Recently Scott Sumner focused his attention on 1946 (here and here), which (he claimed) was quite embarrassing for Keynesians. This is the opening of his second post, which gives a flavor of his analysis:
Over at Econlog I did a post discussing the austerity of 1946. The Federal deficit swung from over 20% of GDP during fiscal 1945 (mid-1944 to mid-1945) to an outright surplus in fiscal 1947. Policy doesn’t get much more austere than that! Even worse, the austerity was a reduction in government output, which Keynesians view as the most potent part of the fiscal mix. I pointed out that employment did fine, with the unemployment rate fluctuating between 3% and 5% during 1946, 1947 and 1948, even as Keynesian economists had predicted a rise in unemployment to 25% or even 35%—i.e. worse than the low point of the Great Depression. That’s a pretty big miss in your forecast, and made me wonder about the validity of the model they used.
Everyone got that? Keynesians are big on fiscal policy being the key to avoiding recessions, and so it’s really awkward for them that there was so much fiscal tightness in 1946, with no plunge into Depression. Sumner thinks this is a pretty big smoking gun to tell us that Keynesian models are wrong. I agree with him.
But what’s interesting is that the end of World War II also coincided with extreme monetary tightening. I am old school and like the monetary base as a key indicator. Check it out:
Can’t get a much crisper “regime change” than that, right? From December 1941 – December 1945, the monetary base almost doubled, but starting in 1946 the base was basically flat for the next 5 years.
As far as short-term safe interest rates, they were steady throughout 1946 but then began rising sharply in mid-1947:
But as we all know, Market Monetarists are not fooled by the monetary base or interest rates. Instead they focus on NGDP growth as the ultimate criterion of whether monetary policy is tight or loose.
On this count, it’s not as clear cut as with the monetary base, but nonetheless (using annual data) you see the growth in NGDP collapsed to zero after the war:
And, Sumner himself reports that if you look at the beginning of 1945 through the beginning of 1946, NGDP actually drops 10%. (For context, using quarterly data, the biggest drop from the preceding period in NGDP during the 2008 financial crisis was -7.7%. So for an annual drop of 10% after World War II, that was way way worse of a monetary shock, if you’re a Market Monetarist.)
So, I think the above shows that there was, by all accounts, monetary tightening (or at least a failure to engage in “monetary offset”) following World War II. Since the standard Market Monetarist story is that massive fiscal contraction is indeed bad because it reduces Aggregate Demand, but can be offset with appropriate monetary loosening, it seems that this year 1946 poses a pretty big challenge to the Market Monetarist model as well as the Keynesian model.
Someone brought this up in the comments of Scott’s Money Illusion post. And yet, not only did Scott not provide a satisfactory explanation, he blew the guy off like it was a stupid question.
P.S. It’s not just 1946. The Market Monetarists tried to say Canadian fiscal austerity only worked in the 1990s because of monetary offset, but there again I showed (here and here) that using all sorts of reasonable metrics, the Bank of Canada tightened right at the crucial moment.