The End of the Great Depression 1939-41: Policy Contributions and Fiscal Multipliers

This paper is about the size of fiscal multipliers and the sources of recovery from the Great Depression. Its contributions begin with a new quarterly data set for the interwar period that allows development of a VAR model of the U. S. economy over the period 1920-41. The quarterly data facilitate an estimate of the growth rate and level of potential real GDP, and this in turn allows us to date the end of the Great Depression as the period between 1939:Q1, when the output gap was 21.9 percent, and 1941:Q4, when the output gap was -1.3 percent. By using VAR dynamic forecasting and examining the effect of innovations to each variable individually, this paper’s baseline result is that 89.1 percent of the 1939:Q1-1941:Q4 recovery can be attributed to fiscal policy innovations, 34.1 percent to monetary policy innovations and the remaining -23.2 percent to the combined effect of the basic VAR dynamic forecast and innovations in non-government components of GDP (N). The paper attributes the negative innovations of N in the second half of 1941 to capacity constraints. Traditional Keynesian multipliers assume that there are no capacity constraints to impede a fiscal-driven expansion in aggregate demand. On the contrary, we find ample evidence of capacity constraints in 1941, particularly in the second half of that year. As a result our preferred government spending multiplier (which starts in 1940:Q2 and subtracts out the forecasts of the no-shock basic VAR model) is 1.80 when the time period ends in 1941:Q2 but only 0.88 when the time period ends in supply-constrained 1941:Q4. Only the 1.80 multiplier is relevant to situations like 2009-10 when capacity constraints are absent across the economy. Two sets of new insights emerge from a review of contemporary print media. We document that the American economy went to war starting in June 1940, fully 18 months before Pearl Harbor, in contrast to the widespread assumption in the previous literature that Pearl Harbor marked the beginning of WWII for the United States. We also detail the bifurcated nature of the 1941 economy, with excess capacity in its labor market but capacity constraints in many of the key manufacturing industries. By July 1941, the American economy was in a state of perceived national emergency. We not only show in two alternative sets of quarterly data that private consumption and investment actually declined in late 1941, but we also explain why. Among these examples, shortages of steel prevented auto companies from satisfying demand, and shortages of aluminum needed for aircraft production suppressed production even of the most humble of household objects, like tea kettles and zippers.