The Deficit Connection; E. G. Ross

104 with this nation for awhile is hardly disputed. Even the more optimistic forecasts project several hundred billion dollars in deficits added to the national debt before the end of the decade. Some estimates push a tril lion dollars. While most people regard deficits as bad, there is considerable contro versy over whether deficits are con nected-that is, whether they must lead-to higher prices, to what cur rent political jargon terms "an infla tionaryenvironment." Many analysts, such as economist Fred D. Kalkstein, warn or imply that deficits are ultimately con nected to higher prices via interest rates. Accelerated borrowing to pay for the deficits pushes up interest rates, and the borrowing tends to temporarily dampen or "hide" the THE DEFICIT CONNECTION 105 effects of extraordinary levels of monetary growth. (M1 money supply-primarily cur·· rency in circulation and checking type accounts-averaged over 10 per cent annual growth from mid-1982 to mid-1984, the highest sustained two-year rate since World War II; M2 and M3, much broader money mea sures, also showed abnormally rapid growth.) "The longer the combination of disinflation [meaning less rapidly rising prices] and high interest rates persists ... [a]t some juncture,"

wrote Kalkstein, "the money win begin to flow from our shores ... the dollar will fall ... and the inflation inherent in the Fed's monetary stirn·· ulation will come home to roost." (The Wall Street Journal, 31 July, 1984.) Other economists remain san guine about deficits. For instance, in an August 31st Wall Street Journal letter Hoover In stitution Senior Research Fellow, Milton Friedman, said, "I do not re gard the deficit as a major issue or cause for concern." Coming from the man who has been one of the na tion's more popular and vociferous although less than consistent-mod ern opponents of inflation, this was quite a statement. While Friedman has many times contended that higher money growth and higher taxes lead to price increases, he ap parently found no worrisome connection between deficits and higher prices. Purported gold standard advocate, Congressman Jack Kemp, is another leader of the camp which takes a rel atively benign view of deficits.

Kemp even went so far as to say that the way to handle deficits is through much more rapid monetary growth; he thus proposed to "fight" deficits by inflation-although, as can only be true in the bizzare world of political double-think, Kemp steadfastly stated that this actually amounts to a policy of combatting inflation. Anti-Deficit Magic There are many who share Kemp's view that with enough economic growth, deficits will eventually "take care of themselves." If this sounds strangely similar to the old (but apparently not yet worn out) no tion that monetary stimulus (i.e., in flation) is a good play for prosperity, read on ... On its own terms, how would this "modern" notion work its anti-defi cit magic? To use a sports analogy, perhaps as a skilled slalom skier averts ob stacles, growth will bypass all the impediments of (ever-increasing) government interferences in the economy and skim along joyously unabated for the next several years.

But in order to make a continuous uphill run possible, our growth-skier 106 THE FREEMAN February will be endowed with a jetpack con taining a clever mixture of "supply side" and Keynesian doctrines. So powerful, yet controllable, will this mixture be, that the skier will not only effortlessly avert obstacles and speed ever higher, he will be able to tow a bobsled full of happy, taxable workers and producers behind him. In short, through this enormous economic ingenuity, growth will per mit continued expansion resulting in the U.S. Treasury's ultimately taking more revenue from more freshly employed workers and prof itable companies. Under this view, the new revenue would supposedly be used to pay for what are now deficits. Naturally, if somehow this won derful theory did not produce quite enough growth-generated taxation if growth proved a little too slug gish-it might be "necessary" to raise taxes outright.

Sound economics says higher taxes would inhibit growth, but-perish the thought. Economic history sug gests the accelerated money supply portion of the jetpack' s fuel would be unstable and likely explode into higher prices, but-perish the thought. In "answer" to these "dangerous" thoughts, the public is treated to an interesting argument: 1. It will not be necessary to raise taxes if the Federal Reserve "cooperates" and doesn't, as Kemp put it, "flirt with deflation," Le., if the Fed keeps pumping up the money supply. 2. The money supply will not be vola tile if there's enough growth to "ab sorb" the new money. Hence, one point conveniently supports the other: More money is needed for growth, which will then justify the money supply increases. This argu ment deserves an economic "Circu lar Reasoning Award." Actually, most economists now ac cept the view that monetization of debt eventually leads to higher prices. But this does not get to the core of the matter at hand. For what if deficits were entirely financed by borrowing or taxation-i.e., without monetization?

Political Factors This question forces us to refocus on a broader context, to include in our economic view at least some of the major machinations of modern politics. Politics is inextricably in tertwined with any economy and the nature of political favor-brokering is inextricably intertwined with a full understanding of the connection be tween deficits and higher prices. Without getting into the "I'm hon estly coercive" arguments fro~ the morally smug advocates of "openly" higher taxes, let's move on to those advocates who believe that if deficits are financed out of existing supplies of money, inflation (by which they mean rising prices) cannot rear its 1985 THE DEFICIT CONNECTION 107 ugly head to strike at America's pocketbook. In other words, if the Fed does not add greater quantities of money to the economy and the government only borrows or taxes to meet its overspending, there is no "inflationary impact."

How would this work? The borrowing portion of the ar gument holds that those who lend to the government would have lent the money to someone anyway; whoever gets the borrowed money will in some fashion spend it. For example: if a savings and loan is lent money, the firm relends the money to a homebuyer, who then spends the money in the housing market; if a car manufacturer is lent the money-perhaps by sale to the public of corporate bonds-the com pany uses the money to purchase what it needs to make automobiles. So, what's the difference if the gov ernment is lent the money-through sale of Treasury bills, notes, or bonds? Doesn't the government then turn around and spend the money just as the savings and loan or car company would? Isn't this just a "macroeconomic" reshuffling of the cards? No, it is not. But the argument rests on an interesting premise-out of the same epistemological grab bag that so reliably gives us levitation, clairvoyance, and mental spoon bending. The premise is that gov ernment can, in theory, reliably spend money for purposes which are productive, for instance, delivery of mail, road maintenance, dam con struction, courts of law, police, and so on.

Marking the Deck in Favor of Government But despite the theory, often mo tivated by desperate binges of Roo seveltian political nostalgia (Le., of how Roosevelt "pulled us out of the Depression," which he did not), most government money in fact goes into nonproductive-or at best, far less productive fields-than does money which is left in the private economy. And this is an important clue to dis covering the deficit connection to higher prices. This is where we be gin to get involved in political mach inations. Increased lending to 'gov ernment is not a question of reshuffling the economic deck, but of marking the deck in favor of govern ment growth. (Incidentally, Roosevelt knew of the unproductiveness of government spending, but he was the "Great Communicator" of the emerging Keynesian liberals and successfully exploited a combination of public ig norance about economics and dis guised appeals to something for nothing in order to shift blame from government to the bleeding and bat tered remnants of 1930's business, thus terribly prolonging, rather than relieving, the Great Depression.) 108 THE FREEMAN February The reason most government directed money tends to end up in unproductive ventures is precisely because it is politicized money, money governed mainly by the whims of politicians rather than by the judgments of markets. In most of today's studious tomes of economic analysis, this fact is at best given to ken treatment. (To his great credit, Milton Friedman gave the subject prominent, if incomplete, treatment in Tyranny of the Status Quo.) Not only does government lack the foresight and standards by which to rationally prejudge what is or is not productive (the most fundamental practical reason for having free mar kets), but no matter how it acquires its money, government does not really have to suffer failure in the marketplace.

Witness the Postal Service, which has historically been a money-losing operation, and yet grows larger and continues to require government subsidies or abnormal price hikes for its services year after year. As of this writing, the postal primates are en gaging in a new round of typical gov ernment monkey business, demand ing a 23-cent first-class stamp as well as steeper rate hikes for some other classes of mail. If the Postal Service were truly private, investors and users would long ago have relegated it to the marketplace junkyard. Even worse, look at the various "entitlement" programs. The agencies which disburse money for all manner of purposes, ranging from medical care to food stamps, have conspicuously limited connections to the marketplace. For instance, as economist Alan Greenspan noted in a column (WSJ, 4 September, 1984), Medicare and Medicaid operate un der hundreds of price controls-con trols which virtually divorce con sumers of medical services from true medical costs.

The Ticket to Success Modern political history shows that regardless of the money it squanders, if an agency is popular with politicians, it will survive-and grow. The prevailing, though seldom admitted, standard of what is good becomes what is approved; what is good becomes what those in power say is good; a pat on the head from a politician becomes more precious than profits, more prized than prices; politics, not markets, become the agency's "ticket to success." When one discounts expenses for the legitimate government func tions of defense and courts of law, all the rest, a majority, amounts to re distributing purely politicized money, coercively gathered from millions of individuals, to special in terests selected by the favoritism of those in power. Despite decades of glorious cam paign rhetoric from both major par ties to the contrary, government con1985 THE DEFICIT CONNECTION 109 tinues to grow and now comprises about one-quarter of the total econ omy (GNP), up from about one-fifth just four years ago.

As men ranging from Bastiat to Smith to Mises to Hazlitt have il lustrated, it is a political rule of thumb that regardless of how it gets it, the more government gets to spend the more it becomes accus tomed to spending. I admit it is hardly an attractive analogy, but government's appetite is much the same as that of a grow ing pig; the more you feed it, the big ger it grows and the more food it de mands. And remember that it doesn't matter at all to the pig's metabolism how you went about getting the food; the animal will grow just as well on borrowed food as it will on food gath ered by "legitimate" means. Just as increased taxes lead to in creased inflation and expand the government's appetite, so does a bor rowing-financed deficit. Each year of deficit spending accustoms politi cians to a new, higher level of spend ing-spending to redistribute to powerful supporters, whom the pol iticians hope will constitute a grate ful voting majority.

Given the outlandish modern po litical appetite, taxes, inflation, and borrowing reinforce each other. When one becomes insufficient, pol iticians switch to another. This is precisely why we see so many demands for "standby" (higher) taxes and why Ronald Rea gan-with ample Congressional "en couragement" -signed several tax increase measures in the three years after signing into law near the be ginning of his administration a per sonal income tax reduction. As sad and disgusting as it may be, in good times or bad times for the citizenry as a whole, politicians want only good times for themselves. This is why no matter how badly the econ omy is doing, the politicians refuse to cut overall government spending. They make cuts in some programs, but others increase; they accept a change of diet, but squeal in protest at a reduction of diet. The Inflation Tax When the economy slips into reces~ sion, and people are not able to lend the government enough to take care of deficit spending, the government resorts to increased taxation or inflation.

Of course, higher taxes are ex tremely unpopular during reces sions, so inflation commonly be comes the answer to deficit financing. But because the effects of inflation are usually not seriously felt for about two years after it be gins, higher prices are put off to times of prosperity. During such times, because people are at least temporarily better off, they are more generous-including toward govern ment; therefore, it is during eco110 THE FREEMAN nomic recoveries that taxes are nor mally raised and fresh borrowing is begun, firing up government's share of economic activity to an acceler ated, higher level. Eventually, exploding prices and an updraft of taxation create a mushroom cloud of malinvestment and the deadly economic fallout be gins to mutate and kill healthy growth-and recession returns. This gloomy scenario always comes about when government takes more money from the private sector.

Perversely, as we had during the ear ly 1980s, the new round of reces sion usually occurs as prices are still rising. Price increases may slow, but in a fiat-money economy, even dur ing recession, prices seldom actually decrease. In modern vernacular, we get "disinflation" but not general "deflation." Almost any form of financing gov ernment's deficit-growth provides more incentive for government to ex pand-and that expansion leads to inflation. Deficit-borrowing thus be comes just one of several forms of government financing leading to inflation. In sum then, always it is into the process of steadily increased politi cal confiscation of wealth that the question of borrowing-financed def icits must be figured. Financing def icits through borrowing is not a con textless phenomenon. To return to my earlier analogy, borrowing to fi nance deficits is a time-tested way of making Government-the-Porker fat ter and increasing its appetite.

How to regain control and put the porker on a diet is really another subject-outside the scope of this es say. But until our profligate politi cians awaken to the dangers of def icits-no matter how financed-a provocative bumper sticker might be: IF YOU LOVE DEFICITS-OINK! I Reprints . .. A Page on Freedom Each of these brief messages is a handy way to share with friends, teachers, editors, clergymen and others a thought-starter on liberty. It also serves to introduce the reader to our work at FEE. See page 67 for this month's Page on Freedom. (Copies of previous messages are also available; specify title when ordering.) Small quan tities, no charge; 100 or more, 5 cents each. Or, feel free to reprint the message in your own format if you'd prefer. We hope you'll enjoy this feature! Order from: FOUNDATION FOR ECONOMIC EDUCATION, INC. IRVINGTON-ON-HUDSON, NEW YORK 10533 Dean Russell An Ancient Chinese Story IN this particular satire or parable, Bastiat illustrates the ever-present and always-popular concept that government can create jobs and prosperity by means of useless (even destructive) make-work schemes, e. g., digging post holes and then fill ing them in, as was frequently done by our government in the 1930s to get the economy going again. This story is based on the same idea.