Do balanced budgets cause depressions?
If they do, then perhaps they also cause recoveries, because we had a nearly unbroken string of balanced budgets throughout the 19 th century, a period which was punctuated by several severe but short depressions. Of course, association is not causation, except sometimes in the minds of those who want to ignore both theory and evidence when they lead to conclusions that do not support their ideological agendas.
I suspect that ideology concerning the role of government as central planner has more to do with the claim that balanced budgets cause depressions than anything else. Serious economists today, for the most part, no longer accept the discredited Keynesian notion that balanced budgets are harmful and deficits are magically stimulative.
Those who argue that balanced budgets caused the Great Depression (or in any way contributed to it) have two major problems to contend with: theory and empirical evidence.
Take the empirical evidence first. At the start of the decade of the 1920s, the U.S. suffered a serious economic downturn. This came after several years of deficit spending in large measure because of the huge costs of World War I. The federal government's response (during the Harding administration) was to dramatically curtail its own expenditures, slash taxes, reduce its debt, and restore a balanced budget. The downturn not only did not worsen; it completely turned around and by the spring of 1923 we had a labor shortage (See Economics and the Public Welfare by Benjamin M. Anderson, Chapter 53).
I might note also that the decade of the 1930s was accompanied by a string of massive deficits. The economy endured, simultaneously, a 12-year depression.
From the standpoint of economic theory, the notion that balanced budgets cause depressions (and its logical converse, that unbalanced budgets are stimulative) is absurd. It rests on the discredited Keynesian notion that when government has a balanced budget, there is less aggregate spending in the economy. That could only be true if the government took its budget surplus and burned it. But it does not do that; in times of surplus, funds the government doesn't spend sit in banks in the government's accounts, which the banks in turn use (as they would any other deposits) as the foundation for lendingwhich means that somebody else, not the government, borrows and spends the money.
Consider the flip sidethat deficits are somehow stimulative. Example: Government takes in $100 and spends $120. Does that mean that deficit spending has magically "added" an extra stimulus of new aggregate demand to the tune of $20? Where does the government get the extra $20 to spend? If it borrows it (by floating bonds, notes and bills), then the $20 it gets from the buyers of those instruments is exactly $20 that those buyers no longer have. The government's aggregate demand goes up $20, the buyers' aggregate demand goes down $20, the result being merely a redistributive transfer and no net increase in total aggregate demand. Sorry, no stimulus there, unless perhaps you believe that government bureaucracies are more efficient spenders of other people's money that the people who earned it in the first place.
What sometimes seems like a stimulus from deficit spending comes not from the act of government borrowing money from the public and then spending it for them, but rather from the fact that usually, some portion of a deficit is "monetized," meaning that the government's monetary authorities create new money to buy those newly issued government debt instruments. (Of course, you don't need a deficit as an excuse for the monetary authorities to balloon the money supply; they can do that at any time, even with a balanced budget, by employing the various monetary powers they have.)
So we are back to a monetary theory of the business cycle, which we have explained to you before along with the real causes of the Great Depression. To argue that the balanced budgets of the 1920s caused the depression is preposterous Keynesian nonsense, and the fact that the same people who say that usually and conveniently ignore the deficits of the 1930s, the Smoot-Hawley Tariff, the doubling of the income tax in 1932, and a host of other costly interventions, suggests that they may simply be putting a faith in government ahead of serious economic inquiry. This is the difference between religion and science, with in this case state worship being the religion and economics being the science.
Why has there not been a major depression since World War II? Not because of chronic deficits; in fact, we had many surplus budgets in the 1950s; our string of sizable, chronic deficits really began in 1969. We have not had a major depression for several reasons: each time the economy attempted to adjust to the distortions of inflation and monetary manipulations (manifested in recessions), the Federal Reserve re-stimulated things with another round of increases in the money supply and lower interest rates. This on-again, off-again, roller coaster economy parallels our on-again, off-again roller coaster monetary policy. This inflationary stimulus forestalls a deep depression, but at the cost of mini-depressions called recessions, and continuous erosion of the currency's value. Each inflationary stimulus sets us up for the next downturn. The real task of genuine monetary and economic reform is to get the economy off this roller coaster by getting the government's fiscal house in order, cutting burdens on the economy, and putting monetary policy on an even keel.
What was the cause of depressions prior to the Great Depression? Monetary manipulation, every time. Government first inflated, stimulating an unsustainable and artificial boom, and the bust came later as a direct consequence. Our first cyclical depression occurred in 1819, after several years of currency inflation engineered by the Second Bank of the U.S. The next depression came in 1837, after the Second Bank again engineered an inflation (partly to make things appear healthy and get Congress to re-charter the Bank) which was halted when Andrew Jackson killed the bank. The Panic and Depression of 1893 came after several years of monetary inflation and currency mischief on behalf of silver interests, who lobbied Congress successfully for huge silver subsidies, and an outpouring of both silver and paper currency. Other cyclical recessions of the 19 th century had their origins in similar monetary disturbances.