The recent behavior of key fiscal policy variables draws some parallels with the U.S. experience in the Civil War and the two world wars. A specific concern is the possibility of high inflation to finance the accumulated debt.Fiscal policy ; Recessions

Fernando M. Martin

English

Research Papers in Economics

Economic SYNOPSES
short essays and reports on the economic issues of the day
2012 ■ Number 1
I
n response to the financial crisis in late 2008 and the
subsequent recession, the United States has been run-
ning atypically high and persistent budget deficits.
The recent behavior of key fiscal policy variables draws
some parallels with the U.S. experience in the Civil War
and the two world wars.1 The similarities and differences
of these episodes shed some light on the current situation.
A specific concern is the possibility of high inflation to
finance the accumulated debt.
According to the latest estimates from the Office of
Management and Budget (OMB), the primary deficit—
outlays net of interest payments minus revenue—averaged
8.6 percent of gross domestic product (GDP) between fis-
cal years (FYs) 2009 and 2011.2 As a point of reference,
this figure averaged roughly zero from 1955 to 2008. The
top-left panel of the accompanying chart shows that the
magnitude of the recent deficits is similar to those during
the Civil War when the average deficit was about 8.5 per-
cent of GDP. The two world wars are the only times in U.S.
history with higher primary deficit levels. Even during
the implementation of the New Deal policies (1933-36) in
response to the Great Depression, the deficit averaged only
about 3.7 percent of GDP.
A natural consequence of high deficits is a significant
increase in government debt. At the end of FY 2011, debt
held by the public—net of holdings in Federal Reserve
Banks—was estimated at about 56 percent of GDP.3 Only
during World War II and the years immediately thereafter
Fiscal Policy in the Great Recession and 
Lessons from the Past
Fernando M. Martin, Senior Economist
Primary Deficit-to-GDP Ratio
–10
0
10
20
30
1791 1816 1841 1866 1891 1916 1941 1966 1991 2016
Percent
Government Debt Held by the Public-to-GDP Ratio
0
20
40
60
80
100
1791 1816 1841 1866 1891 1916 1941 1966 1991 2016
Percent
Real GDP per Capita (deviations from trend)
–50
–40
–30
–20
–10
0
10
20
30
40
1791 1816 1841 1866 1891 1916 1941 1966 1991 2016
Percent
Annual Inflation (5-year moving average)
–10
–5
0
5
10
15
1791 1816 1841 1866 1891 1916 1941 1966 1991 2016
Percent
NOTE: Years are listed as fiscal years when fiscal-year frequency data are available and as calendar years otherwise. GDP per capita is detrended using a quadratic polynomial. 
Data for 2012-16 are from the most recent OMB estimates. The vertical gray bars highlight the Civil War, the two world wars, and 2009-14. 
SOURCE: Bureau of Labor Statistics, Congressional Budget Office, OMB, Historical Statistics of the United States: Millennial Edition Online, and author’s calculations.was the debt-to-GDP ratio higher. So far, the increase in
the debt-to-GDP ratio relative to the pre-crisis period—
roughly 25 percentage points—is comparable to the rise
during the Civil War, World War I, and the Great Depression
(see the top-right panel of the chart).
Despite the similarities, there are three important differ-
ences between the response of government policy to the
recent recession and the behavior of policy during the
three wars mentioned previously. First, wartime deficits
are explained by large temporary increases in defense
expenditure. However, revenue also increases—and for a
longer period than expenditure—which results in a post-
war fiscal surplus. The current higher deficits follow both
an increase in expenditure and a decrease in revenue. Com  -
pared with the average of the five years preceding the finan-
cial crisis and recession (2004-08), outlays net of interest
payments increased by 5.0 percent of GDP. Two-thirds of
this increase was due to transfers—payments to individuals,
either directly or through grants to states and local govern-
ments. Over the same period, revenue fell by 2.8 percent
of GDP as a result of combined tax cuts, credits, and rebates
and also likely due to depressed economic activity.4
Second, as the bottom-left panel of the chart shows, out-
put during the three wars increased significantly, whereas
it is currently below trend. In part, the difference in output
performance could be explained by the current reliance on
transfers rather than purchases.
Third, inflation increased substantially during all three
wars (see the bottom-right panel of the chart). In addition,
in the aftermath of World War II (1946-48), high inflation
was used to reduce the real value of accumulated debt.
Ohanian (1998) estimates that the reduction of the real
value of debt due to the increase in prices was equivalent
to a repudiation of debt worth 40 percent of gross national
product. In contrast, inflation has remained low between
2009 and 2011, averaging about 1.3 percent annually, well
below the pre-crisis average.
The most recent projections from the OMB estimate
that high primary deficits will persist until the end of FY
2014. By 2016, outlays net of interest payments are esti-
mated to fall to about 19.8 percent of GDP, which is still
1.4 percentage points higher than the average from 2004
to 2008. Assuming revenues climb to 19.3 percent of GDP,
debt held by the public is estimated to reach almost 68
percent of GDP, which would more than double interest
payments in terms of output.5 If past experiences are any
indication, these developments will create strong incentives
to use inflation to reduce the financial burden of fiscal lia-
bilities. An even greater incentive is the fact that over half
of the debt is held by foreign and international investors.
Arguably, the Federal Reserve is more independent and
more committed to a low inflation objective than ever
before. Furthermore, there appears to be a healthy appetite
for assets issued by the U.S. government, as evidenced by
the low yields on U.S. Treasury securities (about zero for
3-month and 1-year bonds) despite the sharp increase in
the stock of debt. Still, the possibility of a high-inflation
episode to alleviate the fiscal burden of accumulated debt,
similar to that experienced after World War II, is a troubling
scenario that should not be lightly dismissed. ■
1 See Goldin (1980), Martin (2011), and Ohanian (1998) for further analysis on
wartime policy.
2 Outlays include all forms of government spending—purchases of goods and
services, transfers to individuals and other grants, and interest payments on the
debt. The fiscal year in the United States begins on October 1 and ends on
September 30 of the subsequent year and is designated by the year in which it
ends. Before 1977, the fiscal year began on July 1 and ended on June 30. 
3 According to the OMB, estimated debt due to the Troubled Asset Relief
Program at the end of 2011 is about 1.0 percent of GDP.
4 Taylor (2011) provides a description and analysis of specific fiscal stimulus
programs.
5 This figure assumes that the Federal Reserve System will not unwind its recent
purchases of U.S. Treasury securities. Including holdings by Federal Reserve
Banks, debt is estimated to reach about 76 percent of GDP by 2016.
Goldin, Claudia. “War,” in Glenn Porter, ed., Encyclopedia of American Economic
History: Studies of the Principal Movements and Ideas. New York: Charles Scribner
and Sons, 1980, pp. 935-57.
Martin, Fernando M. “Government Policy Response to War-Expenditure Shocks.”
Working Paper No. 2011-028A, Federal Reserve Bank of St. Louis, October 2011;
http://research.stlouisfed.org/wp/2011/2011-028.pdf.
Ohanian, Lee E. The Macroeconomic Effects of War Finance in the United States:
Taxes, Inflation, and Deficit Finance. London, Taylor and Francis, 1998.
Taylor, John B. “An Empirical Analysis of the Revival of Fiscal Activism in the
2000s.” Journal of Economic Literature, September 2011, 49(3), pp. 686-702.
Economic SYNOPSES Federal Reserve Bank of St. Louis      2
research.stlouisfed.org
Posted on January 6, 2012
Views expressed do not necessarily reflect official positions of the Federal Reserve System.
The recent behavior of key fiscal policy
variables draws some parallels with
the U.S. experience in the Civil War and
the two world wars. A specific concern
is the possibility of high inflation to
finance the accumulated debt.

Fiscal policy in the Great Recession and lessons from the past

http://research.stlouisfed.org/publications/es/12/ES_2012-01-06.pdf

Fiscal policy in the Great Recession and lessons from the past

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