exception of the Korean War period, 1948-1953, the growth rates of G and PDE investment

T A B L E 9-1.

(cont.) Fixed nonresidential investment predicted actual

4.25 -0.25 1.25 7.0 -0.3 9.5 6.8 5.0 4.2

1.7 -6.0 1.4 -8.4 11.5 16.6 6.0 -5.4 2.2

Source: Economic Reports of the President, 1979-86.

166 Why Has the U.S. Operated Below Potential Since World War II? rise and fall together. Hence, there was no "crowding out." Rather, it is demanded in. 12 Even in 1948-1953, crowding out seems unlikely since that period had the second highest rate of investment in structures of the whole thirty-seven years studied. Some of the more significant supply-side aspects of our demandside emphasis are also revealed in table 9.2. For example, in the slower growing long period, 1968-1985, the resources available to produce output, i.e., Ks„ Kpde, and CLF, grow either at the same or at a faster rate than they do in the period of more rapid advance, 19481968. Hence we see that the expansion of output was not constrained by available inputs during 1968-1985. Augmented supply factors did not produce augmented output growth. Supply did not create enough demand. Measures such as Q/Ksl, Q/K^ and QI(CLF-Eg) in table 9.2 are often used as expressions for the partial productivity functions of the TABLE 9-2. Annual Percentage Changes in Government Purchases, GNP, Gross Investment, Civilian Labor Force, Capital Stock, and Output-Input Ratios (1948-85 and selected subperiods)

Period

Government purchases of goods and services (G)

Total government receipts (NIPA)/GNP (Tx/GNP)

Gross product (GNP)

-0.14 3.48 3.25 Shorter Subperiods 0.12 1948-53 14.42 5.20 1953-60 0.13 2.42 0.49 1960-68 4.63 0.26 4.39 0.72 -0.81 1968-83 2.30 NA 1983-86 4.31 3.63 Longer Subperiods 0.18 1948-68 5.50 3.90 -0.50 1968-85 1.15 2.50 Weighted Avarage of High G periods, 1948-53 and 1960-68 0.21 4.70 8.40 Weighted Average of Low G Periods, 1953-60 and 1968-83 2.34 0.65 -0.51 1948-85

Ail calculations from three-year annual averages of the beginning and ending dates except capital. Sources: Economic Report of the President, 1987; Statistical Abstract of the United

Why Has the U.S. Operated Below Potential Since World War II? 167 various inputs. Unfortunately, Q is properly so connected with inputs only when the economy (or sector) is operating at or near full employment. A decline in capital and labor partial productivities of the sort seen in the sluggish 1968—1983 period in the table makes no microeconomic statement. The failure of Q to grow sufficiently is not caused by inadequate or ill-designed capital or by an excessively teenage and female work force. It is caused by a failure in the management of aggregate d e m a n d . When QIKS„ QIKpde and Q/(CLF - Eg) all decline together, the government has failed. We recognize that the available resources plus technology set limits to output rise. But we cannot discover the effect of technological advance, together with output/capital or output/labor potential, unless we enable society to purchase the potential output represented by the growth of those supply factors. The last two rows of table 9.2 touch further on the m a t t e r of

T A B L E 9-2. (cont.) Gross private investment structures Cst)

Gross private investment, equipment (>Dde)

Average gross and net capital stock structures equipment (Kst) (Kode)

2.92

3.96 2.67 4.56 Shorter Subperiods 6.21 0.66 1.67 4.61 2.91 1.32 2.57 3.55 4.72 7.66 4.48 3.18 3.47 1.56 2.76 4.58 -0.37 8.55 Longer Subperiods 3.64 4.58 4.06 2.59 2.77 4.52 1.61 4.33 Weighted Average of High G Periods, 1948-53 & 1960-68 4.97 5.15 4.68 2.60 Weighted Average of Low G Periods, 1953-60 and 1968-83 2.79 2.70 4.25 1.99

States; John C. Musgrave, "Fixed Reproducible Tangible Wealth in the United States: Revised Estimates," Survey of Current Business, January, 1986; Survey of Current Business, August, 1987.

168 Why Has the U.S. Operated Below Potential Since World War II? potential. They average the good growth years together and the poor g r o w t h years together. They show that G N P growth in the years of relatively high government spending rates is double that for the years of low government spending growth. These measures may be thought of as crude approximations of potential output with active government and without active government. G N P , investment, and capital will grow in either case, but in the postwar period the chief cause of robust advance of the nation's wealth appears to have been government spending.

SUMMARY All prevailing growth theories pertaining to advanced market economies are predominantly supply-side theories. While there are, of course, crucial contributions by factor inputs in the development process, the prevailing models neglect one blade of the scissors. Our theory calls

TABLE 9-2. (cont.)

Period 1948-85 1948-53 1953-60 1960-68 1968-83 1983-86

Civilian labor force (CLF) 1.77 Shorter 0.81 1.44 1.60 2.35

Government civilian employees (LFq) 2.90 Subperiods 3.28 3.11 4.50 2.01

Output of business sector (Q) 3.23 4.46 2.56 4.45 2.36

Longer Subperiods 1.34 3.71 1948-68 3.79 2.27 2.57 1968-85 1.96 Weighted Average of High G Periods, 1948-53 and 1960-68 1.30 4.03 4.45 Weighted Average of Low G Periods, 1953-60 and 1968-83 2.06 2.36 2.42 All calculations from three-year annual averages of the beginning and ending dates except capital. Sources: Economic Report of the President, 1987; Statistical Abstract of the United

Why Has the U.S. Operated Below Potential Since World War II?

169

for correction of this glaring defect by the incorporation of long-run demand into all models of potential growth. The supply-side explanations of both actual and potential growth presume the empirical validity of S a y ' s L a w for the long run. Such presumption would possibly be proper for the United States in the nineteenth century. Today it is incorrect because economic evolution itself has negated and reversed the law. Now, within a wide relevant range of economic performance, demand is the initiator and creates its own supply. In the second place, the supply-side theories give an excessive and obsolete weight to the growth impact of fixed capital investment, ignoring the impressive work of Denison and others. These theories also continue to rely heavily upon investment demand stimulus to buttress their dependence upon S a y ' s L a w for the long run. Their reiteration of S a y ' s mechanical connection between capital supply and the demand for its output capacity is the only sense in which

TABLE 9-2.

(cont.)

Measures of productivity of private inputs structures equipment (Q/Kst) 0.54

Equipment labor ratio labor

K

(Q/Kode)

Q/(CLF-LFg)

pde^ (CFL-LFg)

-1.27

1.57

2.44

Shorter Subperiods 2.75 0.00 1.23 -0.38

-1.64 -1.13 -0.02 -2.12

1.17 -0.19

-0.76 -1.86

3.91 1.31 3.26 -0.05

2.27 2.25 3.29 2.14

Longer Subperiods 2.74 0.24

2.67 2.16

Weighted Average of High G Periods, 1948-53 and 1960-68 1.81

-0.64

3.51

2.90

Weighted Average of Low G Periods, 1953-60 and 1968-83 -0.26

-1.81

0.38

2.18

States; John C. Musgrave, "Fixed Reproducible Tangible Wealth in the United States: Revised Estimates," Survey of Current Business, January, 1986; Survey of Current Business, August, 1987.

1 7 0 Why Has the U.S. Operated

Below Potential

Since

World

War 11?

these theories concede that demand has something to do with fueling the growth engine. The mistaken emphasis on physical capital accumulation reveals a third defect in the ruling growth models to which we have called attention: they are essentially laissez faire constructs. Acknowledgement of the long-established presence of big government is considered ancillary to long-run growth analysis. Government is allowed to intrude mainly and merely into such matters as subsidization of sectors, regulation, research, and education of the labor force. Big government as the decisive, dynamic, autonomous source of demand growth, historically coming to replace private fixed investment is, like the demand side in general, omitted from the usual model. A fourth defect resides in the neglect of the fact that public spending growth, unlike private investment, generates income and spending without directly adding much to our chronically capacity-bloated market economy. 13 This constitutes a colossal oversight in a theory that purports to address itself to the growth process in an advanced mixed-market system. The oversight is shockingly congenial to the habit of burying Domar's insightful recognition of the dual character of private investment as both spending and capacity-creating. Finally, the supply-side method for construction of potential growth estimates ignores the considerable demand elasticity of inputs, particularly labor input.14 It is the failure to heed this demand factor that creates what Angus Maddison calls "the mystery concerning acceleration and slowdown" of growth in the advanced economies in recent times (1987:676). This is but one example of the fact that endlessly debatable insolvables will plague our theory of potential growth until full consideration is given to the decisive influence of autonomous, robust, public demand growth. NOTES 1. "Many modern inventions are directed towards finding ways of reducing the amount of capital investment necessary to produce a given result." J. M. Keynes, "The Economic Consequences of a Declining Population,"

Eugen-

ics Review (April 1937), 29(1):14. 2. W e do not emphasize in our discussion Keynes' thesis that a declining population rate adversely affects the demand for capital goods. That thesis pertains primarily to residential construction investment. The adverse effects on business fixed investment, with which we are concerned, while positive, are indirect and ancillary. 3. Continuous series for the period from the 1870s to the 1950s are available in John W . Kendrick, Productivity

Trends in the United States (Princeton,

Why Has the U.S. Operated Below Potential Since World War / / ? 171 N J . : Princeton University Press, 1961), pp. 290-291, table A-I; pp. 298-299, Table A—III; and pp. 324-325, table A-XVI. The large drop in the level occurred between the 1920s and the 1950s. See the dramatic graphical representation for the total gross investment ratio in Jeffrey A. Frankel, "International Capital Mobility and Crowding Out in the U.S. Economy," National Bureau of Economic Research Working Paper No. 1773 (December 1985), p. 12a, figure 1. The gross fixed-investment ratio now averages about 10 percent (of GNP), and the net only i'/z percent (of NNP), with net investment an ever declining share of gross investment. 4. Of the many data sources, one may refer to Lance E. Davis et al., eds, American Economic Growth (New York: Harper and Row, 1972), p. 34, table 2 - 9 and p. 286, table 8-1, with the discussion, pp. 288-289. The nineteenthcentury rise in capital/output, with capital more broadly defined, is documented in Robert E. Gallman, "The United States Capital Stock in the Nineteenth Century," in Stanley Engerman and Robert E. Gallman, eds., Long Term Factors in American Economic Growth (Chicago: University of Chicago Press, 1987), pp. 184-200, especially table 4.7. The twentieth-century secular drop in capital/output accompanying the investment ratio drop is discussed in John E. LaTourette, "Aggregate Factors in the Trends of Capital Output Ratios," Canadian Journal of Economics (May 1970), 2(2):255-275. Relevant data for post-World War II may be found in John A. Musgrave, "Fixed Reproducible Tangible Wealth in the United States: Revised Estimates," Survey of Current Business (January 1986), 66(1):63, table 8, and the Economic Report of the President (Washington, D.C.: GPO, January 1987). 5. A noteworthy part of this rise is apparently due to an increase in the number of hours worked by, and a general increase in the degree of efficient utilization of, plant and equipment. See the discussion in Edward Dension, Why Growth Rates Differ: Postwar Experience in Nine Western Countries (Washington, D.C.: Brookings Institution, 1967), pp. 154-155; and Murray F. Foss, "Changing Utilization of Fixed Capital: An Element in Long Term Growth," Monthly Labor Review (May 1980), 108(5):3-8. 6. This statement considers the immediate postwar years and the expansive Korean War years, embracing the whole period 1947-1953, as somewhat aberrant for representation of a peacetime potential pattern. It also assumes that the economic influence of the Vietnam War was too moderate to warrant treatment of the 1960s as similarly aberrant. 7. From 1962 to 1968 real government purchases increased at a 4.9 percent rate, then fell absolutely in 1969 by $6 billion (1982 dollars). They averaged a large one fourth of GNP during 1962—1969. Gross fixed nonresidential investment averaged 10.5 percent. 8. For the treatment of growth rates in the capital stock, we follow Denison in using a simple average of Musgrave's gross and net stock (Kg + Kn/2) because of the defects of each if taken alone as indicator of capacity or input change. See Denison, Why Growth Rates Differ, p. 141. 9. Civilian labor force growth rates were 1.93 percent yearly over 19621969 and 2.66 percent from 1969 to 1979.

172 Why Has the U.S. Operated Below Potential

Since World War

II?

10. All output rates are calculated from three-year averages centered on the initial and terminal years. 11. The phrase is from Paul A. Samuelson, Economics, 1 Ith ed. ( N e w York: McGraw-Hill, 1980), p. 239, figure 14-1. 12. Eisner's term is " c r o w d in." Robert Eisner, How Real is the Federal Deficit? ( N e w York: Free Press, 1986), p. 109. 13. Of course, public capital outlays add to the social infrastructure. 14. The bogey of inflation has produced a big crack in the conventional method of determining potential labor supply; public policy now defines a high "natural" rate of unemployment.

REFERENCES Cornwall, John, and Wendy Cornwall. " T h e Political Economy of Stagnation." Journal of Economic Issues (June 1987), 2:789. Domar, Evsey D. Essays in the Theory of Economic Growth. N e w York: Oxford University Press, 1957. Economic Report of the President. Washington, D.C.: GPO, various years. Eisner, Robert. "Capacity, Investment, and Profits." Quarterly Review of Economics and Business (Autumn 1964), 4(3): 11-12. Maddison, Angus. "Growth and Slowdown in Advanced Capitalist Economies." Journal of Economic Literature (June 1987), 25(2):649. Walker, John F., and Harold G. Vatter. "Stagnation—Performance and Policy: A Comparison of the Depression Decade with 1973-1984." Journal of Post Keynesian Economics (Summer 1986), 8(4):523.

CHAPTER 10

International Dimensions of a High Growth Rate J O H N F. W A L K E R H A R O L D G. VATTER

The future career of the U.S. foreign balance is a matter of increasing policy concern. We share that concern and join with those who advocate policies to reduce the current external deficits to at least more moderate magnitudes. The current deficits are of very recent origin and historically aberrant. For example, in the half century from 1929 to 1979 real exports of goods and services increased at a compound annual rate of 4.4 percent while real imports rose at 4.6 percent. That growth rate occurred in the context of a modest real GNP growth rate of 3.1 percent. After World War II, exports and imports rose even faster relative to GNP growth, and import growth was almost a percentage point higher than export growth. Hence, we can observe that the United States has returned in contemporary times to the early and mid-nineteenthcentury pattern of moderately negative balances on its external goods and services flow. The historical record thus shows that the United States has also had a rising propensity to import, especially in the contemporary era. Furthermore, the robust periods in the U.S. growth rate following World War II have been accompanied by an increase in the growth rate gap between imports (6.8 percent) and GNP (3.6 percent). But the record also reveals that the big jump in the import propensity in 1983 was historically exceptional. It should not be cause for panic. It would appear tempting to attack the negative foreign balance by slowing GNP growth. That would exploit the U.S. import propensity by putting it into reverse. Import growth would fall and thus help close the negative current account balance. This grim menace to the rest of the world's American market fits 173

174 International Dimensions of a High Growth Rate nicely into the whole multipronged threat mounted by the so-called "soft-landing" advocates against a high domestic growth rate. The current soft-landing orthodoxy is essentially, anti-Keynesian, prosaving, proinvestment for growth, and antigovemment spending. It attacks high growth in order to contain inflation, the " N u m b e r One Economic Problem." Its references to desirable growth are always to "noninflationary growth." It attacks high employment for the same reason, buttressed by the belief in a high "natural unemployment" rate. It ignores or denies the role of government expenditures as the unique leading sector in the economic growth process. Its "investment engineers" adhere to an outmoded reliance on the interest rate sensitivity of business fixed investment and on "autonomous" fixed investment as the prime growth and productivity stimulant. With the exception of investment demand, this group persistently denigrates the strategic role of demand in the determination of long-run expansion. To investment engineers, autonomous investment means the investment that would occur if the government adopted their investment-subsidizing and government-restraining policies. Accompanying the import explosion of the 1980s, the same group has attacked the import-buying public for "living high on the hog" and not saving enough. The attack on the lowered personal saving rate (gross business saving has not fallen) and on government dissaving (deficits) invokes the utterly unsustainable, pre-Keynesian belief that investment is a function of savings. In these essays we have critiqued all the listed attacks on high growth except the external imbalance argument. We have tried to show that the attacks involve misleading, atavistic rationales; plain empirical error; and unacceptable human policy goals. The investment engineers almost always maintain that potential real GNP growth for the next twenty years will not exceed approximately 2.5 percent, which is substantially below the actual record of the preceding century. They further argue that attempts to exceed potential growth only produce inflation. These low, 2.5 percent growth prescriptions ignore not only past history but also the great, global human tragedy represented by a slow-growing American giant. The standard orthodox, slow-growth prescription for a return to a sustainable domestic and international performance to correct the "overspending by consumers and government" in the 1980s is: slow down private consumer spending, slow down public spending, cut the government deficit,

International Dimensions of a High Growth Rate 175 avoid low interest rates, except in order to enhance private saving and investment, and cut the deficit in the external current account balance. This program, which we can show is internally inconsistent, is premised upon the soft-landing estimate of a 2.5 percent potential annual output growth, entirely driven by supply-side calculations. Note that this percentage is composed of 1.5 percent labor force (not labor input hours) growth and only 1 percent output-per-worker growth! We have shown elsewhere that a 2.5 percent growth potential is contractive nonsense. The United States would not accept such a rate for a minute if it were adopted by any of our important trading partners. It presumes that either nothing can be learned from history or that past accomplishments of the United States and other economies can no longer be even approximated. Gloomy growth projections at present are widespread around the world, usually linked by "natural unemployment rates" with inflation fear and the belittling of the human costs of slow growth. However, as the World Bank's international economics department director Jean Baneth pointed out, "the most dangerous thing is the gradual acceptance that if all we have is 2 percent growth, that's o.k., without thinking that for many people real earnings will remain basically unchanged throughout their lifetimes." 1 From 1947 to 1967, when in the United States real government expenditures were rising at more than 5 percent a year and real GNP was rising at 4 percent, output per hour in the nonfarm business sector was increasing at 2.7 percent. This was a fine "labor productivity" record, racked up with less than 1.2 percent annual increase in labor input hours in the business sector. Let all future forecasters note this rate. Real employee compensation per hour increased a vigorous 2.9 percent a year, in sharp contrast with the 0.8 percent in the years of slow economic growth that followed (1967-1982). There is no reason to call 1947-1967 either a miracle or a nonrepeatable performance. Even if it be thought of as extraordinary, the United States can still surely get 2.5 percent growth in output per hour on top of 1.5 percent labor hours growth. But it takes high demand growth to get a high productivity rate. Recognition of that widely unacknowledged fact at once calls to our attention the proclivity of the slow-growth advocates to ignore demand considerations generally. It is precisely because of their tendency to obliterate demand influence that we have labeled their con-

176 International

Dimensions of a High Growth Rate

tractive program internally inconsistent. The idea that the United States can have a vigorously growing economy approximating its potential by suppressing the expansion of both of its t w o m a j o r demand streams, consumption and government, is the pinnacle of absurdity. W e see no reason to relinquish the feasibility of our 4 percent growth policy on the basis of the prevailing Brookings, Congressional Budget office, and R. J. Gordon arguments about the potential growth rate. N o r do w e entertain either the desirability or necessity of relinquishing the policy in order to cut the external deficit. We will take up this latter issue b e l o w . But first let us take a brief look at a simulation of the 2.5 percent " s l o w - g r o w t h " model and compare it with a schematic model of our own high-growth program.

HIQH AND LOW GROWTH PROJECTIONS Table 10.1 sets out projections of selected major real spending streams up to 2007 on conventional slow-growth assumptions in contrast with our high-growth policy assumptions. The top panel of the three in the table gives projections for a real G N P growth rate of 2xh percent a year. This rate predominates among current potential estimates based on exclusively supply-side reasoning. The t w o top panels include residential construction with personal consumption expenditures. Aside from the historical and theoretical logic underlying such inclusion, it contributes to segregation of business fixed investment, which we consider the strategic category for production capacity growth and dynamic spending. This is quite traditional: from the classicals on, it was considered the prime mover of long-run growth and is still viewed as such by contemporary investment engineers. G N P minus inventory change is used for the first G N P column. For the last column, w e use net exports from the national income and product accounts rather than the "balance on goods and services" in the international transactions accounts. Further in the top panel we assume consumption's (as defined) share of G N P decreases at 0.5 percent a year for ten years to liquidate " l i v i n g high on the h o g , " partly because of high imports, as in the 1980s. Thereafter, consumption rises pari passu with G N P , yielding a historically consistent consumption ratio (to G N P ) of 66.4 percent. T o fit the conventional slow-growth bias, w e allow real government purchases of goods and services (G) to grow for a time at only 2 percent a year. This pulls down the ratio of G to G N P from 1987's

International

Dimensions

177

of a High Growth Rate

percentage (20.5) to a more c o m f o r t i n g 19.8 percent by 1994. Thereafter, G g r o w s at the s a m e rate as GNP. We next presume that appropriate d o m e s t i c a n d international policies get the net export deficits d o w n by a b o u t $20 billion a year. At that rate the balance b e c o m e s zero in 1994. It d o e s not upset the basic projections if it takes a little longer. TABLE 10-1. Projections of Major Real Spending Streams, Slow-growth and High-growth Assumptions, and Projected High-growth Savings/Investment Balances, 1987-2007 (billions of 1982 dollars)

Year

Consumption GNP plus minus gross inventory residential change investment (GNP) (C)

Gross fixed nonresidential investment (If)

Net export of goods and services (X-Mp)

Total government purchases (G)

Slow 2-1/2 percent GNP Growth (Slow G Growth)

1987 1994 2007

GNP C 3812.7 2716.2 4532.1 3070.1 6247.6 4138.4

a GNP 71.25 67.7 66.2

If If

445.1 557.4 878.7

/GNP G 11.7 780.2 12.3 896.3 14.1 1217.6

G^ GNP (X-Mp) 20.5 -128.8 19.8 0.0 19.5 0.0

High 4 percent GNP Growth (High G Growth) 1987 1994 2007

3812.7 2716.2 5017.2 3398.0 8354.1 5642.8

71.25 67.7 67.5

445.1 576.0 965.1

11.7 11.5 11.6

High-growth Savings/Investment (S-lf)

1987 1994 2007

(411.7-445.1) -33.4 (664.5 - 576.0) 88.5 (1053.6-965.1) 88.5

780.2 1033.7 1742.9

20.5 20.6 20.9

128.8 0.0 0.0

Balances

(T-G)

=

(X-Mp)

(-88.5)

=

-128.8

(-88.5)

=

0.0

(-88.5)

=

0.0

St. Disc.

-6.9 0.0 0.0

Source for 1987: Economic Report of the President, January 1989, pp. 310-311. Symbols in bottom panel: S = gross private savings; T * total government receipts; St. Disc. = statistical discrepancy.

178 International Dimensions of a High Growth Rate Fixed investment then becomes a residual variant against total output. We find that the investment/GNP ratio, already historically high in the 1980's (i.e., around 12 percent, whereas since about 1910 it has averaged a bit more than 10 percent), reaches a most implausible 14.25 percent in 1997 and remains at that level thereafter. Such a result violates everything we have experienced in the past regarding the investment ratio and the average partial productivity of capital. The implausibility develops, of course, because of the slow growth of G N P in the context of our other spending-stream assumptions. The next panel down presents our high 4 percent GNP growth model. We also have consumption's share of G N P falling slowly at first to wash out the historically high consumption ratios of the eighties. Consumption's share of GNP declines 0.5 percent a year for ten years. This is the same share assumption as in the upper panel. Thereafter, it rises at the same rate as GNP, ultimately yielding a consumption/ G N P ratio about a percentage point higher than in the conventional slow-growth model. Real G in our model is, of course, the prime mover of long-run growth. This is consistent with our rejection of Say's Law, long run, and its replacement with aggregate demand as the growth-strategic side of the economy. Furthermore, we anticipate that Wagner's Law, as traditionally measured, is operative though muted. Hence, for that reason and to perform the prime-mover role we assume that G grows very slightly faster than GNP, that is, at 4.1 percent a year. At that rate the G/GNP percentage will stand at a historically modest 20.87 in 2007, and 21.27 in 2027. Of course, no one would expect it to rise forever. But some future consensus can make the appropriate decisions on the optimum size of government spending, as well as government administrative involvement in the economy. Exports in the high-growth panel behave exactly the same as in the conventional model. They become zero in 1994 and remain such thereafter. Calculation of the appropriate residual for business fixed investment in the high-growth model now reveals two striking comparative outcomes. The first of these is the investment ratio, //GNP, which would be 11.5 percent around the time the consumption ratio stabilizes, government is on its steady growth course, and the foreign balance becomes practically equalized. The investment ratio remains close to the historically high 1987 level throughout the high-growth projections, in contrast to the unfeasible higher ratios in the slowgrowth model. We see no reason why an investment ratio of 11.5 percent could not provide the antiinflationary capacity expansion

International Dimensions of a High Growth Rate 179 necessary to accommodate whatever the growth in exports envisioned by the reduction in the trade deficit. A second striking contrast with the orthodox model is the fact that the level of fixed investment in the high-growth model immediately rises faster than the level in the slow-growth scenario. And both the absolute and relative gaps in the level grows apace, despite the higher investment ratio in the orthodox model. The reason for both our higher investment volume and the growing gap between the two volumes of investment is, of course, overwhelmingly because our GNP is growing faster. And this is demand-side realistic. So we say to the investment engineers: if you desire a love affair with a high level of business productivity-stimulating investment, you should support a high economic growth rate. In the bottom panel of table 10.1 the projections of the savingsinvestment balances are presented only for the high-growth model. The actual real values for 1987 are again used for the initial magnitudes. Our equation for this balance, making it consistent with the categories in the two top panels, is: Real gross private saving = Gross private domestic investment minus Residential investment plus or minus Change in business inventories plus Net exports plus or minus Statistical discrepancy minus (All government receipts minus government purchases) Thus for 1987 (in $ billion): 411.7 = 674.8 - 195.2 - 34.4 -128.9 + 6.9 + 88.5 The expression for the real savings-investment balance is: Gross private saving minus business fixed nonresidential investment plus (all government receipts minus government purchases) equals exports minus imports. Thus for 1987, our initial year, we have (in billions of 1982 dollars):

180 International Dimensions of a High Growth Rate (411.7-445.l) + ( - 8 8 . 5 ) = 128.8, with a statistical discrepancy of - 6 . 9 . The net exports deficit is again assumed to be reduced to zero by 1994. We next assume the fiscal deficit is unchanged over time. This seems to us the only reasonable way to go because any attempt to cut it significantly would likely induce recession of unknown duration, whereas we want sustained 4 percent growth. Holding the fiscal deficit at the 1987 level places the full responsibility for the accommodation required by elimination of the net export deficit on the savingsinvestment balance and the GNP growth rate. The projected magnitudes of that accommodation are shown in the second row (for 1994) of the bottom panel of table 10.1. It will be seen that savings are required to rise by more than 61 percent, in the period 1987-1994, which is very much faster than the required 29 percent for fixed nonresidential investment (3.75 percent per year). On an annual basis, gross private savings would have to increase by more than 7 percent a year. This is a big order. The highest rate for an extended period after World War II was 4.43 percent a year from 1961 to 1971. But the 7 percent would be helped by our assumption regarding the slow rate of consumption rise of only 3.25 percent per annum in those early years. The 7 percent a year rate of total savings growth is, of course, high because of the rapidity with which we assume the external deficit to fall. A slower rate of decline in the external deficit would cut the rate of savings rise required. It would, of course, slow down the rate of increase in the GNP. Any policy attempt to sustain the GNP growth rate by, for example, increasing government purchases would, of course, require raising savings and the savings rate. Only in such a way, others things equal, could the necessary offsetting cut in the savings-investment balance be achieved. In the high-growth model, the ratio of real total private savings to G N P is 10.8 percent in 1987. With the assumed high growth of savings, it becomes 13.2 percent in 1994, more than half a percentage point below the 1980 level. With slowed savings growth after 1994, the proportion becomes 12.6 percent in 2007, which is a bit more than 1 percentage point below 1980. But as the projections show, this rather low ratio does no apparent harm to the moderately high fixed investment ratio of 11.6 percent in 2007. Leaving the all-government budget deficit constant at $88.5 billion will, of course, add that much to the public debt in each succeeding

International Dimensions of a High Growth Rate 181 year. However, in ratio to G N P the all-government debt must fall over the long run. This follows from the fact that we are adding a constant amount yearly to the debt, but GNP is growing exponentially at 4 percent. The economy will grow out of its public debt. The real deficit relative decline in our high growth simulation drops from 2.3 percent of real G N P I N 1987 to about 1.1 percent in 2007 and 0.5 percent in 2027. The debt-to-GNP ratio falls more slowly than the deficit-to-GNP because of the constant annual amounts (the deficits) added to the debt. But both ratios fall continuously until they become trivial. Since the annual deficit is influenced by the interest charges on the accumulated public debt plus the yearly additions to that debt, the advantages of low interest rates are to be stressed.

EXTERNAL IMBALANCES IN THE 1980s

Turning now to the problem of the current account external deficit inherited from the 1980s, we should note that the economic expansion pattern in that decade (1982 to 1987) differed significantly from, for example, the robust 1960s, which we have used as a normative model. The difference points to the necessity for our policy prescriptions. It is true that total output, prompted primarily by rapid real public expenditures expansion, grew at about 4 percent a year from the 1982 depression year through 1987, despite the explosion of net imports. But unlike the 1960s, when government spending was primarily tax financed, the government spending growth was financed largely by big nominal budget deficits as usually measured. These deficit demands on the loanable funds, and most importantly together with a decline in personal saving funds, plus continued inflation and high nominal interest rates, contributed to a rise in the U.S. real interest rates relative to some of the major international trading countries. The exchange value of the dollar, expressing the operation of market forces and flexible exchange rates (contrasted to the fixed exchange rates of the Bretton Woods system used in the 1960s), rather than a cooperative international policy, remained, therefore, very high throughout the years 1981-86. Additionally, foreigners maintained a strong demand for dollars because they bought U.S. assets speculatively and in search of a politically safe place to put their funds. The rise in the dollar's exchange value discouraged exports and encouraged imports, helping to turn the foreign balance into large negatives. Direct and powerful reinforcement of these negatives came from the fact that many other countries slashed their budget deficits and public expenditures so that they grew more slowly relative to the

182 International Dimensions of a High Growth Rate robust expansion in the United States. We agree with supply sider Marc A. Miles of H. C. Wainwright & Co. that trade surpluses and deficits result mainly from differential national rates of economic growth. 2 The reasons for the explosion of the foreign balance deficits, (the net exports in the national income and product accounts and the current account), beginning in 1983, provide a general guide for their reduction in the upcoming years. Those reasons are best detected if two time periods are delineated: (1) from about the mid-1970s to 1981; and (2) from 1981 to 1985. In the first period the lengthy gradual decline in U.S. merchandise competitiveness was operative but of minor weight. More important was the fact that prices being paid for imports were rising faster than prices received for U.S. exports. From 1975 to 1981, import prices rose 11.1 percent a year; export prices increased 7.8 percent a year. Furthermore, the multilateral trade-weighted value of the dollar was not rising before 1981; it could not have contributed to the moderate merchandise account deficits through 1982 (see figure 10.1). Meanwhile, net nominal receipts in the U.S. foreign investment income account were still drifting upward. They peaked in 1981, thus dampening up to that year the episodic deficit indications in the overall balances on both goods-and-services and current account. We know that the spread between the U.S. and other countries' interest rates strongly affects the foreign exchange value of the dollar. But the explosion of the U.S. short-term nominal interest rates in 1979 was accompanied by a sufficient simultaneous jump in foreign rates to hold down the emergence of an interest rate spread with expectational momentum until 1981. It was in that year, however, that the momentum of the interest rate differential took effect, raising the dollar's nominal exchange value index from 1980's level of 87.4 (March 1973 = 100) to 102.9. That leap thereafter peaked out only in 1985. But until differentially high U.S. real interest rates destroyed the dollar's competitiveness, there was nothing critical or alarming in the world of the U.S. foreign balance, i.e., before the third quarter of 1982. In our second period, 1981 to 1985, the foreign balance deficits increased every year and reached unprecedented heights, overpowering the nation's positive net investment incomes. The dollar had undoubtedly become overvalued compared with its relatively stable 1973-1980 trend value. There is wide agreement that dollar-denominated assets had also become an economically desirable and politically "safe haven" for

International Dimensions of a High Growth Rate 183 funds from around the world. The associated high demand for dollars from that source also contributed to the high valuation placed on the dollar. Indeed, it has been said that the foreign exchange market in contemporary times is more influenced by capital transactions than by trade transactions, at least in the short run. The goods-and-services deficits were exacerbated by the fact that the United States was expanding relatively rapidly and imports are income elastic, while total real exports were practically constant from 1982 through 1986^. Slow growth in the world economy added its influence to the high dollar to help kill off world demand for U.S. products. It follows that, aside from the need for high rates of foreign economic growth, reduction of the U.S. foreign balance deficits in the future requires a policy emphasis on the exchange value of the dollar and its determinants. Such an emphasis is consistent, incidentally, with the fact that when the dollar began to fall in 1985^, the percentage increases in the goods and services, current account and merchandise deficits also fell in 1986. Figure 10.1 T r a d e - W e i g h t e d Value of the Dollar

Source: Bulletin of the Federal Reserve Bank of Philadelphia, March/April 1989, p. 15.

184 International Dimensions of a High Growth Rate Among the determinants of the dollar's exchange value, most Americans would probably not want to forfeit the advantages of the U.S. "safe haven" differential. But much could be done to contain the U.S. price inflation differential that underlies the nominal interest rate differential. Since domestic nominal interest rates follow domestic price movements, inflation must be contained if the foreign balance deficit problem is to be liquidated. But containment through bolstering the market's high interest rates response to price increases is clearly destructive. Therefore, some other inflation policy is called for. The best alternative is probably an abiding incomes policy. T o get high interest rates down, inflation must be contained. They must come down if the exchange value of the dollar is to fall. The high interest rate policy route raises the dollar, augments the external deficit, fails to contain inflation, and may generate unemployment. Hence, there is no way that route should be preferred to an incomes policy. Through an incomes policy, reconstitution of the pre-1981 foreign balance relationships would be much more realizable than could be hoped for through another fiasco of high interest rate meddling. Such imbalances as obtained in the 1980s are in no one's long-run interests. International coordination is imperative, and in the current context, as Barry Bosworth has pointed out, " . . . other countries must be willing to allow the dollar to decline and to replace the stimulus they now receive from exports to the United States with domestic measures." 3 The fast growth in U.S. GNP in the 1980s kept the savings/investment relationship moderately positive, but not sufficiently so to offset the dissaving represented in the growing federal budget deficits. That dissaving mirrored the current account deficits, giving rise to the fallacious belief by some that the budget deficits caused the external balance deficits. That fallacy ignored the decisive nexus of external relationships in which the U.S. economy was involved. While the federal budget deficits no doubt had some influence on nominal interest rates, the record indicates that its "crowding out" influence was minor. Certainly, it would be a policy mistake to concentrate on the budget deficit to cut the dollar's exchange value. Any attempt to quickly reduce the budget deficit significantly would induce economic recession of unknown duration and depth. Unfortunately, many economic commentators seem willing to take this risk. History reveals no recent time when any large budget deficit reduction took place without economic contraction. The years coming out of World War II (1946, 1947) demonstrated that clearly. It was also

International Dimensions of a High Growth Rate 185 demonstrated when the all-government budget went from a $65 billion deficit in 1975 to a surplus of $ 11.5 billion in 1979. With the associated slowdown in G, real G N P stagnated from 1978 through 1982. Furthermore, budget deficit reduction would likely have harmful effects on the rest of the Organization for Economic Cooperation and Development (OECD) countries. The probable consequent U.S. slowdown has been estimated to net a quarter to a half percent reduction in the growth rates of the other OECD countries, to say nothing of the adverse impact of that reduction on the third world. W e know of no macroeconomic theory that confidently predicts long-run growth after a short recession to be sufficiently strong as a result of the recession to produce a growth rate for the recession and subsequent expansion combined that is higher than the growth rate for the same period without the recession. Figure 10.2 illustrates this point. If the recession is short and then the growth rate is high, it is possible to be richer after a few years. W e would call this a forecast with a " u s e f u l " recession. It is also possible to be forever poorer. W e would call this a forecast with a " c o s t l y " recession. Whenever total real G N P is below the growth trend for a long time (five to ten years), the recession is costly because the present value of a lost dollar this year is $1 and the present value of a gained dollar in ten years is much smaller $1/(1 + R)>0, where R is the rate of interest. The positive balances on external account in the 1960s should Figure 10.2 Real GNP Growth Paths Before and After a Recession

a o

«CD a> o

J 0 1

I

I 2

I 3

I 4

I 5

Years

I 6

7

I 8

I 9

186 International Dimensions of a High Growth Rate certainly not be taken to imply either the desirability or the feasibility of positive balances in the future. It would be absurd to expect the United States to grow through export-led expansion at this historical juncture in the world economy. In the same vein, the United States expects other countries to pursue policies that further domestic-led growth. Comparison with the economy in the 1960s is enlightening. During that decade both the United States and the rest of the world grew rapidly. World trade, buttressed by successive General Agreement on Tariffs and Trade (GATT) rounds of multilateral tariff reductions grew faster than gross domestic products of the group of advanced countries, just as U.S. trade relative to its G N P did for the whole half century 1929-1979. In the United States the high growth rate in the 1960s was led by even faster, generally tax-financed, increases in government spending. The U.S. external balance was moderately positive. The fast growth in GNP brought high and rising gross private savings, both personal and business. This made the savings-investment balance in modest surplus. That surplus was enough to offset the small federal budget deficits that emerged. The pattern of the 1960s is in general a model to be emulated by the United States in the coming years. However, the declining relative importance of the United States in the world trading system, together with the rising relative importance of its foreign balance, make international cooperation imperative. Cooperation is much more imperative than it was in the 1960s. The United States certainly still carries enough weight to elicit that cooperation. Specifically, there will have to be agreement on the absolute necessity for robust economic expansion all around, particularly expansion through fiscal policy. Governments cannot be permitted, in pursuance of domestic macroeconomic policies, to manipulate nominally flexible exchange rates to continually stimulate exports for one country at the expense of exports for other countries. Such measures violate the second amendment to the International Monetary Fund (IMF) agreement. Using interest rates to manipulate foreign trade should also be prohibited; central banks are always too prone to raise interest rates in the name of antiinflationism. And finally, there will have to be joint recognition on the part of the advanced countries that, if for no other reason than their own self-interest, the third world's problems of indebtedness, access to markets, terms of trade, and internal growth require special joint governmental planning and coordination on a global scale. The prescription of a high growth rate will entail an even higher

International

Dimensions of a High Growth Rale 187

g r o w t h rate of goods and services imports. High import elasticity, in the context of relatively free international intercourse, is amply indicated by past experience. In the future, therefore, U.S. macropolicy, both domestic and foreign, w i l l have to proceed with the presumption of a rapid long-run import increase. U.S. exports will, therefore, also have to rise faster than the targeted rapid G N P growth. That pattern is also rooted in past experience. Furthermore, the necessity for robust, sustained export rise in the future w i l l be heightened by the large foreign deficits inherited f r o m the 1980s. The United States historically maintained persistently positive foreign balances by virtue of its international creditor policy. But this role has been withering a w a y , and it must, therefore, be anticipated that the abiding positive foreign balances will also disappear. The consequent probable, and indeed desirable, scenario is approximate long-run import-export equality. The overall record since W o r l d War II suggests that the income elasticity of import demand should be rather less that 2. The requisite accompanying export g r o w t h will place great responsibilities on trading partners. But they can hardly question the legitimacy of that policy goal. Export growth support absolutely demands the pursuit of an integrated domestic and foreign economic policy on the part of the United States. The domestic part w i l l have to include a number of basic economic objectives. These include, among other more minor goals: 1. 2. 3. 4.

low interest rates low inflation rates approximately balanced government budgets good productivity performance

There is good reason to believe that a high interest differential between U.S. and foreign interest rates raises the exchange value of the dollar, as has been pointed out. This policy would frustrate the future need to raise U.S. exports and thus contribute to reduction in the trade deficit. But there are other excellent reasons for abjuring high interest rates. One is that they increase interest payments on the U.S. government debt, making it more difficult to cut the fiscal deficit and finance more pressing expenditures. Another is that they are a costly and uncertain w a y to contain inflation, despite widespread belief in high places that they are a m a j o r weapon. For example, moderately high nominal interest rates and very low or negative real rates in the 1970s

188 International Dimensions of a High Growth Rate appear to have had nothing much to do, one way or another, with the inflation of that decade. When the inflation rate exploded at the end of the 1970s, the nominal interest rate followed suit, and the real rate did not become positive until the inflation had already spent its force in 1981. The inflationary trend was not broken by high interest rates. We discuss this matter below. The trend was broken by a much more potent weapon: contraction of the economy. The severe contraction in real GNP began in 1979; the GNP remained practically stagnant thereafter until 1983; the capacity utilization rate averaged a shockingly low 77 percent over the four years 1980-83. This broke the back of the high CPI inflation rate. The process was helped by the drop in the price of energy. The five-year stagnation of real GNP from 1978 through 1982 was itself the result mainly of secular stagnation in real government purchases from 1970 to 1983—the economy's largest single nonconsumption spending stream. But if this denigration of high interest rates as an antiinflation weapon is accepted for the period 1970 to 1982, what are we to say about the years of lower inflation, 1983 through 1987? The coincidence of moderate inflation rates with persistently high nominal, and historically the highest real, interest rates, beginning in 1982, in undeniable. Moreover, the buoyant expansion of the economy in the context of large government fiscal deficits would presumably exert upward pressure on the price level. Hence, the moderate inflation in the 1980s would seem to support the standard belief in the inflation-controlling power of high interest rates. But there were other influences operating in the 1980s that can help explain the reigning in of inflation. Three such influences come to mind. The first is the continuation of low capacity utilization rates averaging less than 80 percent and never exceeding 81 percent. The average for the buoyant noninflationary 1960s (1959-1969) was 84.6 percent. (The highest year-to-year change in the Producers Price Index (PPI) in the 1960s was the 3.8 percent increase in 1969.) The second restraining influence was high average unemployment rates of 7.5 percent. Few would deny that this was substantially above the so-called "natural" rate. The third inflation-containing influence was the flood of cheap imports, as we have mentioned. Their magnitude was large: more than 11 percent of real G N P by 1983 and bigger than nonresidential fixed investment. The import price deflator dropped 7.9 percent between 1981 and 1986, the latter year being the last before the inflation rate turned up again. The energy price index in

International Dimensions of a High Growth Rate 189 the CPI fell 9 percent. The GNP price deflator over the same period rose 21 percent. But here the devil must be given his due: high relative interest rates in the United States through 1985 that sustained the dollar's high value must have contributed to the cheap import influence. These are important inflation-restraining influences. They leave the interest rate influence sullied but perhaps not necessarily unbowed. However, high interest rates are a two-headed monster. It should be recognized that interest, like wages and the price of petroleum, is a cost. If we can speak of high wages as an inflationary influence and treat the "pass-through" of high oil prices as inflationary, the same effects should obtain regarding high interest costs. It is a mistake to look upon high interest only as a demand restraint. The pass-through effect is inflationary. For example, for nonfinancial corporate business, current dollar employee compensation per unit of output rose by two thirds between 1977 and 1987, but net interest cost per unit of output, while a small part of unit costs to be sure, rose a whopping 139 percent! Who is generating inflation? The possible demand-side influence emanating from continued highlevel nominal and real interest rates in the expansion of the 1980s is a checkered one, to say the least. They failed to restrain a powerful real residential construction boom (13 percent a year, 1982-87), in this supposedly interest-sensitive form of investment. They failed to restrain a very vigorous expansion of real producers' durable investment (7.4 percent a year). They failed to restrain real purchases of consumer durables (also allegedly interest sensitive) that increased at a rate in excess of twice that for a vigorously rising total real consumption. As for nonresidential business structures, it is conceivable that high interest could have contributed to the stagnation of such outlays. However, those outlays also staged a miserable performance in the 1970s. It seems more likely that their sickly growth rate of only 1.22 percent a year for the long time span 1970 to 1986 represented the well-known relative secular fall in that component of business fixed investment. The relative fall has obtained throughout the twentieth century and has deep-rooted technological causes. In the 1980s very high real interest rates were associated with a rapid economic expansion. Since interest rates did not restrain the economic growth, they could not create recession. If recession is what restrains inflation, interest rates are a weak or useless antiinflation tool. The proper conclusion from all this is that a Federal Reserve policy

190 International Dimensions of a High Growth Rate of supporting high interest rates is either a costly and too blunt inflation control weapon or, more likely, no weapon at all. The antiinflation excuse for high rates is seriously undermined by the powerful role played by other factors in breaking the inflation of the 1970s. The continuation of a high interest rate pattern in the 1980s apparently did not seriously dampen the economic expansion in the 1980s. We do not know, because it was operating counter to the fiscal expansiveness in the Reagan years. The most we can say is that the high rates did damage U.S. exports and to that extent ran counter to the "longest expansion." The basic philosophy of the Fed is antithetical to sustained economic growth at high employment. Its overwhelming absorption with the threat of inflation makes this inevitable. When the economy begins to even approach high employment, the Fed wishes to pare back that expansion and engineer the economy "safely" below potential. It is fortunate that the Fed's efforts to dampen growth have in fact become increasingly ineffective in recent times. As for the money "supply," it hardly knows any more how to define that "target." Its interest rate policies are essentially dependent adjustments to already market-determined rates. To the small extent to which it can take any initiative that will have some influence, it typically moves for higher and, it is hoped, growth-dampening rates. As for velocity, the Fed has, of course, little if any direct means of control. When the economy grew robustly in the 1960s, it was due primarily to a rapid growth in public expenditures. When it grew rapidly in the Reagan years, it was again due primarily to a vigorous expansion in government purchases. The Fed was a mere bystander, accommodating at best, and all the while protesting the inflationary danger and hoping for a slowdown. When the economy stagnated and inflated at its highest twentieth-century rates during the grim years 1969-1983 the Fed was basically helpless. In every boom during that unhappy time of mass unemployment and colossal outputs foregone the Fed all too typically viewed with alarm the imminent potential, not of high employment, but of resumed inflation. Meanwhile the economy was stagnating primarily because real government purchases were stagnating (a sick 0.67 percent a year). Reliance on the Fed to help the economy grow at its potential for a sustained period is a snare and a delusion.

THE FEDERAL RESERVE AND THE END OF THE 1970s INFLATION

It is a part of the conventional wisdom of the economics profession that the Federal Reserve played a substantial role in ending the infla-

International Dimensions of a High Growth Rate 191 tion of the 1970s. We will show that like so m a n y conventional wisdoms, this one is incorrect. Interest rates are prices, and normally when all other prices rise, interest rates rise with them. For interest rates to act to stop inflation they must rise more than other prices. If they rise sufficiently more than other prices they may choke off the growth of alleged interestsensitive industries, and if those industries are enough of the economy we will have a recession that may end the inflation at enormous cost to society. To get at the relative rise of interest rates as the inflation of the 1970s wound down, we calculate the real rate of interest, using some version of the equation: Nominal Interest Rate - Actual Inflation Rate = Real Interest Rate. There are, of course, dozens of nominal interest rates. We will use the discount rate of the Federal Reserve Bank of New York. It is unequivocally set by the Federal Reserve. The Federal Reserve in World War II fixed the entire term structure of interest rates in the government securities market at the low levels of the Great Depression. That conclusively proved it can control most if not all interest rates. It does not prove that in more normal times the Fed chooses to exercise that power. There is a large literature using the term structure of interest rates to calculate expected interest rates and expected inflation using variations of the Hicks-Lutz equations. (Strangely, those equations were first developed by Irving Fisher.) Most of the participants in that literature refer to market expectations, not Federal Reserve expectations, which means they assume the market, not the central bank, has set the interest rates. The Federal Reserve discount rate typically moves less and after the change in other short-term interest rates. Hence, the Fed does not move the interest rates, it moves its own interest rate after the market has changed, and generally in the same direction but by a smaller magnitude than the market change. Figure 10.3 illustrates this pattern. Just as there are many nominal interest rates there are m a n y price indices. We have chosen to use the PPI. The discount rate is a measure of the short-term cost of funds to banks. The PPI measures the change in costs to businesses, who are the banks' principal customers. The equation for the real interest rate given above is estimated by Discount Rate, Federal Reserve Bank of New York

annual percentage = Real Discount Rate. change, PPI

192 International Dimensions of a High Growth Rate W e have calculated this equation for the 108 months from January, 1976, through December, 1984. For the discount rate of the Federal Reserve Bank of N e w York w e used the monthly rate as reported in the 1979, 1982, and 1984 editions of Business Statistics. The same sources provided seasonally adjusted monthly changes in the PPI for finished goods. W e adjusted the monthly rates to annual rates so that they would be comparable to the discount rates. The equation clearly demonstrates two ways of changing the real interest rate. Any change in the discount rate, ceteris paribus, is positively associated with a change in the real rate. Similarly any change in the level of the inflation rate is inversely associated with a change in the real rate. W e are interested in the question, "which change is most associated with changes in real interest rates?" In the 108-month period we can observe 107 monthly changes in the PPI, the discount rate, and the real rate. The equation predicts Figure 10.3 Federal funds

'72

1973

1974

'75

Source: Federal Reserve Bulletin, September 1975, p. 539.

International Dimensions of a High Growth Rate 193 that increases in the level of the PPI rate will result in decreases in the real rate, and decreases will result in increases in the real rate. If the PPI does not change, neither will the real rate. In the 107 observed months the real rate changed as predicted by the change in the PPI 101 times, or 94.4 percent of the time. The only cases where the real rate changed differently than the change predicted from the PPI change are cases where there was no change in the PPI. Hence, the only possible change was from the nominal discount rate. In the 107 months there were only six such events. A similar calculation for the discount rate finds that a positive association between the change of the discount rate and the real rate or no change in the discount rate associated with no change in the real rate occurs in only 35 of the 107 cases (32.7 percent of the cases). The changes in the real rate are therefore overwhelmingly explained by the changes in the PPI. Whenever the effects of the PPI change and the discount rate change were in opposite directions, the PPI effect dominated, and the real rate moved in the direction predicted by the change of the PPI. By carefully working through the monthly d a t a we were able to date the end of the inflation. It was between April and May of 1981. The change is illustrated below

April 1981 May 1981

Discount Rate

PPI Rate

Real Rate

13.00 13.87

11.35 3.66

1.65 10.21

Almost all of that large increase in the real rate is caused by the fall in the PPI. Furthermore, in the two years. May 1979-April 1981, the real rate averaged - 0 . 7 8 percent, while the inflation averaged 12.39 percent, and during the two years. May 1981-April 1983, the real rate averaged 9.34 percent while the inflation averaged only 2.46 percent. When the inflation ended, the discount rate, which had not risen as much as the inflation rate, did not fall with all the other prices. Hence, the real rate rose. This was not fighting inflation by increasing interest rates. This was refusing to lower nominal interest rates sufficiently after the inflation had ended. Table 10.2 clearly demonstrates (1) the fall of the inflation rate well before the rise in the real interest rate, (2) the coterminous ending of the inflation, and (3) the generation of high real interest rates by the refusal of the Fed to lower the discount rate sufficiently. The inflation peaked in the Nov. 1979-April 1980 period after hav-

194 International Dimensions of a High Growth Rate ing risen for most of the preceding three and a half years. The discount rate peaked much later in the May 1981-October 1981 period, after a rise lasting five years. The inflation rate rose almost 12 percentage points in the three and a half years. The discount rate rose 7.7 percentage points in five years. From its peak the inflation rate fell 12.6 points in two years. The discount rate fell 4.2 points in the two years after its peak. Changes in the real rate were primarily explained by changes in the PPI, not changes in Fed policy. In the period herein reviewed the Fed changed from interest rate targeting to nonborrowed reserve targeting (October 1979 to September 1982), then back to interest rates. It is our contention that the Fed is always attempting to control some interest rates no matter what target it is using. Since the Fed was not holding rates up to stop the high inflation, which had ended, it is fair to ask why it did not lower the discount rate to keep the real interest rates at reasonable levels, by historical standards. We are not on the Open Market Committee, which usually TABLE 10-2. Real Interest Rate Calculation (in percent) average of monthly rates

Semi-annual period May "76 to Oct. '76 Nov. '76 to Apr. '77 May '77 to Oct. '77 Nov. '77 to Apr. '78 May '78 to Oct. '78 Nov. '78 to Apr. '79 May '79 to Oct. '79 Nov. '79 to Apr. '80 May '80 to Oct. '80 Nov. '80 to Apr. '81 May '81 to Oct. '81 Nov. '81 to Apr. '82 May '82 to Oct. '82 Nov. '82 to Apr. '83 May '83 to Oct. '83 Nov. '83 to Apr. '84

Discount rate New York Federal Reserve

All Items PPI, monthly at annual rate

5.50 5.28 5.43 6.31 7.43 9.50 10.23 12.42 11.06 12.72 13.98 12.18 12.39 8.68 8.50 8.56

3.26 8.35 5.58 8.75 8.31 12.03 12.37 15.20 11.48 10.50 4.29 2.66 2.61 0.29 2.64 3.31

Real rate 2.24 -3.07 -0.15 -2.44 -0.88 -2.53 -2.13 -2.78 -0.42 2.22 9.68 9.52 9.78 8.39 5.86 5.25

Source: Business Statistics, 1979, pp. 36, 83; 1982, pp. 27, 63; 1984; pp. 26, 65.

International Dimensions of a High Growth Rate 195

makes such decisions, but it is worthwhile to speculate about its motives. Three likely candidates for the motive of the Fed in its high real interest rate policy are: (1) to end inflationary expectations by (a) holding real rates high until the principal players in the market are convinced that the Fed will never again allow such an inflation or (b) holding real rates high until investment and other allegedly interestsensitive activities collapse, causing a recession and convincing the actors in the market that expecting inflation in a depressed economy is unwise; and/or (2) to attract sufficient foreign funds to enable business to easily get the funds to invest because it believes the high federal deficit might otherwise crowd private investors out of the market. Former Federal Reserve Chairman Arthur Burns was a great champion of the inflationary-expectations theory of inflation. Since the quid and the quo in all loan contracts occur at different times there must be an expectation in every loan contract. Unfortunately, the measurement of inflationary expectations has not been a great success. It is an introspective estimation of probable future price movements on the part of the buyers and sellers of bonds. There is no reason they should usually agree. Nor is there any evidence that market forces would produce a generally accepted evaluation. It is much like marginal utility, but there is no accepted Neuman-Morgenstern Index. Burns, as chief economist for the Cabinet Committee on Price Levels, was at least partly responsible for predicting a terrible inflation in the early 1960s if contractionary economic policies were not adopted. Of course, expansionary policies were adopted and prices were quite stable. The point here is that Burns' inflationary expectations were unequivocally wrong on at least one important occasion. His successors in the Fed of the 1980s, who included many he had known well and influenced, may have made a similar mistake. The notion that high interest rates can cause a recession, which in turn will end an inflation, is not well supported in recent economic experience. Using the same calculation of the real interest rate that we used in table 10.2, we have estimated the real rate of interest for the two quarters preceding the peaks for the four business cycles from 1969 to 1981. The results are shown in table 10.3. The end of a cyclical expansion was not usually associated with high real interest rates, although it could be said the 1981 peak involved such an association. Both the 1969 and 1981 rises in real interest rates were caused by falls in prices, however, not increases in the discount rate. If the Fed

196 International Dimensions of a High Growth Rate believed it could quickly cause a recession by raising interest rates it w a s believing a theory, not a tested proposition. It soon learned that a long expansion could be generated in the face of high real interest rates. In the first fifteen quarters of the great economic expansion of the Reagan administration, the real interest rate averaged 7.40 percent. That is, high interest rates were associated with an expansion, not a recession. Unfortunately the Fed did not then have this information when it chose to hold nominal and consequently real interest rates up. The only clear case of the Fed's driving up real interest rates that may have helped produce a recession was 1982. The third interpretation of Fed motivation, that U.S. absorption of foreign funds sustained the level of domestic investment in the 1980s, has some element of validity. Investment was historically on the high side and foreign funds were pouring into the country. The mechanisms of this fund attraction is probably not what the Federal Reserve had in mind, however. The process seems to have gone like this: first, the Fed supported high real interest rates. Second, to get the high American interest rates, foreigners had to invest here in dollars, so they traded most foreign currencies for dollars, driving the value of the dollar up. Third, the high dollar priced U.S. goods out of most foreign markets and exports stopped growing. Since the United States was in an economic expansion for most of the period, imports rose faster than the economy, as they usually do in an expansion. The TABLE 10-3. Real Interest Rate, the Two Quarters Preceding Cycle Peaks

Quarter 1969ii 1969iii 1973ii 1973iii

Real interest rate 0.08 3.2 -3.73 -22.8

1979iii 1979iv

-4.95

1981 i 1981 ii

0.2 6.7

-0.6

Source: Calculated from Economic Report of the President, 1971,1975,1981,1982.

International Dimensions of a High Growth Rate 197 result was a large trade deficit, substantially supported by the Federal Reserve. Table 10.4 illustrates this pattern. A number of observers have associated the trade and budget deficits, claiming the latter caused the former. We believe that the causation, to the minor extent it exists, goes through the Federal Reserve's reaction to budget policy. The United States had large budget deficits in the late 1970s, but no National Income and Product Accounts (NIPA) net export deficits, probably in part because real interest rates were negative, the real international interest rate differential was insignificant, and the dollar was cheap. The United States had large budget deficits again in the 1980s, and when combined with high domestic real interest rates and international interest rate differentials, it did experience historically large net export deficits. But neither the rest of the government nor the market forced the Fed to support high real rates. Such rates were a policy decision on the part of the unelected monetary authority. The pattern of the two periods is shown, using annual data, in table 10.5. The monetary authority has at least some effect on the government budget, just as the budget has an effect on the monetary authority. In the period 1982-87, the American economy grew strongly, and most of the major components of GNP, except exports, grew strongly as well. High interest rates did not significantly dampen growth of total gross investment, as is often postulated; nor did consumption, government spending, and imports grow slowly. We have accordingly calculated the GNP for 1987, assuming all TABLE 10-4. Real Interest Rates, the Value of the Dollar, Real Exports, and Real Imports (compound annual rates of change)

Period

Real interest rates

1976ii to 1981 i 1981 i to 1985i 1985Ì to 1988ii

-26.5 126.4 -36.5

Multilateral trade weighted value of the dollar (March 1973 = 100) -2.6 13.4 -45.5

Real Real exports imports (1982 = 100) 8.52 -2.63 7.68

6.53 8.13 8.80

Source: Calculated from Economic Report of the President, 1978, 1979, 1981, 1982, 1984,1985,1987,1989. Data are reported as of March, June, September, December 1976-79, and quarterly thereafter. Our calculations assume this makes no difference.

198 International Dimensions of a High Growth Rate components grew from 1982 through 1987 at the experienced rate, except exports. We assume exports to grow 8.5 percent per year, which is the average for the period 1976» to 198 lj. The result is a real GNP that is $116.5 billion (or 3 percent) higher than the actual real GNP we experienced. Assuming a marginal all-government tax rate of 33 percent, government revenues would be $38.4 billion higher and the all-government deficit would have been $66.5 billion instead of $104.9 billion. To achieve such a growth in exports would have required low real interest rates to help produce a falling dollar. Those same low rates would also have lowered the interest costs to the government substantially. The net interest outlays of the federal government in 1987 were $138.6 billion, the three-month bill rate averaged 5.82 percent and the PPI increased 2.1 percent. Consequently the real rate on T-bills was 3.72 percent. Near the end of the last long economic expansion, in 1967 the three-month Treasury bill rate was 4.32 with a PPI growth rate of 1.1 for a real T-bill rate of 3.22. If the Fed were able to drive the real Treasury bill rate down to the 1967 level, the nominal rate would fall 0.5 percentage point or 8.6 percent. An 8.6 percent reducTABLE 10-5. The Real Interest Rate and the Budget and Trade Deficits (in percent)

Year

Federal Reserve Bank of New York discount rate

Yearto-year changes PPI, total finished goods

Real interest rate

Federal budget Net deficit exports (+) NIPA or basis imports (-) (as a % of GNP)

1974 1975 1976 1977 1978

7.83 6.25 5.50 5.46 7.46

15.4 10.6 4.5 6.4 7.9

-7.6 -4.3 1.0 -0.9 -0.4

-0.8 -4.3 -3.0 -2.3 -1.3

1.1 1.9 1.1 0.0 0.0

1981 1982 1983 1984 1985

13.42 11.02 8.50 8.80 7.69

9.2 4.1 1.6 2.1 1.8

4.2 6.9 6.9 6.7 5.9

-2.1 -4.6 -5.2 -4.5 -4.9

1.1 0.8 -0.2 -1.6 -1.9

Source: Economic Report of the President (January, 1989). B-66, p. 384; B-79, p. 401; B-2, p. 311.

Tables B-71, p. 390;

International Dimensions of a High Growth Rate 199 tion in the federal interest bill would move the budget another $11.8 billion toward balance. The Federal Reserve high real interest policy in the 1980s increased the interest costs of the government debts a n d by helping to kill exports lowered income and income tax receipts and consequently increased the deficit it claims to oppose. If the United States had to have the foreign savings to finance some of the deficit and investment growth, the Federal Reserve should have d e m a n d e d a return to the selective credit controls it used to restrict the growth of consumer and other " u n w a n t e d " credits in the 1940s and 1950s. If Americans were living "high on the h o g " in the 1980s their h a n d m a i d e n was a monetary authority that presided over an explosion of all types of credit from increasingly unregulated financial institutions. The only certain victims of this policy were American exporters. The International Monetary Fund's World Economic Outlook (April 1989) discusses macroeconomic objectives in the case of countries like the United States, which have both large budget and external deficits. The writer(s) happily favor low interest rates for some of the reasons we have advanced. However, the desirable sustenance of the current expansion, together with reduction in external deficits, will likely strengthen, according to the World Economic Outlook, the ogre of inflation. As usual, the discussion ends u p with the admittedly undesirable recommendations for an "unavoidable tightening of monetary policy" and reduction in the "absorption of savings by g o v e r n m e n t " (p. 39), i.e., budget deficit cuts. Equally revealing of this policy inconsistency and bankruptcy, there is as usual no discussion of incomes policy as an escape f r o m these dilemmas. It is always better to slow down growth, but when the international arena is the focus, that prescription is devastatingly embarrassing for these experts. Pompous, weasel, opinionated, conventional, respectable verbiage is the end product. The overt ogre for these authorities is inflation. The unmentionable ogre is the governmental intervention that an incomes policy entails. Our ogre is the tragedy of lost output and employment forgone. Our ogre will condemn the next generation in the advanced countries for the first time to zero improvement in its average material level of living, a condemnation process now u n d e r w a y in the United States. This same ogre will c o n d e m n much of the third world to accelerated starvation. The United States in recent years has found itself even more dependent on economic forces operating through its foreign balance. It is no longer able to bask in the insularity of a balance of international

200 International Dimensions of a High Growth Rate payments that amounted to a very minor portion of its domestic economic activity. There is every reason to anticipate an increase in the interdependence of the United States with the rest of the world. N o one expects that this matter can be turned over to "the market" to let things work themselves out. On the contrary, the foreign economic policies of the government have become, and will continue to become, more and more important in respect to their influence on domestic economic activity. Here again, an enhanced role for government is inevitable. But that enhancement may well not be accompanied by much public spending or employment increase; rather it could require more policy-making activities by existing agency staffs. High interest rates threaten to damage more than U.S. export markets. They also support large service charges on the mammoth third world debt to the developed countries. Those charges are an enormous burden on third world export earnings, and therefore on its domestic development needs. The ability of the third world to make payments on principal is in inverse ratio to those high service charges. The third world debt nexus is inextricably connected with growth rates in the advanced creditor countries. For example, if the United States pursues a high growth rate policy, third world exports to it will rise. That will ease the service charge burden also, along with interest rate reduction. The United States, with its large foreign indebtedness, also has to make substantial payments to foreign holders of U.S. assets. These service charges add greatly to the U.S. current account deficit. The higher the interest rate on those assets, the greater the drain on the current account. Cooperative requirements have become increasingly acknowledged by the great trading nations at various international conferences, such as the GATT rounds for open trade policies, the Plaza Agreement of the Group of Five in September 1985, the Louvre Accord of the Group of Seven in February 1987, the Venice Economic Summit of June 1987, and the Versailles Economic Summit meeting. The Tokyo Economic Summit of the seven largest industrial countries (G-7) in May 1986 was particularly significant for its comprehensive appreciation of the problems requiring coordinated attention to nurture the integrity of the multilateral trading system. These included nonpegged but also nonflexible exchange rate controls, promotion of noninflationary economic growth, and coordinated attention to differential GNP growth rates, inflation rates, interest rates, unemployment rates, fiscal deficit ratios, current account and trade balances, monetary growth rates, reserves, and exchange rates. The

International

Dimensions

of a High Growth Rate 201

G-7 leaders explicitly endorsed policy coordination on this b r o a d range of p e r f o r m a n c e a n d policy m a t t e r s . The w i d e s p r e a d self-interest pressure for cooperation is f u r t h e r u n d e r s c o r e d by the fact t h a t lowering the exchange value of the d o l l a r to close the exceptional U.S. external deficit cannot be a simple acrossthe-board r e d u c t i o n vis-à-vis all o t h e r currency units. Selective a n d differential a d j u s t m e n t s will be r e q u i r e d because, for example, o t h e r trade-deficit economies w o u l d have to b e a r a disproportionate s h a r e of the a d j u s t m e n t b u r d e n if the dollar were depreciated u n i f o r m l y (see, e.g., the review of William Cline's "American Trade A d j u s t m e n t : The Global I m p a c t . " ) 4 Such cooperative p r o g r a m s are a n d will be historic b r e a k t h r o u g h s in the t w e n t i e t h c e n t u r y ' s trend t o w a r d replacement of beggar-myneighbor n a t i o n a l misguided sovereignty with g r e a t e r i n t e r n a t i o n a l coordination o p e r a t i n g w i t h i n the f r a m e w o r k of a n international set of rules. The t r e n d is invincible because, like the assured g r o w t h of g o v e r n m e n t internally, vested economic interest will require it. And a high g r o w t h r a t e by the United S t a t e s is entirely consistent w i t h the vested interests of o t h e r countries, both a d v a n c e d a n d third w o r l d . A strong American d e m a n d for the t h i r d world's p r o d u c t s is a "foreign a i d " p r o g r a m of the very best kind. NOTES

1. Jean Baneth, cited In New York Times (December 27, 1987), p. 24. 2. Marc A. Miles, New York Times (December 30, 1987), p. CI. 3. Barry Bosworth, "Fiscal Fitness: Deficit Reduction and the Economy," Brookings Review (Winter/Spring 1986), p. 7. 4. Anonymous, "Review of William Cline, 'American Trade Adjustment: The Global Impact,' IIE paper no. 26," The Economist (May 6, 1989), p. 63.

CHAPTER 11

The Inevitability of Government Growth HAROLD G. VATTER JOHN F. WALKER

"They are proposing to put the national government in your bathroom," concludes John Genovese, vice president for product development at American Standard Inc. "They" are a group of members of Congress, led by Senator Wyche Fowler, Jr. of Georgia and Representative Chester Atkins of Massachusetts, who have introduced a bill setting Federal water conservation standards for plumbing fixtures.1 One hundred years ago a conservative German economist, Adolf Wagner, observed that the government had been growing faster than the private sector of the economy for much of the nineteenth century. He predicted that the pattern he observed for that century would continue in the industrial nations as long as they continued to grow. This prediction that the government will grow faster than the rest of the economy has been tested many times in many countries and has always proved correct. Economists now call it Wagner's Law. Since it has been proven correct for many countries for more than a century and has never been found incorrect, it is probably the most accurate economic prediction ever made.

THE ERA O F BIG G O V E R N M E N T

Americans have always thought of big government in peacetime as an ogre to be exorcised if at all possible. But in spite of ourselves the creature seems to become ever more distended. The federal government, which is deemed out of touch with the grass roots, is particularly derided. Hence it is sporadically vowed with renewed vehemence that the government must be cut down to size at all costs. A whole series of presidents have taken this vow. President Carter 202

The Inevitability

of Government

Growth

203

liked to discuss an era of governmental limits and asserted that government could not do everything. President Reagan unabashedly called for a reduction in the share of the economy going to the government. That is, these presidents have asserted that Wagner's Law must and can come to an end. But they have also advocated economic growth and a further expansion of the benefits of the modem industrial economy, which they mistakenly associate with an end to the growth of government. After 1970 the growth rate of government employment slowed. For six years all government civilian employment hovered about its historic peak of some 16 million persons. Federal employment, always much smaller than combined state and local employment, is only slightly higher today than it was in 1970. Only the state and local work force has continued its invincible upward creep, although it too has distinctly slowed. Thus on balance it begins to look, at least on the basis of the employment criterion, as though the first phase of a stoppage may have been completed. These changes may be seen in table 11.1 for government employment (in thousands of persons). The concomitant battle of the government cutters to call a halt on the expenditures front also seems to have been victorious—at least in the relative sense of government spending as a share of total economic activity. Government purchases of goods and services was about 21.5 percent of GNP in 1970 and 20.4 percent in 1987. Voila! Modern conservative economic advisers describe the government as an institution hampering growth and taking resources away from the "productive" private sector. Wagner also divides the economy

TABLE 11-1. Government Civilian Employment, Selected Years, 1950-1987 (thousands)

Year

Federal

1950 1960 1965 1970 1980 1987

1928 2270 2378 2731 2866 2943

State and local

Total

4098 6083 7696 9823 13375 14120

6026 8353 10074 12554 16241 17063

Civilian labor force 62208 69628 74455 82771 106940 119865

Source: Economic Report of the President, 1988, pp. 284, 297.

Government employment as percent of civilian labor force 9.7 11.0 13.5 15.2 15.2 14.2

204 The Inevitability of Government Growth into a private and public sector, but Wagner, an advisor to Otto Von Bismarck, did not see government as unproductive. In one minor sense the contemporary conservatives are correct. For government purchases or employment to grow faster than GNP or the labor force forever is impossible because at some point it takes all of the GNP or the labor force: at that point, therefore, its share of the total could no longer increase. Wagner's Law is usually tested by measuring the percentage of GNP or total employment accounted for by the government over long periods of time. Those percentages have been rising since the 1830s. For some contemporary mixed economies such as Sweden's, government spending, including social security, is more than 50 percent of GNP, and public employment is, at least in the Swedish case, 40 percent of total employment. Employment measures are the smaller of the two criteria, but they are still large. The operation of Wagner's Law must soon come to an end for such societies, if it be interpreted to mean share of GNP. But there is more to the size of government than nominal public spending and employment, as every regulated person or group, every lobbyist, every tax accountant, every military contractor, every subsidized farmer, knows full well. We have connected government and private employment in many ways. For example, when we decide to build a star wars defense system, we do not need more soldiers, we need more physicists, technicians, and assemblers in the laboratories and factories of the private sector. But surely government causes those nominally private jobs. We will now examine the connections between government and private budgets and employment. We will also see that the government control of economic affairs is much bigger than budget or employment data would imply. There are seven different ways to manipulate the government tax and spending system (what is commonly but mistakenly thought of as the government budget) to achieve redistribution or public guidance micromanagement goals. These different methods have varying effects on public and private outlays and employment. They are as follows. 1. A tax may be increased and the money collected given to an allegedly deserving group. This increases most peoples' taxes, increases the income of the deserving group who can spend as it wishes, and increases government employment by the cost of managing the transfer. The cost of the transfer depends upon how tightly we control the behavior of the recipients. If we view eligibility to receive as clear and easy to establish and the recipients' spending as their private

The Inevitability of Government Growth 205 business, then very few government employees are needed for very many recipients. For example, the Social Security Administration in 1986 served 37,622,000 beneficiaries with 78,000 employees, or 482 beneficiaries per employee. On the other hand, a program like food stamps has both much stricter and less clear requirements for its recipients, who can use the benefits only for food. They are assumed to be temporarily in need and are consequently regularly retested for eligibility. All of these characteristics increase administrative personnel and costs. The Highway Trust Fund, which taxes gasoline and diesel sales to support highway contractors, state highway departments, and the trucking industry, is another example of this manipulative method. With taxes and government transfers rising together this system tends to keep the budget in balance. 2. Tax credits or deductions may be given to taxpayers who donate resources to socially approved institutions. In this case tax receipts go down. Government spending is unchanged unless there is a balanced budget rule. Resources to the approved institution are presumably increased and government employment to enforce the rules is but little affected. Recipients under this system include most churches, universities, scouting, the Cancer Society, and other antidisease foundations, the Red Cross, community centers like auditoria, convention centers, statues, etc. There is much debate about how dependent on tax breaks these various institutions are. The great churches and universities raised very large sums before such tax breaks existed and certainly could again. Most European cities included many fine public buildings financed by popular subscription long before the income tax and its deductions were invented. We cannot know how dependent on the tax code modern churches and other socially useful charities are without repealing the charitable gift provisions of the income tax. Given the strength of the supporters of such guidance subsidies, that is unlikely to happen. Some churches employ an income tax called the tithe. They typically define tithable income as gross income. They also have successfully advocated deducting the tithe from taxable income for the government. Consequently they have connected the church and state budgets so that increases in taxes do not reduce the tithe but increasingly tithes does reduce taxes. Budgetarily such churches are connected to the state no matter what they and the first amendment say. 3. The government contracts with a private organization to perform socially mandated services or production. This can be financed with tax increases, cuts in other government spending, debt, or a

206 The Inevitability of Government Growth combination of the three. The results are that either government employment goes up to monitor the private agency or down if the government fires some or all of its employees who had been doing the job now contracted out to the private agency. Private agency employees, whose existence and functions are thus dictated by the changing public budget, increase. If private contractors are more efficient than the government by more than the increased monitoring costs, the total cost of the program will fall. If the reverse is true it will rise. Contracting out is often combined with quality of service changes that make these comparisons difficult. No form of contracting out of government-developed and financed services changes the fact that ultimate responsibility for the service and the people who provide it rests with the government.) Examples of the system include substitution of: foster parents for public orphanages, private nursing homes for public hospices or hospitals, and defense contractors for federal arsenals. 4. The government identifies a need and supplies the goods or services to fill that need itself. Such programs can be financed by taxes, cuts in other government services, debt, or a combination of the three. The results are indeterminate in terms of numbers of government employees and size of budget. However, much of the longrun increase in the size of the government, its budget, and taxes is explained by this traditional type of activity. Examples that are still not contracted out in most of the country include: police, fire departments, the armed forces, the parks, data collection and publication, prisons, the census, etc. 5. Tax credits or deductions can be given for imaginary expenses or expenses that are not allowable for the rest of society. What most would consider income can be excluded from the income tax. These sorts of provisions (loopholes) lower tax revenues and increase the disposable income of the recipients. The effect on the budget and government employment depends on whether the Congress funds the provisions with other tax increases, spending cuts, or debt. All cases and combinations are possible. These sorts of devices are particularly popular with business. They are significant to the oil industry, virtually all financial institutions, exporters, and homeowners. 6. Government requires businesses to supply directly to their employees or their employees' dependents services the government deems socially beneficial. Examples currently include: pensions, medical insurance, and day care for minor children. Such a system could cover all of the social services of the welfare state, which is how it is done

The Inevitability of Government Growth 207 in J a p a n . There cradle to the grave security is tied to e m p l o y m e n t , i.e., socialism for the worker, free m a r k e t s for the needy. 7. The g o v e r n m e n t can connect its own budget to the b u d g e t of some o t h e r p a r t y to g u a r a n t e e some m i n i m u m income to the o t h e r p a r t y . It can f u r t h e r protect the government budget against excessive d e m a n d s by r e q u i r i n g that p a r t or all of the nongovernment income paid to the other p a r t y be offset with p a r t i a l or total reductions in the g o v e r n m e n t g r a n t to the other p a r t y . If the government g r a n t is reduced by less t h a n the increase in the other income the g r a n t e e receives, the grant reduction system is called a negative income tax scheme. If the g o v e r n m e n t grant is reduced by a n a m o u n t equal to the o t h e r source of income or to zero if there is any other source of income, the g r a n t e e is said to be locked in. That is, the g u a r a n t e e d m i n i m u m income is also a m a x i m u m . These sorts of schemes are c o m m o n in welfare programs and have been advocated by some groups for f u n d i n g defense a n d f a r m p r o g r a m s . It is unlikely that any truly independent economic agent would accept such a system. Welfare recipients accept t h e m because they have no other choice. By having several different welfare p r o g r a m s , each of which defines g r a n t s f r o m o t h e r welfare p r o g r a m s as income that justifies g r a n t reductions, it is possible to produce effective rates of grant reduction (income taxation) above 100 percent. In such a case a person on aid for dependent children (AFDC), food s t a m p s , and some special educational p r o g r a m s for the poor might find that earning a scholarship (another grant) or some income from a job reduced the g r a n t s by more t h a n the value of the scholarship or earned income. In such cases the negative income tax plans in the individual welfare prog r a m s produce a m o r e powerful lock-in t h a n the old welfare p l a n s provided. Although welfare reform is one of the most c o m m o n p r o g r a m s throughout history, it is clear that welfare expenditures a n d the employment of social workers h a s increased. Connecting the budgets of the needy with the g o v e r n m e n t budget eliminates the possibility of private charity as a replacement for the government, since not even the Salvation Army is likely to give f u n d s to the poor if the government p r o m p t l y takes most or all of the f u n d s given. Income as a b i r t h r i g h t has often been advocated as a r e p l a c e m e n t for welfare. We could then give everyone enough to support a decent life. Those w h o w a n t e d more could work to earn enough to buy the extras they w a n t e d . Detailed inspections to make sure the n u m b e r of welfare c h e a t s w a s held d o w n could be eliminated, a n d thus the n u m b e r of g o v e r n m e n t employees r u n n i n g the welfare p r o g r a m s re-

208 The Inevitability of Government Growth duced. Of course, total government expenditure and taxes would be very high. The surprise in this case is that many, if not most, social workers are employed by welfare departments to deny benefits to the needy and thus lower the total cost of government. In N e w York State the social workers once impressed upon the State the need to increase their salaries by writing up and approving for every kind of welfare every legal applicant they could find. That was much more expensive for the State then giving the social workers a raise. Replacing the welfare system with income as a birthright paid to all would lower government employment but raise taxes to produce tne enormous sums involved in giving everyone money. In all seven of these cases the influence of the government over other parts of society is, and promises to be, substantial. But, only in (1) do taxes unequivocally rise, and only in (1), (4), and (7) is it likely that government employment will increase. Therefore budget and employment measures do not get at the true influence of the government on the economy. There is a another criterion for measuring the size or influence of the government in the economy and society. The criterion is administrative involvement in the economic and social process. We find that the growth of administrative involvement is the basic change in the character of Wagner's Law that has developed in the twentieth century. Such involvement encompasses a wide range of government guidance programs, but they usually employ very few people, and often do not cost very much money. However, they exert sufficient government influence over the way the so-called private sector behaves to eliminate the notion of truly " p r i v a t e " activities in many of our industries and in the economy and society at large. In the 1930s all capitalist nations suffered a disastrous depression with high and rising unemployment rates. It seemed as though Karl Marx's predictions of an end to the capitalist system through increasingly horrible business cycles was being fulfilled. But many nations developed a new system whereby the government through its spending and through the manipulation of consumer and investment spending by tax and subsidy programs could drive unemployment down and G N P up. We call this system Keynesian economics after its great English champion, John Maynard Keynes. The Keynesian perception of unemployment equilibrium that so mightily contributed to the establishment of the mixed economy in the United States and elsewhere in the 1930s is a phenomenon of the highest import for anticipating the government's future role. As crys-

The Ine\'itability of Government Growth 209 tallized in the Employment Act of 1946, a powerful new social consensus assigned to government permanent responsibility for overcoming the failure of the market to provide sustained high employment. Many of the heterogeneous social and political components of that consensus were quite unaware that anything had gone awry with the private investment growth mechanism. What was perceived was only the immediate malaise. In the following decades, the continued public insistence on largescale government expenditures prevented the making of a test that might show whether the economy could provide sustained high employment through the old, almost exclusive reliance upon private consumption and investment. But reliance on large public expenditures has persisted in the absence of such a test. The experience since the end of World War II is that the U.S. economy grows at about 4 percent per year when government spending grows rapidly and at only a little more than 2 percent per year when government spending grows slowly. This is illustrated in the table 11.2. Although there have been many prophets forecasting extensive periods of rapid economic growth with little or no government growth, we have not had such a period since about 1910. We have every reason to believe that such a period is impossible in the contemporary U.S. economy. Presidents, presidential candidates, the U.S. Congress, and the aggregate of state and local government officials that push for significant reductions in public spending are advocating deliberate sabotage of the material betterment that Americans so dearly and proudly cherish. Government spending directly or indirectly makes up part or all of TABLE 11 -2. Average Annual Compound Percentage Growth Rates, GNP and Government Purchases (1982 dollars) Period

GNP

Government purchases

1947-53 1953-60 1961-68 1969-83 1983-87

5.3 2.0 4.5 2.2 3.9

15.1 0.5 5.0 0.6 4.5

Source: Calculated from Economic centered three-year aveages.

Report of the President,

1988, pp. 250-251 using

210 The Inevitability of Government Growth the income of nearly two thirds of the population. If it does not grow, then their income and their suppliers' sales will suffer. In some short periods to be sure, particularly in cyclical recoveries following some years of investment stagnation, business fixed investment still exhibits its historic vigor. But even in such instances in the contemporary mixed economy, e.g., during 1960—65, a recovery's investment surge seems to require government stimulus. In 1960-65, that stimulus came initially from large deficit-connected j u m p s in government purchases in both 1961 and 1962. That was followed by three wellpublicized tax cuts directed at boosting investment and corporate profits: depreciation liberalization and an investment tax credit in 1962, and a previously expected cut in personal and corporate profits taxes in February 1964. The basic point so far as the demand side is concerned is that in the intermediate and long-run periods business will sustain fixed investment only if the nation's biggest single customer, government, grows steadily by between 3.5 and 4.5 percent a year for a m i n i m u m of about three years. We have developed a world where government total spending must grow for GNP to grow. The public decision to discard laissez faire over a half century ago in the United States, and the subsequent rise of big government, was an irreversible change. That upheaval created in the form of the "mixed economy" a partial but growing fusion of the market system with a greatly enlarged government sector. Big government changed the composition of total demand. It cut private household consumption from laissez faire's three fourths to about two thirds of total spending. Already by the end of the Great Depression government purchases had permanently superseded gross business investment in plant and equipment, making it the second largest of the four great spending streams. Business investment developments reveal in microcosm much of the history of business-government manipulative involvement. Still erroneously considered an almost sacred source of economic growth and productivity rise, business succeeded in making "private" investment the spoiled child of public policy. Public mortgage risk underwriting, sympathetic interest rate policies, liberal depreciation tax privileges, investment tax credits, and corporate bailouts have been easily wrung from many a willing Congress and the Federal Reserve Banks, allaying the earlier business fear of big government's "interference." The interference was so benign that, unlike household consumption of private market products, the share of strategic plant and equipment investment in GNP has persistently remained as high as it was in the laissez faire 1920s. Business tangible investment spending can no longer provide a

The Inevitability of Government Growth 211 viable substitute for any reduction in government expenditures. Indeed, changes in the character of technological progress have made the advance of knowledge and its embodiment in trained human beings a major partial substitute for the embodiment of technology in plant and equipment investment. The productivity importance of capital goods has been thus further reduced and the importance of intangible investment in scientific research enhanced. As a result, the community's commitment to economic growth and productivity rise has raised the demand for more spending, private and public, on education, science, engineering, and research. President Reagan and Congressman Kemp were associated with a relatively new group of semi-Keynesian conservatives called supplyside economists. This group has a hoary faith in the power of private investment spending on capital goods to lead an economic expansion —hence, all the public inducements and tax subsidies, especially to "private" investment in business plant and equipment. But the history of such investment belies these alleged powers. Technological advance has made improved capital goods so productive that the growth of expenditure on them typically creates more capacity to supply additional products than it does demand for those additional products. So unless the net production of such investment goods is restrained to its customary modest 10 to 11 percent of total demand, depressing excess capacity results. Capital saving investment has killed itself off as a demand growth stimulus by its own capacity-raising successes. It is distressing to the supply-siders, but most instructive to the rest of us to realize, for example, that from 1968 to 1985 real gross business investment spending on producers' durable equipment rose at a vigorous 4.33 percent a year, yet GNP expanded at only a sickly 2.5 percent a year. High (publicly subsidized) investment has not, therefore, despite the conventional wisdom of the supply-siders and their followers, been necessarily connected with high growth rates of total product. Instead, we had in that distressingly long period underutilized capacity and relatively slow growth. It is essential to appreciate these limitations of the growth role of investment, not only to dispel supply-side illusions, but more importantly to grasp the vital notion that autonomously rising government expenditures are in the long run the only escape from the contemporary economic stagnation malaise. Yet so overwhelming is the public denial of the usefulness of public spending that almost no one dares express the notion that we need it to maintain economic growth— even the minority who is conscious of it. Application of the principle that the economy needs growing de-

212 The Inevitability of Government Growth mand to buy the growing supply that investment creates yields the bottom line for the future growth of government spending: it must rise approximately as fast as GNP (as it did from 1983 to 1988 under the stimulus of large, unwanted federal government deficits). In the past it has grown faster. Between 1968 and the recession trough of 1982 government spending stopped growing approximately as fast as GNP, explaining the long-run slowdown in GNP growth. Whatever the future growth rate of government spending, it will be a policy decision. In the future there will be no dearth of targets upon which to spend large and growing public sums. Many of these targets will be spelled out below. But let us note here that the list of big price tag items, in addition to the disastrously deteriorated social infrastructure, the global spread of multifaceted pollution, and the mountains of toxic plus nontoxic waste materials, includes the decontamination and decommissioning of a vast empire of now useless nuclear weapons and the structures and materials used to manufacture them. This monstrous inheritance from more than four decades of proliferating atomic armaments continues to accumulate, and not only in this country. The future mounting social costs are today for the first time being publicly revealed and appraised. The task of demolition and disposal, to some extent in "national sacrifice zones," could eventually become "one of the largest public works programs in history," in the words of a spokesman for the Natural Resources Defense Council. The federal Energy Department has become notorious for scandalously underestimating the costs of such work. Yet even its current estimate already amounts to $200 billion. But in the future we can add to government's spending growth the element of pervasive public involvement in much, if not most, of the economy's activities. This additional element of public participation will assure total government's continued relative growth. Some of what we call public involvement in the economy is no doubt represented in the expenditure or employment totals. There is a certain overlap. But very substantial kinds of public intervention bear little connection with either the budget or the number of employees in the pertinent agencies. For example, the government performs a vast oversight and assistance role in the activities of our financial institutions and related financial markets. But its great influence on that sector is insufficiently expressed in the number of people working for the Securities and Exchange Commission, the Federal Deposit Insurance Corporation, the Federal Reserve Banks, the Farm Credit Administration, the Home Loan Bank Board, or the section of the Internal Revenue Service that indulges "financially troubled" banks.

The Inevitability of Government Growth 2 1 3 The long-run expansion of government participation in the social process has made obsolete our traditional practice of separating what is public from what is private. In becoming the final buyer of a big portion of business output and of the available labor supply, government has created spreading interactions between such transactions and the remaining ostensibly private market transactions that are not so directly and immediately involved. The business products and labor services sold in the government " m a r k e t " sustain not only the total of economic activity directly. They indirectly sustain and multiply all other sales via the government-provided income that subsequently goes to market in successive rounds of spending on household and investment goods. The interweaving of all the big spending streams has thus tended to destroy the public/private distinction so deeply imbedded in our thinking. This contemporary fusion of the public with the private by virtue of the government's enormous pecuniary role is further enhanced by the vast extension of government nonpecuniary interventions in economic and social affairs that constitutes the essence of the transformed Wagner's Law. While such sources of fusion are more subtle than public employment and spending, examination of their increasing pervasiveness and depth will show that the combined impact of the two powerful influences is already quantitatively immense in the United States. And the comprehensiveness of the future potential for such involvement points to ever greater enlargement of the area of fusion, i.e., of the public character of formerly private decision-making. Some of the detailed forecasts of government expansion in the pages that follow bear the imprint of our personal advocacy. But, aside from our stipulation that if the economy is to grow, government spending, as the economy's leading sector, must grow, this is not basically an advocacy analysis. "Inevitability" means history is going to make it happen. It may seem that w e have tended to " v i e w with a l a r m " many of the current developments in society and the economy. If so our sole purpose has been to stress the fact that these developments are harbingers of responses that will in almost all cases necessarily entail some extension of governmental administrative and/or fiscal intervention.

GUIDANCE THROUGH REDISTRIBUTION

Government's redistributive role encompasses programs under which it raises funds from one person and gives those funds to someone else

214 The Inevitability of Government Growth to spend or save. The objective is to attempt a fair adjustment to the inherently unfair distribution of income (and wealth) emanating from the market system. Examples of such programs are Social Security, welfare, and veterans' pensions. To implement our prediction about the future expansion of the quite immeasurable public-private fusion process, our first objective is to explore government's large-scale attempts to reshape this unequal distribution of income. A basic function of government is to maintain social harmony, or social "balance." Administratively this means continuous attention to the resolution of conflicts. Almost all government activity reflects that objective in one way or another. There comes to mind at once the prominent example of intervention into labor management relations. This intervention has grown to enormous size since the passage of the National Labor Relations Act in 1935. The list of agencies, which includes Mediation and Conciliation Service, National Mediation Board, National Labor Relations Board (NLRB), the various state mediation and conciliation services, and the courts, reveals that the government has become a permanent de facto third party to all major industrial disputes. Some of the same work was done by the militia and the army in the nineteenth century. The purportedly redistributive work of government is the main device whereby the maintenance of some kind of balance between clashing income groups is achieved. Government manipulative involvement (see the fourth section, below) does somewhat the same thing, albeit to a lesser degree and in combination with other objectives. We treat here primarily intergroup conflicts and conflicts between institutions such as businesses, industries, social organizations, and government. Redistributive activities encompass what amounts to government grants via the tax system, as well as certain features of the public budget and fiscal or monetary policy. The enormous variety of tax subsidies through loopholes, exclusions, exemptions, and deductions constitutes a m a j o r form of public redistributive grants. There is considerable doubt, however, about whether all the jockeying within the public subsidy and revenue edifice has in general reduced income inequality. Nevertheless, doubt has not checked, but rather has probably stimulated, the rising volume of maneuvering for concessions. Indeed the growth in size and complexity of the revenue edifice has made the ground for adroit manipulation more fertile. In this expanding public revenue arena, the growing fusion of the public and the private is impressively apparent. The quasi-private taxpayer and the armies of deductible tax accountants and tax attor-

The Inevitability of Government Growth 215 neys are interwoven with the revenue bureaucracy and its growing enforcement troops. The involvement is total and grows with population, income, and the ever more complex revenue laws. Americans characteristically focus their redistributive urge primarily on income rather than wealth. With the decline of inheritance taxation (a regressive tax trend) and the mounting attack on the property tax, a parochial public has directed its economic firepower ever more insistently toward the income and sales tax battleground. Economic history indicates that any lull in this ongoing conflict is unlikely to continue for long; the u p w a r d march of the tax juggernaut, with its propensity to make "private" citizens participate in the administration of the revenue system, will be resumed with ever greater intensity. In the unquestioned absence of 100 percent deficit financing, the required long-run growth of public expenditures will ensure ever larger revenues of one kind or another and therefore make certain that this arena of redistributive conflict will also grow. The drive for greater equality through government programs long ago produced the graduated income tax. In more recent times, the "war on poverty," the burgeoning of public transfer payments to persons (such as public assistance and Social Security payments), and the associated rise of the welfare state expressed the same basic drive. The explosion of public transfers and intergovernmental grants (mainly federal to state and local) for partly distributive purposes was the most striking development in the growth of public expenditures in the 1960s and 1970s. Analysts found that the rising tide of public transfer expenditures brought a touch of improvement for the lowest quintile of income receivers, at least until the 1970s. This mild redistribution occurred in spite of a generally regressive system of financing Social Security benefits. The market-produced, unequal distribution of income and wealth has proved remarkably immutable to the public efforts to effect distributive reform. Some of that imperviousness was even reinforced by certain taxation and spending policies. Consequently, in the future the war for redistribution will continue to be waged on all fronts. The battles for greater or lesser equalization are also fought within the confines of the nominally private market framework. But the main arena has been and will no doubt continue to be in the public policy sphere. "Privatization" is impossible. Nor does long-run rise in per capita income dampen the redistributive urge. A large body of evidence has shown that people are motivated strongly, not alone by impecuniousness, but by the drive to enhance their relative position in the distributive hierarchy. Feelings of injustice on simple distribution grounds are widely

216 The Inevitability of Government Growth reinforced by their fusion with interpersonal rivalries connected with m a n y related kinds of social differentiation. Public programs and practices expressing the link between feelings of distributive unfairness and some special ethnic or socioeconomic characteristic come readily to m i n d . Affirmative action and comparable-worth policies, for example, have grown out of the connection between women's status and relatively low income. Advocates of labor-power training a n d other public educational subsidies have long expressed the fact that the educationally and occupationally disadvantaged are not only a drag on productivity but are also often deprived of income and property. The taxation of a p a r t of the Social Security benefit payments of high-income retirees expresses the conviction that being elderly is not necessarily a justification for a tax subsidy. The Tennessee Valley Authority represents the tie between deprivation of opportunity and the disadvantageous condition of the people in an entire region. Similarly, we have established public distributive commitments for veterans, the farmers, AFDC mothers, the disabled, and numerous other special groups. Justice has long been a privilege all too largely reserved for the wealthy, despite o u r profession of equality before the law. The future will bring pressures to reduce these economic constraints and open the door, not only to increased pro bono services through the b a r association, but also to the greater provision of legal aid to the impecunious and other deserving groups at taxpayers' expense. Indeed a few states have already established compulsory pro bono publico programs. If the poor get legal aid in the civil courts they will be able to force the various governments to perform many already m a n d a t e d acts that they avoid or limit for budgetary reasons. Many of these group needs are met in part by the private market. But it has long been endemic in American society to turn to government to help overcome the market's failure to treat adequately ethnic, cultural, educational, regional, and other forms of social differentiation. So long as these disparities abide, as indeed they may be expected to do, the characteristic appeal to government for greater equity will continue to be reinforced. Many public programs, such as health care for the growing cohort of aging veterans, will have to expand. The expenditures component of the underwritten economy has a multitude of distributive aspects. Government spending influences both the level and composition of GNP. Overcoming economic stagnation, in p a r t through steadily rising public expenditures, m e a n s

The Inevitability of Government Growth 217 that employment will be higher and unemployment lower than otherwise. As a result the low-income groups will have higher absolute and possibly relative incomes. Also, a public guarantee that total demand will not fall drastically insures that profits, the income most subject to the economic cycle, are less likely to fall. Unfortunately, the community has not been well informed regarding these distributive effects of public expenditures. Aside from the repugnancy elicited by chronic unemployment, it will not be primarily the explicit distributive impulse that will ensure the future growth of government spending. Rather, it will be largely the public's conviction that economic growth for many reasons is a good thing. Neither the community nor economic theory approves of cycle fluctuations and the shattered expectations they cause. While the distributive effects of prosperity and depression are always one determinant of the public's preference for stability, almost everyone's economic goals harmonize with government's cyclical stabilization policies. Hence, the community's insistence on a public fiscal and monetary stabilization role, given the inevitability of short-term fluctuations, is assured for the foreseeable future. Monetary policy is pertinent to the distributive work of government chiefly through its connection with short-run inflation and deflation. For example, the adverse impact of inflation on the poor and on the creditor groups is well known. Other important groups, such as firms with foreign markets, desire a stable price level. Bankers are rock-ribbed antiinflationists. These groups, among oihers, will most certainly ensure a continuing prominent role for this form of government intervention. The connection between monetary policy and the distributively important rate of interest is of commanding importance. Monetary policy, a strategic collective service in the United States, consists almost entirely of open market operations. The Federal Reserve is the largest buyer and seller of the national debt. Furthermore, it will trade only with registered security dealers, that is, firms it has inspected and authorized to trade with itself in government securities. The registered security dealers agree to stand ready to buy from and sell to the " F e d " at almost a moment's notice. That means they must carry an inventory of government bonds. Such inventories can drop substantially in value if the interest rate rises. But the firms take no inventory risk since the Fed insures them against it. This so-called "market" consists of the Fed on one side (supply or demand), and on the other side (demand or supply), firms that it inspects and insures against this major business risk. It is this " m a r k e t " along with the

218 The Inevitability of Government Growth federal funds rate that helps to set the interest rate against which all other interest rates are adjusted. So the government, through this f o r m of administrative involvement, controls and w i l l continue to control one of the most critical prices in our mixed capitalist economy. Equally certain is the future task of government, primarily the federal, in the determination of the overall level of wages, as well as prices. If w e look at G N P from the " f a c t o r " (overwhelmingly labor) supply side, the control of the government is probably clearer than it is f r o m the product demand perspective. Wages and salaries make up almost 75 percent of G N P . Government wages and salaries amount to almost one fifth of that total. Labor income is thus directly controlled by the government to an extraordinary extent. Furthermore, since 1923 the United States has run an essentially closed immigration society. American wages for almost every occupation are higher than those of people with the same skills in the same occupations in other societies. The country could significantly lower the labor costs of production of everything by a changed policy of allowing open immigration. Government in fact further raised wages, or the costs of employing workers, by various union-authorizing laws, occupational safety and health laws, pension rules, minimum wage laws, and Social Security taxes. The wages responsibility of government has somewhat deceptively appeared to date to be a sort of " u n d e r d e v e l o p e d " activity, confined pretty much to intervention in particular industries (e.g., steel). But there has been for a long time a de facto wage-price p o l i c y — w h i c h is, of course, a distribution policy—based primarily on fiscal and monetary intervention and secondarily on episodes of explicit wage and price controls lasting short periods of time. There is nothing new about it, and it has a promising future not yet appreciated. If we should seek to permanently control incomes and prices directly, we w o u l d not be essentially changing the aims of economic policy. The contemporary wage-price policy of the federal government has been to cut inflation drastically by restrained public spending and monetary measures that have produced substantial unemployment, a chronic shortfall of real G N P below potential, and a consequent prostration of the real wage rate. In N o v e m b e r 1988 total private nonagricultural average gross weekly earnings were $167 (in 1977 dollars). They had been falling, with minor oscillations, since 1972 and were at the same level as 1961! This reflects a wage-price policy that is obviously heavily laden with distribution effects. Steady growth at high employment will continue to c o m m i t the government to massive involvement in a wage-price policy in place of the wage-price outcomes of the private market system. But the differ-

The Inevitability of Government Growth 219 ences will be notable. Since there will be high employment with a t t e n d a n t u p w a r d pressures on money wages and prices, explicit, continuing, public wage-price (general and relative) controls in some form will be desirable so long as stable prices remain a community goal. If this objective is heeded, government administrative involvement will go far beyond the bounds of traditional fiscal and monetary policy, the more so because wage and price movements have to be m a d e consistent with the discipline of the now very large foreign balance. This scenario is the most probable one. The realization of such a scenario would not represent the first time there was broad public support for government-imposed controls over prices and wages. Redistributive activity, as we have pointed out, often takes income away from the currently working population to support other groups who are deemed deserving. Traditionally the deserving have included such groups as: children, the aged, the infirm, the handicapped, the retarded, the disabled, the insane, veterans, farmers, small business, depressed areas, and oil companies. Support for these groups may take the form of direct governmental services such as schools, elder hostels, veterans' hospitals and Medicare, publicly financed prostheses, sheltered workshops, asylums, lithium maintenance programs, orphanages, and foster care. In other cases the disadvantaged are just given money to buy their sustenance in the market like the rest of us. Social Security retirement and unemployment compensation are examples of support for the deserving with money r a t h e r than services. There are many programs maintaining the income and services of special dependent groups and they are primarily financed and administered by the government. Governor Cuomo of New York has labeled 1988-1998 the "Decade of the Child." Politicians of every stripe have come to recognize that government at all levels must help working parents take care of children. The New York Times reported " m o r e than 100 child-care bills were introduced in congress this year." 2 Fifty-two percent of the mothers of children a year old or younger are in the labor force already. Welfare reform through workfare will, if at all successful, deprive legions of children of their single-parent mothers' daily care. All future antipoverty programs will have to respond to the fact that one in every five children in the United States is below the poverty line. Sixteen percent of all children under sixteen years at present lack any health insurance coverage (19 percent for blacks and 27 percent for Hispanics). The Decade of the Child will demand the allocation of substantial public, as well as private, resources. A family with a retarded child, or a severely physically handicapped m e m b e r , or a victim of one of the seriously debilitating dis-

220 The Inevitability of Government Growth eases that take a long time to kill is faced with a large long-run drain on its resources. Today it is AIDS, Alzheimer's disease, multiple sclerosis, etc. Yesterday it was tuberculosis, polio myelitis, malaria, etc. Social insurance makes us all pay a little bit of the costs of such problems. For the families who need the assistance, it makes loving care easier for the families of the victims. Without the financial assistance of social insurance the victim often economically and emotionally destroys the family. Society has in the past made an outrageous political decision, to quote Anna Lou Dehavenon, a leading authority on hunger in the United States, "to administer a form of gradual economic genocide through conscious blindness and chronic neglect" against the growing army of the homeless. 3 A significant effort to reverse that neglect by government at all levels, following many years of public policy retrenchment, will likely appear. "Contemporary American homelessness is an outrage, a national scandal," declaimed a committee report of the prestigious, sedate National Academy of Sciences to the U.S. Congress. 4 The Academy's committee cited an earlier 1988 study estimating that 735,000 Americans are homeless on any given night, while 1.3 to 2.0 million will be homeless for one or more nights some time in a year. The broader, related issues of homelessness—low-income housing, income maintenance, the availability of client-oriented support services, and access to health care for the poor and uninsured—point to the considerable magnitude of this national scandal. The impetus for public action has been heightened by the beginnings of action organization by the homeless themselves. Various social commentators have advocated turning back the clock, asserting that some or all of these programs should be borne by the family, the church, or the nonprofit sector of the economy. But no one has provided serious evidence that in the contemporary world families acting independently, or the churches, or the private foundations can raise the enormous sums involved in these many programs. The tabulation below shows, for example, the total spending of the Social Security Administration on Old Age Survivors and Disability Insurance (OASDI) compared with total private charitable giving. 5 In Billions of Dollars 1970 1984

OASDI Total private philanthropy including gifts to churches

Percent I ncrease

31.9

186.2

583.7

20.7

79.8

385.6

The Inevitability of Government Growth 221 If we repealed the Social Security tax, working people would receive an increase in their net pay. Their employers would receive a decrease in labor costs. The Social Security tax we see reported on our paychecks as F.I.C.A. is less than half of what the government receives. Employers pay the rest. It is absurd to imagine that employees and their employers would give all of the tax cut to the charities. Certainly they would keep some for other purposes—charity begins at home. Nor do the private philanthropies primarily allocate their funds to help the economically needy. The $79.8 billion in philanthropic giving in 1984 was allocated as follows: Religion Health & Hospitals Education Social Services Arts & Humanities Civic & Public Other

$37.7 11.3 11.1 8.6

5.1 2.2 3.9

Obviously a transfer of resources from Social Security to private philanthropy would benefit churches, schools, and the arts. But the public would not tolerate financing of those worthy enterprises by lowering the already near-poverty level of incomes of millions of the aged. There is no evidence that increasing affluence leads to growing altruism. Consequently, in the likely absence of a massive increase in the resources and organizational ability in the parts of philanthropy devoted to aiding the poor and needy, we cannot expect "privatization" of that sector to substitute for government. In our concentration on the relationships between government and the private sector (business firms and households), analysts often seriously neglect the large nonprofit sector of society. Yet government has widely turned to nonprofit organizations, e.g., educational institutions, health delivery organizations, private welfare agencies, community action groups, and libraries, to help deliver substantially publicly funded services. Even if the publicly financed and administered share of these services should grow but little, the likely continued growth of the sector itself will ensure increasing public commitments. We have in the last century gone through several astounding demographic changes that are the cause of much of the increase in Social Security spending. In 1900 the life expectancy at birth of the average American was 47.3 years. The biggest differences among groups

222 The Inevitability of Government Growth were between blacks with 33.0 years and whites with 47.6. By 1985, expectancy at birth had increased to 74.7 years and the biggest difference between groups was between males at 71.2 and females at 78.2. The average American male did not achieve a life expectancy at birth of sixty-five years until the end of the 1940s. For black males it was the end of the 1960s. So very few people retired until the second half of this century, because a very high proportion of them were dead before they got to retirement age. By 1986 there were 29.2 million Americans over the age of sixty-five. If the family, an institution that had never done much for the aged because they were so few, were saddled with the enormous increase in costs to support this gerontologic explosion, it would lose most savings for the education of the grandchildren and the old age of the children. Private support of this new burgeoning dependent aging population would produce the most unpleasant intrafamily dilemmas. Imagine a couple with two children nearing college age and at the same time four grandparents near retirement. If the children are sent to the cheapest local colleges they would cost about $5,000 per year each. Meanwhile the four grandparents, if supported at only poverty level incomes, would cost a similar amount. Four grandparents and two children at $5,000 each would be a $30,000 bill each year. Mean after-tax income of families with a head of household forty to fortyfour years old was $32,787 in 1986. Obviously, the family does not make enough to support the grandparents and the expensive children at the same time. This bleak scenario would force the working generation to adopt some combination of policies involving either abandoning the grandparents to save the childrens' future or sacrificing the children's future to support the grandparents. Neither is a likely alternative. Public financing of the aged through Social Security forces most of the population to pay its largest personal tax every year of their working lives just to finance the pensions of the old. But it removes the psychological hell associated with abandoning parents or condemning children to bad jobs because the grandparents will not die. These benefits are sufficiently great to guarantee the survival of Social Security. The demographic fact is the baby boom will eventually retire just as its predecessors do now. When that happens Social Security taxes will be extremely high. There is no ethically acceptable substitute. " H o n o r thy Father and thy Mother" means pay very high taxes for the next half century.

The Inevitability of Government Growth 223 The expansion of government involvement in society and the economy is widely appraised in terms of a tradeoff between equity and efficiency. The actual evolution of that involvement indicates that government has been assigned by the social consensus to a growing monopoly of the determination of equity solutions. But it also shows that government has increasingly intruded into the efficiency area: it does many things more efficiently than the private market, which itself is shot through with inefficiencies, "x-efficiencies," and unmet social requirements. For example, the sovereign public has adjudged the government to be the more efficient dispenser of water, healthcare, justice, currency and coin, fire protection, etc. A large share of the acknowledged inefficiencies of which government is accused, for example, almost the whole of the package of biases built into the tax system, has emanated from insistent pressures exerted by conflicting private sector forces.

UNDERWRITING E C O N O M I C P E R F O R M A N C E

Government's underwriting role encompasses policies to control the rate of economic growth, the level of employment, the rate of unemployment, inflation, and the value of the economy's asset network. Examples are deliberate structuring of budgetary expenditures and receipts, public works employment, monetary policy, and insurance of the liabilities of financial institutions. Some of these activities have been touched upon in the first section, and the overlapping redistributive aspects of monetary policy have been referred to in the second section. Adolf Wagner did not envision the assumption by the central government of responsibility for growth at high employment without inflation. But his basic insight that society's evolving consensus would demand more and more government involvement to serve the community's wants clearly remains as a brilliant perception anticipating the enlarged role of the state under future circumstances. Underwriting the economy's performance requires in the first instance the public expenditure obligation. In this section the reference is again to governmental intrusion and private-public fusion through administrative involvement. The intrusion has and will increasingly affect two great spheres within the total structure and process of the economic system. The first is managing the macroeconomy. The second is the very large and strategic financial sector. The third is the comprehensive collection of human activities that are concerned with technological advance.

224 The Inevitability of Government Growth Americans are deeply committed to a long-run rise in the gross national product. This requires a concomitant rise in the sum of the spending of the four major sectors of the economy: household consumers, business investors in capital goods, government, and foreigners (taken net).

Underwriting Finance Like the vast public utility sector, the equally vast financial sector in the United States is nominally for the most part private but is profoundly "affected with a public interest." The transportation and public utility industry, which today accounts for about 9 percent of GNP and 29 percent of the total gross stock of private nonresidential capital, has been subjected to quite strict public regulation throughout the twentieth century. As basic infrastructure of the system, we could not allow the functioning of any major segments to falter. The financial sector is not only strongly affected with a public interest; it is the lifeblood of every nook and cranny of the money economy. The fact that it too has been kept nominally private should not permit any illusions regarding its overwhelming public character. Moreover, it is infinitely more sensitive to external shocks and to the internal transmission of disruptions in its parts than the public utility sector. Every Catholic at the end of confession is directed by the priest to say a prayer called the act of contrition. In that prayer the penitent promises to "avoid the near occasions of sin." The finance industry, largely invented and developed by the Catholic Lombards and Venetians, is a near occasion of sin. There are so many opportunities to enrich oneself at the expense of customers, suppliers, other community groups, or society in general that financial scandal is a constant in the life of a market economy. Banks and other depository institutions claim to wisely invest their depositors' money in many relatively small, safe, sure, short-term loans widespread over the community to minimize risk. Unfortunately, they often make relatively large, risky loans in small parts of the community. Surprisingly often they loan much of the money to themselves, their closest friends, and family. The principal problems with depository institutions in the late 1980s are concentrated in the large commercial banks and the savings and loan institutions. Many of the large commercial banks have loaned significant fractions of their resources to the businesses and governments of some of

The Inevitability of Government Growth

225

the countries of the third world. In many cases there is no possibility that much of the money w i l l ever be repaid. As Mexican President Salinas said in an interview " I would only say that after six years of stagnation, after six years in which real wages went down 50% in real (sic) terms; after six years in which the Mexican population increased by almost eight million people, w e have no choice but to grow again. But we cannot grow if we continue sending abroad every year five percent of GDP. What I have said is through negotiation w e could solve the problem of the debt in the sense that it does not inhibit the possibility of Mexico growing again." 6 Nations like Mexico negotiate with our government over these debts. This has put the government into several difficult positions. W e need to deal with these nations to maintain important foreign policies. But these foreign governments see our government as an agent of our banks, forcing them to raise taxes and remit foreign trade earnings that hurt their employment and G N P growth. Consequently they are less likely to respond to other American government interests. Our government banking regulators have been forced by this foreign loan crisis to redefine bank capital and suspend several of the rules we impose on our banks to make sure they are " s a f e . " If we did not suspend the rules some of the largest banks in the country would be bankrupt. The last time large numbers of banks started going broke in this country, the whole economy collapsed. The government finds changing the rules and bailing out the banks a better solution. W e are now learning that letting foreign banks loan to U.S. businesses involves government action and the credit reputation of society. The New York Times reported, BankAmerica, which acted as the trustee for notes backed by $1 billion in student loans, said its decision (to increase loan loss reserves) came after the Education Department on Tuesday rejected its proposal for restoring Federal guarantees on the loans. Without the guarantees, defaults on the loans will have to be covered by Citicorp and several large Japanese banks, which have issued letters of credit supporting the notes. 7 We have already learned that allowing banks to loan to foreigners involves governmental assumption of some risk. In unscrambling the poisonous omelette of loans from foolish American banks to unlucky, corrupt, and/or venal underdeveloped countries we have increased

226 The Inevitability of Government Growth government costs in protecting the banks from the bank inspectors and protecting the countries from economic collapse and revolution. Other large banks have failed because they were badly managed while primarily doing business within the United States. A large bank failure continues to be a problem for the government because it brings near-certain regional economic distress and possibly national financial panic. Since bank deposit insurance is limited to $100,000, families can be reasonably protected against bad bank behavior, but their employers cannot. A large business such as General Motors averages sales of $400 million per business day, most of which will be deposited somewhere that same day. If the banks fail, the large depositors suffer terrible losses and thus must retrench, which means laying off significant numbers of employees. To prevent economic collapse through bad bank management the federal bank regulation agencies—Federal Reserve, Comptroller of the Currency, and the Federal Deposit Insurance Corporation (FDIC) —have undertaken to prevent the failure of large banks. Among the banks saved in recent years are Franklin National, First of Pennsylvania, Continental Illinois, Seattle First National, and First Republic Bank of Dallas. In several cases these save-the-banks policies have been very expensive to the government agencies. Utter competitive market failure of a large fraction of the country's savings and loan associations has developed during the 1980s. For most of its history the savings and loan (S&L) industry was protected from adverse market forces by careful government regulation. Largely in response to S & L lobbying the government allowed them to compete in a wide range of services with commercial banks. They could not handle it and are dying like flies. To protect large savings accounts, avoid special regional problems like the complete collapse of all finance in Texas, and avoid general financial panic, the government has striven to prevent S & L bankruptcies. The tools used to save the S & Ls are essentially the same as those used to save the badly managed large commercial banks: forced mergers of weak institutions into stronger institutions, suspension of reserve rules, payments to and/or tax breaks for profitable businesses to take over the unprofitable ones, and, if all else fails, direct government ownership and operation of the worthless business. Two more federal agencies, the Federal Home Loan Bank Board and the Federal Savings and Loan Insurance Corporation (FSLIC), have joined the Fed, the FDIC, and the Treasury in managing S & L bailouts. There are several as yet unresolved issues. The S & L bailouts are currently estimated to cost $50 to $100 billion. The books on the

The Inevitability of Government Growth 227 biggest bank bailout. Continental Illinois, will not be closed for several years but could easily be in the billions. Who should pay for all this insurance service? It is likely the taxpayers a n d bank customers will pick up a large fraction of the bill. Should only large banks be protected from failure? That is the current, patently unfair, behavior of the government. Since the government pays when banks make mistakes, should it share in profits when banks succeed? Should the government be expected to fire bank officers as soon as it suspects they are threatening the financial security of their institution, as the FSLIC has recently proposed? Posing these questions reveals clearly that the government takes great risks in allowing depository institutions to exist. It pays huge sums to correct their mistakes. It is increasingly involved in their dayto-day management. It will increasingly make the great decisions involving their policies. None of this is unique to American government. The New York Times notes "Although deposit insurance is rare in most other industrialized countries, the governments in these countries implicitly stand behind their banks." 8 It cites L. William Seidman, the head of the FDIC on an important foreign relations issue. When First Republic Bank of Dallas was bailed out, the government paid off in total all the bank deposit liabilities, but it did not pay off the commercial loans to the bank's holding company. This has caused Japanese investors who lent to the holding company to complain. If the rest of the world cannot be sure of its loans to our banks, then New York will not lo/ig be a world money center. Insurance companies hold great assets so they can compensate the victims of the many disasters facing life and property. Security requires that the holdings be broadly spread so that no natural disaster can affect much of the assets. A surprising n u m b e r of insurers throughout the history of the industry have put too m a n y of their investments in one place. Again the family is a popular repository of the clients' funds. The federal government, unlike the state governments, has never been as active in insurance regulation as it has been in other areas of finance. It has, however, gigantic insurance operations of its own that were developed as responses to the needs of m a n y groups in the population who either could not get service f r o m private insurance companies or were dissatisfied with the rates and services offered. Among the federal government insurance p r o g r a m s are: old age, survivors, and disability insurance; u n e m p l o y m e n t insurance; Medicare; Railroad Retirement; FDIC; FSLIC; Securities Investor Protec-

228 The Inevitability of Government Growth tion Corporation (SIPC); The Pension Benefit Guarantee Corporation; crop insurance; life insurance for veterans; life and health insurance for the armed forces; Federal Housing Administration (FHA); special programs for the merchant marine; insurance of student loans. The government also limits the liabilities and thus the insurance costs of a number of industries, including atomic power and international airlines. States have done a great deal of insurance regulation. It varies from requiring policies to be written in a form of English that nonlawyers can read without undue effort, to specifying fault or no-fault systems for different types of coverage, to ordering rate rollbacks or increases for various public purposes. In popular conversation and their own television commercials insurance companies are famous for promising prompt, considerate, caring service, then refusing to pay when needed or delaying payments for months. The citizens of California have begun to attempt to control the behavior of automobile insurance companies by referenda. In 1988 they voted for Proposition 103, which rolled back rates. The notion is surprisingly similar to the Proposition 13, which rolled back taxes. Pensions are a form of insurance. Most pension plans that have actually paid significant sums to the retired are government owned and operated. Private pensions are an old and generally unsuccessful idea. Alicia H. Munnell 9 observed " A 1965 cabinet committee report on the status of the U.S. private pension system cited many examples of overstrict participation and vesting requirements, lack of coverage for workers who change jobs frequently, inadequate pension funding, mismanagement of pension assets, and plans that terminated without enough assets to fulfill benefit commitments." Munnell further concluded that, "the passage of the Employment Retirement Security Act (ERISA) had eliminated most of these problems." ERISA set up government rules and agencies to force employers who had pension plans to be significantly more responsible than they had been. The government is heavily involved in the operation of private pensions. A significant positive element of ERISA was the creation of the Pension Benefit Guarantee Corporation (PBGC). This Corporation guarantees the payment of pensions to employees of a program and is empowered to force employers to meet certain standards. It should significantly increase the numbers of people expecting to receive pensions who actually do receive them. Until ERISA was passed in 1974 the number of ways an employee

The Inevitability of Government Growth 229 could be denied a pension was legion. Most extraordinary was the fact that if the pension plan was shut down by the employer and there were insufficient funds to pay the promised pensions, then no pensions were paid and the liabilities of the company ended with whatever they had bothered to put into the plan. For example, when Studebaker closed its auto plant in 1964, most of the workers received either reduced pensions or no pension at all. Yet Studebaker continues to be a profitable business. Now a promised pension is much more likely to be paid. The government will take as much as 30 percent of the assets of a corporation to fund unfunded liabilities in its pension plan. The financial security of the corporation and its pension are thus linked and there is significant inducement to management to either abandon the notion of private pensions or manage the program with the needs of the workers in mind. Unfortunately, as Robert J. Lynn has shown, the modern private pensions system still has significant limitations: ERISA is simply a regulatory act. Erisa neither requires the creation of private pension plans nor insists that plans provide a minimum retirement benefit . . . the statute permits deferral of vesting for ten years. . . . Through Individual Retirement Accounts (IRAs) it facilitates portability of pension credits, but it falls far short of insisting on the portability of coverage that characterizes social security . . . it does not assure a pension to the surviving spouse. ERISA does not preclude termination of a pension plan. 1 0 If we privatize pensions under ERISA rules, a large fraction of adults will have no income in their old age. If the purpose of pensions is to support the elderly population, the system does not work. If the purpose is to make income in old age a lottery where those employees whose careers perfectly follow the best pension rules get generous retirement incomes and people who choose their careers by more normal criteria are often impoverished in their "golden" years, then private pensions are a good system. But it is unlikely the public will choose this lottery scenario. The elderly will be an increasing fraction of the total population until the baby boom begins to die off in the second quarter of the twenty-first century. Until that time systems designed to lower the potential incomes of the old will face massive political opposition from those very numerous elderly and their numerous children, who will recognize that cutting mother's pension means raising the chil-

230 The Inevitability of Government

Growth

drens' support p a y m e n t s for mother. Government, already very active in the pension field, will have to become more active. Conservatives who w a n t to lower Social Security taxes will have to accept tighter public controls, such as m a n d a t o r y pension p r o g r a m s for most employers, to get their goal. In the securities m a r k e t s brokers are supposed to be market makers who arrange for buyers and sellers to meet and deal quickly and cheaply. Unfortunately, they often use insider information to trade on their own account, which makes it easy to cheat some of their customers. The ancillary service of holding their customers' assets in street n a m e s (the broker's name) has wonderfully compounded the possibilities for f r a u d . In the 1960s the great scandals surrounding brokers were connected to the discovery that the "back office" m a n a g e m e n t of customers' accounts was so bad that m a n y firms could not find significant a m o u n t s of customers' securities left with the brokers for safekeeping and trading convenience. The federal government responded by creating the Securities Investor Protection Corporation (SIPC) to protect customers against broker m i s m a n a g e m e n t . Of course, that intervention also increased the willingness of people to do business with the brokers. In more recent years brokers have been caught perpetrating the following nefarious activities: elaborate insider trading schemes in which they trade for their own account at the expense of their customers accounts; complex check-kiting schemes; computer-driven, automatic buy-and-sell schemes connecting several markets purporting to guarantee higher probable returns to assets; and development of ever more abstract "securities" like an S & P Index future that can be bought and sold to generate huge commissions and possibly perform some insurance function. The Bush administration has promised to increase resources policing this "crime in the suites." Public awareness of the pervasiveness of private-sector fraud throughout our society and its political superstructure has also increased in recent times. Indications that this awareness will produce government countervailing action may be found in public action against insider manipulation of the securities markets and bribery or extortionate pricing involving military contractors. Antifraud legislation is most likely to spread, especially at the federal level, and the consequent enforcement will require additional regulation with its attendant permeation of private market affairs. Some examples of the pervasiveness of fraud are defense equipment that does not work or is outrageously priced; insurance that

The Inevitability of Government Growth 231 does not insure; lots for homes bereft of public utilities and/or incapable of supporting structures; fatty diet foods; canned m e a t s from animals that died of natural causes; unrepairable, " l e m o n " new cars; "safe," uninsured banks; poisonous nostrums; firetrap luxury hotels; flammable baby clothes; lawyers' fees that exhaust inheritances and the lifetimes of litigants; certified accounts showing profits for firms that promptly file for bankruptcy; iatrongenic (medical-system-caused) disease; and travel bargains that go nowhere. Scandals calling for government intervention in the securities area abound. Many of the country's largest companies have been recapitalized by retiring equity and replacing it with debt. When the outstanding debt of a c o m p a n y as a proportion of its capital gets very high, the interest rates on that debt reach levels that were called usurious as recently as the 1960s. The bonds issued by such a c o m p a n y are appropriately called junk bonds. The n a m e reflects the market opinion of their worth, even though the market has gobbled them up in recent years. When a corporation issues junk bonds its credit rating falls and the value of bonds issued before the junk bonds drops. This can be a severe capital loss for the bondholders, who have organized the Institutional Bondholders Rights Association to d e m a n d from the government more protection of their property values. This activates one of the principal and growing functions of g o v e r n m e n t — t o mediate between competing groups. There are two main reasons for such recapitalization. The first is to protect the current m a n a g e m e n t from corporate takeover by groups who think the company could be better m a n a g e d . In this case the excessive debt is to eliminate any potential takeover profits for the outsiders. If no one can make money taking over the c o m p a n y the existing m a n a g e m e n t is safe although the company may be m a d e sick. A second reason to recapitalize is to enable some group to take over the company with little equity of their own so they can resell it later for a profit. The takeover group may consist of entrepreneurs who honestly believe they can better m a n a g e the company or rearrange its assets in a way that will induce the market to increase its evaluation of the worth of the company. As such it is reasonable market behavior that should not elicit government intrusion. Unfortunately, existing managements have been successfully lobbying state legislatures to restrict or prohibit this activity. The takeover group m a y be the existing m a n a g e m e n t . If managers, the presumed fiduciary agents for the owners, think they know how to increase the value of a company and choose to do it for themselves

232 The Inevitability of Government Growth rather than for the owners, they are committing ethical if not legal fraud. When huge profits are consequently made manipulating the capital structures to put those companies ever deeper into debt, the ownership interests are likely to make sure that the government will soon be involved to police such behavior. The government now has an additional reason to make sure there will never be another severe recession because the inescapable debt bills of over-leveraged companies would increase bankruptcies among the largest corporate employers. It is likely, therefore, to have to do for large nonbank corporations what it has done for large banks, i.e., make bankruptcy impossible. Lockheed and Chrysler are signs that we are moving in that direction. The government may have to increasingly restrict investment banking to funding new investment, for the investment banking-brokerage system we have now conforms to Keynes' complaint, "When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done." 11 Some large brokers are also investment bankers. Both groups have been active in inventing new types of securities. Both earn substantial commissions trading the securities. However, financial advice to large corporations and the marketing of large blocks of securities to enable the recapitalization of businesses has become the hallmark of the modern investment bank. In a typical leveraged buyout by management, the managers contract with an investment bank for financial advice and assistance in selling bonds. For often enormous fees and commissions the investment bank organizes the deal and sells the junk bonds as liabilities of the corporation. The bond proceeds are used by management to buy back the stock of all owners except themselves. The management pays itself large salaries and bonuses from corporate funds. If managers successfully increase the value of the corporation, or sell enough of the corporation's real assets to pay off the bonds, they become owners of a great asset, the surviving company. If they fail, the corporation fails and the bondholders lose. In every case management and the investment banks are well paid. In no case does this activity increase the stock of real capital in the economy. A reasonable description of modern investment banks in such cases is that, like the medieval pawnbroker, they bleed the corporations who perform socially necessary acts. Freeing interest rates from the medieval condemnation of the church and the tight regulation of the state required a recognition of the difference between investment and consumer loans. If one borrows to

The Inevitability of Government Growth 233 buy seed for the farm, the seed will multiply and there is a surplus that can pay the interest charge. But when one borrows to feed one's family, there are no more resources at the end of the process than at the beginning, so there is no w a y to pay back more than w a s borrowed. Similarly, converting a corporation's capital from equity to debt in no w a y increases the real productive resources of the business. It is in form a consumer loan and likely, therefore, to be tightly regulated. The great financial industries: banking, savings and loan, insurance, brokering, investment banking, were all developed by private entrepreneurs and facilitated the operation of the private market system. Many are of great age and most appear in every capitalist economy. They provide incredibly useful services, creating and dealing in debt. Unfortunately, much of modern finance increases uncertainty. A gold coin is a l w a y s socially acceptable as gold. A bank deposit is not a l w a y s socially acceptable as anything. That depends in part upon the behavior of the banker. Insurance pays only if the insurance company is properly managed. Brokers have often failed to keep track of customers' accounts. Investment bankers often direct savings into strangely unproductive channels. Private pensions have all too infrequently been paid to those w h o thought they were covered. It has fallen to government to reduce the uncertainty finance creates. As finance invents new types of securities, accounts, or transactions, new uncertainties afflict its customers and new opportunities for enrichment appear. Whenever these proliferating uncertainties produce significant losses w e must expect government action to reduce the uncertainties. That is w h y so many of the m a j o r financial industries have attached to them governmental insurance companies to protect the customers from the behavior of the finance industry. We can expect this process to expand indefinitely. This illustrates the fact that for the foreseeable future the principal enemy of the U.S. market economy is neither c o m m u n i s m nor big government. It is irresponsible business managers increasing the probability of economic collapse. These same managers have great resources at their disposal, which can be used for productive purposes, but increasingly they use them for private pecuniary gain as a substitute for new products and services. In a well-functioning market economy the big gains are associated with new outputs, not new forms of leverage. The most startling of the new developing roles for government is to discipline, reward, and monitor the behavior of the managers of the great businesses and thus to protect the economy, the

234 The Inevitability of Government Growth owners of wealth, and the citizens generally from the worst of their behavior. Underwriting Technology The third great sphere for administrative involvement to underwrite the general performance of the system is technological performance. Technology is a public good. Government concern with production technology, including support for great new industries such as the postal service, the railroad, and motor vehicles, goes far back in economic history. Government responsibility for the social infrastructure backing up the industrial modernization process has always been assumed. In the major case of agriculture, a "small business" activity, the government as early as the Civil War granted land to state colleges under the Morrill Act to encourage programs in "agriculture and the mechanic arts." Experiment stations for agriculture were initiated by the states and became firmly established by the federal Hatch Act in 1887. Education is also an essential component of the social infrastructure and is the handmaiden of technical advance. The spread of public education, gradually from literacy then up to the highest levels, has forcefully testified, among other things, to public involvement in preparation of the labor force for modernization of the economy's production system. But aside from education the intrusion of government made few direct inroads into the sphere of nonfarm technological research and its application until more recent times. This " R & D " (research and development) was left up to private business. That limitation has now been thrown off. The single most important force making that necessary is the fact that modern technology's incredible complexity requires its union with pure and applied science. It also requires the organization and integration of esoteric developments in a variety of scientific and technical fields—physics, chemistry, biology, engineering, mathematics. Even the very large corporations have increasingly found the consequent educational and R & D demands overwhelming. Since at the same time the progress of productivity in the economy has also become an ever more insistent social goal, technology and scientific education are profoundly affected with a public interest. The successful implementation of government policy to elicit greater expenditures on education stemmed not only from the new technological imperatives corollary to society's growth commitment but also

The Inevitability

of Government Growth

235

f r o m the c o m m u n i t y ' s dedication to equality of o p p o r t u n i t y in general. T h a t requires e q u a l i t y of access to e d u c a t i o n . Happily, this d e m o c r a t i c belief has received p o w e r f u l s u p p o r t f r o m the technical req u i r e m e n t s of the c o m p u t e r society. The diffusion of secondary a n d higher e d u c a t i o n h a s been the expression of e x p a n d i n g d e m o c r a c y , as well as the d e m a n d of society's ever m o r e complex technological f o u n d a t i o n s . It also contributes, as it m u s t c o n t i n u e to c o n t r i b u t e , to g r e a t e r citizen p a r t i c i p a t i o n in the d e t e r m i n a t i o n of g o v e r n m e n t policy. W i d e r c o n t a c t with the social sciences a n d h u m a n i t i e s , in p a r t i c u l a r , h a s e n h a n c e d p o p u l a r knowledge of social b e h a v i o r a n d of the a m e n a b i l i t y of social problems to h u m a n intervention. It is not essential to the g o v e r n m e n t g r o w t h a r g u m e n t t h a t all or even most p u b l i c sector a d m i n i s t r a t i v e activities e x p a n d relative to p o p u l a t i o n g r o w t h in the f u t u r e . It is e n o u g h t h a t s o m e i m p o r t a n t ones relatively e x p a n d a n d t h a t most of the r e m a i n i n g i m p o r t a n t ones grow at c o n t e m p o r a r y rates. Hence, it is sufficient to observe, in the a r e a of h i g h e r e d u c a t i o n e n r o l l m e n t s , for e x a m p l e , that the public/ p r i v a t e r a t i o h a s been a r o u n d 3.5 since the late 1970s a n d t h a t enrollm e n t projections t h r o u g h 1993 show that the n u m b e r s a n d their proportion of the college age p o p u l a t i o n a r e expected to be s u s t a i n e d . An accelerating r a t e of technological a d v a n c e continuously generates f u n c t i o n a l illiteracy in a s u b s t a n t i a l fraction of the labor force. To overcome this skill obsolescence, g o v e r n m e n t , as well as business, will have to u n d e r t a k e large p r o g r a m s t h a t r e t r a i n w o r k e r s d u r i n g their work life, not just in their youth. The p r o g r a m will h a v e to e x p a n d as a f u n c t i o n of both technological a d v a n c e a n d increase in the size of the labor force. While p r i v a t e business provides, a n d will n o d o u b t c o n t i n u e to provide, some of the r e q u i r e d r e t r a i n i n g , exp a n d e d p u b l i c p l a n n i n g a n d financing will u n q u e s t i o n a b l y be demanded. The record s h o w s that p r i v a t e business firms u n d e r i n v e s t in p u r e science, research, a n d h u m a n training because they c a n n o t c a p t u r e most of the r e t u r n s . Hence, it is no t e m p o r a r y accident t h a t these activities h a v e been c e n t e r e d in the nonprofit a n d public sectors, a d e v e l o p m e n t a t t e s t i n g to the public a n d n o n m a r k e t c h a r a c t e r of cont e m p o r a r y science a n d technology. In the field of basic research the federal g o v e r n m e n t alone h a s been providing a l m o s t t w o t h i r d s of the funds. There a r e n o p r i v a t e p r o f i t m a k i n g universities. Technology h a s gone increasingly p u b l i c a n d therefore h a s evoked g o v e r n m e n t p a r t i c i p a t i o n in a m y r i a d of o t h e r ways. For e x a m p l e , it has involved the creation of whole new g o v e r n m e n t - a i d e d industries,

236 The Inevitability of Government Growth big public intervention in established industries, and the decline or demise of obsolete private activities. These industrial shifts strike all sectors of the economy and society. The effects of the "productivity miracle" in postwar agriculture under the nurturing hand of the Department of Agriculture is a case in point. The continued urbanization of the economy and society replenishes and expands just those kinds of societal changes that absorbed much of Adolph Wagner's attention in connection with the formulation of his growing-government thesis. A good part, although not by any means all, of the urbanization trend can be traced back to scientific and technological progress. The chain of causation is loose and goes in both directions. For example, both the private motor vehicle and public transit have contributed to the peculiar patterns of urban population and industry agglomeration. Also, the technological revolution in agriculture after World War II threw the final millions of the farm population into both cities and the rural nonfarm peripheries of those cities. The long-run rise in income per head, traceable primarily to productivity rise and thus back to technological advance, stimulated the great growth in the urban service sector. An increasing governmental concern with technology, and with technological research and assessment, is guaranteed by several additional imperatives. One is the search for alternative energy sources. The dismantling of the public Synfuels Corporation will turn out to be a short-sighted, budget-retrenching move responding to the temporary easing of the petroleum supply situation in the mid-1980s. Another imperative is the necessary public involvement in the galaxy of technologies connected with environmental protection, e.g., radioactive and other toxic waste disposal; the correction of water, air, and foodchain contamination; and ordinary refuse and sewerage management. A major reason for intervention into the progress of technology stems from private pressures for, and public recognition of, the need to make import-competing industries more productive. This is but the other side of the protectionist coin. In the contemporary world of U.S. productivity competition in important sectors, it is widely believed that the competitive threat from either big high-tech, or smaller lowwage, foreign countries cries out for government R & D assistance and other subsidies to the affected industries. The clamor has been most evident during the recent years of large foreign trade deficits. The deficits may or may not persist. The assistance definitely will. A further source of pressure is the military. While military technology is nominally specific, there is overlap with civilian science and

The Inevitability of Government Growth 237 technology, the more so as the required activity goes backward toward the purely scientific. The persistent U.S.-U.S.S.R. hostility assures an expanding role for this type of government involvement. Any industry, and the n u m b e r is sizeable, in which the national security interest is present, is a likely object of some kind of federal intervention. A strong governmental influence can be expected for this reason to continue in aviation, computers, semiconductors (particularly with respect to R & D), space exploration, and the accumulation a n d management of strategic materials stockpiles, which in the past has included even ordinary m a n u f a c t u r e d goods such as machine tools. The erosion of R & D outlays in recent years has p r o m p t e d the Council on Competitiveness, a prestigious private lobbying group, to sound the a l a r m calling for substantial fund increases. The call emphasizes the need for a much larger government civilian c o m m i t m e n t to correct the overweening past emphasis on military research. On the side of private effort relative to GNP, such f u n d s have been lower than in the 1960s. They may soon be lower still because corporate financial restructuring has begun to crowd out R & D owing to the resultant burgeoning of interest costs. A consequent shift to the public exchequer is highly probable. Meanwhile the military-industrial complex has become at least as public as private. "Contracting o u t " fails to describe the situation. As Murray W e i d e n b a u m has noted, "The close a n d continuing relationship between the pentagon a n d a relatively small group of industrial firms," highly concentrated in a few states, the "governmental orientation of these companies and the military's reliance on t h e m , " the "erosion of the basic entrepreneurial character of the firms," the necessity to take on some of " t h e i r internal decision-making functions" if the taxpayer is to be protected, and the resulting low level of competition of military business, have all moved us toward "the arsenalization of the defense industry." 1 2 It is a fiction that the specialized a r m s contractor is separate f r o m the a r m e d services. Contractors are an extension of the Department of Defense and will proliferate with the growth of military purchases. Growing acknowledgement of the military—private-sector fusion process is revealed in the recent call by an independent advisory panel of the Defense Science Board for the Pentagon to intrude into the whole a r e n a of federal economic policy determination. For fear of "an increasing loss of technological leadership to both our allies and adversaries," the panel recommended greater Defense D e p a r t m e n t influence over taxation, environmental policy, education, and trade legislation.

238 The Inevitability of Government Growth PUBLIC GUIDANCE OF INDUSTRIES, SOCIAL G R O U P S , AND OCCUPATIONS

Government pursues a veritable galaxy of programs to shape, control, manipulate, expand, contract, support, prohibit, or redirect particular industries, institutions, and group behavior. Examples are antitrust, farm subsidies, occupational safety and health, tariffs, tax exemptions, and prohibitions or restrictions on the production and sale of certain products.

Interest G r o u p s

The reasons for the continued growth of such extensive public guidance are usually to be found in the exercise of pressure on government by vested interest groups. Hence, it is not to be thought that the "guidance" we refer to is something foisted upon the affected sectors. Of course, in a society of conflicting interest groups, one group may prompt the government to exercise controls over another. Such intervention will likely appear coercive to the controlled persons. We use, however, the more neutral term "guidance" to cover such cases, as well as all cases of sympathetic and direct governmental response to vested interest pressure for intervention. Vested interest groups as defined here are organized entities devoted to the protection and enhancement of their property rights. In their own way, they too are engaged in the war for income redistribution and special favors. They may be individual business firms, business or professional associations, nonprofit organizations, churches, or governmental units. Except for their own membership they do not usually press for enlargement of human rights and the welfare safety net. Examples are such politically skilled and articulate pressure organizations as the Business Roundtable, the American Medical Association, the American Bar Association, the American Farm Bureau Federation, the Emergency Committee for American Trade, the National Rifle Association, the State of Texas, The Northeast-Midwest Institute, and the "Mormons." Social scientists widely agree that these particular subsegments of the population typically possess political clout that is larger than their relative importance, i.e., their numerical importance in the socioeconomic mosaic. Matthew Purdy wrote they can be a "welter weight as an industry but a heavy weight as a lobby." 1 3 The reasons for this have been well put by Robert Haveman and Robert Hamrin:

The Inevitability of Government Growth 239 By means of their economic power, their familiarity with the channels of government decision-making, their knowledge of the details of policy issues, and, most importantly, their ability to organize and orchestrate the views of their members, vested interests are able to gain and sustain programs and policies which provide them subsidies or confer protected economic positions on them. These "welfare programs" for special interest groups are visible in the disbursement of subsidies implicit in government taxing and spending policies, the decisions of regulatory bodies.. . . and the imposition of tariffs and import quotas. 14 The standard claim by these pressure groups that they speak also for the public interest as a whole has an element of veracity. But it has less legitimacy than the similar claim advanced by the more community-wide organizations. For the vested interest, the allegation of concern with the public interest is ancillary to its devotion to property enhancement. Of course, the organized broad social segments devoted to improving the human condition, as distinguished from vested interests, also pursue their objectives through the appeal to government either for help or to resist incursions into favored public policy by their adversaries. Much vested interest interventionism is usually thought of as regulation, a major form of administrative involvement. These regulatory activities of local, state, and federal government are likely to be performed with only moderate appropriations and staff. Indeed they are very frequently understaffed. They are nonetheless of great economic and social importance. Employment and expenditures criteria of government size are inappropriate for them because such criteria do not indicate the scope a n d depth of the interventionist impact of the regulation. As Federal Communications Commissioner Nicholas Johnson once pointed out, "the impact of this sector of governmental activities on the functioning of the economy . . . is almost impossible to overestimate." 1 5 The citation above from Haveman and Hamrin refers to familiarity and knowledge as important characteristics of the pressure group establishment. Political pressure is exerted, however, not necessarily on the basis of reliable information about a rival's political influence, but on the basis of the pressure group's own influence level. Furthermore, pressure groups often think their rivals are as powerful as they are. This heats up the intensity of the influence effort. Decades of experience have much enlarged the lobbying and pub-

240 The Inevitability of Government Growth licity expertise of all pressure groups; it has also converted those that have the means into permanent residents of the various seats of government across the nation. John R. Commons perceived long ago in his classical study of collective action that the pressure establishment had already formed in Washington an alternative "occupational parliament," the "informal American counterpart of Mussolini's 'corporate state.' " 1 6 This perceptive observation is consistent with the fusion notion that such nominally private entities are in one vital respect governmental accessories. They are parapublic. Their long-term growth is also a part of the enlargement of public sector involvement. It was estimated that in 1986 there were approximately 2,700 different political pressure groups of all types located in Washington, D.C., alone. They employed about 30,000 people. To this must be added the even greater legions of accessories sited in the seats of state and local governments. Government itself is frequently made accessory to the pressure group. Largess in one form or another is passed out to members of the Congress as an established procedure. "When our Congressmen hanker for a full-paid family junket in Palm Springs, they need only call their friendly lobbyist," as the headline of a lengthy piece in the Washington Post expressed it.17 This link of corruptive activity is firmly institutionalized and expanding in magnitude. Economic maximization means both maximizing benefits and minimizing costs. The two-sided objective is precisely what drives the conflicting redistributive and reallocative policy activities of vested pressure groups. The perception of market failures is as important a rationale to these organizations as to anyone else. To the farm bloc and the private agricultural organizations behind it, prices below parity are considered a market failure, and the farm price support program is invoked. To small competitor firms in a dominant-group industry, the superior market power of oligopolistic rivals is likewise viewed as a market failure, and the anitmonopoly laws are invoked. Said Isaiah Berlin, "freedom for the pike is death for the minnows." 1 8 The same goes for firms facing foreign competition. They call for protection. All the costs involved for the underdogs are, in the view of the top dogs, in accordance with the law of supply and demand, and it will be invoked by the top dogs to try to maximize their positions—hence, the struggle over regulations and tax subsidies. In these cases the top dogs stand for noninterference with the law of supply and demand, and struggle with the interferers. But, in the words of John R. Commons,

The Inevitability of Government Growth 241 Interference with the laws of supply and demand has always been the main objection raised against all collective action, whether against protective tariffs, against immigration restriction, against labor unions, or against corporations; but these interferences have nevertheless been repeated and cumulated for a hundred years, because the alternatives of noninterference under the circumstances were deemed worse than the interferences.19 The maximization of cost overruns on government contracts or of liberal depreciation allowances is a bit different. These are straight, time-honored profit maximization cases, but their perpetrators do not lay explicit claim to the law of supply and demand. But while the rationale is somewhat different, the same redistributive effort is nonetheless at work; in these cases (other) taxpayers pay. Nonprofit organizations such as churches, church schools, private universities, and other sacrosanct entities also insist that (other) taxpayers subsidize them through what George F. Will has aptly called "the traditional use of the tax code as an instrument for micro-managing distributive justice." 2 0 Competition for government contracts and the retention of locally sited military bases is again straight maximization beyond the confines of the market as viewed in the narrow, private, supply/demand sense. Viewed from the demand side, this implies that the government imposes its goals upon firms and individuals when evaluating the purchase of a product or operating a base. Community endeavors to attract and hold military bases and ordnance or ship repair facilities are perhaps the most obvious cases of the link between domestic economic objectives and the size of the military budget. They are a close kin to all state and local government efforts to attract and coddle new industries. The same goes for the appeal of declining industries and their communities to the federal government for help. The government bailout is the ultimate public weapon in the United States for obviating insolvency. All such localized public activities are filled with future interventionist promise. Shifts in production patterns often disrupt the existing regional economic activity contours, creating special social problems and distressed communities. Private groups and local governments spring into action. A call for government bailout likely follows. Accentuating regional and intraregional disparities in expansion and decline will unquestionably require enlargement of long-existing public commitments to influence the location decisions of business firms. Although this facet of industrial policy has traditionally been the province of

242 The Inevitability of Government Growth the state and local governments, the federal government has also formally made itself responsible under the 1970 Urban Growth and New Community Development Act. An additional upcoming public responsibility is in the field of "industrial policy." This involves government support for the improvement of technologically or managerially lagging industries. The stimulus stems from what is thought to be the superiority of Japanese and German business organization and the persistent challenge of subsidized European competition in world markets. The old business-government partnership rejecting private market decisions when they were inconvenient, time-honored as far back as the laissez faire era, has gotten a new lease on life via these industrial policy advocates. Sector advocacy policies of one kind of another are built-in features of business-government and government-government relationships. Like the deep government involvement in labor-management relations, some of these sector policies are also regulatory for public interest purposes. The goals of income redistribution and public guidance of sectors involve the use of many of the same tools. Tax policy and special spending rules in the federal budget are the principal avenues used to achieve these two different goals. Income redistribution is usually thought of as a system of tax everyone to support the deserving. Of course, the deserving sometimes turn out to be the wealthy. Public guidance of certain groups assists those favored activities to flourish, often through tax cuts and spending subsidies. Although the budget is used in often identical ways to achieve the two goals, the intentions of the government and the arguments for and against the recipients of public favors are couched in completely different terms. Redistribution arguments are dominated by ideas like equity, social justice, inducement to work, and welfare cheating. Public guidance arguments are full of discussions about market failure, national security, inducements to invest, violations of the free market, and other critical national issues. The distinction between redistribution programs and public guidance programs is not so much in what the government does, but rather in why it does it. Public guidance is particularly apparent in the federal tax system. As so incisively expressed by Norman Ornstein, "the tax system . . . comes close to being incorporated into the genetic material of the American economy." 2 1 The individual taxpayer filling out Form 1040 today puts in an average of fifteen hours. The taxpayer hires armies of tax-deductible accountants and lawyers whose fate is interwoven with the tax-collecting bureaucrats. The tax preparation industry grows

The Inevitability of Government Growth 243 ever larger, complaining about big government even as it totally depends on bigger and more complex government for its " p r i v a t e market" success. Increasing numbers of firms and industries " e a r n " more lobbying for tax changes than they do from producing goods and services. The programs described above are often invented by private groups and lobbied for in the halls of Congress or the state legislatures. In such lobbying the budget implications of small programs can safely be ignored. A subsidy, say, 10 percent of sales, to a small industry is so minor relative to society that the public is not likely to notice what has happened. T o the industry the subsidy is large. Any group can make the same claim. However, 10 percent of receipts for many groups is noticeable. That is what we see developing at present.

The Environment The environmental movements of the 1970s laid the groundwork for what will be one of the greatest single sources of government concern in the future. T o be sure, environmentalism demanded public attention to more problems that pollution, but certainly pollution was its main target. And it is pollution that promises to become by far the largest and most expanding environmental problem in the years ahead. There are good reasons for this and for a growing appeal to government to shape the solutions. There are certain large and growing activities that generate continuing, pervasive, and cumulative harmful effects on people and the environment. The chief culprits include motor vehicles, aircraft, the "smokestack" industries, chemicals, paper making, cigarette smoking, driving, rock music, the biotechnology industry, nuclear power (including nuclear weaponry), irrigation agriculture, agricultural chemicals, and oil transport. In combination with a growing wasteful population, the rise in per capita income, and urban concentration, the harmful spillovers from these expanding activities are compounded by at least the square of population increase. While urbanization has produced a flood of social amenities, it also greatly enlarged the urban problem areas—congestion, pollution, commutation, slum housing, blight, drug pushing and addiction, crime and the governmental burden of law enforcement, the alleviation of poverty and hunger, educational discrimination, and ethnic conflicts. Relief from these urban disamenities requires public intervention. And the future persistence of these disamenities, if not their exacerbation, is assured.

244 The Inevitability of Government Growth There are elegant examples of state government attacks on pollution, such as Oregon's requiring deposits on soda containers and also local governmental responses, some as extensive as the new (1989) Los Angeles air quality rules. Most environmental rules will, however, probably have to be national. If one city raises its taxes or the costs of local businesses to fight pollution, it places itself at a competitive disadvantage in the competition with other cities to attract new industries and jobs. A small state like Connecticut or New Jersey with a bottle deposit law could be thoroughly trashed with out-of-state containers that would not be picked up by scavengers since there would be no deposit to reclaim. The necessary surveillance of the potential hazards of nuclear power demands public attention to radiation protection, nuclear safety and health, and the disposition of radioactive wastes. In early 1980 the Energy Department estimated cleanup costs of $92 billion at plants under its control. Estimates of more than $200 billion for complete atomic industry cleanup are common. The government will have to learn to clean up after itself. A related phenomenon has always been the very high level and the long-run rise in enterprise and household energy consumption in the United States. On a global comparison, the U.S. level has always been far above countries with closely approximating per capita income levels. With this high energy consumption that shows no evidence of significant abatement there has also developed, by virtue of the peculiar chemical composition of society's energy use, high toxicity and voluminous hazardous waste emissions. Nuclear power and weapons, in particular, were introduced after World War II in the absence of both adequate accident controls and a technology for dealing with the disposal of the lethal wastes produced by it. "Public attention" may require a more extensive effort than the simple assignment of a government agency to a task. Given the enormous proliferation of such agencies within the vast public bureaucracy, agency self-monitoring and interagency policing have become an additional government responsibility in an increasing number of cases. Although the constitutional checks and balances among the three branches of the federal government, widely mirrored also at the state level, can bear some of the necessary surveillance responsibilities, experience has shown that further institutionalization of whistle blowing within the bureaucracy is essential. The work of the federal General Accounting Office (GAO) is a case in point. One of GAO's most dramatic revelations was of the multibillion-dollar supervisory and maintenance failure of the U.S. Energy Department while it operated

The Inevitability of Government Growth 245 some of the country's nuclear weapons production and research facilities. Major government agencies in numerous cases will clearly require the establishment of oversight bodies to guard against the perpetration of such enormous fiascos as the Energy Department cleanup case. And given the prevalence of fraud, the future will have to bring with it more than one "task force" to discover and prosecute the armies of offenders. Much of the costs to the taxpayer may well be fails accomplis: agencies present the bill to the Congress ex post facto, for example, and the system of "checks and balances" is largely irrelevant. S & L bailout costs is a further illustration of this enormous problem and the need for super agencies to keep down the magnitude of the superfunds, by preventing such huge problems from developing. The United States government is currently preparing a plan to present to the 1990 United Nations Environmental Program Conference dealing with fuel conservation. The New York Times reported that the United States may recommend nuclear power as an energy source that produces little carbon dioxide and thus does not exacerbate the greenhouse effect. 22 This means use of government-controlled radioactivity pollution to substitute for government-controlled burning of hydrocarbons and carbon dioxide pollution. Choosing either the Scylla of radioactivity or the Charybdis of carbon dioxide requires greater government involvement. Many respected physical scientists have described potential human-caused changes in the environment that could bring about sudden mass destruction, such as nuclear winter, a severe atmospheric heat increase (the greenhouse effect), a significant thinning of the ozone layer, a big release of supervirulent viruses, or nerve gases. If any of these scenarios is correct the market is irrelevant; only the government can act to stop these developing sources of trouble. The profit motive has by itself not demonstrated a capability for coping with most environmental problems. Indeed, the private sector may be said to have exhibited an almost Olympian insouciance toward the rational management of pollutive spillovers of all kinds—noise, air, water, acid rain, biogenetics, solid waste, the ozone layer, and the greenhouse effect. Markets often reward the destruction of resources that may be essential to human existence. We, the people of the earth, have survived the almost complete cutting of the forests of Ohio and Indiana to create farms and the severe reduction in the forests of Oregon to create lumber, but we may not survive the elimination of all tropical forests for the same goals. Tom Wicker has pointed out that 68 percent of the wildlife habitat in Southeast Asia (mostly for-

246 The Inevitability of Government Growth ests) has disappeared. 2 3 Similar figures apply to subsaharan Africa and the Amazon basin. Clearly the third world cannot use the United States as a resource exploitation model. This makes it hard for the third world to believe it should copy our reliance on private markets as a general development model. Someday soon we of the first world will have to seriously attempt to conserve scarce natural resources rather than just "develop" them. A major U.S.-Canadian dispute is acid rain. The New York Times reported "The Environmental Protection Agency estimates that the various proposals to cut the pollution that causes acid rain by about 50 percent would cost from $16 to 33 billion over the next 20 years. Scientists believe that cutting the pollution in half would lead to a similar reduction in acid rain." 2 4 Only expanded international governmental cooperation can arrest this explosive environmental degradation. The history of hazardous waste disposal by private enterprise, and by government, has been marred by a variety of covert dirty tricks. The enormous and growing management task in this area appears, therefore, to be intrinsically social. Increasingly we have learned that we must sort the contents of dumps because two or more harmless items can react with one another to produce a harmful chemical. Several potential and actual dump explosions from West Virginia to New Jersey testify to this problem. Only government is likely to finance research into the chemistry of landfills of different compositions. The disposal of the mountains of ordinary garbage and trash produced by our well-to-do society is commanding increasing attention by state and local governmental units. The city of Boston, for example, has been caught in the crossfire between residents of South Boston, who protested the location of an incinerator there, and the residents of the city's posh suburb of Weston, who fought its location in their area. The search for landfills across state lines between New York, New Jersey, and Pennsylvania has brought state interventionist legislation and a rash of court cases. Unfortunately, as Jan Huismans, an environmental waste expert for the United Nations Environmental Program, has observed, many experts are coming to the conclusion that landfills, possibly can never be a safe means of disposal. Garbage barges ply international waters in search of an accepting country. The U.N. has been trying to develop a treaty limiting the international movement of waste. Currently the United States is arguing for free movement of waste to anyone who wants to receive it. Nations as poor as Nigeria, Guinea-Bassau, and Haiti have chosen to

The Inevitability of Government Growth 247 reject paid foreign waste d u m p s after deliveries were publicized. The clear current trend is that we must live for the most part in our own waste. Refuse increases much faster than the population in affluent societies, and an increasing role for government, in that obnoxious realm, is assured. The emergence of great new industries is also continually taking place, and any of these may possess large, potential, socially harmful, spillover effects at some point in their evolution. For example, the great new government-created space industry has already produced a space junkyard threatening the viability of the communications satellites. Most economists, when studying the great externality, pollution, address it as a problem in finding a rule or scheme that will build the social costs unrecognized by the market into the price structure so that the market can continue to be a principal tool. To an economist the social goal would be to make the otherwise unregulated price equal to, or a better approximation of, the social opportunity cost as estimated by the government. For different circumstances public policy prohibitions, m a n d a t e d behaviors, taxes, or subsidies may be necessary. Such pressures in either case make the government very active in judging "private" individual behavior and prices. Either option is acceptable as long as the results achieve the social goal. Continuous policing is necessary even though the market is used as a control mechanism. Pollution is endemic in several m a j o r growth industries that produce inputs for virtually all other industries. No firm of any size can exist without using paper and goods made from oil, steel, or the products of chemical companies. If we eliminate or significantly reduce the pollution directly or indirectly produced by paper, steel, oil, and chemical companies, we will raise the costs of production to all of their customers (the whole of society). The cost increases will be in proportion to the share of polluting goods in total costs of the customers if we choose to control pollution through mandatory price increases. We might choose to reduce the pollution through mandatory behavior of the polluting firms, such as requiring steel mills to install scrubbers in all their smokestacks. If we then passed a program to publicly install, maintain, and inspect the scrubbers, the costs would pass through the public budget instead of the private price system. If adding scrubbers became an additional government function financed through taxes, the costs would be allocated to society according to the shifting and incidence of taxes. Each different approach will change

248 The Inevitability of Government Growth the price structure and the relative size of various public and private budgets and administrative responsibilities. There are innumerable other ways to deal with this problem, but all of them have the characteristic that the government decides the private market is functioning inadequately and then sets out to cause the right thing to happen and to sustain such behavior through continued enforcement. Whenever society has neglected these problems for a long time, the cleanup, medical assistance to the victims, and quarantining of the region will be publicly financed because the accumulated "liability" in a legal sense will be diffuse and often attach to groups without sufficient resources to effect a solution. The superfund has a super future. In such a system, which is what we have today and will have in the foreseeable future, it is erroneous to say that the market alone allocates resources. If left alone, market agents will produce increasing demands for public cleanup of their messes, which will require increased taxes. If we modify market prices to reflect the true social costs of things, then prices are set by the market plus the government modification. If we try to abolish the market and centrally set prices, we will be beset by black markets and lose some of the benefits of market feedback mechanism. In every case the government is involved. Technological change may make a once efficient solution to some environment problem inefficient and lead to the search for a new solution. In every case efficient, equitable, and correct will be defined and continuously asserted with the intervention of the state, not by the market alone. Furthermore, as Alan Peacock has pointed out, "the setting of regulatory standards, and the subsequent enforcement of those standards, involves a continuing process of bargaining," including bargaining over the costs of compliance ("negotiated compliance.") 2 5

T h e Organizational R e v o l u t i o n and Occupational C h a n g e

The unfolding of the organizational revolution that began with the rise of big business, the related farmer's revolt, and national labor unions in the latter half of the nineteenth century has been a most relevant social development in the twentieth. The changing role of the public sector has expressed the surges of activism mounted by large and small organized, vested interest pressure groups and broad public interest groups. Both direct and regulatory government programs

The Inevitability of Government Growth 249 have represented either single-group pressure, intergroup conflicts, or goals held in common by large numbers of people and organizations. The creation of a large network of public interest groups, including governmental units, devoted to influencing public policy has evolved into perhaps the highest expression of the democratic impulse in an organizational society bedeviled by an ever more insistent need to have access to technical and other esoteric information. There may be no other way for the individual citizen to cope with the information society, and government assistance in the provision of information, a long-established public function in many areas, will be increasingly demanded in the future. But even when they are designed to be enduring, particular public programs and their administration can terminate. Vulnerability to discontinuance or deregulation stems from the ceaseless ebb and flow of private organized power directed toward government. A case in point is the virtual demise of the Small Business Administration. In addition, rivalry between the different levels of government in our federal system, as well as interagency rivalry at the same level, can reduce or eliminate the activity of a particular governmental body, though not necessarily its functions. On the other hand, careful cultivation of the agency's public constituency and participation in Congressional log-rolling can provide almost permanent program protection, as the history of the Army Corps of Engineers amply demonstrates. Bureaucracies are born, persist, and maximise their objectives by conforming to their public constituencies. All intrusions into the unfettered performance of the private market system have required the crystallization of new, market failure perceptions on the part of voters, organizations, or coalitions of organizations. Examination of the evolution of such critical perceptions is essential for understanding the past and anticipating the future career of government involvement. The history of the social perception of environmental damage is today only in its beginning phase. It was easy for traditionalists to entertain the hopeless dream that a return to the old laissez faire order could be reconstituted. However, the clash of this conservative dream with the dominant Keynesian high-employment and stability policy produced a Keynesian victory in the form of a world of big governments. Once that revolution was accomplished, the next phase was characterized by constant nit-picking over the size of the government budget, the deficit, and the debt ceiling. As it turned out, the d e m a n d for high employment through big

250 The Inevitability of Government Growth government was one expression of an intrepid new form of egalitaria n i s m — t h e dogged insistence upon the public guarantee of a welfare safety net. A major social effect of the income security revolution was a massive reordering in the occupational structure of society. In the first place, employment in the civilian public sector came to be a permanently huge proportion of total civilian employment. A side effect of that was insinuation of a cyclically stable component into the job total. Another far-reaching shift in the occupational structure was effected by the postwar international security and "credibility" policy of the United States, which stipulated the maintenance of a very large military force. By the late 1980s, the armed forces exceeded 2 million and Department of Defense civilian employees topped 1 million. All public direct employment was more than 19 million, or about 17 percent of total jobs. Any occupational examination should also recognize the involvement of persons nominally engaged in the private sector but actually caught up in government-connected work. This is part of the publicprivate fusion process. Untold millions of persons not on a public payroll and hundreds of millions of elusive labor hours per year in the so-called private sector must always either be engaged in the production of goods and services for government account or in the paperwork and other jobs required by government or busily trying to influence public policy. These are additional examples of cross-sectoral fusion that are pertinent to the notion of public involvement. The occupational reordering process has been pretty well completed, so far as the public sector is concerned. But the absolute growth of direct government employment and indirect public job involvement by nominally private sectors in the future is certain. For what it is worth, the Bureau of Labor Statistics has projected a very slow total public civilian employment rise that works out to be 0.4 percent per year between 1980 and 1995. Total government civilian employment actually grew at 0.7 percent per year from 1980 to 1987. Another great occupational shift in contemporary times has been the movement of women from the household into the labor market. This trend has been evident for many generations, and its origins and persistence have little if anything to do with the emergence and development of the mixed economy. The labor force participation rate of women increased from 33.3 percent in 1954 to 56.0 percent in 1987. In the same period the male labor force participation rate dropped from 85.6 to 76.2 percent. If these trends continue, women will make up an absolute majority of workers by early in the next century.

The Inevitability of Government Growth 251 The rising female participation rate has affected public policy in many ways and will continue to do so in the future. A number of related women's issues have prompted government intervention, e.g., public aid to "families with dependent children," child care and maternity support for working women, payments for abortion clinics, affirmative action, and comparable-worth wage rates. The way women's labor is organized in our society is profoundly changing. Many of these changes require increased administrative involvement on the part of the government. Some will demand significant public spending increases. Women increasingly assert that they have the same rights and responsibilities as men and in economic relations should be treated as men's equals. If the philosophic individualism that underlies both our major political and economic theories is accepted, they will win this argument. Like any large group asserting significant new rights, those rights are opposed by a substantial fraction of the population. Both sides in these battles use the power of government to preserve " g o o d o l d " rights or create "just n e w " rights for various groups. In the 1830s large numbers of young women worked in the mills of Lowell, Massachusetts. They were housed in company-owned dormitories, allowed to date company-approved young men only during company-approved hours, and only if they had attended companyapproved churches. The employer exercised almost all of the rights of a medieval father over his employees. The young women who worked there had few rights of their own. The government now denies employers such authority over their workers. There was a fire in the Triangle Shirt Waist factory in N e w York in 1911. One hundred forty-six young women died at their jobs because the employer locked them in the factory and made no provision for their escape in an emergency. Almost a century after Lowell the difference between prison and employment for young working women was still not great. Strangely, discrimination was the woman worker's friend in the early twentieth century. Many states tried to pass laws protecting women and children from the worst behavior of employers. The Supreme Court consistently found such laws unconstitutional. By the mid 1920s Congress had passed, and many states were approving, a constitutional amendment to enable legislatures to constrain the behavior of the employers of women and children. Then the Court reversed itself and allowed legislation protecting women and children from employers. Employers thought it was a part of the wage relationship to dictate

252 The Inevitability of Government Growth much of the private behavior of their employees of both sexes. Freedom as we now practice it comes largely from the government's redefinition and surveillance of the wage contract through agencies such as the NLRB and the Fair Employment Practices Commission (FEPC), i.e., through administrative involvement. When we agree to sell our labor for eight hours a day we relinquish control over our behavior for those eight hours but very little control over the rest of our lives. Banks can discriminate against convicted robbers. Hospitals can fire typhoid carriers. However, most of the employer control of private lives has been ended by sustained government intervention in this century, although we still see court cases debating the right of farm workers to use a toilet during work hours. Women having achieved special status in the labor laws in the 1920s are now trying to get equal social status. Both are reasonable. Special status in the 1920s improved their job conditions then. Equal status would improve their job conditions now. As women have done more and more of the total work they have demanded the right to be included in the better jobs: the professions, the clergy, management, the skilled trades. With the exception of traditional women's work such as nursing and school teaching, progress in these areas has been slow despite some government intervention on their behalf. The government itself employs surprisingly few senior female managers and will not allow a female naval officer to serve on a combat ship. If we continue to preach that "all men are created equal" and include women in the definition of men, increased administrative involvement in upgrading women's employment will continue. With most of the women working in the market we are forced to develop new systems to do the nonmarket work women are abandoning. The great social task here is the raising of children. The response of society, and in particular of its public educational establishment, to the postwar baby boom was a major reason for the growth of state and local government from 1950 to the early 1970s. The federal government also made very substantial and increasing contributions to both welfare and the educational expansion. Infant humans are helpless. Some adult must spend almost full time with them their first year at least. Many psychologists believe that the early years of childhood mold the character for life and that the character turns out best if the child spends lots of time with an adult who loves it. This problem afflicts many modern societies. We are in the middle of a great many experiments in baby raising throughout the industrial

The Inevitability of Government Growth 253 vorld. Babies can be raised in collective groups like the children of he Israeli kibbutz. Babies, like the children of the English upper classes, could be raised by hired nannies. Children could be cared for >y their parents while the parents work their jobs. Some work places n several countries include nurseries. Children of shopkeepers in inderdeveloped countries often grow up in the shop under their parent's eye. We could extend mandatory schooling down to the age of wo or three and through the summers. We could enlarge the existing •lead Start programs to cover many or all of the children. We could encourage a great expansion of the nursery school indusTy. We could declare the parent-child relationship fundamental, test tach new parent, and assign the psychologically superior one to raise he child to school age, denying the parent the right to work and providing them a decent subsidy for the period. Such a program vould amount to a simple expansion of AFDC, although done proptrly it would be much more expensive. We cannot tell which of these or other solutions will work best. But i system to raise decent, productive children will be found. The govirnment will be an active participant in the process. It will take both .'ignificant administrative involvement and public spending. No soci(ty can long survive without a good baby-raising mechanism. An additional occupational change was the almost complete expuliion of the black population from southern agriculture in the course •f, and partly caused by, the post-World War II technological revoluion in farming. As late as 1960 there were still 2.6 million blacks in he farm population, but their presence had all but disappeared by 986, when there were only 145,000 nationwide. These people moved almost entirely into urban ghettos, whence nany were caught up in the enduring black civil rights movement, "he social distress and discontent among the completely urbanized ifrican-American population, with its high unemployment, crime, ill iealth, and poverty rates and its high incidence of educational and ob discrimination, will remain a virile source of the continued appeal Dr public intervention through the foreseeable future. On the other hand, World War II and its high employment afternath opened up new opportunities for blacks. One channel of warime and postwar opportunity was jobs, both low level in goods production and low to medium level in the rapidly growing service sector, mother channel was improved education, an area in which there was idvance comparable to that of whites despite substantial continuing ;aps in the level. Black trade union membership also rose substanially. But an equally important effect of the war was heightened

254 The Inevitability of Government Growth black consciousness and political activism, an activism that dovetailed with the general growth of social participation addressed to government by the population at large. The fact that the war was fought against German authoritarianism and racism enormously bolstered the democratic and equalitarian forces inherent in American society. President Roosevelt's FEPC, President Truman's order desegregating the armed forces, and the G.I. Bill of Rights for veterans were but initial moves inaugurating a great postwar wave of humanism running though public activism and its consequent expansion of public policies. The height and persistence of that humanistic wave was and will continue to be much enhanced by the fact that the United States found itself after the war in the position of a showcase under scrutiny by the rest of the world. The United States welcomed and encouraged this international showcase role. The federal government with great popular support was happy to demonstrate, or such was the intention, that the "free enterprise system" and the American political system were a single package that is economically and morally superior to the Soviet system, superior to Swedish "socialism," economically superior to competing advanced capitalist countries, and a sparkling model for the underdeveloped countries to emulate. The pursuit of the showcase role added a flood of encouragement to the rising autonomous currents of democracy, humanism, and government concern at home. World War II thus contributed immensely to the ensuing decades of a heightened social activism addressed to public policy that unfolded jointly with maturing and ever more sophisticated popular organizational developments. The political activism of sections of the trade union movement (particularly the AFL-CIO), the civil rights movement, the rise of the public interest group (e.g., Naderism), the environmental movement, affirmative action, and the social litigation explosion (e.g., the class-action suit) are prominent illustrative forms assumed by this democratic upsurge. All of them will continue to elicit government involvement in some way. But there were other forces making for the flowering of this grandiose Second New Deal in addition to the fillip from the international showcase role. The inherent egalitarian drive in American society exhibited a new and surprising vigor. Out of that exhilaration sprang an enormous growth in income security coverage (e.g., the extension of Social Security and the general enhancement of the welfare transfer payment), the public policy concern with the persistence of poverty and the quality of urban life, the expansion of higher education

The Inevitability of Government Growth 255 as an entitlement (this in addition to the imperatives of advanced technology), the new "social regulation," and the environmental protection laws. In all m a j o r social policy areas other than national health insurance and housing the United States turned out to be emulating and approaching in comprehensiveness the fearsome Swedish welfare state. Until inflation after the early 1970s handed the traditional, laissez faire supply-sider a new weapon against equalitarianism and economic expansion, the momentum of these social programs was apparently unchallenged. Certainly the rate of progress was stalled during the Carter-Reagan presidencies.

Health The health services sector of the economy has grown to more than 11 percent of G N P and more than 8 percent of all private nonagricultural employment. It is already to a large extent public, and the portion that is not directly public is by no means purely private. Few activities are as strongly affected with a public interest as the health of the people. The state and local government public health system long ago attested to the incapacity of the private market to cope with a large body of community-wide health concerns (largely for the underclass) as distinguished from the health interests of particular individuals. In the United States and Japan most of the social services commonly associated with a welfare state are tied to employment in large businesses and institutions. Cradle-to-grave security is a j o b right, not a civil right. The large institutions and businesses are offering retirement incomes; medical, dental and legal insurance; child care for employed parents; special scholarships for employee children; released time for special parenting problems; and a host of other benefits. But the private costs of reviewing the many potential employee services and administering the current contracts for the services chosen, i.e., managing the " p r i v a t e welfare state," are increasingly burdensome. A single mandated public program can use f e w e r total managers, eliminate the competition between businesses to provide " w e l f a r e state" services, and generally make calculating employment costs for employers and income for employees easier. Consequently it is increasingly common for private institutions to advocate socialization (antiprivatization) of these welfare services. The costs of socialization to such businesses are the benefits to the noncovered people government may add to the program. The benefits are a " m o r e level playing

256 The Inevitability of Government Growth field" through increased costs to the businesses that do not offer these services and the elimination of employee benefit departments. The aging of the population is the next great demographic change. There are now 30 million Americans over the age of sixty-five. This population is highly politically conscious and well organized, which helps explain the rise in public share of national health services and supplies expenditures from one third in 1970 to 39 percent in 1986. The elderly have been the second very large group (after the veterans) to secure significant government involvement, beginning with the two-class system of Medicare and Medicaid in 1965. These programs have been expanded in the usual piecemeal way; Medicare now covers the victims of acute renal failure (loss of both kidneys) no m a t t e r what their age, and since 1986 the limited total costs have been converted to an open budget program by including insurance for catastrophic medical costs. Early in this century governments required children to be inoculated against the great communicable diseases. Later we m a d e exceptions for Christian Scientists and other groups. Now we face AIDS, which may be the worst plague since syphilis swept Europe and measles America in the sixteenth century. How we will control, quarantine, and/or treat the victims and protect the "clean" is as yet unknown. If the worst medical predictions are fulfilled it will be a giant expense in dollars and possibly in civil rights. As usual the United States has lagged behind other developed countries in relinquishing a private approach to a social insurance problem. Even Medicare is jointly administered by the federal governments' Health Care Financing Administration (HCFA) and private contractors such as Blue Cross/Blue Shield and other commercial insurance carriers. And less than half of the medical expenses of the elderly are reimbursed through Medicare. The total health bill for 1987 was paid 41 percent by the government, 34 percent by private insurers, and 25 percent by individuals. Only the United States and South Africa, among the advanced industrial countries, lack some kind of national public health care program ensuring protection to all residents. The same two countries are the only developed ones where loss of a job implies loss of medical care benefits. A critical part of medical care is pharmaceuticals. There is m a j o r government activity testing drugs for effectiveness. There are pressures to eliminate Food and Drug Administration (FDA) controls on drugs for the hopelessly ill. There are pressures to increase government spending to maintain production of effective drugs for rare

The Inevitability of Government Growth 257 diseases, areas where small total sales prohibit profits. Some drugs that may help fight major diseases, like AZT, which may delay AIDScaused death, are so expensive most people cannot afford them. Again the call is for government support. An example of pyrrhic cost cutting cited in the New York Times is the closing of major hospital outpatient pharmacies. Referring to the patients who have relied on the closed outpatient pharmacies, Mr. Baxter (senior vice president for corporate planning at the New York City Health and Hospitals Corporation, which runs the city's 16 public hospitals) said that for lack of appropriate medications, many of these people may get sicker and then show up in our emergency rooms or show up back in the institutions that are closing these services. He also said that because the hospitals would no longer fill outpatient prescriptions, many of the poor patients who relied on them for medicine would, "in a sort of ripple effect," simply go to overcrowded public hospitals for medication and care. 26 Some 37 million Americans, including one in every five children, have neither public nor private health insurance coverage. Fifty million more have inadequate coverage. The Wall Street Journal reported "Each year despite statutes against the practice, hospitals dump— that is transfer for economic, not medical, reasons—an estimated 250,000 people." 2 7 Many millions of the employed earn too little to finance individual health coverage and too much to be eligible for Medicaid. The growth of low-paying service employment has much enlarged the size of this uninsured stratum of workers. The ostensibly cared-for elderly are by no means adequately provided for, as evidenced by the growing gap in long-term care. Our presumption that the government will have to expand its intervention into the health care field is not simply based on the large unmet needs of a vocal uninsured public. Nor does it rely heavily on a national sense of embarrassment over the U.S. failure to perform its international showcase role in the provision of public health insurance when compared with other advanced democracies, as well as with the socialist and communist countries. Rather we rely chiefly on the fact that a very heterogeneous crosssection of the public is coming to recognize that a comprehensive governmentally organized and mandated program is the most costeffective response to the groundswell of public demand for full medical coverage. A heterogeneous social consensus was created in Massachusetts to

258 The Inevitability of Government Growth deal with the two major, critical objectives of expanded access and cost containment. The Massachusetts plan for health insurance for all its residents at minimal public budget cost was hammered out by an irresistible ad hoc coalition of state officials, hospital directors, insurance company executives, health care advocates, and organized labor. While some small business spokespersons voiced opposition, the Smaller Business Association of New England supported the plan. The most ardent opponents were physicians, i.e., the profession that has benefited inordinately from the prevailing for-profit public/private system. Buttressing the formation of the Massachusetts consensus is an economic and political logic that promises long-run invincibility for the whole nation. This logic has been perceptively and incisively outlined by Peter Passell.28 The tax for mandated health coverage delivered by employers will be shifted to employees, but this, like Social Security, is viewed by most as a legitimate consumer expense like any other living expense. From the individual's standpoint, the rates with mandated benefits are far below the cost of nongroup coverage. Closely related is the fact noted by Robert Brandon of Citizen Action that inclusion of the uninsured lowers the premiums and taxes of the insured, costs that are presently inflated to cover some of the health care outlays for the uninsured. Furthermore, as Passell adds, private insurance companies support mandated coverage because it enlarges their market volume. Big businesses support it because they already provide expensive health benefits, and the inclusion of competing business under required universal insurance corrects that discriminating condition. Similarly, organized labor supports it because it reduces a cost advantage enjoyed by nonunion employers with uninsured workers. The New York Times reported, "Willis B. Goldbeck, president of the Washington Business Group on Health, an employer's group, added: 'There has been a growing willingness among big-business people to consider a government role on a level never seen before in this country. There might very well be support for the government being responsible for everybody other than full time workers, and for companies having the option of paying taxes into a Government pool or providing a minimum health benefit.' " 2 9 Business support for a publicly mandated system financed by a payroll tax is also in accord with the growing policy of insurers to transfer costs to employer health plans and with the consequent proclivity of employers to further pass the buck by shifting an increasing portion of health costs to employees. The logic of vested interests is

The Inevitability of Government Growth 259 thus conjoined with both personal and social concern for good health care. The incapacity of the private market is conjoined with the domestically evolving perception of the superiority of the alternative social insurance route. And finally the glaring comparative defects of the present American health system, defects in the v i e w of almost everyone except British Prime Minister Margaret Thatcher, are conjoined with the U.S. endeavor in other respects to play a global showcase role. N o t too long ago, f e w health needs were dealt with socially. But today, growing government administrative involvement in the health care field is as assured as Social Security.

Infrastructure The physical capital of the urban/social infrastructure, e.g., water supply and sewerage systems, city roads and streets, intercity highways, farm-to-market roads, bridges, railroad roadbeds, airports, prisons, waste disposal facilities, and urban mass transit, has been poorly maintained and modernized and insufficiently expanded in recent times. These systems are the vital silent partners of all other economic and social activities, without which they would cease to function. They provide public goods, and they typically operate under noncompetitive conditions. Consequently, they are highly public, intimately connected with the governmental establishment. This is a fact of considerable import for the future of government activity because of the enormous refurbishment and expansion requirements that are impending. A large fraction of all the tennis courts, jogging paths, bicycle lanes, soccer fields, softball fields, etc., are owned by the government. It is commonplace to observe that the population is increasingly concerned with fitness, and the medical profession confirms the connection between fitness and health. Either w e improve the public physical activity/recreation facilities or w e increase our medical expenditures. Either w a y an aging athletic population implies bigger government. Deteriorating infrastructure has been partly responsible for the supply-side influence on the productivity slowdown in recent times, as pointed out by Alan Blinder, David Aschauer (see figure 11.1), and others. Arkansas' governor has noted that federal budget pressures and changes in the federal tax l a w in the 1980s hastened the decline in public infrastructure spending that reaches back as far as the 1950s.

260 The Inevitability of Government Growth The decline in the public nonmilitary capital stock growth rate will have to be reversed. Take vehicular transport alone. The Brookings Review cites the Secretary of Transportation: one fifth of the most important 100,000 miles of highways are in poor condition; on our principal roads and streets, 95,000 bridges are in need of substantial repair; congestion besets 60 percent of all rush-hour traffic on main routes in suburbia. 3 0 The 2.8 million miles of local rural roads present a like picture, even as the traffic volume continues to expand. The National Council on Public Works Improvement estimated that expenditure of an additional $20 billion a year would save $100 billion a year in vehicleoperating costs. Failure to do so thus amounts to an enormous subsidy largely to the manufacturers of tires and shock absorbers. Restoration of the Interstate System to 1983 performance levels would require outlays of some $84 billion (in 1985 dollars) between now and the year 2000. The Brookings Review extends its analysis to air transportation requirements and beyond to the third world: " . . . sustained world prosperity is impossible when vast areas are disconnected from the economic mainstream." Thus " . . . to finance the transportation infrastructure needed to support modern industry and agriculture in the Third World, to decongest megacities and guide urban growth, and to Figure 11.1 Tandem Downturn: U.S. Productivity and Government Investment 2

-3 1950

1955

1960

1965

Source: David Alan Aschauer, Chicago

1970

1975

1980

Fed. Letter, September 1988.

1985

The Inevitability of Government Growth 261 build mutually beneficial trade among rich nations and poor . . . will turn out to be the greatest public works program in history." 3 1 The United States, no less than other developed countries, will be called upon to c o n t r i b u t e — i n its o w n material and moral interests. The bill for rehabilitation and expansion in other infrastructure areas boggles the mind. In September 1988, the Congressional Budget Office estimated annual infrastructure investment needs (in 1982 dollars) for highways, bridges, other transportation, drinking water, wastewater treatment, and drainage at $52.6 billion. Other estimates of the same needs range from $64.3 to $118.2 billion. At the time of the estimates, spending on these programs was $44.5 billion or between 39 and 87 percent of needs. This is only part of the total infrastructure. Another example is the $70 billion in deferred maintenance of higher education facilities reported by the National Association of College and University Business Offices in 1988.

Crime and Drugs There is an explosion of criminal population in the United States. Table 11.3 gives the dimensions of the problem for the early 1980s. Aside f r o m the victims, the costs of this terrible development are mostly borne by state and local governments. The last row in table 11.3 shows the totals that would obtain if the rates of increase are sustained to the year 2000. These numbers are too large. The growth must slow down. A federal study of the urine of people arrested in twelve large cities finds that more than 60 percent of them used illegal drugs. This proves the connection to most police. Drug dealers are increasingly TABLE 11 -3. Adults Under Correctional Supervision (thousands)

Year

Jail

Federal prison

State prison

Parole

Probation

Total

1980 1984 1986

191.0 221.8 NA

20.6 27.6 36.5

295.4 417.8 487.4

220.4 268.5 NA

1,118.1 1,711.2 NA

1,845.5 2,665.4 NA

Projected at annual percentage increases, 1980-84: 2000

403.3

88.9

1,671.9

591.4

9,388.2

11,597.3

Source: Statistical Abstract of the United States, 1987, pp. 172-3, Statistical Abstract of the United States, 1988, p. 175.

262 The Inevitability of Government Growth violent and well armed. Among the preferred weapons are assault rifles. The New York Times reports that most victims of assault rifle attacks are "drug dealers and other violent criminals." It quotes a study in the Journal of the American Medical Association saying "the annual cost of treating gunshot wounds nationwide was $1 billion, with 85 percent of it borne by the taxpayer." 3 2 When President Bush defends the right of private citizens to bear antipersonnel rapid-fire guns, he increases the police, hospital, rehabilitation, and welfare expenditures of government. We cannot let drugs continue to do so much damage to us all. The regulation of drugs is clearly a federal government responsibility. It is regulation of interstate and of international trade, which are responsibilities unequivocally assigned to the federal government by the constitution. Strangely, the federal commitment to end the illegal drug trade does not show up strongly in the federal courts reports on disposition of criminal cases. Table 11.4 shows a substantial increase in the percentage of federal imprisonments assigned to drug offenders. It also shows very little increase in the total number of imprisonments. The 8,152 narcotics imprisonments in 1986 is slightly more than one for every three high schools in the country. The Reagan administration argued that it was hard on the illicit drug industry. Indeed convictions and imprisonments for violations of the federal Drug Abuse Prevention and Control Act have increased. The average sentence has increased from 55.6 to 64.6 months. But the average time served is only 19.4 months and has increased only two months since 1976. If we had kept the drug violators for their full T A B L E 11-4. U . S . District Court Criminal D e f e n d a n t s Imprisoned

Year

Total

Narcotics

Percentage narcotics

1972 1976 1977 1982 1984 1985 1986 1987

16,832 18,478 19,613 15,857 17,710 18,679 20,621 23,344

3,050 5,039 5,223 4,586 5,756 6,786 8,152 9,907

18 27 27 29 33 36 40 42

Source: Statistical Abstract of the United States, various years, Tables entitled, "U.S. District Courts—Criminal Cases Commenced and Defendants Disposed of".

The Inevitability of Government Growth 263 sentences there would have been 26,433 of them in federal prisons by 1985, making u p 80 percent of all federal prisoners. As long as the total federal prison population is so small and drug imprisonments are so small we cannot honestly say we have a serious antidrug program in the Department of Justice. Serious, extensively imposed sanctions against illegal drug manufacturing, distribution, sale, and use would involve untold millions in prison and vast armies monitoring or counseling them. Repression requires the Leviathan. The U.S. government has been actively restricting the private market in the sale of drugs since the passage of the first Pure Food and Drug Act in 1908. For m a n y of the products of the pharmaceutical industry this has presented no significant problems. Unfortunately, some of the opiates, m a r i j u a n a and its derivatives, several forms of cocaine, and a m p h e t a m i n e s are now illegally produced or imported and marketed throughout the nation. These black markets are pervasive and very profitable and, as part of a vast underground economy, evade taxation while greatly increasing government law enforcement expenditures. Much of drug law enforcement consists of a t t e m p t s to interdict smugglers and discover and destroy the domestic and foreign farms and factories where the dope is produced. New York City has financed a special high-cost a n t i d r u g policy. The New York Times reports "Despite the more than $500 million spent by the city in the last fiscal year on drug-related enforcement alone—more than twice the amount spent in 1986—the presence of crack is more pervasive, more violent and more insidious in its effect on New Yorkers, particularly the poor." 3 3 It is all very reminiscent of the hopeless a t t e m p t s to enforce alcohol prohibition in the 1920s. We cannot incarcerate the drug consumers, for their n u m b e r s are legion. President Reagan in a speech as far back as August 1986, proposed that it was time to repress d e m a n d . He suggested that critical service workers and public employees be subjected to mandatory urine or blood tests. Those not giving up their "bad habits" could then be fired from their jobs. For the rest of the society such sanctions would be voluntary but encouraged. This is illustrative of the present misguided policy. If drug consumption is as pervasive as the government claims, such a policy would literally destroy the economy by depriving it of its principal input, labor. If only 5.5 percent of the employed are users, firing them would double the unemployment rate and massively increase unemployment compensation and welfare spending. For almost eighty years the government has been telling people to

264 The Inevitability of Government Growth neither want nor consume "recreational" (mind-destroying) drugs. The effect has been to stimulate consumption, we believe. (Since its activities are illegal there are no good data on the industry.) For that same period we have been jailing, confiscating property from, and calling dirty names the suppliers of these substances. Yet their numbers have surely grown. The American government has never been particularly successful at inducing the population to stop consuming products the government considered bad for them and/or society. We have known since the early 1960s that cigarettes were a threat to life and health. Health warnings have been required on cigarette packages since 1966 and cigarette advertising since 1972. Cigarette consumption per capita peaked about 1965, which was the time it became obvious that cigarettes were dangerous. Unfortunately the decline has so far been distressingly slow, 0.9 percent per year. At that rate, to cut per capita consumption in half will take eighty years. Obviously, the government as a teacher encouraging people to abandon certain products is not very quick or efficient. We doubt that any amount of spending on education to reduce drug consumption in combination with the present antidrug law enforcement policies will be much more successful than the tobacco program. Demand control will require a lot of useful exhortation for a very long time and with probably very little result. If a big result is possible it would surely involve massive public spending. Most of the drugs are relatively simple derivatives from long domesticated and hardy plants that successfully grow in many different conditions. There is much news coverage about banks suspected of laundering illegal profits from drug businesses and foreign governments supporting, or even controlled by, drug industries. Our former ally General Noriega of Panama is a particularly egregious recent example. The Honduran army, which is a critical part of our antiSandinista program, apparently profits from the American drug trade as much as or more than its profits from our military support. 3 4 With these costly friends who needs enemies? Several hundred trials and confiscations of drug dealers' and drug producers' property each year here and abroad do not seem to slow entry into what is apparently a very profitable industry that is easy to enter. So far the government has tried two approaches. The first is to discourage demand through education, media campaigns, and criminal penalties for users. The second is to discourage supply by increasing the risk of doing business in the dope industry through loosely enforced criminal penalties, property confiscations, spraying para-

The Inevitability of Government Growth 265 quat on the fields, sending the U.S. Army to Bolivia, and hassling customers and suppliers. Neither approach is new. Both were used in the attempt to reduce alcohol consumption in the 1920s. That experiment was a notorious failure. We should not continue to imitate our failures. A number of commentators have recently noted the similarity between the problems we had with alcohol prohibition and the problems we are having with the prohibitions on the production, sale, and consumption of "recreational" drugs. David Boaz, vice president of the conservative Cato Institute, argued on the Op-Ed page of the New York Times that we should legalize drugs and thus eliminate the illicit drug trade. 35 We concur but with some very special exceptions. There is no benefit to society in eliminating the Mafia and the Medellin drug merchants if we replace them with the American Marijuana Company, General Cocaine Inc., and the United Poppy Growers Assn. Such a policy simply trades in low-life drug pushers for corporate sales forces, media specialists, and advertising agents. Anyone with an ounce of faith in American business knows we can sell dope faster than they can. But the goal is to get rid of the broad use of mind-hampering drugs by people generally unaware of or unconcerned with their personal or social damages. We must both legalize these drugs and completely eliminate the potential for profit in their production and sale. The federal government should open shops all over the country and give away abused drugs to anyone who wants them. Making the drugs free destroys the profit potentials for all possible suppliers. It also takes the thrill out of forbidden contraband. These shops should be easily accessible to most of the population all hours of the day. They should be staffed by pleasant clerks willing to help any person get numb. Without courteous staffing some people will prefer to do business with bootleggers even though the prices are higher, for the service might be better. If private merchants find a new dope and try to develop a market for it, we should add it to the free list as soon as people start buying and using it. With drugs available everywhere, very few people will try to make a living retailing drugs. The government with its enormous resources can hire the peasants of Latin America or the Golden Triangle to produce the raw materials for us. Since these are among the poorest people on earth the costs will be minimal. Since most of the chemistry is so simple that ill-trained people working in motel rooms can at present produce many of the popular junks, the processing costs should also be low.

266 The Inevitability

of Government Growth

W e should not try to cover the costs of the drug program by selling the drugs at low prices. The price of dope must be zero. T h e revenue potential of a sales program is enormous and the government might be tempted to make itself into a drug salesman to avert some fiscal crisis. The goal is to reduce consumption, not increase it. W e should not permit American farmers to grow the marijuana, coca, opium poppies, etc. They have a long history of successfully getting Congress to increase their incomes. N o one, including government, should make any money from dope in America. The legalization route by itself is faulted because it opens profit potential and lobbying to raise prices and income. Only with the total elimination of the possibility of profit f r o m drugs will the private supply be dried up. The savings from reduced law enforcement, drug-connected crime, jail spaces, border patrols, etc., should more than cover the cost of the program. The people generally would benefit from lowered crime, lower taxes, and less pressure to invade poor neighboring countries. A similar approach was taken by the Catholic Church in the eleventh century when it founded a chain of pawnshops throughout Italy. The purpose of the pawnshops was to make consumption loans to the poor at a " l o w " 10 percent rate of interest. That deprived the moneylenders of their 24 to 36 percent usury. It worked. This action entailed a price for the Church, for she had long maintained that receiving interest was immoral. It did so to reduce the exorbitant exactions that the moneylenders were imposing on the poor people of the time. Similarly, if we give crack a w a y to citizens, we will be enabling them to freely choose to maintain their bad habits.

Defense Professors Peacock and Wiseman have explained Wagner's Law as governmental responses to great crises like large wars or depressions. After the crisis is over the government does shrink relative to the economy, but it does not return to its prewar level. Rather it remains forever somewhat larger relative to the economy. There is good evidence that this ratchet hypothesis is correct. It follows that people dedicated to avoiding ever larger government should then be dedicated to avoiding w a r and economic crises. Unfortunately our wars may be dictated by the behavior of other societies or by the political success of prowar factions within our o w n society. Strangely, the prowar Theodore Roosevelt had no w a r in his presidency but got the Nobel Peace Prize for helping end the Russo-

The Inevitability of Government Growth 267 Japanese War. Woodrow Wilson, whose 1916 campaign slogan was "he kept us out of War," got us in the next year. Neither of these cases is neatly connected to the usual theories of economic development. It seems clear that the Mexican War was beneficial for the United States in a long-run sense. It is hard to make an economic case for World War I or the Vietnam War. Few societies have gained more from war than the successors of Mohammed, who in one hundred years extended their control from a little region around Mecca and Medina to a giant empire covering everything from Persia to Spain. Few societies have lost more to war than the Paraguayans, who declared war on the Triple Alliance of Brazil, Argentina, and Uruguay. From 1865 to 1870 they managed to have more than three quarters of their male population killed and lost a significant fraction of their land area. We do not believe that war can be successfully predicted with the usual economic analyses. It may come, and if it does, government will grow relative to the economy—if there is any economy left. If we expect war and prepare for it, government will grow relative to the economy even if the expectation is incorrect. We can afford as much defense as we need. Deciding need is a perennial controversy. We note that defense expenditures (our current euphemism for war preparations) are based on theories. For more than forty years the United States has had the theory that the communists are trying to take over the world. It has led us to the brink of world war on the borders of Greece and off the shores of Cuba. It has led us to large regional wars in Vietnam and Korea plus smaller engagements in Nicaragua, Guatemala, Grenada, etc. Some of these, like Korea, clearly stopped the expansion of communist governments. Other cases are much less clear. If we a r m ourselves on the theory that the communists are trying to take over the world with large quantities of atomic and conventional forces and we engage in an a r m s race to counter that threat, the growing government is no help unless the perceived threat is correct. Another theory of takeover is that the Mexicans are reclaiming Texas and California by the invasion of millions of relatively poor people into those regions. Defense against the Mexican invasion requires very different kinds of public expenditures. The Strategic Air Command and Trident missile submarines are no threat to the Mexican invaders. To stop illegal immigration we need a bigger and better equipped border patrol and Coast Guard. We might consider an "Iron Curtain," which has significantly reduced illegal emigration in Europe.

268 The Inevitability of Government Growth Rich societies are naturally targets of poor societies. Much of the Bible consists of stories of poor nomadic peoples trying to conquer the richer farmlands of Palestine from the miserable deserts of Sinai, Arabia, and the Trans-Jordan. The rich United States may attract more than one potential conqueror. It may be that both the Mexicans and the communists are coming. Our treatment of the Japanese is a striking example of defense policy dominated by peculiar theories. We negotiated a r m s limitation treaties with the Japanese in the 1920s. We fought a war with her in the 1940s. We then wrote into her constitution severe restrictions on a r m a m e n t s and armies. Now we complain that she does not spend enough on "defense," which frees funds for investment, which makes her grow faster, while we spend too much on defense, which some say is a partial cause of our slow growth. One currently popular solution to this dilemma is to encourage the Japanese to rearm! Then they will have fewer resources to invest and will consequently grow more slowly. Their a r m a m e n t s will defend us against the Chinese and Russians so we can spend less on defense, which frees funds for investment, which produces growth for us. In the 1930s as countries began to rearm in preparation for World War II one of the benefits they got was an economic boom. The Napoleonic Wars had the same effect more than 150 years earlier. Rearmament does not slow economic growth. It accelerates it. Disarmament is associated with postwar depressions. So the argument above should have the effect of increasing the rate of economic growth in Japan while reducing it in the United States, exactly the opposite of the stated goal. Perhaps we should seriously consider imitating Japan's military, even though it would involve some loss in the stimulus provided by a large military budget. It is also hard to believe that the world will be more peaceful if people like the Japanese are encouraged to return to their military traditions. The assumption that the Japanese would use a stronger military to defend the United States against Russia and China is also strange. The last time she had a strong military she used it to invade every nation on the Pacific Rim except Russia and Latin America but including the United States. A better lesson is to say that Japan, a nation with a relatively small defense force and bereft of offensive weapons, has been able to grow rapidly for forty-years and no one has attacked it. We might imitate them.

The Inevitability of Government Growth 269 International Influences Meanwhile, particularly since World War II, great "objective" and policy changes have occurred in the rest of the world and in the U.S. relationships to these changes. Within that explosive international combination, a number stand out most prominently: 1. The increasing economic interdependence of nations. New elements of great future policy import have been added as the interdependence evolved, e.g., nuclear power and weaponry, the use of outer space, exploration of the ocean beds and Antarctica, electronic telecommunications, international pollution, the mass migration from the third world to the developed countries, the explosion of third world indebtedness to the developed countries. 2. The West-U.S.S.R. conflict and the assumption by the United States of responsibility for the dominant role in dealing with it. As the conflict evolved, acceptance of the "domino theory" as a policy precept led both powers to intervene anywhere and mobilize allies everywhere. 3. The development of powerful competitors determined to challenge U.S. economic hegemony in the world economy. 4. Governmental commitment in the big trading nations to assure satisfactory domestic economic performance. 5. The emergence of Communist China and the third world as a self-assertive, loose coalition with certain common objectives, e.g., foreign aid, price parity with products from the developed countries. 6. A great increase in the size of the U.S. foreign balance relative to total domestic economic activity. 7. The global spread of the giant multinational corporate conglomerate, supported by home governments. Merely taking stock of these developments is sufficient to indicate the enormity of the required future governmental involvement. Prior to the annual joint meetings of the World Bank and the International Monetary Fund in September 1986, the Group of Five (the United States and its four major trading partners) were faced with a "surveillance exercise" regarding the rift in the group over the exchange value of the dollar. The exercise involved group examination of each member country's price performance, growth rate, public budget, balance of payments, exchange rates, and forecasts of all those economic indicators. What better example of the indis-

270 The Inevitability of Government Growth pensable connection between domestic and international matters? It is as true in the international as in the domestic economy that A's options depend upon B's choices. It is also a unique feature of international relationships that government neither can nor wishes to "privatize" or "deregulate" any of them. Furthermore, the force of none of the seven categories of change listed is likely to be vitiated or arrested in the foreseeable future. On the contrary, they are all pregnant with future implications of government expansion. And no American government can afford to stand aloof from the grave responsibilities foisted upon it by these momentous developments. Petroleum is a vital international industry. It is an industry whose output and prices we would like to deregulate but the governments of the rest of the world are not likely to allow it. Organization of Petroleum Exporting Countries (OPEC) is a cartel formed by nations who control the price and output behavior of the oil companies operating within their borders. Other societies also control their oil companies for a variety of reasons. Many large capitalist countries have nationalized one or more of their large oil companies, and of course, the communist countries own their oil organizations. This pattern is illustrated in table 11.5. Given the extent of global government commitment to manage the petroleum industry, the U.S. government will try to control oil and gasoline prices in the country and the world or it will let other countries' governments do it. But it is not likely to be a free market in the usual sense. The government will in the future have to protect American consumers and businesses from oil and gasoline price shocks such as struck the country in the 1970s. GOVERNMENT A S ENTREPRENEUR

In teaching the theory of a market economy, western economists have developed a fourth factor of production, the entrepreneur, who accumulates parts of the other three factors: land, labor, and capital, and uses them to produce something the entrepreneur believes the community will want and buy in sufficient volume to cover costs of production and yield an income. Although physically identical to other people, entrepreneurs behave differently. They accumulate resources, innovate, and produce at risk. They do not know if they will have an income until after the production and sale of the good or service has been completed. If entrepreneurs did not exist, the goods and services available in the market would never change and the society would be stable in types of output.

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Entrepreneurial activity, centered upon both risk assumption and risk reduction, is usually described as an individualist act and associated with businessmen. These associations are incorrect. All societies, not just market economies, perform the entrepreneurial function and develop new products and technologies that increase their output, satisfaction, and technical sophistication. We have encouraged entrepreneurial activity among our businessmen and we get a lot of it. Government has significantly increased the probability of successful business entrepreneurship with such things as the patent, copyright, and mining claim laws. In each case if a private firm or individual can discover or develop a process, symbol, or resource product that the market is expected to value, the government will secure the individual's rights in that symbol, process, or resource. In the case of mining claims the government will actually convert property from public to private ownership as a part of this process. Government and private entrepreneurs jointly produce the value in patents, trademarks, and mining claims. However, we allow the TABLE 11 -5. Nations Owning Oil Companies

OPEC countries Algeria Ecuador Gabon Indonesia Iran Iraq Kuwait Libya Nigeria Qatar Saudi Arabia United Arab Emirates Venezuela

Capitalist countries with governmentowned oil companies on the Fortune 500 foreign industrialists list and not in O P E C Argentina Austria Brazil Canada Colombia Finland France India Italy Malaysia Mexico Norway Spain Turkey West Germany

Communist countries with large oil production or potential China Rumania U.S.S.R.

Source: Fortune, July 31,1989, pp. 290-314. For OPEC membership as of 1985, The World Almanac, 1985, p. 626.

272 The Inevitability of Government Growth private holders to get most of the income f r o m such activity. Other societies have other rules, but their people continue to develop new processes, invent popular symbols, and search for minerals. Much of the research and the direct services of government agencies such as the Department of Commerce; the research, pamphlets, seminars, and loans of the Small Business Administration; the data collection and dissemination of the Bureau of the Census; the Commercial Counsellor Service; the Weather Service; the county agent system; and the land grant universities are dedicated to making the lot of the private entrepreneur less uncertain a n d more likely to be profitable. These historically rooted activities are entrepreneurial in and of themselves. Government also has for long acted as a risk-taking, innovating entrepreneur on its own account. It collects resources and produces or makes possible private production that could not occur without the government's taking part or all of the risk. In 1803 President Jefferson had printed and sold a special issue of bonds to raise the money necessary to pay for the Louisiana Purchase. Those "unofficial" government bonds were never listed as part of the national debt. But they enabled the government to almost double the area of the nation. We are comfortable with the idea that the output of the United States today is higher than it would be if we had not purchased Louisiana. In the logic of microeconomic profit theory the government earned a share of that extra output to which it contributed. But we do not keep our social accounts in a such a way as to allow for the measurement or even the existence of such long established productive government activity. Much of government entrepreneurship is associated with largescale or long-time projects entailing m a j o r uncertainty. Anything that costs more than any private business has ever raised or takes longer to complete than a private entrepreneur's or a corporate executive's lifetime is not likely to be undertaken by the private sector. Louisiana, the space program, the atomic industry, the transcontinental railroads, the early canals, the interstate highway system, most of the great bridges, the large municipal airports, air traffic control systems, m a j o r sewer works, m a j o r flood control projects, city transit systems including streets, the pacification of conquered territories (the West), and long-distance movement of water for irrigation are some of the significant areas of government innovation and risk assumption. Like all innovative entrepreneurial activity, government produces, in its unique role as citizen representative, in the face of uncertainty. Not all such activity is successful. In the canal boom of the 1830s and

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1840s many canals were built but scarcely used. Similar mistakes still occur in building roads. The boundaries of the Mexican cession were drawn by negotiators uncertain of the terrain of southern Arizona, forcing the corrective expense of the Gadsden Purchase. The market system needed the Gadsden land to get the nominally private Southern Pacific Railroad into southern California. We say "nominally" private because federal government land grants paid to construct the roadbed and the cities paid to construct the terminals. Even with all that government risk assumption, the railroad went bankrupt. In private industry, bankruptcy frequently leads to a sale of the assets of the concern to other businesses who try to find other uses for them. In railroad bankruptcy, a government proceeding, the resources have typically been preserved as a railroad, and some system to cancel debts and paper assets is substituted for breaking up the real assets, which are necessary social infrastructure. This may make little private market sense. But for most transcontinental railroad owners, their most interesting alternative was land speculation. If good transport between the regions of a nation is necessary to preserve and develop the nation, as is widely believed, holding railroads to a profit rule in a frontier economy would doom that frontier to a lower development path that would make it a different society and eventually a different country. All the railroads to California went bankrupt. The government transferred the risks to itself and kept them operating anyway. Today California is our richest state. The bankruptcy of the Penn Central railroad, a badly managed giant company dominating overland transport in America's industrial heartland, produced a more recent example of successful governmental entrepreneurship in the railroad industry. The government took over the assets of Penn Central, sold off some, and managed the rest. It is now called Conrail and is again profitable and therefore about to be returned to private ownership. Simply, government managers succeeded where private managers had failed. The result is more government-preserved private enterprise. The space program is the largest and most obvious current example of the United States as direct entrepreneur. It has now consumed at least $6 billion in 1982 dollars of federal expenditures every year since 1963. We have gotten some good returns: communications, weather, geological survey, and spy satellites. Because of the limited lifting capacities of rockets we have been induced to do a great deal of research on microminiature electronics systems. Many of these have developed independent, successful, commercial lives. Several of

274 The Inevitability of Government Growth the satellites are privately owned and there is much discussion of the development of private rockets. However, private expenditures on space ventures are but a tiny fraction of the government expenditures. This relationship can be expected to continue for the foreseeable future. It is important to remember that some things should never be private. Rockets were developed by governments to deliver bombs. The nuclear industry is the child of the atomic b o m b industry. Reactors make fissionable materials. No sensible society wants these weapons factories or their products freely for sale on the market. Often the role of government as innovating entrepreneur has been to develop a new industry until most of the large risks have been absorbed into the public budget, then to encourage private businesses to take over the government-created industry. It was a governmentfinanced gun production contract that induced Eli Whitney to develop the system of interchangeable parts. It was a government-financed telegraph line that enabled Samuel F. B. Morse to demonstrate the value of telegraphy. Many of the wonders of modern agricultural technology were first developed in the land grant universities and agricultural experiment stations and are now commercially produced and sold. The entrepreneurial function is to innovate and to bear both risk and uncertainty (i.e., noninsurable risk, commitments the probabilities of whose outcomes cannot be predicted in advance). It includes not only risk assumption for oneself. It also protects others a n d their property against the risk of possible losses of various kinds. This second kind of entrepreneurship, which likewise entails the minimization of risk, is associated with insurance, both private and social. Much risk is insurable, that is, the probability of a variety of pertinent outcomes can be roughly calculated. Prior to the early twentieth century in the United States, protection against certain risks was instituted by private businesses and addressed largely to the insurance of private property. Voluntary life insurance for a relatively few individuals, and later groups, was the m a j o r exception to the emphasis of private insurers on private property. Thus we had marine, fire, casualty, and liability insurance, overwhelmingly for private business by private insurance entrepreneurs. Government Insurance

Such insurance arrangements were contracted for voluntarily, and the government was not engaged in compulsory insurance activities.

The Inevitability of Government Growth 275 It only regulated such activities increasingly as time passed and as the public demanded protection against fraud and other h a r m f u l actions. Three severe limitations in the larger position and role of the publicly regulated, private insurance business gradually emerged and became glaring in the twentieth century. The first grew out of the ever-expanding investment connections of this burgeoning insurance industry with the entire network of banks, trust companies, and securities markets. Indeed, the connections necessarily had to extend beyond the financial sector deeply into nonfinancial business and households. To properly insure property against a large disaster like the San Francisco earthquake or the Chicago fire, the industry needed large amounts of assets distributed all over the country. Each company in the industry needed to hold a part of the total portfolio that was similarly distributed. Consequently the insurance industry became the largest holder of real estate in the country and one of the largest customers of stock brokers, real estate brokers, and banks. It was also a principal rival of the banks and trust companies in making loans to large businesses. To lower its risks the insurance industry developed rules about such matters as the quality of building construction and the maintenance of boilers. Businesses that did not pass insurance inspections could not be protected. Similarly, individuals were required to have medical checkups and were not protected if the results were not optimistic. The insurance industry was a pioneer in interfering with the day-to-day affairs of other private businesses and families. The insurance industry refused to insure the owners of ill-constructed buildings and ill-maintained boilers against the loss of their property and the losses incurred in lawsuits against the owners of such property for the torts they imposed on innocent third parties. But it did not have the power or the interest to say private entrepreneurs could not purposefully operate equipment and buildings that threatened the lives of their neighbors, employees, and customers. Only government can do that. The insurance industry often taught the government how to inspect buildings and boilers. But the people generally were not safe until the government m a n d a t e d safe building practices, boiler construction and maintenance, and reasonable tort insurance coverage by property holders to protect their neighbors. Government in effect became a sales agent for insurance coverage. This occurred early with fire, casualty, and marine insurance and much later with auto insurance.

276 The Inevitability of Government Growth These interrelationships within finance and with businesses and families have today made the insurance industry, because of its scope, more affected with a public interest than the public utility industry. There is no way it can retain an exclusively private entrepreneurial character. A second and more far-reaching limitation has been the failure of private insurance entrepreneurship to provide at all adequately for insurance to individuals against exposure, as emphasized by Roy Lubove, "to the long and short-term risks which interrupt income flow: accident, sickness and maternity, old age and invalidity, unemployment, or death resulting in impoverished dependency." The defection of private insurance entrepreneurship in these great areas of h u m a n risk and uncertainty continued for so long that the risks were finally assumed, to a major though incomplete extent, by government in the form of compulsory social insurance. This area of government risk-reducing entrepreneurship began in Germany in the late nineteenth century and spread throughout the developed economies, coming last to the United States in the 1930s. Even with half a century of foreign government development to guide them, American insurance companies avoided social insurance. Like all peoples faced with needs and no market response we turned to the government, which did respond, albeit more slowly than other governments. Public assumption of these risks is the hallmark of the developing welfare state everywhere. There is in the United States today a continuing cry to eliminate government-operated social insurance and replace it with various private contractual arrangements. Most private pensions and health insurance programs were developed, significantly enough, after social insurance. There is no evidence of private market a t t e m p t s to remove the day-to-day risks of life for most of the population until after the government had shown such devices were possible. If we do at some future date "privatize" these programs, it will not change the fact that the government was the original risk taker and resource collector, i.e., entrepreneur, in this great area. Furthermore, as with privatization in general, government would have to monitor the system continuously. It is certain that without government rules many of the least profitable parts of social insurance would be eliminated by any profitoriented insurance program. For example, most private pension programs are designated benefit programs. That means the pension beneficiary receives a known invariant a m o u n t per month after retirement. The risk to the pension insurance company is reduced to the

The Inevitability of Government Growth 277 risk that the recipient will live too long after retirement. Social insurance increases the monthly payments to long retired people because we judge standards of living for the old today against those of the young today. If workers continually earn more and the elderly do not, then the elderly become most of the poor. This grim dilemma is true whenever there is real economic growth increasing the incomes of the employed or when inflation increases the money incomes of the employed. We can privatize social insurance only if the government forces private insurance companies to act like government insurance companies. Otherwise, privatization is simply a significant reduction in the standard of living of the sick, the weak, orphans, the old, and the poor. If private action is determined by government fiat, as it must be to a significant extent in this case, then "privatization" does not change the extent of government influence in the economy significantly. The third great failure of the private insurance sector was its utter incapacity to underwrite the insolvency of the big nonfinancial firms and sectors that held in their hands the fate of the entire economy's performance. Indeed, it was never a part of the vision of private insurance entrepreneurship to succor the nonfinancial business or household sectors in the case of impending general economic crisis or disaster. For domestic insurance companies to offer insurance against a general economic collapse to their many business customers, they would have to hold significant assets within the economy that were not affected by the collapse (impossible by definition) or hold a significant share of their assets in other countries not affected by the vagaries of our economic cycle. The best example of an economy whose economic performance is unrelated to the GNP of the United States but whose assets are large enough to be significant in a portfolio securing the assets of American businesses is the Soviet Union. Although they understand the principles behind spreading risk, American insurance executives are far too conservative to use those principles if it involves investing in countries with anticapitalistic governments. There are some American insurance company investments in foreign capitalist markets. Unfortunately, large economic cycles seem to strike all capitalist countries at about the same time so there is little possibility of avoiding cycle risk by investing overseas. The failure of private insurance to protect its business customers from the economic cycle and economic stagnation has led to ever greater calls for government to provide such protection. Even in the

278 The Inevitability of Government Growth salad days of private insurance the economic crisis of 1857 forced several American state governments to come to the aid of partially constructed railroads. Most Americans have forgotten this government bailout of local big businesses in hard times. But such public underwriting of so-called private assets, together with the government bailout, was the handwriting on the wall. Ever more frequently we have heard that the government cannot allow some large business to fail. Indeed, such government intervention has begun to occur so frequently in contemporary times that, while we in the United States eschew nationalization, we at last are beginning to see "as through a glass darkly" that business and government risk assumption and minimization have become fused. The age of fission into private and public sectors is over. The economic system and the public cannot any longer tolerate a serious fissure in any of its sizable parts. This makes the government the intervenor of first resort. In a basic sense there is no longer, therefore, an independent, private entrepreneurial economy in any large sector of society. Entrepreneurship has gone social. These momentous historical transformations in the evolution of risk assumption are as yet scarcely appreciated. But they are clearly necessary consequences of both the rise of the welfare state and the assumption by the federal government in 1946 of responsibility for the publicly satisfactory performance of the economy. These are the two great hallmarks of the modern mixed-economy era. This has long been recognized in the life insurance industry, wherein most of the large older companies are mutual companies. In such firms the owners are the policyholders. The entrepreneur-risk taker is the collective of all customers. In 1986 there were 391 million life insurance policies in force covering a large proportion of the population of 241 million. They had an average value per family of $69,100. We the people have long been the entrepreneur in that industry. The government has developed many new forms of insurance that in turn have fostered significant increases in private business activity. In the Great Depression a substantial fraction of all of the commercial and savings banks became insolvent. This left their customers bereft of their savings just when they needed them. The government's entrepreneurial response was to develop deposit insurance, which protected small depositors against the failures of bank managers. Certainly the deposits in banks and thus the banks' abilities to make a profit would be less if there were no deposit insurance. In the late 1980s we are learning that the insurance premiums for

The Inevitability of Government Growth 279 bank insurance and the strength of government bank inspection have been insufficient to protect us against widespread failure of commercial and savings banks. This leaves the government in the difficult position of either using funds from the Treasury to bail out the Federal Savings and Loan Insurance Corporation (FSLIC) and possibly the FDIC, or seeing a substantial proportion of the peoples' deposits disappear again. For both the savings banks and the commercial banks the rules governing the amount of capital they must hold against deposits have been suspended in many cases. Banks that by usual legal and accounting definitions are insolvent are allowed to continue in business soliciting deposits from citizens ill informed of their precarious condition. As government conspires to break its own rules to keep the banks alive, it becomes increasingly morally committed to preserve the deposits of the customers of these ill-managed banks. Government has increasingly accepted these responsibilities. It is spending vast fortunes keeping the otherwise dead banks afloat and trying to merge them into still viable institutions. Government often has to subsidize the successful banks to get them to take over the failed ones. Merging the deposits of a failed bank into the deposits of a successful one may reduce the cost to the public bank insurer when compared with paying off on the deposit insurance policies. A major mistake in the government insurance of private bank deposits was limiting the insurance to small deposits. This greatly lowered the premiums the large banks had to pay for their insurance. But if a large bank fails, its big depositors are likely to fail with it, since they will no longer have the deposits needed to pay their bills. Unfortunately, a significant fraction of the large banks in the United States have been very badly managed in recent years. This bad management has led to the failure of several very large banks in major commercial centers. But the economy probably cannot tolerate the failure of a very large city bank. Hence the government has been suspending the reserve rules, searching for merger partners, and in other ways making sure the big banks do not close. Very few cases show more clearly the deep public entrepreneurial involvement with "private business." The most extreme case so far is Continental-Illinois Bank of Chicago, which at one time was the seventh largest bank in the United States. It failed, but we could not afford to let it die. The federal bank inspectors took over the bank, opened its books to the banks of the world, and asked for bids. It was in such bad condition that they got no bids. Consequently the federal government actually runs that bank.

280 The Inevitability of Government Growth It is doing a much better entrepreneurial job than the private managers did. But it has cost the government banking agencies a great fortune to preserve the bank and with it much of the economy of the Midwest. Similar patterns have been widespread in the stock broker industry. In the late 1960s many of the country's most eminent brokerage houses confessed that their bookkeeping practices were so weak they had no idea where many of their clients' assets were, or even if they existed. Yet they were supposedly providing management advice, securities storage and general business wisdom to their clients. As a result the government's Securities Investor Protection Corporation (SIPC) was invented to lower the risks to the citizens of doing business with brokers. It undoubtedly increased the business that nominally private brokers were able to do. An original entrepreneurial innovation from government to the finance industry was what we now call the "conventional" mortgage. In that mortgage a person or family makes a small down payment on a house, then makes a modest regular payment covering some principal and the interest for a long period, like twenty-five to thirty years. This type of mortgage and the underwriting of it was pioneered by the Federal Housing Administration (FHA). It ran an insurance program protecting banks and S & Ls from their customers, the opposite of the FDIC and FSLIC, which protect customers from the banks and S & Ls. When the bank made one of these long-term mortgage loans to citizens, it could, if FHA approved, insure the loan. In such a case, a quarter percent was added to the interest rate the borrower paid. That quarter percent was an insurance premium received by FHA to pay off on defaulted mortgages. After a few years many banks and S & Ls abandoned the use of FHA because they learned that Americans almost never default on home loans. By not using FHA they could keep the quarter percent themselves and thus make more money. But it was government that developed and sold the idea of the insured conventional mortgage and originally took the risk of nonpayment. Government has developed the specialized entrepreneurial skill of risk underwriting to a particularly refined degree. The government created Government National Mortgage Association (Ginnie Mae), Federal National Mortgage Association (Fannie Mae), and Federal Home Loan Mortgage Association (Freddie Mac) and thus established large, stable, federally guaranteed secondary markets for home mortgages. Consequently, the traditional financial institutions were increasingly willing to invest in the new more liquid

The Inevitability of Government Growth 281 (less risky) mortgage pools. A side effect of this government entrepreneurship was increasing competition for Savings and Loan associations. When combined with large interest rate increases in the late 1970s and 1980s and the generally weak S & L management, it led to the de facto death of much of the S & L industry, even as we financed a housing boom in the 1980s. Moral: large interventionist innovations can produce unexpected spillover effects on both government and the rest of society. By paying the costs in the event of failure, government becomes the underwriting entrepreneur. Banks that make profits give them to the stockholders or managers. Banks that lose money are saved by various government agencies. This is not because we love the bankers but because the effects on the community of financial collapse are too horrible for the public to bear. Various special forms of public insurance to enable or expand some private activity are also very common and can reasonably be expected to grow in the future. Many banks have proposed an FHA to protect them from third world and other governments' defaults (which they have recently proved they badly need). The New York Times reported, "The policy being developed by the Administration and the Federal Reserve also implies that taxpayers in the United States and other industrial nations could become liable for some of the debt on which countries stop making payments. The shift in the nation's policy on third-world debt represents an effort to deal with the pressure from Congress, debtor nations and major allies, like Japan and France." 36 The Price-Anderson Act limits the insurance liability of the atomic power industry, thus lowering the costs of running nuclear power plants, and thereby putting a moral burden on the Treasury to cover the costs of an American Chernobyl if we are ever so unlucky. We also insure, and in some circumstances forgive, loans to students, farmers, small businesses, the victims of great natural disasters, etc. The government thus lowers the risks of a very wide range of so-called private activities. It does so by shouldering some or all of the risk burden in those areas. In economic theory, many forms of risk can be ameliorated by futures contracts rather than insurance. Unfortunately, most of the necessary contracts do not exist. Either no private entrepreneur has offered them or no customers have accepted the offer. Since the development of such contracts has been legal for most of the history of private markets we must conclude that private entrepreneurs will not accept this challenge. N o society provides a set of contracts to reduce all the risks in every kind of investment. There is also some very real

282 The Inevitability of Government Growth evidence that futures markets are more dominated by speculation than by hedging (an insurance activity). To the extent government is involved in futures markets it mostly attempts to limit the fraud, excessive leverage, and unproductive speculation that seem rampant in those markets. Qovemmsnt as Ultimate Loss Bearer Increasingly we hear demands on the government to save or reshape the practices of some business because it is in the general interest of either society as a whole or an important group or region. In finance, insurance, public utilities, transportation, and agriculture the government has been a significant force helping to decide the fate of firms or groups of firms for more than a century. The National Banking Acts of the 1860s were aimed at protecting the public from the loose behavior and unstable currencies of the western and southern statechartered banks. National government policy was thereby established to either change the behavior or to eliminate a privilege enjoyed by some private businesses. Government as ultimate loss bearer is not the same as direct government entrepreneurship. If some private risk takers develop a business or industry, produce for a while, and then begin to lose in the higgling of the market, traditional capitalist thinking says they should lose control of their resources, which are obviously ill used since they fail the profitability test. Those resources can then be taken up by new private entrepreneurs who may find a profitable use for them. But preserving formerly unprofitable resources may preserve an inefficient allocation of resources and lower the output of society in general. Businesses in such unpleasant circumstances increasingly cry for government aid. To succeed at this they argue that they have a social importance, that they are not purely private. Business leaders who succeed in such arguments are essentially destroying the logical basis for a private market economy by arguing that their industry is socially necessary and thus deserving of social bailout. Over time, crisis comes to almost every industry, so businessmen are implicitly giving capitalism the death of a thousand small cuts, as each industry in turn tries to prove it deserves social bailout or subsidy. Some industries have long traditions of political action to make sure the government sets the game up so they cannot lose. Oil is a particularly active political industry that virtually always has had special provisions, which at different times have included new forms

The Inevitability of Government Growth 283 of corporate charters from New Jersey and Delaware to lower the private risk of monopolization; taxes on gasoline with spending restricted to the construction of roads; depletion allowances that exceed the cost of the resources depleted or the cost of replacing them; import restrictions for each state, managed by the Texas Railroad Commission; high tariffs, quotas, or prohibitions on the importation of foreign petroleum; rules treating the OPEC cartel price as the market price; and massive bailouts of the economy of the "oilpatch" when world market prices fell. Industries like petroleum have argued that they were socially necessary and deserving of social government help even when they were very profitable. Those entrepreneurs and managers have discovered that manipulating government behavior to protect established patterns or products is often more profitable than developing new or better goods and services. Such businesses often preach against government intervention at the same time they demand more of it. The most strident antiinterventionist attacks are against taxes and other devices that increase business costs, such as employee health and safety regulations. Such group policies make no social sense. If it is the role of government as entrepreneur to make life both less uncertain and more profitable for more and more businesses, then government needs to be paid more profits. If it is to relinquish all entrepreneurial activity and return to laissez faire, then businesses, to be consistent, have got to stop demanding more help. Of course, demanding help is the fundamental civil right of the citizen to petition the government for redress of grievances. So businesses will not stop demanding public underwriting of their profits. Nor can we stop them without losing this fundamental civil right. The general conclusion from all this is that business increasingly petitions the government to make the important microeconomic decisions. Early government entrepreneurial activity was focused on building the empire and expanding the boundaries, population, and influence of the nation. The state has done much to improve the availability and quality of society's resources, which include such diverse programs as the first national park service in the world and the first attempt at general free public education. In the past, government at all levels spent mightily to preserve the nation as one community through such policies as: 1) better communication—Post Office, postal subsidies to airlines in their formative years, the demonstration of the usefulness of telegraphy, launching

284 The Inevitability of Government Growth communication satellites, as well as sorting out and policing the radio spectrum; 2) programs to improve transportation and social infrastructure—port and road construction, railroad land grants, air traffic control, aircraft research, and discipline of the Barbary Corsairs; 3) the containment of rival systems—the Indians, the Monroe doctrine, wars against Canada and Mexico early in our history, against Fascism and Communist expansion later, and most spectacularly the Civil W a r and Reconstruction, which destroyed the most successful noncapitalist economic system in North American history. In the present century, in addition to the necessity for continued traditional infrastructure support, more of the entrepreneurial effort of the government at all levels has been and probably will be devoted to such matters as developing or introducing the use of new goods and services that are valuable to the community—traffic control devices, traffic planning and enforcement equipment, many of the new vaccines; lowering the risks of everyday life—building sewers and water purification and distribution systems, arresting pollution and environmental damage, enforcing mandatory vaccination rules, adopting building codes, inspecting dangerous goods such as aircraft, food, and, increasingly, motor vehicles to make them safer, and most expensively, adopting social insurance to ameliorate the pains of being old, widowed, orphaned, unemployed, injured at work, or old and sick; and lowering the risks of the financial system. In this review of government as entrepreneur we have attempted to show that the governments in the United States have always been entrepreneurial and have become increasingly so. Government entrepreneurship is impressively comprehensive and diverse. It innovates and bears uncertainty directly. In many cases it does so to inaugurate projects that subsequently are turned over to private entrepreneurship that was initially too timorous. In many other cases it underwrites private risktaking through various forms of social insurance. And finally, public entrepreneurship has taken on the abiding burden of anticipating so as to prevent unforeseen overall economic collapse in the private sector. In the new world of public-private decision making the government absorbs part or all of the losses created by failed private entrepreneurship. The profits of successful entrepreneurship remain in private hands. Yet the economic defense of the large incomes and wealth of successful entrepreneurs is in part based on the fact that they faced great uncertainties to produce the goods and services that benefit us so much. With government increasingly absorbing the downside part of the risk, entrepreneurs need to find a new defense for their incomes.

The Inevitability of Government Growth 285 Otherwise society will eventually recognize that government earned part of the entrepreneurs' income and so deserves part of it. The irony of all this is that by demanding and getting so much government aid private entrepreneurs have inadvertently reestablished the logic of their despised progressive income tax, even as the 1986 tax reform effectively abolished it.

GOVERNMENT A S A SELF-REINFORCING GROWTH P R O C E S S

There may well be some functional connections between the long-run rise in per capita income and government growth in certain departments. But a better explanation is found in the built-in propensities of our contemporary society to appeal to government to resolve its galaxy of burgeoning economic and social problems. There is a general concept that brings together the long and no doubt incomplete list of such propensities that we have enumerated. It is attributable to the famous Swedish economist Knut Wicksell, and is called "cumulative causation." In addition to government's spending responsibilities, the growth of government administrative involvement in intergroup conflicts and in the related tasks of coping with market failure exhibits the operation of a law of cumulative causation. This means that the growth of public sector involvement has become self-reinforcing. The reasons for this self-reinforcing development are easy to unearth. Under laissez faire and in the context of low GNPs per capita, the deep-rooted conflicts in society either were directed mainly into the market nexus or they failed to surface as large-scale, organized contests. Yet the evolution of the market system itself produced an end to that era. There emerged an intensification of giant intergroup rivalry and increasingly organized expressions of that rivalry. Concomitantly there developed a growing awareness of market failures and a spreading conviction—initially by business enterprise—that the "unfettered" market could not resolve the important conflicts satisfactorily to the concerned and frequently warring participants. There ensued the emergence of a private policy of transference of the issues to the governmental arena for resolution. Along this route there could be no "omniscient planning," and the public sector expanded willy-nilly as an adversarial arena devoted to conflict resolution and functioning as provider of social alternatives to the perceived, defective private-market solutions—or absence of market solutions—for big socioeconomic problems. Consequently, what was

286 The Inevitability of Government Growth already in the United States a government of many parts, localities, and levels took on more tasks and got ever more interventionist. But there was more to the process than a mere increase in size and proliferation of public tasks. The opportunities for the transfer of intergroup contests to the public sector also grew along with the multilevel government's size and complexity. The concerned groups in the private sector became better organized, worked to acquired expertise at their political pressure and public relations tasks, and became more habituated to, and effective in, that kind of endeavor. Meanwhile, the long-run rise in per capita income and its discretionary component, together with the accompanying spread of education and the democratic impulse, enhanced social perceptivity and provided the means whereby additional groups could get into the act. These challenged the prior hegemony of business in the public arena of conflict over property rights and greatly expanded government intervention into the field of more human concerns. Such historical developments further enlarged and diversified the public sector. At some point in this process the government crossed a size threshold such that it began to function as a powerful invitation to all parties in contest and all organized social strata perceiving some market failure to turn toward government for solutions. The greater governmental intervention elicited additional "protective reactions" and other related pressure activity by the groups involved. Consequently, these activists stepped up their intergroup rivalry for favorable dispensations by government. The various departments of the vast government hierarchy systematically cultivated their respective supporting constituencies. The "incremental rule" linking percentage agency fund requests and additional budgetary appropriations also lent support to the momentum achieved by government agencies. Additional government resources become required also to deal with the growth of internecine, adversarial surveillance between public agencies trapped into overlapping responsibilities for oversight and administration of the same policy. This is illustrated by the interagency jockeying connected with the exposé of the failures of the Energy Department, the Congressional Joint Committee on Atomic Energy, and the Armed Services Committees of the Congress to disclose serious breaches of safety over the years at the Department's nuclear weapons facilities and laboratories in twelve states. Aside from the problem of vested self-interest connections between all the involved parties, the furor from the exposé made it clear that ever more numerous staff experts were called for, and Senator John Glenn

The Inevitability of Government Growth

287

attempted (in vain) to get a new independent safety review board set upSeveral states responded to the safety scandal with prohibitions of the transport and storage of nuclear materials within their borders. Some local governments saw these prohibitions as a threat to their principal local industries. Consequently several federal agencies, several state agencies and some local governments hired additional "experts" to justify every conceivable behavior. By the end of 1988 the New York Times N e w s Service reported, " T h e Energy Department plans a $27 billion to $46 billion program to clean up the radioactive and hazardous wastes left by years of o p e r a t i o n " (at the Hanford works in southeastern Washington state). 37 This nuclear management problem can only get worse until the national government seriously commits resources and staff to solve it. The proliferation of agencies described above is not evidence of commitment. Most of the money is devoted to research and construction of weapons. The other federal agencies are underfunded and denied places in the cabinet where these issues are discussed. Some of the state and local governments may be c o m m i t t e d to safe nuclear waste disposal, but they have neither the p o w e r to force the United States government to move toward it nor the resources to d o it themselves. In nuclear cleanup we see government agencies created to prevent action, not to take it. So it is that to do something and to d o nothing elicit the same response in America. Create a government agency. Crossing the huge government size threshold irreversibly set in motion the process of cumulative causation. A historically new, dynamic system (casually termed the " m i x e d e c o n o m y " ) has evolved as a result. It is now in full operation. The systemic character of the phenomenon consists in the whole nexus of g r o w i n g interconnections between government, the market, and society at large. In the absence of some powerful external constraint, almost all organized, and much individual, decision making must become in the future ever more "affected with a public interest" and therefore a stimulant to additional government participation in decision-making processes. Adolf Wagner's insightful forecast was correct.

NOTES 1. New York Times (March 29, 1989), p. 30 (italics added). 2. Letter to the editor, Johanne C. Dixon, Director, Social Welfare and

288 The Inevitability of Government Growth Family Services, National Urban League, New York Times (November 26, 1988), p. 22. 3. Anna Lou Dehavenon, "The Tyranny of Indifference and the Reinstitutionalization of Hunger, Homelessness and Poor Health," report prepared for the East Harlem Interfaith Welfare Committee (May 1988), p. 1. 4. The committee's report, and reference to complaints against the official d o c u m e n t ' s bland wording by a majority of the experts comprising the committee, was reported in the New York Times (September 20, 1988), p. 1. 5. Statistical Abstract of the United States (Washington, D.C.: GPO, 1987), p. 368. 6. Wall Street Journal (December 5, 1988), p. A14. 7. New York Times (March 9, 1989), p. 1. 8. New York Times (November 27, 1988), sec. 3, p. 1. 9. Alicia H. Munnell, The Economics of Private Pensions (Washington, D.C.: Brookings Institution, 1982), p. 168. 10. Robert J. Lynn, The Pension Crisis (Lexington, Mass.: D. C. Heath, 1983), p. 105. 11. J. M. Keynes, The General Theory of Employment, Interest and Money (New York: Harcourt Brace and Co., 1936), p. 159. 12. Murray Weidenbaum, "A Moderate's Proposals," in Kenneth S. Davis, ed., Arms, Industry and America (New York: H. W. Wilson, 1971), pp. 195-196. 13. Matthew Purdy, Washington Post (September 19, 1986), p. A25. 14. Robert H. H a v e m a n and Robert D. Hamrin, The Political Economy of Federal Policy (New York: Harper and Row, 1973), p. 6. 15. Cited in ibid., p. 254. 16. John R. Commons, The Economics of Collective Action (Madison: University of Wisconsin Press, 1970), p. 33. This work was first published posthumously in 1950. 17. Sheila Kaplan, "Capital Fun in the Sun . . . ," Washington Post (Sept e m b e r 14, 1986), Outlook section, p. 1. 18. Cited in Francis A. Bator, The Question of Government Spending (New York: Harper and Bros., 1960), p. 116. 19. Commons, The Economics of Collective Action, p. 137. 20. George F. Will, "Listen to Bill Bradley," Washington Post (June 5, 1986), p. A23. 21. Norman Ornstein, New York Times (June 26, 1988), sec. 3, p. 1. 22. New York Times (November 26, 1988), p. 8. 23. Tom Wicker, New York Times (November 25, 1988), p. 31. 24. New York Times (February 19, 1989), sec. 4, p. 5. 25. Alan Peacock, ed.. The Regulation Game: How British and West German Companies Bargain with the Government (New York: Basil Blackwell, 1985), p. 96. Cited in Anne Mayhew's review of the book in Journal of Economic Issues (March 1986), 10(1):253. 26. New York Times (March 9, 1989), sec. 2, p. 3. 27. Wallstreet Journal (November 29, 1988), p. Al. 28. Peter Passell, New York Times (May 18, 1988), sec. 4, p. 2.

The Inevitability

of Government

Growth

289

29. New York Times (December 27, 1988), sec. 4, p. 2. 30. Wilfred Owen, " T h e View from 2020: Transportation in America's Future," Brookings Review (Fall 1988), 6(4): 11. 31. Ibid., p. 14. 32. New York Times (February 21,1989), p. 1. 33. 34. 35. 36. 37.

New York Times (February 20, 1989), p. 1. New York Times (February 12, 1989), p. 1. David Boaz. Neiv York Times (March 17, 1988), p. 31. New York Times (March 9, 1989), p. 1. New York Times (December 8, 1988), p. 1.

N A M E INDEX

Alchian, Armen, 71 Allen, William, 71 Alperovitz, Gar, 128 Andreae, Clemens-August, 133-34 Aschauer, David, 259 Atkins, Chester, 202

Cline, William, 201 Coen, Robert M., 10 Commons, John R., 240-41 Cornwall, John, 159 Cornwall, Wendy, 159 Cuomo, Mario, 219

Bacon, R., 140 Balogh, Thomas, 40 Baneth, Jean, 175 Barro, Robert, 102 Bator, Francis M., 57 Baumol, William, 46 Beck, Morris, 130-31, 140, 143-44, 145, 148 Berlin, Isaiah, 240 Bernstein, Peter L., I l l Biehl, Dieter, 140 Bismarck, Otto von, 204 Blinder, Alan, 259 Boaz, David, 265 Borcherding, T h o m a s E., 135, 145 Bosworth, Barry, 184 Brandon, Robert, 258 Brown, E. Cary, 109 Buchanan, J a m e s M., 63 Burns, Arthur, 195 Bush, George, 230

Davis, Lance E., 171 Dehavenon, Anna Lou, 220 DeLeeuw, Frank, 100 Denison, E d w a r d , 7, 10, 14, 101, 161, 169 Domar, Evsey D„ 13, 155-56, 159, 170

Faux, Jeff, 128 Feldstein, Martin, 113 Fisher, Irving, 191 Fowler, Wyche, Jr., 202 Frankel, Jeffrey A., 171 Friedman, Milton, 40, 41, 44, 147

Campbell, G. R., 49 Carter, J a m e s E., 163, 203 Clark, Colin, 140

Galbraith, John K., 40, 48 Gallman, Robert, 8 Garrison, Charles B., 94

Eccles, Marriner, 128 Eisenhower, Dwight D., 114, 160 Eisner, Robert, 161 Eltis, W., 59«, 140

291

292 Name Index Genovese, John, 202 Glenn, John, 2 8 6 - 8 7 Goldbeck, Willis B„ 258 Goldsmith, Raymond, 8 Gordon, Robert J., 93«, 176 Grämlich, E d w a r d , 141

Hale, E. E„ 50 H a m r i n , Robert, 238 Hansen, Alvin, 12, 18 Harrod, Roy, 13. 161 Haveman, Robert, 238 Heilbroner, Robert, 52 Heller, Peter S., 135 Hickman, Bert G., 10 Hiles, Marc A., 182 Hoover, Calvin B., 45 Hoover, Herbert, 128 Huismans, Jan, 246

Marshall, Alfred, 144 Martin, William McC., 128 Marx, Karl, 208 Mayhew, Anne, 94 Meade, J a m e s E., 39 Means, G a r d i n e r C., 44, 52 Mill, John S t u a r t , 6, 12, 36, 38 Mohammed, 267 Morse, Samuel F. B., 274 Mosher, C. F., 55 Munnell, Alicia H„ 228 Musgrave, John C., 20, 112 Musgrave, Peggy B., 130 Musgrave, Richard, 130 Myrdahl, Gunnar, 51, 59—60«

Niskanen, William, 74, 145 North, Douglass, 35

Jefferson, Thomas, 272 Johnson, Nicholas, 239 Joseph, Sir Keith, 40

Oates, Wallace E., 147 Okun, Arthur, 51, 70, 101 Ornstein, Norman, 242 Owen, H„ 59

Kemp, Jack, 211 Kendrick, John, 7, 14 Kennedy, John F., 124 Keynes. John M., 12, 33, 36, 38, 53, 111, 117, 153-54, 161, 208 Kuznets, Simon, 8, 20«, 25-26, 148

Panic, M„ 59 Passell, Peter, 258 Peacock, Alan T., 140, 248, 266 Peterson, W. C., 51 Poland, O. F., 55 Purdy, Matthew. 238

Lerner, Abba, 62 Levy, Michael, 99 Lieberman, Sima, 43 Lubove, Roy, 270 Lynn, Robert J., 229

Quinn, Joseph F., 141

Machlup, Fritz, 14, 15 Maddison, Angus, 42, 159, 170 Malkiel, Burton G., 18 Malthus, Thomas R., 160

Reagan, M., 45 Reagan, Ronald, 114, 118, 124, 128, 163, 202, 211 Ricardo, David, 149, 160 Rivlin, Alice, 113 Rockoff, Hugh, 93 Roosevelt, Franklin D., 254 Roosevelt, Theodore, 266

Name Index 293 Salinas, Carlos, 225 Samuelson, Paul A., 41, 70, 103, 114 Schlesinger, Arthur M., Sr., 64 Schultze, Charles L„ 14, 55n, 59 Schumpeter, Joseph, 18, 35, 36, 50 Seidman, L. William, 227 Solow, Robert, 161

Tait, Alan A., 135 Tarschys, Daniel, 26, 3 2 - 3 3 , 48 Thant, U, 153 Thatcher, Margaret, 259 Thurow, Lester, 126 Titmuss, Richard, 33 Triplett, Jack, 71 Truman, Harry S., 92n, 93, 254

Vatter, Harold G., 14, 2 1 « Volcker, Paul A., 60 von Furstenberg, George M., 18

Wagner, Adolf, 3, 55n, 144, 145, 202, 223, 236 Walker, John F„ 14, 82, 161 Wallich, Henry, 52 Weidenbaum, Murray, 237 Weintraub, Robert E., 80 Whitney, Eli, 274 Wicksell, Knut, 285 Will, George F., 241 Williams, R a b u m , 70 Wilson, Wood row, 267 Wiseman, Jack, 140, 266 Worswick, G. D. N„ 54

S U B J E C T INDEX

Accelerator, 111 Agriculture, 106, 234, 236, 240

Baby boom, 106, 127-28, 143, 149, 222 Blacks, 253-54 Bretton Woods, 181 Budget: balanced public, 1 - 5 ; and full employment, 77, 86, 99-100, 109, 124; public, 64-65, 184, 204-7; and public deficit and crowding out, 156; and public deficit by president, 62-69; and public deficit and trade deficit, 184-85, 197; and public deficit and Vietnam War, 74-76 Bureaucracy, 32, 48, 249, 287

Capacity: investment and, 4, 14, 18, 157-58, 161-62; ratio, 11,111, 113; utilization, 10-11, 156, 157, 159-60, 188 Capital: human, 7, 39, 111, 123, 155, 211; intangible, 123; ratio, 8, 155, 159, 161; stock, 6 - 9 , 109-10, 123, 137, 155, 160 Capital-Labor ratio, 12 Children, 219-20, 222, 229-30, 251, 252-53, 256

Cobb-Douglas function, 10 Cold War, 71, 136, 237 Consumption, 12-14, 38, 174-76, 210 Contracting out, 139, 206, 237 Crime, 243, 261-66 Crowding out, 18, 156, 163, 166, 184 Cumulative causation, 285, 287 Cycles: economic, 44-46, 106, 195; political, 150

Debt: foreign, 200; public, 1-5, 1617, 62-69, 180-81, 187 Demand: management, 53-54; role of aggregate, 155, 156-57, 162, 170, 175-76, 212 Dollar: exchange value of, 181-84, 201 Drugs, 261-66

Education, 221, 264; higher, 143, 234-35, 254-55; and productivity, 211, 234-35; state and local, 133, 145 Eisenhower Stagnation, 114, 160 Elderly, 34, 216, 219, 222, 256, 257 Employment, 122; public, 24, 30-31, 40, 131-52, 250 Employment Act of 1946, 34, 209

295

296 Subject

Index

Employment Retirement Security Act (ERISA), 228-29 Energy, 212, 244-45, 257, 287 Entrepreneur: government as, 27085 Environment, 106, 243-48 Exports, 116, 173, 176-77, 187, 19798; capital, 15-16 Externalities, 46-47

Federal Deposit Insurance Corporation (FDIC), 212, 226-28, 278-79 Federal Housing Administration (FHA), 280-81 Federal Savings and Loan Insurance Corporation (FSLIC), 280 Financial sector, 224-34 Foreign balance, 173-88, 236, 269 Fraud, 230-32, 245, 282 Full Employment and Balanced Growth Act of 1978 (HumphreyHawkins), 124, 148, 162-63 Fusion: public-private, 208, 213, 214-15, 233, 237, 250; and risk taking, 210, 278, 284

General Agreement on Tariffs and Trade (GATT), 186, 200 Government: administrative involvement, 202-89; state and local, 2, 25-26, 246; state and local employment, 147-48; state and local as leading sector, 115, 122, 126; total expenditures of, 130, 156, 181, 200; total expenditures and economic growth, 126-27, 163-64, 170, 174-75, 190; see also Military spending Growth rate: "natural," 154 Guidance: public, 204-7

Harrod-Domar model, 13, 101, 106, 112, 161-62

Health, 221, 255-59, 264 Home Loan Bank Board, 212

Imports, 115, 116, 173, 174, 181, 187 Income: distribution of, 16, 47, 21323, 241; policies, 51-54, 117-18, 128, 218-19; policies and the foreign balance, 184, 199; policies in wartime, 87-88, 93, 96, 99 Industrial policy, 241-42 Inflation, 97, 106, 156, 174, 184; and administered prices, 51-52; and interest rates, 187-201; and Vietnam War, 70-104 Infrastructure, 126, 129, 224, 234, 273, 283-84; and growth, 2 5 9 61; quality of, 106, 212, 259 Innovations: capital saving, 9, 14, 37, 108, 111, 154, 161-62, 211 Insurance: government, 274-82 Interest groups, 238-43, 249, 286 Interest rates, 182-201 International influences, 269-70 International Monetary Fund (IMF), 186, 199, 269 Investment: atrophy of fixed, 6 - 1 9 ; capacity creation of fixed, 4, 38, 127; demand dependency of fixed, 126, 154, 210-11; engineers, 113, 161, 174, 176; fixed, 123, 164, 176-77, 178; ratio (I/GNP), 7 - 1 0 , 26, 111, 112, 159, 178; tax cuts and fixed, 114, 120-22; see also Producers Durable Equipment (PDE); Structures: nonresidential

Kondratieff cycle, 9

Labor force, 122, 132-33, 235 Labor input, 122, 158-59 Leading sector, 5, 110, 125-26, 142, 150, 160; and investment, 113, 174

Subject Index 297 Market failure, 43-48, 57, 216; in the environment, 39-40, 245-46, 247—48; and insurance, 276, 27778; and medical care, 255, 259; perception of, 33, 240, 249, 28586 Military employment, 133-34, 13536, 250 Military spending, 122, 236-37, 241, 266-68; and total government spending, 27-30, 36, 50, 160; in Vietnam War, 70-71, 83-86, 98,

123, 166-67, 175; total factor of, 10-13, 38

Research and development, 14-15, 120, 234, 236-37 Residential construction, 7, 37, 10910, 176-77 Residential stock, 109

102

Mixed economy, 3-4, 6-19, 23-61, 146, 155, 210, 287 Monetary policy, 1-2, 75-77, 89-90, 128, 189-99 Money stock, 75-77, 89, 190 Multiplier, 112

Natural rates, see Growth rate; Unemployment rate Nonprofit sector, 221, 241

Organization for Economic Cooperation and Development (OECD), 185 Organizational revolution, 248-55

Saving, 4, 14-18, 161, 174, 184 Savings and loans, 226-28, 245, 280-81 Say's Law, 38, 41, 154, 169, 178 Securities Investor Protection Corporation (SIPC), 230, 280 Securities and Exchange Commission (SEC), 212 Social balance, 214 Social Darwinism, 35 Social Security, 205, 215-23, 230, 254-55, 258 Stagflation, 43, 53, 57, 190 Stagnation, 36-37, 105-19, 188, 216; and investment, 16, 160-63, 211

Structures: nonresidential, 109, 163-64, 189; see also Investment: fixed Supply side: role of, 13, 54, 156, 166, 168, 211

Pensions, 227-30, 233 Petroleum, 270-71, 282-83 Phillips curve, 88-91, 95, 102, 119 Potential output (GNP), 10-11, 96, 100-2, 116, 154, 174 Privatization, 1, 221, 270, 274, 277 Producers Durable Equipment (PDE), 9, 107-9, 115, 165-67, 189; see also Investment: fixed Productivity: capital, 7, 10-11, 1819, 111-12, 166-67; labor, 10,

Taxation, 48, 204-7, 215, 228; and cut for investment, 114, 124-25, 162, 210; and policy tax, 118-19; redistribution of, 241, 242-43; and Social Security, 221, 222-23, 230; and Vietnam War, 73-74, 83-84, 95-96 Technology, 37, 167, 189, 211, 23437, 242, 248

298 Subject Index Transfer payments: federal to state and local, 27, 36, 145; government to persons, 26-28, 145, 254 Transportation, 260-61, 272, 283-84

Underwritten economy, 216, 223-37 Unemployment, 95, 105, 157-58, 163, 184, 188; "natural" rate of, 102-3, 157, 174, 175, 188 Unions, 34, 254 Urbanization, 34, 236, 243

Wages. 218 Wagner's Law, 26, 178, 266; and a d ministrative involvement, 208, 213, 288; defined, 3, 202; and desire for repeal, 124, 203; measured, 130-52, 204 War on Poverty, 215 Wealth: distribution of, 215 Welfare: public, 40, 46-48, 127, 207 Welfare state. 40, 49, 143, 206, 278 Women: in labor force, 1, 216, 25052 World Bank, 175, 269