Thursday, October 4, 2012

The Recovery from the US Recession of 1920–1921 and Open Market Operations

The US had a recession between January 1920 and July 1921. The Austrians are forever blathering about it, calling it (incorrectly) a depression and arguing that it shows how free markets can “quickly” end deflationary recessions/depressions. I have refuted this nonsense before here and here.

Now the recovery began in August 1921 and continued into 1922.

Did the development and strength of that recovery have something to do with this, described by Murray Rothbard?:
“Member bank reserves increased during the 1920s largely in three great surges—one in 1922, one in 1924, and the third in the latter half of 1927. In each of these surges, Federal Reserve purchases of government securities played a leading role. “Open-market” purchases and sales of government securities only emerged as a crucial factor in Federal Reserve monetary control during the 1920s. The process began when the Federal Reserve tripled its stock of government securities from November, 1921, to June, 1922 (its holdings totaling $193 million at the end of October, and $603 million at the end of the following May). It did so not to make money easier and inflate the money supply, these relationships being little understood at the time, but simply in order to add to Federal Reserve earnings. The inflationary result of these purchases came as an unexpected consequence. It was a lesson that was appreciatively learned and used from then on.”52

52.Yet not wholly unexpected, for we find Governor Strong writing in April, 1922 that one of his major reasons for open-market purchases was “to establish a level of interest rates . . . which would facilitate foreign borrowing in this country . . . and facilitate business improvement.” Benjamin Strong to Under-Secretary of the Treasury S. Parker Gilbert, April 18, 1922. Chandler, Benjamin Strong, Central Banker, pp. 210–11.

(Rothbard 2000: 133).
In other words, an unprecedented open market operation by the Federal Reserve appears to have strongly aided the recovery process in late 1921.

Strong even said explicitly (as quoted in Rothbard’s footnote) “that one of his major reasons for open-market purchases was ‘to establish a level of interest rates . . . which would facilitate foreign borrowing in this country . . . and facilitate business improvement.’”

Once we see that this policy was combined with Fed cuts to the discount rate during the recession of 1920-1921 we see that it used loose monetary policy to end the recession:
Discount Rate of the Federal Reserve Bank of New York
Date | Rate

May | 6%
June | 7%
Dec. | 7%
Jan. | 7%
Apr. | 7%
May. | 6.5%
Jun. | 6%
Jul. | 5.5%
Sep. | 5%
Nov. | 4.5%

Jan. | 4.5%
Jun. | 4%.
Although the rate was raised to 7% in June 1920, the rate was cut from 7% in 1921 to 5.5% by July, and a further cut to 5% in September as the recovery had begun, and then to 4.5% in November. This was when the open market purchases began.

At this point, I think the whole modern Austrian narrative about 1920–1921 falls apart.


Rothbard, Murray N. 2000. America's Great Depression (5th edn.), Ludwig von Mises Institute, Auburn, Alabama.


  1. True. But the narrative was suspect even prior to this. If I recall correctly the reason for this massive deflation was that WWI had led to very high inflation in most economies. When troops returned home with pay to an economy that was turning away from war manufacture this inflation got even worse. However, as the economy converted back to civilian use the inflation fell precipitously and this led to a recession from which the economy bounced back quite quickly.

    This cannot be compared to a financial crisis induced recession or any other recession that is characterised by marked underconsumption/aggregate demand shortage because it simply was not that type of recession. This can be seen in the fact that prices dropped far faster than did output, indicating that it was mainly an adjustment of prices that affected output rather than vice versa, as would be the case in, for example, the Great Depression.

    In short, this was not a recession/deflation marked by chronic and sustained aggregate demand shortage but instead a sharp price adjustment. It's likely that you could find similar such price adjustments across the developing world. This was not a Keynesian downturn -- if I may put it like that.

    This is pretty well known. And even the Wiki page reflects this consensus:

  2. "At this point, I think the whole modern Austrian narrative about 1920–1921 falls apart"

    So as the recover happened without massive fiscal spending does that mean that the whole Keynesian narrative (about recessions in general) falls apart too , and the Monetarists were right all along ?

    1. (1) Recessions can have different causes, the underlying state of the economy can be different, as well as different speeds of recovery. What Keynesian denies this?

      Your notion that "the whole Keynesian narrative (about recessions in general) falls apart" is nonsense, for Keyensianism says that only in the absence of private sector investment/demand the government steps in to provide it.

      In theory, certain recessions might end quickly in the absence of intervention, if the downtown is not caused by severe economic problems (debt delfation, banking collapse etc.) and the private sector returns to growth.

      (2) But the 1920-1921 recession lasted 18 months. This was not short by contemporary or modern standards. So even this whole Austrian narrative on the alleged rapidity and success of the recovery falls apart a so much nonsense.

      Yes, the private sector eventually started growing again: after Fed discount rate cuts and then OMO in the early months of the recovery to aid that recovery.