Two Theories of How America Beat the Great Depression

By John Banks

For more than 80 million Americans, a replay of the 1930s is not a hypothetical possibility. It is already starting to happen.

According to a May poll from the Kaiser Family Foundation (KFF), 26% of Americans — more than one in four — have experienced food insecurity in the past few months. That means skipping meals, reducing meal size due to a lack of money for food, or visiting a food bank or charity in order to eat.

Also, according to KFF poll results, 48% of Americans said they or someone in their household have skipped or deferred medical care in the past few months, while 31% have fallen behind in paying bills or covering basic household expenses.

Then, too, this level of distress is hitting while topped-up unemployment benefits and rent forbearance periods are still in effect. Without new legislation, both of those could end within eight weeks.

Meanwhile, even high-profile public corporations, like Starbucks, are reportedly unable to pay some of their property bills due to a severe cash crunch.

“Nearly half of commercial rents were not paid in May,” the Washington Post reports. “The problem for the U.S. economy is that when businesses like Ross Stores and T.J. Maxx stop paying rent, it sets off an alarming chain reaction. Landlords are now at risk of bankruptcy, too. Commercial real estate prices are falling. Jobs at property management companies and landscapers face cuts. Banks and private investors are unwilling to lend to most commercial real estate projects anymore, and cash-strapped city and local governments are realizing the property taxes they usually rely on from business properties are unlikely to be paid this summer and fall.”

We could hardly have said it better.

That series of cascading chain reactions, in which bankruptcies beget losses beget layoffs, which then beget further bankruptcies, is the deflationary downward spiral in microcosm.

This leads to an important question: When it comes to the pain of the 1930s, how did we end it the first time? How did America beat the Great Depression?

There are two competing theories for how America beat the Great Depression — we’ll call them the Keynesian theory and the Austrian theory — and they both involve World War II.

The Keynesian theory says the United States beat the Great Depression via huge government deficits, incurred in the name of fighting a war.

In order to pursue World War II, and help liberate Europe, the United States had to engage in massive deficit spending. In the 1940s, as a result of World War II, the United States debt-to-GDP ratio rose to its highest level ever at almost 119%. (We are on track to exceed that in the next few years.)

The Keynesian theory was later proven wrong, though, in one very important respect.

When the United States cut back on deficit spending after the war’s needs were met, John Maynard Keynes himself warned that the U.S. economy was at risk of collapsing again, as a result of taking away the deficit spending punchbowl.

But Keynes was wrong — the U.S. economy did not collapse when the deficit spending was withdrawn, and it went on to enjoy a long stretch of booming prosperity. 

The Austrian theory, which stands in contrast to the Keynesian view, did not see deficit spending as the key to America’s Great Depression rebound at all.

From the Austrian point of view, it was all about the accumulation of productive savings. World War II played a role here, too, but in a very different way.

As a result of World War II, a great many Americans had jobs — with soldiers deployed overseas and women in the factories — and yet there wasn’t a whole lot to spend money on, because the “war economy” meant consumer goods were rationed or otherwise in short supply.

The World War II economy thus put money in the pockets of households, via war-related jobs, but also encouraged them to save, because a majority of domestic production was tilted toward the war effort.

As a result of this, when World War II ended, American households had a significant amount of savings to deploy, unencumbered by debt. As American households deployed those savings, to both invest and consume in the aftermath of the war, the U.S. economy enjoyed a boom.

In both cases, World War II was a pivotal event.

But Keynesians would say (and still say) deficit spending drove the recovery, whereas Austrians would say no, it’s not about that at all — it was the large amount of savings accumulated by American households during the war years.

A large study of debt and deleveraging situations, conducted by the McKinsey Global Institute across 45 separate instances since 1930, supports the Austrian theory.

What the McKinsey study more or less found, across multiple countries and time periods, was that, when a large amount of debt has piled up, the only true way out is to counter the debt with a period of saving and belt-tightening.

That is exactly what American households did in World War II: They saved a pile of wages while cutting back their consumption habits. And that basic pattern of increased saving, coupled with reduced spending, was the one consistent path McKinsey found to getting out of a debt jam.

We can further note that, in the early 1980s, a long and prosperous boom kicked off from a starting point of low leverage and debt levels.

In his effort to “break the back of inflation,” Federal Reserve Chairman Paul Volcker inflicted a punishing recession on the U.S. economy in 1981-82, raising interest rates into the teens at one point.

The Volcker recession was painful, but it was also cleansing, as overleveraged and poorly run businesses were shut down, savings were newly accumulated, and the U.S. economy laid a foundation for rebuilding. It was from that springboard of increased saving and reduced spending that a multi-decade period of falling interest rates and rising prosperity levels began. 

Unfortunately, this is not exactly good news as related to our present situation. The playbook for ending the Great Depression is not available to us now.

A new world war is not advisable; even if we had one, it is doubtful households would hunker down and save across the board as a result; and debt and leverage levels are currently so high, there is no way we as Americans could collectively “belt-tighten” sufficiently without risking a collapse.

What, then, is the alternative for moving forward? How do we beat a second Great Depression, if that is what we’re getting?

There is only one option, it seems: Keep going in the same direction and hope a miracle comes along. That is to say, choose the Keynesian route by default, let debts pile further to the sky, and pray.

When it comes to piling on more debt — to help pay off existing debt obligations and to keep the system from imploding on itself — the idea is to keep everything afloat until some radical new technology, or some huge new productivity boom or beneficial outside event, produces an unanticipated burst of wealth creation that helps us “catch up” in terms of using the windfall to absorb prior debts and bring down leverage ratios.

This has happened before — the California gold rush bailed the U.S. out of serious doldrums, for example, with huge amounts of new economic activity and vigor created out of the blue in the West — but the problem with such events is that they are “black swans” in reverse: You can’t predict their occurrence or guarantee them in advance.

And so, if hoping for a miracle doesn’t work — if no techno-productivity deus ex machina comes along in time — and if America has lost the capacity to hunker down, save, and belt-tighten — then we likely keep on leveraging the system (or rather, the Federal Reserve and federal government do) in increasingly aggressive and creative ways, until finally the system has melted down, the economy has been distorted and manipulated into a state of non-functional paralysis, or the currency has been destroyed.