Yet Another Look at Government Stimulus

I know I've belabored this issue to death, but with the costs so large I think it's worth at least one more look. Over two and a half years ago I first predicted that the stimulus packages would not work. Later I posted that the stimuluses probably didn't work in the past (especially the New Deal) and that at best we'll never know if the cost was worth it. I eventually concluded that stimulus as a temporal tax progressive tax is the best and least used argument in favor.

The most famous example of government stimulus is World War II. And it with Ben Bernanke's recent announcement to print an extra $600 billion in a process called quantitative easing (aka increase the money supply), it seems the Federal Reserve's faith in government stimulus has not waned. However, a recent paper published by David Henderson suggest that World War II is a great study on stimulus, except that it proves the opposite of what you might think. First, here's the traditional thought process:

We often hear that big cuts in government spending over a short time are a bad idea. The case against big cuts, typically made by Keynesian economists, is twofold. First, large cuts in government spending, with no offsetting tax cuts, would lead to a large drop in aggregate demand for goods and services, thus causing a recession or even a depression. Second, with a major shift in demand (fewer government goods and services and more private ones), the economy will experience a wrenching readjustment, during which people will be unemployed and the economy will slow.

Now's here's the reality:

Yet, this scenario has already occurred in the United States, and the result was an astonishing boom. In the four years from peak World War II spending in 1944 to 1948, the U.S. government cut spending by $72 billion—a 75-percent reduction. It brought federal spending down from a peak of 44 percent of gross national product (GNP) in 1944 to only 8.9 percent in 1948, a drop of over 35 percentage points of GNP.

While government spending fell like a stone, federal tax revenues fell only a little, from a peak of $44.4 billion in 1945 to $39.7 billion in 1947 and $41.4 billion in 1948. In other words, from peak to trough, tax revenues fell by only $4.7 billion, or 10.6 percent. Yet, the economy boomed. The unemployment rate, which was artificially low at the end of the war because many millions of workers had been drafted into the U.S. armed services, did increase. But during the years from 1945 to 1948, it reached its peak at only 3.9 percent in 1946, and, for the months from September 1945 to December 1948, the average unemployment rate was only 3.5 percent.