The estimable Miles Kimball emails that after http://www.wsj.com/articles/the-depression-that-was-fixed-by-doing-nothing-1420212315 he wonders whether 1920-1921 is not perhaps worthy of more attention.
I agree that it is a very interesting episode: it appears to be the only time in American history in which significant deflationary pressure did not produce a prolonged, deep, grinding slump. Certainly we see a prolonged, deep, grinding slump today; we saw one in the 1930s; and we think we see one back in the Jacksonian era with Jackson’s war on the Second Bank of the United States.
But I do not think it has any lessons at all for us today. It came just after the World War I inflation had boosted the price level and eroded the economy’s debt levels. Thus there was no chance of Fisherman debt-deflation or Koovian balance-sheet recession forces taking hold. And the fact that the run up in wages has been so recent meant that downward wage stickiness was effectively nil. Thus that nominal rigidity that turns a fall in nominal demand into a fall in real production and then to the flight of the Confidence Fairy in the face of general depression was simply absent.
David Frum has just had some smart things to say about this episode:
From David Frum: “The Real Story of How America Became an Economic Superpower”
http://www.theatlantic.com/international/archive/2014/12/the-real-story-of-how-america-became-an-economic-superpower/384034/?single_page=true:
Periodically, attempts have been made to rehabilitate the American leaders of the 1920s. The most recent version, James Grant’s The Forgotten Depression, 1921: The Crash That Cured Itself, was released just two days before The Deluge: Grant, an influential financial journalist and historian, holds views so old-fashioned that they have become almost retro-hip again. He believes in thrift, balanced budgets, and the gold standard; he abhors government debt and Keynesian economics. The Forgotten Depression is a polemic embedded within a narrative, an argument against the Obama stimulus joined to an account of the depression of 1920-21.
As Grant correctly observes, that depression was one of the sharpest and most painful in American history. Total industrial production may have dropped by 30 percent. Unemployment spiked at perhaps close to 12 percent (accurate joblessness statistics don’t exist for this period). Overall, prices plummeted at the steepest rate ever recorded—steeper than in 1929-33. Then, after 18 months of extremely hard times, the economy lurched into recovery. By 1923, the U.S. had returned to full employment.
Grant presents this story as a laissez-faire triumph. Wartime inflation was halted. Borrowing and spending gave way to saving and investing. Recovery then occurred naturally, without any need for government stimulus. ‘The hero of my narrative is the price mechanism, Adam Smith’s invisible hand,’ he notes. ‘In a market economy, prices coordinate human effort. They channel investment, saving and work. High prices encourage production but discourage consumption; low prices do the opposite. The depression of 1920-21 was marked by plunging prices, the malignity we call deflation. But prices and wages fell only so far. They stopped falling when they become low enough to entice consumers into shopping, investors into committing capital and employers into hiring. Through the agency of falling prices and wages, the American economy righted itself.’ Reader, draw your own comparisons!
Grant’s argument is not new. The libertarian economist Murray Rothbard argued a similar case in his 1963 book, America’s Great Depression. The Rothbardian story of the ‘good’ depression of 1920 has resurfaced from time to time in the years since, most spectacularly when Fox News star Glenn Beck seized upon it as proof that the Obama stimulus was wrong and dangerous. Grant tells the story with more verve and wit than most, and with a better eye for incident and character. But the central assumption of his version of events is the same one captured in Rothbard’s title half a century ago: that America’s economic history constitutes a story unto itself.
Widen the view, however, and the ‘forgotten depression’ takes on a broader meaning as one of the most ominous milestones on the world’s way to the Second World War. After World War II, Europe recovered largely as a result of American aid; the nation that had suffered least from the war contributed most to reconstruction. But after World War I, the money flowed the other way.
Take the case of France, which suffered more in material terms than any World War I belligerent except Belgium. Northeastern France, the country’s most industrialized region in 1914, had been ravaged by war and German occupation. Millions of men in their prime were dead or crippled. On top of everything, the country was deeply in debt, owing billions to the United States and billions more to Britain. France had been a lender during the conflict too, but most of its credits had been extended to Russia, which repudiated all its foreign debts after the Revolution of 1917. The French solution was to exact reparations from Germany.
Britain was willing to relax its demands on France. But it owed the United States even more than France did. Unless it collected from France—and from Italy and all the other smaller combatants as well—it could not hope to pay its American debts.
Americans, meanwhile, were preoccupied with the problem of German recovery. How could Germany achieve political stability if it had to pay so much to France and Belgium? The Americans pressed the French to relent when it came to Germany, but insisted that their own claims be paid in full by both France and Britain.
Germany, for its part, could only pay if it could export, and especially to the world’s biggest and richest consumer market, the United States. The depression of 1920 killed those export hopes. Most immediately, the economic crisis sliced American consumer demand precisely when Europe needed it most. True, World War I was not nearly as positive an experience for working Americans as World War II would be; between 1914 and 1918, for example, wages lagged behind prices. Still, millions of Americans had bought billions of dollars of small-denomination Liberty bonds. They had accumulated savings that could have been spent on imported products. Instead, many used their savings for food, rent, and mortgage interest during the hard times of 1920-21.
But the gravest harm done by the depression to postwar recovery lasted long past 1921. To appreciate that, you have to understand the reasons why U.S. monetary authorities plunged the country into depression in 1920.
Grant rightly points out that wars are usually followed by economic downturns. Such a downturn occurred in late 1918-early 1919. ‘Within four weeks of the … Armistice, the [U.S.] War Department had canceled $2.5 billion of its then outstanding $6 billion in contracts; for perspective, $2.5 billion represented 3.3 percent of the 1918 gross national product,’ he observes. Even this understates the shock, because it counts only Army contracts, not Navy ones. The postwar recession checked wartime inflation, and by March 1919, the U.S. economy was growing again.
As the economy revived, workers scrambled for wage increases to offset the price inflation they’d experienced during the war. Monetary authorities, worried that inflation would revive and accelerate, made the fateful decision to slam the credit brakes, hard. Unlike the 1918 recession, that of 1920 was deliberately engineered. There was nothing invisible about it. Nor did the depression ‘cure itself.’ U.S. officials cut interest rates and relaxed credit, and the economy predictably recovered—just as it did after the similarly inflation-crushing recessions of 1974-75 and 1981-82.
But 1920-21 was an inflation-stopper with a difference. In post-World War II America, anti-inflationists have been content to stop prices from rising. In 1920-21, monetary authorities actually sought to drive prices back to their pre-war levels. They did not wholly succeed, but they succeeded well enough. One price especially concerned them: In 1913, a dollar bought a little less than one-twentieth of an ounce of gold; by 1922, it comfortably did so again.
James Grant hails this accomplishment. Adam Tooze forces us to reckon with its consequences for the rest of the planet.
Every other World War I belligerent had quit the gold standard at the beginning of the war. As part of their war finance, they accepted that their currency would depreciate against gold. The currencies of the losers depreciated much more than the winners; among the winners, the currency of Italy depreciated more than that of France, and France more than that of Britain. Yet even the mighty pound lost almost one-fourth of its value against gold. At the end of the conflict, every national government had to decide whether to return to the gold standard and, if so, at what rate.
The American depression of 1920 made that decision all the more difficult. The war had vaulted the United States to a new status as the world’s leading creditor, the world’s largest owner of gold, and, by extension, the effective custodian of the international gold standard. When the U.S. opted for massive deflation, it thrust upon every country that wished to return to the gold standard (and what respectable country would not?) an agonizing dilemma. Return to gold at 1913 values, and you would have to match U.S. deflation with an even steeper deflation of your own, accepting increased unemployment along the way. Alternatively, you could re-peg your currency to gold at a diminished rate. But that amounted to an admission that your money had permanently lost value—and that your own people, who had trusted their government with loans in local money, would receive a weaker return on their bonds than American creditors who had lent in dollars.
Britain chose the former course; pretty much everybody else chose the latter.
The consequences of these choices fill much of the second half of The Deluge. For Europeans, they were uniformly grim, and worse…
From Barry Eichengreen, Golden Fetters:
Economic activity in the industrial countries spiralled downward from the early months of 1920 through the summer of 1921. In July the U.S. economy bottomed out, and by autumn expansion was again underway. No extended recession occurred to impress upon observers the dangers of the policies pursued. Consequently, leading lights within the Federal Reserve System embraced the policy of liquidation. They inadequately recognized the capacity of a policy driven by the imperatives of the gold standard to destabilize the economy. They did not understand the extent to which the pattern of international settlements had come to hinge on foreign lending by the United States. Although the 1920–21 slump revealed that the policy of liquidation could have powerful macroeconomic effects, the economy rebounded quickly and expanded strongly thereafter. Some observers drew the conclusion that the purging of excesses had been quite salutary and urged its repetition on the next occasion, 1928–29, when speculation was again viewed as excessive.
What they failed to appreciate was that a set of very special circumstances was responsible for the U.S. economy’s rapid recovery from the 1920–21 recession. An unusually good harvest in 1921 cushioned the economy’s decline, reducing the prices of the raw materials that served as inputs into a variety of U.S. industries. Even more basically, the policy environment differed fundamentally from that of 1929. With their exchange rates floating against the dollar in 1920–21, European countries were not compelled to follow the Fed in lockstep. Germany, entangled in the international dispute over reparations and unable to put its fiscal house in order, did not mimic the restrictive policies of the United States. The German economy continued to operate under intense demand pressure, causing the mark to depreciate but at the same time moderating deflationary tendencies worldwide. In 1929, having restored the gold standard, Germany would not enjoy the same independence. What was true for Germany was true as well for other countries with depreciating currencies, notably Poland and Austria, both of which managed to largely avoid the effects 1920–21 slump.
Other industrial countries, more successful in avoiding high inflation and more committed to restoring their prewar gold standard parities, felt more pressure to follow the United States. Still, with their exchange rates floating, they could do so at a distance. The United Kingdom was the principal country to capitalize on her freedom to maneuver, allowing sterling prices to fall more slowly than dollar prices through the first half of 1921. As a result, sterling depreciated against the dollar, before making up the lost ground after production had stabilized in the second half of 1921. Sweden similarly pursued less deflationary policies than the United States through the middle of 1921, allowing the krona to weaken against the dollar before reversing the trend once recovery had begun.
The European response had important implications for the United States. From the beginning of 1921 the Fed was on the receiving end of a massive gold inflow. Its reserve ratio rose rapidly, relaxing the constraint on discount policy. German, Austrian, and Polish inflation and the volatility of sterling propelled gold toward the United States. So did the relatively high pressure of demand under which the British and Swedish economies continued to operate. Thus, the refusal of Germany, Austria, Poland, Britain, and Sweden to fully match the restrictive policies implemented in the United States not only moderated the contraction of their own economies but allowed the Fed to reverse course earlier than it could have otherwise. The U.S. recession bottomed out quickly; economic growth resumed. The policy of liquidation, Federal Reserve officials concluded, had only salutary effects. What they failed to realize was that the success of the policy had been contingent on the foreign reaction, a reaction that was possible only because the gold standard had not yet been restored. The situation would be entirely different when recessionary tendencies once again became evident in 1929…
And:
The Fed was determined to eliminate redundant money and credit so that speculative excesses would not recur. The policy came to be known as “liquidation.” In December 1920, the Federal Reserve Board rejected the option of discount rate reductions on the grounds that they threatened to provoke renewed speculative excesses. The following February officials of the New York Fed warned that lower interest rates would provoke an orgy of “wild speculation.” In March the newly appointed Treasury Secretary Andrew Mellon began to lobby for lower rates, but members of the Federal Reserve Board and governors of the New York Fed again warned of the danger of provoking unhealthy stock market speculation. In April the Board rejected similar proposals for similar reasons.
The feeling grew in Washington that the New York Fed lay behind the resistance to reduce interest rates. Mellon and other political appointees intensified their pressure on Benjamin Strong, President of the New York Fed. By May Strong withdrew his resistance in the face of this pressure, and rates were finally reduced. A more immediate concern motivating the maintenance of high discount rates was continued preoccupation with the level of the gold reserve. Although the Fed’s gold cover ratio stopped falling in May, it recovered little through the end of the year. It is hardly surprising that the reserve banks failed to reduce their discount rates significantly until the cover ratio had risen more than marginally above the statutory minimum. If the public attempted to redeem the more than $3 billion of Federal Reserve notes in gold, convertibility would have had to be suspended.
Besides magnifying this risk, a low cover ratio could have other adverse consequences. Aspirations to elevate the dollar to key currency status would have been dealt a blow. Unless the stability of the dollar price of gold remained beyond question, foreign central banks would refuse to hold their exchange reserves in New York. Maintaining high discount rates was viewed as necessary to cement America’s role in the gold standard system. Subsequent observers, with benefit of hindsight, criticized as exaggerated these fears of a short‐run threat to convertibility and a long‐run challenge to the dollar’s key currency status.
But even officials who remained skeptical of the immediacy of the threat saw other reasons to support the policies designed to reduce prices and wages. For example, other countries had already announced their intention to restore the status quo ante. If they reduced wages and prices to 1913 levels while the United States did not, the competitive position of American industry would be eroded. In retrospect, this seems a curious preoccupation. American producers were in an exceptionally strong position relative to their European competitors. A higher level of prices in the United States might have produced gold losses in the short run, but it would have permitted the Europeans to pursue less deflationary policies, which itself would have minimized the Fed’s loss of reserves. The more expansionary posture internationally would benefit all countries. The insular approach of American monetary policymakers reflected their incomplete appreciation of the influence they now exercised over the stance of policy abroad.
Viewed from a longer‐run perspective, however, the American preoccupation with reducing prices was not entirely without logic. Officials within the Federal Reserve System justified it by referring to the danger of a global gold shortage. Little gold had been mined in the course of the war or in the immediate postwar years, and gold production had fallen steadily since 1915. Wartime disruptions to international markets could account for the initial decline in supply but not for the failure of gold production to recover subsequently. Disorganized conditions in Russia played a role, but the principal factor blamed for depressing mining activity was the rise in wage rates and other production costs relative to the fixed dollar price of gold.
Admittedly, gold no longer traded in London at the official price but at higher prices that reflected sterling’s depreciation against the dollar. But the London gold premium incorporated only depreciation of the British currency, not the American inflation. Heightening the danger created by the decline in the supply of newly mined gold was the prospect that the demand would expand rapidly as the world economy recovered. Once countries returned to the gold standard, the demand for yellow metal would rise further. The point was underscored by American and European gold losses in 1919–20 to other parts of the world. Various expedients were proposed, including subsidies for gold production, taxes on gold used for nonmonetary purposes, and reliance on foreign exchange to supplement the gold reserves of central banks. But the only lasting solution was to engineer a decline in price levels, which would increase the real value of existing gold reserves and, by raising real gold prices, enhance the incentive to augment them.
The American recession exerted a powerful influence over the rest of the world. During the boom, the United States had exported capital, fueling money and credit expansion in Europe. American capital exports in 1919–20 (principally trade credits channeled through London) exceeded the amount of lending the United States engaged in during any other two years of the interwar period. Despite the European clamor for U.S. goods, American import demands had been sufficiently strong that the United States had been a net exporter of gold. From the end of 1920, the process operated in reverse. American lending fell off, as shown in Figure 4.5. The United States began to attract gold from the rest of the world on a massive scale. Except insofar as they were willing to permit their currencies to depreciate, other countries were forced to initiate restrictive measures to offset this balance‐of‐payments shock. U.S. foreign lending and the gold and foreign exchange reserves of the Federal Reserve System fluctuated inversely throughout the 1920s, reserves rising when foreign lending fell and vice versa.
