WHY THE GREAT DEPRESSION DID NOT RETURN AFTER WWII
and the resulting lessons for today's policy makers
The failure of the Great Depression to return in 1946 has some lessons for policy makers in today’s downturn both in the USA and the UK. Contemporary opinion in 1945 expected renewed economic decline and unemployment after demobilization.
It is generally conceded that Roosevelt’s New Deal did not stop the Depression, even if there is debate about whether it ameliorated the situation. The New Deal was, in many ways, a continuation of measures taken by President Hoover. Indeed, the first, and most widely praised, act of FDR, the Banking Bill, was virtually all written by Ogden Mills, Hoover’s Under-Secretary of the Treasury.
After all, Henry Morgenthau, Jr, Secretary of the Treasury for the whole of Roosevelt’s presidency, famously testified to the House Ways and Means Committee on May 9, 1939:
“We have tried spending money. We are spending more than we have ever spent before and it does not work. And I have just one interest, and if I am wrong … someone else can have my job. I want to see this country prosperous. I want to see people get a job. I want to see people get enough to eat. We have never made good on our promises … I say after eight years of this administration [worryingly Morgenthau said ‘eight’ when it was actually ‘six’] we have just as much unemployment as when we started. And an enormous debt to boot.”
GDP did not regain its 1929 level until after 1939 while unemployment remained at nearly 20% at the beginning of 1939 despite briefly falling to 16% in 1937. The Roosevelt years had seen vast monetary expansion while increased government expenditure had been funded by big tax increases, especially indirect taxes. While budgets had not been balanced, there were not large deficits. Federal expenditure rose from 3% of GDP in 1929 to 9% in 1939.
From 1939, when British and French armament orders began to flood the US until August 1945, the US was in a war economy characterized by the call-up of 20% of the labour force (about 12 million people) into the military and federal employment as well as the turning over of civilian manufacturing to produce war material. For example, General Motors completely ceased producing cars during the war and turned its massive factories entirely to producing war material. There were, of course, huge budget deficits as well as a low rate of unemployment which reached one per cent in 1944.
In 1945, the return of the 12 million in the US military and federal employment to civil life was widely expected by economic commentators to result in slump and renewed mass unemployment. Actually, between June 1945 and June 1946, nine million military and one million civilians left federal employment. President Truman said (New York Times, September 7th 1945) “obviously during the process there will be a great deal of inevitable unemployment” and on September 1st 1945 Business Week had forecast that unemployment would peak “closer to 9 million than 8 million”. These were spectacularly wrong forecasts but represented the general stance of commentators as the war came to an end.
SO WHY DID THE DEPRESSION NOT RETURN?
After all, unemployment remained below 4% from 1945 to 1947 despite 20% of the workforce being released from the military or defence spending. Moreover, the government was actually pursuing a highly contractionary fiscal policy following its release of the 17% of the workforce it employed in a single year (1945-6). It was dramatically reducing budget deficits by cutting back government spending from $97 billion per quarter in June 1945 to $26 billion by June 1946.
So there was government fiscal contraction, a huge increase in the available labour force yet unemployment remained consistently below four per cent. However, monetary policy remained fairly loose with low interest rates and high inflation.
I would suggest four reasons for the failure of the Depression to return and why 1946 was different.
They can all be summed up by stating that markets cleared and it became possible to invest for profitable production. This cleared the employment market, produced profits and savings which in turn meant further investment.
First of all the labour supply was greatly restricted. Some 5.5 million women and some older workers withdrew from the labour market between 1945 and 1946. Such women retirees were not, however, a financial burden to business as they were dependants of the existing male workers, sharing the same social capital. They did not absorb welfare payments or unemployment pay or require capital. So business faced a situation where a lot of the unemployment disappeared but was not a burden. Immigration had been severely reduced from 1913 and had been non-existent since 1930. The shock of immigration with its need to appropriate capital to employ labour and supply capital goods, such as houses, workers’ capital and social facilities for immigrants, had dispersed into the general economy over the previous 30 years.
Second, real wages had been kept down by wartime controls up to 1945 and fell behind price increases. They also did not keep up with price increases in 1945/6 and so real wages adjusted for productivity fell further.
Other factors kept real wages down and falling in 1946 and 1947, There were natural reductions in overtime and a decline in union strength because recovery was taking place outside the areas where unions were strong, for example, in the leisure industries. The fall in real wages allowed more workers to be hired.
Non-federal employment grew by 2.7 million in a year. It grew another 3.4 million by 1950. This does not include those switching over from producing war material in private industry who now began to supply the civilian market.
In short, price adjustments for labour took place to make labour employable. Price controls were mainly abolished in 1946.
Third, during the war, savings had greatly increased, reaching 25% of national income against 3% in 1939. During the war, these savings were channelled into the war economy but, after 1945, the savings’ pattern of behaviour remained but the war requirements did not. So, savings were available for investment. Some, of course, went on consumption. This was significant because income earners had adjusted to a lower consumption ratio of their income, partly because of government restrictions. Profits rose dramatically in 1946 and, of course, taxes fell so real business income rose even more. Borrowing costs were kept down as the government developed a budget surplus and itself became a supplier of funds to the market keeping interest rates low. The government was emphatically not crowding out borrowers.
Higher returns to capital and rising capital valuations stimulated business to expand.
Fourth, the Depression had burnt itself out.
Nobody was any longer trying to rebuild the economy of 1928. Efforts to do so had cast a pall over the Roosevelt era. Easy money leading to high stock and real estate valuations had led to investments in projects at a far greater rate than there were real resources to complete and pay for these projects. The capital structure of 1946 was now different. There were different population patterns, different products, different technology and different relative prices.
This rebalancing of the capital structure was a long affair. The mal-investments of the 1920s were now 17 years in the past. Business activities such as Goldman Sachs investment trusts, lending to improbable German and South American borrowers or building empty Detroit and New York office buildings, such as the Empire State Building, were shown to be superfluous and were not being repeated. In particular, banks had become cautious. The excesses of the fractional - reserve banking system had been severely curtailed.
In this analysis, recession is not optional – it is a necessary after-shock of an unsustainable boom - and there can be no return to the previous capital structure. Assets must be re-valued while new investment does not go to prop up the failed projects of the past but into future profitable production. It is a long process but fiscal stimulus and monetary expansion aimed at re-establishing the old economic order were bound to fail. Apart from anything else, they were too slow and impacted on markets which had already started to adjust naturally, so they resulted in reflating a capital and production structure which was not viable and had already changed.
There are idle resources in a depression but they cannot be put back to work in the old capital structure since many of its investments had been shown to be superfluous.
It is only market prices that can indicate where these idle resources should now be re-allocated so as to produce the selection of goods which the market now indicates is required.
So resources, in the form of investment and labour, had to be reallocated to future profitable production. This can only be done via the price signals of the market but it takes a long time and it had to overcome massive dislocation.
The long-term solution to the Depression was the return of profitable production. As relative prices and wages changed, there was increasing profitable production in the 1930s but not enough to clear the deep unemployment crisis created by 1929-33.
Spending money or borrowing money, as was done in the Roosevelt years in order to increase or maintain aggregate demand, merely props up the existing productive structure and may entrench parasitic, political and welfare beneficiaries who add to demand but not to market supply. Apart from unwelcome side effects, such as debt and mal-investment, economic recession returns when the stimulus is withdrawn, as in the 1937/8 recession, since the economic structure has not adapted to the new realities or has been distorted to become reliant on monetary and fiscal bailouts. So it delays the return of profitable production.
Profitable production returned in 1946. The labour force was reduced by employee withdrawal while, simultaneously, real wages reduced to make production profitable and labour hiring attractive. Savings were available to finance that production. Meanwhile, the pre-1929 capital structure had been altered and resources shifted to satisfy future demand.
FUTURUS/12 April 2009