There was no US Recovery in 1921 under Austrian Trade Cycle Theory!

Austrian economists and their sympathizers are fond of pointing to the US recession of 1920–1921 as proof that recessions can end “quickly” with a recovery and no government intervention.

In fact, their claims are false and misleading, as I have shown here:

“The US Recession of 1920–1921: Some Austrian Myths,” October 23, 2010.

The following points should be made in response to them:

(1) The recession lasted from January 1920 to July 1921, or for a period of 18 months. This was a long recession by the standards of the post-1945 US business cycle, where the average duration of US recessions was just 11 months. The average duration of recessions in peacetime from 1854 to 1919 was 22 months, and the average duration of recessions from 1919 to 1945 was 18 months (Knoop 2010: 13). Therefore the recession of 1920–1921 was not even short by contemporary standards: it was of average length.

(2) The period of 1920–1921 was not a depression (a downturn where real GDP contracted by 10% or more): it was mild to moderate recession, with positive supply shocks. Christina Romer argues that actual decline in real GNP was only about 1% between 1919 and 1920 and 2% between 1920 and 1921 (Romer 1988: 109). So in fact real output moved very little, and the “growth path of output was hardly impeded by the recession” (Romer 1988: 108–112). The positive supply shocks that resulted from the resumption in international trade after WWI actually benefited certain sectors of the economy (Romer 1988: 111).

(3) there was no large collapsing asset bubble in 1920/1921, of the type that burst in 1929, which was funded by excessive private-sector debt;

(4) Because of (3) the economy was not gripped by the death agony of severe debt deflation in 1920-1921;

(5) There was no financial and banking crisis, as in 1929–1933;

(6) The US economy in fact had significant government intervention in 1921: it had a central bank changing interest rates. The Fed lowered rates and had a role in ending this recession: in April and May 1921, Federal Reserve member banks dropped their rates to 6.5% or 6%. In November 1921, there were further falls in discount rates: rates fell to 4.5% in the Boston, Philadelphia, New York, and to 5% or 5.5% in other reserve banks (D’Arista 1994: 62). By June 1922, the discount rate was lowered again to 4%, and the recovery gained momentum.

It is the height of stupidity to claim that a recession that was ended partly by Federal Reserve intervention through interest rate lowering can be ascribed to the “free market,” or is a vindication of Austrian economics. Nor did the recession end “quickly,” either by contemporary or modern (post-1945) standards.

And there is yet another absurd contradiction here.

An Austrian cannot claim that the recession of 1920–1921 ended with a real and proper recovery. Why? The Fed lowered interest rates. Why did this not cause an Austrian trade cycle and unsustainable boom, distorting capital structure? If it did not, they must explain why the Fed’s lowering of interest rates did not make the market rate fall below the natural rate. How did the economy avoid distortions to its capital structure when it had a fractional reserve banking system and Fed inflating the money supply in 1921/22? How could there have been any real “recovery” in 1921?

In other words, by the Austrians’ own economic theory, the “recovery” of 1921 was no recovery at all: just the beginning of another Austrian business cycle!

BIBLIOGRAPHY

D’Arista, J. W. 1994. The Evolution of U.S. Finance, Volume 1: Federal Reserve Monetary Policy: 1915–1935, M. E. Sharpe, Armonk, New York.

Knoop, T. A. 2010. Recessions and Depressions: Understanding Business Cycles (2nd edn), Praeger, Santa Barbara, Calif.

Romer, C. 1988. “World War I and the Postwar Depression: A Reinterpretation based on alternative estimates of GNP,” Journal of Monetary Economics 22.1: 91–115.