The Business Cycle and Economic Policy

Though Samuelson modernized both the content and the presentation of economics, a striking feature of Samuelson’s book is its roots in interwar “institutionalist” economics, a fact that must have been in his mind when he described it to friends as being very “institutional.”¹⁸ Part I—in which, after describing the economic problems facing any society and sketching how a capitalist system worked, he discussed families, business organization, and government—was always a crucial part of the book.

An important feature of this coverage of the facts of economic life was the provision of voluminous statistical information, much of which originated in New Deal institutions. This was, as he explained to Alan Sweezy, an impor­tant part of the book: “I have tried to draw upon the plentiful up-to-date sta­tistical materials concerning National Income, corporations, etc.—material only recently available in the Survey of Current Business and other sources.”¹⁹ However, the data he used came from a much wider variety of sources than just the Survey of Current Business. The coverage of family incomes relied on the statistics on income distribution and inequality produced by the National Resources Committee in 1935—36 (data with which he had become familiar during his work with the NRPB). The data were also the basis for the discussion of spending patterns that led into his analysis of saving. He used data on the distribution of income across different occupations dating from the late 1930s and 1940s. The account of national income drew on Department of Commerce figures, available only since the mid-1930s.

Samuelson and Hansen were very close while he was writing the book. Samuelson’s coverage of the business cycle and economic policy were entirely consistent with Hansen’s empirical-institutional approach. He began his account of the cycle with a statistical description such as would have been familiar to economists in the 1920s, complete with a “barometer” of busi­ness activity. Attempts to forecast had proved little more reliable than those of fortune-tellers, and aside from allowing for seasonal variations and long run trends, it was possible to do little more than describe the phases of the cycle. Though his description of the four phases of the cycle was taken from Mitchell, he turned to Hansen for a summary of the business cycle in the United States, in which construction activity was a key factor.^[71] He paid his respects to Schumpeter by discussing long waves in economic activity, but concluded that it was too soon to tell whether these were any more than historical accidents.

Hansen's linking the business cycle to activity in the building indus­try provided the first clue to understanding the cycle. The greatest fluc­tuations take place in industries producing durable goods—something supported by the graphs he had presented. He reviewed alternative theo­ries, concluding that what was needed was a synthesis. Of the mecha­nisms internal to the economic system that had been proposed, the one on which he chose to focus was the acceleration principle. Using a numerical example, he showed that this principle led to instability, amplifying fluc­tuations in demand.^h The chapter confirmed the conclusions reached in several other chapters that “the economic system is more or less without a steering wheel”; even if business people and workers act selflessly and effi­ciently, the system may experience inflation or deflation “depending upon the chance circumstances of the complex interaction between investment and saving.”^[72]

The solution to this problem was clearly fiscal policy.

This took him straight into an account of Hansen's views on secu­lar stagnation and the argument for long-term government deficits.^25,i Though it would see rapid technological innovation, Hansen argued that a mature economy such as the United States had would be susceptible to stagnant investment: the frontier, which stimulated an enormous amount of investment in the nineteenth century, had closed, so to sustain invest­ment there was a need for innovations on the scale of electricity and motor vehicles. In the absence of sufficient innovation, and given the tendency of saving to rise, the result would be that aggregate demand would not rise sufficiently fast to maintain a high level of employment. Samuelson por­trayed Hansen as being flanked on one side by less cautious supporters and on the other side by conservatives who agreed with him on the facts but believed the causes lay in government interference with business.

Samuelson may have expunged the statement to which Beadle took exception about the government's being able “to take the social point of view whatever the financial cost,”^[75] but it is hard to see any compromise in his conclusion:

In short, there is no technical reason why a nation fanatically addicted to deficit spending should not pursue such a policy for the rest of our lives or even beyond. The real question is whether such a policy will impinge on an economy that is inflationary or deflationary. So long as private and government spending are only enough to offset sav­ing, that is one thing. If a nation or Congress is misguided enough to continue heavy spending and light taxing after total consumption and private investment have become too large, then inflation will be the outcome.

His key point was that the appropriate level of government spending depended on the balance of saving and investment in the economy as a whole, not simply on what was happening to the government debt.

If inflation became a problem only at full employment, then the con­cepts of deflationary and inflationary gaps, explained in the chapter on saving and investment, would be sufficient to calculate the optimal fiscal stance. But this was not the case, for prices usually started to rise before full employment was reached. This meant that maintenance of full employ­ment required more than just fiscal policy. The problem was a psychological one, for it arose from businesses and trade unions reacting “perversely” to increases in demand. The solution of having a reserve army of the unem­ployed to keep prices down was not acceptable; neither was the solution of direct price and wage controls, with its implication of a high degree of centralized control, consistent with what Samuelson believed were the “philosophical beliefs of the great majority of the American people.”²⁷ Some people believed a little inflation had to be tolerated, but the problem of find­ing “a wage and price policy for full employment” was “America's greatest problem and challenge.”²⁸ It was a problem that involved thinking not just about the balance of saving and investment, but also about the allocation of resources within the economy.

A new chapter, “International Finance and Capital Movements,” supported the internationalism associated with Hansen that Samuelson had defended in the pages of The New Republic a few years before. He sought to undermine fallacies such as that it was always good to have a surplus in the balance of payments. Countries, he argued, went through stages of development in which foreign investment, which raised production, subsequently produced flows of income in the other direction. In general, people understood this, but “[w]hen nationalism rears its ugly (or beautiful) head, matters change.”²⁹ People who would never grumble about interest payments made from one part of a country to another would object to absentee ownership by foreigners. Trade and politics were inter­twined, but in a way that Samuelson argued was too complicated to discuss. Some people sought a world without wars or nationalism, with the freedom to invest and trade freely wherever they liked; others saw military glory as more important than comfortable living, believing that one “super-race” should be able to strip others of their goods so that they could “have [their] cake and cannons too.”³⁰ The world of the last two centuries lay somewhere in between these extremes.

Relegating the more technical discussion of topics, such as fixed and flex­ible exchange rates, the gold standard, and the international trade multiplier to an appendix, Samuelson turned to contemporary problems. His target was isolationism. After reminding readers that exporting goods could create prosperity, as had happened when European countries suddenly demanded American goods during the First World War, and when many loans had been made to the rest of the world in the 1920s, Samuelson listed a series of poli­cies that might raise employment. These “[b]eggar-my-neighbor” policies included tariffs, import quotas, exchange controls, and depreciating the dol­lar. If other countries did nothing, these policies might work, but if, as was certain to happen, they retaliated in kind, the result would be a downward spiral in international trade and the United States would end up worse off.

The first of these policies was the maintenance of full employment through domestically created purchasing power, making it possible to remove tariff barriers and subsidies for inefficient industries. The Marshall Plan was also important, for establishing Western European prosperity was crucial to the containment of communism.^j Canceling wartime debts was a smart move, not something that would hurt Americans. It was also neces­sary to support Britain with loans, for otherwise it would be impossible for Britain to free its trade and return to convertibility—two policies to which the United States attached great importance. Perhaps most important of all was international collaboration through the newly established International Bank for Reconstruction and Development (later the World Bank) and the International Monetary Fund (IMF). Samuelson explained how these institu­tions worked, pointing out that the United States was not acquiring unlim­ited liabilities. The World Bank was a commercial operation that should be able to cover its costs, but in the event that debts did turn bad, the tab would be picked up by all member nations, not just by the United States. The IMF would create greater exchange rate stability and the whole package of reforms would make it possible to move toward freer international trade. It was an unashamedly internationalist policy, supported by domestic demand­management policies.

When defending his position against Beadle, Samuelson had argued that he was trying to keep to a “middle- of- the- road” position, a phrase that implied balance and hence that the textbook was one that could safely be used for teaching.³² This introduces the question of where that balance rested, given that this was the age of the cold war, when certain positions were considered to lie outside the range of acceptable beliefs. Samuelson provided no analysis of this problem, but his friend Arthur Schlesinger Jr. did, in a book pub­lished very shortly after Samuelson’s textbook. The Vital Center sought, as its title implied, to stake out a center ground.³³ Shaped by the cold war with the Soviet Union, it was uncompromising in its anti-communism, unrelenting in its denunciation of those who, in their allegiance to the Communist Party of the United States, were blind to the perils of Soviet totalitarianism. Yet he was also critical of capitalism, for modern industrialism had contributed to the anxiety that lay beneath contemporary politics. Civilization had become “the victim rather than the master of industrialism,” which had shattered the personal ties that held preindustrial societies together.³⁴ Schlesinger’s attack on the right was an attack on business people; they had, he claimed, been effective in raising productivity, but they had become less effective the fur­ther they got from the counting house. “Men accustomed to the exclusive pursuit of their own interests find it hard to assume the role of the politician, who must balance and reconcile the conflicting interests of many groups.”³⁵

Schlesinger even likened communist societies to company towns like Pittsburgh: “Soviet Russia is a Pennsylvania or West Virginia from which there is no escape and in which the steel companies and the government are united in indissoluble bonds.”³⁶ He made the case for a class analysis of American society, contrasting plutocracy unfavorably with aristocracy and its sense of noblesse oblige. The business community was not capable of defending a free society, and government was the means through which the nonbusi­ness classes could protect themselves. Thus, the New Dealers were advancing cautiously out of “the jungle of private enterprise” and “the tyranny of the irresponsible plutocracy.”^37,k

Samuelson had known Schlesinger since they had been students at Harvard, and in the 1950s and 1960s they were both active in advising Democratic Party politicians. We do not know how much contact they had during the time when Samuelson was writing his textbook, but Schlesinger presented a political philosophy that is entirely consistent with the view Samuelson,

k. His understanding of the phrase “middle-of-the-road” is illustrated by his use of it to describe the German social democrat Karl Kautsky (Schlesinger 1949, p. 132). following Hansen, represented in his textbook.³⁸ Samuelson may not have been quite so critical of business and business people as was Schlesinger, but they held the same view on the necessity for government action to regulate, and hence to maintain, a free society. Samuelson’s arguing that a middle-of- the-road position called for significant government intervention, in a book that effectively concluded by talking of redistribution, of the evils of monop­oly, and of the wastes that are found under laissez-faire, could be seen as help­ing to place the center just where Schlesinger believed it had to be.³⁹