We often hear that big cuts in government spending over a short time are a bad idea. The case against big cuts, typically made by Keynesian economists, is twofold. First, large cuts in government spending, with no offsetting tax cuts, would lead to a large drop in aggregate demand for goods and services, thus causing a recession or even a depression. Second, with a major shift in demand (fewer government goods and services and more private ones), the economy will experience a wrenching readjustment, during which people will be unemployed and the economy will slow.
Yet, this scenario has already occurred in the United States, and the result was an astonishing boom. In the four years from peak World War II spending in 1944 to 1948, the U.S. government cut spending by $72 billion—a 75-percent reduction. It brought federal spending down from a peak of 44 percent of gross national product (GNP) in 1944 to only 8.9 percent in 1948, a drop of over 35 percentage points of GNP.
While government spending fell like a stone, federal tax revenues fell only a little, from a peak of $44.4 billion in 1945 to $39.7 billion in 1947 and $41.4 billion in 1948. In other words, from peak to trough, tax revenues fell by only $4.7 billion, or 10.6 percent. Yet, the economy boomed. The unemployment rate, which was artificially low at the end of the war because many millions of workers had been drafted into the U.S. armed services, did increase. But during the years from 1945 to 1948, it reached its peak at only 3.9 percent in 1946, and, for the months from September 1945 to December 1948, the average unemployment rate was only 3.5 percent.
Ask people who lived through that period as young adults what economic conditions were like, and you will inevitably get the answer that they experienced an economic boom. The U.S. economy during the post-World War II years is exhibit A against the Keynesian view that economies will necessarily suffer high unemployment and slow growth when governments make big cuts in government spending. Why did the U.S. economy do so well in the years following World War II given how badly it had done in the years preceding America’s entry into the war? The answer, in a nutshell, is that dramatically reducing government spending and deregulating an economy can take that economy from sickness to health. In short, one of the main things a government can do to help a weak economy recover is to step aside.