Question

Was the Keynesian (mixed market) model instituted in the US, Britain, etc. between World War II and the 1980's appropriate for the times?

Answer 1

War, everybody says, is hell. But many Americans do not really believe this truism, especially when the war in question is World War II. Of course, for the men who had to endure the horrors of combat, the war was terrible — just how terrible, hundreds of thousands of them did not live to say. But the great majority of Americans never experienced the fighting directly. It was something that went on “overseas,” and government censors kept reports of its brutal realities from the public.

For many Americans, at the time and since, World War II actually seemed to be a fine thing, mainly because, as the hackneyed expression has it, “the war got the economy out of the depression” in which it had wallowed for more than a decade. During the Great Depression, many people had despaired over whether the economy would ever again operate satisfactorily. Then, the mobilization for war coincided with what appeared to be a great economic boom.

By 1944, all the usual indicators of economic well-being signaled that the economy was enjoying unprecedented prosperity. Most important, the official rate of unemployment had sunk to just 1.2 percent — the lowest rate ever achieved before or since. After years of turning away qualified job seekers, employers were beating the bushes in search of warm bodies. Official figures showed that the Gross National Product (GNP), adjusted for inflation, had risen some 70 percent since 1939 — later Commerce Department figures would revise the increase upward, making it more than 90 percent.

For the economists who had recently embraced the ideas of John Maynard Keynes, expressed in his General Theory of Employment, Interest, and Money (1936), the war seemed to validate their beliefs. In Keynes’s theory, in contrast to the previously accepted view, an economic depression might continue indefinitely unless government spending, financed by a budget deficit, were increased sufficiently. The Keynesians believed that the federal deficits of the 1930s, never more than $3.5 billion per year, had been too small to lift the U.S. economy from its slough. The huge wartime deficits, however, reaching as high as $55 billion in 1943, seemed to have accomplished precisely what Keynes had said they would.

Ever since, most economists, historians, and educated laymen have accepted the Keynesian conclusion. It seems obvious that the war got the economy out of the depression, that it created a condition commonly called wartime prosperity. How could anyone argue otherwise? Certainly no one can deny that the wartime budget deficits were immense — in terms of today’s dollars, they added some $2.2 trillionto the national debt.

Appearances, however, can be deceptive, and correlations can be spurious. Did American participation in the most destructive event of all time really have positive economic consequences?

When something seems counterintuitive, it often helps to reexamine the terms in which the puzzle is expressed. This is certainly the case with the “wartime prosperity” of World War II. What did this condition consist of?

Consider first the labor market. Although unemployment virtually disappeared, the disappearance owed nothing to Keynesian fiscal policy. In truth, it owed everything to massive conscription. Between 1940 and 1944, the number of unemployed persons fell by 4.62 million, while the armed forces increased by 10.87 million. For the whole war period, more than 10 million men were drafted. The enormous forced withdrawal — the number of draftees was equivalent to nearly 20 percent of the prewar labor force — drastically reduced the number of potential workers and depleted the ranks of the unemployed, and would have done so with or without the government’s budget deficit. The Keynesian correlation is spurious.

But what about the enormous increase of the economy’s total output? This, it turns out, is nothing more than an artifact of the accounting system used by the government to keep the national product accounts. In the official system, spending for military goods and services gets counted as part of the dollar value of national output, as does spending for consumer goods and new capital goods. So every dollar the government paid for the services of military personnel or for the purchase of battleships, tanks, bombers, and other munitions during the war was included in the GNP. Hardly surprising,then, that GNP skyrocketed as the government created a command economy geared for “total war.”

But when we examine the rest of the GNP — the part consisting of spending for civilian consumer goods and new capital goods — we find that after 1941 (adjusted for actual as opposed to official inflation), it declined for two years; and even though it rose after 1943, it was still below its 1941 value when the war ended. Thus, the war years witnessed a reduction of the total real output flowing to civilian consumers and investors — a far cry from “wartime prosperity.”

My estimates of real personal consumption expenditures per capita show a similar pattern — down during the first two years of direct U.S. involvement in the war, up slightly during the next two years, but not up enough to erase the initial declines. Historians who have spoken of a “carnival of consumption” during the war are simply mistaken.

Many aspects of economic well-being deteriorated during the war. Military preemption of public transportation interfered with intercity travel by civilians, and rationing of tires and gasoline made commuting to work very difficult for many workers. More workers had to work at night. The rate of industrial accidents increased substantially as novices replaced experienced workers and labor turnover increased. The government forbade nearly all nonmilitary construction, and housing became extremely scarce and badly maintained in many places, especially where war production had been expanded the most. Price controls and rationing meant that consumers had to spend much time standing in lines or searching for sellers willing to sell goods at the controlled prices. The quality of many goods deteriorated, as sellers forbidden to raise prices adjusted to increased demands by selling lower quality goods at the controlled prices.

After the war ended in the late summer of 1945, a genuine economic miracle took place during the next two years. More than 10 million men were released from the armed forces. Industry, which had occupied itself largely in producing war goods from 1942 to 1945, switched back to the production of civilian goods. The huge government budget deficit disappeared, and during the fiscal years 1947-1949, the federal budget actually had a small surplus. Yet, despite the fears and warnings of the Keynesian economists that such events would plunge the economy back into depression, civilian production boomed, increasing by nearly 27 percent from 1945 to 1946, and the rate of unemployment never exceeded 4 percent until the recession of 1949. Why the economy performed so successfully during the reconversion is an economic mystery that a few economists, including the present writer, have recently begun trying to understand better.

The mainstream economics profession, however, never faced the contradictions between its Keynesian theory and the events of the reconversion. According to this theory, the huge turnaround of the federal budget — from a deficit equal to 25 percent of GNP during 1943-1945 to a surplus during 1947-1949 — should have sent the economy into a tailspin. It did not, which refutes the theory. Ignoring this embarrassing fact, the Keynesians continued to cite the war “boom” as a definitive demonstration of the correctness of their theory. Reflecting the conventional wisdom, a leading textbook in U.S. economic history gave its chapter on World War II the title “War Prosperity: The Keynesian Message Illustrated.”

The lesson was false but, for politicians and certain others, immensely useful. For decades, secretaries of defense helped to justify their gargantuan budget requests by claiming that high levels of defense spending would be “good for the economy” and that reduced defense spending would cause recession. So common did this argument become that Marxist critics gave it the apt name military Keynesianism. On both the left and the right, people believed that huge military spending propped up an economy that, lacking this support, would collapse into depression. Such thinking played an important part in the political process that directed into defense spending some $10 trillion dollars (in today’s purchasing power) between 1948 and 1990.

Military Keynesianism was always an intellectually bankrupt theory. As I have shown above, it was not proven by the events of the war years; all that those events proved was that a command economy can, at least for a while, keep everyone busy building munitions and using them to demolish the nation’s enemies. But the munitions production was far from free. It entailed huge opportunity costs, even though part of it could be accomplished simply by employing workers and capital that had been idle before the war. During the Cold War, however, the nation had very few unemployed resources to call into defense production, and using lots of resources for this purpose meant that the civilian goods that those resources might otherwise have produced had to be sacrificed.

Keynesian economics rests on the presumption that government spending, whether for munitions or other goods, creates an addition to the economy’s aggregate demand, which brings into employment labor and other resources that otherwise would remain idle. The economy gets not only the additional production occasioned by the use of those resources but still more output via a “multiplier effect.” Hence the Keynesian claim that even government spending to hire people to dig holes in the ground and fill them up again has beneficial effects; even though the diggers create nothing of value, the multiplier effect is set in motion as they spend their newly acquired income for consumption goods newly produced by others.

Such theorizing never faced squarely the underlying reason for the initial idleness of labor and other resources. If workers want to work but cannot find an employer willing to hire them, it is because they are not willing to work at a wage rate that makes their employment worthwhile for the employer. Unemployment results when the wage rate is too high to “clear the market.” The Keynesians concocted bizarre reasons why the labor market was not clearing during the Great Depression and then continued to accept such reasoning long after the depression had faded into history. But when labor markets have not cleared, either during the 1930s or at other times, the causes can usually be found in government policies — such as the National Industrial Recovery Act of 1933, the National Labor Relations Act of 1935, and the Fair Labor Standards Act of 1938, among many others — that obstruct the normal operation of the labor market.

So, government policies created sustained high unemployment, and Keynesians blamed the market. The Keynesians then credited the government’s wartime deficits for pulling the economy out of the Great Depression and continued to credit defense spending for preventing another economic collapse. In this way, sound economics was replaced by economic ideas congenial to spendthrift politicians, defense contractors, labor unions, and left-liberal economists.

How much better it would have been if the wisdom of Ludwig von Mises had been taken to heart. In Nation, State, and Economy (1919), Mises said, “War prosperity is like the prosperity that an earthquake or a plague brings.” The analogy was apt in World War I, in World War II, and during the Cold War. It is still apt today.