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Tags: Calvin Coolidge • depression • federal spending • Herbert Hoover • Keynes • Milton Friedman • monetarism • monetarist • money supply • recession • taxes • world war I
The Depression You’ve Never Heard Of: 1920-1921
When it comes to diagnosing the causes of the Great Depression and prescribing cures for our present recession, the pundits and economists from the biggest schools typically argue about two different types of intervention. Big-government Keynesians, such as Paul Krugman, argue for massive fiscal stimulus—that is, huge budget deficits—to fill the gap in aggregate demand. On the other hand, small-government monetarists, who follow in the laissez-faire tradition of Milton Friedman, believe that the Federal Reserve needs to pump in more money to prevent the economy from falling into deep depression. Yet both sides of the debate agree that it would be utter disaster for the government and Fed to stand back and allow market forces to run their natural course after a major stock market or housing crash.
In contrast, many Austrian economists reject both forms of intervention. They argue that the free market would respond in the most efficient manner possible after a major disruption (such as the 1929 stock market crash or the housing bubble in our own times). As we shall see, the U.S. experience during the 1920–1921 depression—one that the reader has probably never heard of—is almost a laboratory experiment showcasing the flaws of both the Keynesian and monetarist prescriptions.
The 1929–1933 Great Contraction
Despite what many readers undoubtedly “learned” in their history classes as children, Herbert Hoover behaved like a textbook Keynesian following the 1929 stock market crash. In conjunction with Treasury Secretary Andrew Mellon, Hoover achieved an across-the-board one percentage point reduction in income tax rates applicable to the 1929 tax year.
Hoover didn’t stop with tax cuts to bolster “aggregate demand”—though analysts at that time would not have used the term. He also signed into law massive increases in the federal budget, with fiscal year (FY) 1932 spending rising 42 percent above 1930 levels. Hoover ran unprecedented peacetime deficits, which stood in sharp contrast to his predecessor Calvin Coolidge, who had run a budget surplus every year of his presidency. In fact, in the 1932 election FDR campaigned on a balanced budget and excoriated the reckless spending record of the Republican incumbent.
It wasn’t merely that Hoover spent a bunch of money. He spent it on just the types of things that we associate today with Roosevelt’s New Deal. For example, he signed off on numerous public-works projects, including the Hoover Dam. Of particular relevance today is the Reconstruction Finance Corporation (RFC) established under Hoover, which quickly injected more than $1 billion to prop up troubled banks that had made bad loans during the boom years of the late 1920s—and this was when $1 billion really meant something.
It is true that Hoover eventually blinked and raised taxes in 1932, in an effort to reduce the federal budget deficit. Today’s Keynesians point to this move as proof that reducing deficits is a bad idea in the middle of a depression. Yet an equally valid interpretation is that it’s horrible to hike tax rates in the middle of an economic disaster. After the bold tax cuts pushed through by Andrew Mellon in the 1920s, the top marginal income-tax rate in 1932 stood at 25 percent. The next year, because of Hoover’s desire to close the budget hole, the top income tax rate was 63 percent. Given this extraordinary single-year rate hike, it is no wonder that 1933 was the single worst year in U.S. economic history. (For what it’s worth, the FY 1933 budget deficit was still huge, coming in at 4.5 percent of GDP. Despite the huge rate hikes, federal tax revenues only increased 3.8 percent from FY 1932 to FY 1933.)
So we see that the standard Keynesian story, which paints Herbert Hoover as a do-nothing liquidationist, is completely false. Yet Milton Friedman’s explanation for the Great Depression is almost as dubious. Following the stock market crash, the New York Federal Reserve Bank immediately slashed its discount rate—how much it charged on loans—in an attempt to provide relief to the beleaguered financial system. The New York Fed continued to slash its discount rate over the next two years, pushing it down to 1.5 percent by May 1931. At that time, this was the lowest discount rate the New York Fed had ever charged since the establishment of the Federal Reserve System in 1913.
It wasn’t merely that the Fed (along with other central banks around the world) was charging an unusually low rate on loans it advanced from its discount window. The entire mentality of central bankers was different during the early years of the Great Depression. Writing in 1934, Lionel Robbins first noted that during previous crises, the solution had been for central banks to charge a high discount rate to separate the wheat from the chaff. Those firms that were truly solvent but illiquid would be willing to pay the high interest rates on central-bank loans to get them through the storm. Firms that were simply insolvent, on the other hand, would know the jig was up because they couldn’t afford the high rates. Yet this tough love was not administered after the 1929 crash, as Robbins explained: “In the present depression we have changed all that. We eschew the sharp purge. We prefer the lingering disease. Everywhere, in the money market, in the commodity markets and in the broad field of company finance and public indebtedness, the efforts of Central Banks and Governments have been directed to propping up bad business positions.”
We therefore see an eerie pattern. When it came to both fiscal and monetary policy during the early 1930s, the governments and central banks implemented the same strategies that the sophisticated experts recommend today for our present crisis. Of course, today’s Keynesians and monetarists have a ready retort: They will tell us that their prescribed medicines (deficits and monetary injections, respectively) were not administered in large enough doses. It was the timidity of Hoover’s deficits (for the Keynesians) or the Fed’s injections of liquidity (for the monetarists) that caused the Great Depression.
The 1920–1921 Depression
This context highlights the importance of the 1920–1921 depression. Here the government and Fed did the exact opposite of what the experts now recommend. We have just about the closest thing to a controlled experiment in macroeconomics that one could desire. To repeat, it’s not that the government boosted the budget at a slower rate, or that the Fed provided a tad less liquidity. On the contrary, the government slashed its budget tremendously, and the Fed hiked rates to record highs. We thus have a fairly clear-cut experiment to test the efficacy of the Keynesian and monetarist remedies.
At the conclusion of World War I, U.S. officials found themselves in a bleak position. The federal debt had exploded because of wartime expenditures, and annual consumer price inflation rates had jumped well above 20 percent by the end of the war.
To restore fiscal and price sanity, the authorities implemented what today strikes us as incredibly “merciless” policies. From FY 1919 to 1920, federal spending was slashed from $18.5 billion to $6.4 billion—a 65 percent reduction in one year. The budget was pushed down the next two years as well, to $3.3 billion in FY 1922.
On the monetary side, the New York Fed raised its discount rate to a record high 7 percent by June 1920. Now the reader might think that this nominal rate was actually “looser” than the 1.5 percent discount rate charged in 1931 because of the changes in inflation rates. But on the contrary, the price deflation of the 1920–1921 depression was more severe. From its peak in June 1920 the Consumer Price Index fell 15.8 percent over the next 12 months. In contrast, year-over-year price deflation never even reached 11 percent at any point during the Great Depression. Whether we look at nominal interest rates or “real” (inflation-adjusted) interest rates, the Fed was very “tight” during the 1920–1921 depression and very “loose” during the onset of the Great Depression.
Now some modern economists will point out that our story leaves out an important element. Even though the Fed slashed its discount rate to record lows during the onset of the Great Depression, the total stock of money held by the public collapsed by roughly a third from 1929 to 1933. This is why Milton Friedman blamed the Fed for not doing enough to avert the Great Depression. By flooding the banking system with newly created reserves (part of the “monetary base”), the Fed could have offset the massive cash withdrawals of the panicked public and kept the overall money stock constant.
But even this nuanced argument fails to demonstrate why the 1929–1933 downturn should have been more severe than the 1920–1921 depression. The collapse in the monetary base (directly controlled by the Fed) during 1920–1921 was the largest in U.S. history, and it dwarfed the fall during the early Hoover years. So we hit the same problem: The standard monetarist explanation for the Great Depression applies all the more so to the 1920–1921 depression.
The Results
If the Keynesians are right about the Great Depression, then the depression of 1920–1921 should have been far worse. The same holds for the monetarists; things should have been awful in the 1920s if their theory of the 1930s is correct.
To be sure, the 1920–1921 depression was painful. The unemployment rate peaked at 11.7 percent in 1921. But it had dropped to 6.7 percent by the following year, and was down to 2.4 percent by 1923. After the depression the United States proceeded to enjoy the “Roaring Twenties,” arguably the most prosperous decade in the country’s history. Some of this prosperity was illusory—itself the result of subsequent Fed inflation—but nonetheless the 1920–1921 depression “purged the rottenness out of the system” and provided a solid framework for sustainable growth.
As we know, things turned out decidedly differently in the 1930s. Despite the easy fiscal and monetary policies of the Hoover administration and the Federal Reserve—which today’s experts say are necessary to avoid the “mistakes of the Great Depression”—the unemployment rate kept going higher and higher, averaging an astounding 25 percent in 1933. And of course, after the “great contraction” the U.S. proceeded to stagnate in the Great Depression of the 1930s, which was easily the least prosperous decade in the country’s history.
The conclusion seems obvious to anyone whose mind is not firmly locked into the Keynesian or monetarist framework: The free market works. Even in the face of massive shocks requiring large structural adjustments, the best thing the government can do is cut its own budget and return more resources to the private sector. For its part, the Federal Reserve doesn’t help matters by flooding the shell-shocked credit markets with green pieces of paper. Prices can adjust to clear labor and other markets soon enough, in light of the new fundamentals, if only the politicians and central bankers would get out of the way.
Pingback by Monsieur Bastiat, Call Your Office | The Freeman | Ideas On Liberty on 18 November 2009:
[...] that one, unlike the Great Depression, was what W. S. Gilbert might have called a short sharp shock. Robert Murphy describes the depression history [...]
Comment by Lee Waaks on 25 November 2009:
I think Mr. Murphy is right to point to the 1920-21 recession as an embarrassment for Keynesians but I’m not so sure if it should be embarrassing for Monetarists (and neo-Austrians) too. As Murphy points out, the 1920-21 recession was painful and, no doubt, some of the pain can be attributed to the reallocation of capital and labor necessary after the collapse. But is it the case that all of the pain must be attributed to malinvestment? Is it not possible that a monetary expansion in response to the increased demand for money might have helped avoid such a painful contraction? After all, the massive reallocation of labor and capital required at the end of WWII did not lead to another Great Depression (as some Keynesians predicted).
Comment by Jonathan Finegold Catalán on 25 November 2009:
Lee Wacks,
Interesting question that I probably couldn’t help to accurately answer. The Federal Reserve actually willingly increased interest rates during the 1920-21 depression (increased reserved ratios). If you agree that meeting the demand for money would have helped, then surely purposefully decreasing the money supply should have been harmful. But, the effects were not so harmful as to seriously postpone a recovery after the initial crash.
On the other hand, to be fair I am not as read up on the “free banker’s” arguments on why banks should expand the money supply to meet demand for money.
Comment by Andrew Lynch on 25 November 2009:
Fantastic article. It’s not so technical that I can’t share it with my mom. I’m also in the middle of reading your Politically Incorrect Guide to the Great Depression…
Terrific stuff. Always look forward to your perspectives.
Comment by Dave true liberal on 2 December 2009:
You do fantastic work Mr. Murphy! I have been studying the 1920 depression and the great depression and you have helped people really understand there are alternatives that perhaps are more efficient when dealing with a depression. The elites just cannot stand doing nothing. Their greed for power and control over the masses just cannot be contained…sadly…
“Fascism entirely agrees with Mr. Maynard Keynes… so far as it goes, serve as a useful introduction to fascist economics. There is scarcely anything to object to in it and there is much to applaud” Benito Mussolini
In a laudatory review of Roosevelt’s 1933 book Looking Forward, Mussolini wrote, “Reminiscent of Fascism is the principle that the state no longer leaves the economy to its own devices.… Without question, the mood accompanying this sea change resembles that of Fascism.”
Comment by Daniel Kuehn on 3 December 2009:
How in the world does waiting three years for substantial deficit spending count as “textbook Keynesianism”????
Hoover isn’t the caricature that a lot of historians make him – I agree with that completely. But this story that Hoover was a Keynesian deficit spender is ridiculous – I don’t know how this meme got started or how it has survived.
Anyway – the main point is 1920-21. Murphy demonstrates that along with Thomas Woods he has no concept of what his opponents advocate. Keynesians argue that fiscal stimulus is only appropriate in a deflationary situation with extremely low interest rates – in other words, in a liquidity trap that create prolonged depression. In 1920 inflation was high and interest rates were high – and the following recession was CAUSED by raising rates and popping the bubble, just like Volcker did in the 1980s. It doesn’t invalidate anything about Keynesianism because Keynesianism doesn’t speak to the 1920 recession, because there was no liquidity trap and no collapse in aggregate demand in 1920!!!!! Keynes predicted prolonged depression that could be remedied by fiscal stimulus under very specific conditions, and those conditions just plain didn’t apply in the U.S. in 1920-21.
This obsession with 1920-21 is bizarre. 1920-21 strongly confirms the monetarist position, and it also is perfectly consistent with the Keynesian position (although somewhat less relevant for the reasons I stated above).
I don’t know why it’s so hard for Austrians/libertarians to comprehend this. You just don’t get it, Murphy.
Comment by joe on 12 December 2009:
so, does anyone have a good counterargument to D. Kuehn?
Comment by cavalier973 on 13 December 2009:
a discussion of the “liquidity trap” concept: http://mises.org/daily/3697
Comment by Jonathan Finegold Catalán on 4 January 2010:
Daniel Kuehn,
I apologize if it seems that I am stocking you! I seem to reply to your posts on Café Hayek, the Ludwig von Mises Institute and now on the Freeman! Admittedly, I have wanted to write a reply for quite some time now, but either never got around to it or completely forgot about it.
First, I am not sure what you are trying to say about Herbert Hoover. That he did not spend as much as Roosevelt, surely not, but to say that he was not a heavy spender and he did not spend in ways which Keynes would later agree with would be patently false. Hoover, up to him, was the greatest peacetime spender in the history of the United States, so let us keep our history straight.
Second, I am not sure what your point is in regard to the depression of 1921. Interest rates were raised after the crash, which absolutely goes contrary to the monetarist position of providing excess liquidity to a shrinking credit bubble. In regards to Keynesian theory, I am not sure you are completely correct in suggesting that Keynesians only support expansionary fiscal policies during a liquidity trap. There is no use regurgitating the same argument I have elsewhere, and so I will not delve further into this particular point (for those unaware, Mr. Kuehn and I are discussing a similar topic elsewhere).
That said, I would definitely be interested in hearing a much better supported version of your argument.
Pingback by Economy Sheds 85,000 Jobs in December | The Freeman | Ideas On Liberty on 8 January 2010:
[...] Timely Classic: “The Depression You Never Heard of: 1920-1921” by Robert P. [...]
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Pingback by The Lesson of Warren Harding Revisited « Mellon's Musings on 23 February 2010:
[...] For America was coming out of World War I. Government was controlling huge swaths of the economy, as it had mobilized land, labor and capital towards war production and away from normal commerce as dictated by consumer demand. In addition to the mass of resources that needed to be reallocated according to market forces, the economy had been further distorted due to the policies of the Federal Reserve which had inflated the money supply by 71% from 1913-1919 (while the physical volume of business had only increased by 9.6%), and whose policies had led to an increase in prices of a staggering 234% between 1914 and 1920. Prices needed to readjust according to the reallocation of resources. In addition, not surprisingly, due to the costs of war, the federal budget had grown to $18.5bn. [...]
Pingback by Links for Federalist Society Debate on the Federal Reserve on 23 March 2010:
[...] Finally, in the talk I alluded to the 1920-1921 depression, in which the federal government cut the budget tremendously and in which the Fed hiked rates to [...]
Pingback by Progressive Pile-Up On the Austrians!! on 8 April 2010:
[...] that when Tom Woods and I cite our favorite counterexample to the monetarists and Keynesians, it is the 1920-1921 depression. [...]
Pingback by Calvin Coolidge - 30th US President on 30 May 2010:
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Pingback by ¿Debilitan los salarios rígidos la defensa de los mercados? - Mises Daily en español on 8 June 2010:
[...] relativamente libre, incluso al afrontar grandes alteraciones en la economía consideremos la depresión de 1920-21. Desde su máximo en junio de 1920, el Índice de Precios del Consumo cayó un [...]
Comment by Jerome on 9 June 2010:
Hi Robert
You are saying ‘The next year [1932], because of Hoover’s desire to close the budget hole, the top income tax rate was 63 percent. Given this extraordinary single-year rate hike, it is no wonder that 1933 was the single worst year in U.S. economic history.’
Indeed the top income tax rate was hiked massively in June 1932. But come on, how can you say that ’1933 was the single worst year in U.S. economic history’? That is either a blatant lie, or just a genuine mistake.
1933 GDP contraction estimates range between -1% and -4% (depending on the USD index you will use). In comparison
In 1932 GDP contracted between -13% and -23%
In 1931 GDP contracted between -6% and -16%
In 1930 GDP contracted between -8.50% and -12%
And surprisingly 1934 GDP expanded between 11% and 17%. If tax rates hikes had such a massive effect, wouldn’t you expect this effect to be long-lasting?
You can check all that here http://www.housingbubblebust.com/GDP/Depression.html
Therefore it would rather seem that hiking top-marginal tax rate have hardly any effect on an economy. This top-marginal tax rate was hiked once again in 1936 to 79% (and indeed there was a dip back into recession in 1937) but then reached 92% and averaged 88% between 1936 and 1980. Was there any other Great Depression? No. Actually quite the contrary. The US managed to build up the very first mass-consumption and mass-production economy in human history. Not only was that the best economy in the world, but the levels of social inequality kept contracting from their top in 1929 to reach a low ebb in the middle of the 1970s. If that is not a success story, I am wondering what it is.
Can you say the same thing about that economy post-1980 when this top-marginal income tax was once again lowered to 22%? A succession of boom and bust has made it what it is today, a complete mess which is dragging the whole world down to hell.
Comment by Jerome on 9 June 2010:
Robert,
Tell me if I am wrong. You are trying to show that thanks to the steep reaction of the authorities, the market managed to reach an equilibrium in 1921, hence the roaring ’20s. Hence you are saying that letting markets act freely is a better solution than intervention (except that you assume they indeed intervened, even though not in a Keynesian way).
But it seems to me that you are not interpreting the chronology correctly. There were a lot of problems in the economy after WWI (and notably a work force overhang created by demobilised soldiers). On top of that the Fed started hiking rates as you said and the Fed Fund reached 7% at the exact same moment where the CPI peaked. From that point the US economy collapsed into this deflationary depression. So first point: you cannot be sure about what would have happened if the Fed had kept from intervening. Not only that was clearly not a free market mecanism, but a Fed-led contraction, but it even seems that this so-called ‘Austrian’ approach itself triggered the problem.
Now what about the roaring ’20s? which you seem to suggest were the great result of the Austrian cleaning mecanism of the 20-21 depression. Well the only problem with that is you forget to specify that the Fed and the government intervened again in 1921 and this time the other way round. They adopted a whole range of Keynesian style measures and you know what? the exact same sort of measure Hoover took 10 years later in 1930 that you are saying prolonged the Great Depression. Wikipedia explains ‘About 300 eminent members of industry, banking and labor were called together in September 1921 to discuss the problem of unemployment. Hoover organized the economic conference and a committee on unemployment. The committee established a branch in every state having substantial unemployment, along with sub-branches in local communities and mayors’ emergency committees in 31 cities. The committee contributed relief to the unemployed, and also organized collaboration between the local and federal governments.’
Fed slashed down interest rates and finally the governement cut down the top-income tax rate from 65% to 22%. All that in 1921, at the very start of the roaring ’20s. If that is not Keynesian, I do not know what that is… Maybe it all ended up in complete catastrophe and I am ready to admit that (same thing happened post-2000). But the fact is that mini-depression is showing nothing specific. The Fed triggered it. And the fed finished it.
Pingback by UCLA: FDR Prolonged the Depression - Page 2 - US Message Board - Political Discussion Forum on 12 July 2010:
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Pingback by A Qualified Defense of Nostalgia « In Between Names on 22 July 2010:
[...] Murphy may feel nostalgic for the Federal Reserve in 1920 (without wanting bring back prohibition and flappers) because he [...]