Friday, November 13, 2009

Krugman On World War II multipliers

As a follow-up to this post, Paul Krugman has as stated earlier repeatedly argued that the experience of World War II proves the benefits of massive government spending. Not necessarily on the military, but spending of any kind.

However, while reported GDP did rise significantly, the fact is that private sector spending fell sharply during that period-following a period when it grew fast (And the official numbers probably gave a too rosy picture since price con. The drop in private spending has led for example Robert Barro to argue that the fiscal policy multiplier* is less than 1.

Krugman here argues against this in the following way:

"Well, the chart below, drawn from Millennial Historical Statistics, shows spending on new homes and cars before, during, and after the war years. Both basically collapsed. Why?

The answer is that (1) There were draconian building restrictions in effect — in fact, the end of those restrictions helped set off the postwar housing boom, and (2) new cars weren’t being produced, because the factories were making tanks instead (and if you did manage to acquire a car somehow, gasoline was rationed)."

But regarding 2), the use of factories to produce tanks instead of cars is in fact a perfect example of the "crowding out" that Krugman denies. And the rationing of gasoline wasn't something the government implemented just for fun. They implemented it because they needed it for the U.S. war machine, again a perfect example of "crowding out".

And as for building restrictions, why were they implemented? Again, hardly for fun. Instead the purpose was clearly to ensure that home builders didn't bid up the price of and so divert the raw materials needed to build houses, and that was also needed in the U.S. war effort. The building restriction were in fact a form of rationing of the resources that could be used for both purposes. That too is a good example of "crowding out" in action.

Krugman would perhaps respond to this by arguing that if the government had simply increased spending and not rationed certain goods, then the crowding out wouldn't have occurred. That is however not true as the example of car production illustrates. The reason for that is that then the market's "rationing system", prices, would have kicked in, and either crowded out private spending or limited the ability of the government to use the resources in its war effort.

This doesn't necessarily mean that fiscal stimulus can never increase GDP. Under the right circumstances and done in the right way, it can do so in the short run and sometimes even in the long run. However, in almost all cases (especially when it doesn't involve reduction of marginal tax rates) it will in fact crowd out other spending, as was clearly the case during World War II. And sometimes the stimulus can crowd out so much private activity that it causes GDP to fall.

*=For those of you who didn't know it, the fiscal policy multiplier is sort of the Keynesian version of the Laffer Curve. It is the increase in GDP caused by fiscal expansion divided by the amount of fiscal expansion. If the multiplier is less than 1 this means that some crowding out of other activities occur.