Roosevelt, Reagan, and Inflation

“When you take a loan, money is created. When you pay it back, money is destroyed.”

Advocates of Liberty, http://www.iowaliberty.org/node/61

According to the now discredited theories of Keynesian economics, the government is suppose to be able stimulate a sluggish economy by deficit spending. Although the economics of John Maynard Keynes has been time and again proven fallacious, it remains a tempting morsel for socialist politicians who are looking for a justification for their big-government policies. In fact, at the current time, Washington is now proposing a “stimulus” package that promises economic recovery by throwing good money after bad.

Keynesian politicians tell us that the government can inflate the economy, and thereby stimulate it, by simply spending more money in that economy than it takes out in taxes. The corollary of this idea is that the government can also “cool down” an overheated economy by simply reducing its expenditures below its intake from taxes. Two seminal moments in American economic history fail to bear this out:

1. Roosevelt’s New Deal. In a desperate attempt to end the great depression, Roosevelt used deficit spending to try to inflate a dangerously deflated economy. Tremendous expenditures on public works and make-work projects were implemented in what was referred to as Roosevelt’s New Deal. Beginning in 1933 and continuing throughout the rest of the decade, the New Deal failed to inflate the economy and stimulate us out of the great depression. Eventually, American private enterprise began receiving large private contracts from the war-torn nations of Europe and the consequent rehiring of workers turned the economy around. Deficit government spending did not inflate the economy.
2. Ronald Reagan’s Cold War Victory. In the 1980’s Ronald Reagan won the Cold War by overwhelming the state-run Soviet economy with the challenge of an expensive new arms race. Reagan’s plan required massive military expenditures that could only be paid for with a deficit budget. Not only did his expenditures go up but he successfully pushed congress to pass large tax cuts which, by Keynesian theory, would have had the same inflationary effect as the deficit military spending. However, rather than inflating as Keynes had promised, the economy under Reagan stopped inflating for the first time in forty years. Again, deficit government spending did not inflate the economy.

Why did government expenditures during these two climactic moments in American history not have the effect on the economy that Keynes would have predicted? Because money, in essence, is really just credit, and the people that create most of the credit in our economy are primarily responsible for determining the supply of money that helps people get jobs while being able to reasonably budget their households. As explained in the previous post to this blog site, banks inflate the economy when they issue credit and they deflate the economy when they reduce their credit. When bankers are confident, they issue as much credit as they can and thereby inflate the economy; when they are afraid and timid in issuing loans, they will invariably deflate the economy’s money supply and reduce the number of jobs available.

Roosevelt failed to inflate the economy because, instead of giving bankers courage, he made them timid and afraid of his wrath. His patrician background had made him distrustful and envious of the nouveau riche money-changers who made our economy work.

Reagan, on the other hand, gave creditors courage to inflate the economy, but that inflation was limited by the governments limit on fractional reserves. The fractional reserve can curb inflation by putting a ceiling on the bank’s creation of money; however, this ceiling does not have a corresponding “floor” that would limit the amount of deflation. Reagan’s government could limit the inflation that threatened his economy, but he would not have been able to limit the amount of deflation that is threatening ours.

Money was the same thing under both Roosevelt and Reagan -- money was just “full faith and credit” and the bankers provided credit once they had full faith.