The End of the Great Depression

Estimates of fiscal multipliers for 1940-41 are relevant to low-utilization situations like 2008-10 only when estimated through mid-1941, because the U. S. economy in the last half of 1941 was subject to severe capacity constraints.

In The End of the Great Depression 1939-41: Policy Contributions and Fiscal Multipliers (NBER Working Paper No. 16380), co-authors Robert Gordon and Robert Krenn conclude that nearly 90 percent of the economic recovery that took place between the first quarter of 1939 and the last quarter of 1941 can be attributed to fiscal policy innovations. Monetary policy innovations also had a positive effect, while innovations in non-government components of GDP had a negative effect.

This paper highlights a paradox in the study of fiscal multipliers: even though proponents of fiscal policy stimulus to cure a weak economy operate in an environment of low capacity utilization, most of the actual episodes of rapid fiscal expansion have taken place either prior to or during wartime episodes in which capacity constraints were operative (including World War II, the Korean war, and the Vietnam war). An ideal test case for measuring the fiscal multiplier occurred in the six quarters between mid-1940 and late-1941, prior to the Pearl Harbor attack. Previous analysts assumed that this period represented a fair test of the multiplier effect, because the unemployment rate was 9.9 percent on average during 1941. However, this paper shows that capacity constraints did exist in 1941, particularly in the second half of the year. The fiscal stimulus in 1940-41 was partly crowded out not by any increase in interest rates, but rather by capacity constraints in critical areas of manufacturing that became increasingly binding in the second half of 1941. Therefore, estimates of fiscal multipliers for 1940-41 are only relevant to low-utilization situations like 2008-10 if they are based on the evolution of the U. S. economy through mid-1941 and exclude the effect of the capacity-constrained last half of 1941.

After reviewing evidence from the 1940-41 editions of Business Week, Fortune, and The New York Times, Gordon and Krenn document that the American economy went to war starting in June 1940, fully 18 months before Pearl Harbor. In February 1941 fully one percent of the American labor force was at work building army training camps for 1.4 million new draftees. Employment in ship-building to expand the U. S. Navy and to supply Lend-Lease aid to Britain accounted for another one percent of the labor force in 1941. As early as June 1941, capacity utilization had reached 100 percent in the production of iron and steel and durable goods of all types.

For this analysis, Gordon and Krenn develop a new quarterly dataset beginning in 1919 and they estimate a model of the U.S. economy for 1920-41 using those data. They show that private consumption and investment actually declined in the last half of 1941, as shortages of steel prevented auto companies from satisfying demand, and shortages of aluminum needed for aircraft production suppressed civilian production of everyday pots and pans. As a result, the government spending multiplier is 1.9 when estimated through mid-1941 but only 0.9 when measured through the end of 1941.

-- Matt Nesvisky