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HISTORICAL BACKGROUND OF MACROECONOMIC POLICIES IN THE UNITED STATES
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Chapters 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26

Chapter 1
General Economic Concepts
Chapter 2
What is Policy?
Chapter 3
History of Macroeconomic Policies in the United States
Chapter 4
Policy Goals: Maximum Employment
Chapter 5
Policy Goals: Maximum Production
Chapter 6
Policy Goals: Price Stability
Chapter 7
Policy Goals: External Balance
Chapter 8
Subsidiary Policy Goals
Chapter 9
Conflicting Policy Goals
Chapter 10
The Policy Makers
Chapter 11
The Policy Instruments
Chapter 12
The Decision-Making Processes
Chapter 13
The Policy Indicators
Chapter 14
The General Economic Model
Chapter 15
Monetarist Monetary and Fiscal Policies
Chapter 16
Keynesian Monetary and Fiscal Policies
Chapter 17
Debt Management Policies
Chapter 18
Incomes Policies
Chapter 19
Supply Management Policies
Chapter 20
The Long Wave
Chapter 21
Contemporary Issues
"History is too serious to be left to historians."

Iain Macleod
British Politician
The Observer (July 16, 1961)

"He who fails to understand history is doomed to repeat it."

George Santana
Spanish Philosopher, Essayist, Poet, and Novelist
The Life of Reason (1905-1906)

  1. Introduction
  2. Constitutional Provisions
  3. Theoretical Limitations: 19th Century Liberal Classicism
  4. Capitalist Crises
  5. Early Monetary Policies
  6. Early Fiscal Policies
  7. Macroeconomic Goals
  8. Post-WW II Fiscal Policies
  9. Post-WW II Monetary Policies
  10. Debt Management Policies
  11. Incomes Policies
  12. Supply Management Policies
  13. Supply-Side Economic Policies
  14. Recent Monetary Policies
  15. Recent Fiscal Policies
  16. Summary
    Readings
    Websites
top    I. Introduction
"Every individual is continually exerting himself to find out the most advantageous employment for whatever capital he can command. It is his own advantage, indeed, and not that of the society which he has in view. But the study of his own advantage naturally, or rather necessarily, leads him to prefer that employment which is most advantageous to society. He intends only his own gain, and he is in this, and in many other cases, led by an invisible hand to promote an end which was not part of his intention."

Adam Smith
British Moral Philosopher and Economist
An Inquiry into the Nature & Causes of the Wealth of Nations (1776)

Historically, the American philosophy toward economic affairs was laissez-faire — hands off! Government keep out! Although this characterization is not true absolutely, it is true relative to the kind of intervention witnessed in other countries and in the United States since World War I.

From its beginnings, the U.S. economy was organized on the basis of maximum opportunity for private competitive enterprise and the widest possible latitude for personal choice in making a living and spending one's income. Any narrowing of the horizons for individual initiative is alien to the nature of the American enterprise system. For example, whenever controls and unusual restrictions on personal action have had to be introduced in an emergency, their abandonment at the end of the temporary period of crisis has been awaited impatiently. Likewise, except for unusual wartime expenditures, the government was expected to follow the principle of fiscal prudence: Spend only what you earn (in tax collections), borrow only when necessary, and repay as quickly as possible.

This laissez faire philosophy started with the publication of Adam Smith's An Inquiry into the Nature and Causes of the Wealth of Nations in 1776, the same year that the U.S. declared its independence from Britain and the monarchical tyranny of King George. Smith advocated a minimal role for government in an economy that was considered to be self-regulated by an "invisible hand." Smith's book explained how individuals acting in their own best interests would act in the best interests of everyone. This laissez faire philosophy dominated American thinking for over 150 years, starting with the Declaration of Independence, and limited the organizers' ability to create a viable new government for the colonies.

In keeping with the laissez faire philosophy, the organizers adopted a federal form of organization. In a federation, the States are the sovereign political units. They have all of the power. The federal government has none. The federal government's powers must be specified in a written contract between the States and the federal government. The contract may give the federal government a lot of power or it may give only minimal power. In either case, if the contract does not say that the federal government can do it, it cannot.

The first contract was the Articles of Confederation of 1777. The Articles, as originally proposed, called for a strong central government. However, by the time the Articles were ratified by all of the States in 1781, the federal government's powers were substantially eroded. The new country soon collapsed because the Articles did not give enough powers to the federal government and the framers of the Articles had to consider redrafting the contract with a different balance of powers. The new contract, the U.S. Constitution of 1787, gave more powers to the federal government. The phrase "a more perfect union" in the Preamble refers to the imperfections in the union under the Articles.

At the same time, British and French philosophers were developing a set of economic theories to legitimize Adam Smith's laissez faire policy. Three theories which became the cornerstone for U.S. economic policies were Say's Law, the Quantity Theory of Money, and David Hume's Price-Specie Flow Mechanism. Say's Law showed how an economy, operating under competitive conditions, would always tend to operate at full employment without the government's intervention. The Quantity Theory of Money explained how inflations and deflations could be prevented by having just the right amount of money in the economic system. Hume's Price-Specie Flow Mechanism showed how trade patterns affected the amount of money flowing into and out of a country and its rate of inflation or deflation. Thus, the only role for government was to "regulate the value of" money by taking money out of circulation during an inflation and putting money back into circulation during a deflation.

In this tradition, the nation approached cautiously the problem of federal intervention respecting employment, the maintenance of economic activity in general, and other social programs of the 20th century. The Presidential Campaign of 1932 was not about deficit spending. It was about fiscal prudence and budget balance. Only after Franklin Delano Roosevelt was elected did he actively propose to unbalance the budget by spending on a myriad of social programs that had been planks in the Socialist Party Platform of 1932. The idea was not well accepted. Many of Roosevelt's spending programs were challenged in the Supreme Court as unconstitutional. Not until 1936, when John Maynard Keynes published The General Theory of Employment, Interest and Money did Roosevelt's idea of public spending for social welfare and employment gain credibility and legitimacy. Since the 1930s, the locus of power has shifted from the States to the federal government. Today, the federal government takes a very active role in macroeconomic affairs.

The purpose of this chapter is to trace the evolution of macroeconomic policies in the United States from their laissez faire foundations to their contemporary status. Today, government intervention is accepted by most people, although its merits are continually debated by the Keynesians and Monetarists.

top    II. Constitutional Provisions
"The sacred rights of mankind are not to be rummaged for, among old parchments, or musty records. They are written, as with a sun beam in the whole volume of human nature, by the hand of the divinity itself; and can never be erased or obscured by mortal power."

Alexander Hamilton
Soldier, Economist, Political Philosopher, Lawyer, Pamphleteer, Founding Father, and US Treasury Secretary
The Farmer Refuted (1775)

Prior to the adoption of the present Constitution, the Continental Congress was without taxing powers. The Revolutionary War had been financed by the taxes of the colonies and by borrowing. After the war, the debt had to be serviced and financial resources were needed to conduct the business of the future central government. Thus, the Constitutional Convention of 1787 was left to deal with the aftermath of the war, its debts, and the new governmental arrangements.

A major goal of the Constitutional Convention was to design a political system that was inherently strong, but which avoided an excessively centralized government with impersonal taxing powers beyond the reach of its citizens. The colonies had just emerged from a war in which its citizens had fought against oppressive "taxation without representation" and the framers of the new government were loathe to make the same mistakes.

The Convention drew up plans for a federation and called it the United States. A federation is a group of smaller political jurisdictions called "states' which are bound together as one union with a central government. In a federation, the States are the sovereign political units and the federal government must have its powers specified in a constitution. Much of what was laid out in the original Constitution delegated basic taxing powers and the provision for the "common defense and general welfare" to the central government. The taxing powers of the States were not specified as this power is vested in their sovereign rights as constituent members of the federation and retained by them under the "residual powers doctrine" of the 10th Amendment.

Federal Powers

In a federation, the presumption is that all powers of the federal government must be expressly stated in the Constitution. Any power not expressly delegated to the federal government is reserved to the States.

General Enabling Statute (Article 1, Section 8) The general enabling statute lays the groundwork for the fiscal, debt management, and monetary policy powers of the federal government.

Fiscal Policy Powers

Fiscal policy powers are budgetary powers. They authorize the government to lay and collect taxes, spend the taxes, finance expenditures, and manage its debt.

Taxing Powers (Article 1, Section 8[1]) The Congress shall have Power
"To lay and collect Taxes, Duties, Imposts, and Excises, to pay the Debts and provide for the common Defense and general Welfare of the United States."
Duties, imposts, and excises are indirect taxes. An indirect tax is one that is levied on someone or something, but can be passed along to someone else who bears the burden of the tax. The opposite of an indirect tax is a direct tax. A direct tax is one where the person or thing on whom it is levied must bear the burden of the tax.

Initially, the clause was interpreted to mean that the federal government had the power to levy only indirect taxes to pay for the common defense and general welfare of the U.S. See Hylton v. The United States, 3 U.S. 171 (1796). As a result, for almost 125 years, the federal government relied solely on import duties, land sales, and interest on loans to the railroads to finance its expenditures.

In 1872, the federal government levied an income tax on wages to help pay off the Civil War debt. The tax was challenged as an unconstitutional direct tax (which must be apportioned according to the census or population in each State), but the Supreme Court upheld the tax as an indirect tax, because workers can pass part or all of the burden for paying the wage tax to their employers by asking for higher wages. In 1894, Congress enacted a broader-based income tax which included taxation of interest, rents, and dividend income (as well as wages). In Pollock v. Farmers' Loan and Trust Co., 157 U.S. 429 (1895) and Pollock v. Farmers' Loan and Trust Co. (Rehearing), 158 U.S. 601 (1895), the Supreme Court held that the part of the tax "which relates to the tax on the rents, profits or income from real estate" is unconstitutional. This part of the tax is a direct tax, which is subject to the apportionment limitation in Article 1, Section 9[4]. Finally, to avoid the whole issue of direct and indirect taxes, in 1913, three-quarters of the States ratified the 16th Amendment which now allows the federal government to levy a tax on income from all sources.

Spending Powers (Article 1, Section 8[1, 12, 13, 16]) The Congress shall have Power
"To provide for the common Defense and general Welfare of the United States."

"To raise and support Armies, but no Appropriation of Money to that Use shall be for a longer Term than two Years."

"To provide and maintain a Navy."

"To provide for organizing, arming, and disciplining the Militia."
Initially, the clause was interpreted to mean that taxes were to pay only for a system of national defense, the principal responsibility of the federal government. Spending on "general welfare" was of little consequence, because, throughout the 19th century, the federal government spent only on wars and administration of the government. However, in 1933, at the request of the newly elected President, Franklin Delano Roosevelt, the Congress began appropriating monies for social welfare programs. Congress appropriated monies for everything from farm subsidies to unemployment insurance. Some of this legislation was struck down by the Supreme Court as unconstitutional, but most of it was upheld after Roosevelt threatened to "pack the court" with younger, more innovative justices who would uphold the new socially-oriented legislation.

Debt Powers (Article 1, Section 8[2]) The Congress shall have Power
"To borrow money on the Credit of the United States."
No one borrows for the privilege of paying interest. One borrows only when one has a need to spend money that one does not have. The power to borrow implies the power to run a deficit — to spend more than one's income. When the federal government fails to raise enough income from taxes, it finances its expenditures by selling Treasury securities. Prior to the 1930s, the federal government primarily incurred deficits to finance wars — the War of 1812, the Civil War, the Spanish-American War, and the Great War (renamed World War I, after World War II). The Treasury sold only bonds to finance these deficits and the bonds were redeemed and retired as quickly as possible after a war had ended.

Throughout the 19th century, the federal government had very little debt to manage. However, Since World War I, the public debt has mushroomed by 520%. The debt was $25 billion after World War I, $250 billion after World War II, pushing $1.0 trillion for the 1980 Presidential election (Reagan railed against Carter for running up the public debt and won the election), almost $3.0 trillion when Reagan left office in 1988, $4.0 trillion when Clinton entered office in 1992 and $5.6 trillion when Clinton passed the reins to George W. Bush in 2000, $10.0 trillion when Bush left office in 2008, and $13.0 trillion as of June 2010.

Throughout the 19th and early 20th centuries, the federal government issued T-bonds. In 1929, the Treasury introduced the T-bill as a cash management tool. The T-bill provided short-term financing until tax payments were made to cover federal expenditures. Today, the Treasury sells a variety of different debt instruments to finance its expenditures, including bills, notes, bonds, inflation-indexed bonds, and special series bonds. Each has a different maturity and different interest rate characteristics. When the Treasury needs to borrow, it must decide which of these different debt instruments to use. When old debt matures, the Treasury must decide which of these different debt instruments to refinance the old debt. The supply of bills, notes, and bonds affects the Treasury's cost of financing and the term structure of interest rates. The process of financing current deficits and rolling over the public debt with the different debt instruments is called debt management.

Monetary Policy Powers

Monetary policy powers deal with money, its issuance, and the regulation of its value.

Coinage Powers (Article 1, Section 8[5, 6]) The Congress shall have Power
"To coin Money."
The power to coin money is as its power implies: the power to mint coin, not to issue paper currency. (In 1868, in Bronson v. Rodes, 74 U.S. 229 (1869), the Supreme Court unanimously affirmed that power, holding that nothing other than coined money had been recognized by the legislation of the national government as lawful money.) The power to coin money was of nominal significance in the early years. Although the federal government, through its Treasury Department, minted full-bodied and token coins, the bulk of all monies were created by state-chartered banks in the form of paper notes. Each bank issued its own notes, which circulated as the domestic money supply. These notes sold at a discount from their face value and the discount varied depending on the creditworthiness and reputation of the issuing bank. Many notes were issued by "wildcat" banks which had inadequate specie and no intention of redeeming the notes. In 1864, the federal government authorized, for the first time, the issuance of a uniform paper note (the "greenback") through its system of nationally chartered banks. Issuance by the banks avoided the constitutional prohibition on printing paper money by the Treasury. In 1913, Congress established the quasi-public, but independent entity known as the Federal Reserve System to issue paper money.

Powers to Regulate the Money Supply and Prices (Article 1, Section 8[5, 6]) The Congress shall have Power
"To regulate the Value of coined Money."

"To provide for the punishment of counterfeiting current coin of the United States."
The value of money depends upon the general level of prices, and, in that context, the Constitution gives the federal government the right to impose price controls in conjunction with control of the money supply. Nowhere, however, in the enabling statutes or elsewhere in the Constitution, does the federal government or its representative agencies have the power to control interest rates, a major contemporary policy tool of the Federal Reserve.

The value of money also depends upon the ability to control its supply. Counterfeiting is one means to increase supply. The ability to punish counterfeiters of current coin allows the federal government to control the money supply. It also gives the government authority over the design of the country's coin to prevent counterfeiting in the first place.

Powers to Regulate Foreign Exchange Values (Article 1, Section 8[5]) The Congress shall have Power
"To regulate the Value of foreign Coin."
Throughout most of civilized history, gold and silver have been considered universal monetary media. Countries have always accepted gold and silver in international exchanges. As paper money overtook gold and silver coins as monetary media, countries "backed" their paper money with gold and silver. Each country agreed to redeem its notes for a specified amount of gold and/or silver. By tying their individual currencies to either gold or silver, each country inadvertently tied its currency to every other currency of the world. Thus, each currency was "fixed" in terms of each other currency by the value of its gold or silver content. A country changed the international value of its currency by increasing and decreasing the metallic content of its notes. An increase in metallic content was an appreciation of the currency and a decrease in metallic content was a depreciation of the currency. Countries experiencing an inflow of gold and silver would appreciate their currencies and countries experiencing an outflow of gold and silver would depreciate their currencies.

More often than not, countries tended to depreciate, but not appreciate, their currencies. This phenomenon occurred because gold and silver were considered universal monetary media, and, during periods of crisis, people tended to hoard these precious metals. Thus, during these crises, when there was not enough gold and/or silver to support all of the paper notes which had been issued, countries would depreciate their currencies to bring their international values into line with the countries' abilities to redeem the notes. In periods of extreme crisis, countries would suspend redemption altogether. The British government suspended convertibility during the Napoleonic wars and the U.S. government during the U.S. Civil War. Britain abandoned the silver standard in 1931 to save employment and the U.S., under President Richard M. Nixon, abandoned the gold standard in 1971 to thwart French President Charles DeGaulle's perverse mercantilist philosophy.

Today, no major industrialized country's currency is backed by a precious metal. Each currency floats against every other currency according to the forces of supply and demand. The central banks of the world have periodically stepped in to buy and sell certain currencies to force a particular set of exchange rates. However, the central banks cannot support a particular exchange rate regime indefinitely, if market forces dictate otherwise.

Additional Powers

Interstate Commerce Clause (Article 1, Section 8[3]) The Congress shall have the power
"To regulate Commerce with foreign Nations, and among the several States, and with the Indian Tribes."
The philosophy behind the Commerce Clause is that the United States is one economic unit; the States are not separate economic units. Although the Commerce Clause is included as a power of the federal government, it is often interpreted as a limitation on the States' powers. Prior to Declaration of Independence, no commerce issues existed, because all trade was controlled by Britain. After the Declaration of Independence, the Continental Congress had no power to control commerce. This led to economic chaos. The country fared no better under the Articles of Confederation of 1787, which were loosely drawn so as to give much power to the States. As a result, individual States set up trade barriers and sanctions on competing goods produced in other States and on goods passing through the several States, especially through New York City ports. Trade wars intensified as each State erected trade barriers rose in retaliation. Also, the southern States, in particular, thought Congress might limit slave importation and give preferential treatment to northern States and their ports. Had the clause not been inserted, the thirteen colonies would probably have devolved into thirteen separate countries.

Necessary and Proper Clause (Article 1, Section 8[18]) The Congress shall have Power
"To make all Laws which shall be necessary and proper for carrying into Execution the foregoing Powers."
Necessary means convenient; in furtherance of. But what exactly is "convenient" or "in furtherance of" has been left to the United States Supreme Court to decide. An early test case involved the issue of whether or not the federal government had the power to charter a bank. Although the Constitution gave Congress the power to mint coin and borrow in the name of the government, it was silent on the matter chartering banks. The issue was finally resolved in 1819, in M'Culloch v. State, 17 U.S. 316 (1819), where the U.S. Supreme Court ruled in favor of the federal government under the necessary and proper clause. See The Necessary and Proper Clause: National Bank Charters.

Supremacy Clause (Article 6, Section 2)
"This Constitution and the Laws of the United States which shall be made in Pursuance thereof; and all treaties made, or which shall be made, under the Authority of the United States, shall be the supreme Law of the Land."
This clause has been interpreted to mean that, in the event of a conflict with state laws, the constitution and federal laws supersede any laws of the States. States cannot pass laws in contravention of either the Constitution or a federal law and certain federal laws have been passed with the specific intent of Congress to preempt any state control.

Limitations on Federal Powers

Explicit Limitations

These limitations are explicitly stated in the Constitution.

Uniformity Clause (Article 1, Section 8[1])
"All Duties, imposts, and Excises shall be uniform throughout the United States."
Any federal tax regarded by the courts as an indirect tax must be levied at a geographically uniform rate. The rate must be the same in all States regardless of the total revenue collected from the individual State. A good example is the cigarette excise tax. It is levied uniformly on all tobacco producers; however, because of the heavy concentration of tobacco producers in North Carolina, the latter is one of the few States to remit these tax collections to the federal government. If, however, all cigarette manufacturers were to move to Texas, then they would still pay the same excise tax rate and Texas would remit the tax receipts to the federal government rather than North Carolina.

The uniformity rule has imposed no significant limitations on the development of the federal tax structure on a nationwide basis. To the contrary, it has contributed to the development of an equal system by requiring equal treatment of tax payers in equal positions, independent of place of residence. Similarly, it is also consistent with the efficiency rule that arbitrary interference with the location of industry should be avoided. Such interference would be caused by regionally differentiated taxes. Nor does the uniformity rule interfere with the use of taxes as a tool of general stabilization policy since tax rates may be raised or lowered on a nationwide basis as required and they may also be levied progressively as the value of the tax base increases. See Knowlton v. Moore, 178 U.S. 41 (1900).

The disadvantage is that fiscal policy makers are not free to use taxing power to deal with problems of regional economic development. For this objective, the government must rely on spending programs.

Apportionment Clause (Article 1, Section 9[4])
"No capitation or other direct Tax shall be laid, unless in proportion to the Census or Enumeration herein before directed to be taken."
Any federal tax regarded by the courts as a direct tax must be apportioned among the States according to population rather than be collected at a uniform rate throughout the country. In effect, the apportionment clause required all direct taxes to be head taxes and tax rates would vary among States in inverse proportion to their per capita tax base.

A good example would be where the federal government wanted to collect $1.0 trillion from a property tax. If 6% of the population lived in Illinois and another 6% in Pennsylvania, both States would be liable for $60 billion in taxes. However, the tax rate in Illinois would have to be twice the Pennsylvania tax rate to raise the same $600 million, if property values were twice as high in Pennsylvania as in Illinois. The federal tax rate would be have to be high in States with low per capita wealth and low in States with high per capita wealth.

The clause was adopted initially as a trade-off which offered the wealthier States a tax assurance in return for lower representation in the Congress. However, the need for such assurance did not materialize for over a century, during which time, federal revenue needs were met with the proceeds from indirect taxes, especially customs duties, land sales, and interest on loands to the railroads.

A major issue arose with the attempt of the federal government to levy an income tax. Is an income tax an indirect tax, which can be passed along and need not be borne, in part or wholly, by the payee? If so, it is not subject to the apportionment limitation. Or is the income tax a direct tax, which must be borne by the payee and cannot be passed along? If so, it is subject to the apportionment limitation.

Prior to 1895, the Supreme Court held that income taxes were indirect taxes, which had to be levied uniformly throughout the country, and that the only direct taxes, which had to be levied in proportion to the population, were capitation taxes (head taxes), poll taxes, and taxes on land. In 1895, however, the Supreme Court reversed itself and, in Pollock v. Farmers' Loan and Trust Co., 157 U.S. 429 (1895) and Pollock v. Farmers' Loan and Trust Co. (Rehearing), 158 U.S. 601 (1895), declared portions of the 1894 income tax unconstitutional. It held that a tax on the income made up of the rents of real estate and one on the income from personal property were substantially direct taxes on the real estate and the personalty and must be apportioned among the States according to population. Such apportionment would have required different federal income tax rates in different States. It would have required higher tax rates in States with low per capita income and low rates in States with high per capita income. It would have been incompatible with the equal treatment of taxpayers with equal capacities to pay on a nationwide basis and would have set up a regressive tax system on an interstate basis.

In 1913, the country bypassed the issue of apportionment altogether when the requisite States ratified the 16th Amendment, which provides that
"the Congress shall have power to lay and collect taxes on incomes from whatever source derived, without apportionment among the several states, and without regard to any census or enumeration."
Prohibition of Export Taxes (Article 1, Section 9[5])
"No Tax or Duty shall be laid on Articles exported from any State."
This clause prohibits taxes on goods produced exclusively for export. It does not prohibit the taxation of goods which may be inadvertently exported. The clause was inserted to protect the cotton export interests of the South and did not impose any severe limitation until later years. It is interesting to note that the clause does not prohibit export subsidies.

Implied Limitations

These limitations arise through court interpretation of the laws.

Welfare Limitation If a tax is interpreted by the courts to be levied for purposes other than the general welfare, it may be held unconstitutional. In some instances, taxes are interpreted to be regulatory rather than revenue measures. For example, in the late 1970s, President Carter imposed a windfall profits tax on oil companies. Although it raised the price of a major resource thus imperiling the general welfare, it was, nonetheless, upheld as constitutional because the revenues were used to support the Federal Trade Commission (FTC). Interpretation of the term "general welfare" has been left to the courts, and it has come to be interpreted in an increasingly broad sense, including regulatory taxes and taxes on selective programs on a regional basis.

State Instrumentalities Doctrine The Supreme Court has held that the basic division of power between the federal and state governments requires that each level of government be prevented from taxing the instrumentalities — the property, securities, and activities -- of the other, to ensure that the taxing power of one level of government would not be used to weaken the powers of the other level of government. Over the years, the attitude of the courts has shifted somewhat on interpretation of the instrumentalities doctrine and, in the future, the Supreme Court might uphold federal taxation of state and local bond interest, were Congress to change the law to make such interest taxable, as it did in 1939 with the wages and salaries of state and local employees.

Due Process Requirement (14th Amendment) The federal government is prohibited from depriving persons of "life, liberty, or property without due process of law." This provision accomplishes three (3) important goals:
  1. It prevents completely arbitrary classification of taxpayers for tax purposes.
  2. It prevents retroactive imposition of taxes.
  3. It ensures the right of appeal to the courts from the decisions of tax-administering agencies.
State Powers and Limitations

Tenth Amendment

In a federation, States are the sovereign political units. They retain all powers not prohibited by the Constitution. This sovereignty was reinforced by the 10th Amendment, which provides that
"The powers not delegated to the United States by the Constitution, nor prohibited by it to the States, are reserved to the States respectively, or to the people."
Immunities Doctrine

States have no limits on their taxing powers, except for the explicit limitation that prohibits the States from levying taxes on goods coming across their borders and the implied limitation which prevents the States from taxing the instrumentalities of the federal government.

Balanced Budget Limitations in State Constitutions

Most States have a constitutional provision which requires them to run balanced budgets. This balance is for current income and expenditures. Capital expenditures, which require financing, must be voted on in a referendum by the citizens of the State.

Regional Limitations

State budgets can have only a narrow localized impact. They are ill-suited for dealing with aggregate economic problems.

top     III. Theoretical Limitations: 19th Century Liberal Classicism
"It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our necessities but of their advantages."

Adam Smith
British Moral Philosopher and Economist
An Inquiry into the Nature & Causes of the Wealth of Nations (1776)

Nineteenth century liberal classicism was a reaction to the rigidly regulated European nation-states of the 16th-18th centuries. To understand 19th century liberal classicism, one must first understand mercantilism, the doctrine that prevailed among the European countries during this earlier period. See Mercantilism, The Columbia Encyclopedia, 6th ed., 2004; Mercantilism, Gerhard Rempel, Professor of History, Western New England College; and Mercantilism and the American Revolution, Carole E. Scott, Professor of Economics, State University of West Georgia.

Nineteenth century liberal classicism sought to liberate economic activity from the domination of the monarchies. Its goal was to find those natural laws that controlled economic behavior, bring people's behavior into compliance with those laws, and then laissez faire.

The period starts with the publication in 1776 of An Inquiry into the Nature and Causes of the Wealth of Nations by Adam Smith. In his book, Smith debunks the myth that treasure or precious metals are the wealth of nations. He explains, instead, how a nation's wealth is its stock of capital and its people and how individuals, pursuing their own self-interest, inadvertently benefit the whole of society. There is no need for government to interfere in material affairs. Government's only roles should be to enact the "natural laws" by which economic participants are to be guided, to administer the courts for the administration of justice, to provide for national security against incursion from without and insurrection from within, and to operate the postal system. Otherwise, government should keep its hands off private economic affairs.

Liberal classicism is premised on the idea of an homo economicus, or economic man. The rational economic man was a theoretical device or concept by which the classical economists endeavored to distill the natural laws of economic behavior. He plays the dominant role in Say's Law and the Quantity Theory of Money, two of the three pillars on which liberal classicism is grounded. The third pillar is the Price-Specie Flow Mechanism enunciated by David Hume before the Quantity Theory was espoused.

Mercantilist Philosophers Classical Economists
Thomas Mun (1571-1641)
Jean Baptiste Colbert (1619-1683)
Sir William Petty (1623-1687)
John Locke (1632-1704)
Bernard de Mandeville (1670-1733)
David Hume (1711-1776)
Adam Smith (1723-1790)
Thomas Robert Malthus (1766-1834)
Jean-Baptiste Say (1767-1832)
David Ricardo (1772-1823)
James Mill (1773-1836)
John Stuart Mill (1806-1873)
Karl Marx (1818-1883)

Say's Law

Say's Law states that the mere act of production creates a sufficient amount of demand to buy all of the goods and services which are produced, or "supply creates its own demand." In his major work, A Treatise on Political Economy, the eminent French economist, Jean-Baptiste Say, argued that man's wants are insatiable, but his means to satisfy those wants is limited by the current availability of resources:

Q = f(R, L, K, E)

where, Q is total output, R is land and other natural resources, L is labor, K is capital, and E is entrepreneurial ability. (NOTE: Neither technology (the method of production) nor a scalar constant was part of the original Classical model.)

To satisfy these wants, a rational economic man will summon all of his productive resources and produce what he can to exchange what he produces for what he wants. The act of producing creates the income necessary to buy all of the goods and services produced by all of the other rational economic men.

E = Y = Q|P,

where E is the expenditure on all newly produced goods and services, Y is the income paid to the factors of production from the sale of newly produced goods and services, and both E and Y are in real terms, Q, having adjusted for prices, P. As a result, economies will always tend to operate at full employment and to produce as much as possible so that rational economic men can satisfy all of their wants and long-term gluts or depressions are theoretically impossible.

The General Model

Assume that an economy produces only two goods: consumer goods and capital goods. Assume further that the demand for consumer goods is D0 and that the demand for capital goods is D0, while the supply of consumer goods is S0 and that the supply of capital goods is S0. Initially, consumer goods sell at pc0 and capital goods sell at pk0.

CONSUMER GOODS MARKET       CAPITAL GOODS MARKET

consumerandcapitalgoodsmkts

The aggregate demand for the economy is AD0, the sum of the demand for both consumer and capital goods. The aggregate supply, however, is fixed at Qmax, because society cannot move outside of its production possibilities. Although the supply of each good is upward sloping because either consumer or capital goods can be expanded at the expense of the other, the supply curve for the aggregate economy is constrained by its resource base and technological limitations.

AGGREGATE OUTPUT         INVESTMENT AND SAVING

agoutputandismkts

The general level of prices is P0 = (pc0 + pk0)/2, and the total output is equal to the sum of the output in the consumer and capital goods markets: Qmax = qc0 + qk0. So long as households and businesses continue to demand D0 goods in each market, the economy will remain in equilibrium at full employment. Total income is Y0 = P0Qmax.

Time-Preference Theory of Consumption

Say's Law embodies the time-preference theory of consumption. The time-preference theory of consumption holds that household spending depends upon interest rates: C = f(i). If interest rates rise, households will forego current consumption in favor of the higher returns and a higher consumption in the future. Less consumption, more saving. If interest rates fall, households will spend more and save less, because the lower rate of return for future consumption is less attractive. People would just as soon spend today than wait for tomorrow. Since consumption depends upon interest rates, so does saving (what is not spent): S=f(i). Saving is positively related to the interest rate.

The amount of investment also depends on the interest rate: I=f(i). Investment, however, is negatively related to the interest rate. The higher the interest rate, the less investment occurs; the lower the interest rate, the more investment occurs. As long as the interest rate is free to rise and fall, the "money market" will be in equilibrium and I(i) = S(i). All saving will be invested, and the economy will produce its full-employment output.

Total income is either spent on consumer goods or capital goods. Spending on consumer goods is consumption (C) and spending on capital goods is investment (I). Investment occurs when some income is saved (S). Therefore,

Y0 = pc0qc0 + pk0qk0

= C0 + S0 = C0 + I0

and

I0 = S0
.

The Guiding Hand

If households decide to save more and spend less, consumption declines and the demand for consumer goods falls from D0 to D1. The excess supply of goods in the consumer goods market puts downward pressure on the price of consumer goods. The price of consumer goods falls from pc0 to pc1, while the quantity supplied of consumer goods falls from qc0 to qc1. The reduction in price of consumer goods decreases their profitability in production and raises the profitability of producing capital goods.

The reduction in demand for consumer goods reduces aggregate demand from AD0 to AD1. Total output falls from Qmax to Q1, as the average level of prices falls from P0 to P1. At Q1, resources which were previously employed in the consumer goods market are unemployed, and the economy, as a whole, is operating at less than full employment.

However, in Say's Law of Markets, the adjustment does not stop there. The decrease in consumption increases saving from S0 to S1. The increase in saving creates an excess of saving over investment in the money market. The excess supply of saving puts downward pressure on the interest rate. As the interest rate falls, the profitability of producing capital goods further increases. Investment becomes more attractive and increases from I0 to I1. This increase in investment increases the demand for capital goods from D0 to D1. The excess demand for capital goods pulls up their price from pk0 to pk1, as output of capital goods increases from qk0 to qk1. The production of capital goods reemploys the idle resources from the consumer goods market and the economy returns to full employment.

The Substitution Effect

Say's Law is based on a system of relative prices, where the substitution effect is dominant; that is, economic units respond to changes in relative prices by substituting less expensive for more expensive commodities and by producing or selling commodities for markets in which the returns are highest. As long as prices are free to rise and fall, resources will be quickly and efficiently reallocated from markets with declining demand to markets with increasing demand. Temporary gluts in specific markets are possible, but once resources have been reallocated to the newly desired goods and services, the economy will return to full employment.

The increased saving would have reduced aggregate demand from AD0 to AD1, leaving unemployed resources in the economy. However, the substitution of capital goods for consumer goods in response to changes in relative prices leaves aggregate demand unchanged at AD0. The general level of prices remains unchanged at P0, even though relative prices have changed, and total output remains at Qmax, even though the composition of total output has changed.

The automatic regulating mechanism in Say's system is flexible wages, prices, and interest rates. As long as wages, prices, and interest rates are free to rise and fall in response to changing demands, the economy will automatically return to full employment. No government intervention is necessary.

Quantity Theory of Money

The Quantity Theory of Money states that the amount of money in circulation determines the absolute level of prices. The Quantity Theory of Money derives from the Equation of Exchange. The Transactions Version recognizes that money must be present in all transactions: MsV identity PT and P = MsV/T and the Income Version recognizes that money circulates only for the purchase of newly produced goods and services which enter into a calculation of GNP: MsVy identity PQ and P = MsVy/Q. It states that the amount of money in circulation determines the absolute level of prices.

The General Model

Classical economists reasoned from Say's Law that the economy would always tend to operate at full employment. Therefore, the total quantity (Q) produced is fixed at some full employment level: Qmax, given the availability of resources. They also reasoned that the velocity (Vy) at which money circulates to buy this full employment output of goods and services is also fixed. The rate of circulation of money depends upon such things as custom and institutional constraints that remain the same for long periods of time. These structural characteristics of velocity include the frequency of receipts and disbursements, the synchronization of receipts and disbursements, the amount of book credit, and the rapidity of communication and transportation; that is, how fast real or physical trade can take place. Classical economists concluded that, if Q and Vy are fixed, P = f(Ms).

AGGREGATE OUTPUT       LABOR MARKET

agoutputandlabormkts

Assume that the economy is in equilibrium at full employment when aggregate demand is AD1 and the general level of prices is P1. If the amount of money increases, people spend more. But, since real output depends on the size of the resource base and technology, which grow only slowly over time, and since money is not a factor of production, an increase in the amount of money in circulation has no impact on aggregate supply, but only on aggregate demand. Therefore, prices rise as individuals try to spend the additional money en masse. Aggregate demand increases from AD1 to AD0 as prices rise from P1 to P0.

Assume that the economy is in equilibrium at full employment when aggregate demand is AD1 and the general level of prices is P1. If the amount of money is reduced, people spend less, aggregate demand falls from AD0 to AD1, and the general level of prices falls from P0 to P1, but the reduction in the money supply has no effect on aggregate supply. As long as wages and prices are fully flexible (and they are in the long run) and as long as labor is not subject to any "money illusion," but rather works for real wages, labor will be gainfully employed at all times.

No Money Illusion

In the classical economic model, workers have no money illusion. They know exactly what their wages will buy at all times. If the money supply expands and aggregate demand rises from AD1 to AD0, prices will rise from P1 to P0 and the demand for labor rises from D(P1) to D(P0). In the short run, businesses try to employ to L0 workers. However, at the money wage of w1, real wages fall. When workers realize that real wages have fallen, the supply of labor decreases from S(P1) to S(P0). This puts upward pressure on the money wage until real wages are restored to their original value and all labor (Lmax) is once again fully and gainfully employed at a money wage of w0.

If the money supply contracts and aggregate demand falls from AD0 to AD1, prices fall from P0 to P1 and the demand for labor falls from D(P0) to D(P1). In the short run, businesses employ less workers a money wage of w0 and labor employment falls to L1, leaving a temporary glut of unemployed workers on the market. However, at the money wage of w0, real wages rise. When workers realize that real wages have risen, the supply of labor increases from S(P0) to S(P1). This puts downward pressure on the money wage until real wages are restored to their original value and all labor (Lmax) is once again fully and gainfully employed at a money wage of w1.

The Proportionality Doctrine

Classical economists went so far as to argue that a proportional change in the amount of money in circulation would have an equally proportional impact on the change in prices.

P = MsVy/Q

ln(P) = ln(Ms) + ln(Vy) - ln(Q)

d{ln(P)}/dt = d{ln(Ms)}/dt + d{ln(Vy)}/dt - d{ln(Q)}/dt

%ΔP = %ΔMs + %ΔVy - %ΔQ

Since Vy and Q are assumed to be constant, % Δ Vy = 0 and % Δ Q = 0. Thus, if the money supply is doubled over night, prices will double. If the amount is halved, prices will decline by 50 percent. Prices will rise and fall by the same percentage as the percentage change in the money supply.

Laissez-Faire Economics

The Quantity Theory of Money, like Say's Law, leaves no room for any kind of government intervention to offset adverse changes in either prices or real output. The only real policy implications are that an economy experiencing inflation can be deflated by the government's hoarding of money and that an economy experiencing deflation can be reflated by the government's dishoarding of money or the minting of new coin for circulation.

One must keep in mind that prior to the 20th century most money supplies consisted of precious metals or token coins backed by precious metals. Therefore, new gold finds or changes in the government's minting policies had a tremendous effect on the money supply. Inflations were always characteristic of "booms," which often resulted from the overexpansion of the money supply, and recessions (depressions) were always accompanied by deflation, which resulted from the contraction or underexpansion of the money supply. Thus, a theory that links money to prices, must pari passu link money to real output; that is, the way to control real output is through the control of prices.

Scottish Approaches of Money, History of Economic Thought Website, New School for Social Research

Price-Specie Flow Mechanism

The 18th century philosopher, David Hume, actually anticipated the Quantity Theory of Money when he formulated his Price-Specie Flow Mechanism. The price-specie flow mechanism relates economic activity and prices to the inflow and outflow of gold from international trade. Hume's thesis was that trade takes place based upon the value of real money balances of potential trading partners, e.g., Country A and Country B.

(Ms/P)A = (Ms/P)B.

First, assume that all international trade takes place based on relative prices. Second, assume that Country A finds a new source of gold (e. g., as Spain did in Mexico). Initially, the new gold will increase the real money balances in Country A. However, as everybody tries to spend the new gold to buy goods and services, aggregate demand and prices begin to rise. Eventually, Country A's prices become higher than those of its trading partner, e.g., Country B. This rise in Country A's general level of prices makes imports from Country B more attractive and exports to Country B less attractive. Country A's imports increase and its exports fall. To pay for its excess of imports over exports, Country A sends gold to Country B. Gold flows out of Country A and into Country B. As gold flows out of Country A, its money supply contracts. As Country A's money supply contracts, its aggregate demand declines and prices fall. Meanwhile, the inflow of gold to Country B increases its money supply and raises its aggregate demand. As Country B's aggregate demand increases, so does its general level of prices. As Country B's prices rise relative to the prices in Country A, the trade pattern is reversed. Subsequently, gold flows out of Country B and back into Country A and the whole process starts anew.

top    IV. Capitalist Crises

Despite the theoretical full-employment implications of Say's Law, the Quantity Theory of Money, and David Hume's Price-Specie Flow Mechanism, capitalist countries tended to experience wide swings in output and prices throughout the 19th and early 20th centuries. About every 20 years or so — 1817, 1837, 1857, 1869, 1873, 1893, 1907, 1921, and 1929 — the U.S. experienced a bad depression. Inflationary "booms' were quickly followed by deflationary financial "crises" and economic "busts." The dominant view was that monetary excesses and waves of speculation were largely responsible for credit expansion and prosperity, on the one hand, and liquidation and depression, on the other.

top    V. Early Monetary Policies

If the U.S. had any conscious macroeconomic policy, it was, for the most part, a loosely constructed monetary policy based on the dictates of the gold standard. Under the gold standard, the stock of money would vary in proportion to inflows and outflows of gold from each nation. Inflationary "booms" occurred when gold was either newly discovered or flowed into a country to cover export payments by foreigners. Financial crises and depressions followed when the newly discovered gold reserves dried up and/or gold flowed out of the country to pay for imports. Thus, the earliest attempts to state an economic "goal" toward which public policy should aim was centered around stabilization of the money supply and the price level — to avoid both inflation and deflation.

Widespread concern over inflation and unemployment reached a peak following the financial Panic of 1907. Up to that point, the U.S. had no central bank. The federal government had experimented in the early 18th century with the First and Second Banks of the United States, but a strong agrarian, hard currency, states' rights group, led by President Andrew Jackson, successfully blocked a renewal of the Second Bank's charter in 1836 and further attempts to establish a U.S. bank were abandoned.

The Independent Treasury System of 1846

In 1846, the federal government adopted the Independent Treasury System (ITS). The ITS required all public debts to be paid in U.S. securities or specie; but this system tended to accentuate cyclical economic activity rather than stabilize it. Only U.S. securities were redeemable in specie. Whenever the federal government spent, it would put specie or the note-equivalent of specie into circulation. This injection added to the reserves of the banking system. From these reserves, the banks were able to expand the money supply by some multiple by making loans and issuing their own bank notes. When it came time to make tax payments to the Treasury, specie and U.S. government securities were transferred from the banks to the Treasury. This removed reserves from the banking system and forced banks to "call" loans, thus, contracting the money supply by some multiple of the tax payments to the federal government. The Treasury had the option of accepting and holding state-bank notes in lieu of U.S. securities or specie. However, the Treasury preferred redemption and, thus, contributed to macroeconomic instability.

The National Bank Acts of 1863/64

The National Bank Acts of 1863/1864 sought to stabilize and standardize the money supply by creating a system of nationally chartered banks, which would issue "greenbacks" backed by U.S. government securities, and by taxing state-chartered bank notes to force the state banks to switch to national charters to issue "greenbacks." The state banks, however, eluded the tax (and the federal government's attempt to centralize banking) by offering demand deposits instead of bank notes to its customers.

During the last quarter of the 19th century, the economy was subjected to several deflationary "crises": The Second Post War Depression of 1873-79, the Depression of 1884, the Panic of 1893-94, and the Silver Campaign Depression of 1896-97. During the 1893-97 period total output fell by almost 20 percent in two years and in 1894 the unemployment rate hit 18%. Yet, when President Grover Cleveland was pressured to provide relief with expanded public works programs, he resisted, and so did many members of Congress. Senator James Berry of Arkansas voiced the dominant mind-set, declaring that "It is not the purpose of this government to give work to individuals throughout the United States by appropriating money which belongs to other people and does not belong to the Senate."

Ten years later, the economy was shook again by the Panic of 1907. Following the Panic of 1907, Congress appointed the National Monetary Commission (Aldrich Commission) to identify the cause(s) of the panic and to suggest measures to avert such depressions in the future. The Commission concluded that the causes of the panic were (1) an inelastic money supply, (2) lack of a uniform currency, and (3) pyramiding of reserves. After several years of thorough consideration, Congress adopted legislation embodying the results of the study by the Commission and by other authorities. The cornerstone of this legislation was the establishment of a central bank, the Federal Reserve Bank System.

Federal Reserve Act of 1913

In 1913, Congress passed the Federal Reserve Act. The purpose of the Act was to establish a central bank which would provide a uniform currency, an "elastic" currency, a central depository for bank reserves, and a national clearing house for checks. The first purpose sought to retire, once and for all, the various bank note issues and to replace them with notes issued by the Federal Reserve. The second purpose sought to eliminate erratic changes in the domestic money supply associated with international gold outflows by making the central bank a lender of last resort to banks when they ran short of required specie. The third purpose sought to prevent the "pyramiding" of reserves by correspondent banks by centrally locating all reserves. The last purpose sought to provide a system by which the banks could clear checks promptly and uniformly throughout the country. The Federal Reserve Act said little else concerning economic policy.

Appeals for further intervention were resisted, however, even during the sharp downturn in 1921, when occasional depressions were still regarded as inevitable and the belief that they could be significantly moderated through government action had not taken hold. However, a step taken that year portended later developments. In 1921, the President's Conference on Unemployment was established to undertake studies that would increase understanding of the operation of the U.S. economy and would thus help to avoid the recurrence of widespread joblessness. The work of this Conference, which made its final report only shortly before the Great Depression began, was reflected in the Employment Stabilization Act of 1931. This Act sought to provide for "advance planning and regulated construction of public works, for the stabilization of industry, and for aiding in the prevention of unemployment during periods of business depression."

The Great Depression

Then came the Great Depression. The causes were many, the cures were few. No matter how hard President Hoover tried to maintain fiscal prudence and to balance the budget, he just could not. The main issue in the Presidential Campaign of 1932 between Hoover and Roosevelt was how to balance the budget. Contrary to popular opinion, the Democratic platform that year contained only two planks:
  1. An immediate and drastic reduction of government expenditures by abolishing useless commissions and offices, consolidating departments and bureaus, and eliminating extravagance to accomplish a saving of not less than 25 percent in the cost of federal government; and we call upon the Democratic party of the States to make a zealous effort to achieve a proportionate result.

  2. Maintenance of the national credit by a federal budget annually balanced on the basis of accurate executive estimates within revenues, raised by a system of taxation levied on the principle of ability to pay.
Not until after Roosevelt was elected did he propose his New Deal. The New Deal, however, turned out to be a series of programs (in parentheses) suggestive of the planks in the Socialist Party Platform of 1932. The initial reaction of the Supreme Court to constitutional challenges to the Roosevelt's New Deal legislation was to strike it down. The laws were invalidated by the Frankfurter Court as overstepping the bounds of providing for the general welfare. Roosevelt responded by trying to "pack" the Supreme Court. He wanted Congress to increase the number of justices on the bench so that he could appoint new judges sympathetic to his programs. While Roosevelt's "Court packing" scheme failed, it achieved the intended purpose of bringing the Supreme Court to "heel." Subsequent challenges to Roosevelt's programs were upheld as providing for the general welfare within the meaning of the Constitution.

Part of the blame for the cause and severity of the depression was laid at the doorsteps of the Federal Reserve. It was perceived that the Fed was either unwilling or unable to prevent the contraction of the money supply. That unwillingness or inability stemmed, in part, from the extremely decentralized structure of the Fed and, in part, from the use of the discount rate as the principal mechanism for regulating money supply growth.

Under the original Act, each district was its own autonomous liquidity facility. Each district had its own gold stock, which it was not obligated to share with or lend to other district banks, each district held its securities independently of other districts, and each district controlled its regional credit availability by raising and lowering its own discount rate. However, liquidity was unevenly distributed among the districts. Supposedly, the lack of any obligation by a surplus district to transfer gold stock or securities to a deficient district and the setting of discount rates which were either too high or not lowered enough in some districts created or failed to prevent a collapse of the banking system.

In 1933 and 1935, Congress passed banking legislation which, among other things, changed the name of the Board of Directors in Washington to the Board of Governors, strengthened the Board's control over the district banks by consolidating the balance sheets of the district banks and by transferring responsibility for and ultimate control over the discount rate to the Board, and created the Federal Open Market Committee (FOMC), the policy-making body of the Federal Reserve, to govern the provision of reserves to the banking system through open market operations. The function of the FOMC was to buy and sell U.S. government securities "with a view to accommodating commerce and business and with regard to their bearing upon the general credit situation of the country." This was the first time that a real macroeconomic goal and a complementary tool were established for the Federal Reserve.

top    VI. Early Fiscal Policies

The economy began to turn around in 1933. However, heavy unemployment persisted. In 1936, John Maynard Keynes published his work, The General Theory of Employment Interest and Money. Keynes' book turned Say's Law on its head, by arguing that "Demand creates its own supply." Keynes explained why saving is not always directed into investment in new capital and he debunked the myth that money was a neutral agent in economic activity. He showed that money had an effect on real output (not just prices), but that the relationship between money and output (velocity) was not stable or predictable and that economic activity had an endogenous effect on the money supply that could, in turn, exaggerate economic upturns and downturns and make them worse.

Keynes advocated adjustments in budgetary positions (fiscal policies) — changes in government spending or tax collections — to change budget deficits and budget surpluses, at times when the relationship between money and output (velocity) breaks down. Fiscal policies bypass dysfunctions in the money markets and change output directly by changing the velocity or rate at which the existing money supply is being spent. Keynes' book lent credence to government intervention in economic affairs and showed how the government could restore the economy to full employment by spending more or taxing less. The book legitimized Roosevelt's New Deal programs and ushered in a new era of federal deficit budgeting.

Whether the New Deal programs were successful in bringing about the economic reversal, or whether the full scale build-up for World War II pulled the U.S. economy out of its worst depression, is still debatable. Spending by the Roosevelt administration on the New Deal was only a drop in the bucket compared to the tremendous increase in production required for WW II. The service of 11 1/2 million persons in the Armed Forces alone reduced unemployment to a minimum and even created a degree of overemployment.

top    VII. Macroeconomic Goals

The ultimate goals of macroeconomic policy are maximum employment, maximum production, price stability, and external balance (equilibrium in the balance of payments accounts).

In 1944, with a positive turn in the tide of the war, memory of the Depression and the expected demobilization of the Armed Forces heightened concern for the nation's economic future and aroused a keen interest in measures to help avoid the widespread unemployment that everyone feared would result from demobilization and reduced spending on arms. In this atmosphere, Congress turned its attention to legislative matters to cope with unemployment, should it emerge as a serious post-war problem.

In the 1944 election, Democrats and Republicans both scrambled to assure the public that they were committed to full employment. The Democratic Party platform said its goal was to "establish and maintain peace, guarantee full employment and provide prosperity," while Republican presidential nominee Thomas Dewey declared that providing "jobs and opportunity for all" was "the business of the government." The rhetoric turned more real with the introduction of the Full Employment Act of 1945.

Congressional staff committees made comprehensive studies of the incidence and duration of unemployment and of possible methods for dealing with it. Extensive hearings were held and a bill, the Full Employment Act of 1945, was introduced in Congress. The bill stated that "All Americans able to work and seeking work have the right to useful, remunerative, regular, and full-time employment, and it is the policy of the U.S. to assure the existence at all times of sufficient employment opportunities..." It provided for a considerably broader attack on unemployment than the public works programs envisioned back in 1931. It would have established a federally guaranteed right to employment. Although the bill passed the Senate, only a watered down version made it through the House. After much negotiation, the bill finally passed overwhelmingly with bipartisan support in both Houses as the Employment Act of 1946.

Subsequently, in 1978, Congress passed the Humphrey-Hawkins (Full Employment and Balanced Growth) Act in 1978 15 U.S.C. §§ 1021, 3101, et seq. Humphrey Hawkins reaffirmed the goals of the Employment Act of 1946, increased the responsibility of the private sector for achieving and maintaining macroeconomic stability, added a fourth macroeconomic goal of external balance, articulated the [current] goals or "dual mandate" of low unemployment and low inflation for the Federal Reserve, and added financial market stability to the responsibilities of the Federal Reserve.

Employment Act of 1946

The first major declaration of macroeconomic policy goals for the U.S. government was contained in the Employment Act of 1946, 15 U.S.C § 1021:
"The Congress declares that it is the continuing policy and responsibility of the Federal Government to use all practical means consistent with its needs and obligations and other essential considerations of national policy, with the assistance and cooperation of industry, agriculture, labor, and State and Local governments, to coordinate and utilize all its plans, functions, and resources for the purpose of creating and maintaining, in a manner calculated to foster and promote free competitive enterprise and the general welfare, conditions under which there will be afforded useful employment opportunities, including self-employment, for those willing, able, and seeking to work and to promote maximum employment, production, and purchasing power."
At the time it was approved, the Employment Act represented a major extension of the traditional American concept of shared private and public responsibility for the nation's growth and improvement. Yet, it gave explicit expression to a continuing interest on the part of the federal government in aspects of economic life that, outside the sphere of monetary policy, had previously received deliberate federal attention only in such emergency conditions as depression and war.

The Employment Act states that it shall be the policy of the Federal government to promote conditions under which there will be afforded employment opportunities by methods that are consistent with the traditional American philosophy of individual freedom and competitive enterprise. Although the Act enlarges the area of explicit federal concern to include the quality of current and expected U.S. economic accomplishments, it does so without diminishing the scope of private, and state and local government responsibility. Far from seeking to centralize economic decision-making in the federal government, the law explicitly acknowledges the multiple sources of economic strength in private individuals and groups and the several levels of government. The degree of centralization in decision-making has varied with administrations; however, only the federal government has the power to print money to sustain long-term deficits. Therefore, much of the responsibility has been assumed by the federal government by default.

The Act does not explicitly require that economic goals be publicly stated as fixed quantitative targets. Instead, the Act contemplates a framework in which the mainsprings of private initiative continue to function on behalf of economic activity, and in which individuals retain a wide freedom of choice. The level of economic achievement was to remain everybody's responsibility and could not be guaranteed by the federal government acting alone.

The Act also established a Council of Economic Advisers to assist the President in implementing the Act, established a Joint Economic Committee composed of Senators and Representatives to review the government's economic policy at least annually, and required that the President submit to Congress an annual Economic Report of the President.

The primary concern of Congress was a lapse into deflation and depression. Congress feared that once de-escalation of the war effort was complete, falling demand would pull down prices, income, and output, and increase unemployment. The newly formed Council of Economic Advisers suggested that an appropriate target for full employment was an unemployment rate between 3 1/2% and 4 1/2%. The Council did not set a target for growth or inflation. At the time, its concern was not for inflation, but rather for deflation.

In the 20 years or so following its enactment, the U.S. economy appeared strong and buoyant. At first, every one seemed relieved that the economy did not slip back into deflation or depression. The low rate of inflation was actually welcomed and helped to pull along production and employment during the first two decades. Despite creeping inflation at an annual rate of 1-2% and a few minor recessions, the economy seemed extremely healthy.

Then, in the late 1960s, the US economy began to fall apart. US involvement in the Vietnam War and President Lyndon B. Johnson's Great Society programs brought a fresh concern over inflation. In 1973, President Richard M. Nixon closed the gold window to foreigners (President Franklin D. Roosevelt had closed it to Americans in 1935), took the US off the gold standard, and allowed the dollar to float. Subsequently, the dollar floated down (depreciated), the US trade deficit worsened, and inflation increased. In 1974-75, the US experienced the most serious downturn since the Great Depression, unemployment rose, and growth slowed. Both inflation and unemployment rose throughout the 1970s, a period subsequently dubbed, "stagflation."

Humphrey-Hawkins (Full Employment and Balanced Growth) Act of 1978

In an attempt to strengthen the federal government's hand in dealing with the macroeconomic problems of inflation and unemployment and a growing trade deficit, Congress passed the Humphrey-Hawkins (Full Employment and Balanced Growth) Act in 1978 15 U.S.C. §§ 1021, 3101, et seq.
"The Congress declares that it is the continuing policy and responsibility of the Federal Government to use all practicable means, consistent with its needs and obligations and other essential national policies, and with the assistance and cooperation of both small and larger businesses, agriculture, labor, and State and local governments, to coordinate and utilize all its plans, functions, and resources for the purpose of creating and maintaining, in a manner calculated to foster and promote free competitive enterprise and the general welfare, conditions which promote useful employment opportunities, including self-employment, for those able, willing, and seeking to work, and promote full employment and production, increased real income, balanced growth, a balanced Federal budget, adequate productivity growth, proper attention to national priorities, achievement of an improved trade balance through increased exports and improvement in the international competitiveness of agriculture, business, and industry, and reasonable price stability as provided in section 1022b(b) of this title."
The Act strengthens the Employment Act of 1946 in five essential respects:
  1. It reinforces and increases role of the private sector to promote full employment, growth in productivity, and stable prices.
    "The Congress further declares and establishes as a national goal the fulfillment of the right to full opportunities for useful paid employment at fair rates of compensation of all individuals able, willing, and seeking to work."
    "The Congress further declares that inflation is a major problem requiring improved government policies relating to food, energy, improved and coordinated fiscal and monetary management, the reform of outmoded rules and regulations of the Federal Government, the correction of structural defects in the economy that prevent or seriously impede competition in private markets, and other measures to reduce the rate of inflation."
  2. It stresses a goal of balanced federal budgets.
    "The Congress further declares that trade deficits are a major national problem requiring a strong national export policy including improved Government policies relating to the promotion, facilitation, and financing of commercial and agricultural exports, Government policies designed to reduce foreign barriers to exports through international negotiation and agreement, Federal support for research, development, and diffusion of new technologies to promote innovation in agriculture, business, and industry, the elimination or modification of Government rules or regulations that burden or disadvantage exports and the national and international competitiveness of agriculture, business, and industry, the reexamination of antitrust laws and policies when necessary to enable agriculture, business, and industry to meet foreign competition in the United States and abroad, and the achievement of a free and fair international trading system and a sound and stable international monetary order."
  3. It calls upon policy-makers to improve the U.S. trade balance, while promoting fair and free trade and a stable international monetary system. (Employment Act of 1946 said nothing international payments balance.)

  4. It mandates that the Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy's long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.

  5. It establishes procedures for developing and reviewing economic policies.

    1. Fiscal policies Once a year, the President must announce to Congress his/her targets for the macroeconomic goals and his/her plans for reaching the targets. For example, the Act requires the administration to set annual numerical goals for key indicators, such as employment and unemployment, production, real income, productivity, and prices over a five year period. Goals for the first two years are considered the operating targets or short-term goals and for the following three years, the intermediate targets or medium-term goals. These goals appear in the Economic Report of the President.

    2. Monetary policies Twice a year, the Chairman of the Board of Governors must announce to Congress the Fed's targets and its plans for reaching the targets.

      1. Each February, in an appearance before Congress, the Chairman of the Board of Governors must specify growth ranges for the monetary and credit aggregates and also present the range and central tendency of FOMC projections for inflation and output in the current year.

      2. Each July, the Chairman of the Board of Governors reports on the FOMC's reassessment of its objections and projections and specifies preliminary targets for the next calendar year.

      3. Although the Act does not require the Board to fulfill its plans for money and credit, it is required to explain the conditions under which such plans should or should not be achieved. It is also obligated to supply an explanation for changes in the targets.

      4. Additionally, the Chairman of the Board of Governors is required to comment on the relationship between its plans for monetary policy and the short-term goals established by the President. These requirements were included in an effort to improve coordination between fiscal and monetary policies.
With passage of the Humphrey-Hawkins Act, the federal government has four ultimate macroeconomic goals: maximum employment, maximum growth, price stability, and external balance and the Federal Reserve has three ultimate macroeconomic goals: maximum employment, stable prices, and moderate long-term interest rates. Only two of these goals overlap. The gap may pose problems for policy-makers when the priority of goals diverges. Moreover, the Federal Reserve has often ignored its third goal, promoting moderate long-term interest rates, since the level of long-term interest rates is more of an intermediate target — part of the transmission process of monetary policy from open market operations to maximizing long-run non-inflationary growth.

The federal government is ultimately responsible for maximum employment, maximum production, price stability, and external balance. The Federal Reserve has a dual mandate of maintaining low unemployment and low inflation. The Fed is also now responsible for maintaining financial market stability.

top    VIII. Post-WW II Fiscal Policies

Post-World War II fiscal policies significantly expanded the use of government spending for the common defense (the military-industrial complex and Viet Nam) and the general welfare (the interstate highway system, the great society, and the beautification of America) of the United States. They also provided for the first active use of discretionary tax changes to stabilize macroeconomic activity.

The Eisenhower Years (1953-1960)

Dwight David ("Ike") Eisenhower was elected in November 1952, two years into the Korean Conflict. The economy was expanding, the unemployment rate was below 3.0%, and prices were barely budging. "Ike" was a commanding presence. Americans liked the fact that he was a five-star general in the U.S. army. He forced China to agree to a cease-fire of the Korean War by threatening to use nuclear weapons. He maintained pressure on the Soviet Union during the Cold War, gave priority to inexpensive nuclear weapons, and reduced the other forces to save money.

Eisenhower played a lot of golf and left most political chores to his Vice President, Richard M. Nixon. He left the economy to run itself. Real GDP grew at an average annual rate of 3.3% with two minor downturns (July 1953 to May 1954 and August 1957 to April 1958). The unemployment rate averaged 4.9%, the annual inflation rate averaged 1.5%, and the annual real trade deficit averaged $18.4 billion or 0.7% of the average annual real GDP of $2,562.7 billion.

Eisenhower was a fiscal conservative, but he refused to roll-back the New Deal. Instead, he enlarged the Social Security program. Eisenhower also launched one of America's most enduring projects, the Interstate Highway System. His experience with German autobahns during World War II convinced him of the benefits of an Interstate Highway System for moving convoys of military vehicles coast to coast in a hurry.

The only criticism of Eisenhower's administration came after he left office and was a direct result of a comment he made in his Farewell Address, on January 17, 1961, about a phenomenon he called the military-industrial complex:
"In the councils of government, we must guard against the acquisition of unwarranted influence, whether sought or unsought, by the military-industrial complex. The potential for the disastrous rise of misplaced power exists and will persist."
Hence forth, Eisenhower would be perceived as the President who presided over the growth of this monolithic complex. While the complex was not necessarily bad, it was perceived as bad. It was, by definition, an all-too friendly and mutually symbiotic relationship between the government and its military forces, on the one hand, and defense contractors, on the other hand, to give both sides what they were looking for — a successful military engagement for warplanners and financial profit for those manning the corporate boardrooms. The taxpayers were shut out.

President Eisenhower, Economic Policy, and the 1960 Presidential Election, Ann Mari May, The Journal of Economic History, L(2), June 1990

The Kennedy-Johnson Years (1961-1968)

John Fitzgerald Kennedy was elected in November 1960, during a downturn that started in April 1960 and bottomed out in February 1961, the month after he took office. Thereafter, he and his successor, Lyndon B. Johnson, had relatively smooth sailing. Real GDP grew at an average annual rate of 5.8%, uninterrupted, for 106 months from February 1961 to December 1969. The unemployment rate averaged 4.8%, the annual inflation rate averaged 2.4%, and the annual trade deficit averaged $30.0 billion or 0.9% of the average annual real GDP of $3,512.5 billion. The biggest problem during their presidencies was increasing inflation.

Tax Collections

The Kennedy Tax Cuts John Kennedy ran for President in late 1960s during an economic downturn. He vowed to "get the country moving again." After his election, his economic advisers, led by chief economist Walter Heller (a Keynesian), urged him to push through Congress a budget with a $10 billion deficit and a tax cut aimed at consumers to feed the deficit. Heller and the Keynesians argued that consumers would spend the new income from the tax cut a "multiple number of times" and that this new spending would create more income and jobs for the unemployed and the newly employed would spend and create more income and more employment.

At first President Kennedy resisted. He even proposed a balanced budget in his first State of the Union address. However, Heller and his team persisted and by mid-1962 Kennedy relented. Initially, Kennedy proposed to use increases in government spending, not tax cuts, to effect the deficit, but that idea died very quickly, because conservatives in Congress opposed it and the President's aides advised that the bond market might respond adversely to additional spending with higher interest rates that could offset the gains from deficit spending. Finally, in August 1962, Kennedy agreed to recommend permanent across-the-board, top-to-bottom cuts in both corporate and personal income taxes. Income Tax Cut, JFK Hopes To Spur Economy 1962/8/13. Unfortunately, Kennedy died before Congress acted on his recommendations.

Lyndon Baines Johnson became President on November 22, 1963, two hours and eight minutes after President Kennedy was assassinated. One of first bills Johnson pushed through Congress was the Kennedy tax cuts. The final version of the bill reduced tax withholding rates, initiated a new standard deduction, boosted the top deduction for child care expenses, and lowered the top tax bracket from 91% on marginal income greater than $400,000 to 70%.

The U.S. economy prospered. Walter Heller boasted,
"The significance of the great expansion of the 1960s lies not only in its striking statistics of employment, income and growth but in its glowing promise of things to come. If we can surmount the economic pressures of Vietnam without later being trapped in a continuing war on inflation when we should again be fighting economic slack, the 'new economics' can move us steadily toward the qualitative goals that lie beyond the facts and figures of affluence."
Unfortunately, the U.S. became trapped in "a continuing war on inflation."

The Johnson Surcharge By 1966, President Johnson was looking to reverse the Kennedy tax cuts to pay for spending on the Viet Nam War and his Great Society programs and to fight inflation. In January and, again, in September 1966, Johnson recommended moderate tax increases to try to restrain the unbalanced pace of economic expansion and Congress approved most of the recommendations rather promptly. As 1966 ended, price stability seemed to be restored. However, in his January 1967 "State of the Union" address, Johnson called upon Congress to enact a 6.0% temporary surcharge on both corporate and individual income taxes to last for 2 years or for so long as the unusual expenditures associated with our efforts in Vietnam continue.

Congress resisted. Arkansas Democrat Wilbur Mills, Chair of the House Ways and Means Committee (the tax writing committee) and one of the most powerful members of Congress, told Johnson that he would not agree to any tax increase unless Johnson cut discretionary spending. The surcharge proposal went nowhere.

By August 1967, President Johnson was growing more concerned about the state of the economy, and he renewed his request for a surcharge. This time he asked for a 10.0% levy, but he was rebuffed by Congress. Future President Gerald Ford, then the House Minority Leader, iterated congressional sentiment:
"If we could only get some cooperation from the White House and the Johnson Administration in the process of reducing nonmilitary, nonessential spending, we could probably avoid the need and necessity for the tax increase that the administration apparently wants Congress to approve."
The turning point came in early 1968 when a growing balance-of-payments deficit raised economic fears to a new height. Johnson agreed to cut discretionary spending by 10.0% and Mills gave Johnson the temporary 10.0% tax surcharge. In 1969 Congress renewed the surcharge through the middle of 1970 but reduced it to 5.0%. Unemployment increased to 4.7% in 1968 and to 6.2% in 1969, before decreasing to 5.6% in 1970 and to 3.3% in 1971.

Historical Perspective: Sacrifice and Surcharge, Joseph J. Thorndike, taxanalysts, 5 Dec 2005

Government Expenditures

The Great Society President Johnson proposed his Great Society program to Congress in January 1965. The program included aid to education, environmental protection, attack on disease, urban renewal, conservation, development of depressed regions, control and prevention of crime, removal of obstacles to the right to vote, the "beautification of America," and a "War on Poverty." The Highway Beautification Act of 1965 was the result of Mrs. Johnson's national campaign for beautification (to plant flowers along the Interstate). Congress enacted many of Johnson's recommendations, sometimes augmenting or amending them, and appropriated monies to implement the specifics. Some programs from the "War on Poverty," such as Head Start, food stamps, Work Study, Medicare and Medicaid, still exist today. Needless to say, spending on the Great Society Programs acted as a major fiscal stimulus to keep the economy expanding throughout the 1960s, but the expansion fueled inflation.

The Viet Nam War President Johnson increasingly focused on the American military effort in Vietnam. He firmly believed in the Domino Theory and that containment required the U.S. to make a serious effort to stop all Communist expansion. Johnson reversed Kennedy's order to withdraw 1,000 military personnel by the end of 1963 and expanded the numbers and roles of the American military following the Gulf of Tonkin Incident. The Gulf of Tonkin Resolution gave the President the exclusive right to use military force without consulting the Senate. By 1968, over 550,000 American soldiers were inside Vietnam; in 1967 and 1968 they were being killed at the rate of over 1,000 a month. Needless to say, military spending on the Vietnam conflict also acted as a major fiscal stimulus to keep the economy expanding throughout the 1960s. However, like the expansion from spending on the Great Society programs, expansion from spending on the Vietnam War also fueled inflation.

In the end, President Johnson was trapped. He, himself, best summed up his dilemma as follows:
"I knew from the start that I was bound to be crucified either way I moved. If I left the woman I really loved – the Great Society – in order to get involved in that bitch of a war on the other side of the world, then I would lose everything at home. All my programs.... But if I left that war and let the Communists take over South Vietnam, then I would be seen as a coward and my nation would be seen as an appeaser and we would both find it impossible to accomplish anything for anybody anywhere on the entire globe."
Inflation increased.

The Ford Years (1973-1976)

Gerald Rudolph Ford, Jr., (born Leslie Lynch King, Jr.) inherited the presidency on August 9, 1974, after Richard M. Nixon resigned. The economy was in the middle of what would be the worst post World War II downturn to date. It lasted from November 1973 to March 1975 and the unemployment rate almost doubled from 4.8% to 9.0%. The annual inflation rate for 1974 was 12.3%. Economists and politicians referred to this period (and the rest of the 1970s) as stagflation.

Stagflation is a period of high inflation and high unemployment. During Ford's two years in office, real GDP grew at an average annual rate of 2.6%. The unemployment rate averaged 7.7%, the annual inflation rate averaged 8.9%, and the average annual trade deficit was $17.9 billion or 0.4% of average annual real GDP of $5,010.4.

Inflation and the WIN Buttons

President Ford sought to tackle inflation first. On October 8, 1974, Ford proposed a 10-point program which included a cap of $300 billion on the federal spending and a $5 billion surtax on corporations and on individuals in the higher income brackets. The centerpiece of his program was a "Whip Inflation Now" plan or "WIN." President Ford's "Whip Inflation Now" Speech.

Ford thought that inflation could be whipped by the simultaneous efforts of little people to inhibit pressure on prices. Each family should make a one-hour "trash inventory" to find waste. Within little more than a week after he had introduced the idea, 101,420 citizens announced themselves as recruits by mailing WIN enlistment papers to the White House. The scary part, however, was Ford's belief that the US could whip inflation by having Americans wear big red WIN buttons. By the end of 1974, some 12 million buttons had been produced. All good intentions notwithstanding, the program was soon viewed as more of a public relations gimmick than a serious assault against inflation. Ford's response to the economic difficulties evoked more ridicule than respect. Retro campaigns: WIN T-Shirts

Profiles of Presidents: Gerald R. Ford - Congress, inflation, and energy

Unemployment and the Ford Rebate

President Ford repeatedly placed himself in the position of appearing indifferent to mitigating unemployment. He insisted that the inflation fight was the greater priority. This led to Ford's veto of a Democratic bill to create more than a million jobs. However, despite an unemployment rate of 9.2%, his veto was sustained.

In March, with unemployment rising rapidly, President Ford relented and made tackling unemployment the administration's priority. Although he clashed with Congress on funding for public works projects, he managed to compromise on a $22.8 billion tax reduction. The Tax Reduction Act of 1975 introduced a new fiscal policy tool — the tax rebate — a temporary, one time payment of income from the federal government to Americans. Each American receiving Social Security benefits received $50, while other taxpayers received a rebate equal to 10% of their tax liability, with the amount of the rebate capped at $200 and a minimum rebate of $100. The Tax Reduction Act of 1975 also introduced the Earned Income Tax Credit, wich is a tax credit for low income taxpayers that is based on earnings and the number of dependents the taxpayer has.

Who Issued the First Tax Rebate? Jonita Davis, eHow Contributing Writer
Profiles of Presidents: Gerald R. Ford - Congress, inflation, and energy

top    IX. Post-WW II Monetary Policies

The Accord

In 1935, Congress reorganized the Federal Reserve and removed the Treasury Secretary from the Board in Washington. However, the Federal Reserve remained closely tied to the Treasury Department. Throughout World War II, the Treasury Secretary compelled the Federal Reserve to peg government security prices to minimize war financing costs. The long bond was pegged at 2.5%, the 12-month bill was pegged at 7/8% to 1-1/4%, and the 3-month bill was pegged at 3/8%. Pegging continued after the war to keep refinancing costs low. However, after the war, the Federal Reserve became concerned about its ability to raise the pegged rates to contain inflation.

The problem with pegging interest rates is that the Federal Reserve cannot achieve both interest rate and money supply targets simultaneously. If the Federal Reserve pegs interest rates, it must be prepared to let the money supply adjust passively to changes in the demand for money. If the Federal Reserve targets a given money supply, it must be prepared to let interest rates adjust passively to changes in the demand for money. By pegging interest rates for the Treasury, the Federal Reserve monetized the federal government's debt. By keeping interest rates artificially low for the Treasury, the money supply grew out of proportion with economic growth.

In 1950, as the United States prepared for the Korean conflict, the Federal Reserve wanted to raise interest rates to prevent monetization of the debt and money supply growth from inducing inflation. In particular, the Federal Reserve wanted to see the 3-month T-bill rate rise from 3/8% to 1/2%. Treasury Secretary John Wesley Snyder disagreed. The Treasury Secretary preempted any increase in interest rates by publicly announcing that the Federal Reserve had agreed to continue its pegs. Not to be outdone, the Federal Reserve publicly disagreed. Federal Reserve Chair Thomas McCabe then asked President Truman to intervene in the dispute.

On March 4, 1951, after much discussion and debate, the Treasury and the Federal Reserve announced that they had reached an Accord:
The Treasury and the Federal Reserve System have reached full accord with respect to debt management and monetary policies to be pursued in furthering their common purpose to assure the successful financing of the Government's requirements and at the same time to minimize monetization of the public debt.
Despite the narrow language of the announcement, the Federal Reserve de facto gained its independence over monetary policy.

The 50th Anniversary of the Treasury-Federal Reserve Accord 1951-2001, Special Report, FRBRich, Winter 2001
Excerpt from The Treasury-Federal Reserve Accord, F. W. Mueller, Jr., The Journal of Finance, 7(4) Dec 1952: pp. 580-599

The Martin Years

No sooner was the ink dry on the Accord when the Federal Reserve's signatory, Chairman Thomas McCabe, resigned. The Truman Administration saw McCabe's resignation as the perfect opportunity to recapture the Fed's subservience. Truman proposed William McChesney Martin, Jr., to be the next Chair of the Fed's Board of Governors, and the Senate approved his appointment on March 21, 1951.

Unfortunately, Martin disappointed Truman. He guarded the Fed's independence zealously... not only during Truman's presidency, but also through Eisenhower's, Kennedy's, Johnson's, and part of Nixon's presidencies. To date, Martin is the longest serving Chair, 18 years and 10 months, from April 2, 1951, to February 1, 1970. (Alan Greenspan is the second longest serving Chair, 18 years and 5½ months, from August 11, 1987, to January 31, 2006, and Marriner S. Eccles, the first Chair of the newly reconstituted Board of Governors under the Banking Act of 1935, is the third longest serving Chair, 13 years and 3 months, from November 15, 1934, to February 3, 1948.)

Martin's tenure spanned one of the most stable economic periods in U.S. history. Real GDP grew at an average annual rate of 5.4% with three minor downturns (July 1953 to May 1954, August 1957 to April 1958, and April 1960 to February 1961), none lasting more than 10 months. (A downturn that would last 11 months started the month before Martin left office.) The average unemployment rate was 4.7%, the average annual inflation rate was 2.3%, and the average annual trade deficit was $25.9 billion or 0.6% of average annual real GDP of $4,261.8 billion.

Whether Martin was just lucky or his monetary policies were "on target" is for history to decide. Martin targeted low inflation and economic stability, but he was not dogmatic about how he achieved his targets. Martin rejected the idea that the Fed could pursue its policies through the targeting of a single indicator and instead made policy decisions by examining a wide array of economic information. As Chairman, Martin institutionalized this eclectic approach within the proceedings of the FOMC, gathering the opinions of all governors and presidents within the System before making decisions. As a result, his decisions were often supported by unanimous votes on the FOMC. (Alan Greenspan ultimately adopted Martin's eclectic philosophy.)

Martin is famous for saying that "[t]he role of the Federal Reserve is to take away the punch bowl just as the party gets going." Apparently, he was very successful at pulling the punch bowl at just the right times.

The Burns Years

Arthur Frank Burns succeeded Martin as Chair of the Fed. He served from February 1, 1970, to March 8, 1978. Burns' economic preoccupation was business cycles. He studied at Columbia University under famous business cycle theorist, Wesley Clair Mitchell, he collaborated with Mitchell on explanations for business cycles, and he was a president of the National Bureau of Economic Research, the organization that sets the official dates for business cycle turning points. Yet, despite all of Burns' business cycle savvy, he was not so disciplined as Martin and is often blamed for the inflation portion of the 1970's stagflation.

Burns had been appointed by President Nixon, who blamed Martin's tight monetary policy for the 1960 downturn and his defeat in the 1960 presidential election. Despite increasing inflation, Burns was given marching orders to keep monetary policy easy and the money flowing. Nixon expected to keep inflation in check with his wage and price controls. However, when Nixon's wage and price controls began to fail, Burns could not rein in money supply growth fast enough to restrain the ensuing inflation.

Moreover, Burns was saddled with cost-push inflation from the Arab oil embargo, rising oil prices, and pressing wage demands by unions. Monetary policy affects only demand. It does not operate on the cost (supply) side.

Burns' record was the worst among Fed Chairs in the post-World War II period up to that time. Real GDP grew at an average annual rate of 3.7%, but growth was unstable. It fluctuated between a high of 5.8% in 1973 and a low of -0.6% in in 1974. The unemployment rate averaged 6.0%, but was as high as 9.0% in 1975 and never fell below 6.0% thereafter. The annual inflation rate averaged 8.8%, but it reached 12.3% in 1974 and stood at 9.0% when Burns resigned from office in 1978. The average annual trade deficit jumped to $49.1 billion or 1.0% of average annual real GDP of $4,912.7, thanks to the increase in oil prices.

The Miller Years

G. William Miller had a very short, but disastrous tenure as Fed Chair. He served just 17 months from March 8, 1978, to August 6, 1979. Miller, a Keynesian, believed that inflation could "prime the pump" of the economy and would, at any rate, be self-correcting. He thus pursued an easy monetary policy and opposed raising interest rates to attack the slow growth-unemployment problems. Miller's policy sent the dollar's value spiraling downward. By November 1978, less than 9 months into his term, the dollar had fallen nearly 34% against the German mark and almost 42% against the Japanese yen. The Carter administration launched a "dollar rescue package." The U.S. sold gold (to buy back dollars from the foreign market), borrowed from the International Monetary Fund, and auctioned Treasury securities denominated in foreign currencies. This package was a short-term fix. The dollar stabilized temporarily, before resuming its fall. Miller needed to be replaced.

The Volcker Years

Enter Paul Volcker. You cannot miss him. He stands a commanding 6 feet 7 inches tall.

Paul Adolph Volcker was appointed by President Jimmy Carter to replace Miller. If someone were to take away the punch bowl, it was Volcker. Volcker acknowledged that the U.S. had a problem with inflation and he determined to do something about it.

Double-Digit Inflation and Monetary Restraint

The economic period from 1973 to 1979 was dubbed "stagflation," a combination of high unemployment rates and high inflation rates. Neither Burns nor Miller seemed to understand the problems or how to correct them, if they could be corrected. The two former Chairs tended toward loose monetary policies to solve the unemployment problem, but, in the end, they failed at achieving a lower unemployment rate and only exacerbated the inflation rate. When Paul Volcker was appointed as Chair in August 1979, the unemployment rate was 6.0% and the inflation rate was 11.8%. The M1 and M2 money supplies had been growing by as much as 10% annually.

Double-Dip Recession and Monetary Ease

Twin Deficits and Foreign Exchange Rate Policies

The "twin deficits" were two related economic problems of the 1980s: the federal government budget deficit and the international trade deficit. The federal government budget deficit is the difference between government revenue (mostly taxes) and government spending and the international trade deficit is the difference between exports and imports. Both deficits occur when someone is spending more than they earn.

Federal Budget Deficit

In 1980, during the last year of Jimmy Carter's presidency, the federal government budget deficit reached $73 billion and the public debt increased to over $900 billion. Presidential challenger, Ronald Reagan, argued that the federal government's bloated size prevented prosperity. He campaigned on a platform that came to be known as "supply-side economics." He promised to lower taxes and decrease federal expenditures to reinvigorate the domestic economy. Reagan argued that lower taxes would encourage saving, investment, and work effort, raise productivity, raise income, and ultimately increase taxes to reduce the federal budget deficits. He also argued for less government spending and regulation to return resources to the private sector and lower business costs.

Trade Deficit

Plaza Accord

Louvre Accord

Real GDP grew at an annual rate of 2.8% with two (2) major downturns (January 1980 to July 1980 and July 1981 to November 1982) followed by rapid rebounds. During the first downturn, real GDP decreased by 8.3% and then it rebounded by 8.2% over the following year. During the second downturn, real GDP decreased by 6.6% and then it rebounded by 8.4% over the following year. The average unemployment rate was 7.7%. It was 6.0% when Volcker took office, it increased to 7.8% during the first downturn, dropped to 7.2% during the rebound, but increased to 10.8% during the second downturn, before slowly decreasing to 6.0% at the end of Volcker's tenure. The average annual inflation rate, as measured by the core Personal Consumption Expenditure Price Index (PCEPI) was 5.8%. It started at 7.3% in 1979, increased to a peak of 10.0% in 1980, and then decreased to an annual average of 3.8% for the last three years of Volcker's tenure. The average annual trade deficit was $??? or ???% of average annual real GDP of $?????.

top    X. Debt Management Policies

Traditional Debt Management

Operation Twist

top    XI. Incomes Policies

Kennedy Wage-Price Guidelines

Real GDP grew at an annual rate of ???% with ??? minor downturns (dates). The average unemployment rate was ???%. The average annual inflation rate was ???%. The average annual trade deficit was $??? or ???% of average annual real GDP of $?????.

Nixon Price Controls

Real GDP grew at an annual rate of ???% with ??? minor downturns (dates). The average unemployment rate was ???%, the average annual inflation rate was ???%, and the average annual trade deficit was $??? or ???% of average annual real GDP of $?????.

top    XII. Supply Management Policies

National Economic Planning

Public Enterprise

Regulation

top    XIII. Supply-Side Economic Policies

Reaganomics

Clinton Tax Increases

Bush Tax Cuts

Real GDP grew at an annual rate of ???% with ??? minor downturns (dates). The average unemployment rate was ???%, the average annual inflation rate was ???%, and the average annual trade deficit was $??? or ???% of average annual real GDP of $?????.

top    XIV. Recent Monetary Policies

The Greenspan Years

Real GDP grew at an annual rate of ???% with ??? minor downturns (dates). The average unemployment rate was ???%, the average annual inflation rate was ???%, and the average annual trade deficit was $??? or ???% of average annual real GDP of $?????.

The Dot-Com Bubble and Irrational Exuberance

The 9-11 Terrorist Attacks and Systemic Risk

The Bernanke Years

Real GDP grew at an annual rate of ???% with ??? minor downturns (dates). The average unemployment rate was ???%, the average annual inflation rate was ???%, and the average annual trade deficit was $??? or ???% of average annual real GDP of $?????.

The Great Recession

Subprime Mortgage Crisis

Collateralized Mortgage Obligations

Credit Default Swaps

Deleveraging

Liquidity Trap

Quantitative Easing

Credit Facilities

Liquidity Facilities

The "Too Big To Fail" Doctrine

Interest on Reserves

Large Scale Asset Purchases

Long-term Treasuries

Mortgage-backed Securities

The Yellen Years

Decompression (?)

top    XV. Recent Fiscal Policies

The Bush Bailout Plan (TARP I)

In 2007-2008, the United States faced the financial crisis, mortgage backed securities (MBS) resulted the financial problem to the US. There are many major financial institutions, such as Lehman Brothers, Fannie Mae, Freddie Mac and American International Group, got financial distress. Since those financial institutions influence the U.S. a lot, the government has to something to rescue and stop the problem become worse.

The Emergency Economic Stabilization Act of 2008, otherwise known as the Troubled Asset Relief Program (TARP I), enacted on October 3, 2008, authorized the Treasury to spend up to $700 billion to buy "troubled assets" from financial institutions. The Treasury is allowed to draw up to $250 billion immediately after the enactment, and then requires the President to certify an additional $100 billion; another $350 billion are subject to further Congressional approval. The main mission of the TARP I is "Buying Bad Assets." The purpose of Troubled Asset Relief Program (TARP) is to stabilize the economy.

TARP I was focused on removing downside risk from balance sheets. The danger of TARP I is you might buy a lot of bad assets, and have only made a medium-sized dent in the downside risk problem.

Real GDP grew at an annual rate of ???% with ??? minor downturns (dates). The average unemployment rate was ???%, the average annual inflation rate was ???%, and the average annual trade deficit was $??? or ???% of average annual real GDP of $?????.

The Obama Rescue Plan (TARP II)

TARP II was focused on shoring up balance sheets. TARP II ignores the downside risk problem and pays more attention in filling capital holes. If the capital increase, the banks have lower leverage ratios and people would have more confidence in them.

Real GDP grew at an annual rate of ???% with ??? minor downturns (dates). The average unemployment rate was ???%, the average annual inflation rate was ???%, and the average annual trade deficit was $??? or ???% of average annual real GDP of $?????.

FAS 157: The Gremlin Behind the 2007-2009 Financial Crisis

FAS 157 provides that.... FAS 157 is one of many accounting standards promulgated by the Financial Accounting Standards Board (FASB). It became effective November 2007.

Jumpstart Our Business Startups (JOBS) Act

The JOBS Act is a law intended to encourage funding of U.S. small businesses by easing various securities regulations. As a result of the subprime mortgage crisis, banks went into lock-down, tightened credit standards across-the-board, and limited lending. Small businesses were shut out. The JOBS Act was a measure to unclog funding opportunities for small businesses. It permits small businesses to bypass restrictive credit standards for bank loans and onerous and expensive SEC registration requirements for going public and to raise money directly online on crowdfunding websites.

top     Summary



top    Readings

Declaration of Independence

Articles of Confederation of 1777

U.S. Constitution of 1787

An Inquiry into the Nature and Causes of the Wealth of Nations, Adam Smith, 1776

The Work of the National Monetary Commission, an Address by Senator Nelson W. Aldrich, before the Economic Club of New York, 29 Nov 1909

Final Report of the National Monetary Commission, 9 Jan 1912

The General Theory of Employment, Interest and Money, John Maynard Keynes, 1936

The New Deal, A. Joyce Furfero

Republicans v Democrats: The Record

It's Official: More Private Sector Jobs Created In 2010 Than During Entire Bush Years

The Historical Lessons of Lower Tax Rates, Daniel Mitchell, The Heritage Foundation, 13 Aug 2003

Comparing the Kennedy, Reagan and Bush Tax Cuts, William Ahern, The Tax Foundation, 24 Aug 2004

Reading the Recent Monetary History of the United States, 1959-2007, Jesús Fernández-Villaverde, Pablo Guerrón-Quintana, and Juan F. Rubio-Ramírez, Review (FRBStL), Jul/Aug 2010, 92(4), pp. 311-38

The Goals of U.S. Monetary Policy, John Judd and Glenn D. Rudebusch, Economic Letter (FRBSF), 1999-04, 29 Jan 1999


top    Websites



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