‘The ‘Twentieth Century Fund is an independent research foundation which undertakes policy studies of economic, political, and social institutions and issues. The Fund was founded in 1919 and endowed by Edward A. Filene. BOARD OF TRUSTEES OF THE TWENTIETH CENTURY FUND Morris B. Abram Georges-Henti Martin H. Brandt Ayers Lawrence K. Miller, Emeritus Peter A. A. Berle, Chairman P. Michael Pitfield Jonathan B. Bingham, Emeritus Don K. Price, Emeritus José A. Cabranes Richard Ravitch ‘Alexander M. Capron Arthur M. Schlesinger, Jr. Edward E. David, Ir. Albert Shanker Brewster C. Denny Harvey I. Sloane; M.D. Charles V. Hamilton Theodore C. Sorensen August Heckscher, Emeritus James Tobin Matina S. Horner David B. Truman, Emeritus James A. Leach Shirley Williams M. J. Rossant, Director A Twentieth Century Fund Report Yale University Press New Haven and London Hyman P. MinskyCopyright© 1986 by Yale University, To Esther All rights reserved. This book may not be reproduced, in whole or in part, in any form (beyond that copying permitted by Sections 107 and 108 of the U.S. Copyright Law and except by reviewers for the public press), without ‘written permission from the publishers. Designed by Sally Harris and set in Times Roman type by Graphic Composition, Inc., Athens, Georgia. Printed in the United States of America by \Vail-Ballou Press, Binghamton, N.Y. Library of Congress Cataloging-in-Publication Data Minsky, Hyman P. Stabilizing an unstable economy. (A Twentieth Cehtury Fund report) Theludes index 1, Economic stabilization—United States, | 2, Economics. 3, United States—Economic policy. L Title. M1. Series. HB3732.MS6 1986 339.5 85-22737 ISBN 0-300-03386-9 ‘The paper inthis book meets the guidelines for permanence and durability of the Committee on Production Guidelines for Book Longevity of the Council on Library Resources. woe 7654321 B37. S~ | - 6G UNIV. OF SYDNSY LIRRBARYContents | List of Tables and Figures ix Foreword xi Preface and Acknowledgments xi : PART I: Introd 1 Economie Processes, Behavior, and Policy 3 PART Il: Economic Experience 2 A Deep Recession but not a Depression in 1975: ‘The Impact of Big Government B 3 A Deep Recession but not a Depression in 1975 and 1982; -* ‘The Impact of Lender-of-Last-Resort Intervention 38 cl 4 The Emergence of Financial Instability in the Postwar Era 8 5 Perspectives on Theory 9 6 The Current Standard Theory: The After-Keynes Synthesis 116 7 Prices and Profits in a Capitalist Economy 141 8 Investment anc Finance 17 9 Financial Commitments and Instability 197 | | PART IV: Institutional Dynamics | 10 Banking in a Capitalist Economy 23 i 1 Inflation 258 | PART V: Policy | 12 Introduction to Policy 287 13 An Agenda for Reform 294 ‘Appendix A: Financing Structures 335 ‘Appendix B: Consumer Prices and Real Wages 3 Index 245 | | SECC CeCe CeCe ei CELE EEE ree eC Cee ee eee CeCe EE t=‘Tables and Figures Tables 2.1 Developments in 1973-715. 16 2.2 Federal Government Expenditures, 1950 and 1969-7524 2.3 Transfer Payments and Disposable Personal Income, 1973-75 25 2.4 Sectoral Surpluses and Deticits, 1972-75 27 2.5 Sectoral Sutpluses and Deficits, 1973-75. 28 2.6 Total Private Domestic Acquisition of U.S. Government Securities, 1972-1534 2.7 Commercial Banking: Net Acquisition of Financial Assets, 1972~ 13 36 REITs, 1972-7561 ‘Commercial Banking: Total Financial Assets, Government Securities, and Loans at Year End 74 4.2 Commercial Banking: Vault Cash and Reserves for Selected Years, 1946-8475 i 4.3 Distribution of Net Public and Private Debt for Selected Years, 1946— 84 78 4.4 Net Public and Private Debt Relative to GNP for Selected Years, 1946~ 84 79 4.5 US. Investment and Internal Sources of Funds, 1961-66 88 4.6 U.S. Money and Bank Credit Annual Rates of Change 89 4.7 Investment and Internal Sources of Funds, 1967-70 92 4.8 Corporate Cash Flows and Federal Government Budget, 1968-72 93, 4.9 Investment and Internal Sources of Funds, 1971-80 95 10.1. Financial Net Worth as a Percentage of Total Financial Assets 246 10.2 Finance Companies 247 11-1 Nonproducticn Workers as a Percent of Total Employment in Manufac- turing 274 11.2 Spendable Weekly Earnings, Average Weekly Earnings, and Weekly Compensation (Current Dollars) 276 11.3 Spendable Weekly Earnings, Average Weekly Earnings, and Weekly ‘Compensation (1967 Dollars) 277 11.4 Compensation of Federal Employees 279 ie SS eee Etx ‘Tables and Figures 13.1 Private Investment and the Federal Deficit 298 13.2. Gross Private Investment and Federal Government Outlays 299 13.3 Budget Outlays as a Percent of Actual GNP and an Estimate of Full ‘employment GNP, Fiscal Year 1983301 13.4 Expected Deficits as a Percentage of Expected GNP 304 13.5 Federal Budget Receipts, Fiscal 1983 307 Figures 4.1. Fixed Investments + Gross Internal Funds, Nonfinancial Corporations, 1950-84 81 4.2 Total Liabilities + Gross Internal Funds, Nonfinancial Corporations, 1952-84 81 4.3 Total Liabilities + Demand Deposits, Nonfinancial Corporations, 1952-84 82 4.4 Open-market Paper and Borrowings from Financial Companies = ‘Total Liabilities, Nonfinancial Corporations, 1952-84 82 4,5 Liabilities + Disposable Personal Income, Households, 1952-84 83 4.6 Liabilities + Money, Households, 1952-84 64 4.7 Financial Net Worth = Total’ Liabilities, Commercial Banking, 1952-84 84 4,8 Total Liabilities = Protected Assets, Commercial Banking, 1952- 84 8S 4,9 Demand Deposits = Total Liabilities, Commercial Banking, 1952~ 84 86 7.1 Total Costs Allowing for the Composition of Costs | 159 7.2 Price Setting 160 7.3 Price Taking 162 1 Price Level of Capital Assets: Relation to Money Supply and Alterna tive Expectations Environments 182 8.2 Investment: Ignoring Financing Considerations 188 8.3 Investment: Impact of Internal Funds and External Finance 197 8.4 Investment Determination: Alternative Configurations of Internal and “External Finance 193 ILL Time Series of Rates of Changes in CPI 255 11.2 Unemployment and Inflation, 1952-79 263 Foreword We have been experiencing for well over a decade a series of profound finan- cial shocks—to oar domestic economy and to the international economy. While we have menaged to weather them without disaster, they have never- theless exacted a heavy toll. We have experienced a loss of competitiveness in our economy accompanied by a steady decline in manufacturing jobs. We have also suffered rising numbers of bankruptcies in both the industrial and financial sectors and, of course, swelling government deficits. Abroad, we hhave witnessed the international debt crisis, which is stil with us and threat- ens to endure for a long time to come. It was a good while ago, well before most of the financial shakeup had taken place, that Hyman Minsky approached the Twentieth Century Fund with the notion of writing a short book arguing that standard economic theory fails to take sufficient account of the destabilizing effect of financial institu- tions upon our ecenomy. It was a project, he said, that would be finished in a year. We were intrigued by his premise and, subsequently, awed by his prescience. ‘A professor of economics at Washington University in St. Louis, Minsky is a Keynesian ata time when Keynesianism has gone out of fashion. In his ‘work for the Fund, he returned to Keynes's General Theory for fresh in- sights, but, in truth, Keynes was only the starting point of his analysis of postwar economic events and his examination of our financial system and ‘what needs to be done to reform it Minsky’s book was long in the making, much longer than either he or the Fund ever thought possible. Nevertheless, it has emerged at a critical time. Despite a strong recovery, the nation’s economic and financial resources are sirained. So, 100, ae those of the international financial network, The Fund, which has been supporting studies of both domestic and international prob- lems, is pleased t9 have sponsored this study, which helps to explain and Clarify the working of the American financial system, the system that is Tooked to by the rest of the world for sustenance and support in times of Although we sometimes wondered whether a book would emerge, it has been worth the wait. Minsky's detailed examination conveys a real sense of xtForeword ‘what is wrong and what is right with our economic structure, and what to do about it, We are grateful for his thoroughness, his perseverance, and his endurance. M. J. Rossant, Director ‘The Twentieth Century Fund July 1985 Preface and Acknowledgments I is now clear that output, employment, and prices in advanced capitalist economies with complicated and evolving financial structures are liable to fluctuate. It is also clear that the instability natural to our type of economy has been stabilized since World War II. In particular, even though there have been enormous stresses and strains in the economic and financial system, @ collapse of asset values, an uncontrlied epidemic of bankruptcies, and a deep and long-lasting depression have been avoided. ‘The instability so evident since the late 1960s was not as marked in the first two decades after World War IL. This leads to the question, “What is there about our type of economy that causes its overall behavior to thange so radically?” ‘The answer to this question requires an understanding of how profit- seeking businessmen and bankers transform an initially robust financial sys- tem (one not hospitable to financial crises) into fragile financial system (one. that is hospitable to financial crises). The market system of determining fi- nancial relations and valuing assets gives signals that lead to the development of relations conducive to instability and to the realization of instability. Peri ods of stability (or of tranquility) of a modern capitalist economy are transi- tory. ‘Stabilizing an Unstable Economy tries to explain why our economy is so liable to fluctuations and how the obvious instability has been contained, Even though the worse that could have happened—a great depression—has been avoided it nevertheless is true that the performance of the economy has ‘been substantially poorer in recent years than in the two decades immediately after World War Il. Furthermore, the success in stabilizing the instability since the late 1960s has been inadvertent, forthe theories underlying policy ignored the critical variables that make it possible to “stabilize” our inher ently unstable system. Policy, while broadly successful, has not addressed the deteriorating performance of the economy, Thus an agenda for reform follows the historical, theoretical, and institutional material ‘Stabilizing an Unstable Economy isin the post-Keyaesian tradition, which {take to mean that Keynes provides us with the shoulders of a giant upon Which we can stanc in order to see far and deep into the essential character of advanced capitalist economies. However, being post-Keynesian does notxiv Preface and Acknowledgments ‘mean being slavishly dependent on the works of the “Great Man.” I hope I ddo not make points by citing Keynes; if I do, I apologize now. ‘My intellectual debts are many: from my education I owe a great debt to Oscar Lange, Henry Simons, and Josef Schumpeter. From recent years [owe a great deal to my colleagues in Trieste—the faculty and students at the Centro di Studi Beonomici Avanzati; in particular the post-Keynesian contin- gent of Jan Kregal, Paul Davidson, and the late Sidney Weintraub. Once again, Iam grateful to Maurice Townsend for his encouragement and the insights he so freely shares ‘A special debt is owed to Joan Robinson, who was often wrong in espe- cially incisive ways. At the Twentieth Century Fund I want to thank Carol Barker, Walter Klein, and Gary Nickerson—especially Gary who kept the faith when I was weary and discouraged. Ted Young whipped a manuscript that was far too Tong into shape, eliminating pearls of wisdom that distracted from the clarity of the message. Beverly Goldberg took over the final preparation of the work, ‘The book could not have been completed without the help and understand- ing of the secretarial staff at the Economies Department at Washington Uni- ‘versity under the supervision of Bess Erlich and Susan Hilton. Special thanks are due Karen Rensing ard Anne Schroeder. When I needed access to data from the monster, Washington University's computer, Chris Varvares came 10 the rescue, PART I: Introduction1 Economic Processes, Behavior, and Policy ‘As we approach the last decade of the twentieth century, our economic world is in apparent disarcay. After two secure decades of tranquil progress follow- ing World War Il inthe late 1960s the order of the day became turbulence— both domestic and international. Bursts of accelerating inflation, higher chronic and higher cyclical unemployment, bankruptcies, crunching interest rates, and crises in energy, transportation, food supply, welfare, the cities, ‘and banking were mixed with periods of troubled expansions. The economic ‘and social policy synthesis that served us so well after World War II broke ddown in the mid-1960s. What is needed now is a new approach, a policy synthesis fundamentally different from the mix that results when today's ac- cepted theory is applied to today’s economic system. i ‘Although vital problems like personal safety, honesty, and intégrity tran- scend pure economic concems, my focus is upon stabilizing the economy. Perhaps naively, a premise in what follows is that if the economy provides basic security and a sense of personal worth for all—because work is a able for all—many social problems will recede to manageable proportions. In an era when performance failures demonstrate the need for economic reform, any successful program of change must be rooted in an understand- ing of how economic processes function within the existing institutions. That understanding is what economic theory is supposed to provide. Even as in- stitutions and usages are not ordained by nature, neither is economic theory. Economic theory is the product of creative imagination; its concepts and constructs are the rsult of human thought. There is no such thing, per se, as national income, aside from a theory of how to combine elements in the ‘economy into this special number; demand curves do not confront sellers— ‘customers do; the way in which money and finance affect the behavior of the system can be perceived only within a theory that allows money and finance 1 affect what happens. Unfortunately, tke economic theory that is taught in colleges and graduate schools—the equipment of students and practitioners of economics over the past thirty years and the intellectual basis of economic policy in capitalist emocracies—is seriously flawed. The conclusions based on the models de- rived from standard theoretical economies cannot be applied to the formula tion of policy for our type of economy. Established economic theory, espe- 34 Introduction cially the highly mathematical theory largely developed after World War II, ccan demonstrate that an abstractly defined exchange mechanism will lead to a coherent, if not an optimum, result." However, this mathematical result is proven for models that abstract from corporate boardrooms and Wall Street. ‘The model does not deal with time, money, uncertainty, financing of owner- ship of capital assets, and investment. If, on the other hand, the factors from which theory abstracts are important and relevant, if financial relations and ‘organizations significantly influence the course of events, then the estab- lished economic theory does not furnish an underpinning for the proposition that coherence results from the type of decentralized market economies that exist. In fact, the Wall Streets of the world are important; they generate de~ stablizing forces, and from time fo time the financial processes of our econ- ‘omy lead to serious threats of financial and economic instability, that is, the bochavior of the economy becomes incoherent? Tn the mid-1960s, after behaving well for some twenty years, the economy began to behave in a manner that cast serious doubts on the validity of the standard theory. Beginning with the credit crunch in 1966, we experienced a sequence of financial near crises (the others occurred in 1970, 197475, 1979-80, and 1982-83), each one growing progressively more severe. OMi- cials and pundits alike responded to these cycles by calling for a rejection of the macroeconomic theory derived from the work of John Maynard Keynes ‘and a return to the presumably tried and true analysis of classical microeco- nomic theory. In truth, however, the economy is now behaving in the way that Keynes's theory holds that @ capitalist economy with a fragile financial structure and a big government is expected to behave. The error is in current ‘economic theory, which grossly misinterprets Keynes's work.? AA theory that denies that what is happening can happen, that sees unfavor- able events as the work of evil outside forces (such as the oil crisis) rather than as the result of characteristics of the economic mechanism, may satisfy the politicians” need for a villain or scapegoat, but such a theary offers no useful guide to a solution of the problem. The existing standard body of 1. A serous statment of this mathematical theory that recopizs is ition is Kemneth 4, naa HH rl Cont Epairins an PH Dy co 2 among modern economist he post Keynesins mot cel acl his view See Fool Daido, Boney and he Rel Waid (Now York: Wiley, 197 Jn Kreps, The Reco uci of Foc! Economy: An fronton to Put Reysion Economics (coon: Ma mils, i913) Hyman P.M, oh Maynard Keyes (ew Yor” Column Univers Fra i875yitymen Ps Miso, Can "TFs een Ap’ aso ny Ponce (Grmont, NY: ME. Share & Co. 1982) Sidney Wels. Reyes, Keynesian, and Monearis Philp: Unsersty of Penaseana Pes. 973). Toba Maynard Keyoes, The Genera Theory of Emplayment neat end Money (New ‘York: Heer Brace 1938), th key work or ndestandng Now cpt ron th {lphisiated, complex, and evolving haan nststons behave Economie Processes, Behavior, and Policy economic theory—the so-called neoclassical synthesis, which takes on both a monetatst and an establishment Keynesian garb—imay be an elegant logi- cal structure, but it fils to explain how a financial crisis can emerge out of the normal functioning of the economy and why the economy of one period _ay be susceptible to crisis while that of anothers not. 7? The economic instability so evident since the late 1960s is the result of the | fragile financial system that emerged from cumulative changes in financial relations and insitwtions over the years following World War Tl. The unin- tended and often umotced changes in financial relations, and the speculative | finance induced by ‘he sucessful functioning ofthe economy, have made the | rules for monetary and fiscal policy based onthe experience ofthe 1950s and | the early 19605 invelid, No set of monetary and fiscal manipulations by them- | selves can reestablish and sustain the relative tranguility of the 1980s and | carly 1960s, Fundamental institutional changes simile in scope to the basic | reforms of the first six years of the Roosevelt presidency are necessary if we | are to recapture such relative tranquility. I reform isto be successfl i needs | tobe enlightened by a theoretical vision that enables us to understand the aes ofthe isa that is now 0 evident _-7 For new erao serious reform to enjoy tore than transitory succes it {Grout be based on he understanding of why decentralized market mecha hism—the fee make ofthe conseraives is an eficent way of banding the many dete of economi ie, and how the nancial instutons of cap ils, eapectly inthe context of production processes the use capital intensive techniques, ae inkerenty disruptive. Thos, while admiing the [oer tes ats we mst cet ha te Jan of fet en Ueetnble fee martets is reared, We must dcvelop economic insitions that contain and consol ability structures, priculary of nancial in "tons and of production processes that equre massive capi investments 9) "Paradoxically, capitalism flawed precisely beuse cannot readily asin ite production recesses that use geal capita aes, : Pj City tte ain ficient. But the flaws of poverty, corruption, uneven distribution of amenities \ and private power, and monopoly-induced inefficiency (which can be sum- \ tmarived inthe aserton that cptalis is unfai) are not inconsistent with the survival of a capitalist economic system. Distasteful as inequality and 4 For the purposes ofthis book, Don Patinkin, Money, Interest and Price, 24 ed. (New ‘York: Harper tnd Row, 1968), wil be considered the made of th nclsiel sythesis This ‘eoclassicl synthesis also the underpinning of Milton Friedman, "A Theoretical Framework for Monetary Anaysi”Jourel of Plical Economy 78 (March-Apll 1970) pp. 193-238: Robert A. Gordon, Friedman's Monetary Framework: A Debate wih His Cries (Chicago University of Chesgo Pres, 1974), and James Tobin, Ast Accumulation and Economic Ac tiny (Chicago: Univesity of Chinago Press, 1980) The necclasieat shes presumably fntegrate the price tery inherit rom Wales with insights derived from Keynes,6 Introduction inefficiency may be, there is no scientific law or historical evidence that says that, to survive, an economic order must meet some standard of equity and efficiency (faimess). A capitalist economy cannot be maintained, however, if it oscillates between threats of an imminent collapse of asset values and em- ployment and threats of accelerating inflation and rampant speculation, es- pecially ifthe threats are sometimes realized, Ifthe market mechanism is to function well, we must arrange to constrain the uncertainty due to business cycles so that the expectations that guide investment can reflect a vision of tranquil progress. ‘The Reagan administration and its program, largely enacted in 1981, may have been a response to a vision that something was seriously wrong with the economy, but it was based on a misdiagnosis of what was wrong and on a theory of how the economy functioned that is inconsistent with the basic institutions of capitalism. The financial fragility that led to the instability so tevident since the 1960s was ignored. The deregulation drive and the success- ful effort to bring the inflation rate down by large-scale and protracted mon- ctary constraint and unemployment exacerbated the financial instability that ‘was so evident in 1967, 1970, 1974~75, and 1979-80. Lender-of-lastresort interventions, which had papered over the problems of the fragile financial structure in the intermittent crises of the late 1960s and 1970s, became vi tually everyday events in the 1980s. The crisis of mid-year 1982—which saw the Penn Square Bank of Oklahoma City fail and the collapse of the Mexican peso—seems to have ushered in a regime of permanent financial turbulence, In 1984-85 we witnessed lender-of-last-resort interventions to ‘manage the reorganization of the Continental Illinois Bank of Chicago, the refinancing of Argentina, the collapse of state-insured thrift institutions in Ohio and Maryland, and a virtual epidemic of bank failures in the farm states. Containing instability is a major task of economic policy in the 1980s; this is far different from the tasks of economic policy in the 1950s and 1960s. ‘The protracted unemployment and bankruptcies and near bankruptcies of firms and banks radically transformed the labor force from being income- ‘oriented to being job-securty oriented. Job security is no longer being guar- anteed by government macroeconomic policy; the only guarantee that labor now enjoys seems to be the right to make concessionary wage settlements, ‘These concessions by workers mean that the cost push part of the business cycle is attenuated—but it also means that consumer demand due to increas ing wage income will be less buoyant during an expansion. If anything, the Reagan reforms made prospects for instability worse—but like many things in the economy and politics the full effect of the reforms will not be felt for some time, Even as a deficitaided strong recovery leeds to an apparent suc cess for Reaganomics, the foundations for another round of inflation, crises, ‘nd serious recession are being lai. Beonomic Processes, Behavior, and Policy 7 Economie systems are not natural systems. An economy is a socal or- sanization created ether through legislation or by an evolutionary process of| invention and innovation. Policy ean change both the details and the overall character of the economy, and the shaping of economic policy involves both 2 definition of goals and an awareness that actual economic processes depend ‘on economic and social institutions. Thus, economic policy must be concerned with the design of institutions as wel as operations within a set of institutions. lnsttutions are both legis- lated and the result of evolutionary processes. Once legislated, institutions take on a life oftheir own and evolve in response to market processes. We cannot, ina dyname world, expect to resolve the problems of institutional ‘organization for alltime. On the other hand, we cannot always be engaged in radially changing institutions. Once an institutional arrangement embod- ies the day's best perception of processes and goal, it should be allowed a run of time in whica details are permitted to evolve and policy is restricted to operations withir the institutional structure. Only a the inadequate per- formance of an ecoromic and social order becomes evident and serious does it become necessary to engage in thorough-going institutional reform, Such atime has arrived. “ The major contours of our present institutional setup were put in-place during the Roosevel: reform era, particularly inthe second New Deal, which was completed by 1936. This structure was a response tothe failures of the emergency legislation of 1933 to foster a quick recovery and tothe spate of Supreme Court rulings invalidating various portions ofthe first New Deal that had been enacted during the one hundred days of 1933. But while our institational setup was composed largely during the early Roosevelt years, ‘our understanding of how the economy functions was radically changed by John Maynard Keyres, whose General Theory of Employment, Interest and ‘Money was published in 1936. ‘There are various schools of Keynesians—conservative, liberal, and rai cal. There are some who believe that Keynes was simply wrong, others who believe that he merely refined existing economic theory, and sil others who believe that he quite correctly broke sharply with previous ideas. But regard- less of the view of what Keynes is al about, it must be agreed that, 10 the fexent thet our insitutional arrangements were, in the main, set prior to 1936, our basic institutional arrangements were not enlightened by percep- tions drawn from the Keynesian revolution in economic analysis. All that we can possibly have are Keynesian operations within a legislated economic structure that reflects a pre-Keeynesian understanding of the economy. Although the full force of Keynes's insights into the workings of a capital- jst economy has not been absorbed into the ruling economic theory and pol- jey analysis, enough of his message—that our economic destiny is control8 Introduction lable—has come through to make conscious management of the economy an avowed aim of governments in the post-World War Il era. The Employment Act of 1946, which set up the Council of Economic Advisers and the Joint Congressional Economic Committee, constitutes a commitment to attempt such management (Once the proposition that economic poticy can shape the course of events is accepted, then answers to “Who will benefit?” and “What production pro- ‘cesses will be fostered?” by policy come to the fore. Furthermore, once we ‘admit that institutions are man-made and at least in part the product of con- scious decision, we must also face the effects of institutional arrangements fon social results. An appeal to an abstract market mechanism as the deter- rminant of “for whom’ and “what kind” is not permissible; what exists are specific, historical market mechanisms.? Economic policy must reflect an ideological vision; it must be inspired by the ideals of a good society. And itis evident that we are faced with a failure of vision, witha crisis in the aims and objectives that economic policy should serve, In 1926, Keynes defined the political problem as a need to combine three things: economic efficiency, social justice, and individ ual liberty. The first needs criticism, precaution, and technical know!- cedge; the second, an unselfish and enthusiastic spirit that loves the ordinary man; the third, tolerance, breadth, appreciation of the cxcellencies of variety and independence, which prefers, above every thing, to give unhindered opportunity to the exceptional and to the as- piring.* We need to bring thi and liberty up to date. Given the vast increase in productive ability inthe past fifty years, we can if need be compromise on the goal of economic efficiency. We—in the United States at least—are rich. This means we can afford to relinguish some ‘output to achieve social justice and individual liberty. This 2bjective may be ‘well served by an economic order involving interventions that affect the re- sults of decentralized market processes. Since huge centers of private power land differences in wealth compromise the goals of efficiency, justice, and liberty, a policy that is willing to forgo some of the presumed advantages of ‘giant firms and vast financial organizations (advantages that may not in fact exist) seems highly desirable. In the light of recent experience, when the stitutions that foster this triad of efficiency, justice, 5, Thre is pli inefectivenees totem in sontemporry economics. (See Thomas J ‘Sarge and Neil Wallace, Rational Expectations aed te Theory of Economic Poli Journal ‘ef Monetary Economies, 1976, pp. 169-83.) Such theorems can be mamained Only as he in fact nstadonal structure I gpore. 6. John Maynard Keynes, “Essays in Persuasion” The Colectad Writings, vl. 9, (New York: St'Marti's Press 1972), p. 311. The essay sided "Liberals and Labec™ Beonomic Processes, Behavior, and Policy 9 difficulties encountered by giant corporations and financial institutions are central to the instability that plagues the economy, the very largest concentra- tions of private power should, in the interest of efficiency as well as stability, be reduced to more manageable dimensions. 1 Social justice rests on individual dignity and independence from both pri- vate and political power centers. Dignity and independence are best served by an economic order in which income is received either by right or through a fair exchange. Compensation for work performed should be the major source of income far all. Permanent dependence on expanding systems of transfer payments that have not been earned is demeaning to the recipient and destructive of the social fabric. Social justice and individual liberty de- ‘mand interventions to create an economy of opportunity in which everyone, except the severely handicapped, earns his or her way through the exchange of income for work. Full employment is a social as well as an economic 004. 1 would be naive to assume that all stated social and economic goals are ‘mutually consistent. Emphasis on one objective may decrease the ability to achieve other goals, so priorities must be set. I tend to favor personal free- ‘dom and democratic rights; the safeguarding of so-called property rights— ‘even if property rights lead to the narrow economic efficiency of orthodox theory—is not to my mind equal to the extension of individual liberty and the promotion of social justice. These beliefs affect my policy positions. ‘Although this book is mainly concemed with economic theory and some interpretive economic history its aim is to draw up an agenda for the reform ‘of our malfunctioning economy. Effective reforms must be consistent with the processes of the economy and not violate the character of the people. ‘Without an understanding of the economie process, and without a passionate, even irrational commitment to democratic ideals, an agenda for change, in response to a perceived need for change, can become the instrument of dem- ‘agogues who play an fears and frustrations and offer panaceas and empty slogans.” “The proposals for reform to be advanced will necessarily be painted with ‘abroad brush. Detai's will have to be refined by Congress, by an administra- tion, and, let us hope, by the debate of an enlightened public willing to think hhard about the direction the economy is to take.* ‘The major flaw of our type of economy is that it is unstable. This instabil- 2. Hear ©, Simons, A Pastive Program for Latex Fare (Chcago: Unies of Chicago ris, 1958), reprinted Henry ©. Stott, Economie Pols fora Free Soe) (Chicago. Unter of Cag ar 14), pt for ecm pra of toa ‘ef and plcyoperatn that eta sodlfpolical xenon rsp of the pa fity years, thesbstaree of Simon's propose at sll wort condetings 8. Ins 1926 pamplet “The End of Lesser Fae” val, Caled Works, Ess in ‘Persation, op. pp 12-94, Keynes ced uke a ening nef te hae bles in legion, namely tc determine what the Ste ought to ake upon isl oat Oy he10 Introduction ity is not due to external stocks orto the incompetence or ignorance of policy makers, Instability is due to the internal processes of our type of economy, ‘The dynamics of a capitalist economy which has complex, sophisticated, and evolving financial structures leads to the development of conditions condu- cive to incoherence—to runaway inflations or deep depressions. But inco- hherence need not be fully realized because institutions and policy can contain the thrust to instability. We can, so to speak, stabilize instability? Exeron’ Kyosen i MeCalsh in bis Princes of Polo! Economy) Burkes Sttement ofthe picy problem vad tonya was day 9: Theres ow apie evidence to indete that anol ystems which ae mutiimen sion ona, snd tine dependent re endgenoanlyunaab Soe Richard L. ay, “Ine ‘lar Grow Cycles” American Economie Revew 72 0.3 Gun 1982), and "The Emergence ‘of Chanr From Casi! Economic Grow” Quarterly Journal of Economics: Aesandro ‘eret,"Flctustions and Grows Keynes Schumpeter, Mar snd the Stuctural Insti of Capitalism,” in R: Goodwin, M. Kurger, and. Werce, Nowinear Modes of Flaca Growth (New Yor: Springer, 983}; Per” Albin, Microeconomic Rewndaion of Cele Irreulries and Choo. Center or th Stay of yom Sete and Indl Complex Sohn Tay Cllege, City University of New York May TO8S. Its also known tht i untae ‘systems are onsrained by celings and floors hen an econometric analysis of the resuing ‘in seven wil indeate at this sytem sabe See John M. Blt, "On the Econometric ‘Approsch to Businest-Cyele Analy” Oxford Economic Papers (N.S), wl. 30 uly 1978). Foran cal analysis of Consaned explosive serer, see Hyman Minsky, “A Linear Moe 8 Chen Growin" Review af Econo and trie Ly na 2, Pa May 1959) and "Monetary Systems and Accleation Model American Economic Review 4 (Bee. 1957), PART II: Economic Experience2 A Deep Recession but not a Depression in 1975: The Impact of Big Government In the first quarter of 1975 (and again in midyear 1982), it seemed as if the American and the world economy was rushing toward a depression that ‘might approach the severity of the Great Depression of the 1930s. Not only ‘was income declining rapidly and the unemployment rate exploding, but vie- ‘ually each day saw another bank, financial organization, municipality, busi- ness corporation, or country admit to financial dificuties. For example, in October 1974 the mult-bliion-dollar Franklin National Bank of New York failed (atthe time it was the largest American bank ever to fail), and in early 1975 the billion-dollar Security National Bank of New York was merged 10 prevent overt failure. During 1974~75 more banks failed, and more assets ‘were affected than in any period since World War II. Moreover, the Real Estate Investment Trust (REIT) industry, with some $20 billion fn assets, experienced a severe run that led to many bankruptcies and work-outs. In 1982, a virtual epidemic of savings banks failed, and in midyear a spectacu- Jar bank failure—that of Penn Square in Oklaboma City—Ied to large losses at some of the citadels of American banking: Chase Manhattan, Continental Mlinois, and Seafirst. Then, in mid-1982 the Mexican peso collapsed, and default on mult-billon-dollar debts by a spate of Latin American countries seemed imminent," In addition, 1975 was marked by New York City’s financial crisis, the failure of W. T. Grant and Company, the need for Consolidated Edison to sell assets to New York state in order to meet payment commitments, and the walking bankruptcy of Pan Am, In 1982, fiscal insolvencies by municipali- ties were averted, but everyday names like International Harvester and Bran- iff were covert or overt bankrupts. In both episodes financial disarray seemed to be contagious, ard there were fears that all asset values would soon be alfected. A financial crisis seemed to be in the making. But in May 1975 and in November 1982 the downward movement was abruptly halted and a strong business cycle expansion began. ‘The episodes of instability so evident in 1974~75 and 1982 were not iso- 1. The exis of 1982+ had an echo in 1984 when he overt lure of Contin inal was prevented by + massive infusion of funds from the Federal Resene, te FDIC, and ¢ onsortium of giant tank, and further ens of Latin debt threatened he solvency of many of the largest Danks B4 Economic Experience lated events. Since 1966, the American economy has intermittently exhibited pervasive instability. Serious threats of financial disarray loomed in 1966, 1970, and 1979, but these financial crises were not of the scope and magni- tude of 1974-75 and 1982. Even though the financial difficulties in 197475, and 1982-83 were more serious than in the other episodes, and even though money-market participants and the regulating authorities began to behave as if a full-fledged financial crisis reminiscent of what happened in 1929-33 ‘was imminent, no full-fledged crisis took place. ‘The difficulties in 1966 were followed by a pause in the growth of income and a slight rise in unemployment; the combination was called a growth recession. The next four episodes of financial trauma, in 1970, 1974-75, 1979, and 1981-82, led to recessions; those of 1974~75 and 1981-82 were serious. The depth of the decline in 197475 and the limping nature of the recovery that followed, due largely to the persistence of financial difficulties, ‘make what happened in 197475 either a mildly serious depression or a deep recession. The recession of 1981-82 can be characterized in the same way. ‘The financial trauma and recession after 1966 are not the only evidence of increased instability in the U.S. economy. The years since 1966 have been characterized by the worst inflation the country has experienced in times of peace. Furthermore, in the expansions that followed each financial crisis, the rate of inflation reached higher levels than after the prior expansion. Al- though unemployment rates have mostly been at high levels and capacity utilization rates at low levels since 1975, the annual rise in the basic inflation rate (the consumer price index [CPI}) never fell substantially below 6 percent ntl after the severe recession of 1981-82. In order to design economic policy for the United States, itis necessary to ‘understand why our economy is significantly more unstable now than earlier in the postwar period and why this instability did not lead to a deep and persistent depression. The performance of the American economy in the past decade may be nothing to be proud of, but at least the disaster of a Great Depression was avoided. What, then, prevented a deep depression in 1975 and 1982? The answer centers on two aspects of the economy. The first is that Big Government stabilizes not only employment and income but also business cash flows (prof its) and as a result asset values.? The second aspect is that the Federal Re- serve System, in cooperation with other government agencies and private 2, This i a proposition derived from the work of Kaleci. See Michael Kalk, Selected sss on the Dynamics ofthe Coptalt Economy (1933-1970) (Cambatdge: Cambriége Un ‘erty Prose, 1971), Chaper 7, "The Determinants of Profs.” See aso Tyan P Minsky Gan 21" Happen gain’ Essays on Instability & Finance (Armonk, NY: ME. Sharpe, fn, 1982) Chapter 3, "Pnance and Profs: The Changing Nature of American Business Cele” pp: 14-38 The Impact of Big Government Is financial institutions, acts as a lender of last resort It will be argued that the combined behavior of the government and of the central bank, in the face of financial disarray and declining income, not only prevents deep depressions but also sets the stage for a serious and accelerating inflatiorito follow. The institutions and usages that currently rule have not prevented disequilibrating forces from operating. What has happened is that the shape of the business cycle has been changed; inflation has replaced the deep and wide trough of depressions. Chronology of the 1973-75 Recession ‘The recession of 1973-75 covered six quarters, from October (or Novem- ber) 1973 to April (or May) 1975, making it the longest recession since ‘World War II. However, these six quarters fall into two phases: a mild dip that ran four quartes, from October 1973 to October 1974, and a precipitous drop that lasted two quarters, from October 1974 to April 1975. Although the frst phase can be attributed to the oll shock repercussions of the Arab- Israeli War in 1973, the second phase resulted from the workings of the During the third quarter of 1974 and the first quarter of 1975, the sky seemed ready to fall. In September 1974, the index of industrial production stood at 125.6 (1967 = 100); six months later, this index was down sharply {0 110.0, a drop at 24.8 percent annual rate. Similarly, price-deflated gross national product (GNP) in 1972 dollars stood at $1,210.2 billion in the third quarter of 1974 and at $1,158.6 billion in the first quarter of 1975, an annual rate of decline of 8.5 percent (see table 2.1), Between September 1974 and March 1975 civilian employment fell at 6.7 percent annual rate If the rate of decline over the six-month period (the last quarter of 1974 to the first quarter of 1975) had continued for another six months, then a very deep depression would have been under way. But instead of continuing to ecline, the economy's fall was checked sharply in the second quarter of 1975, and a slight uptum began. Payroll employment increased in April 1975 over March 1975. The index of industrial production, which was falling at a 23 percent annual rate in the first quarter, tamed around and was increasing at a 10.6 percent rate in the three months ending September 1975. Price- deflated GNP shifted from a 9.2 percent annual rate of decline in the first quarter of 1975 to 2 3.3 percent annual rate of increase in the second quarter Of 1975, and a larger 11.9 percent rise in the third quarter. ‘Two sharp reversals in the path of the economy this took place within approximately six months. First, a modest recession was transformed into a precipitous drop, and then, some six months later, there was a sharp braking of the decline and an almost immediate turnaround to a rapid expansion,The Impact of Big Gorerument ” g/2qe2 ener chen ‘These sudden reverséls are indicative of instability. They are evidence that Ree : the economy was more unstable in 1974-75 than it was earlier in the post. Instability increases uncertainty. It is more dificult to make decisions in an economy that changes sharply than in an economy that changes gradually, Increased uncertainty, in and of itself, is « damper on economic activity, eaan especially long-lived investment. But a more important point, particularly so under capitalism, is thatthe instability tends to be amplified. Decision make rs begin to seck early waming signals and become too sensitive to short. term indicators of chenge in the economy. One result is that investors begin {0 prefer the large immediate financial gains that can be made by being right (on the swings over the more lasting and secure—though smaller —gains that can be made by investments that facilitate longer-run economic growth and. development. In terminology that echoes Keynes, in an unstable economy speculation dominates enterprise What Happened during 1974-75 Unemployment Rates rice Deflaors GNP ns. 121.48 ‘Ofc, Washington, 1976 Tex 972" 100) 103.08 104.86 106.73, 109.01 Over the last quarter of 1974 and the first quarter of 1975, i looked asf the U.S. economy was heading toward a generalized financial crisis, and, if his. {ory was any guide, a deep depression would follow. Income decreased rap_ ly, and the unemployment rate, which had been 5.0 percent in March 1974, Jumped to 8.6 percent in March 1975. In the spring of 1975, financial diff, culties, at times resulting in the bankruptey of banks, specialized financial { Organizations, electric utilities, aitlines, and mercantile companies, either 2 2 7 4 39 233 a1 9. 3 1 5 Price Deflated z 2 1 GNP Growth Rates Annual Rates) Current Dollars occurred or were antcipated. The multi-billion dollar Franklin: Nard Bank filed in October 1974, an the ling bilhon-dolar Security Nesoel Bank was merged into the Chemieal Bank of New York in anwar 1978 | Europeans, too, feared thatthe world economy was heading toward 9 de- f bbacle that would match the conditions of 1929-33. Financial crises compa- | Abe to those inthe United States took place in Germany and Srna | But the precipitous drop of income and the explosive rise of unemploy- ‘ment didnot continue, and no cumulative interactive financial detosorasoe | occurred. The unemployment rate peaked at 8.9 percent in May 199 ot | the index of industrial production, which had alent 109.9 percent in Ava t 4275, stood at 118.5 percent at the end of 1975. A recovery began during |} the second quarter of 1975, and, as 1976 propressed, it becarne clear that the : 3 t : Deflared 1972 Dollars GNP Report ofthe Presiden, Janary 1976, US, Government Pri Dollars Current S i 2 i Worst had not happened. Financial markets and the economy proved resi. ‘ent, and no cumulative debt deflation or deep depression took place. The '-I5 were absorbed, and their repercussions were @. sone: Eoonom ‘Table 2. 1973 1975 (1) Pundits, politicians, and officials have proclaimed thatthe economy es- caped the near crisis of 1974~75 as a result of the normal functioning of ‘market processes. In truth, the braking of the downswi ng and the subsequent18 eonomic Experience recovery were largely the result of strong fiscal measures and prompt lender- oF last-resort interventions. The fiscal measures were partly automatic be- cause of massive entitlement (transfer payment) programs and a tax system in which receipts fell sharply when employment fell and were partly discre- tionary in the form of tax rebates, tax reductions, and extensions of unem- ployment insurance. ‘The situation in 1974-75 is not.an isolated episode of an incipient financial crisis and an associated recession. It was the third such episode in less than a decade, the others occurring in 1966 and 1970. These three near financial crises were triggered when Federal Reserve operations, undertaken in an effort to curb inflation, led to a run-up of interest rates. Attempts, however, by the Federal Reserve to halt inflation prior to the mid-1960s had not trig- ‘ered a near financial crisis, because the financial environment in which the Federal Reserve has operated since the mid-1960s has differed critically from the envionment immediately after World War I. Since 1974-75 there have been two additional episodes of financial trauma: in 1979-80 and in 1982-83. Both followed an exercise designed by the Federal Reserve to curb inflation. Clearly, inthe financial environment that has ruled since 1966, traditional monetary restraint efforts by the Federal Reserve lead to threatened financial breakdowns as well as unemployment and loss of output. (Over the postwar era, the financial structure became increasingly suscep- tible to financial crises. But what determines whether a financial structure is susceptible to financial crisis? The financial interactions that were part of the process that led to the downward thrust of the economy in 1974-75, as well as to the recovery of 1975-76, are not integrated into the standard analysis, ‘of how our economy works and of how policy affects the outcome. Analysis that builds on either the conventional Keynesian or the popular monetarist ‘models cannot explain financial and economic instability. Tn order to understand the events of 1974~75 and other recent business cycles, we need to know not only what happened to income and employment but also how the threat of a debt deflation was both triggered and aborted. ‘The evidence from 1975 indicates that, although the simple Keynesian model in which a large government deficit stabilizes and then helps the economy 0 expand is valid in a rough and ready way, the relevant economic relations are more complicated than the simple model allows. In particular, because what happens in our economy is so largely determined by financial considerations, economic theory can be relevant only if finance is integrated into the struc- ture of theory. ‘The income and financial stabilizers provided by Big Government take time to become effective, Meanwhile, financial pressures in the form of pay- ‘ment commitments on outstanding short-term debts and declining asset val- tues threaten to turn financial tautness into a financial debacle. In order 10 ‘The Impact of Big Government w prevent a full-fledged crisis, refinancing is needed. Such refinancing, or Tender-of last-resort intervention, was carried out by the Federal Reserve System, the Federal Deposit Insurance Corporation (FDIC), and private fi- nancial institutions (mainly the giant commercial banks at the behest of the Federal Reserve) in the post-1965 recessions. Effective lender-of-last-resort actions are necessary if an incipient financial crisis is not to become a full- blown panic, even thoagh Big Government exists ‘A major depression did not occur in 1975 because of two types of govern- iment intervention: (1) Big Government’ fiscal policy: the massive federal deficits in the recessions directly affected income, sustained private financial commitments, and improved the composition of portfolios; and (2) Lender of last resort: refinancings were aptly executed by the Federal Reserve Sys~ tem and cooperating private and public bodies. Impaets of Big Government ‘Although the U.S. government owns very litle of the means of production and provides few services directly, itis big. Unlike governments in many countries, it does not own and operate railroads, electric utilities, and tele phone systems, nor does it run or pay for comprehensive medical services. ‘Aside from the Tennessee Valley Authority, some nuclear installations, and the remnants of a postal system, itis dificult to think of any means of pro- ‘duction owned by the federal government. In spite of a long and glorious history, the naval yards and army arsenals have been abandoned; military procurement now takes the form of contracts to ostensibly private firms. ‘To understand how our government is big, government spending must be divided into four parts: (1) government employment and spending on govern- ment production (¢.g., the armories of history, the postal service, and the ‘personnel portion of military spending); (2) government contracts (c.g. for airplanes and missiles from Lockheed, paper from think tanks such as the Rand Corporation, of highways built by the friendly neighborhood contrac tor); (3) transfer payments (e.g., Social Security, Medicare, unemployment insurance, and Aid to Families with Dependent Children {AFDC)); and (4) interest on the government debt. In recent years neither government employment nor government contracts, aside from the militay, have made government bigger in terms of its aggre {gate demand, financil lows, and portfolio effects. The government is bigger now mainly because military spending, transfer-payment schemes, and the costs of servicing the national debt have grown. Transfer-payment schemes in particular have become so large a part of government since World War IL that the cyclical impact of government spending is now largely determined by their impact. ‘A transfer paymen: is a one-sided transaction, in contrast to an exchange,20 Economic Experience which is ewo-sided. In a transfer payment, a unit receives cash or goods and services in kind without being required to offer anything in exchange, A transfer-payment recipient conforms exactly to the economic status of « de- pendent child. A unit receiving a transfer payment does not provide inputs into the production process, Because the recipient produces no outputs, ‘wansfer-payment receipts are not part of the GNP, although they are part of ‘a consumer's disposable (after-tax) income. If one receives income as the result of a contribution, however meager, to the production of something “useful,” then, roughly speaking, he is putting something into the output pot even as the income constitutes a right to take something out. In a market economy, the market value of what a production tnt finances for its workers and owners to take out cannot be greater than the excess of the unit’ sales proceeds over purchased inputs for any consid cable period of time without the production unit running into financial difi- culties, The excess of sales proceeds over the costs of purchased nonlsbor inputs normally finances the entitlements a production unit's workers and investors can take out of the economy’s output. If GNP is considered to be a ppot, then the value of what the participants in production can take out is related to the value of what they putin, A transfer payment as part of dispos able income finances taking out without requiring any offsetting contribution to the pot. The cliche “fair exchange is no robbery” applies to income re- ceived from work, but it does not necessarily apply to income received as a transfer payment. Today, a good part of the rights to taking out are based on legislated, moral, or customary usages, not on explicit curtent or past contri- butions, ‘A worker on unemployment insurance receives funds without making a current contribution to output. Ifthe same worker received the same income ‘on a work relief or Work Projects Administration (WPA)-Iype program, then he can be presumed to have made a contribution to GNP equal to his income. Ifthe WPA output is useful and is sold, WPA-type relief for the unemployed is ess inflationary than unemployment insurance. Ifthe WPA output is useful even if itis not sold in a market, then it makes a contribution to the well- being of those who find the output useful, and, presumably, a tax or user’s fee offset to all or part of the WPA spending could be collected. The military payroll as well as the income derived from defense contracts are income receipts that make no contribution to current useful output, and are at least as inflationary as transfer payments Because of the greater Weight of transfer payments in government-spend- ing schemes over the past years, the direct impact of much of govemment spending is on disposable income without any inital effect on employment ‘and measured GNP. Measurements and problems of definition are involved, ff course, in these distinctions. Ifthe federal government spent as much on EES Sees ome The Impact of Big Government au ‘employing doctors and nurses, for example, as it now spends on Medicare and Medicaid, then such health care spending would not be considered a transfer payment, but instead & government purchase of goods and ser- Big Government was one cause of the halt in the sharp decline of the economy from the second quarter of 1974 to the first quarter of 1975 and the reversal toward the strong expansion that occurred in the spring and summer of 1975. With Big Government, a fall in income automatically leads to @ ‘massive governmen: deficit ‘To understand how Big Government stopped the economy's fiee fall it is necessary to delve into the different impacts of government deficits on our ‘economy: the income and employment effect, which operates through gover- ‘ment demand for goods, services, and labor; the budget effect, which oper- ates through genera‘ing sectoral surpluses and deficits; and the portfolio ef ‘fect, which exists because the financial instruments put out to finance a ‘deficit must appear in some portfolio. The first effect is familiar and is dealt with in models that set out how GNP is determined. The second and third impacts of government are often ignored; they are important, however, be- cause the economy is both an income-producing and -distributing system and a complicated, interdependent, and sophisticated financial system.” Once these various facets are recognized, the effect of Big Government on the economy is much more powerful and pervasive than is allowed by the standard view, which neglects the financial-flow and portfolio implications of a government deficit. The standard view focuses solely on the direct and secondary effects of government spending, including transfer payments and ‘axes on aggregate demand. ‘The expanded view allows both for the cash flows that other sectors need in order to fulfill commitments and for the need for secure assets in portfolios in the aftermath of a financial disturbance. ‘The reversal, during the winter of 1975, of the steep decline in income took place because the federal government's automatic reflex was to throw ‘money at the problem, without considering longer-term benefits and costs, ‘Thus, the truth of the essential Keynesian proposition—that increased gov. ferment spending ard tax cuts, if carried far enough, will halt a precipitous ecline of the economy—was conclusively demonstrated in the recession of 197475. As a result of the 1975 experience, the issues in economic theory sis tis ei tale ples ee st ra eas ie is ey ee2 Economie Experience and policy that we should have to face are not about the ability of prodigious government deficit spending to halt even a very sharp recession but about the relative efficiency of specific measures and the side and after effects asso- ciated with particular policy strategies. Given the proven power of the defi cits of Big Government, the overriding policy issue really should be the de- termination of the structural effects and objectives of government action. Once government is big, it must be concerned not only with aggregates but with for whom to produce, how to produce, and what kind of output £0 produce, ‘The Reagan effort to reduce government—which has failed so far because ‘of the impact of defense spending, entitlements, and interest payments— ‘would, if successful and if carried oo far, make our economy more suscep- tible to downside instability: The Big Government impact was clearly evident inthe recession of 1982-83 and the recovery of 1983-84. The power of Big Government and enormous deficits to contain downside instability was dem- onstrated Income and Employment Effects Tn the conventional theory of income determination, government ether cre- ates employment (e., hiring people oF buying goods or services), supplies income (e.g, Social Security), oF spends on services for people (e-g., Med- jcare and Medicaid). Government also takes income from people by taxes and fees. When the government hires someone, a useful service is presum- ably provided. Similarly, when the government purchases something ({rom, say, a defense contractor) something useful is presumably produced. On the other hand, when the government transfers income to people, there is no direct effect on employment and output. Nothing that is presumably usefl is exchanged for the income, and the economic impact comes only asthe recip- ient spends the funds that are transferred. Tn the standard view of how government alfects the economy, government spending on goods and services is considered a component of aggregate de- ‘mand, along with consumption and investment, but govemment transfer pay- rents are not. The rules governing consumption spending are expressed as a “function of disposable income, various measures of wealth or net worth, and the payoff from using income to acquire financial asets (ie. interest rates). ‘Transfer payments, as well as Social Security taxes and personal income taxes, enter ito the analysis indirectly by way of disposable income and its effet on consumer spending, ecause of the way matters are measured, the impact on GNP of a dollar spent to hire leaf rakers in the public parks is greater than a dollar given in welfare or unemployment benefits. In 1975 the government distributed some $80 billion in Social Security payments. If 50 percent ofthe amount paid on Social Security had been spent on wages for the aged in a variety of work The Impact of Big, Government 2B programs, then GNP would have been higher by some $40 billion. It is clearly a normative economic and sociological question whether itis better for a country to provide income for the aged through jobs, either in private industry or in make-work projects, or to provide income through transfer payments. It should also be noted that military spending constitutes part of GNP, ‘The distinction between transfer payments, taxes, and goverment spend- ing on goods and services in the calculation of GNP is valid if and, in truth, only if we divorce the measure of GNP from any welfare connotation and treat it purely as an output measure that is transformed into a current period demand for labor (ie., into employment). Government purchases of goods (Such as a bomb or paper clips) and of services (whether of a general, a private soldier, a senator, or an engineer) are related to employment directly, as workers are hired and goods or services are produced. They are also re lated to employment indirectly through consumers” disposable income, as the employed workers, business managers, and profit receivers spend on con- sumption and investment goods. Transfer payments also affect employment indirectly, as they provide additional disposable income for households and additional gross proits for business. Thus, the simple straightforwafd way in which government affects employment is an important part of the picture. Government spending, especially in excess of taxes, is a determinant of icome. In terms of spending, the big increase over the postwar era has been transfer payments to persons and grants-in-aid to state and local govern- ments, as shown in table 2,2. In 1950, early in the post-World War Il era, total federal government spending was $40.8 billion (some 14 percent of GNP); $10.8 billion (about 25 percent of government spending) was transfer payments to persons. In sharp contrast, in 1975 total federal government spending was $356.9 billion (some 24 percent of GNP); transfer payments were $146.1 billion 40 percent of the total government spending). The other ‘government prograns that have grown rapidly are the grants-in-aid to state and local governments. These grew from $2.3 billion in 1950 to $54.2 billion 1975 (from 5 to 15 percent of government spending). ‘There are differences between the ways various major components of gov- ‘emment spending developed over the longer haul of 1950-69 and the seven yeats of ostensibly conservative government under Presidents Richard Nixon and Gerald Ford. Between 1950 and 1969, total government purchases of goods and services increased by a factor of 5, the national defense compo- nent rose by a factor of 5.45, and the civilian government function rose by a factor of 4.51. Over this same period, transfer payments to individuals also increased by a factor of almost 5. Thus, in the period when relatively liberal ‘administrations dominated Washington, government purchases of goods and services and transfer payments to persons increased at about the same rat. ‘In contrast, between 1969 and 1975 federal government purchases ofsof Dollars) Federal Government Expenditures, 1950 and 1969-75 (Bil ‘Table 2.2: Transfer Purchase of Goods & Services GNP. ge? as Other National Defense Toat Total Expenditures Year 286.2 23 140 47 18.7 408 1384 2082 1950 925.5 9824 1065.4 1306.3, 1406.9 1499.0 ua 203 Daa 290 373 40.5 439) 542 na 50.5 93.2 nas 146.1 sdgesae 163 Bs 02 BS na Ta 840 97.5 95.6 96.2 102.0 nny 1231 102.1 2006 248.7 2648 300.1 356.9 1969 0 a n a 7 5 As % of GNP 08 38 i6 49 68 43 1950 1969 104 97 90 87 18 19 82 agdaeaa 0 n n a % 5 976 2 i 8 i i g i i i ; : t a The Impact of Big Government 25 ‘Boods and services rose 26 percent, with national defense spending increas- ing 10 percent and the other civilian functions rising 85 percent—but transfer payments to persoas soared nearly 200 percent! In 1975, they were almost 20 percent greater than government purchases of goods anid services, com- pared with 1950 and 1969, wien they were very much less. ‘Transfer payments consist ofa large array of entitlement programs;as such they tend to increase automatically whenever the economy enters a recession, In addition, because they are programs already in existence, itis relatively ‘easy for Congress and any administration to increase their “generosity” as the economy enters a recession, Although unemployment rates went to 8.9 percent in May 1975, in no quarter during 1973-75 did disposable personal income decline (see table 2.3). One reason was the way transfer payments by government exploded. Between the first quarter of 1973 and the fourth quarter of 1975, disposable Personal income increased by $247.8 billion, and government transfer pay- ments increased by $65.2 billion; 26.3 percent ofthe rise in disposable per- ‘Table 2.3: Transfer Payments and Disposable Personal Income, 1973-25 (Quarterly* 7 teeta eee Government Transfer Payment Government Disposable Disposable Transfer Personal Personal Payments 10 Income Income Individuals % ee neal EEE nD 865.6 1100 12.8 @ 5917 Ls 12:55 6) 914.1 nas 12533 @ 939.9 uns 1250 1974.) 953.8 123.5 12.95 @ 968.2 130.7 13:50 3 996.1 B84 13.89 @ 1015.9 135.5 18.43 1975 a) 1024.0 137.7 15.40 Q 1081.7 169.4 15.66 8 1087.1 m4 15.96 @ maa 175.2 157 EEL aster oun: Economic Report of the Presiden, larity 1976, U.S. Government Pisting Ofice, Washington, D.C, 1976 “All data ae expresed in anal rts, seasonally adjusted ‘Taal government: Fedeal aswell esse wad local goverment26 Economic Experience sonal income was accounted for by transfer payments. As a percentage of disposable personal income, they stood at 12,69 percent in the first quarter fof 1973, peaked at 15.96 percent in the third quarter of 1975, and retreated to 15.72 percent in the last quarter of 1975, [As a result of the explosive growth of transfer payments, in 1975 almost ‘one out of every six dollars that households had to spend or had spent for them on consumption was a result ofa federal or a state program that granted this income or service independently of current work performed (ic., output created). As a case in point, unemployment insurance, which was at a $5.3 billion annual rate in the second quarter of 1974, rose to a $19.4 billion annual rate during the second quarter of 1975. Such a dramatic rise in un- employment insurance payments helps to explain why the sharp downturn ‘was reversed so quickly. Twill ignore questions that must be raised about the efficiency and equity ‘of an economy in which one-sixth of total disposable income is the result of entitlement programs. The existence of a large, increasing proportion of dis posable income that is independent of employment or of the profitability of business is beneficial, for it sustains demand and thus prevents a very deep and sustained fall of the economy during a recession. On the other hand, the existence of such programs, combined with a tendency to expand their scope ‘hen the economy is in recession, is harmful, for they impart an inflationary bias to the economy. The increase in disposable income, even as output and employment decreased in 1973-75, is one reason prices kept on rising throughout the recession. ‘Transfer payments, which provide income without work, set floors to ‘money wage rates. Each improvement in transfer-payment schemes has the effect of raising the price at which some people will enter the labor market ‘The effective productive capacity of the economy is eroded by decreasing labor force participation when price-deflated transfer-payment schemes are improved, especially if, as is our practice, eligibility depends on being either ‘unemployed or out of the labor force. Cash-Flow Effects of Big Government {A fundamental proposition in economics is that the sum of realized financial surpluses (+) and deficits (—-) over all units must equal zero. This follows from the simple point that every time some unit pays money for the purchase of current output, some other unit receives money. Because the different sec- tors of the economy (e.g., households, business firms, goverment, and fi- nancial institutions) are consolidations of elementary units, this proposition also holds for the various aggregations. If the federal government spends ‘$73.4 billion more than it collects in taxes, as it did in 1975, then the sum of ‘The Impact of Big, Government 7 the surpluses and deficits over all other sectors equals $73.4 billion surplus. As is shown in table 2.4 for annual data and table 2.5 for quarterly data in 1973-75, the sum of the surpluses and deficits ofthe various behavioral and accounting sectors was zero (within small margins due to, data imperfec- tions). “The household surplus or deficit is the difference between disposable per- sonal income and personal outlays. Almost always, except in deep depres- sions (and then only in an economy with a small government), households generate a surplus. But this surplus as a percentage of household disposable income varies quite markedly. Table 2.4 shows that household saving ran from 6.08 percent of disposable income in 1972 to 8.05 percent in 1973, 7.52 percent in 1974, and 8.9 percent in 1975. In both 1973 and 1975, the household saving ratio increased sharply. Each jump in the household saving. ratio ig associated with a jump in the deficit of some other subdivision of the ‘economy, In 1973, the jumping deficit was that of business; in 1975, it was the governments cefcit that jumped Private investment is undertaken by the business sector. The business sec- tor deficit is the excess of plant and equipment, inventory, and corporate jectoral Surpluses and Deficits, 1972-78 (Billions of De 1972 _:1973___—~«iSTA Housstiouos Disposable persoral income 8013 903.1 Personal outlays =7519 804 Personal saving (surplus) $494 4727 Business ‘Gross internal furds 1412 Gross private investment 20.2 Deficit or surplus =79.0 Goveanvent Federal gov. deficit orsuplus. 173. 6.9 Slate gov. deficit or surplus 7 __129 ‘Total gov. deficit or surplus =36 60 ‘Total surpluses 44 787 Total deficits =515 _-190 Diserepaney “21 0 3 #36 HAT Houschold savings 1s % of ‘isposable persoral income 608 «805752 8.92 Business deficit as & of ‘BF 0ss private investment 2673 35.88 3240.95 ounce: Economie Report of the President, January 1976. U.S. Government Printing Oe, ‘Washington, D.C., 1716.s| e923 $38 208803 | The Impact of Big Government 2» a) gg 2 BaF pea? i | housing investment over business internal funds (retained earings plus cap- ele| Edd 2 dS § Asese i ital consumption allowances), This deficit was $47.9 billion in 1972, jumped S|] gs) = ef § FR Say | to $79.0 billion in 1973, remained high at $67.8 billion in 1974, and fell 7 " i sharply to $21.5 billion in 1975. The business deficit, asa percentage of eye osqs 5 ageq | 1085 private investment, rose from 26.1 percent in 1973 to 35.8 percent and s} He 3 GR 8 GRRE) Ree i it ani 198; ext and en 10.9 pent 2 g in 1975. Fe ce see tae gate ot 1 ‘The path of the deficit in total government (federal, state, and local) a} He 232 8 WR ags]e | Showed a $10 billion swing in both 1973 and 1974—-a decreas in 1973 but 2 Soe ee Sane | an increase in 1974—and a $60 billion inerease in 1975. The $60 billion bela eee les legates St increase in 1975 must show up either as decrease in the deficits or as an a| ge 388 3 SR 33 8/2 increase in the surpluses of other sectors. Part of it appeared in a $15.6 e Sal = 8 BF }"/ 3 billion increase in household saving, which led tothe household saving ratio § Ha rast Pica ett tele ta | being 8.92 percent of personal disposable income. Another pat showed up 7a eee? | ese & Segels | in the huge increase of $33.1 billion in business gross internal funds, a rise Se) &® = alt . = | ‘of some 23.4 percent. (In 1975, the year of a major increase in unemploy- i Ee re ee eee ‘ment and a sharp cecrease in price- deflated GNP, gross business profits i- || SLES 3 H9gg| creased by 23.4 pena) Anoier compose theft he see he aoe 3) |S) 88 Saf ot He PSE femment deficit was a fall of some $13.2 billion in investment, mainly the E eee result of inventory liquidation. The $60 billion rise in the total government 2) |e] 232 eee 3 ee 33| =\8 | deficit was thus offset by a $15.6 billion rise in personal saving and a $46.3 gy [©] Be 2 BR oT Gas 18 | billion decrease in he business sector deficit. In 1975 te government deficit, 5 iaunaeUEOMeEuDSEEESERiestuaGE-| therefore, was mainly offset bya rise in corporate cashflows. Business prof. El lal = 4 se 2¢ds ¢ae2 3 2/8 its, correctly defined, were sustained and increased even as the country was By |e] S81 2 8B 1 Seem T/e j in severe recession! g Bee eee eee | ‘The data for the fst quarter of 1973 tothe third quarter of 1975 serve to s| le) gS ase = se eeit}4 | emphasize how a major increase inthe goverment deficit is associated with &) js) gale 8 gf 7 SPR tye | movement toward surplus by other sectors of the ezonomy. Gross internal z 4 funds ofthe business sector range in the narrow band of $134.2 to $147.1 a| Is re 3 $e8 3 asgele billion in the eight quarters of 1973-74. No discernible trend was evident 3] |§] S88 288 F sesarys during this time, However, inthe fist thee quarters of 1975, gross internal é S funds of business measured $154.7, $171.8, and $185.6 billion. (The data a * 3 2s z { ae in annual rates and seasonally adjusted.) Between the third quarter of i tes 2 2 HE & 1974 ad he td uae of 195, bss sos eral un ose by £22 3. ceie3 | < 8 percent in spite of the fallin national income and employment. 7 sieii, Ublguteba. f]) "Te federal goverment deficit was at an annual rate of $102.2 billion in % 298228 ,2832 Sebeds 22 F) 6 the second quarter of 1975. This deficit was $94.3 billion greater than the a o42659 22922 232235 32 2) 5 ‘eficit in the second quarter of 1974, so there had to be a $94.3 billion swing 4 ga 82" 856° a F2°3°3 33°) 8 i in other sectors surpluses or deficits in order to oft this massive change a = a 8 ae 18 ‘This swing was brcken down a follows: household personal saving rose by $40.7 billion, busiress's gross intemal funds increased by $28.2 billion, and investment fell by $305 billion. OF the total swing, some S40 billion was { EEE EEE EEE EEE EEE EE Et CP img EEE EEE EEE EEE EEE EE EEE EE EEE EH30 Economic Experience reflected in personal saving, and some $60 billion was reflected in an in- crease in business intemal funds or in a decrease in business investment, ‘Both the annual and quarterly data show that even as the economy plunged into a deep recession the gross internal funds accruing to business increased. Tn the American economy, business is carried on within a system of bor- rowing and lending based on margins of safety. Two measures of the margin of safety are the ratio of the cash flows due on debt to the cash flow debtors receive and the ratio of the present value of expected cash flows discounted lover the future fo the face value of outstanding debts. The boom of the 1970s, land the longer-run evolution of the economy over the postwar era were as sociated with a large increase in short-term debt issues by business and a proliferation of financial institutions that finance such debt by issuing their ‘own, usually short-term, obligations. ‘The major determinant of the quantity ff stich short-term debt that business can carry is the internal funds that are generated by operations. Tm the absence of Big Government and the huge deficit that automatic and discretionary policy combined to generate in 1975, a plunge of the economy, as it occurred in 1974-75, would have been associated with a plunge in corporate cash flows, Business debt-carrying capacity and the margins of safety in the system of borrowing and lending would have decreased. Even in the absence of actual bankruptcies, such decreases in business cash flows ‘would have forced efforts by business to contract commitments. In fac, bu ress gr0ss profitability increased in 1975, so that a forced or induced curtail- ment of commitments did not take place. ‘in 1975, the impact of Big Government by way of the massive deficit it generated was critical in braking the decline and quickly reversing the reces- sion into an expansion, The full import of government as a preventer of ‘cumulative declines and as a sustainer of economic activity cannot be appre ciated without recognizing the significance of the proposition thatthe sum of the surpluses and deficits overall sectors must equal zero. The efficiency of Big Government can be questioned, but its efficacy in preventing the sky from falling cannot be doubted. ‘The above examination is based on accounting identities, which do not “incorporate any behavioral relations. A mete presentation of accounting identities is not a theory and does not lead to any causal inferences. In order to understand what happened, we must look at how the end result is achieved (e., how the sectoral surpluses and deficits, when summed overall sectors, ‘equals zero). We must therefore formulate ideas about what are the determin- ing and what are the determined items in the accounting tables (.e., intro~ duce assumptions on how the economy actually works so that the end result is always achieved). ‘To a considerable extent, household personal outlays are responsive to The Impact of Big Government 3 changes in income. This passive household saving and consumption behavior is attenuated by the existence of both household wealth and consumer debt. ‘Some forty years ago, when John Maynard Keynes first formulated his theory in terms of passive consumption behavior, householdwwealth and con- ‘sumer installment credit were a much smaller part of the total economic picture than in the 1970s, "The large household saving ratios of 1974 and 1975, which were referred to earlier, were in good part a reffection of the collapse of automobile sales, Part of the increase in household saving in 1974-75 took the form of a re- duction in household borrowing to finance automobile and other purchases. Ifa pause takes place in the rate at which consumer credit is extended, even as disposable income is sustained or increased, then the saving ratio will be high, asin 1975, and an improvernent in the liquidity position of households will take place, With a lag, this accumulation of household liquidity will lead to a jump in consumer spending. Those households that have not been strongly and directly affected by unemployment during a recession tend to increase the ratio of spending to disposable income once an accumulation of liquid assets and a decrease of debt relative to income take place. As a result of this impatience to spend, a recession with a high saving ratio, such as that ‘of 1975, is followed by a recovery in which the saving ratio is low When the ratio of saving oat of disposable income falls, the consumer becomes @ “pero” in leading the economy out of a recession. The heroism of the con- sumer, however, isa lagged response tothe high saving ratio of the recession "The observed variability in the ratio of saving to disposable income is evidence that consumer behavior is not fully passive. Nevertheless the rela- tion between consumer spending and present and past developments in the economy is fairly well known and relatively stable. We know that personal ‘outlays will almost always lie between 95 and 91 percent of personal dispos- able income. Furthermore, if the saving ratio is high (ie., toward the 8-9 percent range for atime), then it will soon be followed by a burst of spending that lowers it toward 6 percent. “The household saving entry in tables 2.4 and 2.5 is therefore largely de- termined by how the system is operating and how it has operated inthe recent past, as isthe entry for government revenue. Congress, the state legislatures, ‘and various local authorities pass laws that set tax schedules. AS a result, the amotint collected in taxes, given any set of tax laws, depends on the behavior of the economy. On the other hand, the two items in the tables that vary quite independently ‘of how the economy is currently functioning, and hence are the determining ‘or causal factors in what happens, are business investment and government spending. Business investment is largely, if not completely, determined by today’s views on the future. Of course, the past and present behavior of the32 Beonomic Experience ‘economy, which will help set current views about tomorrow, affects both the scale of the facilites that will be built and the way in which these facilities will be financed. What bankers and businessmen think today about revenues and out-of-pocket costs over the next twenty-five years and more basically determines whether and at what terms financing for long-life projects will be fortheoming. Investment, rather than being currently or historically deter- ‘mined, is based upon views about the future. The other item in table 2.5 that is largely independent of the current oper- ation of the economy is government spending, which is submerged in the government deficit or surplus side of the table. Spending programs that largely consist of the purchase of goods and services are set in the budget and are, within minor limitations, determined by congressional action. An- ‘other component of government spending, which is covered by the rubric of transfer payments, is similar to taxes in that legislation, together with admin- istrative regulations, sets up formulas for entitlement. ‘The actual expendi tures depend on the behavior and economic position of various households, ‘As a consequence of these dependent and independent relations, a fall in income due to a decline in investment spending or a rise in the consumer saving ratio will lead to a rise in takings from entitlement programs and a fall in government tax receipts. Combined with the program of discretionary ‘government spending and tax changes, this will lead to a large increase in the government deficit. This deficit must be offset by an equal move toward ‘surplus by the business and household sectors. As the move toward surplus ‘on the part ofthe business sector leads to an increase in business gross profits afler taxes, an increase in the debt-carrying capacity of the business sector takes place even as the economy moves into a recession, Furthermore, a large household saving ratio will be induced by the govemment deficit; this implies that, with a lag, there will be an autonomous rise in consumer spend- ing. This autonomous tise will take place after the downward movement of the economy has been halted and after the high saving ratio has led to both a decrease in household debt relative to income and a rise in household hold- ings of liquid assets In the absence of a large government sector in 1975, two downward pro- cesses would have been started. First, private investment would have fallen even more than it did because of further inventory liquidation and a decrease in, if not abandonment of, investment programs already in process. Second, disposable personal income would have fallen faster, even faster than per sonal outlays, so that the household sector saving ratio would have been smaller. That is, in the absence of Big Government, an initial retrenchment of investment would have triggered downward movements: Decreases in business inventory investment and household disposable income would have been part of a cumulative process. Both consumption expenditures and in- vvestment expenditures decrease in an effort “by the economy” to eliminate a ‘The Impact of Big Government 3B “virtual” excess of saving (surplus) over investment (deficits), However, the fall in household spending and business investment decreases the flow of business internal funds—which tends to increase the business deficit for any level of investment. A cumulative interactive decline in hoyschold income, household spending, business investment, and business cash flows is likely to occur. This, of course, is the interactive process that leads to deep depres- sions Big Government, with its potential for automatic massive deficits, puts a high floor under an economy's potential downward spiral. Although this high floor is important in itself, itis particularly important in a world with busi- ness and houschold debt because corporate gross profits and household say- ings are essential to validate such debt. ‘Without the emergence of a huge government deficit in 1975, the debt- carrying capacity of business and households would have been severely com- promised. Such compromising, due to an iterative, downward spiral of in- ome and profits, ed to the debt deflations and deep depressions of the past, ‘The sectoral budget impact of Big Government that sustains business profits is precisely what makes such a cumulative interactive decline impossible + Balance-Sheet Implications = Financial instruments are absorbed or created whenever Big Government runs a surplus or a deficit. In particular, whenever Big Government generates a huge deficit during a recession, other sectors, including financial organi- zations such as barks, savings banks, and insurance companies, acquire the government debt issued to finance the deficit. We live in an eccnomy with a complex financial system. In this system the surplus sectors—in 1975 it was households —are not required to acquire di- rectly the liabilities of deficit units. Instead, they can finance these deficits indirectly by acquiring the liabilities of financial institutions. In our economy, ‘banks, savings institutions, insurance companies, and pension funds, among, other institutions, sre likely to be the immediate owners ofthe debts of busi- ness, government, and households. Households acquire the liabilities of fi- nancial institutions such as pension rights, insurance-policy cash-surrender values, demand deposits, and various types of savings or time deposits. Con- sequently, much of the direct impact of swings in deficits and surpluses among sectors will be on the assets acquired and sold by financial institu- tions. ‘Wide swings in :he placement of government debt between several finan- 4. Iving Fisher, “Pve Debt Deflation Theory of Great Depressions,” in Econometrica 1 (02t. 1983, and Booms and Depressions (New York: Adelps, 1932) ae ail fine atements ofthe iterations that esd wa great depression. Soe aso Hyman P. Minsk, "Debt Debation Processes in Today's Instutlonal Enviohiment,” Banco Nacional de Lavoro Quarterly Review 143 (Dee, 1982).