When The US Actually Tried Austerity, It Worked

Now, we all all know “austerity” from deep spending cuts (not the tax hikes, of course) is killing Europe’s economy and would do the same here in America, right?

Well, here’s a story about austerity that critics such as President Obama, Paul Krugman, and Ezra Klein never seem to mention: From 1944 to 1948, Uncle Sam cut spending by a whopping 75% as World War II came to end. Spending as a share of GDP plunged to 9% in 1948 from 44% in 1944.

Superstar economist and devout Keynesian Paul Samuelson—later to become the first American to win the Nobel Prize in economics—predicted such shock austerity would cause “the greatest period of unemployment and industrial dislocation which any economy has ever faced.” That dire, disastrous prediction was widely held by his fellow Keynesians, with one even predicting an “epidemic of violence.”

Except the doomsayers were wrong, even though Washington obviously ignored Samuelson’s call for gradual spending reductions. Despite cuts which dwarfed those seen in the EU today—not to mention those Republicans are calling for here at home—the U.S. economy thrived. There was no mass unemployment despite rapid demobilization of the armed forces. As George Mason University economist David Henderson explains is his 2010 paper, “The U.S. Postwar Miracle” (which this entire post draws upon):

As demobilization proceeded rapidly, employers in the private sector, full of the optimism … scooped up millions of the soldiers, sailors, and others who had been displaced from the armed forces and from military industries. … The number of unemployed people did increase, rising from 0.8 million to 2.3 million, but with a civilian labour force of 60.1 million, the 2.3 million unemployed people implied an unemployment rate of only 3.8 per cent. As President Truman said, “This is probably close to the minimum unavoidable in a free economy of great mobility such as ours.

Of course, liberals are quick to point out the U.S. economy suffered its worst one-year downturn in history in 1946, a drop of 12%. To many Americans, it surely must have seemed like Samuelson was right, that the Great Depression had returned. But no one thought that back then, especially with jobs plentiful unlike during the 1930s. The drop in output was a statistical quirk caused by the removal of price controls. As Henderson explains:

For example, imagine that the free-market price of a pound of filet mignon during the war would have been $1.40 a pound. But imagine further that the government had set the price at $1.00 a pound. Then, when the price control was removed, the price would have shot to $1.40 a pound. Inflation statistics would have recorded some amount of inflation due to this large price increase. But those statistics would have overstated the real price increase because getting beef at $1.40 a pound is better for many of the people who couldn’t, because of the shortage, get it at $1.00 a pound.

Second, those sky-high output figures during the war measured government spending on goods and services, lots of it military hardware, at their cost. But what was all that stuff really worth, in purely economic terms, vs. post-war consumer purchases of homes and cars and nylon stockings? While total output fell by 12% in 1946, private-sector GDP rose by nearly 30%.

Or look at it this this way: Real U.S. output in 1947 was 17% higher than in 1941 despite the decline in government spending. Why was the economy prospering in way it never did during the Great Depression? Taxes were cut a little, and government interference—including price and production controls and rationing—was reduced a lot. But perhaps just as important, Truman dumped many of FDR’s most radical New Dealers. That change boosted business confidence, and companies started to invest again in America.

The typical Keynesian response mostly centres around dismissing the immediate post-war boom as a one-off event complicated by many unique factors. But it happened again, as Henderson notes! After the Cold War ended, overall federal spending fell to 18% of GDP in 2000 from 22% in 1991. But again the economy boomed. Real U.S. GDP grew by 40% with an average annual growth rate of 3.8%. Henderson speculates that perhaps the decline in defence spending freed up knowledge workers to help make technological miracles happen in the private economy.

The lesson here: Spending cuts might well produce prosperity instead of austerity, especially if accompanied by less government interference in the economy and less fear in the private sector of anti-market government policies.

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