by Dr. Carole E. Scott Copyright 1997-2001

The Second World War

War broke out in Europe in 1939. The United States did not declare war until the Japanese surprise attack on Pearl Harbor (Hawaii) on December 7, 194l. Then President Franklin D. Roosevelt (left) declared war both on Japan and her ally, Germany. Prior to that time the U.S. had aided the Allies against these nations.

The War provided immediate benefits to the U.S. economy because it led to a substantial increase in exports. Some war materials were provided the Allies through the Lend Lease program (lending or leasing them). U.S. spending on its military rose from $6 million in 1940 to almost $17 billion by 1941. By 1945, the last year of the War, it had risen to $73.5 million out of a GNP of $211.9 million. (In 1945, federal spending equaled GNP in 1929!) After 1941, gross investment fell to levels comparable to those recorded during the early years of the Great Depression. Not surprising in light of the large number of men serving in the armed forces, the unemployment rate fell from 10 percent in 1942 to 1.2 percent in 1944--a level it has never since achieved. Many people--mostly women--who would not normally have been in the labor force entered it. As had been true during the First World War, women were able to obtain jobs formerly barred to them

Far more economic planning was engaged in during this War than had been true during the Great War (now called World War I). The War Production Board and the Office of Emergency Planning established a system of priorities for a wide range of raw materials, semi-finished goods, and transportation. By 1942, shortages of many goods had developed. By government order, the auto industry shifted completely to producing vehicles for the military. The Office of Price Administration (OPA) set prices, wages, and rents and set up a rationing system for many basic consumer goods, including sugar, butter, tires, and gasoline. Many consumer goods made of metal either disappeared or other materials were substituted for metal. While according to Engel's Law, as people's incomes rise, as they did during the War, the percent of their income spent for food will decline. However, during the War, the reverse took place. Presumably this was due to the unavailability of many consumer durable goods. Once the War was over, Engel's Law held true again. The lack of goods led to an increase in savings. (Personal savings annually rose by eight times during the War.)

Strikes were made illegal. The level of employment in manufacturing rose by 60 percent! Average weekly earnings in manufacturing rose by 80 percent! The prices farmers received soared. Like other essential workers, the rationing system gave them priority over other people. Essential workers were were also exempted from the draft. The production of some consumer goods, such as automobiles, was prohibited, and the plants that produced them were converted to producing goods required by the military.

Proportionately, farmers' incomes rose the most. Income inequality declined just as it had during World War I. Prices rose by about 4 percent a year from 1942 to 1945. However, this understates real inflation because the quality of many goods declined during the War.  To save material, cuffs were eliminated from men's trousers. Woolens were scarce, and women's nylon stockings disappeared from store's shelves.

Click here to read about government policies designed to prevent inflation during World War II like that experienced during many earlier wars.

The War was financed by borrowing and taxing. The federal debt rose from $43.0 billion in 1940 to $258.7 billion in 1945. In 1946, it stood at $269.4 billion. By 1947, it was down to $258.3 billion. Individual income-tax receipts rose from $1.0 billion in 1940 to $19.0 billion in 1945. By 1946, they had fallen to $18.7 billion. In 1947, however, they rose to $19.3 billion.

When the War began, interest rates were at all-time lows. Support provided by the Federal Reserve kept them low. As a result, in 1945 the Treasury borrowed money at an average rate of only 1.94 percent, much lower than the 4.2 percent it paid at the end of World War I.

Banks' holdings of federal debt rose from $21.9 billion in 1940 to $118.0 billion in 1945. (Note the large percent of the federal government's debt held by banks.) M1 (currency and demand deposits) rose from $38.7 billion in 1940 to $94.1 billion in 1945. M2 rose from $66.1 billion to $138.4 billion.

Excise taxes were raised, and special taxes that continued to be collected for decades were levied on luxury goods. To aid in collecting the income taxes, tax withholding (said to be a temporary measure) was introduced. (The Social Security tax introduced in 1937 was already collected in this manner.) The income tax was made more progressive. While taxes had covered 33 percent of World War I government spending, in World War II they covered 46 percent.

Recovery

"According to the orthodox account, the war 'got the economy out of the depression.' Evidence for this claim usually includes (1) great decline in the standard measure of the unemployment rate, (2) great increase in the standard measure of real GNP, (3) slight increase in the standard measure of real private consumption. The entire episode of apparent business cycle expansion during the war years is understood by most writers as an obvious validation of the simple Keynesian model: enormous government spending, financed mainly by issuing debt, spurred by the military economy itself and had multiplier effects on the civilian economy, the upshot being increased real output and employment and decreased unemployment. Some analysts, recognizing the enormous increase of the money stock during the war, blend Keynesian and monetarists explanations, treating them as complements rather than substitutes." [Robert Higgs]

Robert Higgs disagrees. The absorption of the armed forces of 12 million persons meant there had to be an enormous reduction in the unemployment rate. Jobs that put one at serious risk of death and serious injury are not desirable jobs! Four-tenths of the labor force was employed in jobs that did not produce either consumer goods or capital goods that could be used to produce them in the future. Valuing munitions and other war goods purchased by the government that accounted for an enormous percent of total output and consumer goods subject to price controls and rationing is conceptually different from valuing the nation's output in years of peace. Higgs points out, too, that "credit markets experienced total control, as the Federal Reserve undertook to reduce and allocate consumer credit and pegged the nominal interest rate on government bonds at a barely positive level. Two-thirds of the investment in manufacturing plants and equipment during the period from July 1940 through June 1945 was financed by the government, and most of the remainder came forth in response to tax concessions and other de facto subsidies authorized in 1940 to stimulate the rearmament."

People felt they were better off because they had jobs and plenty of money, he believes, and the performance of the wartime economy eliminated the pessimistic expectations created by the Great Depression.

Once the War was over, the economy expanded from 1946 to 1949 "when delayed demand as well as delayed investment and supply from a depression and war-starved domestic economy was supplemented by the demand created by the reconstruction of war-ravaged Europe." [Willis and Primack] In 1949 the nation experienced a mild recession from which the economy's recovery was speeded by the so-called Police Action in Korea that began in 1951.

The post-war recovery came as a surprise to many, including many economists, as they thought the nation would plunge back into depression. The major cause of the expansion, which was initially pretty inflationary, is generally attributed to a surge in consumer demand, particularly for durables. Investment surged as a result of years of little investment. A critical shortage of housing resulting from the low level of building during the 1930s and its halting during the War caused a surge in residential construction. Construction was stimulated, too, by the beginning of suburbanization. Further stimulating the economy was a rise in the birth rate, which had fallen to an all time low during the Great Depression.

During the War, President Roosevelt and Winston Churchill, Britain's Prime Minister, agreed that after the War that there needed to be a reordering of the international system of trade and payments. As a result, the Bretton Woods System (planned at a 1944 meeting at Bretton Woods, New Hampshire) was established after the War. It involved creating a system of fixed exchange rates; increasing the flow of long-term capital; and lowering tariffs and eliminating other barriers to trade. To accomplish these goals, the International Monetary Fund, the International Bank for Reconstruction and Development (World Bank), and the International Trade Organization were established.

After the War, only the U.S. remained on a gold standard. The U.S. was on what is called a gold exchange standard. Foreigners, but not Americans, could exchange dollars for gold. Therefore, the dollar became the world's reserve currency, that is, for foreign exchange purposes, the world's central banks held it and gold. Under the fixed exchange rate system established after the War, central banks promised to maintain a given set of exchange rates. This was accomplished by each central bank buying or selling its nation's currency, depending on whether their it was appreciating or depreciating. The reason for establishing fixed exchange rates was to promote international trade by making it less risky by eliminating foreign exchange risk. (An exporter could lose money on a sale if to the value of the foreign currency the buyer paid him or her fell enough in terms of the exporter's domestic currency.) Many years later this system broke down because nation's were unwilling to follow the fiscal policies necessary to maintain it.

"The British demanded some kind of guarantee that the U.S. economy would be kept, by federal action if necessary, from slipping back into depression. If the U.S. dollar were to become the main, official 'reserve currency' of the new international order, there must be some steady supply of it available--the U.S. had to maintain stable imports so that others could earn dollars. If that did not occur, the U.S. would 'export depression' to the rest of the world by constraining foreign ability to earn dollars and thus maintain their own dollar-backed currencies." [Jonathan Hughes] This led to the Full Employment Act of 1946 in which the federal government took on the responsibility of promoting maximum employment, production, and purchasing power.

"Perhaps the most profound change in the American economy in the postwar period was the continued growth in the size and role of government at all levels, especially at the federal level. Government grew not only in dollars spent but also inpower to control the private sector through legal regulations and bureaucratic decisions." [Walton and Rockoff]

Sources

Robert Higgs, "Wartime Prosperity During World War II?" Cliometric Sessions at 1990 ASSA Meetings, December 28.

James F. Willis and Martin L. Primack, An Economic History of the United States (1989), 391.

Jonathan Hughes, American Economic History (1990), 525.

Gary M. Walton and Hugh Rockoff, History of the American Economy (1994), 589.

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