Depression Lessons: How Much Fiscal Stimulus?

December 13th, 2008

There's lots of talk these days on upcoming fiscal stimulus–how much it should be and how it should be delivered. The NYT Economix blog offers recommendations from several economists, assuming a $500-billion package. Here's one that Greg Mankiw likes.

When it comes to the size of the stimulus–and as Krugman argues quite cogently, in this case size is what matters–the Great Depression, and our recovery from same, gives some pretty solid clues.

So first, a brief history. How did we get into the Great Depression, and how did we get out of it?

  1. Technology and corporate capitalism pre-'29 delivered a huge productivity/efficiency boom.
  2. Absent sufficient redistribution, a smaller percentage of GDP went to wages, and more to profits–there was more money, but it wasn't widespread.
  3. This resulted in insufficient consumer demand to support the upward spiral, and excessive speculative investment from all those profits because there weren't enough productive investments available (because there wasn't enough demand). The log stopped rolling and things fell apart.
  4. The government/Fed response was initially almost nonexistent. They never even touched the most powerful lever–monetary easing–until '31/'32. (Gotta let that creative destruction happen…)
  5. By that point deflation had set in, making monetary easing largely ineffective.
  6. Despite widespread notions to the contrary, net fiscal stimulus '32-'39 was actually quite tepid. In '36 Roosevelt even raised taxes and cut spending out of budget concern, and the still-latent depression surged back.
  7. Starting in '39, orders from Europe increased demand, offering some relief, but with little or no effect on U.S. domestic consumer demand.
  8. During the war years U.S. government (deficit) spending surged spectacularly. The federal debt when from 50% to 120% of GDP. Consumer demand remained low, but for reasons unrelated to monetary or fiscal policy. (50% of output going to the military–and much going overseas–and rationing on everything, right down to clothing.)
  9. Personal savings (especially E Bills) did climb rapidly, and production spiked as government spending (read: demand) put unproductive capacity (plants, financial capital, and people) to work.
  10. When the war ended–with the wheels of the economy rolling full-speed and wartime distortions removed–people started spending their savings and their wages (think: demand), and we entered the great prosperity.
  11. Over the next 35 years that prosperity allowed us to pay down the debt that pulled us out of the Depression, bringing it steadily down, to 35% of GDP by 1980. (Then came Reagan; we're now back to 70%.)

Short story, it was the massive fiscal stimulus of wartime deficit spending that finally broke the Depression's back.

Now we're in the same situation (with the same causes–but with a worse debt position). The Fed has pulled out every monetary stop, and it's still not enough. Fiscal spending it the only shot we have left in the locker.

If we take WWII deficit spending as a model, how much fiscal stimulus should we provide?

If we do half of what we did we World War II–increase our government debt by 35% of GDP–we're talking something like 4 trillion dollars in government deficit spending. Since most proposals include big chunks of productive investment as opposed to mere government consumption (i.e., bombs and bombers), we can probably get by with far less. (Though investment spending takes longer to work.)

If that spending also serves to raise our ongoing government/redistributive spending and (especially) taxing to a responsible level at which a high-productivity economy has the aggregate demand to thrive without meltdowns, the resulting prosperity should allow us to pay off that debt in less than 20 years. (This assumes the kind of more-responsible government we had pre-Reagan.)

I think that puts the current proposals–for stimulus of $500 to $700 billion–in appropriate historical perspective.

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