The Keynesian Controversy: A Critical Assessment of the Effects of Fiscal Policy on the World War II Recovery

The record levels of economic growth between 1941 and 1945 that pulled the United States out of the Great Depression is often attributed as a victory for Keynesian economists.  Faced with a demand shock that was unresponsive to laissez-faire approaches to fiscal management, the United States indirectly proved economist John Maynard Keynes’s theory that fiscal policy could close recessionary gaps when it boosted its expenditures for wartime spending.  However, a closer analysis of the policies adopted during World War II and the economic indicators used to measure United states' growth reveal that many distortions call to question the actual impact that deficit spending had on the World War II recovery.  Analyses of the contributions that technology, price and wage control mechanisms, and labor market distortions reveal the complexities faced by economists in isolating the variables that contributed to the World War II expansion.

Theoretical Framework

The prevalent economic theories of the early 20th century explain the initial response of policymakers to the demand shocks that resulted in the Great Depression.  As Rockoff notes, Western economies were influenced by classical liberal economics (Rockoff 161).  Classical liberal economic theory was developed during the 19th century by scholars such as Adam Smith and John Stuart Mill (161).  Classical economists asserted that maximizing consumption should be the main focus of economic policies and that free trade and limited government intervention in the economy was the best method of promoting consumer spending (161).  A focus on the free market rather than the state as the focus of economic expansion is the primary contribution that classical economics made to future economic theories.

Neoclassical economics emerged as the dominant theoretical framework during the early 20th century and was a continuance of the liberal assumptions that were established by earlier classical economists.  As Mills notes, one weakness of the classic economics model was that it failed to account for the impact that a severe demand shock could have on the economy (59).  Though reduced demand contributed to an unemployment rate of 25 percent during the 1930s, leading neoclassical economists, including Joseph A. Schumpeter, Lionel Robbins, and Irving Fisher, asserted that the policymakers should take no actions to alleviate the recessionary gap (133).  In the view of neoclassical economists, decreased wages and interest rates would eventually result in increased hiring and investments and aggregate supply and demand would naturally return to its equilibrium without interference from the government (133; 139).  Under the assumption that interference would make the economy worse, economists during the Great Depression advised policymakers to allow the recessionary gap to close without the use of fiscal policy.

Economist John Maynard Keynes contributed to the economic theory by challenging the assumptions of neoclassical economists.  First, he criticized Say’s Law, arguing that government borrowing and spending should be used to increase aggregate demand (139).  Keynes challenged the assertion that the government budget deficit should be balanced like a “prudent household,” holding instead that prior attempts to cut budget balance expenditures failed to remedy the 1930s depression (140).  Keynes also argued that the reduction of wages would further decrease demand, widening the recession gap (139).  The increased government spending toward military expenditures during World War II provided economists with the opportunity to test Keynes’s assumption.   

The Effects of Wartime Spending on the U.S. Economy

Government fiscal policies during World War II took a significant departure from the policies advocated by neoclassical economists.  In 1940, the United States began to prepare for its role in the war by subsidizing arms manufacturers and raw material suppliers in order to assist the British military (Sabillon 262).  After the United States entered World War II in 1941, it continued its trend of military spending.  In 1943, defense spending accounted for 45 percent of GDP (263).  Additionally, increased demand from defense manufacturing was accompanied by an unemployment rate of zero (264).  By 1944, the armed forces accounted for 18 percent of the work force, increasing from less than 1 percent during the 1930s (263).  Further, GDP increased by 15 percent annually between 1940 and 1943 (264).  These figures support the assertion that increased government spending on manufacturing boosted the recovery from the Great Depression by supporting in-demand war industries, which resulted in increased demand and lower unemployment.

Research supports the connection that is often made between fiscal policy during the Great Depression and the results that followed.  Through analysis, Ohanian demonstrates the positive relationship between World War II fiscal policy and GNP growth.  As Ohanian notes, real GNP increased by 40 percent between the years 1941 and 145, which resulted in an average growth rate of 8.4 percent per year (Ohanian 23).  Further, government spending increased by 124 percent during World War II, the capital tax rate increased from 44 percent before World War II to 60.2 percent, and the percentage of government expenditures financed by debt and seigniorage totaled 59 percent (25).  Through an economic model simulation, Ohanian demonstrated that modest government spending and the adoption of a balanced budget policy would have required a 3 percent increase in consumption in order to close the recession gap (37).  Thus, Ohanian makes the case that the World War II recovery demonstrated weaknesses in the classical model and validated Keynesian economic theory.

Alternative Views on the Causes of the 1941-45 Recovery

While there is strong support for the link between increased government deficit spending and growth in GDP during World War II, many economists argue that other variables contributed to the wartime expansion.  Dumenil, Glick, and Levy evaluate period data to determine that technological innovation contributed to increased output during World War II (p. 316).  Their analysis reveals that during 1930 and 1945, the annual growth rate of technology totaled 3 percent (Dumenil, Glick, and Levy 318).  Characterizing this rate as a “revolution in technology,” the researchers assert that the increase in autonomous methods of production between 1929 and 1946 led to a 40 percent increase in productivity (319).  This contributed to a growth rate of 3 percent during the period, which was three times the growth rate prior to the war (319).  Thus, technological innovations at the industry level are asserted to be the actual cause of the post-Depression recovery.

Other economists assert that market interference on behalf of the government was a primary factor of the World War II growth rates.  In a case study of the rubber industry, Wendt describes how the United States government lifted key industries during the war.  Because rubber was in shortage yet essential to the war, United States companies were selected to supply rubber internationally, decreasing market competition (204).  Further, the industry branches of the War Production Board were granted the authority to control scarce materials by limiting their use among consumers (214).  Further, Hart-Landesberg asserts that government efforts to control wages were responsible for decreases in unemployment (Hart-Landesberg 400).  In order to reduce inflation, the government entered an agreement with labor unions that curbed wages at 15 percent of growth (404).  The result of this interference is that the actual result of government fiscal policies was distorted.

Criticism of Keynesian Explanation of the Recovery

Along with identifying alternative factors that contributed to the success of the World War II economy, many critics argue that the impact of the policies enacted during the 1940s are overstated.  Steindl presents the argument that the United States economy was in recovery prior to the start of World War II.  As he noted, the economy was 22 percent below its trend but was only 6 percent below its trend by 1942 (180).  To explain the pre-war growth, Steindl asserts that monetary expansion policies that were enacted in 1933 were gradually influencing the economy (179).  These findings on the pre-war growth rates corroborates Dumenil, Glick, and Levy’s findings on the impact that pre-war technological innovation had on growth rates during the 1930s.

Other economists assert that a recovery did not take place during until after World War II.  Horowitz-McPhilips cites leading Keynesian critic Robert Higgs in challenging the assertion that the economy recovered during World War II.  According to Higgs, the economy did not actually recover until the end of World War II, and several features of the war distorted GNP and unemployment figures (Horowitz-McPhilips 327).  For example, the draft artificially reduced unemployment in the male population (327).  Similarly, Aldrich asserts that gender inequality is another factor that may have driven wages down.  As Aldrich finds, though the increase of women in male-dominated manufacturing positions increased from 1 percent to 22 percent between 1939 and 1944, wages remained stagnant for female workers (418).  In manufacturing, the earnings of female workers decreased by as much as 18 percent during the war (418).  Further, Horowitz-McPhilips conclude through a quantitative analysis of wartime media and correspondence that the standard of living during World War II decreased for Americans due to product shortages, the proliferation of inferior goods, and poor labor conditions (326; 395) This distortion created by the draft and the gender gap in pay is another significant factor that challenges the assumption that the GNP and unemployment figures reported between 1941 and 1945 were a reflection of the economic prosperity of the general American public.   

Conclusion

Prior to World War II, the prevalent economic theory argued that interference in the free market by governments is counterproductive.  Because classical economists failed to account for severe demand shocks in the economy, they held that the market would eventually reach equilibrium after a reduction in aggregate demand.  However, economist John Maynard Keynes argued that the government should increase demand through deficit spending in order to stimulate consumer spending and reduce unemployment.  While initially unproven, military spending during World War II enabled economists to finally test Keynes’s theory.  Yet, despite the correlation between increased deficit spending during the war, growth in GDP, and reductions in unemployment, closer analysis challenge the assumption that World War II validated Keynes’s recommendations.  As critics note, technological innovations, price and wage controls, and labor market distortions are among the variables that call into question the efficacy of Keynesian economic policies during World War II.

Works Cited

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Hart-Landsberg, Martin. “Popular mobilization and progressive policy making: Lessons from World War II price control struggles in the United States.” Science & Society 67.4 (2003): 399-428. Retrieved from ProQuest database.

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Mills, John. A critical history of economics. New York: Palgrave Macmillan, 2002. Print.

Ohanian, Lee E. “The macroeconomic effects of war finance in the United States: World War II and the Korean War.” The American Economic Review 87.1 (1997): 23-40. JSTOR. Web. 20 Sep. 2013.

Rockoff, Hugh. America's economic way of war: war and the US economy from the Spanish-American War to the first Gulf War. Cambridge: Cambridge University Press, 2012. Print.

Sabillon, Carlos. On the causes of economic growth the lessons of history. New York: Algora Pub, 2008. Print.

Steindl, Frank G. “What ended the Great Depression? It was not World War II.” The Independent Review 12.2 (2007): 179-197. ProQuest. Web. 19 Sep. 2013.

Wendt, Paul. “The control of rubber in World War II.” Southern Economic Journal 13.3 (1947): 203-227. JSTOR. Web. 20 Sep. 2013.