(False) Perils of Budget-Cutting

THE most common argument against federal budget cuts is a humanitarian one. Reductions in welfare-state programs, we are told, will yield terrible social consequences.

A new argument against budget cuts has emerged of late. It claims that budget cuts of any significance threaten to drag the economy into a recession or worse. These dire predictions, however, are based on an economic paradigm that has been discredited for well over 20 years.

From the mid-1930s until the early 1970s, disciples of the British economist John Maynard Keynes claimed to have solved the mystery of the business cycle. If the economy slows down and unemployment increases, the government must inject spending into the economy by increasing its expenditures or lowering taxes.

Conversely, if the economy begins to overheat, and prices begin rising, the government must remove spending from the economy via lower budgets or higher taxes. While oversimplified, this explanation is basically faithful to the Keynesian model.

The theory was severely tested during 1973-74, a period of inflationary recession or ''stagflation.'' Prices and unemployment were rising. What was the Keynesian planner to do? He obviously could not simultaneously increase and decrease spending.

It can hardly have been a coincidence that in 1974, as the Keynesian model lay devastated, the Nobel Prize in Economics was awarded to F. A. Hayek, a free-market economist of the so-called Austrian school. Economists, desperate for an alternative explanation of business cycles, turned to Hayek.

Stated simply, Hayek's theory is as follows. Suppose the Federal Reserve increases the money supply through credit markets. One result is a lower interest rate. Investment projects that would not have been profitable at a higher rate suddenly become feasible, and businesspeople proceed to engage in a ''boom.'' This process of money inflation cannot continue indefinitely without risking hyperinflation. During the inevitable ''bust,'' therefore, the unsound investments of the boom period, undertaken in response to artificially low interest rates created by Fed inflation, are liquidated. As the late Murray N. Rothbard explains in his book, ''America's Great Depression,'' this is precisely the sequence of events that led to that catastrophe.

If the culprit were insufficient consumer spending, as Keynesians would have it, why are depressions consistently characterized by devastating downturns in capital-goods industries, with consumer-goods industries relatively better off? The Keynesian model cannot account for this; the Austrian theory explains it easily as a result of the malinvestment in capital goods incurred during the boom period.

But what would the Austrian model have the government do during a bust? Nothing. The government must not interfere with the liquidation process; any effort to prop up unsound investments can only prolong the depression. Certainly all inflation of the money supply must cease, lest the entire process begin anew.

Actually, Professor Rothbard did suggest one course of action. The government can cut its budget. Since all government spending must be classified as consumption, cutting the budget increases the social saving/consumption ratio. According to Rothbard, this is precisely what a depressed economy needs: not more consumption spending, but ''more saving, in order to validate some of the excessive investments of the boom.''

The real culprit in depressions, therefore, is not a drop-off in spending or aggregate demand, but the Fed's inflationary policies, which send distorted signals to investors and encourage booms that cannot be sustained.

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