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Modeling fully employed economies
~
U T T E R W O R T H E I N E M A N
N
0264-9993(95)00003-87
Econonlic Modell#l~l, Vol. 12, No. 2, pp. 205 210, 1995 Elsevier Science Ltd Printed in Great Britain
Modeling fully employed economies H 0 Stekler and R W Beckstead This paper simulates a m a c r o e c o n o m y under conditions o f extreme excess d e m a n d (such as m i y h t occur in wartime). These simulations assume the model represents reality, and that when the model breaks down, that the economy would have experienced severe strains. The W E F A model is used to.forecast the behavior o f the economy and then to analyze policy options.for controllin9 it. Ke_vword~':Modeling macroeconomics;Modeling excess demand; Modeling wartime In building macroeconomic models, it has been customary to exclude the years comprising World War II from the database. The argument for excluding those years is that they were atypical and that customary relationships did not hold because markets were not functioning. In making this argument, we are also implicitly stating that it is difficult if not impossible to model and, therefore, to analyze and forecast extreme excess demand (such as might occur during major wars) situations. There are a number of different approaches that might be used to obtain some insights about the problems involved in modeling periods of excess demand. First, we could use the existing equations of a model and, using data from such a period of excess demand, determine whether these relationships replicated the observations of that period. Alternatively, we could reestimate portions of a model to determine whether the estimated equations remained structurally stable. These are conventional techniques for evaluating econometric models. However, our intention was not to evaluate an existing econometric model to determine whether it could replicate conditions prevailing 50 years ago. (Given the changes that have occurred over 50 years, H O Stekler is with the George Washington University, Wshington DC 20052, USA; R W Beckstead is with the Industrial College of the Armed Forces National Defense University, Fort Lesley J McNair, Washington, DC 203196000, USA. The views expressed in this paper are those of the authors and do not reflect the opinions of the National Defense University or the Department of Defense. An earlier version of this paper was presented at the 1993 International Symposium on Economic Modeling. The authors thank the participants of that Symposium for their extensive comments. Final manuscript received August 1994.
we would expect that such replication would not be possible.) Rather we wanted to use a contemporary model to analyze conditions of excess demand, should they occur in today's world. Then by simulating the effects of both traditional and non-traditional policies, it would be possible to determine the efficacy of using such policies to control excess demand. Econometricians usually assume that their models are reasonably realistic approximations of the contemporary real world. We believe that, by making one additional and perhaps heroic assumption, it is possible to model and then forecast the policy effects that can occur during these periods of excess demand. Our assumption is as follows. When the model breaks down, fails to solve, or 9ires unrealistic solutions (such as negative rates of unemployment), it is indicatin9 that the conditions which were assumed would have caused severe strains on the economy. This model failure would also have indicated that the 'normal' market relationships were not functioning. (If extensive supply based models of the US economy had been available, they could have been used as an alternative to the analysis presented here.) Since non-market mechanisms such as rationing were effectively employed in World War II, it would be instructive to determine whether they would still be effective if extreme excess demand developed in the present day US economy. Assumptions ,'orresponding to the implementation of such policies could then be embodied in the model. If the model now provided a 'reasonable' solution, we would argue that such policies would be 'effective' in the current economic environment. At this point we should note that we are not examining optimal policies, with or without feedback loops. Rather we are considering ad hoc policies adopted one year at a time such as were implemented during WWlI. Thus, a decision maker would receive
205
Modelin9 fully employed economies: H 0 Stekler and R W Beckstead Table !. Defense spending and military personnel: base case and excess demand simulation. Defense spending (billion US$ 1982) Base case Excess demand scenario Military personnel (millions) Base case Excess demand scenario
1989
1990
1991
1992
1993
1994
250.8 445.7
242.5 733.3
241.0 1038.8
241.3 1111.5
241.5 806.2
241.7 503.7
2.25 3.5
2.25 5.5
a forecast indicating that the economy would be experiencing extreme excess demand in the following year. The decision maker would only select the policies that would be helpful in stabilizing next year's economy. The types of policies that could be selected will be discussed below. In the next section we present the scenario which is used to simulate the conditions of extreme excess demand. This is followed by a discussion both of the forecasts which were generated year by year throughout this period and the policies which were implemented. Excess
demand
scenario
Although any number of factors might generate a condition of excess demand in the US economy, we have chosen a scenario in which a major war creates this condition. 1 By assuming that a major war occurred during the 1990s, it was possible to generate a simulation in which there was both a significant increase in effective demand but also a diminution of the civilian labor supply resulting from an increase in military manpower requirement. Both factors contributed to the condition of extreme excess demand. The magnitude of the additional defense outlays required to fight this war reflected or were similar to conditions prevailing during World War II. Specifically, it was assumed that the war would last five years with the peak year of military activity occurring in year 3. The subsequent two years of the scenario involved scaled down fighting and demobilization. In addition, it was assumed that there was a year of increasing tension preceding the war and that year would be used for military preparedness, including a build up of the armed forces and increasing outlays on military systems. For the purposes of analysis the period of 1990-94 was chosen as the war years. The required wartime military expenditures were added to the economic activities already forecast to be ongoing in that period. 1Althoughthe end of the Cold War makes such a scenarioextremely unlikely, the economicanalysis and modeling techniques would still apply to any situation in whichthere was extreme excessdemand.
206
2.25 7.5
2.25 8.0
2.25 6.0
2.25 4.0
It was assumed that 8 million men and women would be in the armed forces during the peak year of the conflict. The magnitude of the additional D o D outlays which would be required to support this effort are presented in Table 1. The build up of the armed forces from 2.25 million to 8 million would occur over a four-year period. The concomitant increase in D o D outlays would be from a base level of US$240-250 billion 1982 dollars to a peak exceeding US$1.1 thousand billion (1982 US$). 2 It should be noted that the assumptions embodied in the scenario are dramatically different from those used in some other analyses or forecasts of the economic impact of wartime situations. The papers of Lee and Stekler [1] and Stekler [4] assumed that D o D outlays would resemble those of a Vietnam-like war and would not exceed 10% of GNP. In those analyses, traditional economic relations were maintained, the models always converged and yielded realistic solutions and forecasts. In our scenario, military expenditures would be around 15% of G N P during the first year of the war, and the model might not converge. The WEFA Group Long-Term Annual Model (WEFA G r o u p [5]) was used in the analysis of this scenario. Fiscal only policy (for 1989 and 1990)
Necessity for and size o f tax increases Given the economic conditions that were expected to prevail in 1989, the year of preparation for a war which was to begin in 1990, a policy based on only using fiscal policy was to be implemented. The necessity for at least using fiscal policy was discovered when the forecast for 1989 was generated under the assumption of unchanged fiscal policy? The predictions for 1989 (Table 2) indicate that the economy would experience extremely vigorous growth (10.5%) with a sharp decline in unemployment, to
2The size of the armed forces required to fight this particular war and the calculation of the associated required DoD outlays come from studies conducted at the Industrial College of the Armed Forces. 3In all cases, monetary policy was assumed to follow the reaction function which was embodied in the Wharton model.
Modelin9 fully employed economies. H 0 Stekler and R W Beckstead 3.2%. Strong inflationary pressures would be generated, the manufacturing sector would be greatly stimulated from the increased demand for military systems, and the government deficit would swell. The most important finding is that under these assumptions the model converged and provided forecasts for 1989. This suggests that the demands placed upon the economy would not have been sufficient to cause a general breakdown of traditional market relationships. Such was not the situation for 1990, the first year of the war. If no fiscal restraint were imposed, the model would not converge. This suggests that the economy would have experienced serious problems if no additional policy measures were introduced. In essence this failure to converge is the model's forecast of serious excess demand. It was obvious that new fiscal measures would have to be introduced in 1990 to curtail the excess demand that was forecast for that year. Given this knowledge, we attempted to determine whether a tax increase imposed in 1989 would not only be sufficient to generate a solution for 1990 but would also curtail the inflationary pressures of 1989. The next question was how large the tax increase should be. In 1989, military expenditures were assumed to increase US$250 billion above the baseline outlays. We therefore investigated the effect of a US$125 billion tax increase. 4 We chose this amount because taxes financed 50% of the increase in military expenditures during World War II, and we felt that such a ratio would be appropriate in the contemporary situation.
Results The results (Table 2) quite clearly show that the US$125 billion tax increase enacted for 1989 would have reduced, but not eliminated, the excess demand pressures which prevailed. Capacity utilization would be over 88%, unemployment would still be below 4% and inflationary pressures would continue to exist. Nevertheless we decided that political pressures did not permit the introduction of additional economic restraints in this period of peace but of escalating international tensions. The results also show that the model does not converge in 1990 if the only deviation in policy from the base case were the continuation of the tax increase enacted in 1989. Obviously stronger measures were required to manage the wartime economy from 1990
Table 2. Effects of unchanged fiscal policy and alternative policy of increasing taxes on key economic variables 1988-90.
G N P (billion US$ 1982) No policy change US$125 billion tax increase
1988
1989
3998 3998
4419 4314
Rate of growth of G N P (US$ 1982) No policy change US$125 billion tax increase
3.9 3.9
Change in G N P deflator (%) No policy change US$125 billion tax increase
3.3 3.3
9.0+ 8.7
Unemployment rate (%) No policy change US$125 billion tax increase
5.5 5.5
3.2 3.6
Employment: manufacturing (million) No policy change US$125 billion tax increase
1990
10.5 7.9
8 O
"u 19.5 19.5
21.4 21.0
Value-added manufacturing (billion US$ 1982) No policy change US$125 billion tax increase
897 897
1098 1059
Federal government budget deficit (billion US$) No policy change US$125 billion tax increase
141 141
271 164
O
Wartime economic restraints Wartime policy package Schlesinger [3] noted that as an economy moved from peacetime to increasing wartime tempos (or intensity), the traditional economic restraints would have to be increased and new non-market controls would have to be imposed. Our results confirm this hypothesis. Merely increasing taxes further would not have quickly eliminated all of the excesses resulting from the increased wartime demand pressures. 5 The wartime economic restraints consisted of a package of traditional fiscal constraints and non-market controls. Since military expenditures were increasing further, additional tax increases were enacted every year for the period 1990-92. The increase of 1989 was followed by additional increases. By 1992 the combined tax increases were more than US$570 billion above the prewar level. Additional fiscal restraints were imposed in the form of reduced transfer payments, lower transfers to the states and smaller grants in aid. As a second part of the package, laws and regulations were assumed to have been enacted which
on.
4 Three types of taxes were increased: income, corporate and excise. The increases s u m m e d to US$125 billion and the individual changes were proportional to existing tax collections in the three categories.
5 In these simulations, we always sought to limit tax increases to a m a x i m u m of 50% of the increases in military expenditures. We assumed this to be a political limit because it closely replicated the World W a r II experiences of some major combattants (see Milward [2]). However, tax collections increased by more than this amount, especially from the corporate sector where profits skyrocketed.
207
Modelin9 fully employed economies. H 0 Stekler and R W Beckstead Table 3. Effects of wartime policy package on key economic variables
Table 4. Effects of all adopted economic policites 1989-92.
1990-91. 1989
Real GNP (billion US$ 1982) Rate of growth real GNP (%) Change in GNP deflator (%) Unemployment rate (%) Employment: manufacturing (million) Value-added manufacturing (billion US$ 1982) Federal government budget deficit (billion US$) Industrial capacity
1989
1990
4314 7.9 8.7 3.6 21.0 1059
4641 7.6 5.4 1.5 23.5 1258
1991
e-
= -,~°
164
364 o
88.3
90.4
limited h o u s i n g starts, c u r t a i l e d d u r a b l e c o n s u m p t i o n a n d i n c r e a s e d forced savings. 6 F o r e x a m p l e , h o u s i n g starts were cut b y 50% d u r i n g the first y e a r of the war, followed by a d d i t i o n a l restrictions in the subsequent years. C o n s u m e r e x p e n d i t u r e s were r e d u c e d b y 2 0 % d u r i n g the first y e a r of the w a r (1990) followed b y a d d i t i o n a l restrictions. I n f l a t i o n a r y pressures were s u p p r e s s e d by i m p o s i n g wage a n d price controls. 7 G i v e n the w a r t i m e s i t u a t i o n it was necessary to a s s u m e t h a t the excess d e m a n d c o u l d n o t be fulfilled by increased i m p o r t s . These i m p o r t s c o u l d either be i n t e r d i c t e d o r n o t be a v a i l a b l e d u e to insufficient t r a n s p o r t capacity. In a n y event, i m p o r t s in these s i m u l a t i o n s were s u p p r e s s e d b e l o w p r e w a r levels. Finally, m i l i t a r y e x p o r t s were increased to meet the increased w a r t i m e needs of U S allies. Results G i v e n this large d e m a n d r e d u c t i o n c o u p l e d with the o t h e r p o l i c y changes, the forecast was t h a t the e c o n o m y met its objectives d u r i n g 1990, the first y e a r of the w a r (Table 3). U n e m p l o y m e n t was o n l y 1.5% b u t this was consistent with u n e m p l o y m e n t levels below 2 % which p r e v a i l e d in the U S A d u r i n g W o r l d W a r II a n d c a p a c i t y utilization exceeded 90%. Inflation was high at 5.4% b u t significantly less t h a n rates which p r e v a i l e d p r i o r to the i m p o s i t i o n of wage controls. However, despite the a d d i t i o n a l d e m a n d suppression which o c c u r r e d in 1991, the m o d e l d i d n o t c o n v e r g e in t h a t year. T h e p r o b l e m was a n i n a d e q u a t e l a b o r supply. T h e d e m a n d for l a b o r as reflected in the m a n p o w e r b u i l d u p of the a r m e d forces plus the increased d e m a n d for l a b o r in the m a n u f a c t u r i n g
6 In the model simulations housing starts were controlled directly, by changing an add factor. Consumer expenditures were adjusted by primarily choking off new car production and sales. (In the model this is accomplished by adjusting a variable called the number of new vehicle registrations.) v In the model this was implemented by controlling the wage rate.
208
Real GNP (billion US$ 1982) Rate of growth real GNP (%) Change in GNP deflator (%) Unemployment rate (%) Employment: manufacturing (million) Value-added manufacturing (billion US$ 1982) Federal government budget deficit (billion US$) Industrial capacity utilization
1990
1991
1992
4 3 1 4 4641 4932 5135 7.9 7.6 6.3 4.1 8.7 5.4 5.4 5.8 3.6 1.5 1.5 1.2 21.0 23.5 26.4 28.7 1059
1258
1444
1511
164
364
537
728
88.3
90.4
90.8
90.4
industries exceeded the a v a i l a b l e s u p p l y even after s o m e of the excess civilian d e m a n d was suppressed.
Supply-side considerations A99regate labor constraints In forecasting or m o d e l i n g the e c o n o m i c i m p a c t of situations of extreme excess d e m a n d , it is also necessary to c o n s i d e r w h a t is h a p p e n i n g on the s u p p l y o r c a p a c i t y side of the e c o n o m y . W e have n o t e d that despite i m p o s i n g a s t r o n g dose of fiscal a n d r e g u l a t o r y restraints on private d e m a n d , the m o d e l forecast that the d e m a n d for l a b o r w o u l d exceed the s u p p l y that was willingly m a d e available. B o t h the male a n d female p a r t i c i p a t i o n rates were forecast to be a p p r o x i m a t e l y the same (75% a n d 58%, respectively) as were expected to prevail h a d there been no war. C o n s e q u e n t l y , we felt t h a t the l a b o r s u p p l y m i g h t be increased. These increases c o u l d be in response to patriotic appeals or through some administrative actions. By increasing the l a b o r s u p p l y by 4 million in 1991 a n d an a d d i t i o n a l 2 million in 1992, the male a n d female p a r t i c i p a t i o n rates w o u l d have risen to 81% a n d 6 3 % respectively. 8 U n d e r these circumstances, the m o d e l yields estimates of very low u n e m p l o y m e n t rates, which nevertheless are still consistent with the rates experienced d u r i n g W o r l d W a r II. The m o d e l n o w converges a n d predicts results which a p p e a r sensible (Table 4). 9 W h e t h e r these l a b o r p a r t i c i p a t i o n rates are achievable in t o d a y ' s e c o n o m y is a n o t h e r question. T h e a l t e r n a t i v e to having these l a b o r force increases w o u l d have been to place m o r e d e m a n d restraints on the
8 In World War II, the peak male and female participation rates were 88% and 36%, respectively. Moreover, in WWlI there was an increase in the number of retired individuals who chose to work again. Our analysis already assumes that there will be an increase in the number of people age 65 or more who will return to work. 9There may also be possible capacity constraints in particular industries. These capacity constraints will be discussed below.
Modelin9 fidly employed economies: H 0 Stekler and R W Beckstead Table 5. Capacity utilization levels, base case and excess demand scenarios, 1988-92 (% year). Industry
1988
1989
1990
1991
1992
Textiles {SIC 22) Base Excess demand
89.7 89.7
88.5 94.1
86.1 99.2"
85.8 98.8"
85.6 98.9 ~
Paper {SIC 26) Base Excess demand
94.8 94.8
92.9 96.9
91.9 98.7"
90.9 99.6"
89.9 98.6 ~
Stone, clay, glass (SIC 32) Base Excess demand
82.5 82.5
83.9 89.2
84.4 96.7
86.8 98.6
86.5 95.5"
Iron and steel (SIC 331,2) Base Excess demand
87.5 87.5
89.3 87.5 87.8 87.4 99.3 b 99.1~ 99.7 C 96.7 c
Non-ferrous metals (SIC 333-9) Base 87.5 Excess demand 87.5
91.0 90.6 90.0 87.5 98.9 b 99.5 ~ 99.5 ~ 96.2 ~
Non-electrical machinery (SIC 35) Base 81.3 Excess demand 81.3
86.7 95.5
89.9 98.5"
Electrical machinery (SIC 36) Base Excess demand
77.6 77.6
79.2 96.7
8 0 . 1 79.2 78.3 98.1b 97.4 b 98.4 b
Machinery (SIC 371 ) Base Excess demand
82.0 82.0
83.6 81.0 77.6 77.2 99.4 b 99.1b 98.4 b 98.7 °
Other transport equipment (SIC 372-9) Base Excess demand
86.6 86.6
86.7 84.3 96.9 b 96.6 °
91.7 92.7 98.9 b 98.6 b
85.0 96.3 °
84.3 97.5 °
"Requires movement from preferred to practical capacity. b In addition to a, also requires additional shifts of labor. In addition to b also requires the creation of new plant and equipment (greenfield).
economy than was imposed during WWII. Thus using this model to forecast in this fashion, a policy maker can examine the limits of feasible policy choices. Specific industrial constraints
In addition to the above-mentioned aggregate labor market problems, there would also have been capacity constraints in specific industrial sectors. The W E F A G r o u p long-term model uses the FRB indexes of industrial production and calculates capacity on the basis of the preferred level of utilization. If the output required of this industry exceeds 100% of the preferred capacity, it is assumed that the capacity can be increased in three distinct steps. First, firms would work existing capacity more intensively, moving up the increasing arm of their U-shaped cost curves. Second, industries not operating around the clock would employ additional shifts. Finally, new greenfield facilities would have to be constructed. In Table 4 the capacity utilization rates of the entire industrial sector are presented for each of the years of
the excess demand scenario. These aggregate rates are a mixture or aggregation of individual industry utilization rates. Some of these individual capacity utilization rates reflect preferred utilization, others are based on practical capacity, while still others are derived from increased shifts and/or the addition of more capacity. Thus the aggregate data are an underestimate of the true capacity constraints. The true constraints can only be observed by examining individual sectors of the economy. Table 5 presents the capacity utilization for a select number of industries where constraints appeared in our excess demand scenario. The table also shows the type of actions which would have been necessary to alleviate the capacity problems. The two-digit SIC code industries which are not listed would not have experienced any capacity problems. The industries listed in Table 5 primarily produce durable goods, with textiles and paper being the exceptions. This is not surprising given the nature of the scenario which generated this extreme excess demand. In several cases the capacity constraints merely involved moving from preferred to practical capacity. In most other cases, additional labor shifts would have enabled the industries to be able to meet the demand. These results are consistent with the requirement for additions to the labor supply which was observed above. Only in the case of the metals producing industry was greenfield construction required. The capacity data were not generated in conjunction with the model stimulation runs and only became available later. If the capacity data had been available at the time that the aggregate forecasts were generated, it would have been possible to undertake another forecast iteration. In such an iteration, more emphasis would have been placed on restricting the consumption of goods (such as autos) which are metal intensive. In other words, an additional non-market demand restriction would have been placed on consumption. This indicated that there is a close relationship between demand and supply management policies in a period of extreme excess demand.
The outyears of the scenario We did not examine the policies which would have been appropriate for the last two years of the war. Those years involved diminished fighting and demobilization with a concomitant decline in excess demand pressures. No new restraints would have been imposed, and the policy choices might merely have involved a reduction in the existing restraints. Moreover, there would have been no new information generated
209
Modeling fully employed economies: H 0 Stekler and R W Beckstead about modeling d e m a n d , x°
economies
which
d i s p l a y excess
Summary and conclusions T h e r e are two levels at which we can s u m m a r i z e o u r results. T h e first is m e t h o d o l o g i c a l a n d the o t h e r is empirical. At the m e t h o d o l o g i c a l level, we m a d e a basic a s s u m p t i o n that an e c o n o m e t r i c m o d e l is a valid r e p r e s e n t a t i o n of reality. W h e n it b r e a k s down, it is forecasting t h a t the e c o n o m y w o u l d experience difficulties u n d e r the a s s u m e d conditions. O u r p r o c e d u r e s show that it is possible to use a m o d e l in this way for forecasting in e c o n o m i e s where full or overfull e m p l o y m e n t prevailed. T h e m o d e l also i n d i c a t e d w h e t h e r p r o p o s e d policies (including n o n - m a r k e t regulation) were a d e q u a t e to eliminate the existing problems. 1°While reconversion from a wartime to a peacetime economy would pose a different set of economic problems such as a recession, analyses of these problems were not within the scope of this paper. 1 Finally, it has been pointed out that such analyses can be useful to explain the behaviour of some European economies during the 1950s when these countries did have conditions of overfull employment. Similarly, this type of simulation could be useful in examining the portion of US national security policy which is called "reconstitution'.
210
O n the e m p i r i c a l level, we chose policies for a c o n t e m p o r a r y w a r t i m e e c o n o m y which were similar to those which were selected to stabilize the W W I I U S e c o n o m y . F o r the m o s t p a r t those policies, which in the 1940s were a d o p t e d on an ad hoc basis, w o u l d have been sufficient to stabilize (as m e a s u r e d b y the m o d e l ' s convergence) the U S e c o n o m y of the 1990s. The one question was the a d e q u a c y of the l a b o r pool. In the 1990s, there is no p o o l of u n e m p l o y e d females, which c o u l d be t a p p e d as was a v a i l a b l e in W o r l d W a r II. ix
References 1 2 3 4 5
Lee, D and Stekler, H O 'Modeling high levels of defense expenditures' Journal of Policy Modeling 1987 9 437-453 Milward, Alan S War, Economy and Society, 1939-45 University of California Press, Berkeley and Los Angeles (1977) Schlesinger, James R The Political Economy of National Securi 0" Frederick A Praeger, New York (1960) Stekler, H O 'Forecasting industrial bottlenecks: an analysis of alternative approaches' Economic Modeling 1990 7 263 274 Wharton Econometric Forecasting Associates (WEFA) Long Term Model Structure and Specification WEFA, Bala Cynwyd, PA (1988)
U T T E R W O R T H E I N E M A N
N
0264-9993(95)00003-87
Econonlic Modell#l~l, Vol. 12, No. 2, pp. 205 210, 1995 Elsevier Science Ltd Printed in Great Britain
Modeling fully employed economies H 0 Stekler and R W Beckstead This paper simulates a m a c r o e c o n o m y under conditions o f extreme excess d e m a n d (such as m i y h t occur in wartime). These simulations assume the model represents reality, and that when the model breaks down, that the economy would have experienced severe strains. The W E F A model is used to.forecast the behavior o f the economy and then to analyze policy options.for controllin9 it. Ke_vword~':Modeling macroeconomics;Modeling excess demand; Modeling wartime In building macroeconomic models, it has been customary to exclude the years comprising World War II from the database. The argument for excluding those years is that they were atypical and that customary relationships did not hold because markets were not functioning. In making this argument, we are also implicitly stating that it is difficult if not impossible to model and, therefore, to analyze and forecast extreme excess demand (such as might occur during major wars) situations. There are a number of different approaches that might be used to obtain some insights about the problems involved in modeling periods of excess demand. First, we could use the existing equations of a model and, using data from such a period of excess demand, determine whether these relationships replicated the observations of that period. Alternatively, we could reestimate portions of a model to determine whether the estimated equations remained structurally stable. These are conventional techniques for evaluating econometric models. However, our intention was not to evaluate an existing econometric model to determine whether it could replicate conditions prevailing 50 years ago. (Given the changes that have occurred over 50 years, H O Stekler is with the George Washington University, Wshington DC 20052, USA; R W Beckstead is with the Industrial College of the Armed Forces National Defense University, Fort Lesley J McNair, Washington, DC 203196000, USA. The views expressed in this paper are those of the authors and do not reflect the opinions of the National Defense University or the Department of Defense. An earlier version of this paper was presented at the 1993 International Symposium on Economic Modeling. The authors thank the participants of that Symposium for their extensive comments. Final manuscript received August 1994.
we would expect that such replication would not be possible.) Rather we wanted to use a contemporary model to analyze conditions of excess demand, should they occur in today's world. Then by simulating the effects of both traditional and non-traditional policies, it would be possible to determine the efficacy of using such policies to control excess demand. Econometricians usually assume that their models are reasonably realistic approximations of the contemporary real world. We believe that, by making one additional and perhaps heroic assumption, it is possible to model and then forecast the policy effects that can occur during these periods of excess demand. Our assumption is as follows. When the model breaks down, fails to solve, or 9ires unrealistic solutions (such as negative rates of unemployment), it is indicatin9 that the conditions which were assumed would have caused severe strains on the economy. This model failure would also have indicated that the 'normal' market relationships were not functioning. (If extensive supply based models of the US economy had been available, they could have been used as an alternative to the analysis presented here.) Since non-market mechanisms such as rationing were effectively employed in World War II, it would be instructive to determine whether they would still be effective if extreme excess demand developed in the present day US economy. Assumptions ,'orresponding to the implementation of such policies could then be embodied in the model. If the model now provided a 'reasonable' solution, we would argue that such policies would be 'effective' in the current economic environment. At this point we should note that we are not examining optimal policies, with or without feedback loops. Rather we are considering ad hoc policies adopted one year at a time such as were implemented during WWlI. Thus, a decision maker would receive
205
Modelin9 fully employed economies: H 0 Stekler and R W Beckstead Table !. Defense spending and military personnel: base case and excess demand simulation. Defense spending (billion US$ 1982) Base case Excess demand scenario Military personnel (millions) Base case Excess demand scenario
1989
1990
1991
1992
1993
1994
250.8 445.7
242.5 733.3
241.0 1038.8
241.3 1111.5
241.5 806.2
241.7 503.7
2.25 3.5
2.25 5.5
a forecast indicating that the economy would be experiencing extreme excess demand in the following year. The decision maker would only select the policies that would be helpful in stabilizing next year's economy. The types of policies that could be selected will be discussed below. In the next section we present the scenario which is used to simulate the conditions of extreme excess demand. This is followed by a discussion both of the forecasts which were generated year by year throughout this period and the policies which were implemented. Excess
demand
scenario
Although any number of factors might generate a condition of excess demand in the US economy, we have chosen a scenario in which a major war creates this condition. 1 By assuming that a major war occurred during the 1990s, it was possible to generate a simulation in which there was both a significant increase in effective demand but also a diminution of the civilian labor supply resulting from an increase in military manpower requirement. Both factors contributed to the condition of extreme excess demand. The magnitude of the additional defense outlays required to fight this war reflected or were similar to conditions prevailing during World War II. Specifically, it was assumed that the war would last five years with the peak year of military activity occurring in year 3. The subsequent two years of the scenario involved scaled down fighting and demobilization. In addition, it was assumed that there was a year of increasing tension preceding the war and that year would be used for military preparedness, including a build up of the armed forces and increasing outlays on military systems. For the purposes of analysis the period of 1990-94 was chosen as the war years. The required wartime military expenditures were added to the economic activities already forecast to be ongoing in that period. 1Althoughthe end of the Cold War makes such a scenarioextremely unlikely, the economicanalysis and modeling techniques would still apply to any situation in whichthere was extreme excessdemand.
206
2.25 7.5
2.25 8.0
2.25 6.0
2.25 4.0
It was assumed that 8 million men and women would be in the armed forces during the peak year of the conflict. The magnitude of the additional D o D outlays which would be required to support this effort are presented in Table 1. The build up of the armed forces from 2.25 million to 8 million would occur over a four-year period. The concomitant increase in D o D outlays would be from a base level of US$240-250 billion 1982 dollars to a peak exceeding US$1.1 thousand billion (1982 US$). 2 It should be noted that the assumptions embodied in the scenario are dramatically different from those used in some other analyses or forecasts of the economic impact of wartime situations. The papers of Lee and Stekler [1] and Stekler [4] assumed that D o D outlays would resemble those of a Vietnam-like war and would not exceed 10% of GNP. In those analyses, traditional economic relations were maintained, the models always converged and yielded realistic solutions and forecasts. In our scenario, military expenditures would be around 15% of G N P during the first year of the war, and the model might not converge. The WEFA Group Long-Term Annual Model (WEFA G r o u p [5]) was used in the analysis of this scenario. Fiscal only policy (for 1989 and 1990)
Necessity for and size o f tax increases Given the economic conditions that were expected to prevail in 1989, the year of preparation for a war which was to begin in 1990, a policy based on only using fiscal policy was to be implemented. The necessity for at least using fiscal policy was discovered when the forecast for 1989 was generated under the assumption of unchanged fiscal policy? The predictions for 1989 (Table 2) indicate that the economy would experience extremely vigorous growth (10.5%) with a sharp decline in unemployment, to
2The size of the armed forces required to fight this particular war and the calculation of the associated required DoD outlays come from studies conducted at the Industrial College of the Armed Forces. 3In all cases, monetary policy was assumed to follow the reaction function which was embodied in the Wharton model.
Modelin9 fully employed economies. H 0 Stekler and R W Beckstead 3.2%. Strong inflationary pressures would be generated, the manufacturing sector would be greatly stimulated from the increased demand for military systems, and the government deficit would swell. The most important finding is that under these assumptions the model converged and provided forecasts for 1989. This suggests that the demands placed upon the economy would not have been sufficient to cause a general breakdown of traditional market relationships. Such was not the situation for 1990, the first year of the war. If no fiscal restraint were imposed, the model would not converge. This suggests that the economy would have experienced serious problems if no additional policy measures were introduced. In essence this failure to converge is the model's forecast of serious excess demand. It was obvious that new fiscal measures would have to be introduced in 1990 to curtail the excess demand that was forecast for that year. Given this knowledge, we attempted to determine whether a tax increase imposed in 1989 would not only be sufficient to generate a solution for 1990 but would also curtail the inflationary pressures of 1989. The next question was how large the tax increase should be. In 1989, military expenditures were assumed to increase US$250 billion above the baseline outlays. We therefore investigated the effect of a US$125 billion tax increase. 4 We chose this amount because taxes financed 50% of the increase in military expenditures during World War II, and we felt that such a ratio would be appropriate in the contemporary situation.
Results The results (Table 2) quite clearly show that the US$125 billion tax increase enacted for 1989 would have reduced, but not eliminated, the excess demand pressures which prevailed. Capacity utilization would be over 88%, unemployment would still be below 4% and inflationary pressures would continue to exist. Nevertheless we decided that political pressures did not permit the introduction of additional economic restraints in this period of peace but of escalating international tensions. The results also show that the model does not converge in 1990 if the only deviation in policy from the base case were the continuation of the tax increase enacted in 1989. Obviously stronger measures were required to manage the wartime economy from 1990
Table 2. Effects of unchanged fiscal policy and alternative policy of increasing taxes on key economic variables 1988-90.
G N P (billion US$ 1982) No policy change US$125 billion tax increase
1988
1989
3998 3998
4419 4314
Rate of growth of G N P (US$ 1982) No policy change US$125 billion tax increase
3.9 3.9
Change in G N P deflator (%) No policy change US$125 billion tax increase
3.3 3.3
9.0+ 8.7
Unemployment rate (%) No policy change US$125 billion tax increase
5.5 5.5
3.2 3.6
Employment: manufacturing (million) No policy change US$125 billion tax increase
1990
10.5 7.9
8 O
"u 19.5 19.5
21.4 21.0
Value-added manufacturing (billion US$ 1982) No policy change US$125 billion tax increase
897 897
1098 1059
Federal government budget deficit (billion US$) No policy change US$125 billion tax increase
141 141
271 164
O
Wartime economic restraints Wartime policy package Schlesinger [3] noted that as an economy moved from peacetime to increasing wartime tempos (or intensity), the traditional economic restraints would have to be increased and new non-market controls would have to be imposed. Our results confirm this hypothesis. Merely increasing taxes further would not have quickly eliminated all of the excesses resulting from the increased wartime demand pressures. 5 The wartime economic restraints consisted of a package of traditional fiscal constraints and non-market controls. Since military expenditures were increasing further, additional tax increases were enacted every year for the period 1990-92. The increase of 1989 was followed by additional increases. By 1992 the combined tax increases were more than US$570 billion above the prewar level. Additional fiscal restraints were imposed in the form of reduced transfer payments, lower transfers to the states and smaller grants in aid. As a second part of the package, laws and regulations were assumed to have been enacted which
on.
4 Three types of taxes were increased: income, corporate and excise. The increases s u m m e d to US$125 billion and the individual changes were proportional to existing tax collections in the three categories.
5 In these simulations, we always sought to limit tax increases to a m a x i m u m of 50% of the increases in military expenditures. We assumed this to be a political limit because it closely replicated the World W a r II experiences of some major combattants (see Milward [2]). However, tax collections increased by more than this amount, especially from the corporate sector where profits skyrocketed.
207
Modelin9 fully employed economies. H 0 Stekler and R W Beckstead Table 3. Effects of wartime policy package on key economic variables
Table 4. Effects of all adopted economic policites 1989-92.
1990-91. 1989
Real GNP (billion US$ 1982) Rate of growth real GNP (%) Change in GNP deflator (%) Unemployment rate (%) Employment: manufacturing (million) Value-added manufacturing (billion US$ 1982) Federal government budget deficit (billion US$) Industrial capacity
1989
1990
4314 7.9 8.7 3.6 21.0 1059
4641 7.6 5.4 1.5 23.5 1258
1991
e-
= -,~°
164
364 o
88.3
90.4
limited h o u s i n g starts, c u r t a i l e d d u r a b l e c o n s u m p t i o n a n d i n c r e a s e d forced savings. 6 F o r e x a m p l e , h o u s i n g starts were cut b y 50% d u r i n g the first y e a r of the war, followed by a d d i t i o n a l restrictions in the subsequent years. C o n s u m e r e x p e n d i t u r e s were r e d u c e d b y 2 0 % d u r i n g the first y e a r of the w a r (1990) followed b y a d d i t i o n a l restrictions. I n f l a t i o n a r y pressures were s u p p r e s s e d by i m p o s i n g wage a n d price controls. 7 G i v e n the w a r t i m e s i t u a t i o n it was necessary to a s s u m e t h a t the excess d e m a n d c o u l d n o t be fulfilled by increased i m p o r t s . These i m p o r t s c o u l d either be i n t e r d i c t e d o r n o t be a v a i l a b l e d u e to insufficient t r a n s p o r t capacity. In a n y event, i m p o r t s in these s i m u l a t i o n s were s u p p r e s s e d b e l o w p r e w a r levels. Finally, m i l i t a r y e x p o r t s were increased to meet the increased w a r t i m e needs of U S allies. Results G i v e n this large d e m a n d r e d u c t i o n c o u p l e d with the o t h e r p o l i c y changes, the forecast was t h a t the e c o n o m y met its objectives d u r i n g 1990, the first y e a r of the w a r (Table 3). U n e m p l o y m e n t was o n l y 1.5% b u t this was consistent with u n e m p l o y m e n t levels below 2 % which p r e v a i l e d in the U S A d u r i n g W o r l d W a r II a n d c a p a c i t y utilization exceeded 90%. Inflation was high at 5.4% b u t significantly less t h a n rates which p r e v a i l e d p r i o r to the i m p o s i t i o n of wage controls. However, despite the a d d i t i o n a l d e m a n d suppression which o c c u r r e d in 1991, the m o d e l d i d n o t c o n v e r g e in t h a t year. T h e p r o b l e m was a n i n a d e q u a t e l a b o r supply. T h e d e m a n d for l a b o r as reflected in the m a n p o w e r b u i l d u p of the a r m e d forces plus the increased d e m a n d for l a b o r in the m a n u f a c t u r i n g
6 In the model simulations housing starts were controlled directly, by changing an add factor. Consumer expenditures were adjusted by primarily choking off new car production and sales. (In the model this is accomplished by adjusting a variable called the number of new vehicle registrations.) v In the model this was implemented by controlling the wage rate.
208
Real GNP (billion US$ 1982) Rate of growth real GNP (%) Change in GNP deflator (%) Unemployment rate (%) Employment: manufacturing (million) Value-added manufacturing (billion US$ 1982) Federal government budget deficit (billion US$) Industrial capacity utilization
1990
1991
1992
4 3 1 4 4641 4932 5135 7.9 7.6 6.3 4.1 8.7 5.4 5.4 5.8 3.6 1.5 1.5 1.2 21.0 23.5 26.4 28.7 1059
1258
1444
1511
164
364
537
728
88.3
90.4
90.8
90.4
industries exceeded the a v a i l a b l e s u p p l y even after s o m e of the excess civilian d e m a n d was suppressed.
Supply-side considerations A99regate labor constraints In forecasting or m o d e l i n g the e c o n o m i c i m p a c t of situations of extreme excess d e m a n d , it is also necessary to c o n s i d e r w h a t is h a p p e n i n g on the s u p p l y o r c a p a c i t y side of the e c o n o m y . W e have n o t e d that despite i m p o s i n g a s t r o n g dose of fiscal a n d r e g u l a t o r y restraints on private d e m a n d , the m o d e l forecast that the d e m a n d for l a b o r w o u l d exceed the s u p p l y that was willingly m a d e available. B o t h the male a n d female p a r t i c i p a t i o n rates were forecast to be a p p r o x i m a t e l y the same (75% a n d 58%, respectively) as were expected to prevail h a d there been no war. C o n s e q u e n t l y , we felt t h a t the l a b o r s u p p l y m i g h t be increased. These increases c o u l d be in response to patriotic appeals or through some administrative actions. By increasing the l a b o r s u p p l y by 4 million in 1991 a n d an a d d i t i o n a l 2 million in 1992, the male a n d female p a r t i c i p a t i o n rates w o u l d have risen to 81% a n d 6 3 % respectively. 8 U n d e r these circumstances, the m o d e l yields estimates of very low u n e m p l o y m e n t rates, which nevertheless are still consistent with the rates experienced d u r i n g W o r l d W a r II. The m o d e l n o w converges a n d predicts results which a p p e a r sensible (Table 4). 9 W h e t h e r these l a b o r p a r t i c i p a t i o n rates are achievable in t o d a y ' s e c o n o m y is a n o t h e r question. T h e a l t e r n a t i v e to having these l a b o r force increases w o u l d have been to place m o r e d e m a n d restraints on the
8 In World War II, the peak male and female participation rates were 88% and 36%, respectively. Moreover, in WWlI there was an increase in the number of retired individuals who chose to work again. Our analysis already assumes that there will be an increase in the number of people age 65 or more who will return to work. 9There may also be possible capacity constraints in particular industries. These capacity constraints will be discussed below.
Modelin9 fidly employed economies: H 0 Stekler and R W Beckstead Table 5. Capacity utilization levels, base case and excess demand scenarios, 1988-92 (% year). Industry
1988
1989
1990
1991
1992
Textiles {SIC 22) Base Excess demand
89.7 89.7
88.5 94.1
86.1 99.2"
85.8 98.8"
85.6 98.9 ~
Paper {SIC 26) Base Excess demand
94.8 94.8
92.9 96.9
91.9 98.7"
90.9 99.6"
89.9 98.6 ~
Stone, clay, glass (SIC 32) Base Excess demand
82.5 82.5
83.9 89.2
84.4 96.7
86.8 98.6
86.5 95.5"
Iron and steel (SIC 331,2) Base Excess demand
87.5 87.5
89.3 87.5 87.8 87.4 99.3 b 99.1~ 99.7 C 96.7 c
Non-ferrous metals (SIC 333-9) Base 87.5 Excess demand 87.5
91.0 90.6 90.0 87.5 98.9 b 99.5 ~ 99.5 ~ 96.2 ~
Non-electrical machinery (SIC 35) Base 81.3 Excess demand 81.3
86.7 95.5
89.9 98.5"
Electrical machinery (SIC 36) Base Excess demand
77.6 77.6
79.2 96.7
8 0 . 1 79.2 78.3 98.1b 97.4 b 98.4 b
Machinery (SIC 371 ) Base Excess demand
82.0 82.0
83.6 81.0 77.6 77.2 99.4 b 99.1b 98.4 b 98.7 °
Other transport equipment (SIC 372-9) Base Excess demand
86.6 86.6
86.7 84.3 96.9 b 96.6 °
91.7 92.7 98.9 b 98.6 b
85.0 96.3 °
84.3 97.5 °
"Requires movement from preferred to practical capacity. b In addition to a, also requires additional shifts of labor. In addition to b also requires the creation of new plant and equipment (greenfield).
economy than was imposed during WWII. Thus using this model to forecast in this fashion, a policy maker can examine the limits of feasible policy choices. Specific industrial constraints
In addition to the above-mentioned aggregate labor market problems, there would also have been capacity constraints in specific industrial sectors. The W E F A G r o u p long-term model uses the FRB indexes of industrial production and calculates capacity on the basis of the preferred level of utilization. If the output required of this industry exceeds 100% of the preferred capacity, it is assumed that the capacity can be increased in three distinct steps. First, firms would work existing capacity more intensively, moving up the increasing arm of their U-shaped cost curves. Second, industries not operating around the clock would employ additional shifts. Finally, new greenfield facilities would have to be constructed. In Table 4 the capacity utilization rates of the entire industrial sector are presented for each of the years of
the excess demand scenario. These aggregate rates are a mixture or aggregation of individual industry utilization rates. Some of these individual capacity utilization rates reflect preferred utilization, others are based on practical capacity, while still others are derived from increased shifts and/or the addition of more capacity. Thus the aggregate data are an underestimate of the true capacity constraints. The true constraints can only be observed by examining individual sectors of the economy. Table 5 presents the capacity utilization for a select number of industries where constraints appeared in our excess demand scenario. The table also shows the type of actions which would have been necessary to alleviate the capacity problems. The two-digit SIC code industries which are not listed would not have experienced any capacity problems. The industries listed in Table 5 primarily produce durable goods, with textiles and paper being the exceptions. This is not surprising given the nature of the scenario which generated this extreme excess demand. In several cases the capacity constraints merely involved moving from preferred to practical capacity. In most other cases, additional labor shifts would have enabled the industries to be able to meet the demand. These results are consistent with the requirement for additions to the labor supply which was observed above. Only in the case of the metals producing industry was greenfield construction required. The capacity data were not generated in conjunction with the model stimulation runs and only became available later. If the capacity data had been available at the time that the aggregate forecasts were generated, it would have been possible to undertake another forecast iteration. In such an iteration, more emphasis would have been placed on restricting the consumption of goods (such as autos) which are metal intensive. In other words, an additional non-market demand restriction would have been placed on consumption. This indicated that there is a close relationship between demand and supply management policies in a period of extreme excess demand.
The outyears of the scenario We did not examine the policies which would have been appropriate for the last two years of the war. Those years involved diminished fighting and demobilization with a concomitant decline in excess demand pressures. No new restraints would have been imposed, and the policy choices might merely have involved a reduction in the existing restraints. Moreover, there would have been no new information generated
209
Modeling fully employed economies: H 0 Stekler and R W Beckstead about modeling d e m a n d , x°
economies
which
d i s p l a y excess
Summary and conclusions T h e r e are two levels at which we can s u m m a r i z e o u r results. T h e first is m e t h o d o l o g i c a l a n d the o t h e r is empirical. At the m e t h o d o l o g i c a l level, we m a d e a basic a s s u m p t i o n that an e c o n o m e t r i c m o d e l is a valid r e p r e s e n t a t i o n of reality. W h e n it b r e a k s down, it is forecasting t h a t the e c o n o m y w o u l d experience difficulties u n d e r the a s s u m e d conditions. O u r p r o c e d u r e s show that it is possible to use a m o d e l in this way for forecasting in e c o n o m i e s where full or overfull e m p l o y m e n t prevailed. T h e m o d e l also i n d i c a t e d w h e t h e r p r o p o s e d policies (including n o n - m a r k e t regulation) were a d e q u a t e to eliminate the existing problems. 1°While reconversion from a wartime to a peacetime economy would pose a different set of economic problems such as a recession, analyses of these problems were not within the scope of this paper. 1 Finally, it has been pointed out that such analyses can be useful to explain the behaviour of some European economies during the 1950s when these countries did have conditions of overfull employment. Similarly, this type of simulation could be useful in examining the portion of US national security policy which is called "reconstitution'.
210
O n the e m p i r i c a l level, we chose policies for a c o n t e m p o r a r y w a r t i m e e c o n o m y which were similar to those which were selected to stabilize the W W I I U S e c o n o m y . F o r the m o s t p a r t those policies, which in the 1940s were a d o p t e d on an ad hoc basis, w o u l d have been sufficient to stabilize (as m e a s u r e d b y the m o d e l ' s convergence) the U S e c o n o m y of the 1990s. The one question was the a d e q u a c y of the l a b o r pool. In the 1990s, there is no p o o l of u n e m p l o y e d females, which c o u l d be t a p p e d as was a v a i l a b l e in W o r l d W a r II. ix
References 1 2 3 4 5
Lee, D and Stekler, H O 'Modeling high levels of defense expenditures' Journal of Policy Modeling 1987 9 437-453 Milward, Alan S War, Economy and Society, 1939-45 University of California Press, Berkeley and Los Angeles (1977) Schlesinger, James R The Political Economy of National Securi 0" Frederick A Praeger, New York (1960) Stekler, H O 'Forecasting industrial bottlenecks: an analysis of alternative approaches' Economic Modeling 1990 7 263 274 Wharton Econometric Forecasting Associates (WEFA) Long Term Model Structure and Specification WEFA, Bala Cynwyd, PA (1988)