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Work and prosperity
2 July 2012

A proven formula for growth: Beat the Germans and slash government spending

David Henderson, of the Hoover Institution has a history lesson for us. It concerns the Second World War and its aftermath, so appropriately he begins by lining up a target in his sights:

  • "We often hear that big cuts in government spending over a short period of time are a bad idea. The argument against big cuts, typically made by Keynesian economists, is [that] large cuts in government spending, with no offsetting tax cuts, will lead to a large drop in aggregate demand for goods and services, thus causing a recession or even a depression…" 
  • "But if such claims were true, wouldn’t history confirm them? And wouldn’t the decline in the economy be large when the government cuts spending a lot?" 

The example that Henderson has in mind is the aftermath of the Second World War when the US Government made some truly spectacular cuts in government spending:

  • In a 2010 study for the Mercatus Center at George Mason University, I examined the four years from 1944, the peak of World War II spending, to 1948. Over those years, the U.S. government cut spending from a high of 44 percent of gross national product (GNP) in 1944 to only 8.9 percent in 1948, a drop of over 35 percentage points of GNP." 

35 percentage points! That is some cut back. Obviously, compared to the modern day welfare state, de-mobilising a wartime command economy allows for bigger and faster reductions in government spending. Yet, from a macroeconomic viewpoint, the nature of government spending isn’t the issue, but rather its overall level.

So, what was the result of such a rapid retrenchment?

  • "The result was an astonishing boom. The unemployment rate, which was artificially low at the end of the war because many millions of workers had been drafted into the U.S. armed services, did increase. But between 1945 and 1948, it reached its peak at only 3.9 percent in 1946. From September 1945 to December 1948, the average unemployment rate was 3.5 percent." 

Needless to say, there have been all sorts of arguments as to why these particular circumstances were exceptional. Naturally, these only occurred to the Keynesians after the boom had occurred; beforehand they were confident – as economists tend to be – that their general theories would apply.

Of course, winning a war is a rather special event. There can be no clearer signal to investors and consumers that the crisis is over and normality restored. The anti-austerity economists of our own day should ask themselves whether a sudden splurge of government spending would send anything as clear a signal or whether it would be perceived as a last, desperate throw of the dice.


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