Post-WWII Western European Exceptionalism: The Economic Dimension
J. Bradford DeLong
University of California at Berkeley, and National Bureau of Economic Research
September 1997; revised December 1997
this document: http://www.j-bradford-delong.net/Econ_Articles/ucla/ucla_marshall2.html
I would like to thank Richard Freeman, Robert Waldmann, and especially Barry Eichengreen for helpful discussions. This essay draws heavily upon the ideas of, conversations with, and joint work conducted with Barry Eichengreen. I would also like to thank the National Science Foundation, the Alfred P. Sloan Foundation, and the University of California at Berkeley's Institute for Business and Economic Research for financial support.
After World War II in western Europe the "mixed economy"--that social-democratic halfway house scorned from the left (as failing to solve the structural contradictions of capitalism) and from the right (as opening the door to left-wing totalitarianism)--worked amazingly, remarkably, unbelievably well. It delivered economic growth at a pace that the world had never before seen. It produced an after-tax and -transfer distribution of income that was remarkably egalitarian. It allowed western Europe to pass remarkably smoothly through the final stages of its structural transformation to an industrial economy and society.
So what went right? Where did western European exceptionalism come from? What lessons were learned from the Great Depression and from World War II, and why did these lessons prove so appropriate for managing western European economies in the first post-WWII generation?
And what went wrong thereafter? The post-WWII European miracle lasted for only a single generation, until 1973. Why was western European exceptionalism so temporary? And why did the economic policy lessons learned from the Great Depression, World War II, and the first post-WWII generation turn out to be inappropriate for the post-1973 period?
The short answer is that post-WWII western European economic policy was so successful because it tapped into a virtuous circle. Trade expansion drove growth, growth drove expanded social insurance programs and real wage levels; expanded social insurance states and real wage levels social peace, social peace allowed inflation to stay low even as output expanded rapidly, rapidly expanding output led to high investment, which further increased growth and created the preconditions for further expansions of international trade.
Add all these factors up, and find an extra 1.5 to 2.0 percent per year of productivity growth--the approximate magnitude of the unexpectedly-rapid growth of the post-WWII western European miracle--coming from nothing but the fact that things had started off on the right foot.
Why, then, did the period of western European exceptionalism end?
I believe that western European exceptionalism ended because it was assassinated. It was assassinated by an odd combination of oil barons, union leaders, and monetarists. Without the tripling of world oil prices in 1973 and again in 1979, the pressure to do something to reduce inflation would have been much weaker. It was strong pressure to do something to reduce inflation that broke down the alliance between social democratic welfare-state politicians and union leaders. The first pressured the second to sacrifice the real wages of union members in support of the fight against inflation. The second refused. The consequence was, first, higher inflation and, second, a shift in political power to the right and the turnover of power to make monetary policy to central banks interested in halting inflation no matter what the cost.
Once it was plain that the old consensus politicians could not fight inflation through corporatist dialogue, the new non-consensus politicians won votes by promising that they would fight inflation through monetary restraint--and their monetarist economic advisors assured them that any excess unemployment created by fighting inflation would be transitory and temporary. In the U.S. the monetarists turned out to be right. In Europe the monetarists turned out to be wrong, leaving Europe with its current problems of structural unemployment.
II. The Post-WWII Western European Miracle
A. The Magnitude of the Miracle
Nobody disputes that post-World War II western European economic growth was miraculous. The magnitude of the miracle is clear in the graphs of the broadest of macroeconomic aggregates. In West Germany, France, Italy, and even in Great Britain the level of economic product--GDP--per capita exceeded the best performance of the interwar period by the early 1950s. By 1960 all countries' economic product was higher than not just the best interwar performance, but was well above levels that would have been predicted by extrapolating pre-1939 or pre-1914 trends into the indefinite future.
In West Germany just after reunification, for example, GDP per capita (measured in 1990 dollars) from the late 1970s through the early 1990s was and remained some 40 percent higher than even pre-1914 trends would have predicted, and some seventy percent higher than would have been predicted from the interwar growth trend. In France GDP per capita settled into a new trend some 70 percent higher than the pre-1914 trend--and fully 100 percent higher than the interwar trend.
Italy was even more extreme, with GDP per capita levels settling into a new trend at double what would have been predicted from simple extrapolation from before 1914 or from the relatively stagnant interwar period. Even Britain--Britain which experienced the smallest relative acceleration in growth after World War II of the four--has today a GDP per capita level some 20 to 30 percent above the pre-1914 trend, and some 30 to 40 percent above the interwar trend.
The net result has been to give the average Italian in the early 1990s a measured material standard of living of some $16,500 dollars of 1990 purchasing power: more than five times the measured material standard of living on the eve of the Great Depression. For (West) Germany the coefficient of multiplication is 4.5; for France it is 3.5; and for Britain the coefficient of multiplication is roughly 3.
National statistical agencies, however, are far from perfect. They have a hard time capturing the impact on the material standard of living of the invention of new goods and new types of goods. Walk around Westwood, and see the people wearing polarized sunglasses, listening through earphones to portable CD players, wearing shoes with well-cushioned yet lightweight soles, and drinking the products of espresso machines. Ask yourself the question: when did the increment to material welfare from the ability to make shoes with better soles, polarized sunglasses, or espresso machines enter into national income accountants' calculations of aggregate economic activity? The odds are that each of these improvements never made it into national income accountants' estimates of long-run growth. National income accountants have limited budgets, and very difficult tasks.
Boskin et al. (1996) believe that unmeasured improvements in productivity stemming from new goods and new types of goods average perhaps one percent per year today. It seems reasonable to extrapolate their estimate to cover all of this century, and to hypothesize that unmeasured improvements contributed perhaps half as much in the second half of the nineteenth century, back when technological progress was slower. Before 1850 the issues raised by Boskin et al. are much less important, for most of pre-1850 waves of innovation were in the making of producer, not consumer, goods.
If correct, then the coefficient of multiplication since 1930 in Italy is not a factor of 5 but a factor of 10; in (West) Germany not a factor of 4.5 but a factor of 9; in France not a factor of 3.5 but a factor of 7; for Britain not a factor of 3 but a factor of 6. That is, I think, the proper measure of the post-World War II western European miracle.
Does this seem too large a coefficient of multiplication? It probably is if you are one of relatively poor, for whom the inventions of the past sixty years are a smaller part of your consumption bundle. It probably is too large if you are one of the very rich for whom the principal benefit of wealth is, as Paul Krugman (1997) says, ordering people around: "seeing 'em jump." It probably is too large if you follow Richard Easterlin (1997), believe that increased material wealth does not increase human happiness, and that our restless dissatisfaction and non-satiation today tells us that the twentieth century "triumph of economic growth is not a triumph of humanity over material wants; rather, it is the triumph of material wants over humanity".
But for those from the lower middle class on up to the merely rich, it is hard to imagine anyone who does not view their material welfare as vastly, vastly greater than that of their counterparts of sixty years ago. Consider modern audiovisual and recording technologies, antibiotics, information processing, telecommunications, and transportation. It is hard to escape the conclusion that more than half the differences between 1300 and today in how western Europeans live their material lives have come since the start of the Great Depression.
B. Was the Miracle Inevitable?
From today's perspective it is easy to ignore claims that the western European growth miracle is something in need of special explanation. Is not the "convergence" of western European economies to the approximate level of national product per capita and the approximate long-run growth path of the United States a "natural" process? Was not it bound to happen as technology diffused across national boundaries, as universal secondary education made its presence felt, and as governments allowed market forces to direct investment and to weed out uncompetitive firms (see Mankiw, Romer, and Weil, 1992; Barro and Sala-i-Martin, 1995)?
But there is nothing "natural" about such "convergence" to North American norms. To put it another way, if "convergence" is "natural" to economists it is "unnatural" to political economists. There are many forces and factors that could have blocked the western European growth miracle--and that did block its analogue in many times and places.
There are only only two other places and times that this "natural" process has been operating with strength similar to that of western Europe in the first post-WWII generation. One is North America during its 1860-1950 century of industrialization. A second is East Asia in the past two generations. But in the world as a whole since 1870, and in the world since 1945, the dominant trend has been toward divergence, not convergence (see DeLong, 1988; Pritchett, 1997). Those that are behind in GDP per capita have tended to fall further behind.
Let me expand on this point by sketching out three alternative futures for western Europe as of 1945--alternatives that might have been the future, or that informed observers in 1945 thought might well become the future, but that were vastly different than western Europe's actual experience of relatively stable democracy, growing welfare states with diminishing income inequality, and rapid economic growth.
1. Stalin's Dream
The first we might as well call Stalin's dream: the future that Josef Stalin expected to see in western Europe in the generation after the end of World War II. Or, more accurately, a future that we might speculate Stalin expected, for trying to read the mind of Josef Stalin is an extremely hazardous occupation. For Stalin and his acolytes, all the experience of the interwar period reinforced the interpretation that Lenin (1916), drawing from Hobson (1913), had arrived at in trying to understand the failure of Marx's (1848) predictions of increasing immizeration to come true in the pre-World War I period. The pre-World War I economies had managed to avoid the problems of overproduction, insufficient consumption, and consequent financial crises, deep depressions, and worker immiserization through imperialism: maintaining employment at home by force-flooding the rest of the world with exports. But by 1910 there were no new markets to conquer: imperialist expansion had reached its limits.
Hence, Stalin and his acolytes believed, World War I: the imperialist capitalist powers resort to armed force so that the victors, at least, can restore the conditions for imperial expansion and further prosperity. But because the spoils of empire from defeated Germany, Austria-Hungary, and Turkey were small, the post-World War I prosperity in the victors was short-lived and anemic. Moreover, the bourgeoisie in the losing nations became anxious for a rematch. Hence World War II. World War I had brought their brand of state socialism to Russia and its dependencies. World War II would bring their brand of state socialism to the Balkans and to the Elbe.
So to Stalin and his acolytes the obvious thing to do in the aftermath of 1945 was to cement state-socialist control where the Red Army had marched, to rebuild the economies of the socialist powers, and to wait for World War III (see Djilas, 195?). The centrally-planned direction of investment through the replacement of the anarchy of the market by the logic of socialist development would enable industry in eastern Europe to leap far ahead of western Europe (see Sweezy, 1942): Krushchev addressing the west during Eisenhower's presidency was confident that he and his would "be there at your funeral." Overproduction and underconsumption would push western Europe, Britain, and the United States into a new Great Depression. The U.S. would greedily eye the British and French empires as potential markets to ensure full employment across the Atlantic. Sooner or later World War III would break out with the U.S. on the one side and Britain and France on the other. And in the aftermath of capitalist imperialism's third suicide attempt, state socialism would advance to the Atlantic, or perhaps further.
It is worth pausing at this point to note that Josef Stalin and Paul Sweezy were not alone in expecting economic growth behind the Iron Curtain to leap ahead of growth in the capitalist powers. Governments behind the Iron Curtain were supposed to be able to cut the consumption of their disciplined, regimented, brainwashed, totalitarian citizenry to the bone, leaving more of total economic product for investment. Higher investment would mean faster growth. All knew that the Soviet Union--with one-third of its population under enemy occupation, with only one-quarter of Nazi's Germany's pre-war industrial capacity, facing an enemy with all of the resources of occupied Europe to draw on--had outproduced Nazi Germany in tanks and aircraft during World War II (see Overy, 1997).
A common view in the industrial west after World War II was that the Soviet economy and society was inferior at producing goods for consumers or making it possible to live a free and happy life, but was quite possibly superior at generating long-run growth--particularly long-run growth directed at supporting military power. Swift Soviet construction of nuclear and thermonuclear weapons in the decade after World War II and the extraordinarily successful Soviet space program of the late 1950s and early 1960s gave support to the vision of the Soviet economy as a powerful engine of heavy industrial growth and technological progress.
2. The Argentine Trajectory
A second live possibility--one feared greatly by staff economists like Charles Kindleberger (1987) in the U.S. Department of State--was that post-World War II western European governments would fail: they would either fail to maintain the high level of aggregate demand urged by Keynes (1936), or they would fail to allow the market system to do its job in its place.
Call the second of these possible failures the Argentine trajectory. Had post-World War II western European political economy taken a different turn, governments might have been slow to dismantle wartime allocation controls. The late 1940s and early 1950s might have seen the creation in western Europe of allocative bureaucracies to ration scarce foreign exchange, and the imposition of price controls on exportables in order to protect the living standards of urban working classes.
In response to the social and economic upheavals of the Depression, Argentina in fact adopted such policies: demand stimulation, large-scale income redistribution to politically powerful organized urban workers, and the use of tight controls to manage imports, exports, and the trade balance.
Carlos Díaz-Alejandro (1970) provides what has become the standard analysis of Argentina's post-World War II economic stagnation: At the end of World War II Juan Perón gained mass political support. Taxes were increased, agricultural marketing boards created, unions supported, urban real wages boosted, international trade regulated. Perón sought to generate rapid growth and to twist terms of trade against rural agriculture and redistribute wealth to urban workers who did not receive their fair share. The redistribution to urban workers and to firms that had to pay their newly increased wages required a redistribution away from exporters, agricultural oligarchs, foreigners, and entrepreneurs.
The Perónist program produced almost half a decade of very rapid growth. But then agricultural production fell because of the low prices offered by government marketing agencies to subsidize urban workers. The rural sector found itself short of fertilizer and tractors. Squeezed between declining production and rising domestic consumption, Argentinian exports fell. By the first half of the 1950s the real value of Argentine exports was only 60 percent of the depressed levels of the late 1930s, and only 40 percent of 1920's levels.
The consequent foreign exchange shortage presented Juan Perón with only unattractive options. First, he could attempt to balance foreign payments by devaluing to bring imports and exports back into balance in the long run and in the short run by borrowing from abroad. But effective devaluation entailed raising the real price of imported goods, and thus cutting the living standards of the urban workers who made up his political base.
Moreover, devaluation improves the trade balance only in the long run of two years or more. In the short run devaulation is effece only if it makes international speculators willing to bet their money and provide short-term cpaital inflows--and a resort to foreign funding wouldhave been treason. Second, he could contract the economy, raising unemployment and reducing consumption, and expand incentives to produce for export by decontrolling agricultural prices. Once again, however, this would have cut the living standards of his political base by creating mass unemployment.
The only live option was to control and ration imports. As Díaz-Alejandro writes:
First priority was given to raw materials and intermediate goods imports needed to maintain existing capacity in operation. Machinery and equipment for new capacity could neither be imported nor produced domestically. A sharp decrease in the rate of real capital formation in new machinery and equipment followed. Hostility toward foreign capital, which could have provided a way out of this difficulty, aggravated the crisis...
Subsequent governments did not reverse these policies: the political forces that Perón had mobilized had to be appeased, and the economic interests that lived off of the (few) import licenses or off of the exclusion of foreign competition grew large and active. Thus post-World War II Argentina saw a huge rise in the price of capital goods. Given low and fixed agriculture prices, hence low exports, it was very expensive to sacrifice materials imports needed to keep industry running in order to import capital goods. Unable to invest, the Argentine economy stagnated.
In 1929 Argentina was a developed country: its share of the labor force in industry is intermediate between Germany and Italy--about like France. Its level of national product per capita is sometimes above, sometimes below, but always in the same league as France and Germany (and far above Italy) until the 1950s. Yet since World War II Argentina has stagnated. Measured GDP per capita today is some 60 to 70 percent higher than in 1930 or in 1914 (and taking account of unmeasured improvements in productivity perhaps gives a coefficient of multiplication of 2.5): Argentinians today have access to enough modern consumption technology to give them significantly higher material standards of living than their counterparts of the Belle Epoque. But the gap between what Argentina's level of material productivity is and what it so clearly might have been is immense. And the consequences of slow growth for Argentinian politics have filled the country with sorrow.
Might Western Europe have followed a similar trajectory? Yes. In Díaz-Alejandro's estimation, four factors set the stage for Argentina's decline: a politically-active and militant urban industrial working class, economic nationalism, sharp divisions between traditional elites and poorer strata, and a government that viewed the price system as a tool for redistributing wealth rather than for determining the pattern of economic activity.
At the end of World War II western Europe was at least as vulnerable as Argentina to this populist overregulation trap. The war had given Europe more experience than Argentina with economic planning and rationing. Militant urban working classes calling for wealth redistribution voted in such numbers as to make Communists plausibly part of a permanent ruling political coalition in France and Italy. Economic nationalism had been nurtured by a decade and a half of Depression, autarky and war. European political parties had been divided substantially along economic class lines for a generation.
The constrast between western Europe's successful economic redevelopment after World War II and its unsuccessful redevelopment after World War I is remarkable (see Maier, 1987). And ex ante I at least cannot find strong structural factors that would ensure that western Europe's post-World War II economic trajectory would keep it in, and Argentina's carry it out, of the First World.
3. The Cross of Gold
The third alternative was the crucifixion of the post-World War II European economy upon what turn-of-the-century American presidential candidate William Jennings Bryan called the cross of gold: inappropriate reliance on the gold standard to manage domestic and international economies in an environment in which such reliance would generate cruel and painful deflation.
Such a scenario seems to me at least to be easy to imagine. It requires only (i) a much earlier end of American loans and grants to Europe, (ii) the failure of international capital flows from the United States to fill the gap, and (iii) the control over monetary and fiscal policies in western Europe then of people with the same views as those who control monetary and fiscal policies in western Europe now. Such governments respond to rising prices or to trade deficits by deflation. They respond to trade surpluses by accumulating gold reserves. The first priority is to maintain sound finance: a balanced government budget and a firm commitment not to reduce the gold value of the currency.
Suppose American aid to Europe had come to a sudden and firm end at the end of 1946. Suppose that private international capital flows had not started up to cover the gap between western European exports and imports--after all, American long-term investors in Europe after World War I had lost a fortune. Suppose that western European countries had applied policies--mixtures of devaluation and deflation--in order to avoid running out of foreign exchange reserves. What would have happened then?
Devaluations--no matter how large--would not have helped European countries balance their international accounts in the short run. Devaluation makes exports cheaper, but it also means that less foreign currency is earned for each commodity exported. In a long run of more than two years, devaluation swings the current account toward surplus and can bring imports down and into balance with exports. But in the short run it does not.
In the short run of less than two years, devaluation is more likely to increase than reduce a current account deficit. In the short run, deflation is the only way to close a gap between exports and imports: reduce demand for imports by reducing the incomes of those who buy imports, and the way to reduce the incomes of those who buy imports is to reduce national product and cause unemployment through high interest rates.
The average current-account deficit for the big three western European nations--Italy, Britain, and France--was 3.0 percent of national product. Since imports [M] are a function of the level of national product [Y]:
and since the current account balance, [NX], is equal to the difference between exports [X] and imports:
As long as exports are unchanged, the magnitude of the reduction in national product depends on the size of the increase in imports needed to bring the current account into balance, and on m', the marginal effect of a reduction in national product on imports:
Thus a back-of-the-envelope estimate of the reduction in national product necessary to close the gap between exports and imports of Italy, France, and Britain in 1948 would be roughly 9 percent if the marginal effect of a reduction in national product on imports were equal to one-third: a nine percent fall in total production relative to potential output, and in all probability a five percentage-point rise in unemployment. But this estimate holds only if exports were unaffected by the policies undertaken to bring trade into balance.
In fact things are worse, for exports are not unaffected by the policies undertaken. More than half of European countries' exports in the immediate aftermath of World War II were to other European countries. Were Italy to reduce its current account deficit by reducing imports, it would reduce imports from France--and so boosts France's current account deficit. European countries' attempts to reduce their trade defiicts reduce each other's export earnings as well.
Taking account of the size of intra-European trade and the fact that reductions in national product are an order of magnitude larger than the reductions in the trade deficit doubles the back-of-the-envelope estimate of the post-1947 recession required to balance western Europe's current account: requiring western Europe to balance its current account from 1947 on, using market forces, would have imposed a Great Depression-sized interruption on the course of western European recovery.
Thus I do not undertand eiher of Alan Milward's (1984) two arguments for the relative insignificance of the Marshall Plan. Milward (1984) claims that the Marshall Plan merely postponed a necessary adjustment to reality because it did not permanently solve the dollar gap. To me this seems to miss the point: expanding exports and other sources of financing to match imports was infinitely easier in the early 1950s as a gradual process in the context of the Korean War boom and the contribution of a U.S. army to western European defense than it would have been as a sudden shock in 1947.
Milward's (1984) claim that countries forced to restrict imports suddenly and substantially could still have financed imports of essential capital goods begs the question of how the reduction in other categories of imports was to be achieved. Was it through overall reductions in demand that would cause mass unemployment? Was it through the installation of an apparatus of controls and licenses that would soon have acquired a powerful native political constituency, and pushed western Europe onto the Argentine trajectory? Milward does not say. He simply does not analyze how international payments would have been balanced in the late 1940s in the absence of a Marshall Plan.
Whatever patterns of western European economics and politics would have emerged from such a Great Depression-sized interruption of post-World War II recovery, they would not have been the 1950s as they actually happened. The post-World War II political settlement might not have survived a post-WWII recession the size of the Great Depression: perhaps Stalin's dream would have come true on an accelerated timetable. Moves forward along the Argentine trajectory toward a bureaucracy that licenses every import have proven very hard to reverse, and have had devastating consequences for economic growth elsewhere in the world (see Jones, 199?; Bates, 19??; Diaz-Alejandro, 1970).
How realistic are these three alternative scenarios? The third is very realistic: ex ante there were good reasons to think that it might well happen. Post-World War II and pre-World War II history are littered with examples of countries that faced substantial current account financing difficulties, and found their economies in deep recession as a result. The second in fact happened--to Argentina. It could have happened elsewhere.
The first appears from our standpoint to be not so realistic. The world does not work as Lenin, or Hobson thought. Imperial markets were not essential to the manenance of First World prosperity. The U.S. on the one hand and Britain and France on the other did not come close to military blows over the future of empires, and over Third World markets. Nevertheless, history is full of contingencies. Neither World War I, World War II, nor the Great Depression makes any sense when analyzed as the equilibrium outcome of strategies followed by rational and well-informed governments and private economic agents. One or two major wars or economic disasters in the post-World War II period might well have brought us all appallingly close to 1984 by 1984 (Orwell, 1948).
The particular combination of institutions and policies appeared remarkably well tuned to produce rapid economic growth in the 1950s and 1960s. But things could very easily have been otherwise. They were otherwise in western Europe after World War I, in the southern cone of Latin America after World War II.
III. The Components of Western European Exceptionalism
So what were the components of the European miracle? What were the sources of such rapid post-World War II western European growth?
A. Expanding International Trade
A first and important cause of rapid post-World War II growth was expanded international trade.
Traditionally, western Europe had exported industrial goods to and imported agricultural goods from Eastern Europe, the Far East, and the Americas. After World War II there was little prospect of rapidly restoring this international division of labor. Imports of food and consumer goods for relief diverted hard currency from purchases of capital goods needed for long-term reconstruction. Changes in net overseas assets reduced annual earnings from abroad. The net effect of the inward shift in demand for exports and the collapse of the net investment position was to give Europe in 1947-8 only 40 percent of the capacity to import that it had possessed in 1938.
From this base, the successful export performance of western Europe after World War II is remarkable. By the end of the 1960s the "openness" of the main continental western European economies--the sum of their exports plus their imports, measured as a share of total national product--was easily twice that of the interwar average. World War II marked a watershed between an interwar period in which international trade was a relatively small and stable share of national product, and a period in which trade underwent a strong secular increase not only in its absolute volume, but relative to GDP.
What if this expansion of world trade had not taken place? What if exports and imports as shares of national product had remained at their (relatively low) levels of the interwar period?
The puzzle always facing economists trying to understand economic growth is whether trade causes faster growth or growth causes expanded trade. The most recent attempt to cut this Gordian knot was undertaken by Jeffrey Frankel and David Romer (1996). Their conclusion is that each dollar of expanded imports or exports expands total national product by some thirty-four cents: expanded exports allow an economy to shift labor into the export sectors where it is more productive, and to raise consumer welfare and producer productivity by giving them more power to purchase imports from low-price consumer and capital goods producers in other countries. Expanded trade puts more pressure on domestic monopolies to reduce their excess profits and to become more efficient. Expanded trade allows economies to more easily and productively soak up technological innovations made elsewhere in the world.
Frankel and Romer's estimates allow us to assess how much post-World War II western European growth was aided by the fact that a wide variety of pressures--from the U.S. government seeking faster European unity to French politicians eager to weld the German and French economies together so tightly that neither could ever afford to begin a war again--pushed western European economies into more open configurations with higher import and export shares of national product. A little bit less than half a percentage point per year in post-World War II pre-mid 1970s growth in national product in the major economies of western Europe can be attributed to increased openness.
B. Market-Conforming Government
Renewed growth required, in addition to financial stability and openness to trade, free play for market forces. On this issue the Marshall Plan--specifically, the conditions attached to U.S. aid--tried to constrain western Europeans' choices. Each recipient had to sign a bilateral pact with the United States. Countries had to agree to balance government budgets, restore internal financial stability, and stabilize exchange rates at realistic levels.
Europe was still committed to the mixed economy. But the U.S. insisted that market forces be represented liberally in the mix: this was the price that the U.S. charged for its aid. The demand that European governments trust the market came from the highest levels of the Marshall Plan administration. Dean Acheson (1960) describes the head administrator, Economic Cooperation Administration chief Paul Hoffman, as an "economic Savonarola." Acheson describes watching Hoffman "preach his doctrine of salvation by exports" to British Foreign Secretary Ernest Bevin. "I have heard it said," wrote Acheson, "that Paul Hoffman missed his calling: that he should have been an evangelist. Both parts of the statement miss the mark. He did not miss his calling, and he was and is an evangelist."
Now this point should not be overstated. The price charged for Marshall Plan aid was one that western Europeans might well have paid for its own sake in any event. Support for the market was widespread, although just how widespread was uncertain. At most U.S. and other pressures tipped the balance.
Moreover, post-World War II western Europe remained very, very far from laissez faire. Government ownership of utilities and heavy industry was substantial. Government redistributions of income were large. The magnitude of the "safety nets" and social insurance programs provided by the post-World War II welfare states were far beyond anything that had been thought possible before World War I.
Post-World War II western Europe was so far from laissez-faire that many (including Hayek, 194?) thought it was doomed: doomed to totalitarianism as mixed-economy governments used their economic powers to suppress dissent, and doomed to stagnation as creeping socialism paralyzed the economy.
But the large post-World War II social insurance states in the style of Beveridge (1942, 1944) were accompanied by financial stability, by substantial reliance on market processes for allocation and exchange, and by openness to world trade. The powerful mixed-economy governments took the separation of powers seriously: judges remained independent, pressure from government-owned enterprises to refrain from criticizing governmental policy remained light, and political competition remained free and open. Fears that the social insurance state would inevitably slide into totalitarianism proved as false as the fears that the social insurance state would cripple the market economy.
Thus western Europe's post-World War II bet on a market-heavy mixed economy turned out to be a good one, delivering a relatively egalitarian distribution of income, a high degree of social insurance, and rapid economic growth. It is difficult to figure out how much difference the market-heavy mixed economy made. How much would a marginal step away from market and toward centrally-planned allocations would have harmed post-World War II western European growth? No one knows. Certainly the degree of variation within western Europe, or between western Europe and the United States, was insufficient to generate visible differences in growth performance. Both Germany and Sweden did well. Both Francea nd Italy did well.
Perhaps it is simply best to say that this factor was tied up with all the others: without a market-heavy component of resource allocation under the mixed economy, it is hard to believe that either expanded trade or high investment would have been a significant aid to growth.
C. High Investment
Europe's rapid growth in the 1950s and 1960s 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. 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 year.
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. High investment was a consequence of successful Keynesian demand management.
Thus successful performance at managing the business cycle translated into success at maintaining long-run economic growth. How much success? It depends on how much you believe that high investment is an important source of rapid growth in the sophistication and productivity of technologies that an economy can successfully apply. I believe in the estimates found in DeLong and Summers (1991): they suggest that a five percentage point reduction in investment as a share of GDP--a reduction in the average share that might well have followed from a much more variable cyclical performance--would have produced an 0.8 percentage point per year in the rate of economic growth.
D. Keynesian Demand Management
The post-World War II era was the era of John Maynard Keynes. But what does that mean? It means that Keynes's name was a powerful one to conjure with, because anyone who rejected his intellectual legacy could be accused, convicted, and immediately hanged as a fool who wished to bring the Great Depression back.
But how much of a difference did Keynesian policies actually make? Let's take a look at Keynesian policies--both those adopted for Keynesian reasons, and those adopted for non-Keynesian reasons but that Keynes would nevertheless have applauded.
1. Supreme Allied Commander, Europe
As far as western Europe is concerned, the first "Keynesian" policy was the U.S. government's desire to spend a fortune--and to require that western European governments spend a fortune as well--on the military establishment of NATO. This piece of military Keynesianism was in large part a reaction to the policies of Josef Stalin and Kim Il Sung: the attack on South Korea was an essential step in shifting the American congress from a post-World War II demobilization mindset to a Cold War mobilization mindset. Without Stalin's letting Kim Il Sung off the leash and his attacking South Korea, there was no prospect that congress would have ever approved the blueprint for the Cold War military that Dean Acheson (1969) and company had drawn up in NSC-68, and no prospect that the NATO military establishment as we have known it for the past fifty years would have come into being.
By the mid 1950s, however NATO was in place, just waiting there in case Stalin's successors were to attempt in Germany what Stalin, Mao, and Kim Il Sung had attempted in South Korea: the reunification by force of a country that had been divided in the armistice that ended World War II.
In the mid-1950s Stalin's successors were largely unknown: we today know vastly more about them than anyone west of the iron curtain knew then. The only solid thing known about them then was that they had flourished under Stalin. And they had continued playing the games Stalin played by shooting one of their own number--Lavrenti Beria--in the power struggle that followed Stalin's death.
Stalin their master had exhibited a taste for snatching up territory when he thought it could be taken cheaply--starting with the suppression of the Mensheviks in Georgia, and including the attack on eastern Poland in the opening days of World War II, the annexation of Latvia, Lithuania, and Estonia as well as Moldova in advance of Hitler's attack on Russia.
Western Germany could probably not be snatched up cheaply by a Soviet coup de main. But the fact that occupying western Germany in 1955 would probably be very different from occupying Latvia in 1940 was not wholly reassuring. Stalin also at times exhibited a remarkable degree of bad judgment: allowing Kim Il Sung to launch the Korean War, the unsuccessful attack on Finland in 1939, his belief in the early 1930s that social democrats were the foe of the German Communist Party most worth fighting, and (the mother of all miscalculations) his decision in mid-1939 to become Hitler's ally, in the hope that Russia could then watch Nazi Germany and the western democracies exhaust themselves in trench warfare.
Perhaps Stalin's successors would exhibit a similar appetite for conquest on the cheap, and a similar weak grasp of geopolitical realities.
So by the mid-1950s a full U.S. army--corps, divisions, airwings, and an enormous logistical tail--was sitting in western Germany as a deterrent.The U.S. spent lavishly to project its Cold War military power. Net military transactions amounted to three-quarters of a percent of U.S. national product in the mid 1950s, and total unilateral transfers to Europe to 1 percent of America's national product: approximately 3 percent of western European GDP at that time.
2. Inflation and Economic Growth
Keynesian policies to stimulate demand, however, were 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.
Should things change--and should Keynesian policies be blamed for higher inflation rather than praised for maintaining high employment--then the policy consensus that supported western European exceptionalism might quickly unravel, and did quickly unravel in the 1970s.
Thus one key to Europe's rapid growth was 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 labor markets?
One explanation is that they were not really so accomodating as all that. Inflation in the first half of the 1950s in France, Italy, Britain, and West Germany averaged some 4.3% per year--higher than inflation is today in any of the four countries, and a level of inflation that would cause today's central banks to worry that policy was too loose, raise interest rates, and push unemployment back up.
Why didn't central banks in the 1950s worry about inflation that averaged nearly five percent? Perhaps the most important reason was that this rate of inflation did not (Britain aside) produce frequent balance-of-payments crises. As long as foreign exchange markets were not pressuring the central bank to devalue the currency, central banks were generally happy.
And the key reason that moderate domestic inflation in western Europe could be combined with no pressure on exchange rates was the so-called Balassa (197?) Effect: the fact that a rapidly-growing industrializing economy has a rapidly-rising equilibrium real exchange rate as well, because the process of industrialization is the process of becoming better at producing the industrial manufactures that make up the bulk of international trade.
Thus a fixed exchange rate in the 1950s was compatible with a relatively high inflation rate--an inflation rate several percent per year higher than the United States. As long as central banks focused not on internal balance but on maintaining a fixed exchange rate against the dollar, it did not strike them that the moderate inflation of the 1950s was anything to worry about.
Another conventional explanation of the coexistence of full employment with (relatively) low inflation in post-World War II Europe, 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. A problem with this argument is that the competition of underemployed Italians or Greeks or Eastern European refugees was hardly felt in the United Kingdom, yet labor market behavior was transformed in the U.K. as in other countries after World War II.
But their are other explanations.
Charles Maier's (1987) very convincing 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.
Certainly any comparison of the magnitude and duration of strikes between pre-Nazi and post-World War II Germany cannot help but leave the viewer convinced that industrial relations were completely and fundamentally different before and after.
One potential explanation of relative labor peace is that the Marshall Plan set the mold for post-World War II labor relations. Putting the point in this way serves to underscore that the Marshall Plan was but one of several factors contributing to observed outcomes. Marshall Planners sought a labor movement interested in raising productivity rather than in redistributing income from rich to poor (see Maier, 1987). With labor peace a potential precondition for substantial Marshall Plan aid, labor organizations agreed to push for productivity improvements first and defer redistributions to later. Moreover, money was channeled to non-Communist labor organizations. European labor movements split over the question of whether Marshall aid should be welcomed--which left the Communists on the wrong side, opposed to economic recovery.
Yet another element in the post-World War II supposed success of Keynesianism--policies to boost production and maintain full employment by managing aggregate demand--was the fact that Keynesian policies came as a surprise. It is very possible that the first generation of Keynesian policies were vastly more effective because they represented a change to which firms and workers had not yet adapted. Perhaps in subsequent generations they are likely to generate not faster growth and higher employment but stagflation--the combination of higher unemployment and higher inflation--as individuals and businesses learn to foil the effects of a government-induced boost to the economy by indexing their wages to inflation before the fact.
Here the Bretton Woods System--understood not in the sense of Milward (1984), but of Eichengreen (1997)--played a role.. 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 instead of higher output, higher employment, and greater macroeconomic stability.
Add up the flow of unilateral military transfers to support NATO, the automatic expenditures of the expanded western European welfare state, and the ability to run low interest rates and stimulate investment made possible by the Balassa effect, and it is easy to conclude that there simply was no room for anything like a Great Depression in post-World War II western Europe. The flow of social welfare spending, of American unilateral transfers, of European defense spending, and of investment were all amplified by the Keynesian multiplier to provide a strong base of aggregate demand already close to the ceiling of potential output.
Keeping aggregate demand strong meant that western European investment remained high as a share of national product. I believe in the estimates found in DeLong and Summers (1991): they suggest that a five percentage point reduction in investment as a share of GDP--a reduction in the average share that might well have followed from a much more variable cyclical performance--would have produced an 0.8 percentage point per year in the rate of economic growth: successful demand management not only kept production near potential and reduced the distributional misery of the business cycle, it also significantly accelerated European economic growth.
Yet perhaps the impact of Keynesian doctrines was felt more in what they prevented than in what they did. Had policies in the 1950s and 1960s been like policies in the 1930s, all expenditures would have been cut in an attempt to balance the budget whenever recession threatened. The intellectual dominance of Keynesian ideas prevented the balance-the-budget at all costs policies that had proved so harmful during the Great Depression (see Hall, 1989). And to prevent by ideological force alone even the possibility of something as destructive as Chancellor Bruening's resort to deflation in the early 1930s--that was an important achievement.
E. Virtuous Circles
All these explanations rely, at some level or other, on virtuous circles. One way to think about the post-World War II settlement, and the contrast with the interwar period, is as a coordination problem. Labor, management and government in Europe could, in effect, choose to try to maximize their current share of national income-as after World War I. Inflation, strikes, financial disarray, cyclical instability and productivity problems can all be seen as corollaries of this equilibrium.
Alternatively, the parties could trade current compensation for faster long-term growth and higher living standards, even in present-value terms. Workers would moderate their wage demands, management its demands for profits. Government agreed to use demand management to maintain employment in return for wage restraint on the part of unions. Higher investment and faster productivity growth could ensue, eventually rendering everyone better off.
Such a "social contract" is advantageous only if it is generally accepted. If workers continued to aggressively press for higher wages, management had little incentive to plow back profits in return for the promise of higher future profits. If management failed to plow back profits, workers had little incentive to moderate current wage demands in return for higher future productivity and compensation. If labor relations were conflictual rather than harmonious, productivity would be the casualty. Once western Europe had shifted onto this "social contract" equilibrium path--once workers and management began to behave in a mannger consistent with the superior equilibrium--they had no obvious reason to stop.
IV. The End of the Miracle
Everything went right in western Europe--growth, distribution, price stability, employment stability--up until 1973. Since then things have gone wrong. If western Europe is "exceptional" today, it is exceptional in its high and stubborn structural unemployment, and in the narrow vision of its central bankers.
A. False Monetarist Gods
In the late 1960s and early 1970s western European inflation creeped up from roughly three percent per year to roughly six percent per year, in part because inflation in the United States had creeped up. It is not clear why six percent per year inflation would have represented a crisis: it was little more than the rate of inflation that European governments had tolerated in the early 1950s, after all.
What changed Europe's political economy, and did provoke a crisis, was the explosion in inflation that followed the tripling of world oil prices by OPEC in the fall of 1973. Governments reacted to a fall in aggregate supply by trying to boost aggregate demand--and found themselves with inflation rates in the range of twelve to twenty percent in the mid-1970s and again at the end of the 1970s, when the Fundamentalist Iranian Revolution again disrupted world energy markets.
In the wake of these oil shocks and the rise in expectations of future inflation that the unhinging of the price level's nominal anchors had created, governments had a choice of three strategies:
The "corporatist" strategy was the dominant one tried in the 1970s, and it failed. Some union leaders could not hold their members to the corporatist bargains that union leaders had agreed to. Some union leaders found themselves outflanked in union politics by challengers who denounced those who had comfortably gotten into bed with the politicians. Some union leaders did not think that high inflation was their problem or that their country's social democrats were their party.
In this they were wrong. Consensus politicians generally got one or at most two chances to bring inflation under control by corporatist agreement. After their one or two chances had expired, voters angry at inflation would vote the other guys in--and the other guys would go the central-banker route. Few union leaders in the 1970s understood how damaging the high-unemployment central bank-launched disinflations of the 1980s were going to be to their constituents and their organizations.
By 1985 there were many ex-union leaders and many ex-union members who wished that they had been more willing to cooperate with consensus social democratic politicians in the 1970s.
As inflation remained high in the late 1970s, left-wing economists hastened to assure voters that inflation was just a redistribution and not a very painful one. In the United States Alan Blinder (1986) compared inflation to a head cold--and the provoking of a recession to "cure" inflation the equivalent of submitting to a lobotomy to try to cure a head cold. But left-wing economists were ignored by voters. Faced with a disease--inflation--that the consensus social democratic politicians could not cure, voters and politicians looked for another solution, and the monetarists were there to offer one.
In country after country, consensus social democratic politicians were replaced by those who would or themselves handed over power to manage the macroeconomy to central bankers whose views could be described as "monetarist"--not necessarily in the sense that they believed that chartist-like tracking of M1 was the answer, but in the sense that they believed that if the central bank focused on reducing inflation then the rest of the economy would take care of itself (see Friedman, 1968; Hall, 198?). And, indeed, the politicians and central bankers were assured by monetarist economists that a shift toward an anti-inflation policy would lead at the most to a few years of temporarily high unemployment. The monetarist belief was that business cycles are fluctuations around (not shortfalls below) a business cycle-free long run growth path. Fight inflation, the monetarists told the central bankers, and in a few years you will have the best of both worlds: low inflation and low unemployment. In the long run, Friedman (1968) assured everyone, the average rate of unemployment would be the "natural" rate of unemployment no matter what the rate of inflation was--so there was ultimately no cost to handing control of economic policy over to the inflation-fighters.
As far as the United States is concerned, it appears that the monetarists told the truth: after a decade made more difficult by the destructive and growth-retarding structural fiscal deficits of the Reagan administration, the United States now has a low unemployment, a low inflation rate, and a high share of high-tech private investment in GDP.
As far as Europe is concerned, it appears that the monetarists lied. Unemployment in Europe began to rise in the mid-1970s, and is now more than four times what it was at the start of that decade. There has been no sign of any "natural" rate toward which unemployment tends to return.
B. The Exclusion of the Unemployed
And as unemployment in Europe rose and remained high in the 1980s, it became more and more clear that no one--or, rather, no one powerful in the political nation--really cared. There is a sense in which the European Union today has high unemployment because, in Daniel Cohen's (1996) words, "the war on unemployment is in the hands of governments which represent first and foremost the point of view of the people who have jobs and fear losing them." Unemployment has been feared and regretted, but feared and regretted less than the remedies that would have been necessary to contain it, and that might have harmed the market position of some of the unemployed.
As Cohen (1996) argues, one possible road that western Europe might have taken in response to the stubborn persistence of unemployment would have been to try to construct in Europe the conditions that made the monetarist promise--that unemployment produced by fighting inflation would be temporary--true in the United States. European governments could have attempted to increase the amount of "churning" in the labor market by increasing speed with which those who seek jobs find them: forcing those who have jobs o compete with those who do not.
The distributional consequences of following this "American strategy" are extremely unpleasant (see Mishel and Bernstein, 1996). One consequence is great insecurity on the part of the employed, and a shift in power in labor-management relations back toward management. A further consequence is the steady downward pressure on wages from the potential competition of the unemployed, downward pressure that has led to a vast widening of income inequality in th United States.
A second road to cure European unemployment would have been to try to boost public employment, and to spend large sums of money on reentry programs for the jobless--training subsidies, job search assistance, and much higher subsidies to employers for hiring the unemployed. But these costly reentry programs must be paid for by higher taxation. The fear has been either that higher taxation will slow economic growth, or that programs for the unemployed will crowd out other social benefits.
The European Union has remained stuck in the middle. It has rejected the first strategy. It has not tried the second. The U.S. provides a somewhat positive example of the first strategy. There is no successful example of the second: it is not clear that it is even possible.
Had European political economy taken a different turn, post-World War II European recovery might have been hobbled by clumsy allocative bureaucracies that rationed scarce foreign exchange and placed ceiling prices on exportables to protect the consumption of urban working classes. Yet post-World War II western Europe saw a rapid dismantling of controls over product and factor markets, and the restoration of price and exchange rate stability.
To some degree this came about because underlying political-economic conditions were favorable. After all, no one in Europe wanted a repeat of interwar experience. To some degree it came about because the governments in power believed that the "mixed economies" they were building should have a strong pro-market orientation.
To some degree it came about as a result of a Marshall Plan that gave post-World War II European politicians a little bit of extra room to maneuver, in order to carry out their intentions.
Without such aid, they would likely have faced a harsh choice in the late 1940s between contraction to balance their international payments and severe controls on admissible imports. For budgets to be balanced and inflation to be halted in post-World War II western Europe, political compromise was required. Consumers had to accept higher posted prices for foodstuffs and necessities. Workers had to moderate their demands for higher wages. Owners had to moderate demands for profits. Taxpayers had to shoulder additional liabilities. Recipients of social services had to accept limits on safety nets. Rentiers had to accept that the war had destroyed their wealth. There had to be broad agreement on a "fair" distribution of income, or at least on a distribution of the burdens that was not so unfair as to be intolerable.
Such agreement was easier to reach, the larger the size of the pie available for division among interest groups. Thus at first aid and then rapid economic growth made virtuous circles very possible.
What about Europe today, which is far from exceptional?
It is hard to believe that the differences that separate the slowly-growing, unemployment-ridden western Europe of today from the western Europe of the Great Keynesian Boom are large. Not much has changed, and yet we have wandered from there to here. Perhaps we can change a little bit, and go back from here to there?
Perhaps. Perhaps not. But in any case western European economic management leaves those of us who study and make macroeconomic policy on this side of the Atlantic scratching our head in puzzlement.
What western Europe appears to need are policies that will (a) stimulate demand by expanded government deficits and lower interest rates, (b) free up the labor market and make it easier to hire workers so that higher demand will generate lower unemployment and not higher inflation, and (c) a reform of the social insurance state so that it provides fewer sinecures to those with favroable economic positions and more genuine social insurance.
But when we look at western Europe today, we do not see such policies. Instead, we see policies of continued fiscal contraction in order to meet abstract requirements for future monetary union. These seem, at least to those of us on this side of the Atlantic, completely beside the point. They do not provide firms and workers with stronger incentives to make and find jobs either through government subsidy or through market opportunity. Since either tacking right or left appears unacceptably risky, the decision of European governments has been to stay in the middle, and hope that monetary union will lead something positive to turn up. But what that something positive will be, no one can say.
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