Summer 1997
by William J. Barber

THE WORD emanating from official Washington these days is that the era of Big Government is over. The long controversy over government's role in American economic life, senior leaders from both parties tell us, has finally closed. This is thus an appropriate moment to reflect on the origins of the Big Government era, to review a time in which the posture of government toward economic activity was anything but settled, and when the mix of public and private sectors shifted profoundly in favor of enlarged government involvement. There is little mystery about when this restructuring took place. It dates from the Administrations of Franklin D. Roosevelt. Less well understood, however, are the fits and starts surrounding the reconceptualization of government's role in the New Deal years. Even within FDR's official family, there was controversy about which types of intervention to pursue. These intra-Administration debates ultimately generated a new vision of governmental responsibility for the performance of the economy. The outcome differed not just from doctrines accepted before FDR became president, but also from the heterodox notions that had informed the New Deal's first initiatives. The prescription that emerged at the end of the 1930s then served to underpin the era now alleged to have ended.

Breaking the Rules

When Roosevelt took the oath of office in March 1933, the breadlines, bankruptcies, and bank failures of the Great Depression clearly mandated unconventional departures. Even FDR's Republican predecessor, Herbert Hoover, understood this. While Hoover's rhetoric had continued to glorify old-fashioned orthodoxies, his policies had led the government into terrain that would normally be off-limits. Hoover certainly had no peacetime precedent for creating the Reconstruction Finance Corporation -- an agency designed to bolster the nation's banks and railroads -- and for structuring the RFC's funding as an off-budget transaction.

Roosevelt was unapologetic about breaking the standard rules, which he did at a dizzying pace. While critics branded him a dangerous heretic with no respect for established economic wisdom, FDR was undeterred by such attacks. He admitted "no sympathy for the professional economists who insist that things must run their course and that human agencies can have no influence on economic ills. One reason is that I happen to know that professional economists have changed their definition of economic laws every five or ten years for a very long time."

Roosevelt did not banish economists from his company altogether. He was quite willing to listen, albeit selectively, to members of the profession whose views lay outside the orthodox mainstream. Two diverse strands of heterodoxy -- each with different implications for government's role -- in fact inspired the policy initiatives of FDR's "First" New Deal.

Government as Market Regulator

The dominant faction in Roosevelt's first Administration traced the origins of the Depression to basic structural flaws in the nation's economy. According to "Brains-Truster" Rexford Guy Tugwell, an economist from Columbia University, a laissez-faire regime of "competition and conflict" was responsible for the crisis and only "coordination and control," meaning centralized planning, could correct matters.

Tugwell drew a sharp distinction between the problems of industry and those of agriculture. Manufacturing suffered from unemployment and excess capacity. This he traced to the ability of powerful corporations to suppress production, to increase prices and profits. A planning authority empowered to direct the use of economic resources and control prices and production, Tugwell argued, could lower prices and increase output and employment. The plight of farmers, in Tugwell's view, called for planning with a different focus. Persistent crop surpluses were agriculture's scourge. So Tugwell would subsidize farmers to shrink production, which would wipe out gluts, increase prices, and save farmers from bankruptcy.

In the atmosphere of 1933, Tugwell was hardly alone in seeing an urgent need to "coordinate supply and demand." Prominent businessmen used the same words, but gave them a different operational meaning. They sought coordination, but wanted business trade associations, not Tugwell's bureaucrats, to do the job.

With such widespread backing for economic planning, FDR decided to proceed with Tugwell's program and iron out differences later. He went to Congress and won the authorization to influence price-making in the private sector. The Agricultural Adjustment Act of 1933 used federal authority to restrict supplies of farm products deemed to be in surplus. The National Industrial Recovery Act of 1933 empowered a government bureaucrat, the National Recovery Administrator, to grant immunity from antitrust prosecution to industrial groups that would coordinate supply and demand. Authorizations generally required the acceptance of collective bargaining rights for labor. Reflecting the interests of business, they also required "codes of fair competition" presumed to forestall "destructive" price-cutting.

Government as Guarantor of the Price Level

The second perspective influential at Roosevelt's White House in 1933 traced the economy's ills to the post-1929 collapse in the general price level. This faction, led by George F. Warren of Cornell and Irving Fisher of Yale, also defined a new economic role for the government. Warren and Fisher wanted the government to embark on a program of unconventional monetary manipulations which, in their judgment, would clear a path to recovery.

According to Fisher's "debt-deflation" theory of the Great Depression, falling prices had increased the real burden of debts, with disastrous consequences. Debtors had to allocate more of their declining incomes to pay interest on earlier contracts, which diminished current spending for goods and services. Debtors scrabbling for liquidity, moreover, were forced to sell outputs and assets at distress prices. This compounded the difficulty by driving prices still lower.

The remedy was implicit in the diagnosis. The government should "reflate" the general price level to its mid-1920s elevation to relieve debt burdens and spur spending. Fisher and Warren thus argued that priority should be assigned to enlarging the money supply and to accelerating the velocity of monetary circulation. As a first step in their "reflationary" program, they called upon the president to increase the price of gold, claiming that this action would raise the general price level.

Roosevelt launched such a gold-purchase program in October 1933. By the time the exercise ended, in late January 1934, the price of the gold had risen by about 70 percent over its level of three months earlier.

Dead Ends

The two policy programs influential in FDR's first Administration had one thing in common: They shared a price orientation toward the problem of economic recovery. Other than that, their conceptions of the role of government in the modern economy conflicted sharply.

Tugwell regarded monetary nostrums as ineffective and nonsensical. To the extent they diverted attention from what he took to be critical -- the correction of structural imbalances in agriculture and industry through direct controls -- he saw such manipulations as positively mischievous.

Meanwhile, Fisher, et al. viewed the NRA's "codes of fair competition" as codes of no competition, and scanned the NRA acronym as "No Recovery Allowed." They objected even more to the supply-restricting features of the AAA. Fisher expressed bewilderment over the president's program: "It's all a strange mixture. I am against the restriction of acreage but much in favor of inflation. Apparently, FDR thinks of them as similar -- merely two ways of raising prices! But one changes the monetary unit to restore it to normal while the other spells scarce food and clothing when many are starving or half naked."

By the time FDR's first term ended, however, neither strategy, and neither redefinition of government's role, had much political standing. The enthusiasts for structural intervention grew disillusioned by the realities of the NRA in action. The experience of the first year and a half had convinced Tugwell, as well as his opponents, that businessmen had captured the NRA's code administration. So after the Supreme Court declared the NRA to be unconstitutional in 1935 and struck down the initial version of the AAA in 1936, there was little support for resurrecting the full-blown structuralist agenda.

The Warren-Fisher gold-purchase program had also fallen out of favor as the hoped-for result -- a significant rise in the general price level -- had not materialized. Fisher had offered two reasons for this disappointment. First, FDR had ended the program prematurely, without exhausting his full legal authority to elevate the gold price. Second, FDR had not seized what was literally a golden opportunity to augment the money supply with an issue of "yellowbacks" -- currency supported by the nominal "profit" in value of the Treasury's gold stock accruing from raising the price of gold. Despite Fisher's protestations, however, FDR lost interest in "reflationary" monetarism and its program of raising the gold price.

A Question of Balance

Despite his flirtations with new theories, Roosevelt was decidedly orthodox in one aspect of his economic thinking. He genuinely believed in the desirability of balanced budgets. During the presidential campaign of 1932, he had chastised Hoover for tolerating deficits, and had pledged to balance the federal budget at a lower level of spending. Roosevelt qualified his commitment with a significant rider: The budget to be balanced included only "ordinary" government expenditures. "Extraordinary" outlays, needed to cope with fallouts from the economic emergency, could be treated separately.

In the first two fiscal years for which his Administration was responsible, Roosevelt presided over record-setting peacetime deficits. But with the aid of creative bookkeeping about the categories to which expenditures were assigned, his Treasury's arithmetic could nonetheless show an "ordinary" budget with a modest surplus. FDR could no longer camouflage ordinary deficits after 1936, when Congress over-rode his veto of a bill mandating the pay-out of bonuses to veterans of World War I. Roosevelt, however, could credibly maintain that he should not be held to account for congressional misbehavior.

Official thinking on what was proper in fiscal policy underwent considerable modification in FDR's second term. In early 1937, Roosevelt still sought to submit a balanced budget (defined the old-fashioned way) for the next fiscal year. The objective seemed reachable without undue strain. After all, 1936 had been a good year, the best since 1929, and the momentum of recovery appeared solidly established. That upbeat mood was rudely punctured in August 1937, when the economy went into an unanticipated tailspin. Production and employment fell more precipitously than they had following the stock market crash of October 1929. This sudden reversal of fortunes was perplexing. Business-cycle theorists of the time were at a loss to explain why a downturn should occur when the economy was operating at a level far short of its capacity.

The intellectual challenge posed by the recession of 1937-38 inspired the formulation of a new "model" with fresh implications for the government's economic role. Unlike the earlier claimants for FDR's attention, economists that the New Deal had brought to Washington, not eminent professors at the nation's leading universities, had developed this new mode of analysis. Prominent among these economists was Lauchlin Currie -- a 1934 refugee from Harvard, where his sympathies for New Deal experimentation had not endeared him to the academic establishment -- now on the research staff of the Federal Reserve Board.

The new model focused on links between the government's fiscal operations -- specifically the "net contribution of government to spending" -- and economic performance. Currie's post- mortem on the 1937-38 recession drew attention to the fact that the government had been distinctly stimulative in 1936, due to the payout of the Veterans' Bonus, a once-and-for-all transaction. In 1937, the impact of governmental fiscal operations reversed direction. Nothing replaced the stimulus provided by the transfer payments to veterans. Meanwhile, government had shrunk private purchasing power by beginning the collection of payroll taxes to fund the Social Security system, which was not scheduled to make regular distributions to beneficiaries until 1942.

The analyses generated by Currie and fellow governmental insiders seemed to provide a plausible explanation for the onset of recession. They also suggested that the way in which government deployed its taxing and spending powers was a significant determinant of the level of economic activity. This point of view is often associated with the analysis presented by John Maynard Keynes in his General Theory of Employment, Interest, and Money, which appeared in 1936. But a similar mind-set emerged in the United States, quite independently, as a by-product of the struggle to comprehend the recession of 1937-38. And its persuasive power was enhanced by the fact that it was expressed with an American accent.

Government as Guarantor of Aggregate Demand

The "Curried Keynesianism" of 1937-38 seemed to suggest that the government should mount a deliberate program of deficit spending to expand income and employment. But could the president be persuaded to embrace such doctrine? To be sure, his Administrations had consistently run deficits. But he had regarded them as politically embarrassing, and had held that they were the result of unusual economic circumstances, not his policy preferences. To assert publicly that deficits were desirable in their own right would be quite another matter.

Roosevelt ultimately took this step in April 1938, when he adopted Currie's prescription and announced a "spend-lend" program to spur the economy. He took pains to argue, however, that there was nothing radical about this U-turn. The program, he emphasized, was consistent with traditional, home-grown American notions of the proper role of government in economic life. In Roosevelt's words: "In the first century of our republic we were short of capital, short of workers, and short of industrial production; but we were rich in free land, free timber, and free mineral wealth. The Federal Government rightly assumed the duty of promoting business and relieving depression by giving subsidies of land and other resources. Thus, from our earliest days we have had a tradition of substantial government help to our system of free enterprise.... It is following tradition as well as necessity, if Government strives to put idle money and idle men to work."

By 1940, this notion of aggregate-demand management as the solution to the unemployment problem had approached the status of an orthodoxy among the younger economists employed in FDR's bureaucracy. While this style of thinking remained suspect outside the inner circle, Currie had been officially installed on the White House staff, and was the first to be accorded the title of "economic adviser to the president."

From this position, Currie helped give the program of aggregate-demand management an additional American twist. Using the new macroeconomic framework, Currie advised the President, in March 1940, that the "social and humanitarian aims of the New Deal" were compatible with the dictates of "sound economics." He proposed a program of raising aggregate consumption spending using two types of measures. The first involved sharp increases in the progressivity of the income tax, on the assumption that revenues tapped from the upper end of the income distribution would otherwise swell savings, not consumption. Second, he would allocate the incremental tax receipts to those at the lower end of the income distribution through redistributive transfer payments and enlarged public outlays for health, education, and welfare. Currie was convinced that this strategy could raise aggregate demand sufficiently to restore full employment, and do so in a manner that spoke to Roosevelt's sympathies for society's most disadvantaged.

Pearl Harbor intervened before this "American Keynesian" strategy could be tested operationally. But aspects of this style of thinking lived on as governmental insiders charted plans for a fully employed economy in the postwar world. Their view of government's role in macro-economic management was largely codified in the Employment Act of 1946. For the first time, the federal government formally accepted responsibility for promoting "maximum levels of employment, production, and purchasing power." The "social and humanitarian aims of the New Deal," which Currie and the American Keynesians had linked to their program of macro-management, emerged in the post-war world as the second leg of the Big Government program.

Big Government

No economic policy model is serviceable for all seasons. American Keynesianism, after forty years as the nation's primary model, began to lose influence in the stagflation of the 1970s. Clearly, aggregate-demand management was ill equipped to deal with an economy in which inflation and unemployment were rising simultaneously. Nor did the Keynesian style of thinking seem to address the nation's new economic concerns -- the slowdown in economic growth and an apparent loss of international industrial leadership.

It was then that Chicago-style monetarist doctrines, structured as explicit rejections of Keynesian fiscalism, gained favor in the economics profession and officialdom. Many also came to see the distributional and regulatory policies that accompanied the Keynesian approach as undermining the nation's ability to compete. Congress thus deregulated airlines and trucking to foster competition and lower prices. It allowed energy prices to rise to encourage exploration. And it cut high marginal tax rates to discourage tax avoidance and foster risk-taking under the banner of "supply-side economics" -- the heterodoxy of the Reagan administration.

Ironically, the Reagan years can be seen as a vindication of Keynesianism. The large tax reductions and defense-spending increases, enacted in 1981, is what most Keynesians would have prescribed to fight the recessions of the early 1980s, though probably bolder than most would dare and with a different spending focus. And a prolonged expansion followed.

Whether or not fiscal stimulus deserves the credit for this expansion, the huge budget deficits that emerged spelled the end of Big Government. Added to the old complaints over intrusiveness and adverse incentives came new concerns about the crowding out of investment and a dependence on foreign capital inflows. Even advocates of government activism joined the chorus, as they saw cherished programs sacrificed to keep the deficit from rising.

Government is still big today. Federal outlays are about 20 percent of national output, as they were in 1980. Government still regulates and backstops a great many industries and markets. And through Fed monetary policy, if not through Keynesian fiscal policy, it remains responsible for macroeconomic stability. But because of the current mood in Washington, the federal government has grown less intrusive, and this trend will likely continue.

The dismantling of many New Deal programs seems appropriate. Technical change, and changing understandings of the way regulated markets function, have led to the deregulation of many industries. Various federal social initiatives, much expanded from their New Deal origins, have proven wasteful, ineffective, and even counterproductive.

But there are troubling aspects to the current antigovernment tack that suggest it has gone too far. Some of the attacks on programs that assist those Americans most in need smack of self-righteousness, ignoring the role of fate and the genuine difficulties with which the disadvantaged must contend. And proposals that place the conduct of fiscal policy in a straitjacket, as do certain proposed balanced-budget amendments, seem downright foolhardy.

Politicians and pundits tell us today that "the great debate over the role of government has been resolved for our time." Other politicians and pundits expressed similar sentiments in the 1920s, when heralding a "new era" of "permanent prosperity." Such confidence in the resolution of economic controversy seems to sprout when the economic weather is fair. Our nation, however, has passed through its share of economic and political hurricanes. We should know that fair weather is not something to count on.

New deal, new rules

When Franklin Roosevelt assumed the presidency, in the most difficult days of the Great Depression, it was easy to conclude that the basic structure of U.S. industry needed repair. In response, FDR's "New Deal" launched a series of institutional innovations that produced a pronounced shift in the "mix" of public and private sector activities. They included:

• federal deposit insurance (enacted despite Roosevelt's fear that it might encourage imprudent lending by bankers);
• the Glass-Steagall Act separating commercial from investment banking;
• the Tennessee Valley Authority;
• Social Security (which contained provision for unemployment insurance and transfer payments to the disabled); and
• a substantial extension in the federal government's regulatory jurisdiction over electric power and transportation.

FDR also launched a generalized program of industrial self-government, supervised by the National Recovery Administration, that proved to be an economic, political, and legal failure. In 1935, the Supreme Court declared it unconstitutional. Features of the NRA were nevertheless reincarnated. The Wagner Labor Relations Act of 1935 accorded statutory standing to the rights of workers to bargain collectively. Subsequent legislation also salvaged the equivalent of the NRA code machinery in the crude oil and coal industries.

Most of FDR's structural initiatives had a radical tinge when viewed by the standards of the day. So Roosevelt did his best to give them a conservative spin. Social Security, for example, was based on a contributory principle and paraded as the responsible approach to provision for the elderly. By contrast, FDR depicted a politically popular alternative -- the Townsend Plan to transfer $200 to all persons aged sixty or over, if they agreed to spend every penny and withdraw from the labor force -- as the dangerously radical path not taken.

In part because of FDR's success in framing his programs in traditional terms, many of his New Deal initiatives have survived, even through the widely publicized "demise of Big Government."

Not so big government

At the end of the 1930s, Keynesians in the Roosevelt administration drafted legislation to create a powerful fiscal authority that would be responsible for assuring macroeconomic stability. They envisioned a new federal agency, staffed by experts like themselves, that would be empowered to alter tax rates and to speed or slow spending on public works. This ambitious scheme amounted to a grand design for a "Fisc," with discretionary powers to execute fiscal policy analogous to the powers the "Fed" enjoyed over monetary policy.

Not surprisingly, Congress had no taste for delegating jurisdiction over taxing and spending to "experts" who had never carried a precinct or met a payroll. And while the legislative battle was still in progress, Roosevelt died. So what emerged from the Congressional pipeline as the Employment Act of 1946 was a distinct disappointment to the American Keynesians. The Council of Economic Advisers, created by the Act, lacked operational responsibilities and was only to report on economic conditions. It bore little resemblance to their grand blueprint of a "Fisc."