FISCAL AND MONETARY POLICY

To mobilize financial resources, the United States relied, as it has in most wars, on taxes, borrowing, and creating new money. The war radically changed the income tax. The exemptions for single and married persons were lowered. In 1943, the payroll deduction system for collecting income taxes was introduced, and the term take-home pay entered the language. Together, these innovations meant that the income tax had become a mass tax for the first time. Corporate tax rates were also increased, and an excess profits tax was introduced. As a result of these tax increases and the rapid increase in the tax base, the United States was able to finance about 40 percent of the war with taxes (see Table 25.3). This was a larger share of total spending on the war than had been financed by taxes in the Civil War or World War I. Nevertheless, the United States still had to borrow large sums to help finance the conflict (refer to New View 25.1).

Conceivably, all wartime deficits could have been financed by sales of securities to the general public, but (despite highly publicized war bond drives) it is likely that the interest rates required to market those bonds would have been very high by historic standards. Therefore, the Federal Reserve took the extraordinary step of “pegging” the rate of interest on government securities. It accomplished this by pledging to buy government securities whenever their price fell below predetermined support levels. On the surface, selling bonds to the Fed seems to be a free ride because it minimizes the future interest costs that the government incurs.

The World War II debate over whether to rely mainly on taxes or debt to finance the war (no one thought that relying on printing money was a good idea) continues to be relevant when the United States goes to war. The Roosevelt administration, reflecting one school of thought, proposed financing the greater part of the war by raising taxes. According to the administration, doing so would avoid burdening the younger generation (including those doing the fighting) with having to pay the interest and principal on a large debt in future years. Getting Congress to raise taxes, however, is never easy. Republican congressmen complained that high tax rates discouraged work, and they supported only partial financing through increased taxation. Today, many neoclassical economists, for example Robert J. Barro (1989), agree that “smoothing taxes”—raising them only a bit during wars and relying mainly on debt—is the most efficient way to finance a war. Supporters of deficit finance can also point out that the federal debt reached $259 billion in 1945, 121 percent of GDP, without causing an obvious crisis, as evidence that the economy can tolerate very high levels of debt.

In thinking about this debate, it is perhaps relevant to remind ourselves of what Adam Smith, a proponent of tax finance, had to say:

Wars [iffinanced by taxes rather than debt] would in general be more speedily concluded, and less wantonly undertaken. The people feeling, during the continuance of the war, the complete burden of it, would soon grow weary of it, and the government, in order to humor them, would not be under the necessity of carrying it on longer than it was necessary do so. (Smith 1976 [1776], 925)

On one’s view of things) is that the Federal Reserve must create new money to purchase these securities, and this adds to the inflationary pressures facing the economy.109

In 1939, unemployment remained at the stubbornly high level of 11.3 percent of the labor force. Keynesians claimed that unemployment could be cured with a sufficient increase in government spending, particularly deficit-financed spending. True, the deficit was 3.07 percent of GNP in 1939 (see Table 25.4). What was needed, according to the Keynesians, was simply a much bigger deficit. By 1944 the deficit had been vastly increased, to 22.5 percent of GNP, and unemployment was virtually gone (1.2 percent), one of the lowest rates on record. Most economists, particularly those of the younger generation such as future Nobel Prize winners Paul Samuelson and James Tobin, found this demonstration of the effectiveness of the Keynesian remedy for unemployment convincing.

TABLE 25.4 DEFICIT SPENDING AND THE FALL IN UNEMPLOYMENT

Sources: Economic Report of the President 1987, 244, 280, and 331; and Darby 1976, 8. The last column is derived from Friedman and Schwartz 1982, 124-125.

A number of economists at the time, as well as a growing number since, were still skeptical about Keynes’s cure. For one thing, the data is also consistent with the monetarist claim that a large increase in the money supply would cure the depression. Consider the last column of Table 25.4. The stock of money in 1939 was only slightly higher than that of 1929, but by 1944, it had more than doubled. Some economists have pointed out that the drafting of large numbers of young men into the armed forces removed many individuals who had a high probability of being unemployed from the labor force. As in so many cases, the lessons of history are ambiguous because in the natural experiments of history other factors are seldom as constant as we would like. Whatever reservations economists may now entertain about this demonstration of the Keynesian message, there is no doubt that it had a profound impact on economic policymaking during and in the decades following the war. Even at the time, however, some Keynesians worried that the inflationary pressures produced by wartime deficit spending had been checked only by a set of wage and price controls that would be unacceptable in peacetime.