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January 1966

The Art of Unbalancing the Budget

The idea that the government should live within its means and annually balance its budget was the fiscal policy objective of the nation's leaders until the decade of the sixties. How the unbalanced budget was converted from a vice to a virtue is here told by Neil W. Chamberlain, professor of economics at Yale.

by Neil W. Chamberlain

The effect of the 1965 income tax cut was not only to prolong a period of prosperity but also to consolidate a revolution in economic thought. The federal government had undertaken deficit financing in the past, but always in times of depression or war. This time it purposely pursued a budgetary deficit when the economy was still in the throes of a protracted peacetime expansion, when wise men of a previous generation would have urged a prudent surplus in order to reduce the national debt. The unbalanced budget, which had so recently been an object of revulsion, had taken on respectability. Government deficits had ceased to be a sin and had themselves become the mark of a shrewd Administration's prudence.

This upheaval in applied economic theory is one of the most significant social developments in modern times. The intellectual innovations which led to its adoption can take their place with the more spectacular discoveries in the physical sciences in terms of potential importance to man's welfare. This was not the case of a government stumbling onto a good thing and then converting a political accident into an economic principle. It came as a planned maneuver, based on new concepts which were partly fashioned by the cadre of young economists who came to Washington with the Kennedy Administration but who--as in most such cases--were building on the work of contemporaries and predecessors.

The history of this remarkable development can be traced most simply in three stages of thought concerning the government's budget and when it should be balanced. We commit only slight violence to the facts by treating these as three neat and successive intellectual epochs, as future historians will doubtless do anyway.

The first period lasted longest, from the earliest conception of a nation's governmental budget almost to World War II. During it, the federal budget was regarded as an instrument of governmental housekeeping, performing the same function as a family's budget. The government had certain functions to perform, which had been assigned to it by society: keeping order, carrying the mails, running the courts, providing a monetary system, regulating interstate and foreign commerce, manning the army and navy. A well-administered government would see to it that in carrying out these functions it lived within its means, a feat of good housekeeping comparable with that of the prudent household. Taxes were levied only to provide the revenue needed for the performance of the services which society required. If special circumstances--most commonly a war--obliged the government to borrow funds, this was to be viewed as an unfortunate but temporary expedient. The sooner the debt was extinguished, the better. To produce a surplus at the end of the fiscal year, which could be applied against the national indebtedness, won for a government a crown of glory.

This conception of the budget as a device which disciplined a government to strive systematically to live within its means, year by year, took such firm hold of the popular and political imagination that the few professional criticisms leveled against it were scarcely heard. As iconoclastic an individual as Franklin D. Roosevelt resorted to deficit financing in the Great Depression with reluctance and a resolve to end the nation's fiscal disgrace at the earliest opportunity. Indeed, even John F. Kennedy, who was probably the most economically literate President in U.S. history, made the annually balanced budget a policy objective.

The ground for professional criticism of this housekeeping conception of the federal budget lay in the limited view which it took of governmental functions. It conceived the government's economic role in the same terms as it would any other economic unit, private or public: private business performed certain economic functions, such as providing goods; households performed other economic functions, such as providing labor services; and similarly, the federal government performed still other economic functions. The federal budget was the largest of all budgets, to be sure, even though not by the same margin as today, but this was a difference in degree and not in kind.

Or was it? Was there something about the government's budget that distinguished it from that of the Jones family and of U.S. Steel? Was there some special function connected with it which gave it a purpose other than the economical provision of particular services? There was indeed, said a school of economists, whose minority voice failed to attract much notice until the late 1930s, when John Maynard Keynes became its spokesman. Their view gained ascendancy largely as a consequence of the Great Depression, which lingered on until finally dispelled by wartime activity, and memories of which provided the emotional undertow on which full employment policies rode to legislative approvals in post-war Western Europe and North America. The second stage of our budgetary history was thereby ushered in.


This second-stage school of economic theorists looked on the budget as performing not just one function--proper federal housekeeping--but two. The second function was to preserve the economic health of the nation as a whole. It was the government's duty, said this group, to see that the nation remained prosperous, a duty no less important than preserving law and order and maintaining courts and other such time-honored governmental services. The nation's economic health was the business of the government because no other agent or institution could serve as doctor.

The doctor's implements were not only monetary policy--making money cheaper to use in depressions so that businesses and households would use more of it, hopefully returning the nation to prosperity; the instrument kit of the federal government as economic doctor included its budget as well. In times of depression, it could spend more than it took in, thereby directly putting people and plants to productive use. It did not have to wait for businesses and households to become optimistic enough to borrow money at lower rates of interest. It could put money in their pockets directly by cutting its tax take, or it could itself spend on a variety of projects, or it could increase the amount of money it transferred to people who could be counted on to spend it. All these ways would put the government budget in the red, but it would increase the nation's economic activity. It would put people and plants to work whose services would otherwise be irretrievably lost.

All very well, said more traditional economists, but how long could this go on? How many times could the medicine be repeated? If the government persisted in deficit spending, its debt would double, its credit would crumble, and it would find no buyers for its bonds. Fiscal responsibility could not be evaded. The balanced budget was not a luxury to be dispensed with under pressure but a necessity of a solvent government.


The economic freethinkers had an answer. It might be true that the government could not afford to go on piling up new debt on old every time there was a downturn of business activity. But it would not have to; the fear that government credit would sooner or later go under, in a persistently rising sea of debt, was unwarranted. The alarmists were ignoring the existence of the business cycle, with its alternating phases of boom and depression.

If the economy was depressed at times, experience showed that this was followed by periods of excessive--inflationary--activity. The government as doctor was no less needed in the one case than in the other, but the remedy for one was the opposite of the remedy for the other. In depressions it would spend more than it took in and use budget deficits to bring the economy back to normal. In inflations it would take in more than it spent, and use budget surpluses to restore economic normality. And the surpluses of the inflation end of the business cycle could be used to pay off the deficits of the depression phase of the cycle.

Was it necessary to balance the budget? Yes, but only over the period of a business cycle. Annual balancing was an error, since it ignored the cyclical rhythm of the nation's health. Outgo and income could be matched over an appropriate span of years, in which the minuses of some were wiped out by the pluses of others.

The cyclical-balancing solution did not satisfy very long. For one thing, the nation's needs seemed to expand with time, so that the federal budget tended to rise in good years as well as bad. For another, THE cycle was really a myth. If cycles existed, there were a number of them--inventory cycles, building cycles, short cycles, long waves, and a variety of others. Which one should be used as the period for budget balancing, especially when they all overlapped? Moreover, there was reason to doubt the regularity of any cycles. Average cyclical durations could be determined, but these would hardly do for purposes of budget balancing, which should be guided by the actual state of the economy and not some arithmetic abstraction.


A more daring set of economists began to feel their way toward a different answer. The nation could not count on regular budgetary surpluses to wipe out regular deficits. There was no reason to expect that such cyclical balancing would ever occur. But if the budget were balanced in the good years, then one could afford to run deficits in those years when the economy slowed down. This would mean that the national debt would steadily rise over the years, but this need not cause alarm, since the nation's assets and income were also growing. Not annual budget balancing, not even cyclical balancing, but balancing only in the years of plenty was looked on as the appropriate policy.

The primitive nature of this first formulation of stage-three philosophy is apparent even to the nonprofessional. When is a year a "good" one? How judge the amount of stimulation which the government should inject into a depressed economy by means of its unbalanced budget? The answers could scarcely be left to casual judgment.

A number of theoretical developments, still not fully accepted by all economists, prepared the way to a new solution. We shall have to deal with these once over lightly. First was a more systematic method of defining what was a "good" year, when the government's budget should presumably be in balance. For some time--at least since the closing years of World War II--the "good" year had become synonymous with full employment. Now came the realization that full employment was itself an elastic concept. If it meant that every person wanting a job was to be put to work, this could probably be achieved only at the risk of inflation. An English economist, A. W. Phillips, ran a correlation of unemployment and price levels in England back as far as 1861, and found that when unemployment dropped below 2.5 percent of the labor force, prices rose. Similar statistical studies showed that the "Phillips effect" operated in the United States as well, though the upward pressure on prices came even earlier, when unemployment was at a higher level.

This appeared to imply that if we wanted to avoid unemployment and inflation, we could do so only in terms of a marginal trade-off of one for the other. At what degree of "full employment" would the upward pressure on prices still be tolerable? A compromise point could be selected on the "Phillips curve"--say a 3 percent rate of unemployment accompanied by a 2 percent rise in prices, or a 4 percent rate of unemployment with perhaps only a slight price creep.

Second, with such a compromise determination of what is to be considered full employment, it is then possible to project "potential GNP." This is the total income, in gross terms (that is, not making allowance for the capital used up in producing it), that the economy would be capable of turning out if it were operating at full employment.

Third, we can estimate, using existing tax schedules, how much revenue the federal government would collect if the economy were producing the potential GNP. We can also estimate, on the strength of ongoing governmental programs and anticipated new appropriations, how much the federal government would be spending at the same level of national economic activity.

We can be almost sure that revenues would generally exceed outlays, and sometimes by a considerable margin. Our potential GNP is constantly rising, owing to an expanding population, longer life expectancies, better education, automation, and other influences. If we were to attain our constantly rising potential GNP, the tax take at this always higher figure would mount rapidly. Besides paying taxes on additional income earned, individuals would move into higher income tax brackets.

But government expenditures could not be expected to rise by a similar amount, in part because many of its needs (notably defense) do not automatically expand just because national income has gone up, and in part because philosophically we still tend to limit the role of government--the things for which it can spend its revenues. Thus if the nation were to operate at its potential, the government would run a substantial budget surplus--a "full employment surplus."

And, contrary to our old beliefs, that would not be good but harmful. It would mean that the government would be taking money out of the spending stream so that operations at the potential GNP couldn't be sustained--unless, indeed, the private sector was spending an equivalent amount in excess of its own receipts. The surplus could be used to retire debt, but that would, for the most part, simply extinguish bank loans and put nothing in their place.

In short, the full-employment surplus measures the amount of "fiscal drag" on the economy. It reveals by how much the government's budget is deterring the economy from reaching or maintaining its desired level of performance.

The only point at which the government budget should be in balance is when the nation is operating at its full potential. The only point at which it should seek a surplus is when the economy is attempting to produce more than its potential, generating inflationary pressures. But more than this is implied. Even if the government is running a deficit, it may not be running enough of a deficit to give the stimulus that will carry the economy to its potential. This would be true if, with rising GNP, the federal goverment's budget would come into balance before the potential was realized. It would then be taking in more money than it was spending, thereby acting as a brake on economic activity before its destination was reached.

This was the general line of reasoning behind the income tax cut of 1965 and the excise tax cuts projected for the next few years. By reducing taxes to a level which at full employment would produce only as much revenue as would be needed to cover expenditures, the government necessarily collects less now. It leaves more money in the business and household sectors; if they spend it, as they will in large proportion, this augments economic activity and brings us nearer the full-employment goal.


It is this phenomenon that has given rise to the colorful description of the new fiscal policy as "spending our way to prosperity." In effect, we can buy more and be better off for doing so.

Skeptical politicians have wondered whether such a policy courts inflation. They are uneasy with a policy which appears to reward profligacy. An amusing instance of this attitude occurred during Senate hearings over the proposed income tax reduction A New England lawmaker asked Walter Heller, then chairman of the President's Council of Economic Advisers, why so many people resisted the new fiscal philosophy if, in effect, it promised reward for self-indulgence. Heller said he supposed any public disapproval stemmed from a residual Puritanism--to which the New England senator, still dubious but not doleful, replied that he himself was more of a Puritan than a Heller.

But any earlier doubts now seem largely to have been dispelled as a result of the success of the 1965 tax reduction, and an increasing number of legislators appear to embrace the new approach with enthusiasm. What politician can for long resist the appeal of voting for tax reductions? Is there, then, danger that the new fiscal toy will be overused with inflationary consequences?

Any policy is of course subject to abuse, but as long as the size of budgetary deficits is geared to the full-employment surplus, there is a built-in monitor. In the final analysis, the new fiscal policy is based less on deficit budgeting than on budget balancing. When the potential GNP is reached, the government's outlay will be in line with its income, since that is the point at which the government's budget is planned to be in balance.

Balance the budget? Of course, but what budget? The answer which is now being given is the full-employment budget. At levels short of full employment this means balancing not an actual but a hypothetical budget, the budget as it would be if we were operating at potential GNP. This is not a matter of running in the red in a vague hope that this will do the economy some good, as the bloodletting of earlier days was expected to restore a patient's health. It is the incurring of deficits in an amount which is guided by calculations of potential GNP, which in turn is based on computations of the level of acceptable compromise between unemployment and price increases.


Resistance to the new economics comes from several sources. On the popular front there is still a widespread conviction that the national debt is like a mortgage on the house, with all the attendant hazards. At least part of the initial opposition to last year's income tax reduction stemmed from a belief that adding to the national debt when the economy was running strong was piling up a burden on future generations for the self-gratification of the present. Aside from failing to grasp that present gratification was not the object, but only the removal of a budget barrier to future economic progress, those of this persuasion persisted in believing that future generations would somehow have to pay off that larger debt to someone else. But except for the relatively small proportion of the debt held abroad, the future generations will not have to pay someone else but only themselves. All will pay taxes to the government in varying amounts, and some will receive interest from the government on the bonds which they hold. Some will pay more and receive less than others, proportionately, and vice versa, but what is involved is a redistribution of the income at that time and not a transfer among the generations. The composition of the debt is of course important--who holds it in what amounts and how much they get paid for holding it. The tax structure is also important--who pays into the federal coffers the funds which must be used to pay interest on the debt. This is why federal financing is always open to review and reform. But this is a different matter from looking on the debt as a mortgage on the nation which must be paid to avoid some Simon Legree's foreclosure.

The nation's taxing power permits it to redistribute the national income so that those holding the debt will always be provided for. This does not mean that size of our national obligations is of no consequence; tax collection even for purposes of redistribution always involves more pain to some people than to others. But it does mean that deficits which are economically advantageous to society as a whole need not be avoided because of superstition that we are "mortgaging" the future.

A second reason why the new economics is sometimes resisted is the belief that the statistical calculations which are called for cannot be made with sufficient accuracy to be used as the basis for fiscal policy. The potential GNP of which we talk so glibly, as well as estimates of actual GNP, involves questionable assumptions in regard to business investment, people's employability, productivity, bargaining power, and other variables. The need for guesswork and the possibility of error are evident.

Nevertheless, our knowledge, while imperfect, is improving, and the refinement of our economic understanding serves to pinpoint the areas in which further improvement is most urgent. Arthur Okun, one of the three economists currently composing the Council of Economic Advisers, has said, "All I would claim is that we can do better using our knowledge than ignoring it. We'll make mistakes some of the time, but we'll be pushing in the right direction most of the time."

There is of course no basis for believing that economic "truth" about budget balancing has now, finally, been divulged. We can be sure that a fourth stage in our thinking lies somewhere over the horizon. We might even surmise that it has something to do with the relative advantages of tax cuts versus government expenditures, a matter which so far has been more the subject of vocal inflection than cerebral reflection.

But of one other thing we can also be sure. Our present stage-three thinking represents a vast improvement over its predecessor stages. And whether it appears excessively simplistic to some or dubiously synthetic to others, it is a product of contemporary social science no different in its fundamental importance from current innovations in the physical sciences.

Copyright © 1966 by Neil W. Chamberlain. All rights reserved.
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