The Depression that Wasn't

The only reason why anyone should expect a reduction in government spending to drop us back into a recession would be if you thought that there wasn’t private demand to replace it. It seems eminently obvious that there was private demand to replace it, so what’s the big deal? I don’t see why non-Keynesians always consider this such an amazing point to make. You had years of rationing of consumer demand and low unemployment.

I’ve never heard any Keynesian suggest that the economy is always dependent on government spending for growth. In certain circumstances, they say it is. But not in all circumstances. I’ve heard a lot of non-Keynesians attribute that to Keynesians, but no Keynesians.

@Tracy
The drop in government spending in 1946 has got to be proportionally the biggest in the history of any economy, bigger than the 1980s liberalizations. Anyway those are great examples, I always think free marketers in the U.S. cite Reagan too much and forget Thatcher and the Aussie and NZ reforms.

@Daniel
If I understand the generic New Keynesian model right such a spending drop would cause a short run recession. The “Vulgar Keynesian” story of the 1940s says that we should slip right back into the depression.

If I understand the generic New Keynesian model right such a spending drop would cause a short run recession. The “Vulgar Keynesian” story of the 1940s says that we should slip right back into the depression.

Well I suggest reviewing the two charts on http://en.wikipedia.org/wiki/Great_Depression_in_the_United_States.

There was a recession in the late 40’s where the US retreated from the $2T GDP mark (in 2006 dollars) seen at the peak of the war and didn’t recover to that point until 1950 (at which point war spending was ramping up again due to Korea and the Cold War). Likewise unemployment became very low at the peak of the war and did shoot up again spiking over 5% right before 1950.

Granted this is nowhere near the Great Depression but as I pointed out elsewhere it’s not exactly like the New Deal was repealed on VJ Day. Also Keynes never argued that recessions were caused by pull backs in gov’t spending, although pullbacks could make an existing recession worse.

We spent $25+ billion in aid and the Marshall plan that bolstered demand for U.S. goods in war-torn countries. That’s still seems rather Keynesian to me. Instead of spending to increase domestic consumption, increase foreign consumption. When you’re the only industrialized economy still left standing, you can sit back and watch the profits roll in.

“Tell me, how were FDR’s advisers warning him about another depression when he was dead?”

Hmmm Spencer,

I never realized that it was impossible to talk about what would happen after the war ended prior to the war ending.

Thanks for “enlightening” us.

And look at how silly the WSJ piece is when it tries to explain the lack of a major recession at the end of WWII. It asserts the massive employment during WWII serving in the armed forces and producing arms was ‘unsustainable’. OK so there should have been a massive recession, why wasn’t there. Ohhh because Keynesian ideas were rejected! What do you mean? Well instead of adopting FDR’s massive housing program, a more modest one was adopted! ‘Supply side’ tax cuts were passed.

What ‘supply side’ cuts were those? Hold on to your seats, the top marginal rate under that evil FDR was 94%! Can you believe it! Thankfully the Congress, rejecting evil FDR’s massively high rate, slashed to top marginal rate. Get ready, what did they slash it to! Hang on……

Ohhhh hang on this is good…..

Can you bear it?…..

86.45%

Wow.

Danial Keuhn,

“The only reason why anyone should expect a reduction in government spending to drop us back into a recession would be if you thought that there wasn’t private demand to replace it. It seems eminently obvious that there was private demand to replace it, so what’s the big deal? I don’t see why non-Keynesians always consider this such an amazing point to make. You had years of rationing of consumer demand and low unemployment.”

There are three major problems.

The first is that the Keynesian predicts a certain order of operations. The argument for ‘stimulus’ is based upon the idea that the government spending will keep AD high enough UNTIL consumer spending returns at which point. The lack of wages drives a downward spiral- holding those wages up is ‘necessary’ to prevent the spiral. If real (the key word) wages were high during WW2 why wasn’t there growth in the consumer industry then?

Number two is that wages are (among) the most sticky prices. If everyone was earning bank during WW2 their wage demands in a post WW2 world should be to high to clear the market which causes high UE- and the whole downward spiral/pressure on prices things.

Third is the uncomfortable notion that Keynsians claim WW2 ended the depression and there was real economic growth during that period- but it somehow occurred without satisfying consumer wants (see Boonton’s father in law). This contradicts the idea that there really was recovery during WW2.

Third is the uncomfortable notion that Keynsians claim WW2 ended the depression and there was real economic growth during that period- but it somehow occurred without satisfying consumer wants (see Boonton’s father in law). This contradicts the idea that there really was recovery during WW2.

Again remember Keynes’s quip about burying money in caves? What do we have, massive employment in WWII and massive money creation but rationing and price controls and ‘forced savings’ pushes (‘Buy War Bonds for our boys!’, ‘when you ride alone in your car Hitler is in your passenger seat!’). The war ended and income fell as war industries retooled and GI’s returned home but spending was replaced by bringing out all that unspent money.

Let’s look at the war another way. During the war ‘Sally the rivet girl’ took a job making $1,000 a month. But due to all the restrictions she could only really spend $500 a month. The recovery was real. Sally wanted to be able to spend $500 a month and accepted a job that allowed her too. If she wasn’t she wouldn’t have taken it, she would have demanded more, say $1200 a month if she wanted to spend $600!

Now imagine a slightly alternate universe where the gov’t isn’t so nice. In this Slightly-Stalinish-FDR pushes Sally to work for $500. There are no rations and no ‘buy war bond’ rallies but since she only makes $500 she spends all her income. After the war massive unemployment should result but FDR turns on the printing presses and has his secret police bury some $500 bills in Sally’s basement. After a brief period of financial panic, Sally finds the money and spends it as she looks for new work. That’s a perfectly Keynesian story and it fits the facts (minor post-war recession)

As you can see this is two sides of the same coin. The gov’t could have paid everyone less but reassured them that they would keep the economy humming post war. Or, what really happened, was the gov’t created the post-war stimulus during the war and entrusted it to the people via all the consumption restrictions. When the war ended all the spending happened by individuals bringing out their stashes of ‘stimulus’. Call it a Keynesian militia if you wish 😉

I asked this question in undergraduate Macro (at Duke University) and was told it was the wealth effect. People had forced savings from rationing and forcing their income into savings bonds during the war and there was “pent up” demand waiting when the war ended. [are the magnitudes big enough to account for this????? I’m not so sure]

It’s actually really easy to explain from a Keynesian — or actually freshman textbook economics — perspective. Boonton and AJ already did so.

People spending their savings in massive quantities. (End of rationing and uncertainty.)

Sparing you a thousand words:

http://www.asymptosis.com/wp-content/uploads/2010/04/savings-2.png

“It’s actually really easy to explain from a Keynesian — or actually freshman textbook economics — perspective. Boonton and AJ already did so.

People spending their savings in massive quantities. (End of rationing and uncertainty.)”

This is not a Keynesian explanation- it is no different from the Austrian explanation.

Historically savings rises during a recession/depression. Keynes contended that the increase in savings lowered AD leading to a downward spiral in prices/wages/spending. If increases in savings works as you describe above then recessions/depressions will end themselves via the increase in savings/pent up demand process.

I think what you’re missing here is the savings in WWII was forced. Sally the Rivet Girl wanted to spend more like $900 a month but was ‘forced’ to save only $500. (Don’t confuse this with Sally’s decision to take work if it provides her with at least $500 of consumption per month, that is the point where she is willing to trade off not doing a job with doing a job) The rise in savings rates during recessions is a different animal, caused by uncertainty and fear. During the war, though, unemployment was almost nothing. Whether or not the jobs were sponsored by the gov’t doesn’t really matter to Sally. She can pay her rent each month with her pay she receives.

[Speaking of which, my mother-in-law had a story which may illustrate such a time. She once held 30 jobs in 30 days. Each day going to a new diner or factory and working a different job. That was long after WWII ended but I suspect that was what it was like working in an environment of next to no unemployment]

You’re right that recessions could be self correcting if gov’t could ‘bottle the stimulus’ during booms into private hands. WWII was an exceptional moment because the war provided both gov’t controls to ration consumption as well as the peer pressure to reinforce it. A similiar time might have been the Civil War in the South, but there since the Confederacy lost the war there was massive economic destruction…..and also a generation that stuffed their worthless Confederate dollars in the attic rather than spending them in the post war years.

The US didn’t loose the war, US Dollars didn’t become worthless as the currency was replaced by Japanese Yen or German Nazi Marks. The positive ‘animal spirits’ of the 1945-1950 era were probably an amazing thing to witness and live through. It’s quite believable IMO that could have swamped a natural tendancy towards sinking back into Depression resulting in only a minor ‘recalculation recession’.

Keynes was very aware that psychology was highly unpredictable….and its fair to point out that the more scientific orientated Keynesians often forget this important point. If the US didn’t have a world with Nazi Germany and Japan to contend with, a massive infrastructure program probably could have done the same good in getting us out of Depression BUT providing us with useful capital goods and avoiding the cost of hundreds of thousands of young men. While growth was rapid post WWII, the fact is we probably could have had 1970 in 1955 if the rest of the world had been a little more civilized. But again a ‘Rebuild America’ campaign in place of WWII could very well have lacked the sense of psychological victory that recentered the American economy in the post-war years. [Although this is something I wonder about, if WWII hadn’t happened how long would major things like the space program, atomic energy, large commercial airflight, computers have taken? What contributions would those millions of victims had made to offset that?]

Yet another major problem for Keynesians. Remember that that one of the main arguments against G spending is “crowding out” of private investment. Keynesians argue that this doesn’t happen due to the “multiplier” effect whereby $1 in spending leads to > $1 in economic activity. If the government is stimulating in a Keynesian way then there should be possible for growth in both government AND private spending to occur (near) simultaneously.

I think you’re a bit off here. G only crowds out private investment in a full employment economy. In an economy below full employment G soaks up otherwise unemployed recourses. The multplier being >1 happens in an economy below full employment, as the economy reaches full capacity the multiplier falls until it becomes 0 at which point G becomes purely inflationary. That has historically been a chronic problem for economies in ‘full war mode’ whether you’re talking about WWI, II, the Civil War or numerous other ones. The US in WWII had a relatively good inflation experience because the US had a huge productive capacity to produce both war and consumer goods (plus a lot of it unemployed) AND a major effort was made to limit consumer consumption. The ‘price’ that consumers like Sally extracted for this was the ‘right’ to consume beyond their means after the war when they could start cashing in their savings, war bonds etc. and hit the ‘mall’ without worrying about the ration book.

Top marginal rates are a terrible analysis tool.

True but the WSJ analysis is, I think you have to admit, absurd. Tax cuts are stimulative from a Keynesian POV. OK cutting spending is a favorite policy of Austrians but let’s get real. Post-WWII America was one where Keynesism was vindicated, not rejected! OK Congress didn’t follow the prescriptions of economists to the letter and there was some cutting back but there was no return to ‘normalcy’ meaning the pre-Great Depression paradign. The New Deal was left mostly in place. Unionization was moderately challenged in the 50’s but certainly not rolled back. Spending on the military was cut briefly but social spending was expanded (again not as much as FDR advocated). The Austrians have a post-war period that is a closer fit to their policy recommendations, that is the post-WWI recession but that track record is nowhere near as good as the post-WWII record!

Briefly- the Austrian position is one that basically states that the US was in either a depression or very anemic growth during WW2

Yet we see decreased GDP and increased unemployment following WWII. Likewise we see lower GDP and higher unemployment before WWII. WWII did not solve unemployment by drafting everyone. Unemployment is measured by those looking for work as a percentage of the labor force. Drafted soldiers may remove some unemployed but it also removes them from the labor force. There’s no reason that those left behind wouldn’t continue to experience unemployment in the home economy. Yet they didn’t. They not only were able to consume with the earnings they made during the war (see again Sally the Riverter example) but able to consume the savings they were forced to make after the war.

The argument that this wasn’t all real because it was about producing gov’t war goods rather than consumer goods strikes me as very unsientific….almost akin to the Marxist claims that capitalist economies were really poorer because the consumption taking place isn’t what people really want to do but what capitalists are fooling them into doing! Are you telling me after Pearl Harbor Americans didn’t want bombs dropping on Japan but instead wanted rock’n’roll records produced? For a school that says it thinks a lot about social institutions this is a very odd way to look at the gov’t, like some alien entity that landed on our backs from Mars! The gov’t is an organic entity that is, essentially, all of us.

To claim that the production of war goods in WWII wasn’t really production because the orders were being placed by the Department of War rather than Wal-Mart’s purchasing department is absurd IMO. Likewise the residents of Dresden and Hiroshima didn’t meet illusionary bubbles during the war.

“There’s no reason that those left behind wouldn’t continue to experience unemployment in the home economy.”

Yes there is. Jobs (in the post industrial world) require capital investment, because the capital investment still exists after Johnny America leaves his job to enlist/get drafted into the military there is EVERY reason (ie the profit motive) for that employer to attempt to hire someone to take his place.

“The argument that this wasn’t all real because it was about producing gov’t war goods rather than consumer goods strikes me as very unsientific….”

Lets say you spend $100 on groceries a week. One week you are to ill to shop and you call up your local government agency who agrees to purchase your groceries for you and drop them off at your house. If you do not provide the agency with a list of brands you like, prices you are willing to buy goods at, dietary preferences/restrictions- do you expect to gain the same utility out of a random strangers decisions for your $100 as you would on your own weekly trip to store?

You claim it is unscientific to count gov spent dollars differently from consumer dollars- but it is the opposite that is true. The concept of aggregating GDP for the purposes of understanding growth is based on the idea that consumers face opportunity costs with their decisions and that the expected utility of spending is > than the amount spent. Consumer dollars are inherently different from government dollars because consumer dollars are spent by individuals who reap the vast majority of the rewards/benefits of their purchases. Treating two unlike things as the same is unscientific.

Now return to the grocery analogy above- instead of you being sick and needing someone to shop from you your friendly government agency calls you up and simply tells you that they are going to do all your shopping for you and count that $100 toward GDP in exactly the same way- how is your dissatisfaction in your new food selection captured in GDP?

“almost akin to the Marxist claims that capitalist economies were really poorer because the consumption taking place isn’t what people really want to do but what capitalists are fooling them into doing!”

Marx was wrong because he assumed that his own ideas/preferences were better/more valuable than individual choices. Government spending is much more akin to Marx telling people what they should or shouldn’t do with their money than it is to free market enterprise.

“Are you telling me after Pearl Harbor Americans didn’t want bombs dropping on Japan but instead wanted rock’n’roll records produced?”

You don’t understand the purpose behind calculating GDP. When the government buys a bomb that costs $1,000 they say “this adds $1,000 to gdp because that is how much it costs”- when a consumer buys 200 records for $5 each the consumer is saying “I would prefer to have these 200 records than the $1,000 dollars.”

“To claim that the production of war goods in WWII wasn’t really production because the orders were being placed by the Department of War rather than Wal-Mart’s purchasing department is absurd IMO. Likewise the residents of Dresden and Hiroshima didn’t meet illusionary bubbles during the war.”

No one says the bombs are illusory, only that the prices are.

Next time you think about this argument consider what the Soviet Union did to achieve “growth”. They ordered X tons of nails produced and slapped a value of $y per ton on the nail. The next year they ordered 1.1*X number of tons produced, slapped price Y on it and claimed a 10% growth in the number of nails. The tonnage of nails may well have gone up by 10%- but frequently the nails simply sat in a yard somewhere and rusted because there was little to no use for them. The nails were real but their production did not equal the prices slapped on them by the government.

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Well except it doesn’t ‘go completely against Keynesian economic theory’. If you had to boil Keynes down to one word is isn’t government but spending. If spending is high enough, the economy is good. If not its bad.

You can have a sector of the economy suddenly cut its spending and nothing too bad will happen provided other sector(s) increase spending. The fact seems very clear that gov’t cuts in spending were being offset by dramatic increases in consumer spending. The Austrian argument seems to be this happened because Americans spent WWII fuming at FDR as they read their Hayek and when theh old man was finally dead they wanted to party in order to prove Keynes was wrong. The Keynesian argument is that the gov’t spent WWII having people build up cash but not letting them spend it. When the war ended not only were the living happy to be alive but the US was the winner! And to boot with a brand new superweapon that no one else had, we were the champions!! Why not start enjoying life again?

Weren’t Keynesians worried about the Depression returning after the war ended?

Sure and it was a reasonable fear. Yes people had cash and they were being held back from spending it but how do you measure how much people want to spend their piggy bank funds?

Try to imagine an alternative world. Say the atomic bomb was never invented and say Stalin did a two face suddenly leaping to Japan’s side after Hitler was dead. In that world the policy of demanding ‘uncontitional surrender’ suddenly starts costing the US even more lives and after two horrible D-Day like attempts at invading Japan fail with 75,000 dead Americans each a negotiated end of the war is done. To make it even more gloomy, pretend that Stalin perfects the atomic bomb first, demonstrates it in Europe and announces that he will use it to help Japan if the US tries another invasion.

With the war ending in this gloomy way, the prospect of going immediately into the Cold War with the USSR and while not technically losing not being a great winner. IN this gloomy end to WWII would people be eager to spend up their funds? Maybe not, maybe there would have been a return to the Depression as gov’t cut back and individuals hoarded their savings for fear of more bad news…