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THE EFFECT OF ENDING HOSTILITIES ON OUTPUT AND EMPLOYMENT1 by Paul Davidson Editor, Journal of Post Keynesian Economics Paper written for ENCYCLOPEDIA OF LIFE SUPPORT SYSTEM, a UNESCO Publication Peace is usually considered socially desirable. Yet, the historical record indicates that the 1 ending of hostilities can cause severe economic problems in the form of a significant increase in the rate of unemployment and a downturn in national production even for the victorious nations. One of the most cited economic homilies is that after the end of every war, the cessation of hostilities produces a major recession. The main rationale for this view is that during a period of war, government borrows heavily in the financial markets in order to finance the cost of hostilities in terms of men under arms and materials. During the war governments spend as much as possible on munitions and armaments -- sometimes up to approximately half of the Gross National Product -- to support the expanded armed forces. In so doing, the economy rapidly approaches full employment as demand expands while the available civilian labor force shrinks as able bodied young people are absorbed into the Armed Forces. Once the hostilities are over, government quickly returns to its peace time spending pattern thereby depressing aggregate demand, while simultaneously reducing the size of the armed force and thereby substantially increasing the available civilian labor force. With the demand for labor contracting and the supply of labor in the market place expanding rapidly, a significant increase in unemployment seems inevitable. For example, in 19127 the total federal debt was $3 billion. By the end off 1919 the total federal debt had ballooned up to $25.5 billion an increase of over $22 billion spent primarily on the war effort and subsequent demobilization. In 1920 the U.S. government ran a surplus of almost $291 million as federal government expenditures which had reached a peak of $18.5 billion fell to $6.4 billion in 1920. As government expenditures continued to decline during the 1920s, the federal government’s surplus increased every year reach a peak of $1.2 billion in 1927. Although the surplus each year after 1927 diminished, the U.S. government did not run an 2 annual deficit again until 1931 when the deficit was $462 million. The total outstanding federal debt that had peaked in 1919 at $25.5 billion in 1919 declined throughout the “roaring twenties” to a low of $16.2 billion in 1930. In 1918 the Armed Forces totaled 2, 897,167 persons but by 1920 the number of military personnel on active duty had declined to 343, 3422. By 1929 this number had shrunk to 255,031. Consumer prices which had risen on average by less than 1 per cent a year since the Spanish -American war at the turn of the century, began to escalate in 1917. By 1920 the consumer price index was 58 per cent greater than it was in 1917. With the severe recession of 1920-22, consumer prices dropped by over 16% from 1920 to 1922 and then stabilized throughout the rest of the 1920s. Less government deficit spending after 1919 should have eased conditions in financial markets but the newly created Federal Reserve continued to raise its discount rate from 4 per cent in 1918 to as high as 7 per cent in 1920 and 1921. Typically, private spending cannot expand quickly enough to pick up the slack left by the tremendous reduction in aggregate demand caused by the reduction in war time deficit-financed government spending. Moreover, the relatively high interest rates in 1919-21 held down investment spending. Finally, exports dropped precipitously after the war from a high of $10.7 billion in 1919 to $5 billion in 1922. The result was a substantial recession and significant increase in unemployment in the civilian labor force. Gross National Product decreased by 3.5 per cent in 1919, 4.3 per cent in 1920, and 8.6 per cent in 1921.The unemployment rate increased from 1.4 per cent in 1918 to 11.7 per cent by 1921. A similar story but with a much less dramatic effects occurred in the after World War II period. As a result of the Great Depression, by 1937 the federal debt had increased to $43 billion 3 . By 1940 the total federal debt had increased only to $50.6 billion. Unemployment which had peaked at 25.3 per cent in 1933 and was down to 14.3 in 1937, increased to 19.1 per cent in 1938 after Roosevelt’s disastrous attempt to reduce the spending deficit (a promise in the 1936 Presidential election). The federal deficit was slashed from a Depression high of $4.4 billion in 1936 to $2.8 billion in 1937. By 1940, the unemployment rate still stood at 14.6 per cent. In 1940 the total federal debt was $40.4 billion. By the end of World War II in 1945, however, the federal debt had ballooned to $252 billion as federal expenditures. In 1940 federal government expenditures was less than $10 billion a year in 1940. With preparations for war accelerating, federal government spending increased to $14 billion in 1941. By 1945 federal spending had increased almost sevenfold to $95.2 billion. As a result of this rapid tremendous increase in government deficit spending during the war years of 1941, 1942,1943 and 1944, GNP grew by 16.1 per cent, 12.9 per cent, 13.2 per cent, and 7.2 percent respectively. The armed forces increased from less than half-million in 1940 to over 12 million in 1945. When hostilities ended in mid 1945, demobilization was swift. By 1946 the military had only 3 million under arms. The unemployment rate fell from 14.2 per cent in 1940 to 1.9 per cent in 1945 and then increased to 3.9 per cent with the huge demilitarization of that year. With the end o hostilities in mid 1945, GNP for the entire year of 1945 fell by 0.1 percent. In 1946 as federal government expenditures declined to $61.7 billion and the GNP fell by 11.9 per cent. GNP fell by less than another 1 per cent in 1947 before staring to rise by 4.5 per cent in 1948. Unlike World War I, after hostilities ceased, the downturn was mild and short-lived. The mild increase in post-war unemployment in was due to several factors. First, the G. I. Bill gave 4 millions of servicemen and women the opportunity to attend college upon discharge from the Armed Services. Many accepted the opportunity and swelled college enrollments rather than the civilian labor force. Simultaneously, the millions of women who had entered the labor force during the war years quickly retired from the civilian labor force. Consequently the civilian labor force only increased from 52.8 million in 1945 to 55.2 million in 1946 despite the demobilization of almost 9 million men and woman in 1946 from the armed services during this period. Second, in 1947-48 government expenditures bottomed out at approximately $37 billion and then began to rise with Marshall Plan expenditures beginning in 1947 and the beginnings of the Cold War in 1948 and the outbreak of the Korean conflict in June 1950. Exports which had declined from $16.2 billion in 1945 to $14.8 billion in 1946, immediately began to increase to $19, 8 billion in 1949 as Marshall Plan aid helped finance an export boom. Third, the Federal Reserve had held down interest rates throughout the war period. From 1940 through 1947 the Federal Reserve discount rate was never more than one percent. Only in 1948 when a recovery was already well under way did the Federal Reserve raise the discount rate to 1.5 per cent where it remained until after the Treasure-Federal Reserve Accord of 1950. The rate on U.S. government securities remained below 1 per cent until 1948 and was less than 1.5 per cent until 1950. Such low interest rates permitted rapid investment for conversion to peacetime production. The post-war export boom plus the release of pent-up consumer and investment demand that could be financed at very low interest rates meant a relatively mild recession and then rapid economic growth through out the remainder of the 1940s and early 1950s, despite the fact that 5 total federal government outlays on domestic production went down by 1/3 from $95.2 billion in 1945 to $61.7 billion in 1946. Federal spending fell by an additional 40 per cent to $37 billion in 1947 spending. And remained did not increase substantial (to $43.1 billion) in 1950. In other words, despite the folk-lore that the post second world war period proved the efficacy of large government deficit spending (incorrectly called Keynesian) policy of avoiding a major recession, the facts suggest that it was Keynes’s policy of advocating very low interest rates plus countries that run export surpluses providing the funding to permit countries n balance of payments deficits to continue to purchase exports that avoided the great recession that usually follows the cessation of hostilities. With the start of the Cold War in 1948 national defense rose almost continuously from a low of $13 billion in 1948 to over $81 billion by 1969 The United States suffered only minor recessions after the end of hostilities in Korea until the oil price shock of the 1970s. The end of the Korean war In 1954 resulted in a 1.1. percent decline in GNP and an increase in the unemployment rate to 5.5 per cent. In 1958 there was a 1.4 per cent decline in GNP and as unemployment went up to 6.8 per cent. The 1960s experienced one of the longest peacetime expansions in U.S. history as government expenditures on national defense rose from $45.9 billion in 1960 to $81.2 billion in 1969. Simultaneously exports to the rest of the world jumped from $27.5 billion in 1960 to $55.5 billion in 1969. During the 1960s military Keynesianism expenditures starting with the Berlin Wall and including the Vietnam war plus a rapid growth in U.S. exports to the rest of the world was the major forces behind stimulating economic growth in the United States. In the 1960s a considerable portion of the growth in U.S. exports were financed by government expenditures for foreign aid including military aid as part of the Cold 6 War spending policy. With the election of a Republican Administration in 1969, despite the continuing Vietnam hostilities, government purchases (in real terms) actually declined slightly (less than 1 per cent) and then stabilized for throughout the remainder of the Vietnam War (until 1975). The initial oil price shock of 1973, however, lead to rapidly rising prices which, in turned, induced a tight anti-inflationary monetary policy. Interest rates on Treasury bills rose from 4.07 per cent in 1972 to 7.04 per cent in 1973 and 7.89 per cent in 1974. This resulted in a slow down in the US economy in 1974-75 as invrestment spending declined by almost 40 per cent and the unemployment rate rose to 8.5 per cent as the Vietnam hostilities ended and demilitarization of the armed Services began. With the second oil price shock in 1979 a verye tough Volker antiinflation monetary policy followed where the interest rate on Treasury bills went up to 10.04 per cent in 1979, 11.51 per cent in 1980 and 14.04 per cent in 1981, before falling to 10.69 in 1982. Unewmployment quickly rose from 5.8 per cent in 1979 to 9.7 per cent in 1982 (briefly reaching double-digits during part of 1982). With the ending of the Volker recession in 1982 and the resurgence of military Keynesianism under Reagan plus the huge Reagan tax cuts, government deficits burgeoned from $73 Billion in the recession year of 1980 to 207.8 billion by 1983. As a result the United States recovered from the most serious recession (of 1980-82) since the Great Depression and the economy boomed again until the end of the Cold War in 1989-91. As things deteriorated in the Soviet Union beginning in 1988, national defense expenditures peaked at 303 billion in 1989 and has varied between $265 billion and $299 billion in every year since. (Estimated national defense expenditures are $290 billion for the year 2000). 7 Accordingly, any expansion since 1989 can not be attributed to additional “Keynesian” military expenditures . Except for the brief “Desert Storm” hostilities in the mid-East that lasted less than a week in 1990, the decade of the 1990s has been one of peace without any shooting war or cold war. Real federal government purchases has declined by approximately 8 per cent in the decade of the 1990s. There was a brief recession in 1991-92 where GDP declining by 1 per cent and unemployment rising from 5.3 per cent in 1989 to 7.5 per cent in 1992 as new higher marginal taxerates that had been legislated in 1990 went into effect in 1991. Simultaneously military spending dipped briefly in 1991. Accordingly the end of the Cold War was coincident with a brief recession and a rise in unemployment. Nevertheless, since 1992 there has been a continuous rise in GDP and a continuous drop in the unemployment rate. For the year of 1999, the civilian labor force unemployment rate was 4.2 per cent and the GDP was (in real terms) 33 per cent larger than in 1990. This rate of growth in a decade has not been seen since the 1960s. CONCLUSION What can we conclude from this brief statistical history? First, when the United States engages in actual hostilities or in the Cold War hostilities that provoke a military build-up, a period of economic expansion normally is associated with these hostilities. In the cold war period, the expansion (or lack therefof) was often closely related to the degree that the U.S. perceived increasing military dangers. When the hostilities end or cooled off, however, there was always some economic slowdown oir actual recession and rise in the civilian unemployment rate. This has lead some to argue that the economic prosperity off the United Statesd requires some form of continuous deficit spending by government . The only 8 politically acceptable form of this form of Keynesianism, it is often argued, involves what has been labeled military Keynesianism, i.e., increased deficit spending for expansion of the military defense establishment. The history of the immediate post World War II period and the 1990's, however, shows that military Keynesianism spending is not a necessary condition for producing prosperous growing nation with rapidly increasing GDP and declining unemployment rates approaching full employment of the civilian labor force. What has been different in the both these periods? First the Federal Reserve pursued a very accommodating monetary policy. Especially in the 1990s, whenever it looked like the economy would stall,, the Federal Reserve reduced interest rates quickly and provided liquidity that helped stimulate innovations and investment expenditures. Secondly, whether the United States ran surpluses or deficits in its trade balances, it acted as the engine of growth for its trading partners in the rest of the world. When running surpluses, the United States developed a policy to return these surplus to its trading partners ( the Marshall Plan and other foreign and military aid programs). When the United States has run trade deficits it has treated such deficits with benign neglect and have not ordinarily tried to reduce imports to improve its trade position. The growth of U.S. imports has acted as great stimulus for economic growth of the rest of the world. The resulting prosperity of these foreign nations has fed back into a demand for U.S. exports based on foreigners’s income elasticity off demand for foreign product. In the 1970s and early to mid-1980s when slow growth and significant recession in the U.S. economy reduced the U.S. import demand stimulus to the rest of the workd, the result was to induce a reduction in the rest of the world’s demand for U.S. exports. The result was a feedback mechanism that tend to 9 induce world-wide recession and depression. Except for this period, however, there has been an almost continuous growth in total exportsfrom the United States. This growing market has been a spur to continuing US prosperity. For example, total exports in real terms has increased by 83.8 per cent between 1990 and 1999. Of course, imports have increased by 116 per cent in the same period so that net exports have become more negative (from $-79 billion in 1990 to $-220.6 billion in 1999). But this overemphasis on the increasing negative net exports statistics by many economists have masked how much the foreign sector has been a stimuluas to U.S. growth in the last decade. This huge expansion of U.S. imports relative to exports has been the engine of growth for the rest of the world’s economy and has orvided the rest of the world with significant liquidity in terms of dollars. Nevertheless, given the current international payments system of flexible exchange rates, this continuing balance of payments deficit may createsubstantial international financial complications in the next decade which could result in a global depression. That is why some economists, and even President Clinton called for new international financial architecture when the Russian default and east Asian currencies crisis threatened the liquidity of international capital markets. Uunless we create a new financial architecture for the international monetary and payments system, the persistent substantial deficits in the U.S. balance of payments can force the United States to reign in its import demand. And if that happens, this will cause a global recession that might rival The Great Depression of 1929-1940. But that is another story that I have dealt with elsewhare3. So not unlike the period of the 1950s, the 1990s prosperity has been based on low interest 10 rates and rapidly growing export markets for U.S. products where the growth in these foreign markets (a) in the 1950s was the result of Foreign aid to finance foreign purchases of US goods and (b) in the 1990s export market growth is due to the benign neglect of the deficit in the US balance of payments thereby permitting imports to rise more rapidly than exports -- and thus this deficit import spending inducing Keynesian growth in other nations and the feedback of foreign growth has been the expansion of US markets that have more than picked up the slacked left by the abandonment of the military Keynesianism of the Reagan era. NOTE 1. All statistical data obtained from government sources: historical Statistics of the United States; Colonial Times to 1970 Parts 1 and 2, Bureau of the Census, Washington, 1974 and various issues of Economic Indicators, prepared by he Council of Economic Advisers. 2.Earlier, during thee Spanish-American war, the Armed Forces increased from 43,000 to 235,000 between 1897 and 1898. By 1899 the armed forces was cut to 100,000. 3. See P. Davidson “Is A Plumber Or A New Financial Architect Needed to End Global International Liquidity Problems?” World Development, June 2000. 11