Keynes vs. Reality-2

Great post by Russ Roberts at Cafe Hayek.

"In this earlier post, I noted this 1943 Paul Samuelson prediction:

When this war comes to an end, more than one out of every two workers will depend directly or indirectly upon military orders. We shall have some 10 million service men to throw on the labor market. We shall have to face a difficult reconversion period during which current goods cannot be produced and layoffs may be great. Nor will the technical necessity for reconversion necessarily generate much investment outlay in the critical period under discussion whatever its later potentialities. The final conclusion to be drawn from our experience at the end of the last war is inescapable–were the war to end suddenly within the next 6 months, were we again planning to wind up our war effort in the greatest haste, to demobilize our armed forces, to liquidate price controls, to shift from astronomical deficits to even the large deficits of the thirties–then there would be ushered in the greatest period of unemployment and industrial dislocation which any economy has ever faced.

From Paul Samuelson, “Full Employment after the War,” in S.E. Harris, ed., Postwar Economic Problems, 1943.

Samuelson was wrong. When the war ended, there was massive demobilization of the armed forces and a large reduction in government spending. Yet the economy thrived, unemployment remained very low and there was a huge expansion of private sector employment.

One defense of Samuelson is that this quote is mainly about the dynamics of the labor market–it doesn’t say much about aggregate demand. It doesn’t focus particularly on the drop in government spending. But if you go back to the original article (which you can find by taking a line or two and using Google books–I hope to post more on this later) you will find other passages that make it clear that he saw this as a problem caused by a sudden drop in aggregate demand.

There were a number of interesting comments on the post. Some noted the drop in GDP after the war but forgot that wartime price controls and large amounts of government output made measuring of GDP during the war quite difficult. There was a mild recession in 1945–during the war. The most dramatic change was the one I highlighted–a large expansion of private sector employment with very little unemployment. It was an incredible transition achieved with surprising speed.

I’d like to highlight one comment by Daniel Kuehn:

Samuelson was wrong in forecasting. Keynes wasn’t wrong in theorizing.

Why did Samuelson end up being wrong? Have you ever thought that through?

Because post-war demand was substantial and he didn’t expect that.

High levels of private sector demand and a full employment economy… where the hell do you get “Keynes vs. Reality” from that? That has Keynes written all over it.

All you’re demonstrating is that Samuelson didn’t have a crystal ball. That isn’t exactly a news flash.

This defense of Keynes unintentionally highlights a flaw in Keynesianism at least as practiced by Daniel but I don’t think he’s alone or I wouldn’t single him out. (And I would add that I usually appreciate Daniel’s comments, particularly their tone in the face of criticism from the rest of you.) One, would an economist presume that a change in government spending would have no effects on other types of spending? If government spending shrinks and there is suddenly more resources available to the private sector, why would you not foresee a change in private sector spending? Secondly, the fact that full employment corresponds to high levels of spending (regardless of their source) is very close to a tautology. The challenge is to understand causal linkages and the direction of causation.

In the last few sentences of the previous paragraphs, I had originally referred to private demand. I changed it to private spending. I don’t know what private aggregate demand means, or the phrase “pent-up” demand. The usual way that Keynesians explain the post-war expansion despite the huge cut in government spending is to say, well of course the economy boomed, there was a lot of pent-up demand. What does that mean? There is always pent-up demand in the sense there is a stuff I wish I could have but can’t. But the standard story is that people couldn’t buy washing machines or cars during the war–they were rationed or simply unavailable or unaffordable. So when the war ended, and rationing and price controls ended, people were eager to buy these things. But the reason these consumer goods were rationed or unavailable is because all the steel went into the tanks and planes during the war. So when the war ended, there was steel available to the private sector. That’s why cutting government activity can stimulate the private sector. Fewer resources are being commandeered by the public sector. As the Hayek character says in the Fight of the Century when answering the Keynesian claim that WWII ended the Great Depression:

Wow. One data point and you’re jumping for joy
the Last time I checked, wars only destroy
There was no multiplier, consumption just shrank
As we used scarce resources for every new tank

Pretty perverse to call that prosperity
Rationed meat, Rationed butter… a life of austerity
When that war spending ended your friends cried disaster
yet the economy thrived and grew faster

This earlier post where I discuss Krugman’s claims about rationing and the austerity of the early 1940′s may also be of interest."