“The potency of fiscal policy—both good and bad—has been demonstrated time and again in the past couple of decades.”
—Walter Heller, 1968
Who wrote this? “Fiscal policy is no longer a major tool of stabilization policy in the United States. Over the foreseeable future, stabilization policy will be performed by Federal Reserve monetary policy.”
Milton Friedman? No, it was not a monetarist.
I recently met with Milton Friedman in his home in San Francisco, and asked him who he thought wrote the above statement. “Alan Greenspan?” he queried. No, it wasn’t a Federal Reserve official.
The author is none other than Paul Samuelson! In his latest (15th) edition of Economics, co-authored by William D. Nordhaus, the premier Keynesian economist admits defeat for fiscal policy as an effective countercyclical tool. This is truly an amazing confession, a shocking reversal of his long-standing bias of yesteryear.
It was Samuelson who wrote in his first edition (1948) of his famous textbook, “Today few economists regard Federal Reserve monetary policy as a panacea for controlling the business cycle.” (1st ed., p. 353) Only fiscal policy mattered. His pivotal chapter, “Fiscal Policy and Full Employment Without Inflation,” totally ignored the role of money in the economy.
By the ninth edition (1973), his views had shifted to a middle ground. After labeling monetarism “an extreme view,” he declared, “both fiscal and monetary policies matter much.” (9th ed., p. 329) However, Samuelson stood squarely in the fiscal camp. The title of his chapter, “Fiscal Policy and Full Employment Without Inflation,” remained the same from the first edition until the eleventh edition (1980), the last written solely by Samuelson.
Finally, in the latest edition (1995), Samuelson has thrown in the towel, as if to admit, “We are all monetarists now.” According to the MIT professor, running a federal deficit to jump start the economy “has lost much of its attractiveness to policymakers and macroeconomists.” (15th ed., p. 644) His concluding chapter on government economic policy is now entitled, “Policies for Growth and Stability.”
Why Fiscal Policy Has Become Impotent
In the late 1960s, economists debated the merits of fiscal policy (spending and tax changes) vs. monetary policy (the money supply and interest rates). The Keynesians argued that fiscal policy was the most powerful tool, the monetarists defended monetary policy as the most influential.
Now the debate is over: the monetarists have won.
Under the influence of new theories in economics (especially public choice and rational expectations), Samuelson offers several reasons for an impotent fiscal policy today: increasing delays (a year or more) between changes in the economy and Congressional action on the budget; ineffectiveness of deficits or tax cuts to stimulate consumer spending; and the enormity of the national debt, which severely limits the ability of lawmakers to run higher deficits to fight recession. In sum, declares Samuelson, fiscal policy has become “useless.” (15th ed., p. 644)
Artificial Stimulants Don’t Work
Samuelson’s amazing change of heart reflects a growing realism in the economics profession. It never did make sense to artificially stimulate the economy through makework projects, war production, and other spendthrift programs, as Keynes suggested. But running a deliberate deficit is not only “useless,” it is harmful to the economy. It discourages private saving and forces lawmakers to raise taxes in the future. Indeed, that has been the trend: higher deficits and higher taxes.
The lesson is clear: government needs to move in the opposite direction if it truly wants to stabilize the economy and permanently increase economic growth. By cutting out wasteful spending, it can turn the deficit into a surplus, and reduce taxes sharply.
Monetary Policy Is Useless, Too
Paul Samuelson needs to learn another lesson: Efforts to stimulate the economy through “easy money” Federal Reserve monetary policy are useless, too. If the Fed artificially lowers interest rates and expands the money supply, it can only cause an unsustainable boom-bust cycle. History has demonstrated this “Austrian” insight time and time again. Easy credit may provide temporary recovery, but the long-term effects are serious—more unemployment and recession in the future. In short, there is no free lunch. Active government intervention in the macroeconomy, whether in the form of deficit spending or easy money, is harmful to long-term growth.
Returning to the Classical Model
The best policy is non-interventionism. Taxes should stay low. Government budgets should be limited to essential services, and regularly balanced. The money supply should be stable and non-inflationary. Interest rates should not be manipulated.
There is nothing new about this non-interventionist approach. It represents the old classical school of Adam Smith (balanced budgets, low taxes, sound money, laissez faire).
What is noteworthy is the economics profession’s gradual shift away from Keynesian economics toward the classical position. An examination of Samuelson’s 15 editions of Economics reveals that he has slowly but surely abandoned the tenets of Keynesianism. In the past, he favored deficit spending; now he’s opposed to it. He denigrated savings; now he promotes it. He condoned central planning; now he supports market reforms. Might we see a total conversion to laissez faire by the next edition, due to be released on the 50th anniversary of his first edition? We can only hope.
1. Walter W. Heller, “Is Monetary Policy Being Oversold?” in Monetary Policy vs. Fiscal Policy, by Milton Friedman and Walter W. Heller (New York: Norton, 1969), p. 31.