Federal Versus Non-Federal Debt*
George H. Blackford © 5/15/2013
This note examines the fundamental differences between federal debt and non-federal debt and the lessons that should have been learned from the 1930s with regard to the the way in which these differences relate to economic policy and the stability of the economic system.
There is a fundamental difference between federal debt and non-federal debt that arises from the fact that the federal government has the legal right to print money. Since the federal government can print money there is no reason to believe it will ever be unable to service its debt since it can always print the money it needs if it has to. Non-federal debtors cannot print money. They must service their debts out of income or through the sale of assets and, as a result, are always at risk of being unable to meet their financial obligations.
The fact that the federal government has the power to print money does not mean we do not have to worry about federal debt or that “deficits don’t matter” as was the mantra of the Bush II administration. It matters a lot just how those deficits are created and how they are financed, but the fact that the federal government has the power to print money means that the federal debt problem is a much easier problem to deal with than the non-federal debt problem. It also means that the federal government has the power to mitigate the overall debt problem we face through the judicious management of its budget in a way that non-federal debtors do not.
When the federal government borrows and uses the proceeds to finance an increase in expenditures for goods and services in the face of an economic downturn it increases spending in the economy directly and thereby directly increases the demand for goods and services.
The same is true when the government borrows in this situation to increase transfer payments (such as increased payments for agricultural subsidies, unemployment compensation, or aid to municipalities) or to finance tax cuts that created the need to borrow in the first place, though here the effect on the demands for goods and services is less certain in that these effects are indirect. They can have an effect on the demands for goods and services only to the extent that those who received the transfer payments or tax cuts increase their spending as a result. There is, of course, no guarantee this will occur.
Deficits that occur during an economic downturn that help to maintain or increase expenditures on education, scientific research, public health systems, police and fire protection, bridges, highways, and other forms of public transportation all have the direct effect of stimulating the economy. Even expenditures that arise from increases in the kinds of transfer payments embodied in food stamps, unemployment compensation, school lunch programs, Medicaid, and other kinds of social welfare programs that tend to increase during an economic downturn help to stimulate the economy since most of these transfers go to people who live hand to mouth, and, therefore, are more or less forced to spend.
In addition, most, if not all of these kinds of expenditures, whether direct expenditures or social welfare transfers, have the added benefit of making it possible to improve productivity in the future by improving our public infrastructure and warding off the malnutrition and other health problems that are the inevitable consequence of people becoming destitute in the wake of an economic downturn. Thus, running a deficit to finance these kinds of expenditures and transfer payments during an economic downturn adds stability to the system and has the potential to help the economy grow and, thereby, to reduce the burden of servicing the debt that deficits create.
By the same token, deficits that occur during prosperous times or that are created in the midst of an economic downturn by giving tax cuts and increasing transfer payments to the ultra wealthy who, in turn, use the proceeds to buy the bonds needed to finance the deficits created by the transfers and tax cuts in the first place do not stimulate the economy and do not have the added benefit of having the potential to improve productivity in the future. They simply increase the transfer burden from debtors (i.e., taxpayers) to creditors as they distort the allocation of resources within the system with a dead loss to the society as a whole. In addition, this kind of fiscal irresponsibility on the part of the government has the potential to create chaos within the economic system.
Even though there is no default risk to federal debt, when federal debt grows faster than the GDP it increases the burden of transfers from debtors to creditors which can lead to serious problems, especially if the debt is foreign owned. In addition, there is a huge risk of inflation as the federal debt grows if it reaches the point where the government cannot raise the money to service its debt through taxes or borrowing and is forced to print money. The resulting inflation can have the effect of increasing interest rates and, thereby, making the transfer problem worse as it weakens our position in international markets. If severe enough, hyperinflation can lead to a total collapse of the monetary system as creditors refuse to enter into contracts of any sort that are written in terms of the domestic currency.
Thus, the ability of the federal government to print money is not a blank check that allows the federal government to do whatever it chooses. It only gives the federal government a degree of flexibility in managing its affairs that no other entity within the economic system has, but the federal budget must be managed responsibly if catastrophe is to be avoided. This does not mean that the budget should always be balanced or that federal debt should be paid off as quickly as possible. As we will see, attempting to do so can have disastrous consequences.
What it does mean, however, is that during an economic downturn the deficit and debt must be increased in such a way as to maximize the economic stimulus while, at the same time, alleviating human misery and building up our public infrastructure as much as possible in order to minimize the economic decline and increase our ability to produce in the future. It also means eliminating unproductive or wasteful programs and expenditures during prosperous times and increasing taxes to pay for the government programs and expenditures that are essential to our economic and social wellbeing.
Not managing the budget in this way and, in particular, not increasing taxes to pay for the government programs and expenditures that are essential to our economic and social wellbeing while giving tax cuts to those who have no need to spend the proceeds during an economic downturn is courting disaster. (Stiglitz Klein Johnson Crotty Bhagwati Philips Galbraith Morris Reinhart Kindleberger Smith Eichengreen Rodrik Krugman)
In spite of the fact that 80% of our total debt is non-federal debt, there has been an extraordinary amount of concern since 2008 over the growing national debt. This concern is dangerously misplaced. It is the $47 trillion of non-federal debt that existed at the end of 2013 that we should be most concerned about, not the $12 trillion federal debt. The most serious problem we face today is the fact that the non-federal debt stood at 278% of GDP in 2013. A ratio of this magnitude places a huge transfer burden on the financial system, a burden that places the entire economic system at risk.
The fundamental problem faced by non-federal debtors is that they must service their debts out of income. When they cannot service their debts out of income they must refinance their debts when they come due, and, failing that, they are forced to sell assets. If they lack the assets to sell, their only option is to default.
The forced selling of assets and defaults on non-federal debt leads to falling asset prices that threaten the solvency of those financial institutions that hold similar kinds of assets, not just the creditors of those who sell assets or default on their debts. Since all of the major financial institutions hold similar kinds of assets, a non-federal debt ratio as high as 278% of GDP poses a threat to the entire financial system in that it imposes such a transfer burden on debtors that even a minor shock to the system, such as an increase in interest rates or a slowdown in the rate of growth of GDP, has the potential to initiate a wave of distress selling and defaults that puts the entire financial system at risk. This is, of course, what was in the process of happening in 2007 through the summer of 2009.
The increase in interest rates from 2005 through 2007 led to a fall in housing prices and increasing defaults in the mortgage market which, in turn, led to the downturn in economic activity we experienced from the fall of 2007 through the summer or 2009. This left financial institutions in a precarious situation as they struggled to get as many risky assets off their books as possible for fear of being forced into insolvency should the economic situation get worse. At the same time, debtors found it more difficult to refinance their debts, and many financial institutions were forced to refinance existing loans in order to avoid having to take a loss on those loans. As a result, the financial intermediation process broke down as debtors found it more difficult to meet their financial obligations; financial institutions began to fail, and those that survived refused to make new loans and resisted refinancing existing loans. It took the heroic actions of the Federal Reserve and tremulous actions of the federal government to keep the system form collapsing.
It should be obvious that if the federal government had attempted to balance its budget by cutting its expenditures in this situation the result would have been an even further fall in the economy. This would have decreased the amount of spending which would have forced an even greater number of non-federal debtors to liquidate assets or default on their financial obligations in a situation in which the entire financial system was on the verge of collapse.
It should also be obvious that it is going to be virtually impossible for financial institutions to intermediate between borrowers and lenders in such a way as to allow the economy to recover from this crisis in a reasonable amount of time without further government stimulus since the only way financial intermediation can do this is by increasing debt, and it is virtually impossible for financial intermediation to increase debt with a non-federal debt ratio of 278% in the absence of massive investment opportunities, real or imagined, to justify this increase.
Given the experiences we have had with imaginary investment opportunities over the past thirty years and the disastrous consequences that have followed, it is unlikely we will be able to rely on another stock market or real estate bubble to provide yet another temporary solution to this problem. And since the real investment opportunities needed to accomplish this are wanting, we are not likely to be able to get out of the hole we have dug ourselves into through yet another massive increase in debt.
At the same time, there is no reason to think we can solve this problem by purging the system of debt by balancing the federal budget and forcing debtors to default through conservative monetary and fiscal policy. That certainly didn’t work in the 1930s.
Figure 1 shows the relationship between GDP and total, non-federal, and federal debt from 1929 through 1941. It also shows what happened when the system was allowed to purge itself of debt from 1929 through 1933 by forcing debtors to liquidate their assets or default.
Source: Historical Statistics of the U.S. (Cj870), Bureau of Economic Analysis (1.1.5).
As non-federal debt fell from $175 billion in 1929 to $144 billion in 1933, GDP fell from $105 billion to $57 billion. Thus, in the process of purging $31 billion worth of non-federal debt from the system GDP fell by $47 billion. The end result was an 18% fall in non-federal debt accompanied by an 45% fall in GDP as the ratio of non-federal debt to GDP went from 168% of GDP to 252% of GDP. In the meantime, over 10,000 banks failed along with 129,000 other businesses; the unemployment rate soared to 25% of the labor force, and 12 million people found themselves unemployed by the time this purging of debt came to an end. This was the legacy of Andrew Melon's infamous advice to Herbert Hoover:
. . . liquidate labor, liquidate stocks, liquidate farmers, liquidate real estate… it will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up from less competent people. (Hoover)
The purging of debt from 1929 through 1933 led us into the depths of the Great Depression, and it is instructive to examine just how we got there.
Figure 2 shows[1] the gross domestic product deflator along with the money supply, High-Powered Money, and member bank reserves from 1929 through 1941.
Source: Bureau of Economic Analysis, (1.1.6A), Economic Report of the President 1960 (D40 D42).
As is shown in this figure, the demand for currency outside of banks was unchanged in 1929 and 1930 as currency in circulation remained at $3.6 billion in both of those years. It then increased by $900 billion in 1931 as the banking crisis that began in October of 1930 took hold and increased by an additional $200 million in 1932. By 1933 currency in circulation stood at $4.8 billion and had increased by a total of $1.2 billion since 1930.
This 33% increase in demand for currency outside of banks was met by an increase in High-Powered Money that followed a similar pattern as the increase in the demand for currency, but with a lag: High-Powered Money remained unchanged at $6.0 billion in 1929 and 1930, increased by $844 million in 1931, actually fell by $9 million in the midst of the crisis in 1931 as member-bank reserves fell by $200 million, and then increased by $329 million as the total increased to $7.1 billion in 1933.
This lag in the creation of High-Powered Money on the part of the Federal Reserve, combined with the overall timidity of its response to the crisis, allowed member-bank reserves to fall by $265 million from 1930 through 1932 as banks struggled to maintain their solvency in the face of falling asset prices brought on by the stock market crash and the economic downturn that followed. As a result, the money supply began to fall in 1930 as banks tried to improve their financial situation by refusing to make new loans or to renew existing loans in an attempt to hang on to their reserves. In the process, currency plus all deposits fell by 22% from 1929 through 1933 (from $54.7 billion to $42.6 billion) while currency plus demand deposits fell by 25% (from $26.4 billion to $19.8 billion).
In turn, the process by which this contraction of the money supply took place—banks refusing to make new loans or to renew existing loans—had a devastating effect on prices as business were forced to mark down their inventories and sell them off at a loss. It also had a devastating effect on wages as employers found it impossible to maintain the level of wages they had previously been able to pay as the prices at which they were able to sell the output they produced fell.
The deflation that resulted from 1929 through 1933 as the Federal Reserve sat back and allowed the system to purge its debt is clearly shown in Figure 2 by the 26% fall in the GDP deflator from 119 in 1929 to 88 in 1933.
Figure 3 shows the total outlays, receipts, and surpluses of the federal government from 1929 through 1941 along with the rate of unemployment and the output of goods and services as given by real GDP measured in 1937 prices.
Source: Bureau of Economic Analysis, (3.2 1.1.6A), Economic Report of the President, 1967 (B20).
As is shown in this figure, federal government expenditures gradually increased from 2.8% of GDP in 1929 to 6.5% in 1933 as actual expenditures increased from $2.9 billion to $3.7 billion and tax receipts fell from $3.7 billion to $2.6 billion. In the process the budget went from a $800 million surplus to a $1.1 billion deficit.
In the meantime, real GDP measured in 1937 prices fell from $88.2 billion to $65.0 billion, a 26.3% decrease in the output of goods and services produced. When this fall in output was combined with 25% fall in prices shown in Figure 2 it brought about the 46% fall in GDP shown in Figure 1. Thus, while non-federal debt decreased by $31.2 billion during this period, this decrease was partially offset by a $7.8 billion increase in federal debt as tax revenues fell and emergency spending increased. At the same time, GDP fell from $104 billion in 1929 to $56 billion in 1933 as the total debt ratio exploded from 183% to 295% of GDP and, as was noted above, the non-federal debt ratio increased from 168% to 252% of GDP.
In the end, a net $23 billion of debt was purged from the system by forcing debtors to liquidate their assets or to default on their debts, a reduction equal to 22% of the total in 1929. In the process of purging this debt, the total debt to GDP ratio—and along with it, the burden of servicing the remaining debt—went through the roof as this ratio increased by 111 percentage points to 283% of GDP and the non-federal debt ratio increase by the 84 percentage points to 252% of GDP as gross income (i.e., nominal GDP) fell by 45% and output (i.e., real GDP) by 26%. And it is worth emphasizing again that along the way over 10,000 banks failed along with 129,000 other businesses; the unemployment rate soared to 25% of the labor force, and 12 million people found themselves unemployed by the time this purging of debt came to an end.
It wasn’t until after the Federal Reserve allowed High-Powered Money to increase dramatically following 1933 (Figure 2) in a way that allowed banks to increase their excess reserves dramatically—from virtually zero ($60 million) in 1931 to $770 million in 1933 to $1.8 billion in 1934 and to $3.0 billion in1935—that the purging of debt came to an end. And it wasn’t until after government expenditures had increased to 10.7% of GDP ($6.6 billion) and the government’s budget had gone from a surplus equal to 0.7% of GDP in 1929 to a deficit (negative surplus) of 5.9% of GDP ($3.6 billion) in 1934 (Figure 3) that debt stopped falling and the rate of unemployment began to fall as GDP began to increase (Figure 1).
In other words, the debt problem that was created in the 1920s and was allowed to cripple the economy from 1929 through 1933 was not resolved by forcing debt to be purged from the system through conservative monetary and fiscal policies. It was resolved through the active participation of the Federal Reserve in providing the excess reserves needed by the banking system to end the implosion of the financial system that took place from 1929 through 1933, and through the active participation of the federal government to stimulate the economy through an increase in government expenditures that increased the demand for goods and services and made it possible for the economic system to grow.
Even then it took the 1933 bank holiday in which all the banks were forced to close and then reopened with a deposit guarantee on the part of the federal government before the carnage caused by the downward spiral of debt, GDP, and employment was brought to an end.
It is also worth noting that the deleveraging in the economy that took place as the total debt ratio went from 295% of GDP in 1933 to 163% by 1941 took place through an increase in GDP, not through a decrease in debt. Total debt increased from $168 billion in 1933 to $211 billion in 1941 while non-federal debt increased from $144 billion to $155. At the same time GDP went from $57 billion to $129 billion. (Figure 1) Clearly, it was the increase in GDP that was facilitated by the increase in government expenditures and expansionary monetary policy that led to the decrease in the debt ratio following 1933, not a fall in debt.
Yet another important lesson to be learned from the 1930s, that has particular relevance today, is the results of the change in government policy following 1936 as federal government attempted to balance its budget by cutting its expenditures and the Federal Reserve increased reserve requirements in an attempt to eliminate the excess reserves in the banking system.
As the federal expenditures and excess reserves began to fall from 1936 through 1938 (Figure 2 and Figure 3) the increase in output ended and GDP began to fall again as the rate of unemployment and the debt ratios began to rise. In other words, when the federal government cut its expenditures in 1936 through 1938 and the Federal Reserve tried to eliminate the excess reserves in the banking system during this period, the economic recovery ended and the economy slipped back into a recession. The economic system did not recover from this shock until the federal government and Federal Reserve reversed their policies and government expenditures and excess reserves began to increase again after 1938.
The government’s attempt to return to conservative monetary and fiscal policy in 1936 managed to reduce the excess reserves in the banking system by 68% in 1937 and to nearly balance the federal budget in 1938, but at the cost of a jump in unemployment from 15.6% of the labor force in 1937 to 18.1% in 1938 as the output of goods and services fell by 3.5%, and the federal debt to GDP ratio went from 42.7 in 1937 to 46.2 in 1939. It is exceedingly difficult to explain just how the benefits gained, whatever them may have been, from this exercise in conservative monetary and fiscal policy justified these costs.
There are at least three fundamental lessons that should have been learned from our experiences during the Great Depression.
Conservative Policies Do Not Work
The first lesson that should have been learned from the 1930s is that implementing a conservative monetary and fiscal policies that forces non-federal debt to be purged from the system by forcing debtors to liquidate their assets and default on their financial obligations in the face of an economic downturn is not a good idea. Such policies drove the system into a downward spiral from 1929 through 1933 that didn’t come to an end until after those policies came to an end.
The importance of this lesson is reinforced by the fact that when these self-defeating policies were resumed following 1936 the economic recovery that their abandonment had begun came to an end. The economy again faltered in the wake of these policy changes and began yet another downward spiral that didn’t come to an end until these policies were abandoned for a second time.
A Timid Response Does Not Work
The second lesson that should have been learned from the 1930s is that a timid response on the part of the government to increase reserves and government expenditures in the face of a financial crisis is not enough. This lesson should have been made clear by the fact that the unemployment rate never fell below 14% during the Great Depression and the unemployment problem was not completely overcome until the federal government began to mobilize for World II. It was only after the ideas of a conservative monetary policy and budget balancing fiscal policy were abandoned and the government began to prepare for World War II that government expenditures and High-Powered Money expanded enough
Squandering Our Fiscal Resources Does Not Work
Finally, one of the most important lessons that should have been learned from the 1930s, and one that has particular relevance today, is that in bringing about the recovery from the downward spiral of income, output, and employment in the 1930s the federal government did not resort to squandering its resources on worthless tax cuts and transfers to the upper echelons of the society who were able to use the proceeds to purchase the government bonds needed to finance the tax cuts and transfers.
The increases in government expenditures following 1933 were funded, in part, by at least nine significant tax increases that took place during the Great Depression, starting with the Revenue Act of 1932 which took effect in 1933. (Romer) In so doing the federal government was able to maximize the stimulus effect of its increases in expenditures in the most fiscally responsible way as it partially financed its increases in expenditures by taxing those who were unwilling to spend. This minimized the negative effect of tax increases on spending while, at the same time, mitigated the effect of the increases in government expenditures on the national debt. As can be seen in Figure 1, the federal debt ratio had stabilized quite dramatically by 1935 in spite of the increase in government expenditures and the resulting deficits in the federal budget.
As a result of the tax increases that took place during the 1930s, the federal debt ratio stood at 42% of GDP in 1937, just as it had in 1933, in spite of the oversize deficits that had occurred over the preceding four years as those deficits managed to facilitate a 40% increase in output and a 36% reduction in the rate of unemployment. The federal government would not have been able to accomplish this kind of stability in the ratio of its budget to GDP had it not been for the kind of fiscal responsibility provided by the tax increases embodied in the revenue acts of the 1930s.
By 2008 total domestic debt stood a 364% of GDP, non-federal debt stood at 321%, and federal debt was 43% of GDP. The top 1% of the income distribution claimed 17.7% of total income, and the current account deficit was at 4.6% of GDP. This situation proved to be unsustainable, and there has been very little improvement since 2008. While our current account balance fell to 2.7% of GDP by 2013 and non-federal debt fell by 43 percentage points to 278%, the total debt ratio fell by only 13 percentage points to 351% of GDP. As can be seen from Figure 4, these debt numbers are comparable to those at the depths of the Great Depression.
Source: Federal Reserve (L1), Historical Statistics of the U.S.
(Cj870 Ca9-19), Bureau of Economic Analysis (1.1.5).[2]In comparing today with 1933, only the unemployment rate is better—7.4% of the labor force in 2013 versus 24.9% in 1933—but even this is a mixed blessing. It took four years to reduce the debt ratio by 100 percentage points following 1933, and, as was indicated above, the primary mechanism by which this was accomplished was by putting people back to work as the rate of unemployment fell from 24.9% of the labor force in 1933 to 14.3% by 1937. This, in turn, was accomplished through monetary and fiscal policy as the Federal Reserve allowed High-Powered Money to increase in a way that allowed banks to increase their excess reserves and the federal government to increase both its taxes and expenditures. In the process, GDP increased by 63% output by 44% and prices by 10% as the federal debt ratio stabilized. With an unemployment rate of only 7.4% in 2013 we are not going to be able to reduce the debt ratio by decreasing the rate of unemployment by 10 percentage points as we did in the 1930s without a significant increase in the labor force participation rate which has fallen by 3.7 percentages points since 2000.
Figure 5 shows how the Federal Reserve and federal government have responded to the current crisis. It is clear from this figure that the Federal Reserve has learned the lessons of the 1930s as those lessons pertain to monetary policy in that the Fed dramatically increased the amount of High-Powered Money needed to meet the demands of banks for excess reserves in the midst of this crisis. This figure also indicates that the federal government also learned some of the lessons of the 1930s with regard to fiscal policy in that the federal government allowed its expenditures to increase without attempting to balance its budget, at least this was its initial response. As a result, we have been able to avoid the kind of carnage the economic system went through during the first four years of the Great Depression. At the same time, it is clear that many of the lessons of the 1930s have not been learned.
Source: Bureau of Economic Analysis (1.1.5 3.2 3.3)
As can be seen very clearly in Figure 4, a massive deleveraging took place from 1933 through 1941 as total debt as a percent of GDP fell from 295% to 163%. During that same eight year period the federal debt burden remained relatively unchanged as it went from 42.5% to 43.5% of GDP in spite of the fact that the federal government ran substantial deficits in all but one of those eight years.
When we look at what has happened from 2008 through 2013 we find that, while monetary and fiscal policy were effective in halting the downward spiral of the economic system in 2009, they have done relatively little toward deleveraging the system. The 43 percentage point fall in non-federal debt is relatively small compared to the non-federal debt ratio of 278% in 2013, and the total debt ratio has fallen by only 13 percentage points since 2008. At the same time, the 31 percentage point increase in the federal debt ratio from 43% to 74% of GDP in Figure 4 is disturbing. The federal debt ratio has not stabilized the way it did during the expansion of the 1930s.
As was noted above, the expansion of government expenditures following 1933 took place in conjunction with a number of tax increases that made it possible to stabilize the federal budget as the economy expanded along with federal expenditures. The importance of increasing taxes in stabilizing the budget as government expenditures increase in this situation is one lesson that has not been learned from the 1930s.
A second lesson that has not been learned from the 1930s is that while the increase in government expenditures that followed 1933 was sufficient to reverse the downward spiral of the economy and to bring about a substantial deleveraging of the system, it was not sufficient to solve the unemployment problem. The rate of unemployment remained above 14% of the labor force from 1931 through 1940, and it was not until 1942, the first year in which the country began to mobilize in earnest for World War II, that the unemployment rate fell below 5% for the first time since 1929. As federal expenditures went from 8.9% of GDP in 1940 to 11.0% in 1941 to 20.3% in 1942 the rate of unemployment went from 14.6% to 9.9% to 4.7%, respectively. At the same time the federal deficit went from 3.0% of GDP to 4.1% then to 14.2%. This is what solved the unemployment problem of the Great Depression—a massive government intervention in the economic system, though, clearly, the intervention of World War II was more massive than was necessary to solve this problem.
When we compare Figure 3 with Figure 5 we see a pattern that seems to want to repeat itself. Federal government outlays were actually allowed to fall in 2010, just as they were allowed to fall in 1933, and they barely increased in 2011 through 2013. As a result, there was only an 1.9 percentage point drop in the rate of unemployment from 2009 to 2013, and because of the leveling off of government expenditures after the American Recovery and Reinvestment Act was allowed to run its course, the rate of unemployment was still at 7.7% of the labor force in February of 2013 as the labor force participation rate fell 3.2 percentage points, and millions of discouraged workers left the labor force.
The third lesson that has not been learned from the experience of the 1930s and the thirty years that followed is that the concentration of income at the top of the income distribution was incompatible with the mass-production technologies that served the domestic markets. As has been noted, in spite of the increase in output and employment that followed the government intervention in the economic system that began in 1933, the rate of unemployment failed to fall below 14%. This intervention was not enough to provide the mass markets needed to take full advantage of the productive capacity of the mass-production technologies embedded in our economy given the 15% concentration of income in the top 1% of the income distribution that existed in the 1930s.
As can be seen in Figure 6, this level of income concentration prevailed in the early 1920s as well, and, as we have seen, proved incapable of providing the mass markets required to produce full employment in the 1920s in the absence of speculative bubbles and an increase in debt. In spite of the increase in output and employment that followed the government intervention in the economic system that began in 1933, there were no speculative bubbles or increases in debt to bolster the economy, and the rate of unemployment failed to fall below 14% throughout the 1930s.
Source: The World Top Incomes Database.
It wasn’t until the government literally took over the economic system in 1942 and purchased the potential output that could not be sold to the private sector, given the distribution of income, that the unemployment problem was solved as the system was brought to full capacity. And it wasn’t until after the non-federal debt ratio and the level of income concentration fell during the war—and as the income concentration continued to fall after the war—that the domestic mass markets needed to sustain mass production were able to grow at the pace needed to maintain full employment in the absence of speculative bubbles and dramatic increases in total debt.
Finally, it is worth emphasizing that the dramatic deleveraging of non-federal debt that took place from 143% of GDP in 1940 to 67% in 1945 took place within an environment in which total government expenditures had increased to 36% of GDP by 1945 and the rationing of consumer goods and strict controls on investment expenditures gave households and firms little choice but to pay down their debts as their incomes increased dramatically during the war. This feat was not accomplished through the magical powers of free markets to bring balance back into the economy through the liquidation of households and firms—the kind of liquidation that took place from 1929 through 1933 that drove the economy into the Great Depression of the 1930s.
World War II was hardly an optimal solution to the problems caused by the concentration of income and the overwhelming burden of debt created by the fraudulent, reckless, and irresponsible behavior of those in charge of our financial institutions in the 1920s. It should be obvious that it would have been better to have accomplished the same ends through a somewhat less massive government intervention in the economy to build up our public infrastructure by providing massive improvements in our transportation, public utility, and educational systems than by producing massive quantities of war materials.
All of these things should be obvious, yet, none of these lessons have been learned by the free-market ideologues whose only vision for the future is lower taxes, less government, deregulation, and paying off the national debt.
Endnotes
* This essay was formally Chapter 15 in Where Did All the Money Go?
[1] High-Powered Money is estimated in Figure 2 by the sum of Total, Member-bank reserves from the Economic Report of the President 1960's Table D-42 and Currency outside banks from Table D-40. This sum underestimates the actual value of High-Powered Money in existence at the time by the amount of currency held in the vaults of banks since vault cash was not considered to be part of reserves from 1917 until 1959. (Feinman)
[2] See the Appendix on Estimating Debt at the end of Chapter 3 in Where Did All the Money Go? for an explanation of the way in which the data from the Historical Statistics of the U.S., Federal Reserve Flow of Funds Accounts, and Bureau of Economic Analysis are used in this figure.
