Does The 1920-21 Recession Really Prove That Laissez Faire Saves Us From Recessions?

A major meme among those championing a "do nothing" policy in the face of the recession since 2008 has been how short, if sharp, the 1920-21 recession was. We hear from various sources that prices and wages were flexible, and that President Harding did nothing, with the economy just magically bouncing back all on its own. In contrast, Herbert Hoover is blamed by this crowd for having big business and labor leaders getting together in 1929 to hold the line on wages, thus supposedly bringing about the Great Depression. The problem with all this is that the story about what happened in 1920-21 is largely wrong.

It was indeed an odd recession, with 1920 being the year of maximum demobilization of troops from WW I putting pressure on the labor market, and with a series of inventory adjustments from the end of the war also hitting. This led to the largest one year decline in the price level in US history, somewhere between 13 and 18%, depending on one's source. But in contrast to the story that gets handed out, there was no comparable decline in wages, according to the one source I could find, the National Industrial Conference Board. Wages rose slightly, and did so again in 1921, the worst year of the recession, when the unemployment rate peaked in July of that year. It is true that finally in 1922, wages fell by 8% before returning to rising in the following year, but the turnaround had come already in late 1921.

Now it is true that there was no stimulus from fiscal policy to pull the economy up, this part of the story about Harding being true. As nominal GDP declined from $88.4 billion in 1920 to $73.6 billion in 1921 and then $73.4 billion in 1922 (but real GDP rising in that year as deflation continued), federal spending declined from $11.4 billion in 1920 to $10.5 billion in 1921 and $9.3 billion in 1922.

However, there was another element at work, largely ignored by those touting the policies of Harding in all this, monetary policy. Indeed, Friedman and Schwartz were critical of what went on at that time, ascribing it to inexperience on the part of the Fed policymakers, who had only gotten their operation going in 1913. So, the Fed started raising its discount rate in late 1919, with it reaching 7% in June, 1920, this a year of major deflation. Big surprise the economy tanked. They started changing course in July, 1921 the month of the highest unemployment rate, lowering by a half point per month until it reached 4.5% in November, 1921. So, Harding may not have had a stimulative fiscal policy, but he certainly was in office when the Fed responded with a stimulative monetary policy, which played a key role in ending this recession, one in which real wages had soared rather than declining as the price level plunged, in contrast to the stories being spread about now.