Did World War II Help the US End the Great Depression? | Yizhen (Lucy) Liu, Mount Holyoke College

Abstract

I evaluate whether World War II caused American recovery from the Great Depression and find instead that expansionary monetary policies helped the US emerge from recession. World War II in fact sharmed the US economy at the microeconomic level. I compare US economic performance to predictions from two classical models: a model of the market for loanable funds; and a model of the labor market. I use these two models to test whether monetary expansion or wartime spending fueled the recovery, and find that the increase in the money supply stimulated the US economy and helped end the Great Depression.

Did World War II help end the Great Depression in the United States? The Great Depression is the most well-known recession in the twentieth century; in the US, the GDP did not return to the level before the Great Depression until the US entered World War II, which left major population with the impression that World War II helped to end the recession. Meanwhile, some people believe that the US economy could recover without entering the war, and World War II was accidently happened at the time when the recovery was about to complete. Therefore, whether the war played an important role in helping boost the economy has been a long-lasting debate. I want to figure out whether the US could recover from the Great Depression without entering World War II, and further, if I can generalize this conclusion to answer more widespread problems, like whether entering a war will aid a country in ending a national recession. I plan to approach the topic by trying to answer the following questions: a) Are wars necessary for a country to recover from a recession? b) If a war is not necessary for economic recovery, then what is the main and best source of recovery for a country? And lastly, c) is war positive for the economy? This essay will explore these questions based on five previous pieces of research, and discuss two models that are related to the questions. Even though four of the five research studies focus on the relationship between the Great Depression and World War II, they approach the topic from different viewpoints and hold different perspectives.

A widely accepted idea is that with the huge government spending on World War II armaments, wartime spending fiscally stimulated the economy and was the principal reason for the end of the Depression. However, Romer (1993) mentions that before the preparation of World War II, the US economy had already begun to recover in 1933 because of the increases in the money supply. Thus, she claims that the war cannot be the main source that moved the US out of the Depression, although she acknowledges that World War II has a positive effect. According to Romer (1993), without entering World War II, the US economy was still able to recover from the economic recession. Comparing the consequences of the war and the fiscal policies adopted by the Federal Reserve in the spring of 1932, Romer (1992) expands her idea and points out that even before the war had a noticeable impact on finance, the recovery was nearly completed by prior fiscal policy and spending. Therefore, fiscal policy rather than World War II was the real main source that helped the US end the Great Depression.

On the other hand, though holding the same conclusion that World War II was not the major force that brought the Great Depression to an end, Steindl (2007) argues against Romer’s idea that the main source of recovery was fiscal policy. Steindl (2007) points out that Romer’s analysis has ignored the regression which happened in the late 1930s. During the economic recession from 1937 to 1938, prices declined although the money supply continued to increase. Therefore, the growth of the money supply--caused by fiscal policy initiatives beginning in 1933 and gold inflows from Europe--was not the driving force for the end of the Great Depression because the economy did not fully recover until 1942. Instead, Steindl (2007) argues that two forces helped the economy return to an upward trend. The first one was the increase in money demand, and the second one was the inherent upward movement in the economy obscured by Word War II. Steindl provides a lot of graphs to support his viewpoint, and directly claims that the war was not necessary for economic recovery.

Although Steindl’s argument seems reasonable, Irwin (2012) provides another view on the cause of the 1937-38 recession. Irwin (2012) illustrates that the expansionary monetary policy was based on large gold inflows in the mid-1930s as the M2 money supply grew at about 12% per year from 1934 to 1936, but stopped growing in 1937 and even began to decrease. This was because the Treasury Department decided to block all the gold inflows, starting in December 1936 as the administration was worried about inflation. After the Treasury Department ended the policy in April 1938, the economy began to recover from the second recession in June. Thus, the recession of the late 1930s was the result of the shortage of M2 money supply. Based on Irwin’s conclusion, I argue that Steindl’s view alone is not enough to question the validity of Romer’s theory because the recession of 1937 was also caused by a shortage of money supply. Thus, I use Romer’s viewpoint as the basic assumption in the following analysis.

Both Romer and Steindl admit that World War II had a positive economic effect to some extent (Romer, 1993; Steindl, 2007). In contrast, Horwitz and McPhillips (2013) offer a new approach when they only discuss World War II’s economic impact on American residents. Collecting a series of advertisements from an electric company, and American households’ personal letters during World War II, they draw a conclusion that though the war seemingly led to a boom in macroeconomic aggregates, households’ living standards regressed greatly during wartime (Horwitz & McPhillips, 2013). Hence, World War II did not help the US end the Great Depression, and even worsened the economy based on the regression of average households’ living standards.

After analyzing the five articles, I conclude that the expansionary monetary policy was the primary source of the US recovery, and World War II had a negative effect at the microeconomic level. To verify the statement and to further explore the economic consequences of World War II, I use two models to examine the historical data: the model that explains the market of loanable funds and the model of the labor market. The Great Depression started in 1929 with the stock market crash. Economists generally consider the Federal Reserve’s decision in 1928 to open market sells as the primary source of the recession. During the recession, what worsened the situation was that people did not trust the bank anymore, so they simultaneously drew their money back, which reduced the money supply and caused a higher interest rate. This condition is called a bank panic. Moreover, due to the deflation, the price of goods fell continually, so nationwide consumption also declined because people preferred to put off purchasing goods to the future rather than buying them now. In order to solve the bank panic and stimulate consumption, the Federal Reserve adopted an expansionary monetary policy in 1932, which increased the money supply greatly.

Figure 1: Market for Loanable Funds 

 Source: Williamson (2014) p. 446-448.

I test and verify whether the increase in money supply was the main source of the recovery by analyzing the market of loanable funds. The model consists of an upward-sloping supply curve and a downward-sloping demand curve, with the quantity of loanable funds on the x-axis and real interest rates on the y-axis. The supply curve is upward sloping and the demand curve is downward-sloping because people are more likely to loan to others but less willing to borrow money with higher real interest rates. Their intersection is the equilibrium point. From the model, I can learn that an increase in the money supply will shift the upward supply curve to the right, which leads to the decrease of real interest rates and the increase of the quantity of loanable funds. If the money supply declines, the real interest rate will rise and the quantity of loanable funds will decline. Therefore, the crash of the stock market and bank panic could be the consequences of the decreasing money supply in 1929 and could be solved by the expansionary fiscal policy that was adopted in 1933.

Table 1: Change in GNP during Two Phases of the Great Depression

Source: Romer (1992).

Table 1 lists the years when real GNP decreased in the 1930s; the real GNP had negative changes from 1930 to 1933, but in 1934, it began to increase until 1938. The economic behavior fits the classical model of the loanable funds market when money supply changes. According to Romer (1993), the economy began to recover because of the expansionary policy in 1933, so war was not the main source because the economy began to recover nine years before the war started. If the rise of GNP is considered the beginning of the US recovery, then Romer’s theory is supported by the data above.

After figuring out that the increase in money supply was the main force in recovery, I need to answer the second question: did the war have a positive effect on the economy? Although Horwitz and McPhillips (2013) insist that World War II worsened the economy as the average households’ living standards regressed, no one can deny that the real GDP increased during wartime because the government spending increased. Moreover, participating in war generally increased the demand for labor because of the preparation for armaments, which solved one of the toughest issues which need to be solved during a recession: high unemployment rate. This seemed to be the case for World War II, as demonstrated by the following model.

Figure 2: Labor Market

Source: Williamson (2014) p. 195-196.

In the model of the labor market, the quantity of labor is on the x-axis and the real wage is on the y-axis. The demand curve is downward sloping because employers tend to hire fewer workers or reduce working hours as real wage rises; otherwise, the cost of production will increase. The supply curve is upward sloping because people tend to work more as the rate of real wages rises. The intersection of the supply curve and the demand curve is the equilibrium point. According to the model, the demand curve will shift to the right due to an increase in labor demand. As a result, the real wage and quantity of labor will also increase. Therefore, the increase of labor demand will cause a decrease in the unemployment rate and an increase in the real wage. From Table 2 and Figure 3, I can deduce that during World War II, the unemployment rate fell from 15% to 2%, and the real wage increased from 0.52 dollars per hour to 0.90 dollars per hour. Economic behavior fits the classical model of the labor market when labor demand increases. This fact supports the assumption that World War II increased the demand for labor, and thereby reduced the unemployment rate, which means it had a positive effect on the US economy.

Table 2: Avg. Hourly Earnings in Manufacturing (Production & Nonsupervisory Workers)

Source: Federal Reserve Bank of St. Louis (2018).

Figure 3: US Unemployment Rate, 1940-45

Source: American Social History Project Center for Media and Learning (2018).

From these two models, I can determine that the start and the end of the Great Depression are strongly connected to the market of loanable funds because the recession began as the stock market crashed and recovered as the monetary policy was adopted. Moreover, the unemployment rate, which increases during recessions, is closely related to the labor market. Together with the data and previous studies, the models provide the answer to my question: did World War II helped the US end the Great Depression? I draw the conclusion that to recover from the Great Depression, World War II was not a necessary source. Although it is positive on a macroeconomic level to some extent, its effects on a microeconomic level are negative. Hence, war is not the optimal choice for ending a recession.