Download A note on America`s 1920–21 depression as an argument for austerity

Cambridge Journal of Economics 2012, 36, 155–160
doi:10.1093/cje/ber028
A note on America’s 1920–21 depression as
an argument for austerity
Daniel Kuehn*
Key words: Fiscal policy, Austerity, Economic history
JEL classification: N10
1. Introduction
In the aftermath of the global financial crisis of 2008, employment and output plummeted
at a rate and with an international scope unseen since the Great Depression of the 1930s.
Squeezed between falling tax receipts in all cases and an attempted fiscal policy response in
at least some cases, most governments saw their fiscal positions dip into deep deficits. As
economies continued to flag, these deficits inspired calls for public sector austerity among
politicians, policy analysts and many economists. Proponents of austerity have been forced
to respond to an assortment of Keynesians and even monetarists who took the initiative in
the immediate aftermath of the crisis in the financial markets to make the case that
expansionary monetary and fiscal policy were required to arrest the downturn.
Several justifications for austerity have been furnished, but one notable approach in the USA
has been to use the example of a relatively obscure episode in American economic history: the
depression of 1920–21. Advocates of austerity, from politicians seeking high office1 and
Manuscript received 22 June 2011; final version received 27 September 2011.
Address for correspondence: Daniel Kuehn, Department of Economics, Kreeger Building, 4400 Massachusetts
Avenue NW, Washington, DC 20016-8029, USA; email: [email protected]
* American University, Washington, DC.
1
Representative Michelle Bachmann, a Republican from Minnesota, pointed to austerity in the early
1920s in the face of a deep recession (referencing the 1920–21 depression) in a speech before the House of
Representatives on 27 April 2009. Representative Ron Paul, a Republican from Texas, also mentioned
austerity and the 1920–21 depression in an interview with talk show host Bill Maher on 20 February 2009.
Both representatives sought the Republican Party nomination for the 2012 presidential election.
Ó The Author 2012. Published by Oxford University Press on behalf of the Cambridge Political Economy Society.
All rights reserved.
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This note argues that recent interest in the 1920–21 depression in the USA as
a historical precedent for austerity is inappropriate. Most of the austerity
measures preceded the depression, which had already begun receding by the
time Warren Harding implemented the relatively modest spending and tax cuts
that are cited by modern proponents of austerity. The evidence suggests that the
1920–21 depression was the result of a variety of supply constraints, rather than
a deficiency of effective demand, and is therefore a poor test of the efficacy of
Keynesian fiscal policy.
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populist media pundits2 to libertarian magazines,3 have invoked the 1920–21 depression
and the contractionary American policy response to it as an argument for austerity during
the current crisis. This note makes the case that the 1920–21 depression is inappropriate as
a justification for austerity during a Keynesian downturn. Austerity preceded and in all
likelihood caused the depression, which only abated after the Federal Reserve began
lowering discount rates in May 1921. Furthermore, standard Keynesian analysis only calls
for fiscal stimulus in instances where aggregate demand is deficient and excess money
demand raises interest rates to a level that is inconsistent with full employment. No evidence
exists that suggests that the 1920–21 depression was characterised by these conditions, so the
episode cannot be used to empirically assess the efficacy of fiscal stimulus.
2. The austerity depression of 1920–21
3. The Harding administration and the alleged case for austerity
Warren Harding, a Republican from the state of Ohio, was elected president in November
1920 and inaugurated in March 1921 at the trough in industrial production and the
bottom of the depression. Harding continued Wilson’s policy of austerity and balanced
budgets, and rejected the advice of his Commerce Secretary, Herbert Hoover, who
advised spending on public works to combat the crisis. Harding’s maintenance of the
2
Patrick Buchanan advocated the end of expansionary monetary and fiscal policy and the dismantling of
the Federal Reserve System using the 1920–21 depression as evidence in the magazine The American
Conservative on 22 April 2009.
3
Robert Murphy wrote about the 1920–21 depression in the December 2009 issue of The Freeman.
4
This is based on a 12-month moving average of the National Bureau of Economic Research’s monthly
US Federal Budget Expenditure series (series no. m15005b).
5
This is according to the St Louis Federal Reserve Board’s seasonally adjusted industrial production index
(INDPRO) data series.
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During World War I federal expenditures ballooned and although the new income tax was able
to partially finance the war effort, most of the financing was done through federal borrowing and
by the highly accommodating monetary policy of the Federal Reserve. The role of the Federal
Reserve at this time was expressed unambiguously by the New York Federal Reserve Bank
Governor Benjamin Strong, who told a Congressional committee in 1921 that ‘I feel that I, or
the bank at least, was their [the Treasury’s] agent and servant in those matters’ and further
added that the wartime inflation caused by the low interest rates maintained by the bank were
‘inevitable, unescapable, and necessary’ for prosecuting the war (Strong, 1930).
However, after the war ended the deficit spending of the Wilson administration and the
expansionary policy of the Federal Reserve were sharply curtailed to bring a halt to the
inflation. By November 1919 the Wilson administration balanced the federal budget,
slashing monthly expenditures by almost 75% in a matter of months.4 The New York
Federal Reserve Bank raised the discount rate by 244 basis points over the course of eight
months, with other Reserve System banks following suit. Shortly after these austerity
measures were taken, the 1920–21 depression was under way. Postwar industrial
production in the USA peaked in January 1920 as the economy moved into a major
depression, with production levels dropping by 32.5% by March 1921.5 This loss in output
is second only to the Great Depression in American economic history (Romer, 1999),
although its duration was considerably shorter. Declines in output were matched by
precipitous drops in employment and the price level. The proximate cause of the 1920–21
depression was a deliberate fiscal and monetary retrenchment following World War I.
A note on America’s 1920–21 depression as an argument for austerity
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balanced budget inherited from the Wilson administration through the recovery from the
1920–21 depression is the source of most claims that this downturn represents an
empirical case in favour of public spending cuts. Woods typifies the confusion over
Harding’s record and the role of austerity in the early 1920s when he writes that:
Instead of ‘fiscal stimulus’, Harding cut the government’s budget nearly in half between 1920 and
1922. The rest of Harding’s approach was equally laissez-faire. Tax rates were slashed for all
income groups. The national debt was reduced by one-third. The Federal Reserve’s activity,
moreover, was hardly noticeable. As one economic historian puts it, ‘Despite the severity of the
contraction, the Fed did not move to use its powers to turn the money supply around and fight
the contraction.’ By the late summer of 1921, signs of recovery were already visible. The
following year, unemployment was back down to 6.7 percent and was only 2.4 percent by 1923.
(Woods, 2009, p.23)
Here [during the 1920–21 depression] the government and Fed did the exact opposite of what
the experts now recommend. We have just about the closest thing to a controlled experiment in
macroeconomics that one could desire. To repeat, it’s not that the government boosted the
budget at a slower rate, or that the Fed provided a tad less liquidity. On the contrary, the
government slashed its budget tremendously, and the Fed hiked rates to record highs. (Murphy,
2009, p.25)
This claim that the Harding administration and the Federal Reserve implemented
a policy of austerity that caused the American economy to swiftly recover from a deep
downturn forms the foundation of the recent resurgence of interest in the 1920–21
depression. However, the arguments are flawed by their reliance on a confused chronology
of the economic history of the early 1920s. Contrary to the claims of Woods (2009) and
Murphy (2009), most of the austerity measures were implemented by the Wilson
administration before industrial production peaked in January 1920. The scale of Wilson’s
austerity is presented in the 12-month moving average of federal expenditures presented in
Figure 1, below.
This moving average of federal spending declined from just over $1.6 billion to just over
$0.4 billion before the 1920–21 depression began, and well before Harding was even
elected president. The Harding administration passed its first budget in June 1921, when
industrial production had already been in recovery for three months. Although the new
budget continued the spending cuts, the reductions were nowhere near the magnitude of
those imposed by the Wilson administration before Harding came to office and before the
depression began. Assertions that the Harding administration’s tax cuts were an important
contributor to recovery are also weaker than they appear. While marginal income tax rates
were indeed cut in the Revenue Act of November 1921, the tax base that these rates were
assessed against was also widened by lowering the minimum income level in each of
the income tax brackets. The net effect of the reduced marginal tax rates and broadened tax
base was to modestly raise income tax receipts as a share of income from 1921 to 1922,
although marginal rates facing all tax brackets were lowered. After 1922, this total tax
burden did decline, but by that point the depression was over. Thus, the Revenue Act of
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And Murphy points to austerity during the 1920–21 depression as an important test of
Keynesian fiscal policy recommendations:
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1921 only modestly reduced the tax burden in its initial year and it reduced taxes after the
recovery was well under way (Kuehn, 2011).6
Austerity proponents depend on the argument that substantial cuts to federal spending
moved the economy to a recovery in 1921, but this understanding fails on multiple counts.
The bulk of both fiscal and monetary austerity occurred immediately prior to the onset of
the depression. Any austerity in policy decisions by the Wilson administration, the Harding
administration or the Federal Reserve Board after the depression began were moderate
compared with the considerable austerity measures taken by the Wilson administration
and the Federal Reserve before the downturn. The evidence seems to suggest, even more
clearly than in the case of the Great Depression, that postwar austerity may have even
helped cause the 1920–21 depression. Subsequent monetary easing by the Federal Reserve
occurred concurrently with the economic recovery, which itself was underway by the time
Warren Harding took the oath of office.
A point made by proponents of austerity about the 1920–21 depression that still needs to
be addressed is the question of why the economy recovered so successfully despite the fact
that Harding did not engage in the deficit spending advocated by modern Keynesians
during the current crisis. Deficit spending and monetary expansion aid in economic
recovery through a variety of mechanisms, including:
(1) Supplementing effective demand and inducing a fiscal multiplier effect.
(2) Raising inflation and inflation expectations to encourage investment and reduce
potentially sticky wages.
(3) Lowering interest rates to a level that the marginal efficiency of capital is consistent
with, or at least closer to, full employment.
6
Tax cuts during a recession are one of the few policies that advocates of austerity and expansionary fiscal
policy typically agree on. Austerity advocates defend tax cuts on the grounds of reducing the size of
government, while Keynesians laud tax cuts for increasing deficits and bolstering demand. Regardless of this
limited level of agreement, the Revenue Act of 1921 seems to have had too small of an initial impact, too late
in 1921 to have contributed to the recovery from the 1920–21 depression.
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Fig. 1. Federal income tax receipts and expenditures: 1916–24 (millions of dollars, 12-month moving
average). Source: author’s calculations from NBER series nos m15005b and m15002a.
A note on America’s 1920–21 depression as an argument for austerity
159
7
Author’s calculations from the National Bureau of Economic Research’s export data series (no.
m07023). I owe this insight to Donald Boudreaux.
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However, each of these fiscal and monetary policy transmission mechanisms implicitly
assumes a deficiency in effective demand or excess money demand. In a situation where
demand is consistent with full employment, it need not be supplemented by fiscal policy,
inflation is no longer salutary and is instead confiscatory, and there is no upward pressure
on the marginal efficiency of capital that would discourage investment. Keynesian policy is
therefore highly contingent on the existence of demand deficiencies. Thus, to determine
that Keynesian fiscal policy was appropriate to the circumstances of the 1920–21
depression, it would have to be established that the American economy at the time
suffered from a lack of effective demand. A wide range of evidence suggests that this is not
the case and that in fact the economy was constrained on the supply side.
First and foremost, economic performance during this period appears to track discount
rates. Output flagged as the discount rate was raised and recovered as it fell, suggesting that
the cost of capital played an important role in the downturn and that monetary
retrenchment, rather than the weakness of demand itself, played an instrumental role in
the downturn. This was, of course, Benjamin Strong’s understanding of the role of the
Federal Reserve at the time. Discount rates were raised to choke off inflation and the
unsustainable inflationary boom that was required for the prosecution of the war.
Most of the modern literature on the 1920–21 depression, including Vernon (1991),
Temin (1998) and Kuehn (2011), follows Romer (1988) in arguing that the downturn was
more likely attributable to supply constraints rather than demand constraints. High
American exports during the 1920–21 depression relative to the period after the depression
suggests that a lack of demand for American products was not a major constraint on the
economy.7 These findings for the USA are broadly consistent with Broadberry’s (1986)
work on the UK during this period. In the absence of demand deficiencies, fiscal austerity
would not be nearly as problematic as it would be during a traditional Keynesian
depression.
Another constraint that was not faced by the American economy in 1920 and 1921, but
which played a major role in the Great Depression and the current crisis, is the spectre of
a substantial debt overhang. A long literature on the history of American consumer credit
notes that consumer credit did not emerge as a major force in the economy until after the
1920–21 depression (Mishkin, 1978; Olney, 1999; Watkins, 2000). Furthermore, any
debts that had been built up prior to the downturn would have been substantially eroded by
the wartime inflation. No such inflation was available to relieve debtors during the
approach to the Great Depression or the financial crisis of 2008.
From a Keynesian analytical perspective, Wilson and Harding’s austerity is not expected
to be as damaging as the austerity of President Hoover in the early 1930s, because in 1920
no substantial demand deficiencies plagued the economy. With adequate effective demand
and no liquidity trap, any demand management that was required could be achieved by
adjusting monetary policy. This was accomplished by the Federal Reserve System, when it
initiated discount rate reductions in May 1921 to keep the recovery on track. The
assessment presented here suggests that the American monetary and fiscal response to
the initial wartime inflation and the subsequent 1920–21 depression is comparable to the
experience of Federal Reserve Chairman Paul Volcker, who tamed inflation in the early
1980s by inducing a deep but relatively short recession that did not require a fiscal response
by the Reagan administration.
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4. Conclusion
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Kuehn, D. P. 2011. A critique of Powell, Woods, and Murphy on the 1920–1921 depression,
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10, 24–6
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29, no. 3, 572–80
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Proponents of austerity and fiscal stimulus alike should take care in assessing the lessons of
the 1920–21 depression. The evidence is clear that despite the declarations of several
politicians demanding immediate deficit reduction, the 1920–21 depression does not offer
any support to the claim that austerity is appropriate to an economy that is experiencing
deficient effective demand, or even the claim that it aided recovery in the early 1920s.
Austerity measures were implemented before the beginning of the 1920–21 depression and
are mistakenly attributed to Warren Harding, whose modest fiscal contraction paled in
comparison to that of the Wilson administration. Keynesians should also be careful to
demarcate when deficit spending is an appropriate recession-fighting strategy. The
example of the 1920–21 depression is instructive for this demarcation. Austerity is not
obviously problematic when the economy is constrained on the supply side, despite its
destructive consequences when demand is weak. This is not to say that supply-side
problems always merit a policy response of austerity, of course. Egalitarianism and
humanitarianism can plausibly motivate reasonable levels of deficit spending on social
programmes or income maintenance.
Modern proponents of austerity have few arguments in their favour, and the record of
the 1920–21 depression offers no additional support for contractionary fiscal and monetary
policy in a recession characterised by low effective demand, high debt levels and
financial crisis. Citations of Warren Harding’s policy response to the 1920–21 depression
as evidence in favour of austerity in the current crisis are therefore inappropriate.