Learn from the Success of 1945, not the Failure of 2009

We can learn about economic recovery today by reviewing what happened during the Great Recession earlier this century and what happened at the end of World War II.

Even though Congress has already added $3 trillion of emergency outlays to the budget in the past 12 months, Joe Biden wants Congress to add another $1.9 trillion to the burden of federal spending as part of his so-called American Rescue Plan.

But Mr. Biden is bringing a new twist to the profligacy. Instead of trying to justify the new spending by saying it is needed to compensate households and businesses for government-mandated lockdowns, he is making the Keynesian argument that the new spending is a way of stimulating the economy.

The same approach was used when he was Vice President, of course, but did not yield positive results. President Obama’s American Recovery and Reinvestment Act added lots of debt to the nation’s balance sheet, but the recovery was very weak by historical standards.

Mr. Biden and his team apparently think the anemic results were a consequence of not spending enough money. Hence, the huge $1.9 trillion price tag for his plan.

Will his approach work? If history is any indication, we will get a mix of bad economics with bad fiscal policy.

We can learn about economic recovery today by reviewing what happened during the Great Recession earlier this century and what happened at the end of World War II.

Balance Sheets vs Pandemics

The first thing to understand is that today’s economic problems are quite dissimilar from the Great Recession. That downturn, which began in late 2007, was the result of an unsustainable housing bubble caused by overly accommodative monetary policy from the Federal Reserve and misguided housing policies. This bubble misallocated both labor and financial resources, created an oversupply of housing, left the household sector deeply in debt, and undermined the soundness of many banks and other financial institutions.

The recovery from the Great Recession was slow and protracted because it took years to clean up the mess from the bursting of the housing bubble. Households slowly rebuilt their savings and cleaned up their balance sheets. Unemployed workers that were drawn into housing and housing finance took time to change occupations, find new jobs, and move to new locations. Banks had to work out problem loans and rebuild their capital before they could make new loans to growing businesses.

Obama’s stimulus did not drive that healing process and spending more money would have done little to accelerate it.

Our current economic problems, by contrast, were not triggered by a credit-driven misallocation of labor and financial resources or over-investment in one sector. Instead, the cause was exogenous—a pandemic. Unlike 2007, the US economy was strong and healthy in February 2020.

Learning from World War II

The closest historical analogy to the current situation is what happened after the defeat of Nazi Germany and Imperial Japan.  Keynesians feared that demobilization would throw the US economy into a deep depression as federal spending was reduced. Paul Samuelson even wrote in 1943 that a failure to come up with alternative forms of government spending would lead to “the greatest period of unemployment and industrial dislocation which any economy has ever faced.”

Guided by this sentiment, President Harry Truman proposed “a 21-Point Program for the Reconversion Period” shortly after the war ended. But his plan, which was basically a reprise of Franklin Roosevelt’s New Deal, was largely ignored by Congress.

Did the economy collapse, as the Keynesians feared?

Hardly. There was only a very brief downturn as the economy adjusted to peacetime conditions.

Spared a repeat of FDR’s interventionism, the economy enjoyed strong growth. One of the big tailwinds for growth is that the forced savings accumulated during the war years allowed consumers to go on a peacetime buying binge.

1945 All Over Again

The current economic conditions are somewhat reminiscent of the ones that existed after World War II. The limited ability to spend money during the pandemic has helped boost the personal saving rate from 7.3 percent in the fourth quarter of 2019 to a peak of 26.0 percent in the second quarter of 2020 before trailing off to a still historically high 13.4 percent in the fourth quarter of 2020.  In aggregate terms, personal saving soared from $1.2 trillion in 2019 to $2.9 trillion in 2020.

There are still some troubling numbers in the job market, but remaining job losses are highly concentrated in a few industries that are shut down or operating on a limited basis due to Covid-19 restrictions. These restrictions on sports, live entertainment, cinemas, museums, and restaurants will soon be relaxed as more Americans are vaccinated, and pent-up demand funded with more than $1 trillion in excess savings will resuscitate these sectors, returning the jobs that have been lost.

These are some of the reasons why the Congressional Budget Office (CBO) forecasts that real GDP will reach its pre-pandemic level by the third quarter of this year, the size of the labor force will return to its pre-pandemic level in 2022, and employment will reach its pre-pandemic level by 2024.

All without any additional “stimulus,” just as the economy prospered after World War II despite (or perhaps because of) the failure of Mr. Truman’s 21-point proposal.

President Biden’s team is either unaware of this history, or they simply do not care. Perhaps they simply want to take advantage of the current environment to reward key constituencies. Or they may be trying to resuscitate the tattered reputation of Keynesian economics by spending a bunch of money so they can take credit for an economic recovery that is already destined to happen.