Friday, June 29, 2012

Does fiscal policy work?

The military buildup or World War II is often cited as a successful prediction of Keynesian economics. Usually forgotten is what happened at the end of the war. David Henderson summarizes:
In a 2010 study for the Mercatus Center at George Mason University, I examined the four years from 1944, the peak of World War II spending, to 1948. Over those years, the U.S. government cut spending from a high of 44 percent of gross national product (GNP) in 1944 to only 8.9 percent in 1948, a drop of over 35 percentage points of GNP. The result was an astonishing boom. The unemployment rate, which was artificially low at the end of the war because many millions of workers had been drafted into the U.S. armed services, did increase. But between 1945 and 1948, it reached its peak at only 3.9 percent in 1946. From September 1945 to December 1948, the average unemployment rate was 3.5 percent.

There was a sharp decline in real GNP at the end of the war, but Henderson says that is an artifact of the ending of price controls. The price controls hid what the actual prices were, so the jump in the price index was not capturing a real rise in prices. But that illusion of a jump resulted in a decline in reported real GNP. (An implication of this is that real GNP was overstated during the war because the price index was not capturing the rise in prices.)

How does Henderson explain the boom?

But why did this postwar boom occur? The answer, in a nutshell, is that the U.S. economy went from being centrally planned, with price controls and government allocation in large sectors of the economy, to being much more free market. During the New Deal, Franklin Roosevelt had many advisors who were hostile to free markets. But during the war, Roosevelt, although he centrally planned the economy for the duration, kicked out most of his anti-market advisors, people like Ben Cohen, William O. Douglas, trust-buster Thurman Arnold, price controller Leon Henderson, and Felix Frankfurter. In 1945 and 1946, Harry Truman got rid of the remaining New Dealers, including two of the most prominent ones: former Vice President Henry Wallace and Harold Ickes.

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