Queen's University, Kingston, Ontario, Canada
Published by Edward Elgar Publishing, Cheltenham, UK and Northampton, MA, June 2000. ISBN 1 84064 417 6. $80.00. For ordering and other information, go to http://www.e-elgar.co.uk
Introduction - 1
1. What Went Wrong? - 8
2. Estimating the Output Gap - 22
3. The CEA Model of Taxes and Aggregate Demand - 48
4. The Macroeconomic Effects of the Tax Cut - 77
5. The Inflationary Aftermath - 102
6. Fiscal Drag and the Burden of the Debt - 126
7. Taxes and Voter Welfare - 147
8. Lessons to be Learned - 171
Appendix: Documents - 185
Bibliography - 203
Index - 221
The full text of the Intruduction and Chapter 8 follows, with references listed at the end:
The most prominent landmarks on this historical journey are two pieces of legislation. The Revenue Act of 1964 is popularly known as the Kennedy-Johnson tax cut, although neither of these two presidents did any of the heavy lifting required to bring to life this best-known event of postwar stabilization policy. Its sequel, The Revenue and Expenditure Control Act of 1968, on the other hand, is an orphan and is simply known as "The Surcharge" despite the realization that President Johnson sacrificed the last of his political capital to get this bill through Congress.
In any event, this book deals only tangentially with presidential involvement in macroeconomic management and much more with the decisions, advice and actions of the three Chairmen of the Council of Economic Advisers (CEA) during the 1960s: Walter Heller (29 January 1961 to 15 November 1964), Gardner Ackley (16 November 1964 to 15 February 1968) and Arthur Okun (15 February 1968 to 20 January 1969). They are the true authors of the "new economics" that attempted to manipulate total aggregate demand in the US economy to coincide with "potential" output which in turn was consistent with the ultimate goal of "full employment." The role of the Council is critical in reconstructing this policy experiment. With the notable exception of McLure (1972), most of the profession has accepted the evaluation that fiscal policy in the early 1960s was a success and that the Council was the source of that success. Here is a sampling of previously expressed opinion:
As far as I can determine there has not been a thoroughly objective and detached evaluation of the Kennedy-Johnson tax cut. Most of the historical record has been provided by the participants: Heller (1967), Okun (1968), Schlesinger (1965), Sorensen (1965), the oral history involving interviews with past CEA chairmen by Hargrove and Morley (1984) and testimony by CEA chairmen before the Joint Economic Committee (JEC), especially in 1963-65. In the same category is an internal CEA study (J92) entitled "Fiscal Policy History," probably authored by a member of the staff, David J. Ott, in late 1968. It was intended to be part of the administrative history project (J95) required of all major units in the government, but Okun suggested that it be kept secret for a minimum of 20 years (J91) and even then he predicted (J94) that "the scholar who is out to trace the fiscal policy decisions of late 1965 - early 1966 will not get much help from this manuscript."
Independent and arm's-length studies such as those by Flash (1965), Norton (1977) and Stein (1988) cover a longer time span and a broader set of topics, but they do not contain a detailed economic analysis of fiscal policy in the 1960s. Two recent fiftieth-anniversary symposia in the American Economic Review (Feldstein, Solow, Stiglitz, 1997) and the Journal of Economic Perspectives (Schultze, Stein, 1996) are devoted more to personal reminiscences and re-affirmations of previously claimed achievements than anything substantive. Stein (1996a, Chapters 15-18) and McLure (1972) come closest to what is needed. The first of these is a balanced and nonpartisan study, rich in insight and sympathetic to the revolutionary nature of the CEA's plans for fiscal policy in the 1960s. Its strength is a detailed account of how decisions were reached, but what it lacks is more easily seen as a matter of the author's preferences. Nevertheless a more quantitative evaluation of the Kennedy-Johnson fiscal experiment is still needed, which Stein (p. 517) admits is "beyond my capacities as an econometrician." The second, an early and effective critique of the Kennedy-Johnson Council and their enthusiasm for aggressive fiscal policy, anticipates many of the conclusions to be reached here, but in 71 pages including a discussion of the Nixon period, this essay does not have sufficient elaboration and documentation to be considered the last word on the subject. To fill the remaining void, what follows is macroeconomic history written for those specialists who are looking for a detailed economic evaluation - both qualitative and quantitative - of this path-breaking experiment in activist stabilization policy.
This book can be considered to be revisionist history. It is more critical of the performance of the members of the Council of Economic Advisers in the Kennedy-Johnson administrations than has been the case in the past. This re-assessment is perhaps inevitable since Walter Heller set an overly confident and self-congratulatory tone in the Godkin Lectures that he gave at Harvard University in 1966, before the dust had settled on the fiscal-policy experiment. It is supremely ironical that Heller would have better served his long-term goal of more active fiscal policy had he taken a more skeptical approach when these lectures were published in his book, New Dimensions of Political Economy. Contrary to his claim (1967, p.72) that this was a "textbook tax cut" and that "Careful appraisal of the tax cut's impact on GNP shows a remarkably close fit of results to expectations," it will become obvious that Heller's presentation of textbook macroeconomic theory was deliberately fuzzy and that it is virtually impossible to connect the numerical predictions made in 1963 with the outcomes in 1964-65. Moreover the success of the "new economics" cannot be claimed on the basis of the elimination of the output gap by 1965. The story continued without interruption into 1968, with the last three years characterized by escalating Vietnam war expenses, rising inflation and an inability to legislate a timely tax increase. As John Kenneth Galbraith warned President Kennedy in 1962 (B2), "Tax reduction is highly irreversible." This lack of symmetry in fiscal policy in the 1960s is an important element in the subsequent demise of countercyclical stabilization initiatives by the time we reach the 1980s.
By the same token, this is not an ideological vendetta against Keynesian macroeconomics based on latter-day neoclassical theory. I now consider myself to be a "practical" macroeconomist without any doctrinal allegiances, but I have vivid and fond recollections of Keynesian theory as taught to graduate students at the University of Michigan exactly contemporaneous to the Kennedy-Johnson tax cut. Macroeconomic models available at that time were more than adequate to deal with business cycles; it was the Council's interpretation and implementation of these models that was less than ideal. The demise of activist policies is often blamed on the current dominance of modern neoclassical macroeconomic theory because it can prove that such policies are ineffective for their intended purposes. In an economy that has strong equilibrating powers, predictable changes in tax rates will not have any lasting effects on the demand for goods and services and employment, except perhaps by stimulating more labor supply. Despite this widely accepted view, one of the conclusions to be reached here is that the tax cut was very effective as an instrument of demand management and that it eliminated the existing output gap of about $30 billion. My criticism of the tax cut stems not from an assertion that Keynesian macroeconomics was inappropriate for the situation, but from the evidence that it was misapplied. It is the transition from established macroeconomic theory to policy making where quality deteriorated.
In that context, a critical re-assessment of the Kennedy-Johnson tax cut does not involve abstract economic analysis; instead it represents a judgment of economics in action outside of the ivory tower and beyond the journal article. Performance relative to a set of ideas, rather than the ideas themselves, is the focus of attention here. As such, an evaluation of this legislation makes it virtually impossible to avoid criticism of specific individuals and of the institutions that they served. In similar circumstances Gordon (1961, p. vii) wrote, "when one believes a policy to be wrong, one should attack the policy itself, not the person in charge of it." However he and the other economists who sent a letter to the Canadian Minister of Finance "wanted to say without disguise or ambiguity of any kind, not only that the policy and operations of the Bank [of Canada] are wrong, but that as professional economists we have lost all faith in their ever being made right under the present management." While Gordon was satisfied when the governor of the Bank, James Coyne, was fired, my goal is to expose the unalterable political nature of the Council and its consequent economic ineptness.
Success or failure in the policy arena is an evaluation of the process of implementation; yet this is a subject to which most economists pay scant attention. Our work is done when we have proven a theorem or subjected a hypothesis to empirical testing, but the translation of theory into practice is often perceived as too bland or boring to occupy the minds of our most prominent colleagues. Moreover we are aware that political considerations are often at odds with economic efficiency, but we are unable to make critical judgments in an explicitly political environment. Because of our lack of understanding we set very low standards of performance. It is a strange set of priorities for our profession to pursue theoretical errors with relentless energy and enthusiasm while we abide with equanimity or indifference policy errors that have large real costs to sizable groups in the population.
In economic policy advising, it is too easy to define and to take credit for success and almost as easy to avoid responsibility for errors. The economics profession has largely accepted Walter Heller's assessment of the Council's stellar performance during the implementation of the tax cut, but I hope to convince the reader that such self-serving propaganda should not be taken at face value. There is no way to soften the blow. Heller, Ackley and Okun, the most able of academic economists of their era, when put into the political context of the Council of Economic Advisers, made egregious mistakes that have remained hidden from view. At the same time, I remain convinced that they and other members of the Council acted with good faith and honest intentions and I certainly do not wish to impugn their motives by suggesting some far-fetched conspiracy. Also I will try to avoid criticism that comes with the benefit of hindsight by deliberately taking a 1960s perspective to this project. Exceptions to this self-imposed rule are acknowledged at the place where they occur.
The methodology employed in this book represents a major departure from my previous endeavors. I am not an economic historian by training and experience, but I have tried to concentrate on the reconstruction of events and their context from primary sources. In addition to reading the standard economic literature, I also combed the CEA and Congressional documents of the day for relevant information. Because that left some critical gaps in my understanding, I resorted to a search of the private papers of the CEA chairmen during this period. Public statements by the Council, including the Economic Report of the President ( ERP), are not trustworthy sources of unbiased economic analysis and prediction; private communications, not initially intended for public inspection, often reveal what we need to know to reconstruct the historical record. Citations for and quotations from these sources play an important part in documenting the assertions that are made in this study. My own reading of other historical works has left me with the impression that too many of them are inadequately documented and my reaction to this perception is to rely on direct quotation rather than paraphrase, on primary rather than on secondary sources and on transparency rather than style. Documents that are vital to this study, but difficult to locate, are reprinted verbatim in the Appendix to this book. The bibliography contains not only the list of published material cited in the text but also archival material. Moreover this work includes a great deal of quantitative material. In order to allow for independent replication of my empirical results, I have included most of the data used in this study and their sources as appendices to the chapter where they are relevant. Also step-by-step calculations of important variables are included in the text to show the reader the process by which they were derived. It may appear old fashioned to print data in this electronic age, but this method is still the only one that provides a reliably permanent record.
A short outline of the book concludes this introduction. The principal aim of this study is to reconstruct the policy framework and apparatus that initiated the application of "modern" fiscal policy as it was envisaged by the Kennedy-Johnson Council of Economic Advisers. The first step, found in Chapter 2, is to identify the nature of the macroeconomic problem to be solved: namely the elimination of the output gap of approximately $30 billion. Although the US economy was not technically in a recession in the early 1960s, the CEA was convinced of continuing underperformance and introduced their goal as the achievement of potential GNP, that level of output that could be produced by a labor input consistent with 4 per cent unemployment. The second step involves reconstructing the macroeconomic model that the CEA deployed in making their predictions. In other words, what was their view of the link between a $10 billion tax cut and the need to raise the total demand for goods and services by $30 billion? The answer to this question is undertaken in Chapter 3. The next step, in Chapter 4, involves estimating a small version of the IS-LM-AS model of the macroeconomy and predicting, after the fact, the effects of the tax cut on output, interest rates and inflation rates for the following twelve quarters. The differences between the model forecasts with and without the tax cut and its timing are taken as the predictions of the effects of the tax cut itself. In Chapter 5 the emphasis shifts to the appearance of a negative output gap and the need to reverse the previous stimulus to aggregate demand. The lack of symmetry in 1967-68 is the focus of this discussion.
To this point, the analysis concentrates on the macroeconomic effects of the tax cut, but there was an equally important debate raging at the time concerning the budgetary effects. This issue will be raised in Chapter 6. Subsequently, in Chapter 7, the discussion turns to the need to translate economic advice by the CEA into policy recommendations and ultimately into legislation. The political process by which such results are achieved involves voters and their representatives assessing their self-interest in the policy proposal. There is no guarantee that optimal policies from the viewpoint of the "representative agent" are those that satisfy a majority of voters. The problem of finding the characteristics of the "median voter" is compounded by the existence of participation costs that disfranchise many voters and by the unpredictable effects of lobby and pressure groups. The long drawn-out battle over the 1968 tax surcharge is taken as a vivid example of the difficulties in getting the public to accept a tax increase. From all the previous material Chapter 8 attempts to draw lessons for the conduct of fiscal policy as a stabilization instrument. The main conclusion is that taxes are too blunt and unreliable an instrument to use for this purpose and that the "new economics" was discredited not by recent advances in macroeconomic theory, but by poor execution. An Appendix reproduces important documents that are part of the historical record of this period.
This last chapter dwells on the lessons that could be learned from the episode in stabilization-policy implementation which started with the planning for The Revenue Act of 1964 and ended with the passage of The Revenue and Expenditure Control Act of 1968. It is almost too late for such an exercise. This book could and should have been written many years ago by one of the participants, preferably Walter Heller, Gardner Ackley or Arthur Okun, who were the successive Chairmen of the Council of Economic Advisers and in that position would have had the detailed knowledge of events and arguments that cannot be reconstructed at this stage. Their recollections in the oral-history project (Hargrove and Morley, 1984) do not substitute for a detailed ex-post evaluation of the benefits and costs of the stabilization-policy decisions in this period. The reason that the authors of this project did not ask any probing questions is that Heller, Ackley and Okun would not have participated in what they would have characterized as a witch-hunt. Even the administrative history project undertaken in 1968 (J92), which was meant to be kept secret for 20 years, does not contain the kind of self-evaluation that was needed for a critical assessment of the countercyclical fiscal policy that was attempted by the Kennedy and Johnson Administrations.
At the current time, activist fiscal policy has become so discredited that it is virtually irrelevant to suggest that there are lessons to be learned from events that transpired almost thirty years earlier. But history has a way of repeating itself if people forget what went wrong the last time that someone promoted a "new and innovative" policy that governments should pursue. It is this fear that some economist will attract serious attention by advocating once again a countercyclical policy based on changes in tax rates on individual and corporate income that creates some urgency to the task at hand. What follows is a list of suggested improvements in the application or implementation of stabilization policies. They are gleaned from the critical assessment of the actions taken or not taken by the Council of Economic Advisers between 1962 and 1968. Both positive and negative lessons make up this list.
The concept of potential GNP was a superb innovation in macroeconomic theory even if its implementation and measurement left a lot to be desired. Okun's great insight was to balance the previous emphasis on aggregate demand with an easy-to-comprehend supply side of the macroeconomy: how much output could be produced if 96 per cent of the labor force were employed? This also simplified policy decisions to a large extent, as the Council of Economic Advisers pointed to the $30 billion output gap to justify the tax cut they were proposing during 1962-63 when economic growth was already relatively high. Previous emphasis on dating business cycles, pioneered by Wesley Mitchell at the National Bureau of Economic Research, required a great deal of information about the amplitude and timing of cycles and how indicators of business conditions should be interpreted. Instead Okun's production-function approach brought to the forefront the idea that a macroeconomy made supply decisions as well as demand decisions. Firms derived a demand for workers based on their anticipations of sales; they also had to determine the hours that they worked, the capacity utilization of their existing capital, the replacement of worn-out equipment and investment in new capital. These magnitudes also varied during a business cycle and could easily be confused with demand conditions. However, Okun convinced the Council of Economic Advisers and the rest of the profession that it was useful to think of equilibrium or sustainable values for factor inputs and their productivity in order to generate a value for potential GNP.
If governments were still interested in stabilization policy, Okun's concept would continue to be useful today. A positive output gap should lead to expansionary policy decisions, but a negative gap should also call forth contractionary moves. Lack of symmetry in the application of both of these rules, rather than the rules themselves, tolled the death knell of activist fiscal policy. Although Fellner (1982) has criticized the concept of potential output as a policy target because it substituted for an inflation target, there is no reason to believe that they are incompatible objectives. If properly chosen, potential output is the dividing line between rising and falling inflation. From that perspective, fiscal policy could be geared to matching potential output through short-run changes in aggregate demand and the monetary authorities could fix on a Friedman-style monetary growth rule to achieve whatever inflation rate was considered desirable in the long run. The danger from such an allocation of responsibilities comes from an upward bias in measuring potential output, as happened in 1965 and again in 1967. By that time the Council of Economic Advisers became too optimistic about long-term trends in the US economy and revised the previous growth of potential GNP from 3.5 to 3.75 per cent and again to 4 per cent per annum. This meant that aggregate demand was being pushed too far through expansionary fiscal policy and inflation accelerated in the absence of tighter monetary policy. The lesson is for the Council to be conservative in the estimation of potential GNP or its trend and to listen to competing views about this vital macroeconomic indicator. It is important to avoid translating potential output into maximum output.
The ultimate aim of the Kennedy Council of Economic Advisers was to reduce the unemployment rate to 4 per cent. Looking back at this period, Solow and Tobin (1988, p. 9) recollect:
If the target unemployment rate in the labor market had all these beneficial effects, it might have made more sense to deal directly with the unemployment gap rather than indirectly with the output gap. Somehow the advantage of a clearly specified goal that was easily measured was lost in the Council's deliberations and decisions.
If 7 per cent unemployment was bad news, how did the Council react when the unemployment rate fell below 4 per cent? Again the lack of symmetry made the previous goal unacceptable when policies had to be initiated that would raise the unemployment rate. It was easier to argue that inflation was the consequence of ill-mannered businesses and unions than to admit that excess demand had appeared in the labor market in 1965 or 1966. Moreover the Kennedy-Johnson Council convinced themselves that 4 per cent unemployment was only an interim goal and that there were no serious structural problems in the labor market that would preclude a falling equilibrium unemployment rate. Although natural rates remain elusive in their estimation or measurement, hindsight suggests that this rate was rising rather than falling during the 1960s and 1970s. By aiming for 4 per cent and even lower, instead of 5-6 per cent, such policies would generate continuing excess demand in the labor market with rising wages and inflation. In deciding on macroeconomic goals, there is a need to avoid wishful arguments and to concentrate on hardboiled analysis.
If governments are to move total aggregate demand to equal potential output, the tax rate is the clumsiest and least reliable instrument that can be used for this purpose. It would be more sensible to depend on variations in direct government demand for goods and services than to manipulate private disposable income to achieve the same result. There are two reasons why taxes on income are the wrong instrument: (1) the connection between taxes and aggregate demand is not strong or contemporaneous and (2) tax changes have too much political baggage attached to them.
Modern consumption theory relies on expectations of life-time resources as the budget constraint instead of currently observed disposable income. Thus it is possible that an announcement of a permanent tax increase that is not actually implemented will have a larger immediate effect on consumption expenditures than an explicitly temporary tax increase that does go into effect. As Romer (1996, p. 251, emphasis in original) noted:
Since stabilization that relies on tax changes will require such changes rather frequently as an economy moves through a business cycle, they will be viewed by households as temporary and lose their effect on aggregate demand. In a speech on 17 April 1967, Gardner Ackley warned, ``we must accustom ourselves to the idea of frequent adjustment of tax rates." (The New York Times, 18 April 1967, p. 20). From that perspective, adjustments to direct government demand for goods and services will have much more predictable and immediate effects on total demand. There has been much discussion in the past (e.g., Teigen, 1970) of having a list of public-works projects that could be accelerated during recessions or slowed down during a boom period. But even here, it is possible to imagine how political intrigue can interfere with macroeconomic requirements.
One must also have concerns about the political difficulties of realizing "optimal" tax rates whether for macroeconomic purposes or for reasons of efficiency and equity. Within two years of The Tax Reform Act of 1986 which concentrated on the latter issues, McLure (1988, p. 303) found that "attempting to implement a conceptually correct income tax ... is impracticable." Later Auerbach and Slemrod (1997, p. 628) concluded that "Advocates ... will ... be frustrated that a retrospective analysis of the most comprehensive attempt in history to achieve this goal offers little hard evidence of the fruits of this effort." Neither of these studies asks why economic analysis of tax reform did not prevail in the political process. The reason is that everyone's idea of optimality is different, depending mainly on their endowments and tastes and these differences are impossible to reconcile in a system of representative government.
If I were asked to design an optimal tax system based on my own preferences, two features would be paramount: (1) that my taxes be as low as possible so that I can enjoy as much in the way of private goods as my resources will allow and (2) that everyone else's taxes be as high as possible to allow me to have as much in the way of public goods as I want. Of course all voters have the same conflicting aims, which makes it impossible to achieve a Pareto improvement as any tax reform that is implemented will have some losers. For example, widening the tax base and lowering the tax rate may improve efficiency of the tax system, but some groups will be potential losers in such legislation. Those who have political power, especially through effective lobbying, will continue to receive tax-exempt status and those without political power will have to pay higher taxes to compensate for the exemption. It is useless to pretend that the gainers from tax reform could compensate the losers and still have something left over because compensation schemes such as these are never implemented and all participants are aware of this fact.
Hence any proposal to change taxes leads to conflict in the political arena and such conflicts pay no attention to macroeconomic or microeconomic optimality. One lesson from the 1960s experience is that it is probably easier to get politicians to approve tax reductions during a period when actual output is below potential output than to obtain tax increases when the output gap is negative. From a long-term perspective, governments should either respond symmetrically or not at all. In that framework it is best to leave tax rates at levels that will balance the budget on average during the business cycle and not to tempt fate with fine-tuning.
Somehow an antidote must be found for the extravagent claims and promises that economists make once they become policy advisers. Three previously quoted statements by former Chairmen of the CEA need a closer examination to make this point. In his book (1967, p. 61) Heller wrote, "Standards of economic performance must be recast from time to time. Recasting them in more ambitious terms was an indispensable prelude to the shaping of economic policies for the 1960s which would be suitable to the tremendous output capabilities of the U.S. economy." What is the basis of the imperative "must be recast?" After defeating Richard Nixon by the narrowest of margins, what was President Kennedy's political mandate to move to a much more aggressive role in stabilization policy? What was the economic evidence that required "more ambitious" policies, especially when one considers that this was written in 1966-67, not in 1961-63 before the experiment was undertaken? My assertion is that activist fiscal policy has been abandoned in large measure because previous promises about its beneficial effects, such as those made by Heller, could not be achieved. Hence, less ambition will lead to fewer disappointments. In The Economic Report of the President for 1968 Gardner Ackley as Chairman of the Council stated (p. 86):
This is essentially a statement that the macroeconomy does not face any uncomfortable trade-offs. There are no sacrifices needed to reach the goal for which the tax change is intended. In 1963-64 unemployment could be reduced to 4 per cent without any inflationary effects and in 1966-68 inflation could be reduced to its previous level without creating any additional unemployment. No empirical evidence is supplied to support such a hypothesis. By 1968 there were several pieces of evidence that should have led to the rejection of such absurd notions. First, work on the Phillips curve had progressed to the point where it was considered to be established and incontrovertible. Its main conclusion was: inflation increased as unemployment decreased. Both the 1962 and 1963 Economic Reports of the President acknowledged this fact: "In less extreme circumstances, aggregate demand may press hard upon, but not exceed the economy's productive capacity. Increases in prices and wages may occur nevertheless" (1962, p. 45) and "Although wage pressures undoubtedly would be somewhat stronger at lower levels of unemployment, unit labor costs need not be higher because a considerable improvement in productivity would be the direct consequence of return to higher rates of capacity utilization." (1963, p. 85). Second, Ackley (1966, p. 69) made the case for wage-price guidelines by stressing the fact that inflation accelerated well before full employment was reached. Third, the recently experienced recession in early 1967 reduced both the inflation rate and output simultaneously: in 1966:4, inflation was 3.68 per cent and the output gap was -1.40 per cent; in 1967:2 inflation had fallen to 2.46 per cent, but the output gap had also been reduced to -0.51 per cent.
This inconsistency in Council statements about economic relationships can be ascribed to political requirements overwhelming economic reasoning. In its Reports the Council felt that it could only provide "good news" and not "bad tidings." If the evidence had shown that a tax increase would leave the inflation rate unchanged but reduce output and employment, there is not the remotest chance that the Council would have publicized that information.
Instead of arguing for greater autonomy for - or candor from - the Council, it is better to recognize its explicit political role and to rely on other elements of the profession to provide critical evaluations of government policies. The recent article by Auerbach and Slemrod (1997) is a move in the right direction; by the same token, the American Economic Association would find it uncomfortable to be the "official opposition" by providing one or more of its journals for this purpose. Ultimately we need to make ex-post policy research more respectable among macroeconomists once more; the resulting output will find a suitable venue. Another possibility is to allow dissenting opinions in the Reports submitted by the Council to the President. This actually happened in 1953, when John D. Clark wrote: "Many fluctuations will develop within our free, erratic economy during the next 3 years, but I am unable to see changes in business conditions which would bring about a recessionary trend threatening enough to require new counterdeflationary action by Government." ( ERP, 1953, p. 102).
Even a thoroughly modern Chairman of the Council, Joseph Stiglitz (1997, p. 113), was moved to ponder: "The question is whether government is simply an arena for bargaining by special interests, or whether government can rise above that to represent the will of all." The answer to this rhetorical question is that the Council's contribution is, at best, to be an arbiter between competing special interests. Stiglitz concluded (p. 113), "the Council of Economic Advisers plays a vital part in looking out for that little-represented special interest known as the national interest." For an eminent public-finance economist to suggest that a government could "represent the will of all" is breathtaking in both its scope and its implications. Having raised the issue, how would Stiglitz characterize special interests and how would he prevent them from having access to governments? How would he run monetary policy when lenders want high interest rates and borrowers want low interest rates? How would he decide exchange-rate policy when importers want the value of the dollar to rise and exporters want its value to fall? How would he solve the Social Security impasse when the old want to maintain current benefits and the young want lower premiums? Who represents the national will when people with jobs want high wages, but the unemployed want low wages? These are just some of the issues in which government policies will always create some losers and some winners with both groups forming lobbies to protect or promote their interests. In the real world it is senseless to assume that the representative agent is neither a borrower nor a lender, is both an exporter and an importer, is neither young nor old and is only randomly unemployed. Instead economic agents have different endowments of physical and human capital and of other attributes, the value of which is favorably or adversely affected by governmental intervention. The result is conflict and tension wherever collective action is contemplated. With fixed and opposed attitudes on noneconomic issues such as abortion, smoking and gun control among the voting public, we cannot even begin to predict how economic conflicts will be resolved. As a profession we must recognize that we have made no useful advances in our analysis or understanding of special interests since the Stolper-Samuelson theorem was published in 1941 and Olson's The Logic of Collective Action in 1971.
In a more recent article that appears to contradict his earlier presentation, Stiglitz (1998) probably agrees with this assessment and acknowledges the decisive role of special interests in government policies. He provides four reasons for the failure of Pareto improvements: (1) the inability of governments to make commitments, (2) coalition formation and bargaining, (3) destructive competition and (4) uncertainty about the consequences of change. Nevertheless there is still the naive belief that special interests can be overwhelmed by an appeal to obvious efficiency gains. In discussing Superfund, a policy aimed at dealing with toxic waste, he asserts (p. 12), "Surely there must be an alternative which can benefit the environment, provide strong incentives not to pollute in the future, and have economic benefits today, with only the lawyers being worse off." Why lawyers, of all groups that could be enumerated in this context, would meekly surrender in the face of such overwhelming logic is not explained. He concludes (p. 21):
He recommends greater transparency, participation and democracy in government, but none of this will happen. As long as individuals differ in their endowments, tastes and their ability to protect them, we will have a complicated network of overlapping special-interest goups which will render public-choice decisions essentially unpredictable. No amount of wishful theorizing will make it otherwise.
One of the evolving functions of The Economic Report of the President is to record the Council's economic analysis of the problems faced by the government in power and to provide their economic rationale for any initiatives or remedies that are being considered. In the 1960s this was not a well-developed feature of the Reports. Although output, inflation and unemployment were all determined within an overall macroeconomic framework, the Council tended to compartmentalize these important variables. In the beginning the link between taxes and aggregate demand depended on the multiplier--accelerator model. Later inflation was to be fought with guideposts based on a model of noncompetitive behavior in strategic markets. Finally the tax surcharge would only affect inflation because the Council assumed a supply curve for the whole economy that was vertical in the region in which the policy change was to be implemented. It is perhaps not surprising, given this methodology, that macroeconomic policy decisions at that time now appear to be so inconsistent.
The challenge facing the Council is to incorporate the various shocks to the system into a unified macroeconomic model that will predict the effects of these shocks on all the important macroeconomic variables. This task is made all the more difficult by conflicting views on interventionism and the models that support these positions. Whatever one's view on this issue, it must be recognized that the federal government continues to make major decisions on taxes and expenditures that have macroeconomic effects through aggregate demand for goods and services; whether they are intended or not is almost irrelevant. In that environment the Council still needs to enunciate its view of fiscal-policy effects on output, inflation, interest rates, unemployment and sustainable debt-to-GDP ratios.
At the same time the Council should resist the temptation to design models that fit only the circumstances of the day. It was the inability to anticipate excess demand in the labor market that contributed to the expansionary bias in fiscal policy in the 1960s. By 1965, when the output gap had become negative, the Council should have used their existing model - as flawed as it was - to persuade themselves that contractionary policy was required; instead they resorted to voluntary wage and price guidelines and in 1967 to an upward revision in potential GNP. Both of these manoeuvers allowed the Council to concentrate on further reductions in the unemployment rate and blame the unsatisfactory inflationary performance on other factors.
The prestige of the Council of Economic Advisers has fallen considerably since its heyday of the 1960s and the giants of the economics profession are no longer beguiled by the prospect of serving as members. In this light should the Council continue in its present form and with its current function or should it be abolished? Since it is a relatively inexpensive agency and since the President is entitled to the best economic advice that is available, one is tempted to save the CEA and to try to improve its performance by learning the lessons from past mistakes. Schultze (1996, p. 31, emphasis in original) has offered the following suggestion: "Instead of offering advice that seeks to balance economic insights, institutional views, political costs and other considerations, CEA members should see themselves as partisan advocates of the efficient solution." Unfortunately as the story of the Kennedy-Johnson tax cut unfolded in this book, it became obvious that Heller, Ackley, Okun and other CEA members were convinced that they adhered to these principles and they took pride in advocating "the new economics" as an efficiency gain. To Heller, there was no inconsistency between being a partisan advocate of economic efficiency and a partisan Democrat (K15). To Ackley, suppressing embarrassing information (B24) achieved some greater good. To Okun, twisting the ears of businessmen to dissuade them from price increases (B54) was a Pareto improvement. Who was there in 1962 to warn them that their noble experiment was to lead directly to the demise of stabilization policy a few years later? Nothing in the record shows that these three chairmen had any doubts about their intentions or their actions. In the end, even if one disagrees with Norton's verdict (1977, p. 213) that "little blame was seriously put on the shoulders of CEA," it is probably not worth the effort to repeal the section of The Employment Act of 1946 that established the Council and it would be vindictive to scale back its appropriations, but it is time to recognize its inescapable and irredeemable political role and to pay much less attention to its economic statements and evaluations.
I am reminded of the jester Rigoletto, in Verdi's opera of the same name, whose function it was to entertain the Duke of Mantua, a role that he presumed gave him power at the court beyond his humble station in life. Instead his daughter is seduced by the Duke, he is ridiculed by his enemies, he hires an assassin to kill the Duke, his daughter willingly replaces the Duke as the victim and the opera ends tragically with Rigoletto crying out the words: "Ah, la maledizione!" A similar curse involving the illusion of grand achievements has befallen the Council of Economic Advisers, when in fact their role is to amuse and indulge the President. As an example of this servile function, in March 1964, Heller wrote to the Secretaries of the Treasury, Commerce and Labor (J12):
After that it is difficult to take seriously Okun's recommendation that the Council must "be nonpolitical enough to give the President the straight unadulterated truth about the economy and economic policy, even when he won't enjoy hearing it." (J96). No one on the Council had the moral courage of the minor but heroic character in the opera, Count Monterone, who openly challenged the Duke after his daughter was seduced and paid for it with his life.
Economists think of themselves as benign imperialists because the rules that govern economic behavior can be applied in many other areas of human endeavor. Modern political economy involves economists urging governments to achieve economic efficiency on the basis that if the electorate attributes improvements in its welfare to policy changes, it will reward the incumbents who initiated them. Our great contribution is to make political action more rational and beneficial. What we, as a profession, have failed to see - until Stiglitz brought it to our attention - is that there are virtually no Pareto improvements to be found in government intervention; there are always some winners and some losers. Charles Schultze, who presided over the Council during the woeful years of the Carter Administration, is fully aware of this limitation. He writes (1996, p. 31):
As much as I agree with his assessment, I also wish he could have resisted the temptation to salvage the role of the economist turned policy adviser: "However, by viewing each decision as one step in an endlessly repeated process, I believe that economic advisers can justify consistently opting for the efficient solution in policy debates, in the belief that choosing the efficient approaches will in the long run advance the national welfare."
There are still too many economists who continue to believe that good economics makes for better politics. In the early years of academic economists as policy advisers - John Maynard Keynes was probably the first prominent example - economics may have held the upper hand. Since then that power has been eroded as economic policies must now achieve popularity, not efficiency. The scientific and practical progress made in opinion polling has had a much more pronounced effect on policy decisions than all the economic models of Pareto efficiency put together. Even in the Kennedy-Johnson era the advice rendered by the CEA was deeply colored by political imperatives, as the record now clearly shows, but this should not really come as a surprise to anyone who truly understands the dictum: "No one is immune to incentives." Because they control the purse strings of the burgeoning public sector, politicians and bureaucrats set the rules by which the game will be played and economists, who have lots of ideas but precious little power, must accept these rules if they are to be policy advisers. The political arena is expressly designed as a place for adversarial confrontation. In order to win, each side needs economic experts, not as advisers, but as propagandists. Given the enormous stakes involved in these battles, the productivity of policy advisers is much more likely to be measured in terms of their ability to "sell" a program to the electorate than on their economic analysis of its benefits and costs. In the fullness of time this incentive system will lead economists to tell their political masters only what they want to hear instead of what they need to know and I, for one, cannot suggest a way of reversing this disturbing trend.
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K15 Heller to President, "The Slowdown in the Recovery and Its Implications for Policy," 21 March 1962, Heller Papers (5: 3/6/62 - 3/15/62).
B2 Galbraith to President, "Tax Reduction," 6 June 1962, Ackley Papers (15: Memos to White House Staff - John Kenneth Galbraith).
B24 Ackley to President, "Budget Policy for FY 1967," 26 December 1965, Ackley Papers (13: Memos to the President - Nov. - Dec. 1965).
B54 Okun to President, "Weekly Price Report," 18 November 1967, Ackley Papers (11: Meetings - Regarding Prices - Nov. 24, 1967).
B59 Ackley, "The Role of the Economist as Policy Adviser in the United States," Essays in honour of Guiseppe Ugo Papi, 1973, Ackley Papers (26: Speeches, Journal Articles and Letters to the Editors).
J12 Heller to Hodges, Wirtz and Dillon, memo about 'economic (good) news notes' for the President, 21 March 1964, Okun Papers (156: Memos for the President, Jan.-March 1964).
J91 Okun to David Ott, "Fiscal Policy History," 4 November 1968, Okun Papers (156: Memorandum for the Files).
J92 David Ott, "Fiscal Policy History," 4 November 1968, Okun Papers (156: Memorandum for the Files).
J94 Okun to Califano, "CEA's History Project," 27 December 1968, Okun Papers (181:Memos for the WH Staff, July 1968 - Jan. 1969).
J95 "The Council of Economic Advisers During the Administration of President Lyndon B. Johnson: November 1963 - January 1969," Okun Papers (176: CEA Papers, 1963 - 1969).
J96 Okun, "How Political Must the CEA Be?" 29 December 1973, Okun Papers (78: AEA Meeting).