Monday, 27 October 2008

The great escape

Having outlined Greg Mankiw's view, see here, of what got us into the 1930s depression, I now take a look at Robert Higg's view of what got us out. Higgs writes in a column, Our Economic Past ~ The Great Escape from the Great Depression, in "The Freeman: Ideas on Liberty" - October 2008, Vol. 58 No. 8, that
With regard to the Great Escape, economists have also reached substantial agreement, but unfortunately they have come to agree on an interpretation that is almost completely wrong.

It is wrong factually because it places the Great Escape in the early 1940s, around the time the United States became a declared belligerent in World War II, whereas the economy did not return to what we may properly describe as prosperity until after the war. Economists have misconstrued the specious “wartime prosperity” as the real thing, but diverting nearly 40 percent of the total labor force into military-related employment and producing mountains of guns and ammunition do not create genuine, sustainable prosperity, as people would discover if they tried to operate an economy on this basis for more than a brief period. The true Great Escape did not occur until 1946.
He goes on to say
After the war most of the wartime economic controls were discontinued, more than 10 million men were mustered out of the armed forces, and the released warriors and civilian war workers quickly found private employment or left the labor force for home or school. The unemployment rate in 1947, when the transition was nearly complete, was less than 4 percent.

The standard interpretation of the transition after 1945 emphasizes that during the war people had accumulated enormous amounts of bonds and bank deposits, and afterward these financial holdings were “released” to finance consumer spending, especially for durable goods whose production had been prohibited or greatly diminished during the war. This interpretation, however, makes no sense: the bonds one man sold another bought, leaving the economy’s overall holdings unchanged. Similarly, the money one man spent by drawing down his bank account reappeared in the sellers’ bank accounts, leaving the economy’s overall bank deposits unchanged. In fact, holdings of liquid assets did not decline at all after the war. People financed their spending for consumer goods by reducing their saving rate.

Nor did people attempt to reduce their holdings of liquid assets by decreasing their demand for cash balances—equivalently, by increasing the average dollar’s “velocity of expenditure.” Velocity actually fell slightly during the immediate postwar years (because, some economists have conjectured, people still expected postwar deflation).

Nor did consumers reduce their holdings of government bonds. Although the amount of outstanding government debt declined between 1945 and 1948, this occurred almost entirely because of reductions in the holdings of commercial banks and corporations other than banks and insurance companies.
What then drove the postwar business expansion?
While consumers were financing their postwar spending binge simply by reducing their saving rate, which had risen to extraordinary heights during the war, businesses financed their postwar investment surge by selling government securities acquired during the war; by retaining more of their current earnings, in part because business taxes were reduced substantially after 1945; and by entering the capital markets, where stocks and bonds could be sold on very attractive terms. Even greater business expansion was prevented mainly by lack of materials, rather than by lack of desire to invest or lack of financial resources—to the great astonishment of the elite Keynesian economists, who had forecast that a severe postwar depression would occur when the government reduced its purchases of war-related goods and services.
Higgs goes on to argue here, as he has before, that the Keynesians policy makers of the time had failed completely to understand that the prewar depression had persisted for so long in large part because of "regime uncertainty". During the Second New Deal, the period 1935 to 1938, the Roosevelt administration had created extreme apprehension in the minds of investors and businessmen about the security of their private property rights, and thus had discouraged these people from making the large volume of long-term investments necessary for the economy's full recovery and for its sustained long-run growth. By the time that World War 2 ended, Roosevelt was dead and the most zealous advisers and administrators of the Second New Deal had left government service altogether or had been placed in less influential positions. This resulted in a considerably more auspicious view being taken of the future security of private property rights than had been true before the war. This change in outlook was sufficient to induce a great deal of long-term private investment for the first time since 1929. Higgs writes
Because “regime uncertainty,” which had dominated the later 1930s, no longer cast such a dark shadow over business and investment, the economy finally recovered from the Great Depression and the economic hardships of the war years, even as it simultaneously reallocated about 40 percent of the labor force from war-related uses to civilian uses.
Higgs ends by noting
The year 1946, when civilian output increased by about 30 percent, was the most glorious single year in the entire history of the U.S. economy. By 1948, real output was back on its long-run growth trend, and during the decades that followed, the economy was spared the sort of deep and long debacle that a congeries of wrongheaded government policies had caused during the 1930s.

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