Though I have written extensively about the Recession of 1920, it is worth revisiting it per Glenn Beck’s show last night. Beck rightly pointed out that the policies of decreased taxes and decreased government spending implemented by both Harding and Coolidge paved the way for the dramatic economic growth of the roaring 20s. What Beck didn’t mention was that prior to this period of unprecedented economic expansion, President Warren Harding had inherited one of the worst recessions in American history. This Recession of 1920-21 is another one of the dirty secrets glossed over in the Progressive history books.
By late 1919, America was facing inflation in prices as measured by CPI of 20%. Between 1920 and 1921, unemployment doubled from 5.2 to 11.7%. During this same period, from their peak in June of 1920, prices declined by 15.8% on a year-over-year basis, a 50% greater deflation in prices than during ANY 12-month period during the Great Depression. So what was Harding’s proposal to deal with this mess? To understand how to get out of recession, Harding looked towards how we got into it in the first place.
For America was coming out of World War I. Government was controlling huge swaths of the economy, as it had mobilized land, labor and capital towards war production and away from normal commerce as dictated by consumer demand. In addition to the mass of resources that needed to be reallocated according to market forces, the economy had been further distorted due to the policies of the Federal Reserve which had inflated the money supply by 71% from 1913-1919 (while the physical volume of business had only increased by 9.6%), and whose policies had led to an increase in prices of a staggering 234% between 1914 and 1920. Prices needed to readjust according to the reallocation of resources. In addition, not surprisingly, due to the costs of war, the federal budget had grown to $18.5bn.
One will note the parallels to our economic situation today. Just as war led resources to be allocated away from where an unfettered economy would have directed them, so too did the artificial boom fueled by the Federal Reserve and various government policies lead resources to be misallocated towards assets such as houses and stocks during our most recent boom and bust cycle. While unsustainable businesses and concomitant rises in prices developed in the private sector, the government too drastically increased.
Harding understood the root cause of recession. As he noted in his inaugural address:
The economic mechanism is intricate and its parts interdependent, and has suffered the shocks and jars incident to abnormal demands, credit inflations, and price upheavals. The normal balances have been impaired, the channels of distribution have been clogged, the relations of labor and management have been strained. We must seek the readjustment with care and courage…All the penalties will not be light, nor evenly distributed. There is no way of making them so. There is no instant step from disorder to order. We must face a condition of grim reality, charge off our losses and start afresh. It is the oldest lesson of civilization.
And so what was his big Keynesian stimulus plan to bring the economy back from the abyss? He argued during his Republican nomination speech:
Gross expansion of currency and credit have depreciated the dollar just as expansion and inflation have discredited the coins of the world. We inflated in haste, we must deflate in deliberation. We debased the dollar in reckless finance, we must restore in honesty. Deflation on the one hand and restoration of the 100-cent dollar on the other ought to have begun on the day after the armistice, but plans were lacking or courage failed. The unpreparedness for peace was little less costly than unpreparedness for war. We can promise no one remedy which will cure an ill of such wide proportions, but we do pledge that earnest and consistent attack which the party platform covenants. We will attempt intelligent and courageous deflation, and strike at government borrowing which enlarges the evil, and we will attack high cost of government with every energy and facility which attend Republican capacity. We promise that relief which will attend the halting of waste and extravagance, and the renewal of the practice of public economy, not alone because it will relieve tax burdens, but because it will be an example to stimulate thrift and economy in private life.
And so, shockingly Harding practiced what he preached. Regarding deflation, the Federal Reserve jacked up interest rates from 4.75% in January 1920 to 7% in June 1920, and held this rate through the aforementioned major drop in prices through May of 1921. Harding slashed the federal budget from $18.5bn in 1919 to $6.4bn in 1920 all the way down to $5.1bn in 1921. Meanwhile, the government actually ran surpluses during these years, allowing them to pay down the debt by $300mm from 1920-21. The Chief Economist of Chase National Bank of the era, Benjamin Anderson summed Harding’s philosophy and his attack on the recession as follows:
The idea that a balanced budget with vast pump-priming government expenditure is a necessary means of getting out of a depression received no consideration at all. It was not regarded as the function of the government to provide money to make business activity. It was rather the business of the US Treasury to look after the solvency of the government, and the most important relief that the government felt that it could afford to business was to reduce as much as possible the amount of government expenditure, which had risen to great heights during the war; to reduce taxes—but not much; and to reduce public debt.
Nor did the government increase public employment with a view to taking up idle labor. There was a reduction in the army and navy in the course of these years, and there was a steady decline in the number of civilian employees of the federal government. This policy on the part of the government generated, of course, a great confidence in the credit of the government, and the strength of the gold dollar was taken for granted. The credit of the government and confidence in the currency are basic foundations for general business confidence. The relief to business through reduced taxes was extremely helpful.
According to Anderson, how did the recession end?
…we took our losses, we readjusted our financial structure, we endured our depression and in August 1921 we started up again. The rally in business production and employment that started in August 1921 was soundly based on a drastic cleaning up of credit weakness, a drastic reduction in the costs of production, and on the free play of private enterprise. It was not based on governmental policy designed to make business good. (See Benjamin Anderson’s Economics and the Public Welfare or his gratis “The Return to Normal“)
Now we can debate fiscal and economic policy all day, but across the spectrum, it should be clear to all that a government that intervened and created the conditions for economic crisis will not be able to solve it. If government’s can create prosperity when the private sector is imperiled, then why would Americans be against government central planning when all is rosy? Do the rules of economics not apply during downturns?
If we can agree that recessions are the result of resources being improperly allocated, then we can also agree that the only way to return to economic health is to allow for their reallocation according to the market. This involves allowing nonproductive business ventures to go belly-up, prices to naturally fall where they have unjustifiably risen and reduction in the size of government allowing resources to be released to entrepreneurs to reverse the ills of the artificial boom and spur growth. All measures that impede the natural cleansing of an economy will only ensure pain and suffering like that witnessed over the last few decades in Japan. Harding had things right and it would do our lawmakers good to follow his lesson: central planning and government control creates problems; innovative Americans are the only ones who can solve them.
1. The interest rate is a price – the price of credit like the price of any good. In a free market the price would be set like the price of any good at the intersection of the supply of funds (our savings), and demand for funds (businesses’ and individuals’ investing wants). Instead, we have an interest rate that is arbitrarily picked by a handful of economists from the Federal Reserve Banks. To repeat, one committee centrally plans the cost of credit, of which interest rates on all debt are directly or indirectly based.
2. The Federal Reserve has the monopoly power to print or inflate the money supply, thus artificially lowering the cost of money (the aforementioned interest rate). This means that they can (and always do) devalue the money in your pocket as every dollar printed decreases the value of all dollars to come before them. Inflating the money supply may not lead to an increase in prices if an equal or greater amount of goods is produced, but the purchasing power of the dollar will still be reduced because without printing money, your dollars would have been able to buy more goods. Alternatively, if more dollars are printed than goods are produced, prices will increase though not necessarily uniformly across all goods. Inflation may not manifest itself in explicitly higher prices but merely impede prices from falling for certain goods as they would were the money supply to remain constant.
3. When you deposit money in a regular checking account, the bank doesn’t hold onto this money. Banks only keep a small percentage of the money you deposit on hand in their reserves, lending the majority of the money you (or the Fed for that matter) deposit to others who lend it to still others and so on, in the process substantially increasing the money supply. This is known as fractional reserve banking. If everyone in America or even a decent percentage of Americans tried to take their money out of the bank on a given day, millions would be unable to access their cash. Effectively, even with FDIC Insurance, all of the banks are insolvent as they do not hold anywhere near 100% of the money you deposit in their vaults, nor does the FDIC have the funds to cover all deposits. The hypothetical that the Fed could potentially print up money for the FDIC to distribute is beyond the scope of this post.
4. The government’s debt is merely an insidious tax like inflation. Government debt can only be paid down by taxing the people. This tax can occur through direct confiscation by government, or indirectly when holders of our government’s debt demand a higher rate of interest, which in turn signals to markets that our economy is not generating sufficient revenues to pay down the debt, which leads to a perception of economic weakness and thus an increased cost of borrowing for everyone in the economy. If the government prints money to pay down debt (which in and of itself should cause our debt holders to flood the markets with our debt and thus raise interest rates on everyone), this will represent a tax on the people as well.
5. Deflation, or a decrease in the money supply is the only antidote to inflation. If the money supply is decreased, each dollar in your pocket becomes worth more. The concomitant fall in prices will correct the artificial initial rise in prices from government printing of money. In the process, since decreasing the money supply increases the cost of money, unsustainable enterprises with heavy debt loads will be put out of business, cleansing the economy by freeing up unproductive resources. Where debtors benefit from an increase in the money supply because they can pay down their borrowings with cheaper dollars, creditors will benefit from a decrease in the money supply because they are paid back with more valuable dollars, which is one of the reasons why government prefers to inflate as it can lessen its own debt load and that of many of its constituents.
6. Deflation in prices while a symptom of deflation of the money supply is also the natural result of increases in productivity, as goods produced more cheaply in greater quantities (in the absence of money printing) will lead to falling prices which benefits consumers. The so-called “paradox of thrift” that the MSM uses to vilify deflation in prices is wrongheaded, as people will spend on all sorts of products knowing that over time they will fall in price, as we have witnessed with numerous electronics over the years. Even during a depression, when asset prices fall to certain levels there will always be buyers. And if people are paying off their debt and/or saving in a time of falling prices in lieu of spending, this will be good for the economy because increasing the pool of real savings lowers the interest rate and allows businesses and individuals to borrow funds for investment at lower cost, legitimately stimulating the economy.
7. Despite the wishes of President Obama, all taxes are passed on to consumers as companies raise their prices to compensate for the increased cost of doing business.
8. Government cannot create wealth. All it can do is take money from some people and redistribute it to others. Every dollar the government uses must be taken from the private economy. Printing money to pay for things as we noted merely devalues your dollars, effectively taxing you. Government financing through debt represents a claim on your wealth, a tax which as noted may be paid directly or indirectly. Thus, while federal, state and local taxes may appear on a historical basis relatively low, the tax rate is deceptively masked by excluding government bilking through inflation and debt. Government is a wealth killer, not a wealth creator.
9. The real estate problem in our economy centers on the fact that people owe more money on their mortgages than they are able to pay down. The only fix to this problem is for people to either generate more income to service their mortgages, or default. Any intervention to keep people in homes they can’t afford will merely perpetuate market imbalances, propping up the value of real estate and preventing qualified buyers from purchasing homes at fair prices. There will be no true recovery in the mortgage-backed securities market until the forces of supply and demand sort out this mess.
10. Our economic crisis at the most basic level occurred because too much money and credit were pumped into the economy, given that again the interest rate was set artificially low not by supply and demand in the market but by government fiat. The recession signals that we must fix the distortions and malinvestments resulting from the centrally planned interest rate. The healthy path to recovery is to allow prices to fall (aided by debt repayment), liquidate failed enterprises (encouraging reallocation of land, labor and capital to more productive and profitable lines of business) and encourage saving to increase the pool of loanable funds for economic expansion. Any actions to the contrary (i.e. more or less all government policies being implemented or bandied about) will merely prolong the pain.
In my study of political economy, one of the most overlooked yet fascinating historical episodes I have come across is the Recession of 1920-21. A handful of free-market economists have tackled this crisis, and I decided to throw in my lot with them and pursue the subject further myself.
Below is the abstract for my critique of the acutely sharp downturn (so you know what you’re getting into) and the embedded paper in Scribd format. Scribd however is a bit screwy in its formatting of the paper, failing to capture various diagrams for example, so I strongly suggest instead reading the Word doc downloadable HERE.
Abstract: Many attribute our current recession to the evils of unbridled capitalism. In response, our leaders have embarked on the typical Keynesian recession prescriptions in order to stimulate the economy and lead the nation out of the economic doldrums. Unbeknownst to most Americans however, prior to the Great Depression, policymakers used different tools to help guide the country out of recessions. Herein we examine the causes, responses and insights gleaned from the Recession of 1920-21, the last downturn in which leaders relied on the age-old policy of laissez-faire, combined with massive reduction in government and encouragement of deflation.
In a recent New York Times Op-Ed entitled “Till Debt Does Its Part,” Nobel Prize-winning economist Paul Krugman rebuffs those few reactionary souls who argue that all this debt we are incurring is a bad thing. He assures us,
…don’t fret about this year’s deficit; we actually need to run up federal debt right now and need to keep doing it until the economy is on a solid path to recovery. And the extra debt should be manageable. If we face a potential problem, it’s not because the economy can’t handle the extra debt. Instead, it’s the politics, stupid.
Sometimes you really have to wonder what the standards are for winning a Nobel Prize. We have an economy built on consumer debt which relative to disposable income increased from a low in 1945 to its peak in 2007. As the Daily Reckoning further notes, we have $20 trillion in excess debt to work through over the coming years. Yet while on the private side, we need to pay for our sins, liquidate our debts, allow malinvestments to go belly up and start over on more solid fiscal ground, apparently the public sector can just keep on trucking.
As the sage Mr. Krugman notes,
Right now deficits are actually helping the economy. In fact, deficits here and in other major economies saved the world from a much deeper slump. The longer-term outlook is worrying, but it’s not catastrophic. The only real reason for concern is political. The United States can deal with its debts if politicians of both parties are, in the end, willing to show at least a bit of maturity. Need I say more?
Explain this to me exactly. When are deficits a help to an economy in distress? If the whole reason we are in economic distress is because of a glut of debt, then why is the answer to pour more gasoline on the fire? Any company that still functions in any semblance of a free market knows that if it can’t service its debt, it will be forced to make difficult decisions, potentially opting for bankruptcy. It cannot continually slop at the trough of the debt market.
But Krugman seems to think that the government can have its cake and eat it too. Where a sober person might argue that in hard times, a government must tighten its belt, like a business or a man, Krugman seems to think that incurring more and more debt, in essence stretching out the inevitable painful liquidation whilst creating another debt/currency crisis down the road is better. Why have one financial crisis when you can have two or three stretched out over a longer period of time? You get the sense that Krugman’s agenda is more political than economic sometimes.
Which brings me to my next point. Krugman believes the only reason for concern over the debt is “political.” Proud of this claim, Krugman states, “Need I say more?” Well yes, I think you need do so. Our currency, and the debts run up by our government denominated in our currency are backed by the full faith and credit of the United States government; which is to say our money and debt are backed by our economy, our people. If we are in for a prolonged period of negative private sector growth, high unemployment and increased intervention in all aspects of life, especially our economy, how can Krugman make the assumption that the ability to continue adding to our debt solely rests on the “maturity” of the politicians? Can Barney Frank snap his fingers and suddenly make the world buy our paper?
If the politicians wish to be “mature” they can remove themselves from the private sector, slash spending and taxes, let whole swaths of industry go belly up and allow people to foreclose on their homes and pay off their debts. Alternatively, if the politicians wish to be immature, they can do so through intervention and coercion.
Krugman as one might expect opts for the latter, immature route. Mind-numbingly, he proclaims:
If governments had raised taxes or slashed spending in the face of the slump, if they had refused to rescue distressed financial institutions, we could all too easily have seen a full replay of the Great Depression.
As I said, deficits saved the world.
In fact, we would be better off if governments were willing to run even larger deficits over the next year or two. The official White House forecast shows a nation stuck in purgatory for a prolonged period, with high unemployment persisting for years. If that’s at all correct — and I fear that it will be — we should be doing more, not less, to support the economy.
Krugman, going along with his Keynesian (read socialists) brethren, forgets about the failures of all of the interventionism even before his idol FDR ever got into power during the Depression, in addition to the disastrous results of similar policies (which he of course advocated) over the last two decades in Japan. These frauds continue to peddle the same illogical government gobbledygook that prolonged the Depression, all the way to “cash for clunkers”, the modern day equivalent of FDR’s forced killing of crops and slaughtering of pigs.
Mr. Krugman seems to think that interventionism is what saves economies. Might I ask then, why not intervene from the start? If the state is so good at managing crises, why not let it manage all industry in good times as well? Is the free market only sufficient when the Dow is rising? And if deficits are the cure-all, then why do nations ever default on their debt? Why is Zimbabwe the way Zimbabwe is? Could it be that perhaps the central planners are not so divine after all?
To be fair, Krugman, digressing notes:
But what about all that debt we’re incurring? That’s a bad thing, but it’s important to have some perspective. Economists normally assess the sustainability of debt by looking at the ratio of debt to G.D.P. And while $9 trillion is a huge sum, we also have a huge economy, which means that things aren’t as scary as you might thinkHere’s one way to look at it: We’re looking at a rise in the debt/G.D.P. ratio of about 40 percentage points. The real interest on that additional debt (you want to subtract off inflation) will probably be around 1 percent of G.D.P., or 5 percent of federal revenue. That doesn’t sound like an overwhelming burden.
Even though all this debt we’re adding on might not actually be so great, we have a huge economy. Ah, the panacea of the huge (albeit shrinking) economy – an economy based on consumption, services and debt, the hallmarks of any economic powerhouse. He also argues that a rise in debt/GDP of 40% is OK, since this debt will only be 5% of federal revenue, which doesn’t sound so overwhelming. So essentially, because it’s only 5% of a massively-sized federal government which will have ever-decreasing tax revenues necessitating continued debt financing (to pay for more boondoggles), we should be OK to pay off our debt (with devalued dollars I suppose?).
What might our lenders think about that? Krugman has an answer for this too.
Now, this assumes that the U.S. government’s credit will remain good so that it’s able to borrow at relatively low interest rates. So far, that’s still true. Despite the prospect of big deficits, the government is able to borrow money long term at an interest rate of less than 3.5 percent, which is low by historical standards. People making bets with real money don’t seem to be worried about U.S. solvency.
I would challenge the assumption that the US government’s credit will remain good. As Krugman notes, our debt/GDP is going to rise significantly, “The official White House forecast shows a nation stuck in purgatory for a prolonged period, with high unemployment persisting for years,” and as I mentioned government is intervening in the economy on an unprecedented scale, but relax, our friends in the Far East will continue to bankroll us. Krugman should take a page from Milton Friedman’s playbook (along with those of Hayek, von Mises and Bastiat) and remember that there is no such thing as a free lunch. All government can do for “revenue,” is directly tax, or indirectly tax through issuing debt (taxing future generations and/or devaluing the currency) or printing money.
While Krugman argues that the people “making bets” don’t seem worried about our solvency, as numerous publications have noted, the Chinese are buying less treasuries and stockpiling commodities (however short-lived the Times may think it will be), indicating that they are diversifying out of dollar-denominated assets. Meanwhile, the government has had to take the drastic measure of purchasing its own Treasuries, with the Fed committing to buy $300bn in notes (i.e. printing $300bn) and also monetizing the debt more discretely. In other words, the government has had to keep its own borrowing costs down artificially, making up for the lack of demand of its primary dealers by bidding for its own debt. But look at the YTD yield curve for the 10-Year Treasury, and tell me that the markets aren’t reacting at all to our fiscal recklessness:
Moreover, just because rates haven’t spiked by 500bps in the last year, does that mean that market participants really aren’t scared about our solvency? Markets can stay irrational for long periods of time, just look at the housing bubble or any of the other bubbles which after the fact have seemed so obvious. Further, I would argue that creditors like China are being perfectly rational. The Chinese are trying to shift their money towards assets with real tangible value like commodities, while doing as little as possible to spook the government debt markets, because doing so would hurt the value of their own paper. If they flooded the markets with Treasuries, all of their dollar-denominated assets would plummet in price. It’s not in their interest for there to be a run on the US government yet. But that doesn’t mean that they won’t slowly but surely make their exit from US paper assets, leading to higher borrowing costs for our government and less confidence in our dollar. As I mentioned, there is no free lunch.
Krugman notes that other governments that have practiced similar profligacy like Belgium and Italy never faced financial crises in the early 1990s, but there are obvious notable differences. We are the biggest economy in the world. We were the most prosperous one. We have the world’s reserve currency. We are not accustomed to the kind of fiscal stagnancy faced in Europe. I just do not see that Krugman’s comparisons hold water. A more apt comparison in my eyes would be the US versus the British Empire circa its collapse.
Regardless, I want to return to the fundamental point that going into more debt to solve a problem caused by too much debt makes no sense. One might argue that sometimes debt can be beneficial and not cause long term harm. One might cry that parents are right to take out a mortgage on a house to raise their children. If the family can reasonably expect to generate the cash flows to retire this debt over time, then this will certainly be fine. But the US is like one giant family of drug-addled deadbeats looking to buy a mansion in the Hamptons, having already foreclosed on its subprime mortgage, maxed out all of its credit cards and traded in its Rolexes to the local pawn shop. And its only cash flows are those it can obtain by plundering its citizenry.
Debt is OK if you can reasonably expect to pay it off. To incur even greater debt in the face of debt that you will already be unable to service is downright immoral and will lead to severe consequences for the people.
These deficits in and of themselves are also not productive. They represent a stealing of wealth from future generations. As I mentioned, the only way to pay down the debt will be to tax future Americans, either directly or indirectly through inflating the money supply and thus devaluing the currency. Further, regarding what the debts are actually being used to finance, as I have argued in accordance with sound Austrian economics, the deficit spending for bailing out failing ventures stops the market from naturally adjusting, and leads to less productive if not downright destructive “jobs,” and labor being diverted from the private sector.
So in some respects again, Krugman is right that our politicians need to be mature. But the people get the government they deserve, and as of yet though there have been some bright signs, the majority of people don’t seem to want to deal with the pain that mature servants would bring them today for a brighter tomorrow.
It is worth noting that in Krugman’s delusion, he actually makes a redeeming comment:
Over the really long term, however, the U.S. government will have big problems unless it makes some major changes. In particular, it has to rein in the growth of Medicare and Medicaid spending.
He actually has me for a second, until the subsequent stanzas:
That shouldn’t be hard in the context of overall health care reform. After all, America spends far more on health care than other advanced countries, without better results, so we should be able to make our system more cost-efficient.
But that won’t happen, of course, if even the most modest attempts to improve the system are successfully demagogued — by conservatives! — as efforts to “pull the plug on grandma.”
Keep it classy, Paul.
2. Do you believe it is our right as citizens to know how the TARP money is being spent, and what banks are using as collateral for the cash they are receiving?
3. Why will the economic stimulus package work, and historically has this type of stimulus ever worked?
4. Why does the Federal Reserve still hold gold in its reserves?
5. What is the paper USD intrinsically worth, and can you explain why it is okay for you to have a monopoly on it?
6. Can you name a fiat currency that has not eventually failed? (the answer can be found here)
7. Why has the purchasing power of the dollar decreased 95% since the Federal Reserve was created in 1913?
8. Can you explain why after a bubble bursts, falling prices are bad for consumers?
9. Can you explain why if inflation makes the price of goods higher for the consumer that it is good for the economy?
10. If we saw that pumping in massive amounts of credit to our financial system led to an unsustainable bubble, why is the goal of your policies to create massive amounts of credit?
First, a slightly off-topic point: how perfect would 2pac’s “Changes” have been as the theme song for Barack’s campaign? Anyways, moving on, I know it’s a little early to start criticizing B. Obama since he has not yet taken office, but based on his appointments and proposed plans, I do think this list is somewhat merited. Without further ado, the 5 reasons (thus far) Obama is not about change:
1. His staff which is composed of almost all of Bill Clinton’s old cronies
2. The stimulus plan which results in massive increases in government spending, while further increasing our deficit for years to come
3. His choice for Vice President, Joe Biden – a real outsider in Washington
5. Massive pork-barrel spending with no signs of budget cuts ANYWHERE (except maybe in defense – smart move) – I thought he was going to go through the budget line-by-line but haven’t heard much talk of that lately; either way, increased spending and long-term debt is surely the way to prosperity
Change we can believe in!