Lessons from the Great Depression: What Really Ended the Great Depression? (Part 3 of 3)

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7 MIN READ - Keynesian economists warned President Harry Truman in 1945 that a rapid cutback in World War II spending would set off Great Depression 2.0. Instead, in another of what would become a near-century long track record of wrong predictions, the U.S. experienced the greatest annual expansion of private GDP in its history.

V. CONSUMERS DURING THE WAR

As government war spending ramped up in 1942 and 1943, official GDP records reflected a near vertical trajectory of economic growth. Looking at the numbers it would seem the U.S. economy was entering new, higher dimensions of prosperity annually.

U.S. nominal GDP: 1941-1945
1941: $129.3B
1942: $166.0B (+28.4%)
1943: $203.1B (+22.3%)
1944: $224.4B (+10.5%)
1945: $228.0B (+1.6%)

1941-1945 inflation-adjusted change in GDP: +52% 
(Source: BEA and inflationdata.com)

However keeping in mind that GDP is mathematically calculated by adding all consumer spending, private business investment spending, government purchases, and net exports (Y = C + I + G + Nx), massive government war materiel purchases artificially inflated the GDP results. If we isolate only consumer and private investment spending, the resulting private GDP picture looks closer to stagnation:

U.S. nominal private GDP 1941-1945
1941: $100.5B
1942: $100.8B (+0%)
1943: $107.3B (+6%)
1944: $117.8B (+10%)
1945: $132.4B (+12%)

1941-1945 inflation-adjusted change in private GDP: +14%
(Source: BEA and inflationdata.com)

(Note: Only government *purchases* are included in GDP calculations. Simple transfers and payments—such as Social Security, Medicare and Medicaid payments or salaries of government employees—aren’t counted. Thus changes in government spending typically have less impact on GDP movements, with World War II being a major exception since so much government spending during the early 1940’s was on armament purchases)

Weak private GDP performance more accurately portrays the plight of the private sector during the war. The average citizen spent very little because the economy was producing so few consumer goods, a harsh reality reflected by everyday rationing.

Life during the war meant enduring shortages of everyday consumer items like gasoline, tires, sugar, meat, silk, shoes, cotton, leather, nylon, butter, coffee, poultry, milk, eggs, vegetables, and canned foods to name a few. To illustrate how inadequate this list is consider that the federal government set up over 8,000 rationing boards to delegate how scarce consumer items would be distributed.

In 1942 rationing boards declared the butter allotment would be 12 pounds per person per year. Coffee was limited to one pound every five weeks (less than a cup a day). In 1943 meat was limited to 28 ounces per person per week. Canned food was reduced to 28% below normal consumption.

In 1943 all recreational driving was banned although this restriction might have eventually become self-fulfilling since production of consumer automobiles had already ground to a halt.

These are just a few examples.

Rosie Riveter may have been gainfully employed in wartime factories, but at home she could buy nothing but scarce necessities.

For this reason, while on paper some economists consider the Great Depression over by 1941, other economists view the Great Depression as a slump that lasted until 1946 when taking private-only GDP and consumer well-being into account (the COCEA wholeheartedly agrees with the latter view).

Finally the U.S. enjoyed full employment during the war, with jobless levels falling to under 3%. However one must also mathematically adjust for conscription. Nearly 12 million men were drafted out of the labor force and sent to fight overseas, so one can hardly consider World War II a model of private sector voluntary civilian employment.

VI. KEYNESIANS PREDICT THE GREAT DEPRESSION OF 1946.

As the war neared conclusion in 1945, President Harry Truman was already consulting with his advisers on how to reduce the federal government’s enormous military budget. In 1945 federal spending was 47% of GDP and Washington had racked up a national debt equal to 120% of GDP—a record then and ever since.

By this time Keynesian economists ruled academia and the intelligentsia, and they offered no shortage of dire and ghastly warnings against a sudden drawdown in government spending—predicting it would hurdle America back into Great Depression 2.0. Truman and Congress, they argued, must continue borrowing and spending at the same wartime rate if recovery was to persevere. In the words of one of America’s most famous Keynesian economists:

“[If government cuts spending] there would be ushered in the greatest period of unemployment and industrial dislocation which any economy has faced.”

-Paul Samuelson, Economics Science Nobel Laureate

 “After the War, Full Employment” (1943)

His co-author Harvard Economics Professor Alvin Hansen, who in the early 1940’s was the most influential American Keynesian economist (in fact dubbed “the American Keynes”) also urged:

“When the war is over, the government cannot just disband the Army, close down munitions factories, stop building ships, and remove all economic controls.”

And there was no shortage of bleak projections from other Keynesian bureaucrats, economists, and journalists, all calling for federal spending not to be slashed:

-In August 1945 the Office of War Mobilization and Reconversion forecasted a spring 1946 unemployment rate of 12%.

-In September 1945 Business Week predicted postwar unemployment of 14%.

-In December 1945 Economist Isidore Lubin (Labor Department) predicted 6-9 million unemployed (9-14%) in 1946.

-Also in December 1945 Economist Robert Nathan (War Production Board Planning Committee Chair) predicted 9-10% unemployment come spring of 1946.

-In 1945 economists Leo Cherne (Research Institute of America) and Boris Shishkin (AFL economist) predicted a 35% postwar unemployment rate.

Fortunately for America, Harry Truman ignored them all. More concerned about America’s staggering postwar national debt, he slashed federal spending from $106.9 billion in 1945 to $66.5 billion in 1946, and again to $41.4 billion in 1947. In nominal terms the budget was cut by 37.8% in 1946 and a total of 61.3% by 1947. 

In real terms the cuts were much larger, 47.3% in 1946 and an extraordinary 70.2% reduction by 1947 (source: Census Bureau).

VII. THE AMERICAN ECONOMY BOOMS AND KEYNESIANS LOOK FOR ANOTHER THEORY

Truman’s cutback of federal spending by nearly half in 1946 and 70% by 1947 was the worst fiscal nightmare Keynesians like Paul Samuelson and Alvin Hansen could have ever dreamed of, and the aftermath should have been much worse than even their own forecasts of double-digit unemployment. So what happened in the end?

Looking strictly at raw GDP again, American economic activity fell from $228 billion in 1945 to $192 billion in 1946 in real terms, or down 15.8%. And a contraction of 15.8% would indeed represent the greatest decline in GDP during any single year in American history—truly a great depression.

So why don’t we read about The Great Depression of 1946 in history books? 

Because the drop is exaggerated by huge declines in government purchases. 

Looking at purely private sector GDP (private consumption + private business investment + net exports), real GDP surged from $131.6 billion in 1945 to $156.2 billion in 1946, a gain of 19%. An increase of 19% represents the greatest expansion in private economic output during any single year in American history—truly an economic boom.

That’s right, instead of the apocalyptic Great Depression 2.0 predicted by Keynesian economists, the private economy experienced the single greatest year of growth in American history—then or ever since. That's about as bad a call as any economists have ever made.

Private business investment alone rose a staggering 126% that year, another record by far.

Unemployment followed the same trend. Instead of 10%, 14%, 25%, or 35% joblessness as predicted, the USA remained at full employment throughout with the unemployment rate standing at 3.6% in 1946 and 3.6% again in 1947. Remarkably the labor market remained tight even with 12 million men in uniform returning to civilian life.

Economist Michael Sapir, who compiled employment data for Congressional review in his 1946 paper “Actual Developments vs Washington Forecasts” in the “Review of Economic Forecasts for the Transition Period,” offered an apt mea culpa by concluding:

“For this quarter [1Q46] total civilian… …unemployment was predicted at a level of 8.1 million, three times the actual figure, 2.7 million.”

And in a huge understatement summarized…

“…It cannot be claimed that this is a very good record!”

Nevertheless Keynesians were undeterred. Despite their theory falling flat on its face, they quickly pivoted to a new explanation for the unexpected boom. By late 1946 they had all synchronized to a different theory that massive government borrowing and spending had cultivated “pent-up demand” which then exploded in an orgy of spending when wartime rationing ended.

Many of the same economists who had predicted Great Depression 2.0 in 1945 were engaged in full-fledged historical revisionism in 1946:

“The country came out of the war rich in monetary assets and monetary savings and desperately short of consumers' durables, houses, business plant and equipment. This laid the groundwork for a vast postwar prosperity.”

-Alvin Hansen
“The Postwar American Economy Performance and Problems”

“We have a postponed consumer demand, enterpriser ambitions, and purchasing power which hold the potential of some years of great activity.”

-Edwin Nourse, Chairman, CEA December 1946

“Even with the decline in government spending, aggregate demand was sufficient to maintain full employment... Consumption increased rapidly in the face of a decline in GNP. Here lies the main part of the answer to the mildness of the reconversion recession.”

-Robert Gordon (Keynesian economist)
“Business Fluctuations”

“A striking aspect of the postwar economy was the failure of predictions of postwar depression made by most economists. In general, the effect of deferred demand, financed by accumulated liquid holdings, was underestimated.”

-Harold Summers
“The Performance of the American Economy Since 1919”

VIII. UNDETERRED BY THE DATA

As we demonstrated in Part 2 of this series on the end of the Great Depression, the investment and employment recovery began over a year before Pearl Harbor when General Motors President William Knudsen convinced Franklin Roosevelt to roll back his most radical and anti-business New Deal policies and allow American industry to produce the “Arsenal of Democracy.” Roosevelt’s death and a Republican takeover of Congress in the 1946 midterms ensured that the New Deal would not return.

To this day Keynesian economists have stuck with “pent-up demand” to explain the enormous and permanent postwar recovery, despite the largest reduction in government spending in U.S. history. In their opinion, federal government borrowing and spending over 100% of GDP on war provided Americans the purchasing power needed to finally get the economy growing. And furthermore, not being allowed to spend their incomes during the war—when soldiers were overseas lacking anything to buy and American workers were unable to spend in face of strict rationing—helped unleash a fury of consumer spending in 1946 when “pent up demand” was at last released into the economy.

Once again the COCEA believes the “pent-up demand” argument is extremely weak and temporally inconsistent.

The Keynesian theory is that consumers were loaded up with income that they had been unable to spend for years, and that 1946’s flood of consumption spending finally bolstered businesses with confidence to invest in and expand their operations. That investment led to more hiring which armed even more consumers with purchasing power and the “virtuous income cycle” was set in motion—standard demand-side theory.

However looking at the actual data (source: BEA) from 1945 to 1946 consumption expenditures rose by 20% in nominal terms ($120 billion to $144 billion), but given the 18% inflation rate that year—unleashed after years of wartime price controls were finally lifted—the real spending growth was less than 2% ($120 billion to $122 billion in 1945 dollars). By contrast, private investment spending rose by 167% nominally and even 126% when adjusted for inflation.

If the Keynesian theory really held true then 1946 should have been a flat year for private investment, because consumer spending rose by only 2%. Yet for some reason other than consumer demand the country experienced a 126% real gain in private business investment. Investment spending preceded consumer spending, a reverse casual relationship from the Keynesian theory and a series of events more consistent with the relaxation of FDR-era regulations and government getting out of the way.

And even if the Keynesian explanation credibly fit the evidence, what sort of solution to depression is it anyway? The conclusion is that when faced with double-digit unemployment (11% in 1937, 15.6% in 1939) the only remedy is to borrow 100% of GDP, spend it on war for four years during which time no one is allowed to buy anything and consumer goods are tightly rationed, the public lives at a primitive, bare sustenance level, and then release everyone to go shopping only in the fifth year?

Such a prescription is not only needlessly arduous and absurd, but it’s discredited by the facts. 

Before the 1930's America had already experienced depressions with unemployment at low and mid-teen double digits (the Depressions of 1837, 1873, 1893, and probably the Depression of 1819), yet somehow managed to recover from them all without a world war and giant public debt imposed on future generations. 

In all of those cases the federal government slashed spending, borrowed virtually nothing, didn’t pay millions to shift from private to public employment, imposed no rationing, and sent no one overseas to die in battle. Yet full employment was achieved in less time in most cases, the worst being after 1837 and 1893 which required seven years (equal to the 2008-2015 Obama-era "recovery").

20 months and 20 articles into this Great Depression series, the COCEA believes the free market alternative narrative is vastly superior: government meddling in the monetary system started the 1929 recession, and an unprecedented intrusion of regulations, tax increases, spending, and trade tariffs turned it into the Great Depression.

The same government intrusions that precipitated the Great Depression didn’t magically end it when applied even more forcefully. Rather it was government finally getting and staying off the backs of American industry that ultimately delivered the long-obstructed recovery.
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Additional reading on the Great Depression of 1946 that never happened (Taylor, Vedder, et al) can be read at

https://ideas.blogs.nytimes.com/2010/06/15/the-great-de-stimulus-of-1946/

https://www.cato.org/policy-report/mayjune-2010/stimulus-spending-cuts-lessons-1946

https://www.mercatus.org/publication/economic-recovery-lessons-post-world-war-ii-period

http://www.aei.org/publication/what-austerity-in-1946-tells-us-about-the-possible-economic-impact-of-the-sequester/

No Paul Krugman, Red States Aren’t Moochers and Your Math is Just Awful.

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6 MIN READ - The Cautious Optimism Correspondent for Economic Affairs and Other Egghead Stuff dispels Paul Krugman’s recent recycling of the worn-out myth that red states are “deadbeat welfare queens.”

Earlier this week New York Times columnist and economist Paul Krugman wrote a piece echoing an old fable chanted for years by liberal progressives that red states are (in Krugman’s words) “moochers” and “takers."

Or put more bluntly by leftists who unthinkingly parrot the same legend: “red states are welfare queens” or “red states are deadbeats.”

Krugman’s op-ed can be read at the following URL:

https://www.nytimes.com/2019/07/01/opinion/2020-democrats-taxes.html

(additional examples of “red welfare states” pieces are included at the bottom of this article)

On the surface the claim that red states are bigger moochers or deadbeats than blue states seems counterintuitive given the conventional wisdom that blue state megacities like New York, Los Angeles, Chicago, or even Washington DC have large populations living off of government assistance.

However Krugman and liberal pundits contend that red states are full of the rural poor who take government welfare money too, and blue state cities host more high earners who pay a larger share of federal taxes.

In fact this leads us to the crux of their only evidence: that blue states pay more in federal taxes than they receive back in federal spending. Or in Paul Krugman’s own words “Richer [blue] states subsidize poorer states. And the reasons are clear: Rich states pay much more per person in federal taxes, while actually getting a bit less in federal spending.”

Look up any assertion that red states are the true “welfare queens” and this will be the clincher supporting their position.

However the allegation itself is not true—nearly ALL states receive more in federal outlays than they pay in federal taxes, the difference between red and blue state outlays is explained entirely by non-welfare expenditures like defense and transportation, the elderly who paid into pension programs while working in blue states but receive benefits in their red state retirement homes are not “deadbeats,” and during recessions the imbalance tips towards blue states which much more resemble “moochers” than red states in good times.

I. NEARLY ALL STATES RUN SURPLUSES WITH WASHINGTON

First there's receipts and outlays. As a group, all states receive more in federal spending than they pay in federal taxes. In FY17 receipts from the 50 states plus District of Columbia (50 + DC) were approximately $3.1 trillion (excluding miscellaneous non-state specific payments, from overseas for example) and outlays were $3.7 trillion. And when divided into two fiscal groups, both red and blue states received more in federal spending than they paid in federal taxes.

But how can all states collectively receive more than they pay in? The answer is deficit spending. In FY17 the federal government spent $660 billion more than it collected in taxes. The result was a net surplus for nearly all states, a circumstance that will hold just as true in 2019.

There are a handful of exceptions. In FY17 ten states out of the 50 + DC (19.6%) did pay more than they got back, and only two (Nebraska and North Dakota) were solid red states with one swing state (New Hampshire), but when grouping all blue states together the collective result is still more federal money received than taxes paid.

II. DEFENSE SPENDING IS NOT WELFARE, IT’S PAYING FOR PROTECTION

But even the exception states that pay more than they receive aren’t victims being forced to prop up red-state deadbeats. New York, which had by far the largest federal funding shortfall of $35 billion, also ranked 50th out of 50 + DC states in federal defense outlays as a percentage of GDP with another blue state, Oregon, at dead last—the result of being less interested/successful in holding onto its military assets during the post-Cold War base realignment and closures of the 1990’s plus lacking a large military contractor industry.

If New York received defense payments equal to the 2017 national average of 3.6% of GDP (3.1% plus veterans affairs payments equal to 0.5% of GDP), the state would have gained an additional $38 billion in spending from Washington’s $695 billion defense + veterans affairs budget (source: Office of Economic Analysis and Rockefeller Institute of Government) closing all of the gap and putting the state into a surplus.

The same is true for another large deficit blue state, Illinois, which paid $4.6 billion more than it received in federal outlays. Illinois ranked #42 in military spending and had it received the national average in military expenditures would have netted an additional $17.8 billion, eliminating the gap and making it (according to Krugman) a major “moocher” state.

On the whole, red states receive a much larger share of defense outlays than blue states due both to a stronger commitment to keep their military bases and general political friendliness to the military plus some luck in geographical location (Alaska receives a very large share of its relatively small GDP in defense spending due to its proximity to Russia and the Arctic Circle).

Shrink the military benefit of red states down to the blue state level and Alabama, Texas, Georgia, and Utah join the short list of deficit states too. The 7-2-1 blue/red/swing ratio of deficit states reverses to red/blue at 6-5-1.

So when counting military spending, blue states aren’t “subsidizing” red states. In fact if blue states weren’t paying up then they would truly be “moochers” because red states would be subsidizing their protection. A smaller tax surplus simply reflects the bill that blue states rightly fork over for the security that red states disproportionately provide them.

One would think Paul Krugman, a Nobel Prize winning economist, would know all this. But Krugman has been a dishonest political hack for some time and has a long history of misrepresenting the facts to lead readers towards his own political conclusions.

III. TRANSPORTATION AND SOCIAL SECURITY PENSIONS AREN’T WELFARE EITHER

Any remaining difference between red state surpluses and blue state surpluses can be accounted for with federal transportation dollars (again, not welfare). It’s no surprise that large, sparsely populated red states tend to receive a greater share of transportation funds relative to their federal tax payments precisely because they’re so large.

While it’s true that giant twelve-lane highway projects in California or New York are more expensive than two lane rural highways in Montana, blue state megaprojects carry far more local residents per mile of road laid. Thus it’s no surprise that the largest recipients of per-capita federal transportation money are large red states like Alaska, North Dakota, and Wyoming and not dense blue states like California, Connecticut, and Massachusetts.

And then there’s giant Social Security and Medicare outlays for the elderly. Social Security (excluding unemployment benefits) and Medicare represented nearly 40% of federal spending in FY17 at over $1.5 trillion (well over double $590 billion for defense plus $105 billion for veterans affairs). In FY2019 the two programs will spend over $1.7 trillion.

Although spending by state data is lacking, there’s little question that red states receive a disproportionate share of pensions for the elderly relative to the taxes they pay since so many workers in blue states relocate (or flee) to red states for retirement in search of A) warmer weather, B) lower cost of living particularly for housing, C) lower taxes—or even zero state income taxes in Florida, Texas, and Tennessee. By contrast fewer workers in warm, low tax red states retire and move to New York, New Jersey, Connecticut, Massachusetts, Michigan, or Minnesota to live out their golden years.

The main destination for retirees is typically considered Florida but other red states like Texas and Arizona also host large numbers of retirees.

The irony of course is this unfavorable migration of seniors for blue states is largely the result of their own high-tax and regulatory policies that make life so expensive that retired workers move out and take their pension benefits with them. They pay taxes while working, and when they retire their payroll tax contributions suddenly dry up in their old blue states while the pension checks arrive just as quickly at their new red state residences—a double blow for blue state finances.

Paul Krugman's accounting considers this "mooching" too, but nearly all of these retirees aren’t “welfare queens.” They worked during their productive years and as Krugman himself would point out “they paid taxes all that time and are now entitled to get some of it back in pension benefits.” The net result by state is a receipts/outlays deficit if you’re a blue state, but not if you're a retiree.

Given the enormous size of these programs and the similarly sized receipts from payroll taxes, any adjustment for retiree finances shifts the real “welfare queen” states solidly in the blue camp.

IV. COUNTING ONLY HALF OF THE CYCLE: RED STATES DURING EXPANSIONS, BLUE STATES DURING RECESSIONS

Krugman also fails to mention that the receipts/outlays benefit tilts as far as possible against blue states during economic expansions, but that during recessions the numbers move in the opposite direction—against red states—which is why he’s bringing up the subject now and not in the half decade after 2008.

A clear example is the 2007-09 recession and tepid recovery when blue state economies like Michigan, California, Illinois, Oregon, and Nevada were particularly hard hit while red states such as Texas, the Dakotas, Oklahoma, Nebraska, and mountain states fared much better. The result was a higher proportion of federal tax revenues coming from red states while blue state unemployment rolls swelled.

See October 2009 unemployment by state here:

https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgEx85h1rAfef1nTVfXbXjunil58bkfCFvrLsm7k_WoT0aR9CsS8N8V-w44Pg6YNQNByLvh8ehpso4-nb16zyREGR6yaZXO1Tu6prRmQ7ZpsH2KlJ0SjKQgl98C1ZF5YqiMA-4dgwP64wI/s1600/StateUnemploymentOct2009.jpg

Also back in July of 2009 CNBC compiled the “Top 15 Welfare States” from National Conference of State Legislatures surveys on payouts from Temporary Assistance to Needy Families (TANF) programs that are funded through federal grant blocks. Of the 15 states, 13 were solid blue including the District of Columbia and California at #1.

See results here:

https://www.cnbc.com/2009/07/21/The-Biggest-US-Welfare-States.html

Once the numbers are adjusted during recessions, and then defense, transportation and pension outlays are factored on top of it, the calculus changes from a breakeven between red and blue states during good times to blue states becoming the obvious “moochers” during bad ones.

V. AND AS FOR REAL WELFARE SPENDING…

And so long as we’re talking about actual welfare spending and not just the entire federal budget, an analysis of state and local welfare spending as a share of GDP for the 50 + DC states reveals just where the true moocher dollars are spent.

The state rankings are here:

https://www.usgovernmentspending.com/state_spending_rank_2019p40c

It’s not clear how much of each state’s welfare spending was funded by federal block grants, but of the top half of big welfare spenders (25 states) a full sixteen were solid blue with blue-leaning Maine adding a 17th. Some of the biggest blue spenders were California (#11), Minnesota (#9), Massachusetts (#7), Oregon (#3) and Bernie Sanders’ Vermont topping the list at #1. Of the bottom 26 a full seventeen were solid red with only six states that could be considered reliably blue (Colorado, Delaware, Nevada, Virginia, Washington, Wisconsin).

(Note: This analysis was compiled in 2019 when the link ranked states by fiscal year 2018 budgets. Since then the order of states may have changed.)

So when considering the overall economy the big picture is cyclical. When times are good blue states draw smaller surpluses from Washington, DC which can be viewed as paying back the disproportional welfare and unemployment funds they draw during bad times.

When factoring in differences in federal defense and transportation outlays, the difference in good times disappears and in bad times it causes blue states to slip into the “moocher” category.

When excluding Social Security and Medicare imbalances, where the recipients are overwhelmingly people who had paid in earlier, blue states start to look even more like the net takers even in economic expansions.

And when isolating pure welfare spending, this conclusion is confirmed with blue states topping the list.

That’s a lot of stuff that Krugman missed, or rather deliberately threw in the wastebin along with his reputation.
___________

ps. A few examples of the “red welfare states” accusation from 2009 (but using data from 2005, during an expansion of course):

https://www.dailykos.com/stories/2009/10/13/792808/-

And two more from AP and the Washington Post written in 2017:

https://beta.washingtonpost.com/news/made-by-history/wp/2017/10/30/blue-states-already-subsidize-red-states-now-red-states-want-even-more/

https://www.apnews.com/2f83c72de1bd440d92cdbc0d3b6bc08c

How Economic Regulations Almost Killed the American Revolution—Until Free Markets Saved It

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4 MIN READ - On this July 4th holiday the Cautious Optimism Correspondent for Economic Affairs and Other Egghead Stuff asks readers to thank economic deregulation for saving the Revolutionary War and securing America’s independence.

Most students of American history are taught that the winter of 1777-78 was the darkest period of the American Revolution; when General George Washington’s army of 12,000 men camped at Valley Forge after retreating from yet another defeat at the Battle of Germantown (just north of Philadelphia).

The Continental Army sojourned in Valley Forge for six months, enduring harsh winter conditions, the constant threat of enemy attacks, and a chronic shortage of food and supplies which in turn created environmental conditions conducive to disease outbreaks such as typhoid, dysentery, influenza, pneumonia, and typhus. After long marches many men literally had no boots or clothes. Blankets were in short supply. Food deliveries were inconsistent.

The General Marquis de Lafayette later recalled in his memoirs that “the unfortunate soldiers were in want of everything; they had neither coats, hats, shirts, nor shoes; their feet and legs froze till they had become almost black, and it was often necessary to amputate them."

George Washington himself wrote to the President of the Continental Congress “we have no less than two thousand eight hundred and ninety-eight men now in camp unfit for duty, because they are barefoot and otherwise naked…. I am now convinced beyond a doubt, that, unless some great and capital change suddenly takes place, this army must inevitably be reduced to one or other of these three things: starve, dissolve, or disperse in order to obtain subsistence in the best manner they can."

In all 1,500 horses died, 1,700-2,000 of Washington’s men succumbed to exposure or disease, and of the surviving men over a third (about 4,000) were unable to fight due to hunger and their weakened condition.

Yet somehow the circumstances reversed themselves in the summer of 1778 and the Continental Army went on to win a string of victories. Why the dire winter, and what caused the sudden turnaround?

Well the less well known story is what caused ration and supply deliveries to be so lacking and inadequate in the first place: government price controls.

In 1775 the Continental Congress authorized the printing of fiat paper Continental notes to finance the war. As is nearly always the case, overissue quickly gave rise to inflation and by the time the Continental Army settled in Valley Forge commodity prices were already six times the prewar average and rising.

Seeing the state of Washington’s army the legislature of Pennsylvania unfortunately decided to aid the revolutionary cause by implementing limited price controls—limited meaning applied only to those commodities needed by the army. It was thought this would ease the burden of high prices and lift any shortfall of food and supplies. 

But as history has consistently demonstrated for four thousand years, the new price ceilings simply reshaped the problem from inflation to something even worse: shortages. Any government-mandated price level set below the previous market-clearing equilibrium stimulates higher demand and, particularly in the case of 1777-78, reduces supply and the predictable result is chronic shortages; just as Richard Nixon's price controls created the gas lines of the 1970's, or price ceilings in the Soviet Union and Venezuela led to empty store shelves.

Farmers and suppliers, themselves dealing with the problem of near-hyperinflation, simply stopped selling their commodities at what they viewed as moneylosing prices. Some even quietly sold their food and supplies to the British who not only paid market prices above the artificial ceiling but also settled in gold coin instead of increasingly worthless Continental notes. 

In February of 1778 the legislature tried authorizing commissioners of every Pennsylvania city “the power to seize, at stated prices, all provisions necessary for the army.” But as is usually the case when governments are authorized to seize food and supplies from the public, even fewer of those goods and supplies are produced and what few are often mysteriously disappear.

The Continental Army was on the cusp of extinction thanks to severe shortages brought about by very economic regulations that were enacted to help it. 

As the late Professor Percy Greaves tells us, “Valley Forge taught George Washington and the Pennsylvania advocates of price control a very costly lesson. They had hoped for plenty at low prices. Instead they got scarcity and indescribable misery.”

Fortunately the delegates of the Second Continental Congress, many of whom were students of economics and readers of Adam Smith and the French physiocrats such as Quesnay, Turgot, and Montesquieu, were more enlightened on the subject of price controls and took counteraction. On June 4, 1778 the Congress overrode Pennsylvania and other likeminded state legislatures with a decree that:

“Whereas… … it hath been found by experience that limitations upon the prices of commodities are not only ineffectual for the purpose proposed, but likely productive of very evil consequence… … resolved, that it be recommended to the several states to repeal or suspend all laws or resolutions within the said states respectively limiting, regulating or restraining the Price of any Article, Manufacture, or Commodity.”

Almost immediately the food rations and supplies reappeared and by June 28th the Continental Army, benefiting from Prussian General Baron Friedrich von Steuben’s training, was engaging a larger British force at the Battle of Monmouth in a standoff that officially resulted in a draw, but which demonstrated the revitalized American army could now hold its own against what was previously thought to be a superior enemy.

With France’s entry into the war the rest is history. The revolution’s victory was eventually sealed with General Cornwallis’ surrender at Yorktown three years later.

So on this July 4th let’s all give thanks to deregulation and a pivotal dose of free market capitalism for saving the American Revolution. Had the state regulators maintained their way the Continental Army as well as the new republic would have been handed to King George’s armies on a silver platter. And far from cooking hot dogs and celebrating our independence on July 4th we’d probably be reciting our oaths of loyalty to the Queen and Church of England instead.

To learn more about the Valley Forge price controls crisis read Percy Greaves’ 1952 article at:

https://fee.org/articles/from-price-control-to-valley-forge-1777-78/