The recent mid-term elections were a citizen referendum for reductions in the size and scope of the federal government. But can federal spending and the budget deficit actually be reduced substantially without sending gross domestic product (GDP) into a tailspin and increasing unemployment to extraordinary levels?
Liberals and economists with Keynesian sympathies have always argued that substantial reductions in federal spending when economic activity is weak (like now) would be disastrous. Really? Let’s see what actually happened the last time the Congress actually reduced government spending in any meaningful way.
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The period 1945-1950 is (almost) a scientific test of the Keynesian hypothesis. Despite repeated warnings by most mainstream economists that cutting government spending at the conclusion of WW 2 would bring back the Great Depression, the Congress dramatically lowered government spending between 1945 and 1950. Federal government expenditures fell from $106.9 billion in 1945 to $44.8 billion in 1950. Defense spending took the biggest hit falling from $93.7 billion in 1945 to just 24.2 billion in 1950. In just 5 years, government spending (as a % of GDP) fell from 45% in 1945 to just 15% in 1950 and the annual federal budget deficit fell from $53.7 billion in 1945 to only $1.3 billion in 1950.
But what happened to overall economic output and unemployment? Despite the massive economic transitions from wartime to domestic production, GDP actually increased (confounding all of the Keynesians) from $223 billion in 1945 to $244.2 billion in 1947 and then to $293.8 billion by 1950. And despite millions of returning servicemen and women, the unemployment rate averaged a very low 4.5% between 1945 and 1950. Economic disaster? Hardly.
History, of course, never repeats itself exactly and 2010 is not 1945. But one thing is clear: Cutting back federal government spending and annual deficits in the immediate post-World War 2 period did not hamper the economy; far from it. Indeed, as government spending and wartime price controls receded, the private market economy expanded strongly and unemployment stayed reasonably low. The Keynesians, dead wrong in theory, were also dead wrong in practice as well.
December 4, 2010