XX. The Great Keynesian Boom

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-XX. The Great Keynesian Boom-

A. Europe’s “Supergrowth”

1. The pace of Europe’s post-World War II recovery
Even the most casual glance at numbers and growth rates reveals that growth and recovery after World War II was astonishingly rapid. Considering the three largest Western European economies—Britain, France, and Germany—the Second World War inflicted much more damage and destruction on a much wider area than the First. And (except for France) manpower losses were greater in World War II as well. The war ended with 24 percent of Germans born in 1924 dead or missing, and 31 percent disabled; post-war Germany contained 26 percent more women than men.
In 1946, the year after the end of World War II, GNP per capita in the three largest Western European economies had fallen by a quarter relative to its pre-war, 1938 level. This was half again as much as production per capita in 1919 had fallen below its pre-war, 1913 level.

Yet the pace of post-World War II recovery soon surpassed that seen after World War I. By 1949 average GNP per capita in the three large countries had recovered to within a hair of its pre-war level, and in comparative terms recovery was two years ahead of its post-World War I pace. By 1951, six years after the war, GNP per capita was more than ten percent above its pre-war level, a degree of recovery that post-World War I Europe did not reach in the eleven post-World War I years before the Great Depression began. What post-World War II Europe accomplished in six years had taken post-World War I Europe sixteen.

The restoration of financial stability and the free play of market forces launched the European economy onto a two-decade long path of unprecedented rapid growth. European economic growth between 1953 and 1973 was twice as fast as for any comparable period before or since. The growth rate of GDP was 2 percent per annum between 1870 and 1913 and 2.5 percent per annum between 1922 and 1937. In contrast, growth accelerated to an astonishing 4.8 percent per year between 1953 and 1973, before slowing to half that rate from 1973 to 1979.

Moreover, the post-World War II recovery did more than just rapidly restore Western Europe to its previous peacetime long-run growth path. French and German growth during the long-post World War II boom carried total production per capita to levels that far outstripped their economies’ pre-1929 or even pre-1913 growth trends. In both France and West Germany labor productivity had outstripped their pre-1913 trends by 1955, and thereafter saw no noticeable slackening of growth. The dynamic of western European growth after World War II is an order of magnitude stronger than had hitherto been seen.

2. The transformation of West Germany
Consider, as an example, the west German economy. In the 1950s it certainly boomed. Recovery in the 1940s can be understood as recovering the productive capacity that had existed before the war, with the added benefit of an extra decade and a half’s worth of technology. But the German economy in the 1950s crashed through the output-per-capita levels that would have been projected by someone connecting pre-World War II peaks, and has come to rest since 1973 at about its pre-1913 growth rate, at a level of output-per-capita some forty percent higher than anyone would have dared to project on the basis of the pre-World War II experience.

The magnitude of the boom came as a surprise to the Germans. The real value of a basket of German stocks multiplied eightfold during the 1950s—without any reinvestment of dividends—for an average real return of twenty-five percent per year.

In addition the German economy showed itself able to absorb a very large population displaced from the east in a relatively small number of years. Unemployment in 1950 was ten percent. By 1960 it was down to one percent of the labor force.

This reduction of unemployment from double-digit levels to zero-digit levels took place with no sign of inflation or excess demand pressure at all: the average inflation rate from 1949 to 1970 was 1.7 percent per year. And this reduction of unemployment did not trigger anything like the degree of labor strife that had characterized pre-World War II (and pre-World War I) Germany.

3. The Moderation of Europe’s business cycle

Europe’s rapid growth in the 1950’s and 1960’s was associated with exceptionally high investment rates. The investment share of GNP was nearly twice as high as it had been in the last decade before World War II or was again to be after 1972. Accompanying high rates of investment was rapid growth of productivity. Even in Britain, the laggard, productivity growth rose sharply between 1924-37 and 1951- 73, from 1 to 2.4 percent per annum. This high investment share did not, however, reflect unusual investment behavior during expansion phases of the business cycle. Rather, it reflected the tendency of investment to collapse during cyclical contractions and the absence of significant cyclical downturns between 1950 and 1971.

Since most post-World War II recessions—on both sides of the Atlantic—have been generated by central banks fearing that rising wages and prices will set off a destructive inflationary spiral (or responding too late to such a spiral already in progress), the first place to look to understand the absence of European recessions between 1950 and 1971 is at the labor market. What created such “labor peace,” such a combination of full employment with very little upward pressure on wages in excess of productivity gains?
Some of Europe’s cyclical stability was due to the advent of Keynesian stabilization policy. But Keynesian policy was effective only so long as labor markets were accomodating. So long as increased pressure of demand applied by governments in response to slowdowns produced additional output and employment rather than higher wages and hence higher prices, the macroeconomy was stable. Investment was maintained at high levels, and rapid growth persisted.

The key to Europe’s rapid growth, from this perspective, was its relatively inflation-resistant labor markets. So long as they accomodated demand pressure by supplying more labor input rather than demanding higher wages, the other pieces of the puzzle fell into place. What then accounted for the accomodating nature of postwar labo markets?

The conventional explanation, following Kindleberger (1967), is elastic supplies of underemployed labor from rural sectors within the advanced countries and from Europe’s southern and eastern fringe. Elastic supplies of labor disciplined potentially militant labor unions. Another explanation is “History.” Memory of high unemployment and strife between the wars served to moderate labor-market conflict. Conservatives could recall that attempts to roll back interwar welfare states had led to polarization, destabilizing representative institutions and setting the stage for fascism. Left-wingers could recall the other side of the same story. Both could reflect on the stagnation of the interwar period and blame it on political deadlock.

Thus Charles Maier points to a labor movement—and to management organizations—that were more interested in raising productivity rather than in redistributing income from rich to poor. It seemed a better strategy for labor organizations to push for productivity improvements first and defer redistributions to later. Indeed, especially in West Germany the pattern of labor relations looks completely different after than it had looked before World War II.

B. The Bretton Woods system

1. Bretton Woods

Yet another potential explanation is the Bretton Woods System. Bretton Woods linked the dollar to gold at $35 an ounce and other currencies to the dollar. So long as American policy makers’ commitment to the Bretton Woods parity remained firm, limits were placed on the extent of inflationary policies. So long as European policy makers were loath to devalue against the dollar, limits were placed on their policies as well. Price expectations were stabilized. Inflation, where it surfaced, was more likely to be regarded as transitory. Consequently, increased pressure of demand was less likely to translate into higher prices than into higher output, and higher employment, as long as everyone believed that the ultmate determinants of inflation lay in U.S. monetary policy because of the dollar’s role as key currency in the system.

International monetary disorder—financial crises, devaluations, hyperinflations, trade restrictions for balance-of-payments reasons—had been a principal obstacle to recovery after World War I. The international monetary system has relatively little role in the history-of-events of the generation after World War II because not much went wrong: another example of the principle that “happy is the land that has no history.”

When the delegations—the American delegation headed by Treasury Assistant Secretary Harry Dexter White, the British delegation headed by John Maynard Keynes, and the other delegations—met in the somewhat faded and under-plumbinged mountain resort of Bretton Woods,1 New Hampshire to build a post-WWII international monetary system, their minds were focused on what they saw as the lessons of the interwar period.

Keynes and White drew somehat different lessons from the interwar period. Keynes looked forward to a world in which countries could change their exchange rate parities relatively freely, and foresaw the application of trade and exchange restrictions in order to keep the requirements of the balance of payments from interfering with the pursuit of full employment. He looked to an International Monetary Fund that would provide extensive balance-of-payments financing (“subject to increasingly demanding conditionality and penalty interest rates” imposed on both trade-surplus and trade-deficit countries).2 White, by contrast looked forward to a world of free capital flows and fixed and rarely-adjusted exchange rates. In White’s conception, countries would be allowed to change their exchange rates only if the IMF permitted it..3
The Bretton Woods system that they wound up constructing departed from the gold exchange standard in three interlinked ways:

Exchange rates were fixed and pegged, but the pegs were adjustable in response to “fundamental disequilibrium.” The idea was to avoid a situation like that of Britain in the late 1920s, when either devaluation or deflation is called for, and adherence to the rules of the game of the gold standard would force deflation and a prolonged depression. Countries were allowed to adjust their currencies by up to ten percent—after consulting with the IMF—in cases of “fundamental disequilibrium,” although larger changes were supposed to wait upon formal IMF approval. Controls on international capital flows were explicitly allowed: Keynes and White had no desire to see international speculators move exchange rates and upset governments’ policies.4

2. The IMF
The International Monetary Fund was established to be a referee. It would extend financial support to countries that needed more reserves to ride out a temporary balance-of-payments deficit. It would be the judge of whether “fundamental disequilibrium” existed and thus of whether exchange rate pegs should be changed.

The Bretton Woods conference of 1944 set up the post-World War II international economic system which was to prove extraorinarily successful. In intention, obedience to the rules of the International Mondetary Fund would provide macroeconomic equilibrium. Countries would maintain fixed exchange rate parities vis-a-vis one another. When one country ran a persistent balance of payments deficit that threatened to exhaust its reserves, it could borrow from the IMF. In return, the IMF would seek macroeconomic policy adjustments in order to bring the balance of payments back to a sustainable level, or, in the case of “fundamental disequilibrium,” would recommend a devaluation.

The existence of the Bretton Woods framework made it much easier to achieve and maintain a régime of low tariffs and free trade. With stable exchange rates, a chief weapon that domestic industries could pressure governments to use to protect them (and a chief excuse for protection) would not be in operation. And to the extent that the IMF’s rules helped keep employment high and Great Depressions at bay, there would be little pressure for protectionism. Absent macroeconomic collapse, it would be hard to make a case that protecting countries would gain more than—as they cut themselves off from the international division of labor—they stood to lose.
The Bretton Woods system did not work as designed. Even from the beginning the idea of an adjustable peg proved to be, as Eichengreen puts it, an “oxymoron.” Moreover, the IMF’s ability to oversee what was going on and to pressure countries to adopt system-stabilizing policies soon proved very limited. And the IMF’s resources were always much to small to handle any of the post-World War II payments problems that it was supposed to address.

3. Free trade
A second institution, itself not the creation of Bretton Woods but a stopgap that grew up when the institution envisioned at Bretton Woods, the International Trade Organization, failed to be born, was the General Agreement on Tariffs and Trade. It established general rules-multilateralism and non-discrimination-that meant that trade liberalisation for one would become trade liberalisation for all, and established, for the first time, an ongoing institution dedicated to the reduction of barriers to trade throughout the world.
The Bretton Woods framework, and GATT, were successful. The average tariff imposed by the United States declined by nearly 92 percent over the 33 years from the Geneva Round of 1947 to the Tokyo Round of 1974-79. From 1953 to 1973, world real GNP grew at an average rate of 4.7 percent, and world trade at a rate of 7.5 percent per year.

[Figure: the expansion of world trade]

Did trade liberalization cause the trade expansion? To a large degree, yes. Did the trade expansion drive the economic prosperity of the long Keynesian boom? It seems likely that, to some degree, it did. Intra-industry trade became very important in the post-World War II era. World trade became not the exchange of coffee for washing machines, but the exchange of small cars for large cars, or of high-priced silks for moderate-priced synthetics.

The post-World War II industrial world was populated by a large number of firms making differentiated products, and then selling these products worldwide. The added scope of the market allowed for a greater division of labor, and here—in consumers’ choice certainly, and in productivity possibly—was a major gain from trade. Moreover, many World Bank and other studies have documented a strong link between trade liberalization and economic performance in the developing world. There is no reason to think that such a link does not exist for the industrial west as well.
4. Technological diffusion and multinational enterprises

As industries in the industrial core became more and more mechanized-more and more characterized by “mass production”-they should have become more and more vulnerable to foreign competition from other, lower wage countries. If Ford can redesign production so that unskilled assembly line workers do what skilled craftsmen used to do, why can’t Ford also-or someone else-redesign production so that it can be carried out by low wage Peruvians or Poles or Kenyans rather than by Americans, who are extraordinarily expensive labor by world standards?

Industries do migrate from the rich industrial core to the poor periphery, but they do so surprisingly slowly. One reason is added risk-political risk of all kinds tends to make investors wary of committing their money in places where it is easy to imagine political disruptions from the left or the right.
Moreover, there are substantial advantages for a firm in keeping production in the industrial core, near to other machines and near other factories making similar products. It is much easier to keep the machines running. A reliable electric power grid is much more likely to be found in the industrial core. And so are the services of specialists needed to fix the many things that can go wrong-minimum efficient scale for an industrial civilization can be far larger than the apparent minimum efficient scale for a plant.

These factors are an order of magnitude more important for industries that are in technological flux than for those that have a settled, relatively unchanging technology. A principal advantage of locating near the firms that make your machines comes from the interchange and feedback of users and producers-feedback that is valuable only if designs are still evolving. And the principal advantage of a machine-knowing and relatively well-educated labor force is the ability to adapt to using slightly different machines in somewhat different ways—once again, valuable only if small changes are constantly being made.

As industries reach technological maturity, freeze their production processes into set patterns, and become businesses in which sales are made on the basis of the lowest price, they tend to migrate to the periphery of the world economy: handed down to poorer countries as, in the words of a Japanese development advisor, older siblings hand down to younger ones clothes they no longer need.

[Figure: Multinationals]
5. America’s economic edge
Thus the maintenance of American industrial preeminence throughout the twentieth century depended on the constant introduction of new products and processes that did require immediate feedback, and that could not be easily copied or reproduced outside the United States. This required that the United States continue to be the locus of invention and innovation.
The process of technological change did not make leaps. Continuity of development and the importance of hands-on experience are crucial. In this context, “continuity” means that most innovation and productivity growth is the result not of single, discrete, major inventions or borrowings but rather of a continuous and ongoing process of improvement and adaptation, no one step in which is particularly important or noteworthy. In this context, “experience” means that the skills needed to handle and productively use modern technology are most easily and rapidly gained by using modern technology.

As Nathan Rosenberg puts it: “most inventions are relatively crude and inefficient [at first].They are, of necessity, badly adapted to many of the ultimate uses to which they will eventually be putthey offer only small advantages, or perhaps none at all.”

Consider that, that over the forty years from 1870 to 1910, the lion’s share of cost reduction in American railroads was contributed by incremental changes in the design of freight cars and locomotives. One by one, these changes were small and barely noticed: most of them have origins that are unknown today. But over forty years they added up to a doubling of the effective power of locomotives and to a tripling of the capacity of freight cars. There is a similar pattern in the CAT scanner industry: only the explosion of incremental improvements and developments in the decade after invention made the CAT scanner a useful device rather than an intriguing toy.

How are such incremental improvements made? Clearly they are made by those who are already very familiar with the technology and its uses. Without workers and managers with hands-on experience, the process of technology transfer and technological adaptation becomes impossibly difficult. The principle that hands-on experience is the best, and perhaps the only, way to develop expertise at the technologies of the industrial revolution, and indeed to develop the technologies themselves, is not limited to technologies narrowly embodied in machines. It applies to the “technologies” of modern business organization as well, to the Ford Motor Company’s attempt to transplant mass production to Great Britain in the period during and after World War I as well as to the attempts of Japanese producers to transplant what is called “lean production” back to the United States in the 1980’s.

It is worth noting that mass production had similar difficulties diffusing throughout the United States in the beginning. Only one firm—General Motors—could even come close to matching Ford’s productivity levels in the 1920s and the 1930s, and General Motors found its transition to mass production eased by its ability to hire the production management team that had invented mass production at Highland Park as its individual members, one after the other, fell out of favor with Henry Ford.

C. Stabilizing the global economy

1. The key role of the United States
But successful maintenance of macroeconomic stability under the Bretton Woods system required that the United States be stable. It was the key country of the system. The dollar was the key currency.
If the United States turned deflationary, then the fixed-parity rules of the Bretton Woods system would oblige other countries to turn deflationary as well. If the United States turned inflationary, then the fixed-parity rules of the Bretton Woods system would oblige other countries to turn inflationary as well. The fact that other countries pegged their currencies in terms of the dollar meant that there was no substitute for stability at the core.

2. Post-WWII American economic policy
For the first post-World War II generation—up until 1970, say—American economic policy produced a reasonably stable economy. With the exception of the shock of the Korean War, inflation was low. Fluctuations in unemployment were kept within moderate bounds.
To some degee this improvement in economic performance reflected an increase in economic knowledge and in the structural resilience of the economy. A high share of government spending in GDP meant that in any recession government spending, continuing more-or-less unchanged, acted as an enormous sea-anchor for the economy, moderating shifts in aggregate demand. Thus the structural resilience of the economy was higher. Improvements in economic knowledge prevented presidents from proposing and congresses from passing laws that raised taxes and cut spending in the middle of a recession. All political parties became good at discussing how a “cyclical” deficit in a recession was good, and should not be confused with a bad “structural” deficit that reduced long-run capital formation and growth. (Of course, some politicians—most of them members of the Republican Party—then became very bad at identifying a “structural” deficit when it did occur.)
J. Bradford De Long and Lawrence Summers (1986) argued that increases in wage and price rigidity had played a role in eliminating the possibility of a chain of debt, deflation, bankruptcy, high real interest rates, more debt, and deflation that had turned the recession of 1929-1931 into the Great Depression. The point is theoretically sound, but differences in how economic policy was made and in expectations of economic policy made it extremely unlikely that any Great Depression-like situation would be allowed to emerge.5
Was the relative stability of the American economy up until 1970 more than simply a matter of good luck? The only answer I can give is a firm “maybe.” Christina Romer has constructed a consistent chronology of business cycles for the past century in the United States. According to her chronology, recessions have become rarer (although not shorter). Certainly compared to the 1916-45 (“interwar”) period, and probably compared to the 1886-1915 (“prewar”) period, there has been a reduction in the share of the time that the economy has spent in recession.

Statistics on American Recessions: Duration and Frequency


Fraction of Time in Recession

Average Duration of Recessions

Number of Recessions per Thirty Years


















Average Level and Variability of American Unemployment


Average Unemployment

Standard Deviation of Unemployment
















But the major improvement in performance stems from the fact that the post-World War II era has seen no repetition of the Great Depression. If the Depression is put to one side, then there are some weak signs that the variability of unemployment is lower and the sizes of recessions smaller since World War II than before. But these extra improvements relative to the pre-Great Depression era—if they are true improvements in economic performance, and not just figments of the data—are relatively small, and not much to boast about.

For whatever reasons, the political and economic environment within the industrial nations was extraordinarily favorable in the years immediately after World War II. All parties and economists were terrified lest the Great Depression return. To fight off this possibility, politicians and economists paid very close attention to the lessons of the Great Depression and of the New Deal, which were seen as roughly three:

  • unemployment is the disease

  • high demand is the medicine

  • the federal government—though loose monetary policy and deficit spending—is the doctor.

Confidence in the mixed economy commitment to maintain spending, demand, and production-helped, perhaps more than the commitment itself, to keep the post-WWII era free of Great Depressions. Instead, the mixed economies risked an acceleration in inflation, rather than even a small chance of a severe Depression. Over time, this pro-inflation bias intensified, became anticipated, and so lost some of its efficacy at preventing unemployment. And over time this pro-inflation bias laid the foundations for other, new forms of macroeconomic distress.

When these new forms of macroeconomic distress emerged, the Bretton Woods system—the whole post-World War II macroeconomic order—the economic miracle of the Great Keynesian Boom—broke down. It broke down remarkably quickly. It took less than five years to go from confidence that the economy could be successfully managed to the time of macreoconomic troubles from which the world economy has not fully emerged even today.

1 Very good skiing, however. And in the summer the climb of Mount Washington is beautiful.

2 See Barry Eichengreen (1997), Globalizing Capital ().

3 See Richard Gardner (1969), Sterling-Dollar Diplomacy (New York: McGraw Hill).

4 Barry Eichengreen (1997), Globalizing Capital (), argues that this was to some extent a misreading of the pre-World War I and interwar experience. A stable system in which international investors and currency speculators have confidence benefits from capital mobility: it is only an unstable system in which governments are trying to commit themselves to and to follow incredible policies that needs capital controls.

5 DeLong and Summers (1986, 1988); Fisher (1933); Bernanke (198?). As a counter to the unlikelihood of a Great Depression coming again, consider Japan.

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