A Question on the Causes of the Recession of 1920-21

Economics Economics Questions
1

I wrote the below to a couple of professors on the matter and wanted to get the opinions of those in the Mises community:

"In doing my research, it appears as if there is a split for example between Professor E.W. Kemmerer and Benjamin Anderson on the causes of the boom. As you have indicated and as is clear objective fact, money and credit increased significantly between 1913 and 1920. Kemmerer believes this is the primary reason that we saw terrible price inflation. Anderson on the other hand argues that while monetary inflation certainly amplified the artificial boom, the real problem was our out-of-whack export balance with Europe. Would we have been able to have such a one-side export trade were it not for the Federal Reserve-induced increase in money and credit? Was this export balance a mere symptom of government intervention, or is there some other cause at root?

Obviously, the whole reason for the distortions and imbalances in the economy is policies implemented in the war effort, part-and-parcel tied to the increase in money and credit, but given that Anderson seems to consider the expansion of money and credit as a secondary factor in the boom-bust cycle, I was wondering if you could briefly comment on this."

Thanks all!

2

Benjamin Anderson refers to this export balance and the outflow of gold on page 74. I think he suggests that these were the direct catalysts for the crash. It is compatible with Professor E.W. Kemmerer’s views (I do not know his views, so I am basing this conclusion on what you have presented). In the beginning of the chapter (chapter 7) he does suggest that the expansion of the monetary base had everything to do with the crash of 1920:

The quantity theory of money is invalid. It was clear as early as May 1919 that the boom was thoroughly unsound, that the commodity prices prevailing were dangerously high and very precarious, and that the longer the boom lasted, the more violent the rea ction would be.

He does, however, say that monetary reasons were secondary. Benjamin Anderson is not infallible. His conclusion would similar to saying that the crash of 1929 had more to do with the uncertainty created by the passage of the Smoot-Hawley tariff through legislation (although it was not signed as law until June 1930) than with monetary expansion. But, upon objective analysis you can see how Anderson’s opinions can work together with the opinion that the crash was entirely based upon credit expansion.

In Money, Bank Credit and Economic Cycles, Jesús Huerta de Soto suggests that the crash will occur when either credit stops expanding at an accelerating rate, or when it stops altogether. Benjamin Anderson’s explanation of the outflow of gold, I think, coincides. He says that there was a decrease in the monetary base, which makes sense within the Austrian framework of credit and capital. So, they are both, in a sense, right.

3

Jonathan,

I appreciate the response. I suppose that while the increase in money and credit does underly both arguments, the export imbalance was still caused by government tinkering, which did have the effect of undermining the quality of our money and credit. This does mesh with ABCT.

Still I must say that this is not quite as cut-and-dry an issue as the causes of the Great Depression or our current struggles.

4

Jonathan,

I appreciate the response. It seems to me that regarding the artificial boom, the increase in money and credit is a definite factor on both sides. If we consider the export balance as an outgrowth of government tinkering, then this still is consistent with the ABCT. As you say, perhaps like Smoot-Hawley it merely exacerbated a problem that was already brewing.

Nevertheless, it does not seem as elegant an answer as that to the causes of the Great Depression or our current downturn.

As for the bust, on all sides there is agreement that prices needed to fall and the economy restructure, and thus there was a forced liquidation caused by a raising of rates back to near their natural position, and a massive decrease in government expenditure.

Thanks again for your input.

5

I do not think that Benjamin Anderson was as “hard Austrian” as many more “modern” Austrian scholars. At the time, the Mises’ theory was still in its infancy. Benjamin Anderson was influenced by Mises’ Theory of Credit and Money, but it is clear that in Economics and the Public Welfare he does not take an Austrian approach in the same way that a modern Austrian might take it. But, like I mentioned above, I think that Anderson’s comments have to be carefully interpreted. I think he suggests that this trade imbalance, and outflow of gold, was a direct catalyst. I think that it is clear from his writings, and with a more complete understanding of Austrian monetary theory, that the real underlying cause was monetary expansion. That sudden contraction is what sparked the malinvestments to actually show themselves.

There have been two recentl articles on this recession that I know of:

Woods Jr., Thomas E., The Forgotten Depression of 1920. Ludwig von Mises Institute. 27 November 2009.

Total bank deposits more than doubled between January 1914, when the Fed opened its doors, and January 1920. Such artificial credit creation sets the boom–bust cycle in motion. The Fed also kept its discount rate (the rate at which it lends directly to banks) low throughout the First World War (1914–1918) and for a brief period thereafter. The Fed began to tighten its stance in late 1919.

Economist Gene Smiley, author of The American Economy in the Twentieth Century, observes that “the most common view is that the Fed’s monetary policy was the main determinant of the end of the expansion and inflation and the beginning of the subsequent contraction and severe deflation.”[12] Once credit began to tighten, market actors suddenly began to realize that the structure of production had to be rearranged and that lines of production dependent on easy credit had been erroneously begun and needed to be liquidated.

Murphy, Robert P., The Depression You’ve Never Heard of: 1920-1921. The Freeman. December 2009.

At the conclusion of World War I, U.S. officials found themselves in a bleak position. The federal debt had exploded because of wartime expenditures, and annual consumer price inflation rates had jumped well above 20 percent by the end of the war.

To restore fiscal and price sanity, the authorities implemented what today strikes us as incredibly “merciless” policies. From FY 1919 to 1920, federal spending was slashed from $18.5 billion to $6.4 billion—a 65 percent reduction in one year. The budget was pushed down the next two years as well, to $3.3 billion in FY 1922

Unfortunately, not much on its causes.

6

Jonathan,

On Anderson, I agree, especially having read some of his other pieces (albeit during the same era) in the Chase Economic Bulletin. Indeed, while Anderson refutes that the increase in money and credit was the main cause, overall his interpretation is that the war threw the economy out of whack, and that government intervention kept alive many unsustainable business lines and contributed to the artificial boom and bust. He agrees that the necessary liquidation involved deflating the money supply to properly restructure the economy.

On Woods and Murphy, they both certainly seem to be of the opinion that the problems of the day were quite simply caused by a massive increase in money and credit from the inception of the Federal Reserve to the bust, accompanied by unsustainable government spending that continued after war ended. Their interpretation seems very clean, and I tend to think it accurate, especially given that many other economists and even bank executives of the day agreed that the major cause of the US’ ills was monetary inflation.

I just found it striking that Anderson, a contemporary of the Austrians and one generally in agreement with them failed to point to the fundamental cause of an increase in money and credit, and in thoroughly producing my paper, want to take into account the various viewpoints presented.

One of the refreshing parts of my study has been the fact that in the post-war years, most of the people in the economics community were not deceived by the ridiculous Krugman claptrap and honestly looked at root causes as opposed to symptoms of our policies.

7

This is pretty basic macroeconomics, actually. In almost any principles of macro class, you should learn that a loose monetary policy causes net exports to increase, because investors will borrow money from the loose monetary policy country and invest in tighter monetary policy countries and because a devalued currency lowers the prices of goods in one country relative to the prices of goods in countries with tighter monetary policies.

8

That certainly makes sense but it is important to note that all countries had been devaluing their currencies during this time period, probably mitigating the impact of the carry trade and the extent of the trade imbalance. Nevertheless, I am sure it was one of the factors driving this trade, in addition to government financing of this trade with Europe.

9

It seems to me that almost anything can cause malinvestment. There’s the time preference aspect, but also the balance of goods/services aspect. However, I can only see how the former can cause a crash as we know it.

10

I think the key behind Anderson’s explanation is the decrease in the supply of gold.

11

Because gold was the reserve of the time? IIRC that is what Greenspan said about the GD as well.

12

Specifically because of the contraction which took place in 1920 which tightened the money market. In regards to the Great Depression, I’m not sure when gold began to leave the U.S.; if I interpreted correctly from Garet Garret’s The Bubble That Broke the World this occured after the initial 1929 crash. In regards to the direct events which catalyzed the 1929 crash, even Rothbard is very ambiguous. I wrote a critique of one of Krugman’s blog posts on protectionism before and during the Great Depression, and I touched on this point ( Did Protectionism Cause the Great Depression? ) :

The Austrian theory of the trade cycle dictates that a boom will end in three different ways: a slowing of the credit expansion, a cessation of the credit expansion or hyperinflation.[6] Although Austrian analyses of the Great Depression have accurately portrayed the rise in the supply of credit between 1922 and 1928, few (to none) actually pinpoint the series of events which directly catalyzed the market crash of October 1929. It is possible that business uncertainty depressed investment, thus borrowing, leading to a slowing in the expansion of credit. Certainly, this theory deserves a closer and objective look.

I have not been able to take a complete look at Friedman and Schwartz’ A Monetary History of the United States (I did use it for some continued research on the 1937 recession, but have not read it in full). Where did Greenspan make that comment?

13

Very simply, it was the Fed and the end of WWI, which had propped up an artificial war economy.

14

Don’t forget the fact that during the war the demand for US goods rose enormously for obvious reasons, industry in Europe was under heavy command-style economic policy and completely diverted over to war planning boards. In the years after the war was over European industries retooled back to peace time production the demand for US goods dropped. We can safely say then that panic of 1920-21 was caused not only by government monetary inflation, but also the temporary removal of competing industries in other parts of the world. In short, the division of labor was hampered and disrupted, but as we all know, was sorted out in due time without much interference from the state.