1

Fiscal Policy on the New Frontier

Now, let us turn to the problem of our fiscal policy. Here the myths are legion and the truth hard to find.

—JOHN F. KENNEDY, COMMENCEMENT ADDRESS, YALE UNIVERSITY, JUNE 11, 1962

The beginning of the “New Economics,” a term coined by the media for the already old idea of using fiscal policy to influence economic activity, can be dated precisely to June 7, 1962. At a press conference that day, President John F. Kennedy promised to ask Congress for “an across-the-board reduction in personal and corporate tax rates which will not be offset by other reforms—in other words, a net tax reduction” (Stein 1969, 407). His tax proposal took a long time to be put into concrete form within the administration and then to wend its way through a recalcitrant Congress. It eventually became law in February 1964, after his death and at least in part as a tribute to the assassinated president. The Kennedy-Johnson tax cut, as it has been called ever since, was quickly hailed as a great success.

Fiscal stimulus had been deployed before, of course, by the Swedes in the 1930s (Türegün 2017) and by Franklin Roosevelt’s New Deal, although the magnitudes then were puny relative to the immense need,¹ and on a massive scale during World War II, though the last of these was certainly not motivated by any Keynesian reasoning. So, the New Economics was not as new as the media made it out to be. Still, it was a sharp departure from the fiscal legacy of Dwight Eisenhower’s administration.

Background: Eisenhower and the Three Recessions

As Herbert Stein (1969) argued in his definitive history of how the “fiscal revolution” came to America, Eisenhower and his team understood basic Keynesian ideas but were reluctant to employ them because the president did not want to stray far from a balanced budget. Eisenhower was also almost obsessed by fears of inflation, which he associated with budget deficits (Stein 1969, chap. 11), even though the inflation rate (as measured by the Consumer Price Index [CPI]) averaged a mere 1.4 percent during his presidency.² Although the average real growth rate over Eisenhower’s eight years was a respectable 2.9 percent, one reason why inflation remained so low was that his two terms were marred by three recessions.

The first of these, in 1953–1954, was basically caused by a sharp fiscal contraction. In part, this recession was a normal adjustment from wartime to peacetime: federal defense spending fell sharply as the Korean War ended. But it was not necessary to couple that drop in defense spending with declines in nondefense spending too—unless you were firmly tied to the mast of the balanced budget ideology. Eisenhower was.

Unlike 1953–1954, the recessions of 1957–1958 and 1960–1961 cannot be laid directly at the doorstep of the Eisenhower administration. The former was part of a worldwide slowdown, though a tightening of monetary policy played some role too. (Inflation was still the main worry then.) Fighting inflation with monetary policy probably played a larger role in causing the 1960–1961 recession. More to the point of this chapter, the administration and Congress did little to mitigate either slump.³ The fiscal inaction as the 1960–1961 recession developed was particularly noteworthy because it greatly chagrined the vice president, Richard M. Nixon, who fought a losing battle for fiscal stimulus within the administration and then lost the 1960 election to Kennedy by a razor-thin margin (Nixon 1962, 309–10). Nixon believed that the recession cost him the 1960 election, and he may well have been right. As we will see in chapter 4, it was a lesson he would not forget.

The New Frontier and Tax Cuts

Attitudes began to change quickly when Kennedy replaced Eisenhower as president in January 1961, but you couldn’t have anticipated that from Kennedy’s 1960 campaign. The young senator from Massachusetts campaigned on a pledge to “get America moving again,” as if the country had stood still under Eisenhower. Yet Kennedy also ran as a fiscal conservative, seeing no contradiction there (Stein 1969, 376). That fiscal conservatism perhaps reflected the views of his wealthy and domineering father, who had been a titan of Wall Street and held views that were characteristic of that circle at that time (Tobin 1974, 19). If anything, Nixon sounded a bit more Keynesian than Kennedy during the 1960 campaign.

But Kennedy, who was born in 1917, had grown up in the Keynesian era, was intellectually curious, and wanted to hear from the experts he had brought to Washington. That group of advisers, led by Walter Heller of the University of Minnesota, chair of Kennedy’s original Council of Economic Advisers (CEA), was composed mostly of enthusiastic Keynesians, which was probably no coincidence.

One member of that stellar group was the estimable James Tobin of Yale, a subsequent Nobel Prize winner whom Kennedy hired as a CEA member. Tobin famously demurred when the president-elect called to ask him to join the new administration. “I’m afraid you’ve got the wrong guy, Mr. President,” Tobin replied. “I’m an ivory tower economist.” Kennedy responded, “That’s the best kind. I’m an ivory tower president” (Noble 2002). (It is easy to imagine Kennedy smiling his famous smile as he said this over the phone.) Tobin later recalled that, true to that vignette, “Innocent of economics on inauguration day, he was an interested and apt pupil of the professors in the Executive Office Building” (Tobin 1974, 24).

So what was new about the New Economics? Certainly not the basic theoretical framework. The underlying ideas dated from Keynes’s General Theory, which had been published in 1936. By 1961 its message was standard fare, at least in left-of-center circles and probably beyond, even though many conservatives of the day condemned Keynesian ideas as “socialist.” (They weren’t strong on definitions.) Heller later noted that “the rationale of the 1964 tax-cut proposal came straight out of the country’s postwar economics textbooks” (1966, 72). Indeed, the premier such textbook of the day was written by MIT’s Paul Samuelson (1948), who was the acknowledged intellectual leader of Kennedy’s team of economists even though he never took a position in Washington.

Perhaps the most important and obvious feature of the New Economics was that the Kennedy-Johnson tax cut was the first deliberate and avowedly Keynesian fiscal policy action ever undertaken by the U.S. government. While the ideas were not new, acting on them was. It is in this sense that the Kennedy-Johnson tax cut is rightly seen as a watershed event.

It was also considered revolutionary at the time to cut taxes when the federal budget was already in deficit and the economy was recovering rather than mired in recession. Indeed, Robert Solow, who was on the CEA staff then, recalled to me (in personal correspondence) that the Kennedy economic team went through mental gymnastics to argue that the deficit would not exceed Eisenhower’s largest deficit. That was deemed important.

Prior to the Kennedy tax proposals,⁴ countercyclical fiscal policies were considered emergency measures to be reserved for deep recessions, such as the situation faced by Roosevelt. Looking back a few years later, Heller wrote, with perhaps a tinge of hyperbole, that: “John F. Kennedy and Lyndon B. Johnson stand out, then, as the first modern economists in the American Presidency. Their Administrations were largely free of the old mythology and wrong-headed economics which had viewed government deficits as synonymous with inflation; government spending increases as a likely source of depressions that would ‘curl your hair’; and government debts as an immoral burden on our grandchildren” (Heller 1966, 36–37). Were Heller alive today, he probably would be shocked to see that all three of these pre-Keynesian ideas live on, if only at the lip service level.

While Heller doubtless exaggerated, there does seem to have been a sharp intellectual break between the Eisenhower and Kennedy administrations. In a 1972 lecture at Princeton, Tobin looked back at what he saw as “new” in the New Economics, listing three main items:

1.              The notion “that government could and should keep the economy close to a path of steady real growth at a constant target rate of unemployment” (which the New Frontiersmen set at 4 percent) (Tobin 1974, 7);

2.              getting rid of “the taboo on deficit spending” (10); and

3.              seeking “to liberate monetary policy and to focus it squarely on the same macro-economic objectives that should guide fiscal policy” (11).

The first item represents clear advocacy of what would first be praised and later derided as “fine-tuning.” An even clearer clarion call for fine-tuning came from Heller in his (1966) book in which he asserted that fiscal policy appropriately “became more activist and bolder” in the early 1960s (68). In fact, he claimed, “we now take for granted that the government must step in to provide the essential stability at high levels of employment and growth that the market mechanism, left alone, cannot deliver” (9). This necessary activism, he added, means that “not only monetary policy but fiscal policy has to be put on constant, rather than intermittent, alert” (69). Precious few economists would go that far today.

The third item on Tobin’s list is notable in light of the monetarist-Keynesian debate that would follow (see chapter 2), one in which Tobin would play a leading role. But it is even more notable—indeed jarring from a modern perspective—for its lack of fealty to the now-sacred doctrine of central bank independence. It may seem amazing from a modern perspective, but belief in central bank independence was not holy writ then, not even among economists. Indeed, the January 1964 Economic Report of the President had warned the Federal Reserve—in print—that “it would be self-defeating to cancel the stimulus of tax reduction by tightening money” (CEA 1964, 11). Gardner Ackley of the University of Michigan, who replaced Heller as CEA Chair in November 1964, was even more blunt: “I would do everything I could to reduce or even eliminate the independence of the Federal Reserve” (Meltzer 2009a, 457). Modern-day Ackleys would never say such a thing. The belief in central bank independence now runs deep.

Allan Meltzer, the renowned monetarist and historian of the Federal Reserve, has criticized Fed Chair William McChesney Martin for being too pliant at the time. “Policy coordination ensnared Martin in administration policy,” Meltzer claimed. “He willingly sacrificed part of the Federal Reserve’s independence for the opportunity to be part of the economic ‘team,’ make his views known to the president, and coordinate policy actions” (Meltzer 2009a, 445). This judgment seems harsh in view of Martin’s subsequent clash with Johnson (see below). Besides, is policy coordination really such a bad thing, especially if it does not imply Federal Reserve subservience to the White House? If the Fed saw that a big tax cut was coming, might it not want to adjust monetary policy accordingly? Yale’s Arthur Okun, who succeeded Ackley as chair of the CEA, rendered a much kinder judgment: “The Federal Reserve … Board put on an outstanding performance in 1966, making wise judgments and, most of all, having the courage to act promptly and decisively on them” (Okun 1970, 81).

My own view—and I think it is the historical consensus—is far closer to Okun’s. And don’t forget that the dominant attitude in the early to mid-1960s was that the Fed would and should “accommodate” expansive fiscal policy,⁵ an early version of what modern economics now calls “fiscal dominance.”⁶ When it came to stabilization policy, monetary policy occupied the back seat, not the driver’s seat, at the time. Indeed, Kennedy confessed that he helped himself remember the difference between fiscal and monetary policy by the fact that “monetary” and “Martin” both began with the letter M (Stein 1969, 4),

But it was the second item on Tobin’s list that was the real political stickler. The balanced budget ideology was not only alive and well at the time, it was dominant. And it made Kennedy hesitant to propose anything as radical as a tax cut with the budget already in deficit. Heller, Samuelson, and Tobin worked hard to persuade the new president intellectually. But support from Congress was underwhelming, and his own treasury secretary, C. Douglas Dillon, a Wall Street Republican, opposed the idea. (Dillon favored tax reform, not a tax cut.) Hard as it is for a modern reader to imagine, selling a tax cut to Congress in those days was hard work! Political gravity pulled strongly toward a balanced budget.

President Kennedy nonetheless decided to make a large tax cut the centerpiece of his New Economics. His stated intention when he announced the tax cut on June 7, 1962, was to get it through Congress quickly. But that was not to be—not even close. The idea of enacting a fiscal stimulus in a nonrecessionary environment was considered revolutionary, even heretical, at the time. Congress and the White House also had to decide on how much tax reform should be packaged with the tax cut (in the end, there was little) and how much expenditure cutting should accompany the tax bill (in the end, there was some), for both of those decisions would influence the impact of the tax package on the budget deficit and therefore the legislation’s prospects in Congress. Last, but not least politically, Congress and the administration had to decide on the distributional aspects of the tax cut—who would gain how much? There were also a few other “minor” distractions that year, such as the Cuban Missile Crisis of October 1962 and the November 1962 midterm elections!

Kennedy’s CEA thought that a tax cut of about $10 billion—then about 13 percent of federal income tax receipts and about 1.4 percent of gross domestic product (GDP)—was about right. It would approximately close both what we now call the GDP gap and what they then called the full-employment surplus.⁷ It is unlikely, however, that such macroeconomic subtleties swayed many members of Congress, who loved the idea of cutting taxes but were still strongly attached to the balanced budget ideology. Nonetheless, the Revenue Act of 1964, when fully phased in, reduced federal tax receipts by about $11.5 billion per year—close to the CEA’s original target.

The bill that finally passed Congress in 1964 was a tax cut, not tax reform. It reduced the top marginal tax rate for individuals from a confiscatory 91 percent to “only” 70 percent (times have certainly changed!), and it reduced the lowest bracket rate (other than zero) from 20 percent to 14 percent. It also shaved the top corporate rate from 52 percent to 48 percent.⁸

With a peak multiplier of, say, 1.5, a tax cut of that size would have been expected to boost real GDP by about 2.5 percent. But the Heller CEA expected far more. According to Stein (1969, 431–32), the CEA based its analysis on a multiplier closer to 3 than to 1.5, perhaps assuming monetary accommodation.⁹ Consequently, real GDP growth (using today’s data) rose from a healthy 4.1 percent pace over the four quarters of 1963 to an even healthier 5.2 percent over the four quarters of 1964 (remember, the tax cut did not pass until late February) and then to a perhaps unhealthy 8.5 percent pace during the four quarters of 1965. The economy was skyrocketing. Consistent with this, the unemployment rate dropped from 5.5 percent in December 1963 to 5 percent in December 1964 and then to 4 percent in December 1965 (figure 1.1). The Kennedy team’s interim unemployment target was achieved.

FIGURE 1.1. Unemployment and inflation, 1960–1969.

Source: Bureau of Labor Statistics.

Yet inflation remained quiescent. Using the December-to-December CPI measure, the inflation rate dropped from 1.6 percent during 1963 to 1.2 percent during 1964 and then rose only to 1.9 percent during 1965 (see figure 1.1).¹⁰ What would soon become the “Vietnam inflation” was barely getting started by late 1965.

On balance, the U.S. economy in 1965 really did look and feel like Camelot. Commensurately, the New Frontier’s economists looked like geniuses. As Okun, a member of the CEA at the time, remembered it, “The high-water mark of the economist’s prestige in Washington was probably reached late in 1965. At that point, for a brief moment, even congressmen were using the appellation ‘professor’ as a term of respect and approval” (Okun 1970, 59). I served in Washington in the mid to late 1990s, first on Bill Clinton’s CEA and then on the Federal Reserve Board, during what was probably the next high-water mark for economists. I can assure you that the “water” then never rose that high.

Was Kennedy’s economic team really a bunch of geniuses? Well, with Tobin as a member of the CEA, the likes of Robert Solow and Kenneth Arrow on the CEA staff (imagine that!), and Paul Samuelson kibitzing from the sidelines, one could certainly answer yes. That’s four future Nobel Prize winners. But the New Frontiersmen were simply acting like good textbook Keynesians. And their leader, Walter Heller, was blessed with the kind of political and media savvy that you don’t often find in academia. He understood Washington.

As noted earlier, Kennedy’s CEA pegged what would later become known as the natural rate of unemployment at 4 percent. It was an educated guess based on paltry data. Looking back today, the Congressional Budget Office (CBO) estimates that number to have been far higher at the time: 5.7 percent in the fourth quarter of 1965. If the CBO’s modern estimate is even close to correct, the United States already had a sizable inflationary gap in 1965, meaning that economists should have been expecting rising inflation, which by then was just barely visible. But they weren’t.

In fairness, the Kennedy-Johnson economists could not have predicted the sharp military buildup that followed, though they did have a better inkling than most (including the Federal Reserve) because the administration’s budget planning preceded the actual surge in Vietnam-related spending. Real defense spending jumped by 15 percent from 1965:4 to 1966:4 and then by another 7 percent from 1966:4 to 1967:4.¹¹ Largely for that reason, the economy overshot full employment, and the inflation rate (December-to-December CPI) rose to 3.3 percent in both 1966 and 1967 and then to 4.7 percent in 1968 (see figure 1.1). Americans viewed that inflation rate as excessively high at the time, just as they would today.

Leader of the New Frontiersmen

Walter Heller of the University of Minnesota was the acknowledged leader of the band of economists who came to Washington with President Kennedy in 1961, acknowledged not so much for his intellectual prowess—in that regard, he was no match for future Nobel Prize winners such as James Tobin and Robert Solow—but rather for his teaching ability (in the broad sense), his political sensibility, and his knack for turning a phrase. Heller may well have been the most influential chair of the CEA in history. Indeed, he called himself an “educator of Presidents” (Kilborn 1987b), a claim not made by many CEA chairs since.

Heller was born in Buffalo, New York, to German immigrant parents. He attended Oberlin College and received his PhD in economics from the University of Wisconsin in 1941. After teaching there for a few years he joined the University of Minnesota faculty in 1946, where his early academic work focused on taxation. That specialty led him to an interlude as tax adviser to the U.S. military government in West Germany before and during the early years of the Marshall Plan. In that post, he was involved in both the currency and tax reforms that helped West Germany recover.

Heller met Kennedy mostly by chance: Minnesota senator Hubert Humphrey introduced them at a campaign event in 1960. After the two chatted, Heller went home and wrote Kennedy a single memo. It must have been an exceptional one, because President-elect Kennedy shocked Professor Heller by offering him the chairmanship of the CEA (TIME 1961). It was a surprising choice made, according to Kennedy biographer Richard Reeves (1993, 26), “mostly because he was not from Harvard or Yale. There were too many Ivy Leaguers around [Kennedy] already.”

As an enthusiastic Keynesian who had Kennedy’s ear, Heller helped persuade the young president to advocate a sharp cut in marginal tax rates, even though the economy was recovering and there was a budget deficit. The media dubbed this idea the New Economics. Later Heller helped Kennedy develop “voluntary” wage-price guidelines, which they hoped would keep inflation in check as the economy boomed. (Less luck there.)

Heller stayed on at the White House after Kennedy’s assassination and suggested what became the War on Poverty to President Lyndon Johnson. But when Johnson insisted on huge new spending on the Vietnam War without raising taxes, Heller resigned in November 1964 on the grounds that such a policy would be inflationary. He was clearly a two-sided Keynesian. Sometimes Keynesian thinking called for expansionary fiscal policy, but sometimes it called for contractionary policy. Politicians tend not to like the latter.

So, price stability went by the board due to what economists—both then and now—would brand a policy error: piling a mountain of defense spending on top of an economy that was already at (if you believed in 4 percent) or well beyond (if you believed in 5.7 percent) full employment. Astute readers will notice the similarity to the fiscal policy choices of the early Trump administration in 2017–2018, when Congress cut taxes and raised spending even though the unemployment rate was then near 4 percent (more on that episode in chapter 17). As Hegel (1899, 6) had sagely observed, “What experience and history teaches us is that people and governments have never learned anything from history, or acted on principles deduced from it.”

Meanwhile, Back at the Fed

The unsustainable boom started losing steam at about the same time that inflation began to climb. Over the five quarters from 1966:2 through 1967:2, real GDP growth slowed to a 2.4 percent annual rate—including one quarter of roughly zero growth (1967:2). In some business cycle chronologies this episode is called a “growth recession,” a term that was once in common use but seems to have disappeared from the lexicon once real recessions started reappearing. What slowed the economy down then? Not fiscal policy. (More on that shortly.) It was mostly monetary policy.

The federal funds rate—which was not the Fed’s primary policy tool then—had been creeping up slowly, almost unnoticed, for years, starting at around 2 percent in the summer of 1961 and topping 4 percent by November 1965. From a modern perspective, it seems inconceivable that Presidents Kennedy and Johnson, not to mention their economic advisers, could have failed to notice this development. However, in those days more attention was paid to the money supply, and M2 growth (as we measure it today)¹² was not doing anything exciting.¹³ Besides, you would certainly expect a strengthening economy to push up interest rates. So, you might argue that the Fed was just being passive, perhaps too passive, in letting the market raise rates.

In those early days, however, the task of actively managing aggregate demand growth was thought to fall more in the province of fiscal policy. The Federal Open Market Committee, at the time, saw itself as a bulwark against inflation, not as an agency responsible for steering, not to mention fine-tuning, the economy (FOMC 1975, 70). The Fed’s famous dual mandate for low inflation and low unemployment was not added to the Federal Reserve Act until 1977.

While most Fed officials could not be called practitioners of Keynesianism at the time—indeed, Martin was not trained in economics at all—they understood that part of their duty was described by Chair Martin’s famous aphorism: “The Federal Reserve … is in the position of the chaperone who has ordered the punch bowl removed just when the party was really warming up.”¹⁴ And by 1965, Martin and his colleagues felt that the “party” was getting too hot. He began speaking publicly about his concerns that the economy was in danger of overheating due to growing expenditures on the Vietnam War.¹⁵

In June 1965, Martin laid down the gauntlet in a speech at Columbia University in which he worried out loud about the “disquieting similarities” between the current economic and stock market situations and those of the 1920s. Oh my, 1929 redux? That thought sent a shiver down traders’ spines, and the market fell. More to the current point, Martin’s speech angered President Johnson so much that he asked his attorney general if he could legally remove the Fed chair from office. (He couldn’t without cause.)

Late in November 1965, Martin warned Henry Fowler, then Johnson’s treasury secretary, that the Fed might vote to raise the discount rate at its next meeting on December 3. Fowler relayed that Thanksgiving cheer to Johnson along with some advice that the president didn’t need: “We ought to really try to hold him back now.” As noted earlier, central bank independence was far from the accepted norm then.

Johnson replied ominously that he was “prepared to be Jackson if he [Martin] wants to be Biddle.” The president apparently knew his monetary history. The reference was to the so-called Bank War between President Andrew Jackson and Nicholas Biddle, the president of the Second Bank of the United States, in 1833–1836. That “war” ended badly for Biddle, leaving the United States without a central bank for seventy-eight years.

But Martin, though warning his Fed colleagues of the potential threat to their independence, did not hold back. The December discount rate hike passed by a 4–3 vote, which meant that Martin had cast the deciding vote. A livid President Johnson, who was recuperating from surgery at his Texas ranch at the time, summoned the Fed chair down to banks of the Pedernales River for one of his famous barbecues.

Though I imagine Texas beef was served, the real purpose was to barbecue Martin. “Martin,” complained the president, “my boys are dying in Vietnam, and you won’t print the money I need.” The Fed chair was apparently unmoved, telling Johnson that the president and the central bank had different jobs to do and that the Federal Reserve Act gave the Fed authority over interest rates. No fiscal dominance there. The president must have accepted Martin’s assertion, if reluctantly, since he nominated him for yet another term a year later. It no doubt helped that the long boom of the 1960s kept on going. The 106-month expansion (by National Bureau of Economic Research dating) lasted until December 1969 and in so doing smashed all previous records.

Bill Martin, who by then had been the Fed’s chair for over fourteen years, wasn’t the only observer who worried about an overheating economy and inflation in 1965 and 1966. So did the thoroughly Keynesian members of Johnson’s CEA, which was then chaired by Gardner Ackley and included as a member Arthur Okun, who would later succeed Ackley.

The Fed’s Longest-Serving Chair

William McChesney “Bill” Martin, unlike most subsequent chairs of the Fed, had no degree in economics. From the Fed’s founding in 1913 through Martin’s era, U.S. presidents did not deem formal training in economics important to the job. Rather, they sought to appoint hard-money men (until Janet Yellen became chair in 2014 they were all men) with integrity and judgment. Martin was all these and more. You might even say he was born to the office: his father had served as president of the Federal Reserve Bank of St. Louis.

Martin’s sterling career on Wall Street began with the St. Louis brokerage firm A. G. Edwards, where he became a full partner after just two years. By 1931 he had a seat on the New York Stock Exchange (NYSE). His work on stock market regulation in the wake of the 1929 crash landed him first on the NYSE’s board of governors and then, at age thirty-one, in its presidency. That meteoric rise earned him the nickname “the boy wonder of Wall Street.”

After World War II Martin entered government service, landing in the Treasury Department at a time (1949) when the Federal Reserve was trying to reclaim its independence from the Treasury. (The Fed had lost that independence while pegging interest rates during the war.) He wound up part of the Treasury–Federal Reserve team that negotiated the famous Accord between the two in 1951. Almost immediately thereafter, President Harry Truman appointed Martin chair of the Fed, perhaps mistakenly thinking that Martin would help him bring the Fed to heel again.

But Martin proved to be an effective defender of the Fed’s independence, clashing with several presidents—most notably with President Johnson in 1966. Nonetheless, as noted in the text, Johnson reappointed Martin—just as Truman, Eisenhower, and Kennedy had done before him. Martin was truly an institution, the longest-serving Fed chair in the central bank’s history. One of the Fed’s two main office buildings in Washington bears his name.¹⁶

Johnson’s economists argued that the coming surge in aggregate demand from defense spending could and should be countered, or at least mitigated, either by cutbacks in civilian spending or by tax increases. In the modern argot, the federal government should “pay for” the upsurge in military spending. But Johnson rejected spending cuts because they would have crimped his Great Society plans. For him, it would be guns and butter. In his words, “I was determined to be a leader of war and a leader of peace. I refused to let my critics push me into choosing one or the other. I wanted both” (Goodwin 1976, 283). The president also rejected tax increases because they would have made the costs of the Vietnam War much more visible to the voters and thereby undermined support for the war. So, in Okun’s words, “the economists in the administration watched with pain and frustration as fiscal policy veered off course” (Okun 1970, 71). It would not be the last time economists watched fiscal policy decisions “with pain and frustration.”

This failure to turn from fiscal stimulus to fiscal restraint, or at least toward less stimulus, was notable for three reasons. Most obviously, it opened the door to what became the Vietnam inflation; by 1969, the inflation rate was up to 6 percent (see figure 1.1). Less obviously but at least as important for the themes of this book, it gave Keynesian economics a bad name—unfairly. Critics would soon start claiming that Keynesian policies had an inflationary bias. Keynesians, it was alleged, advocated stimulus when the problem was fighting unemployment but did not advocate restraint when the problem was fighting inflation. The charge wasn’t true then, and it isn’t true now. But the criticism gave a big boost to the rise of monetarism (see chapter 2) and is occasionally leveled even today. For example, two economists criticized the “Keynesian” nature of the Coronavirus Aid, Relief, and Economic Security (CARES) Act, the first big fiscal package enacted to combat the recession of 2020, writing that “the last thing we need at this moment is a Keynesian stimulus. Since the lockdowns constrain supply, stimulating demand would lead only to a rise in prices” (Seru and Zingales 2020). They were as wrong in 2020 as wrong can be. But they were not alone.

Finally, a die (of sorts) was cast. In theory, fiscal policy is symmetric. You raise taxes or cut spending to rein in aggregate demand, just as you cut taxes or boost spending to spur aggregate demand. In practice, however, fiscal policy in the future would be used (with rare exceptions) only to expand demand. When contracting demand was the order of the day, policy makers would turn to monetary policy instead, thereby taking the onus off politicians and lodging it squarely at the Fed’s Constitution Avenue headquarters.¹⁷

This is good politics, I suppose. But introductory textbooks explain why it is bad economics. Looser budgets and tighter money will generally produce higher real interest rates, hence a lower investment share in GDP and eventually a slower growth rate of potential GDP. This is precisely what happened in the 1965–1968 period. For example, the share of business investment in GDP fell from about 18 percent in 1966:1 to about 16 percent in 1967:2, and the CBO now estimates a sharp drop in potential GDP growth after 1968.¹⁸

The fiscal spigot was not turned off until a tax increase finally passed in June 1968, and then its power was undermined by making it explicitly temporary.¹⁹ Monetary policy was left to shoulder the burden of fighting inflation alone. As mentioned earlier, the Fed raised its discount rate in December 1965, and the federal funds rate drifted up to 4.1 percent by November 1966.

The financial events of 1966 were quickly dubbed a “credit crunch.” In those days, monetary policy derived much of its power from what was called “disintermediation” due to the Federal Reserve’s Regulation Q, which placed ceilings on the interest rates that banks were permitted to pay to their depositors. Regulation Q, a leftover from the reactions to the Great Depression, was based on the quaint theory that ruinous competition for deposits had been a major factor behind bank failures in the 1930s. The regulation was defanged in stages by the Depository Institutions Deregulation and Monetary Control Act of 1980, leaving monetary policy less powerful (but also less distortionary), and finally eliminated entirely by the Dodd-Frank Act of 2010. But in Regulation Q’s heyday, which included the 1966 credit crunch, banks and thrifts would see deposits flee to higher-yielding alternatives whenever market interest rates rose above the regulation’s ceilings—a process dubbed disintermediation.

Such reallocations of households’ liquid assets might seem inconsequential; after all, the funds didn’t disappear. But the sloshing around of money had profound effects on the housing sector because financing for home mortgages came from banks and thrifts, not from Treasury bills and money market instruments, and there was no such thing as mortgage-backed securities then. So, any serious bout of disintermediation threw housing into a slump. Residential investment fell by 22 percent between 1966:1 and 1967:1.

FIGURE 1.2. Federal funds rate, 1964–1970.

Source: Board of Governors of the Federal Reserve System.

The growth recession and perhaps even Johnson’s attacks on the Fed, induced the central bank to ease up a bit in 1967. But much more tightening was to come. By November 1967 the federal funds rate was up to 4.1 percent, and it eventually peaked at 9.2 percent in August 1969 (figure 1.2). Three months later, with the unemployment rate sitting at 3.5 percent, the U.S. economy slipped into the 1969–1970 recession, which would raise the unemployment rate to 6 percent—its highest level since late 1961.

A second, now-archaic, factor also pushed the Fed toward tighter money at intervals during the late 1960s and early 1970s: gold outflows. The U.S. dollar, in particular its peg to gold at $35 per ounce, was the linchpin of the Bretton Woods system of fixed exchange rates. The other leading industrial countries pegged their currencies to the dollar so that, for example, with the value of the French franc pegged at 20 cents, France was effectively on an ersatz “gold standard” at 175 francs per ounce of gold. There was a catch, however. The international exchange value of the dollar could not fall when it needed to—say, when U.S. inflation ran repeatedly above German inflation. Instead, the U.S. balance of payments deficit would widen, and gold would in principle flow out.

FIGURE 1.3. U.S. monetary gold stock, 1950–1970.

Source: Federal Reserve Bank of St. Louis.

Back in the 1960s, “losing gold” would alarm Federal Reserve officials—and others too. Losing gold created a presumption that interest rates should rise, thereby mimicking what would have happened automatically under the classical gold standard. Importantly, the loss of gold reserves turned out to be a secular problem: the U.S. monetary gold stock declined steadily from the late 1950s to the late 1960s (figure 1.3), until President Nixon finally broke the link to gold in August 1971 (more on that in chapter 4). But gold was at least a putative influence on monetary policy during the Kennedy-Johnson years.

Chapter Summary

Keynesian economics came to U.S. fiscal policy in the New Frontier. Monetary policy was seen as subsidiary then, its main job being to “accommodate” the 1964–1965 tax cuts. And Federal Reserve independence was far from being a sacred cow. In fact, it was barely a sacred calf. What we might call a “soft landing” in 1965—at 4 percent unemployment and sub–2 percent inflation—was upset by the Vietnam buildup shortly thereafter. It was a classic case of excess demand, making the remedy clear: tighter monetary and fiscal policies. But both monetary and fiscal policy fell “behind the curve” in the fight against inflation, although the Fed did jack up interest rates substantially, thereby drawing the ire of President Johnson. As the 1960s drew to a close, the United States was entering a mild recession, but inflation was still the problem of the day. And Keynesian economics had been tagged, unjustly, with a reputation it would struggle to shake off for decades: it was allegedly inflationary.

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1. E. Cary Brown’s (1956) once-classic paper concluded that “fiscal policy … seems to have been an unsuccessful recovery device in the ’thirties—not because it did not work, but because it was not tried.”

2. Here and throughout the book, I use modern data, not the real-time data policy makers would have seen at the time, with some rare exceptions. The differences rarely matter much, and where they do I take note of them.

3. On this episode, see Stein (1969, chaps. 12–13).

4. I use the plural here because the Investment Tax Credit, originated by Kennedy’s CEA, was enacted in 1962.

5. CEA (1965, 66) As one small indicator of lack of independence, what is now known as the Troika for macroeconomic policy (the Treasury, the Office of Management and Budget, and the CEA) was then organized to include the Fed and became known as the Quadriad.

6. Many scholarly papers discuss and model fiscal dominance. Among the earliest is Leeper (1991).

7. Stein (1969, 431–33). It is worth remembering that measuring potential GDP, which Okun did as a CEA staffer, was a new idea in those days. Current CBO estimates show very small GDP gaps then.

8. These and other historical tax rates come from the Tax Foundation (n.d.).

9. In the mainstream theory of the day, just as in the mainstream theory of today, fiscal multipliers are larger when monetary policy prevents (or limits) interest rate increases.

10. In those days, there was no need to distinguish between “core” inflation, which excludes food and energy prices, and “headline” inflation, which includes them. The food and energy shocks that drove this distinction would come later.

11. Here and throughout, dates like 1965:4 are shorthand for the fourth quarter of 1965.

12. M2 today includes cash held by the public, checkable deposits in banks, small-denomination time deposits, and balances in retail money market funds (MMFs). MMFs did not exist in the 1960s.

13. The measured Ms have, however, changed numerous times since then.

14. The exact words are often quoted differently. My source is the Fed’s history website (Martin 1955, 12).

15. The history of this episode, including all the quotes that follow, comes largely from Granville (2017).

16. The other is named for Marriner Eccles.

17. Symmetrically, a folk adage of the day held that monetary policy only worked in the contractionary direction. Monetary expansion was like “pushing on a string.”

18. I don’t want to exaggerate the point. The CBO’s estimated drop in potential GDP growth is too large to be explained by a two-point drop in the investment share in GDP. See, for example, CBO (2021).

19. See, among others, Eisner (1969) and Blinder (1981b). For more on this issue, see chapter 2 in this volume.