Monday, November 8, 2010

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.


Jazzbumpa said...

The depressions of 1920-21 and 1929-on occurred in very different circumstances. My cursory check uncovered this list:

1920 preceded by large deficits, 1929 preceded by surpluses.

1920 preceded by high inflation,
1929 preceded by no inflation.

1920 preceded by war,
1929 preceded by peace.

1920 depression possibly softened by export strength.
1929 ???

1920 evidently not near the 0-interest rate bound,
1929 probably approaching it.

1920 gold standard not in force, 1929, gold standard in force.

During the 1920-1 depression, deflation was a local U.S. phenomenon. Europe was experiencing inflation, and Austria had hyperinflation.

In the 1929 depression, deflation was a nearly world-wide phenomenon.

Every bit of this gets ignored by Austerians and New Deal denialists.

Some of this is probably more important than the rest. I find the gold facts to be especially intriguing. There are probably more differences than can be discovered 20 minutes of fumbling around on the intertubes. That's
about how log this took.

They're now making the same claims about post WW II, too, BTW.


Shag from Brookline said...

To what extent did the lack of financial regulation during the 1920s contribute to Hoover's 1929? If 1922-28 were the good old days, for whom were they the good old days? What did income inequality look like in those good old days?

Jazzbumpa said...

Shag - the regulation put in during the depression were a reaction to the non regulation of the 20's.

For income disparity, check here and scroll down to the top 1% Income share chart.

In those respects, the 20 were a lot like the past decade.

Th major fundamental difference between 20-21 and the GD is that 20-21 was caused by excess supply of goods, services and labor - the post hints at this - while 29 on was a failure of aggregate demand just like now.

Denialists refuse to recognize that context matters, and policy needs to change with circumstances.


Jazzbumpa said...

Here's the link for income inequality.

Scroll down to 2nd graph.


Daniel said...

Hi Barkley - you might be interested in a paper of mine that recently got accepted to the Review of Austrian Economics on the 1920-21 downturn:

As I mentioned on Coordination Problem, all the evidence I had when writing this suggested declining wages over this period (although as you note, the decline still wasn't as sharp as the price decline). Enjoy.

Lord Keynes said...

A fascinating post.
Over how many sectors of the economy does the wage data you refer to cover? (in the National Industrial Conference Board data)

Here is my take on the recession of 1920-1921:

MH said...
Barkley Rosser,
I just finished reading this book. I don't see any increase of wage rates.
Oh, and about discount rate.

Chili Dogg said...

You mention the decline in interest rates and claim they were important in ending the depression. However, I have read that the interest rates were high (6-7%) until the middle of 1921, and then they dropped a little each month after that. Given that the depression was over in August 1921 (if I remember correctly), it's hard to see how dropping interest rates would have had any significant effect. Please correct me if I am wrong.