Monday, December 1, 2014

Is 1921 A Role Model For Modern Macroeconomic Policy?

I am going to join in the piling on of Robert J. Samuelson that Dean Baker and now a few minutes ago my Econospeak colleague, pgl, have been engaging in.  But I want to take this a bit further.

So, the regrettable RJS in today's WaPo has fallen all over himself praising the new book by Jame Grant, _The Forgotten Depression_, which was also recently the subject of much praise at a Cato  Institute Symposium.  A number of economists have pushed Grant's line previously, among them Steve Horwitz, Larry White, and Lee Ohanian, with White participating in the Cato Institute hagiographic orgy, although a bit more on that in a minute.  RJS is completely suckered in, as noted by Baker and pgl.  Even though the non-farm unemployment rate hit 15.3% in 1921, after sharp falls in wages and prices, there was a rapid bounceback, in contrast to the Great Depression and the Great Recession.  Therefore all the claims that the Great Depression was due to trying to adhere to the gold standard are clearly wrong, and modern economists clearly have a "fragile grasp of reality."  If only we had let wages and prices crash in 2009, we would be la la land right now.

Let me look at the bigger picture on all this by comparing more closely the 1920-21 episode with the events immediately following WW II, as well as the Reagan recession of 1982 and our more recent experience.  I would suggest  as a good check on Grant's account, "Three Great American Disinflations," by Michael Bordo, Christopher Erceg, Andrew Levin, and Ryan Michaels, 2007, published by the Board of Governors of the Fed. I shall use numbers and accounts from it.

So, what happened back then?  We were  dealing with a regime shift from a no-gold standard period during WW I to a reimposition of it after the its end, basically a postwar adjustment. The most important actor here is one not mentioned at all in Samuelson's article, and pushed to the remote sidelines by Grant, who is all about wages and prices here, even though usually he is all about interest rates, with his newsletter, Grant's Interest Rate Observer, the basis for RJS calling "a respected financial commentator," (unlike RJS himself, but, hey, Grant does get on TV a lot). 

In any case, the Fed held its discount rate at 4% through 1919, while fiscal policy contracted, but a major  inflation broke out into double digits.  At the end of that year the Fed began to tighten, partly in accord with the reimposition of  the gold standard, and gold had been flowing out of the US quite heavily during 1919.  The discount rate was pushed from 4 to 6 percent, with the commercial paper rate about a point above it moving in tandem roughly.  The response was the deflation (20% decline in overall price level, with wages also falling substantially), along with a 30% decline in industrial production, and the rise of unemployment to 15.3% (funny, but aren't wage declines supposed to obviate laying off workers?).

When all this was hitting the fan hard in 1921, the Fed reversed course and lowered the discount rate back down to 4%.  The economy then went into its rapid rebound.  I note that in his remarks at Cato, at least Larry White did note this point as a caveat on all the proceedings.  Bordo et al also note that both Irving Fisher and also Friedman and Schwartz pinpointed the role of the Fed in all this and declared it to have behaved very irresponsibly in the entire episode.  But for Grant and Samuelson, the Fed barely even existed then.

So, what about these other episodes?  I  shall stay away from the GD, leaving its explanation to be what it long has been, overly strong adherence to the gold standard, with the Fed failing at the most crucial moment in Sept. 1931 as the global financial crash hit the US, pushing the unemployment rate up from 8% at the beginning of the year to a 1921 level of 15% by the end of the year. Of course, reimposing the gold standard was the trigger for the crash of 1921, if not its rebound. In any case, let us look at the other three episodes.

I  think we get a nice test of Grant's argument here.  In none of these, 1945-46, 1982-83, or 2007-10, did we see either deflation or wage declines.  However, in one of them there was only a very brief downturn, one quarter at the end of  WW II; one of them there was a pattern that resembled 1921, a sharp fall in output with sharply rising unemployment, followed by a rapid rebound, the Reagan recession, and then the deep fall followed by the slow recovery in the most recent episode.  What differentiates these?  Well, monetary policy.

At the end of WW II, in contrast to the end of WW I, there was no tightening of monetary policy.  Interest rates remained low through the immediate postwar fiscal contraction.  There was a brief dip, but it went nowhere, and the economy became the postwar boom. We must note that in both of these episodes we are dealing with massive regime shifts with huge changes in expectations.  It was only in 1951 with the Fed-Treasury Accord that we finally observe noticeable interest rate increases.

In the Reagan recession, this clearly was brought on by the extremely tight monetary policy of Volcker that had been put in place to crack entrenched inflation.  Interest rates were well into double digits.  So, when the economy plunged in 1982, pushing the unemployment rate over 10%, there was ample room for the Fed to respond, as it did in late 1982, with substantial cuts in interest rates, which it delivered after Mexico threatened to default on its debts and Reagan held back further rounds of his tax cuts.  The economy indeed rebounded sharply in 1983, giving Reagan his "Morning in America" for taking 49 states in his 1984 reelection. 

But, let us be clear.  This did not happen due to Reagan (or Volcker) allowing any deflation or wage cuts.  This was overwhelmingly a story like 1921 in that the recession was largely brought on by tight monetary policy and ended because of a loosening of that policy.  Neither Grant nor Samuelson provide a whisper of recognition of  this.

Finally, why the slow recent recovery? Well, I think there is more going on, but some of it has indeed been the inability of the Fed to provide much stimulus.  It had lowered interest rates in 2003-04 to help Bush get reelected (oh, and supposedly to avoid falling into a Japanese style deflation), with these being raised a bit a few years later, which contributed to the ending of the housing bubble.  But as that bubble declined they lowered rates prior to the full collapse of the financial sector in September 2008.  When the Minsky Moment arrived, they had had little regular  ammo available and had to resort to extraordinary measures to keep 2009 from becoming 1931, which they succeeded in doing.  But, once those extraordinary measures were removed, there we were, basically stuck at the ZLB, with them unable to provide much further stimulus.

This is a situation not remotely comparable to  1921, and those seriously posing it as an alternative are seriously misguided and misguiding.

Barkley Rosser


ProGrowthLiberal said...

I'm a bit new to the history of what really happened in 1920-21 but as I catch up, it does seem Krugman was writing about this in April 1921 and Daniel Kuehn had an interesting paper back in the fall of 2010 (see my update). I guess neither Grant nor RJ Samuelson bothered to read this research before writing their nonsense. Your post adds to the discussion.

ProGrowthLiberal said...

There is something else bizarre about this Grant thesis that we allowed price deflation in 1921 but not during the Great Depression. Note that from 1913 to 1920, the CPI (base early 1980's = 100) doubled from circa 10 to circa 20 by 1920. During the next couple of years, the Federal Reserve tight money had it drop from 20 to 17 where it stayed until 1929 (tight money ended as you noted). From 1929 to 1933, the CPI dropped from 17 to 13. So what is Grant talking about when he says we did not try deflation. And Friedman and Schwartz noted, monetary policy was too tight. And we got the Great Depression. Yes FDR changed monetary policy as well as fiscal policy and for the next 4 years, we saw recovery. Yes that ended in 1937 when FDR took the fiscal austerians advice - unfortunately. said...


You are on the money, so to say. The argument by the "1921 is the model!" gang really focuses on the period before 1931. It is indeed true that Herbert Hoover resisted calls for wage declines, and Lee Ohanian has been the academic who has probably most strongly made the case that this was important in aggravating the GD. But indeed there was actual deflation during the GD, if not as severe as the sharp decline in 1920-21 that was then partly undone in the bounceback.

However, needeless to say, even Ohanian, and certainly people like Grant, ignore the other things that were going on after 1929 that were not going on during the earlier episode. In particular, other nations were going into sharp declines, largely triggered by the tight money policy in the US under the rules of the gold standard, long the argument of Barry Eichengreen and Charles Kindleberger. This all came to a head in 1931 with the crash of the Creditanstalt bank in Vienna in May 1931, which triggered the ultimate wave of bank failures of all time that moved across the globe, from eastern Europe through Germany and France and Britain, finally reaching the US at the end of the summer. This is why Friedman and Schwartz pinpointed September of that year as the critical moment. The Fed should have loosened its monetary policy all the way, but it basically did nothing, continuing an essentially tight policy, with the result being a massive wave of bank failures (with no FDIC to pay depositers for their lost savings), and the truly horrific plunge into the Full depths of the Great Depression. The whole downward wage stickiness simply falls by the roadside in the face of that catastrophic event, which indeed, Ben Bernanke knew about and set out to avoid in 2008-09, and why he promised Friedman face to fact that under him there would be no repeat of 1931. said...

I have to add two more things. One is there in my post, but I want to really stress it. Both new classical and new Keynesian DSGE models contain assumptions that if wages were to fall, full employment would be maintained, more or less. They even misrepresent Keynes as having made this the basis of his theory, which he most certainly did not. So, the fact that the UR shot up to 15.3% when wages and prices were allowed fo fall sharply really gives the lie to something that is just asserted and assumed repeatedly all over the place.

The other is that Herbert Hoover really does come out looking not so bad, partly thanks to all these people who think that 1921 was the way to go criticizing him. In fact, he was Commerce Secretary under Harding, and while it has not been widely advertised (supposedly there was no fiscal stim in 1921), by the end of 1921 there was in fact an increase in public works spending coming down that was driven by Hoover. So, the bounceback from the 1921 decline was aided by both fiscal and monetary policy stimulus, which you do not hear from Grant or any of these others.

Indeed, Hoover attempted fiscal policy after 1929, mostly for investment in airports and dams (they do not call it the Hoover Dam for nothing), but he was somewhat held back by Congress, and, ironically, FDR criticized him for his deficit spending and ran on a balanced budget platform, much as did Reagan in 1980, only to abandon it once in office as did Reagan. This is all a bit more complicated than many like to acknowledge.

ShaunP said...

There was a time when I really found Grant persuasive. I subscribed to his newsletter for years, but I finally woke up eventually when I became more knowledgeable. The guy is a con man and one of the smartest morons you will ever read. You will lose lots of money if you take his advice.

Nick Rowe said...

Barkley and PGL: good posts. I decided to add my twopenceworth: said...

Thanks, Nick.

Hope you did not lose too much money paying attention to Grant, Shaun P.

João Marcus said...

A "monetary history" of the period:

Sandwichman said...

Not only was Hoover Commerce Secretary under Harding, he was also chairman of Harding's Conference on Unemployment that proposed a full range of "remedies for the business cycle" including unemployment insurance, counter-cyclical spending on public works, improved economic statistics and responsive monetary policy.

The conference report, edited by Wesley C. Mitchell, could even be regarded as somewhat of a prophetic blueprint for the New Deal policies of public works and economic stabilization.

This history raises the question of to what extent the "signaling" from the Harding Conference may itself have been an element in the restoration of business confidence.

Bruce Wilder said...

Barkley Rosser makes an important point, highlighted in his subsequent comment, regarding the relationship between falling wages and employment.

One thing I've never understood about the Ohanian argument regarding the Great Depression is how a period of high unemployment and falling wages was going to get the economy to full-employment, if the only full-employment equilibria available were at higher wages and labor incomes in manufacturing industry. Unemployment is an unrelenting pressure in the wrong direction, at least for the 1930's.

I think it is at least somewhat plausible that, after the run-up in wages (and farm incomes) during WWI that subsequent peacetime full-employment equilibria were available at lower wage levels in the return to normalcy.

In any case the policy in 1921 was a political decision to redistribute income at labor's expense. And, the subsequent choice to offer cheap credit rather than wage increases as a means of creating effective demand for the expanding industrial output of the 1920s New Economy contributed to the conditions that made the debt-deflation of the Great Depression possible.

In the context of the 1930s, a critical problem was that the only conceivable full-employment equilibria were probably at a higher industrial wage level. High unemployment is a blunt policy instrument pressing down wages, when all the solutions require higher wages. Reducing wages was not a feasible path to growth or full-employment in the 1930s U.S.

It is a significant tell, I think that the con-men selling the 1921 model like to refer to the subsequent boom of the 1920s, as if there was one. In fact, the 1920's U.S. economy was highly unstable:there would be two more business cycles completed between 1921 and 1929; it was a very bumpy ride, despite the proliferation of the revolutionary technologies of the New Economy of autos and electricity and mass-production processes and agricultural revolution.

media said...

This is irrelevant but here we go

1. My mom now lives with her old college friend (u chicago)---he was the son of a small town banker, she was from a family associated with the most elite one room unheated unelectrified school house in n dakota (and they lost their 40 acre homsestead eventually to the bank) . They both go to Obama's church in hawaii (he moved there cuz he had a chance to experience warm weather year round). He manages stocks for others and gets Grant's newsletter. I looked at it when i visited (payed my way too) in between falling off hawaii's mountains---he was advocating buying cigarette stocks last one i saw.

2. I saw a Samuelson column recently (at thanksgiving since i dont get newpapers) (some people think he is the ex-MIT economist who had some nice papers in PNAS in the 70s and random walk i thought was ok). He said according to a new OECD report the US is number 2 after France in terms of being the biggest 'welfare state'. My view is that means he is talking about himself---write a paragraph once a week and get paid in full. I just wonder how they do these calculations. Medicaid for example i think is treated as income, but it may go in your pocket and then go right out into the health care system's pockets, which often are unequal---nurses and technicians i met were often complaining and such, but that might not be the case for JHU adminstrators and others who just bought the hospital . (Of course they redistribute some to dope addicts in Mobtown (B(e)More!)willing to work as guinea pigs (i used to do that until i realized i had imprinted wrongly in school, and was actually a hamster better suited to spinning wheels). 'please prove you're not a robot' said...

Thanks, Bruce.


On Samuelson's silly column, see my post about it just a few before this one. I think I make pretty good mincemeat of it.