Fiscal contraction and economic expansion: the 2013 sequester and post-World War II spending cuts.

• Author: Taylor, Jason E.

Proposals for government spending cuts are almost always accompanied by doomsday predictions from Keynesian-influenced economists. For example, Richard K. Vedder documents that when the Second World War ended in 1945, Keynesians loudly declared that if government spending declined, the economy would return to the Depression-era conditions of the 1930s (Vedder and Gallaway 1991, 1998; Taylor and Vedder 2010). In fact, the government's role in the U.S. economy declined dramatically as government spending went from 41.8 percent of GDP in 1945 to only 17.9 percent in 1946. Furthermore, over 9 million military personnel returned to civilian economic life and millions of civilian jobs related to the war effort disappeared. In anticipation of these cuts, the consensus forecast was that the unemployment rate would return to die double-digit numbers of the 1930s. Yet, despite the large government contraction, unemployment was less than 2.3 million, or a rate of 3.9 percent, in 1946, and 2.6 million, or a rate of 4.4 percent, in 1947--achieving "full employment," as defined by economists. As Taylor and Vedder (2010: 6) note, "The 'Depression of 1946' may be one of the most widely predicted events that never happened in American history."

A similar episode occurred in 2012 and 2013 when government spending cuts associated with the Budget Control Act (BCA) of 2011 and the sequester were implemented. It was widely predicted that if the sequester's across-the-board cuts in federal spending were executed, the economy would be thrown back into those conditions seen in the Great Recession of 2007-09, or worse. Yet, as was the case in 1946, significant cuts occurred despite these dire warnings. Nominal government spending fell in both 2012 and 2013--the first time that government spending had fallen two years in a row since the 1950s. Once again the dire predictions did not come to pass. Monthly employment numbers grew at a faster rate after the spending cuts than they had prior to them, and GDP grew at around the same pace pre- and postcuts. The "sequester-induced contraction of 2013," which was a major part of the ominous sounding "fiscal cliff' over which the country was supposedly going to topple, was--like the post-WWII government contraction--another of the most widely predicted events in U.S. history to never happen. This paper compares these two episodes and looks for policy lessons.

World War II Spending Cuts: Fear of the Depression's Return

By the outbreak of war in Europe in late 1939, President Franklin Roosevelt's New Deal economic programs had been in place for nearly seven years with only limited success at ending the Great Depression. While unemployment was lower than it was in 1933, many contemporaries viewed this reduction as being the product of government relief jobs rather than a bona fide, permanent recovery. Government employment via Depression-era agencies like the Works Progress Administration, it appeared to some, would have to remain part of the economic landscape indefinitely. In fact, Bateman and Taylor (2003) show that this fear caused long-term economic goals to continue to be a large part of the objectives of New Deal "alphabet agencies" even after the nation entered the Second World War.

Between 1942 and mid-1945, the United States was essentially a command economy and unemployment practically disappeared. (1) The Controlled Materials Flan, introduced in November 1942, was created and operated inside the War Production Board to harness the production capacity of the nation for military purposes. The Office of Price Administration rationed or restricted consumer durables like automobiles and office chairs with metal frames. Labor was also commandeered or otherwise directed by the federal government into military purposes. The Selective Service registered and drafted citizens into the military, while the Employment Service and the War Manpower Commission used incentives to mobilize and employ labor into jobs of highest military priority. At its peak, the war effort supported 45 percent of the nation's civilian labor supply, while another 12 million citizens, representing around 18 percent of the total (military plus civilian) labor force, were employed directly by the military (U.S. Bureau of the Budget 1946). The unemployment rate fell below 2 percent as the United States went from a dramatic labor surplus in the 1930s to a labor shortage during the war.

In light of all this, it is easy to understand why policymakers so feared that a rapid transition from the command-oriented economy described above to a market-oriented one following the war would bring back high unemployment. If the war ended the Depression, what would the end of the war bring? As the war ended after the Japanese surrender in mid-August 1945, the National Resource Planning Board predicted that over the next year, unemployment would rise to between eight and nine million, representing 12 to 14 percent of the labor force. John Snyder, director of the Office of War Mobilization and Reconversion, submitted a report in which he forecast that eight million people would be unemployed by the spring of 1946 (U.S. Office of War Mobilization and Reconversion 1945: 5). The press followed suit as the September 1, 1945, issue of Business Week predicted that unemployment would peak "closer to 9,000,000 than 8,000,000." (2) These predictions were relatively optimistic compared to some others. Leo Cherne of the Research Institute of America and Boris Shishkin, an economist for the American Federation of Labor, predicted 19 and 20 million unemployed, respectively, which would have translated to an unemployment rate around 35 percent (Ballard 1983: 17-18).

Even in the face of these dire warnings, within six weeks of the Japanese surrender, the Controlled Materials Plan was, with a few exceptions, ended so that resource allocation was once again left to die private sector. Furthermore, Ballard (1983:135) notes that by the end of 1945, 80 percent of all war contracts had been settled. Despite the massive decrease in government production and the discharge of over 10 million men and women, who had been employed directly by the military either as soldiers or civilian workers, into the private sector, the postwar unemployment problem did not materialize. Table 1, which provides key labor force and employment data for 1939 to 1950, shows that as the government withdrew, the private sector grew. Vedder and Callaway (1993: 171) refer to this as a "classic case of 'reverse crowding out.'" The smooth transition of labor resources from government-directed to market-directed production was viewed as a miraculous event. Vedder and Gallaway (1993: 158) write, "We know of no other episode in American economic history tiiat more clearly illustrates several neoclassical and Austrian economic insights than" the postwar transition.

The Post-Great Recession Era and the Government Spending Sequester

In 2008, the federal government began to take extraordinary steps in an effort to combat the "Great Recession." President George W. Bush signed the Keynesian-oriented, $152 billion Economic Stimulus Act of 2008, which sent checks to U.S. households in hopes that the country could spend its way out of the downturn. In 2009, President Barack Obama outdid the Bush stimulus by more than a factor of five with the American Recovery and Reinvestment Act--an $831 billion stimulus consisting of tax rebate checks, infrastructure spending, and smaller amounts of spending on health, education, and renewable energy, among other categories. The Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 brought another $916.8 billion in stimulus by prolonging the Bush tax cuts, cutting payroll taxes, and extending unemployment coverage. The Middle Class Tax Relief and Job Creation Act of 2012 extended the payroll tax cut provisions, which was said to create another $167.6 billion in stimulus. Of course, it could be argued that extending tax reductions already in place is not true stimulus so much as an avoidance of contractionary policy. All told, however, the major and minor stimulus legislation from 2008 to 2012 amounted to over $2 trillion in new federal spending and tax rates below what they would otherwise have been (Firey 2012).

In light of these actions, the federal budget deficit averaged nearly $1.3 trillion between 2009 and 2012, adding over $5 trillion to the national debt in just four years (U.S. Office of Management and Budget 2014a). Given this quick...