Fiscal Policy, the Great Depression, and World War II
One of the more persistent fallacies credits fiscal policy during World War II with ending the Great Depression. Genuine fiscal policy, of course, requires an increase in government borrowing, either by the government spending more, taxing less, or doing both. By that standard, as the classic 1956 article by E. Cary Brown demonstrated, neither Presidents Hoover nor Roosevelt conducted much in the way of fiscal policy prior to the war. Both were believers in balanced budgets, and so strived to accompany their expenditure increases with tax increases. Indeed, their most serious peacetime deficits resulted from congressionally enacted veterans’ benefits that they both resisted.
So why did U.S. involvement with World War II seemingly end the depression? Two reasons: (1) The draft conscripted 22 percent of the prewar labor force. Forcing people to work at low wage, high-risk jobs can always reduce unemployment, which is why slave societies never face an unemployment problem.
(2) Monetary policy accommodated the huge increases in government borrowing during World War II. By pegging the interest rate on Treasuries at very low rates (2.5 percent for T-bonds, and 0.375 percent for T-bills), the Fed automatically monetized the debt. The money stock nearly tripled with the result that seigniorage covered almost one fourth of the war’s cost. That is the highest seigniorage percentage for any U.S. war outside of the two hyperinflations: the American Revolution and the Confederacy. In other words, what looked like fiscal policy was really monetary policy in disguise.
And even then, the only reason monetary policy was effective at raising output was because it drove prices and wages above Hoover’s and Roosevelt’s explicit and implicit floors. Murray Rothbard was the first to emphasize the detrimental impact of these price and wage floors in America’s Great Depression (1963), followed by Richard Vedder and Lowell Gallaway in Out of Work (1993), but now with the work of Harold Cole and Lee Ohanian, this realization has gained mainstream respectability among economists.
Moreover, Bob Higgs has pointed out that, although World War II coincided with an increase in U.S. output, most of that output went into war production rather than enhancing well being. If you look at real consumption per capita, and adjust for wartime controls, there was not much improvement until the end of the war. Which leads to what in my opinion is devastating historical evidence against fiscal policy. The enormous decrease in government spending after World War II, followed by four years of surplus and a nearly 50 percent fall in the national debt as a percent of GDP, constitutes the most contractionary fiscal policy in all of U.S. history, another observation you can find in Vedder and Gallaway. If Keynesian theory were correct, there should have been a massive depression, which is what nearly all economists were predicting at the time. But the demobilization saw no real recession or significant unemployment.
Japan’s lost decade is often cited as an example of monetary policy’s ineffectiveness. Be that as it may, the Japanese also tried fiscal policy throughout the decade with no discernable benefits. In fact, there is no really good empirical evidence for the effectiveness of fiscal policy, as Tyler Cowen, among others, has reminded us repeatedly on his blog, Marginal Revolution. The econometric studies are all over the map. Some have even recently found that tax cuts have far greater multipliers than expenditure increases, in outright contradiction of Keynesian theory. Other studies get high multipliers only by assuming the debt is automatically monetized. For example, more than half the stronger multipliers in Greg Mankiw’s popular intermediate macro text are the result of accommodating monetary policy.
My best guess is that the expenditure multiplier from pure fiscal policy is probably close to zero or, if you consider supply-side effects, possibly negative. But this cuts both ways. I believe that the tax multiplier is also close to zero. Any justification for tax cuts depends on their supply-side, not demand-side, effects. This goes as well for all the interminable debates about how the government spends the stimulus.
In short, Obama’s stimulus package is simply a “Hail Mary” pass. As John Cochrane of the University of Chicago has aptly put it in his recent critique of fiscal stimulus, “public prayer would work better and cost a lot less.” If the American people are lucky, the stimulus will merely be ineffectual. If not, it will make matters worse. Counter-productive government intervention under Bush has already turned a relatively minor recession into something nearly as bad as the recession of 1982. Any further deterioration will increase the clamor for still more disastrous government intervention. The only positive thing I can say about the stimulus package is that, by driving up the U.S. government debt, it will probably bring about a Treasury default much sooner than otherwise.