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