The Great Imbalance: A Critique of the Recession of

1920-21

Causes, Responses and Insights

Abstract: Many attribute our current recession to the evils of unbridled

capitalism. In response, our leaders have embarked on the typical
Keynesian recession prescriptions in order to stimulate the economy and
lead the nation out of the economic doldrums. Unbeknownst to most
Americans however, prior to the Great Depression, policymakers used
different tools to help guide the country out of recessions. Herein we
examine the causes, responses and insights gleaned from the Recession of
1920-21, the last downturn in which leaders relied on the age-old policy of
laissez-faire, combined with massive reduction in government and
encouragement of deflation.
 I. Introduction

Today the United States finds itself in one of the longest and deepest recessions in

its history. Many have blamed deregulation, greed and a naive ideological adherence to

free market capitalism for our current woes. As such, the US has embarked on a course

of policies largely Keynesian in nature, including deficit spending, public works projects

and a variety of policies revolving generally around increasing demand and lessening the

blows of the deleveraging private sector. In many ways, this era has paralleled that of the

Depression, with President Obama playing FDR and George W. Bush playing Hoover.

Popular refrains in contemporary America include “We are all Keynesians now,”

and “There are no libertarians in financial crises.” With Keynesian nostrums en vogue,

the liberal economic schools appear to have grown obsolete. And on some levels this is

understandable, given that the Keynesian prescriptions for our maladies seem to reflect

common sense. If people are out of work, let the government gainfully employ them. If

the private sector is overlevered, counteract their delevering by levering up the public

sector. If banks are failing to generate credit, print money and force it into their coffers,

so that they lend and the economy can once again grow.

However, as Frédéric Bastiat, the sage 19th century French theorist, political

economist and assemblyman noted in his work That Which Is Seen, and That Which is

Not Seen, the prudent economist looks at the consequences of actions both intended and

unintended. This is analogized in the so-called “broken window fallacy,” in which a boy

throws a rock through a shopkeeper’s window. One observer argues that this is a

blessing because the glazier will now have work in installing a new window, stimulating

the economy. However, what he misses is the fact that had the window not been broken,

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the shopkeeper would have perhaps used the money now being paid to the glazier to buy

a new set of shoes, employing the shoesmith, or a book, increasing his knowledge

(Bastiat, 1-4). There are other considerations as well. What if the boy is employed by

the glazier to break windows? Then this act would be regarded as theft, not stimulus.

Finally, if it is economically beneficial to break one window, why not break all windows

everywhere? Extending the analogy, classical liberals argue that government represents

the boy throwing the rock through the window, causing unintended, damaging

consequences in its economic intervention, and distributing wealth from one class to

another, never creating it. It is under Bastiat’s essential insights that we will proceed.

Herein I will first develop the theoretical underpinnings to our study, in giving an

elementary summation of what a free market entails, introducing to it a central bank and

then giving a brief overview of the results of central banking under the Austrian theory of

the business cycle. Next, I will analyze within this framework the Recession of 1920-21,

the conditions it created and the policy prescriptions applied to it for economic

correction. Upon explaining how we exited from the deep recession, I will enumerate the

insights from a political economy perspective that this historical episode provides us.

Finally, I would be remiss in not briefly divulging why I chose to study the

Recession of 1920-21. This was a particularly brutal recession not unlike the one we are

experiencing today. Yet policymakers did not undertake Keynesian countermeasures,

which made me as a contrarian naturally curious. This was in fact the last recession in

which US representatives administered what I would come to discover were their age-old

recovery policies – they decreased the size of government, encouraged economic

contraction and restructuring, and generally unencumbered the economy, allowing it to

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self-correct. I contend that these antidotes were as proper in the early 1920s as they are

today.

II. The Free Market

Before intervening in the paradigm of free market capitalism with the introduction

of a central bank, we must ask what the characteristics of a free economy entail.

According to Adam Smith, capitalism has as its root the defining feature that it is based

on self-interest. After all, it “is not from the benevolence of the butcher, the brewer, or

the baker that we expect our dinner” (“The Wealth of Nations by Adam Smith: Chapter

2”). As Austrian economist Murray Rothbard argues, free-market capitalism “is a

network of free and voluntary exchanges in which producers work, produce, and

exchange their products for the products of others through prices voluntarily arrived at”

(“Capitalism versus Statism”). Professor George Reisman provides the following

definition that encompasses both the economic and political aspects of a capitalist

system:

Laissez-faire capitalism is a politico-economic system based on private

ownership of the means of production and in which the powers of the state
are limited to the protection of the individual’s rights against the initiation
of physical force. This protection applies to the initiation of physical force
by other private individuals, by foreign governments, and, most
importantly, by the individual’s own government. This last is
accomplished by such means as a written constitution, a system of division
of powers and checks and balances, an explicit bill of rights, and eternal
vigilance on the part of a citizenry with the right to keep and bear arms.
Under laissez-faire capitalism, the state consists essentially just of a police
force, law courts, and a national defense establishment, which deter and
combat those who initiate the use of physical force (Reisman).

To summarize, capitalism is a system in which self-interested individuals pursue

the good life as they subjectively define it. People work, and exchange the fruits of their

labor for goods, services or more abstract wants in mutually beneficial trade. The liberty

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to do so is protected by a government that ideally serves as a referee, preventing us

against aggression such as fraud, theft and the like by others and by government itself,

allowing us to freely pursue our summa bonum.

The US today is of course far removed from this type of system. Even back in the

go-go 1920s, the country had started to shed the yoke of laissez-faire due to the

introduction of the Federal Reserve, imposition of the income tax, and the creation of

various government bureaucracies to go along with their regulations. Most important to

our study is the creation of the Federal Reserve in 1913, as it is essential to the business

cycle. Throughout US history, there had been a variety of central banks, all of which had

failed due to artificially expanding the supply of money and credit on top of gold, or

through setting the gold-silver ratio improperly (Rothbard 2005, 45-179). The Federal

Reserve however was by far the most powerful, and in this author’s view, dangerous

national bank to be created.

From a political economy perspective, the Federal Reserve represents a powerful

institution shrouded in mystery. I would like to demystify this however for our

undertaking. The Fed is a lender of last resort that effectively cartelizes the major US

banking houses. It is the banker’s bank. Its board members are granted a monopoly over

the money supply of the American people, as they set the interest rate through open

market operations. In this way, the Fed is anathema to the free market, as it represents a

government monopoly over the commodity of money (though the bank is nominally

quasi-private), in its sole right to coin and regulate its value. Today, unconstrained by a

gold standard, the Fed has the power to create paper money out of thin air as it sees fit.

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In earlier centuries in Europe, money had been privately coined. However, as

government’s grew, central banking supplanted the private money system, nominally

with the intention of ensuring a more “elastic” monetary system theoretically to prevent

downturns such as those of the Panic of 1907 (Rothbard 2005, 40). The fundamental

point as we will see is that though in 1920, government played a much smaller role in the

economy than it would during the Depression and in modern-day America, the Federal

Reserve still created just as much havoc.

III. The Austrian Theory of the Business Cycle

Essential to understanding the functioning of an economy is an explanation of the

business cycle. Murray Rothbard lays out the perpetual peril that has inflicted man

throughout time when it comes to the sinusoidal tide of economic development:

Entrepreneurs are largely in the business of forecasting. They must invest

and pay costs in the present, in the expectation of recouping a profit by
sale either to consumers or to other entrepreneurs further down in the
economy's structure of production. The better entrepreneurs, with better
judgment in forecasting consumer or other producer demands, make
profits; the inefficient entrepreneurs suffer losses. The market, therefore,
provides a training ground for the reward and expansion of successful, far-
sighted entrepreneurs and the weeding out of inefficient businessmen. As
a rule only some businessmen suffer losses at any one time; the bulk either
break even or earn profits. How, then, do we explain the curious
phenomenon of the crisis when almost all entrepreneurs suffer sudden
losses? In short, how did all the country's astute businessmen come to
make such errors together, and why were they all suddenly revealed at
this particular time? This is the great problem of cycle theory (Rothbard
2000, 8).

The Austrian Theory of the Business Cycle explains how businessmen invariably come to

make the cluster of error characteristic of the boom-and-bust cycle. To expound upon

this theory, we will examine the free capital market, and then the effects of introducing a

central bank, the Austrians’ main culprit in causing the chronic economic ups and downs.

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 In a free market, individuals earn money and choose to consume some of it and

invest the rest of it, according to their so-called “time preference.” During certain times

in life, individuals will want to consume much while saving little, while at other times

they will choose to forego current consumption and save so that they can consume more

later. Saved or invested money represents the capital stock that can be loaned out to

other individuals or businesses. In an uninhibited market, the point of equilibrium based

upon the supply of and demand for funds will dictate the interest rate of the economy

(Garrison, 64).

The interest rate is a price just like any other that serves as a signal to businesses

and consumers. Lower interest rates will indicate that the capital available for investment

in projects is large; people are willing to forego consumption now to reap greater benefits

down the road, leading businesses to undertake longer-term projects. Higher interest

rates will indicate that the capital available for investment is small; people are willing to

forego future goods to consume the fruits of their labor now, leading businesses to

undertake shorter-term projects (“The Forgotten Depression of 1920”). The interest rate

structure of an economy, embodied in the below “Hayekian triangle” governs in Austrian

jargon the intertemporal pattern of resource allocation:

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(“An Austrian Theory of the Business Cycle”)

The horizontal base of the triangle represents the element of time in economic

development, required for things such as R&D, commodity extraction, etc. The vertical

legs represent the value of the different inputs created in the steps towards producing the

final output, with the last leg representing the value of the completed good. The slope of

the triangle represents the interest rate. The length and height of the triangle will change

in response to changing time preferences amongst consumers, altering the interest rate

structure accordingly (“Hayekian Triangles and Beyond”).

The structure of production coordinates the time preferences of all people across

the economy. In this way, the demands of the consumers direct the supply of producers,

with economic activity ensuing according to this relationship. As Auburn Professor

Roger Garrison notes, “the natural rate guides the economy along a sustainable growth

path. That is, governed by the natural rate, unconsumed current output (real saving) is

used for augmenting the economy’s productive capacity in ways that are consistent with

people’s willingness to postpone consumption” (“Natural and Neutral Rates of Interest”).

Were an economy to function as such, theoretically it would be devoid of booms

and busts. Surely certain assets might boom in price whilst others might bust based upon

the desires of consumers, but the sole effect would be the changing values of goods

relative to each other; the rise in the prices of some assets would lead to an offsetting fall

in the prices of others. In addition, in this theoretical economy, there would still be

8
business failure. After all, man is fallible, and competition will always yield winners and

losers. But capital markets governed by natural interest rates would ensure that most if

not all businesses in a particular sector or in the economy as a whole would not

artificially boom and bust together. Entrepreneurs would avoid the cluster of error

because the price signal of the interest rate dictated solely by the market would lead them

to undertake profitable, sustainable projects. The more adept entrepreneurs would

survive, and the less adept would perish.

However, when the Federal Reserve is empowered to control the money supply,

the capital base that had been governed by the market is thrown into disequilibrium.

Below we show an economy in which the market for loanable funds is in equilibrium –

i.e. where the supply of and demand for capital, and thus the interest rate is freely set by

market participants, not a central bank.

(“Capital-Based Macroeconomics,” 17)

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The intersection of supply and demand meets the optimal point on the production

possibilities frontier in the tradeoff between consumption and investment amongst

consumers. A Federal Reserve that can set the interest rate however will invariably be

unable to choose this market rate of interest, thus throwing an economy off of the PPF.

No individual or group of economists can centrally plan an interest rate, just as no central

planner can set the price properly for any good. It is a problem of economic calculation,

requiring comprehending and synthesizing unlimited variables – variables that

dynamically change, whose effect can only be borne out through infinite transactions by

market participants. Central planners are also not subject to the market, where their

effectiveness or lack thereof would be shown by the profit-and-loss mechanism. The

caveat is that that central planners do compete against other central planners in foreign

exchange markets, though the US today holds the upper hand by default as manager of

the world’s reserve currency. One might ask in general why we want governments

dictating the value of our money in the first place, and though this is for another paper,

certainly our study will fan the flames of this question. In any event, central planners will

generally choose to set an interest rate low to induce businesses to increase their

investments in projects and thus spur economic growth. Below we see what happens

when the central bank sets an interest rate artificially low:

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(“Capital-Based Macroeconomics,” 42)

The effect of the pumping of money and credit into the capital markets is

economic disequilibrium. On the one hand, low interest rates signal to businesses that

they should invest in long-term projects. On the other, low interest rates incentivize

people to borrow and spend more. As one can see, the effect is that this new artificially

low interest rate pushes the economy off of the PPF. The mismatch between the

consumers increasing their spending and businesses increasing their investment due to

the artificial infusion of credit ultimately leads to a bust. Businesses will commence

projects they would not have undertaken were the interest rate to accurately reflect

consumer demands, and consumers will purchase more than they would have were the

interest rate to accurately reflect their desired trade-off between consumption and

investment. Put succinctly, the “intertemporal mismatch between earning and spending

patterns eventually turns boom into bust” (“The Austrian Theory of the Business Cycle”).

And again, this is because there is an artificial increase in the pool of capital; the lesson is

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that the only way to truly stimulate investment is to build the pool of capital through a

real increase in saving. It is also worthy of note that the system of fractional reserve

banking whereby deposits nominally supposed to be warehoused by banks are lent out to

other institutions and pyramided upon facilitates the process of creating additional money

and credit (“End the Fed”).

This overall process is well analogized in Ludwig von Mises’s magnum opus,

Human Action, in which he compares the situation for businesses to that of a

masterbuilder of a house who runs out of bricks before the house can be completed.

Since he assumes there will be more loanable funds and free resources than there actually

are to complete a bigger house than he would have constructed had the interest rate

properly signaled the time preferences of the consumer, he squanders resources on an

unsustainable project, making society poorer. To heal these wounds, when all the

masterbuilders err because of government creation of money and credit, society must

endure a recession to properly adjust the interest rate structure and reallocate the

misapplied resources (“The Forgotten Depression of 1920”). In our forthcoming

discussion on the recession of 1920-21, we will see the above scenario played out, with

the activities of war further contributing to the economic imbalance.

IV. Causes and Symptoms of the Recession of 1920-21

The US economy found itself at the edge of the abyss in 1920. As economist

Benjamin Anderson put it, the situation “was shot through with abnormalities, stresses

and strains. The movement was in almost every case away from equilibrium” (Anderson,

74). Undoubtedly, a significant amount of this disequilibrium is attributable to the

economic disruptions created by World War I. In war, we see a heavy emphasis placed

12
upon natural resources and labor, necessary allocation of money to heavy industrial

sectors and major government intervention in an economy in order to finance and direct

the war effort, as we will see shortly.

Before looking at the other causes of the economic struggle that the US would

find itself in between 1920 and 1921, we should note that war is another example of the

broken window fallacy. It is considered common knowledge that war is economically

productive. Many attribute our exit from the Great Depression itself to war. Yet war is a

time in which the government, like the boy, effectively throws rocks through many

windows, except the rocks represent the use of far more valuable commodities. In war,

government drastically reallocates economic resources. It does not make us more

productive at the aggregate level, but rather shifts resources from some industries towards

others, such as heavy industry and technology. It does so on the basis of governmental

planning, with the economy ceasing to function on the basis of consumer demand and

free enterprise. War is beneficial to the extent that it employs people, and it may

encourage development of certain technologies that contribute to a higher standard of

living following the war (Murphy, 145-64). This criticism is not to condemn all war, as I

certainly believe there are situations in which war is merited, regardless of economic

cost. It is to say however that to characterize war as economically productive is a

wrongheaded and dangerous fallacy. Otherwise, why not destroy the infrastructure of our

own country so we can employ everyone to rebuild it? The effects of war are the same as

the effects of central banking – due to government intervention, the economy is thrown

out of balance, with unsustainable artificial booms in certain industries that will bust in

economic adjustment.

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 Distortive as the war effort was for the economy, many have argued that it was

the Fed that caused the painful boom-and-bust cycle that led to the Recession of 1920-21.

Paraphrasing the words of former National City Bank President Frank Vanderlip, a

February 1920 New York Times editorial notes,

“the Federal Reserve system opened the door to the inflation of the
country’s credit and asserted that the “brake” against inflation provided for
in the act had not been used because of political considerations…the
Treasury…kept rates low and opened up the door to great expansion. The
treasury…took a circumscribed view of the financial situation…for the
purpose of enabling the Government to borrow at an advantage…[and]
failed to understand the consequences of such a policy…Because of
inflation…prices since 1914 have shown an advance of 234 per cent, with
the result that the Dollar will purchase but 43 cents worth of its value in
1914…In the war period the currency had increased 68 per cent…while
the deposits in commercial banks increased 103 per cent, but there was no
substantial increase in production (“Vanderlip Attacks Federal Reserve”).

Princeton economist E.W. Kemmerer calculated that from 1913 to 1919, money in

circulation increased 71 percent while the physical volume of business increased by 9.6

percent (9-14). Indeed, it is no wonder that Woodrow Wilson under whom the Federal

Reserve was incepted later lamented:

“A great industrial nation is controlled by its system of credit. Our system

of credit is privately concentrated. The growth of the nation, therefore, and
all our activities are in the hands of a few men who, even if their action be
honest and intended for the public interest...by very reason of their own
limitations, chill and check and destroy genuine economic freedom…we
have come to be one of the worst ruled, one of the most completely
controlled and dominated, governments in the civilized world -- no longer
a Government by free opinion, no longer a Government by conviction and
the vote of the majority, but a Government by the opinion and duress of a
small group of dominant men” (Wilson, 185/201).

Kemmerer attributes this inflation in the money supply to both the large inflow of

gold from Europe during the war in exchange for materials we shipped overseas, and the

14
fact that the Federal Reserve withdrew gold certificates and coin from circulation,

substituting for it Federal Reserve notes backed by a gold reserve of only 40 percent. On

the former point, four major factors triggered the gold expansion: bankers seeking profits,

bankers wanting to patriotically support the nation, and Government desiring to finance

itself with minimal disturbance to business and at a low rate of interest (Kemmer, 14-18).

On the latter, while in 1913, Federal Reserve notes in circulation were non-existent, by

1919 its notes numbered $2.8 billion, roughly $1.5 billion of which was uncovered by

gold. Legal reserve requirements for banks were significantly reduced, with national

banks in reserve cities required to hold 25% worth of their deposits in reserve, while so-

called country backs only had to keep 15% on reserve, 3/5th of which had to be held by

national banks. Time deposits were subject to even lower reserve rates. Overall, these

policies pushed interest rates artificially low. Kemmerer gleans a fundamental insight

from our situation directly in line with the Austrian theory we spoke to earlier:

We bought our low interest rates on government paper at the price of very
high prices for commodities. We kept interest rates down by a policy that
kept pushing the price level up. The fundamental economic law which
makes the interest rate the resultant of the interaction of the forces of
demand and supply in the capital market was forcing up the real interest
rate under the influences of a world wide destruction of capital and an
unprecedented demand. “Present goods were at a large and ever-
increasing premium over future goods.” The fundamental economic law
determining the real interest rate could not be annulled by the policy of
the federal reserve board of artificially depressing the market rate of
discount through inflating the country’s supply of bank notes and deposit
currency. When the discount rate was artificially pushed down prices
bulged up (24-5).

It is to this that we can attribute the great increases in prices of all goods that we will

speak to shortly, as Kemmerer notes that without the monetary inflation, while

commodity prices would have risen due to increased demand, this would have been offset

15
by falling prices in other goods (33). With a constant monetary stock, again all that

would change would be the proportions of the values of goods relative to each other

depending on the demand for them.

Indeed in the years preceding the recession, interest rates had been kept artificially

low. In addition however, according to economist Jacob Hollander, government

extended fiat credit through the issuance of Treasury certificates of indebtedness, a

principal cause in the price inflation. As Hollander states, “additional credit was created

by Government fiat, utterly unrelated to commercial requirement. This credit, disbursed

in the course of Government expenditure, found its way into individual accounts and

tended to swell the amount of deposit currency over and above the amount of currency”

(Hollander, 62).

Benjamin Anderson attributes the out-of-whack economy only partially to the

inflation of the supply of money and credit. Anderson considers the fundamental

problem of inflated prices (which I will describe shortly) in the US economy to shortages

in a variety of resources due to a too-great trade balance that had been run up for five and

a half years prior to 1920. Anderson argues that the impetus behind this problem was

that the one-sided export trade was “financed by the government…[and] going on the

basis of unfunded credits” (1979, 71). In addition, following the war, trends in our gold

supply reversed: “despite our tremendous export balance of trade we were losing gold

heavily...We had an export balance with Europe only, and we could not draw on Europe

for payments to the non-European world to pay for our import surplus from them” (1979,

74). Nevertheless, Anderson notes that “the handling of the Federal Reserve rediscount

rate permitted the expansion to move faster and go further than would otherwise have

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been the case,” as during 1919 the rate was held at 4 percent while money market interest

rates steadily increased (1979, 71). Ultimately, the major outgrowth of these problems of

finance was a 25.4 percent increase in loans and investments of Federal Reserve member

banks from April 1919 to 1920 (Anderson 1949, 71).

Anderson attributes other problems directly to the war. He recounts that war led to

a misallocation of labor in industrial fields, overproduction of military products and

underproduction of consumer ones and railroad congestion that severely handcuffed

trade. Anderson also notes that given wartime suspension of antitrust law accompanied

by price-fixing, rationing and allocation, many prices remained fixed following the

armistice (Anderson 1979, 62). He further argues that the five million men who

withdrew from the Army and Navy after the armistice were poorly absorbed into the

economy, as reflected in decreased production between 1918 and 1919 (Anderson 1921,

3-37). Thus, Anderson sums the situation leading to shortages of goods and higher prices

as follows: “The net result of diminished production, increased exports over imports, and

increased domestic consumption and extravagance, is that shortages of goods are

markedly greater at the present moment than they were at the time of the armistice”

(Anderson 1949, 64). We might note that people may have spent extravagantly given

that interest rates were artificially low. As Anderson argues, “it was not until the end of

1919 that artificially low rediscount rates were discontinued.” These rates at the least

contributed to extravagance on the supply side as “…unduly low money rates…tempted

businessmen to borrow money which they otherwise would not have borrowed for the

purposes of business expansion, and alike tended to the overdevelopment of non-essential

industries” (1921, 26). Compounding these problems, Economics Professor Warren

17
Persons noted that: “High taxes were a factor contributing to insolvency when prices

turned downward. The rates of surtax levied upon large incomes have been so heavy as

to divert investment from taxable securities to non-taxable government and municipal

bonds” (18-19).

Though as we have noted, government increased the supply of money and credit,

following a sharp reduction of production for wartime purposes and a substantial

liquidation of bank credit amongst businesses, borrowing rates eased and between 1919

and 1920 there was one last temporary post-war boom (Anderson 1949, 61). Anderson

notes:

From many causes, then, costs of production rose with startling rapidity
during the second half of 1919 and the first half of 1920: (a) labor costs
rose; (b) Interest Rates and Money Rates rose; (c) rentals rose; (d) Raw
materials rose; (e) Railroad congestion made for a vicious increase in
costs, even though railroad rates did not rise; (f) Coal rose; and (g)
Declining managerial efficiency led to rapidly rising costs. As costs rose,
businesses which were unable to advance their prices faced declining and
vanishing profits, and this was true even of businesses whose prices were
rising but whose prices were rising less rapidly than their costs. With the
decline in profits in a sufficiently large number of important businesses, a
boom must come to an end. Credits are based on earnings power. As
earning power diminishes creditors get nervous and begin to press for
collection, liquidation is forced, and reaction and crisis come” (1921, 11).

Anderson notes in the Chase Economic Bulletin that “It was very difficult for men to fail

in a period of rapidly rising prices, and a good many inefficient business men who would

normally have been weeded out by the severe process of competition, was able to

continue in business and to extend weak positions (Anderson 1921, 20).”

It is clear that government intervention in our economy threw the system out of

equilibrium. Land, labor and capital were diverted to fight the war, government

intervened to artificially keep its borrowing costs low to finance the war and imposed

18
regulations and levied taxes to coordinate and fund war efforts, and perhaps most

importantly, Federal Reserve stewardship led to a significant expansion of money and

credit before, during and after wartime. It is tough to attribute the recession primarily to

one factor, but clearly the recession occurred when the illusory boom and concomitant

inflation in prices stopped and reversed. War is a major factor in this equation, but the

massive increase in money and credit over time at the very least amplified the boom-bust

cycle.

The results of the misaligned economy, distorted for years by poor monetary

policy and war were staggering. By late 1919, the CPI was running at 20 percent. The

unemployment rate between 1920 and 1921 grew over 100 percent, from 5.2 to 11.7

percent. Between 1920 and 1921, production fell by a staggering 21 percent. From their

peak in June 1920, prices fell by 15.8 percent, a 50 percent greater deflation in prices

than during any 12-month period during the Great Depression. Commodity prices were

especially hard hit, collapsing by over 100 percent in a single year, and putting many a

farmer out of business (Anderson 1949, 87-8). Wholesale prices fell from a level of 248

to 141 by measure of the BLS index. “Credit policy came to be centered on the question

of solvency. Business policy for a great many corporations ceased to be concerned

primarily with profits and came to be concerned primarily with solvency (Anderson

1949, 82). The collapse is well-depicted here:

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(“The Crisis of 1920 in the United States: A Quantitative Survey”)

V. Governmental Response to the Recession of 1920-21

Deep as the downturn of 1920-21 was, and imbalanced and distorted as the

economy may have been as a result of the factors mentioned heretofore, today we hear

nary a mention of this recession. Given the rapidity of the collapse in prices and increase

in unemployment, this is hard to fathom. Part of the reason undoubtedly is the fact that

the recession passed quite quickly, as by 1922 the US returned to a path of staggering

prosperity. The natural question that we have to ask ourselves as we sit in the US today

with 10% unemployment (over 17% if we go by broader measures), having witnessed a

tremendous collapse in housing prices amongst those of other assets is, how did we

recover from this type of deep downturn in the Recession of 1920-21?

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 Economists during the recession seem to be rather consistent in their appraisal of

what was needed fix the American economy. A.C. Miller, a member of the Federal

Reserve Board at the time put it plainly:

“There can be little question of what form the correction should take.
Where there has been inflation there must follow deflation, as a
necessary condition to the restoration of economic health. Contraction of
bank deposits and currency, through the liquidation of war loan accounts,
is clearly indicated as the next and necessary step in the process of
bringing the credit currency and price situation back to normal. Those who
in our liberty loan campaigns were persuaded to borrow and buy must now
be made to save and pay. “Save and pay up” should henceforth be our
slogan. The problem of correcting a state of banking inflation is mainly a
problem in saving. We must either put more goods behind the outstanding
volume of credit and currency-that means production-or we must reduce
the volume of credit and currency to suitable proportions-that means
saving (Miller, 318).

Chase National Bank economist Benjamin Anderson concurred, arguing that the

domestic readjustment must consist of the liquidation of credit, the readjustment of

industries and the readjustment of the price system (Anderson 1921, 28).

Princeton economist E.W. Kemmerer, though acknowledging the pain of deflation,

specifically for those such as debtors, claimed that deflation would be a favorable policy

because “our present gold base is altogether inadequate safely to support the present

paper money and deposit currency circulation,” and “that inflation’s work has not yet

been completed and…therefore some of the otherwise evil results of our inflation

experience would still be avoided or mitigated by deflation.” (Anderson 1949, 63-69) He

further argued generally that the Federal Reserve rate should be set above the market rate

of interest, so as for rediscounting to only be implemented in times of emergency,

following Bagehot’s dictum that a central bank should lend freely but at a punitive rate of

interest against sound collateral in a time of panic (Anderson 72, Bagehot, 56-7). Jacob

21
Hollander, professor of Political Economy at Johns Hopkins University acknowledged

that though economically efficacious, deflation would prove politically perilous, noting:

Deflation is hard in practice and painful in effect, and a democracy is not

likely to have strength or to show courage enough for heroic operation.
But to tolerate an ill is one thing, to aggravate it is another. If the Treasury
be not willing to enter upon the hard, straight course of currency
contraction and credit restriction, let it at least avoid the treacherous ease
of further bank borrowing” (“Fiat Credit and High Prices”).

These words are probably even truer today, as certainly Paul Volcker can attest.

Most important however were the words and actions of the President who

inherited the post-war recession, Warren Harding. Harding, though not considered the

most eloquent President in the annals of American political rhetoric outlined his policy

for handling the recession in his Republican nomination speech:

Gross expansion of currency and credit have depreciated the dollar just as
expansion and inflation have discredited the coins of the world. We
inflate it in haste, we must deflate in deliberation. We debase the dollar in
reckless finance, we must restore in honesty. Deflation on the one hand
and restoration of the 100 cent dollar on the other ought to have begun the
day after the armistice, but plans were lacking or courage failed…We will
attempt intelligent and courageous deflation, and strike at government
borrowing which enlarges the evil, and we will attack high cost of
government with every energy and facility which attend republican
capacity. We promise that relief which will attend the halting of waste
and extravagance and the renewal of the practice of public economy not
alone because it will relieve tax burdens but because it will be an example
to stimulate thrift and economy in private life…There hasn’t been a
recovery from the waste and abnormalities of war since the story of
mankind was first written except through work and saving, through
industry and denial, while needless spending and heedless extravagance
have marked every decay in the history of nations…(“Speech accepting
the Republican nomination”).

He also made some insightful points in his Presidential inaugural speech:

The economic mechanism is intricate and its parts interdependent, and

has suffered the shocks and jars incident to abnormal demands, credit
inflations, and price upheavals. The normal balances have been impaired,
the channels of distribution have been clogged, the relations of labor and
management have been strained. We must seek the readjustment with care

22
 and courage. Our people must give and take. Prices must reflect the
receding fever of war activities. Perhaps we never shall know the old
levels of wages again, because war invariably readjusts compensations,
and the necessaries of life will show their inseparable relationship, but we
must strive for normalcy to reach stability. All the penalties will not be
light, nor evenly distributed. There is no way of making them so. There is
no instant step from disorder to order. We must face a condition of grim
reality, charge off our losses and start afresh. It is the oldest lesson of
civilization (“Inaugural Address”).

It is simply unfathomable that a politician today would have the intestinal fortitude to

utter words as stark yet truthful as those uttered by Warren Harding in 1920. Even more

shocking, Harding was a politician whose candor was met with concordant action.

Harding understood that in order for the economy to properly adjust to prewar

conditions, prices needed to fall from their inflated levels, and rebalance in accord with

demand as dictated by the consumer. Thus, as economist Robert Murphy notes in his

Politically Incorrect Guide to the Great Depression:

…the (New York) Fed hiked its discount rate from 4.75 percent up to 6
percent in one fell swoop in January 1920. The Fed then hiked again to a
record-high 7 percent in June 1920. Despite the fairly severe depression—
recall that unemployment averaged 11.7 percent in 1921—the Fed held
steady to its record-high rate for almost a full year, not cutting until May
1921, after the depression was basically over (78-9).

Raising interest rates naturally had the effect of forcing companies that had survived due

to artificially cheap credit to become insolvent and enter bankruptcy, where businessmen

would discern the value of the assets of the failed enterprise, purchase them and put them

to more profitable lines of use. This economic restructuring is essential for economic

progress. As Don Boudreaux argues regarding our modern-day auto companies, “The

bigger the unprofitable firm, the more vital it is that it be allowed to fail” (“Bankruptcy

Doesn’t Equal Death”).

23
 Second, as Harding understood that cutting down the size of government would

put more money back in the hands of businesses and households, as illustrated below, he

slashed the Federal budget, retreating significantly from the persistently high spending

levels of wartime:

This reflected Harding’s belief that the government’s role in the private economy should

be diminished in order for the nation’s economy to return to growth and prosperity.

Harding was fiscally conservative in both the short and long-term, as reflected in the

figures below:

Though Harding significantly slashed the budget, tax receipts outweighed expenditures

during and after the recession, allowing him to pay down a fairly significant part of the

national debt given the limited timeframe. During his presidency, Harding would also

reduce income tax rates across the board, with the highest tax rate falling from 73% in

1921 to 25% by 1925 under the care of Treasury Secretary Andrew Mellon (Murphy, 22).

Benjamin Anderson summarizes Harding’s fiscal policy as follows:

The idea that a balanced budget with vast pump-priming government

expenditure is a necessary means of getting out of a depression received
no consideration at all. It was not regarded as the function of the
government to provide money to make business activity. It was rather the
business of the US Treasury to look after the solvency of the government,
and the most important relief that the government felt that it could afford

24
 to business was to reduce as much as possible the amount of government
expenditure, which had risen to great heights during the war; to reduce
taxes—but not much; and to reduce public debt.

Nor did the government increase public employment with a view to taking
up idle labor. There was a reduction in the army and navy in the course of
these years, and there was a steady decline in the number of civilian
employees of the federal government. This policy on the part of the
government generated, of course, a great confidence in the credit of the
government, and the strength of the gold dollar was taken for granted.
The credit of the government and confidence in the currency are basic
foundations for general business confidence. The relief to business
through reduced taxes was extremely helpful (1949, 92-3).

Overall, Anderson feels that the best example of the efficacy of Harding’s policies

is shown by way of comparison between the US and Japan during the 1920s. He notes:

The great banks, the concentrated industries, and the government got
together, destroyed the freedom of the markets, arrested the decline of
commodity markets, and held the Japanese price level high above the
receding level of the last 7 years. During these years, Japan endured
chronic industrial stagnation and at the end in 1927, she had a banking
crisis of such severity that many great branch bank systems went down, as
well as many industries. It was a stupid policy. In the effort to avert
losses on inventory representing one year’s production, Japan lost 7 years.
The US was different, we took our losses, we readjusted our financial
structure, we endured our depression and in August 1921 we started up
again. The rally in business production and employment that started in
August 1921 was soundly based on a drastic cleaning up of credit
weakness, a drastic reduction in the costs of production, and on the free
play of private enterprise. It was not based on governmental policy
designed to make business good (1949, 88).

Harding understood that only in allowing the economy to properly restructure could

prices of goods and wages for labor return to equilibrium. For the inflation in money and

thus prices, and the boom in illusory industry, the economy needed to correct itself with

the equal and opposite reaction of deflation in money and thus prices, and the bust in

illusory industry. The policies that contributed to falling prices and the liquidation of

malinvestments certainly contributed to the sharpness of the downturn we spoke to

25
earlier, but this temporary pain was deemed a necessary evil that would quickly return

America to the path of prosperity.

In closing this chapter, I’d like to note that there is great irony in Anderson’s

analysis when one considers Japan’s lost decade, and the fact that the US today is

following many of the same policies the Japanese took both in the early 20th century and

over the last two decades (“The Cause of Japan’s Boom and the Reasons for Its

Prolonged Bust”). More important is our recognition of the contrast in policy between

Harding and every President since. Harding argued that in times of distress, the size of

government must be cut back just as the household cuts back, saving must be encouraged

and so interest rates must be tightened, and the resultant necessary but painful liquidation

of enterprises and fall in prices must occur so as to foster a new period of economic

growth, or as Harding would put it, “a return to normalcy.” Of course given the

dominant Keynesian philosophy in dealing with downturns today, for a politician to take

a stance such as Harding’s seems foolish if not suicidal.

VI. Lessons for Today

Throughout history while the world has evolved, man at root has remained the

same. One of our greatest failures as humans is our inability to learn from the past. In

the case of economic history, I attribute our lack of proper understanding to at best

miseducation, and at worst ignorance, the results of which are particularly harmful. The

Recession of 1920-21 in particular provides an example of a time when policymakers

acted in a way completely contrary to that of any financial crisis since. The results were

that we sustained a harsh but quick restructuring of our economy, and came out the other

side poised for a period of tremendous economic growth and prosperity. Yet who has

26
ever learned of this lesson in a textbook? Where are the mainstream economists and

historians holding this case up as a shining example of successfully confronting economic

pain? Are the rules of recession different now than they were throughout the history of

mankind?

Taken in a vacuum, one might be able to say that the Recession of 1920-21 is but

one mere example of a policy by happenstance working. However, if we look back at the

American experience in all previous recessions, every crisis was met with the same

hands-off, laissez-faire response. Despite banking panics and maladies created by

artificial expansion of money and credit, albeit mitigated by a gold standard, the country

experienced astounding industrial growth and gently falling prices along with a

strengthening dollar, rewarding the American people with an increased living standard

and ascendant position in the world (Rothbard 2000, 5-179). The specifics of downturns

may differ – the 1920-21 crisis was not a subprime one, nor were their trillions of dollars

in derivatives being traded around the world, nor was there a Fannie Mae or Freddie Mac

or any of the thousands of other regulations, bureaucracies, interest groups and other

political influences as in contemporary America, nor was the US a net debtor nation. But

there clearly was great government intervention given the massive imbalances created by

our monetary policy and war. But we survived, adjusted and flourished. Dare I say if we

had continued to follow the policies of letting markets adjust, encouraging the

readjustment of prices and liquidation of failing enterprises to cleanse the economy of

problems caused by government intervention in the first place, eliminating the moral

hazard that characterizes markets today, we might be all the stronger for it.

27
 Moreover, in the early 20th century there was a commitment to certain principles

that the US, along with all great powers historically have lost. Saving and thrift are to be

favored to consumption and profligacy. A prosperous nation must produce more than it

consumes. Wealth emanates from the producers, entrepreneurs and the people, under the

invisible hand of the market, not from enlightened central planners. In times of economic

struggle, governments just as people must tighten their belts. Most important is the

notion that the proper role of government is to protect the life, liberty and property of the

people. We have forgotten these very principles that built our nation to its (fast-

crumbling) hegemonic position. It seems to me that this is the price of success. With

wealth and splendor we forget the toil and sacrifice that was needed to achieve them.

With the growth of the welfare state and the intrusion of government into all sorts

of spheres that in my view our Founders could have never imagined, we have squandered

the fruits of the labors of our forefathers. Adding to our struggles are the policies during

our current depression of continued regulations, bailouts and spending programs intended

to stop our economy from readjusting. I am not without compassion for those hurt by

downturns. It is the moral duty of each of us to judge if and how we should help out our

fellow man during times of struggle. But in my view, government-imposed morality in

current depression policies is both immoral and economically harmful. Its costs far

outweigh its benefits over the long run. These policies will merely indebt our children

and our children’s children, prolong the downturn and further endanger our position as

the leading world power. Governmental action will not solve crises but perpetuate new

ones down the road that will only lead to more intervention and a greater tie of the state

to society.

28
 There is however a beneficial role that our leaders can play in helping our country

back on its feet. Murray Rothbard in his America’s Great Depression puts it better than I

could:

it [government] can drastically lower its relative role in the economy,

slashing its own expenditures and taxes, particularly taxes that interfere
with saving and investment. Reducing its tax-spending level will
automatically shift the societal saving-investment–consumption ratio in
favor of saving and investment, thus greatly lowering the time required for
returning to a prosperous economy. Reducing taxes that bear most heavily
on savings and investment will further lower social time preferences.
Furthermore, depression is a time of economic strain. Any reduction of
taxes, or of any regulations interfering with the free market, will stimulate
healthy economic activity; any increase in taxes or other intervention will
depress the economy further.

In sum, the proper governmental policy in a depression is strict laissez-

faire, including stringent budget slashing, and coupled perhaps with
positive encouragement for credit contraction (2000, 22-3).

I fear that it will take a great many hardships before this lesson is learned. Fortunately,

history tells us that out of crisis comes great opportunity. With this downturn has come

the opportunity for lovers of liberty to educate people on historical episodes such as the

Recession of 1920-21 that bring out fundamentally important insights. Armed with

historical understanding, an actively engaged public will be able to effectuate the change

necessary to return our nation to peace and prosperity. A knowledgeable populace is

dangerous to usurpers of liberty, and it is only a knowledgeable populace that can restore

the Republic to its rightful place as the last, best hope of man on Earth.

29
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