Monday, January 13, 2014

How Keynesian Economics Won World War II

...and created the greatest middle-class in world history.

John Maynard Keynes began his theoretical work (Treatise on Money, published in 1930) to examine the relationship between unemployment, money and prices back in the 1920s. A central idea of his work was that if the amount of money being saved exceeds the amount being invested — which can happen if interest rates are too high — then unemployment will rise.

He argued that aggregate demand determined the overall level of economic activity, and that inadequate aggregate demand could lead to prolonged periods of high unemployment. According to Keynesian economics, government intervention was necessary to moderate "boom and bust" cycles of economic activity. He advocated the use of fiscal and monetary measures to mitigate the adverse effects of economic recessions and depressions.

Keynes was deeply critical of the British government's austerity measures during the Great Depression. He believed that budget deficits were a good thing, a product of recessions.

At the height of the Great Depression in 1933 Keynes published The Means to Prosperity, which contained specific policy recommendations for tackling unemployment in a global recession, chiefly "counter-cyclical" government spending*.

* Keynesian economics advocates the use of automatic and discretionary counter-cyclical policies to lessen the impact of the business cycle. One example of an automatically counter-cyclical fiscal policy is progressive taxation. By taxing a larger proportion of income when the economy expands, a progressive tax tends to decrease demand when the economy is booming, thus reining in the boom. When the government adopts a counter-cyclical fiscal policy in response to a threat of recession the government might increase infrastructure spending. (As an aside: Keynes also makes one of the first mentions of the " multiplier effect".)

Classical economists at the time believed that "supply creates its own demand", and that in a "free market" workers would always be willing to lower their wages to a level where employers could profitably offer them jobs (when in those days, what was good for the boss, was also good for the worker).

An innovation from Keynes was the concept of "price stickiness" — the recognition that, in reality, workers often refuse to lower their wage demands, even in cases where a classical economist might argue it is rational for them to do so. Due in part to price stickiness, it was established that the interaction of "aggregate demand" and "aggregate supply" may lead to stable unemployment equilibria — and in those cases, it is the government (also acting as a referee), and not the free market, that economies must depend on for their salvation.

In Keynes's greatest work (The General Theory of Employment, Interest and Money) he argues that demand, not supply, is the key variable governing the overall level of economic activity. Aggregate demand, which equals total un-hoarded income in a society, is defined by the sum of consumption and investment. In a state of unemployment and unused production capacity, one can only enhance employment and total income by first increasing expenditures for either consumption or investment. Without government intervention to increase expenditure, an economy can remain trapped in a low employment equilibrium.

Keynes advocated "activist" economic policy (intervention) by government to stimulate demand in times of high unemployment — for example, by spending on public works — or preparing for war. "Let us be up and doing, using our idle resources to increase our wealth," he wrote. Keynes' General Theory work is often viewed as the foundation of modern macroeconomics.

Following the outbreak of World War II, Keynes's ideas concerning economic policy were adopted by leading Western economies. Keynes argued in his work How to Pay for the War (published in 1940) that the war effort should be largely financed by higher taxation* — and especially by compulsory saving (essentially workers lending money to the government), rather than deficit spending, in order to avoid inflation. He argued that compulsory saving would act to dampen domestic demand, assist in channeling additional output towards the war efforts, and would be fairer than punitive taxation; and would also have the advantage of helping to avoid a post-war slump by boosting demand once workers were allowed to withdraw their savings (and later events proved him to be 99.99% correct).

* The Iraq and Afghanistan wars were the very time time in U.S. history that taxes weren't raised to pay for American wars. George W. Bush did THE EXACT OPPOSITE, and lowered taxes — contributing to current U.S. government debt. The crisis of World War II led Congress to pass four excess profits tax statutes between 1940 and 1943. After the war in 1945 Congress repealed the tax, effective 1 January 1, 1946. The graph below shows the debt incurred during World War II. (There was not enough government spending to stimulate the economy after the 2007-09 recession as multinationals were investing and hiring more overseas.)

Gov't debt


By the first years of American involvement in World War II, wartime manufacturing facilities had been established throughout the nation, creating a tremendous demand for labor. Within months of the U.S. declaration of war, the national unemployment rate plummeted an astounding 10% from its 1940 level. War mobilization—that is, the rapid production of military equipment, vehicles, weapons, and ammunition, along with the fortification of American borders and military bases abroad — coupled with the military draft, created a vast labor shortage. Employers were desperate to fill positions as quickly as possible to meet production demands and needed to hire workers en masse. Positions had to be opened then, not simply to the traditional labor force, but also to women and non-whites (those who had long been excluded from many skilled and high-paying industries).

Wartime mobilization contributed not merely to a temporary respite from the Great Depression, but planted the seeds for tremendous post-war economic growth. In order to maintain a military large enough and strong enough to fight on two major war fronts, the federal government required most manufacturers to halt production of consumer items. Car manufacturers, for instance, were ordered to cease normal operations and, instead, to assemble armored vehicles to be used on the battlefield.

The demand for labor was so great all across the nation that proprietors had to offer high wages and other fringe benefits to lure potential laborers — young, old, married, unmarried, white, black, immigrant, and women — away from competitors. Businesses practically begged for workers, offering extraordinary incentives such as medical care, exemption from the military draft, daycare facilities, and even paid maternity leave, a perk previously unimagined. To be sure, these were surreal shifts for so many Americans who were affected by the Great Depression and were intimately familiar with scarcity and hopelessness.

While Americans had fewer products to buy during the war, they were earning much more than ever before. As a result, families were compelled to save money throughout the war years. Once the war ended and manufacturers discontinued production for war mobilization, consumer products once again filled store shelves. A population buoyed by full employment, rising wages, growing prosperity, and renewed national confidence began to spend—and to spend enthusiastically.

New expectations, new wages, and new options that were created by the World War II home front mobilization had sparked a post-war economic boom — and the most prosperous period in the nation's history.

Economic aid flowed to war-ravaged European countries under the Marshall Plan, which also helped maintain markets for numerous U.S. goods. And the U.S. government itself recognized its central role in economic affairs. The Employment Act of 1946 stated as government policy "to promote maximum employment, production, and purchasing power."

During the 1950s, the number of workers providing services grew until it equaled and then surpassed the number who produced goods. And by 1956, a majority of U.S. workers held white-collar rather than blue-collar jobs. At the same time, labor unions won long-term employment contracts and other benefits for their members.

Growing demand for single-family homes and the widespread ownership of cars led many Americans to migrate from central cities to suburbs. Coupled with technological innovations such as the invention of air conditioning, the migration spurred the development of "Sun Belt" cities such as Houston, Atlanta, Miami, and Phoenix in the southern and southwestern states. As new, federally sponsored highways under Dwight D. Eisenhower created better access to the suburbs, business patterns began to change as well. Shopping centers multiplied, and many industries soon followed.

During the 1950s, Keynesian policies were adopted by almost the entire developed world and similar measures for a mixed economy were used by many developing nations as well. By then, Keynes's views on the economy had become mainstream in the world's universities. Throughout the 1950s and 1960s, the developed and emerging free capitalist economies enjoyed exceptionally high growth and low unemployment. Professor Gordon Fletcher has written that the 1950s and 1960s, when Keynes's influence was at its peak, appear in retrospect as a Golden Age of Capitalism.

And then came Ronald Reagan and his admiration for Milton Friedman and "the invisible hand" of Adam Smith, whose principles are often distorted today in debates about "free markets" regarding the self-regulating behavior of the free market, where individuals can make profit, and maximize it without the need for government intervention — benevolent or not.

After the Powell Memo, by 1979 the middle-class had peaked — then came Reaganomics and the Republican strategy of Starve the Beast (starving government spending) and the long decline in both manufacturing and the middle-class, when "trickle up economics" had created the largest income gap between rich and poor not seen since before the Great Depression.

The total number of manufacturing jobs in the U.S. had hit its historical high peak in 1979 (when union membership had also peaked), but these numbers have since been in a continuous decline. The last time the U.S. had this few manufacturing jobs was just after WWII, when manufacturing was retooling from military production to consumer production. This one graph below from the St. Louis Fed tells the whole story since 1979.

This post is continued here, and focuses more on the period between 2000 and 2014, because that's when the U.S. employment-population ratio and the labor force participation rate had both peaked at their all-time highs in 2000 — but have since been in a steady decline ever since, because of the escalation of offshoring of jobs.

No comments:

Post a Comment