Why was the fiscal multiplier so small in World War II?
That is the topic of a new and fascinating paper by Gillian Brunet, who is on the job market this year from UC Berkeley. Here goes:
“Stimulus on the Home Front: The State-Level Effects of WWII Spending” (job market paper)
World War II is often viewed as a quintessential example of government spending stimulating the economy. In this paper I use war production spending to quantify the idiosyncratic factors affecting estimates of the fiscal multiplier during World War II. Newly digitized war supply contract data allow me to construct state-level panel data on U.S. defense spending for 1940-45 and examine state-level outcomes. Using within-state variation I estimate a multiplier of 0.25 to 0.3, depending on the estimation approach. This implies an aggregate multiplier of roughly 0.3 to 0.4 given wartime economic conditions. I also find small employment effects: an additional job-year is associated with $165,000 – $255,000 of spending (in 2015 dollars). I find evidence that the effects of stimulus were systematically larger in states that had lower employment levels pre-war. To explain why the stimulative effects of war spending were so small, I look for guidance from the historical narrative. I show that unique features of the wartime economy significantly reduced the stimulative impact of wartime spending. Conversion from civilian manufacturing to war production reduced the initial stimulus from war production. At least 75 percent of the income generated by war spending went into increased saving and income taxes, implying that the add-on effects from increased consumption were minimal in the short run.
This seems exactly right to me. When an economy is rationing-constrained and doing supply-side switching at such a rapid pace, I don’t think it is very easy to simply pull unemployed resources out of nowhere into new production. This raises the bigger question, however, of what exactly did drive economic recovery. I say don’t be fooled by wartime gdp figures, there was not a true wartime recovery in terms of consumption, quite the contrary. But come the postwar era, so many of the right pieces seemed to be in place. Dare I mention “increased saving”? I know that is anathema to the usual Keynesian approach, at the very least this remains a mystery and the simple stories would seem to fail.