Thursday, October 18, 2007

Schumpeter, War, and the Woeful Deficiency of Economic Theory

Was Schumpeter correct when he wrote: "Economics is a very unsatisfactory science. But it would have to be much more unsatisfactory than it is if such an event as a war, however extensive and destructive, sufficed to upset its teaching."

Was Schumpeter correct when he wrote: "Economics is a very unsatisfactory science. But it would have to be much more unsatisfactory than it is if such an event as a war, however extensive and destructive, sufficed to upset its teaching."

Schumpeter, Joseph A. 1954. History of Economic Analysis (NY: Oxford University Press): p. 1146

During all-out wars when a country's very existence is at stake, only the most foolish leader would rely on markets to run the economy. Also, during wartime, many people (excluding corporate executives?) respond to nonmarket incentives, allowing the economy to produce much more than conventional economic theory would predict.

Here is a short section from my book, Transcending the Economy:

Earlier, we discussed how economies cast aside the market when society mobilizes for war. People too behave differently during wars. Rather than performing work in a perfunctory manner, many people redouble their efforts on the job in order to contribute to the mobilization.

I do not deny that many people are unmoved by patriotic fervor. Nor would I suggest that wartime profiteering is unknown. The point is that such individualistic motives recede during times of war, while more socially-oriented behavior becomes more common.

People even leave traces of this changed motivation in the statistical residue of the times. For example, Robert Lucas, a conservative economist who won the Nobel Prize in Economics for his work in developing techniques that cast doubt on the effectiveness of government policy, estimated the average level of economic efficiency for the United States economy by calculating the trend of the ratio of output per unit of capital between 1890 and 1954. He found that, at times, for instance during depressions, the actual output per unit of capital fell below his trend line. At other times, the actual output per unit of capital exceeded the trend line.

Lucas discovered that during the war years, 1944 through 1946, the output per unit of capital surpassed the trend line by more than 20 percent. At no time, before or after, did the United States economy match this remarkable performance (Lucas 1970, p. 154).

This achievement is extraordinary because during this period, many of the most qualified workers were in the military rather than on the shop floor. The workers who replaced them had considerably less work experience. Because of decades of discrimination, the black workers who came from the South to work in Northern factories had far less education than the workers that they replaced. Similarly, many women without much experience in working for wages effectively "manned" the assembly lines.

Conventional economic theory suggests that industrial efficiency should have suffered dire consequences from this reliance on a supposedly less qualified labor force, yet Lucas shows that nothing of the sort happened. Instead, productivity soared.

Of course, we are accustomed to expecting productivity to increase during war time. War stimulates demand, which makes the economy work more efficiently. In addition, Lucas himself attributes some of the marvelous performance of the wartime economy to the use of overtime in industry.

While increased demand and overtime may have been a factor in stimulating the economy, emotional forces were also at work. War can make people pull together. War can create a sense of urgency. At times, powerful ideals can motivate working during times of war.

In the United States, World War II called forth just such a sense of idealism. People who labored in the factories in the United States during the war often did their best in order to contribute to the struggle against fascism. Such ideals were more compelling than greed for most workers.

Casey B. Mulligan, a colleague of Lucas's at the University of Chicago, found further statistical evidence suggesting the influence of ideals (Mulligan 1998). According to economic theory, only changes in monetary incentives can change behavior. When wages fall, work effort should shrink accordingly.

He found that roughly ten million more civilians were employed during the war than if employment had followed its prewar trend (Mulligan 1998, p. 1040), even though "after-tax real wages of manufacturing production workers were lower in absolute terms (and even lower relative to trend) during the war years 1942-1945 than in the few years immediately preceding and following the war" (p. 1044). Mulligan reported on his efforts to attempt to develop alternative explanations within the confines of standard economic theory to interpret this bulge in employment even though real after-tax wages were falling. In every case he failed, suggesting that patriotic idealism lay behind the rise in labor force participation. In other words, more people were working than would be expected based merely on the desire to earn more wages. Instead, people were coming into the labor force to contribute to the war effort.

Eventually, the patriotic consensus frayed around the edges. Workers became frustrated seeing their sacrifices unmatched by their employers who were enjoying unparalleled profits. As a result, toward the end of the war, strike activity began to pick up. Still, the spirit of community was sufficiently strong to produce the high levels of productivity that caught the attention of Robert Lucas.

Similarly, Israel mobilized 15 percent of its labor force for the Yom Kippur War, but the Gross National Product declined only 5 percent (Maital 1982, p. 114). The decline in production might not seem to be as impressive as the experience of the United States, but remember the United States had time to adjust to the wartime demands, while the Yom Kippur War was a brief affair.

The wartime experiences of Japan and Germany offer even more powerful illustrations of the ability of people to overcome adversity. Jack Hirshleifer, an economist from the University of California at Los Angeles, reported that ten days of bombing raids during July and August 1943 destroyed half the buildings in Hamburg. Yet, within five months the city had regained up to 80 percent of its productive capacity (Hirshleifer 1987, pp. 32-33). The United States government was interested to find out what determined the effectiveness of the Allied bombing attacks. John Kenneth Galbraith, the famous Harvard University economist, assembled a team that included some of the most prominent economists in the world. These researchers found that bombing only made the Germans more resolute. According to the findings of the survey, "the air raids of 1943-4 ... may have kept up the tension of national danger, and created the requisite atmosphere for sacrifice" (cited in Galbraith 1994, p. 131; see also Galbraith 1981, p. 205; and Scitovsky 1991, p. 258).

On August 6, 1945, the United States Air Force dropped an atomic bomb on Hiroshima. The next day, electric power service was restored to surviving areas. One week later, telephone service restarted (Hirshleifer 1987, p. 34).

No doubt the Germans and the Japanese, like their counterparts in the United States, worked overtime to rebuild their economic capacity, but even trebling the average work day would not have sufficed to accomplish what they did. Their success in reconstructing their economy required enormous creativity and ingenuity.

We also see a more intensive development of new technologies during periods of crisis. Ordinarily, the typical large corporation is timid about exploring new ideas, yet the same people, who typically display little creativity within the confines of the large corporations, are more inclined to promote great scientific breakthroughs under the urgency of war.

Based on his reading of Japanese history, Shigeto Tsuru, an important Japanese economist, proposed the concept of creative defeat, meaning that a horrendous defeat can unleash a torrent of energy and ingenuity. The end result can be an even greater level of economic development than would have occurred in the absence of the setback. In his words: "Japan is an example of a fantastically creative response to defeat. One recalls that Schumpeter used to puzzle the students of his 'Business Cycle' course ascribing the Japanese boom of 1924-1925 to the Great Kanto Earthquake of 1923. The defeat in the last war brought about, of course, a far greater scale of devastation in the economy of Japan, necessitating a fresh renovating start in almost every aspect" (Tsuru 1993, p. 67).


Shag from Brookline said...

So let's apply this reading to the goal of rebuilding Iraq and the US's responsibility as invader and occupier. Where is the "fresh renovating start in almost every aspect"? If Iraq were left to the Iraqis, might Iraq's recovery have been speeded up? said...

Obviously this has much to do with how much support for the war there is in the first place. When one's own country is under attack, clearly there is much more support.
Bush, of course, tried to invoke 9/11 for our war in Iraq, but large numbers of people never bought into that, even if many did. And even the latter realized that the connection was at best vague and distant, that the war in Iraq was a war of choice on the other side of the globe, opposed by most of the world.

Of course, Schumpeter was also noting that command methods tend to get used in wars. Reportedly, Lenin was motivated to go to command by observing its use by the Germans in WW I. The effectiveness of it in wartime may explain why many command economies attempted to maintain a wartime atmosphere at all times, but this cannot be done. The "violation of economic theory" does involve the extraordinary, which cannot be maintained all the time, despite efforts at Stakhanovite "moral incentives" and all that.

Shag from Brookline said...

"I do not deny that many people are unmoved by patriotic fervor. Nor would I suggest that wartime profiteering is unknown. The point is that such individualistic motives recede during times of war, while more socially-oriented behavior becomes more common."

An excess profits tax was imposed for WW II. After the war, there were congressional investigations of war profiteering, etc. As a post-Korean, pre-Vietnam draftee, I was a part of a legal/accounting group of GIs examining Armed Services procurement contracts during WW II looking for fraud, overcharges, failure to comply with specs, etc. This was before Ike's farewell speech warning of the Military Industrial complex. Today the complex is even greater. Perhaps this complex "improves" the economy. Is the War on Terror the equivalent of attempts "to maintain a wartime atmosphere at all times ...."? Is what is going on today a "violation of economic theory ...."? Do we have faith based "moral incentives" at work that "involve the extraordinary"? Is "more socially-oriented behavior becom[ing] more common"? In addition to "guns and butter" we got tax cuts!

Michael Perelman said...

Barkley is correct to note that when people identify with their government in times of need some combination of Stakhanovite "moral incentives" and command can generate impressive results. An Iraqi environment, lacking cohesiveness except about the desire to rid the country of invaders, is unlikely to accomplish much. I suspect that in many ways it would replicate the unhealthy conditions of the United States economy today, riddled with crony capitalism of the worst kind as well is an excessive emphasis on financial manipulation rather than building anything real.

Anonymous said...

No doubt patriotism played a part but from what I can tell, both nominal and real wages rose quite substantially as govt financed industrial expansion, 'conversion', took-off and as millions of working age men volunteered and were conscripted, something on the order of 15-16 million over course of the war. As well, the creation of still greater regional economic uneveness driving internal migration.

Placed against the Depression years with a marginal recovery tipping over in 1937-38, I'm not sure that 1940-45 isn't easily understandable...but then that the cynical me.

The other me would prefer otherwise.

Anonymous said...

Sheesh - 'volunteered or were conscripted'

NBER Macro History, ch 8.
Rockoff, H.

Michael Perelman said...

But something like 40% of the GDP was siphoned off into the military. The Lucas study that I mentioned indicates that given the available resources that the economic performance was quite good.

Anonymous said...

I wasn't questioning the reality of what was an improved economy but instead that this might not be so easily seperable from depression time devalorization, the overall conversion effort and war economy.

Michael Perelman said...

Juan, I agree with you. I have written in several places, including The Confiscation of American Prosperity, about the combination of the Depression and the war working together.

Peter Dorman said...

I have tried to make the same point, Michael, about the anarchist achievements in Spain during the revolution of the 1930s. The history is interesting, but it can't be generalized to normal (non-cataclysmic) times.

Anonymous said...

Yes. My non-cynical side says that the social psychology of grand projects should not depend on crises but history says otherwise.