Grand Pursuit

by Sylvia Nasar

  After Dunkirk, in light of the growing likelihood that the United States would be drawn into the war, the Roosevelt administration had become preoccupied with paying for it. The US economy was already being converted to aid for European allies, and a larger bill was coming due for the military buildup that was under way. One unwelcome side effect of shifting the economy to a wartime footing was that inflation had reappeared. Between 1940 and 1941, consumer prices jumped 5 percent, the largest one-year increase since 1920. While hardly scary by present standards, the surge was enough to revive unpleasant memories of post–World War I inflation and cost-of-living protests, along with the severe recession that followed and was seen as a direct consequence.

  During World War I, tax revenues had covered two-thirds of Washington’s costs. The rest was financed by issuing bonds. A reasonable inference would be that the government was borrowing to close the gap between revenues and spending—reasonable, but wrong. Most of the “borrowing” was a disguised form of printing more money. The newly created Federal Reserve had urged its member commercial banks to lend their customers money with which to buy war bonds. To increase their reserves commensurately, the banks, in turn, had borrowed from the central bank

  by discounting the loans at the Federal Reserve—i.e. borrowing from the Federal Reserve on the security of loans for which government bonds served as collateral. As a result, while . . . currency and deposits at the Federal Reserve . . . increased by $2.5 billion . . . only about a tenth of that represented direct purchases of government securities; the remainder consisted of credit extended to member banks.38

  The result of the massive expansion of the money supply was a surge of inflation. For farmers, miners, and real estate developers inflation had meant a giddy extension of the wartime boom. But when the Federal Reserve jacked up interest rates, wholesale prices plunged by 44 percent and the boom turned into a nasty slump. The political fallout swept Republican Warren Harding, who campaigned on the slogan “A Return to Normalcy,” into the White House. For the officials at the Democratic Treasury, how to avoid a repetition of this disaster was Topic A after World War II.

  By the time the Friedmans moved into their apartment near Dupont Circle, a short walk from the Treasury building, the Treasury secretary’s bulldog assistant, Harry Dexter White, was growling that things weren’t going very well. “It’s getting away from you,” he hissed at Galbraith after one meeting about the inflation problem. “You must get moving.”39 The secretary had already ordered the Tax Division to prepare a restructuring of the federal tax system. Virtually all of the debate in Washington about fighting inflation concerned the relative effectiveness of wage and price controls versus taxation. Ultimately, the Roosevelt administration embraced both.

  Selective price controls to avert “price-spiraling, rising costs of living, profiteering and inflation” had already been in effect since April 1941, and the OPA had been created to administer them.40 After Bernard Baruch told a Congressional committee, “I do not believe in piecemeal price fixing. I think you have first to put a ceiling over the whole price structure, including wages, rents and farm prices . . . and then adjust separate price schedules upward or downward, if necessary,”41 the Office of Price Administration was granted sweeping powers to set prices and wages in most industries.

  The Treasury and the OPA had initially been at odds over the tax estimates, since one of Baruch’s arguments for more authority over business was that granting it would reduce the need for tax hikes. But once the General Maximum Price Regulation was enacted in 1942, the two agencies were able to agree on taxes. Friedman’s first major assignment was to estimate how much taxes had to be raised to contain inflation.

  On May 7, 1942, during his first appearance before a congressional committee, Friedman proposed $8.7 billion of additional taxes as “the smallest amount that is at all consistent with successful prevention of inflation.”42 Following Keynes’s reasoning in defense of the 1940 Keynes Plan, Friedman pointed out that with government demand and household income soaring, it was essential to restrict consumer spending to prevent a situation in which more money was chasing a fixed output of consumer goods. As Friedman told the committee a trifle pompously, “Taxation is the most important of those measures; unless it is used quickly and severely, the other measures alone will be unable to prevent inflation.” Among those other, less potent measures, Friedman listed “price control and rationing, control of consumers’ credit, reduction in governmental spending, and war bond campaigns.”43 Nowhere did Friedman mention monetary policy. Looking back on his wartime work in 1953, Friedman attributed the oversight to “the Keynesian temper of the times,”44 but Friedman numbered among Keynes’s American disciples and would do so until the late 1940s.

  True to his Keynesian convictions, Friedman was inclined to view the income tax as “more effective in preventing an inflationary price rise and . . . a better distribution of the cost of the war” than a sales tax, which of course was regressive.45 That summer, he helped develop a proposal for a consumption tax, largely as a measure to avoid raising income tax rates. White, who was very taken with the idea of taxing spending instead of income, proposed combining the consumption tax with Keynes’s suggestion for compulsory savings accounts that couldn’t be tapped until after the war. After a stormy Treasury meeting that ended with a vote of sixteen to one against the plan, Morgenthau decided to back White and took the proposal to Congress anyway. It was dead on arrival. This contretemps was Friedman’s first exposure to the challenges of getting legislation enacted, writing speeches for his superiors, and, eventually, trooping up to Capitol Hill to testify before congressional committees.

  Without a doubt, the key to any tax plan was tax collection. This is where Friedman placed his stamp on government forever. Before 1942, income taxes were due on the previous year’s income in four quarterly installments. It was the taxpayer’s responsibility to come up with the money when it was due. That posed no problems, either to taxpayers or to the tax collectors, as long as tax rates were low and only a small fraction of the population paid them. In 1939, fewer than 4 million returns were filed, and the total collected was less than $1 billion, roughly 4 percent of taxable income. The Friedmans’ income placed them among the top 2 percent of American households, but their tax bill was just $119, less than 2 percent of their taxable income. They had no trouble paying the whole amount on March 15, the deadline for filing federal taxes before 1955. Under the planned overhaul, their tax bill would be something like $1,704, or 23 percent of their taxable income. It was obvious that if the Treasury wanted to collect more taxes, it would have to find a way to collect the income at the time it was earned, not a year later.

  The solution was tax withholding at the source. The Treasury collected taxes from employers when they paid their workers’ wages. Recipients of other kinds of income—interest, dividends, money earned by the self-employed—were required to pay taxes quarterly on income earned that year based on advance estimates of liability by the recipient. A major departure from German and British practice, which had relied on collecting taxes at the source for years, was that payments would be treated as tentative and subject to adjustment later. The only serious opposition came from the IRS, which envisioned “an almost insuperable burden” for tax collectors, opposition overcome by having IRS officials visit businesses to study payroll practices so that the mechanics of withholding could be designed with those practices in mind.46

  Friedman was back on Capitol Hill. This time he got a lesson in getting to the point and keeping things simple. When he started to answer a question by Texas senator Tom Connally, he cleared his throat and said, “There are three reasons. First . . .” Connally cut him off. “Young man, one good reason is enough,” said the senator, who was wearing his trademark flowing black neckpiece in place of the usual bow tie.47 The Treasury secretary, a man of “meager intellectual capacity” in Friedman’s opinion, always insisted that his aides explain problems in terms that a high s
chool student like “my daughter Joan” could grasp—even after Joan went off to college.48

  In his weekly dispatch from the British Embassy, Isaiah Berlin, the historian of ideas, called it “a tax bill of unprecedented dimensions” and reported that the new law was expected to raise $7.6 billion.49 On the twenty-second of August, he wrote excitedly that “the tax bill will affect more citizens than any ever passed by Congress.”50 For the first time, the United States had a broad-based income tax. A family of four with an income of $3,000 owed no tax in 1939 but owed $275 in 1944; a $5,000 family’s taxes went from $48 to $755; a $10,000 family’s from $343 to $2,245. Income taxes collected in 1939 equaled little more than 1 percent of personal income; by 1945, the figure had jumped to just over 11 percent. Morgenthau sent the withholding proposal to Congress in early 1942, and the Current Tax Payment Act of 1943 was introduced in the Senate on March 3, 1942.

  The most enduring effect of Friedman’s wartime efforts was to create “an enormously powerful revenue-raising machine.”51 That machine was so powerful, Herbert Stein pointed out, that revenues would rise faster than GDP for decades after the war because of the interaction between economic growth and progressive tax rates. As incomes rose, more and more taxpayers would be pushed into the higher tax brackets. That dynamic ensured that postwar administrations could keep raising spending while cutting tax rates occasionally without running huge deficits. What’s more, withholding rendered taxation far less painful.

  It was now possible to manipulate taxes to stabilize the economy. Before the war, Stein observed, taxes were too small a share of national income to leave much scope for stimulating or restraining the economy. More important, large swings in tax collections became automatic. When the economy slumped, tax revenues fell; when it rebounded, the opposite happened. Thus Keynesian stimulus became automatic in recessions, Keynesian restraint in booms. The irony was that Friedman, the future patron saint of low taxes and small government in the Reagan years, made it possible.

  Chapter XIII

  Exile: Schumpeter and Hayek in World War II

  While history runs its course it is not history to us. It leads us into an unknown land and but rarely can we get a glimpse of what lies ahead.

  —Friedrich Hayek, The Road to Serfdom, 19441

  For Keynes and many of his disciples who were called to serve their countries, the war was a time of intense engagement, extraordinary intellectual challenge, and unprecedented influence. For Schumpeter and Hayek, the Second World War was a time of enforced inactivity, isolation, and exile. They were out of favor intellectually. As émigrés, they were not asked to join the war effort. They were left behind in shells of universities populated by the old, disabled, alien, and female. They could not rejoice in the inevitable Allied victory without also mourning the suffering and devastation on the enemy’s side.

  As eyewitnesses to—and victims of—the collapse of the Austro-Hungarian Empire after World War I, they could imagine possibilities that those who had come of age in the United States or Britain did not and could not. Keynes was not only determined that the Allies would not make the same mistakes after the war as in 1919 but also confident that his voice would be heard and his viewpoint would prevail. Fifty-six when Britain declared war on the Axis, he was in a position to influence governments and public opinion in ways that he could not at thirty-six. He was the leader of a revolution in economic thought with many adherents, Churchill’s de facto Chancellor of the Exchequer, the chief British financial negotiator in Washington, and one of the architects of the postwar monetary system.

  Schumpeter was haunted by a sense of personal failure, depressed by the catastrophe engulfing Europe and Japan, and alienated by prowar fervor. He grew increasingly isolated from his colleagues and students at Harvard. He did not bother to hide his bitterness over the fact that Americans condemned Germany and Japan categorically while embracing the Soviet Union as an ally. As a result, he attracted the attention of the FBI, which investigated him for more than two years.

  For Schumpeter, the political triumph of left- and right-wing Socialist parties in Europe after World War I had proved that economic success alone was no guarantee of a society’s survival. Capitalism and democracy were an unstable mixture he believed. Successful businessmen would conspire with politicians to bar the entry of new rivals, government bureaucrats would stifle innovation with taxes and regulation, and hostile intellectuals would attack capitalism’s moral flaws while singing the praises of totalitarian regimes and even, on occasion, secretly or openly providing aid and comfort to the West’s sworn enemies. His fear that bourgeois society was spawning its own gravediggers, as Marx had predicted, had hardened into certainty.

  Instead of joining the war effort like other Austrian expatriates in the United States, the fifty-six-year-old Schumpeter poured his premonitions into the book that most shows him as the ultimate ironist that he was. Published in 1942, when faith in free enterprise was dwindling in the West, Capitalism, Socialism and Democracy was an encomium disguised as a funeral oration that challenged Keynes’s conclusion that capitalism was innately failure-prone. Whatever its shortcomings—financial crises, depressions, social strife—it was in capitalism’s nature to deliver the goods to that “nine parts of mankind” who had been enslaved and impoverished throughout human history. “The capitalist engine is first and last an engine of mass production,” Schumpeter asserted confidently at a time when American GDP had barely recovered from the Great Depression.2 Thanks to that engine, he wrote in an oft-quoted passage, modern working girls could afford stockings that were once too costly for any women, even queens a century earlier. If the United States economy were to grow as fast in the half century after 1928 as in the half century before, he observed in what turned out to be a gross underestimate, the US economy would be 2.7 times bigger in 1978 than in 1928. He wasn’t predicting that outcome—the opposite, as it turns out—only impressing his readers with the power of the “ingenious mechanism.”

  Having argued that competition was an ingenious social contrivance for harnessing creative genius and raising living standards, Schumpeter promptly prophesied the system’s demise. To his own rhetorical question “Can capitalism survive?” he replied, “No. I don’t think it can.”3 The entrepreneur, the creative force in capitalism’s success, was under attack, as was the ideology of economic liberalism, not only in the Soviet Union but in the West. As one reviewer commented, he “predicted the triumph of socialism but proceeded to deliver one of the most passionate defenses of capitalism as an economic system ever written.”4

  Doubtless, the feeling that opportunities for extraordinary individuals were shrinking reflected Schumpeter’s middle age and depressive tendencies. He was haunted by thoughts of death and fears that he had become little more than an anachronism himself. At Harvard, his ideas were increasingly regarded as quaint, just like his courtly manner and flowery speech. “A new economics” was needed, he wrote in his diary, but he did not feel up to creating it. In a statement of unconscious irony, he added, “I do not carry weight.”5

  • • •

  When Friedrich von Hayek and his family had moved to London in the fall of 1931, he had expected to return to Vienna. Within two years, he recognized that his exile would likely be permanent. For several years, Hayek found himself at the head of the liberal economic camp in his adopted country. By the time he became a British subject in 1938, however, his disciples had deserted him. As John Hicks, a prominent Keynesian, recalled in 1967, “It is hardly remembered that there was a time when the new theories of Hayek were the principal rival of the new theories of Keynes.”6

  Hayek’s sense of intellectual isolation was compounded by the gloomy developments in Austria. Well before Hitler marched into Vienna and declared Anschluss in 1938, Hayek’s old associates—including Ludwig von Mises, who had been fired from a university post—had begun to drift abroad to escape growing anti-Semitism. In 1935, he wrote to Fritz Machlup, a Jewish member of his old Geist-K
reis seminar, who had informed him of his decision to stay in America permanently. As a Jew, Machlup had had little choice. Hayek agreed, but added that “the mass emigration of intellectuals from Vienna and especially the demise of our school of economic thought pains me deeply.”7 And the following year: “The speed of the intellectual surrender and the corruption of politics (to say nothing of finances) is shattering.”8

  Days after Hitler’s troops marched into Vienna to cheering crowds, Hayek was making the rounds of his former Geist-Kreis friends, who told him horror stories about Gestapo arrests, firings, and harassments. That year he applied for and got British citizenship. He attacked the Nazi regime in print and condemned anti-Semitism. He became involved in efforts to help Jewish colleagues on the Continent to emigrate.

  Hayek’s unhappy marriage compounded his misery. He had been pressing his wife for a divorce that she refused. What’s more, he had never stopped loving Helene. He had seen her in August 1939, just before the news of the Stalin-Hitler pact signaled the inevitability of war and the impossibility of meeting again until it was over.

  By the time war finally came, Hayek’s isolation had turned into virtual seclusion. Barely forty, a full decade younger than Keynes, he felt old. He had, among other things, completely lost his hearing in one ear. His deafness epitomized how cut off he had become both from his old world and his adopted one. He had stayed in London during the first six weeks of the blitz to show his loyalty to Britain and his indifference to danger, but eventually he was forced to follow the LSE—shrunken now to a few dozen female students and himself—to Cambridge, where the school remained for the duration of the war. His wife and children went to stay in the country, his old ally Lionel Robbins went to Whitehall, and one by one his other colleagues disappeared to do war work.