I am Harding, Hear me Roar: Keynesian Economics Fail
I am Harding, Hear me Roar: The 1920s and the Failure of Keynesian Economics
20th century America began with the decline of Classical liberalism, the natural rights, limited government, free market political and economic philosophy of the American founders. That perspective was replaced in the minds and hearts of the political and intellectual elite in America by progressive interventionism, the philosophy of government social engineering to cure alleged defects of the free society.
The first three presidents of the 20th century (not counting Garfield) were open progressives: Teddy Roosevelt, William Howard Taft, and Woodrow Wilson. They gave us a variety of interventionist legislation and government growth. And war. Lots of war, and conquest, fueled by progressive visions of American empire and US moral superiority.
There was an interlude, however, of nearly a decade, in which Americans had second thoughts and backed away from progressive ideas and policies.
Warren Harding became president early in 1921, in the midst of a far worse economic contraction than Barak Obama inherited in 2009. From January 1921 through the spring and summer of 1922, Gross National Product fell by nearly 24%. The unemployment rate rose from 5.2% in 1920 to 11.7% in1921.
Harding was not a man of progressive mindset. Indeed, he had been elected in public reaction against two decades of such policies. He continually decried high tax rates, government waste, and interference in the private sector.
He meant it. He appointed Andrew Mellon his Treasury secretary and with the help of Congress they began what became a series of large-scale reductions in both tax rates and spending. Federal expenditure declined from $6.3 billion in 1920 to $5 billion in 1921, then to $3.2 billion in 1922, an absolute decline of nearly 51% in just two years.
Harding’s Revenue Act of 1921 raised the personal income tax exemption for married couples and reduced all income tax rates. The top rate fell from 74% to 58%. Federal revenue collected fell from $6.6 billion in 1920 to $5.5 billion in 1921 (partly due to the contraction), and then down to $4 billion in 1922 (despite a rapid economic recovery).
That meant the federal budget ran a surplus of $300 million in 1920 (Wilson’s last year), $500 million in 1921, and $800 million in 1922. The surpluses were used to pay down federal debt.
What happened to the recession? It ended with an extremely rapid expansion in 1922. Real GNP rose by an astonishing 14.6%, reducing the unemployment rate to 6.3% that year. In 1923 Real GNP rose another 11.7%, reducing national unemployment to a mere 2.4%.
The Harding fiscal policies were not the only reason the huge 1920-21 contraction ended so quickly. The recession began with a discount rate increase and money supply contraction initiated by the Federal Reserve in January 1920. That reduced aggregate demand for goods and services, and prices began falling.
Harding’s crucial action here was inaction. He refused to interfere with the natural stabilizing mechanisms of the market (unlike both Hoover and Roosevelt in the 1930s).
Prices fell relative to wage rates, raising real wage rates to unemployable levels: thus the contraction. But then dollar wage rates fell relative to product prices, reducing the real wage back down to employable levels, bringing recovery.
In August of 1923 Harding died of pneumonia and his Vice President Calvin Coolidge became President. Like Harding, Coolidge was no man of the interventionist left. He retained Mellon as Treasury Secretary and, winning re-election by a large majority in 1924, they continued reducing tax rates, in 1924, 1926, and 1928.
They also continued holding spending down, running budget surpluses and paying down federal debt every year. From $25.5 billion in 1919, the National Debt had been reduced to only $16.2 billion by 1930, a total reduction of nearly 36.5%. Per capita real output and income rose very rapidly over the whole of the 1920s despite two trivial recessions, in 1924 and 1827. The “Roaring Twenties” were well named.
Then came the great depression, initiated, like the 1921 contraction, by a deliberate Federal Reserve monetary contraction. In 1936, six years into the Depression, John Maynard Keynes published his General Theory of Employment, Interest and Money.
All that was original in Keynes’ theory boiled down to a proposition that a market economy was naturally unstable, but the government could manipulate total demand and stabilize the economy near full employment by simply altering the state of its budget.
If the economy had too little production and excess unemployment, the government could run a deficit, spending more than its revenue. That would raise aggregate expenditure, increasing output and employment. If inflationary pressures existed at full employment, the government could run a budget surplus, thus reducing aggregate demand until the inflationary pressures ended. Running a surplus at or below full employment, however, would contract output and employment further.
The entire decade of the 1920s was a refutation of Keynes’ claims before they were even made. If budget deficits are expansionary and surpluses are contractionary, then why did the 1920-1922 recession end when Harding not only ran federal surpluses, but increased their magnitude? And why was real output growth so rapid and unemployment rates so low thereafter though the government ran even larger surpluses?
A major difference between the roaring ‘20s and the depressed ‘30s was that the interventionist Hoover and Roosevelt administrations massively increased spending and ran sequential budget deficits as specific anti-depression policies. In1938, just two years after Keynes gave theoretical sanction to these policies, Henry Morganthau, Roosevelt’s own Treasury secretary, wrote the following in his diary. “We are spending more than we have ever spent before and it does not work . . . After eight years of this administration we have just as much unemployment as when we started . . . and an enormous debt.”
Having failed to learn from history, we are, circa 2008-2012, repeating it.
Comments
Right... So we were doing
Right... So we were doing awesome in the late 90s because the Clinton administration was running a surplus?
Or perhaps a credit-fueled tech boom (thank you Chairman Greenspan) brought in enough extra tax revenue to run a surplus which was eventually whittled away by the combination of lower tax rates and the bursting of the tech bubble.
The U.S. didn't climb out of recession and into furious growth in the 1920s thanks to Harding's policies or lack thereof. An insane expansion in credit it is what got the U.S. out of the recession and we all know how well that ended.
I'm a pretty big believer in letting the markets do their thing provided the appropriate macro-prudential supervision is in place (more Volcker, less Greenspan/Bernanke please) but this argument is awful and doesn't debunk anything. There's a bigger picture here that you're failing too look at. 2008-2012 is very different from 1920-22 which was not a credit crisis but a typical cyclical contraction (regardless of its magnitude). The Fed's been pushing on a string for a while and if you're interested in seeing what happens when you try to cut your deficits, run a surplus in times like these, I would encourage you to take a look at Greece/Spain/Italy. Considering the Dollar is outperforming the Euro as it is, we'd be letting our pants down in the currency wars as well.
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According to international
According to international data from 1960-1994 a deficit of less than 5% of GDP corresponds to slightly less than 1% GDP growth. A balanced budget corresponds to ~ 2% GDP growth. A surplus corresponds to ~3% GDP growth.
Source: Figure 11.1, page 227. The Elusive Quest for Growth. William Easterly.
"high budget deficits create bad incentives for growth because....anticipation of future tax hikes to reduce deficit and service the public debt...possibility of inflation...lead to general macroeconomic instability which makes it hard to tell which projects are good and which firms should get loans."
Source: page 226. The Elusive Quest for Growth. William Easterly.
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Excellent post. A silver
Excellent post. A silver banana for you.
I am not cocky, I am confident, and when you tell me I am the best it is a compliment.
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GoodBread: Right... So we
Right... So we were doing awesome in the late 90s because the Clinton administration was running a surplus?
Or perhaps a credit-fueled tech boom (thank you Chairman Greenspan) brought in enough extra tax revenue to run a surplus which was eventually whittled away by the combination of lower tax rates and the bursting of the tech bubble.
The U.S. didn't climb out of recession and into furious growth in the 1920s thanks to Harding's policies or lack thereof. An insane expansion in credit it is what got the U.S. out of the recession and we all know how well that ended.
I'm a pretty big believer in letting the markets do their thing provided the appropriate macro-prudential supervision is in place (more Volcker, less Greenspan/Bernanke please) but this argument is awful and doesn't debunk anything. There's a bigger picture here that you're failing too look at. 2008-2012 is very different from 1920-22 which was not a credit crisis but a typical cyclical contraction (regardless of its magnitude). The Fed's been pushing on a string for a while and if you're interested in seeing what happens when you try to cut your deficits, run a surplus in times like these, I would encourage you to take a look at Greece/Spain/Italy. Considering the Dollar is outperforming the Euro as it is, we'd be letting our pants down in the currency wars as well.
Cosign to everything in this post
I agree with your central
I agree with your central premise, however; Harding did gamble away all of the fine china in the White House.
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Before the end of Ronald
Before the end of Ronald Reagan's first term he reversed a trend of rising annual deficits/GDP that had begun when Kennedy became President. The Deficit/GDP ratio fell almost every year after that and we actually started running surpluses in 1997. Yes, GoodBread, that is part of the story of the good economy of the 1990s. I actually give more credit to the divided government (not Clinton). Beginning in 1995, both houses of Congress had Republican majorities. The republicans turned down all democratic big spending plans (like HillaryCare) and Clinton vetoed Republican big spending plans. Federal spending rose by less than GDP and the relative size of the federal government (total federal expenditure/GDP) fell by over 10% in the last half of the 1990s (down to 18% of GDP; it is about 26% of GDP now). That retrenchment of government released resources to the private sector for productive uses, and the economy grew rapidly. Also, the welfare reform of 1996, putting time limits on welfare collection and ending the free ride, also helped. Many people dropped off of the welfare rolls and simply went to work, producing real goods and services instead of simply consuming what others produced. That both added to real GDP and reduced necessary expenditures. As for Greece, Spain and Italy seriously reducing tax rates and backing away from their welfare states, I haven't seen that. They can't. They over committed themselves to income redistribution they to too many people for too long and don't dare seriously try. And now here we are with ObamaCare expenditures looming, having made massive 'stimulus' expenditures and deficits that have, by any valid measure, greatly slowed our recovery. Government size fell and we ran surpluses and we had a good economy in the nineties. We have massively increased the size of government and run deficits and had a lousy economy since then. Figure it out.
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Whitecollerands: I hadn't
Whitecollerands: I hadn't heard about Harding and the White House China. That's funny. Thanks. And thanks to you eokpar02 for the banana.
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Chaos2Order: Before the end
Before the end of Ronald Reagan's first term he reversed a trend of rising annual deficits/GDP that had begun when Kennedy became President. The Deficit/GDP ratio fell almost every year after that and we actually started running surpluses in 1997. Yes, GoodBread, that is part of the story of the good economy of the 1990s.
Categorically untrue. Regan presided over the largest rise in US Debt/GDP since WWII. I'm not sure where you get your data but all govt data on the matter proves you wrong and a simple trip to Wikipedia could be instructive (http://en.wikipedia.org/wiki/US_deficit).
I think you are missing the point, however. I never credited Clinton with helping the U.S. run a budget surplus. There were far more powerful macro forces at play thanks to monetary policy (ultra-low rates) and credit expansion over the 1982-2006 period. That major credit cycle is now over and monetary policy levers are now useless. Furthermore, as much as the current administration is spending, it can't do all that much in the face of massive debt deleveraging. However, government spending is indeed a part of the equation for GDP and should the government drastically cut back, GDP will fall. The private sector has no plan on spending as consumers are still nursing their wounds and a cash buffer is awfully convenient considering the lack of credit availability and equity volatility in the markets at the moment.
Your argument is interesting but it completely disregards monetary forces which were far stronger than Harding's austerity measures. As such, while it is pointless to dabble in counterfactuals, I would be willing to bet that if the U.S. were to drastically cut spending this year, growth would suffer significantly in the short-to-medium term and unemployment would trend far higher.
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As an uninformed individual,
As an uninformed individual, it seems both sides of arguments theoretically make sense.
I can't wait to see which side was more insightful with regards to Today's economy in 5-10 years down the road.
GoodBread: Your statement
GoodBread: Your statement that "Ronald Reagan presided over the largest rise in US debt/GDP since WWII is (a) perfectly correct and (b) no refutation (in fact, it is an actual implication) of what I said. In all of US history there is no series of rising deficits/GDP such as that which began the first year of Kennedy's Presidency. That ratio had an increasing trend (got larger) for the next twenty-three years, the last three of which were Reagan years. The deficit in any year is the addition to the debt. So yes, the deficits as a fraction of GDP were the largest (with therefore the largest additions to the debt) of the series during the first three Reagan years. But those deficits were a result of incentives imbedded in Congress by two decades of Keynesian and welfare-statist thought that he (Reagan) could not instantly reverse, and the Reagan 1st term deficits were not off that former trend. Nevertheless, near the end of his first term the deficit/GDP ratio started getting smaller, and that 23 year trend was completely reversed, with sequentially smaller deficit/GDP ratios until the budget was brought into balance, and then a short series of surpluses was produced starting in 1997. I have calculated the whole series of deficits since 1960 myself, using data from time series in The Economic Report of the President (various years). I think I know what the data says. Reagan completely changed the culture of spending, though Bush the Younger and Obama have now changed it back, big time.
Next, it is hard to get away with claiming that monetary policy was expansive, or money growth particularly rapid in the 1920s, when the price level rose in only three years of that decade, and actually declined slightly in the others after 1922. If you want to see the actual money growth numbers for the twenties, see Milton Friedman and Anna Jacobson Schwartz' Monetary History of the US. It is also hard to make the case for excessively rapid money growth in the nineties when the inflation rate was stable at around 2%.
As for what would happen if the deficit was reduced now, it would depend on whether it was reduced by large tax increases or by major expenditure reductions (or, as I would prefer, by a combination of tax reductions and even larger expenditure reductions, as Harding and Coolidge did). The first method would send us back into recession in a big way. The second would cause a major expansion (and the third, an even larger expansion).
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Fair enough on the latter
Fair enough on the latter years of Reagan being better in terms of deficits however I think you are very much underestimating the impact the wider economy had on these deficits. Debt/GDP started rising again fairly quickly under Bush I when the 80s recovery hit a rough patch into the early 90s.
I think you're confusing correlation with causation here. If the economy is performing well, the government should spend less and there will of course be far less automatic stabilizers which account for a great deal of Obama's deficit spending. Looking at money growth and inflation is completely irrelevant. The 1980s-2000s were considered to be the "great moderation" as inflation remained low for the most part and the economy saw an incredible boom. But as is now evident, that boom was fueled by extremely cheap credit which found itself employed in increasingly misguided vechicles (from ridiculous tech startups to CDOs) and crashed spectacularly, not all too differently from the 1920s.
Of course large tax increases would send us back into recession. But so would large spending cuts. The only fiscal stimulus you are proposing is tax cuts and I do agree that those would stimulate the economy, even though the numerator on our debt/GDP would probably climb.
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At what level of debt/gdp
At what level of debt/gdp does it become important to end/reduce deficit spending?
A government spending cut of X dollars will only increase GDP if X dollars are returned to the taxpayer. If those X dollars were gained from debt, instead of taxation, we reduce today's GDP for tomorrow's lower debt level (which, in the long run, would positively impact GDP).
Personally, I think, the fact that the US has been undergoing various forms of stimulus spending for the past four years, indicates we need a change from the recent model of stimulus. Stimulus spending has done relatively little (if the goal of stimulus is to increase investor confidence and increase lending) at a relatively high cost. Stimulus spending (actually, any government spending) should focus on creating long-term economic gains, instead of delivering a short-term solution that could negatively impact the country in the future (not just long term debt, but bailout obligations for banks and major industries).
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Yes, GoodBread, the first
Yes, GoodBread, the first Gulf War recession did temporarily interrupt the trend of declining deficits that eventually led the federal budget to surplus. Temporarily.
As for your assertion that the rapid economic growth of the 1990s was fueled by massive credit expansion, I cannot remotely agree. Federal reserve policy was highly constrained over the whole period. Average annual real GDP growth was 3.19% over 1990-1999, while the average annual growth of M2 (currency plus demand deposits) was only 3.9%. That is a very low level of money and credit growth by historic comparison (all these numbers are from the Economic Report of the President for 2011, tables B-2, B-3, and B-69). The average annual inflation rate was just 1.76%, so real cash balances only grew annually by 2.14% (3.9 - 1.76), which is less than enough to finance the additional transactions necessitated by the real output growth. Apparently the demand for real money balances actually fell marginally due to increased availability of ATMs, rising use of credit and debit cards, and other developing efficiencies of the payments system. But they merely filled the gap.
As for interest rates being low, credit expansion can lower interest rates only temporarily, before market forces restore them to the natural rate. In this case, interest rates fell for the same reason they had fallen over most of the 1980s: disinflation. Declining inflation rate expectations reduced the inflation component in those rates (the Fisher Effect). Clearly, this was a supply side driven expansion, not a Federal Reserve money and credit fueled one. Low tax rates (beginning with ERTA in 1981) and expenditure constraint causing the relative size of the government (total expenditure/GDP) to fall and release resources to the private sector for productive uses did it.
Since you have twice mentioned the tech stock boom and bust as indicative of excess credit expansion (you sound almost Austrian in this, but I would not want to accuse you falsely), I should say I regard that as a side show, not central in any way to the overall economic expansion. When an economy is growing well, there are always some sectors doing better and others doing worse, and markets have to do their job of allocating and reallocating resources in accord with relative price changes. Some sectors will even rise more rapidly than the average, then fall. That was the dot-com bubble and crash.
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21 Lives, your question is
21 Lives, your question is deep. For over 140 years of our history the federal government followed a balanced budget policy, only running sequential deficits during wartime, then running sequential surpluses immediately following the war to pay down the debt, before returning to small, random surpluses and deficits during peacetime. I prefer that policy, which was driven by an ingrained protestant cultural ethic of hard work and household frugality (living within one's means) applied to government.
If what you are asking, though, is what level of Debt/GDP becomes a severe burden threatening economic and social collapse, that starts when debt payments (interest and principle) themselves become a large enough part of the budget that they start crowding out other expenditures (mostly for income redistribution and social insurance) near and dear to the politician's and their client group's hearts, so that they are faced with unpleasant options. So I would look at the debt/GDP ratios of Greece, where the very hint of reducing subsidies is causing riots, and say to myself "We better stop long before that point". Sorry I can't be more precise.
I can't get a clear fix on your middle paragraph, so I'll let that go.
Everything you say in your third paragraph strikes me as exactly correct. Thanks for commenting.
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