Friday, December 5, 2014

US Monetary Policy and the Recession of 1920–1921

There are all sorts of discussion of this at the moment such as here, here, here, here, here and here.

The libertarian commentary is attempting to deny that monetary policy had a significant role in the recovery of 1921.

In response to this, it can be said, firstly, that the American banking and financial system did not collapse in 1920–1921, as in 1929–1933. Confidence in banks was, more or less, maintained. An important reason for this was undoubtedly the Federal Reserve banking system acting as a lender of last resort with its discounting policy in 1920 to an extent sufficient to avert a mass panic and bank runs, as argued by Wicker (1966: 223). Indeed, the evidence shows that the number of bills discounted by Federal Reserve banks soared until nearly the end of 1920. This fact alone is enough to damn the idea that the recovery from recession in 1921 was unaided by significant government intervention. Without a basic lender of last resort in 1920, admittedly following the classic guidelines of Bagehot to lend at a penalty rate to businesses in distress, it is unlikely recovery would have been so easy or rapid in 1921.

To some extent too, the US economy was just lucky in 1920–1921: discount rate policy proved sufficient to avert banking collapse (instead of bailouts and much more radical intervention that was required in 1929–1933 but not done), the economy was not hit by the type of debt deflation (except perhaps to some extent amongst farmers) as it was in 1929–1933, nor were financial markets affected by the collapse of a massive debt-fuelled asset bubble as in 1929, nor were aggregate demand shocks as bad either. Even the price deflation was partly, and perhaps even significantly, the result of positive supply shocks after the end of WWI and the resumption of shipping, trade and production (Romer 1988: 110; Vernon 1991), not simply from severe aggregate demand shocks.

To return to monetary policy, while the broad US monetary aggregates M1 and M2 did fall in late 1920 and 1921, they clearly did not suffer a disastrous collapse to the same extent as money supply from 1929 to 1933. For example, the broad money supply as measured by M2 fell by about 6.37% from Q3 1920 to Q2 1921, but began growing again in Q3 1921, as can be seen in the graph below (with data from Balke and Gordon 1986: 803).

In contrast, M2 contracted by an incredible 35.31% between 1929 and 1933, as credit contraction, bank runs and over 9,000 US bank failures (Wells 2004: 51) destroyed demand-deposit money and savings held by the public, while the 1920–1921 recession did not have such mass bank runs or liquidity crises in banks (Friedman and Schwartz 1963: 235), and even if some bank failures did occur one wonders whether the M2 monetary contraction was caused more by negative credit growth than by loss of deposits.

The second element of US monetary policy in 1920–1921 was the discount rate as set by regional Federal Reserve banks. At the beginning of 1921 the discount rates of the Federal Reserve banks were either 6% or 7% (data in Discount Rates of the Federal Reserve Banks 1914–1921, 1922). In May a number of regional Federal Reserve banks began lowering discount rates from 7% to 6.5%. Then in July a number of rates were cut from 6% to 5.5%, and to 4.5% to 5% by the end of the year. The recovery from the recession is usually dated to July 1921, so that discount rate cuts did indeed precede the recovery.

The libertarians claim that these rate cuts did not necessarily create loose monetary policy or easy money, but most probably the rate cuts beginning in May 1921 had a great influence on the economy by way of expectations and business confidence – especially by helping to create confidence and expectations of continuing rate cuts and looser monetary policy in the future, as indeed did happen.

Another point that seems to be ignored is that the Federal Reserve system embarked on a proto-form of quantitative easing from late 1921 in which the Federal Reserve banks bought government bonds from November 1921 to June 1922 and tripled such holdings from $193 million in October 1921 to $603 million by May 1922 – a fact even noted by Rothbard (2000: 133), who complained that, to the Federal Reserve officials, “[i]nflation seemed justified as a means of promoting recovery from the 1920–1921 slump, to increase production and relieve unemployment” (Rothbard 2000: 133). Strange how modern libertarians seem to have forgotten this.

Balke, Nathan and Robert J. Gordon. 1986. “Appendix B Historical Data,” in Robert J. Gordon (ed.), The American Business Cycle: Continuity and Change. University of Chicago Press, Chicago. 781–850.

Discount Rates of the Federal Reserve Banks 1914–1921, Government Printing Office, 1922.

Friedman, Milton and Anna Jacobson Schwartz. 1963. A Monetary History of the United States, 1867–1960. Princeton University Press, Princeton.

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

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

Vernon, J. R. 1991. “The 1920–21 Deflation: The Role of Aggregate Supply,” Economic Inquiry 29: 572–580.

Wicker, Elmus R. 1966. “A Reconsideration of Federal Reserve Policy during the 1920–1921 Depression,” The Journal of Economic History 26.2: 223–238.


  1. David Glasner has a post on this too:

  2. Really the key point is that the government ran massive deficits in WW1 and this accumulated as private sector savings that could flow into the economy after the economy adjusted without management in 1920-1921.

    The post-WW2 adjustment was much cleaner and more successful though as it was managed.

    But there is your intervention... right there...

    1. That is a fascinating point!

      Also, the US government was committed to maintaining the gold standard in 1920-1921 which seems to be a major reaosn why they wanted deflation to return to pre-war prices.

  3. I think war has become a necessary process in the democracy-capitalism cycle. As institutions become dominant, politically and economically, they distort market forces, such as carriage makers. World War I ended the lives of many carriage companies that might have had extended lives otherwise. I'm sure there are similar after World War II. Total war helps us forget our institutional ties in favor of our country. When soldiers come back their traditional institutional/career ties become reset and market forces are reset. A unfortunate phenomenon.