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An Examination Of Elasticity As An Econometric Guide To Fiscal Policy

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An Examination Of Elasticity As An Econometric Guide To Fiscal Policy

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Content This d issertation has been 62— 6072 m icrofilm ed exactly as received MACBETH, Thom as G eorge, 1935— AN EXAMINATION OF ELASTICITY AS AN ECONOMETRIC GUIDE TO FISCAL POLICY. U n iversity of Southern C alifornia, P h.D .f 1962 E con om ics, finance University Microfilms, Inc., Ann Aibor, Michur : s Copyright by THOMAS GEORGE KACBE 1963 AN EXAMINATION OF ELASTICITY AS AN ECONOMETRIC GUIDE TO FISCAL POLICY by Thomas George Macbeth A Dissertation Presented to the FACULTY OF THE GRADUATE SCHOOL UNIVERSITY OF SOUTHERN CALIFORNIA In Partial Fulfillment of the Requirements for the Degree DOCTOR OF PHILOSOPHY (Economics) AUGUST 1962 UNIVERSITY O F SO U T H E R N CALIFORNIA GRADUATE SC H O O L U N IV ER SITY PARK LO S A N G ELES 7 . C A LIFO R N IA This dissertation, written by Thom as G e o r g e M acb eth under the direction of h.X$...Dissertation Com mittee, and approved by all its members, has been presented to and accepted by the Dean of the Graduate School, in partial fulfillment of requirements fo r the decjree of D O C T O R OF P H I L O S O P H Y Dean Date August, 1962 DISSERTATION COMMITTEE Chairman TABLE OF CONTENTS CHAPTER PAGE I. INTRODUCTION.................................. 1 Statement of the Problem................ 1 Purpose of the Study........................ 4 Significance and Value of the Study ........ 5 Elasticity as a Fiscal Economic Indicator of Federal Government Finance ............ 5 Possible Usefulness of Elasticities Involving the Federal Budget Balance and National Income...................... 8 Methodology of the Investigation ............ 9 Review of the Literature.................... 13 Organization of remainder of the dissertation .............................. 15 II. ECONOMIC ENVIRONMENT AND GOVERNMENT FINANCE IN THE UNITED STATES FROM THE LATTER PART OF THE EIGHTEENTH CENTURY TO THE PRESENT . . . 17 Economic Environment and Government Finance Before 1 8 1 5 .............................. 19 ii ill CHAPTER PAGE Economic Environment and Government Finance 1815-1839 . . .......................... 21 Economic Environment and Government Finance 1840-1860 25 Economic Environment and Government Finance 1860-1900 28 Economic Environment and Government Finance 1900-1916 35 Economic Environment and Government Finance 1917-1939 39 Economic Environment and Government Finance 1940-1961 52 III. GENERAL PRINCIPLES CONCERNING THE APPLICATION OF ELASTICITY TO FISCAL ECONOMICS.......... 60 Computation of the Federal Budget Balance Elasticity of National Income . ........ 60 General Observations on the Interpretation of the Federal Budget Balance Elasticity of National Income........................ 64 Identification of the Influence of Ante- marginal Federal Government Expenditure upon National Income...................... 73 iv CHAPTER PAGE Identification of the Influence of Post' marginal Federal Government Expenditure U pon National Income...................... 88 Simultaneous Changes in both the Level of Federal Government Expenditure and Federal Taxation .................. 91 Summary of the Analytical Tools Developed . . 93 IV. A REVIEW OF GOVERNMENT FINANCIAL HISTORY WITH ELASTICITY AS A GUIDE ........ 95 Period I: 1789-1889, Small G/Y, Large U/G . . 96 1810-1839 97 1840-1859 102 1860-1889 106 Period II: 1890-1916, Small G/Y, Small U/G . . 113 Period III: 1917-1946, Volatile G/Y, Large U / G ...................................119 Period IV: 1947-1961, Large G/Y, Small U/G . . 127 Reconciliation of the Federal Budget Balance and the Rate of Change Elasticities with History.................................131 Period I .................... 131 V CHAPTER PAGE Period I I ...................................133 Period III .................................134 Period I V ......... .....................136 V. FISCAL POLICY AND ELASTICITY AS A GUIDE THERETO.......................................138 New Deal Fiscal Policy and the Great Depression, 1933*1941 138 First Phase: Relief and Recovery, 1933-1934 ............................. 138 Second Phase: Recovery and Reform, 1935-1937... .......................... . 146 Third Phase: Confusion, Inflation, Stabilization, and Stagnation, 1937-1939... ............................. 152 Alvin Hansen's Reflections on the Great Depression and Fiscal Policy ............. 161 Conclusions on Fiscal Policy during the Great Depression with Elasticity as a Guide...................................164 Fiscal Policy during the Second World War and the Reconversion Period 1941-1946 . . , 165 vi CHAPTER PAGE Fiscal Policy in the Contemporary Period, 1947-1961 174 Continuation of Postwar Inflation, 1947-1948 174 Elasticity as a Guide to Fiscal Policy in 1947-1948 179 The 1948-1949 Recession .................. 189 Elasticity as a Guide to Fiscal Policy in 1948-1949 191 Recovery, the Korean War, and Postwar Inflation, 1950-1953 .................... 198 Elasticity as a Guide to Fiscal Policy in 1950-1953 202 The Recession of 1953-1954 ................ 207 Evaluation of Fiscal Policy in the 1953-1954 Recession through Elasticity . . 210 Expansion and Boom, 1955-1957 214 Elasticity's Pronouncements on Fiscal Policy during the Expansion of 1955-1957 217 The Sharp Recession of 1957-1958 .......... 221 vli CHAPTER PAGE Elasticity's Insights into the Anti- Recesslon Fiscal Measures of 1957-1958 . . 227 Expansion 1959-1960 232 Elasticity as an Index to the 1959-1960 Period of Expansion.......................234 Recession and Revival, 1960-1961 ...... 237 Judgments Based on Elasticity of Fiscal Policy after 1960 241 VI. SUMMARY AND CONCLUSIONS ON ELASTICITY AS A GUIDE TO GOVERNMENT FINANCE AND FISCAL POLICY . . . ...................................248 Theoretical Implications of Elasticity .... 249 Historical Insights of Elasticity on Government Finance and Fiscal Policy .... 257 Elasticity as an ex ante Guide to Fiscal Economics and Fiscal Policy.................263 BIBLIOGRAPHY...........................................265 APPENDIX........................... 273 LIST OF TABLES TABLE I. Gross National Product and Its Chief Components, In 1929 Prices, 1919-1929 . . II. Excess of Federal Government Expenditures over Receipts, Including and Excluding Social Security Accounts, 1933-1939 . . . III. The Federal Budget Balance Elasticity of National Income, the Unbalance of the Federal Budget, the Rate of Change Elasticity, and the Stage of the Net Federal Expenditure Product of National Income ................................ IV. FBBEY, RCE, and Stage NFEPY, 1941-1946 . . V. FBBEY, RCE, and Stage NFEPY, 1947-1948 . . VI. Derivation of the Incremental GNP-to-CPI Ratios ...................... VII. FBBEY, RCE, and Stage NFEPY, 1948-1949 . . VIII. FBBEY, RCE, and Stage NFEPY, 1950-1953 . . PAGE . 45 51 . 65 . 171 . 181 . 184 . 193 . 203 viii ix TABLE PAGE IX. FBBEY, RCE, and Stage NFEPY, 1953-1954 .... 212 X. FBBEY, RCE, and Stage NFEPY, 1954-1957 .... 219 XI. FBBEY, RCE, and Stage NFEPY, 1957-1958 .... 229 XII. FBBEY, RCE, and Stage NFEPY, 1959-1960 .... 235 XIII. FBBEY, RCE, and Stage NFEPY, 1960-1961 .... 243 XIV. Derivation of the Quarterly Incremental GNP-to-CPI Ratios since 1961 244 LIST OF FIGURES FIGURE PAGE 1. The Behavior of the Federal Budget Balance Elasticity of National Income from 1799 through 1961............ '............... 71 2. Positive Income at at Least One Point........... 84 3. Multimodal (Bimodal) Net-Federal-Expenditure- Product-of-National-Income Curves...............101 4. Income Generation of the Unbalance............... 110 5. Derivation of the NFEPY Curves................... Ill 6. Interrelationships of the FBBEY, RCE, and the FEPY Curves.............................112 7. Derivation of a Feasible Long Run AFEFY Curve . . 160 x CHAPTER I INTRODUCTION STATEMENT OF THE PROBLEM Economists have had much to say about the proper use of fiscal policy since John Maynard Keynes provided the English speaking nations with an acceptable framework of those forces which determine national income. They became aware of the possibility of infinitely many equilibria levels of national income in both the short run and the long run. In order for an economic system to achieve its economic potential, it became logically apparent that an exogenous force had to be exerted upon the functioning of a pure market economy to counteract excessive deviations in either direction from a full employment equilibrium.1 1Full employment in this instance being said to exist when all those who wanted to work at the going wage rate for their particular grade of labor could find one or more jobs within a reasonable length of time which em ployed them for as many hours per year as they chose to work. 1 The only exogenous force of sufficient economic strength to oppose the cumulative trend of the private market forces was government finance. Thus, the idea that the government should act countercyclically with respect to its net con tribution to the income flow developed from bits and frag ments in the body of economic knowledge prior to Keynes to a fairly sophisticated network of analysis provided by Alvin Hansen and many others. This analysis has grown to sufficient size and depth to stand alone as a legitimate field within the huge superstructure of economics. The field of fiscal economics provides much logical analysis according to which the many detailed programs of federal government fiscal policy are designed to achieve desired levels of national income flow. At the time of this writing the objectives of fiscal policy are, in con junction with other types of economic policy, to provide two types of economic stability— employment and price. The other three economic goals of growth, efficiency, and equitable distribution of the national product have not yet received important consideration in fiscal policy. Some fiscal policy measures, particularly relating to growth, do, of course, exist. But they are not of sufficient mag nitude to assert that fiscal policy is actively concerned with promoting growth, efficiency, and equitable distribu tion. Macroeconomlcally, fiscal policy seeks to promote stability by increasing or decreasing the magnitude of the income flow through the use of governmental financial tools. Microeconomically, it utilizes these financial powers of government selectively. The first approximation to government finance is to offset its expenditures by an equivalent amount of taxation when it does not want to change the level of national in- 9 come. More sophisticated analysis has shown that a bal anced budget ceteris paribus would increase national income by the change in the amount of the government expenditure on initial round, but this rule of thumb is the best simple approximation to a neutral government fiscal policy there is. If the government thinks it wise to raise the level of national income, it can and should exert stronger leverage on national income by spending more than the amount of revenue it receives, and if it thinks contraction to be in order, it should spend less than its receipts. The problem with fiscal policy is not that the 2Trygve Haavelmo, "Multiplier Effects of a Balanced Budget," Econometrics, 13:311-18, October, 1945. logical framework is either incorrect or overly incomplete. It is that the parameters of the economic model are not known. Dynamic economic theory goes far in amplifying one’s understanding of what courses of financial action the government should take to promote a desired change in the level of income, but this is not sufficient when definite statements of policy are required. The policy maker needs to know by how much he should alter government spending and/or taxation to cope with the current fiscal economic problem. Present theory is not equipped to yield these answers, and it is likely that it may never be able to yield perfect ones. PURPOSE OF THE STUDY The purpose of this study is to extend to the field of fiscal economics and fiscal policy two Isomorphic con structs of an economic indicator which has proved helpful in many other economic applications. Especially, it is to be determined here whether measures of elasticity (show ing the rates of proportional change of two interrelated economic variables) can serve as a measuring rod of fiscal policy. 5 SIGNIFICANCE AND VALUE OF THE STUDY If these constructs of elasticity prove to be an adequate guide, the gap between fiscal economic theory and the requirements of successful fiscal policy would be suf ficiently bridged until such time when no gap existed (if ever). If these measures of elasticity prove a failure, it will have been determined that this classic economic tool cannot be used in place of more developed theory as a guide for fiscal policy. The utility of this examination, how ever, would not end with the answer to this question. There will be some interesting by-products forthcoming as the major question to be resolved in this study carries with it other avenues of exploration. ELASTICITY AS A FISCAL ECONOMIC INDICATOR OF FEDERAL GOVERNMENT FINANCE The first device to be computed and utilized as a guide to the fiscal economic effects of federal financial operations is the "federal budget balance elasticity of national income." It itself is utilized to provide some conclusions and is incorporated in the computation of the second device, the rate of change elasticity. The federal budget balance elasticity of national income is computed by dividing the proportional change in the Gross National Product by the proportional unbalance in the federal budget. The result shows the responsiveness of national income to the federal government's net contribution to the circular flow of Income. The federal budget balance elasticity of national income reveals whether national income changed more than proportionally, equally proportionally, or less than equally proportionally as a result of some specific amount of net government expenditure. Furthermore, the sign of the coefficient shows whether national income moved in the same or in the opposite direction. The fact that the co efficient might take on a negative sign suggests that there will be problems in interpreting the values of the co efficient. Indeed this is true, and this is why the pur pose of this study is to prove as a testing ground for elasticity as a guide to fiscal economic relationships. Unlike the commonplace price elasticity of demand, the federal budget balance elasticity of national income relates two variables which are not completely causally related. In price theory the establishment of a schedule of demand Is based on the premise that every quantity which would be purchased at different prices was known and'set forth. The reasons why each different quantity versus price was that given magnitude were not considered. Then It followed that at elasticities greater than one the total outlay could be Increased by lowering the price. When price had been lowered too much, the coefficient of elas ticity would fall below one, Indicating that the Increased quantity of sales would be Insufficient to recover the per- unit loss In price. No such meaning can be associated with the federal budget balance of national income, however, because national income is not solely determined by govern ment expenditure. It was not possible to set forth every amount of national income which would exist for every unit of government expenditure. If this could have been done, the problem of this whole inquiry would not exist. It is because this gap in our knowledge does exist that this research continues. The rate of change elasticity is the elasticity of the fedetal budget balance elasticity of national income with respect to the percentage change in the unbalance. This elasticity is a measure of causation and proves to be a much more powerful tool than the federal budget balance elasticity itself. Its derivation and interpretation is deferred to Chapter III. POSSIBLE USEFULNESS OF ELASTICITIES INVOLVING THE FEDERAL BUDGET BALANCE AND NATIONAL INCOME It appears that elasticities involving the federal budget balance and national income could yield several pos sible Insights into the major problem of determining the effects which fiscal policy measures have upon national Income. (1) They might serve as an eye-opener in reviewing governmental financial history by forcing one to search for reasons why the federal budget balance elasticities of national Income and the rate of change elasticities had certain value for a given period of time. (2) They might serve as a reasonably accurate guide as to where the total net federal expenditure product of national income stands In relation to the Law of Variable Proportions. This would help to Identify the productiveness of ante-marginal and post-marginal spending as well as that at the margin. (3) They might be possible to compute ex ante how much of an un-balance in the federal budget is required to bring about some specific quantitative change in national income. Looking ex post, they might show what impact net government spending had upon national Income. (4) They might show that federal government fiscal policy had a strong or weak, positive or negative effect upon the spending behavior of the private sector of the economy, especially if no exogenous forces exerted signifi cant exhilarating or depressing pressures upon economic motivation. (5) They might show whether federal fiscal policy was executed well— forecasting, timing, competitiveness of federal spending with private spending, application to "trouble spots," income generating power of federal ex penditures, proper debt management, excellence of the tax structure, etc. METHODOLOGY OF THE INVESTIGATION The methodology of this investigation is first to establish an object whose analysis holds the key to 10 successful fiscal policy. The definition of fiscal policy employed throughout this study Is the conscious manlpula* tlon of the financial powers of government to promote some economic goal. The most Important Influence of the manipu lation of government financial powers is upon national in come, therefore, the analysis of fiscal policy derived here Is wrapped up in examining variations in the size of national income. The starting point in examining variations in the size of national Income is the establishment of Income it self as a product. The national economy is a producer and the thing it makes Is national Income. Looking at income in this way, it is possible to apply many of the analytical tools developed in the theory of the firm to the study of national income. The manufacture of national Income is declared to have two productive agents. One of these is the private sector which includes all parts of the national economy (state and local governments, too) other than the federal government. The companion factor is the federal govern ment. The means of producing national income is through expenditure by each body. Expenditure constitutes effective demend, and effective demand is nearly always capable of eliciting supply. Production then constitutes income in a non-trading economy or leads to income with the execution of exchange. The purpose of dividing the produc tion of national Income into two agents is to apply the Law of Variable Proportions. From the Law of Variable Proportions is gleaned insight into how the size of national income changes as one factor is varied In amount while the other is held fixed. Since the purpose of this study is to explore the fiscal economics of fiscal policy, it is decreed that federal government expenditure is the variable factor and all other spending is to be held un changed in amount, i.e., comprise the fixed factor. In theory the problem is thus determinable. At some level of government spending the rate of national income produc tivity of government expenditure can be read. It follows that a change in the level of government spending will yield a different rate of Income productivity in nearly all circumstances. But if these values could be determined in the real world as readily as they are conceptualized in theory, there would be much less chance for error in fiscal policy than there is in fact. Some approach must be 12 devised for computing what the rate of Income productivity of government expenditure is at any and all levels of government spending. This study provides such an approach. The results herein produced do not trace out the whole federal government expenditure product of national income, but they do provide a means of indexing the marginal productivity of government spending at some existing level and at levels nearby. The resulting indexes of the income productivity of government spending are then utilised to expose new in sights into the effects which government fiscal operations have upon the level of national income and thus to a large extent the potential effects of fiscal policy upon economic welfare. All the while an appraisal Is made of whether this technique for estimating the income productivity of federal government spending is sufficiently accurate to retain it for future use. In more technical terms this means that the declaration of the private sector's spending as a "fixed" factor in Income production might be an untenable assumption. This it will be if private motivations are not similar from year to year or from economic cycle to economic cycle. 13 REVIEW OF THE LITERATURE The literature on this specific topic Is nonexistent, for the Idea of applying elasticity analysis to fiscal policy Is the major contribution of this thesis. Contigu ous literature on fiscal economics and economic fluctu ations exists In both quality and quantity, but little of this literature Is applicable. On the theoretical side, Richard A. Musgrave's Theory of Public Finance. Bent Hansen's Economic Theory of Fiscal Policy, and Challis A. Hall, Jr.*s Fiscal Policy for Stable Growth have become standard textbooks on fiscal economics. Of special theoretical Interest to this study were journal articles by John M. Cassels, "On the Law of Variable Proportions," E. J. Working, "What Do Statistical 'Demand Curves' Show?" Birge and Shea, "A Rapid Method for Calculating the Least Squares Solution of a Polynomial of Any Degree," and Trygve Haavelmo, "Multiplier Effects of a Balanced Budget." In combination these articles laid the groundwork for the derivation of the net federal expendi ture product of national Income as a measuring rod of the effects of fiscal measures on the gross national product 14 and In turn o£ elasticity as a slngle-polnt Index to the net federal expenditure product of national Income. On the historical side, MThe American Economy In the Thirties** by Arthur Smithies, Fiscal Policy and Business Cycles by Alvin H. Hansen, *'The Economic Reports of the President and the Problem of Inflation*' by Frank W. Fetter, and Lewis H. Kimmel's Federal Budget and Fiscal Policy 1789-1958 provided the best analyses of fiscal policy. These had to be supplemented by contemporary thoughts, re actions, and data; therefore, a number of articles of limited scholarly content and various governmental publica tions are drawn upon in Chapter V to provide a more com plete historical background of fiscal policy. Again on the historical side but with respect to government finance before the Great Depression, certain textbooks on economic fluctuations yield most of what is necessary. Maurice W. Lee's Economic Fluctuations. Studenskl and Krooss' Financial History of the Uhited States, and Robert A. Gordon's Business Fluctuations were especially good for constructing Chapter IX. 15 ORGANIZATION OF REMAINDER OF THE DISSERTATION In the next chapter a traditional historical sketch of economic environment and government finance is presented to establish what types of observations on government finance are now possible without aid of elasticity. In Chapter III the federal budget balance and the rate of change elasticities are derived in theory, and specific coefficients from 1799 through 1961 are set forth in tabular and graphic form. General relationships among the individual elasticities are set forth, and the findings are grouped for subsequent analysis. In Chapter IV government financial history is inter preted in the light of these elasticities. Before each distinct period an interpretation of the corresponding elasticities is set forth as an index of the character of fiscal policy in that period. The period is then reviewed historically in the light of insights afforded by elas ticity. Chapter V analyzes fiscal policy to promote stabili zation and growth from 1932 to 1961, contrasting the re flections of popular and scholarly writers on federal fiscal operations with the conclusions on fiscal policy 16 derived from the coefficients of elasticity. The concluding chapter explores the possibilities of using the federal budget balance elasticity of national income and the rate of change elasticity as predictive guides for fiscal policy, as well as an over-all evaluation of them as guides to federal government financial history. CHAPTER II ECONOMIC ENVIRONMENT AMD GOVERNMENT FINANCE IN THE UNITED STATES FROM THE LATTER PART OF THE EIGHTEENTH CENTURY TO THE PRESENT The purpose of this chapter is to explore the his torical evolution of the two components of national income in order to provide insight for the task of naming inter esting values of the federal budget balance elasticity of national income and the rate of change elasticity. It was useful to divide the production of national income into two parts so that one could be treated as a fixed factor and the other as a variable factor. The preconditions of applying the Law of Variable Proportions to the study of the medium of fiscal policy--national income--are, as in all other types of production, that at least one factor be fixed in amount and at least one factor be variable in amount. The private sector was chosen as the fixed factor; the federal government sector was chosen as the variable factor. The private sector was defined to include all 17 18 types of spending except that done by the federal govern ment. It was noted that if the private sector did not undergo a serious structural change in its income producing performance, it was permissible to treat it as fixed, even though it varied in amount. It would be desirable to trace separately the per formance of the private sector and the performance of the federal government sector in affecting the level of national income. This is not possible, however, before the Great Depression, because government finance was not appraised in the light of what effects it would have upon national income before the Keynesian Revolution. The closest thing to this type of consideration came when it was held, especially in the 1920's by the Coolidge Adminis tration, that prudent federal government finance would show the way to the rest of the economy to put its affairs in similar good order. Good housekeeping would lead to a dissolution of many elements in the internal structure of the national economy which would otherwise emit cancer ous cells into the circulatory system. The state of confidence would rise everywhere and curtail the 19 t 1 psychologically oriented forces of economic Instability. The history of fiscal policy before the Keynesian Revolu tion Is therefore treated as an Intertwined branch of business cycle history from 1800 to the New Deal Era. The treatment of the prevailing economic conditions and federal fiscal policy are more separated In the review of the last quarter century. This separation becomes more pronounced as more recent periods are explored. ECONOMIC ENVIRONMENT AND GOVERNMENT FINANCE BEFORE 1815 The United States was a primitive, frontier type economy whose component parts were badly coordinated in the late eighteenth and early nineteenth centuries. Its mone tary system was barely adequate In providing either a medium of exchange of sufficient quantity and quality or in establishing a healthy and safe banking system to stimu late the accumulation and transfer of loanable funds.^ ^Lewis H. Kimmel, Federal Budget and Fiscal Policy 1789-1958 (Washington, D.C.: The Brookings Institution, 1959), pp. 89-98. 2 C. Lowell Harries, Money and Banking (Boston: Allyn and Bacon, Inc., 1961), pp. 511-12. The lack of land transportation facilities Isolated many parts of the country from the seaport trading centers. Despite these structural weaknesses, the IJhlted States ex* perlenced high-level prosperity coupled with rising prices except for minor Interruptions up to the War of 1812. Profits In the carrying and shipbuilding trades were high, stimulating much private saving. This saving later pro vided a nest-egg from which domestic Industrial development was launched after the War of 1812. Foreign developments dominated the economy. When France and England were at war, American exports and shipping expanded; when peace was achieved In Europe at the beginning of the nineteenth century, a sharp adverse bal ance of trade ensued. The Embargo Act of 1808 caused the commerce of Hew England to sag severely, but the economy turned up thereafter when the restrictions on foreign trade were relaxed. The reimposition of the Non-Intercourse Act in 1811 and the following declaration of war in 1812 de pressed the economy once more. Although the federal government expanded from a 9 million dollar level to a 30 million dollar plateau, the economy had a depression. The expansion of the federal government from 1 to 3 per cent of national income was not large enough to reverse the con traction of national income. War finance had to come from the sale of government bonds to the public. The buyers consisted to a large extent of state chartered banks in the South and West, since the Bank of the Uhited States had expired and the New England area was hostile to the whole war. The purchase of these bonds allowed the weak state banks to expand their note issues which set the stage for Insolvency and depression whenever foreign trade fell off. By 1819, national income at 876 million dollars still had not reached its 1809 plateau (915 million dollars).^ ECONOMIC ENVIRONMENT AND GOVERNMENT FINANCE 1815-1839 From the past came a weak monetary system, the west ward migration of a discontented population, primitive communication and transportation facilities, nearly useless factories geared to war materials production, an outmoded war goods trade, and an uncertain disposition of government Robert F. Martin, National Income in the Ohited States. 1799-1938 (New York: National Industrial Conference Board, Inc., 1939), p. 6. finances. The creation of the Second Bank of the Halted States in 1816 solved the major problems of the banking system and government finance for a decade after an Initial period of mismanagement. Bat Europe's heavy buying of American agricultural commodities had caused agricultural facilities and bank credit to become overextended before sound management of the Second Bank of the United States again policed the note issue of state banks. Manufactur ing, which had prospered thanks to the embargo on foreign products during the War of 1812, suffered after the war when foreign competition resumed. The 1819-1821 depression intensified the westward migration with unemployed workers.^ The construction of the Erie Canal brought external economies of scale to manufacturing and commerce. Trans portation and communication facilities were increased on a wide scale in the prosperous decade of the 1820's. National income rose roughly 100 million dollars between 1819 and 1829. Since the decade estimates are for the specific years mentioned rather than an average income, the average Sfaurlce W. Lee, Economic Fluctuations: An Analysis of Business Cycles and Other Economic Fluctuations (Home wood, Illinois: Richard D. Irwin, Inc., 1955), pp. 118-19. 23 m y have been somewhat higher. The federal government reduced its level of spending to an average of 17 million dollars and a decline from a 2.6 per cent 1810-19 average per cent of national income to 1.7 per cent. Furthermore, the federal government withdrew from the economy an average of 5 million dollars more than it spent. This it did mainly via its sales of land to the public and its receipt of customs duties.^ The opening of the West was accompanied by heavy capital Investment in canals. This was the dominant form of Investment in the 1830's. Speculation in both urban and rural land was touched off by this investment. The birth of the railroad construction movement came at this time too. Andrew Jackson's victory over Henry Clay spelled doom for the Second Bank of the United States, and the collapse of this monetary policeman paved the way for the resusqption of wildcat banking. Wildcat banks eagerly supported the speculation in real estate and transportation facilities. Foreign capital and the united States Treasury flowed into 5Annual Report of the Secretary of the Treasury on the State of the Finances (Washington, D.C.: Government Printing Office, 1960), p. 10. these state banks, intensifying speculation that ouch more. National income increased about 650 million dollars during the 1830-39 decade. Much of this was Inflationary. The Panic of 1837 was touched off when Jackson's Specie Circular of July 1836 required specie payment for public land and European balances were withdrawn from American banks. With the financial support of the land speculation bubble withdrawn, it burst. Strangely, a sharp recovery came in 1838, making the severe depression in 1837 one of the briefest on record.* Government expenditure was such a small component of national income at 1.5 per cent that it would have been nearly powerless in reviving the economy or in contracting it. Its 1837-38 deficits were moderately uplifting, but the recovery in Europe was the dominant force of recovery. The collapse of the privately operated Second Bank of the Uhited States in 1839 touched off another liquidity crisis. Over the decade, the federal government averaged a net withdrawal of 7 million dollars per year from the income flow.7 op» cit.. pp. 120-22. 7Annual Report of Secretary of Treasury, p. 10. 25 ECONOMIC ENVIRONMENT AND GOVERNMENT FINANCE 1840-1860 Economic decline continued until 1843 ee the quan tity of bank notes fell from an 1837 peak of 149 million dollars to 58.6 million dollars in the trough year 1843, and bank loans and discounts fell over 50 per cent to 255 million from 525 million dollars* Wholesale and retail prices fell sharply, land values were slashed, state governments experienced serious financial conditions, and unemployment ran high. The creation of the Independent Treasury in 1840 and again in 1846 worsened economic condi tions as the government hoarded funds in the Spring when tariff duties poured forth revenue and injected them into the income stream in the Fall when it received little revenue. The greatest demand for funds came in the Spring, just when the federal government was hoarding. The money markets thus overexpanded and severely contracted season ally, leading to extreme financial insecurity. Economic recovery commenced in 1843 as the deadwood was cleared out by the long depression. Foreign purchases of American goods soared when England repealed her tariffs and Ireland suffered a potato famine. Transportation facilities 26 continued to grow and carry the economy along with it. The War with Mexico had led to an optimistic atmosphere in 1846 which led to increased production, employment, prices, and exports. A financial panic in Great Britain depressed the American economy once more in 1847. This pall hung over the economy until the discovery of gold in California ex* hllarated it once again. Federal government spending occupied a very tiny portion of national income at 1.3 per cent and government revenues again exceeded spending. Once again federal finance was too weak to reverse any Important Income trend. National Income at the end of the 1840*49 decade was approximately 800 million dollars higher than in 1839. Prosperity continued with gigantic advances in rail* road building until speculation in the stock market, real estate, and California gold mining coupled with severe stringency in the money markets produced panics in 1854*55 and In 1857. Recovery in 1858*59 was only partial. The early part of the decade must have been quite vigorous as national income in 1859 at 4.3 billion dollars was nearly 2 billion dollars higher than in 1849.® Government spending ®Martin, on* cit.. p. 6. 27 averaged 58 million dollars over 1850-59, but It remained only 1.3 per cent of national income. The average budget was virtually balanced with an average of only one million dollars more in receipts than expenditures. The 1840-60 period saw the major determinants of economic fluctuations change from foreign influences to domestic events. Both the timing of the turning points and the magnitude of the ensuing fluctuations gravitated toward American developments wer this score. Changes in the internal structure of the economy brought this about. The emergence of the factory system as the major medium of pro duction brought with it economies of scale, increased specialization, and a growing receptivity of new techno logical processes. Agriculture became more commercially competitive as garden-size farms were merged into larger mono-crop tracts. Increased sales of agricultural goods provided a broader base of purchasing power for manu factured products. All this was nurtured by improving water, rail, and highway facilities. But this improved comuunlcatlon made the economy more vulnerable to financial stringencies in local regions. Fluctuations now could be spread throughout the system with great speed. Wildcat 28 banking made any equilibrium tenuous. The seaport areas in Hew England, Hew York, Philadelphia, and New Orleans became the financial centers of the nation. The larger banks in these cities began to assume the functions of bankers' banks by holding reserves for the whole nation and perform ing many clearing operations. These banks provided the claims to capital needed for internal real goods and specu lative expansion. ECONOMIC ENVIRONMENT AND GOVERNMENT FINANCE 1860-1900 In the latter part of the nineteenth century the United States economy came of age. Railroad construction blanketed the continent. The United States shifted from a net importer to a net exporter. Corporations came to dominate the industrial scene. Large-scale manufacturing became commonplace. The labor force was swollen by immi grants who provided the labor needed to make American manu facturing competitive with the best in Europe. National banking legislation placed the currency portion of the total money supply on a sound, homogeneous basis. The Civil War provided the stimulus needed to tip 29 the balance of the Northern economy away from agriculture and toward manufacturing. Agriculture, too, was mechan ized. The South was devastated by the war and continued as a weak, dependent agricultural economy. Federal government expenditure Increased twentyfold from 63 million dollars In 1860 to 1.3 billion dollars In 1865. This was a record Increase for federal government spending. The government did not have sufficient revenue raising power to withdraw enough purchasing power from the private sector to avoid serious inflation. Wholesale prices doubled from the beginning of the war to the end. Food prices rose 116 per cent. After the war recession set In in 1867.^ By 1869 national Income stood at 6.3 billion, government spending averaged 506 million, the average annual deficit was 238 million,^ and government spending mounted to 7.4 per cent of national income.The percentage unbalance was a record 47 per cent. A financial crisis, started in 1869 by the specula tive cornering and subsequent sudden withdrawal by Gould 9Lee, op. cit.. pp. 130-32. * - °Annual Report of Secretary of Treasury, p. 10. 11Martin, op. cit.. p. 6. and Flak from the gold market, continued until 1871, but without injury to railroad construction. Speculation In railroad combinations led to the stunning failure of Jay Cooke and Company In mid-September of 1873. This, coupled with the exposure of the Tweed Ring in New York and the Credit Moblller, led to a severe depression. American production sagged severely all through the 1870's. Social discord ran high as unemployment mounted and labor unions nearly collapsed. Agriculture, however, prospered during this period, buoying up what was left of public confi dence.^ By 1879, national income at 7.2 billion dollars was slightly higher than it was the decade before.^ Government spending averaged 276 million dollars per year- half that of the Civil War decade.1* * It comprised 3.8 per cent of total national income. The federal government taxed an average of 16 per cent more than it spent during this decade. Railroad construction boomed in the early 1880's, ^Lee, op. cit.. pp. 133-37. ^Martin, op. cit.. p. 6. ^Annual Report of Secretary of Treasury, p. 10. and with it expanded the whole economy, particularly the steel Industry. Immigration regained its former tempo after a lull during the 1873-79 depression. Expansion was so great that hardly any unemployment was experienced despite the Increase in the supply of labor. Investment became more internally oriented as investment banking houses grew. The improved transportation facilities and the Increased size of the population created an environment more conducive to large-scale enterprise. Corporations grew up everywhere. But agriculture began to slump after 1881 because of crop failures in corn, wheat, and cotton. Depression came in 1882 with rural areas severely hit. Unemployment increased in the cities, and foreign trade declined. A wave of bank runs Intensified the depression for a while, but after 1885, it advanced the cause of re covery. High interest rates lured capital back into the market; the state of confidence In investment was checked from catastrophic decline by the faith held in the value of railroad property. Investment was advanced on all fronts in the late 1880's. By 1889, national income had risen to 11 billion dollars.^ Government spending averaged ^Martin, op. cit.. p. 6. 263 million dollars while government revenue withdrew 101 million dollars more from the economy than government expenditure injected. As a per cent of national income government spending fell to 2.5 per cent. A large surplus budget balance was experienced over this decade, running some 38 per cent. Foreign insolvency led to massive liquidation of foreign holdings in the United States. The money market became so tight in 1890 that bank reserves actually dipped below the minimum 25 per cent level required by national bank legislation. A record domestic wheat crop coupled with crop failures abroad provided a strong stimulant to the American economy in 1891. Iron and steel production continued the upsurge, lifting the whole economy out of de pression but not to prosperity levels. The Silver Act of 1890 forced the United States Treasury to buy 4.5 million ounces of silver per month. This increased the money supply so much that the gold base approached the w<iH— > level. As this minium level was approached, banks, the federal govenmient, and foreign investors began to hoard gold. Banks were ordered to supply gold for exportation by foreign deposit holders, prompting them to demand gold 33 for their holdings of greenbacks end Treasury Notes. Anticipating an imminent abandonment of gold by the United States government, the stock market panicked in May 1893. This in turn touched off a widespread financial collapse. Bank failures abounded in 1892-98. Reserve pyramiding, sanctioned by the National Banking Act of 1863, was clearly at fault for the severity of the 1893 contraction. The economy turned up in 1894 but not for long. William Jennings Bryan and the free-silver party introduced new uncertainty into the economy in 1896, causing investment to drop off. The defeat of the free-silver party paved the way for economic expansion in the middle of 1897. Foreign demand for American goods increased as prosperity had brought inflation to them. The tkiited States was experi encing deflation at the same time, so the relative prices of American goods fell below the foreign domestic prices. This differential was widened more by the introduction of more efficient methods of production in the Uhlted States in response to the depression of 1893-97. Exports of finished manufactures Increased nearly 25 per cent and semimanufactured products to over 20 per cent. Agricul tural exports complemented these. Total exports ranged as high as 615 million dollars. The first graat combina tion movement got underway in 1897, as collapsed financial structures of the preceding depression years were re financed. Investors were trumped up everywhere by profes sional promoters and underwriting syndicates. This strong boom was turned to depresslonary panic early in 1900, as the Boer War put a halt to gold flows from South Africa in 1899. European markets tightened in response to the un certainties shrouding the conflict and the loss of new gold flows. This Instigated heavy recall demand upon the Ameri can money market. Government spending in 1899 held the same percentage portion of national income, 2.5, as it did ten years earlier. But national income had Increased to 15 billion dollars.^ The federal government incurred a small 3 per cent deficit as 13 million dollars net were poured into the income stream.*7 16Ibid. 17Annual Report of Secretary of Treasury, p. 10. 35 ECONOMIC ENVIRONMENT AND GOVERNMENT FINANCE 1900-1916 The 1900-01 panic did not Injure the economy but merely slowed Its upward surge. Refinancing and reorgani zation plans were postponed a while but Industrial con struction and new construction forged ahead. Although the capital financing of railroads was already accomplished in the nineteenth century, corporate consolidations via hold ing companies provided a new outlet for investlble funds. Stock market speculation produced some ripples through the American economy, however, the Mreal goods" sectors were not hurt. In 1904 began a strong boom period once more which lasted until 1907. Prices were slow to rise at first, but they increased with increasing momentum as ex pansion progressed. Employment became nearly full. The rapid rise of retail prices prompted workers to demand higher wages. Management granted these willingly and passed them on in higher prices. Output was nearly at capacity; the demand for capital was very strong. Interest rates increased as bank reserves neared the 25 per cent minimum. Reorganizations accelerated during this period as the supply of capital became short. Investment funds were 36 increasingly delivered in short-term loans. Europe ex pended vigorously st the sane time. England's bank re serves reached the danger point in late 1906, which set the stage for panic in the susmer of 1907. This panic extended to the Ohited States when the Knickerbocker Trust Company failed in late October 1907. This quickly spread to all the Hew York banks which collectively fell to 50 million dollars below the required reserve position. Their attempts to ration withdrawals precipitated a wave of hoarding throughout the country. The general decline which preceded the panic continued at an accelerated pace. Un employment mounted, production declined, private investment nearly caaie to a halt, and commercial failures increased markedly late in 1907. The depression bottomed out in mid- 1908 and recovery ensued in late sussser of 1908. Since the banking system was basically at fault for this crisis, the "Aldrich Monetary Commission" was appointed by the Senate to appraise American banking. Their suggestions led to the Federal Reserve Act in 1913. Government finance was mildly countercyclical during most of the decade. Federal spend ing gradually slipped as a per cent of national Income over the decade. It started at 2.8 per cent in 1900 and fell 37 to 2.1 par cent In 1909. The surpluses and deficits were smell percentagewise end in absolute tense. Typically, they were a trifle under 10 per cent and ran from 30 to 90 million dollars. Although the aaiount of exertion by federal fiscal policy was miniscule during this decade, it was directionally accurate except for an 89 million dollar deficit in 1909. National income rose sharply, 5 billion dollars in 1909.18 The economy experienced its longest contraction since the 1880fs in 1910-11. But the amplitude of this decline was so small that the economy was barely phased. Recovery was led by agriculture in 1912, which yielded bumper crops at the same time Europe was experiencing crop failure. The money market tightened as Europe withdrew balances for hoarding and domestic economic expansion drew down excess reserves. Contraction of credit in late 1912 and early 1913 chocked off industrial production in early 1914. Retail trade followed suit, but employment held fast until the last half of 1914. The sudden outbreak of World War I forced the London and New York Stock Exchanges 18 £bid. to clot* to avoid tha ravages of worldwide liquidation. Markets for over 50 per cent of the nation's cotton, one fifth of its wheat, and basic siaterials such as copper, steel, and oil were lost. Bank runs were cheeked by call' lag upon special legislation and an emergency currency established in 1908 but hitherto held in abeyance. Revival came at the end of 1914, but it was not vigorous. Pessi mism over future developments retarded Investment and pro duction. England reopened shipping lanes to an acceptable degree early in 1915, so that orders from the Allied nations could be materialized in the llhited States. Met exports increased from 500 million to 3 billion dollars in 1916. National income skyrocketed in 1916 by 9 billion dollars after a modest 500 million dollar increase in 1915. Government spending played practically no part In this as it still hovered around the three-fourths of one billion dollars level in 1916. As a percentage of national income, it had fallen from 2.0 in 1910 to 1.5 in 1916. The de ficits and surpluses were trivial both in absolute and in percentage terms. National income increased by a record 8.8 billion over the previous year when it reached a level 39 of 48.4 billion dollars in 1916.19 ECONOMIC ENVIROMENT AMD GOVERNMENT FINANCE 1917-1939 The Uhited States entered the war in 1917, and in so doing, launched a new era of government finance. Un balances were typically large percentagewise and total government finance fluctuated between large and small per centages of total national income. The small prewar sur pluses and occasional deficits were superseded by large deficits in 1917-19, of 853 million, 9.0 billion, and 13.4 billion dollars. The percentages of these deficits to federal government spending were 43, 71, and 73 per cent respectively. Government spending increased from 734 mil lion in 1916 to 1.98 billion in 1917, 12.7 billion in 1918, and 18.5 billion dollars in 1919.^ The money supply in creased 80 per cent between 1914 and 1919. Before 1917, the primary cause was the influx of specie into the United States from abroad; after 1917, federal fiscal operations were the primary cause. The medium of expanding the money 20Ibld. 40 supply was through augmenting demand deposits rather than printing much new currency. The establishment of the Federal Reserve System Increased the money expansion poten tial of the commercial banking system, thus commercial banks were enabled to support the massive increase in government bonds. Lending by the Federal Reserve System to member banks greatly facilitated the flotation of govern ment securities. All this produced strong Inflationary pressures which lifted retail prices 83 per cent over their 1913 level and wholesale prices 99 per cent over this same base. Inflation effected a pronounced redistribution of Income with much inequity resulting. The peak of the war boom came in August 1918, and a moderate recession ensued due to the delay of production brought about by reconver sion to peacetime production. Expansion resumed in April 1919, however, and continued until January of 1920. The 1919-20 boom closely resembled the post World War II boom. Strong pent-up demand for investment goods led the way. Consumers had a similar repressed demand for consumer durables, especially houses, automobiles, and clothing. A large volume of liquid assets In both deposits and government bonds, coupled with high-level monetary 41 Incomes, assured these demands would be effective. Foreign demand for American goods was still abnormally high. And government expenditures remained high after the war ended, just as they did in 1946. In both postwar periods monetary control had been subserviented to financing the Treasury. The expectations of falling prices which had dampened post war demand at first were soon dispelled. Optimism grew as the population spent freely in accordance with its in flationary psychosis.^ Axmual national income increased all during the war years up to 1921. In 1917 it increased by a record 12.4 billion dollars to 60.8; in 1918 it again increased by a record amount, achieving a level of 77.9 billion dollars. Income increased at slower paces in 1919 and 1920 when it advanced successively to 84.6 and 91.6 billion dollars. It is interesting to note that government spending assumed a record 22 per cent of total national income in 1919, yet national income rose only 7 billion dollars. National in come increased another 7 billion dollars the next year 21 Robert A. Gordon, Business Fluctuations (New York: Harper and Brothers, 1952), pp. 363-64. yet federal epending was reduced by two-thirds in one year to 6.4 billion from 18.5 billion dollars. This severe reduction in government spending no doubt contributed heavily to the severe depression Which started in January 1920. National income fell nearly 22.0 billion dollars to 70.0 from its 1920 level of 91.6. The Federal Reserve System was rendered powerless to fight inflation in 1919, when it was committed to supporting the government bond market. Credit thus remained plentiful. Pent-up consumer demand plus large government deficits paced this inflation ary spiral. Wholesale and retail prices averaged 15-20 per cent higher in January 1920 than those nine months earlier. Prices did not start down as soon as general production either. When excess reserves became exhausted, commercial banks did not experience a liquidity panic as before the establishment of the Federal Reserve System. This is be cause the Federal Reserve Board extended credit to member banks when their excess reserves were depleted. There was no banking institution of sufficient strength to act countercycllcally before the enactment of the Federal Reserve System. Deflation was severe despite the banking system's maintenance of the supply of money and credit. 43 Production, employment, exports, end domestic seles sharply declined also. Beginning with the 1920's, economic fluctuations assumed their present mature form. America became a credi tor nation after the war, but the citisenry thwarted the natural tendencies toward assuming an "adverse" balance of trade by enacting high tariffs and supporting foreign demand with loans. Prices moved contrarily to the cyclical conditions. The depression trough in 1921 saw higher prices as measured by the Wholesale Price Index than the full-employment years 1927~29. Retail prices declined a little over the decade. This perverse movement of prices is largely explainable by the rapidly increasing output per man-hour. Cost structures declined faster than demand in creased. Innovation was the key as increased output over the decade was only 10 per cent attributable to the in creased employment of labor. The percentage amount of investment was actually lower than that of the prewar or postwar periods. Consumer spending remained high, but agriculture sagged after 1921. The automobile industry mushroomed to one eighth the value of all manufactures, and it increased the demand for complementary industries 44 such ms tires, petroleun, glass, steel, and other sietals. Mew highway construction soared, suburban areas became accessible and practicable, real estate speculation was in tensified, and installment selling was introduced on a large scale. In Table I it is noted that CMP in 1929 prices rose by nearly 15 billion dollars between 1921 and 1923, by 12 billion between 1923 and 1928, and 6.5 billion in 1929. Consumer goods marked over four-fifths of the increase in GNP. The most significant development in total capital formation in the twenties was that investment reached a peak in 1923 and then continued upward during the rest of the decade after a slight fall off in 1924. The twenties witnessed the highest per cent-of-GMP outlay for both pro ducer and consumer durables of any normal peacetime period. This investment led to vast excess capacity and saturation of demand which were major contributors to the severity of the Great Depression. The money supply increased only 20 per cent while gross national product was increasing over 40 per cent between 1922 (74.3) and 1929 (104.). Velocity increase explained part of this divergence. Business enterprise TABLE I GROSS NATIONAL PRODUCT AND ITS CHIEF COMPONENTS, IN 1929 PRICES, 1919-29 (In billions of 1929 dollars) 1919 1920 1921 1922 1923 1924 1925 1926 1927 1928 1929 Flow of consumers' goods 50.2 52.2 53.8 56.5 61.9 66.0 64.9 70.0 71.7 73.2 76.4 Perishable 19.9 21.0 21.8 22.6 23.5 25.3 25.1 26.3 26.8 26.7 28.0 Semldurable 7.5 6.5 7.8 8.9 9.8 9.0 9.9 10.0 11.2 11.2 11.8 Durable 5.0 4.9 4.0 5.1 6.6 6.9 7.8 8.6 8.2 8.4 8.8 Services 17.8 19.8 20.1 20.0 22.0 24.8 22.0 25.1 25.5 26.9 27.8 Gross capital formation 16.3 15.6 10.4 12.4 16.9 14.2 18.0 18.6 17.8 17.4 20.7 Producers' durables 5.4 5.3 3.6 4.2 5.8 5.4 6.0 6.5 6.1 6.5 7.5 Construction 5.9 4.7 5.6 7.4 8.1 9.1 10.2 10.7 10.8 10.6 10.3 Change In Inven tories 2.8 4.2 0 0.3 2.8 -0.9 1.6 1.2 0.4 -0.4 2.4 Foreign Investment 2.1 1.4 1.3 0.5 0.2 0.6 0.3 0.1 0.5 0.7 0.4 Total GNF 66.4 67.8 64.2 68.9 78.8 80.3 82.9 88.5 89.5 90.6 97.1 Source: R. A. Gordon, Business Fluctuations (New York: Harper and Brothers, 1952), p. 368, citing Simon Ruznets. National froduct Since 1869 (1946), pp. 35, 36, 41, 46, 52. a* Ul turned more toward internal expansion instead of depending upon commercial loans. They thus directed their banks to create more primary time deposits instead of creating addi tional derivative deposits. Commercial banks became swollen with time deposit reserves which carried the burden of interest cost. Uith the decline in commercial loans, banks allowed more of their excess reserves to be exhausted by their creation of deposits for securities and real estate speculators. This set the stage for the stock mar ket crash in October 1929. Residential construction fell sharply in the late twenties, making the economy even more vulnerable to a general depression. Government finance played a minor role throughout the decade. What little countercyclical policy was per petrated was at the hands of the Federal Reserve Board. Government spending comprised a falling percentage share of total national income as the decade wore on, falling from 7.0 per cent in 1920 to 3.2 per cent in 1929. Proportion ately large budgetary surpluses were realised each and every year, but in relation to total national income, these surpluses hardly ever exceeded 1 per cent. Since the government used these surpluses to retire public debt, 47 not ouch purchasing power was siphoned away from the aggregate Income flow. After June 1929, the economy turned down until March of 1933. Gross national product fell about 30 per cent between 1929 and 1932. Industrial production dropped nearly SO per cent. Private investment plusneted well below that needed for replacement. Durable goods output sank to less than one-third of the 1929 level at one point. Prices fell precipitously and disproportionately. Farm prices fell to less than one-half their 1929 peak, but in- 22 dustrial prices fell less. Overextended consumer credit worsened the deflationary pressures already experienced as personal Income declined. Construction activity fell al most to zero. Speculation in real estate left many with heavy mortgage obligations once the downswing developed. Conmercial banks failed as they buckled under the losses they experienced in the collapse in real estate prices. Bank runs ruined many others. Exports could not be sus tained when loans to foreigners were terminated. When England went off the gold standard in the fall 22Ibid.. p. 389 of 1931, gold was withdrawn from the United States at an alarming rate. The Federal Reserve Board Invoked tight money to check these withdrawals, but this seriously in jured the domestic economy. The downturn was sharply accelerated. To minimize the Influence of the loss of gold in the future, Congress passed the Glass Steagall Act in 1932, allowing government securities to be used as col lateral in place of commercial paper. America's attempt to play "beggar-thy-neighbor" in 1930 with the passage of the Smoot-Hawley Tariff led to international retaliation.2^ Fiscal policy was more the product of unavoidable results than of cognizant design. In 1930, fiscal policy was contractionary. The federal government withdrew 700 million dollars more from the system than it injected. The next three years saw deficits of 0.5, 2.7, and 2.6 billion dollars, but government spending as a per cent of national income was still too small to reverse such a sharp down turn.^ National income fell from 104 in 1929, to 91 in 1930, 76 in 1931, 59 in 1932, and 56 billion dollars 23Ibid.. p. 392. 2^Annual Report of Secretary of Treasury, p. 10. 49 in 1933. It Is obvious that a government of less than five billion dollars could not halt such a landslide. The upturn was the longest in history to that date, but it was also far from complete. It was vigorous for two years, but it tapered off thereafter. National Income was, respectively, 65 in 1934, 73 in 1935, 83 in 1936, and 91 billion dollars in 1937. At the peak in 1937, unemploy ment still numbered several million, retail sales were below 1929 levels, and construction lagged seriously. Gross national product had not matched its 1929 level, and with a larger population, it was even less satisfactory. Investment ran 25 per cent below its rate in 1929. In raising the level of government spending and the deficits to 6.69 and 3.6 billion dollars respectively in 1934, 6.52 and 2.8 in 1935, 8.49 and 4.4 in 1936, and 7.76 and 2.8 billion dollars in 1937, the New Deal government experi mented with various federal aid and reform programs; the feelings of insecurity generated by the latter (e.g., the National Recovery Administration) dampened the buoying effects of the former. * _ It is clear . . . that however much of a stimulant the NBA program may have been in the short run, the passage of time could only disclose it to be a deter rent to expansion. At heart the codes were devices 50 designed to raise costs, restrict output, and Indi rectly or In sosie cases directly, by the Inclusion of such provisions within the codes, discourage new in vestment. As the novelty wore off the NRA program, these points began to become painfully clear." A sharp downturn came In Kay 1937, and the economy splraled down for thirteen months until June 1938. This downturn was the Joint product of the uneven pace of the preceding recovery, uncertainty as to the future course of monetary and fiscal policy, the fearful announcement effects of the increase in reserve requirements by the Board of Governors, and the fear of businessmen that they had extended their inventories too far. Government spend ing did not counteract this decline when the level of spending was reduced by one billion dollars and the deficit shrank 1.6 billion dollars from its former level. Taxes for social security significantly outweighed its payments in 1937-39. This was a serious offset to government spend ing in these years.Gross national product fell from 91 in 1937 to 85 billion dollars in 1938. 25 Lee, op. cit.. p. 231. ^*G. Soule, MPresent Industrial Depression,** Hew Republic. 93:62-64, November 24, 1937. TABLE II EXCESS OF FEDERAL GOVERNMENT EXPENDITURES OVER RECEIPTS, INCLUDING AND EXCLUDING SOCIAL SECURITY ACCOUNTS, 1933-1939 (In millions of dollars) Year ( 1) Federal Deficit Excluding Social Security Accounts ( 2) Surplus on Social Security Accounts (3) Net Deficit 1933 1934 1935 1936 1937 1938 1939 1,368 2,899 2,600 3,756 1,628 3,044 3,358 58 49 62 281 1,452 1,084 1,145 1,310 2,850 2,538 3,475 176 1,960 2,213 Source: R. A. Gordon, Business Fluctuations (New York: Harper and Brothers, 1952), p. 399, citing National Income Supplement,Survey of Current Business, July, 1947, Tables 5 and 10. The decline bottomed out with the depletion of in- ventories in June 1938. Berely had this natural recovery atarted when war-antidpation orders poured into the economy. Federal government apending waa increaaed over two billion dollars in 1939 and a deficit, 2.7 billion dol lars larger than that in 1938, of 3.9 billion dollars was 27 incurred. ' At this point stabilization policy gave way to war finance. ECCWOMIC ENVIRONMENT AND GOVERNMENT FINANCE 1940-1961 The federal government expanded expenditures modestly in 1940 to 9.06 billion dollars and to 13.3 bil lion dollars in 1941, but each war year thereafter saw gigantic increases. Spending reached 34.0 in 1942 , 79.4 In 1943, 95.1 In 1944, and 98.4 in 1945. Huge deficits, approaching 50 per cent of federal expenditures were in curred. Gross national product increaaed dramatically in both real and inflationary terms— from 101 in 1940 to 126 in 1941, 159 in 1942, 193 in 1943, 211 in 1944, and 27 Annual Report of Secretary of Treasury, p. 10. 53 214 billion dollars In 1945. Ikiemployment fall almost to zero. Taxation covered only 51 per cent of the federal government1• expenditure during these years, but It Is not fair to condeem taxation policy when the level of govern ment spending was being ever Increased without much advance warning. If tax rates had been set so high as to cover any conceivable Increase In federal spending, the result might have been too depressing of the marginal efficiency of capital. The war could have been lost by an oppressive tax structure. Price and wage control in World War II was sur prisingly successful, much more so than many economists thought was possible In view of the Inflationary gap created by the government's deficit spending. There were many Inequities; some black markets flourished; and perhaps some goods would have been In larger supply or of better quality in the absence of price control. On net balance, however, price and wage con trols clearly aided the war effort. As long as It was politically Impossible to meet the full cost of the war by taxes, price and wage controls prevented a sharp inflationary spiral that would have created grave political and social tension and would have distributed the burden of the war effort in a highly inequitable manner. Okifortunately, the success was only temporary. The end of price control in 1946 let loose the In flationary pressures which had been bottled up. . . . On net balance, despite the mistakes that anyone can point to, this country managed the economic side of the war quite well. We were able to put forth a prodigious productive effort, which resulted in a tremendous flow of armaments of all types. We were able to do this 54 while putting twelve million men end women into the armed services and at the same time maintaining the living standards of the civilian population. Resources were diverted promptly to war uses by a system of direct allocation controls. While deficit financing, particularly from the banks, created a large infla tionary potential, prices were held in check and the real burden of the war was distributed reasonably equitably through direct controls involving rationing and price and wage controls— as well as through heavy, progressive taxation (which should, however, have been heavier than it was).*8 After the end of World War II the level of govern ment spending was sharply reduced. It was cut to 60.4 in 1946, 39.0 in 1947, and 33.0 billion dollars in 1949. Also, the budget was balanced with small surpluses and deficits with 1948 as an exception. President Truman clearly stated that strong inflationary pressures had to be met by taxing more than the federal government spent. This was accomplished by producing a 26 per cent surplus budget (8.4 billion dollars) while lowering federal spend ing from 39.0 to 33.0 billion dollars. Large amounts of private purchasing power had poured forth after the war to keep production and prices at heady levels. All the while monetary policy had been abrogated by the pegging of the 2®Gordon, op. cit.. pp. 425-26. 55 federal securities markets by the Federal Reserve System. Whatever restraint to Inflation there was to be thus had to come from fiscal policy. Except for 1948, fiscal policy played a neutral role, but with total stabilisation policy flying on one wing, fiscal policy should have been more than neutral in this inflationary period. It should have been strongly deflationary.^ After the Accord of March 1951 between the Treasury and the Federal Reserve offi cials, monetary policy was re-established as an important weapon for promoting contraction of bank reserves whenever inflation, loss of gold, etc. warranted it, and thus the demands upon fiscal policy alone are no longer as great as they were during the postwar period. The outbreak of the Korean War caused fiscal policy to be oriented to war more than to stabilization, but President Truman's emphasis on longer range budget planning than for one year in his last budget message clearly marked a new public awareness of fiscal policy and the long run objective of stabilization. The Eisenhower Administration was faced with strong Inflationary pressures and high O Q **Lee, op. cit.. pp. 476-77. budgetary deficits as it took office in January 1953. Fiscal policy called for holding fast the tax rates while curtailing government expenditures. But before this policy took effect, a contraction developed in 1953-54. Personal income tax and the excess profits tax (enacted early in the Korean War) yields were reduced five billion dollars. The President declared that this bolstered confidence at a time when trade and employment were slipping. Eisenhower also endorsed the use of public works and lesser measures of government spending to revive a depressed economy instead of relying solely upon monetary policy and the "built-in stabilisers." From 1950-54, the federal government ad vanced its spending as a per cent of national income from 14 per cent to 20 per cent and then down to 19 per cent. The percentage sizes of the deficits and the one surplus in 1951 were around 10 per cent of government spending. The level of government spending advanced from 39.5 to 74.1 and then down to 67.5 billion dollars. National income In creased very sharply in 1950-53, as it advanced from 285 to 363 billion dollars. Mich of this Increase was in flationary. On the surface the Eisenhower Administration would appear vulnerable to criticism for lowering the level 57 of government spending during 1954, when national income was declining two billion dollars. Government spending was reduced in 1955 to 64.4 bil lion dollars, but taxes yielded a proportionally smaller amount of revenue. Thus, the percentage of the deficit increased 2 per cent.30 National Income was rising vigor ously. Except for a surplus budget of 3 per cent, 1956 presented the same pattern as 1955. National income in creased significantly once more from 392 to 415 billion dollars. Throughout the first nine months of 1957, the worry of the administration was with inflation. Both mone tary and fiscal policy were aimed at contraction. Payments for services rendered were lagged, too, so as to avoid the problem of passing the legal debt limit of 275 billion dollars. It is likely that these stabilization policies helped bring about the contraction in late 1957. This con traction bottomed out in May 1958, but not with much addi tional federal government appropriations. The level of spending remained at 16 per cent of national income and the deficit ran only 2.8 billion dollars. Eisenhower's faster 30 Annual Report of Secretary of Treasury, p. 10. release and execution of government contracts had the same effect as additional government spending while there re mained unspent appropriations. The large increase in federal spending and in the deficit did not come until 1959. Government spending increased 8.9 billion dollars to 80.3 billion dollars, as government revenues declined enough to leave a deficit of 12.4 billion dollars— 16 per cent of federal government expenditure. Gross national product barely increased for the whole of 1958 by 2 billion dollars, but it resumed a vigorous growth in 1959 by rising 38 billion to 483 billion dollars. Another recession was experienced in the fourth quarter of 1960 which caused in come growth to taper to 22 billion dollars. This increase has been lagging farther behind in 1961.^ This completes this traditional historical sketch of economic environment and government finance in the United States from the latter part of the eighteenth century to 1961. In the next chapter, the specialized tools of this study are forged. These tools allow one to review the events of this chapter with more quantitative insight into **^Kimmel, op. cit.. pp. 246-57. 59 the influences which federal finance has, both potential and realized, upon national income. CHAPTER III GENERAL PRINCIPLES CONCERNING THE APPLICATION OF ELASTICITY TO FISCAL ECONOMICS COMPUTATION OF THE FEDERAL BUDGET BALANCE EIASTICITY OF NATIONAL INCOME The federal budget balance elasticity of national Income Is the first analytical device developed and uti lized In this study. Its computation is by the traditional method used by economists for computing elasticity. Unfor tunately, it Is not feasible to utilize least-squares curve fitting techniques*1 here. Such methods would require ex tensive utilization of electronic computers. The expense of making these calculations is prohibitive at this stage in the development of the study. *One such method is that by Raymond T. Birge and John D. Shea, "A Rapid Method for Calculating the Least Squares Solution of a Polynomial of Any Degree," University of California Publications in Mathematics (Berkeley: Uni versity of California Press, 1927), Vol. 2, No. 5, pp. 67- 118. 60 61 The national income figures for the period 1799 to 1899, were available only as decennial estimates.^ Fur thermore, Gross National Product estimates were not available for this period. Utilization of National Income figures in lieu of GNP estimates in computing the desired elasticities is not a serious shortcoming. The miniscule size of government spending and indirect business taxes of the nineteenth century makes GNP and NI nearly identical. What is a serious loss is the lack of annual data for that century. Much is lost when ten years are grouped as one. Another problem arose in connection with the GNP figures for the years 1897 to 1909. The figures used by the National Industrial Conference Board for these years were computed at "original cost depreciation.in order to make these coincide with its own current dollar GNP estimates beginning with 1909, an adjustment of 2.2 billion dollars had to be added to the 1908 figure to bring the ^Robert F. Martin, National Income in the United States, 1799-1938 (New York: National Industrial Conference Board, Inc., 1939), p. 6. 3 The National Industrial Conference Board, Inc., The Economic Almanac 1958 (New York: Thomas Y. Crowell Company, 1958), p. 401. 62 1908-9 elasticity Into focus with those following. Beginning with 1909 and ending In 1956,^ all the GNP data are consistent. All Income figures used in computing the federal budget balance elasticities of national Income are expressed in current dollars, I.e., dollars of the given year. These are the appropriate ones for use here because the objective is to ascertain relationships con cerning the income generation power of net federal govern ment spending, whether that income be cheap or dear in real purchasing power. Inflation or deflation is no object here. The sameness of the 1948 and the 1949 figures to the nearest one hundred million dollars required a special treatment of the GNP estimates for those years.^ The GNP estimates for 1957 through 1961^ were drawn from the Department of Commerce Statistics as presented 4Ibid., p. 394. ^Using the consumer price index, multipliers of for 1948 and l .»Q3:Q for 1949, yield GNP estimates of 95.5 95.5 261.7 b. for 1948 and 260.4 b. for 1949. Ibid.. p. 71. ^The 1961 figures are projected second quarter rates. 63 by the Board of Governors of the Federal Reserve System.7 These estimates differ from the National Industrial Confer ence Board's by a few billion dollars for similar years. To avoid inconsistency of data two different Income figures for 1956 are employed In computing the 1955-6 coefficient of elasticity and in the 1956-7 coefficient. Fortunately, the federal government's finances for every year between 1789 and 1960, were clearly and con sistently set forth in the Annual Report of the Secretary of the Treasury for I960.® Each coefficient of elasticity was derived by sub tracting the national income of the previous year from the given year and dividing this difference by the average of income for the two years. The result was divided by the difference between federal government expenditures and federal government receipts divided by the total federal government expenditures in the given year.9 No averaging 7Board of Governors of the Federal Reserve System, Federal Reserve Bulletin. 47:845, July, 1961. ® Annual Report of the Secretary of the Treasury on the State of the Finances (Washington, D.C.: Government Printing Office, 1960), pp. 394-99. 9The expected A g/G is reformulated as (G-R)/G in order to align the federal budget balance elasticity of 64 of federal government expenditures Is appropriate because the unbalances are not computed from anything In the pre vious year. These unbalances are uniquely determined for each federal fiscal year. In column nine of Table III are presented the federal budget balance elasticities of national income since 1799. GENERAL OBSERVATIONS ON THE INTERPRETATION OF THE FEDERAL BUDGET BALANCE ELASTICITY OF NATIONAL INCOME In Interpreting the various federal budget balance elasticities of national Income one should concentrate his attention on the absolute sizes of the coefficients over a period of time rather than the signs which the coeffi cients assume. A positive sign shows that national income national income with the requisites of fiscal policy. This technique removes the problem of computing separately the contractionary effects of taxation upon national income. The separate computation of the expansionary effects of federal government expenditure and the contractionary effects of federal government revenue collection is not possible because both the amount of federal spending and the amount of federal revenue collection vary from period to period. One or another must be fixed in amount to study the Influence of the other on national income. TABLE III THE FEDERAL BUDGET BALANCE ELASTICITY OF NATIONAL INCOME, THE UNBALANCE OF THE FEDERAL BUDGET, THE RATE OF CHANGE ELASTICITY, AND THE STAGE OF THE NET FEDERAL EXPENDITURE PRODUCT OF NATIONAL INCOME CD (2) (3) (4) (5) (6) (7) (8) (9) (10) (U) (12) Chg G/Y U/G Chg Chg. Stage Year Y Y G Exp Unbal U/G FBBEY FBBEY RCE NFEPY 1799 0.7 -- 0.006 0.9 M ■» mm « -- -- a* mm 1809 0.9 + .2 0.009 1.0 -.004 41 — - 0.73 mm mm — 1819 0.9 - .0 0.023 2.6 +.003 12 +63 - 0.36 +0.4 + 0.16 2-3 1829 1.0 + .1 0.017 1.7 -.005 29 -41 - 0.37 -0.0 + 0.01 2-3 1839 1.6 + .7 0.024 1.5 -.007 31 - 3 - 1.60 -1.2 +14.7 2-3 1849 2.4 + .8 0.031 1.3 -.006 20 +11 - 1.95 -0.4 - 0.44 1UWY 1859 4.3 +2. 0.058 1.3 -.001 2 +18 -27.3 -25. - 1.07 1UWY 1869 6.8 +3. 0.506 7.4 +.238 47 +49 + 0.96 +28. + 0.98 2 1879 7.2 + .4 0.276 3.8 -.045 16 -63 - 0.35 - 1.3 + 1.05 2-3 1889 11. +3. 0.263 2.5 -.101 38 -22 - 1.01 - 0.7 + 1.19 2-3 1899 15. +5. 0.390 2.5 +.013 3 +42 +10.9 +12. + 1.01 2 1900 18.6 +1.* 0.521 2.8 -.046 9 -12 - 0.81 - 2. + 4.16 2-3 1901 20.3 +2. 0.525 2.6 -.063 12 - 3 - 0.73 + 0.1 - 0.47 1UWY 1902 21.0 +1. 0.485 2.3 -.077 16 - 4 - 0.21 + 0.5 - 3.83 1UWY 1903 22.8 +2. 0.517 2.3 -.045 9 + 7 - 0.95 - 0.7 - 2.15 1UWY 1904 22.0 -1. 0.584 2.7 +.043 7 +16 - 0.49 + 0.5 + 2.62 2-3 1905 23.9 +2. 0.567 2.4 +.023 4 - 3 + 2.04 + 3. - 5.80 1 1906 28.3 44. 0.570 2.0 -.025 4 + 9 - 3.88 - 6. -11.56 1UWY 1907 30.9 +3. 0.579 1.9 -.087 15 -11 - 0.59 + 3. - 1.34 1UWY 1908 26.9 -4. 0.659 2.5 +.057 9 +23 - 1.59 - 1. -12.4 1UWY 1909 33.6 +5. 0.694 2.1 +.089 13 + 4 + 1.12 + 3. +29.7 2 1910 35.2 +2. 0.694 2.0 +.018 3 -10 + 1.78 + 0.7 - 0.35 1 TABLE III (continued) THE FEDERAL BUDGET BALANCE ELASTICITY OF NATIONAL INCOME, THE UNBALANCE OF THE FEDERAL BUDGET, THE RATE OF CHANGE ELASTICITY, AND THE STAGE OF THE NET FEDERAL EXPENDITURE PRODUCT OF NATIONAL INCOME (1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11) (12) Chg G/Y U/G Chg Chg. Stage Year Y Y G Exp Unbal U/G FBBEY FBBEY RCE NFEPY 1911 35.8 +1. 0.691 1.9 -.011 2 - 4 - 1.10 - 3. 4- 1.13 2-3 1912 39.4 44. 0.690 1.8 -.003 0 4- 1 -24.3 -23. - 1.58 1UWY 1913 39.5 4- .1 0.725 1.8 4-. 000 0 4- 0 4- 4.59 4-29. 4- 1.14 2 1914 39.1 - .4 0.735 1.9 4-. 000 0 - 0 -18.7 -23. 4-179.4 2-3 1915 39.6 4- .5 0.761 1.9 4-. 063 8 4- 8 4- 0.15 4-19. 4- 1.03 2 1916 48.4 +9. 0.734 1.5 -.049 7 -15 - 3.02 - 3. 4- 0.19 2-3 1917 60.8 4-12 1.98 3.3 4-. 853 43 4-50 4- 0.53 4- 4. 4- 1.05 2 1918 77.9 4-17 12.7 16. 4-9.0 71 4-28 4- 0.35 - 0.2 - 0.84 1 1919 84.6 4- 7. 18.5 22. 4-13.4 73 4- 1 4- 0.11 - 0.2 -53.3 1 1920 91.6 4- 7. 6.40 7.0 -0.3 5 -77 - 1.75 - 2. 4- 1.00 2-3 1921 70.0 -22 5.12 7.3 -0.5 10 - 5 4- 2.69 4- 4. -12.9 1 1922 74.3 4- 4. 3.37 4.5 -0.7 22 -12 - 0.27 - 3. 4- 3.26 2-3 1923 85.5 4-11 3.29 3.9 -0.7 22 4- 0 - 0.65 - 0.4 -180.4 1UWY 1924 85.1 .4 3.05 3.5 -1.0 32 -10 4- 0.01 4- 0.7 - 5.54 1 1925 93.6 4- 9. 3.06 3.3 -0.7 23 4- 8 - 0.41 - 0.4 - 7.05 1UWY 1926 97.8 4 - 4. 3.10 3.2 -0.9 28 - 5 - 0.16 4- 0.3 - 5.03 1UWY 1927 95.8 - 2. 2.97 3.1 -1.2 39 -11 4- 0.05 4- 0.2 -11.43 1 1928 98.3 4 - 3. 3.10 3.2 -0.9 30 4- 9 - 0.09 - 0.1 -27.2 1UWY 1929 104. 4- 6. 3.30 3.2 -0.7 22 4- 8 - 0.27 - 0.2 - 3.27 1UWY 1930 91. -13 3.44 3.8 -0.7 21 4- 1 4- 0.64 4- 0.9 4-134.5 2 1931 76. -15 3.58 4.7 40.5 13 4-34 - 1.37 - 2. - 0.68 1UWY 1932 59. -18 4.66 8.0 4-2.7 59 446 - 0.45 4- 0.9 4- 0.79 2-3 1933 56. - 3. 4.62 8.2 4-2.6 56 - 3 - 0.08 4- 0.4 -32.4 1UWY os Os TABLE III (continued) THE FEDERAL BUDGET BALANCE ELASTICITY OF NATIONAL INCOME, THE UNBALANCE OF THE FEDERAL BUDGET, THE RATE OF CHANGE ELASTICITY, AND THE STAGE OF THE NET FEDERAL EXPENDITURE PRODUCT OF NATIONAL INCOME (1) Year (2) Y (3) Chg Y (4) G Exp (5) G/Y (6) Unbal (7) U/G (8) Chg U/G (9) FBBEY (10) Chg FBBEY (11) RCE (12) Stage NFEPY 1934 65. + 9. 6.69 10. +3.6 54 - 2 +0.27 40.4 -107.0 1 1935 73. + 8. 6.52 9.0 +2.8 43 -12 +0.26 -0.0 + 0.16 2 1936 83. +10 8.49 10. +4.4 52 + 9 40.25 -0.0 - 0.20 1 1937 91. + 8. 7.76 8.5 +2.8 36 -16 40.26 40.0 - 0.11 1 1938 85. - 6. 6.79 8.0 +1.2 17 -18 -0.37 -0.6 +16.5 2-3 1939 91. + 6. 8.86 9.7 +3.9 44 +26 40.15 40.5 + 5.51 2 1940 101. +10 9.06 9.0 +3.9 43 - 0 40.23 40.1 -60.8 1 1941 126. +25 13.3 11. +6.2 46 + 3 40.48 40.3 +10.5 2 1942 159. +34 34.0 21. +21.5 63 +17 40.38 -0.1 - 0.75 1 1943 193. +33 79.4 41. +57.4 72 + 9 40.26 -0.1 - 2.82 1 1944 211. +19 95.1 45. +51.4 54 -18 40.17 -0.1 + 1.44 2 1945 214. + 2. 98.4 46. +53.9 55 + 1 40.02 -0.2 -107.4 1 1946 209. - 4. 60.4 29. +20.7 34 -21 -0.06 -0.1 + 8.66 2-3 1947 232. +23 39.0 17. - 0.8 2 -36 -5.38 -5. + 0.86 2-3 1948 257. +25 33.0 13. - 8.4 26 -24 -0.40 +5. - 1.01 1UWY 1949 257. - 1. 39.5 15. + 1.8 5 +30 -0.11 40.3 + 0.35 2-3 1950 285. +28 39.5 14. + 3.1 8 + 3 +1.30 +1. + 4.81 2 1951 328. +43 44.0 13. - 3.5 8 -16 -1.60 -3. + 0.06 2-3 1952 345. +17 65.3 19. + 4.0 7 +15 40.83 +2. + 0.33 2 1953 363. +18 74.1 20. + 9.5 13 + 6 +0.39 -0.4 - 1.11 1 1954 361. - 2. 67.5 19. + 3.1 5 - 8 -0.12 -0.5 + 4.01 2-3 1955 392. +31 64.4 17. + 4.2 7 + 2 +1.45 +2. + 6.90 2 1956 415. +23 66.2 16. - 1.6 3 - 9 -2.32 -4. + 1.87 2-3 TABLE III (continued) THE FEDERAL BUDGET BALANCE ELASTICITY OF NATIONAL INCOME, THE UNBALANCE OF THE FEDERAL BUDGET, THE RATE OF CHANGE ELASTICITY, AND THE STAGE OF THE NET FEDERAL EXPENDITURE PRODUCT OF NATIONAL INCOME (1) Year (2) Y (3) Chg Y <*) G Exp (5) G/Y (6) Unbal 1957 443. +24 69.0 16. - 1.6 1958 445. + 2. 71.4 16. + 2.8 1959 483. +38 80.3 17. +12.4 1960 504. +22 76.5 15. - 1.2 1961 502. - 3. 78.9 16. - 0.8 (7) (8) (9) (10) (11) (12) Chg Chg Stage U/G U/G FBBEY FBBEY RCE NFEPY 2 + 0 -2.36 -0.0 -0.21 1UWY 4 + 6 40.10 +2. 40.29 2 16 +12 40.54 40.4 +1.17 2 2 -17 -2.74 -3. +1.21 2-3 1 + 1 +0.60 +3. +6.76 2 KEY: Y = National Income G = Federal Government Expenditure Unbal = unbalance of the Federal Budget FBBEY = Federal Budget Balance Elasticity of National Income RCE = Rate of Change Elasticity NFEPY = Net Federal Expenditure Product of National Income UWY = Underwater Income, as definitely determined by the signs of the Federal Budget Balance and the Rate of Change Elasticities *Thi8 discrepancy is due to a shift of national income data. The average annual income for the 1889-1899 decade was 15. billion dollars, but the national income figure for 1899 per se was 17.3 billion dollars. O N 00 increased when the budget was balanced with a deficit or decreased when the budget was balanced with a surplus; a negative sign shows that the level of income and the direc tion of fiscal policy moved oppositely. A negative sign is not to be understood as meaning that fiscal policy was "good" and vice versa. It is indeed possible that the private sector of the economy pulled so hard in the oppo site direction that the federal government's fiscal policy was overwhelmed. A negative sign of the federal budget balance elasticity of national income likewise does not suggest that fiscal policy was exerted in insufficient measure, for the fiscal policy goal may well have been to modify a divergent movement in national income while not seeking to change its direction. For example, in an ex pansionary period fiscal policy may not want to halt in creases in national income but merely slow down the rate of increase. The direction of fiscal policy measures might be contractionary, while the expansionary of the private economy was strong enough to eclipse these fiscal policy measures. The real object of concern Is the absolute responsiveness of national income to fiscal policy meas ures. If the responsiveness is increasing or decreasing 70 over some period of fiscal policy, this deserves the major portion of one's attention. It appears from the coefficients of the federal budget balance elasticity computed that federal government finance in the Uhited States falls into four major time periods. This can be appreciated visually by refering to Table III, pages 65-68, and Figure 1. The first period is from 1789 to 1889. During this century the unbalance of the federal government's budget was typically larger than 10 per cent of annual government expenditure. During this time the federal budget balance elasticity of national in come assumed high values both plus and minus, but these absolute magnitudes were not as steep as they were in period two. In the second period the unbalance of the federal budget was usually smaller than 10 per cent of the total federal government expenditure. This caused these co efficients to assume the most extreme values of all four periods. The small unbalances saw points farther up the net federal expenditure product of national income curve than those of the earlier and later larger unbalances. The values of the federal budget balance elasticity of - P e r io d 1 UB u s u a l l y l a r g e r th a n 10% G P e r io d 2 UB u s u a l l y l e s s th a n 10% G P e r io d 3 UB u s u a l l y l a r g e r . th a n 20% G P e r io d 4' UB u s u a l l y l e s s th a n 10% G 3- 1 9 S T -I- -2- F ig u r e i. T h e Be h a v io u r o f t h e F e d e r a l Bu d g e t Ba l a n c e El a c t ic it y o f N a t io n a l In c o m e fr o m 1799 T h r o u g h i96i. -o H national income were typically much greater than one, in dicating that national income was very responsive to net government expenditure. But this does not mean that total national income was proportionally more affected by govern ment finance. Indeed it is true that the total amount of change can be very small at the same time when the marginal rate of change is high. This is simply due to the fact that not enough ante-marginal units were incurred to exert a strong influence on the total. This period lasted from about 1890 through 1916. The third period was bounded by the beginning of the First World War for the United States and the conclusion of the reconversion period following World War II. Between 1917 and 1946, the federal government unbalance was the largest it had ever been. Usually, it exceeded 20 per cent of total federal government spending. This large unbalance brought about small values for the federal budget balance elasticities as advanced points along the net federal ex penditure product of national income curve of net govern ment expenditure were reached. The fourth period, 1947-1961, saw small unbalances once more as economic crises were again occasional rather than typical. The imbalance for these years was Ilka those Just before World War 1— typically less than 10 per cent of total federal government expenditure. The federal budget balance elasticities were again large, but not as volatile as those between 1890 and 1917. Undoubtedly, this is attributable to the much larger percentage role played by federal government spending in the composition of total national income. A more advanced point on the net federal expenditure product of national income curve was the more recent point of departure. The federal budget balance elasticity of national income provides insight into the income productivity of the unbalance of the federal budget. But additionally one needs to know the income productivity of antemarginal net federal spending in order to identify its stage of income productiveness in relation to the Law of Variable Propor tions and in the larger problem of appraising and esti mating fiscal policy measures. IDENTIFICATION OF THE INFLUENCE OF ANTEMARGINAL FEDERAL GOVERNMENT EXPENDITURE UPON NATIONAL INCOME One way of identifying the influence of antemarginal federal government expenditure upon national Income is to construct a time lag elasticity between the positive change from year to year of the federal budget balance elasticity of national income and the positive change in the proportional amount of the unbalance of the federal budget in relation to total federal government spending. The result is the rate of positive change of the federal budget balance elasticity versus the rate of positive change of the unbalance of the federal budget as presented by the "rate of change elasticity" involving these two.10 In Table III, pages 65-68, the information needed to com pute the rate of change elasticity is set forth as well as the rate of change elasticities themselves in column eleven. The "rate of change elasticity" shows whether a cer tain percentage change in the magnitude of the unbalance as a per cent of government expenditure is accompanied by an elastic, unitary, or inelastic response in the federal budget balance elasticity of national income. A coeffi cient of 1.10 would show that a 1 per cent increase in the ^Symbolically, the rate of change elasticity equals Pos. AFBBENI /Average fbbEHI * Pos- A ^/Average £ G g unbalance-as-a-per-cent-of-government expenditure would be accompanied by a 1.1 per cent increase in the federal budget balance elasticity of national income. If the prior federal budget balance coefficient had a value of 0.80, the resulting federal budget balance coefficient would equal 0.80 + 0.01 X 1.10 X 0.80 or 0.8088. An original national income of five hundred billion dollars would be expected to rise 4.04 billion dollars (0.01 X 0.8088 X $500 b.) when the federal government increased its positive unbalance (deficit spending) from four billion dollars to 4.8 billion dollars, if the level of federal government expenditure remained unchanged (at its original level of eighty billion dollars). This elasticity differs from the federal budget balance elasticity of national income in that its values allow one to estimate the probable effect a change in the positive size of the federal budget imbalance would have It is permissible to use the rate of change elasticity as a multiplier over a small interval of change in the unbalance of the federal budget. This procedure is all the more validated by the computation of the rate of change elasticity over a finite interval (making it an "average" elasticity). 76 upon national income if the private sector did not change its expenditure pattern dramatically. The federal budget balance elasticity of national Income fails to provide this information for it relates a single percentage change in national income to a single value of federal budget un balance as a percentage of federal government spending. The federal budget balance elasticity of national Income thus fails to identify the probable influence of the ante- marginal dollars of federal government expenditure upon national income. Precise fiscal policy demands at least this much knowledge. The utilization of elasticity does not yield perfect results, but theoretically it stands a good chance of providing tolerably accurate estimates.^ The sign of the rate of change elasticity is assigned by the division of the numerators of each com posite fraction. The numerators themselves assume a plus sign when the new value of the numerator is larger in 19 *The computation of elasticity by arithmetic means introduces a linear bias into the estimation of the shape of the net federal expenditure product of national income curve. This linear bias is not serious when the rate of income productivity of each dollar of net federal spending does not differ sharply from that of the contiguous dollar. 77 a positive direction than the old value and a minus sign when the opposite holds. This can be seen in Table III, pages 65*68. A plus sign for a coefficient of the rate of change elasticity means that a percentage Increase in the un balance of the federal budget as a per cent of federal government expenditure would lead to an increase in the sensitivity of national income to federal fiscal un- 13 balances. This shows that at the margin the income generation power of net federal spending was in the di minishing or decreasing returns phase. The use of the rate of change elasticity allowed one to observe the approximate behavior of antemarginal net federal spending upon national income. Since the federal budget balance elasticity of national income was more sensitive there, the presumption of diminishing or decreasing returns is verified. A minus sign for a coefficient of the rate of change elasticity means that a percentage increase in the un balance of the federal budget would lead to a decrease in 13 Income rises more than proportionally as the un balance is increased. 78 the sensitivity of national income to federal fiscal un balances. By analogous reasoning to that above, the income generation power of net government spending would lie in the increasing returns phase.^ The signs of the rate of change elasticities are more meaningful than were the signs of the coefficients of the federal budget balance elasticities of national income. The federal budget balance elasticities merely related the sensitivity of income to net federal government expendi ture. No cause and effect relationship was imputed. But the rate of change elasticity promises more in terms of cause and effect, because it was constructed by contrasting how the sensitivity of income to net federal spending varied when the size of the unbalance was changed (over time). This included a reconciliation of the signs of ^Increasing returns is known to exist between the antemarginal net federal expenditure product and the mar ginal net federal expenditure product of national income because the percentage rate of income increase exceeds the percentage increase in the unbalance (reading from right to left on the total net federal expenditure product of national income curve the minus sign of the rate of change elasticity shows this). See John M. Cassels, "On the Law of Variable Proportions," Readings in the Theory of Income Distribution (Philadelphia: The Blackiston Company, 1951), pp. 103-118, especially p. 107. the federal budget balance elasticities. If the federal budget balance coefficient had a lower negative value in the following year than in the original year, the co efficient was said to have increased, and a plus sign was thus assigned to the numerator of the rate of change elas ticity. Similarly, a less positive value was noted as a decrease in the federal budget balance elasticity, and a minus sign was accordingly affixed to the numerator of the rate of change elasticity. The rate of change elasticity is a better indicator of causality than the federal budget balance elasticity of national income because it shows how total income is related to changes in the variable factor of net federal spending. It can be a good index of the net federal ex penditure product of national Income although it is not a direct measure of federal expenditure productivity. It fails to measure the Income generation power of net federal expenditure directly, because the "fixed factor" of private expenditure is not held constant as "doses" of the variable factor are added to it. If no extraordinary change occurs in private spending, the rate of change elasticity will serve a priori as a good indicator of income productivity. 80 Interpreting the rate of change elasticities as indexes to net federal expenditure productivity of national income in the light of a variable "fixed factor" will be the diffi cult task of the section on government financial history. Uhfortunately, it was necessary to derive the co efficients of the rate of change elasticity from time studies, which forces one to relax the assumption of ceteris paribus. If there were a perfect correlation be tween these time series data and the theoretical requisites of instantaneous data, the coefficients of elasticity would indicate more clearly the income generation power of net federal government spending, but the complicating element of a variable fixed factor would still exist even in the "theoretical answers." The amount by which the theoretical answers differ from those produced here is due to the errors of parametric change permitted in the lapse of time and the inferior mathematical methods which per force were employed here. A plus sign showed that income was more sensitive to the unbalance when the unbalance was increased. The income generation power of net government spending had definitely passed the apogee of Increasing returns and was in the diminishing returns phase. Likewise a plus sign showed that income was less sensitive to the unbalance when the unbalance was decreased. Logically, this amounts to the converse of the first statement. A negative sign declared that income was less sensitive to the unbalance when the unbalance was decreased, and the converse, that income was more sensitive to the unbalance when it was increased. Government net expenditure was in a state of increasing returns regarding its income generating potential. There are several implications for fiscal policy of the stage of the total net federal expenditure product of national income. The first is that if Stage 1 is clearly in effect, the "fixed*' quantum of non-federal government spending was so large relative to the variable quantity of federal government spending that total national income could have been increased more by coupling a given increase in net federal expenditure with less "private" spending! But still more productive would have been to extend the margin of government expenditure until the fixed factor of "private" spending was utilized at some point of di minishing returns and thus total income increased but at a diminishing rate. This reasoning is likewise valid in reverse if income is to be reduced. If Stage 3 is clearly in effect, a reduction of the variable factor of federal spending should be carried out to increase total national income. The lesson for fiscal policy is that it cannot be at maximum effectiveness when either Stages 1 or 3 are in effect; only Stage 2 permits optimum effectiveness of fis cal policy with respect to stabilization and growth. If Stage 1 holds, the whole level of federal government ex penditure should be increased. Taxation may accompany it also if that seems desirable without altering the basic point made here. If Stage 3 attains, the lefel of federal government expenditure should be reduced (assuming that "private" spending is unalterable). Just as in physical production the only proper stage of the total net federal expenditure product of national income is Stage 2. Now wherein in Stage 2, it should lie is also dependent upon the social cost of producing national income as well as the social gain of national Income. Where the marginal expenditure product of national 83 income equals the marginal social cost of producing it is determined the social optimum with respect to income pro* duction. Fiscal policy is not actively concerned with determining this social optimum point (except Insofar as the social disutility of instability of national income and, more in the future than now, the social satisfaction derived from growth of national Income affect the deter minants of the social income optimum); therefore, the criticism of the level of federal finance per se ends once Stage 2 is in effect. One provisional conelusion of this dissertation can thus be stated. If the rate of change elasticity has a negative sign, the antemarginal portion of the unbalance lies wholly in the stage of increasing returns with respect to the income generating power of federal government ex penditure, provided that the private spending pattern does not change significantly. The corresponding federal budget balance elasticity may be either positive or negative, as illustrated in Figure 2. If the rate of change elasticity has a positive sign, the region of diminishing returns has everywhere been reached or exceeded within the margins of the federal government's net expenditure, ceteris paribus. 84 Unbalance Increasing Using the Federal budget Balance Elasticity of national Income AuFEPY MwFEPY Unbalance Increasing Using the Rate of Change Elasticity UNDERWATER in ATI Oh AL Ii\CCl.L Unbalance Increasing + Using the Federal Budget Balance Elasticity of National Income AuFEPY Unbalance Increasing Using the ♦“Rate of Change Elasticity - M i - j FEPY FIGURE 2 POSITIVE I.iCO ;E AT AT LEAST 0;.E . OliAI KEY: A,FEPY= Average ;et federal Expenditure Product of Rational Income, " . ’ NFSFYs Marginal Ret Federal Expenditure Product of ■ational Income* Y=. ational Income* 85 If it is accompanied by a positive-valued coefficient of the corresponding federal budget balance elasticity of national income, net federal spending may be declared as falling within Stage 2. The third stage or decreasing re turns phase would have to be marked by a positive sign for the rate of change elasticity coupled with a negative sign for the federal budget balance elasticity of national in come, but this coexistence is not mutually exclusive of Stage 2. The potential existence of a state of "underwater national income" makes certain identification of Stage 3 difficult. In such a period the private sector's influence upon total national income is so strongly contractionary that no amount of positive unbalance of net federal spend ing at a given level of federal spending will buoy up the change in national income from a negative to a positive amount. (In a strongly expansionary period, the opposite chain of reasoning holds.) In such a period both diminish ing returns and decreasing returns bear a positive co efficient for the rate of change elasticity. Thus what might appear to be Stage 3 may really be Stage 2. All government spending which appears to lie in Stage 3 has this other possibility. Deciphering whether positive net 86 government spending is truly destructive of national income or whether national income lies in the "underwater dilemma" must be done via other analysis. Two guides appear valid a priori to this identi fication. First is the existence of known "underwater" national income regions near that under consideration time- wise. Second, the coincidence of a strong contractionary or expansionary period with the year or years in doubt hints strongly at "underwater" income. It is probably safe to declare all net federal ex penditure before World War I which could lie in either Stage 2 or Stage 3 but whichever cannot be labeled defi nitely as subject to "underwater" income, because the total of government expenditures prior to World War 1 was too small to reverse a significant contractionary movement in national income even with the complete elimination of federal taxation (or the opposite in expansionary periods where federal taxation equal to the total of government expenditure coupled with no federal spending could not reverse the upward movement of national Income). The period between World War I and the beginning of World War II likewise appears to fall in the region of "underwater" income when that is indicated to be a possi bility. Although federal government spending as a per cent of total national income was somewhat larger than that before World War I, the unbalance of the federal budget was usually a large enough per cent to reduce the potential Impact of the complete elimination of federal taxation (or in the opposite case, federal spending) to where the resultant amount of such a tax reduction would still be smaller than the change in national income. To clinch the argument further the Great Depression definitely branded several years as subject to "underwater income." The Second World War saw several periods of increas ing returns as did various postwar years up through 1961. This leads to the probable conclusion that federal govern ment expenditure has never in the history of the United States been so large as to be subject to Stage 3 in rela tion to its income generation (or destruction in negative cases). This does not gild the lilly of federal government finance; it merely declares it to be fairly far removed from losing its positive grip upon the behavior of national income. This means that the direction of fiscal policy has not come to the point where it must be carried out in 88 a perverse direction, i.e., reduce government spending (whatever is done about federal taxation is a separate con sideration which is not relevant to this point) when ex pansion of national income is desired, and the opposite. The frequent appearance of increasing returns sug gests that the total level of federal government activity might better be increased somewhat if the objective of maximizing its control over the behavior of national income is desired. Of course, this goal alone does not justify an increase in the financial sphere of federal activity. Numerous other considerations and goals would have to be reconciled in such a decision. The thoughtful economist should not be disturbed by this conclusion, therefore, no matter what his political philosophy, if he concurs with the methodology herein employed. IDENTIFICATION OF THE INFLUENCE OF POSTMARGINAL FEDERAL GOVERNMENT EXPENDITURE UPON NATIONAL INCOME The identification of the influence of postmarginal federal government expenditure upon national income is handled in nearly the same way as the identification of antemarginal federal government expenditure. The tech nique Is to develop a quantity which can be deducted^ from the federal budget balance elasticity of national income to trace the income generating power of postmarginal federal spending. Again the rate of change elasticity will serve this purpose, and it can be handled in the same way as it was in tracing antemarginal income productivity. Although the level of federal government spending is changed as well as the percentage size of the unbalance, the relevant item is still the percentage change in the unbalance. The analytical technique employed here is to add on to the existing percentage unbalance an additional percentage amount of net government spending. Since this increases the denominator of the imbalance portion of the rate of change elasticity as well as the numerator of that same portion, a correction formula must be utilized if one wants to compute the amount of additional government spending re quired to increase the unbalance by some desired per cent. ***A deduction occurs because a more advanced point on the net federal government expenditure product of national Income curve is to be examined. Negative Income production does not alter this procedure (contractionary fiscal policy). The correction formula la O.Olx + O.OOOlx + O.OOOOOlx + . . . where x la the deaired percentage increaae in the unbalance-as-a-per-cent-of-federal-government-expenditure. The corrected percentage adjustment formula for federal government spending is thus x + O.Olx + O.OOOlx + O.OOOOOlx + . . . . To obtain the desired quantity to be deducted from the index of net federal government expenditure produc tivity- -the federal budget balance elasticity of national income— one should multiply the federal budget balance elasticity times the rate of change elasticity times the percentage change in the unbalance. Thus, for example, if national Income is 500 billion dollars with federal spend ing equal to SO billion^dollars, a 1 per cent Increase in the unbalance-as-a-per-cent-of-federal-government- expenditure brought about solely by additional federal government expenditure would cause the federal budget balance elasticity of national income to fall by the fol lowing quantity if the original federal budget balance elasticity equaled 0.80, and the rate of change elasticity had a value of 1.10: 0.80 X 1.10 X 0.01 or 0.0088. The postmarginal federal budget balance elasticity would thus become 0.80 * 0.0088 or 0.7912. An Increase In the un balance of the federal budget of 1 per cent brought about solely by increased federal government spending would probably be accompanied by an increase in national income of approximately 0.01 X 0.7912 X $500 b. or 3.96 billion dollars. But whereas it took a tax reduction of only 0.8 billion dollars to achieve an Increase of 1 per cent in the federal unbalance, given the level of government expendi ture equal to and maintained at 80 billion dollars, it took 0.01010 X 80 billion dollars or 0.80800 billion dollars of additional federal expenditure to increase the imbalance 1 per cent (while holding the level of federal taxation constant at its former level). SIMULTANEOUS CHANGES IN BOTH THE LEVEL OF FEDERAL GOVERNMENT EXPENDITURE AND FEDERAL TAXATION The simultaneous change in both the level of federal government expenditure and federal taxation could be treated by the above methods by computing the effects of both separately from some original starting level of federal government expenditure. Reductions in the level of taxation or government expenditure could be treated 92 respectively as positive and negative tax reductions. In creases in either government spending or taxation likewise could be treated as positive and negative expenditure increments. Both the use of antemarginal and postmarginal analysis could be employed on a single period change in fiscal policy. For example, if the original level of national income were 500 billion dollars, the original federal government expenditures 80 billion dollars, the federal budget balance elasticity of national income 0.80, and the rate of change elasticity 1.10, an increase of federal tax take of 1.6 billion dollars coupled with a de crease in federal expenditures of 2.4 billion dollars would likely see national income change in about the following manner:^ (1) Tax increase: - fo.8 - 0.8 X 1.10 r!i£ + 0.01 idi'Tt 1 .80 80 ([^i + o.oi tig*)] [ *300 b.j = $7.9 b. 17 The correction formula is applied to the tax in crease because the dollar amount of the tax increase was cited rather than the percentage change in the unbalance. (2) Expenditure decrease: - f 0.8 + 0.8 X 1.10 X ' 80^ * $500 b0 " - $12.4 b. The combined effect of these contractionary operations would then yield a destruction of national income of approximately 20.3 billion dollars. SUMMARY OF THE ANALYTICAL TOOLS DEVELOPED This chapter developed the major analytical tool of this dissertation and a derivative compound of it which will be used in evaluating fiscal policy in the remainder of this work. The federal budget balance elasticity of national income and its derivative, the rate of change elasticity, provide the following insights into fiscal economics: (1) An index to the magnitude of the marginal net federal expenditure product of national income for a given period of time. (2) The equipment to develop a reasonable estimate of the income generating power of a small percentage change in the unbalance of the federal budget. This change In the unbalance may be brought about by changing either or both the total amount of federal spending or federal taxation. (3) The stage of the total net federal expenditure product of national Income with respect to the Law of Variable Proportions. CHAPTER IV A REVIEW OF GOVERNMENT FINANCIAL HISTORY WITH ELASTICITY AS A GUIDE The methodology of this chapter is to classify and reconcile the various values of the federal budget balance elasticity of national income and the rate of change elas ticity with the events of their day. All the while these elasticities will be tested to see whether they provide a sufficiently accurate guide to the behavior of the total net federal expenditure product of national Income to permit their use as indexes for future fiscal policy meas ures . Government financial history is divided into four periods according to the percentage size of the unbalance of the federal budget. The first period is marked by un balances which normally exceed 10 per cent of total federal spending. This period lasts from 1789 through the decade ending in 1889. The second period, 1890-1916, is charac terized by small percentage unbalances of less than 95 96 10 per cent on the average. The crisis era, 1917-1946, was typified by large unbalances, exceeding 20 per cent much of the time. The contemporary period, starting in 1947, features small percentage unbalances of the federal budget. PERIOD I: 1789-1889, SMALL G/Y, LARGE U/G1 The constraints of the available data require that the analysis of this period proceed from the decade 1809- 1819. The data for income and for government finance date back to 1799, but a one period time lag is required to com pute the federal budget balance elasticity of national Income, and two periods are needed to yield rate of change elasticities. Since the income data are available only by decades, two periods necessarily require twenty years. Data on government financial operations are available for each year starting with 1789, but no Income data are available for the 1789-99 period. Thus, Table III, pages 65-68, starts from 1799, but the analysis of this section G/Y equals federal government expenditure as a per cent of national income. U/G equals the unbalance of the federal budget as a per cent of federal government expenditure. 97 can be declared as starting from 1789. The unbalance of the federal budget during this decade is similar in charac ter to that of the century following, so it is assumed that approximately the same conclusions hold for it as for the remainder of Period I. One can be confident that national Income was in the vicinity of national income in 1799, so no complications would arise for that reason. 1810-1839 For 1810-1819 and 1820-1829, the coefficients of the federal budget balance elasticity of national income are very similar In that they were both negative and inelastic. Since the government spent 12 per cent more than it taxed on the average during 1810-1819 (i.e., it spent 100 per cent but taxed only 88 per cent) while Income declined and in 1820-1829 it taxed 29 per cent more than it spent as Income increased,2 both federal budget balance elasticities were negative. At -0.36 for 1810-19 and -0.37 for 1820-29, 2 It is correct to say "was negative" instead of "was falling." The directional change in federal spending does not determine the sign of the denominator of the rate of change elasticity. This is because net spending, not gross spending, comprises the numerator of the denominator. they show that at the margin the change in national income per unit of net federal injection was less than propor tional and perversely related. The fact that these co efficients are less than unity does not imply some in salubrious conclusion as did inelasticity with respect to the sales curve of the firm in price theory. It is not legitimate to suppose that the total net federal expendi ture product of national Income is being lowered by net federal spending, as one might think on first reading. Reflection on this matter causes one to realize that the product involved in the federal budget balance elasticity of national Income is not the total net expenditure product of national income but instead a multiplication of the level of Income and the corresponding magnitude of the un balance. In the analysis of the demand curve of the firm the multiplicative union of price and quantity of sales yielded total revenue. Whenever a firm operated at an inelastic point, its total revenue was a decreasing function of sales. This precluded the attainment of maxi mum profit (marginal revenue is negative for all points of less than unitary elasticity) by the firm. But what valid meaning is attachable to a falling product of the level of national income and the associated federal unbalance? The federal budget balance elasticity of national income is an index of the total net federal expenditure product of national income, but it is not itself the total net federal expenditure product of national income. In this latter meaning, though, it is useful to identify the index of the margin as being -0.36 and -0.37, respectively,, for the decades 1810-19 and 1820-29, if for no other reason than to graph these values to serve as a visual appreciation of the character of the historical behavior of the marginal net federal expenditure product of national income. The rate of change elasticities of these two decades were positive and less than unity (40.16 and 40.01). The inelasticity of both sets of coefficients shows that what ever type of unbalance was in effect was not proportion ately productive or destructive of national income. The positive sign implies that the total net federal expendi ture product of national income was in a state of diminish ing or decreasing returns. If it lay in diminishing returns, a state of "underwater income" would have to have been in effect. This is true because only "underwater income" permits any other stage than decreasing returns to prevail when the sign of the federal budget balance elasticity of national income Is minus. The third decade, 1830*39, also, seems to lie in diminishing returns coupled with "underwater Income," but its absolute magnitude is large and is therefore analyzed later. Clearly, the first three decades, 1810*39, were similar in that the net federal expenditure product of national income appears to be in a state of diminishing returns. Two possibilities exist. Either the average net federal expenditure product curve had a very brief increasing returns phase, or it was multimodal. The latter case is illustrated in Figure 3. Since the percentage size of government spending was such a small fraction of total national income, ranging from 0.9 to only 2.6 per cent, it is likely that the average net federal expenditure product curve was multimodal but still in Stage 1 over-all. This possibility appears plausible for all net federal spending up to World War I and fairly often thereafter. Why was the marginal net federal expenditure product of national income relatively low during this score (assuming that the federal budget balance and the rate of change elasticities were good indexes of it)? Was 101 Y diminishing returns returns r RCE FIGURE 3 ... 'LTI.V.ODAL ( BIlUODAL) i»mi1 — j A D ai< iiL— EXAA^< D1TUj.iE— 'R0 D: J::T - 0 F- i IAT10 h A L -1 ..C0 i/ui CURVES Between a and b, the rate of change elasticity has a positive value, but it returns to minus values with additional units of input (net government spending). 102 Increasing returns in effect or diminishing returns with "underwater income?" And finally, why was the rate of change elasticity small for this period? History must provide these answers for this and all subsequent periods. From 1830 to 1839, the tax surplus was inversely destructive of income at the margin of government expendi ture to a more than proportional degree. The federal budget balance elasticity indicated this by its value of -1.60. The fixed factor of private spending was so power ful a creator of income that it made federal taxation appear to augment national Income. The large absolute value of the rate of change elasticity, +14.7, indicates that successive reduction of government spending would soon overcome the strong, opposite-pulling "fixed factor" of private expenditure and make taxation highly destructive of national income. 1840-1859 Again, two decades demonstrate much affinity by the signs of their federal budget balance and rate of change elasticities. From 1840 to 1859, national income rose as the federal government taxed more than it spent. This led to minus signs o£ the federal budget balance elasticities of the two decades. Likewise, it was computed that the signs of the rate of change elasticities were negative* From this information it is logically deduced that the net federal expenditure product of national income either lay in the increasing returns phase or the net federal expendi ture product curve was multimodal. In view of the extreme smallness of government spending as a per cent of national income, it appears that stage one was the more likely interpretation. Since the sign of the federal budget balance elasticity was negative, it is reasoned that a state of "underwater income" was in effect. If "underwater income" holds, by definition it follows that the strength of the opposite-pulling private sector was so strong that at no point of unbalance of the given federal budget would there be a positive value of the net federal expenditure product of national income. Even for an unbalance of 100 per cent, the direction of national income could not have been changed. In this score it 1b very plausible that a 100 per cent unbalance would not have had a significant effect on national income. Is it not true a priori that a reduction of government spending of at most 31 million dollars would not have been sufficiently powerful to re verse an income increase at minimum of 800 million dollars? Average annual national income increased 800 million dol lars from 1.6 to 2.4 billion dollars in 1840-49 and 1.9 billion dollars more to 4.3 billion dollars during 1850-59. All the while the federal government was taking in more revenue than it spent. For 1840-49, it averaged a surplus of 6 million dollars which was 20 per cent of average annual government expenditure. In 1850-59, the tax surplus dipped to one million dollars, an amount equal to only 2 per cent of average annual government expenditure. The sharp increase of the federal budget balance elasticity from -1.95 to -27.3 is very much expected and makes safer the assumption that no Important structural change occurred in private motivations and the parametric relationships between the fixed private factor and the variable net public expenditure component of total national Income. The absolute values of the federal budget balance elasticities moved from moderately elastic to very elastic, i.e., from -1.95 in 1840-49 to -27.3 in 1850-59. These were accompanied by an Inelastic absolute value of the rate of change elasticity in 1840-49 and an approximately unitary value of the rate of change elasticity in 1850-59* The specific values of the rate of change elasticities were -0.44 for 1840-49 and -1.07 for 1850-59. The net federal expenditure product of national income curves thus appear to have rather flat slopes throughout their lengths because the values of the rate of change elasticity are low. In creasing returns here are characterized by a long, flat net federal expenditure product curve, and the normal larger proportional length of the diminishing returns phase strongly suggests that the net federal expenditure product is even less steep for stage two. The descent in stage three would likely be gradual, too, since increasing and diminishing returns were rather lengthy in terms of the number of units of net federal spending required to gener ate their courses. Henceforth, as a general principle it is very likely that low absolute values of the rate of change elasticity mean that the total, marginal, and average net federal expenditure product of national income curves are flat-sloped, requiring many inputs of net federal expenditure to produce modest changes in their altitudes (Y-axis readings). High-valued coefficients of the rate of change elasticity suggest steep slopes for 106 the net federal expenditure product curves. 1860-1889 The Civil War decade saw average annual national income increase 2.5 billion dollars to a new high of 6.8 billion dollars. Government expenditure increased nearly ninefold during this same period. A new high of 7.4 per cent was reached for government expenditure as a per cent of national income. This larger percentage makes it much more likely that the net federal expenditure product of national income has been carried beyond the increasing returns stage to some point in the diminishing returns stage. The positive signs of both the federal budget balance and the rate of change elasticities virtually assure the existence of stage two. The large percentage size of the deficit imbalance, 47 per cent, promises a low value for the federal budget balance elasticity, and this was realized in fact. The federal budget balance was approximately unitarily elastic at +0.96. The correspond ing rate of change elasticity was virtually identical at +0.98. For the first time in the history of the United States, it was certain that the level of government spend ing was extended sufficiently far to make the fixed factor 107 of private spending fully productive. In this period national income would not have been increased by "throwing away" some of the private spending. Before 1860-69, the objective of increasing national income would have been advanced by reducing the size of the private sector! This Is the meaning of increasing returns. Historically, this might have meant that the private sector was not properly policed to prevent destructive competition and/or that there was congestion of private production facilities due to the lack of social facilities. Highways might have been overcrowded; slums, disease, social tension, and the like might have been augmented by further private spending (leading to further private production). The net effect would have been less national income. As in the previous twenty years the net federal expenditure product curves had gentle slopes. The twenty years after the Civil War decade exhibit similar properties. National income increased from 6.8 billion dollars in 1860-69 to 7.2 billion dollars in 1870-79 and from that figure to an average annual Income of eleven billion dollars during 1880-89. The federal government reduced its level of spending nearly 50 per cent to about 276 million dollars for 1870*79 and 263 million dollars for 1880*89. Coupled with this reduction In government spending was a tax surplus for both decades. In the first one the unbalance was 16 per cent of government expenditure. The unbalance was increased to 38 per cent in the second decade. The expected values for the federal budget balance elasticity are to be higher in absolute value than that observed for the Civil War decade. Also, the signs are clearly minus since national income increased despite contractionary federal government fiscal policy. The observed federal budget balance elasticities were nega* tive, but they failed to exceed that of the Civil War decade in absolute value. In fact, the elasticity was larger in the second decade than in the first (-1.01 > -0.35), yet the percentage size of the unbalance increased. This is in part to be explained by the percentage decrease in government spending to national Income but perhaps not fully. If the decrease in government expenditure as a per cent of national income were not fully responsible for the increased elasticity, it would then be true to say that some shift had occurred in the net federal expenditure product curves which, of course, was attributable to 109 changes in the parameters. In Figure 4 are illustrated the relationships between changes in the level of government spending and the size of the unbalance. Figure 5 illustrates the derivation of the net federal expenditure product curves for seme specific level, b, of gross federal government expenditure. The rate of change elasticities for these twenty years, 1870-89, were both about unltarily elastic at +1.05 and +1.19, respectively. This implies gently sloping curves for the net federal expenditure product of national Income. Since the signs of the federal budget balance elasticities were both negative and the signs of both rate of change elasticities were positive, diminishing returns coupled with "underwater income" is suggested. The like lihood of multimodal federal expenditure product curves is reduced since a cluster of diminishing returns was observed for the whole latter half of the nineteenth century. In Figure 6 the general relationship of the rate of change elasticity and the federal budget balance elasticity to the gross federal expenditure product of national Income curves is shown. To make this peculiar to the period from 1870-89, one has only to lower the whole diagram into the fourth quadrant. 110 The imbalance < — of the federal budget Y b a FIGURE 4 INC0,1E GENERATION OF THE UNBALANCE a=the amount of government spending offset by revenues* b=gross federal government spending* a sets the points on the federal expenditure product of national income curves from which the income-generating influence of the unbalance is observed. Ill Y b a FIGURE 5 DERIVATION OF THE iMFEPY CURVES a=the amount of government spending offset by taxation, b=gross federal government spending, b-a=the unbalance of the federal budget. 112 +Y point o f diminishing returns The rate of change elasticity is an index of this -^sh The federal budget balance elasticity is an index of ^— this — = ? » AFERI iviFEFY FIGURE 6 I iT 0 ■ \ RELAT10riSHIP OF Tite FBBEY, FOE, A:iD THE FEPY CURVES a=the amount of government spending offset by revenue. b=gross federal government spending. b-a=the unbalance of the federal budget. t=the lowered level of taxation. a-t=the amount of the tax reduction. 113 PERIOD II: 1890-1916, SMALL G/Y, SMALL U/G3 The nineteenth century closed with the last decade, 1890-99, witnessing a vigorous Increase In national Income from 11 billion to 15 billion dollars at the same time the federal government was spending 3 per cent more than It taxed. Fiscal policy then had a positive relationship, yielding a very large value of the federal budget balance elasticity of national income. At +10.9, this was one of the highest absolute values observed. With the decline of the unbalance as-a-per-cent-of-government-spendlng from 38 to 3, and the continuing ratio of government expenditure at 2.5 per cent, an important shift of the net federal ex penditure product curve is not likely. A similar reduction of the unbalance from 20 per cent in 1840-49 to 2 per cent in 1850-59, coupled with an even smaller reduction in the proportional size of government spending (1.5 to 1.3 per cent) produced a huge change in the absolute values of the federal budget balance elasticities (-1.95 to -27.3). The rate of change continued to be positive and unitarlly See footnote 1, p. 96. 114 elastic (+1.01); therefore, It Is again likely that di minishing returns prevailed. The year 1900 had a somewhat Inelastic and negative value for the federal budget balance elasticity (-0.81). A 6 percentage point Increase In the absolute unbalance plus a 0.3 percentage point Increase In the ratio of government spending to national Income accompanied a large falloff In the absolute value In the federal budget balance elasticity from the 1890-99 decade. There appears to have been an Important change In the relationship of the federal government sector to national Income between 1890-99 and 1900. The high degree of elasticity for the 1900 rate of change elasticity reinforces this conjecture. At 44.16, this value Is the highest since the 1829-39 decade. A fairly steep set of net federal expenditure product curves Is Indicated, whereas the conjecture for the previous six decades was that gently sloping curves obtained. The obvious question Is why did this change occur? This funda mental change could have been mostly attributable to changes In the private sector to national Income, or It might represent an Important changed relationship between the private sector and the federal government sector. 115 A state of diminishing returns was probably in effect for 1900. Beginning with 1901 and continuing virtually un challenged until 1913 is the proposition that the net federal expenditure product of national Income lay in the increasing returns phase. Except for single, lntersticed phase computations, the mass of calculations validates this. And furthermore, the frequent certain determination of "underwater income," coupled with the facts that the ratio of federal government spending to national income was always less than 3 per cent and that the imbalance per centage was usually less than 10 per cent, strongly sug gests that the net federal expenditure product of national income was consistently in the increasing returns stage and that it was subject to "underwater Income.” The federal budget balance elasticities over nearly the same period, 1901 up to 1912, fell into two distinct groups. The first set consisted completely of inelastic values; the second set contained unitarlly to fairly highly elastic values with only one exception. For the years 1901-04, the federal budget balance elasticities were, chronologically, -0.73, -0.21, -0.95, and -0.49. From 1905 on, the values were +2.04, *3.88 in 1906, -0.59 in 1907, -1.59 in 1908, +1.12 in 1909, +1.78 in 1910, and -1.10 in 1911. The increase in elasticity of the second set over the first set is partly explainable by the de crease in the percentage of government expenditure to national income. This drop was from an average of roughly 2.5 per cent to 2.1 per cent. These elasticities also behaved normally with respect to the percentage size of the unbalance. They rose when the unbalance percentage was reduced, and vice versa. For example, a four point in- crease in the unbalance percentage over 1908 was accom- *8 panled by an absolute decline of 0.47 for the federal budget balance elasticity for 1909; a three point decrease in the 1905 unbalance from that in 1904 carried with it an absolute upward change in the federal budget balance elas ticity of 1.54. It Is interesting to note that unbalances less than 2 or 3 per cent are typically associated with very highly elastic values of the federal budget balance elasticity, but that values of 5 to 10 per cent for the unbalance are associated with coefficients whose absolute values are less than 2*00. The influence of the percentage level of government expenditure to national income is 117 a major determinant, too, and must be considered In com puting accurate correlations between the percentage size of the unbalances and the federal budget balance elasticities of national Income. Precise correlation between these two Is not the object of endeavor here. Later on, when Period IV Is tinder consideration, It will be apparent that the absolute values of the federal budget balance coeffi cients are smaller than those observed here In Period II. The rate of change elasticities for 1901-13 are everywhere moderately to highly elastic except for 1901 and 1910. The most extreme values occur In 1905-6 and In 1908-9. Specifically, the values of the rate of change elasticities for these years were -5.80 in 1905, -11.56 in 1906, -12.4 In 1908, and +29.7 In 1909. In the years 1905 and 1906, no obvious change in private spending habits occurred to make the rates of change elasticities high, but national Income rose faster than usual. Perhaps the ex planation lies here, especially If the period were in flationary. It appears that the extreme values for 1908 and 1909 lie in the fact that national income fell sharply In 1908 and rose sharply in 1909. A clear-cut case for assuming that new private expenditure patterns change 118 significantly during this period probably lies in a survey of financial history of that day. Beginning with 1912, the federal budget balance elasticities are extremely large for each year except 1915 up to 1917, the beginning of Period III. Likewise, the federal expenditure product appears to have advanced beyond the point of diminishing returns. In view of the dwindling percentage of government spending to national income and the small percentage unbalances incurred during this period, it is not clear from this juncture why the net federal expenditure product of national income should have drifted into stage two. No doubt it lay very near the point of diminishing returns before this time, and that might have explained the periodic lapses of values into stage two Instead of the existence of multimodal federal expenditure product of national income curves. In two of these five years "underwater income" logically follows from the combination of the signs of the federal budget balance and the rate of change elasticities, but in only one, 1916, is that verdict to be believed. For 1914, multimodal federal expenditure product curves appear likely. The extremely high value for the rate of change elasticity 119 for 1914 suggests this all the more. This extreme value, +179.4, Is surrounded by nearly unitarily elastic co efficients for contiguous years: -1.58 for 1912, +1.14 In 1913, +1.03 In 1915, and +0.19 for 1916. The explanation for the huge federal budget balance elasticities of -24.3 in 1912, +4.59 in 1913, and -18.7 in 1914 is undoubtedly due to the realization of average annual unbalances of zero per cent (to the nearest 1 per cent) of the federal budget. With the unbalance at 8 per cent in 1915 and 7 per cent in 1916, the resulting federal budget balance elasticities were inelastic (+0.15) and fairly strongly elastic (-3.02). PERIOD III: 1917-1946, VOLATILE G/Y, LARGE U/G4 The third period was launched by America's entry into World War I. Whereas before 1917, the percentage size of government expenditure to national income exceeded 3 per cent only in the Civil War era, this figure became an absolute floor to the level of government spending. It has never been undercut, and indeed there is no reason to think it ever will be. During this period of crises the level 4See footnote 1, p. 96. 120 of government spending ranged widely, from 3.1 per cent in 1927 to 46.1 per cent in 1945 of national Income, but the unbalance was chronically large, only once falling below 10 per cent (5 per cent in 1920). This age of chaos was to bring about extreme shifts in the federal expenditure product of national Income curves, as is developed below. The first startling fact is the frequent appearance of increasing returns, even with large and advancing pro portional levels of government expenditure. The second startling fact is the Terpsichorean movement of the rate of change elasticity. A third but not surprising earmark was the extremely low absolute values of the federal budget balance elasticity of national income. The beginning of war finance in 1917 saw national income increase by a record 2 billion dollars as the abso lute quantity of government spending was nearly tripled. The unbalance increased from a 7 per cent surplus to a 43 per cent deficit. Government spending as a per cent of national Income mounted to 3.3 per cent from its lowest proportion since the decade of 1849-59, 1.5 per cent. This was a sharp reversal of the post Civil War trend which was a gradual tapering off of the proportion of federal 121 spending to national Income. The rate of change elasticity assumed a familiar value of approximately unitary elas ticity at +1.05, but the absolute value of the federal budget balance elasticity fell markedly from -3.02 In 1916 to +0.53. The net federal expenditure product continued In stage two. A new record Increase In national Income was set In 1918, when national Income Increased from 60.8 to 77.9 billion dollars. Government spending was Increased more than sixfold, and it occupied a 16 per cent share of national income. The unbalance was an astronomical 9.0 billion dollars, more than ten times any previous un balance, and over one hundred times the typical unbalance in all of Period II. The unbalance was 71 per cent of total government spending— indeed a very expansionary first approximation to fiscal policy. Respectively, the federal budget balance and the rate of change elasticities were +0.35 and -0.84 for 1918. The +, - signs of these elas ticities define stage one for the net federal expenditure product of national income. Without any nearby values of one, one might write off an isolated declaration of in creasing returns as a perverse region on the assumed 122 multimodal average net federal expenditure product curve. With the repeated recurrence of stage one in the computa tions, one is more prone to accept this paradoxical result as valid. The cause of this has to have been a dramatic shift of the federal expenditure product of national income curves. The only cause of this by definition, then, was an important change in the parametric relationship of the private sector. What caused this change in the income generating power of the private sector? Since America was at war, the following kinds of reasons are likely: 1. The public was motivated to work harder than it had in the past, resulting in more production and rein vestment, and thus more income. No doubt the production of additional social capital conferred external economies on the private sector, adding to its physical and monetary output. 2. The potential refrain from increasing private investment spending prompted by public mistrust of in creased government spending was swept aside by lucrative government contracts. 3. Rapid price increases Induced lax spending habits and other spending purely caused by money's erosion as a store of value. Since the private sector was induced to change its spending parameters, the later reduction of the absolute and percentage level of government spending in all likeli hood left the public with much of its newly-found frame of mind and modes of economic performance. Logically then, a state of increasing returns could have existed for all of Period III, especially since increased government activity in the 1930's would have come early enough to buoy up a gradually leftward-shifting federal expenditure product of national income curve (people will forget prior exhilara tion when Mback-to-normalcy” is fully realized). Government expenditure and the unbalance of the federal budget reached their pre-World War II peaks in 1919. National income increased (from 77.9 billion to 84.6 billion dollars) but less than proportionally to the in crease in federal spending (12.7 to 18.5 billion dollars). With a deficit balance of (+) 13.4 billion dollars and an unbalance of 73 per cent as well as government spending at a record level, it is little wonder that the federal budget balance elasticity reached a record absolute low of 0.11. This figure was later undercut, but it was a record low for that time. At -53.3, the rate of change elasticity 124 suggested a nearly vertical net federal expenditure product of national income curve within a small region of the existing level of federal taxation. Its minus sign de clared that the portion of the net federal expenditure product in effect was increasing returns. In 1920, the first of eleven consecutive surplus balances was realized. This abrupt reversal of government finance did not accompany a depression of national income in 1920, as it rose from 84.6 to 91.6 billion dollars. That depression occurred the next year with a sharp 21.6 billion dollar decline in national income. The level of government spending was reduced from 18.5 to 6.4 billion dollars between 1919 and 1920. The percentage unbalance was also greatly reduced— from 73 to 5 per cent. The result was an elastic federal budget balance elasticity of -1.75 for 1920. Since the government taxed more than it spent in this year, the interpretation follows that taxation was an effective destroyer of income at the mar gin. A unltarily elastic rate of change elasticity states further that an expenditure reduction would be accompanied by equi-proportional increases in the federal budget balance elasticity. The apogee of the average "federal 125 taxation 'disproduct* of national Income curve" appears to have lain very near the level of taxation In 1920-1923, as It fluctuated between Increasing and diminishing returns each year. Throughout the nineteen twenties the (negative) net federal expenditure product of national income curve seems to have been leftward-shifting, as Indicated by the fact that small increases in the per cent of government spending to national income in the nineteen thirties produced di minishing returns. Whereas a ratio of government spending to national Income of 7.3 per cent In 1921 was accompanied by increasing returns, an increase from 3.2 to 3.8 per cent and again from 3.6 to 4.7 per cent in the late twenties and early thirties was sufficiently large to invoke diminishing returns where increasing returns had prevailed. The rate of change elasticities in the 1920's were very volatile but nearly always elastic; the federal budget balance elas ticities were all inelastic between 1921 and 1946, except for a slightly elastic value of -1.37 in 1931. The Great Depression decade failed to produce peculiar values of the federal budget balance elasticity as one might expect-. The rate of change elasticity, too, 126 followed previous trends by continuing the volatile pattern of the twenties except for the frequent appearance of Inelastic coefficients. Diminishing returns appeared fre quently, as did increasing returns. After 1933, "under water Income” seldom reared its head. It had pervaded the 1920’s. The intermittent occurrence of inelasticity for the coefficients of the rate of change elasticities In the 1930's, where rate of change inelasticity was virtually un known in the 1920' s, seems to be the only new development in the absolute values of the two elasticities. This spas modic movement might mean that the private sector changed Its spending habits frequently during the Depression decade. Whatever leftward-shifting of the federal expendi ture product curve transpired in the 1920's was reversed by increased government spending during the Great Depression and World War II. This is corroborated by the determina tion of increasing returns for many years throughout the thirties and early forties. World War II brought even larger unbalances as a per cent of national income than those experienced during 127 the Great Depression. The absolute levels of government expenditure reached all time record levels. From an eight billion dollar government In the later 1930's the United States advanced In large steps to a 98.4 billion dollar level at Its peak. During this time national Income (Gross National Product after 1909) Increased from 91 billion dol lars In 1939 to 214 billion dollars In 1945. As a per cent of national Income, government spending rose from 9.7 per cent to 46 per cent over the same period. The frequent appearance of Increasing returns Is probably due to the exhilaration of the war effort and the other reasons set forth for the same phenomenon In World War I. PERIOD IV: 1947-1961, LARGE G/Y, SMALL U/G5 Grouping the years 1947 and 1948 Into Period IV Is merely a matter of choice. Since 1947 had a small un balance of 2 per cent and 1948 a large one of 26, Including both year8 In Period III would be an acceptable procedure. In the contemporary period government spending as a per cent of national Income remained stable at between ^See footnote 1, p. 96. 128 13 and 20 per cent. This was more than a 50 per cent de crease from its peak of 46 per cent in 1945. The average annual unbalance was now normally less than 10 per cent, a phenomenon seen only once in all of Period III. This sharp decline in the unbalance probably will yield moder ately elastic values for the federal budget balance elas ticity of national income but ones which are less high absolutely than those for Period II, due to the lower per centage of government spending to national Income as long as Period IV prevails. Statistics bear out this conjec ture. With regard to the rate of change elasticities, it was observed that they varied between inelastic values and fairly high ones (maximum: 6.90) but no extremely high ones were observed. Furthermore, no consecutive negative values were observed. Usually, three or four consecutive positive values appeared before a single negative one. The years could be grouped in terms of elastic and inelastic values. Beginning with 1951, the inelastic years occurred in pairs, the elastic ones in triplets or quadruplets. These relationships were purely empirically derived, and no theory explaining these phenomena is advanced. 129 A third generalization about the contemporary period is that the net federal expenditure product of national income appears to fall beyond the point of diminishing re turns. Only in 1948, 1953, and 1957 were increasing re turns Indicated. Increasing returns for each of those years seem plausible, but the declaration of "underwater income" for 1957 is surely incorrect. If the government had not spent anything in 1957 (69.0 billion dollars less spending), this reduction seems to be large enough to reverse the 24 billion dollar increase in national Income. Of course, a very large reduction of government spending might induce some increase in private spending, if the cumulative downward process of depression does not receive the opportunity to injure the state of confidence. In defense of the statistics, it should be remembered that the rate of change elasticity like other measures of elasticity is not accurate over large intervals. Hence, it becomes a less reliable index to the character of the net federal expenditure product of national income. To wipe out a 24 billion dollar increase in national income would have required a large reduction in federal government expendi ture (the unchanged quantity here is the level of taxation 130 as the imputed goal of fiscal policy was to promote sta bility through contracting the flow of national Income). This reasoning holds for other candidates for "underwater income" (with diminishing returns) in 1947, 1949, 1954, 1956, and 1959. In the light of the inflationary spending psychology observed for 1951, a huge reduction of govern ment spending (theoretically, 100 per cent) while leaving taxation intact may not have been successful in depressing national income below its 1950 level. It now appears that government finance is of sufficient strength to reverse any movement of national income in one year, leaving "under water income" a relic of the past. The frequent determination of diminishing returns absolves contemporary fiscal policy of being subject to the basic flaw that the private sector is either too large (increasing returns) or too small relative to federal government expenditure to permit the maximization of con trol of fiscal policy on national income. Reflecting on the four periods, it appears that fiscal policy is not politically capable of attaining maxi mum control over national income in any period wher*» the level of government expenditure is being increased. This holds because Increasing returns typically occur at the very time the level of government spending Is being greatly expanded. The chain of reasoning Is not that more govern ment spending leads to Increasing returns, but that a period of exhilaration leads to more government spending. Mass psychology then augments the size of the private spending sector too much to be fully masticated by govern ment spending. The federal government Is not allowed to expand still more to keep pace due to the traditional political opposition. In the absence of exhilaration the federal expenditure product curve drifts leftward over time, because the private sector gradually remolds Its economic activities to mesh ever closer to optimality with the existing level of government spending. Mb clear example of decreasing returns has been discovered yet, but If and when It occurs, fiscal policy will have to be con ducted In reverse. Such periods would find either private decadence or government spending enervating. RECONCILIATION OF THE FEDERAL BUDGET BALANCE AND THE RATE OF CHANGE ELASTICITIES WITH HISTORY Period I In retrospect the period from 1789 to 1889 was characterized by inelastic to slightly elastic values of the federal budget balance elasticity of national income except for the large -27.3 coefficient for 1850-59. This large coefficient accompanied the.only small unbalance of this century, however (2 per cent). The other low-valued coefficients were due to the large percentage sizes of the federal government's unbalances. The fact that these federal budget balance elasticities were more elastic on the whole than those of Period III was attributable to the smaller percentage portion of national income consisting of federal spending. The rate of change elasticities were quite inelastic at first, then they settled down to approximately unitary elasticity. The early inelastic values of the rate of change elasticity show that the federal budget balance elasticities for these years were not sensitive to alter ations In government finance. Furthermore, since the federal budget balance elasticity was Inelastic, the two combined show that national income was not sensitive to federal government fiscal operations. Historically, this seems attributable to the backward state of the American economy with respect to production for a profit. 133 Production was still highly oriented to the direct satis* faction of individuals* wants rather than for exchange. A non-exchange oriented economy would not normally ex perience a high acceleration effect. As the factory move ment and industrialization advanced, the effects of govern ment finance upon national income became more pronounced. The one high value of the rate of change elasticity was for the 1830-39 decade. Since this period was characterized by strong speculative inflation, it appears that additional net government taxation during this decade would have had percentagewise a pronounced deflationary influence upon national income. Period II Period II yielded mostly moderately to highly elas tic values of the federal budget balance elasticity of national income. Small unbalances coupled with small per centage proportions of federal government spending were clearly the cause. The large rate of change coefficients showed that national Income was potentially very sensitive to federal fiscal operations in percentage terms. This reflects the advancing degree of economic maturity. Production was 134 becoming much more oriented to pro£lt making Instead of for immediate personal satisfaction. There were thus stronger acceleration effects than In Period 1. A second important reason for the high values of the rate of change elasticity was that the federal expenditure product of national income hovered in stage one and near to the point of diminishing returns in stage two. The rate of change of the federal expenditure product of national income is fastest in this region. Period III The federal budget balance elasticities reached their lowest absolute values in this period because the un balances of the federal budget reached its highest average level. The increase in government spending as a per cent of national income throughout this period over Period 11 contributed to this result. The main force, however, was the percentage size of the unbalance because within any one year the community had adjusted its spending patterns to the prevailing economic conditions and thus to the per centage level of federal spending. Politics being what they are causes government spending to follow the general 135 economic conditions rather than vice versa. Thus, the statement that the private economic community adjusts its expenditures to the existing economic situation and (by that act) to the level of federal spending is valid. The rate of change elasticities achieved their highest values before and after the Great Depression. This bespeaks a mature private economy (strong acceleration effect), but an immature federal government sector. The latter is indicated as in Periods 1 and II by the frequent appearance of stage one. Recall that an economy experi encing increasing returns for government expenditure is one in which the private sector is too large relatively to the public sector to produce an optimum level of national in come. An optimum level of national Income here means one which satisfies the economic objectives of the times and which is most efficiently produced. The low values of the rate of change elasticity suggest that pessimism was strong. ^ Private spending was not very responsive to government expenditure. ^Although increasing returns are in effect, it is possible to have inelastic values of both the federal budget balance and the rate of change elasticities. 136 Period IV The reduced percentage sites of the federal budget unbalances have brought to date more elastic federal budget balance elasticities of national income than in Period 111, but less elastic than those of Period II. The increased percentage of federal government spending to national In come brought this diminution. The rates of change elasticity, although still elas tic, have dipped below those values for Periods II and III. They exceed those of Period I on the average. The fact that they are less elastic than before is probably due to the attainment of points farther into diminishing returns than in the past. The net federal expenditure product of national income normally becomes less steep as more ad vanced points in stage two are reached. The lack of a crisis period has allowed the public's exhilaration to sag markedly. They thus produce less income per given quantity of stimulus. The fact that a moderately high and stable degree of elasticity remains hints at a strong state of confidence of the private sector in the probable desirable consequences forthcoming from federal government expendi ture. The latter part of Period III and all of Period IV were subject to deliberate manipulations of government financial powers with the Intent of fulfilling one or more macroeconomic objectives. Fiscal policy became distinct from economic environment. For this reason more detailed analysis Is required for recent years. This Is undertaken below. CHAPTER V FISCAL POLICY AND ELASTICITY AS A GUIDE THERETO NEW DEAL FISCAL POLICY AND THE GREAT DEPRESSION ' , 1933-1941 First Phase: Relief and Recovery. 1933-1934 By modem standards of appraisal the goal of fiscal policy during this period would be to raise aggregate demand and employment. Itader such strong deflationary pressures, few economists would oppose either increasing the level of federal government spending or the size of the deficit or both. The acceptance of any measure of expan sionary fiscal policy, however, was not forthcoming until the late thirties. The New Deal administration incurred deficits in its early years because tax receipts declined as a result of falling income, emergency measures to aid the unemployed forced federal spending for humanitarian reasons, and its leaders felt it necessary to spend for resource development. Fiscal policy was directtonally 138 139 correct in that the federal government spent more than it taxed, but it is probably true that neither the level of federal spending nor the size of the deficits were large enough to lift the economy out of the depression. Presi dent Roosevelt*s early views on the matter were that a deflationary policy by the federal government was correct and that recovery lay in aggregative manipulation of the general price level. Public works were admissible only as a last resort. The economic objectives of the New Deal were to provide relief and promote recovery from the de pression. The techniques for promoting the former were often blended with reform measures which retarded recovery. The New Deal . . . has a twofold purpose. One is to lead the country out of its present economic de pression. The other is to bring about far-reaching and permanent reforms in its economic structure. The real problem lies in the fact that what seems to be the natural remedy for one difficulty is not compatible with what seems to be the natural remedy for another.1 Furthermore, the increase in liquor taxes, the provision of emergency taxes on corporations and capital stock to finance public works, processing taxes to finance the AAA, and moderate Increases in income, estate, and gift taxes *T. F. Woodlock, ”1934*s Challenge to the New Deal," American Magazine. 117:18-19, January, 1934. 140 were hardly In step with contemporary thinking on appropri ate recovery policy. The New Deal followed the "mainten- ance deficit" policy of the Hoover administration meaning that federal deficits were merely offsetting the contrac tions In state and local government expenditures. At first they did not fully make up for the contraction In state and local government contraction, but they probably curbed the extent of contraction by about 20 per cent.^ Although the greater part of the deficits realized under the early days of the New Deal was forced by emergency relief spending and the failure of tax yields to live up to expectations, the New Deal spending can be credited with Inducing roughly 66 to 80 per cent of the 1933-1935 recovery.3 Statistics showed that Investment In buildings and plant equipment were strong reflatlonary forces, but these Investments did not occur until the latter half of 1935. They appeared to be Induced by Improving economic conditions rather than themselves leading the economy upward.4 The NBA boom of 2Gerhard Colm, "Public Spending and Recovery in the United States [1936]," Essays In Public Finance and Fiscal Policy (New York: Oxford university Press, 1955), p. 124. 3Ibid.. p. 127 4Ibid.. p. 130. 141 May 1933 - May 1934 had a fairly strong accelerator effect because of anticipations of impending prosperity, but overexpansion, culminating in liquidation in May - August 1934, and the lingering uncertainties and mistrust of the New Dealers retarded the expenditure-inducing impact of federal government spending. This uncertainty was borne out by variations in stock prices during July 1933 and March 1935.5 The implementation of expansionary fiscal policy in the early thirties faced much opposition due to the pub lic's insistence upon an annually balanced budget and other fears of governmental intervention. For example, the fol lowing question demonstrates the fear which the public had in fiscal operations: Will the administration be able so as [sic] to manage the national finances as to convince the coun try that a continuance of the New Deal will lead neither to radically cheapened money nor, alterna tively, to excessively high federal taxation?^ Congress was active during the first year of the New Deal, instituting NRA control of industrial wages and hours 5Ibid.. pp. 132-33. Clark, "Federal Finances and the New Deal," Atlantic Monthly. 154:754-62, December, 1934. and self-regulation of enterprise with the government as a partner in the National Recovery Act. Public works or public"benefiting private works were voted 3.3 billion dollars, and an additional 0.5 billion dollars was granted to the Federal Emergency Relief Administration to disburse for unemployment relief. The Civilian Conservation Corps was established to utilize the young. Agricultural prices were to be raised by curtailing production, but the ex penses of this were to be borne by processors. Federal salaries were slashed 15 per cent and veterans' benefits cut. President Roosevelt was given control over the issuance of emergency currency and permitted to take the United States off the gold standard. Reform measures passed included the power of the Federal Trade Commission to pass on all new security issues, the control of rail roads, the separation of Investment banking from commercial banking, the establishment of the Federal Deposit Insurance Corporation, the passage of other bank reforms, and the creation of the Tennessee Valley Authority. All this was approved by Congress in its March 9-16 session in 1933. On January 3, 1934, Congress voted another 950 mil lion dollars for civil works and relief. The currency was put on a managed International gold standard. The Reconstruction Finance Corporation was continued, and its lending power extended by 850 million dollars. The federal government was permitted to guarantee 2 billion dollars of farm mortgage bonds. But again taxes were raised as all alcoholic beverages legalized by the repeal of prohibition were tariffed.7 But even with all this there remained the problem of severe unemployment, heavy indebtedness, espe cially in the private sector, the extreme relative poverty of farmers in relation to people of other occupations, lack of profit, international currency disorder, and a lack of confidence by capitalists and enterprisers leading to o inertia. Insight into the strengths and weaknesses of early New Deal fiscal policy is afforded by the brilliant guidelines and criticisms of William Trufant Foster. His analysis, written in December 1933 would score high if rendered by a contemporary critic: Every government should start with the needs and capacities of human beings instead of financial statistics 7"A Year of Roosevelt,'4 Newsweek. 3:5-8, March 3, 1934. ^Woodlock, op. cit.. p. 19. as a point of departure for economic recovery. Consumer purchasing power must be increased to promote justice for debtors. Public works should be undertaken on a broad scale, because timid pump-priming is insufficient to uplift the economy. Runaway inflation presents no problem because the United States is not heavily in debt to other coun tries, the level of taxation has not exceeded America's taxable capacity, large gold reserves are held, the politi cal structure is strong, the reflation has a long way to go before inflation threatens. There is nothing to fear in incurring debt, because the worst consequence forthcoming would be a worsened distribution of income. Industry must plan its production, distribution, and conditions of labor in the public interest instead of exclusively pursuing per sonal gain, but the New Deal must respond by establishing conditions leading to profit. The foreign trade balance should be ignored in policy-making for it is too small to Q be a problem. The New Deal administration is guilty of making q 7W. T. Foster, "Economic Consequences of the New Deal," Atlantic Monthly. 152:748-55, December, 1933. several errors, notes Foster. They Include the erroneous attempt to raise prices and end overproduction which actually must be accomplished by reducing output. This is clearly opposite to what is needed. Investment in capital equipment should not be discouraged as it was under the National Securities Act. Likewise, the talk about a thirty hour week is economically ridiculous. The fixing of indi vidual prices will not bring about the increase in the general price level desired by the administration.^ Finally, "the administrators of the New Deal seem rather doubtful about the necessity of profits. They seem com mitted, at any rate, to arbitrary regulation of wages and hours, and such regulation is Inconsistent with reliance on the profit incentive to restore employment and produc tion."11 The Gross National Product fell another 3 billion dollars from its 59 billion dollar level in 1932 to a low of 56 billion dollars in 1933. This was accompanied by an increase in federal spending of 2 billion dollars over 1932 and a deficit of 3.6 billion dollars. This deficit was 10Ibid.. p. 752 11Ibid.. p. 753. over one-half the size of total federal spending, thus the federal budget balance elasticity of national incone assumed a small absolute value. Throughout the Great Depression and World War II the federal expenditure product of national income was rising. This phenomenon was probably attributable to the public's sacrifice of forced leisure, and later, voluntary leisure in favor of produc tion. This was verified by the frequent negative values of the rate of change elasticities. During the "first phase" of the New Deal the rate-of-change-elasticitles were nega tive and assumed very large absolute values. The negative values imply that federal government spending was too small; the large absolute values suggest that a very steep portion of the net federal expenditure product curve was traversed, thus the point of diminishing returns appears rather far distant. The level of federal spending was probably highly inadequate relative to the level of private spending. Second Phase: Recovery and Reform. 1935-1937 In the second phase of the New Deal the need to con tinue stimulating recovery remained, but the New Dealers devoted much of their attention to reforming society and 147 devising means of reenacting the measures which the Supreme Court voided by Its proclamations of unconstltutionallty. The President still believed In the annually balanced budget doctrine and sanctioned deficit spending on the exigencies of his relief and reform measures. The deficit was not the result of fiscal plans laid by the government to achieve economic goals. It was rather the net result of the budgetary requirements of relief and reform measures and the political lnfeasi- blllty of Increasing taxation pari passu with expendi tures. Expenditures depended on the amounts required to provide WPA employment for the unemployed and the new taxes ware based largely on the Administration's program to redistribute wealth and Income. It was thus a matter of accident rather than design If the fiscal policy actually pursued did In fact promote recovery at the desired rate.12 During the second phase of the New Deal, Congress passed the Social Security Act, established the WPA, NYA, and the FHA, approved the National Labor Relations Act, and the Fair Labor Standards Act. These programs were Insti tuted to promote public security and establish labor's status. Investors were at best neutral to these programs. Coupled with President Roosevelt's crusade on "economic 12 ^Arthur Smithies, "The American Economy In the Thirties," In Alvin H. Hansen and Richard V. Clemence, eds., Readings In Business Cycles and National Income (New York: W. H. Norton and Company, Inc., 1953), p. 52. royalists,” they depressed the state of confidence. The New Deal pushed through Congress laws regulating public utilities, increasing state and gift taxes and individual surtaxes, and establishing an undistributed profits tax as well as a graduated corporate net income tax. Except for the surtaxes and undistributed profits taxes, these meas ures do not appear frightening by today's standards, but it is hardly exaggerating to say they disturbed confidence in 1935-37. On the grounds of stimulating economic re covery the New Deal was fortunate that the Supreme Court declared the National Recovery Act unconstitutional. It was not working, and it was not conducive to confidence. But the administration's attempts to "pack the court" and otherwise circumvent the charges of unconstitutionality upset investors' confidence. The tendency of public officials to yield to pres sure groups, particularly labor, worsened the fears of investors.^ New Dealers continued on with repressive tax policies and threats of abolishing all holding companies, 13Ibid.. p. 49. 14 P. V. Ward, "Ickes Surrenders to Bureaucracy," Nation. 140:679-81, June 12, 1935. 149 yet they capitulated to labor's demands for increased wages^ in a time of falling prices.16 unfortunately, a controversy as to the Intentions of certain powerful fi nancial Interests arose to muddle further the state of con fidence. It was held by some that enterprise deliberately held back Investment to thwart the NRA and the New Deal so that President Roosevelt would lose the 1936 election. The well-grounded suspicions that certain powerful financial interests were doing their utmost to retard recovery were confirmed when a statement was issued, under the sponsorship of the Ifeilted States Clumber of Commerce, attacking particular aspects of the New Deal, and promising the American people that, If part of the President's legislative program were shelved, industry would pour such a huge sum of money into commercial channels as to dwarf the $4,000,000,000 needed for furtherance of the Rooseveltlan plans. Specifically, the statement attacked the Omnibus Banking Bill, the Utility Holding Company legislation, the Wagner Bill, and the Unemployment Insurance measure.1? 15”As a result of the NRA codes, the wage policy of the PWA and the WPA, the Wagner Act, and the Public Con tracts Board, the hourly earnings of factory workers in 1937 were 21 per cent above 1929, and of other types of labor from 10 to 15 per cent above 1929. The prices of finished goods, however, were 12 per cent below 1929, and so also was the cost of living." S. H. Sllchter, "Great American Experiment," Atlantic Monthly. 163:471, April, 1939. 16R. Holey, "Spending and Recovery," Newsweek. 11:40, April 25, 1938. 17 R. T. Kennedy, "Business Recovery and NRA," Coeisonweal. 23:49, November 8, 1935. 150 Robert H. Jackson, Assistant Attorney General In charge of the anti-trust division, sanctioned Kennedy* s point of view and pressed forward the New Deal's assault on "economic royalists" when he pointedly declared in November 1937: We are engaged in a struggle to keep from being a nation controlled by a couple of dozen corporations. [The "monopolists" had "priced theemelves" along with the rest of the country into the new depression. Business had implored the government to return to the ways of orthodoxy, and in response] "in the last fiscal year the governmental net contribution to purchasing power was reduced about $275,000,000 a month— on the assurance and expectation that business activity would make up for the reduction. . . • But monopoly, by trying to skim all the cream of the recovery for it self, belied the plain meaning of its promise." Monopoly presented a picture of "aristocratic anarchy"; there was a "strike" of capital against its government, and the "private regimentation of Industry and com merce" had become a "dangerous menace to political and economic freedom. A common reaction to these proclamations was that: It may well be that private cooperative enterprise is trying to provide jobs for as many people as pos sible; but this laudable ambition was certainly not fostered and encouraged by the rabble-rousing speeches of Mr. Jackson and Mr. Ickes. Why were they made? The rather ludicrous attempt was made to blame business *®W. Millie, "Cross Purposes in the New Deal, Virginia Quarterly Review. 3:359, July, 1938. 151 for the current recession. Business cannot escape Its share of censure. But the New Deal Itself Is by no naans blameless.19 Meanwhile, President Roosevelt himself did all he could to dispel the notion that he wanted to declare a general vendetta against all business, but his words were more unsettling on balance than soothing when he Included * ' the following remarks: [It was not nsrely "monopoly” which should be ended; it was] "tax avoidance . . excessive capitalization, investment write-ups and security manipulations, price rigging and collusive bidding, . . . high pressure salesmanship, . . • the use of the patent laws to enable larger corporations to maintain high prices, . . . unfair competition which drives the smaller pro ducers out of business, . . . intimidation of local or state governments . . . by threatening to move else where," [as well as actual migrations] "in pursuit of the cheapest wage scale." [In addition to all of which, something should be done, at least, about the] "concentration of economic power" [in general].20 The federal budget balance elasticities of national income were positive and small, normal for large percentage unbalances. The rates of change elasticities also assumed small values for these three years, indicating that federal spending hovered around the point of diminishing returns. 19"Facing Facts in 1938," Commonweal. 27:309, Janu ary 14, 1938. 20Millis, o p . cit.. p. 359. 152 In 1935, It lay slightly beyond this point, in 1936 and 1937, It lay slightly before diminishing returns. Govern ment spending mas reduced from its 1936 high of 8.49 bil lion dollars to 7.76 billion dollars in 1937, but the single annual rate of change elasticity for 1937 was not fine enough to reflect the downturn in late 1937. The rate of change elasticity, however, did alter significantly the next year. Third Phase: Confusion. Inflation. Stabilization. and Stagnation, 1937-1939 During the third phase of the New Deal program the modem approach to expansionary fiscal policy emerged. It took a sharp downturn from an unsatisfactory peak in early 1937 to convince President Roosevelt and other New Dealers that little investment was to be induced by the demonstration effect of federal economy. From 1929 to 1933 the federal government tried hard to economize. Business sank lower and lower; federal revenues withered away; and the budget showed no signs of a balance. From 1934 to 1937, the federal govern ment spent considerable sums for relief and public works, in order to save the unemployed from starving or from losing skill and morale. In spite of a common belief that we could not spend our way into prosperity, business improved; the federal revenue rose; and the budget began to approach a balance. In 1937, under 153 pressure from friends end opponents, the Administra tion, Instead of balancing the budget by heavier income taxes, began to taper off its expenditures, hoping that this evidence of economy mould encourage business to expand and take on more workers. But business had been betting on further public spending; when the policy was changed It promptly went into a tail spin.21 Thls cutback in federal spending from 8.49 billion dollars in 1936 to 7.76 billion dollars in 1937 and 6.79 billion dollars in 1938 was not the only depressant. On the tax side, tax receipts were increased somewhat over these three years. The level of federal spending was not only lower, but the size of the unbalance was reduced. President Roosevelt had trapped himself into undertaking this "economy" drive through public statements which con veyed the impression that government spending was massive. By the standards of some the prevailing levels of federal spending and federal deficits were actually small. In our opinion, the President's strategy was mis taken in allowing the spending program to be repre sented as gigantic when in reality it is small. A really large program, represented as not alarming in its proportions, would have provided more stimulation in fact, and might have been less frightening to ^D. C. Coyle and J. G- Frederick, "Government Spending: Success or Failure?" Forum. 101:218, April, 1939. 154 the timid souls who, In positions of private power, run our economy. 22 The collection of social security taxes at a time when tax reduction was sorely needed further Illustrated the lack of coordinated fiscal policy In time of depression. It was not until the following year that fiscal policy began to assume contemporary form. One of the principal reasons for the current stop page of governmental stimulation to purchasing power is the collection of social-security taxes. These taxes are being used to build up a fund out of which there will come future unemployment benefits, old-age pensions and the other payments that the new law obligates the government to make. The taxes taken in are invested in government bonds. . . . In terms of real goods and services, the government is not saving a single thing that the unemployed, the aged and the other beneficiaries will eventually use. It is saving pieces of paper. . • . Vhat the beneficiaries will receive must come out of the stock of goods and services that are available when they cash their government checks. A whole nation can no more save against future needs by this method than it can pass the real cost of a war on to future generations.** The administration did not believe it had to act to revive the economy after the 1937 downturn until the Spring ^"Roosevelt's Expansion Program," New Republic. 94:346, April 27, 1938. G. Soule, "Present Industrial Depression," New Republic. 93:63, November 24, 1937. 155 o£ 1938. In part this recession was initiated by the federal government's "economy drive" and worsened by the lack of countercyclical moves, but . . . many other factors, deserving the utmost atten tion, underlay the 1937 recession^ Notably, there was the breaking out of the sit-down strikes, perhaps fostered in part by certain government policies, with their adverse effect upon production. Rapid increases in wage rates during the latter part of 1936, beyond increases in production, undoubtedly tended to throw the price structure out of balance in some lines. There was an increase in bank reserve requirements and the partial sterilization of gold, later abandoned. There was the operation of new taxes. And it is not to be forgotten that the attention of Congress and the country was largely concentrated on the Supreme Court measure rather than upon the solution of pressing economic problems.24 In April 1938, President Roosevelt finally recog nized that the annually balanced budget approach to fiscal policy was a failure. In his "Recomnendatlons Designed to Stimulate Further Recovery," he declared that recovery would have to come about via expansionary fiscal policy. He asked Congress for more spending power to be used in expanding the WPA, NYA, farm security, and CCC programs. The most significant feature of this request was that 2^A. A. Ballantine, "Employment and Federal Finance; Imagined Magic of Continued Deficits," Vital Speeches. 6:152, December 15, 1939. 156 he asked for no additional tax revenue. This meant that net federal government spending was declared to have a stimulating effect upon the total economy. Accordingly, the level of federal spending was Increased from 6.79 bil lion dollars in 1938 to 8.86 billion dollars in 1939. The deficit was permitted to increase from 1.2 billion to 3.9 billion dollars annually over these same years.^ The battle between the defenders of the pump-priming thesis and the stagnationists mounted during this time. Neither side won outright, but the edge went to the pump primers. This intellectual contest marked the permanent establishment of fiscal economic theory and probably the acceptance of fiscal policy. The Employment Act of 1946 and President Eisenhower's subsequent acceptance of fiscal policy gave it formal recognition. The New Dealers acted as though the Stagnation Thesis of Alvin Hansen was actually a forecast by estab lishing progressive personal Income and corporate net 25 Smithies, op. cit.. p. 52. 157 Income tax rates which prevented saving^** and a tax on un distributed profits which drained and discouraged saving. Unfortunately, the tax structure reflected adherence to the overinvestment thesis as well as contempt for saving. With plant and equipment wearing out such a point of view was doubly injurious. ^ The efforts of the New Dealers to prevent the re covery from being based in large measure upon the expansion of investment limited the increase in con sumer purchasing power. • . . All in all, it is conservative to estimate that the government's policy of discouraging investment meant the employment of 1,000,000 fewer men in the capital-goods and construc tion Industries in 1937. . . . It is not extravagsnt to guess that 1,000,000 more jobs in the capital-goods and construction Industries would have meant 500,000 more jobs in the consumer-goods industries. In the second place, the government has attempted to Increase consumer purchasing power by methods which have tended to prevent larger consumer incomes from generating an expansion in investment. The efforts to raise consumer incomes by increasing the price of labor have, of course, raised production costs and thus made it more difficult for managements to discover attrac tive opportunities for profitable plant expansion. 26 v"The rates on incomes above $50,000 are now so high that they probably discourage investment more than saving, because they virtually prohibit very wealthy men from venturing their funds in risky end pioneering ven tures." S. H. Slichter, "Business Looks Ahead," Atlantic Monthly, 164:592, November, 1939. 27 'Slichter, "Great American Experiment," p. 472. 158 The enonoua expenditures of the government in excess of its receipts had the immediate effect of raising consumer demand, hut they have not had the secondary effect of inducing enterprises to embark upon long-range plans. Boards of directors have felt that the situation created was too artificial, too temporary, and too uncertain to provide a sound basis for large new cosmitments. They have wanted to know when and how the budget would be balanced, and whether balancing it would mean a new collapse of business. The President has said that the budget can be balanced by the growth of national income. Business managers have wondered whether a drastic tax increase will not be necessary, and they ask who will pay the new taxes and what the taxes will do to business. . . . Pending an answer to these questions, managers do what any sensible person would do— they restrict commitments, and as the money spent by the government reaches busi ness enterprises and their owners, it piles tip in the form of idle deposits. The very measures which the government employs to prevent recovery from becoming too largely an expansion of investment naturally tend to prevent the growth in consumer incomes from stimulating more investment.2* * The federal budget balance elasticities of national income remained low as expected during 1937-1939, but the noticeable reduction in the percentage of the 1938 un balance— from 36 per cent in 1937 (Itself a lower figure that the typical high-forties percentage) to 17 per cent in 1938, was accompanied by a small absolute increase in the federal budget balance elasticity from 0.26 to 0.37. 28Ibid.. pp. 472-74. 159 The rate of change assumed an unexpected positive value on economic grounds. But reflection on this logically reveals that the 1937-38 descent was so strong as to overwhelm the expansionary deficit the federal government incurred and leave the sign of the 1938 federal budget balance elas ticity negative. Furthermore, the reduction of the per centage size of the unbalance yielded a positive rate of change elasticity, suggesting a diminishing returns relationship with a status of "underwater income." In view of the fact that the large federal government expenditures of World War 11 accompanied sharp rises in GNP, it is very probable that some perverse region of the multimodal federal expenditure product curve was observed (see Chap ter III). The fact that positive rate-of-change- elasticities are observed for every year of downturn in the economy since 1927 suggests that the economy is unable to adjust in one year to its new long run federal expendi ture product curve. A further implication of this is that no percentage level of federal government spending, no matter how high, is certain to yield decreasing returns in the (very) long run. Figure 7 Illustrates a feasible long run trend (Wagner's Law). This bald statement although 160 Y 3R SR. Federal Government Expenditure FIGURE 7 DERIVATION OF A FEASIBLE LOrG RUli AFEPI CURVE AFEPY: Average Federal Expenditure Product of national Income, 161 not a defense of collectivism clashes with views held by many Americans. Russia's rapid growth rate strongly sug gests that there Is no single optimum cosiblnatlon of government spending and private spending In the (very) long run, but it Implies Instead that the optimum combination in terms of income production of private and public spending is a function of the mental attitudes of the population at any given time toward its government's spending. Alvin Hansen's Reflections on the Great Depression and Fiscal Policy Professor Alvin H. Hansen's reflections on fiscal policy in the Great Depression are helpful in establishing some common grounds on which all other economic insights into this period can be contrasted with the insights derived from the federal budget balance and the rate of change elasticities. (1) Recovery from the 1932-3 trough was vigorous and rapid, but it peaked out at an unsatisfactory high in 1937 (the peak in 1937 was 7 per cent below the 1929 level in per capita output and much below the 1929 percentage level of employment). 162 (2) The administration failed to counter this severe depression until the second quarter of 1938* It should have undertaken a vigorous program of expansion in Septem ber 1937, when danger signals were sufficiently indicative. The stock market crash of October 1937 could have been avoided to a large extent. (3) Fiscal policy was a salvaging program, not a really expansionary one: refinancing urban and rural debt, rebuilding the weakened capital structure of the banks, and supporting railroads at or near bankruptcy, especially by the Reconstruction Finance Corporation, the Home Owners' Loan Corporation, and the Farm Credit Administration. These measures cost 18 billion dollars. Also the federal government aided state governments. Of the collective 1934-1939 deficit of 18.7 billion dollars, 13.8 billion was for unemployment relief alone. The Agricultural Adjustment program spent 3.2 billion and public works (mainly grants- in-aid or substitutes for diminishing local outlays), amounted to 5.4 billion dollars in the same period. (4) The programs which the federal government had to undertake were not as productive as those abandoned by private enterprise. They were emergency measures which had 163 to cope with tnanan misery: (a) the distress of unemployed urban .workers, (b) the distress of fanners with declining income and burgeoning debt, (c) the weakened capital posi tion of banks, railroads, and other industries, and (3) the weakened fiscal position of state and local goverxsnents. (5) Federal public works did not rise by enough to offset declining state and local government spending after 1930-31 until 1936. (6) Federal expenditures induced by the depression averaged 3.8 billion dollars annually from 1933 on, and they included an annual outlay of 940 million dollars on public works between 1934-1940, as contrasted with 464 mil lion dollars between 1930-33. Relief expenditures (direct relief, work relief, WPA, CCC, etc.) increased from zero in 1930-32 and 360 million in 1933 to 2.243 billion dollars in 1934-1940. The Agricultural Adjustment program averaged 592 million dollars per year. (7) The other one-half of the federal government's expenditures was for the traditional functions of govern ment (average total annual federal government expenditure was 7.8 billion dollars).29 29Alvin H. Hansen, Fiscal Policy and Business Cycles (New York: W. U. Norton and Company, Inc., 1941), pp. 83-89. 164 Conclusions on Fiscal Policy During the Great Depression with Elasticity as a Guide Using elasticity as a guide to fiscal policy in the Great Depression one Is able to obtain greater insight into the reaction of the economy to federal government fiscal operations. Some of the conjectures of economists about the interrelationships of the federal government and the rest of the economy during this period are consistent with the quantitative variations in the federal budget balance and the rate of change elasticities. (1) The frequent appearance of increasing returns for the net federal expenditure product of national income suggests that federal government spending was too small relatively to the spending of the private sector to produce an optimum quantity of gross national product. (2) Annual data instead of monthly or quarterly data prevent a closer examination of the influence of specific fiscal policy measures on gross national product. (3) During the years of uncertainty and fear of the New Deal policies, 1935-37, the gross national product was less than unitarily sensitive to federal government spend ing. 165 (4) Between 1938 and 1941, the gross national product was highly sensitive to changes In the percentage unbalance of the federal budget. In part this sensitivity seems attributable to the spend-for-prosperity policies of the New Deal in the late thirties and war spending there- after. Strong multiplier and accelerator effects seem to have emerged In response to federal government spending. It Is also possible that the vigorous private sector had outstripped the need for federal government stimulation as war time demand began to uplift the economy. FISCAL POLICY DURING THE SECOND WORLD WAR AND THE RECONVERSION PERIOD, 1941-1946 The objective of fiscal policy during World War II was to achieve the largest possible increase in taxes so as to curb inflation and restrict war profiteering without imposing too great a shock on the economic system.^0 in terms of the equation of exchange the war machine required an increase in the quantity of money; direct controls were ^Lewis H. Kimmel, Federal Budget and Fiscal Policy 1789-1958 (Washington, D.C.: The Brookings Institution, 1959), p. 230. 166 to restrain velocity, price increases, and contra-military transactions; and monetary and fiscal policies were to assist in holding down M, V, and F while allowing war- oriented productive transactions to Increase. Direct controls were extended several times during the war to curb inflation and promote the production of durable goods. Total governmental policy was clearly successful in promoting durable goods production as the in dexes of durable and non-durable goods production diverged from a ten point difference (115 for durable goods, 105 for non-durable goods) in mid-1940 to an eighty point differ ence (215 for durable goods, 135 for non-durable goods) by the end of 1941.^ in April 1942, another round of sweep ing direct and indirect economic controls was enacted to fight inflation. Ceilings were placed on retail and whole sale prices, charge-accounts and credit extension were virtually eliminated, tax exemptions were sharply curbed when only 500 dollars Income instead of the 750 dollars previously allowed for individuals was tax free. Similarly, 31 "Tighter Controls All Along Line; Managed Economy Now Virtually a Fact,” Business Week. January 31, 1942, p. 13. 167 the tax-free base for couples was reduced from 1,500 to 1,000 dollars. Purchases of savings bonds were forced In a ntanber of cases and strongly pushed In many others. Tax rates were Increased with excess profits rates reaching 95 per cent from a previous level of 75 per cent.^2 Another round of controls Imposed rationing. Farm prices were no longer supported above parity. President Roosevelt proposed that all income be limited to 25,000 dollars per year after taxes, but this suggestion was hotly rejected.33 A year later the anti-inflationary policies seemed to be working fairly well but with some loopholes in wage rates and farm prices remaining. President Roosevelt's "hold the line" order on wages and prices continued to dominate the domestic outlook news this week. Its lnmediate implications were plain to be seen. Commodity and security markets sold off. The Bankhead farm-price bill lay moribund in the arms of a Senate committee. John L. Lewis shifted the em phasis of his demands on the bituminous coal industry from $2-more-a-day and "portal-to-portal" pay to a guaranteed annual wage for hie miner a. All along the line, inflation drivers were in retreat.34 32"Sweeping Economic Controls Agreed on to Fight Inflation," Mawsweek. 19:44, April 20, 1942. 33r. Robey, "War on the Third Front; Anti-Inflation Program," Mewsweek. 19:58, May 11, 1942. 34”Hold the Line Gets Results, But There Are Loop holes for Inflationary Forces," Business Week. April 17, 1943, pp. 13-14. 168 Congress not only paved the way for improved wartime complicity in income tax returns by instituting a withhold ing system but guaranteed less evasion in the postwar period when the motivation to cheat was certain to be stronger. The collection of taxes at the source and time of income receipt improved the automatic stabilization potentialities of income taxes. The most important wartime innovation was the adop tion in 1943 of withholding of income taxes on salaries and wages. In recommending a system of withholding in 1941 and 1942, the stated objectives of the Treasury were "to ease the payment problems of taxpayers" and to remove "the spectre of overhanging tax liabilities for earnings in a prior year." From a longer-range view point, the fact that withholding involved a basic change in collection and administrative procedures was of secondary Importance. Withholding was essential if fiscal policy was to become an effective component of a peacetime stabilization program.35 But there was evidence that the administration's anti-inflationary policies were becoming more politically- oriented with little economic potency. Although President Roosevelt advocated that a national service act be passed to conscript striking workers, ^ he proposed other measures ^Kimmel, op. cit.. p. 231. ^^"President's Program," Commonweal. 39:339, Janu ary 21, 1944. 169 which gave the government hardly any additional power to oppose inflationary forces.^ Just after the conclusion of the war the Truman Administration showed even less sin cerity in countering the strong inflationary forces present in the economy as it sanctioned a 15 to 30 per cent in crease in wages in the oil industry, an increase of the minimum wage level by fifteen cents, and advocated that unemployment compensation of 25 dollars per week for 26 weeks be allowed to all discharged war workers, federal employees, and others. Also, Washington hinted it would permit prices to rise. 3** On balance it has often been said that fiscal policy was fairly good during World War II with the exception of inadequate taxation. Too much inflationary potential was allowed to remain in the public's hands. Professor William J. Feliner indicated the magnitude of this tax deficiency when he said, 37R. Robey, "President Roosevelt's Five-Point Pro gram," Newsweek. 23:61, January 24, 1944. 38 R. Robey, "For This, Thank Washington; Inflation ary Move," Newsweek, 26:78, October 22, 1945. 170 The proposition that a linear (that Is to say* pro portionate) Income tax of about 10 per cent, applied to all Income without exemption and superimposed upon the Income tax structure that actually prevailed, would presumably have prevented the formation of any appreciable Inflation potential. Given such a tax, and given the direct controls necessitated by specific shortages, it would not even have been necessary to use war bond "drives" as a further means of reducing the demand for goods. 39 . . . in these years the ex post potential may be estimated at between 15 and 18 dollars for every 100 dollars of disposable in come. 0 . . • The ex ante potential must have been greater because part of it got unloaded into an in flationary process and therefore does not appear in the ex post potential. The cost of living Index rose by about 9 per cent in 1942, 3 per cent in 1943, 2 per cent in 1944, and 2 per cent In 1945. In addi tion to this rise, such phenomena as quality deteri oration, the disappearance of cheap brands, and illegal transactions also were in the nature of price increases, so that the "true" rise of the cost of living undoubtedly exceeded the figures just given.^ The statistics of government spending, deficit spending, and gross national product reveal important rela tionships as to the ability of the federal government to curb inflation. See Table IV. War spending produced decreaslngly strong multiplier- accelerator effects as the war wore on. This is evidenced ^William J. Fellner, "Postscript on War Inflation: A Lesson from World War II," American Economic Association Readings in Fiscal Policy (Homewood: Richard D. Irwin, Inc., 1955), p. 137. 40Ibid., p. 143. 4XIbid.. p. 144 TABLE IV FBBEY, RCE, AND STAGE NFEPY, Year Y Chg Y G Exp. UnB. 1941 126. +25 13.3 + 6.2 1942 159. +34 34.0 +21.5 1943 193. +33 79.4 +57.4 1944 211. +19 95.1 +51.4 1945 214. + 2. 98.4 +53.9 1946 209. - 4. 60.4 +20.7 Stage NFEPY by the decreasing rate of change of gross national product as government spending Increased. With respect to the percentage slse of the deficit, the federal budget balance elasticity steadily declined throughout the ear. The rate- of-change-elastic!ties suggest that federal spending was not sufficiently large to permit efficient production of national Income in 1942 and that federal spending mas even less adequate in 1943. These pronouncements arise from the fact that the net federal expenditure product of national Income lay in increasing returns both years. In view of the inflationary problems of the war period, the united States was fortunate to experience "inefficient" income production, because it was compelled to spend more than it taxed. Recalling that this "inefficiency" could be removed by increasing net federal spending or by reducing private spending, the latter was clearly the desired solution. Direct controls and taxation helped keep the private sector as low as it was, but further decreases would have been welcomed, provided that the output-income ratio was not reduced. If the purely inflationary spending could have been sorted out and reduced, the result would have ap proached optimality more closely still. 173 The income productivity of federal government spend ing was pressed into the diminishing returns stage in 1944, when the rate of change elasticity became positive and moderately elastic. But it bobbed back into increasing returns in 1945, returning to diminishing returns in 1946. After the war ended the private sector took the initiative in producing income as the federal government sharply re duced both the level of its spending and the size of its deficit. Immense stockpiled savings (pent-up demand) were spent after the war and kept aggregate demand at a full employment level until 1948. The net federal expenditure product of national in come curve drifted leftward during the war as the exhila rating effects of federal spending dwindled until 1946 (since the war no secular "setting down" of the net federal expenditure product curve has been manifest). This secular leftward shifting of the net federal expenditure product curve attested to the efficacy of direct controls, defense bond sales, and other measures in preventing the realiza tion of an inflationary spiral. Without these measures an inflationary psychosis would soon have emerged wherein federal spending would have been increasingly productive of income— just the opposite of what happened. 174 FISCAL POLICY IN THE CONTEMPORARY PERIOD, 1947-1961 The contemporary period Is marked by several charac teristics. One is the lack of an all-out national effort to cope with some economic problem. Related to this is the large, but not as large as in World War II, role of federal spending to national income. The sizes of the budget deficits and surpluses are also small percentages of total federal spending. Data on the gross national product are also superior to those before 1947. Quarterly rates allow one to study the responsiveness of gross national product to seasonal fiscal operations. Finally, the period is featured by the bipartisan acceptance of fiscal policy as a legitimate and essential undertaking. Continuation of Postwar Inflation. 1947-1948 Pent-up demand still had not been dissipated during the larger part of 1947-48. The task of fiscal policy was to help reduce the strong inflationary pressure of this latent demand. Congress, headed by the Republican majority, favored a tax cut in mid-1947, but this was clearly bad 175 on economic grounds as prices were already moving upward. ^ The Truman Administration was saddled with the unpleasant job of having to convince the public that such a tax cut was unwise. But President Truman and his advisers occasionally lapsed into thinking that this postwar inflationary boom was solid prosperity. The President even advocated in creased social security payments, housing subsidies, and foreign loans (stimulating exports) which would add to the already-strong inflationary pressures.^ Price increases had already outstripped the 18 per cent average dollar in crease per capita between early 1946 and late 1947 to the point where average buying power actually slipped 8 per cent over the same period.^ Other economic developments in the latter half of 1947 indicated that this prosperity was built upon a bed of quicksand. Rising prices made con struction a very tenuous undertaking with a sudden cutback ^"Economic Outlook," Nation. 165:60, July 19, 1947. ^H. Hazlitt, "Midyear Economic Report of the Presi dent," Ntewsweek. 30:78, August 4, 1947. ^"Perils to Business in 1948: Start of a New Price Spiral; Report of CEA,” U.S. News. 24:11, January 23, 1948. possible once the spell o£ confidence broke. Inventories had accumulated to the point where their potential liqui dation posed more of a threat to the maintenance of produc tion and employment than at any time since World War II began. New investment was already leveling off, and con sumers were consuming their savings. A mountain of credit had been extended to consumers--it increased by 10 billion dollars in the last half of 1947 alone--making a severe liquidity crisis more imminent. Production still was in capable of satisfying demand without inflation, prompting President Truman to ask for firmer controls over the dis tribution of goods, prices, and credit and that taxes be kept up, the federal debt reduced, and savings bond sales be promoted in his 1948 Economic Report.Eight months later President Truman continued to press for more controls to cope with inflation, but he did not shelve his demands for higher minimum wages and increased federal spending on housing, education, electricity, and federal government employees1 salaries. The President's requests for an excess-profits tax was criticized by Henry Hazlitt on the 45Ibid.. pp. 11-13. 177 grounds that It would reduce more production than It siphoned Inflationary income. Consumer credit controls were requested by the President but not credit limitations for house-building. Also, Truman asked for more power to vary reserve requirements (by the Board of Governors) as well as the power to control allocation and inventory build-up of scarce commodities, limit rent advances, ration products in short supply, and hold down prices on specific scarce commodities.^ From historical evidence fiscal policy in the post war period appears to have been tolerably well designed and carried out but that the analysis of the Council of Eco nomic Advisers did not always convey the impression that the Council had a firm grasp of applied economics. Fiscal policy must be ranked ahead of monetary policy proper as a damper on monetary expansion in 1945-48. The Treasury withdrew from the money mar kets as a net borrower. It redeemed a significant fraction of its outstanding securities, which the public and the banks had been led to regard as near cash and as a demand claim on cash. From mid-1947, its cash surplus drew funds from the public either H. Hazlltt, "Will Inflation Stop Inflation? President Truman's Eight-Point Anti-Inflation Program," Newsweek. 32:61, August 9, 1948. 178 for destruction, as securities were redeemed out of bank portfolios, or for hoarding in the general fund. In consequence of pressure by both the Treasury and the Federal Reserve System, the public and the banks were compelled to sacrifice liquidity In financing the postwar expansion in the demand for current output. The Economic Reports of the President for 1946-48, advocated holding the line against inflation by keeping taxes up and instituting other controls which admirably countered public opinion, yet they revealed that the Council favored the maintenance of a high level of monetary expenditure.4* * Not until the 1948 Report did the Council admit that the monetary situation was an Important force in the current inflation. The fact that the money supply in 1947 was three and one-half times its 1939 level was not stressed as a prime cause of inflation. "The reader of the Reports gets the impression that the heart of the problem of inflation is in the attitude of business men and labor leaders.”49 The reason why the Council did not propose 4^Edward S. Shaw, Honey, Income, and Monetary Policy (Chicago: Richard D. Irwin, Inc., 195(7), p. 463. 48Frank Whitson Fetter, "The Economic Reports of the President and the Problem of Inflation," American EcnuMri*; Association Readings in Fiscal Policy (Homewood: Richard D. Irwin, Inc., 1955), p. 171. 49Ibid., p. 173. 179 that monetary demand be reduced probably lay In ita belief "that the Impact of demand changes is almost exclusively upon production and employment rather than upon prices. The Council's concern about falling personal dis posable income and the decrease in the quantity of goods and services available for consumption was inconsistent with the President's measures to increase foreign loans and induce domestic Investment. A decline in real personal disposable income in a period of full employment is to be expected if investment and net foreign spending increase and should not loom large as a maladjustment in the in ternal economy sorely in need of correction.^ Elasticity as a Guide to Fiscal Policy in 1947-1948 The proper goal of fiscal policy in this period was to reduce inflationary pressures by contracting the level of gross national product. Since monetary demand was exerting far more pressure upon the general price level than upon transactions, both monetary and fiscal policy should have exerted a strong contractionary force upon it. 50Ibid.. p. 177. 51Ibid.. p. 172 180 Since the Boerd of Governors of the Federel Reserve System had their hands tied by their commitment to support the market prices of Treasury securities at par, fiscal policy, had a bigger job to do. In Table V the positive signs of the rate of change elasticities Indicate that government finance mas conducted on a sufficient scale to expand or contract the gross national product by some desired amount without waste throughout 1947. In 1948, the public sector fell to too small a size relatively to the private sector to permit fiscal measures to counterbalance the aggregate spending and hoarding propensities of the private sector. The ad ministrations 4.8 billion dollar revenue cut in the Spring of 1948 weakened its hold on the level of income. Although the low values of the rate of change elasticity suggest that the financial powers of the federal government were not far from being able to control the size of the gross national product efficiently, the criticism that federal finance was too timidly conducted in 1948 remains. The rate of change elasticities had inelastic values throughout this period except for the first and third quar ters in 1947 and the third quarter in 1948. Their positive Y FBBEY, Chg Y RCE, AND G Exp. TABLE V* STAGE NFEPY, 1947-1948 Year and Quarter G.R. UnB. FBBEY RCE Stage NFEPY 1947-1 226. + 5 10.6 14.2 -3.3 -0.14 +7.78 2-3 2 230. + 4. 13.4 11.3 +2.5 40.08 40.92 2 3 236. + 6. 9.7 10.2 -0.2 -0.15 +2.62 2-3 4 245. +10. 7.9 9.8 -1.5 -0.31 40.43 2-3 1948-1 250. + 4. 8,1 14.2 -6.1 -0.14 -0.63 1 2 258. + 8. 8.8 9.4 -0.6 -0.24 -0.32 1 3 264. + 6. 9.2 9.2 40.0 40.17 +5.86 2 * See Appendix for a complete tabulation from 1946 through 1961. 182 signs along with thslr high values hint that In each case government financial measures had a firm grip upon the in come generating power of the private sector. For the first and third quarters of 1947, this lnplles that fiscal policy was good as well as effective since the federal govenseent taxed more than It spent In each case. Net taxation was efficiently destructive of gross national product which was the objective of fiscal policy at this time. President Truman's requests of Congress in 1948, for more controls to curb inflation, are consistent with the negative signs of the rate of change elasticities. The administration had lost control of the Income producing powers of the total economy. The abnormally large 6.1 bil lion dollar tax surplus in the first quarter of 1948, coupled with increasing returns for the negative net feder al expenditure product of national Income, infer that per haps federal government financial measures were Inadequate to control efficiently the size of gross national product because the quality of fiscal policy measures was itself lacking. Historical data corroborate this in that the administration was Introducing Inflationary measures, such as higher minimum wages and increased federal spending 183 on housing, education, electricity, and federal government employees' salaries. The announcement effects of these measures helped to Intensify their inflationary forces. A second quarter revenue reduction of 4.8 billion dollars openly strengthened the inflationary forces. Confounding the critique of fiscal policy, though, was the lack of selective controls to curb consumer and investor credit and the inability of the Board of Governors to contract member bank reserves. Fiscal policy was appropriate on balance but not adequate. Using the postwar years as a crude guide to "normal" growth, it is roughly true that the long run ratio of the annual percentage increase in gross national product to the annual point increase in the Consumer Price Index is 2:1. See Table VI. Thus, the 1947 Incremental GNP-to- CPI Ratio of 1.36 (11.0/8.1) indicates that gross national product in 1947 was roughly 0.64/1.36 X 2 X 23 billion dollars larger than that which would have occurred in a normal year. Assuming that the long run normal also 52 This assumes that a reduction of gross national product would result in lower prices pari passu, i.e., each 1 per cent decline in GNP would be accompanied by a one- half point drop in the CPI. TABLE VI DERIVATION OF THE INCREMENTAL GNP-TO-CPI RATIOS Chg. T L Inc. Consumer Annual Year Y Y in GNP Price Index CPI Chg. % Chg. GNP/Chg. CPI 1946 209. - 4 - 1.9 83.4 +6.5 - 0.29 1947 232. +23 +11.0 95.5 +8.1 + 1.36 1948 257. +25 +10.8 102.8 +7.3 + 1.48 1949 257. - 1 - 0.4 101.8 -1.0 + 0.40 1950 285. +28 +10.9 102.8 +1.0 +10.90 1951 328. +43 +15.1 111.0 +8.2 + 1.84 1952 345. +17 + 5.2 113.5 +2.5 + 2.08 1953 363. +18 + 5.2 114.4 40.9 + 5.78 1954 361. - 2 - 0.6 114.8 +0.4 - 1.50 1955 392. +31 + 8.6 114.5 -0.3 -28.65 1956 415. +23 + 5.9 116.2 +1.7 + 3.47 1957 443. +24 + 5.8 120.2 +4.0 + 1.45 1958 445. + 2 + 0.5 123.5 +3.3 + 0.15 1959 483. +38 + 8.5 124.6 +1.1 + 7.72 1960 504. +22 + 4.6 126.5 +1.9 + 2.42 Total 90.2 45.6 Average 6.0 7. 3.0 "Points" Optimum Ratio is 6.0X/3.0 "Points" or 2:1. represents the optimum level of income sens economic fluctuations, fiscal and monetary policy measures should have curbed gross national product at a level 21.6 billion dollars lower than the actual 232 billion dollars in 1947. Without aid from monetary policy, fiscal policy would have to have carried the burden alone in 1947 and in succeeding years until the Harch Accord of 1951. Nevertheless, the assumption that fiscal policy was wholly to blame for any lndiscretlonary changes in gross national product, although unreasonable, will be made henceforth, because monetary policy is not under treatment in this study. As in 1947, fiscal policy was appropriate but inadequate in 1948. The Incremental GNP-to-CPI Ratio was 1.48, suggesting that GNP was 0.52/1.48 X 2 X 25 or 17.6 billion dollars too high. From the analysis of Chapter III it is noted that the quantitative influence of fiscal operations upon gross national product could be estimated by the following equation: For antemarginal action: [FBBEY + (RCE) (FBBEY) (AU)] [GNP (AU)] - Desired A gNP For postmarginal action: (FBBEY - (RCE)(FBBEY)(AU)][GNP (AU)] - Desired AGNP Since 1947 and 1948 both have negative federal budget balance elasticities, these equations cannot be applied to the annual data. Furthermore, these formulae cannot be used for those percentage changes in the un balance which would allow the rate of change elasticity to render the federal budget balance elasticity negative. Only in the case of decreasing returns (Stage 3) of the federal net expenditure product of national income would negative values of the federal budget balance elasticity of national income be admitted to the above equations. Stage 3 has no applicability at this time because federal finance does not appear to have reached destructive propor tions in its influence upon the level of gross national product at any time in American history. In order to obtain some notion of the adjustments in federal finance needed to yield the "optimum** level of gross national product in 1947 and in 1948, quarterly data are used. Only the second quarter of 1947 and the third quarter of 1948 experienced positive federal budget balance elasticities, so they are chosen. The fourth quarter of 1948 also yielded a positive federal budget balance elas ticity, but that quarter is known to have been the begin ning of a recession. 187 2nd Quarter t°-08 * (0.92)(0.08)<x)] [$232 b.53 *) - 1947; Tax -$21.6 b. Incraase Only: (0.08 - 0.0736 x)x = -21.6/232 -0.0736x2 + 0.08x + 0.0932 » 0 Using the quadratic formula: x . -(0.08) t V(0.08)2 - 4(-0.0736)(0 0932) 2(-0.0736) x = + 0.544 t VO.0064 + 0.0274 -0.1472 x = 0.544 ± (-1.248) Discarding the negative value of x on the assumption that Stage 3 is not in effect (in fact, Stage 2 was indicated): x =1.792 If a value of x greater than unity results, the application of linear mathematical methods to the estima tion of fiscal policy measures is invalid. Values of x mean that the unbalance-as-a-per-cent-of-federal-government- 53 An annual figure for GNP Is used to correspond to the annual CPI. 188 expenditure would have to be altered by more than one hundred percentage points. This conclusion would have to be dismissed on both the grounds that It represents too wide a variation in the unbalance to be estimable without the actual mathematical formula of the net federal expendi ture product of national Income at hand and by the fact that intuitively it is obvious that postwar government fi nance could alter the gross national product by more than 21.6 billion dollars in either direction if the unbalance were allowed to approach 100 per cent. The expenditure-reduction case cannot be checked either because it yields a complex-number solution. The negative remainder under the square root radical indicates an imaginary number is coupled to the real root portion: Y0.0064 - 0.0274 = V-0.0210 3rd Quarter 1948: Tax Increase (kily: [0.17 - (5.86)(0.17)(x)][$257 b. x] - -$17.6 b. -0.996x2 + 0.17x = -17.6/257 -0.996x2 + 0.17x + 0.0685 * 0 189 x „ -(0.17) ± V (0.17)2 - 4("0.996)(0*0685) 2(-0.996) x - -0.085 t (-0.276) And since only positive values are acceptable, x equals 0.191. In percentage terms x equals 19.1. This is proba bly too large a deviation to yield an accurate estimate of the adjustments needed in fiscal policy to produce the optimum level of gross national product, but the estimate is advanced anyway. If taxes had been raised about (0.191)($33.0 b.)^ or 6.3 billion dollars, gross national product would have been the desired 17.6 billion dollars lower. The federal expenditure-reduction case, as in 1947, cannot be examined because it yield a complex-number solu tion. The 1948-1949 Recession During the last few months of 1948, a recession had begun, but it was not perceived by the administration even 54 The figure for government expenditures is always used here because the elasticities are constructed with the unbalance related to it rather than taxes. as lata as January 7, 1949. The President recommended a tax Increase of 4 billion dollars together with an increase In social security contributions.^ The Council of Eco nomic Advisers had been ruffled by Congress's reduction of taxes early in 1948, when inflationary forces seemed strong, and perhaps it felt that this reduction had to be restored. In his Midyear Economic Report the President declared that federal government cash deficits were neces sary to oppose other forces making for decline. An expan sion of public works spending did not appear necessary at that time, but plans for public works should be drawn up to cope with a more serious business decline, should one occur. Trunan abandoned his earlier request for 4 billion dollars more in corporate taxes. Instead, he favored an increase in estate and gift taxes, the repeal of taxes on the transportation of goods, and carry-over allowances for corporations liberalized. The RFC ought to be allowed to extend loans for longer periods of time. The minimum wage level should be raised to 75 cents per hour; the amount, duration, and coverage of unemployment benefits should ^Economic Report of the President, reprinted in U.S. ltews. 26:82, January 14, 1949* 191 be extended; veterans' unemployment compensation ought to be extended to July 25, 1950; and social security should be expanded. Mainly on other grounds besides the countering of the recession the President wanted approval of Point Four (to develop virgin or backward foreign landa), the original Reciprocal Trade Agreements Act, and the Brennan Plan for farm supports. The President's total program opposed the left-wingers (Senators Murray, Sparkman, and Humphrey and Council of Economic Advisers member, Leon Keyserllng) who wanted a 15 billion dollar economic Expan sion bill.56 Early in 1950, the recession had passed, and the President reported that federal government fiscal measures had had an important bearing upon the successful readjust ment of the economy.5^ Elasticity as a Guide to Fiscal Policy in 1948-1949 The fiscal policy objective of this period extending from the fourth quarter of 1948 to the end of 1949, should 56,,it * s Deflation, So No New Taxes,** Newsweek. 34:13-14, July 18, 1949. •^Economic Report of the President, reproduced in U.S. News. 28:78-79, January 13, 1950. 192 have been («• it was) to Increase aggregate demand. The economy was experiencing contraction. From historical accounts of the federal government's fiscal measures, it is observed that the administration was not aware of the de cline in the fourth quarter of 1948. Not until midyear did President Truman ask for a federal government cash deficit to counter the recession. The negative signs of the first four rate of change elasticities, see Table VII, brand government finance as being conducted on too small a level to expand or contract the gross national product by some desired amount without waste, from the last quarter in 1948 through the third quarter of 1949. This was a continuation of the timid level of federal fiscal operations in the early part of 1948. Only in the last quarter of this recession did the public sector operate on a sufficient level to counter balance the aggregate spending and hoarding propensities of the private sector. The rate of change elasticities became increasingly inelastic during the first three quarters of the recession (i.e., the fourth quarter of 1948 and the first and second quarters of 1949) but turned abruptly to highly elastic TABLE VII FBBEY, RCE, AND STAGE NFEPY, 1948-1949 Year and Quarter Y Chg. Y G Exp. G.R. UnB. FBBEY RCE Stagi NFEF 1948-4 266. +2. 10.2 8.7 +1..5 +0.05 + 0.55 1 1949-1 260. -6. 9.8 12.4 -2.6 +0.15 - 0.14 1 2 256. -3. 10.9 8.1 +2.9 -0.08 - 0.06 1 3 259. +2. 11.0 9.3 +1.8 40.06 - 29.6 1 4 257. -2. 10.0 8.4 +1.5 -0.04 +112.0 2-3 193 values in the third tnd fourth quarters of 1949. The low valued rate of change elasticities imply that government finance was close to exerting efficient control on the size of gross national product (the net federal expenditure product of national income was close to the point of di minishing returns). The high-valued negative rate of change elasticity for the third quarter of 1949 hints that government finance was rather far from being adequate to control the level of income efficiently. In view of the large positive rate of change elasticity for the fourth quarter of 1949, the relationship of the private to the public sector seems to have been changing sharply. Whereas the public sector had had very weak control over the magni tude of gross national product before the fourth quarter, it suddenly acquired a fully adequate rein. The net federal expenditure product of national income appeared to commence a leftward drift in the fourth quarter of 1949, indicating that the private sector had adjusted to the manipulations of federal finance. The unrest and inap propriateness of the administration's fiscal measures over most of the recession were probably the major cause of this loss of federal control. Had the federal government 195 Increased its third end fourth quarter deficits in 1949 instead of decreasing them, the recession might have bottomed out six months sooner than January 1950. The large negative rate of change elasticity for the third quarter in 1949, coupled with an Increase in gross national product, advances that the private sector was commencing a recovery, largely on its own and that it might have made a full recovery had not net federal spending been reduced. Thus what good fiscal policy there was in this period was not consciously exerted, and what fiscal policy was con sciously exerted was not good. The Incremental GNP-to-CPI Ratio for 1949 was low at 40.40. Gross national product had fallen 0.4 per cent while the Consumer Price Index had dropped one whole point. This meant that the contraction in gross national product was accompanied by a more-than-proportional reduction in prices. To arrest excessive deflation in accordance with the hypothesized optimum Incremental GNP-to-CPI relation ship of 2:1, gross national product would have to be raised 1.60/0.40 X 2 X 1 billion dollars or 8.0 billion dollars. The estimation equations for the fiscal measures needed to yield an optimum level of gross national product 196 in 1949 are drawn from the first and third quarter data in that year, because the annual data include a negative federal budget balance elasticity of national income. Negative federal budget balance elasticities in the second and fourth quarters prevent the use of those data too. First Quarter [0.15 - (-0.14)(0.15)(x)][$257 b. x] - x = -3.57 ± Vo.0225 - 0.0026 0.0420 x « -3.57 t 3.36 And since x 0 for both values, the expenditure-increase case has no economic meaning in Stage 1 (of the NFEPY). First Quarter [0.15 + (-0.14)(0.15)(x)][$257 b. x] - 1949; Increase + $8.0 b in Expenditures (0<15 + o.0210x)x - + 8.0/257 Only 0.0210x + 0.15x - 0.0312 - 0 Using the quadratic formula: x - -(0.15) t >/(0.15)2 - 4(0.0210)(0.0312) 2( 0. 0210) 1949; Tax Reduction Only -0.0210X2 + 0.15x - 0.0312 - 0 + $8.0 b. 197 Using the quadratic formula: x - + 3.57 ± Vb.0225 - I - 0.0026 0.0420 x * 3.57 t 3.77 x * 7.34 and *0.20 But x is greater than unity or less than zero, so this case cannot be examined either. Third Quarter [0.06 - (-29.6)(0.06)(x)][$257 b. x] * 1949; Increase + $g.O b. ^Expenditures (() Q6 + 1 775x)x . 0<0312 1.755x2 + 0.06x - 0.0312 = 0 Using the quadratic formula: x - -(0.06) t 7( 0. 06)2 - 4(1.755)(-0.0312) 2(1.755) x = -0.017 ± 0.135 x - +0.118 and -0.152 Since there exists a value of x such that 0x1, the appropriate expenditure increase would have been 11.8 per cent of prior government spending, (0.118)($39.5 b.), or 4.7 billion dollars. 198 Third Quarter 1949; Tax -1.755x2 + 0.06x - 0.0312 - 0 Reduction Only 2 This case cannot be examined because 4ac b , yield ing a complex-number solution. Recovery, the Korean War, and Postwar Inflation. 1950-1953 By January 1950 President Truman had cause for opti mism as the economy had bottomed out of the recession. For six months at least it appeared that the economy would con tinue to expand. Optimism was tempered, though, by the knowledge that private enterprise investment had to in crease if recession were to be averted. It had fallen 19 per cent in 1949 from its 1948 level, and it was likely to fall behind its 1949 rate in 1950. The President ad mitted that business confidence was lacking in the future. R. A. Lester was critical of the administration's inertia in using public policies to control the economic cycle. It is not enough to preach individual enlightenment and benign economics if periodic over-expansion of the capital-goods industries is practically inherent in a capitalistic economy geared to satisfy changes in 58Ibid.. pp. 61, 71-72, 80-81 199 demand promptly. The Council has not faced up this problem. Certainly much stronger medicine Is needed than ’ ’ confidence," bull sessions and the Adminis tration's housing programs. Confronted by a rather appalling job, the Council seems to place insufficient emphasis on the monetary, tax and expenditure policies of the federal government as stabilising devices. By confining its thinking to normal procedures and customary mays of spending money (rather than considering more flexible but unconven tional means such as changing tax burdens with eco nomic conditions or possibly consumer subsidies or per- capita bonuses), the Council has tended to restrict its horizon and its arsenal of weapons for overcoming instability. The result is too great reliance on its own gratuitous advice to the public, on automatic occurence of budget deficits with slumps, and on good luck. The defense spending requirements of the Korean War changed the emphasis of President Truman's fiscal policy. Whereas the federal government had been increasing its deficit and calling for a tax reduction, forcing down in terest rates, supporting government bonds, increasing government loans for farm price supports, spending for housing, aid to both small and big business, foreign aid, and "artificial" exports,^ the necessity for placing ^R. A. Lester, "Truman Economics, 1950 Model," New Republic. 122:11-13, January 23, 1950. ^H. Hazlitt, "Salvation Through Spending," News week, 35:76, June 12, 1950. 200 the economy partially on a war footing required an increase in taxes to offset the inflationary pressures generated by the heavy increase in both private and federal government spending. Private capital expansion was nurtured by government priorities in the allocation of scarce resources and by federal financial assistance, as well as by induce ment by federal spending. ^ The criticism was often made that the administration merely paid lip-service to the doc trine that the government must practice "rigid economy in its nondefense activities,” because it continued to spend for many projects which were not "essential."^ Although the Truman Administration had a tendency to spend more than the temper of the times would graciously accept, it did contribute the practical application of the cyclical budgat thesis. The budget was neither annually balanced nor balanced over the cycle, but budget planning over a period of several years was carried out. An example of this longer range planning appeared late in 1951, when budget plans were formulated with the following time table ^Kimmel, op. cit.. p. 246. 6^H. Hazlitt, "Mr. Truman's Wrong Remedies," News week, 37:72, January 22, 1951. 201 in mind: 1951 was a boom year with some weak spots. Defense outlays were rising. Heavy government spending and private investment in plant and equipment would make 1952 a year of boom also. The first part of 1953 would be prosperous, but sluggishness would develop in the second half of the year when arms spending was cut. In 1954, government spending would very likely be cut at least 20 billion dollars.^ The Eisenhower Administration endeavored to reduce the deficits which had become habitual under the New Deal and Fair Deal Administrations. Since inflation appeared to be dangerous in the early months of 1953, the President sent a special message to Congress on May 20 calling for full maintenance of all taxes during 1953 but a reduction in personal income taxes effective on January 1, 1954.^ Secretary of the Treasury George Humphrey had already raised the government interest rate. The new administra tion seemed to have no long run economic plans in mind Timetable of the Business Boom/' U.S. News. 31:11-13, December 14, 1951. ^Kimmel, op. cit.. p. 247. 202 at this time, causing the wolves to begin their howls early.^ Elasticity as a Guide to Fiscal Policy In 1950-1953 Fiscal policy In early 1950 was correctly aimed at expanding the economy and Inducing more private Investment. Businessmen lacked confidence In the future, so the federal government had to lower taxes as well as maintain high federal spending. A small reduction In spending and in taxes was Indicated. The advent of the Korean War required a large boost in federal spending for military purposes and therefore an increase in taxes to curb inflationary pres sures. With inflationary pressures still strong after the Korean War, a curtailment of federal spending without a reduction in total taxes became appropriate fiscal policy. The positive signs of the rate of change elastici ties (see Table VIII) in every quarter except the third and fourth quarters of 1951, declare that government finance was large enough relatively to the private sector to con trol efficiently the level of gross national product in ^"Economic Policies,** Commonweal. .58:112-13, May 8, 1953. TABLE VIII FBBEY, RCE, AND STAGE NFEPY, 1950-1953 Year and Quarter Y Chg. Y G Exp. G.R. UnB. FBBEY RCE Stage NFEPY 1950-1 266. + 9. 9.1 10.2 -2.1 +0.25 + 0.15 2-3 2 274. + 9. 10.1 8.2 +1.9 +0.22 + 1.61 2 3 293. +19. 9.1 9.4 -0.3 -0.53 + 0.17 2-3 4 304. +11. 10.0 9.1 40.9 +0.28 + 1.66 2 1951-1 318. +14. 11.1 16.8 -5.7 -0.31 +13.5 2-3 2 326. + 9. 14.5 12.9 +1.6 40.15 + 1.86 2 3 334. + 7. 15.0 12.4 +2.6 40.13 - 0.32 1 4 333. - 1. 16.3 11.4 +4.9 -0.01 - 4.32 1 1952-1 341. + 7. 16.3 20.4 -4.1 -0.12 + 0.08 2-3 2 341. + 0.3 18.6 17.9 40.7 40.004 + 1.01 2 3 347. + 6. 17.8 14.0 +3.9 40.08 + 1.29 2 4 359. +12. 18.7 13.3 +5.4 40.16 + 2.42 2 1953-1 365. + 6. 17.5 21.0 -3.5 -0.09 + 0.65 2-3 2 369. + 4. 20.6 17.0 +3.6 +0.05 + 0.23 2 203 204 this period of expansion and Inflation. Moderately large values of the rate of change coefficients frequently occurred, leaving the Impression that the point of the net federal expenditure product of national income In effect lay well to the right of the point of diminishing returns. This augers well for the level of government finance; the excellence of fiscal policy Is considered below. First quarter tax receipts at 10.2 billion dollars in 1950 were higher than the tax take In the fourth quarter of 1949, but 2.2 billion dollars lower than taxes in the same quarter one year before. In the second quarter taxes were seasonally lower and about "normal.M Government spending was reduced moderately from the levels employed one year before to combat the recession. The Korean War induced heavy spending in the private economy one-half year before the federal government com menced abnormally large spending. Taxes lagged behind federal spending the last three quarters of 1951, but this was not serious in view of the fact that the private sector of the economy was slowing down a bit toward the end of 1951. Historical analysis suggests that there was more government spending than necessary to fight the war and 205 maintain the other functions of government; therefore, federal spending was probably too high rather than taxes too low In 1952* Heavy spending by the federal government was not offset by taxes in 1952, but selective controls, rationing of critical goods, and a freer hand for monetary policy helped keep the general price level from advancing rapidly. All the while new federal debt was steadily ad- vancing, laying a potentially strong inflationary base. In conclusion, fiscal policy seems to have been appropriate and adequate In 1950, partly because of good luck; appropriate but Inadequate on the taxation side in 1951; and appropriate but too heavy on federal government expenditures in 1952. Over-all, the federal government increased the public debt more than necessary. Again quarterly data must be used to estimate how much taxes should have been Increased in 1951. The second and third quarters experienced positive federal budget balance elasticities of national income and, therefore, are potentially suitable to quantitative examination. An In cremental GNP-to-CPI Ratio of 1.84 for 1951 leads to the proposition that gross national product should have been reduced by 0.16/1.84 X 2 X 43 billion dollars or by 206 7.5 billion dollars. A tax increase of 29.4 billion dol lars is advanced by the second quarter data. This figure is not reliable because the dollar change of federal taxation is not a small per cent (66.2 per cent) of federal expenditure. The use of flnite-dlffetence estimation methods require small changes to be accurate. The third quarter figures fall to yield any meaningful economic solu tion. A positive federal budget balance elasticity for 1952 offers hope for procuring an expenditure-reduction solution from annual data. But an Incremental GNP-to-CPI Ratio of +2.08 identifies 1952 as an above-normal year for prosperity without inflation. Extravagant government spending was not sufficiently inflationary to drive the Incremental GNP-to-CPI Ratio below +2.00. Some additional assumption must be made in this case. The possibility of experiencing no rise in the Consumer Price Index is in serted here as the hypothetical goal of fiscal policy. To have avoided the 2.5 point rise in the Consumer Price Index completely in 1952 gross national product should have been reduced roughly 2.5 X 2/2.08 X 2 or 4.8 billion dollars. By the same finite difference estimation methods used above 207 a feasible 5 per cent cutback in government spending is dictated. In monetary terms the expenditure-reduction needed to avoid any rise in the Consumer Price Index was approximately 0.05 X $65.3 b. or 3.3 billion dollars. The Recession of 1953-1954 The economy turned down in the summer of 1953. Secretary of the Treasury Humphrey declared that the ad ministration did not favor postponing the December 31, 1953 expiration of the increased personal income tax and the excess profits tax enacted early in the Korean War. The Excise Tax Reduction Act of 1954 reduced revenues another one billion dollars over the three billion dollar cut in income taxes and two billion In excess profits taxes. Revision of the Internal Revenue Code in August 1954 re sulted in a 1.4 billion dollar loss in revenue for the fiscal year 1955. The types of revisions favored invest ment by business as depreciation allowances were liberal ized, losses could be "carried back" for a longer period of time, retained earnings were made less subject to taxes, and a limited dividend credit was allowed. ^ The reduction 66Neil H. Jacoby, Can Prosperity Be Sustained? (New York: Henry Holt and Company, 1956), p. 40. 208 in all revenues was estimated to be a net of 6.1 billion dollars on an annual basis.^ "This unequivocal promise of tax relief to both families and business firms bolstered confidence at a time when trade and employment were slip ping slightly. In coming months these well-timed tax reductions are likely to give substantial support to con sumer and investment markets," stated the Economic Report of the President.^ Furthermore, the Treasury Department financed the deficit by issuing short-term securities. According to Neil H. Jacoby, this maturity of security was selected in order to "leave the long-term money market open to private investors."^ "Even more significant . . . were Federal actions to reduce the cost and increase the availa bility of credit." The money supply rose by almost 10 bil lion dollars in the year following October 1953. Bond prices rose, business loan rates fell sharply, real estate mortgage money became cheaper. "Billions of dollars of ^Klnmel, op. cit.. p. 248. £Q ^ Economic Report of the President (Washington, D.C.: United States Government Printing Office, 1955), p. 52. ^Jacoby, o p. cit.. p. 39. 209 investment were made in municipal improvements, buildings, industrial plants and machinery, homes, automobiles, and consumer durable goods which would have been deferred had credit been hard to get."7® The objective of the ad** ministration was to induce private expenditure rather than spend for public projects. Barriers to private investment were removed whenever feasible.7^ This rosy view of the administration's policies, however, was not shared by all who were competent to judge. Sumner H. Slichter declared that business improved in spite of government policy. 72 Some maintained that President Elsenhower should have cut consumption taxes in order to bolster consumer demand. Only investment spending had been facilitated by the Eisenhower Administration's fiscal 73 policies. Paul Douglas branded the President with making three important errors in countering the recession. First, he failed to analyze correctly the facts of the rapid 70Ibid.. pp. 39-40. 7lIbid.. p. 40. 72,'Republican Economic Policy: It Works," Fortune. 50:65, July, 1954. 73P. H. Douglas and R. Bolling, "Action to Prevent Depression," Hew Republic. 130:10, March 22, 1954. 210 recession In economic activity during 1953 as they really were. Then his pollyannalsh "prosperity Is just around the comer" attitude lulled him into Ignoring present diffi culties. Finally, he failed to propose a bold program for dealing with iunediate, pressing problems.^ Arthur Burns, Chairman of the Council of Economic Advisers, seemed to reply that a "bold program" was not necessary, because the public's confidence in the Eisenhower Administration led them to keep up spending.^ Evaluation of Fiscal Policy in the 1953-1954 Recession Through Elasticity The fiscal policy objective in this recession was appropriately to revive the economy by expanding the size of the gross national product. Heavy taxation of the private sector along with massive government spending in the preceding period increased the likelihood that a tax reduction would have a stimulating effect. The decline of the rate of change elasticity from 2.42 in the fourth 74 "Tax Policies As Weapons," Comaonweal, 59:464, February 12, 1954. ^A. F. Bums, "From Ike's Business Adviser: The Recession Is Ended," U.S. Hews. 37:46, October 29, 1954. 211 quarter of 1952 to 0.65 in the first quarter of 1953 and 0.23 in the second quarter posited the conclusion that the private sector was becoming less sensitive to federal government spending. The key to recovery thus seemed to lie in less government intervention rather than more. Tax reductions were exhilarating to the private sector according to the sharp increase in the rate of change elasticity (see Table IX). As usual when the private sector is sharply jabbed by federal financial ma nipulations, the net federal expenditure product curve shifted far to the right so that increasing returns set in. A temporary state of increasing returns is probably un avoidable, but a prolonged period of it hints at insuf ficient fiscal operations. Large rate of change elastici ties throughout the recession meant that the Eisenhower Administration was rather far from controlling the income- producing performance of the economy efficiently. That the economy snapped out of the slump so quickly was probably linked to its thirst for a tax relief, even if a small one. The recession might have ended in the first quarter of 1954, if the government had not allowed tax receipts to reach a postwar high of 21.9 billion dollars in that t TABLE IX FBBEY, RCE, AND STAGE NFEPY, 1953-1954 Year and Quarter Y Chg. Y G Exp. G.R. UnB. FBBEY RCE Stage NFEPY 1953-3 367. -2. 18.2 13.9 +4.3 -0.02 -15.7 1 4 361. -6. 17.3 12.5 +4.8 -0.09 - 7.80 1 1954-1 360. -1. 15.5 21.9 -6.4 +0.02 - 0.03 1 2 359. -1. 17.8 17.0 40.8 -0.12 -26.5 1 3 362. +3. 16.6 11.7 +4.9 +0.05 + 2.64 2 212 213 same quarter. Recovery was so strongly underway In the private sector that gross national product only fell one billion dollars, the low absolute value of the rate of change elasticity at 0.03 holds that this inexcusable taxation did not scuttle the recovery of the private sector. Fortunately, the governaent cut taxes and in* creased spending in the second quarter of 1954. It managed to avert a blowout of optimism In the private economy. A third-quarter 5.3 billion dollar slash in taxes was great enough to carry the net federal expenditure product of national income into the diminishing returns stage, as the recession came to an end. Based u p insights afforded by elasticity, federal finance was inadequately applied throughout all the early phases of the recession. It was appropriate in every quarter except the first of 1954. Its stress u p tax re duction as a resuscitating device was most apropos. The Incremental GNP-to-CFI Ratio for 1954 cannot be used to estimate optimum income in 1954, because both prob lems of recession and inflation existed at this same time. A gross national product of about 375 billion dollars in 1954 would have been about optimal, though, considering 214 that it would have seen income rise a below-normal twelve billion dollars over its 1953 level instead of falling two billion dollars. The need for restoring the public's con fidence in government finance plus the increasing debt management problems Insisted that increments to the public debt be modest at most. The government was not in a good position to spend for growth, as it did in 1955. The one quarter that needed correction as to the direction of fiscal policy cannot be quantitatively ex plored by the finite difference methods used to approximate the necessary fiscal changes needed in earlier periods, because the algebraic solutions of x have no economic in terpretation, Expansion and Boom, 1955-1957 Fiscal policy in the early part of 1955 was aimed at stimulating growth. Accordingly, federal, state, and local public works were expded as part of the growth objective. The President declared that the government must do its part to advance human welfare and economic growth in those areas where individuals were unable to achieve these ends them selves,^ But by October 1955 Arthur Burns observed that 7W l , op. cit,, pp, 249-50, 215 certain public and private measures had been taken to restrain the boom:77 (1) The widespread tendency toward Increasingly liberal credit terms, which existed several months ago, has apparently run its course. (2) Some improvement In the quality of new mortgage loans is now under way. The same is true of the consumer installment loans being made by some important lenders, though by no means all. (3) The growth of brokers' loans has been moderate and in recent months has stopped. (4) Although the total expansion of loans by com mercial banks and other financial institutions has been continuing at a rapid rate, the loan funds are coming preponderantly from past and current savings, not from newly created money. Even allowing for seasonal factors, the sum of demand deposits and currency in the hands of the public increased only 2 per cent between the first of this year and the beginning of Septem ber. Thus, the strength of the boom late in 1955 was still not worrisome. The average level of prices has continued to move within a narrow range. While the prices of some in dustrial materials have of late risen spectacularly, the average of industrial prices is merely 2 or 3 per cent above a year ago. The average of all wholesale prices has risen still less and the average of con sumer prices has remained almost perfectly steady.7® 77A. F. Burns, "Good Times Ahead, 400-Billion-Dollar Economy," U.S. News, 39:48-51, October 14, 1955. 78Ibid Income, output, and employment rose significantly in 1956 without serious inflation, so that the year was one of genuine prosperity. But 1956 saw prices become increas ingly maladjusted as the year wore on. In January 1957, the President announced that inflation was a basic and con tinuing threat to prosperity. He warned business and labor leaders to restrain their price increases and wage demands.^ The Secretary of the Treasury flatly declared in February that the federal government tends to broaden too far all the time, that it should tax at least as much as it spends, and that both federal spending and federal taxation must be reduced in order to avoid setting the stage for depression.Federal expenditure programs were closely reviewed to effect economy. Not only was inflation a worry, but the debt celling of 275 billion dollars was very close to being violated. "There is also some evidence that payments were made less promptly than usual, because 79 « Economic Report of the President (Washington, W D.C.: Uhited States Government Printing Office, 1957), p. 3. 80 G. M. Humphrey, "We Are Spending Too Much Money," U.S. News. 42:54-57, February 8, 1957. 217 81 of the near-impingement on the debt limit.” Gabriel Hauge, White House staff economist, related the White House's outlook on the economic status in March 1957:M (1) The boom is slowing down along with inflation. (2) Inflation is still a long-run danger and must be opposed by public policy. (3) Interest rates should be raised to stimulate saving. (4) Future tax cuts should favor investors and savers. Elasticity's Pronouncements on Fiscal Policy During the Expansion of 1955-1957 The proper goal of fiscal policy in 1956-57 was to promote growth by expanding the level of gross national product. Inflation ceased to be a problem in 1955 and throughout most of 1956. The economy was so ripe for growth in 1955, that a large increase in monetary demand was actually accompanied by a slight drop in the Consumer ^Kimmel, op. cit.. p. 252. 82 ^Gabriel Hauge, "Ike's Adviser on Business Sizes Up the Outlook," U.S. News. 42:122, March 22, 1957. 2X8 Price Index. Inflationary forces gathered strength in 1956, but still not enough to warrant significant fiscal restraint. But in 1957, prices began to move up fairly rapidly. The fiscal policy goal in the early part of 1957, was appropriately to reduce monetary demand in order to prevent worsening cost-price maladjustments. The positive signs of the rate of change elastici ties (see Table X) in most of the quarter-annual segments of this period mean that the level of federal fiscal oper ations was on a sufficiently large scale to alter the size of the gross national product efficiently. The three quar ters in which increasing returns prevailed were probably periods of careless optimism on the part of the private sector. Especially in the fourth quarter of 1955 and the second quarter of 1956, this interpretation seems plausi ble, because monetary and fiscal measures were being taken to restrain the boom. Revival from the 1953-54 recession began to acceler ate sharply in the last quarter of 1954 and would probably have soared early in 1955, had not the heavy tax receipts flowed in. This dampened the private sector's lust for spending until late the following year. But by the end Year a Quarte 1954-4 1955-1 2 3 4 1956-1 2 3 4 1957-1 2 3 TABLE X FBBEY, RCE, AMD STAGE NFEFY, 1954-1957 Y Chg. Y G Exp. G.R. UnB. FBBEY RCE 371. + 9. 15.0 10.6 +4.4 +0.15 -147.0 384. +14. 15.7 19.8 -4.2 -0.22 + 0.24 393. + 9. 17.3 18.2 40.9 40.13 + 2.62 403. +10. 17.0 13.0 +4.0 40.15 + 0.11 409. + 6. 16.2 12.2 +3.9 40.09 - 29.8 411. + 2. 15.6 22.2 -6.6 -0.03 + 0.55 415. + 4. 17.8 20.7 -2.9 -0.06 - 0.75 421. + 6. 16.4 14.7 +1.7 40.09 + 1.09 431. +10. 17.5 13.4 +4.0 40.14 + 0.58 436. + 6. 17.4 21.7 -4.3 -0.08 + 0.15 441. + 5. 18.2 21.2 -3.0 -0.07 + 0.34 446. + 4. 18.0 15.4 +2.5 +0.06 + 1.11 of 1955, Che physical limits of Che economy's productive capacity and the horizons of consumer demand were being more closely approached, leaving monetary demand to become more inflationary and frivolous. The large absolute value of the rate of change elasticity for the fourth quarter in 1955, pointed to the inflationary psychology that was gain ing momentum. Large tax surpluses were allowed during the first six months of 1956 to curb the boom. For a while the inflation psychosis wore off as a result of the govern ment's taxation, but by the end of 1956, a new round of injudicious spending began to snowball. Once again taxes were allowed to exceed expenditures over the first six months of 1957, and the third quarter seasonal deficit was somewhat below normal for that time of year. Partly due to fiscal measures, the boom was losing steam. The Federal Reserve Board's tight money policies also muffled the typical third-quarter optimism. Fiscal policy in this period received a strong vote of confidence from the interpretations and evaluations afforded by elasticity. Whenever the rate of change elas ticity indicated a changing relationship between the public and the private spending sectors, fiscal policy was correctly expanding or contracting the national income. In 1957, there was some increase in the Consumer Price Index which was not matched by rising quantities of goods and services. The Incremental GNP-to-CPI Ratio was +1.45, leading to the prima facie conclusion that the level of national income was still too high even after contraction ary monetary and fiscal measures. But the fact that Income reduction would have to have approximated 0.55/1.45 X 2 X 24 or 18.2 billion dollars meant that internal economic maladjustments had rendered inflation insensitive to feasible fiscal policy measures. The Sharp Recession of 1957-1958 Economic indicators pointed to a sick economy in the last quarter of 1957. It was suffering from both contrac tion and price maladjustments. Stock market prices were falling. The federal government cut back on its defense spending very abruptly. Much uncertainty existed as to whether the economy could continue to enjoy prosperity after three straight years of it had already passed. Prices were rising in industries with excess capacity and falling sales. Interest rates were at a 24-year high. Inventories were clearly excessive both in relation to 222 current and expected axles. New orders and the length of the work week were falling. Unemployment started to rise. Yet an Increase in the money supply of 0.6 per cent led to a 2 per cent rise in gross national product. The Federal / V Reserve Board was vigorously combatting inflation* as evidenced by the marked rise in demand deposit turnover (velocity) in the latter part of 1957.®^ Right now top FRB officials feel that* Inflation aside* capital spending has got too high, and Chairman Martin has hinted that the Fed may "overstay the boom"— i.e.* keep the money screws on even if a down turn begins in order to force a thorough business readjustment. The alternative* he seems to feel* would be a major depression. Fiscal policy had to cope with several problems which called for conflicting remedies. Whatever policies were undertaken were certain to be criticized from the out set. The monopolistic elements of wage-push inflation demanded overwhelming application of monetary policy to force an appropriate readjustment of prices and indebted ness. There seemed to be only a choice between accepting short-term recession or a depression in the long run. **3"New Test for the New Economy*" Fortune. 56:115-16* October* 1957. ^Ibid.. p. 116. Public debt was in an unsatisfactory condition with the Treasury caught between the goals of attempting to re finance in longer term securities to avoid the headaches of refinancing short-term paper and of endeavoring to finance the federal government's anti-recession measures via bor rowing. This dilemma caused competition between the oe government and private sectors for scarce funds. That the federal government did not come forth with a major tax cut during the recession was criticized by some. They pointed out the pessimistic air created by the retention of such high taxes during the slump. Also, they pointed to the businessmen1 s contempt and fear of expanding the government's power every time a dip in economic activity occurred. Thirdly, they lauded the favorable announcement effects and the speed with which tax cuts act to buoy up confidence. Others pointed out that tax cuts were too general to have much effect on the depressed areas in the economy. They feared that a great portion of the tax re duction would be saved or hoarded, placing that much 85M. Nedler, "Criticizes Monetary and Federal Debt Policies," Commercial and Financial Chronicle. 187:1405, March 27, 1958. 224 financial stress on our government's debt position with little anti-recession benefit forthcoming from it.**** The administration adopted a wait-and-see policy during the first half of 1958, and proclaimed in March that it would undertake a seven-point anti-recession program. This program was not vigorous, nor was it laissez-faire: New York Times (March 9, 1958), p. 1. The seven points included: (1) acceleration of public works pro jects for which funds had been appropriated; (2) an early start on certain reclamation projects; (3) stimu lation of construction of homes for people of modest means; (4) an amendment to the highway act suspending certain expenditure limitations for three years; (5) giving preference to labor-surplus areas, and especially small business, in awarding military pro curement contracts; (6) making funds more readily available to veterans for the purchase of homes; and (7) special grants for payments to unemployed persons who had exhausted their benefits under state employ ment compensation laws.**? Criticisms on the expenditure side centered around timing and inadequacy of the spending. R. L. Reierson objected to Eisenhower's fiscal measures on the grounds that they were perverse, worsening the economy's maladjust ments : Qf. R. B. Anderson, "Our Fiscal Situation and Its Impact on the Economy," Commercial and Financial Chronicle. 189:792, February 12, 1959. ^Kimmel, op. cit.. fn., pp. 253-54. 225 It Is sad but true that fiscal policy has not been used to any important extent to support credit policy during the recent business boom. On the contrary, especially in 1957, fiscal problems added to the dif- ficulties of the Federal Reserve. The Treasury, at the peak of the boom, was running only a nominal budget surplus, and large cash borrowings had to be undertaken to replenish its cash balance. President Eisenhower claimed that the economy was beginning to feel the effects of his acceleration in the placement of defense contract awards by the end of 1957. This was no doubt true, but true also are the facts that the economy continued to drop until May 1958, and that net federal spending was very meager until the third quarter of 1958. The 900 million dollar drop in defense spending in the fourth quarter of 1957 left the administration's policy rightfully open to the criticism of bad timing. Slichter went on to say that we were spending too little as well as acting too tardily. [President Eisenhower's proposed increase in federal spending in early 1958] . . . reflects the government's lack of familiarity with the problems of the country and its inadequate planning for dealing with the recession. . . . This situation is Illustrated by Mr. Eisenhower's reply on Feb. 26 to a question con cerning his stand on raising unemployment benefits as 88 R. L. Reierson, "Outlook for Federal Reserve and Treasury Policy," Journal of Finance. 13:321, May, 1958. 226 recommended in his Economic Message of 1954. He re plied that the matter had not been brought to his attention recently, and he suggested that the reporter ask Secretary Mitchell to discuss the matter with him so that he would not have to resmmber it. Thus, the President has to be reminded to think of the plight of more than four million unemployed.” In rebuttal to the President's announcement that defense contract awards would be stepped up from 7.9 bil lion dollars in the second half of 1957 to 13.4 billion dollars in the first half of 1958, Slichter declared that defense contract letting takes weeks to have any effect. More time is lost whenever subletting occurs. Thus, the total time between the awarding of the contracts and the financial impact upon the economy is about one-half year.9* * As a summary evaluation of fiscal policy during the 1957-8, the Eisenhower Administration was correct in treat ing it as a moderate inventory readjustment cycle. Panicky spending and sweeping tax cuts were wisely avoided. What public works were undertaken were short-term, appropriate for recessions of that magnitude and severity. But by gq 7S. H. Slichter, "Current Outlook for Business and Industrial Relations," Commercial and Financial Chronicle. 187:1041, March 6, 1958. 90Ibid 227 delaying the stronger measures of his fiscal policy until the middle of 1958, the President missed out on the favor able secondary buoying effects of a demonstrated firmness and consistency of fiscal leadership. The President's fiscal measures expanded investment spending at a time of excess productive capacity and reduced consumption spend ing, whereas the reverse treatment would have been appro priate, according to Leon H. Keyserling. Elasticity's Insights into the Anti-Recession Fiscal Measures of 1957-1958 Historical analysis has shown that much of the blame for the severity of the 1957-58 recession lay in the strangulation measures of the Board of Governors of the Federal Reserve System and in the wait-and-see policy of the federal government. Thus, the "obvious" statement that 4 this recession called for both a tax reduction and an ex penditure increase of significant proportions is not really accurate, because the seriousness of the recession was intertwined with public financial policies themselves. H. Keyserling, "Economy in 1958," New Republic. 138:13-14, January 13, 1958. 228 The federal government should have started with public financial policies themselves. The federal government should have begun Its public works spending by January 1958f when the recession was clearly in effect. Likewise, It should have announced a tax cut late in 1957 to avoid the contractionary effects of heavy tax collection In the first two quarters of 1958 and their secondary dampening influences upon consumption and investment motives. The % appropriate goal of fiscal policy was to maintain aggregate demand, leaving to monetary policy nearly the whole burden of forcing Improvement in the internal financial structure of the economy. The net federal expenditure product of national in come (see Table XI) lapsed into an increasing returns phase, as it always does whenever a major compositional change occurs in the income producing relationship of the private and the federal government spending sectors. Well timed fiscal policy will thrust the net federal expenditure product of national income into stage two before one-half year has passed. The Eisenhower Administration was at least three months too slow in launching its recovery meas ures, because the net federal expenditure product lay in TABLE XI FBBEY, RCE, AND STAGE NFEPY, 1957-1958 Year and Quarter Y Chg. Y G Exp. G.R. UnB. FBBEY RCE Stage NFEPY 1957-4 439. - 7. 18.1 13.9 +4.2 -0.09 -20.0 1 1958-1 426. -13. 17.3 20.6 -3.3 40.19 - 0.27 1 2 429. + 3. 18.6 19.2 -0.6 -0.04 - 2.15 1 3 439. +10. 19.4 15.0 +4.5 +0.13 + 1.43 2 4 457. +18. 20.5 13.9 +6.6 " ■ : . , i ■ i +0.23 + 1.71 2 229 230 increasing returns for three quarters. Finally when the public works spending started in the third quarter of 1958, the rate of change elasticity turned positive indicating that an efficient relationship between the private and pub lic sectors with respect to income production had been restored. The surplus budgets of the first and second quarters of 1958 were indeed sad blotches on the escutcheon of the Elsenhower regime. The rate of change elasticity for the first quarter was especially disparaging. Its low value shows that the slope of the net federal expenditure product curve was nearly flat. In view of the medium-sized tax surplus this probably means that a point very close to the stage of diminishing returns was experienced. The ugly conclusion follows, then, that the surplus budget of that quarter was nearly efficient in its destruction of gross national product. This is government fiscal policy in reverse gear! A small second quarter surplus indicated that the administration was still at rest on its fiscal- policy hands. Fortunately, the government acted decisively (even if tardily) to expand the economy in the last half of 1958. 231 A low Incremental GNP-to-CPI Ratio of +0.15 stresses the seriousness of the cost-price maladjustments which had developed out of prolonged prosperity. Rational calcula tions of materials and labor purchases by enterprise and consumer durables by consumers had been postponed too long. Almost all monetary demand increases were going into price rises. Fiscal policy thus was not logically suitable In simple aggregative terms to cope with this period. But selective fiscal policy measures plus a tight-money policy by the Federal Reserve Board would have provided the best approximation to stabilization that non-direct controls could offer. Suitable fiscal policy goals for the first and second quarters of 1958 are difficult to ascertain. It would have been reasonable to produce a nearly-balanced budget in the first quarter and a deficit of 4.5 billion dollars in the second. This would have been the some mag nitude of fiscal policy actually followed but advanced three months in time. Economists were certain of the existence of a recession by late autumn of 1957, and the administration could have started its preliminary relief spending at least three months earlier. 232 If the budget had been balanced in the first quarter of 1958 by an additional federal spending of 3.3 billion dollars, the gross national product probably would have been 16.3 billion dollars^ higher than its actual level. This would have seen income at 3.5 billion dollars (annual rate) higher than the fourth quarter of 1957. If the federal government then had incurred a 4.5 billion dollar deficit in the second quarter, prosperity would have re turned by July 1958.^ Expansion 1959-1960 Output and income reached new high levels by the first quarter of 1959. The economy sustained expanding prosperity throughout 1959 and up to May of 1960. Unem ployment, however, remained uncomfortably high throughout this period. The steel strike which began July 15 and con tinued another 116 days had a dampening effect on pros perity. The federal government incurred its largest 92[0.19 - (0.19) (-0.27)(0.191)1[(0.191)($426 b.)] equals 16.3 billion dollars. ^Unfortunately, the probable effects of this hypo thesized fiscal policy on gross national product curve cannot be checked. The federal budget balance elasticity is negative. 233 deficit since 1946 in 1958-9. In fiscal 1959* the total deficit was 12.4 billion dollars, but all but 1.4 billion dollars of this came in the last six months of 1958. This meant that the government was not caught in the position of stimulating a prosperous economy. For fiscal 1960, the administration proposed a balanced budget at 77 billion dollars with the objectives of forestalling inflationary pressures, keeping expansion down to a sustainable rate, and restrain rising pressures of demand in the capital and credit markets. Due to unexpected increases in expenditure programs not directly subject to administrative control, the con tinuing uncorrected deficit of the Post Office Department, and Congress's appropriations in excess of those requested by the President for particular federal programs, actual expenditures in the last six months of 1959 exceeded esti mated expenditures. The President still expected a budget surplus of 200 million dollars for fiscal 1960, because tax receipts for fiscal 1960 were expected to exceed the Janu ary 1959 estimates.^ ^Economic Report of the President (Washington, D.C.: United States Government Printing Office, 1960), pp. 41-42. 234 Elasticity as an Index to the 1959-1960 Period of Expansion The proper fiscal policy measures for 1959-60 were to ineur some additional debt in order to restore the economy to a level of prosperity. The cunctatious intro duction and execution of fiscal policy measures in the 1957-58 recession made these expansionary measures neces sary. Government expenditures had to remain at a high level to complete the public works projects started in the second half of 1958. General tax reduction was not de sirable, but special tax concessions favoring growth would have been particularly fitting at this time. The net federal expenditure product of national in come (see Table XII) was moderately active in this period. Government finance was alternatively in the increasing returns phase and in the stage of diminishing returns. This fluctuation between phases was in large measure attributable to the volatile net federal expenditure prod uct curve, but it also bespeaks a barely adequate level of federal finance. Perhaps both federal expenditures and federal taxes should have been increased to assure effi ciency in the control of gross national product. TABLE XII FBBEY, RCE, AND STAGE NFEPY, 1959-1960 Year and Quarter Y Chg. Y G Exp. G.R. UnB. FBBEY RCE Stag* NFEF 1959-1 470. +13. 19.6 19.5 +0.0 +0.17 - 0.16 1 2 485. +14. 21.2 19.8 +1.4 40.17 + 0.01 2 3 481. - 3. 19.1 17.3 +1.8 -0.04 - 9.23 1 4 486. + 5. 20.1 16.3 +3.8 40.06 +14.9 2 1960-1 501. +15. 18.7 21.7 -3.0 -0.20 + 0.15 2-3 2 506. + 5. 18.6 22.5 -3.9 -0.07 - 3.64 1 235 236 The most violent shifts of the net federal expendi ture product curve occurred in the last half of 1959. A shift from a point well in advance of the point of di minishing returns to a point markedly past the boundary of the second stage accompanied a modest 0.9 billion dollar increase in government spending and a 2.0 billion dollar increase in the deficit. The 116-day steel strike was probably the major cause of these phenomena as it coincided exactly with their occurrence. The private sector was rendered too small in relation to the public sector, making Stage Three a plausible approximation to the truth. The forced layoffs made government spending appear to be de structive of gross national product when in fact the "normal" functional relationship of the public and private sectors with respect to income production was temporarily rendered inoperative. The private sector was temporarily incapable of stimulation by the public sector as the private income-output functions were bounded by an ab normally low upper limit imposed by striking steel workers. Fiscal policy was praiseworthy for the most part in this period except for the final quarter. The administra tion was obsessed by the need for a tax surplus to retire 237 QC some of the federal debt and by the bogey of Inflation. It thus allowed government revenues to mount to a new post war high for one quarter. The economy was thus nudged into a recession by contractionary monetary and fiscal policies. Recession and Revival. 1960-1961 The 1938-1960 recovery terminated at an unsatis factory level, according to both Arthur F. Burns and the Heller-led Council of Economic Advisers, for three main reasons. The Federal Reserve Board too vigorously pursued the tightening of money and credit. There was confusion in both government and private enterprise circles as to the probable future state of economic affairs. And the steel strike slowed down the momentum of recovery. Both agreed that aggregate demand was insufficient to employ the economy at an acceptable percentage level of the effective labor force. Recovery had to exceed the peak reached in May 1960, because "reasonable full employment" had been reached only fleetingly since 1956. QS Since the Incremental GNP-to-CPI ratios for 1959 and 1960 both exceeded 2.00 (indicating less-than-normal inflation) and the Consumer Price Index itself advanced only 1.1 and 1.9 points respectively, the dangers of in flation in this period were visionary. President Kennedy took office at a time when the economy was still contracting. His economic "task force," headed by Paul A. Samuelson, spelled out the problems facing the new President as how to cope with the: (1) ex panding power of Russia; (2) outflow of gold; (3) need for achieving both automation and maintenance of employment; (4) competition from foreign producers without imposing tariffs; (5) need for increasing the purchasing power of the lowest quarter of income receivers; and (6) necessity of aiding the underdeveloped nations.Accordingly, President Kennedy accelerated defense procurement, federal highway and post office construction, payment of income tax refunds and veterans' insurance dividends, and awarded government contracts to small business in depressed areas whenever practicable.^ Other measures featured by the administration were aid to depressed areas, medical care for the aged, extended unemployment compensation, and aid to the dependent children of the unemployed.Much of ^"Economic Prospects," Commonweal, 73:426, Janu ary 20, 1961. ^"Closing the Confidence Gap," Time. 77:11, Febru ary 24, 1961. 98"Recession Is Over," Life. 50:34, April 14, 1961. President Kennedy's recovery program featured measures to expand consumption on the grounds that consumption spending was more deficient than investment spending. Furthermore, recovery could be induced more quickly by aiding consump tion, advised the Council of Economic Advisers.^ The recession bottomed out in the first quarter of 1961, with only an 8 per cent drop in production. The 1957-8 recession saw production fall 14 per cent.^^ The strategy of the administration to promote growth had been to increase government spending and incur a large deficit in 1961, then cut taxes by roughly three billion dollars and increase government spending another 724 million dol lars in fiscal 1962. Business growth was expected to yield enough increase in revenue to balance the budget. Esti mated revenue before the tax cut was 92 billion dollars; estimated federal spending in 1962 was 89 billion dollars. But the Berlin crisis upset these calculations. Government expenses were expected to rise an additional 3 to 5 bil lion dollars, and a tax increase, therefore, might have ^"An Answer to Arthur F. Bums," New Leader. 44:19-20, July 3/10, 1961. Recession I® Over,” p. 34. 240 to be legislated. Kennedy wanted to maintain and en courage investment, so he refused to consider any "punitive" tax measures, even though he had a revenue raising prob lem. 102 As the economy expanded in the third and fourth quarters of 1961, monetary and fiscal measures were being readied to control the impending boom. Excess reserves were held lower than they were after the 1957-8 recession, but the Federal Reserve Board was not controlling the money supply, because there still existed idle capacity, and the stock market was not soaking up an excessive amount of credit. The administration's fiscal measures were geared to the long-run rather than to temporary economic stimula tion. Urban renewal, resource development, pollution con trol, training and retraining of the unemployed, foreign aid, and space research were the main problems on hand.^^ Spending Spiral: It's Definite and Higher Because of Berlin," U.S. News. 51:60-61, July 31, 1961. 102"ls Kennedy Shifting Course?" U.S. News. 51:41, August 14, 1961. 103"Controlling the Next Boom," U.S. News. 51:63, August 28, 1961. 241 Judgments Based on Elasticity of Fiscal Policy after 1960 The proper objective of fiscal policy In 1960-61 was to revive the economy from a mild recession and promote long run growth. A tax cut applicable in the first quarter of 1961 but highly touted throughout the last half of 1960 would probably have revived the economy. Since the Presi dency was certain to change hands, the leading candidates, Kennedy and Nixon, would both have to have pledged support for such a tax cut. As it was, tax receipts were somewhat less than normal for the first quarter (not as a result of tax cuts) but devoid of the spending responses which could be expected to follow a tax-cut proclamation. Government spending for recovery and growth had to be undertaken with moderation in order to avoid frightening the private sector into hoarding. The Kennedy Administration had the addi tional problem of winning the confidence of the apprehen sive private sector. Economic studies showed that addi tional government spending was needed to aid consumption spending and that taxes had to be reduced selectively to induce spending for investment. Federal finance in this period was conducted on a large enough scale to control the level of gross national 242 product efficiently (see Table XIII). Only in the first quarter of 1961 did the federal government lose its grip, and this was attributable to a slight surplus balance. Net taxation of 0.1 billion dollars in the first quarter coupled with falling national income led to the realization of increasing returns. Since the first quarter is normally a period of large surplus balances, fiscal policy ends were at least approximately served. Prior to 1961, the fourth quarter rate of change elasticity hinted at a mild recession in that gross national product was fairly positively sensitive to govern ment stimulation. A serious downturn would probably have carried the net federal expenditure product of national income curve into the increasing returns phase. Prosperity was manifest in the second quarter with a boom in sight; therefore, fiscal measures in both the second and third quarters were seasonally contractionary. The fairly large positive second quarter rate of change elasticity (despite a surplus balance) and the very large third quarter rate suggested that the private economy was expanding rapidly. The Quarterly Incremental GNP-to-CPI Ratios (see Table XIV) show that inflation in 1961 was insignificant. TABLE XIII FBBEY, RCE, AND STAGE NFEPY, 1960-1961 / Year and Quarter Y Chg. Y G Exp. G.R. 1960-3 505.1 - 1.3 19.8 18.6 4 504.5 - 0.6 20.5 16.8 1961-1 500.8 - 3.7 19.8 19.9 2 516.1 +15.3 21.6 22.4 3 525.8 + 9.7 20.7 18.3 Stage UnB. FBBEY RCE NFEPY +2.2 -0.02 + 0.17 2-3 +3.7 -0.01 + 1.41 2-3 -0.1 40.04 - 1.58 1 -0.8 -0.18 + 2.06 2-3 +2.4 +0.16 +32.0 2 243 TABLE XIV DERIVATION OF THE QUARTERLY INCREMENTAL GNP-TO-CPI RATIOS SINCE 1961 Year and Chg. Per cent Consumer Quarterly X Chg. GNP Quarter Y Y Chg. Y Price Index CPI Chg. Chg. CPI 1961-1 500.8 - 3.7 -0.7 127.47 40.1 - 7.0 2 516.1 +15.3 +3.1 127.5 +0.03 +103.3 3 525.8 + 9.7 +1.9 128.1 40.6 + 3.2 244 245 Fiscal policy would have had little resistance on this front to Incurring large deficits had they been necessary. Only in the first quarter of 1961 was inflation somewhat of a problem, and that was ascribable to the mildness and brevity of the recession. Consumer prices were not forced down by the slight decline In aggregate demand; they rose by a trifling 0.1 "points." Estimation equations for the effects upon gross national product of changes in federal fiscal measures can be computed for all but the second quarter of 1961. The negative sign of the second quarter federal budget balance elasticity of national income makes that calculation impos sible by the techniques employed in this study for the same reason explained earlier. The following equations are derived in the usual manner: First Quarter 1961 - Antemarglnal Action: -0.0632x2 + 0.04x - (Desired) Change in GNP . 0 500.8 First Quarter 1961 - Postmarginal Action: +0.0632x2 + 0.04x - (Desired) Change in GNP = 0 500.8 Third Quarter 1961 - Antemarglnal Action: +5.12x2 + 0.16 - (Desired) Change in GNP = 0 525.8 246 Third Quarter 1961 - Postmarginal Action: -5.12x2 + 0.16 - (Desired) Change in GNP = Q 525.8 Since there existed no problem of inflation or de pression in 1961, fiscal policy had no target or desired change in gross national product as it frequently had in earlier periods. In order to obtain some inkling of the probable effects on gross national product of changes in fiscal operations, the above equations are solved for x equals 1 per cent. In the antemarglnal cases taxes or government spending are reduced 1 per cent while in the postinarginal cases taxes or government spending are in creased. If x equals 0.01, Dollar Amount of Change in GNP Change in GNP Year and Tax or Expendi- Antemarglnal Postmarginal Quarter ture Change Cases Cases 1961-1 0.792 b. 0.200 b. 0.200 b. 3 0.828 b. 1.110 b. 0.572 b. Government financial operations would appear to be very ineffective in the first quarter of 1961, but this is probably not true except for very small values of x. Of course, substitutions of larger values for x in the above equations would not bring about a higher ratio between government fiscal changes and changes in gross national product. Linear difference methods assume a constant slope which is a bad approximation of the net federal expenditure product of national income for any but infinitesimal values of x. Only a tax cut or an expenditure reduction would yield a larger dollar change in gross national product on the first dollars of fiscal manipulation in the third quarter. CHAPTER VI - t SUMfARY AMD CONCLUSIONS ON ELASTICITY AS A GUIDE TO GOVERNMENT FINANCE AND FISCAL POLICY The objective of this study was to explore the con tributions which constructs of elasticity could make to the analysis and appraisal of fiscal policy. This investiga- tion immediately led to a dichotomy between elasticity as a guide to the study of governmental financial history and elasticity as a guide to the analysis of fiscal policy. The distinction arose because the conscious manipulation of the financial powers of government to promote economic stabilization did not begin with the establishment of the Constitutional government of the United States. Of course, government finance prior to the 1930's did have an income- producing relationship with the private sector of the economy. This relationship was capable of examination and served as pastoral grounds for the refinement of the tools later applied to modern fiscal policy. By Itself the analysis of government finance with elasticity as a guide 248 249 proved to be an Interesting byproduct en route to the more specialized investigation of fiscal policy. As a single index of the turning points in the eco nomic cycle and the excellence of fiscal policy in counter ing the cycle, elasticity analysis provided many insights not afforded by other techniques. The analysis of applied fiscal policy in Chapter V pointed out that elasticity often could not serve as a quantitative guide to the Income effects of manipulations in federal financial operations. Uhder certain conditions, though, elasticity was able to produce a feasible dollar estimate of the effects on the gross national product which changes in the federal budget unbalance would render. Also, estimates of the change in the unbalance needed to produce some desired change in gross national product were obtainable. THEORETICAL IMPLICATIONS OF EIASTICITY Elasticity was established as a guide to the produc tion of national income. To take advantage of the powerful theoretical analysis of the law of Variable Proportions, the multiplier-accelerator interactions of dynamic income theory were capsuled in a monetary product whose size represented the annual measured-output of goods and serv ices In the American economy. This product was declared to have two productive agents, the private sector Including state and local governments, and the federal government sector. Each segment Is essential to the other, and either when fixed in size poses a constraint upon the amount of income which variable quantities of the other will yield in combination with it. In order to have an efficient com bination of the two with respect to the production of in come, the point of diminishing returns (of the federal expenditure product of national income) must have been passed. Given the private sector as the fixed factor of income production, the stage of increasing returns declares that the private sector is too large relatively to the federal government sector (the variable factor of income production). Either the private sector should be reduced in relative monetary size or the federal government sector increased to achieve efficiency. Efficiency income produc tion means that some specific amount of national income is being produced with the lowest total of the Inputs of the private and the federal government sectors. The decreasing returns stage states that too much variable factor has been 25X added to the fixed factor to produce income efficiently. In this case the private sector should be increased or the federal government sector decreased. Only the diminishing returns stage is free of the criticism of relative dis- proportionality. The utilization of the Law of Variable Proportions implies a federal expenditure product of national income. The establishment and study of the net federal expenditure product of national income are substituted for the separate analyses of the expenditure product and expenditure reduc tion curves of federal government spending and taxation, respectively. The tracing out of the federal expenditure product curve of federal spending and the expenditure re duction curve of federal taxation assumes more knowledge about the shapes of each than is empirically observable readily. Use of the net federal expenditure product of national income allowed the analysis of the unbalance of the federal budget which in turn incorporated portions of both the expenditure product and the expenditure reduction curves separately delineated by federal expenditures and federal taxation. The effects of the unbalance of the federal budget were objects which could be empirically 252 observed through the medium of elasticity. Two measures of elasticity were needed to analyze the Influence of the federal budget unbalance upon national income. The first, the federal budget balance elasticity of national income, showed the ratio of the percentage size of the change in income to the percentage size of the un balance. This measure failed to qualify as a measure of elasticity in the traditional sense on two counts. First, it was impossible to hold the size of the private spending sector constant while varying the federal government sector. This would have required the collection of the in come data over infinitesimally small time intervals. The closest approximation to this is three months! Further more, it would have required complete knowledge of the net federal expenditure product of national income. This knowledge cannot be perfectly estimated by any method, nor even roughly estimated by the current methods employed by the profession. A second measure of elasticity, the rate of change elasticity, was constructed, therefore, to approximate the responsiveness of the federal budget bal ance elasticity to percentage variations in the size of the unbalance. The rate of change elasticity, then, was the 253 ratio of the percentage size of the change in the federal budget balance elasticity of national income to the per centage size of the change in the federal budget unbalance. In combination the federal budget balance elasticity of national income and the rate of change elasticity were able to estimate important features of the actual net federal expenditure product of national income. If the sign of the rate of change elasticity were negative, a rising average-net-federal-expenditure-product-of-natlonal- income curve was assured. If the rate of change elasticity were negative, the average net federal expenditure product curve was downward sloping. A positive sign of the federal budget balance elasticity of national income suggested either stages one (increasing returns) or two (diminishing returns) of the net federal expenditure product of national income were in effect. A negative sign of the federal budget balance elasticity implied stage three (decreasing returns), "underwater national income" (wherein a negative sign of the federal budget balance elasticity would obtain for every antemarglnal dollar of net federal expenditure or taxation), or a multimodal net-federal-expenditure- product-of-national-income curve. By combining these 254 two sets of information, the stage of the net federal ex penditure product of national income was usually deter minable. Identification of the stage of the net federal expenditure product of national income permitted the construction of a formula to estimate the monetary impact on national income which certain specific manipulations in federal expenditure and federal taxation had. This formula involved the adjustment of the federal budget balance elasticity of national income by the addi tion or the subtraction of a quantity produced by multi plying the rate of change elasticity times the percentage change in the unbalance times the federal budget balance elasticity of national income. The addition or subtraction of this quantity was a function of whether the hypothesized fiscal changes were antemarglnal or postmarginal. The resultant measure of elasticity allowed the estimation of the net federal expenditure product of national income over a small distance. This estimation assumed that the average net federal expenditure product did not change slope dramatically over this interval. When the rate of change elasticity assumed low absolute values, the estimation of the postmarginal cases were not likely to be accurate. 255 Low absolute values of the rate of change elasticity are normally associated with points near the apogee of the average-net-federal-expenditure-product-of-national-income curve. A second complication arose when the values of the rate of change elasticity were non-negative and absolutely large enough to yield a complex number when subjected to the quadratic formula. A third limitation on this arith metical estimation of the net federal expenditure product curve was that only small percentage changes in the un balance could be safely estimated by the linear difference methods employed. A fourth complication was that negative federal budget balance elasticities could not be estimated unless a certain identification of stage three (decreasing returns) had been made. The identification of stage three was never made with confidence. The stage of the net federal expenditure product of national income proved helpful in identifying cyclical turning points. The appearance of increasing returns after a long period of diminishing returns suggested an important variation in the income-producing relationships of the private and the federal government sectors. This variation was due to some exhilaration or depression of the private 256 sector. Exhilaration of the private sector permits more government spending to occur before diminishing returns set in; depression of the private sector indicates the non-idle portion of the private sector requires more government spending to keep it productive. Increasing returns thus lent insight into the timing and extent of fiscal measures. If increasing returns lasted longer than three to six months, the possibility of laggard countercyclical fiscal action was suggested. If normally large changes in the unbalance without diminution of the level of federal fi nance, i.e., G/Y or R/Y (see Chapter III) failed to place the net federal expenditure product of national income into the diminishing returns phase, the Indication was that cyclical maladjustments were severe and perhaps gaining momentum. In the absence of other strong psychological forces, this phenomenon would imply that some aspect of federal fiscal policy Itself was to blame. If small changes in the federal budget unbalance produced diminish ing returns, fiscal policy was probably highly effective and/or the cyclical disturbance of the private- sector was mild. 257 HISTORICAL INSIGHTS OF ELASTICITY ON GOVERNMENT FINANCE AND FISCAL POLICY Be£ore the end of World War II the proportional size of federal government spending to the spending of the private sector vas too small to exert efficient control over national Income. Furthermore, the level of federal fiscal operations was frequently so low that an unbalance of 100 per cent would have been Insufficient to reverse the economic cycle. This presence of "underwater income" often explained why the federal budget balance elasticity of national Income had a negative value when the level of federal government spending was intuitively too low to have produced decreasing returns. The size of federal government spending as a per cent of national income increased secularly without ex periencing decreasing returns. This suggests that the private sector became increasingly able to cope with the income producing activities of the federal government sector. The contemporary period beginning in 1947 finds an efficient proportional relationship between the private and federal government sectors with respect to the pro duction of gross national product. This conclusion is 258 predicated upon the predominant occurrence of diminishing returns for the net federal expenditure product of national income based on annual data. World War II was accompanied by increasing returns most of the time hinting that given sufficient power and external exhilaration the federal government sector can lash the private sector Into pro ducing goods and services without enervation. The experi ence of Great Britain with a high degree of federal govern ment control and expenditure but without war time stimula tion does advance the warning that the federal government can get too large relatively to the private sector* The rate of change elasticities based on annual data were low from 1789 to 1889, high from 1890 through 1946, and moderately elastic from 1947 to 1961. This declares that the private sector became Increasingly mature and more responsive to federal government fiscal manipulations over time up to 1947. After 1947, the federal government sector passed into the mature state the private sector reached before the advent of the twentieth century. As this hap pened, the marginal responsiveness of the private sector to the federal government sector declined, but this was attributable in no small measure to the large peacetime 259 proportional increase in the federal government sector. The review of fiscal policy with elasticity as a guide shows that federal government deficit spending during the Great Depression was too small relatively to the private sector to increase the size of the gross national product efficiently. The uncertainty and fear generated by the New Deal policies during 1935-7 were manifest in below- normal rate of change elasticities. Extremely high rate of change elasticities for the next three years reflected the newly instituted spend-for-prosperity policies of the New Deal and the stimulation of war demand from abroad. Net federal spending during World War II was inef ficiently productive of national income. The gross national product grew very fast to be sure, but the federal government sector was too small relatively to the private sector to permit that income to be produced with a minimum of effort. This was fortunate considering that there was a severe problem of inflation and that the requirements of war prohibited a reduction of the private sector. Only if it were possible to sort out and discard the wasteful meas ures of private expenditure, would it have been wise to promote efficiency in income production. The declining 260 federal budget balance elasticity indicated that the net- federal-expenditure-product-of-national-income curve drifted leftward during the war. This attested to the in creasing hold which direct controls came to have on the inflationary forces of wartime demand. Quarterly data bn gross national product permitted the detailed study of fiscal policy Itself after 1947. In 1947, the Truman Administration did a good job of cur tailing inflation, but in 1948, it failed to control the inflationary forces efficiently, even though federal revenue receipts produced large surplus unbalances. The expenditure programs of the Administration were unusually consumption-oriented and carried with them strong multi plier and accelerator effects. Higher-minimum-wage legis lation intensified the already-strong inflationary pres sures . Expansionary fiscal policy was too timidly conducted to take charge of the 1948-49 recession. Recovery was mainly due to the optimism and resilience of the private sector. The administration was not aware of the existence of the recession until six months after the downturn and failed to act decisively, therefore, until the middle 261 of 1949. The high rate of change elasticity in the fourth quarter of 1949 signaled the upturn of the economy. The economy was becoming very highly sensitive to net federal spending, suggesting a recovery was launched. Fiscal policy was appropriately and adequately formulated in the 1950-53 period, although taxation was deficient in 1951 and federal government spending excessive in 1952. Further tax reductions in 1953-54 were perfectly tuned to reviving the depressed economy. The private sector was saturated with federal government spending at that time but ripe for stimulation by tax reduction. An unfortunate 6.4 billion dollar revenue surplus in the first quarter of 1954 prolonged the recession another six months. Four consecutive appearances of increasing returns using quarterly data showed that the Administration did not act decisively to end the recession. Fiscal policy in 1955-57 did a good job of promoting growth without very much inflation. Whenever the rate of change elasticity indicated a changing relationship between the private and the federal government sectors, fiscal policy was correctly expanding or contracting the national income. 262 The Eisenhower Administration was at least three months too slow in launching its public works spending to combat the 1957-58 recession. Likewise a heavily publi cized tax cut effective in the first quarter of 1958 might have averted much of the economy's descent. An increase of both federal government spending and federal taxation would have assured efficient federal con trol over the level of gross national product in 1959-60. The extension of federal expenditure and taxation would have carried the marginal net federal expenditure product past the first boundary of efficiency, the point of di minishing returns. The occasional appearance of Increasing returns indicated that the federal government periodically lost its efficient grip on income. Fiscal policy was fairly good during this period until the second quarter of 1960. At this time the Administration pursued a debt re tirement and anti-inflation program. This was not in keep ing with the downward trend of the economy and helped bring on a recession. The recession bottomed out in the first quarter of 1961. Fiscal policy was both adequate and appropriate in promoting recovery. A large rate of change elasticity for 263 the third quarter showed that the economy was expanding rapidly, and its positive sign indicated that federal fi nance clearly had efficient control of the level of the gross national product. ELASTICITY AS AN EX ANTE GUIDE TO FISCAL ECONOMICS AND FISCAL POLICY One of the first tasks which fiscal policy makers would have to undertake would be to derive polynomials of a higher degree than one to increase the accuracy of the measures of elasticity. As indicated at the outset of Chapter III, this was not feasible at this writing because of financial limitations. Given superior measures of elasticity economists advising the federal government could compute the federal budget balance and the rate of change elasticities for each quarterly period or more often if reliable gross national product statistics can be procured. Along with other cyclical indicators these measures of elasticity would be helpful in predicting the phase of the cycle and in esti mating the monetary impact which various alterations in the percentage size of the unbalance and/or in the absolute 264 amount of total federal spending or taxation would have on gross national product. Some means of devising what gross national product ought to be in a given period would have to be derived. The Incremental GNP-to-CPI Ratio developed in Chapter V would be better than no quantitative guide at all, but more sophisticated techniques would be desirable and at times necessary. Given a clearly defined gross- national-product target, the techniques of this study could be applied to indicate what monetary changes in government spending and taxation would be necessary to approach this target. The specific measures, if in combination yielded more-than-average secondary spending responses, would be cut short of the levels projected by elasticity; if these indi vidual measures were known to exert less-than-average secondary spending responses, the fiscal policy adjustments suggested by elasticity would be surpassed. BIBLIOGRAPHY BIBLIOGRAPHY A. BOOKS Abbott, Charles Cortez. The Federal Debt: Structure and Impact. New York: The Twentieth Century Fund, 1953. Gordon, Robert A. Business Fluctuations. New York: Harper and Brothers, 1952. Hall, Challis A., Jr. Fiscal Policy for Stable Growth. New York: Holt, Rinehart and Winston, 1960. Hansen, Alvin H. Fiscal Policy and Business Cycles. New York: W. W. Norton and Company, 1941. Hansen, Bent. The Economic Theory of Fiscal Policy. London: George Allen Press, 1958. Harriss, C. Lowell. Money and Banking. Boston: Allyn and Bacon, Inc., 1961. Holmans, A. E. United States Fiscal Policy 1945“1959. London: Oxford University Press, 1961. Jacoby, Neil H. Can Prosperity Be Sustained? New York: Henry Holt and Company, 1956. Kimmel, Lewis H. Federal Budget and Fiscal Policy 1789- 1958. Washington: The Brookings Institution, 1959. Lee, Maurice W. Economic Fluctuations: An Analysis of Business Cycles and Other Economic Fluctuations. Homewood: Richard D. Irwin, Inc., 1955. Martin, Robert F. National Income in the United States 1799-1938. New York: National Industrial Conference Board, Inc., 1939. 266 267 Maxwell, James A. Fiscal Policy: Its Techniques and Institutional Setting* New York: Henry Holt and Company, 1955. Musgrave, Richard A. The Theory of Public Finance. New York: McGraw-Hill Book Company, Inc., 1959. Shaw, Edward S. Money. Income, and Monetary Policy. Chicago: Richard D. Irwin, Inc., 1950. Studenskl, Paul, and Herman E. Krooss. Financial History of the United States. New York: McGraw-Hill Book Company, Inc., 1952. B. PUBLICATIONS OF THE GOVERNMENT, LEARNED SOCIETIES, AND OTHER ORGANIZATIONS Annual Report of the Secretary of the Treasury on the State of the Finances. Washington, D.C.: Government Printing Office, 1960. Economic Report of the President. Washington, D.C.: Government Printing Office, 1949. Economic Report of the President. Washington, D.C.: Government Printing Office, 1950. Economic Report of the President. Washington, D.C.: Government Printing Office, 1955. Economic Report of the President. Washington, D.C.: Government Printing Office, 1957. Economic Report of the President. Washington, D.C.: Government Printing Office, 1960. Midyear Economic Report of the President. Washington, D.C.: Government Printing Office, 1947. Midyear Economic Report of the President. Washington, D.C.: Government Printing Office, 1948. 268 National Industrial Conference Board. The Economic Almanac. New York: Thomas Y. Crowell Company, 1958. C. PERIODICALS "A Year of Roosevelt/' Newsweek. 3:5*8, March 3, 1934. "An Answer to Arthur F. Bums/' New Leader. 44:19*20, July 3/10, 1961. Anderson, R. B. "Our Fiscal Situation and Its Impact on the Economy," Commercial and Financial Chronicle. 189:792, February 12, 1959. Ballantine, A. A. "Employment and Federal Finance: Imagined Magic of Continued Deficits," Vital Speeches. 6:152, December 15, 1939. Board of Governors of the Federal Reserve System. Federal Reserve Bulletin. 47:845, July, 1961. Bums, A. F. "From Ike's Business Adviser: The Recession Is Ended," U.S. News, 37:46, October 29, 1954. _______. "Good Times Ahead, 400*Billion*Dollar Economy," U.S. News. 39:48-51, October 14, 1955. Clark, G. "Federal Finances and the New Deal," Atlantic Monthly. 154:754-62, December, 1934. "Closing the Confidence Gap," Time. 77:11, February 24, 1961. "Controlling the Next Boom," U.S. News, 51:63, August 28, 1961. Coyle, D. C., and J. G. Frederick. "Government Spending: Success or Failure?" Forum. 101:218*22, April, 1939. Douglas, P. H., and R. Bolling. "Action to Prevent Depression," New Republic. 130:10, March 22, 1954. 269 "Economic Outlook/' Nation, 165:60, July 19, 1947. "Economic Policies," Commonweal. 58:112*13, May 8, 1953. "Economic Prospects," Commonweal, 73:426, January 20, 1961. "Facing Facts In 1938," Commonweal, 27:309, January 14, 1938. Foster, W. T. "Economic Consequences of the New Deal," Atlantic Monthly. 152:748-55, December, 1933. Haavelmo, Trygve. "Multiplier Effects of a Balanced Budget," Econometrica, 13:311-18, October, 1945. Hauge, Gabriel. "Ike's Adviser on Business Sizes Up the Outlook," U.S. News, 42:122, March 22, 1957. Hazlitt, H. "Mr. Truman's Wrong Remedies," Newsweek, 37:72, January 22, 1951. _______. "Salvation Through Spending," Newsweek. 35:76, June 12, 1950. "Will Inflation Stop Inflation? President Truman's Eight-Point Anti-Inflation Program," Newsweek. 32:61, August 9, 1948. "Hold the Line Gets Results, But There Are Loopholes for Inflationary Forces," Business Week. April 17, 1943, pp. 13-14. Humphrey, G. M. "We Are Spending Too Much Money," U.S. News. 42:54-57, February 8, 1957. "Is Kennedy Shifting Course?" U.S. News. 51:41, August 14, 1961. "It's Deflation, So No New Taxes," Newsweek, 34:13-14, July 18, 1949. Kennedy, R. T. "Business Recovery and NRA," Commonweal. 23:49, November 8, 1935. 270 Keyserling, L. H. "Economy in 1958/' New Republic. 138:13-14, January 13, 1958. Lester, R. A. "Truman Economics, 1950 Model," New Republic. 122:11-13, January 23, 1950. Millis, W. "Cross Purposes in the New Deal," Virginia Quarterly Review. 3:359, July, 1938. Mbley, R. "Spending and Recovery," Newsweek. 11:40, April 25, 1938. Nadler, M. "Criticizes Monetary and Federal Debt Poli cies," Commercial and Financial Chronicle. 187:1405, March 27, 1958. "New Test for the New Economy," Fortune. 56:115-16, October, 1957. "Perils to Business in 1948: Start of a New Price Spiral," U.S. News. 24:11, January 23, 1948. "President's Program," Commonweal, 39:339, January 21, 1944. "Recession Is Over," Life, 50:34, April 14, 1961. Reierson, R. L. "Outlook for Federal Reserve and Treasury Policy," Journal of Finance. 13:321, May, 1958. "Republican Economic Policy: It Works," Fortune. 50:65, July, 1954. Robey, R. "For This, Thank Washington: Inflationary Move," Newsweek, 26:78, October 22, 1945. _____ . "President Roosevelt's Five-Point Program," Newsweek, 23:61, January 24, 1944. _______. "War on the Third Front: Anti-Inflation Program," Newsweek. 19:58, May 11, 1942. "Roosevelt's Expansion Program," New Republic. 94:345-46, April 27, 1938. 271 Slichter, S. H. "Business Looks Ahead," Atlantic Monthly. 164:592, November, 1939. _. "Current Outlook for Business and Industrial Relations,” Commercial and Financial Chronicle. 187:1041, March 6, 1958. _. "Great American Experiment," Atlantic Monthly. 164:471, April, 1939. Soule, G. "Present Industrial Depression," New Republic. 93:62-64, November 24, 1937. "Spending Spiral: It's Definite and Higher Because of Berlin," U.S. News. 51:60-61, July 31, 1961. "Sweeping Economic Controls Agreed on to Fight Inflation," Newsweek. 18:44, April 20, 1942. "Tax Policies As Weapons," Commonweal. 59:464, February 12, 1954. "Tighter Controls All Along Line: Managed Economy Now Virtually a Fact," Business Week. January 31, 1942, p. 13. "Timetable of the Business Boom," U.S. News. 31:11-13, December 14, 1951. Ward, P. W. "Ickes Surrenders to Bureaucracy," Nation. 140:679-81, June 12, 1935. Woodlock, T. F. "1934*s Challenge to the New Deal," American Magazine. 117:18-19, January, 1934. D. ESSAYS AND ARTICLES IN COLLECTIONS Birge, Raymond T., and John D. Shea. "A Rapid Method for Calculating the Least Squares Solution of a Polynomial of Any Degree," Uhlveraitv of California Publications in Mathematics. Berkeley: University of California Press, 1927. Pp. 67-118. 272 Cassels, John M. "On the Law of Variable Proportions/' American Economic Association Readings in the Theory of Income Distribution* Philadelphia: The Blackiston Company, 1951. Pp. 103*18. Colm, Gerhard. "Public Spending and Recovery in the United States," Essavs in Public Finance and Fiscal Policy. New York: Oxford University Press, 1955. Pp. 113-35. Feliner, William J. "Postscript on War Inflation: A Lesson from World War II," American Economic Association Readings in Fiscal Policy. Homewood: Richard D. Irwin, Inc., 1955. Pp. 137-54. Fetter, Frank Whitson. "The Economic Reports of the Presi dent and the Problems of Inflation," American Economic Association Readings in Fiscal Policy. Homewood: Richard D. Irwin, Inc., 1955. Pp. 170-78. Smithies, Arthur. "The American Economy in the Thirties," Readings in Business Cycles and National Income. Alvin H. Hansen and Richard V. Clemence, editors. New York: W. W. Norton and Company, Inc., 1953. Pp. 46-63. Working, E. J. "What Do Statistical 'Demand Curves' Show?" American Economic Association Readings in Price Theory. Homewood: Richard D. Irwin, Inc., 1952. Pp. 97-115. APPENDIX APPENDIX THE FEDERAL BUDGET BALANCE ELASTICITY OF NATIONAL INCOME, THE UNBALANCE OF THE FEDERAL BUDGET, THE RATE OF CHANGE ELASTICITY, AND THE STAGE OF THE NET FEDERAL EXPENDITURE PRODUCT OF NATIONAL INCOME (1) (2)1,3 (3) (4) 2 (5)2 (6) (7>2 (8) (9) (10) (ID (12) (13) Chg Chg Chg Stage Year-Q GNP GNP G Ex G.R. G/Y UnB. U/G U/G FBBEY FBBEY RCE NFEPY 1946-1 198 -- 12.2 13.3 25 -1.1 9 — — — — 2 206 + 6. 13.5 9.9 26 +3.6 27 +35.6 40.12 - - — — — 3 217 +11 9.3 9.5 17 -0.1 1 -27.7 -0.30 -0.42 + 2.15 2-3 4 221 + 4. 9.2 9.0 17 +0.1 1 + 2.2 +0.11 40.41 + 0.01 2 1947-1 226 + 5. 10.6 14.2 19 -3.3 31 -32.3 -0.14 -0.25 + 7.78 2-3 2 230 + 4. 13.4 11.3 23 +2.5 19 +49.9 40.08 40.22 + 0.92 2 3 236 + 6. 9.7 10.2 17 -0.2 2 -20.8 -0.15 -0.23 + 2.62 2-3 4 245 +10 7.9 9.8 13 -1.5 19 -16.9 -0.31 -0.16 + 0.43 2-3 1948-1 250 + 4. 8.1 14.2 13 -6.1 75 -56.3 -0.14 40.17 - 0.63 1UWY 2 258 + 8. 8.8 9.4 14 -0.6 7 +68.5 -0.24 -0.10 - 0.32 1UWY 3 264 + 6. 9.2 9.2 14 +0.0 0 + 6.8 +0.17 40.41 + 5.86 2 4 266 + 2. 10.2 8.7 15 +1.5 15 +14.7 40.05 -0.12 - 0.55 1 1949-1 260 - 6. 9.8 12.4 15 -2.6 27 -41.2 +0.15 40.10 - 0.14 1 2 256 - 3. 10.9 8.1 17 +2.9 27 +53.1 -0.08 -0.23 - 0.06 1UWY 3 259 + 2. 11.0 9.3 16 +1.8 16 -10.2 40.06 +0.14 -29.6 1 4 257 - 2. 10.0 8.4 16 +1.5 15 - 1.4 -0.04 -0.10 +112.0 2-3 1950-1 266 + 9. 9.1 10.2 14 -2.1 23 -38.1 -0.25 -0.21 + 0.15 2-3 2 274 + 9. 10.1 8.2 15 +1.9 19 +41.9 +0.22 +0.47 + 1.61 2 274 THE FEDERAL BUDGET BALANCE ELASTICITY OF NATIONAL INCOME, THE UNBALANCE OF THE FEDERAL BUDGET, THE RATE OF CHANGE ELASTICITY, AND THE STAGE OF THE NET FEDERAL EXPENDITURE PRODUCT OF NATIONAL INCOME (1) Year-Q (2)1.3 GNP (3) Chg GNP (*)2 G Ex (5)2 G.R. (6) G/Y (7)2 UhB. (8) U/G (9) Chg U/G (10) FBBEY (11) Chg FBBEY (12) RCE (13) Stage NFEPY 3 293 +19 9.1 9.4 12 -0.3 3 -22.1 -0.53 -0.75 + 0.17 2-3 4 304 +11 10.0 9.1 13 +0.9 9 +12.3 +0.28 +0.81 + 1.66 2 1951-1 318 +14 11.1 16.8 14 -5.7 51 -60.4 -0.31 -0.59 +13.5 2-3 2 326 + 9. 14.5 12.9 18 +1.6 11 -62.4 +0.15 +0.46 + 1.86 2 3 334 + 7. 15.0 12.4 18 +2.6 17 + 6.3 +0.13 -0.02 - 0.32 1 4 333 - 1. 16.3 11.4 20 +4.9 30 +12.8 -0.01 -0.14 - 4.32 1UWY 1952-1 341 + 7. 16.3 20.4 19 -4.1 25 -55.3 -0.12 -0.11 + 0.08 2-3 2 341 + .3 18.6 17.9 22 40.7 4 +29.0 +0.004 +0.116 + 1.01 2 3 347 + 6. 17.8 14.0 21 +3.9 22 +18.1 +0.08 +0.076 + 1.29 2 4 359 +12 18.7 13.3 21 +5.4 29 + 7.0 +0.16 +0.08 + 2.42 2 1953-1 365 + 6. 17.5 21.0 19 -3.5 20 -48.9 -0.09 -0.25 + 0.65 2-3 2 369 + 4. 20.6 17.0 22 +3.6 18 +37.5 +0.05 +0.14 + 0.23 2 3 367 - 2. 18.2 13.9 20 +4.3 24 + 6.1 -0.02 -0.07 -15.7 1UWY 4 361 - 6. 17.3 12.5 19 +4.8 28 + 4.2 -0.09 -0.07 - 7.80 1UWY 1954-1 360 - 1. 15.5 21.9 17 -6.4 41 -69.1 +0.02 +0.107 - 0.03 1 2 359 - 1. 17.8 17.0 20 +0.8 5 +45.8 -0.12 -0.033 -26.5 1UWY 3 362 + 3. 16.6 11.7 18 +4.9 30 +25.0 +0.05 +0.066 + 2.64 2 4 371 + 9. 15.0 10.6 16 +4.4 29 - 0.2 +0.15 +0.10 -147.0 1 1955-1 384 +14 15.7 19.8 16 -4.2 27 -56.1 -0.22 -0.37 + 0.24 2-3 2 393 + 9. 17.3 18.2 18 +0.9 5 +32.0 +0.13 +0.35 + 2.62 2 275 THE FEDERAL BUDGET BALANCE ELASTICITY OF NATIONAL INCOME, THE UNBALANCE OF THE FEDERAL BUDGET, THE RATE OF CHANGE ELASTICITY, AND THE STAGE OF THE NET FEDERAL EXPENDITURE PRODUCT OF NATIONAL INCOME (1) Year-Q (2)1’3 GNP (3) Chg GNP (4)2 G Ex (5)2 G.R. (6) G/Y (7)2 UnB. (8) U/G (9) Chg U/G (10) FBBEY (11) Chg FBBEY (12) RCE (13) Stage NFEPY 3 403 +10 17.0 13.0 17 +4.0 24 +18.4 40.15 40.02 + 0.11 2 4 409 + 6. 16.2 12.2 16 +3.9 24 + 0.4 40.09 -0.06 -29.8 1 1956-1 411 + 2. 15.6 22.2 15 -6.6 42 -66.3 -0.03 -0.12 + 0.55 2-3 2 415 + 4. 17.8 20.7 17 -2.9 16 +26.0 -0.06 -0.03 - 0.75 1UWY 3 421 + 6. 16.4 14.7 16 +1.7 10 +26.7 40.09 +0.15 + 1.09 2 4 431 +10 17.5 13.4 16 +4.0 23 +12.4 40.14 40.05 + 0.58 2 1957-1 436 + 6. 17.4 21.7 16 -4.3 25 -47.5 -0.08 -0.22 + 0.15 2-3 2 441 + 5. 18.2 21.2 17 -3.0 17 + 8.2 -0.07 40.01 + 0.34 2-3 3 446 + 4. 18.0 15.4 16 +2.5 14 +30.4 40.06 +0.13 + 1.11 2 4 439 - 7. 18.1 13.9 17 +4.2 23 + 9.3 -0.09 -0.15 -20.0 1UWY 1958-1 426 -13 17.3 20.6 16 -3.3 19 -42.3 40.19 40.28 - 0.27 1 2 429 + 3. 18.6 19.2 17 -0.6 3 +15.9 -0.04 -0.23 - 2.15 1UWY 3 439 +10 19.4 15.0 18 +4.5 23 +26.4 40.13 40.17 + 1.43 2 4 457 +18 20.5 13.9 17 46.6 32 + 9.0 40.23 40.10 + 1.71 2 1959-1 470 +13 19.6 19.5 17 40.0 0 -30.0 40.17 +0.06 - 0.16 1 2 485 +14 21.2 19.8 18 +1.4 7 + 6.4 40.17 40.002 + 0.01 2 3 481 - 3. 19.1 17.3 16 +1.8 9 + 2.8 -0.04 -0.21 - 9.23 1UWY 4 486 + 5. 20.1 16.3 17 +3.8 19 + 9.5 +0.06 40.10 +14.9 2 1960-1 501 +15 18.7 21.7 15 -3.0 16 -35.0 -0.20 -0.26 + 0.15 2-3 2 506 + 5. 18.6 22.5 15 -3.9 21 - 4.9 -0.07 40.13 - 3.64 1UWY 276 THE FEDERAL BUDGET BALANCE ELASTICITY OF NATIONAL INCOME, THE UNBALANCE OF THE FEDERAL BUDGET, THE RATE OF CHANGE ELASTICITY, AND THE STAGE OF THE NET FEDERAL EXPENDITURE PRODUCT OF NATIONAL INCOME (1) (2)1'3 (3) (4)2 (5)2 (6) (7)2 (8) (9) (10) (11) (12) (13) Chg Chg Chg Stage Year-Q GNP GNP G Ex G.R. G/Y UnB. U/G U/G FBBEY FBBEY RCE NFEPY 3 505 - I. 19.8 18.6 16 +2.2 11 +32.1 -0.02 40.05 + 0.17 2-3 4 505 - 1. 20.5 16.8 16 +3.7 18 + 6.9 -0.01 +0.01 + 1.41 2-3 1961-1 501 - 4. 19.8 19.9 16 -0.1 1 -18.5 40.04 40.05 - 1.58 1 2 516 +15 21.6 22.4 17 -0.8 4 - 3.2 -0.18 -0.22 + 2.06 2-3 3 526 +10 20.7 18.3 16 +2.4 12 + 4.2 40.16 40.34 +32.0 2 4 G Ex = Budget Expenditures G.R. = Net Budget Receipts UnB. = Net Budget Surplus or Deficit *~U. S. Income and Output, A Supplement to the Survey of Current Business (Washington: U.S. Government Printing Office, 1958), pp. 120-21, 166-67. 2 Treasury Bulletin (Washington: U.S. Government Printing Office, 1946-1961), in passim. ^U. S. Department of Comnerce, Survey of Current Business (Washington: U.S. Government Printing Office, 1958-1961), in passim. 277

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Creator Macbeth, Thomas George (author)

Core Title An Examination Of Elasticity As An Econometric Guide To Fiscal Policy

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Advisor [illegible] (committee chair), McDonagh, Edward C. (committee member), Phillips, E. Bryant (committee member)

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