Fiscal Policy as a Recession Fighter: Lessons from the Interwar Period

By Gregor Smith, Queen’s University

One of the legacies of the recession and slow growth in developed economies during the past decade has been a revived consensus that discretionary fiscal policy can be used to counteract recessions, especially at times of very low interest rates. Jason Furman, chair of the US Council of Economic Advisors, outlines the theory and evidence behind this revival.

These circumstances of slow growth and low interest rates remind one of the Great Depression, so it’s natural to ask what lessons for fiscal policy the interwar period holds. Unfortunately, a disadvantage of studying that time period is that the data are sparse. National accounts data are incomplete and are available only at an annual frequency. That makes it very difficult to isolate the “shocks” (unexpected changes in fiscal policy) that are used in modern statistical studies to measure the multiplier for government spending. But there is also an advantage of studying this time period: There is a rich diversity of international experiences both in the severity of depressions and in the stance of fiscal policy. That diversity should help isolate whether fiscal policy helped recovery or not.

My joint work with Nicolas-Guillaume Martineau studies the period from 1920 to 1939 for twenty countries: Argentina, Australia, Austria, Belgium, Brazil, Canada, Czechoslovakia, Denmark, Finland, France, Germany, Hungary, Italy, Japan, the Netherlands, Norway, Portugal, Spain, Sweden and Switzerland. To illustrate the diversity of experiences, figure 1 shows real national income per capita for five countries, scaled so that 1920=100. The figure shows the countries with the most and least growth in the interwar period, as well as two intermediate cases including Canada. The great heterogeneity in growth rates is evident, as countries such as Portugal and Japan grew, albeit with cycles, while Austria stagnated. The very different paths for Spain and Canada during the 1930s show that there was not simply a single, world cycle. Figure 2 shows that there also was heterogeneity in real government spending per capita, where again we show the extreme cases and two intermediate ones. The role of the state expanded enormously in Japan while government spending also grew significantly in Sweden late in the 1930s. Real government spending per capita was relatively constant in Canada, while it declined in Czechoslovakia.

We don’t ignore the US and the UK. Fishback (2010) and Middleton (2010) describe research on their interwar stabilization policies. We focus on smaller, open economies and use output growth in these two larger economies as exogenous variables that help us isolate the effects of domestic fiscal policy. Growth in the US and the UK significantly affected growth in the smaller economies, which shows that one can detect some significant statistical effects even in the annual data.

The challenge in deducing whether government spending led to recovery is that it is endogenous. We don’t know whether Japan experienced rapid growth because of fiscal stimulus or, conversely, whether its rapid growth simply allowed the expansion of government spending. The central idea in our paper is this: If fiscal reaction functions varied across countries or over time periods then we can separate these two effects and so measure how growth in government affected output growth.

When we apply this method, we find—to our surprise—that fiscal policy was actually less counter-cyclical in the 1930s than it had been in the 1920s, despite the spread of Keynes’s ideas. We then use this difference in the fiscal reaction functions to measure the response of output to government spending, finding that it is statistically insignificant. This negative finding doesn’t change when we control for the effects of monetary policy (or the timing of departures from the gold standard) on output growth. And it also is unaffected when we group countries according to (i) how large their government sectors were, (ii) how large their public debts were, or (iii) whether they had a fixed or floating exchange rate.

Some modern research on fiscal multipliers focuses on defence spending (rather than total government spending), arguing that such spending is more likely to be exogenous and not influenced by the business cycle. As you might imagine, during the 1930s not every country was eager to report its defence spending. But we use reports from the League of Nations (1924–1940) to measure it. We again find little evidence of an effect on output growth.

The 1920s and 1930s saw a wide range of experiences of fiscal policy and growth, during periods of high unemployment and low interest rates. Yet our research finds that increases in government spending did not lead to faster recovery from recessions or depressions. Given the limitations of the data we’re modest about this conclusion. But, at the least, it suggests that commentators on today’s fiscal policies can’t really point to the interwar period to settle the debate over the effectiveness of fiscal stimulus.

Note: This research won the Harry Johnson Prize, for the best article published in the Canadian Journal of Economics in 2015.


Furman, Jason (2016) The New View of fiscal policy and its application. VoxEU, 2 November 2016

Fishback, Price V. (2010) US monetary and fiscal policy in the 1930s. Oxford Review of Economic Policy 26, 385–413.

League of Nations (1924–1940) Armaments Year-book, 1924–1940. Geneva: League of Nations.

Martineau, Nicolas-Guillaume and Gregor W. Smith (2015) Identifying fiscal policy (in)effectiveness from the differential counter-cylicality of government spending in the interwar period.Canadian Journal of Economics 48, 1291–1320.

Middleton, Roger (2010) British monetary and fiscal policy in the 1930s. Oxford Review of Economic Policy 26, 414–41.