The 1920-21 depression in the United States was as sharp as it was short. In just three years, production shrunk by a third before rebounding smartly. The drop was almost as savage as that of the Great Depression. Yet the policy response was totally different.

The government of Woodrow Wilson, followed by Warren Harding, cut spending and then cut it some more. The Federal Reserve raised interest rates right up to 1920. This is precisely the opposite of the policy prescriptions recommended today by most economists – which is to spend more and cut rates.

So were Wilson and Harding right, or lucky? And do the early 1920s hold any lessons for today?

During World War I, US government spending ballooned, financed by borrowing and by a compliant Federal Reserve. During the war, the Fed was, in the words of New York Federal Reserve Governor Benjamin Strong: “[the Treasury's] agent and servant”.

By 1919, the war was over, but inflation had surged to an annual rate of 27%. In response, the Wilson administration slashed spending. By November 1919, the federal budget was balanced, with federal spending down an astonishing – by 2012 standards – 75% from its peak.

The Fed had only been established in 1913, so the post-war inflation of 1919-20 was the first test of the new system. Under Governor William P Harding, they set about their inflation-busting task with vigour. The various Federal Reserve banks raised interest rates by 244 basis points over the course of eight months, with rates peaking at 7% in June 1920.

The Fed’s aggressive tightening seems to have yanked the economy to a halt. Output peaked in January 1920 when the Fed raised rates by 1.25% – still the sharpest single rise in the entire history of the system. Employment and output fell slowly at first, then collapsed in the summer after the final rate rise in June 1920.

The word collapse is overused – but it’s entirely appropriate in this case. Production dropped by a third in just over a year. Wholesale prices more than halved. Indeed, the price collapse was probably the biggest the US has seen in its entire history. And the fall in output was second only to the Great Depression.

This severe deflation, combined with high nominal interest rates, meant that real (adjusted for inflation) interest rates were exceptionally high. This led to widespread bankruptcies – farmers who’d borrowed to expand their output in response to high food prices during the war and the inflation which followed found they could no longer keep up with interest payments, as high real rates combined with falling prices for their output made the debts unbearable.

Yet the terrible years of 1920-21 aren’t burned into folk memory in the way that the Great Depression is. Why not? The reason that the 1920-21 depression wasn’t ‘Great’, with a capital ‘G’, is that it was short. The economy went from sickening free-fall to rampant roaring ’20s growth without pausing at the bottom.

And that sudden recovery is what’s sparked so much interest in 1921 today.

These crashes are meat and drink to economists. They don’t have labs in which they can simulate all the variables that go into a real-life economy. So big, unusual events like the 1920-21 depression are the only way to put their theories to the test.

But there’s a lot more at stake here than the pride of a few obscure academics. How we understand and digest these big stories will determine how – and whether – we’ll find a way out of the depression begun in 2008.

And as with everything in economics, there’s a lively debate over this story. In this case, we have the Austrians in one corner, and the monetarists in the other.

For Austrian economists like Robert P Murphy, it’s “almost a laboratory experiment showcasing the flaws of both the Keynesian and monetarist prescriptions”. The recession “purged the rottenness out of the system”, says Murphy, setting the scene for the strong decade of growth that followed. Prices fell in 1921, and then markets cleared – once prices had fallen far enough, demand picked up.

So, then, is liquidation and price discovery the cure for sick economies? Do we ‘earn’ a rebound with a firm crash?

Well, there’s certainly no way to spin this as a Keynesian story. Harding succeeded Wilson as president, and enthusiastically continued where his predecessor left off. He oversaw a further fall in government spending throughout the worst of the depression.

But what about monetary policy? Monetarists (who argue that most booms and recessions we see in the real economy are a result of changes in the price or quantity of money – for example, changes in interest rates) would argue that the economic collapse tracked the Fed’s tightening in 1919 and 1920, and then seemed to relent when the Fed cut rates in mid-1921.

But management of monetary policy can only explain half of the monetarist theory. The other half is the demand for loans in the economy. Monetarists would argue that the economy was ‘running hot’ in 1919, just as was the case years later in 1980.

In other words, demand was high – and it’s easier to hold spending down by tightening monetary policy and imposing fiscal austerity than it is to boost spending when the economy is ‘running cold’. When there is strong demand for loans, a rate-cut from 7% to 4% can massively stimulate the economy. Without sufficient demand, 4% interest rates can be high enough to kill off spending entirely.

So like Paul Volcker’s 1981 war on inflation, the 1920-21 depression was deep and short. And it was both brought on by, and cured by, changes in monetary policy.

Whether 1921 has any relevance today hinges on this question of demand.

In economics, demand is an elusive, theoretical thing – like dark matter. And in the same way that physicists use dark matter to plug holes in their equations, economists need demand to reconcile their theories to reality. For more mainstream economists, the dark matter of demand explains why Fed loosening in 1921 and 1982 created instant growth, but the same trick failed in 1930 and 2009.

Sceptical Austrians don’t rely on such sleights of hand. For Austrians, the economy prospers when markets clear, and markets clear when prices are allowed to adjust. Many see the 1920-21 deflation as a savage ordeal. But for Austrians, that ordeal was necessary to clear markets and it led to years of plenty. And Austrians would argue today that if we’d had a similar collapse post-2008, and had allowed asset prices to find a natural clearing level, rather than bailing out the banks and slashing interest rates, we’d be in a much better state today.

But given that the Fed shows no sign at all of tightening monetary policy any time soon, it doesn’t look like we’ll be getting a chance to test the William P Harding / Warren Harding solution, regardless of how well it might have worked in the ’20s.

Sean Keyes
Contributing Editor, MoneyWeek (UK)

Publisher’s Note: This article originally appeared in MoneyWeek (UK)

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