A Guide for the Perplexed on Great Depression Fiscal Policy

Justin Fox is needlessly worried. He writes:

The uncertainty of stimulus :: The Curious Capitalist - TIME.com: From a Congressional Budget Office estimate released today on the impact of some amendment or other to the Senate stimulus bill:

The macroeconomic impacts of any economic stimulus program are very uncertain. Economic theories differ in their predictions about the effectiveness of stimulus. Furthermore, large fiscal stimulus is rarely attempted, so it is difficult to distinguish among alternative estimates of how large the macroeconomic effects would be. For those reasons, some economists remain skeptical that there would be any significant effects, while others expect very large ones.

It's sort of like that mutual fund boilerplate, "Past performance is no guarantee of future results." Except that we're not even sure of what the past performance was. (And I say this as somebody who thinks the stimulus legislation is on balance a good idea.)

Well, why should we be certain of what past performance was? There haven't been a great many uses of large-scale fiscal policy to try to cure depression. And in those cases in which it has been tried, a lot else has been going on.

But when fiscal boost was tried on a large enough scale, it certainly did the job. And it is reasonable to infer (with all the caveats provided by the CBO) that what is true in the very large will be true in the merely large as well. Eugene Fama says that it is theoretically impossible for fiscal stimulus to boost output: World War II proves him wrong. Robert Barro says that the multiplier is zero: World War II proves him wrong. Benn Steil says that Jacques Rueff in 1947 conclusively proved that fiscal policy could not boost employment: World War II proves him wrong.

The extent to which the Great Depression and World War II changed how economists thought--and how those who know their history still think--cannot be overstated. And even those economists who don't know their history should be forced to come up with a reason why the lessons of the Great Depression do not apply to today.

As I am going to say in class a couple of weeks from now:

The end in the Great Depression of laissez faire--the idea that the government should keep its hands off of the economy--as a doctrine for guiding economic policy did not mean the end of the market economy as a social resource allocation mechanism. "Keynesianism" and the doctrine of the "mixed economy" that it supported emerged in the nick of time, soon became the ruling ideologies in the industrial core of the world economy, and provided North America and western Europe with a Keynesian escape route from what had seemed the insoluble crises of the interwar period.

The Keynesian escape route opened up key ground in the middle between fascist-style regimentation and socialist-style national planning. Keynes argued that the market economy and capitalist order could be salvaged, and salvaged by relatively minor reforms. An activist welfare-state government with a commitment to full employment had the tools to eliminate Great Depressions, and could put economies back onto the road to Utopia. If only governments would reduce interest rates to get private agents or would themselves spend money freely (without raising taxes) in times when total demand was low, and raise interest rates to reduce private spending and themselves raise taxes (without raising spending) in times when total demand was high, then fiuctuations in employment and production could be greatly reduced, and Great Depressions avoided.

Belief in this escape route was strongly reinforced by facts. Those countries that had tried it by accident during the Depression--had infiated early, printed money, ensured low interest rates, and run large budget deficits--managed to survive the Depression much more easily than others. World War II provided final proof, were any necessary--"vindication by Mars," as John Kenneth Galbraith calls it. That component of unemployment, called "structural" or "permanent" during the 1930s, that was seemingly-immune to both the self-adjusting forces of the market and the armament of the New Deal vanished entirely in the 1940s as the federal budget deficit approached and then exceeded the levels that had long been recommended by John Maynard Keynes. And the United States fought World War II without reducing civilian consumption: all of U.S. war production came from new capacity or from capacity that stood idle at the end of the 1930s.

Demand expansion--deliberate attempts by governments to put the unemployed back to work by deficit spending and loose-money low interest rate policies--was successful in the 1930s and 1940s. It put the unemployed back to work. It did not contain within itself the seeds of a renewed Great Depression. It did not explode into hyperinflation. The coming of "stablization policy" enlarged the policy steps that could be undertaken without forcing a definitive break with the market-capitalist order, and without forcing a choice between Hitler's way and Stalin's.

In later years--in the second and third post-World War II generation--tasks of macroeconomic management would prove harder, and the truth of the doctrines of Keynes's disciples if not of the doctrines of Keynes himself would become less clear.

Comments

[Moon Kil Woong:]

Simply put we do not follow Keynes anymore. We do not save in good times to finance economic weakness in bad times. Constant stimulus is not economic policy. It is no economic policy whatsoever. Anyone calling this a return to Keynsian policy is gravely mistaken. He would never encourage this.

Likewise, he would probably not encourage trying to stop de-leveraging of a clearly over-leveraged economy. He would probably advise the government to wait until the market bottoms to stimulate since Keynsian style stimulus is suppose to help an economy stuck in a rut, not insure it keeps running on fumes for a few more years.

It is sad that I have to even point any of this out and that the Treasury or Fed doesn't have the brains or the balls to do the same.

Feb 11 04:09 AM

[socrateazz:]

Hmmm! Are the assumptions correct? What caused WWII to force the US out of the depression? In my eyes there are three really important reasons. The wealthy started using some of that wealth to create war goods. Those moneys went to workers. That caused demand for goods to increase causing more need for workers. A shortage of workers caused wages to increase (of course unions take credit for such) causing more demand for goods. The second reason is similar. The need for war goods caused a need to put more folk into supplying those goods. Since there was a shortage of workers, Rewards needed given to get Joe to work one place and not another. Joe could go where he wanted and get rewarded whatever he wanted. A countries middle class is a good indicator of how good any economy is. The american middle class exploded while the number of super rich declined markedly. When did that change? When demand started to consistently exceed supply. In the 1970's if you do not know. Demand for too few goods caused inflation during that period. workers had gorwn an expectation to increase their wealth with little real effort to produce. That had to change Reagan helped make that change. The problem was leaders really believed the the change was a permanent need. The change actually was situational. Balance is needed for a good economy. In the late 1970's demand overwhelmed production and since workers did not have incentive to produce more, they did not. workers started to overvalue their worth. Things have shifted to an excess of production. Now workers are undervalued. Government had an excellent opportunity to balance supply demand during the 1990's by increasing minimum wage. The fix today will not be as pleasing. But continuationof the recent past is not going to fix things.The things government is talking about are stiches on a five foot gash. Put a stitch here while the knife is cutting over there.

Feb 11 07:59 AM

[Jason Rines...:]

Those are all interesting assumptions Mr. Delong. Here's mine: It was not the debts incurred and wartime manufacturing that lifted the U.S. out of Depression, it was the high paying skilled jobs that were produced because of technology advances such as jet power, nuclear power, the computer etc, etc. This created massive new demand and job creation in these fields that lasted decades.

Feb 11 08:36 AM

[john s. gordon:]

socrate - a case could be made that hitler/tojo made it possible to end the 1930-29 depression.

britain (having allowed its industrial base to wither during 1920-1938) needed materiel & exhausted their gold reserve to buy that materiel from u.s factories. after the gold was gone, lend-lease provided the 'lubricant".
> jack

Feb 11 09:02 AM

[refatx:]

"And the United States fought World War II without reducing civilian consumption: all of U.S. war production came from new capacity or from capacity that stood idle at the end of the 1930s."

I have no idea how you came to this idea. But it is wrong, wrong, wrong. After 1942 it was impossible to purchase a new vehicle. Gasoline was rationed to less than 10 gallons a month. New tires could not be purchased (rubber rationing). And the list went on and on.

Feb 11 10:13 AM

[margel:]

I would add to other examples of fiscal stimulus policies that were highly successful -- the Marshall Plan in Europe and the postwar US boom.

Feb 11 12:53 PM

[Hmm?!:]

Ah.........not really.

John Maynard Keynes proposed that government could save money during expansions and spend during recessions to help minimize the impact of natural economic cycles. He also specifically spoke out against deficit spending in his work.

Every economics textbook in America speaks of the mistakes made by government to create the depression. What you are talking about I have no idea!

As a matter of fact Keynes ideas are still considered theories. Please see link below.

en.wikipedia.org/wiki/...

Feb 12 12:42 AM

[Old Rick:]

Brad asserts that the WWII is PROOF POSITIVE that fiscal stimulus "does the job". I wonder why then the massive 10-year fiscal stimulus of both the Hoover and Roosevelt administrations from 1930 to 1940 did not do the job. I believe that unemployment on the eve of WWII was still around 20%. The WWII case is, I think, better explained by Jason Rines above.

Feb 12 01:27 PM