The Crash That Cured Itself

The Spanish Flu of 1918 is an event that, unsurprisingly, is being revisited by many observers today. And yet, at the same time, another major event occurred a century ago which we would also do well to remember: namely, the largely forgotten economic depression of 1920.

We all hear, from time to time, about the ghost of the 1929 Crash, of the dreadful decade of the Thirties, of the Great Depression from which the world (supposedly) only recovered at the cost of a new World War. It is even likely that, in the COVID-19 context we currently face, many people believe that, unless all national and international governments and organizations move ahead with drastic measures, we are condemned to a similar fate. Nonetheless, the depression of 1920 can provide us with a starkly different picture.

After the end of World War I, some months of high profits and renewed expectations followed. Unfortunately, due to the gigantic inflation and government controls introduced during the war, as well as the deaths caused by that same war and the pandemic that followed, a great economic readjustment was unavoidable, which eventually came along in 1920.

Renowned financial analyst James Grant, author of the book The Forgotten Depression: 1921: The Crash That Cured Itself, provides shocking data for the United States. Grant tells us that the Federal Reserve index of industrial production fell by 31.6% from 1920 to 1921. In comparison, in the crisis years 2007-09, it “only” fell by 16.9%. And with respect to the unemployment rate, Grant estimates that it may have reached as high as 15.3%.

Meanwhile, according to Grant, “over the course of 12 months, wholesale prices plunged by 36.8 percent, consumer prices by 10.8 percent and farm prices by 41.3 percent (for speed of decline, not even the Great Depression would match the break of 1920–21). The Dow Jones Industrial Average, then comprising 20 stocks rather than today’s 30, crested in November 1919 at 119.62 and bottomed in August 1921 at 63.9, for a peak-to-trough decline of 46.6 percent.”

It seems abundantly clear that the situation was dire. Profits drastically fell, companies were liquidated and taken over in a wave of bankruptcy procedures, until … it all reverted. As professor, banker and “Austrian” fellow traveller Benjamin M. Anderson (1886-1949) described it in his memoirs, “in 1920-1921 we took our losses, we readjusted our financial structure, we endured our depression, and in the month of August, 1921, we started up again. By the spring of 1923 we had reached new highs in industrial production and we had labour shortages in many lines.” Historian Thomas E. Woods, Jr. concurs: “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.” The economy was ready for the Roaring Twenties.

What had happened? What did the government do to push the economy out of the ground? The answer is: nothing. Or better still: it cut spending to balance the budget and reduce public debt. There were no massive liquidity “bazookas” shot by central banks, no giant stimulus programs from the Ministry of Economy, no price or profit margin controls. President Wilson had suffered a severe stroke at the end of 1919, which left him practically disabled for the rest of his presidency, while his successor, Warren G. Harding, declared the following in his 1920 acceptance speech for the Republican presidential nomination:

“Let us call to all the people for thrift and economy, for denial and sacrifice if need be, for a nationwide drive against extravagance and luxury, to a recommittal to simplicity of living, to that prudent and normal plan of life which is the health of the republic. 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.”

Thus, the federal budget was reduced from 18.5 billion dollars in 1919 to 3.7 billion dollars in 1922 and public debt fell from 26 billion dollars at the end of 1919 to 22.3 billion dollars in June 1923.  One can easily see why Grant described this depression as “the crash that cured itself”. As he ironically notes, “by the lights of Keynesian and monetarist doctrine alike, no more primitive or counterproductive policies could be imagined.”

But wouldn’t it have been better if the government had “softened” things a little bit? That would probably have been achieved at the cost of stagnation, as in the case of the Thirties, and of greater problems in the future, as in the case of Japan, described by Anderson:

“[E]arly in 1920, the great banks, the concentrated industries, and the government got together, destroyed the freedom of the markets, arrested the decline in commodity prices, and held the Japanese price level high above the receding world level for seven 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 seven years, only to incur greatly exaggerated losses at the end. The New Deal began in Japan in early 1920.”

The First World War was seen by the state bureaucracies of the West as a definitive proof of how tasteful an extensive state control of the capitalist engine could be. On the other hand, the disintegration of the classical gold standard and the return to a blatant use of central banks to finance war debts at the cost of inflation had marked the end of the classical liberal world order based on international commerce and financial discipline. Still, some traces of the cultural values and traits that had led to its extraordinary ascension could still be found, specially in the American population. One need only remember that both the Federal Reserve and the Income Tax, as we know it today, had only been established in the United States a few years before, in 1913.

Since then, much has changed, including, of course, the legal, institutional and even cultural context of our economies. Economy means people – and modern society does not seem to have the cultural and institutional “anchors” that would allow it to endure, like in the 2020-21 shock, so drastic a recipe as that circumstantially applied a century ago. And yet, the “Forgotten Depression” can still teach us important lessons: that there was once a time when individuals and communities used to overcome even the worst depressions, by making use of their freedoms; and that the interventionist and spendthrift state is often more part of the problem than it is of the solution. These are important insights we need to keep in mind especially today.