Freeman

THE CALLING

Democracy, Deficit, and Debt

Buchanan and Wagner's classic.

APRIL 08, 2010 by STEVEN HORWITZ

In the last week I’ve reread James Buchanan and Richard Wagner’s classic book on Public Choice macroeconomics, Democracy in Deficit:  The Political Legacy of Lord Keynes.  First published in 1977, it was reissued in 2000 as part of Liberty Fund’s publication of Buchanan’s collected works.  I first read the book almost 25 years ago in graduate school and realized while rereading it that a great deal of the material had entered my intellectual DNA without my realizing this book was the source.  It is one of those books that can profoundly change the way people think about economics – in this case, macroeconomics and the politics of the federal budget.

What Buchanan and Wagner argue is that the legacy of Keynes, whether intended or not, has been to disrupt the old tacitly accepted “fiscal constitution,” by which politicians treated the federal budget largely like a household budget.  Debt was justified for only two basic reasons:  war or similar emergencies and long-term capital expenditures that required large upfront costs.  Such debts were expected to be repaid as soon as possible because long-term indebtedness was considered both economically imprudent and immoral. Why immoral? Because the cost was a burden on future generations that had no say in the matter.

Keynesian economics changed all this by constructing an intellectual justification for viewing the federal budget as a tool for managing the economy rather than a constraint under which politicians operate.  Keynesianism argued that in recessions budget deficits could stimulate aggregate demand and lead to recovery, while in good times surpluses would both prevent excessive growth and pay back the debt.

This idea, known as “functional finance,” looks good on the blackboard but has a fatal flaw.

Enter Buchanan and Wagner.  What Public Choice teaches is that we cannot disregard the actual political processes by which economic policy is implemented.  In the language of economics, those processes have to be “endogenized” – made part of the theory itself.  As I wrote in a recent Freeman article, saying government ought to handle the budget as the Keynesians propose is not the same as saying it can or will do so.  We must ask: Under the incentives built into our political institutions, is functional finance in the politicians’ self-interest?

Buchanan and Wagner say no.  Politicians love deficits because spending on their constituents gets them votes but raising taxes costs them votes.  Politicians are always vote-seekers, so those incentives and disincentives hold whether the economy is in a recession or a period of high growth.  Surpluses in growth periods are incompatible with those incentives. Thus the record of the U.S. government since the 1930s:  All but a small handful of years saw budget deficits, with the last decade’s deficits growing dramatically.  Suffice it to say the United States was not in recession all that time!

Once the lock was off the refrigerator, politicians began to gorge themselves.  Early on, their ability to run deficits and accumulate debt was limited by the reluctance of the Federal Reserve to cooperate and by the remnants of the gold standard still in place in the 1940s and 50s.   But with the abandonment of gold in 1971 and with changes in the Fed’s guiding principles, there was no longer a monetary check on the federal budget and little to hold back the appetites of vote-seeking politicians.  Writing in 1977, Buchanan and Wagner predicted that the decades to follow would bring increasing deficits, larger debt, and possibly significant inflation if the Fed buys up the rising debt.

Those predictions have been mostly right on the money, so to speak.  The total U.S. government debt is now well over $12 trillion.  Buchanan and Wagner were outraged by annual deficits in the tens of billions, but February’s deficit was $220 billion!  The future that Buchanan and Wagner foresaw almost 35 years ago is now here.

Thankfully, we haven’t yet seen the inflation they feared, but the recent expansion of the monetary base and of the Fed’s powers — including, for the first time, the ability to buy securities directly from the Treasury — suggest that high inflation may not be that far away.

Democracy in Deficit is essential reading for understanding how we got into our current fiscal mess.  Its lesson — that economic theorists cannot afford to ignore political incentives — is as timeless as its concern about the debt’s burden on our children and grandchildren.

ABOUT

STEVEN HORWITZ

Steven Horwitz is the Charles A. Dana Professor of Economics at St. Lawrence University and the author of Microfoundations and Macroeconomics: An Austrian Perspective, now in paperback.

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