Even before the economic recovery had really taken hold, many people expressed doubts about its durability—doubts that continue today. The usual debate was not and is not about whether inflation would accelerate and real growth stagnate, but when. Several prominent economic forecasting firms are already talking about another recession in 1979 or sooner, and most seem resigned to a fairly permanent inflation rate of around five to six percent.
Why all this gloom? Can we really expect no better than alternating periods of reversal and recovery, with chronic inflation ranging only from bad to worse over the cycle? Must the economy remain in perpetual crisis?
These questions are difficult to answer. Fundamental institutional changes have so increased uncertainty for both economic forecasters and business planners that it has become extremely difficult to make the sorts of long-term plans (and investments) that are essential to continuing prosperity.
Over the years, a number of institutional devices evolved which had the effect of providing discipline within our political and economic system, so that any excesses that developed would tend to be self-correcting. Some of these devices constituted an implicit constitution—rules that limited the nature of decisions that could be made by political and monetary authorities. Others had the effect of inducing productive behavior on the part of individuals and business enterprises.
One such tradition was the balanced budget rule—the broadly accepted view that governments should, except in exceptional circumstances such as war or depression, keep operating expenditures in line with tax revenues. In the 135 years from 1796 through 1930, the Federal budget was in deficit only 39 times, and about half of those deficits occurred during war years. This balanced budget rule suffered a massive intellectual assault in recent decades. Attempts were made to substitute an alternative rule, such as running budget deficits in recessions and surpluses in booms. But no alternative rule really put any effective constraint on political officials, who face strong pressures to increase government spending, and none to increase taxes. The inevitable result of giving up an imperfect fiscal rule in favor of no rule at all has been chronic and growing budget deficits.
As governments sell securities to finance these budget deficits, interest rates are bid up for all borrowers. Central banks then come under pressure to offset the rise in interest rates by rapidly expanding bank reserves. This ultimately results in more inflation, and an inflation premium is then added to interest rates. But it is easy to lose sight of such long-term effects when faced with short-term political and economic problems. And that leads us to the necessity of some workable mechanism to ensure long-term predictability in the monetary measures of value, both domestic and international.
Historically, the supply of money had been kept in some relation to gold reserves, or adjusted to maintain the value of major currencies in relation to one another. Under this system, there was some assurance that periods of inflation (which were a wartime exception) would be reversed, and that long-term stability in the purchasing power of major currencies would be the norm. There was also some assurance that the major currencies would be good substitutes for each other.
The discipline on the monetary authorities under either the gold standard or fixed exchange rules has been ended, but no other rule now effectively constrains the monetary authorities of the world.
Now, it is no doubt possible to devise, on paper, a better rule to avoid the massive monetary gyrations of recent years. But the best that has yet been accomplished toward implementing such an alternative is the quarterly money supply targets of the U.S. Federal Reserve System—targets which are neither long-range nor binding, and which have inspired dangerous legislation aimed at giving discretionary authority over monetary policy to the Congress. Again, the predictable consequence of abandoning imperfect rules for no rules is to make it impossible to foresee whether monetary policy, here and abroad, will be more or less inflationary in the years ahead. No mechanism provides incentives for political and monetary authorities to maintain a stable monetary unit of predictable value. In monetary policy, as in fiscal policy, there is no generally accepted rule, no discipline.
Of course, the ultimate discipline of harsh reality still remains. Excesses in fiscal and monetary policies can't be continued forever without eventually leading to economic chaos and disaster. There are still no free lunches. But without the institutional rules that provide an early warning when trouble is ahead, the nation and the world can rush headlong into economic and political turmoil—raging inflation, deep recession, and the political instability that follows from such crises of political-economic policy.
The loss of discipline over fiscal and monetary authorities has been compounded by a loss of discipline over governmental authorities. This is partly a result of the tremendous advantage that incumbent politicians have in elections, due to such things as the growing importance of media exposure, the ability to buy votes with special interest legislation, and "campaign reform" laws designed to restrict financing of challengers. Once elected, politicians can generally assume that they have tenure, thus reducing their incentive to be responsive to the electorate.
Moreover, an ever-larger number of tasks is delegated to unelected bureaucrats who have the authority to change the rules of commerce at whim, making it nearly impossible to determine if today's business decision will run afoul of tomorrow's regulatory edict. The traditional rule that has been lost here is the rule of law—the idea that there should be a sphere of uncoerced individual choice in which all actions are permitted except those that violate clear laws, known in advance.
There has also been a weakening of discipline over political authorities because of the increasing centralization of political decisions, and of the tax base needed to implement those decisions.
As late as 1940, state and local government tax revenues exceeded Federal tax revenues by nearly 75 percent. By 1975, the roles had been reversed, and the Federal government was extracting 59 percent more from taxpayers than state and local governments were.
More and more money has been transferred from consumer-determined uses to politically-determined uses, and within the political sphere the transfer has been from states and localities to the Federal government. The centralization of the tax base brought an accompanying shift of control.
The Federal government—by the way it allocates expenditures, transfer payments, and grants to states and localities—now has a very large and growing impact on decisions about who shall produce what for whom. Yet the trends toward centralization, bureaucracy and incumbency mean that citizens have less control than in the past over how these decisions are made about how to spend the citizens' own earnings.
Benefits from government spending have become concentrated on politically influential groups, while the costs are diffused and camouflaged by the sheer complexity of Federal financing and transfers. The unfortunate result is that politicians can more easily organize supporters by offering new spending programs to select groups than by offering tax reductions to the population as a whole.
At the state and local level, politicians can gain support by spending Federal grants without bearing any personal responsibility for the Federal taxes need to either finance those grants directly, or to service the increased Federal debt. Even the discipline of competing governments—the exodus of productive businesses and individuals from overtaxed communities—is being thwarted by plans to provide larger Federal grants and loans to communities that suffer the consequences of undisciplined government spending.
The issue of discipline spills over to the private sector as well, and to public policies affecting private incentives and behavior.
By providing a wide variety of cash and in-kind benefits to broken families, for example, we have removed the incentive to maintain intact families, and shifted some of the responsibilities of parenthood from parents to taxpayers. In many cases, a low-income household head can earn little more, after taxes, than is provided from tax-free welfare benefits. To a lesser extent, the same is true of long-term unemployment benefits, especially when supplemented by additional employer-financed benefits or by food stamps. By taxing employers and workers in order to finance benefits to nonemployers and non-workers, productive behavior is discouraged and nonproductive behavior is rewarded.
Now, we are a compassionate society, and sincerely want to help people in temporary distress or with permanent disabilities. But programs intended to alleviate a temporary loss of earned income have been regarded by some recipients as a permanent claim to goods and services produced by other people. One person's "right" to an unearned income necessarily entails another person's obligation to provide that income. The "welfare rights" mentality destroys family responsibility, discourages self-improvement, and demoralizes overburdened taxpayers.
A variation on the theme is the right to guaranteed employment at the taxpayers' expense. If it worked, such a policy would eliminate one source of discipline that restrains excessive wage demands—namely, the worry that such demands would reduce employment. More likely, the taxes used to finance more government jobs would simply result in fewer jobs in the private sector. And, as both Britain and New York City have demonstrated, the more the government becomes involved in employment, the less is its ability to govern.
In all of this discussion, one theme stands out clearly: the theme of discipline. The nation and the world have lost awareness of the discipline inherent in many traditions, institutions and rules.
The old rules may not have been perfect, but they may have been the best we could expect in a world of imperfect people dealing with imperfect information. We must either revive the old rules or develop new ones, since the alternative is policy by whim—bouncing from one problem to another, reacting in no predictable fashion. Such a policy creates paralyzing uncertainty among those real people that we so carelessly refer to as "the economy."
The economy need not be plagued by perpetual crisis. We are not at the mercy of blind forces. But if we continue to drift as we have in the past decade, we will almost surely stumble repeatedly into the old mistakes.
Contributing editor Alan Reynolds is a vice president of the First National Bank of Chicago, where he supervises business and economic research.