CHAPTER 3 HISTORICAL BACKGROUND OF MACROECONOMIC POLICIES IN THE UNITED STATES

"History is too serious to be left to historians."

Iain Macleod

1. Introduction
2. Constitutional Provisions
   1. Federal Powers
   2. Limitations on Federal Powers
   3. State Powers and Limitations
3. Theoretical Limitations: 19th Century Liberal Classicism
   1. Say's Law
   2. The Quantity Theory of Money
   3. Price-Specie Flow Mechanism
4. Capital Crises Throughout the 19th and Early 20th Centuries
5. Federal Reserve Act of 1913
6. The Great Depression
7. Employment Act of 1946
8. Humphrey-Hawkins (Full Employment and Balanced Growth) Act of 1978
9. Debt Management Policies
10. Incomes Policies
11. Supply Management Policies
12. Supply-Side Economic Policies
13. Monetary Policies
14. Summary
    Readings
    Websites

    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

Historically, the United States government's policy toward economic affairs was laissez-faire --- hands off! Government keep out! Although this is not true absolutely, it is true relative to the kind of intervention witnessed since World War I.

From its beginnings, the U.S. economy has been 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 Wealth of Nations in 1776, the same year that the U.S. declared its independence from Britain. 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 people's 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 contact may give the federal government a lot of power or it may give only minimal power. In either case, if the contract doesn't say that the federal government can do it, it can't.

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 and the framers of the Articles had to consider redrafting the contract. 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. David 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. The idea was not well accepted. Many of his 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.

    II. Constitutional Powers and Limitations

"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

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 powers 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.

     II-A. 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."

Initially, the clause was interpreted to mean that only indirect taxes could be levied. 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. See Hylton v. The United States, 3 U.S. 171 (1796).

For almost 125 years, the federal government relied solely on import duties and land sales to finance its expenditures. In 1872, the government levied an income tax on wages to help pay off the Civil War debt. 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, however, Congress enacted a broader income tax which included taxation of interest, rents, and dividend income. 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

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.

Our current public debt, approximately $7.3 trillion, originated with the financing for World War I. 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. This occurred, for example, in 1933, when Britain abandoned the silver standard and, in 1973, when the United States, under President Richard M. Nixon, abandoned the gold standard.

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 1, Section 6[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.

     II-B. Limitations on Federal Powers

Specific 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.

For example, if the federal government wanted to collect $10 billion from a property tax and 6% of the population lived in Illinois and another 6% in Pennsylvania, both states would be liable for $600 million in tax collections. If, however, property values were twice as high in Pennsylvania, then, the tax rate in Illinois would have to be twice the Pennsylvania tax rate to raise the same $600 million. 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.

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.

     II-C. 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 Tenth 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.

     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

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., 2001; 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)

     III-A. 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." The French economist, Jean-Baptiste Say, argued that man's wants are insatiable, but his means to satisfy those wants is limited.

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, the rational economic man will summon all of his productive resources and produce what he can to exchange 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. Therefore, economies will always tend to operate at full employment and to produce as much as possible to satisfy all 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 p_c0 and capital goods sell at p_k0.

Consumer Goods Market

Capital Goods Market

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 Q_max, 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

The general level of prices is P₀ = (p_c0 + p_k0)/2, and the total output is equal to the sum of the output in the consumer and capital goods markets: Q_max = q_c0 + q_k0. 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 = P₀Q_max.

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 = p_c0q_c0 + p_k0q_k0

= 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 p_c0 to p_c1, while the quantity supplied of consumer goods falls from q_c0 to q_c1. 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 Q_max 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 p_k0 to p_k1, as output of capital goods increases from q_k0 to q_k1. 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 Q_max, 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.

     III-B. The Quantity Theory of Money

The 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: M_sV PT and P = M_sV/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: M_sV_y PQ and P = M_sV_y/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: Q_max, given the availability of resources. They also reasoned that the velocity (V_y) 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 V_y are fixed, P = f(M_s).

Aggregate Output

The Labor Market

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 (L_max) 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 (L_max) 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 = M_sV_y/Q
ln(P) = ln(M_s) + ln(V_y) - ln(Q)

d(ln(P))/dt = d(ln(M_s))/dt + d(ln(V_y))/dt - d(ln(Q))/dt

% P = % M_s + % V_y - % Q

Since V_y and Q are assumed to be constant, % V_y = 0 and % 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

     III-C. 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.

(M_s/P)_A = (M_s/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.

     IV. Capital Crises Throughout the 19th and Early 20th Centuries

Despite the theoretical full-employment implications of Say's Law, the Quantity Theory of Money, and the 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.

If the U.S. had any conscious macroeconomic policy, it was, for the most part, to follow 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.

In 1846, the federal government adopted the Independent Treasury System, which 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 National Bank Acts of 1863/1864 sought to stabilize and standardize the money supply by taxing state-chartered bank notes and forcing banks to issue "greenbacks," which were backed by U.S. government securities. But banks eluded the tax and the 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.

     V. 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 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 sought to eliminate erratic changes in the domestic money supply associated with international gold flows. The central bank could add reserves to the system when demand was high to prevent financial crises and could drain reserves from the system when demand was slack. The third sought to prevent the "pyramiding" of reserves by correspondent banks by centrally locating all reserves. The last sought to provide a system by which the banks could clear checks promptly and uniformly throughout the Nation. The 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 make 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."

     VI. The Great Depression

Then came the Great Depression. The causes were many, the cures were few. No matter how hard Hoover tried to maintain fiscal prudence and to balance the budget, he just could not. The main issue in the 1932 campaign 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 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 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.

The economy did begin 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, but arguing that "Demand creates its own supply." Keynes debunked the myth that money was a neutral agent in economic activity. He explained why saving is not always directed into investment in new capital. He also showed that money had an effect on real output (not just prices), but that the relationship between money and output was not stable or predictable and that economic activity had an endogenous effect on the money supply. Keynes advocated changes in government spending or tax collections, which change the velocity of money, at times when the relationship between money and output breaks down. 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 justified 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.

With the turn in the tide of the war, however, 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.

     VII. 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 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 targets 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 a deflation or a 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 Vietnam War and President Lyndon B. Johnson's Great Society programs brought a fresh concern over inflation, and the 1974-5 downturn was the most serious since the Great Depression.

    VIII. 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, Congress passed the Humphrey-Hawkins (Full Employment and Balanced Growth) Act in 1978 15 U.S.C. §§ 1021, 3101, et seq. The Act strengthens the Employment Act of 1946 in four essential respects:

1. It emphasizes the increasing role of the private sector to promote full employment, growth in productivity, and stable prices.
   
   
2. It stresses a goal of balanced federal budgets.
   
   
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. (Nothing had been said about international payments balance in the Employment Act of 1946.)
   
   
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. It requires the President, once a year, to delineate to Congress its targets and to outline its plans on how they intend to reach them. 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. It requires the Chairman of the Board of Governors, twice a year, to delineate to Congress their targets and to outline their plans on how they intend to reach them.
      

      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 nothing in the Act requires 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 balance-of-payments equilibrium 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.

     IX. Debt Management Policies

Debt management policies are a problem only for governments which issue debt securities with maturities (e.g., bills, notes, and bonds). If the government were to finance its excess expenditures with permanent debt, the problems of funding the new debt and refunding the old debt when it matures would never occur. Permanent debt is created through either the printing of money or the issuing of "consols". Money is a non-interest-bearing debt with no maturity. Consols are interest-bearing securities issued in perpetuity. Because money and consols have no maturity, the problem of redemption or refunding never occurs. The government is required only to pay the interest expense each period. While other governments have made use of consol financing, the U.S. government has never issued this type of permanent debt. Thus, it is continually faced with the task of determining the maturity schedule of its issues to finance both current deficits and the maturing debt.

The U.S. government did not always face this problem. Debt management policies are a phenomenon of the twentieth century. Except for unusual wartime expenditures, the U.S. government followed the principle of fiscal prudence for the first 150 years of its existence. Thus, throughout its early history, up through World War I, the federal government had very little debt. When it did have to raise funds to pay for wartime expenditures, it did so by making "loans." These loans were mostly bonds, which were sold to banks. They were quickly retired after each war by increasing taxes.

Treasury bills were first introduced in 1929 as a means to cover the federal government's frequent short-term cash deficits. At that point, the personal and corporate income taxes had been implemented and provided the primary source of income for the federal government. However, withholding of personal income taxes did not occur until World War II and businesses were required neither to file quarterly estimated tax returns nor to remit portions of their annual tax liabilities to the federal government periodically throughout the year. Thus, while the federal government's fiscal year ran from October 1 to September 30 (as it still does), the largest single source of federal revenues was not received until April of each year. Even today, with withholding and quarterly estimated tax payments to the federal government, personal and corporate tax liabilities are settled only in the spring; therefore, it is not unreasonable to expect that the Treasury might have a temporary short-fall in receipts during the fall and winter months, even if its overall annual budget were in surplus. T-bills are well suited to this seasonal ebb and flow of Treasury cash. Since their maturities are short, they have a ready-made market among banks and other tenders, and their prices adjust readily to changing market conditions.

The problem of debt management arose only as the federal government began to amass such a significant amount of debt of varying maturities that it was no longer a question of when the debt would be retired but rather how it was to be refunded or "rolled over" when it matured. Even then debt management was of insignificant importance because long-term interest rates stayed mostly below the maximum ceiling rates of 3.5%, 4.0%, 4.5%, and 4.25% for coupons on government bonds, mandated by the Victory Liberty Loan Acts of 1917 and 1918. However, starting in the late 1960s, as interest rates rose, the Treasury had to get special permission from Congress continually to float bonds with coupon rates in excess of the 4.25% limit. The hassle of appealing to Congress to get these exemptions encouraged the Treasury to substitute bills and notes, neither of which have interest rate limitations. As a result, the average maturity on the federal government's debt has fallen by half since World War II to four years and seven months. Almost half the debt (42%) matures each year. To obviate the need for bond financing, Congress repealed the last Victory Liberty Loan Act in 1982.

     X. Incomes Policies

Throughout the 18th and 19th centuries, the government had no incomes policies. In fact, if Say's Law and the Quantity Theory of Money were to hold, the government's role was to keep wages and prices as flexible as possible. After all, gluts and shortages could only occur if prices failed to respond to changing market conditions.

The first wage and price controls were imposed during World War I, when the federal government regulated various food prices. At the urging of the federal government, some local governments put controls on rents. When the rent controls were challenged in the courts, the Supreme Court upheld them since they did not constitute an unconstitutional taking of private property, a ruling that would have been inconceivable prior to World War I. This ruling also paved the way for congressional passage of laws instituting minimum agricultural prices and minimum wages during the 1930s and allowance for the Federal Reserve's Regulation Q, setting maximum interest rates on bank deposits.

During World War II, the federal government imposed broad-based controls on wages and prices and rationed many goods including food, tires, gasoline, and shoes. To enforce compliance, the Office of Price Administration (OPA), a special agency of the executive branch, imposed indirect sanctions. An indirect sanction is the imposition of a penalty by a government agent other than the one legislatively authorized to penalize the specific breach of law or regulation. While such sanctions were first widely used by the government during World War I, during World War II, they were the government's main weapon for controlling prices and the flow of raw materials and manpower. In Steuart v. Bowles, 140 F.2d 703 (1944), the OPA was accused of unlawfully having suspended a fuel-oil dealer's access to supplies because he violated rationing regulations. The law authorizing the controls had given no such power to the OPA, but the Court found such sanctions to be constitutional. Indirect sanctions are still around and were used most recently during the Carter Administration. President Jimmy Carter's wage-price guideline efforts "relied entirely on indirect sanctions" imposed by the Council on Wage and Price Controls, a special agency of the executive branch with no legislative authority.

In the early 1960s, President John F. Kennedy instituted voluntary wage and price guidelines to curb the creeping inflation. They did not work. Ten years later, President Richard M. Nixon had to take harsher measures against an even higher rate of inflation. In August 1971, he instituted Phase I of his wage and price control program. Phase I involved mandatory freezes on wages and prices and rents for ninety days. Subsequent phases, regulated increases in wages and prices. This was the first and only time that mandatory wage-price controls were used when the nation was not at war.

     XII. Supply-Side Economic Policies

Supply-side economic policies are the most recent adaptation of macroeconomic policies. In fact, they are a child of the 1980s, born of the Reagan administration. They are a hybrid or combination of policies --- taxes, government spending, and regulation/deregulation --- designed to alter relative prices and, therefore, consumption, saving, and investment decisions. Some economists would argue that supply side economics is a throwback to the days of laissez-faire Classical economics, when Say's Law emphasized the importance of supply to the overall "wealth of a nation," the response of economic participants to changes in relative prices, and the maxim, "the government that governs best governs least." Other economists would argue that the policies of supply-side economics, especially the huge federal budget deficits, are nothing more than massive doses of Keynesian fiscal stimulus.

Yet, there are major differences. The biggest difference between supply-side economics and Classical economics is that the latter recognizes certain nominal roles for the federal government, but ignores the level and structure of taxes, which are incidental to raising revenue to support these legitimate government activities and not an instrument of supply-side management. Supply-siders, on the other hand, argue that tax rates are simply another set of prices and that the level and structure of tax rates are instrumental in manipulating aggregate supply; that is, participants in the private sector can be encouraged to change their behavior toward increasing the supply of goods and services by changing the tax code. The biggest difference between supply-side economics and Keynesian economics is that the federal budget deficits were not part of the original supply-side design. Rather, the overall size of the federal government was to have been reduced and the composition as well as the level of its expenditures and tax collections altered.

     XIII. Monetary Policies

Why should I reinvent the wheel?

Marvin Goodfriend, Monetary Policy Comes of Age: A 20th Century Odyssey, Economic Quarterly (FRBRich), 83(1) Winter 1997

     XIV. Summary

From its beginnings, the structure and organization of the United States has been one based on maximum opportunity for private competitive enterprise and on the widest possible latitude for personal choice. In a federation, such as the United States, a constitution is the sine qua non of the federal government's powers, with all other powers being reserved for the states, respectively. The U.S. Constitution has only indirectly limited the federal government from certain policy alternatives. Over the years, the constitutionality of federal government policies have been modified and amended by the Supreme Court, which has interpreted the Constitution with varying degrees of construction, validating some laws and invalidating others, that would give the federal government more control. Any constraints on policy making were, therefore, self-imposed, consistent with the goal of achieving maximum personal freedom.

The theoretical bases for most policy-making throughout the 18th and 19th centuries were three classical precepts: Say's Law, the Quantity Theory of Money, and Hume's Price-Specie Flow Doctrine. First, Say's Law states that "Supply creates its own demand," denying prolonged periods of deficient demand. Second, the Quantity Theory of Money states that "The amount of money in circulation determines the absolute level of prices," denying any role for money in the determination of real output. And, third, the Price-Specie Flow Doctrine states that prices are regulated by the inflow and outflow of specie during the normal course of international trade and that the only way a country can avoid severe bouts of both inflation and deflation is to regulate the amount of money in circulation, e.g. neutralize money inflows and monetize money outflows. All three theorems basically deny fundamental or real economic problems and, therefore, deny a significant role for government policy-making in aggregate economic matters. If any stabilization policy can be deduced from these theorems, it is to "follow the dictates of the gold standard" under the Price-Specie Flow Doctrine.

Contrary to theoretical constructs, however, western "capitalist" economies have been subject to "crises" and "panics" throughout their modern history; but, it was not until the 20th century that most western governments realized that intervention might be necessary to stabilize aggregate economic activity and prices. In 1913, the U.S. Congress established the Federal Reserve System as the central bank and supreme domestic authority on money matters. Then, starting in 1933, Congress passed several laws designed to legitimatize budgetary policy for economic stabilization. The first official stabilization goals of maximum employment, maximum growth, and stable prices were set forth in the Employment Act of 1946, which was subsequently addended in 1978 with the Humphrey-Hawkins (Full Employment and Balanced Growth) Act in 1978 to include equilibrium in the balance-of-payments accounts.

To achieve these goals, the federal government has relied on indirect control of demand through the use of monetary, fiscal, and debt management policies. The U.S. government has shied away from national economic planning, has engaged in only minimal production activities, and has imposed incomes policies (wage and price controls) only in emergency (war) and economically undesirable (inflationary) environments. The government has not been so shy in regulating economic activity. In fact, by the mid-1970s, economic participants began to feel the burden of overregulation and the decade of the 1980s was devoted to deregulating many industries and reducing the amount of government intervention in economic activity. The program was dubbed "supply side economics."

     Readings

A History of the Federal Reserve Bank of Atlanta, 1914 - 1989 (FRBAtl), 1989 (Note: This article also provides an excellent description of the original Federal Reserve before its consolidation in 1933.)

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

The General Theory of Employment Interest and Money, John Maynard Keynes, Harcourt, Brace and Company, New York, 1936

Making Monetary and Fiscal Policy, G.L. Bach, Brookings Institute, Washington, DC, 1971: chs. 1, 2

Glass-Steagall and the Regulatory Dialectic, Joao Cabral dos Santos, Economic Commentary (FRBClev), 15 Feb 1996

U.S. National Economic Policy, 1917-1985, Anthony S. Campagna, Praeger, New York, 1987

Constitutional Limitations of the Federal Budget, William Cox, Economic Review, May-Jun 1979, 73-76

The American Monetary System, Robert A. Degen, D.C. Heath and Co., Lexington, MA, 1987

The Federal Reserve System: Purposes and Functions, Board of Governors of the Federal Reserve System, Washington, DC, 1996: chs. 1, 2

Our Banking History, Alan Greenspan, Speech, Annual Meeting and Conference of the Conference of State Bank Supervisors, Nashville, TE, 2 May 1998

Crisis and Leviathan: Critical Episodes in the Growth of American Government, Robert Higgs, Oxford University Press, Oxford, 1987

Democracies in Crisis: Public Policy Responses to the Great Depression, Kim Quaile Hill, Westview Press, Boulder, CO, 1988

Why Didn't the United States Establish a Central Bank Until After the Panic of 1907? Jon R. Moen and Ellis W. Tallman, Working Paper, 9-16 (FRBAtl), Nov 1999

Lessons from the Panic of 1907, Jon Moen and Ellis Tallman, Economic Review (FRBAtl) 75, May/June 1990, 2-13

Panic of 1907, Jon Moen, EH.Net Encyclopedia, edited by Robert Whaples, 15 Aug 2001

Public Finance in Theory and Practice, 5th ed., Richard A. Musgrave and Peggy B. Musgrave, McGraw-Hill, New York, 1989: ch. 2

The New Deal, A. Joyce Furfero

America's Great Depression, Ross Nordeen

The "Hundred Days" of F.D.R., Arthur Schlesinger, Jr., New York Times, 10 Apr 1983: 3(1, 8, 9)

The Dollar Standard Spinning Gold Into Dross, Richard W. Stevenson, New York Times, 28 Dec 1997

Part 7: British Financial Warfare: 1929; 1931-33: How The City of London Created The Great Depression, Webster G. Tarpley, Dec 1996

To Regulate the Value of Money: An Analysis of the Power of Government to Create and Set a Value on Money, Edwin Vieira, Jr., Foundation for the Advancement of Monetary Education, Ltd., New York, NY

Hell Bent for Election, James P. Warburg, Doubleday & Co., Inc., New York, 1935

Paul Warburg's Crusade to Establish a Central Bank in the United States, Michael A. Whitehouse, The Region (FRBMinn), May 1989

Mercantilism, The Columbia Encyclopedia, 6th ed., 2001

Mercantilism, Gerhard Rempel, Professor of History, Western New England College

Mercantilism and the American Revolution, Carole E. Scott, Professor of Economics, State University of West Georgia

The money economy: mercantilism, classical economics and Keynes' general theory, G.R. Steele, The American Journal of Economics and Sociology, Special Invited Issue: Money, Trust, Speculation and Social Justice - Part 2: Trust and Money, Oct, 1998

     Websites

The U.S. Constitution Online
America 1900 WGBH, Public Broadcasting Corp. of Boston
Federal Reserve History (A webpage of articles and hyperlinks sponsored by FRBMinn)
The Federal Reserve System: An Overview of Times and Events (FRBMinn)