To Cut Budget, Concentrate on Growth, History Shows: Echoes

Reform the process. That's the solution often put forward these days to control federal spending. Budgets? They require triggers, one of Washington's favorite new words, to automatically restrain deficits. The debt ceiling? That's all about fiddling with the rules, too.

But controlling the budget isn't merely about rules. It's also about the will of legislators and voters to change law and policy in all fields, from monetary to tax, as well as to change what might be called the spending culture.

That, at least, is what the evidence suggests from the successful budget-cutting experiment of the 1920s.

In its dire aspect, the period after World War I resembled today. The country had just been through a trying war. Liberty Bonds had sounded like a good vehicle to fund the troops, but the debt from those bonds soon took the U.S. economy hostage. Yet somehow Congress, and Presidents Woodrow Wilson, Warren Harding and Calvin Coolidge, managed to reduce the administrative budget to just $3 billion by 1929, when Coolidge left office, from more than $6 billion at the end of Wilson's last term in 1920.

How did they do it? Reforming the process was part of the story. Under Harding, Congress enacted the Budget and Accounting Act of 1921, which strengthened presidential say over the budget and gave the chief executive the power to withhold money that had been appropriated to government departments. It helped presidents and departments get a handle on what they were spending.

But process alone would not suffice, as even Charles G. Dawes, the director of the new Bureau of the Budget, recognized. He deemed his office a "pitiful machinery," its power so limited "one might as well be handed a toothpick to tunnel Pike's Peak." Dawes told the country that to succeed at budget cutting the U.S. must wage a militant campaign against spending. A World War I veteran, he was calling for a peacetime war on profligacy, the mirror opposite of President Lyndon Johnson's War on Poverty.

Such federal austerity didn't kill or maim, but it wrought collateral damage on a scale that would elicit gasps from today's lawmakers. It started during Wilson's administration. To demonstrate its determination to pay off the war bonds, the U.S. government had to send a signal that it was serious about inflation. Between October 1919 and June 1920, the New York Federal Reserve increased the rate it charged other banks, to 7 percent from 4 percent. That reduced inflation expectations, but also forced a recession so sharp that in 1921 unemployment momentarily increased to 12 percent overall.

There was no Social Security or Medicare then, but there was an entitlement that loomed. The veterans lobby amounted to the AARP of the era. A large number of soldiers had come back from Europe permanently disabled. Their plight led to a push for a pension, known as a bonus, that in total would have cost $4 billion over the long term — the equivalent of a single year's federal budget.

Harding vetoed the generous version of the bonus. Coolidge later did the same to a more modest bill. Congress overrode Coolidge's veto, but the presidential hostility to larger veteran spending intimidated the vets so much that the size of the eventual deal didn't impede the budget balancers that decade.

Army spending had already plummeted to $1.6 billion in 1920 from $9 billion at the end of the war. Under Harding and Coolidge, it sank to $1 billion a year in 1921, and then to $426 million in 1929. The military was thrifty with the cash it did receive. "Veterans Bureau Saves Millions" read a 1925 headline in the Wall Street Journal. Imagine: The Veterans Bureau had returned $66 million of its annual appropriation to federal coffers.

The federal government made cuts of this kind across the board: The number of paid civilian-government employees declined to 579,000 in 1929 from 655,000 in 1920. The post office grew, but the judiciary shrank. By using a new sizing, or treatment, to process paper dollars, government printers were able to make the bills last 20 percent longer.

Such small gestures were buttressed by the dramatic tax cuts of the period: The top marginal income-tax rate declined to 25 percent in 1925 from 77 percent at war's end. All in all, economic growth proved so strong that vets suspended their marches and built new lives.

The 1920s tell us that without a strong platform for growth — reduced spending, sound monetary policy and low taxes — our own rewriting of debt-ceiling rules and tinkering with triggers will also prove mere "pitiful machinery."

(Amity Shlaes, a Bloomberg View columnist and a senior fellow in economy history at the Council on Foreign Relations, oversees the Echoes blog. The opinions expressed are her own.)

© Copyright 2011 Bloomberg

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