Paul Volcker
Paul Volcker; drawing by David Levine

Federal fiscal policy is adrift without a rudder. Norms that guided presidents and Congresses in the past have been ignored, and no workable new principles have emerged. Neither is there any consensus in popular opinion, among business and financial elites, or among economists.

The ancient orthodox norm was annual budget balance. It still commands ritual lip service, even from an administration and Congress that have doubled the federal debt in five years. Ronald Reagan, while presiding over deficits of unprecedented size, supports a constitutional amendment forbidding deficits; most members of Congress, though in the House not the necessary two thirds, find it politic to vote for it.

The goal of an annually balanced budget, to be sure, is now enshrined in the Gramm-Rudman-Hollings law, which is now governing budget making despite the Supreme Court decision against one of its procedural steps. The law prescribes a schedule that would reduce deficits to zero in 1991 and thereafter. However, it is unlikely that the Gramm-Rudman law will restore budget balance. Hitting its target would require, in 1991, a surplus of about $120 billion, 2 percent of GNP, of federal revenue over expenditures, apart from payments of debt interest. Revenue now falls short of expenditures, other than interest payments, by more than 2 percent of GNP. Given the impasse between the President and Congress on how to meet the Gramm-Rudman deficit reduction schedule—whether by tax hikes, defense economies, or cuts in civilian outlays—the schedule cannot be met without invoking the mindless, automatic, “across the board” cuts Gramm-Rudman prescribes, which both sides would find intolerably destructive.

To balance the budget may seem a natural and simple rule—far from it, as Professor Eisner cogently and clearly explains. He stresses three defects in conventional federal budget accounting: capital expenditures (e.g., for land, roads, and buildings) are not distinguished from current outlays, a practice that would put most business, households, and state and local governments in apparent deficit too. No allowance is made for appreciations and depreciations in the market values of federal assets (e.g., loans, lands, and mineral rights) and debts. Full interest on Treasury securities is charged as expense even though a large part of that interest may just be compensation for inflation, which lowers the real burden of the debt. (I return to this issue of “inflation accounting” below.) There are other, technical reasons too. Anyone who thinks the rule could be frozen into the Constitution in a short amendment will learn better by reading Eisner’s book.

The idea of annually balancing the budget was long ago discredited by serious examination and by experience. Why annual? Why not monthly, or biennial, or across a business cycle? Efforts to keep government budgets balanced during cyclical declines in business activity proved futile during the Great Depression, notably in the United States under Hoover and in Germany under Bruening, where they hastened the end of the Weimar Republic. By raising taxes and cutting government expenditures, political leaders pushed their economies down further and faster.

Yet Gramm-Rudman makes the same mistake. To adhere to its schedule for eliminating the deficit would require stiffer budget cuts the weaker the economy; and, unless the Federal Reserve acted aggressively and promptly to lower interest rates, those measures would make recession or stagnation worse. Just recently, downward adjustments in economic forecasts confronted budget makers with the necessity to find $20 billion more in revenues or expenditure cuts to meet the deficit target for fiscal year 1987.

The revenues yielded by a given tax code and the outlays resulting from given legislation—especially social insurance and other entitlements—are sensitive to the state of the economy. Deficits that result from cyclical fluctuations in business activity have none of the economic consequences, good or ill, that may come from deficits caused by new tax legislation and new expenditure programs. The large impact of the budget on the economy is approximated by the “structural deficit” (positive or negative), known as the “full employment deficit” when Truman’s Council of Economic Advisers introduced it into Washington policy deliberations. Whatever its name, it is calculated as if the rate of unemployment were constant, in order to eliminate the effects of cyclical fluctuations on the budget. Readers unfamiliar with these and other standard concepts of fiscal economics can find them well expounded in Eisner’s book.

In the years immediately following World War II, serious efforts were made to build a consensus for a fiscal rule to replace the old orthodoxy of annual budget balance. The Committee for Economic Development, thanks to the initiatives of its research director Herbert Stein, acquainted opinion leaders in business, labor, and politics with the ideas of economists. Two plausible rules emerged—to balance the budget over the period of a business cycle, or to balance the “full employment budget.” They amounted to the same thing if “full employment” was the midpoint of the cycle, but the second choice would produce more and larger deficits if full employment occurred only at the peaks of cycles. Some economists were opposed to either policy, believing that maintaining prosperity and high employment would frequently require continued deficit spending. Conservatives, on the other hand, feared that any departure from budget-balance orthodoxy would destroy the only discipline capable of curbing politicians’ inherent propensities to spend.


A rough consensus did emerge in practice, somewhere in between the two rules. Automatic deficits resulting from cyclical recessions became acceptable, and most administrations and Congresses of both parties deliberately employed new measures of fiscal stimulus to hasten recoveries. (For example, the Eisenhower administration cut taxes in 1953; the Kennedy–Johnson administration cut taxes in 1964 to keep the recovery going; and in 1974 Congress pushed an antirecession package of tax rebates and new expenditures onto a reluctant President Ford.) The “full employment” budget was generally in slight surplus. However, the economy was rarely at “full employment,” defined most of the time as 4 percent unemployment. So the actual budget was usually in deficit. Still, thanks to the vigorous growth of the economy from cycle to cycle and thanks to inflation, federal debt fell sharply relative to the size of the economy—from 120 percent of GNP at the end of World War II to 23 percent on the eve of Reaganomics.

Now the postwar consensus has crumbled, as Herbert Stein has noted with sadness and nostalgia. There are several reasons. First, it is victim of the Reagan ideological revolution, which rejected all the macroeconomic principles and policies of the preceding forty years. Reaganomics views the budget as an instrument of supply-side policy, not as an instrument to manage aggregate demand for goods and services. The President remains a faithful, if lonely, believer in the Laffer-curve theory that growth stimulated by tax cuts will balance the budget. Anyway, he and his advisers have always viewed their huge deficits as a weapon to bludgeon Congress into drastic cutting of federal civilian spending. The euphoria and desperation created by the Reagan fiscal revolution do not foster sober consideration of principles of fiscal policy.

Second, the discipline of economics itself is in turmoil. Influential young “new classical” theorists reject such concepts as “full employment” and “normal unemployment.” They do not regard business cycles as aberrations but as moving “equilibria,” “optimal” responses to the ever-changing natural economic environment. They assert that budgets and deficits have very little to do with short-run aggregate economic activity, but affect only the composition and efficiency of national production.

Third, no consensus now exists on the unemployment rate at which the budget should come into balance, or on the unemployment rate, if any, at which federal economic policy should aim. Conservative European governments now regard 8, 9, or 13 percent unemployment as normal and shape their budgets to balance at those rates. In this country too, both Washington policy makers and the general public accept unemployment rates higher than those considered tolerable in previous decades. The distressing inflations of the 1970s are commonly blamed on overstimulation of the economy by macroeconomic policy makers trying to make unemployment unnaturally low. The oil shocks that triggered those inflations fade from memory. No one thinks 4 percent unemployment is attainable now. The rate has been 7 percent for the last two years, while inflation rates have declined.

Fourth, and most important of all, the monetary policy of the Federal Reserve has become the dominant instrument of macroeconomic management. If any fine or coarse tuning of the economy is done, it’s the Fed that calls the tune, through its control of money and interest rates. After all, Chairman Volcker and his colleagues can make nine or ten moves a year. The budget makers in the executive and Congress can make only one, and in recent years their procedures, politics, and conflicts have become so complex that national economic prospects and strategies play little role in the outcome.

In the 1950s and 1960s the Federal Reserve was inclined to accommodate the credit and money demands of the private sector and the Treasury. Now the Fed, well entrenched in its independence, has its own ideas where the economy should be going and how fast. The Fed has the tools to work its will. Ever since the Depression and World War II, interest rates have been important determinants of spending on houses, business construction, and consumers’ and producers’ durable goods.

Since 1973 the combination of floating foreign exchange rates and the amazing international mobility of private funds seeking high interest rates has magnified the power of monetary policy over national business activity. The high interest rates engineered by the Federal Reserve in the early 1980s attracted funds throughout the world into dollar assets, caused the dollar to appreciate against other major currencies, and made US goods expensive to foreigners and foreign goods cheap to Americans. The resulting import surplus has been a huge drag on the economy ever since.


Clearly it makes no sense to make fiscal policy, or to specify a rule to guide it, without considering simultaneously what monetary policy will do and what it ought to do. The right question is “What should be the mix of monetary and fiscal policy?”—not what either should be independently of the other.

Although Eisner recognizes that monetary policy matters, he ignores the implications of that recognition for judgments about fiscal policies. Eisner says that the Carter administration provoked the recession of 1980 by fiscal cut-backs because both the administration and its critics were misled by conventional measures of the deficit. This charge is an improbable reading of history. That recession, and the one that followed close upon it in 1981, stemmed from the Federal Reserve’s decision in October 1979 to dedicate monetary policy single-mindedly to the conquest of inflation, a decision inspired by the reappearance of double-digit inflation during the second oil crisis.

Eisner’s account of the 1983–1984 recovery is similarly flawed. Although he seems somewhat discomfited by the size of the Reagan deficits, structural as well as actual, he credits the recovery to them. But it was the Fed’s reversal of policy in late summer 1982 that turned the economy around. No doubt the Reagan fiscal stimuli, as they were phased in, gave a big push to aggregate demand. But the Fed nevertheless managed the recovery in 1983–1984, braking it when it seemed too fast, and relaxing the brakes when GNP growth faltered. From the summer of 1984 on, the Fed stopped the recovery at around 7 percent unemployment, although record deficit spending continued unabated.

Could we have had the same recovery, the same path of GNP and employment, under the much more moderate fiscal regimes of the pre-Reagan years? I think the answer is clearly “yes”; the Federal Reserve had plenty of room to lower interest rates further and faster. Would it have done so? That is more debatable. Although the Fed’s change of heart in 1982 signaled its willingness to adjust its policy to macroeconomic performance rather than to money supply targets, it is possible that residual monetarist concerns would have prevented the Fed from fully replacing fiscal stimulus absent or withdrawn.

Why should we care whether the economy is stimulated, or restrained, by one instrument or the other? The key issue is “crowding out.” Funding the Federal debt and paying interest on it absorbs private saving that otherwise could be channeled to investments that will benefit Americans in the future—homes; new plants and modern equipment; education and research; schools, sewers, roads provided by state and local governments; and income-earning properties in foreign nations. As Eisner says, this crowding out is the way, the only way, in which federal borrowing today can hurt our children and our children’s children.

Eisner agrees that federal deficits, properly measured, absorb private saving. He is right to point out that this may sometimes be a virtue, not a vice. Sometimes private investment activity is just too weak to make use of the saving that the country would supply in full prosperity; then the economy sinks below its potential because there is not enough spending, not because there is too little saving. In these circumstances government deficits do not crowd out anything; they absorb saving that would otherwise not have been used; and deficit spending raises GNP and employment. Indeed Eisner argues that fiscal stimulus usually primes the economic pump enough to induce additional private investment, along with extra saving to match. Thus there is “crowding in,” not crowding out.

Certainly those orthodox Cassandras who bewail “crowding out” in slack economies, even in 1932 or 1982, are like innkeepers who turn guests away when half their rooms are empty. I sympathize with Eisner’s exasperation with Peter Peterson and his five hundred–odd pillars of the establishment who, in 1982, were calling for restrictive budgets in the face of double-digit unemployment rates. Those who oppose deficits in all economic weather ignore the necessity for compensatory monetary stimulus if their orthodox fiscal strictures are not to worsen national economic performance. Likewise Eisner overlooks the alternative of taking up economic slack by monetary stimulus, which would add equally to private saving but divert none of it to financing deficits. Of course, both Eisner and I think the economy is much too slack right now, with unemployment at 7 percent, industrial capacity below 80 percent, and inflation continuing to decline. But we need to persuade Paul Volcker and his colleagues of this, not Ronald Reagan, Robert Dole, and Tip O’Neill.

Eisner is also understandably exasperated with the orthodox fiscal conservatives who, like Reagan himself in 1980 and 1981, falsely accused all postwar administrations of reckless fiscal profligacy. I suspect Eisner started his book to refute those influential conservative errors and never did reach an unambiguous position regarding the high Reagan deficits from 1982 on. With respect to them, his book’s title is misleading, and has misled well-meaning lay commentators like Tom Wicker in The New York Times. The Reagan deficits are real all right, and the Reagan fiscal policy is a drastic departure from the past, whatever system of accounting you use.

Discussion of “crowding out,” however, does focus the fiscal debate on the right issue, the impact of the federal budget on national saving. Some economic theorists say deficits have no such impact on savings, because taxpayers will offset federal dissaving, represented by budget deficits, by extra saving in anticipation of taxes that will be levied later to service or repay public debt. Eisner rightly gives this farfetched idea short shrift. In any case, during the Reagan years, future tax increases were explicitly ruled out. Therefore, expecting “crowding out,” financial markets raised long-term interest rates to record premiums above short-term rates, until the Gramm-Rudman bill encouraged hopes of fiscal correction.

The relevant measure of the federal deficit for macroeconomic analysis and policy is, as Eisner knows, the amount of private saving it absorbs. Eisner should have concentrated on this concept, rather than on accounting logic. His calculations adjusting debt increase for inflation make sense only if the private sector saves an extra amount to make up for its having suffered real capital losses on Treasury securities as a result of inflation. There is no empirical evidence of such behavior. Most of these losses are not immediately felt or seen by savers, who own government securities mostly indirectly, through insurance companies, pension funds, and other financial intermediaries. Although in the long run savers appear to adjust their financial planning for real capital gains and losses, these responses are slow and uncertain compared to their propensities to save from income. The net saving of the private sector has been a lower share of net national product during the 1980s than during the two previous decades, at the same time that the government’s dissaving has greatly increased.

Eisner does not deal adequately with the obvious orthodox riposte to his argument that the deficits of the 1970s were really surpluses if we take account of high inflation: Maybe the deficits caused the high inflation. If it takes inflation to remove the sting of deficits, it is no consolation to know how low the deficits became in real terms after inflation did its job. To that argument there are answers, but Eisner does not give them.

During the 1980s Reagan and Volcker gave the country a bizarre and extreme mix of easy fiscal and tight monetary policies unprecedented in our history. Compared to the feasible alternative, tighter budgets and easier money, their mix resulted in a lot of crowding out, partly at the expense of domestic investment, mostly in the form of mammoth import surpluses, depleting our nation’s net claims on the rest of the world, and making the US a net debtor. Moreover, until recently at least, the prospect was for ever-larger crowding out, ever-increasing growth in public debt relative to GNP and in federal deficits relative to private saving. We were caught in a vicious spiral: deficits, more debt, more interest charges, bigger deficits, higher interest rates, more crowding out, and so on. We may be escaping this frying pan by Gramm-Rudman and falling into fires.

Lester Thurow, in the other book under review, is a fervent opponent of crowding out. To restore the United States as a competitive “world class” economy, he proposes to raise gross domestic investment from 16 percent to 25 percent of GNP without borrowing abroad. He has a program to increase national saving. He would turn the vast federal deficits into vast surpluses. How? He would replace personal and corporate income taxes with a progressive personal consumption tax and a value-added tax, and revamp federal expenditure programs, notably Social Security and health care. If these measures did in fact add 9 percentage points to the national saving rate, the Federal Reserve would have to see to it that the potential extra saving was used for productive domestic and foreign investments rather than wasted in recession and stagnation. Thurow leaves implicit this essential plank of his platform and does not address the Federal Reserve directly. Unfortunately, since Thurow presented his ideas in his 1984 Lubin lecture, quite different issues have enthralled Washington.

The other 1984 Lubin Lecturer was the distinguished social scientist Daniel Bell. Macroeconomics and fiscal policy are just not his element. He has interesting insights into the recent politics of federal deficits and into social trends, but readers seeking guidance through the mazes of deficits and Reaganomics are advised to look to Eisner and Thurow, among other economists.

In December 1981 I wrote in this journal:

The Reagan economic program is advertised to cure inflation and unemployment, to revive productivity, investment, hard work, and thrift. It probably cannot achieve those wonderful results. What it is sure to do is to redistribute wealth, power, and opportunity to the wealthy and powerful and their heirs. If that is its principal outcome, the public will become considerably disenchanted.

The disenchantment has not yet come. President Reagan has in large degree succeeded in his chief ideological aims. He has so impoverished the federal government that civilian programs are starved for funds. He has ensured that the Treasury will not have adequate tax revenues by his demagogic triumph over Mondale on the issue of increased taxes. He has destroyed the progressivity of the federal tax system by insisting on drastic cuts in top tax rates as the price for closing loopholes that never should have been there, many of which he himself added in 1981. He has, it is true, paid a price and, according to his own rhetoric, endangered the national security in the bargain. Congress has stunted the real growth of defense spending and has made defense vulnerable to the Gramm-Rudman knife. The budget impasse is still unresolved. History will not treat kindly the spectacle of the 1986 tax reform. The President and Congress spent all their energies on a measure that is, at best, revenue neutral at a time when the obvious fiscal priority is for additional revenue.

For the years beyond Reagan and Gramm-Rudman, we will need consensus on some guidelines for fiscal policy, or rather on the mix of monetary and fiscal policies. The late Arthur Okun, a great economist and wise public servant, advised the makers of both these policies to keep to the middle of the road. We’re not there now. One extreme to be avoided is indefinite growth in federal debt relative to the economy. Five years of Reagan’s budgets raised the ratio of debt to gross domestic product from 23 to 38 percent. We should return that ratio to a downward long-term trend while preventing Gramm-Rudman from destroying the automatic and discretionary up-and-down movements in revenues, outlays, and deficits that served us well by mitigating business cycles in the past.

Any new administration will need more revenues than the tax code it will inherit in 1989 can yield. Thurow tells how to obtain revenues without impairing, and instead quite possibly enhancing, both the incentives for private saving, investment, and risk taking and the progressivity and fairness of the tax system. Once the arbitrary, ideological, and political ceiling on tax revenues is removed, the public, the Congress, and the President can rationally separate the two big fiscal issues—budget balance and budget size.

This Issue

September 25, 1986