Tuesday, September 07, 2010

The myth of World War Keynesian spending

Paul Krugman has written yet another column berating us for our stubborn refusal to acknowledge that we need to spend more money on stimulus. In his eyes, we should be recreating World War II without that whole war and Holocaust action.
From an economic point of view World War II was, above all, a burst of deficit-financed government spending, on a scale that would never have been approved otherwise. Over the course of the war the federal government borrowed an amount equal to roughly twice the value of G.D.P. in 1940 — the equivalent of roughly $30 trillion today.

Had anyone proposed spending even a fraction that much before the war, people would have said the same things they’re saying today. They would have warned about crushing debt and runaway inflation. They would also have said, rightly, that the Depression was in large part caused by excess debt — and then have declared that it was impossible to fix this problem by issuing even more debt.

But guess what? Deficit spending created an economic boom — and the boom laid the foundation for long-run prosperity. Overall debt in the economy — public plus private — actually fell as a percentage of G.D.P., thanks to economic growth and, yes, some inflation, which reduced the real value of outstanding debts. And after the war, thanks to the improved financial position of the private sector, the economy was able to thrive without continuing deficits.
Now you might think that this guy is a Nobel Prize winner and writes from an elevated perch at the New York Times, he must really know what he's talking about. Au contraire. He really doesn't seem to have a grasp of history. Victor Davis Hanson looks at this argument from a historian's view.
I’m not an economist, but as an historian, I consider this an abject misreading of the postwar period, at least through the early 1950s. The war years were characterized by frenetic hyperactivity: Americans worked long hours, women were brought into the work force, new towns and manufacturing centers sprang up, and people gave up necessities — all on the assurance that this furious pace and consumer scarcity would be short-lived.

As WWII ended and the clean-up began, there was an enormous amount of pent-up global demand for goods. Given the wreckage in Europe, Japan, and Russia and the underdevelopment of India, Asia, and South America, we were about the only ones with the industrial and commercial wherewithal to supply the world rebound — often receiving cheap oil, gas, minerals, and interest in exchange, which supplemented our own vast supplies of comparatively cheap and easily recoverable resources. Nor should we forget the psychological element: Americans, after winning two wars, were enormously confident about their newfound international stature and influence.

At home, four years of consumer deprivation during the war and the weak demography of the 1930s had combined to create huge demand, all while society was increasingly leaving the farm for good and becoming suburbanized. The result was that in the late 1940s and 1950s, the birth rate soared and consumers enthusiastically made first-time purchases of washers, dryers, fridges, cars, etc. Thus, the American economy grew by leaps and bounds.

Today’s situation is not comparable: We are in hock to foreign creditors for trillions and have not been a net creditor since the 1980s. A China, Brazil, South Korea, Taiwan, or India is as or more likely to supply recovering demand for food, steel, or electronics. One can read Krugman-like arguments in Greek newspapers today — that only more massive borrowing can stimulate Greek demand, provide jobs, and grow Greece out of its recession. As if present-day deficits and aggregate debt with soon-to-be-rising interest payments don’t really matter.
Well, yeah. That should be obvious, shouldn't it? But Krugman loves this point. William L. Anderson who writes the Krugman in Wonderland blog echoes Hanson's argument and then points us to this paper by Robert Higgs refuting the common argument that the massive federal spending of World War II was what lifted us out of the Great Depression with the rather basic point that employing people as soldiers fighting a dangerous war is not the optimal way to reverse unemployment. The parallels that Krugman clings to just aren't there. And once we discard that argument, we're left with this question that Peter Robinson asks.
In the four decades since, have there been any instances in which a Keynesian fiscal stimulus has actually worked? In Canada or Sweden? In Belgium or France? For that matter, in Andorra, San Marino, Liechtenstein or Monte Carlo?
Well, has it? Even if there is an example somewhere, has spending for the sake of stimulus worked in American history?


Rick Caird said...

Krugman is a classic liberal. When his prescriptions do not work, he babbles about the idea being correct, but we just didn't do enough of it.

Keynesian economics has never passed beyond a theory. I am glad there are voices point out WWII was not a Keynesian experiment. The post war period was not a response to a Keynesian stimulus. Rather, it was a response to a period of deprivation, an expanded manufacturing capability, and most of all, a pent up demand from returning service men starting families and wanting homes.

Whenever the question is asked of where there is an example of Keynesian stimulus working, there is no answer. Robinson left out the non example of two decades of "stimulus" in Japan.

I keep asking this question: at what point does Princeton realize that having a tenured professor operate as a political hack columnist is bad for their academic reputation.

LarryD said...

Like most self-labeled "Keynesians", Krugman conveniently overlooks that Keynes's prescription included that governments should run a surplus during the boom times, which would pay for the deficit they ran in bust times.

I think the whole notion of trying to do away with the business cycle is misplaced. Accept it as a characteristic of any economy capable of growth, and learn to live with them.

Bubbles occur even in markets with perfect information, what seems to work best in ameliorating them is for many participants to be familiar with bubbles (such as by having been through one before).

The best way to recover from a bubble is to let it work out, those who over-leveraged need to suffer the consequences, to correct their behavior and deter other from making the same mistakes. And everyone needs to fix their balance sheets.

Right now, that's only partially happening, the government is busy trying to pump the housing bubble back up, which never works.