The Magazine

The Ultimate Stimulus?

World War Two and economic growth

Sep 12, 2011, Vol. 16, No. 48 • By ARTHUR HERMAN
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As Washington waits for President Obama’s plan on how to revive the economy and pull us out of our 9 percent unemployment rut, a growing chorus on the left is calling for us to go to war—or at least the economic equivalent of war. 

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Leading the chants is ultra-Keynesian Nobel Prize-winning economist Paul Krugman, who argues that the only thing that will save the economy now is “a burst of deficit-financed government spending” on a scale like that launched in World War Two. In fact, “if we discovered that space aliens were planning to attack and we needed a massive [military] build-up,” he said on a recent television show, “this slump would be over in 18 months.” 

Krugman says this not because he’s a great fan of our military (he’s not) but because he’s a fan of big deficits as a form of economic stimulus. During World War Two, that involved government borrowing to the tune of $30 trillion in today’s dollars—a sum that makes Obama’s 2009 $800 billion stimulus look like pocket change. But since that’s what turned around the economy in World War Two, wiped out 9 percent unemployment, and finally ended the Great Depression, goes the argument, then that’s the scale of spending that is required now. 

But did World War Two really end the Great Depression? A growing body of evidence from economists and historians suggests the opposite. Far from turning around the numbers in a burst of government-financed economic activity, the massive mobilization for war may actually have prolonged the Depression, and even deepened aspects of it. And far from setting the stage for the boom of the fifties and afterward, as the textbooks suggest, the economic policies of the war had to be reversed to make way for the postwar boom—yet some of those very policies are being pressed on Obama and the country today. 

This flies in the face of conventional wisdom, the evidence for which at first seems overwhelming. The explosive growth in defense spending from 1941-45—from $1.5 billion in 1940 to $20 billion in 1942 and $42 billion in 1944 (or in current dollars, a defense budget roughly eight times larger than the one today)—was accompanied by a similar explosion in GNP, which more than doubled. As America’s factories turned out planes and tanks and other munitions in unheard-of numbers, unemployment plummeted from 9.5 percent to about 1.2 percent even as wages soared far faster than business profits, thanks to a wartime excess profits tax. “Pyramid-building, earthquakes, even wars may serve to increase wealth” by multiplying economic demand across the board, John Maynard Keynes had written in 1936. To generations of Keynesian economists and their students, America’s experience in World War Two seemed to prove it. 

Yet those amazing numbers are softer than they look at first glance. 

To quote one of the leading skeptics of the Keynesian “multiplier effect,” economist Robert J. Barro, “the data show that output expanded during World War Two by less than the increase in military purchases.” Other measures of economic output in the form of private consumption, private investment, nonmilitary government purchases, and net exports actually fell so that resources could go to military production. 

In fact, when you take the government share out of the GNP growth numbers, a very different picture emerges. Economist Robert Higgs has shown that nongovernment GNP growth, which was moving ahead in 1940, actually slowed down in 1942 and then slowed still further in 1943. Far from getting stimulated by the frenzy of government spending, the nongovernment share of GNP recovered its earlier pace of growth only once the war was over. 

In short, the war may have killed off a recovery already under way. All evidence suggests that the crucial turnaround from the Great Depression came before U.S. entry into the war: GNP jumped from $90.5 billion in 1939 to $124.5 billion just before Pearl Harbor, when government spending was still at relatively low levels. Then with mobilization, private consumption and investment slowed and headed south—while government deficit spending headed sharply north, rising from $6 billion in 1940 to $89 billion in 1944. 

Still, advocates of the conventional wisdom will reply, at least all that government spending and all-out wartime production ended unemployment. Yet those numbers turn out to be equally illusory. 

The biggest change in the employment picture was the fact that some 16 million men were pulled out of the labor market and into the armed services—more than 22 percent of the prewar labor force. Most were draftees, and most were young men in the prime of life who, under normal circumstances, would have been making cars or refrigerators or stamping out parts for children’s toys or stringing telephone wires, instead of dropping bombs on German cities or lobbing mortar shells on Japanese positions on Iwo Jima. 

No one can deny their service to their country was invaluable. Its value to the economy is another matter. Instead of producing things of value, they were destroying them in prodigious amounts. Certainly it was in a laudable cause; but it came at a huge economic cost not just in the materials that were being blown up, shot up, or sunk at sea, but in the lost opportunities all that robust manpower could have applied to generating things people really wanted and valued.

Nor were they alone. In fact, the massive new work force mobilized by the war included not just members of the armed services but civilian armed services employees and military logistics and supplies employees. All were serving their country, and all were drawing a paycheck—but few were doing anything that an economist could classify as producing goods or increasing capital. On the contrary, their salaries, like those of the armed forces, sucked money out of the economy in the form of rising tax dollars and soaring borrowing. In effect, they were net consumers, not producers, of economic resources—as are most government employees today. 

Yet by 1943 they made up 42 percent of the American work force, before falling back to 10 percent when the war was over. 

But what about the people who were making those bombers and tanks and machine guns and artillery shells, the Rosie the Riveters who worked overtime in the defense plants and shipyards? Surely they must have been adding something of value to the economy. 

There’s certainly no denying that they were making things, and mobilizing skills that were in high demand, in exchange for pay. Very good pay, in fact, especially for those at the bottom of the social scale. The war drew African Americans, rural whites, and women into the industrial workforce for the first time and gave them skills, wages, and opportunities most had never dreamed possible. In this sense, the World War Two myth does hold true. The war’s unprecedented demand for labor set off a social revolution which the fifties and sixties broadened and deepened.

But again, the high-cost goods these workers were making were not made for use in the ordinary way cars or houses            or books or newspapers are, as goods or services in a market economy. The civilian workers engaged in the war effort were building B-24s and aircraft carriers and submarines meant for only one purpose, or supplying tools and parts for these sophisticated engines of death and destruction. Those planes and ships that survived the war generally wound up on the scrap heap, instead of contributing their full value to future economic growth. 

In fact, that productive effort came at considerable personal sacrifice. As anyone who lived during those years will tell us, American workers on the home front were forced to live under a welter of wartime restrictions and rationing, even as Washington dictated an end to production of civilian durable goods—with the Office of Price Administration actually telling restaurants how much they could charge for a meal. Americans learned to do without, in order to make sure there was enough steel for warships, enough aluminum for airplanes, and enough wool, cotton, and nylon for uniforms and parachutes. 

What’s remarkable isn’t that Americans by and large accepted these restrictions as a way of life. This was war, after all, and most who stayed at home recognized that their sons and brothers and husbands serving overseas were making a far greater sacrifice. What is remarkable is how the American economy still managed to produce both guns and butter in those years. 

Despite the wartime restrictions, Americans ate better, consumed more meat, shoes, clothing, and used more energy than they had before the war. And even though the United States wound up producing the most munitions of any country in World War Two, it was also the least mobilized of all the major combatants—largely because its economy was still the most productive in the world before the war started. 

In short, it wasn’t the war that created a strong economy. It was the strong economy that made mobilization for war possible in the first place. All the war did was sacrifice present growth to a massive rearmament to defeat the Axis. Yet “as the war ended,” writes Higgs, “real prosperity returned almost overnight.”


 

This postwar boom has always posed a problem for Keynesians like Krugman. As government spending plummeted with the coming of peace— military spending alone collapsed from 37.5 percent of GDP in 1945 to just 5.5 percent in 1947—many predicted that, without this prop and with the new burden of millions of returning veterans looking for work, the economy would sink once more into the abyss. Paul Samuelson, later the dean of American Keynesian economists, wrote that unless the government did something drastic, “there would be ushered in the greatest period of unemployment and industrial dislocation which any economy has ever faced.”

Instead, after a brief hiccup in 1946, the economy rebounded, growing from $231 billion GDP in 1947—roughly what it was in 1945—to $258 billion in 1948, and from there to $285 billion in 1950. Unemployment, despite the dire predictions, increased only to 3.9 percent between 1945 and 1947, in spite of the fact that some 10 million new workers came into the civilian labor market.

The only way Keynesians could explain it was that all those saved paychecks from the war translated into a consumer spending spree, as pent-up demand finally found an outlet in consumer goods like new cars and refrigerators and houses people had wanted but couldn’t have. That, it seemed, was enough to compensate for the drop-off in government expenditure, which had put all that money in those workers’ bank accounts in the first place—exactly as a good economic stimulus should. 

On only one point is this picture accurate. Although war workers were often forced to move into poor and inadequate housing and work longer hours under dangerous conditions—the war saw a 30 percent rise in the number of workers disabled on the job—they were also being paid a lot. With consumer choices contracting, there was little to do with that extra money but save it. (In fact, economist Mark Skousen argues that those aggregate private savings actually propped up a Federal Reserve wartime monetary policy based on deficit borrowing combined with flat interest rates.) 

But long ago Milton Friedman and Anna Schwartz noticed something that undermined the Keynesian explanation. The postwar period saw no fall in savings. People’s liquid assets actually continued to grow after the war, from a record $151 billion at the close of 1945 to $168.5 billion by the start of 1948. If something stimulated the economy, it wasn’t people unwinding their savings accounts. 

Instead, the biggest trigger to growth turns out to have been a sharp rise in private capital investment, which the New Deal had slowed—one reason the Great Depression lingered as long as it did, Higgs argues—and the war had all but halted. That investment jumped from $10.6 billion in 1945 to $46 billion in 1948, as plants expanded and retooled for the production of civilian goods. Even though the overall personal savings rate fell, the private investment rate soared from 5 percent to almost 18 percent, with the biggest leap coming in 1946—a leap that would be reflected in GNP numbers only two years later. Meanwhile, business savings almost doubled in the same period, from $15.1 billion to $28 billion—providing a sure way to finance expansion and hiring. 

This rebirth of business confidence, indeed, was the one positive contribution World War Two did make to the future of the economy. 

The sheer breathtaking volume and diversity of wartime production gave people a new respect for American business, whose image had taken a severe beating during the Depression and from New Deal rhetoric. Businesses, including the most productive sectors like automobiles and steel, had made sizable profits from wartime production (though, again, profits had jumped less than wages), and many had built hefty stocks of government securities. Others had gained valuable experience in the techniques of flexible mass production and had learned to apply managerial and engineering skills to what had seemed insurmountable problems, from building the immensely complicated B-29 to creating the atomic bomb. With the release from wartime restrictions and regulations, all that was needed was one more shove to trigger a real boom and complete the shift back to making things the market, not the Pentagon, wanted. 

This time the shove came from Washington, in the form of a tax cut. The Revenue Act of 1945 cut the top marginal tax rate from 94 percent to 86.45 percent, and the lowest marginal rate from 23 percent to 19 percent. It also reduced corporate tax rates and eliminated FDR’s wartime excess profits tax and price controls. At the time, Georgia senator Walter George, chairman of the Senate Finance Committee, predicted the tax cut would “so stimulate the expansion of business as to bring in a greater total revenue.” He was right. Revenues soared even as government expenditure continued to fall, and America’s postwar boom was on. In the two decades after 1948, GNP grew at an average annual rate of 4 percent—while a Republican Congress elected in 1946, followed by a Republican president in 1952, ensured that nothing stood in the way of the renewed flow of prosperity.

Private capital formation and investment, restored business confidence, tax cuts and reduced regulation, and a Republican president—there in a nutshell was a genuine formula for economic stimulus, as opposed to the Keynesian distortions of the economy during World War Two. As for those millions of wartime workers and producers, the Rosie the Riveters and the Barney Rooses (inventor of the Army Jeep) who toiled so hard and sacrificed so much, we can always be grateful for what they did. Together with our men and women in uniform, they won a world war, and in the process they drew Germany and Japan, two of the world’s most highly educated and productive nations, back into a global free-market economy. 

But they didn’t save our economy then, and invoking their memory won’t save Obama now—or save our economy from the damage he and his Keynesian friends have already done.

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