The Waterloo of Keynesianism (Military and Domestic)

Note: In part, this post is an answer to a query by Mark Hatlie.

While it is perilous for any historian to predict the future, we may well be headed for the Waterloo of Keynesianism (both military and domestic) and that is a good thing.

Crudely put, Keynesianism (so named for the British economist John Maynard Keynes) is the theory that government’s can speed long-term recovery by running high deficts so as to stimulate aggregate demand or investment. It is the entire basis of Obama’s stimulus plan. To some extent, Keynesian ideas were the basis of Bush’s massive bailout and big spending policies, most especially his now forgotten “stimulus checks.”

The popularity of the Keynesian theory is something a puzzle (at least to me). Few ideas more defy ordinary common sense. Taken in today’s context, it seems akin to telling an individual who has recklessly run up a hundred thousand dollar credit card debt to spend even more on fixing a driveway or garage (infrastructure). For some reason, such advice (which would be considered utter lunacy when applied to individuals) is widely accepted as the best method of economic recovery when taken by governments.

Probably no event is more commonly cited as a Keynesian spending success story than World War II. Variants of this thesis can be found among across the political spectrum. On the right, neocon Conrad Black argues that World War II “had restored prosperity after the free market had failed.” On the left, Paul Krugman similarly writes: “There's nothing magic about spending on tanks and bombs rather than roads and bridges. The reason World War II worked more effectively than the WPA [in terms of promoting economic growth] as that it was *bigger.*”

While Krugman might prefer that this “bigger” spending be on roads and bridges, rather than bombs, this does not change the fact he still accepts the overall premise that spending on wars can be good for the economy. If this is true, one wonders why he never praised Bush’s bloated military budgets. If anyone should have greater reason to call this theory into question, it is antiwar historians. Fortunately, one has.

In a seminal article for the Journal of Economic History, Robert Higgs convincingly challenged the Keynesian theory of World War II as put forward by Krugman, Black and others.

While unemployment disappeared during the war, it was hardly a step forward. Moving men and women from the unemployment lines to the killing fields of Anzio did not represent economic progress in any meaningful sense. During the war, Americans at home suffered from rationing, shortages, more accidents on the job, longer hours, and many other measures of economic deprivation. Moreover, as Higgs points out, “real personal consumption declined. So did real private investment. From 1941 to 1943 real gross private domestic investment plunged by 64 percent; during the four years of the war it never rose above 55 percent of its 1941 level; only in 1946 did it reach a new high.”

According to Higgs, genuine prosperity did not begin to return until the last months of 1945 and 1946. This prosperity occurred under a policy of reverse Keynesianism which included massive reductions in spending because of demoblization, rapid steps toward price decontrol, and scaled back deficit spending.
Higgs sums it up:

World War II, the so-called Good War, has been a fount of historical fallacies. One of the greatest – and one of the most pernicious for subsequent policymakers – is the notion that prosperity prevailed during the war. Although Americans might have been dying in the Pacific and European theaters of war, people on the home front actually benefited from the war, because it propelled the economy at long last out of the Great Depression. This view of the war would be sufficiently egregious if it were true, but despite the claims of historians for the past half century, it is not true.

In my view, Obama's best hope to bring lasting recovery is to let the economy go through a short, but sharp, readjustment. He needs to remove the malivestments, not perpetuate them. Obama can facilitate this readjustment to a more sustainable level by cancelling the bailout, cutting spending, and pruning deficits. Another worthy goal would be to dismantle the Federal Reserve which helped to create this mess through its easy credit policies.

Most of all, however, Obama should end our costly empire by closing down our overseas bases and bringing home the troops. Only then, can we start to get our financial house in order and move towards genuine economic well being.