Krugman vs. Cato on Cutting Back Spending

Paul Krugman writes today, "Both textbook economics and experience say that slashing spending when you’re still suffering from high unemployment is a really bad idea." I can't speak for the particular textbooks Krugman reads, but Cato Policy Report just looked at the most significant example of slashing spending in American history -- the quick, sharp spending cuts after World War II. Economists Jason Taylor and Richard Vedder find:

the "Depression of 1946" may be one of the most widely predicted events that never happened in American history. As the war was winding down, leading Keynesian economists of the day argued, as Alvin Hansen did, that "the government cannot just disband the Army, close down munitions factories, stop building ships, and remove all economic controls." After all, the belief was that the only thing that finally ended the Great Depression of the 1930s was the dramatic increase in government involvement in the economy. In fact, Hansen's advice went unheeded. Government canceled war contracts, and its spending fell from $84 billion in 1945 to under $30 billion in 1946. By 1947, the government was paying back its massive wartime debts by running a budget surplus of close to 6 percent of GDP. The military released around 10 million Americans back into civilian life. Most economic controls were lifted, and all were gone less than a year after V-J Day. In short, the economy underwent what the historian Jack Stokes Ballard refers to as the "shock of peace." From the economy's perspective, it was the "shock of de-stimulus."

If the wartime government stimulus had ended the Great Depression, its winding down would certainly lead to its return. At least that was the consensus of almost every economic forecaster, government and private....

What happened? Labor markets adjusted quickly and efficiently once they were finally unfettered — neither the Hoover nor the Roosevelt administration gave labor markets a chance to adjust to economic shocks during the 1930s when dramatic labor market interventions (e.g., the National Industrial Recovery Act, the National Labor Relations Act, the Fair Labor Standards Act, among others) were pursued. Most economists today acknowledge that these interventionist polices extended the length and depth of the Great Depression. After the Second World War, unemployment rates, artificially low because of wartime conscription, rose a bit, but remained under 4.5 percent in the first three postwar years — below the long-run average rate of unemployment during the 20th century. Some workers voluntarily withdrew from the labor force, choosing to go to school or return to prewar duties as housewives.

But, more importantly to the purpose here, many who lost government-supported jobs in the military or in munitions plants found employment as civilian industries expanded production — in fact civilian employment grew, on net, by over 4 million between 1945 and 1947 when so many pundits were predicting economic Armageddon.

Household consumption, business investment, and net exports all boomed as government spending receded. The postwar era provides a classic illustration of how government spending "crowds out" private sector spending and how the economy can thrive when the government's shadow is dramatically reduced.

Krugman says that experience teaches us that controlling spending would "deepen the slump" and cause tax revenues to fall. But the experience of 1945-47 is that a spending cut far deeper than we could dream of today -- from $84 billion to $30 billion! -- led to an economic boom.