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Democracy in Deficit opened the door for much of the current work on political business cycles and the incorporation of public-choice considerations into macroeconomic theory. Even in the area of monetarism, Buchanan's landmark work has greatly influenced the sway of contemporary theorists away from the nearly universally held belief of Keynesian theory. Democracy in Deficit contributes greatly to Buchanan's lifelong fiscal and monetary rules to guide long-term policy in macroeconomics. The book serves to bolster Buchanan's central beliefs in the necessity of a balanced-budget amendment to the US Constitution and in monetary rules rather than central bank discretion.
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The Collected Works of
James M. Buchanan
vol u m e 8
Democracy in Deficit

James M. Buchanan and Richard E. Wagner,
Big Sky, Montana

The Collected Works of

James M. Buchanan
volume 8

Democracy in Deficit
The Political Legacy of Lord Keynes

James M. Buchanan and
Richard E. Wagner

liberty fund
Indianapolis

This book is published by Liberty Fund, Inc., a foundation
established to encourage study of the ideal of a society of free
and responsible individuals.

The cuneiform inscription that serves as our logo and as the design
motif for our endpapers is the earliest-known written appearance
of the word ‘‘freedom’’ (amagi), or ‘‘liberty.’’ It is taken from a clay
document written about 2300 b.c. in the Sumerian city-state of Lagash.

Foreword and coauthor note q 2000 by Liberty Fund, Inc.
Democracy in Deficit: The Political Legacy of Lord Keynes q 1977
by Academic Press, Inc.
All rights reserved
Printed in the United States of America
04 03 02 01 00
04 03 02 01 00

c
p

5 4 3 2 1
5 4 3 2 1

Library of Congress Cataloging-in-Publication Data
Buchanan, James M.
Democracy in deficit : the political legacy of Lord Keynes / James M. Buchanan and
Richard E. Wagner.
p. cm. — (The collected works of James M. Buchanan ; v. 8)
Originally published : New York : Academic Press. c1977. With a
new foreword.
Includes bibliographical references and index.
isbn 0-86597-227-3 (hc : alk. paper). — isbn 0-86597-228-1 (pbk : alk. paper)
1. United States—Economic policy. 2. Fiscal policy—United
States. 3. Keynesian economics. I. Wagner, Richard E. II.
Title. III. Series: Buchanan, James M. Works. 1999 ; v. 8.
hc106.6b74 2000
330.973809—dc21
99-24064
liberty fund, inc.
8335 Allison Pointe Trail, Suite 300
Indianapolis, IN 46250-1684

Contents

Foreword

xi

Preface

xvii

Acknowledgments

xxi

I. What Happened?
1. What Hath Keynes Wrought?

3

The Political Economy
A Review of the Record
The Theory of Public Choice
Fiscal and Monetary Reform

4
5
7
8

2. The Old-Time Fiscal Religion

10

Classical Fiscal Principle
Fiscal Pr; actice in Pre-Keynesian Times
Balanced Budgets, Debt Burdens, and Fiscal Responsibility
Fiscal Principles and Keynesian Economic Theory
The Fiscal Constitution
3. First, the Academic Scribblers
‘‘Classical Economics,’’ a Construction in Straw?
The Birth of Macroeconomics
The New Role for the State
The Scorn for Budget Balance
The New Precepts for Fiscal Policy
Budget Deficits, Public Debt, and Money Creation
The Dreams of Camelot

10
13
16
21
23
25
26
29
31
32
33
34
37

viii

Contents

4. The Spread of the New Gospel
Introduction
Passive Imbalance
Built-in Flexibility
Hypothetical Budget Balance
Monetary Policy and Inflation
The Rhetoric and the Reality of the Fifties
Fiscal Drag
The Reluctant Politician
Political Keynesianism: The Tax Cut of 1964
Economists, Politicians, and the Public
Functional Finance and Hypothetical Budget Balance
5. Assessing the Damages
Introduction
The Summary Record
Budget Deficits, Monetary Institutions, and Inflation
Inflation: Anticipated and Unanticipated
Why Worry about Inflation?
Inflation, Budget Deficits, and Capital Investment
The Bloated Public Sector
International Consequences
Tragedy, Not Triumph

38
38
38
41
42
43
45
47
49
50
52
53
56
56
57
59
61
62
66
71
73
75

II. What Went Wrong?
6. The Presuppositions of Harvey Road
Introduction
The Presuppositions of Harvey Road
The Economic Environment of the ‘‘General Theory’’
Strings Can Be Pulled
The Great Phillips Trade-off
Post-Keynes, Post-Phillips
Reform through National Economic Planning

79
79
80
83
85
87
90
92

Contents

7. Keynesian Economics in Democratic Politics
Introduction
Budgetary Management in an Unstable Economy
Taxing, Spending, and Political Competition
Unbalanced Budgets, Democratic Politics, and Keynesian Biases
Deficit Finance and Public-Sector Bias

ix

95
95
96
98
101
106

8. Money-Financed Deficits and Political Democracy

110

Introduction
Budget Deficits Financed by Money Creation
Benevolent and Independent Monetary Authority
The Political Environment of Monetary Policy
The American Political Economy, 1976 and Beyond

110
111
114
117
125

9. Institutional Constraints and Political Choice
Introduction
The Public Economy and the Private
Fiscal Perception and Tax Institutions
Debt-Financed Budget Deficits
Money-Financed Budget Deficits
Institutions Matter

129
129
130
131
138
147
149

III. What Can Be Done?
10. Alternative Budgetary Rules
Budget Balance over the Cycle
Built-in Flexibility
Budget Balance at Full Employment
The Budget Reform Act of 1974
Short-Term Politics for Long-Term Objectives
11. What about Full Employment?
Introduction
Current Unemployment and the Quandary of Policy

153
154
155
157
162
164
167
167
167

x

Contents

The Keynesian Theory of Employment
The Inflation-Unemployment Trade-off
The Inflation-Unemployment Spiral
Biting the Bullet
So, What about Full Employment?
12. A Return to Fiscal Principle

170
172
174
177
178
180

The Thrill Is Gone
The Case for Constitutional Norms
The Case for Budget Balance
Fiscal Decisions under Budget Balance
Tax Rates and Spending Rates as Residual Budget Adjustors
A Specific Proposal
Debt Retirement and Budget Surplus
In Summation

180
182
183
184
185
187
189
190

Author Index

195

Subject Index

197

Foreword

Democracy in Deficit, by James M. Buchanan and Richard E. Wagner, represents one of the first comprehensive attempts to apply the basic principles of
public choice analysis to macroeconomic theory and policy.1 Until the 1970s,
macroeconomics was devoid of any behavioral content with respect to its
treatment of government. Government was simply treated as an exogenous
¢ ), which behaved in the way prescribed by a given macroeconomic
force (G
theory. In this approach, government invariably acted in the public interest
as perceived by the host theory. Both the so-called Keynesian and monetarist
approaches were beset by this problem, although it was the inherent contradictions of the Keynesian theory that attracted the attention of Buchanan
and Wagner.
Democracy in Deficit led the way in economics in endogenizing the role of
government in discussions of macroeconomic theory and policy. The central
purpose of the book was to examine the simple precepts of Keynesian economics through the lens of public choice theory. The basic discovery was
that Keynesian economics had a bias toward deficits in terms of political selfinterest. That is, at the margin politicians preferred easy choices to hard ones,
and this meant lower taxes and higher spending. Thus, whatever the merits
of Keynesian economics in using government fiscal policy to ‘‘balance’’ the
forces of inflation and deflation and employment and unemployment in an
economy, its application in a democratic setting had severe problems of incentive compatibility; that is, there was a bias toward deficit finance. And, of
course, there is no need to reiterate here the evidence in the United States
1. James M. Buchanan and Richard E. Wagner, Democracy in Deficit: The Political Legacy of Lord Keynes (New York: Academic Press, 1977), volume 8 in the series.

xi

xii

Foreword

and elsewhere for the correctness of the Buchanan insight on Keynesian economics. It is all too apparent that the thesis of this book has been borne out.
Democracy in Deficit led the way to modern work on political business cycles and the incorporation of public choice considerations into macroeconomic theory. For example, there is a literature today that discusses the issue
of the time consistency of economic policy. Does a conservative incumbent
who cannot stand for reelection run a deficit in order to control spending by
a liberal successor? One can easily see the hand of Buchanan in such constructions. In this example, term limits (a public choice phenomenon) are at
the center of a macroeconomic model.
Moreover, monetarism has not escaped the inspection of public choice
analysis. Buchanan and others have pioneered work on the behavior of fiat
money monopolists. This public choice work stands in stark contrast to
earlier work by Keynesians and monetarists who supposed that economists
stood outside and above politics and offered advice to politicians and central
banks that would be automatically adopted. Otherwise, policymakers were
misguided or uninformed. If they knew the right thing, they would do the
right thing. This approach to macroeconomics is now largely dead, thanks to
books like Democracy in Deficit. Today, the age-old adage that incentives
matter is heeded by macroeconomists, and it is recognized that political incentive—not the ivory tower advice of economists—drives macroeconomic
events.
Democracy in Deficit is also closely related to Buchanan’s interest in fiscal
and monetary rules to guide long-run policy in macroeconomics. Such rules
are needed to overcome the short-run political incentives analyzed in this
book and to provide a stable basis for long-run economic growth. Buchanan’s
lifelong dedication to the goal of a balanced budget amendment to the United
States Constitution and to a regime of monetary rules rather than central
bank discretion can be seen in this light.
The real alternative to fiscal and monetary rules is, after all, not the perfection of economic policy in some economic theorist’s dream. It is what the
rough and tumble of ordinary politics produces. The problem is to find a
feasible solution to long-run economic stability and growth. Viewed in this
way, there is really no conflict between rules and discretion, and, thanks in
part to Buchanan’s insistence on this point, the world today seems poised to

Foreword

xiii

have more rule-based economic institutions. Democracy in Deficit is but one
of Buchanan’s many intellectual efforts toward this end.
Robert D. Tollison
University of Mississippi
1998

Richard E. Wagner

The analytical core of the argument in Democracy in Deficit is simple and
straightforward. Indeed, the argument is perhaps the single most persuasive
application of the elementary theory of public choice, which focuses primary
attention on the incentives faced by choosers in varying social roles.
Richard Wagner and I did not sense any purpose of the book beyond that
of laying out the elementary propositions along with the implications. Wagner, as colleague and coauthor, was helpful in placing the concept into its
history-of-ideas context, and in his continued insistence that even the simplest arguments must be elaborated to be convincing to skeptics.
Neither Dick Wagner nor I suffer fools gladly, but without our mutually
enforcing constraints, a book by either of us would have surely lapsed too
readily into polemics.
James M. Buchanan
Fairfax, Virginia
1998

Preface

The economics of Keynes has been exhaustively discussed, in the popular press,
in elementary textbooks, and in learned treatises. By contrast, the politics of
Keynes and Keynesianism has been treated sketchily and indirectly, if at all.
This is surprising, especially in the light of accumulating evidence that tends
to support the hypotheses that may be derived from elementary analysis.
Our purpose is to fill this void, at least to the extent of initiating a dialogue.
We shall advance our argument boldly, in part because our central objective
is to introduce a different aspect of Keynesianism for critical analysis. Those
who feel obligated to respond to our prescriptive diagnosis of economicpolitical reality must do so by taking into account elements that have hitherto been left unexamined.
The book is concerned, firstly, with the impact of economic ideas on political institutions, and, secondly, with the effects of these derived institutional changes on economic policy decisions. This approach must be distinguished from that which describes orthodox normative economics. In the
latter, the economist provides policy advice and counsel in terms of preferred
or optimal results. He does not bother with the transmission of this counsel
through the processes of political choice. Nor does he consider the potential
influence that his normative suggestions may exert on the basic institutions
of politics and, through this influence, in turn, on the results that are generated. To the extent that observed events force him to acknowledge some
such influence of ideas on institutions, and of institutions on ideas, the orthodox economist is ready to fault the public and the politicians for failures
to cut through the institutional haze. Whether they do so or not, members
of the public ‘‘should’’ see the world as the economist sees it.
We reject this set of blindfolds. We step back one stage, and we try to observe the political along with the economic process. We look at the political
xvii

xviii

Preface

economy. The prescriptive diagnosis that emerges suggests disease in the political structure as it responds to the Keynesian teachings about economic
policy. Our specific hypothesis is that the Keynesian theory of economic policy produces inherent biases when applied within the institutions of political
democracy. To the extent that this hypothesis is accepted, the search for improvement must be centered on modification in the institutional structure.
We cannot readily offer new advice to politicians while at the same time offering predictions as to how these same politicians will behave under existing
institutional constraints. By necessity, we must develop a positive theory of
how politics works, of public choice, before we can begin to make suggestions for institutional reform.
In our considered judgment, the historical record corroborates the elementary hypotheses that emerge from our analysis. For this reason, we have
found it convenient to organize the first part of this book as a history of how
ideas developed and exerted their influence on institutions. We should emphasize, however, that the acceptability of our basic analysis does not require
that the fiscal record be interpreted in our terms. Those whose natural bent
is more Panglossian may explain the observed record differently, while at the
same time acknowledging that our analysis does isolate biases in the fiscal
decision processes, biases which, in this view, would remain more potential
than real.
Some may interpret our argument to be unduly alarmist. We hope that
events will prove them right. As noted, we are pessimistic about both the direction and the speed of change. But we are not fatalists. This book is written
in our faith in the ability of Americans to shape their own destiny. We hope
that the consequences predicted by the logic of our argument will not, in
fact, occur, that our conditional predictions will be refuted, and that institutions will be changed. Indeed, we should like to consider this book to be
an early part of a dialogue that will result indirectly in the destruction of its
more positive arguments. We offer our thoughts on Keynesianism and the
survival of democratic values in the hope that our successors a century hence
will look on the middle years of the twentieth century as an episodic and
dangerous detour away from the basic stability that must be a necessary element in the American dream itself.
Our analysis is limited to the impact of Keynesian ideas on the United
States structure of political decision making. The ‘‘political legacy’’ in our

Preface

xix

subtitle should, strictly speaking, be prefaced by the word ‘‘American.’’ We
have not tried to incorporate a discussion of Keynesian influences on the political history of other nations, notably that of Great Britain. Such a discussion would be valuable in itself, and the comparative results would be highly
suggestive. But this extension is a task for others; we have chosen explicitly
to restrict our own treatment to the political economy that we know best.

Acknowledgments

Many of the ideas developed in this book have been recognized by many persons for many years, and these have been hinted at in various passing references. We have, ourselves, lived with these ideas for many years, and one of
us has a draft of a speech written as early as the middle 1950s which contains
in very general terms much of what we say here. Many of the ideas themselves are not, therefore, new or novel. Instead, they are ideas whose time has
come. Our efforts here are motivated by the conviction that purpose may
now be served by extending these ideas more fully and by presenting them
systematically.
Specific acknowledgments are limited to those who have been helpful in
bringing this book into being. We are directly indebted to our colleagues and
graduate students who have been exposed to various aspects of our argument and who have made helpful comments. Among our colleagues at the
Center for Study of Public Choice, we should especially note the assistance
of Victor Goldberg, Nicolaus Tideman, and Gordon Tullock. We also acknowledge the helpful comments of Thomas Borcherding, of Simon Fraser
University; Fred Glahe, of the University of Colorado; James Gwartney, of
Florida State University; and Robert Tollison, of Texas A&M University.
This book emerged as part of the continuing research program of the
Center for Study of Public Choice, which provided the facilities for our efforts. Work on this book was also greatly facilitated by Liberty Fund, Inc., of
Indianapolis, Indiana, which incorporated the effort into its overall program,
directed toward study of the ideals of a free society. Some of our research was
also supported by the Ford Foundation. Peripheral inputs into our own thinking during the final stages of the writing were provided by the participants in
a Liberty Fund conference, ‘‘Federal Fiscal Responsibility,’’ at Hot Springs,Vir-

xxi

xxii

Acknowledgments

ginia, in March 1976. The papers and discussion of this conference will be
published separately.
Mrs. Betty Ross provided the clerical assistance that has by now come to
be expected and without which our manuscript production would probably
grind to a screeching halt.

part one

What Happened?

1. What Hath Keynes Wrought?

In the year (1776) of the American Declaration of Independence, Adam Smith
observed that ‘‘What is prudence in the conduct of every private family, can
scarce be folly in that of a great kingdom.’’ Until the advent of the ‘‘Keynesian
revolution’’ in the middle years of this century, the fiscal conduct of the
American Republic was informed by this Smithian principle of fiscal responsibility: Government should not spend without imposing taxes; and government should not place future generations in bondage by deficit financing of
public outlays designed to provide temporary and short-lived benefits.
With the completion of the Keynesian revolution, these time-tested principles of fiscal responsibility were consigned to the heap of superstitious nostrums that once stifled enlightened political-fiscal activism. Keynesianism
stood the Smithian analogy on its head. The stress was placed on the differences rather than the similarities between a family and the state, and notably
with respect to principles of prudent fiscal conduct. The state was no longer
to be conceived in the image of the family, and the rules of prudent fiscal
conduct differed dramatically as between the two institutions. The message
of Keynesianism might be summarized as: What is folly in the conduct of a
private family may be prudence in the conduct of the affairs of a great nation.
‘‘We are all Keynesians now.’’ This was a familiar statement in the 1960s,
attributed even to the likes of Milton Friedman among the academicians and
to Richard Nixon among the politicians. Yet it takes no scientific talent to
observe that ours is not an economic paradise. During the post-Keynesian,
post-1960 era, we have labored under continuing and increasing budget deficits, a rapidly growing governmental sector, high unemployment, apparently permanent and perhaps increasing inflation, and accompanying disenchantment with the American sociopolitical order.
3

4

What Happened?

This is not as it was supposed to be. After Walter Heller’s finest hours in
1963, fiscal wisdom was to have finally triumphed over fiscal folly. The national economy was to have settled down on or near its steady growth potential, onward and upward toward better things, public and private. The spirit
of optimism was indeed contagious, so much so that economic productivity
and growth, the announced objectives for the post-Sputnik, post-Eisenhower
years, were soon abandoned, to be replaced by the redistributionist zeal of
Lyndon Johnson’s ‘‘Great Society’’ and by the no-growth implications of Ralph
Nader, the Sierra Club, Common Cause, and Edmund Muskie’s Environmental Protection Agency. Having mastered the management of the national
economy, the policy planners were to have moved on to quality-of-life issues.
The ‘‘Great Society’’ was to become real.
What happened? Why does Camelot lie in ruin? Viet Nam and Watergate
cannot explain everything forever. Intellectual error of monumental proportion has been made, and not exclusively by the ordinary politicians. Error
also lies squarely with the economists.
The academic scribbler of the past who must bear substantial responsibility is Lord Keynes himself, whose ideas were uncritically accepted by American establishment economists. The mounting historical evidence of the effects of these ideas cannot continue to be ignored. Keynesian economics has
turned the politicians loose; it has destroyed the effective constraint on politicians’ ordinary appetites. Armed with the Keynesian message, politicians
can spend and spend without the apparent necessity to tax. ‘‘Democracy in
deficit’’ is descriptive, both of our economic plight and of the subject matter
for this book.

The Political Economy
This book is an essay in political economy rather than in economic theory.
Our focus is upon the political institutions through which economic policy
must be implemented, policy which is, itself, ultimately derived from theory,
good or bad. And central to our argument is the principle that the criteria
for good theory are necessarily related to the political institutions of the society. The ideal normative theory of economic management for an authoritarian regime may fail completely for a regime that embodies participation
by those who are to be managed. This necessary linkage or interdependence
between the basic political structure of society and the economic theory of

What Hath Keynes Wrought?

5

policy has never been properly recognized by economists, despite its elementary logic and its overwhelming empirical apparency.
Our critique of Keynesianism is concentrated on its political presuppositions, not on its internal theoretical structure. It is as if someone tried to
make a jet engine operate by using the theory of the piston-driven machine.
Nothing need be wrong with the theory save that it is wholly misapplied.
This allows us largely but not completely to circumvent the troublesome and
sometimes complex analyses in modern macroeconomic and monetary theory. This does not imply, however, that the applicable theory, that which is
fully appropriate to the political institutions of a functioning democratic society, is simple and straightforward or, indeed, that this theory has been fully
developed. Our discussion provides the setting within which such a theory
might be pursued, and our plea is for economists to begin to think in terms
of the political structure that we observe. But before this step can be taken,
we must somehow reach agreement on the elements of the political decision
process, on the model for policy making, to which any theory of policy is to
be applied.
At this point, values cannot be left aside. If the Keynesian policy precepts
for national economic management have failed, there are two ways of reacting. We may place the blame squarely on the vagaries of democratic politics,
and propose that democratic decision making be replaced by more authoritarian rule. Or, alternatively, we can reject the applicability of the policy precepts in democratic structure, and try to invent and apply policy principles
that are consistent with such structure. We choose the latter.1 Our values dictate the democratic decision-making institutions should be maintained and
that, to this end, inapplicable economic theories should be discarded as is
necessary. If we observe democracy in deficit, we wish to repair the ‘‘deficit’’
part of this description, not to discard the ‘‘democracy’’ element.

A Review of the Record
We challenge the Keynesian theory of economic policy in this book. Our
challenge will stand or fall upon the ability of our argument to persuade.
There are two strings to our bow. We must first review both the pre-Keynesian
1. For a formulation of this choice alternative in a British context, see Robin Pringle,
‘‘Britain Hesitates before an Ineluctable Choice,’’ Banker 125 (May 1975): 493–496.

6

What Happened?

and the post-Keynesian record. Forty years of history offers us a basis for at
least preliminary assessment. We shall look carefully at the fiscal activities of
the United States government before the Great Depression of the 1930s, before the publication of Keynes’ General Theory.2 The simple facts of budget
balance or imbalance are important here, and these will not be neglected in
the discussion of Chapter 2. More importantly for our purposes, however,
we must try to determine the ‘‘principles’’ for budget making that informed
the political decision makers. What precepts for ‘‘fiscal responsibility’’ were
implicit in their behavior? How influential was the simple analogy between
the individual and the government financial account? How did the balancedbudget norm act to constrain spending proclivities of politicians and parties?
There was no full-blown Keynesian ‘‘revolution’’ in the 1930s. The American acceptance of Keynesian ideas proceeded step by step from the Harvard
economists, to economists in general, to the journalists, and, finally, to the
politicians in power. This gradual spread of Keynesian notions, as well as the
accompanying demise of the old-fashioned principles for financial responsibility, is documented in Chapters 3 and 4. The Keynesian brigades first had
to storm the halls of ivy, for only then would they have a base from which to
capture the minds of the public and the halls of Congress. Chapter 3 documents the triumph of Keynesianism throughout the groves of academe, while
Chapter 4 describes the infusion of Keynesianism into the general consciousness of the body politic—its emergence as an element of our general cultural
climate.
Even if our review of the historical record is convincing, no case is established for raising the alarm. What is of such great moment if elected politicians do respond to the Keynesian messages in somewhat biased manner?
What is there about budget deficits to arouse concern? How can the burden
of debt be passed along to our grandchildren? Is inflation the monster that it
is sometimes claimed to be? Why not learn to live with it, especially if unemployment can be kept within bounds? If Keynesian economics has and
can secure high-level employment, why not give it the highest marks, even
when recognizing its by-product generation of inflation and relatively expanding government? These are the questions that require serious analysis
2. John Maynard Keynes, The General Theory of Employment, Interest, and Money
(New York: Harcourt, Brace, 1936).

What Hath Keynes Wrought?

7

and discussion, because these are the questions that most economists would
ask of us; they are explored in Chapter 5.

The Theory of Public Choice
Our second instrument of persuasion is a theory for decision making in democracy, a theory of public choice, which was so long neglected by economists. This is developed in Chapters 6 through 9. Keynes was not a democrat,
but, rather, looked upon himself as a potential member of an enlightened
ruling elite. Political institutions were largely irrelevant for the formulation
of his policy presumptions. The application of the Keynesian precepts within
a working political democracy, however, would often require politicians to
undertake actions that would reduce their prospects for survival. Should we
then be surprised that the Keynesian democratic political institutions will
produce policy responses contrary to those that would be forthcoming from
some idealized application of the norms in the absence of political feedback?
In Chapter 7, it is shown that ordinary political representatives in positions of either legislative or executive authority will behave quite differently
when confronted with taxing and spending alternatives than would their benevolently despotic counterparts, those whom Keynes viewed as making policy, whose behavior is examined in Chapter 6. In Chapter 8, the analysis of
Chapter 7 is extended to the behavior of monetary authorities, and monetary
decisions are considered as endogenous rather than as exogenous variables.
A crucial feature of our argument is the ability of political and fiscal institutions to influence the outcomes of political processes, a subject that we explore in Chapter 9. Institutions matter in our analysis. While this position is
generally accepted by those who call themselves ‘‘Keynesians,’’ it is disputed
by many of those who consider themselves ‘‘anti-’’ or ‘‘non-Keynesians.’’ These
latter analysts argue that institutions are generally irrelevant. With respect to
institutions, we are like the Keynesians, for we do not let an infatuation with
abstract models destroy our sense of reality. Instead, we accept the proposition that institutions, like ideas, have consequences that are not at all obvious
at the time of their inception, a point that Richard Weaver noted so memorably.3 At the same time, however, our view of the nature of a free-enterprise
3. See Richard M. Weaver, Ideas Have Consequences (Chicago: University of Chicago
Press, 1948).

8

What Happened?

economic order is distinctly non-Keynesian, although ‘‘Keynesianism’’ must
to some extent be distinguished from the ‘‘economics of Keynes.’’ 4
The theory of public choice discussed in Chapters 6–9 is not at all complex, and it offers satisfactory explanations of the post-Keynesian fiscal record. The Keynesian defense must be, however, that the theory is indeed too
simplistic, that politicians can and will behave differently from the predictions of the theory. We do not, of course, rule out the ability of politicians,
intelligent persons all, to learn the Keynesian lessons. But will the voterscitizens, who determine who their political representatives will be, accept the
proffered wisdom? This is a tougher question, and the familiar call for more
economic education of the public has long since become a tiresome relic.
The Keynesian who relies on a more sophisticated electorate to reverse the
accumulating record leans on a frail reed.

Fiscal and Monetary Reform
In the last three chapters of the book, we return to what may be considered
the main theme. Even the ardent Keynesians recognized, quite early, that
some replacement for the fiscal rule of balanced budgets might be required
as guidance for even the enlightened politicians. In Chapter 10, we examine
the alternative rules for fiscal responsibility that have been advanced and
used in the discussion of fiscal and budgetary policy. These include the rule
for budget balance over the business cycle, and, more importantly, the rule
for budget balance at full employment which continues to inform the official
economic pronouncements from Washington, even if it is largely disregarded
in practice.
Chapter 11 represents our response to what will seem to many to be our
most vulnerable point. What about unemployment? Our criticism of the implications of the Keynesian teachings may be widely accepted, up to a point.
But how are we to respond to the argument that the maintenance of highlevel employment is the overriding objective for national economic policy,
4. See Axel Leijonhufvud, On Keynesian Economics and the Economics of Keynes (London: Oxford University Press, 1968); and G. L. S. Shackle, ‘‘Keynes and Today’s Establishment in Economic Theory: A View,’’ Journal of Economic Literature 11 (June 1973): 516–
519. A somewhat different perspective is presented in Leland B. Yeager, ‘‘The Keynesian
Diversion,’’ Western Economic Journal 11 (June 1973): 150–163.

What Hath Keynes Wrought?

9

and that only the Keynesian teachings offer resolution? These questions inform this chapter, in which we question the foundations of such prevalent
attitudes.
Chapter 12 offers our own substantive proposals for fiscal and monetary
reform. Our emphasis here is on the necessity that the reforms introduced
be treated as genuine constitutional measures, rules that are designed to constrain the short-run expedient behavior of politicians. Our emphasis here is
in the long-range nature of reform, rather than on the details of particular
proposals. To avoid charges of incompleteness and omission, however, we
advance explicit suggestions for constitutional change, and notably for the
adoption of a constitutional amendment requiring budget balance.

2. The Old-Time Fiscal Religion

Classical Fiscal Principle
The history of both fiscal principle and fiscal practice may reasonably be
divided into pre- and post-Keynesian periods. The Keynesian breakpoint is
stressed concisely by Hugh Dalton, the textbook writer whose own political
career was notoriously brief. In the post-Keynesian editions of his Principles
of Public Finance, Dalton said:
The new approach to budgetary policy owes more to Keynes than to any
other man. Thus it is just that we should speak of ‘‘the Keynesian revolution.’’ . . . We may now free ourselves from the old and narrow conception
of balancing the budget, no matter over what period, and move towards
the new and wider conception of balancing the whole economy.1

In this chapter, we shall examine briefly the pre-Keynesian history, in terms
of both the articulation of fiscal principle and the implementation of fiscal
practice. As noted at the beginning of Chapter 1, the pre-Keynesian or ‘‘classical’’ principles can perhaps best be summarized in the analogy between the
state and the family. Prudent financial conduct by the government was conceived in basically the same image as that by the family or the firm. Frugality,
not profligacy, was accepted as the cardinal virtue, and this norm assumed
practical shape in the widely shared principle that public budgets should be
in balance, if not in surplus, and that deficits were to be tolerated only in
extraordinary circumstances. Substantial and continuing deficits were interpreted as the mark of fiscal folly. Principles of sound business practice were
1. Hugh Dalton, Principles of Public Finance, 4th ed. (London: Routledge and Kegan
Paul, 1954), p. 221.

10

The Old-Time Fiscal Religion

11

also held relevant to the fiscal affairs of government. When capital expenditures were financed by debt, sinking funds for amortization were to be established and maintained. The substantial attention paid to the use and operation of sinking funds in the fiscal literature during the whole pre-Keynesian
era attests to the strength with which these basic classical principles were held.2
Textbooks and treatises embodied the noncontroverted principle that public budgets should be in balance. C. F. Bastable, one of the leading publicfinance scholars of the late nineteenth and early twentieth centuries, in commenting on ‘‘The Relation of Expenditure and Receipts,’’ suggested that
under normal conditions, there ought to be a balance between these two
sides [expenditure and revenue] of financial activity. Outlay should not
exceed income, . . . tax revenue ought to be kept up to the amount required to defray expenses.3

Bastable recognized the possibility of extenuating circumstances, which led
him to modify his statement of the principle of budget balance by stating:
This general principle must, however, admit of modifications. Temporary
deficits and surpluses cannot be avoided. . . . All that can be claimed is a
substantial approach to a balance in the two sides of the account. The safest rule for practice is that which lays down the expediency of estimating
for a moderate surplus, by which the possibility of a deficit will be reduced
to a minimum. [Italics supplied]4

Classical or pre-Keynesian fiscal principles, in other words, supported a budget surplus during normal times so as to provide a cushion for more troublesome periods. And similar statements can be found throughout the preKeynesian fiscal literature.5
Aside from the simple, and basically intuitive, analogy drawn between gov2. For a thorough examination of these classical principles and how they functioned
as an unwritten constitutional constraint during the pre-Keynesian era, see William Breit,
‘‘Starving the Leviathan: Balanced Budget Prescriptions before Keynes’’ (Paper presented
at the Conference on Federal Fiscal Responsibility, March 1976), to be published in a conference volume.
3. C. F. Bastable, Public Finance, 3rd ed. (London: Macmillan, 1903), p. 611.
4. Ibid.
5. For a survey of the balanced-budget principle, see Jesse Burkhead, ‘‘The Balanced
Budget,’’ Quarterly Journal of Economics 68 (May 1954): 191–216.

12

What Happened?

ernments and individuals and business firms, these rules for ‘‘sound finance’’
were reinforced by two distinct analytical principles, only one of which was
made explicit in the economic policy analysis of the period. The dominant
principle (one that was expressed clearly by Adam Smith and incorporated
into the theory of economic policy) was that resort to debt finance by government provided evidence of public profligacy, and, furthermore, a form of
profligacy that imposed fiscal burdens on subsequent taxpayers. Put starkly,
debt finance enabled people living currently to enrich themselves at the expense of people living in the future. These notions about debt finance, which
were undermined by the Keynesian revolution, reinforced adherence to a
balanced-budget principle of fiscal conduct. We shall describe these principles of debt finance and debt burden more carefully in a subsequent section
of this chapter.
A second analytical principle emerged more than a century after Smith’s
Wealth of Nations, and it was not explicitly incorporated into the norms for
policy. But it may have been implicitly recognized. It is important because it
reinforces the classical principles from a different and essentially political or
public-choice perspective. In 1896, Knut Wicksell noted that an individual
could make an informed, rational assessment of various proposals for public
expenditure only if he were confronted with a tax bill at the same time.6 Moreover, to facilitate such comparison, Wicksell suggested that the total costs of
any proposed expenditure program should be apportioned among the individual members of the political community. These were among the institutional features that he thought necessary to make reasonably efficient fiscal
decisions in a democracy. Effective democratic government requires institutional arrangements that force citizens to take account of the costs of government as well as the benefits, and to do so simultaneously. The Wicksellian
emphasis was on making political decisions more efficient, on ensuring that
costs be properly weighed against benefits. A norm of balancing the fiscal
decision or choice process, if not a formal balancing of the budget, emerges
directly from the Wicksellian analysis.
6. Knut Wicksell, Finanztheoretische Untersuchungen (Jena: Gustav Fischer, 1896). Translated as ‘‘A New Principle of Just Taxation’’ in R. A. Musgrave and A. T. Peacock, eds.,
Classics in the Theory of Public Finance (London: Macmillan, 1958), pp. 72–118.

The Old-Time Fiscal Religion

13

Fiscal Practice in Pre-Keynesian Times
Pre-Keynesian fiscal practice was clearly informed by the classical notions of
fiscal responsibility, as an examination of the record will show.7 This fiscal
history was not one of a rigidly balanced budget defined on an annual accounting basis. There were considerable year-to-year fluctuations in receipts,
in expenditures, and in the resulting surplus or deficit. Nonetheless, a pattern is clearly discernible: Deficits emerged primarily during periods of war;
budgets normally produced surpluses during peacetime, and these surpluses
were used to retire the debt created during war emergencies.8
The years immediately following the establishment of the American Republic in 1789 were turbulent. There was war with the Indians in the Northwest; the Whiskey Rebellion erupted; and relations with England were deteriorating and fears of war were strong. Federal government budgets were
generally in deficit during this period, and by 1795 the gross national debt
was $83.8 million. But by 1811 this total had been reduced nearly by half, to
$45.2 million. And during the sixteen years of this 1795–1811 period, there
were fourteen years of surplus and two years of a deficit. Moreover, the surpluses tended to be relatively large, averaging in the vicinity of $2.5 million
in federal budgets with total expenditures that averaged around $8 million.
The War of 1812 brought forth a new sequence of budget deficits that lasted
through 1815. The cumulative deficit over this four-year period slightly exceeded $65 million, which was more than one-half of the cumulative public
expenditure during this same period. Once again, however, the gross national
debt of $127 million at the end of 1815 was steadily reduced during the subsequent two decades. In the twenty-one years from 1816 through 1836, there
were eighteen years of surplus, and the gross debt had fallen to $337,000 by
the end of 1836.
John W. Kearny, writing in 1887 on the fiscal history of the 1789–1835 period, reflected the sentiment that the retirement of public debt was an im7. Numerical details by year can be found in the ‘‘Statistical Appendix’’ to the Annual
Report of the Secretary of the Treasury on the State of the Finances (Washington: U.S. Government Printing Office, 1976).
8. For a survey of our budgetary history through 1958, see Lewis H. Kimmel, Federal
Budget and Fiscal Policy, 1789–1958 (Washington: Brookings Institution, 1959).

14

What Happened?

portant political issue at that time. The primary vehicle for accomplishing
this policy of debt retirement was the Sinking-Fund Act of 1795, as amended
in 1802. Under these acts, substantial revenues were earmarked and set aside
for debt retirement. Kearny’s assessment of the 1795 act expresses clearly the
attitude toward deficit finance and public debt that prevailed:
The Act of the 3d of March, 1795, is an event of importance in the financial
history of the country. It was the consummation of what remained unfinished in our system of public credit, in that it publicly recognized, and ingrafted on that system, three essential principles, the regular operation of
which can alone prevent a progressive accumulation of debt: first of all it
established distinctive revenues for the payment of the interest of the public debt as well as for the reimbursement of the principal within a determinate period; secondly, it directed imperatively their application to the
debt alone; and thirdly it pledged the faith of the Government that the appointed revenues should continue to be levied and collected and appropriated to these objects until the whole debt should be redeemed. [Italics
supplied]9

The depression that followed the Panic of 1837 lasted throughout the administration of Martin Van Buren and halfway through the administration
of William Henry Harrison and John Tyler, terminating only in 1843. This
depression seems clearly to have been the most severe of the nineteenth century and has been described as ‘‘one of the longest periods of sustained contraction in the nation’s history, rivaled only by the downswing of 1929–33.’’ 10
During this seven-year period of economic stress, there were six years of deficit, and the national debt had soared to $32.7 million by the end of 1843.
Once again, as stability returned, the normal pattern of affairs was resumed. Three consecutive surpluses were run, reducing the national debt to
$15.6 million by the end of 1846. With the advent of the Mexican-American
War, deficits emerged again during 1847–1849, and the gross debt climbed to
$63.5 million by the end of 1849. Eight years of surplus then ensued, followed
9. John W. Kearny, Sketch of American Finances, 1789–1835 (1887; reprint ed., New York:
Greenwood Press, 1968), pp. 43–44.
10. Lance E. Davis, Jonathan R. T. Hughes, and Duncan M. McDougall, American Economic History, rev. ed. (Homewood, Ill.: Richard D. Irwin, 1965), p. 420. See also Reginald
C. McGrane, The Panic of 1837 (New York: Russell and Russell, 1965).

The Old-Time Fiscal Religion

15

by two years of deficit, and then the Civil War. By the end of 1865, the gross
public debt of the United States government had increased dramatically to
$2.7 billion.
Once hostilities ceased, however, twenty-eight consecutive years of budget
surplus resulted. By the end of 1893, the gross debt had been reduced by twothirds, to $961 million. The rate of reduction of outstanding debt was substantial, with approximately one-quarter of public expenditure during this
period being devoted to debt amortization. Deficits emerged in 1894 and 1895,
and, later in the decade, the Spanish-American War brought forth four additional years of deficit. By the end of 1899, the gross national debt stood at
$1.4 billion.
The years prior to World War I were a mixture of surplus and deficit, with
a slight tendency toward surplus serving to reduce the debt to $1.2 billion by
the end of 1916. World War I brought three years of deficit, and the national
debt stood at $25.5 billion by the end of 1918. There then followed eleven consecutive years of surplus, which reduced the national debt to $16.2 billion by
1930. The Great Depression and World War II then combined to produce sixteen consecutive years of deficit, after which the gross national debt stood at
$169.4 billion in 1946.
Until 1946, then, the story of our fiscal practice was largely a consistent
one, with budget surpluses being the normal rule, and with deficits emerging
primarily during periods of war and severe depression. The history of fiscal
practice coincided with a theory of debt finance that held that resort to debt
issue provided a means of reducing present burdens in exchange for the obligation to take on greater burdens in the future. It was only during some
such extraordinary event as a war or a major depression that debt finance
seemed to be justified.
While the history of our fiscal practice did not change through 1946, fiscal
theory began to change during the 1930s. One of the elements of this change
was the emerging dominance of a theory of the burden of public debt that
had been widely discredited. The classical theory of public debt, which we
shall describe more fully in the next section, suggests that debt issue is a means
by which present taxpayers can shift part of the cost of government on the
shoulders of taxpayers in future periods. The competing theory of public
debt, which had been variously suggested by earlier writers, was embraced
anew by Keynesian economists, so much so that it quickly became the ortho-

16

What Happened?

dox one, and well may be called the ‘‘Keynesian’’ theory of public debt. This
theory explicitly denies that debt finance places any burden on future taxpayers. It suggests instead that citizens who live during the period when public expenditures are made always and necessarily bear the cost of public services, regardless of whether those services are financed through taxation or
through debt creation. This shift in ideas on public debt was, in turn, vital in
securing acquiescence to deficit financing. There was no longer any reason
for opposing deficit financing on basically moral grounds. This Keynesian
theory of debt burden, however, is a topic to be covered in the next chapter;
the task at hand is to examine briefly the Smithian or classical theory.

Balanced Budgets, Debt Burdens,
and Fiscal Responsibility
Pre-Keynesian debt theory held that there is one fundamental difference between tax finance and debt finance that is obscured by the Keynesians. In the
pre-Keynesian view, a choice between tax finance and debt finance is a choice
of the timing of the payments for public expenditure. Tax finance places the
burden of payment squarely upon those members of the political community during the period when the expenditure decision is made. Debt finance,
on the other hand, postpones payment until interest and amortization payments on debt come due. Debt finance enables those people living at the
time of fiscal decision to shift payment onto those living in later periods,
which may, of course, be the same group, especially if the period over which
the debt is amortized is short.
In earlier works, we have offered an analytical defense of the classical theory of public debt, and especially as it is compared with its putative Keynesian replacement.11 We shall not, at this point, repeat details of other works.
Nonetheless, a summary analysis of the basic classical theory will be helpful,
since the broad acceptance of this theory by the public and by the politicians
was surely a significant element in cementing and reinforcing the privatepublic finance analogy.
11. See James M. Buchanan, Public Principles of Public Debt (Homewood, Ill.: Richard
D. Irwin, 1958); and James M. Buchanan and Richard E. Wagner, Public Debt in a Democratic Society (Washington: American Enterprise Institute, 1967).

The Old-Time Fiscal Religion

17

What happens when a government borrows? Before this question may be
answered, we must specify both the fiscal setting that is assumed to be present and the alternative courses of action that might be followed. The purpose
of borrowing is, presumably, to finance public spending. It seems, therefore,
appropriate to assume that a provisional decision has been made to spend
public funds. Having made this decision, the question reduces to one of choice
among alternative means of financing. There are only three possibilities: (1)
taxation, (2) public borrowing or debt issue, and (3) money creation. We
shall, at this point, leave money creation out of account, because the Keynesian attack was launched on the classical theory of public borrowing, not upon
the traditionally accepted theory of the effects of money creation. The theory
of public debt reduces to a comparison between the effects of taxation and
public debt issue, on the assumption that the public spending is fixed. The
question becomes: When a government borrows, what happens that does
not happen when it finances the same outlay through current taxation?
With borrowing, the command over real resources, over purchasing power,
is surrendered voluntarily to government by those who purchase the bonds
sold by the government, in a private set of choices independent of the political process. This is simply an ordinary exchange. Those who purchase these
claims are not purchasing or paying for the benefits that are promised by the
government outlays. They are simply paying for the obligations on the part
of the government to provide them with an interest return in future periods
and to amortize the principal on some determinate schedule. (This extremely
simple point, the heart of the whole classical theory of public debt, is the
source of major intellectual confusion.) These bond purchasers are the only
persons in the community who give up or sacrifice commands over current
resource use, who give up private investment or consumption prospects, in
order that the government may obtain command over the resources which
the budgetary outlays indicate to be desirable.
But if this sacrifice of purchasing power is made through a set of voluntary
exchanges for bonds, who is really ‘‘purchasing,’’ and by implication ‘‘paying
for,’’ the benefits that the budgetary outlays promise to provide? The ultimate
‘‘purchasers’’ of such benefits, under the public debt as under the taxation
alternative, are all the members of the political community, at least as these
are represented through the standard political decision-making process. A
decision to ‘‘purchase’’ these benefits is presumably made via the political

18

What Happened?

rules and institutions in being. But who ‘‘pays for’’ these benefits? Who suffers private costs which may then be balanced off against the private benefits
offered by the publicly supplied services? Under taxation, these costs are imposed directly on the citizens, as determined by the existing rules for tax or
cost sharing. Under public borrowing, by contrast, these costs are not imposed currently, during the budgetary period when the outlays are made. Instead, these costs are postponed or put off until later periods when interest
and amortization payments come due. This elementary proposition applies
to public borrowing in precisely the same way that it applies to private borrowing; the classical analogy between private and public finance seems to
hold without qualification.
Indeed, the whole purpose of borrowing, private or public, should be to
facilitate an expansion of outlay by putting off the necessity for meeting the
costs. The basic institution of debt is designed to modify the time sequence
between outlay and payment. As such, and again for both the private and the
public borrower, there is no general normative rule against borrowing as opposed to current financing, and especially with respect to capital outlays.
There is nothing in the classical theory of public debt that allows us to condemn government borrowing at all times and places.
Both for the family or firm and for the government, there exist norms for
financial responsibility, for prudent fiscal conduct. Resort to borrowing, to
debt issue, should be limited to those situations in which spending needs are
‘‘bunched’’ in time, owing either to such extraordinary circumstances as natural emergencies or disasters or to the lumpy requirements of a capital investment program. In either case, borrowing should be accompanied by a
scheduled program of amortization. When debt is incurred because of the
investment of funds in capital creation, amortization should be scheduled to
coincide with the useful or productive life of the capital assets. Guided by this
principle of fiscal responsibility, a government may, for example, incur public debts to construct a road or highway network, provided that these debts
are scheduled for amortization over the years during which the network is
anticipated to yield benefits or returns to the citizens of the political community. Such considerations as these provide the source for separating current and capital budgets in the accounts of governments, with the implication that principles of financing may differ as the type of outlay differs. These
norms incorporate the notion that only the prospect of benefits in periods

The Old-Time Fiscal Religion

19

subsequent to the outlay makes legitimate the postponing or putting off of
the costs of this outlay. There is nothing in this classically familiar argument,
however, that suggests that the costs will somehow disappear because the
benefits accrue in later periods, an absurd distortion that some of the more
extreme Keynesian arguments would seem to introduce.
The classical rules for responsible borrowing, public or private, are clear
enough, but the public-finance–private-finance analogy may break down
when the effects of irresponsible or imprudent financial conduct are analyzed. The dangers of irresponsible borrowing seem greater for governments
than for private families or firms. For this reason, more stringent constraints
may need to be placed on public than on private debt issue. The difference
lies in the specification and identification of the liability or obligation incurred under debt financing in the two cases. If an individual borrows, he
incurs a personal liability. The creditor holds a claim against the assets of the
person who initially makes the decision to borrow, and the borrower cannot
readily shift his liability to others. There are few willing recipients of liabilities. If the borrower dies, the creditor has a claim against his estate.
Compare this with the situation of an individual who is a citizen in a political community whose governmental units borrow to finance current outlay. At the time of the borrowing decision, the individual citizen is not assigned a specific and determinate share of the fiscal liability that the public
debt represents. He may, of course, sense that some such liability exists for
the whole community, but there is no identifiable claim created against his
privately owned assets. The obligations are those of the political community,
generally considered, rather than those of identified members of the community. If, then, a person can succeed in escaping what might be considered
his ‘‘fair’’ share of the liability by some change in the tax-share structure, or
by some shift in the membership of the community through migration, or
merely by growth in the domestic population, he will not behave as if the
public debt is equivalent to private debt.
Because of this difference in the specification and identification of liability
in private and public debt, we should predict that persons will be somewhat
less prudent in issuing the latter than the former. That is to say, the pressures
brought to bear on governmental decision makers to constrain irresponsible
borrowing may not be comparable to those that the analogous private borrower would incorporate within his own behavioral calculus. The relative ab-

20

What Happened?

sence of such public or voter constraints might lead elected politicians, those
who explicitly make spending, taxing, and borrowing decisions for governments, to borrow even when the conditions for responsible debt issues are
not present. It is in recognition of such proclivities that classical principles of
public fiscal responsibility incorporate explicit limits on resort to borrowing
as a financing alternative, and which also dictate that sinking funds or other
comparable provisions be made for amortization of loans at the time of any
initial spending-borrowing commitment.12
Without some such constraints, the classical theory embodies the prediction of a political scenario with cumulatively increasing public debt, unaccompanied by comparable values in accumulating public assets, a debt which,
quite literally, places a mortgage claim against the future income of the productive members of the political community. As new generations of voterstaxpayers appear, they would, under this scenario, face fiscal burdens that
owe their origins exclusively to the profligacy of their forebears. To the extent
that citizens, and the politicians who act for them in making fiscal choices,
regard members of future generations as lineal extensions of their own lives,
the implicit fears of overextended public credit might never be realized. But
for the reasons noted above, classical precepts suggest that dependence could
not be placed on such potential concern for taxpayers in future periods. The
effective time horizon, both for members of the voting public and for the
elected politicians alike, seems likely to be short, an implicit presumption of
the whole classical construction.
This is not, of course, to deny that the effects on taxpayers in later budgetary periods do not serve, and cannot serve, as constraints on public borrowing. So long as decision makers act on the knowledge that debt issue does,
in fact, shift the cost of outlay forward in time, some limit is placed on irresponsible behavior. That is to say, even in the absence of classically inspired
institutional constraints on public debt, a generalized public acceptance of
the classical theory of public debt would, in itself, exert an important inhibiting effect. It is in this context that the putative replacement of the classical

12. For an analysis of the possibilities for debt abuse within a political democracy, see
James M. Buchanan, Public Finance in Democratic Process (Chapel Hill: University of North
Carolina Press, 1967), pp. 256–266; and Richard E. Wagner, ‘‘Optimality in Local Debt
Limitation,’’ National Tax Journal 23 (September 1970): 297–305.

The Old-Time Fiscal Religion

21

theory by the Keynesian theory can best be evaluated. The latter denies that
debt finance implements an intertemporal shift of realized burden or cost of
outlay, quite apart from the question as to the possible desirability or undesirability of this method of financing. The existence of opportunities for cumulative political profligacy is viewed as impossible; there are no necessarily
adverse consequences for future taxpayers. The selling of the Keynesian theory of debt burden, which we shall examine in the next chapter, was a necessary first step in bringing about a democracy in deficit.

Fiscal Principles and Keynesian Economic Theory
There was a genuine ‘‘Keynesian revolution’’ in fiscal principles, the effects
of which we attempt to chronicle in this book. But we should not overlook
the fact that this fiscal revolution was embedded within the more comprehensive Keynesian theory of economic process. As Chapters 3 and 4 will discuss in some detail, there was a shift in the vision or paradigm for the operation of the whole economy. Without this, there would have been no need for
the revolutionary shift in attitudes about fiscal precepts.
This is illustrated in the competing theories of public debt, noted above.
Analyses of the effects of public debt closely similar to those associated with
those advanced under Keynesian banners had been advanced long before the
1930s and in various countries and by various writers.13 These attacks on the
classical theory were never fully effective in capturing the minds of economists, because they were not accompanied by a shift away from the underlying paradigm of neoclassical economics. A nonclassical theory of public debt
superimposed on an essentially classical theory of economic process could,
at best, have been relevant for government budget making. But the nonclassical theory of public debt advanced by the Keynesians was superimposed on
the nonclassical theory of economic process, a theory which, in its normative
application, elevated deficit financing to a central role. A change in the effective fiscal constitution implied not only a release of politicians from the constraining influences that prevented approval of larger debt-financed public
budgets, but also a means for securing the more important macroeconomic
13. For a summary of the literature, see Buchanan, Public Principles of Public Debt, pp.
16–20.

22

What Happened?

objectives of increased real income and employment.14 To be sure, it was recognized that deficit financing might also increase governmental outlays, possibly an objective in itself, but the strictly Keynesian emphasis was on the effects on the economy rather than on the probable size of the budget as such.
And it was this instrumental value of budget deficits, and by implication of
public debt, that led economists to endorse, often enthusiastically and without careful analysis, theoretical constructions that would have been held untenable if examined independently and on their own.
There is, of course, no necessary relationship between the theory of public
debt and the theory of economic process. A sophisticated analysis can incorporate a strictly classical theory of public debt into a predominantly Keynesian
theory of income and employment. Or, conversely, a modern non-Keynesian
monetarist could possibly accept the no-transfer or Keynesian theory of debt
burden. The same could scarcely be said for fiscal principles, considered in
total. The old-time fiscal religion, that which incorporates both the classical
theory of debt and the precept which calls for budget balance, could not
readily be complementary to an analysis of the economic process and policy
that is fully Keynesian. In terms of intellectual history, it was the acceptance
of Keynesian economic theory which produced the revolution in ideas about
fiscal principles and practice, rather than the reverse.
14. For examinations of this categorical shift in the scope of fiscal policy during the
1930s, see Ursula K. Hicks, British Public Finances: Their Structure and Development, 1880–
1952 (London: Oxford University Press, 1954); and Lawrence C. Pierce, The Politics of Fiscal Policy Formation (Pacific Palisades, Calif.: Goodyear, 1971). With reference to Great
Britain, Hicks noted:
Fiscal policy in the sense of a purposeful marshalling of the armoury of public finance
in order to influence the level of incomes cannot be said to have been recognized as an
art before the middle or late 1930s. Up to that time considerations of public finance ran
in terms only of the effects of individual taxes and outlays, on particular aspects of economic life, without regard to the total effect. [p. 140]

With reference to the United States, Pierce observed:
Until the late 1930s, the role of the government budget was limited to providing public
services, raising taxes to pay for them, and, less often, influencing the distribution of
income among regions and individuals. It is only since the late 1930s that economists
and political leaders have come to believe that they can also use the federal budget to
help avoid most of the economic ills associated with high levels of unemployment, price
inflation, and economic stagnation. [p. 1]

The Old-Time Fiscal Religion

23

The Fiscal Constitution
Whether they are incorporated formally in some legally binding and explicitly constitutional document or merely in a set of customary, traditional,
and widely accepted precepts, we can describe the prevailing rules guiding
fiscal choice as a ‘‘fiscal constitution.’’ As we have noted, thoughout the preKeynesian era, the effective fiscal constitution was based on the central principle that public finance and private finance are analogous, and that the norms
for prudent conduct are similar. Barring extraordinary circumstances, public
expenditures were supposed to be financed by taxation, just as private spending was supposed to be financed from income.
The pre-Keynesian or classical fiscal constitution was not written in any
formal set of rules. It was, nonetheless, almost universally accepted.15 And its
importance lay in its influence in constraining the profligacy of all persons,
members of the public along with the politicians who acted for them. Because expenditures were expected to be financed from taxation, there was
less temptation for dominant political coalitions to use the political process
to implement direct income transfers among groups. Once the expendituretaxation nexus was broken, however, the opportunities for such income transfers were increased. Harry G. Johnson, for instance, has advanced the thesis
that the modern tendency toward ever-increasing budget deficits results from
such redistributional games. Governments increasingly enact public expenditure programs that confer benefits on special segments of the population,
with the cost borne by taxpayers generally. Many such programs might not
be financed in the face of strenuous taxpayer resistance, but might well secure acceptance under debt finance. The hostility to the expenditure programs is reduced in this way, and budgets rise; intergroup income transfers
multiply.16
Few could quarrel with the simple thesis that the effective fiscal constitution in the United States was transformed by Keynesian economics. The oldtime fiscal religion is no more. But, one might reasonably ask, ‘‘so what?’’
The destruction of the classical principles of fiscal policy was to have made
15. See Breit.
16. Harry G. Johnson, ‘‘Living with Inflation,’’ Banker 125 (August 1975): 863–864.

24

What Happened?

possible major gains in overall economic performance. If so, we should not
mourn the passing of such outmoded principles.
Keynesianism offered the promise of replacing the old with a better,
more efficient fiscal constitution. By using government to control aggregate
macroeconomic variables, cyclical fluctuations in economic activity were to
be damped; the economy was to have both less unemployment and less inflation. If interpreted as prediction, the Keynesian promise has not been
kept. The economy of the 1970s has not performed satisfactorily, despite
the Keynesian-inspired direction of policy.

3. First, the Academic Scribblers

John Maynard Keynes was a speculator, in ideas as well as in foreign currencies, and his speculation was scarcely idle. He held an arrogant confidence in
the ideas that he adopted, at least while he held them, along with a disdain
for the virtues of temporal consistency. His objective, with The General Theory of Employment, Interest, and Money (1936), was to secure a permanent
shift in the policies of governments, and he recognized that the conversion
of the academic scribblers, in this case the economists, was a necessary first
step. ‘‘It is my fellow economists, not the general public, whom I must convince.’’1 In the economic disorder of the Great Depression, there were many
persons—politicians, scholars, publicists—in America and elsewhere, who
advanced policy proposals akin to those that were to be called ‘‘Keynesian.’’
But it was Keynes, and Keynes alone, who captured the minds of the economists (or most of them) by changing their vision of the economic process.
Without Keynes, government budgets would have become unbalanced, as
they did before Keynes, during periods of depression and war. Without
Keynes, governments would have varied the rate of money creation over
time and place, with bad and good consequences. Without Keynes, World
War II would have happened, and the economies of Western democracies
would have been pulled out of the lingering stagnation of the 1930s. Without
Keynes, substantially full employment and an accompanying inflationary
threat would have described the postwar years. But these events of history
would have been conceived and described differently, then and now, without
the towering Keynesian presence. Without Keynes, the proclivities of ordinary politicians would have been held in check more adequately in the 1960s
1. John Maynard Keynes, The General Theory of Employment, Interest, and Money (New
York: Harcourt, Brace, 1936), p. vi.

25

26

What Happened?

and 1970s. Without Keynes, modern budgets would not be quite so bloated,
with the threat of more to come, and inflation would not be the clear and
present danger to the free society that it has surely now become. The legacy
or heritage of Lord Keynes is the putative intellectual legitimacy provided to
the natural and predictable political biases toward deficit spending, inflation,
and the growth of government.
Our objective in this chapter is to examine the Keynesian impact on the
ideas of economists, on the ‘‘Keynesian revolution’’ in economic theory and
policy as discussed within the ivied walls of academia. By necessity as well as
intent, our treatment will be general and without detail, since our purpose is
not that of offering a contribution to intellectual or scientific history, but,
rather, that of providing an essential element in any understanding of the
ultimate political consequences of Keynesian ideas.2

‘‘Classical Economics,’’ a Construction in Straw?
Keynes set out to change the way that economists looked at the national economy. A first step was the construction of a convenient and vulnerable target,
which emerged as the ‘‘classical economists,’’ who were only partially identified but who were, in fact, somewhat provincially located in England. With
scarcely a sidewise glance at the institutional prerequisites, Keynes aimed directly at the jugular of the targeted model, the self-equilibrating mechanism
of the market economy. In the Keynesian description, the classical economist
remained steadfast in his vision of a stable economy that contained within it
self-adjusting reactions to exogenous shocks, reactions that would ensure that
the economy as a whole, as well as in its particular sectors, would return toward a determinate set of equilibrium values. Furthermore, these values were
determinate at plausibly desired levels. Following Ricardo and rejecting Mal2. In various works, Professor Axel Leijonhufvud of UCLA has examined the impact
of Keynesian ideas on economists in some detail. We are indebted to his insights here,
which supplement our much less comprehensive examination of the intellectual history.
Robert Skidelsky, ‘‘Keynes and the Revolt against the Victorians,’’ Spectator, 1 May 1976,
pp. 14–16, contrasts the Keynesian and the Victorian world views. While the Victorian
emphasis was on a goal-directed life, the Keynesian emphasis stressed living in the present. Keynes’ assault on saving and thrift is one consequence of this shift in Weltanschauung.

First, the Academic Scribblers

27

thus, the classical economists denied the prospects of a general glut on markets.3
It is not within our purpose here to discuss the methodological or the analytical validity of the Keynesian argument against its allegedly classical opposition. We shall not attempt to discuss our own interpretation of just what
pre-Keynesian economics actually was. The attack was launched, not upon
that which might have existed, but upon an explicitly defined variant, which
may or may not have been caricature. And the facts of intellectual history
attest to the success of the venture. Economists of the twentieth century’s
middle decades conceived ‘‘classical economics’’ in the image conjured for
them by Keynes, and they interpret the ‘‘revolution’’ as the shift away from
that image. This is all that need concern us here.
In this image, ‘‘classical economics’’ embodied the presumption that there
existed built-in equilibrating forces which ensured that a capitalistic economy would generate continuing prosperity and high-level employment. Exogenous shocks might, of course, occur, but these would trigger reactions
that would quickly, and surely, tend to restore overall equilibrium at highemployment levels. Such an image seemed counter to the observed facts of
the 1920s in Britain and of the 1930s almost everywhere. National economies
seemed to be floundering, not prospering, and unemployment seemed to be
both pervasive and permanent.
Keynes boldly challenged the basic classical paradigm of his construction.
He denied the very existence of the self-equilibrating forces of the capitalist
economy. He rejected the extension of the Marshallian conception of particular market equilibrium to the economy as a whole, and to the aggregates
that might be introduced to describe it. A national economy might attain
‘‘equilibrium,’’ but there need be no assurance that the automatic forces of
the market would produce acceptably high and growing real output and highlevel employment.4
Again we need not and shall not trace out the essential Keynesian argument, in any of its many variants, and there would be little that we might add
3. For a recent, careful restatement of this position, see W. H. Hutt, A Rehabilitation of
Say’s Law (Athens: Ohio University Press, 1974).
4. See Axel Leijonhufvud, ‘‘Effective Demand Failures,’’ Swedish Journal of Economics
75 (March 1973): 27–48, for a description of these two alternative paradigms and a discussion of how they influence the economist’s analytical perspective.

28

What Happened?

to the still-burgeoning literature of critical reinterpretation and analysis. What
is important for us is the observed intellectual success of the central Keynesian challenge. From the early 1940s, most professionally trained economists
looked at ‘‘the economy’’ differently from the way they might have looked at
the selfsame phenomenon in the early 1920s or early 1930s. In a general sense
of the phrase, a paradigm shift took place.
Before Keynes, economists of almost all persuasions implicitly measured
the social productivity of their own efforts by the potential gains in allocative
efficiency which might be forthcoming upon the rational incorporation of
economists’ continuing institutional criticisms of political reality. How much
increase in social value might be generated by a shift of resources from this
to that use? Keynes sought to change, and succeeded in changing, this role
for economists. Allocative efficiency, as a meaningful and desirable social objective, was not rejected. Instead, it was simply relegated to a second level of
importance by comparison with the ‘‘pure efficiency’’ that was promised by
an increase in the sheer volume of employment itself. It is little wonder that
economists became excited about their greatly enhanced role and that they
came to see themselves as new persons of standing.
Once converted, economists could have readily been predicted to allow
Keynes the role of pied piper. But how were they to be converted? They had
to be convinced that the economic disaster of the Great Depression was something more than the consequence of specific mistakes in monetary policy,
and that correction required more than temporary measures. Keynes accomplished this aspect of the conversion by presenting a general theory of the
aggregative economic process, one that appeared to explain the events of the
1930s as one possible natural outcome of market interaction rather than as
an aberrant result produced by policy lapses.5 In this general theory, there is
5. One important element in the articulation of this Keynesian position was the presence of persistently high unemployment throughout the 1930s. Such a record seemed to
vitiate the classical belief in a self-adjusting economy. This entire record, it now turns out,
is false, for substantial numbers (2–3.5 million) of governmental employees were counted
as being unemployed. When a correct accounting is made for such persons, the pattern
changes starkly to one of a rapid and continuous reduction in unemployment from 1932
until the recession of 1937–1938, which itself resulted from the Federal Reserve’s doubling
of reserve requirements between August 1936 and May 1937. This piece of detective work

First, the Academic Scribblers

29

no direct linkage between the overall or aggregate level of output and employment that would be determined by the attainment of equilibrium in labor and money markets and that level of output and employment that might
be objectively considered desirable. In the actual equilibrium attained through
the workings of the market process, persons might find themselves involuntarily unemployed, and they could not increase the overall level of employment by offers to work for lowered money wages. Nor could central bankers
ensure a return to prosperity by the simple easing of money and credit markets. Under certain conditions, these actions could not reduce interest rates
and, through this, increase the rate of capital investment. To shock the system out of its possible locked-in position, exogenous forces would have to be
introduced, in the form of deficit spending by government.

The Birth of Macroeconomics
As if in one fell swoop, a new and exciting half-discipline was appended to the
classical tradition. Macroeconomics was born almost full-blown from the
Keynesian impact. To the conventional theory of resource allocation, now to
be labeled ‘‘microeconomics,’’ the new theory of employment was added,
and labeled ‘‘macroeconomics.’’ The professional economist, henceforward,
would have to be trained in the understanding not only of the theory of the
market process, but also the theory of aggregative economics, that theory
from which predictions might be made about levels of employment and output. Even those who remained skeptical of the whole Keynesian edifice felt
compelled to become expert in the manipulation of the conceptual models.
And perhaps most importantly for our history, textbook writers responded
by introducing simplistic Keynesian constructions into the elementary textbooks. Paul Samuelson’s Economics (1948) swept the field, almost from its
initial appearance early after the end of World War II. Other textbooks soon
followed, and almost all were similar in their dichotomous presentation of
subject matter. Courses were organized into two parts, microeconomics and
is due to Michael R. Darby, ‘‘Three-and-a-Half Million U.S. Employees Have Been Mislaid: Or, an Explanation of Unemployment, 1934–1941,’’ Journal of Political Economy 84
(February 1976): 1–16.

30

What Happened?

macroeconomics, with relatively little concern about possible bridges between
these sometimes disparate halves of the discipline.
Each part of the modified discipline carried with it implicit norms for social policy. Microeconomics, the rechristened traditional price theory, implicitly elevates allocative efficiency to a position as the dominant norm, and
applications of theory here have usually involved demonstrations of the
efficiency-producing or efficiency-retarding properties of particular institutional arrangements. Macroeconomics, the Keynesian consequence, elevates
high-level output and employment to its position of normative dominance,
with little or no indicated regard to the efficiency with which resources are
utilized. There are, however, significant differences in the implications of these
policy norms as between micro- and macroeconomics. In the former, the
underlying ideal or optimum structure, toward which policy steps should legitimately be aimed, is a well-functioning regime of markets. At an analytical
level, demonstrations that ‘‘markets fail’’ under certain conditions are taken
to suggest that correctives will ‘‘make markets work’’ or, if this is impossible,
will substitute regulation for markets, with the norm for regulation itself being that of duplicating market results. Equally, if not more, important are the
demonstrations that markets fail because of unnecessary and inefficient political control and regulation, with the implication that removal and/or reduction of control itself will generate desired results. In summary, the policy
implications of microeconomics are not themselves overtly interventionist
and, if anything, probably tend toward the anti-interventionist pole.
The contrast with macroeconomics in this respect is striking. There is nothing akin to the ‘‘well-functioning market’’ which will produce optimally preferred results, no matter how well embedded in legal and institutional structure. Indeed, the central thrust of the Keynesian message is precisely to deny
the existence of such an underlying ideal. ‘‘The economy,’’ in the Keynesian
paradigm, is afloat without a rudder, and its own internal forces, if left to
themselves, are as likely to ground the system on the rocks of deep depression as they are to steer it toward the narrow channels of prosperity. Once
this model for an economy is accepted to be analytically descriptive, even if
major quibbles over details of interpretation persist, the overall direction of
the economy by governmental or political control becomes almost morally
imperative. There is a necessary interventionist bias which stems from the
analytical basis of macroeconomics, a bias that is inherent in the paradigm

First, the Academic Scribblers

31

itself and which need not be at all related to the ideological persuasion of the
economist practitioner.

The New Role for the State
The Keynesian capture of the economists, therefore, carried with it a dramatically modified role for the state in their vision of the world. In this new
vision, the state was obliged to take affirmative action toward ensuring that
the national economy would remain prosperous, action which could, however, be taken with clearly defined objectives in view. Furthermore, in the initial surges of enthusiasm, few questions of conflict among objectives seemed
to present themselves. Who could reject the desirability of high-level output
and employment? Politicians responded quickly, and the effective ‘‘economic
constitution’’ was changed to embody an explicit commitment of governmental responsibility for full employment. The Full Employment Act became
law in the United States in 1946. The President’s Council of Economic Advisers was created, reflecting the political recognition of the enhanced role of
the economists and of economic theory after Keynes.6
The idealized scenario for the then ‘‘New Economics’’ was relatively
straightforward. Economists were required first to make forecasts about the
short- and medium-term movements in the appropriate aggregates—consumption, investment, public spending, and foreign trade. These forecasts
were then to be fed into the suitably constructed model for the working of
the national economy. Out of this, there was to emerge a prediction about
equilibrium levels of output and employment. This prediction was then to
be matched against desired or targeted values. If a shortfall seemed likely,
further estimation was to be made about the required magnitude of adjustment. This result was then to be communicated to the decision makers, who
would, presumably, respond by manipulating the government budget to accommodate the required changes.
This scenario, as sketched, encountered rough going early on when the
immediate post–World War II forecasts proved so demonstrably in error.7
6. Stephen K. Bailey, Congress Makes a Law (New York: Columbia University Press,
1950), is the standard legislative history of the enactment of the Employment Act of 1946.
7. Such forecasts include S. Morris Livingston, ‘‘Forecasting Postwar Demand,’’ Econ-

32

What Happened?

Almost from the onset of attempts to put Keynesian economics into practice,
conflicts between the employment and the price-level objectives appeared,
dousing the early enthusiasm for the economists’ new Jerusalem. Nonetheless, there was no backtracking on the fundamental reassignment of functions. The responsibility for maintaining prosperity remained squarely on
the shoulders of government. Stabilization policy occupied the minds and
hearts of economists, even amidst the developing evidence of broad forecasting error, and despite the sharpening analytical criticism of the basic Keynesian structure. The newly acquired faith in macroeconomic policy tools was,
in fact, maintained by the political lags in implementation. While textbooks
spread the simple Keynesian precepts, and while learned academicians debated sophisticated points in logical analysis, the politics of policy proceeded
much as before the revolution, enabling economists to blame government
for observed stabilization failures. The recessions of the 1950s, even if mild
by prewar standards, were held to reflect failures of political response. Economists in the academy were preparing the groundwork for the New Frontier,
when Keynesian ideas shifted beyond the sanctuaries to capture the minds
and hearts of ordinary politicians and the public.

The Scorn for Budget Balance
The old-time fiscal religion, which we have previously discussed in Chapter
2, was not easy to dislodge. Before the Keynesian challenge, an effective ‘‘fiscal constitution’’ did exist, even if this was not embodied in a written document. This ‘‘constitution’’ included the precept for budget balance, and this
rule served as an important constraint on the natural proclivities of politicians. The economists who had absorbed the Keynesian teachings were faced
with the challenge of persuading political leaders and the public at large that
the old-time fiscal religion was irrelevant in the modern setting. As a sacrosanct principle, budget balance had to be uprooted. Prosperity in the naometrica 13 (January 1945): 15–24; Richard A. Musgrave, ‘‘Alternative Budget Policies for
Full Employment,’’ American Economic Review 35 (June 1945): 387–400; National Planning Association, National Budgets for Full Employment (Washington: National Planning
Association, 1945); and Arthur Smithies, ‘‘Forecasting Postwar Demand,’’ Econometrica 13
(January 1945): 1–14. Such postwar forecasts were criticized in Albert G. Hart, ‘‘ ‘ModelBuilding’ and Fiscal Policy,’’ American Economic Review 35 (September 1945): 531–558.

First, the Academic Scribblers

33

tional economy, not any particular rule or state of the government’s budget,
was promoted as the overriding policy objective. And if the achievement and
the maintenance of prosperity required deliberate creation of budget deficits, who should be concerned? Deficits in the government budget, said the
Keynesians, were indeed small prices to pay for the blessings of high employment.
A new mythology was born. Since there was no particular virtue in budget
balance, per se, there was no particular vice in budget unbalance, per se. The
lesson was clear: Budget balance did not matter. There was apparently no
normative relationship, even in some remote conceptual sense, between the
two sides of the government’s fiscal account. The government was different
from the individual. The Keynesian-oriented textbooks hammered home this
message to a continuing sequence of student cohort groups. Is there any
wonder that, eventually, the message would be heeded?

The New Precepts for Fiscal Policy
The new rules that were to guide fiscal policy were simple. Budget deficits
were to be created when aggregate demand threatened to fall short of that
level required to maintain full employment. Conversely, and symmetrically,
budget surpluses were to be created when aggregate demand threatened to
exceed full-employment targets, generating price inflation. A balanced budget
would rationally emerge only when aggregate demand was predicted to be
just sufficient to generate full employment without exerting inflationary pressures on prices. Otherwise, unbalanced budgets would be required. In this
pure regime of functional finance, a regime in which the government’s budget
was to be used, and used rationally, as the primary instrument for stabilization, budget deficits or budget surpluses might emerge over some cumulative
multiperiod sequence. Those who were most explicit in their advocacy of
such a regime expressed little or no concern for the direction of budget unbalance over time.8 In the wake of the experience of the Great Depression,
however, the emphasis was placed on the possible need for a continuing sequence of deficits. The potential application of the new fiscal principles in
8. The clearest exposition of a position that was widely shared is found in Abba P. Lerner, The Economics of Control (New York: Macmillan, 1944), pp. 285–322.

34

What Happened?

threatened inflationary periods was discussed largely in hypothetical terms,
appended to lend analytical symmetry to the policy models.

Budget Deficits, Public Debt, and Money Creation
The deliberate creation of budget deficits—the explicit decision to spend and
not to tax—was the feature of Keynesian policy that ran most squarely in the
face of traditional and time-honored norms for fiscal responsibility. But there
was no alternative for the Keynesian convert. To increase aggregate demand,
total spending in the economy must be increased, and this could only be
guaranteed if the private-spending offsets of tax increase could be avoided or
swamped. New net spending must emerge, and the creation of budget deficits offered the only apparent escape from economic stagnation.9
If, however, the flow of spending was to be increased in this manner, the
problem of financing deficits necessarily arose. And at this point, the policy
advocate encountered two separate and subsidiary norms in the previously
existing ‘‘constitution.’’ Deficits could be financed in only one of two ways,
either through government borrowing (the issue of public debt) or through
the explicit creation of money (available only to central government). But
public debt, in the classical theory of public finance, transfers burdens onto
the shoulders of future generations. And money creation was associated, historically, with governmental corruption along with the dangers of inflation.
Retrospectively, it remains somewhat surprising that the Keynesians, or
most of them, chose to challenge the debt-burden argument of classical
public-finance theory rather than the money-creation alternative. (By so doing, quite unnecessary intellectual confusion was introduced into an important area of economic theory, confusion that had not, even as late as 1976,
been fully eliminated.) Within the strict assumptions of the Keynesian model,
and in the deficient-demand setting, the opportunity cost of additional gov9. For completeness, we should note here that the Keynesian theory of policy, as developed in the 1940s and 1950s, included the balanced-budget multiplier. Aggregate spending
in the economy might be increased by an increase in government outlays, even if budget
balance is strictly maintained, because of the fact that the increased tax revenues would
be drawn, in part, from private savings. The standard exposition of this proposition is
William J. Baumol and Maurice H. Peston, ‘‘More on the Multiplier Effects of a Balanced
Budget,’’ American Economic Review 45 (March 1955): 140–148.

First, the Academic Scribblers

35

ernmental spending is genuinely zero. From this, it follows directly that the
creation of money to finance the required deficit involves no net cost; there
is no danger of price inflation. In the absence of political-institutional constraints, therefore, the idealized Keynesian policy package for escape from
such economic situations is the explicit creation of budget deficits along with
the financing of these by pure money issue.
In such a context, any resort to public debt issue, to public borrowing, is
a necessary second-best. Why should the government offer any interest return at all to potential lenders of funds, to the purchasers of government
debt instruments, when the alternative of printing money at negligible real
cost and at zero interest is available? Regardless of the temporal location of
the burden of servicing and amortizing public debt, there is no supportable
argument for public borrowing in the setting of deficient demand. In trying
to work out a supporting argument here, the Keynesian economists were confused, even on their own terms.
Because they unreasonably assumed that deficits were to be financed by
public borrowing rather than by money creation, the Keynesian advocates
felt themselves obliged to reduce the sting of the argument concerning the
temporal transfer of cost or burden.10 To accomplish this, they revived in sophisticated form the distinction between the norms for private, personal financial integrity and those for public, governmental financial responsibility.
Budget balance did matter for an individual or family; budget balance did
not matter for a government. Borrowing for an individual offered a means
of postponing payment, of putting off the costs of current spending, which
might or might not be desirable. For government, however, there was no
such temporal transfer. It was held to be impossible to implement a transfer
of cost or burden through time because government included all members
of the community, and, so long as public debt was internally owned, ‘‘we owe
it to ourselves.’’ Debtors and creditors were mutually canceling; hence, in the
macroeconomic context, the society could never be ‘‘in debt’’ in any way
10. Richard A. Musgrave, in reviewing Alvin Hansen’s role in the selling of Keynesianism in the 1940s, acknowledged the pivotal position occupied by the classical theory of
public debt when he wrote: ‘‘The battle for full employment had to be continued, and the
counteroffensive, built around the alleged dangers of a rising public debt, had to be met.’’
See Musgrave’s contribution to the symposium on Alvin H. Hansen: ‘‘Caring for the Real
Problems,’’ Quarterly Journal of Economics 90 (February 1976): 5.

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What Happened?

comparable to that situation in which a person, a family, a firm, a local government, or even a central government that had borrowed from foreigners
might find itself.
This argument was deceptively attractive. It did much to remove the charge
of fiscal irresponsibility from the deficit-creation position. Politicians and the
public might hold fast to the classical theory, in its vulgar or its sophisticated
variant, but so long as professional economists could be found to present the
plausible counterargument, this flank of the Keynesian intellectual position
was amply protected, or so it seemed.
The ‘‘new orthodoxy’’ of public debt stood almost unchallenged among
economists during the 1940s and 1950s, despite its glaring logical contradictions.11 The Keynesian advocates failed to see that, if their theory of debt burden is correct, the benefits of public spending are always available without
cost merely by resort to borrowing, and without regard to the phase of the
economic cycle. If there is no transfer of cost onto taxpayers in future periods (whether these be the same or different from current taxpayers), and if
bond purchasers voluntarily transfer funds to government in exchange for
promises of future interest and amortization payments, there is no cost to
anyone in society at the time public spending is carried out. Only the benefits
of such spending remain. The economic analogue to the perpetual motion
machine would have been found.
A central confusion in the whole Keynesian argument lay in its failure to
bring policy alternatives down to the level of choices confronted by individual citizens, or confronted for them by their political representatives, and, in
turn, to predict the effects of these alternatives on the utilities of individuals.

11. The ‘‘new orthodoxy’’ was first challenged explicitly by James M. Buchanan in 1958.
In his book, Public Principles of Public Debt (Homewood, Ill.: Richard D. Irwin, 1958),
Buchanan specifically refuted the three main elements of the Keynesian theory, and he
argued that, in its essentials, the pre-Keynesian classical theory of public debt was correct.
Buchanan’s thesis was widely challenged and a lively debate among economists took place
in the early 1960s. Many of the contributions are included in James M. Ferguson, ed.,
Public Debt and Future Generations (Chapel Hill: University of North Carolina Press, 1964).
For a summary treatment, see James M. Buchanan and Richard E. Wagner, Public Debt in a
Democratic Society (Washington: American Enterprise Institute, 1967). Buchanan sought to
place elements of the debt-burden discussion in a broader framework of economic theory
in his book, Cost and Choice (Chicago: Markham, 1968). For a later paper that places the
debt-burden discussion in a cost-theory perspective, see E. G. West, ‘‘Public Debt Burden
and Cost Theory,’’ Economic Inquiry 13 (June 1975): 179–190.

First, the Academic Scribblers

37

It proved difficult to get at, and to correct, this fundamental confusion because of careless and sloppy usage of institutional description. The Keynesian economist rarely made the careful distinction between money creation
and public debt issue that is required as the first step toward logical clarity.
Linguistically, he often referred to what amounts to disguised money creation as ‘‘public debt,’’ notably in his classification of government ‘‘borrowing’’ from the banking system. He tended to equate the whole defense of deficit financing with his defense of public debt, as a financing instrument, when,
as noted above, this need not have been done at all. On his own grounds, the
Keynesian economist could have made a much more effective case for deficit
financing by direct money creation. Had he done so, perhaps the transmission of his message to the politicians and to the public would have contained
within it much stronger built-in safeguards. It is indeed interesting to speculate what might have happened in the post-Keynesian world of fiscal policy
if the financing of budget deficits had been restricted to money issue, and if
this means of financing had been explicitly acknowledged by all parties.

The Dreams of Camelot
But such was not to be. The Keynesian economists were able to remain within
their ivory towers during the 1950s, secure in their own untested confusions
and willingly assessing blame upon the mossback attitudes of politicians and
the public. In the early 1960s, for a few months in history, all their dreams
seemed to become potentially realizable. The ‘‘New Economics’’ had finally
moved beyond the elementary textbooks and beyond the halls of the academy. The enlightened would rule the world, or at least the economic aspects
of it. But such dreams of Camelot, in economic policy as in other areas, were
dashed against the hard realities of democratic politics. Institutional constraints, which seem so commonplace to the observer of the 1970s, were simply overlooked by the Keynesian economists until these emerged so quickly
in the 1960s. They faced the rude awakening to the simple fact that their
whole analytical structure, its strengths and its weaknesses, had been constructed and elaborated in almost total disregard for the institutional world
where decisions are and must be made. The political history of economic
policy for the 1960s and 1970s, which we shall trace further in Chapter 4, is
not a happy one. Can we seriously absolve the academic scribblers from their
own share of blame?

4. The Spread of the New Gospel

Introduction
Economists do not control political history, despite their desires and dreams.
Our narrative summary of the Keynesian revolution cannot, therefore, be
limited to the conversion of the economists. We must look at the spreading
of the Keynesian gospel to the public, and especially to the political decision
makers, if we are to make sense of the situation that we confront in the late
1970s and the 1980s. The old-time fiscal religion was surprisi