Deficit Spending

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DEFICIT SPENDING

The Great Depression marked a turning point in America's fiscal history. Prior to the 1930s, balanced federal budgets in which tax receipts exceeded expenditure were the norm, but thereafter they have been rare. The unbroken sequence of unbalanced budgets that operated from fiscal year 1931 to fiscal year 1947 heralded the predominance of deficit budgets in the second half of the twentieth century. In contrast to the post-World War II period, however, Depression-era fiscal policy was only belatedly influenced by the new Keynesian economic theories.

The budget moved from a $734 million surplus in fiscal year 1929 to a $2.7 billion deficit in fiscal year 1932. President Herbert Hoover initially regarded deficits as a short-term necessity while the economy underwent correction. Under his lead, Congress cut taxes, increased public-works spending, and established loan programs to assist state and local public works and state unemployment relief. These measures were utterly insufficient to boost recovery, but Hoover held back from large-scale deficit spending for fear of engendering big government. Moreover, the tax-increasing Revenue Act of 1932 vainly attempted to restore balanced-budget orthodoxy so that government borrowing would not crowd out business from tight credit markets. Its reduction of purchasing power only aggravated economic decline with the consequence that the deficit remained stubbornly high.

Hoover came under attack most often not for the inadequacy of his deficit spending but for its excess. Business leaders feared that unbalanced budgets would have severe inflationary consequences if government expanded the money supply to ease its borrowing requirements. To the mass public, deficits were evidence of government extravagance and mismanagement. In the 1932 presidential election, therefore, economic and political considerations induced Democratic candidate Franklin D. Roosevelt to promise that his administration would balance the budget.

The core ideas of what became known as Keynesianism—that consumption rather than investment drove economic growth and that public spending could stimulate mass purchasing power when the private economy was in recession—had few adherents. In the 1890s, University of Pennsylvania economist Simon Patten had pioneered the idea that increased consumption was the foundation for economic well-being, a view later promoted by his students, Wesley Mitchell and Rexford Tugwell, and journalist Stuart Chase in the 1920s and 1930s. Meanwhile, lay analysts William Truffant Foster and Waddill Catchings turned the conventional economic belief that consumption was the result of production on its head in a number of popular tracts, such as Plenty (1925), Business without a Buyer (1927), and The Road to Plenty (1928). They further contended that government spending was the best means to counteract recession when many people lacked private income to spend. British economist John Maynard Keynes promoted similar views in works like The Means to Prosperity (1933). "Too good to be true—You can't get something for nothing," Roosevelt had commented in the margin of his copy of The Road to Plenty. He was similarly unimpressed with Keynes, whom he dubbed "a mathematician rather than a political economist" after their 1934 meeting.

Nevertheless, Roosevelt had no more success than Hoover in balancing the budget. New Deal emergency spending on public works, relief, and rural programs drove up federal outlays to $6.6 billion in fiscal year 1934 and $8.2 billion in fiscal year 1936, well above Hoover's largest budget of $4.7 billion in fiscal year 1932. Tax revenues could not cover this expansion in a depressed economy, so the deficit grew to $4.3 billion in fiscal year 1936 compared with $2.6 billion in Hoover's fiscal year 1933 budget. Ever mindful of his campaign pledge, Roosevelt viewed the New Deal deficits as an embarrassment rather than an instrument for recovery. Accordingly, he repeatedly raised taxes—both direct and indirect—and was a reluctant spender. Significantly, congressional enactment over the presidential veto of a $2.2 billion appropriation for immediate payment of the World War I veterans' bonus helped make the fiscal year 1936 deficit the largest operated by the New Deal. The true measure of New Deal fiscal activism was not the actual deficit but the full-employment deficit that would have accrued had the economy been operating to its full potential. This hypothetical index differentiates between intentional policy and the effect of depressed economic activity on the tax base. It reveals that only four New Deal budgets—fiscal years 1934, 1936, 1939, and 1940—operated expansionary deficits, while the others provided no greater stimulus than Hoover's budgets of fiscal years 1930 to 1932. Moreover, in contrast to Hoover, Roosevelt could have operated larger deficits without fear of driving up interest rates because the early New Deal had liberated monetary and credit policy from Federal Reserve control.

In 1937 Roosevelt's fiscal orthodoxy prompted his decision to balance the fiscal year 1938 budget as an anti-inflation precaution in advance of full recovery. The reduction of federal spending coincided with the first collection of the social security taxes, which sucked purchasing power from the economy, and the tightening of monetary policy. The combined effect of these three actions tipped the recovering economy into deep recession. Roosevelt now faced a stark choice of adhering to orthodoxy or spending his way out of recession. Conservative advisers led by Treasury Secretary Henry Morgenthau insisted that a balanced budget was vital to restore business confidence. Conversely, Federal Reserve chairman Marriner Eccles, a longtime advocate of counter-cyclical policy, warned that only deficit spending would restore purchasing power in the economy. The effort to speed recovery by placating business, he told Roosevelt, had "borne no fruits in either dollar terms or goodwill." Once a lone voice, Eccles now found himself at the center of a group of liberal New Dealers whom the recession had converted to the same cause. These included such cabinet members as Harry Hopkins, Harold Ickes, and Henry Wallace, as well as younger officials spread throughout the federal bureaucracy, such as Laughlan Currie, Mordecai Ezekiel, Leon Henderson, and Aubrey Williams. They found theoretical justification in Keynes's recently published master work, General Theory of Employment, Interest, and Money (1936), which contended that in advanced industrial economies permanent deficits were needed to boost consumption and full employment.

The battle for the president's ear ended in victory for the spenders. Though unconvinced about permanent deficits, Roosevelt adopted Keynesian remedies against the recession and justified these with Keynesian rhetoric. In April 1938 he recommended that Congress appropriate $3 billion for emergency spending and credit programs without corollary tax increases to boost "the purchasing power of the Nation." Federal spending consequently rose beyond $9 billion in both fiscal years 1939 and 1940, and the deficit grew from $0.1 billion in fiscal year 1938 to $2.8 billion in fiscal year 1939.

In marked contrast to the early New Deal, the later New Deal adopted deficit spending as its principal weapon against recession. Presidential statements that routinely justified deficits as necessary to compensate for underconsumption helped to break down the public's antipathy to unbalanced budgets. By 1940 important socioeconomic groups, including farmers and organized labor, had come to regard fiscal activism as essential. Deficit spending also acquired intellectual legitimacy with the growing acceptance of Keynesian doctrine among professional economists. However the triumph of the new thinking was far from complete. Lacking a strategy to determine the requisite level of compensatory finance, the New Deal deficits of fiscal years 1939 and 1940 were too small to generate full recovery, which had to await the expansion of defense expenditure in 1941. Moreover, a congressional coalition of Republicans and conservative Democrats had been emboldened by liberal reverses in the recession-affected 1938 midterm elections to enact reductions in New Deal appropriations in 1939. For this group, deficits had become a political evil as the embodiment of big government.

America's experience in World War II finally institutionalized deficit spending as national economic policy. Driven by military needs, the federal deficit skyrocketed from $6.2 billion in fiscal year 1941 to $57.4 billion in fiscal year 1943. The conjunction of massive deficits and dramatic growth of the economy by 56 percent between 1941 and 1945 seemingly provided justification of Keynesian theory, even in the eyes of business leaders. This was the foundation for enactment of the Employment Act of 1946, which consolidated Roosevelt's economic legacy. Like New Deal fiscal policy, the legislation was imprecise and limited, most notably in its failure to guarantee full employment. Nevertheless it formally mandated the federal government's obligation to combat recession and rising unemployment and established the president as the manager of prosperity. In essence, the priority of fiscal policy had changed from protecting capital markets in 1932 to protecting and creating jobs by 1946, and deficit spending had become the essential instrument to achieve this new purpose.