The Economic Consequences of Mr. Clinton

The belief that balancing the budget must takeprecedence over every other economic considerationhas captured the minds of President Bill Clinton andhis advisers. In this essay a former economic policymakertakes a critical look at the economic logic and portentoushistory behind a new orthodoxy he regards as dangerous

I N 1925, a decade before his General Theory of Employment, Interest, and Money revolutionized thinking about economic policy, John Maynard Keynes wrote an essay titled "The Economic Consequences of Mr. Churchill." He took the then Chancellor of the Exchequer to task for having brought the pound back to the gold standard too soon after the First World War and at too high a value. Keynes predicted dire economic consequences. He was right. The British economy stagnated, resulting in years of unemployment above 10 percent even before the Great Depression. Because Britain was still central to world trade, its deflation spread deflation around the globe.

Seventy years later the world economy, now led by the United States, is on a dangerously parallel path. In the 1990s received economic wisdom has substituted for the gold standard deficit reduction as the central instrument, with zero inflation as the central goal, of economic policy.

The effects are disturbingly similar to those of the orthodoxy of the 1920s before Keynes's General Theory suggested that deliberate government deficits could be used to stimulate employment. In recent years the richest nations in the world have suffered increasing unemployment (and in the United States increasing inequality) and social unease even in good times, with worse to come when the cycle turns down.

Keynes contended that Churchill had erred because "lacking . . . instinctive judgement, he was deafened by the clamorous voices of conventional finance; and, most of all, because he was gravely misled by his experts." The same is true of Bill Clinton. In his first few months as President he surrendered the traditional liberal Democratic stress on expanding demand, leaving conventional finance in possession of the field. This not only weakened the government's ability to increase the demand for labor but also made impossible more than nominal investment in programs to improve the adaptability of job seekers to available jobs. One major reason for the President's defection was that his own experts in the ranks of academic economists and in his Administration had turned to pre-General Theory orthodoxy. Therein lies an important part of the tale that climaxed but did not end in the 1994 Republican congressional victory and the great budget battle of 1995-1996. A high point was the President's acceptance, in mid-July of last year, of the Republican goal of a balanced budget in seven years. By then the only real issue that remained was the rate of federal withdrawal from support of the economy and of those left behind by prosperity.

With balance as the sole criterion for budgeting, and zero inflation as the sole objective, what used to be called full employment has been forgotten, even though the Humphrey-Hawkins Act of 1978 still mandates it as a central national goal. The problem is one of long-term change, not recession. Even the low unemployment rates of the good times of the 1980s and 1990s almost match the highs of the 1950s and 1960s. Unemployment of six to seven percent was severe recession then; now when unemployment dips below six percent, storm warnings go up: too low an unemployment rate might be inflationary.

At the same time, inequality of earnings and income has been increasing among wage and salary earners and among American families. The rich have been getting much richer, the poor significantly poorer. And the future looks bleak to the insecure middle class, whose fearful members are tempted to blame their ills on those who are worse off than they are. Economic stimulus is not the cure for all these problems, but lacking stronger economic growth than we have had, no remedy is possible.

When the business cycle turns down again, and unemployment rises from its already high lows, the political and social effects may go beyond grumbling and petty meanness to expanding extremism in many areas of American life.

Clinton's Case

TO say that the previously Keynesian economists in the Clinton Administration have been captured by conservative orthodoxy is not to say that they are wrong. The Keynesian models used through the 1960s broke down under the shock of oil-price increases in the 1970s. Unemployment went to levels higher than had been seen since the Depression, but attempts to reduce it by fiscal stimulus caused inflation to accelerate to rates not seen since the aftermath of the Second World War.

When the collapse of oil prices in the early 1980s made possible a return to both lower unemployment and lower inflation, the Reagan Administration tried "supply-side" economics. The resulting deficits were so huge that the Federal Reserve had to raise already high interest rates to unprecedented levels to avoid overstimulation of the economy. Supply-siders had contended that cutting tax rates would raise tax revenues, but David Stockman Reagan's budget director, knew better. He later admitted that he had deliberately used the deficits to paralyze government social spending and "dismantle" federal programs put in place since 1933.

Stockman's scheme worked. The Democratic economists of the Clinton Administration contend that although the deficits are not the fault of the Democrats, their huge presence must nonetheless dominate the Administration's fiscal policies.

Their line of argument:

  • Over the past several decades the increase in U.S. productivity has slowed.

  • Productivity is increased primarily by increasing capital investment, but investment has been decreasing.

  • A major reason for the shortfall in investment is that because deficits must be financed by borrowing, they compete with private investment for borrowable funds, thus raising interest rates and crowding out productive investment in the private sector.

The Demand-Side Alternative

THOSE who advocate a return to stimulus counter:

  • The argument that productivity increases have slowed ordinarily compares the decades before 1972 with the decades thereafter. Increases since then have in fact been slower than those of the 1950s and 1960s, but once the petroleum problems of the 1970s stopped affecting the system, productivity began to increase significantly more rapidly.

  • The quantity of investment is only one factor in increasing productivity, and not the strongest one. Technological change, including organizational change, contributes virtually twice as much, and improving worker education almost as much. And in any case, business investment in plant and equipment, as a percentage of GDP, has in fact been relatively high since the end of the oil shocks.

  • The crucial issues have to do with the crowding out of private-sector investment and with interest rates. In the world of classical economics, in which involuntary unemployment is by definition impossible, the total quantities of productive resources available at any time, including borrowable funds, are fixed. Thus any funds used by government must be taken away from private uses, and taking them raises interest rates for those wanting to borrow for private investment. But in the Keynesian (and the real) world, if demand is so slack as to make most investment expenditures seem risky, low interest rates may have little effect. Attempts to use monetary policy in such circumstances have been likened to pushing on a string.

Economists never have arrived at a satisfactory theory for weighting the various factors that affect investment. The cost of borrowable funds is certainly one of them, but only one. Taxation may also have important effects on investment incentives: if the returns from investment are increased by tax reduction, investment will increase. That is the central point of supply-side economics. It is a good point in the abstract, but the relative weight of the tax effect remains open to debate.

Presented by

Robert A. Levine, an economist with the RAND Corporation, was deputy director of the Congressional Budget Office from 1975 to 1979.

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