Arnold Kling  

The Austerity of 1945-1947, a third time

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I want to return to the Vedder-Galloway paper, that I mentioned here. I want to make it clear that I have a lot of problems with that paper, and I will not be basing my own views on it. More below the fold.

[UPDATE: Revisiting the 1945-47 austerity is something that has occurred to folks at Cato recently as well. See Jason E. Taylor and Richard K. Vedder. Same Vedder who had written the paper with Galloway 20 years ago.]

1. As I said in my earlier post, I think that one should just ignore the estimates for real GDP that use recent years as the base year. Although V-G understand that the real GDP figures are messed up, their attempt to fix them is neither necessary nor sufficient. Either you have to go back and fix the real GDP numbers using raw data from the period, or you should just stick to nominal GDP.

2. They try to argue against the view that "pent-up demand" created the recovery. Again, I do not know why you would want to make that argument, nor do I think they succeeded.

From an accounting perspective, something had to create the recovery in demand. GDP rose and government spending fell. That leaves consumer spending, investment, and next exports. Regardless of which of those rose (all three did, in fact), it tells you nothing about Keynesian theory. It tells you something about accounting. If consumer spending rose because of "pent-up demand," I do not count that as a win for Keynesian theory. As David Henderson points out, real Keynesians at the time did not think that "pent-up demand" was going to produce full employment.

To me, "pent-up demand" is just an ex post rationalization. It says, "even though government was cutting spending, the economy recovered on its own." Why argue with that?

V-G want to argue that it was not pent-up demand because assets did not fall. Instead, the saving rate fell. To me, that does not prove their case.

3. V-G want to say that there is an alternative explanation for the recovery, which is that real wages fell. But relative to textbook macro, that is not an alternative. Textbook macro has an aggregate supply curve that depends on prices rising and real wages falling. Moreover, the evidence that V-G cite for lower real wages is not all that dramatic. To me, the drop that they demonstrate appears to be within the range of measurement error.

I want to emphasize that we are not in the same situation today that we were in 1945. I just use the 1945-1947 episode to caution against a simple mechanical view that government spending always drives the economy,

Comments and Sharing

COMMENTS (6 to date)
matt mcknight writes:

Wouldn't the return of 15M soldiers have made a large impact on demand, as many of them sought housing? New housing starts in 1946 were a lot higher than 2009. It's not so much that the demand was pent up, it was that it was stuck fighting bad guys overseas.

Ted writes:

I don't know why you insist on using old-style Keynesian theory that nobody takes seriously anymore. This is like beating a straw man that died 40 years ago.

As I wrote in your other post, nothing about New Keynesian theory implies a recession must ensue if government reduces spending (although it can, especially if the monetary authority won't pick up the slack). Furthermore, assuming an independent central bank, New Keynesian analysis suggests that government spending can only ever-so slightly effect demand when nominal interest rates aren't zero (and even when nominal interest rates are zero it requires special cooperation between the central bank and the fiscal authority to work). For government spending to have large effects on demand in an economy where the zero lower bound isn't binding, the government spending would have to be so large to be practically infeasible and once you are getting to spending that much surely government consumption begins to buy things that are approximately perfect substitute for private consumption so the multiplier would go to zero.

But, simply put, you are picking on a theory that people haven't taken as entirely accurate for decades. Should I write a post attacking monetary policy because Irving Fisher didn't exactly get it right?

But onto the more substantive point. I guess pent-up demand is possible, especially because of war-time rationing, but I'm skeptical of how powerful of an explanation that can be.

There is a far more plausible explanation anyway, and one that can possibly fit with the "pent up" demand story. Wars are extremely expensive and they often blow up the debt. WWII was, of course, no different. The debt to GDP ratio was almost 120% in 1945. Prior to central bank independence what invariably happens after wars is that government resort to inflation to help the debt. Why would 1945 be any different? An indeed it wasn't, inflation was quite high over the 1945-1948 period (1943 was 6%, 1944 it was 1.64%, 1945 is was 2.27%, 1946 it was 8.43%, 1947 it shot up to 14.65%, 1948 it was 7.74%). If the public has rational expectations they should have been anticipating loose monetary policy in the near-future to help erode our debt burden. The expectations of near-term inflation in the future should reduce the real interest rate now and spur output (as well as consumption due to expectations of inflation eroding their purchasing power - which would complement any 'pent up demand' story). To me, 1945 looks like a story of rational expectations concerning ever-so-expected post-war inflation.

Lord writes:

The other significant reason for the quick response was there was no doubt about what needed doing only about how fast it could be done. All the wartime industries could retool to produce consumer goods. No one sat around wondering what next.

Milton Recht writes:

To Lord:

There was serious doubt at the time. Some feared that there would be a return to depression level consumption and were afraid to invest. Others believed that the economy would not return to pre-war levels.

As an example, Sears and Montgomery Ward were about equal size at the end of WWII. Sears believed that the economy would not return to depression levels and aggressively expanded their number of stores. Montgomery Ward believed the economy would decline and did not aggressively expand their retail store presence.

For several decades after WWII, Sears was a much more dominant retail force than Montgomery Ward and Ward filed for bankruptcy in the 70s.

fundamentalist writes:


But, simply put, you are picking on a theory that people haven't taken as entirely accurate for decades.

The problem is that many mainstream economists, such as Krugman, DeLong and Sumner, advocate the old style Keynesian economics. Neo-Keynesians may have moved on, but many haven't.

Lord writes:

As I said, no doubt about what, only about when. The what would propel some investment even if a recession was expected. It certainly wouldn't prevent durable goods manufacturers from retooling, only the pace. Many did expect another recession as there had always been after wars, but most didn't take that as reasons not to invest but as opportunity to do so. It is a far different story after a financial crisis because there is no obvious retooling, no obvious pent up demand, no obvious innovation that is waiting in the wings. That is a far greater uncertainty than what awaits after a war. The price controls during the war may have helped since there was no need for a forced deflation of prices to restore an arbitrary gold standard.

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