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Tuesday, January 16, 2007

Robert Lucas: Deficit Finance, Inflation, and Inconsistency In Fiscal Aims

Here are two commentaries on deficits and their consequences by University of Chicago economist Robert Lucas. They appeared in the New York Times on August 26 and August 28, 1981. The first essay looks at fiscal policy and government credibility during Hamilton's tenure as Secretary of the Treasury in the Washington Administration in the late 1700s, and the second looks more specifically at supply-side policies under the Reagan administration. A teaser:

The most discouraging application of this logic is ... ''supply-side'' economics...  Is the general principle being advanced here that taxes must always be reduced, independent of the effect on the deficit, because all taxes have disincentive effects? This is a nonsense principle...

Here's the first:

Deficit Finance And Inflation by Robert E. Lucas Jr., Economic Scene, NY Times, August 26, 1981: The question of deficit finance is at the center of public discussion of economic matters today, as it is in any society undergoing serious price inflation, and as it should be, for there is no more basic connection in economic affairs than that linking deficit finance and inflation. Though Milton Friedman's aphorism that ''inflation is always and everywhere a monetary phenomenon'' is true (or as true as economic aphorisms get), it is equally true that sustained monetary expansions are always and everywhere a consequence of printing money to cover the difference between Government expenditures and tax revenues.

Today, deficit spending is rationalized by the novel doctrines of supply-side economics. Yesterday, the same policies were defended by the logic of Keynesian economics. In the effort to hold onto my fiscal sanity in this era of theoretical innovation, I found it helpful to reread Alexander Hamilton's two remarkable ''Reports on the Public Credit,'' delivered to the Congress in 1790 and 1795 in his capacity as Secretary of the Treasury in the Washington Administration.

The 1790 Congress was faced with the question of whether to honor the Revolutionary War debt, which, since it had been issued by a government no longer in existence, was not clearly the responsibility of the Government formed by the 1789 Constitution. Honoring the debt meant in practice, then as now, levying taxes - taxes with the distorting effects on incentives that taxes always have - in order to acquire the resources to discharge these obligations.

Many argued that the best decision was simply to disclaim responsibility for the debt, and so to avoid the tax distortions involved in what would be, after all, just a shuffling of resources from one set of citizens to another. This repudiation would be accompanied by the solemn promise that all debts incurred in the future by the new Government would be faithfully repaid. This policy, if it had been possible to carry it out, would indeed have been the economically correct one.

But how, exactly, might the Congress in 1790 have issued credible promises about the way future debts were to be honored by future Congresses? Hamilton saw that this question was at the center of the issue. He argued that what the 1790 Congress was really deciding, whether it described what it was doing in these terms or not, was not merely the disposition of the Revolutionary War debt but also the general policy that the United States Government was to adopt toward its national debts.

For Hamilton, the outstanding war debt represented an opportunity for the new republic to demonstrate its adherence to a policy of honoring its debts by a specific action that would be incomparably more convincing than any mere promise could possibly be. Incurring the tax distortions involved in doing so would be, he argued, an investment in credibility that would (and indeed, did) yield returns for many years.

Hamilton's powerful statement of this issue is no less relevant today than it was in 1790, nor has it, in my view, been outdated by any more recently discovered economic principles. It has clear implications for deficit spending, since if debt is to be incurred in situations of national emergency, such as in major wars and serious depressions, and if it is to be utlimately retired with interest, then clearly nonemergency situations must be periods of budget surplus. I see no way around this arithmetic.

The institution of modern central banking is new since Hamilton's day (though he did his best to help bring it into existence). Today's Congress, unlike that of 1790, can repudiate debt as it pleases without the painful necessity of having even to mention the word. It does so by legislating expenditures in excess of tax receipts under all circumstances, and leaving it to the central bank to make up the difference by ''printing money'' (really, of course, creating new bank reserves as book entries).

The resulting inflation lowers the ''real'' value of the remaining debt, so that although bond-holders receive the dollars promised on the face of the bond, the dollars do not command the resources they commanded at the time the bond was purchased. In effect, though no one has to come right out and say so, the Government has defaulted on part of its debt. Of course, as Hamilton spelled out, people quickly learn that this partial default is the norm. This is why the current yield on United States Government obligations maturing in the year 2005 is now about 14 percent.

The Reagan Administration, like the Washington Administration in which Hamilton served, took office under circumstances of widespread uncertainty concerning the principles about which economic policy was to be formulated. Now, as then, the main source of uncertainty centers on whether the United States Government is willing to tax its citizens directly at a level sufficient to pay for its past and current spending commitments, or whether these payments are to be put off via verbal promises into the indefinite future.

The Washington Administration took the course of meeting its obligations rapidly, through the levy of current taxes (unpopular as taxes tend always to be), consigning these obligations to history and simultaneously announcing a set of principles governing future fiscal policy in the most forceful possible way. The Reagan Administration has chosen the opposite course.

And here's the second:

Inconsistency In Fiscal Aims, by Robert E. Lucas Jr., Economic Scene, NY Times, August 28, 1981: When Alexander Hamilton persuaded Congress to honor the Revolutionary War debt in 1790, even though the tax increase needed to carry this policy out was patently not in the immediate interests of the citizens of the United States at the time, the central element in his argument was the recognition that a policy decision taken today is, like it or not, an announcement of general principle by which analogous situations are to be treated in the future.

Today, I wish to apply this point of view to the economic policies of the Reagan Administration. The main elements of these policies are well known. Government expenditures are being reduced, with a seriousness that marks an obviously genuine change of direction. Tax rates are simultaneously being reduced, to levels that will surely increase the deficit, even taking the expenditure cuts into account. The Federal Reserve is being enjoined to keep the growth rates of monetary aggregates to levels consistent with perhaps a 4 percent to 5 percent annual price inflation, come what may. Future tax cuts have already been legislated, and future expenditure cuts are also promised, sufficient to bring the budget in balance by the end of the President's current term.

The arithmetic of this combination of actions and promises works out, mainly because the sizes of the future expenditure cuts have been left unspecified. They will, it is claimed, be as big as necessary to release tax revenues large enough to service the debt created by the tax cuts, to bring the budget into balance by the end of his term, and to let the Federal Reserve resolutely refuse to ''monetize'' this debt with an inflationary increase of money.

We are not, however, interested in arithmetically possible futures so much as in the future that will in fact be ours to enjoy. Hamilton's principle that fiscal actions speak more loudly than promises implies that we can best predict this future by imagining that the Reagan Administration and Congress will determine the economic policies best suited to 1983, '84 and '85 using roughly the same principles they used to arrive at 1982's policy mix.

The most discouraging application of this logic is to the Kemp-Roth tax cut and the ''supply-side'' economics used to rationalize it. Here the idea -the only idea - is that taxes involve costly incentive effects. This is true in our situation, but the difficulty is that it is true in any situation. Is the general principle being advanced here that taxes must always be reduced, independent of the effect on the deficit, because all taxes have disincentive effects?

This is a nonsense principle, and it is only fair to assume that this is not what the Administration wishes to enunciate. It wishes to assure us by words that this is one last fling before we once again impose on ourselves the disciplines of fiscal restraint. It is precisely the self-deception, and the futility, involved in thinking about economic policy in this way that Hamilton opposed so forcefully in 1790.

By honoring the war debt under circumstances in which default would have been exceptionally easy and convenient, Hamilton's policy demonstrated the United States Government's credit-worthiness in a very powerful way. By passing a deficit-increasing tax cut in a situation that cannot possibly be viewed as an ''emergency,'' the current Administration is demonstrating a lack of seriousness in an equally effective way. If the circumstances of 1981-82 call for a budget deficit, what, if any, configuration of economic conditions would call for a budget surplus?

Can a resolutely ''monetarist'' central bank, restraining monetary growth no matter what else is happening, insulate the economy from the effects of this fiscal dishonesty? The Administration has boldly wagered all of Paul Volcker's chips on this possibility, but it is buying only time. Certainly, the Federal Reserve can peg the growth rate of monetary aggregates for a couple of years, more or less independent of fiscal policy. But it is not within the abilities of any central bank to make things work out right in a society that insists that the real resources spent by its government can exceed, on a sustained basis, the resources that government extracts from the private sector via taxes.

The expectation, on the public's part, of future inflation is certainly a major factor fueling inflation today. The Administration explicitly recognizes this fact, and is attempting to deal with it through announcements of future monetary policies that are consistent with price stability.

This, it seems to me, is a step in the right direction. Simultaneously, it is pursuing a fiscal policy of stepped-up deficit spending, a policy that, if sustained, is obviously inconsistent with its monetary promises. It is, in other words, issuing two conflicting statements about the willingness of the Federal Government to meet its obligations in a noninflationary way. In light of the history of the past 15 years, is there a serious doubt as to which of these two messages is the most credible?

The Reagan policies are not, in any logical sense, inconsistent with an eventual return to price stability. There is no way to be certain, now, whether or not its promises will be kept. But the Administration has let an opportunity to restore credibility in United States monetary and fiscal policy slip by, and the real test will come, as seems always now to be the case, in the future.

    Posted by on Tuesday, January 16, 2007 at 12:15 AM in Budget Deficit, Economics, Inflation | Permalink  TrackBack (1)  Comments (37)

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