What (if anything) can we learn from 1921?
By Scott Sumner
There has a been a recent flurry of blog posts on the 1921 depression–especially why it was so much less severe than the Great Depression. One unfortunate aspect of the dispute is that it has become linked to a misleading ideological debate over the role of government. Thus libertarians are often seen as pointing to the quick recovery from the 1921 depression as an example of why an activist government is not needed. Liberals then respond that the libertarians have mischaracterized what actually happened.
I happen to think the 1921 depression does have a few libertarian-friendly implications, but not necessarily the same ones that others have been pointing to. So first let me explain where I am a bit uncomfortable with the libertarian position (and equally uncomfortable with the Keynesian response.)
Many people wrongly believe that the ideological debate over small government is somehow linked to the debate over stabilization policy. Thus supporters of small government sometimes argue that a free market economy will recovery from a recession on its own, whereas big government proponents like Paul Krugman are equally dismissive of those claims. That’s not really a meaningful debate, at least in the context of 1921 and the 1930s. In both cases we had a Federal Reserve conducting monetary policy. The choice was not between more or less monetary policy, but rather more or less expansionary monetary policy. Not more or less, but different.
There is no generally accepted notion of a passive central bank. A central bank that is not changing interest rates at all, may be very actively changing the monetary base, and vice versa. Or the exchange rate. There are an almost infinite number of potential indicators of the stance of monetary policy. Arguing that one central bank is more active than another is like arguing that a captain that sets his steering at ENE is more actively steering the ship than one who sets the wheel at NNE. The policies are simply different. This debate should have nothing to do with ideological disputes over the role of government in spending, regulation and nationalization. (Of course abolishing the Fed might be relevant to the debate, but it isn’t relevant for 1921.)
Aggregate demand (NGDP) fell sharply during 1920-21, and then rose sharply over the next few years. Ditto for RGDP. NGDP fell sharply in 1929-30, and then continued to fall sharply all the way up to March 1933. Then it rose sharply until 1937, before falling during 1937-38, and then rising up through WWII. Ditto for real GDP, although the path of RGDP was considerably worse than I would have expected, if AD had been the only problem during the 1930s.
The AS/AD model can explain why the 1929-33 contraction was far worse than 1920-21; NGDP fell for a much longer period, and by a much larger amount. But why was the fall in NGDP so much more severe in 1929-33? That’s really complicated; I have a 500-page book coming out next year (hopefully) that explains the decline using a gold standard model. But the basic idea is already there in earlier papers by myself, and people like David Glasner and Clark Johnson. Too much demand for gold.
Because we now have a fiat money system, the explanation for why the 1920-21 decline in NGDP was much shorter and milder than 1929-33 has no implications for current policy disputes.
So far I have been downplaying the idea that we can learn from the 1921 recession. But I do believe there is one message that is consistent with libertarian views—artificial attempts to control wages are very counterproductive. Unfortunately the evidence is complex, but I’ll sketch out the basic conclusions here. For a variety of reasons, nominal hourly wages were much more flexible in the 1921 depression than the Great Depression:
1. Post-WWI prices were artificially high, and were expected to decline back to “normal.” That made workers more willing to accept wage cuts in 1921 than 1930.
2. President Hoover pressured big companies not to cut wages during the Depression. This pressure had some effect, especially in 1930 and early 1931 (less so afterwards.)
3. An executive decree by FDR forced wages 20% higher in the summer of 1933, and there were additional wage shocks on four other occasions (in the spring of 1934, early 1937, late 1938 and late 1939.)
As a result the decline in NGDP led to a bigger fall in RGDP, and more importantly a much slower recovery, than if wages had been as flexible as in 1921. I believe that with 1921-style wage flexibility, the Great Depression would have ended about 1935, even if NGDP had followed the same path it actually followed.
Now of course Keynesians like Paul Krugman argue that with greater wage flexibility you get more deflation. They don’t generally talk about NGDP, but the clear implication of this view is that NGDP would be lower with more wage flexibility. And this is where the 1921/Great Depression comparison is most interesting. The wage cuts of 1921 were some of the most aggressive ever seen in American history, and yet NGDP stopped falling almost at the same moment. In contrast, there were far fewer wage cuts in 1930, and the fall in NGDP kept getting worse and worse, partly due to feedback effects of the Depression itself.
So count me as a moderate of the 1921 debate. My best guess is the following counterfactual: With the same monetary policy and the path of NGDP that actually occurred during the period after 1929, but the Harding-era laissez-faire attitude toward labor markets, the Great Depression would have ended around late 1935. That’s a six year depression if we count both the contraction and recovery to near full employment. Using the same method, the actual Great Depression was almost 12 years long (with full recovery in late 1941), but the 1921 depression was only about 2 1/2 years long (say mid-1920 to late-1922). So we went from a 2 1/2 year to a 6-year depression due to much worse monetary policy, and from a 6-year to a 12-year depression due to the bad monetary policy being accompanied by really bad labor market policies. Or at least that’s my best guess.
PS. George Selgin explains why indicators like interest rates are unreliable during this period. David Glasner discusses the problem of gold hoarding, and the reasons for post-WWI wage flexibility. Nick Rowe shows why a gold standard has some “level targeting” properties (although I’d argue they are too weak to be reliable, and I’d guess he would as well.) David Henderson discusses a recent post by Bob Murphy.