Regime uncertainty: why the Great Depression lasted so long and why prosperity resumed after the war.

• Author: Higgs, Robert

"There have been endless analyses of individual economic policies; there has been little attention to changes in policy regimes."

--PETER TEMIN (1989, 134)

The Great Depression is one of the most studied topics in American economic history, and one about which scholars remain in serious disagreement. Perhaps the topic is too big, and its study would be more fruitful if it were broken down into subtopics. Thus, one might consider separately the causes of the Great Contraction, the unparalleled macroeconomic collapse between 1929 and 1933; the Great Duration, the twelve successive years during which the economy operated substantially below its capacity to produce; and the Great Escape, generally understood to have been brought about, directly or indirectly, by American participation in World War II. The Great Contraction has received the most attention, and its investigators show no signs of reaching a consensus. The Great Duration has received somewhat less study, though still a good deal, and the range of views among students of this aspect of the Great Depression is perhaps slightly narrower. Regarding the Great Escape, there seemed until recently to be hardly any disagreement.

In a paper published in 1992, however, I called into question the prevailing understanding of the Great Escape by challenging the reality of "wartime prosperity" during World War II. In the present paper I extend that argument, attempting to shed new light on the Great Duration and the Great Escape. For present purposes I make no attempt to explain the Great Contraction, merely recognizing that it occurred and that it had certain aspects, including most notably a collapse of private investment.

In the earlier paper I argued that a return to genuine prosperity--the true Great Escape--occurred only after World War II ended, not during the war as suggested by the idea of wartime prosperity. During the war years the economy operated essentially as a command system, and as a result the normal measures of macroeconomic performance (e.g., gross domestic product, the price level, and the rate of unemployment) were either conceptually or statistically incomparable with corresponding measures before and after the period subject to the wartime distortions.

In my understanding, one simply cannot speak with confidence about such matters as, for example, the rate of growth of real GDP or the rate of inflation from year to year during the period from 1941 to 1947. From 1941 through 1945, vast quantities of munitions were produced along with a restricted set of price-controlled civilian goods, some of which were physically rationed (Krug 1945; Harris 1945). Comprehensive price controls, gradually imposed in 1941 and 1942, were not abandoned for good until late in 1946 (U.S. Bureau of the Budget 1946, 235-73; Rockoff 1984, 85-176). Because the actual wartime prices could not even have approximated the prices of an economy in full competitive equilibrium, they cannot serve as appropriate weights for the construction of a meaningful national product aggregate. Unemployment virtually disappeared as conscription, directly and indirectly, pulled more than 12 million potential workers into the armed forces and millions of others into draft-exempt employments, but under the prevailing conditions the disappearance of unemployment can hardly be interpreted as a valid index of economic prosperity (Higgs 1992, 42-44).

Given the institutional discontinuity created by the wartime command economy, our understanding of the period from the late 1930s to the late 1940s, so far as it depends on the usual macroeconomic measures, must necessarily contain a huge gap. To insist on using the standard measures notwithstanding the complete evaporation of their institutional underpinnings would mislead us far more than frankly facing up to the fact that, for the war years, the usual measures have no real substance. One can compute them, of course, by making a great many assumptions and swallowing hard. But the wartime numbers that look so solid and comparable sitting there in the middle of a long time series are essentially arbitrary.

What we can say with confidence is that as of 1940, the economy had not yet recovered fully from the Great Depression; when the meaningfulness of the macroeconomic indexes began to fade in the second half of 1940, the Great Escape had not yet been completed. For the next five years the war-command system foreclosed conventional comparable measurements of the performance of the macroeconomy. Then, from mid-1945 until perhaps as late as the first quarter of 1947, the demobilization, reconversion, and decontrol of the economy continued to muddy the macroeconomic waters. Finally, certainly by 1948 and probably by 1947, economic conditions were sufficiently free of wartime distortions and their postwar carryovers that we can confidently make comparisons with, say, 1940 or earlier years. What we see then, of course, is that the postwar economy enjoyed a high degree of prosperity, whether judged by its low unemployment rate or by its high real GDP relative to the corresponding index for any prewar year.

We know, then, that sometime during the period of 1941 to 1947, the economy made its Great Escape. In my 1992 paper I argued that the war years themselves witnessed a deterioration of economic well-being in the sense of consumer satisfaction either present (via private consumption) or prospective (via accumulation of capital with the potential to enhance future civilian consumption) and that the Great Escape actually occurred during the demobilization period, especially during its first year, when most of the wartime controls were eliminated and most of the resources used for munitions production and military activities were returned to civilian production.

In light of the foregoing observations, we may justifiably adopt the following chronology: Great Depression, 1930 to 1940; transition to the war economy, 1940 to 1941; war-command economy, 1942 to 1945; demobilization, reconversion, and decontrol (the true Great Escape), 1945 to 1946; postwar prosperity, 1946 and beyond.

I shall argue here that the economy remained in the depression as late as 1940 because private investment had never recovered sufficiently after its collapse during the Great Contraction. During the war, private investment fell to much lower levels, and the federal government itself became the chief investor, directing investment into building up the nation's capacity to produce munitions. After the war ended, private investment, for the first time since the 1920s, rose to and remained at levels sufficient to create a prosperous and normally growing economy.

I shall argue further that the insufficiency of private investment from 1935 through 1940 reflected a pervasive uncertainty among investors about the security of their property rights in their capital and its prospective returns. This uncertainty arose, especially though not exclusively, from the character of federal government actions and the nature of the Roosevelt administration during the so-called Second New Deal from 1935 to 1940. Starting in 1940 the makeup of FDR's administration changed substantially as probusiness men began to replace dedicated New Dealers in many positions, including most of the offices of high authority in the war-command economy. Congressional changes in the elections from 1938 onward reinforced the movement away from the New Deal, strengthening the so-called Conservative Coalition. From 1941 through 1945, however, the less hostile character of the administration expressed itself in decisions about how to manage the war-command economy; therefore, with private investment replaced by direct government investment, the diminished fears of investors could not give rise to a revival of private investment spending. In 1945 the death of Roosevelt and the succession of Harry S Truman and his administration completed the shift from a political regime investors perceived as full of uncertainty to one in which they felt much more confident about the security of their private property rights. Sufficiently sanguine for the first time since 1929, and finally freed from government restraints on private investment for civilian purposes, investors set in motion the postwar investment boom that powered the economy's return to sustained prosperity notwithstanding the drastic reduction of federal government spending from its extraordinarily elevated wartime levels.

What Happened to Investment?

As economic historian Alexander Field (1992) has written, "no coherent account of the depth and duration of the Depression can ignore the causes of fluctuations in investment spending" (786). Figure 1 illustrates both real gross domestic product (GDP) and real gross private investment (GPI) from 1929 to 1950.(1) As the figure shows, both real GDP (bars, left-side scale) and real GPI (thin line, right-side scale) plunged from 1929 to a trough in either 1932 or 1933, the former by 29 percent, the latter by 84 percent. Both variables recovered rapidly after 1933: by 1937, real national product had regained 96 percent of its loss in the Great Contraction, and investment had recouped 64 percent of its loss. The "Roosevelt recession" of 1937 to 1938 cut short the recovery: real GDP fell by 4 percent in 1938, gross investment by 34 percent. Real national product recovered quickly after 1938, and in 1939 it finally exceeded its previous peak value of 1929. (Of course, this level of GDP was no longer a "full-employment" level; the rate of unemployment [Derby variant] was 11.3 percent.)(2) Investment recovered more slowly. Even in 1941, when stimulus from the defense mobilization had become substantial, real GPI had not quite regained its 1929 level. For what the data are worth, they show that private investment plunged to very low levels during the years the United States was a declared belligerent. After the war ended...