What 'guns and butter' means

Posted: Dec 18, 2003 12:00 AM

The old 1960s slogan "guns and butter" is suddenly everywhere. A feature story in The New York Times was headlined, "Bush Can Have Both Guns and Butter, at Least for Now." A Wall Street Journal column by Holman Jenkins was titled, "An Oldie but Goodie: Guns Plus Butter." Columnist Pat Buchanan writes, "LBJ cut taxes and embraced a guns-and-butter budget. ... Bush is traveling the same road."

With federal spending up by 7.6 percent a year over the past two years, even before the staggeringly expensive Medicare and energy legislation the White House supported, it is hard to quarrel with the idea that President Bush is the biggest spender since LBJ. What I object to is the universal misuse of the economic concept of a guns and butter tradeoff, particularly when used to blame inflation on supposedly inadequate taxes during the Johnson administration.

The TV show "West Wing" once ran an episode called "Guns Not Butter." But the fictional President Bartlett is supposed to be a former economics professor. In economics, the tradeoff between guns and butter refers to the whole economy, not just the federal branch of government. And it has nothing to do with inflation.

Economic textbooks use the choice between guns and butter to illustrate "the production possibility curve." If we assume (pretend) the economy only produces those two goods, that it is at full employment and that productivity gains are impossible, then the only way to produce more guns would be to lure labor and capital out of the butter industry. Just look at North Korea, where the gang of thugs in charge would rather starve everyone than cut back on weapons. Yet notice that balancing the North Korean budget would be entirely irrelevant to their cruel choice of guns over butter. The people would still starve.

Despite these quibbles, I can imagine a potentially instructive way to apply the guns and butter metaphor to federal spending: Just replace butter with federal transfer payments, and guns with federal hiring and purchasing. But before we see what that tells us, we first have to unravel a stubborn historical hoax about guns and butter in the '60s.

The author of that New York Times story on this topic, Niall Ferguson, wrote that, "In the late 1960s ... deficits were partly financed by printing dollars, which ultimately led to higher prices." Economist Gary North likewise wrote, at lewrockwell.com, that Johnson "did not raise taxes until he imposed a mild 10 percent income tax surcharge in 1968. By then, the Fed had pumped in so much money to fund the debt that price inflation was becoming a problem."

Ferguson and North are offering a theory about inflation that makes monetary policy virtually irrelevant, just a passive pawn of the budget. In their view, budget deficits in the '60s supposedly forced a helpless Fed to print money. Whether this explanation is right or wrong, it has nothing to do with "guns and butter." Inflation cannot churn more butter nor manufacture more guns.

As for the endlessly repeated myth that "guns and butter" caused inflation in the '60s, nobody looks at the facts. The deficit in fiscal 1967 was only 1.1 percent of GDP, which cannot begin to explain why the Fed kept the interest rate on fed funds below 4 percent until the end of that year.

Far from being mild, as North describes it, the surtax of mid-1968 put the top tax rate up to 77 percent and also slashed profits. Did that help? On the contrary, inflation did not become a major problem until after the surtax was enacted. Then inflation got much worse in 1969, when the budget was in surplus. Measured from December to December, consumer inflation was 3 percent in 1967, 4.7 percent in 1968 and 6.2 percent in 1969. The bond market was not impressed. The yield on 30-year Treasuries was 5.5 percent before the surtax, but rose above 6.7 percent a year later and to 7.8 percent by the start of 1970. By that time, the recession became so obvious that even President Nixon (who had extended the surtax beyond the original mid-1969 expiration) finally decided to scrap it. The recession ended November 1970, but inflation that year was still 5.6 percent.

Johnson's effort to use fiscal policy to fix a monetary problem failed completely. President Nixon's wage and price controls failed even more spectacularly, leaving inflation at 8.7 percent in 1973 and 12.3 percent in 1974.

North is right that the Fed pumped in a lot of money. But it didn't need new federal debt to do that. Old debt works just fine. In all the years from 1915 and 1960, the Fed accumulated just $27.3 billion in Treasury securities, paying for them by creating bank reserves out of thin air. By 1970, the Fed's hoard of T-bills had more than doubled, reaching $62.1 billion. That's all you need to know about why inflation accelerated in the late '60s. Guns and butter had nothing to do with it. If you're curious what went wrong again in the late '70s, and what went right after 1981, feel free to download a paper of mine on the fiscal-monetary policy mix at http://www.cato.org/events/papers/reynolds.pdf.

As I mentioned earlier, a distinction similar to guns and butter could be applied to the federal budget. I mentioned this recently at the West Wing (the real one, not the show). Real federal purchases, consumption and investment excludes transfer payments such as Social Security benefits and farm subsidies. Transfer payments are larger and may have a larger impact on the economy, but in a different way. Transfer payments discourage productivity activity among those who receive them, because you have to promise to not work, save or plant crops in order to get the check. Transfers also discourage those paying for them, namely taxpayers.

Federal purchases, on the other hand, use resources that would otherwise be available to private business. Federal consumption mainly means salaries. Increased federal hiring, whether civilian or military, reduces the supply of private workers and makes labor costs higher than otherwise. Federal investment means buildings and equipment, including military equipment. Increased federal buying of land, equipment and office space also makes those resources more scarce and expensive. The resulting increased costs to business translate into reduced profitability and therefore less investment. "Crowding out" is real, not financial.

This is where any story about accelerating inflation after 1968 being caused by "guns and butter" breaks down completely. Real federal purchases in 1968 amounted to $498.1 billion in 1996 dollars, little changed from the previous year, but then fell steadily to $385.3 billion in 1974. That drop reflected the ending of the Vietnam War, of course, yet that was also when inflation quadrupled from 3 percent to 12 percent.

Federal purchases then kept rising to $606.8 billion by 1990, but declined again $525.4 billion by 1998. That drop reflected the ending of the Cold War, of course, and the peace dividend helped provide real resources to keep the private economy expanding. By the third quarter of this year, however, real federal spending for consumption and investment was up 27 percent to $668.8 billion.

Those using LBJ "guns and butter" analogies to predict inflation ahead need to be reminded that rising inflation after 1967 happened when there was much less spent on guns (and much more on transfer payments). Although some of the rapid rise in real purchases in the past few years may be necessary for defense, it is nonetheless limiting future economic progress by absorbing labor, land and equipment. But if inflation ever does accelerate again as it did after 1967, don't blame guns and butter. Blame the Fed.