When the U.S. Really Did Try Austerity, it Worked!

Now, we all all know “austerity” from deep spending cuts (not the tax hikes, of course) is killing Europe’s economy and would do the same here in America, right?

Well, here’s a story about austerity that critics such as President Obama, Paul Krugman, and Ezra Klein never seem to mention: From 1944 to 1948, Uncle Sam cut spending by a whopping 75% as World War II came to end. Spending as a share of GDP plunged to 9% in 1948 from 44% in 1944.

Superstar economist and devout Keynesian Paul Samuelson—later to become the first American to win the Nobel Prize in economics—predicted such shock austerity would cause “the greatest period of unemployment and industrial dislocation which any economy has ever faced.” That dire, disastrous prediction was widely held by his fellow Keynesians, with one even predicting an “epidemic of violence.”

Except the doomsayers were wrong, even though Washington obviously ignored Samuelson’s call for gradual spending reductions. Despite cuts which dwarfed those seen in the EU today—not to mention those Republicans are calling for here at home—the U.S. economy thrived. There was no mass unemployment despite rapid demobilization of the armed forces. As George Mason University economist David Henderson explains is his 2010 paper, “The U.S. Postwar Miracle” (which this entire post draws upon):

As demobilization proceeded rapidly, employers in the private sector, full of the optimism … scooped up millions of the soldiers, sailors, and others who had been displaced from the armed forces and from military industries. … The number of unemployed people did increase, rising from 0.8 million to 2.3 million, but with a civilian labor force of 60.1 million, the 2.3 million unemployed people implied an unemployment rate of only 3.8 percent. As President Truman said, “This is probably close to the minimum unavoidable in a free economy of great mobility such as ours.

Of course, liberals are quick to point out the U.S. economy suffered its worst one-year downturn in history in 1946, a drop of 12%. To many Americans, it surely must have seemed like Samuelson was right, that the Great Depression had returned. But no one thought that back then, especially with jobs plentiful unlike during the 1930s. The drop in output was a statistical quirk caused by the removal of price controls. As Henderson explains:

For example, imagine that the free-market price of a pound of filet mignon during the war would have been $1.40 a pound. But imagine further that the government had set the price at $1.00 a pound. Then, when the price control was removed, the price would have shot to $1.40 a pound. Inflation statistics would have recorded some amount of inflation due to this large price increase. But those statistics would have overstated the real price increase because getting beef at $1.40 a pound is better for many of the people who couldn’t, because of the shortage, get it at $1.00 a pound.

Second, those sky-high output figures during the war measured government spending on goods and services, lots of it military hardware, at their cost. But what was all that stuff really worth, in purely economic terms, vs. post-war consumer purchases of homes and cars and nylon stockings? While total output fell by 12% in 1946, private-sector GDP rose by nearly 30%.

Or look at it this this way: Real U.S. output in 1947 was 17% higher than in 1941 despite the decline in government spending. Why was the economy prospering in way it never did during the Great Depression? Taxes were cut a little, and government interference—including price and production controls and rationing—was reduced a lot. But perhaps just as important, Truman dumped many of FDR’s most radical New Dealers. That change boosted business confidence, and companies started to invest again in America.

The typical Keynesian response mostly centers around dismissing the immediate post-war boom as a one-off event complicated by many unique factors. But it happened again, as Henderson notes! After the Cold War ended, overall federal spending fell to 18% of GDP in 2000 from 22% in 1991. But again the economy boomed. Real U.S. GDP grew by 40% with an average annual growth rate of 3.8%. Henderson speculates that perhaps the decline in defense spending freed up knowledge workers to help make technological miracles happen in the private economy.

The lesson here: Spending cuts might well produce prosperity instead of austerity, especially if accompanied by less government interference in the economy and less fear in the private sector of anti-market government policies.

  1. Todd

    Great. GDP seems to be a terrible measure of prosperity when you have widespread price controls and rationing as we did in WWII. 

    Also of interest is the period in the early 1920′s when Federal spending plummeted after WWI. 

    [Quick note:  Maybe I am wrong, but I don't think David Henderson is a faculty member at George Mason.]

  2. Southern Pessimist

    When I entered the workforce in the early 70′s, I was worried that a perfect economic storm was brewing. Hundreds of thousands of soldiers were returning from Vietnam and millions of women were entering a workforce that had never accomodated women quite so well. I was sure that there would never be enough jobs for all of us. I don’t know what prevented that doomsday scenario, but it wasn’t Keynesian economic policy. Government spending represents money that everyone would spend on real stuff if the government would let us do it.

  3. Fake John Galt

    Econstories hits on this with their “Fight of the Century” video

    http://econstories.tv/2011/04/28/fight-of-the-century-music-video/

  4. James Pethokoukis
    C

    Also, if you read the study I mention, it addresses many of the obvious criticisms such as “there was all that pent up demand!” and such

  5. Jager

    There was was actually a depression in 1920 that was worse then our current recession. Pres. Harding cut taxes, cut Federal spending almost in half and reduced the national debt by something like 30%.

    This did not cause disaster but the roaring 20′s where the economy boomed.

  6. Todd
    James Pethokoukis: Also, if you read the study I mention, it addresses many of the obvious criticisms such as “there was all that pent up demand!” and such · 1 hour ago

    Pent up demand.  I love that argument. Even Great Depression scholar David Kennedy falls for that:

    World War II fuels the phenomenal economic growth of the quarter century after 1945 in all kinds of ways. It creates a big pent-up consumer demand, which is explosively powerful after 1945, and people are seeking to buy products that weren’t available in wartime, and they’ve got all these fat paychecks from the war era that they weren’t able to spend then, that they spend after the war.

    By that rationale, the way to generate economic growth is to just make it illegal for people to purchase goods and services that they want, and then all of a sudden remove those restrictions. That is even more incoherent than the Keynes story. 

  7. James Pethokoukis
    C

    Less is more!

    Todd

    James Pethokoukis: Also, if you read the study I mention, it addresses many of the obvious criticisms such as “there was all that pent up demand!” and such · 1 hour ago

    Pent up demand.  I love that argument. Even Great Depression scholar David Kennedy falls for that:

    World War II fuels the phenomenal economic growth of the quarter century after 1945 in all kinds of ways. It creates a big pent-up consumer demand, which is explosively powerful after 1945, and people are seeking to buy products that weren’t available in wartime, and they’ve got all these fat paychecks from the war era that they weren’t able to spend then, that they spend after the war.

    By that rationale, the way to generate economic growth is to just make it illegal for people to purchase goods and services that they want, and then all of a sudden remove those restrictions. That is even more incoherent than the Keynes story.  · 3 minutes ago

  8. Fat Dave
    Joseph Eagar:   The 1940s were a very different time from today’s globalized world.

    Something a lot of economists overlook is that foreign competition had been eliminated.  All of the industrialized nations of Europe and Asia had much of their industrial base bombed flat.  Taking German, Japanese, and French, and reducing Britain’s, production out of the market boosted our flow of exports, which had been lagging since Smoot-Hawley.  By the mid-Seventies, Germany and Japan, under our tutelage, had rebuilt their industrial bases and become strong competitors again.  I don’t think we want to revive manufactures in the U.S. by carpet-bombing our major competitors.

  9. Fat Dave
    Jager: There was was actually a depression in 1920 that was worse then our current recession. Pres. Harding cut taxes, cut Federal spending almost in half and reduced the national debt by something like 30%.

    This did not cause disaster but the roaring 20′s where the economy boomed. · 18 hours ago

    By the middle of 1915, the Allied demand for foodstuffs caused American farmers to expand cultivated acreage and there was a boom in American agriculture.  By 1920, European farms that had been battlefields had returned to cultivation, causing a bust for American farmers.  That depression continued for farm families throughout the Twenties.  As a family friend told me once, we didn’t see what was so “Great” about the Great Depression.  Their standard of living hadn’t been affected.

  10. liberal jim

    I have not looked at the numbers in the last couple of months, but total debt as a percent of GDP is at least 300% higher than ever.  Essentially all Bush and Obama have done is exchange a small fraction of the private debt for public debt.   Until a sizable portion of this debt is liquidated little will change.   Austerity (by this I mean federal spending below 14% of GDP) is  in the long run the answer, but saying when the government did this or that in 1946 or 1920, when debt was 1/3 or less the level it is now, and if we did the same thing now something similar would happen is foolish at best.

  11. Joseph Eagar

    Few, if any, Republican policy wonks truly argue that “expansionary austerity” exists.  Why else would the Ryan plan take a full decade to balance the budget?  If we don’t cut the deficit, the dollar is going to collapse–our foreign creditors will stop funding the borrowing needs of our economy.  Cutting spending isn’t going to be painless, but the alternative is far worse.

    The 1940s were a very different time from today’s globalized world.  James, if you really believe austerity can be expansionary, let me ask you this:  would you support letting all of the Bush tax cuts expire?  If you oppose it on that grounds that it would lead to short-term economic dislocation you are, fundamentally, making a Keynesian argument.

  12. Joseph Eagar
    James Pethokoukis: Also, if you read the study I mention, it addresses many of the obvious criticisms such as “there was all that pent up demand!” and such · 10 hours ago

    From the article:

    “While the personal saving rate did fall substantially from a wartime peak of 25.5 percent in 1944 to 9.5 percent in 1946 and 4.3 percent in 1947, it remained positive.”

    That is supposed to prove that pent-up demand didn’t exist.  That is a crap argument;  “drawing down savings” is almost always used to refer to increasing consumption by saving less (a flow argument) not a stock argument.

    I’m not sure I’d call that article a “study,” it’s more like a political document.  It has the tone of explaining “facts” to laymen, not making a true scholarly case.  It also conflates the post-war austerity to 90s austerity drive, which is an utterly insane comparison (the situations were completely different).

  13. Joseph Eagar
    James Pethokoukis: Less is more!

    Todd

    Pent up demand.  I love that argument. Even Great Depression scholar David Kennedy falls for that:

    World War II fuels the phenomenal economic growth of the quarter century after 1945 in all kinds of ways. It creates a big pent-up consumer demand, which is explosively powerful after 1945, and people are seeking to buy products that weren’t available in wartime, and they’ve got all these fat paychecks from the war era that they weren’t able to spend then, that they spend after the war.

    9 hours ago

    There is something to that, in the sense that increased demand led to inflation and higher nominal wages, and essentially wiped out much of the debt overhang from the 1930s.  The demand itself wasn’t the decisive factor; the inflation it created was.

  14. Jager
    liberal jim:   Until a sizable portion of this debt is liquidated little will change.   Austerity (by this I mean federal spending below 14% of GDP) is  in the long run the answer, but saying when the government did this or that in 1946 or 1920, when debt was 1/3 or less the level it is now, and if we did the same thing now something similar would happen is foolish at best. · 2 hours ago

    The actions of the 1920s, cutting spending and taxes, grow the economy and allows for debt to be repaid. Tax cuts generally provide increased revenue. This combined with decreased spending is how Harding reduced the debt by over 30%. This is not “foolish at best” but a blue print to get the exact debt reduction that you are calling for. 

  15. James Of England
    Jager: There was was actually a depression in 1920 that was worse then our current recession. Pres. Harding cut taxes, cut Federal spending almost in half and reduced the national debt by something like 30%.

    This did not cause disaster but the roaring 20′s where the economy boomed. · 13 hours ago

    I came to the thread intending to say essentially this. Almost all political commentary can be enhanced by lauding the example of Harding, our least appreciated great President.

  16. James Of England
    Joseph Eagar: Few, if any, Republican policy wonks truly argue that “expansionary austerity” exists.  Why else would the Ryan plan take a full decade to balance the budget?  If we don’t cut the deficit, the dollar is going to collapse–our foreign creditors will stop funding the borrowing needs of our economy.  Cutting spending isn’t going to be painless, but the alternative is far worse.

    The 1940s were a very different time from today’s globalized world.  James, if you really believe austerity can be expansionary, let me ask you this:  would you support letting all of the Bush tax cuts expire?  If you oppose it on that grounds that it would lead to short-term economic dislocation you are, fundamentally, making a Keynesian argument. · 3 hours ago

    You’ve just been on fire, lately, Joseph! Although I don’t always agree with you, perhaps not even half the time, you’ve been even more incisive and data driven than usual. I just thought I should note that my not replying to you is often because either you’d said something accurate perfectly or because a rebuttal with 200 words would be too difficult.

  17. liberal jim
    Jager

    liberal jim:   

    The actions of the 1920s, cutting spending and taxes, grow the economy and allows for debt to be repaid. Tax cuts generally provide increased revenue. This combined with decreased spending is how Harding reduced the debt by over 30%. This is not “foolish at best” but a blue print to get the exact debt reduction that you are calling for.  · 2 hours ago

    I agree that what Harding did did help the economy grow and helped end the recession.  However total debt, not just government debt, was 1/4 of what it is today.  The cost of servicing debt is a hindrance to growth.  If the debt which has been accumulated was used to invest in capital producing investments then you and the GOP’s pipe dream might work once again.  However most of the debt was used to buy consumer goods.  The government has been encouraging consumption in stead of saving for a half a century or more.  If you have a way for a country whose GDP is made up of 90% consumption and government spending which has been sustaining itself with debt of continuing the farce indefinitely I would like to hear it. 

  18. James Pethokoukis
    C

    I certain wouldn’t expect austerity to boost short-term growth, particularly if it contained tax increases. But I do believe confidence counts and a lack of it can retard growth. Also note a new EU study just came out showing that a whopping 40% of Europe’s austerity has been tax hikes — that in a region already heavily taxed. No wonder it’s double dipping.

  19. James Pethokoukis
    C

    Also, the macro point here is that the Keynesians predicted Great Recession 2.0 + a breakdown in civil order if spending fell sharply. Instead it was the start of a a 25-year boom. 

  20. Jager
    Joseph Eagar, let me ask you this:  would you support letting all of the Bush tax cuts expire?  If you oppose it on that grounds that it would lead toshort-termeconomic dislocation you are, fundamentally, making a Keynesian argument. 

    Raising Taxes does not help the economy does not help the economy in the short term or long term. Increased taxes rarely create significant increased revenue .

    The “Bush Tax” cut argument just does not work. This has been the tax rate for a decade. It is not Keynesian to say that the tax rate should remain the same it has been for a decade. 

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