The Forgotten Depression—1921, by James Grant

The Forgotten Depression—1921: The Crash That Cured Itself, by James Grant. New York: Simon & Schuster, 2014. 281 pp., $28 (hardcover).

It is widely accepted today that economic downturns require massive “countercyclical” government interventions, such as increased government spending to “stimulate” the economy, and suppression of interest rates by the Federal Reserve to encourage business expansion, home sales, and the like. Government intervention, almost everyone believes, is necessary to rescue the economy, lest it cascade ever downward, throwing more and more people out of work and businesses into bankruptcy.

James Grant, the founder of Grant’s Interest Rate Observer, challenges that dogma. In The Forgotten Depression—1921: The Crash That Cured Itself, Grant tells the story of the economic slump of 1920–21, “America’s last governmentally unmedicated depression” (p. 1), and compares the results of the nonintervention to the downturn of 1929–30, which was met with massive intervention and subsequently collapsed into a great depression.

The seeds of the 1920–21 depression were sown by U.S. monetary policy surrounding World War I. The wartime price increases were initially ignited by a massive fear-driven influx of gold from Britain, France, and Germany, which had abandoned the gold standard, into the then-neutral United States, “whose currency was still as good as gold” (p. 49). This temporarily swelled the U.S. money supply, igniting a short-term rise in the cost of living. Under the gold standard, Grant explains, prices can fluctuate in the short term but are “uncannily stable over the long run” (p. 49).

But that initial uptick was made rampant by a fledgling Federal Reserve buying up massive amounts of federal government debt to finance America’s entrance into the war. Grant offers an in-depth examination of this period in chapters 1–3, “The Great Inflation,” “Coin of the Realm,” and “Money at War” (pp. 11–54). As Grant observes, the largely Fed-driven wartime inflationary boom “set the stage for a worldwide deflationary depression” (p. 54).

The slump began in January 1920 under the administration of Woodrow Wilson and ended in July 1921 under the Warren G. Harding administration. Neither administration took so-called corrective action to counter the business cycle. Wilson, though leading a heavily statist administration, was too preoccupied with his League of Nations cause and, later, recovery from a stroke, to pay much attention to the crashing economy. Grant terms Wilson’s inaction “Laissez-Faire by Accident” (chapter 4, pp. 55–66). Harding was deliberately intent on letting the market correction take its natural course (chapter 12, pp. 135–41).

The 1920–21 depression, Grant shows, was a severe one. As he notes in chapter 5, “A Depression in Fact” (pp. 67–79), unemployment soared as wages fell sharply, business income plunged, commercial failures tripled, farm income—which then comprised nearly a fifth of the economy—fell by more than half, and stock prices plummeted by nearly half. Wholesale prices, consumer prices, and farm prices plunged by 36.8 percent, 10.8 percent, and 41.3 percent, respectively, exceeding “for speed of decline . . . even the Great Depression” (p. 68). “The perpendicular plunge in commodity prices was something new in post-Napoleonic history,” Grant observes. “Never before had they fallen so far and so fast” (p. 182). As Grant observes:

The 1920–21 affair was the 14th business-cycle contraction since the panic year of 1812. Commercial and financial disturbances of one kind or another occurred in 1818, 1825, 1837, 1847, 1857, 1873, 1884, 1890, 1893, 1903, 1907, 1910 and 1913. . . . “In this period of 120 years,” according to a contemporary [congressional] inquest, “the debacle of 1920–21 was without parallel.” (pp. 5–6)

“So depression it was,” Grant concludes. “What would the government do about it?”

It would implement settled doctrine, as governments usually do. In 1920–21, this meant balancing the federal budget, raising interest rates to protect the Federal Reserve’s gold position and allowing prices and wages to find a new, lower level. Critically, what it would not do was what the Hoover administration so energetically attempted to do a decade later: There would be no federally led drive to maintain nominal wage rates and no governmentally orchestrated work sharing. For this reason, not least, no one would wind up affixing the label “great” on the depression of 1920–21. (pp. 71–72)

Conventional wisdom leading into the depression held that deflation was a necessary corrective to the prior inflation. Every member of President Woodrow Wilson’s Federal Reserve—including Chairman W. P. G. Harding (no relation to President Harding)—

shared a generally laissez-faire approach to economic and monetary policy. None expressed a doubt about a dollar defined as a weight of gold. None, with the exception of [John Skelton] Williams, so much as intimated that the Federal Reserve had any business trying to override the structure of market-determined prices. Inflation had distorted prices. Now deflation must set them right. (p. 94)

By late 1921, amid widespread hardship, the economy turned around—with a bang: The 1920s boom was underway.

But as the economy was left free to run its 1920–21 corrective, though painful, course, a new economic theory was gaining ground. Economists such as Irving Fisher and John Maynard Keynes argued for a new monetary policy. Stability was to be the new ideal, explains Grant, “stability of prices most of all. The gold standard was yesterday’s orthodoxy. A new century called for currencies, the gold value of which was not inflexible” (p. 123). On this theory, government must intervene in business downturns to protect the stability of prices and wages. This theory would get its test soon enough.

The 1920s was a time of great technological innovation. But, unlike the period of the late nineteenth century, Grant observes, consumer prices increased by 0.7 percent a year during the 1920s.

In the late 19th century, prices had actually fallen in response to innovation. As it cost less to make things, so it cost less to buy them. There was no technological dividend for the consumers of the 1920s.

The Federal Reserve seems not to have allowed it. Gold no longer constrained the policy-makers. Neither did the classical central-banking doctrine on which the Federal Reserve was founded. The post-1922 central bank was germinating enough money to create enough inflation to offset the tendency of prices to fall on account of sustained advances in manufacturing and agricultural efficiency. (p. 209)

So the Federal Reserve, on full “stabilization” mode, was inflating again. But compared to 1916–1919, when consumer prices soared by double-digit rates—11, 17, 18.6, and 13.8 percent, respectively (p. 15)—consumer prices appeared relatively stable. The Fed’s new policy seemed to be working. But the apparent stability, as measured by consumer price indexes, was an illusion. Between 1922 and 1929, the prices of investment assets soared instead. “Inflation,” Grant observes, “had broken out in places where the stabilizationists weren’t looking” (p. 211).

Once again, the stage was set for a deflationary correction, beginning with the 1929 stock market crash. But this time the government’s reaction, under Herbert Hoover, would be the opposite of a decade earlier. “Presidents Wilson and Harding, each for his own reasons, had met the depression of 1920–21 with inaction. [Hoover] chose a whirlwind of intervention (p. 213).”

“[A] living experiment in economic policy was unfolding on a national scale (p. 215),” Grant observes. “Public-works spending, farm-price maintenance, and wage support were rather the new, constructive responses to the weakening of aggregate demand” (p. 214).

“As posterity knows,” concludes Grant, “the experiment failed” (p. 215). Whereas the comparatively short 1920–21 crash was followed by “a powerful, job-filled recovery (p. 1),” the 1929–33 crash, which experienced “a commodity price decline . . . not so severe as in the 1920–21 collapse (p. 216),” dragged on for four years, followed by years of grinding stagnation.

“Why wasn’t the 1920–21 affair just as terribly ‘great’ as the one that enveloped Herbert Hoover?” Grant posits (p. 213). “The trouble with Hoover’s policy,” Grant amply shows, “is that it didn’t conform more closely to Wilson’s and Harding’s nonpolicies” (p. 217). As Grant modestly concludes:

There are no controlled experiments in economics. No one living through the Great Depression could be exactly sure how to apportion blame among the domestic and foreign causes. Still less can posterity be certain. What we can observe, even at this great distance of years, is that the price mechanism worked more freely in 1920–21 than it was allowed to do in 1929–33. “[T]he end result of what was probably the greatest price-stabilization experiment in history proved to be, simply, the greatest and worst depression,” concluded one of the wisest of the contemporary postmortems of the Depression, Banking and the Business Cycle, published in 1937.

The depression of 1920–21 was terrible in its own way. In comparison to what was to follow, it was also, in its own way, a triumph. (p. 218)

A “triumph,” that is, for “the hero of my narrative, . . . the price mechanism, Adam Smith’s invisible hand” (p. 2). Grant, according to the front inside jacket of the book, wrote “The Forgotten Depression” as “a free-market rejoinder to Bush’s and Obama’s Keynesian stimulus applied to the 2007–9 recession.”

It’s a strong rejoinder. “I write in the fifth year of a historically lackluster recovery from the so-called Great Recession of 2007–09,” Grant notes (p. 2). “The Great Depression was the historical touchstone of the advocates of a muscular federal response to our own Great Recession” (p. 3). But, Grant argues, “Over and done with in 18 months, the depression of 1920–21 was the beau ideal of a deflationary slump. This is not—so far—history’s verdict. Nor is it yet, with a few notable and enlightened exceptions, the economists’. . . . I hope they may reconsider” (p. 212).

The Forgotten Depression, rich in facts and insight, is a good contribution toward that much-needed reconsideration.