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Economics "Ask the Instructor" Clip 41 Transcript
Is a recession inevitable after a major war is over?
A major war definitely qualifies as an external shock to the economy. Government spending soars at the
outset of a war. This causes aggregate expenditures to increase. Assuming that crowding out is not
complete, the economy’s aggregate demand curve shifts to the right. However, once the war is over,
military spending typically declines. The question is whether the decline in military spending that usually
follows a war is certain to cause a recession. The short answer is no.
Recessions did occur after both the Korean and Vietnam conflicts. But any shock to the economy
can cause shifts in either aggregate demand or aggregate supply and, therefore, fluctuations in economic
activity. In fact, three of the six recessions that have occurred since World War II have been associated
with rising oil prices. But exactly what happened to the economy during the years immediately following
World War II, our nation’s most expensive war.
The decrease in military spending that occurred after WWII dwarfs the decreases that followed
either the Korean or Vietnam conflicts. For example, between 1953 and 1956 military spending fell by
about 27 percent. Following the Vietnam conflict, military spending fell by only 10 percent.
In contrast, military spending fell by a whopping 90 percent following WWII. Because the
decline in military spending was not entirely offset by increases in other types of government spending,
federal spending overall declined by about 58 percent between 1945 and 1948.
The U.S. economy did experience a recession after WWII. But it was not as severe as many had
predicted. Constant dollar GDP in 1946 was about 12 percent below the 1945 level. Why was the
economic downturn not more severe? Apparently, some crowding-in, the opposite of crowding out
occurred! In other words, the reduction in government spending was partly (but not completely) offset by
increases in private sector spending by household and businesses. For example, private investment
increased by over 200 percent between 1945 and 1948. And consumer spending increased by over 15
percent.
Pent-up demand is the reason usually given for the large increases in consumer spending that
occurred after WWII. This refers to the fact that consumers had been forced to defer buying consumer
goods because much of the economy’s plant and equipment had been converted from producing consumer
goods to producing military output. In fact, no cars were produced during the war years. Auto plants had
been converted to the production of military hardware such as army trucks and jeeps.
In summary, there was a lot of concern immediately after WWII, particularly on the part of
economists who had studied the new Keynesian theory, that there would be a huge deficiency of demand,
which would cause the economy, to sink into a deep depression. The concern is understandable given that
most of the decade prior to WWII had been characterized by depression. Some would interpret the fact that
the economy avoided a major recession as supporting the classical model. Others would cite the 12 percent
drop in output as evidence in support of the Keynesian model. Those who support the classical model
believe that the economy adjusts relatively quickly; those who accept the Keynesian model think that the
adjustments require many months or even years.