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Fiscal Policy in the Shadow of the Great Depression

Before the Great Depression the U.S. government borrowed in time of war, and almost invariably ran peacetime surpluses to pay off accumulated war debt. The possibility of using the government deficit as a tool of macroeconomic management was never considered. The Great Depression itself broke this pattern: both the Hoover and the first Roosevelt Administrations wished to maintain the pattern of peacetime surpluses, but both found the austerity required to achieve surplus in the midst of the Great Depression to be politically impossible. In the end—backed by Keynesian and Keynesian-like economic theories—the political nation made a virtue of necessity by concluding that large deficits in time of recession helped moderate the business cycle. In the generation after World War II, economists and politicians moved toward a consensus position on deficits set out by the CED [Committee on Economic Development]: set tax rates and expenditure plans so that the budget would be in surplus or in balance at high employment, but do not take any steps to neutralize the “automatic stabilizers” set in motion as the budget swings into deficit when recession threatens (and perhaps take discretionary action to further stimulate the economy in recession should the “automatic stabilizers” be seen as too small to be fully effective). Unfortunately, the American political system seems unable to hold more than one idea at a time. The idea that “cyclical” deficits in recession could be good appears to have weakened attachment to the idea that persistent “structural” deficits that lowered the national savings rate were a bad idea. The Reagan administration called for large tax cuts—and Congress never refuses a presidential call for a tax cut—that created substantial and damaging structural deficits in the 1980s. Confusion between “cyclical” and “structural” deficits appears to have played an important role in the creation of the structural deficits of the 1980s. And revulsion in the 1990s against the persistent “structural” deficits has led to proposals for balanced-budget amendments to the Constitution that would eliminate the government’s ability to run beneficial “cyclical” deficits to moderate recessions.