Welfarism and Its Consequences

Reprinted from Man vs. the Welfare State by Henry Hazlitt and used with permission. Copy­right © ¹969 by Arlington House, New Rochelle, New York.

In the early nineteen thirties, in the depth of the Great Depression, the theory became fashionable that the cause of all depressions was Lack of Purchasing Power. The people just did not have enough money, and because of un­warranted pessimism they were refusing to spend enough even of what they had. The solution was therefore simple: at such a time the government should boldly in­crease its own spending, "prime the pump," and "get things mov­ing again."

Naive advocates of this theory assumed that more government spending was the whole answer. The more sophisticated advocates saw that the increased spending would not give people more pur­chasing power if the government kept the budget balanced and took it all away again in higher taxes. The thing to do was to spend more without taxing more. The trick, in other words, was deliberately to unbalance the budget—to run a deficit.

Most of the champions of defi­cits—including the eminent John Maynard Keynes himself, the theory’s chief architect—at least publicly professed to believe that the required deficit could be fi­nanced by selling bonds directly to the public, to be paid for out of savings. But again, the more sophisticated deficiteers must have seen that a man who buys a $1,000 bond out of his savings surrenders that much purchasing power for the life of the bond. In short, he loses just as much buying power as the government gains. On net balance, no new buying power has been created.

How, then, can the government "create" new purchasing power?

It can do so only if it does not in­crease taxes at all, but "sells" its bonds to the banking system, and if the banks "pay" for them by creating deposit credits on their books in favor of the government. This leads to an increase in "the money supply"—that is, an in­crease either in the amount of cur­rency or of demand bank deposits.

If the government’s new bonds are sold directly to member banks, there tends to be a dollar-for-­dollar increase in the money sup­ply compared with the amount of new bonds. But if the govern­ment’s securities get into the hands of the Federal Reserve Banks, they are used to create what is called "high-powered" money. This can lead to the crea­tion of about $6 of new money for every dollar of new government securities.

High-Powered Money

It is not easy to give a satis­factory but short explanation of the reason for this to readers without any previous knowledge of monetary theory. When mem­ber banks "buy" government bonds and "pay" for them by creating a deposit credit on their books against which the government can draw, they are adding to the na­tion’s supply of purchasing media. They are creating money out of government promises, and some would say they are creating money out of thin air.

Now if a member bank that has bought such government bonds sells them to its regional Federal Reserve Bank, it can ask that Reserve bank to credit the pro­ceeds to the member bank’s re­serves with that Reserve bank. But if the member bank is a "city bank," it is required to keep a reserve with the Federal Reserve Bank of only 16½ per cent against its net demand deposits. This means that the member bank is entitled to lend, and so create de­mand deposits for, about six times the amount of its reserves with the Federal Reserve Bank. That is why money created directly or in­directly by the Federal Reserve Banks is called "high-powered" money.

Thus new "purchasing power" is brought into being. Thus peo­ple have more money to buy more goods, create more jobs, stimulate more output, and restore pros­perity.

At least so it seems for the moment. But soon there are other consequences.

If there have been heavy un­employment and much "idle ca­pacity," the new monetary pur­chasing power in the system, by increasing the demand for com­modities, may indeed lead to an increase in production, and hence to an increase in employment. This has been hailed as the great Key­nesian contribution to economic theory and policy. But there are fatal flaws in it.

Return to Coordination

Unless there were some serious lack of coordination among prices, costs, and wages, mass unemploy­ment would not exist in the first place. When it does exist, the only appropriate cure is individual ad­justment of prices, costs, and wages to each other—the return of coordination. But this can be brought about automatically only if the competitive forces of the market are given free play.

The reason the Keynesian medi­cine can work—under special con­ditions and for short periods—is that by increasing monetary de­mand and prices it may increase both sales and profit margins, and so restore production and employ­ment. Yet this could be done even more effectively—and without the poisonous side-effects and after­effects—by restoring freedom of competition and individual coordi­nation of prices and wages.

The Keynesians think in terms of aggregates. Their remedy is to increase the total money supply, and thereby to bring the price "level" sufficiently above the wage "level" to restore or maintain profit margins and so keep the wheels of industry spinning at full speed.

This remedy is defective in two respects. It tacitly assumes that there is a uniform discrepancy be­tween prices and wages and a uni­form percentage of "idle capacity" throughout industry. Neither is true. If "industry" is estimated to be operating at 80 per cent of capacity, we must remember that this figure is at best an average. It may cover a situation in which, say, industry A is operating at only 60 per cent, industry B at 63 per cent, and so on up to in­dustry M at 97 per cent and in­dustry N at 100 per cent. If we try to expand the money supply enough to return industries A and B to full capacity, we may com­pletely "overheat" industries M and N and produce serious pro­ductive distortions and bottle­necks.

What is more, an increase in the stock of money, contrary to Keynesian theory, will begin to force an irregular increase in prices long before "full capacity" has been reached and the "slack" taken up—if only for the reason that the "slack" is never uniform throughout industry. In a very short time, also, with the increase in prices and the increase in the demand for labor, wages will start climbing too. Then, if the previous trouble was that most wages were already too high in relation to most prices, there will again be discoordination between wages and prices; and the Keynesian prescription will call for still fur­ther doses of government spend­ing, deficits, and new money.

Chronic Inflation

So the Keynesian medicine must lead to chronic deficits and chronic inflating of the money supply. This is precisely what we have had. It is no accident that we have just run eight annual deficits in succession, and that we have had 32 deficits in the last 38 years. It is no accident that the U. S. money supply (currency plus de­mand deposits) has been increased more than five-fold—from $36 bil­lion at the end of 1939 to $199 billion in September, 1969. And so it is no accident that, in spite of a tremendous increase in indus­trial production in this thirty-year period, consumer prices have in­creased (to June, 1969) by 164 per cent.

Today the Federal government is spending in a single year 269 times as much as in the fiscal year before the outbreak of World War I. The recent increase in annual spending is being attrib­uted by government spokesmen to the cost of the war in Vietnam. Yet though in 1970 scheduled na­tional defense expenditures are$35.6 billion greater than in 1960, total expenditures are $103.1 bil­lion greater. This means that non­defense expenditures alone have increased $67.5 billion in the same period. It is not the war, but the determination to impose the wel­fare state, that has led to this incredible squandering.

Money vs. Reality

A central fallacy of Keynesian­ism, as of all inflationary nos­trums, is that they chronically confuse "income" in terms of paper money with real income in goods and services. It is possible to increase paper-money income to any amount by debasing the currency. But real income can only be increased by working harder or more efficiently, saving more, investing more, and produc­ing more.

So let us not be too impressed by politicians who constantly cite the increase in dollar incomes, in dollar "gross national product," to show that we never had it so good. In Italy today, as a result of past inflations, it takes 624 lire to buy an American dollar. So anyone in Italy with an annual income or even total property worth more than $1,600 American dollars is already a millionaire in his own currency.

The debasement of the dollar over the past thirty years resulted in a succession of problems, in­cluding a chronic "deficit" in the American balance of payments.

How Domestic Inflation Creates International Problems

The "balance-of-payments prob­lem" has arisen not merely be­cause of our domestic inflation but because of the combination of this with the so-called "gold exchange" standard and the world monetary system set up at Bretton Woods in 1944. Under that system each government undertook to keep its own currency unit within 1 per cent of parity in either direction by buying or selling that currency against other currencies in the foreign exchange market. In ad­dition, the United States Govern­ment undertook to make the dol­lar the world’s "reserve currency" and anchor currency by guarantee­ing to keep it convertible at all times (for foreign central banks, but not for its own citizens) into gold at the fixed price of $35 an ounce.

Though only central banks, and neither American nor foreign pri­vate citizens, have the right to ask for this conversion, keeping the dollar convertible into gold at this fixed price has proved increasingly embarrassing to our monetary authorities, especially since 1957. During the last decade we have been sending or spending abroad for various purposes—to pay for imports, for foreign aid, and for the support of our armed forces in Europe and in Vietnam—bil­lions of more dollars each year than we have been getting back in payment for our exports and earnings on our capital invested abroad.

This excess of outgoing dollars is called the "deficit" in our bal­ance of payments. From the end of 1957 to the end of 1967 this deficit ran at an average of $2.8 billion a year. At the end of 1968 the cumulative total was in the neighborhood of $30 billion. In early 1969 the deficit on a "liquid­ity" basis was running at an an­nual rate of $6.8 billion.

As a result, our monetary gold stock had fallen from $22.8 billion at the end of 1957 to only $10.4 billion in July, 1969. Against these reduced gold reserves the United States had liquid liabilities to foreign official institutions of $10.8 billion, plus short-term liabilities to private foreigners of $22.6 bil­lion—a total of nearly $34 billion. In much discussion our dollar liabilities to private foreigners are not counted as a potential de­mand on our gold reserves because private banks, firms, and individu­als cannot directly demand gold for their dollars. But under the International Monetary Fund agreements they can always indirectly sell their dollars at par to their respective central banks.

In sum, against United States gold reserves of only about $10 billion there are more than three times as many potential foreign dollar claims for gold.

Treating the Symptom

As our gold has drained out, and as foreign dollar claims against it have mounted, the blame has been put on this "deficit" in our balance of payments. But in­stead of dealing with the main cause of this deficit—domestic in­flation—our governmental author­ities have allowed the inflation to go on, and have even increased it, while trying to stop the symptom. They have treated the deficit in the balance of payments as itself the problem, and have adopted desperate measures to try to halt it by direct controls.

Their first major control, im­posed in 1964, was a penalty tax on purchases by Americans of foreign securities. To make such foreign investments the culprit responsible for a balance-of-pay­ments deficit was not only arbi­trary but implausible on its face. In the five years 1958 to 1962 the aggregate net outflow of $16.6 bil­lion for new foreign investment was offset by $15.4 billion of in­come from previous investment. Even the Secretary of the Treas­ury, who had asked for the pen­alty tax, conceded: "In the long run the outflow of American capi­tal to foreign countries is more than balanced by the inflow of income earned on that capital."

He urged the tax, in fact, "only as a temporary measure to meet our problem pending more funda­mental solutions." Of course, the more fundamental solutions were never adopted, so not only was the "temporary" security tax renewed, but on January 1, 1968, the Presi­dent added mandatory controls on direct investments by American corporations abroad.

The implication of these meas­ures is that our private foreign investment has been one of the chief causes of the deficit in our balance of payments. This is clearly untrue. It is Federal spend­ing, through foreign aid and mili­tary outlays, that has been in deficit. In recent years the private sector as a whole, as a result of export surpluses and income on private investments abroad, has continued to generate a payments surplus.

In 1967 our total new foreign investments—including bank loans, purchases of foreign securities, and direct investments in factories and sales facilities—amounted to $5.6 billion. But the income from these and earlier private invest­ments came to $6.2 billion.

At best, then, all these foreign investment restrictions and pro­hibitions are shortsighted. Any reduction we make in new foreign investment today means a corres­ponding reduction in investment income tomorrow.

If the Federal government, in­stead of picking foreign invest­ment as the culprit chiefly respon­sible for our balance-of-payments deficit, had put punitive tariffs on the further import of foreign lux­uries—liquors, wines, perfumes, jewelry, furs, and automobiles —its action would still have been a mistake, but much less damaging to our future economic strength. These tight curbs on direct for­eign investments by American corporations must severely hamper their ability to compete success­fully with other international cor­porations in Europe and the rest of the world.

The President’s own Economic Report of 1967 pointed out that: "U. S. investment abroad gener­ates not only a flow of investment income but also additional U.S. ex­ports. From a balance-of-payments point of view this is an additional dividend." The U. S. Department of Commerce found, in fact, that in 1964 $6.3 billion, or 25 per cent of our total exports in that year, went to affiliates of American com­panies overseas.

It is hardly too much to say that direct foreign investments, with the exports and income to which they give rise, are the greatest single source of long-range strength in our balance-of-pay­ments position.

Still worse, from the standpoint of their direct restriction on per­sonal liberty, were the Johnson Administration’s proposals (for­tunately not enacted) to have Con­gress impose practically prohibi­tive penalty taxes on Americans traveling abroad.

The Failure of Direct Controls

The whole effort to eliminate our balance-of-payments deficit by direct controls over arbitrarily se­lected individual items is doomed to failure. Such controls may suc­ceed in changing the relative amounts of different items, but cannot change the end result. At best we can make our immediate balance of payments look better at the expense of our future balance. We cannot unilaterally cut down our purchases or travel or invest­ments abroad without also cutting down our sales abroad and our investment income from abroad. In his Economic Report of 1968, President Johnson himself con­ceded that "by provoking retalia­tion" we may "reduce our receipts by as much as or more than our payments."

The whole so-called "balance-of‑payments problem" would never have arisen except under the ar­bitrarily contrived International Monetary Fund gold-exchange sys­tem set up at Bretton Woods in 1944. It could not exist if the United States and other countries were on a pure "floating" paper standard with rates fluctuating daily in a free market, because under such a system the fluctua­tions would themselves set in mo­tion the self-correcting forces to prevent unwanted deficits or sur­pluses from arising. Nor could the balance-of-payments problem exist if the United States and other leading countries were on a full gold standard. A "deficit" in the balance of payments would then lead to an immediate outflow of gold. This in turn would lead to immediately higher interest rates and a contraction of currency and credit in the "deficit" country, and the opposite results in the "sur­plus" countries, and so bring the so-called deficit to a halt.

Postponing Self-Correction

Under the Bretton Woods sys­tem and the "gold exchange" standard, however, no self-correc­tion of this sort is allowed to take place. When we "lose" paper dol­lars abroad, we simply print more at home to take their place. And when Europe gains these dollars, they find their way into the cen­tral banks, where they become ad­ditional "reserves" against which the European governments issue still more of their own currency. Thus, further inflation, in both the "deficit" and the "surplus" country, seems to take place auto­matically.

In the IMF system there are no freely fluctuating market rates for individual currencies to reveal and correct international imbalances. Market rates are not allowed to fluctuate by more than 1 per cent above or below parity. At that point each government is obli­gated to buy or sell its own or for­eign currencies to prevent any further departure from parity.

These currency-pegging opera­tions are supplemented by the so-called gold-exchange standard. This arrangement, which goes back to international agreements in 1921 and 1922, permits central banks to count not only their gold but their holdings of dollars (and of British pounds) as part of their reserves. The arrangement was adopted in the belief that there was a "shortage of gold" and a "shortage of international li­quidity." As a result the world’s monetary "reserves" today consist of about $42 billion in gold plus about $28 billion of "reserve cur­rencies," of which more than $15 billion are American dollars. As credit and other currencies are issued against these reserve cur­rencies, the reserves themselves are inflated.

They Still Want Gold

The real reason the American monetary authorities fear a con­tinued "deficit" in the balance of payments is that they have given the central banks of other coun­tries the right to demand gold for their dollars at $35 an ounce. They have seen more than half our gold reserves flow out in the last twelve years, and they are fearful of los­ing any more.

They long ago persuaded the Federal government to prohibit American citizens from holding or asking for gold. In the last few years they have resorted to in­creasingly desperate expedients. Where possible, they have brought political pressure on foreign cen­tral banks to keep them from ask­ing for gold for their dollars. Early in 1968 they stopped feed­ing out gold to hold down the price in private markets in Lon­don, Paris, and Zurich. They now try to maintain an inherently un­stable two-price system, with offi­cial monetary gold at $35 an ounce and nonmonetary gold free to sell at whatever price supply and demand fix.

Early in 1968 the Administration also got Congress to abolish the remaining gold-reserve re­quirement of 25 per cent against Federal Reserve notes, on the plea that this was necessary to reas­sure foreign central banks by making all remaining United States gold holdings available to them. But what this action really did was to remove the last legal limitation on the amount of paper money that the Federal Reserve system may issue.

Finally, the American govern­ment has pressed for the creation by the International Monetary Fund of "special drawing rights" (SDR’s), or "paper gold," to "sup­plement" dollars as international reserves. The only thing this pur­posely complicated scheme can do is to adulterate reserves still fur­ther and make it possible for na­tions to issue still more paper money against these paper SDR’s, which are declared with a straight face to be just as good as gold if not better.

All these schemes are unsound, and in the end all of them will prove futil. The truth is that no solution of the monetary problem, national or international, will be possible until inflation is stopped, and that it will not be stopped as long as we have the welfare state.