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Why Economic Policies Inspired by the Great Depression Fail

Economics / Economic Theory May 03, 2010 - 03:12 AM GMT

By: Gerard_Jackson


Best Financial Markets Analysis ArticleThe latest quarterly survey by the National Association for Business Economics reports that the stimulus did not promote recovery. (In case you didn't know, the country's phony media are frantically pushing the idea that happy days are on the way, something they would never do under a Republican administration.) Any conundrum here is a direct result of fallacious economic reasoning. The idea that the level of output and employment is a function of aggregate spending was a very old fallacy that Keynes successfully resurrected and which is now part of orthodox economic theory even though it has been thoroughly refuted by experience.

If the spending approach is correct then it follows that a significant reduction in spending would quickly cause output to contract and unemployment to rise. It also follows that if the demand for labour keeps rising after spending is slashed then there must be something seriously wrong with the theory. Very few people realise America actually experienced this phenomenon.

During WWII economists fretted that once peace returned and military spending severely curbed the country would return to the same levels of unemployment that prevailed in the 1930s. Paul Samuelson for one expected an unemployment rate of 8 million. Their solution was what became the fashionable Keynesian nostrum of maintaining government spending.

Despite the fears and objections of these economists post-war spending was indeed drastically slashed. The fiscal years 1944 to 1947 saw spending dive from $95 billion to $36 billion -- a $59 billion cut, an astounding 62 per cent reduction. (During the same period defence spending fell by about 76 per cent.) To the utter surprise of these Keynesians, instead of the economy rapidly sinking into depression with unemployment rocketing to 8 million or so it boomed and full employment was maintained at under 4 per cent.

This achievement is all the more amazing when we consider that at the same time "fourteen million World War II servicemen [had] returned to civil life". (Harry Truman, State of the Union, 6 January1947.) Now Keynesians tend to treat surpluses as contractionary and yet the US budget went into surplus in 1947 where it remained until 1950. (Incidentally, students won't find any of these facts in any economics textbook.)

Keynes was once challenged for changing his mind on monetary policy. (The man was notorious for continually changing positions). He tartly replied: "When the facts change, I change my mind. What do you do, sir?" Yet when his disciples were faced by the post-war facts of an enormous drop in government spending accompanied by the restoration of full employment despite mass demobilisation their response was to rationalise them away in terms of their Keynesian paradigm. They did this by conjuring up the phantom of pent up consumer spending.

According to this explanation war-time spending by the government greatly restricted personal consumption which resulted in people accumulating large amounts of financial assets, including savings accounts. When the war ended the use of these assets to demand consumer goods offset the reduction in government spending by maintaining the demand for Labour. This prevented the return of mass unemployment and the emergence of large-scale idle capacity.

Very plausible but utterly false. To begin with, it is estimated that consumer spending only rose by about $14 billion while we know that government spending dropped by $59 billion. Therefore aggregate spending must have contracted by $45 billion. (In fact, figures show a drastic fall in GDP at the time even though there was full employment and a rapid expansion in the production of consumer goods.) The idea that pent up consumer demand was responsible for the post-war recovery does not hold.

For Keynesians supply creates demand. For the classical and other pre-Keynesians demand can come only from production. John Stuart Mill succinctly presented this view when he declared that "demand constitutes supplies". In other words, to demand something one must first offer something up. This would be obvious in a barter economy. Mill's father explained

that consumption is posterior to production, as it is impossible to consume what is not produced. Consumption in the necessary order of things is the effect of production, not production the effect of consumption. (James Stuart Mill, Commerce Defended, C. and R. Baldwin, 1808, p. 79).

Therefore the real pent up demand could only be on the production side. Once the war ended all of the productive capacity that had been devoted to producing war materiel was now directed to the production of consumer goods. This is where the increased demand came from, not postponed consumer demand as asserted by Keynesians. No matter how much is held in the form of financial assets by the public it cannot command an increased quantity of consumer goods unless the capital goods necessary for their production are available. And an increase in the quantity of capital goods can come only from an increase in the quantity of savings.

This leads to the conclusion that the problem in the 1930s was not demand deficiency but withheld capacity. (W. H. Hutt, The Keynesian Episode: A Reassessment, LibertyPress, 1979). Hoover and Roosevelt implemented policies that ensured that production and hence demand would be severely curbed. Maintaining real wage rates significantly in excess of productivity prevented real prices and costs from adjusting to the new monetary conditions resulting in unemployment being kept at a tragically high level.

Irrespective of what Keynesians assert real wages did exceed productivity during this period. The following table clearly shows that the PARW¹ (the inflation adjusted real wage divided by productivity) tracks the unemployment rate. This is precisely what marginal productivity theory predicts. One should also note that GNP started to rise when the real adjusted wage began to fall. (Inflation not only raises nominal GDP it also reduces unemployment by lowering the cost of labour relative to the value of its marginal product².)

Once the country was at war the Roosevelt administration did what every government at war does -- it resorted to the printing press. Now one of the effects of this inflationary induced war-time boom was to cut real wages by allowing them to once again correspond with productivity. When hostilities ceased industry found costs and relative prices were finally being allowed to adjust to real economic conditions. (This process even repealed for a time Roosevelt's minimum wage rate). In Hutt's terminology withheld capacity had been released and it was this discharge of productive power that drove the post-war economic boom.

The lesson for today should be crystal clear. However, I get the feeling that the last thing the Obama administration is interested in is learning anything from economic history let alone allowing the free market to do its work. So I guess Americans will have to put up with Obama and his supporters blaming the market for the present state of the economy instead of political meddling and the Fed's appalling monetary mismanagement.

¹These figures were constructed by me.

²From 1933 to 1937 the wholesale price level rose by 21.5 per cent (Federal Reserve Bulletin, May 1941, p. 453). For the same period the consumer price index rose by about 11 per cent (Historical Statistics of the United States).

By Gerard Jackson

Gerard Jackson is Brookes' economics editor.

Copyright © 2010 Gerard Jackson

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