Economics

When the U.S. really did try austerity, it worked!

Now, we all all know “austerity” from deep spending cuts (not the tax hikes, of course) is killing Europe’s economy and would do the same here in America, right?

Well, here’s a story about austerity that critics such as President Obama, Paul Krugman, and Ezra Klein never seem to mention: From 1944 to 1948, Uncle Sam cut spending by a whopping 75% as World War II came to end. Spending as a share of GDP plunged to 9% in 1948 from 44% in 1944.

Superstar economist and devout Keynesian Paul Samuelson—later to become the first American to win the Nobel Prize in economics—predicted such shock austerity would cause “the greatest period of unemployment and industrial dislocation which any economy has ever faced.” That dire, disastrous prediction was widely held by his fellow Keynesians, with one even predicting an “epidemic of violence.”

Except the doomsayers were wrong, even though Washington obviously ignored Samuelson’s call for gradual spending reductions. Despite cuts which dwarfed those seen in the EU today—not to mention those Republicans are calling for here at home—the U.S. economy thrived. There was no mass unemployment despite rapid demobilization of the armed forces. As George Mason University economist David Henderson explains is his 2010 paper, “The U.S. Postwar Miracle” (which this entire post draws upon):

As demobilization proceeded rapidly, employers in the private sector, full of the optimism … scooped up millions of the soldiers, sailors, and others who had been displaced from the armed forces and from military industries. … The number of unemployed people did increase, rising from 0.8 million to 2.3 million, but with a civilian labor force of 60.1 million, the 2.3 million unemployed people implied an unemployment rate of only 3.8 percent. As President Truman said, “This is probably close to the minimum unavoidable in a free economy of great mobility such as ours.

Of course, liberals are quick to point out the U.S. economy suffered its worst one-year downturn in history in 1946, a drop of 12%. To many Americans, it surely must have seemed like Samuelson was right, that the Great Depression had returned. But no one thought that back then, especially with jobs plentiful unlike during the 1930s. The drop in output was a statistical quirk caused by the removal of price controls. As Henderson explains:

For example, imagine that the free-market price of a pound of filet mignon during the war would have been $1.40 a pound. But imagine further that the government had set the price at $1.00 a pound. Then, when the price control was removed, the price would have shot to $1.40 a pound. Inflation statistics would have recorded some amount of inflation due to this large price increase. But those statistics would have overstated the real price increase because getting beef at $1.40 a pound is better for many of the people who couldn’t, because of the shortage, get it at $1.00 a pound.

Second, those sky-high output figures during the war measured government spending on goods and services, lots of it military hardware, at their cost. But what was all that stuff really worth, in purely economic terms, vs. post-war consumer purchases of homes and cars and nylon stockings? While total output fell by 12% in 1946, private-sector GDP rose by nearly 30%.

Or look at it this this way: Real U.S. output in 1947 was 17% higher than in 1941 despite the decline in government spending. Why was the economy prospering in way it never did during the Great Depression? Taxes were cut a little, and government interference—including price and production controls and rationing—was reduced a lot. But perhaps just as important, Truman dumped many of FDR’s most radical New Dealers. That change boosted business confidence, and companies started to invest again in America.

The typical Keynesian response mostly centers around dismissing the immediate post-war boom as a one-off event complicated by many unique factors. But it happened again, as Henderson notes! After the Cold War ended, overall federal spending fell to 18% of GDP in 2000 from 22% in 1991. But again the economy boomed. Real U.S. GDP grew by 40% with an average annual growth rate of 3.8%. Henderson speculates that perhaps the decline in defense spending freed up knowledge workers to help make technological miracles happen in the private economy.

The lesson here: Spending cuts might well produce prosperity instead of austerity, especially if accompanied by less government interference in the economy and less fear in the private sector of anti-market government policies.

42 thoughts on “When the U.S. really did try austerity, it worked!

  1. The premise of James’ misleading post is easily refuted:
    http://socialdemocracy21stcentury.blogspot.com/2011/07/post-1945-boom-in-america.html
    The post WWII austerity did little, if at all, to kick-start the recovery. It most likely went against it.
    To add to the points on the link provided (for those who would read), debt as a share of GDP would have gone up in the years following WWII if for the spending cuts alone, since GDP over those years fell dramatically more than did the spending.

    And yet, the ratio fell tremendously, and continued to fall for decades.

    • Correction: The spending cuts were significant there, but still:
      http://www.finfacts.ie/irishfinancenews/article_1023103.shtml
      Since 2007, Euro-zone nations adopted austerity, and we’ve seen the results, a stagnant economy and a ballooning debt/GDP ratio.

      What’s more:
      http://www.city-data.com/forum/politics-other-controversies/1526533-net-change-government-spending-under-obama.html
      This link shows how under this president, government spending has barely increased at all. For all the talk on how the President of the United States Barack Obama is bankrupting the government, spending levels have only increased modestly, as compared to the previous president, where spending climbed over 85%. What’s more, much of the Bush II-era spending was not paid for at all, and went largely towards the wars in Iraq/Afghanistan, a prescription-drug provision, and soaring entitlement spending and anti-poverty programs due to a slackening economy.

      In WWII, however, the economy doubled, unemployment plummeted, and we emerged in 1945 as the world’s superpower.

      • In WWII unemployment did not plummet. The unemployed went overseas to kill Germans, Japanese, and Italians, while a huge portion of production went into goods whose only purpose is to explode.

        We didn’t really recover from the depression until after WWII.

        • The Keynesians who claim the economy was doing well during WWII are doing what we as business managers see silly ivory-tower people doing quite often: measuring the wrong things. Like really, really bad managers, they focus on the creation of activity instead of the creation of value and don’t (or at least pretend not to) understand the difference between the two.

      • Ahhh. It’s getting easier to identify a obummer troll. You just keep on believing the tripe your masters are feeding you when the Romney landslide rolls over you and I don’t have any more faith in Romney than I do in obummer to clean up this mess we are in. I am sad that our country will have to suffer so much as we try to put things right. The “new world order” is endemic in so many of our institutions, it’s going to be a very tough future.

      • “Since 2007, Euro-zone nations adopted austerity, and we’ve seen the results, a stagnant economy and a ballooning debt/GDP ratio.”

        No, they didn’t. They agreed that at some point in the future they would cut public spending, but none got around to it. Europe’s public sectors are as bloated as ever.

        The highest debt-to-GDP ratio is none other than Japan (2.13-1), the world leader in Keynesian economics.

        “This link shows how under this president, government spending has barely increased at all. For all the talk on how the President of the United States Barack Obama is bankrupting the government, spending levels have only increased modestly, as compared to the previous president, where spending climbed over 85%.”

        Barely? Federal outlays in FY 2010 were $3.7 trillion, according to the CBO. In 2008, it was $2.9 trillion. That’s about 28 percent in 2 years. I hope for your family’s financial sake you don’t consider that “barely” an increase.

        In 2000, it was $1.8 trillion, so Bush increased spending 61 percent in 8 years, which is bad, but it’s only half as bad as the rate of his predecessor.

        Public sector austerity allowed companies to invest in consumer goods instead of bombs and bullets. People who are buying their government bullets aren’t buying themselves houses. People who are off killing foreigners aren’t building houses.

  2. What this chart alone does explain is how this change in demand from the Federal Government compared to the change in demand from consumers. During the Post War period, those firms that banked on significant pent-up demand from consumers did very well as solders coming home established families, and money saved for years as there were few consumer goods on the market during the war years started being spent.

    Therefore the decline in Federal spending became swamped by a wave in consumer spending due to a drawdown of savings and very rapid household formations after the war. You can also add the beginning of the baby boom as a reason for an expansion of families plus things like VA mortgages that allowed returning Servicemen to buy homes with less money down than was possible before the war. This increase in demand through a relatively cheap government program helped develop towns like Levitown and other mass produced post-war housing in the near suburbs of American cities.

    This is not true today. We do not have expanding consumer demand from a drawdown of savings and rapid household creation. In fact we have just the opposite as consumers save to deal with reductions in retirement accounts and the need to save more due to low returns on bonds and other savings instruments. Also we don’t have millions of men and women jumping to create new families in a short period.

  3. Off course we cut spending. We had just been fighting the biggest war in our country’s history ffs! Are you retarded??

    • The point is that the Keynesians were predicting that such a cut in spending would send us back into the great depression and instead the economy boomed.

  4. The position of US consumers, and the position of the US in the global economy now is nowhere near comparable to 1946. For one thing, as noted, there was tremendous pent-up demand among consumers. For another, as the economy transitioned to civilian production, there was a huge pool of savings for consumers to draw on, the result of diminished consumption due to rationing and high saving rates (remember War Bonds?). There was demand for everything after years of little production of consumer goods; people needed housing (there was a huge post-war shortage) and cars (consumer production during the war was essentially halted) as well as clothing and other consumer products that were available in limited quantities during the war. And, they had the money with which to buy what they wanted. In fact, there is a case to be made that consumers now are in nearly an opposite position from 1946; they are heavily indebted and sated with consumer goods.

    The end of the Cold War and the subsequent boom was a one-off event, the result of the tech boom of the ’90s. Before the boom, President Bush was turned out of office by a bad economy, which really didn’t hit its stride until 1995. Had the personal computer not revolutionized the economy then, it it far from clear that a robust boom would have taken place.

      • Absolutely. Don’t forget that this nation had depressed consumer spending not only during World War II (when cars weren’t manufactured as well as many other consumer products) but the reduction in spending and emphasis on saving during the Depression.

        Meanwhile, we not only have an overabundance of housing, but tons of consumer goods to burn through (as anyone visiting thrift shops, Goodwills and Salvation Army stores can attest to, not to mention our own closets.

        So austerity programs will cause disruptions and will hurt businesses and people that rely on that income stream. That’s why they’re fighting so hard to avoid knife.

        (This is not an argument against austerity, BTW, but an explanation that it won’t be easy, and it will be fought against. The question is more like, “Do we really want to support programs that in essence put a thumb on the scale in favor of certain corporations? Or do we want to pursue policies that treat a dollar of income from Apple, Inc., the same as a dollar from the local business?”

    • Well said. I enjoy reading succinct comments like yours. Just two points of contention: In my experience, President Bush was turned out of office for 2 reasons: 1. He was a RINO that did not keep his pledge of “No New Taxes” (I still have a vivid memory of him fervently making that pledge) which inspired the mercurial Ross Perot to garner enough prescient Ron Paul follower votes to allow Bill Clinton to “steal” the win. 2. My memory of the PC revolution is that it caused the loss of many jobs and the uncompensated increase of the workload of those able to grasp the new efficiencies of this equipment, with it’s never ending upgrades and applications. We are still working through the problem of those left behind by this “revolution” and have discovered that that hiring them all for the post office and other government agencies is not a viable alternative. God Bless America. RICO all banksters and their prostitute politicians and Impeach Eric Holder.

    • The “pent-up demand” excuse from the Keynesians is one of the most unintentionally funny explanations in the history of economics. Apparently, a lot of demand suddenly appeared … out of nowhere! … in 1946. Right after the Keynesian policies (massive deficit spending, breaking windows, killing millions of people, etc.) stopped, but that’s just a coincidence. In that case, the assertion seems to be that in order to get out of a recession, we need the Keynesians to hold the economy’s head underwater for nearly two decades, maybe mix in a world war, and by that time people will have learned their lesson and start demanding stuff. Over ten million killed and a large chunk of a continent traded away into subjugation under the Soviet Union? Hey, can’t make an omelet without breaking a few eggs. That’s Keynsianism for you.

      There is always lots of pent-up demand. I’ve got a very, very, very long list of things I’d like to buy, if the economy was good enough to support the income levels that would allow me to purchase them. I’m sure I’m not alone in this. But I also had a very, very, very long list of things I wanted to buy when the economy was smoking hot. There may be an end to pent-up human demand for stuff, but we’re not nearly advanced enough to even see a clear path to getting there. The notion of the magically appearing demand should be transparent even to a kindergarten child. If it was building up before, why didn’t people start doing something about it in 1945? or even 1938? Maybe people were thinking “You know, we’re poor as crap but darn it this just doesn’t suck enough for us to start demanding stuff on our own. Good thing the government is out there demanding stuff for us!” Somehow, grown adults buy into this. Amazing.

    • “The position of US consumers, and the position of the US in the global economy now is nowhere near comparable to 1946. For one thing, as noted, there was tremendous pent-up demand among consumers.”

      That’s exactly the point being made by those favoring public sector austerity – that lower demand by the public sector didn’t matter because private demand grew to replace it and overtake it. When people aren’t paying taxes for more bombs and bullets and “stimulus”, they are free to spend money more productively on houses and cars. Foregoing public sector austerity is visiting it upon the private sector.

      “… there is a case to be made that consumers now are in nearly an opposite position from 1946; they are heavily indebted and sated with consumer goods. … Had the personal computer not revolutionized the economy then, it it far from clear that a robust boom would have taken place.”

      You are right on the cusp of demonstrating the point of the column here, too. The private economy is the driver of growth – there is always a new consumer good the public wants or needs. You may be thinking of consumer goods along the lines of “toys” – iPhones, big-screens, etc, but there is plenty of consumer goods no one has yet and that the private sector shall one day provide, such as affordable, zero-emission transportation or replacement organs or fully online colleges. We’ll be sated with goods a year or two after we have invented all there is to invent.

      The post-war boom and tech boom didn’t just happen. The austerity was partly why they happened. The tech boom should have benefitted Japan at least as much, but it didn’t, however it did benefit the Asian Tigers. Japan has educated, hard-working citizens, but for a long time it had the one of the highest (arguably the highest) combined business tax rates plus enormous public debt paying for the biggest Keynesian experiment of all time.

      Sure, no two economic circumstances are ever the same, but there are definitely patterns. Mr. Pethokoukis probably should have used more examples, but the ones he cited are pertinent to his argument.

  5. I know we keep hearing about austerity, but what government actually cut spending in the Eurozone? Are we back to the old game of saying cutting the growth in spending is a cut? Show me a government that has cut spending or entitlements 10% and I’ll eat my hat!

  6. Great post. I believe Professor Henderson is a associate professor at the Naval Postgraduate School and a Hoover research fellow.

  7. Don’t forget that Harding slashed taxes and cut spending and pulled the US out of the Depression of 20-21 in short order.

  8. As correct as the article is about spending and the share the government extracts from the economy, we often miss the effect that interest rates and inflation have on the business cycle.

    Easy money, artificially low interest rates and inflationary monetary policy sets in motion an unsustainable boom which ends either when interest rates go back up or cannot fall any farther, forcing “austerity” in a more general sense and collapsing the inflationary bubble. This collapse, being painful, is called depression or recession.

    Our current cycle won’t reset and allow sustained growth until the remaining inflationary dollars are squeezed out of the market and interest rates return to natural levels.

    If we did away with the inflationary side of the cycle we could do away with the recession side of the cycle.

  9. I see the Keynesians are out in opposition to the post. But Keynesian economics has never worked. It did not work in 1946 (and remember Krugman still preaches WWII ended the Depression”). It has not worked in Japan. It did not work for FDR. It has not worked for Europe. It has not worked for the US in the 2008-2012 period. Never has such a widely touted hypothesis failed so completely and s consistently, but continues to be a working hypothesis. If economics were the science the Keynesian claim it is, then the academic economists should do what the physicists do: When a hypothesis does not work, can it and get a new hypothesis that might work. Where do economists think Einstein’s Relativity and then quantum mechanics came from. They came because the working hypotheses no longer worked. Only in the Social Sciences is hypothesis subservient to Political Correctness and the Primrose path becomes the yellow brick road to the wizard.

    • Rick,
      Your last sentence is correct insofar as it goes. I’ll agree with you on the so-called ‘science’ of economics. However, in climatology political correctness rules against all the empiracal evidence.
      TennDon

  10. The economy boomed? Not for me, or my family. Both my parents grew up literally dirt poor, farming stony ground. I was born in ’46 and by ’55 Eisenhower was on TV begging people to spend money. What money? We didn’t have any. Wages were little more than starvation wages, unless you were ‘in the union’ or well connected to the rich and power full. by the time I left high school wages were still terrible and the only work for a high school kid was common labor at slave wages. Pay was so bad you could make more on unemployment by the ’70′s. So I’ve worked my entire life for wages that we half the ‘national average’ or less, and now at 65 I have a run down hovel in the wilderness and I’m reduced to the subsistence living my parents enjoyed in the ’30′s.

  11. I don’t find James Pethokoukis’s argument especially convincing, but it strikes me as being the wrong argument anyway: the real question is: “If not massive spending cuts, then what? If it is even possible in theory for government to spend its way out of a bad recession, what evidence is there that this government, controlled by these politicians, has the skill and will to do so? And if it does not, then what is the alternative?”

  12. Ending WWII resulted in dramatic cuts in the US budget. The budget cuts were largely overseas. Domestic programs were not cut. Thus, I don’t think those cuts quality as “austerity”.

    Note: the US budget after WWII exceeded the budget prior to the war.

    http://www.usgovernmentspending.com/spending_brief.php

    Meanwhile, ending the gold standard had a huge economic impact. As each nation abandoned the gold standard, economic recovery soon followed. No nation on the gold standard returned to economic growth.

  13. It’s no secret excessive government regulations and interference hamper the private sector. Just recently, Bloomberg had a story about how France is full of companys with 49 employees. Why? Because of a truckload of burdensome government regulations that kick in when a company hits the magic number of 50 employees. Does anyone really think that businesses will shrug off mandates like Obamacare and higher energy costs due to no coal/more expensive oil and a general climate of anti-business rhetoric (pay your fair share, you fat cats!) day after day and keep hiring and expanding like it’s 1999? Would you, especially if you’re not GE or Goldman Sachs but Sam’s Lawn Service and you don’t have access to cheap capital, courtesy of the Federal Reserve? If so, try investing your own time and money in a business and come back and tell me how well it works out for you.

  14. Blah Blah Blah to all you naysayers. If 800 billion didnt fix sh_t then more is not either needed or wanted. If you think a government agency knows how to allocate money better than the market your too stupid or just plain ignorant of how markets work to comment here. Try flower arranging as a hobby or career, economics aint your strong suit.

  15. “There is a reason why it’s called Capitalism; it’s because Capital is what Fuels it.” Jacksonian Libertarian

    So many look at the Capital markets like they are some bottomless pit of money; instead of being a limited supply of money, the demand for which determines the price in interest rates. When the Government comes in and bites off a big chunk of that capital every year, the remaining supply goes up in price in order to reduce demand.

    Without affordable capital for consumers and businesses to borrow, jobs cannot be created. At the present time developed nations are sucking the fuel tank dry, competing for capital with consumers and businesses, and crowding them out of the market with the unfair credit risk advantage of a Central Government. The US Government is taking over $1.3 Trillion a year from the fuel tank, and has taken $6+ Trillion since 2008. That is $6+ Trillion that would have been used to buy consumer items like homes, cars, appliances, restaurant meals, or for businesses to start up or expand to create the jobs to meet those consumer needs.

    Looking at the period of time after WWII, the US Government was paying off the Debt, and thereby flooding the capital markets with money that had previously been sucked out starting with Herbert Hoover at the start of the Great Depression 1.0. Using this fact we can see that if the US was to stop draining the fuel tank and instead paid off the national Debt, the economy would instantly recover.

  16. You should also look to the post-WWI period for another example of successfully ending a recession through austerity. The depth of that recession/depression was breath-taking, but severe cuts in government spending reversed the economic fortunes of the US and launched the country into the Roaring Twenties.

  17. Your chart merely shows govt spending over time and two periods of recession. If govt spending “as a share of GDP plunged to 9% in 1948,” I would contend that caused the recessionary period you show in the chart. However by 1950 govt spending increased to almost 15% of GDP and recession ends. Your chart is useless in supporting your premise. And without noting percents of GDP after 1948 you are actually using it to mislead. If % of GDP were noted your chart would show that reducing govt spending by 1948 caused the recession and clearly show that sharply increasing govt spending from 9% of GDP to 15% by 1950 helped end the recession.

  18. Keynesians typically mention the concept of pent-up demand. Prove to me that pent-up demand is an unusual characteristic that exists only during those times when a Federal Government is consuming nearly all of the production of the private sector as occurred during our Second World War. I hold that most individuals will act in a manner that coincides with their best interests, that individuals will typically attempt to improve their financial positions whether it be through increased income or increased net worth, and that pent-up demand is continuous throughout all types of economic conditions.

    The ability of the private sector to absorb additional workers after the end of the Second World War was not a one-off occurrence. That ability came as a result of our Federal Government reducing it’s role in the decision-making processes of private businesses after the end of the war. Private businesses once again were able to make financial decisions based on which actions would be economically advantageous to those businesses and allocating their resources of production to those efforts which would bring the best financial return.

  19. Great post. This reminds me very much of the work done that has exposed FDR and his policies as the reason the Great Depression lasted so long… what’s funny is that the media has reported the studies done proving the problems created by FDR but society has ignored it. If the policies only made the Great Depression worse… why on earth would they work now?

  20. Gah. Reading this piece of trash masquerading as economics scholarship just chewed some minutes out of my life that I’ll never retrieve.

    It’s too cute by half to omit the economic benefit to North American

  21. I believe the main point of getting the government out of it’s own and everybody else’s way is valid. There is a lot of deferred activity going on now. Companies that are doing well are parking their cash out of reach of Obama. If Government now is akin to a large old corporation whose cash flow is declining but the Home office is getting bigger the overhead is killing off profits. These companies eventually collapse. Housing is stalled Energy is stalled manufacturing is stalled and investment is stalled. If the choke hold is taken off the US and we can get started especially ahead of other countries. Growth will happen and capital will flow here first. There are a lot of things to fix but economic growth can make the fixing an easier proposition.

    • “These companies eventually collapse”….. Not if they are not allowed to. Bailouts anyone? “There are a lot of things to fix but economic growth can make the fixing an easier proposition.” I don’t know… I think there is no way for economic growth is we don’t fix some of the major underlying corruption issues first. End the “war” in Afghanistan and the “war” on drugs now, then we may have a chance.

  22. This article does not take into account the many distinctions that exist between post WWII America and the current day. Many before me have described them in adequate detail, so I will simply summarize by saying yhat this article for all its statistics, draws incorrect conclusions that are not accurate or logical.

    • “Accurate or logical”? Umm, yeah using real world examples does constitute accuracy and logic. Though the technological landscape has drastically changed, 70 years is not that long ago, in economic trending. Fear still controls, and greatly cripples, our economy. And no, that fear will not stop because Obama tells you its ok, now (as the failures in his stimulus plans have shown).

  23. BYW, the “unemployed” were turned into soldiers in large part, which caused them to be psid as part of the war budget. Therefore they were not “on the dole” but actually government employees, which is not the answer to today’s problems. We need for companies to stop sitting on assets in fear, and boldly restart the engine of the economy with jobs, which will create salaries, tax base, demand for goods, and spending which will start a cycle of growth!

  24. The worst kind of austerity was the risk-taking austerity imposed on the Western World, when bank regulators decided that the capital requirements for banks should be based on the perceived risk of default of borrowers, even though that risk had already been cleared for by the banks in the interest rates, the amounts loaned and other terms.

    What these regulations delivered, as should have been expected, were just dangerous obese bank exposures to what is officially perceived as not-risky, and, for us, and economic growth, equally dangerous anorexic exposures to what is officially perceived as “risky”.

    What the Western world most need now is the sparkplugs, the risk-takers, the “risky” small business and entrepreneurs, back into its economic engine. But, unfortunately, what do our Western World leaders know about sparkplugs?

Leave a Reply

Your email address will not be published. Required fields are marked *

You may use these HTML tags and attributes: <a href="" title=""> <abbr title=""> <acronym title=""> <b> <blockquote cite=""> <cite> <code> <del datetime=""> <em> <i> <q cite=""> <strike> <strong>