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.
Back in the olden days, people simply bartered products. One might trade a couple of loaves of bread for a fish. In order to ease this process so people didn’t have to bring their produce to market, over time people turned to gold, later paper money backed by gold and ultimately paper money backed by faith in government as currency in trade. Money itself should thus be considered as merely a commodity to be exchanged for other commodities. It only differs from other goods to the extent that it is not consumed like milk or sugar or a house. Its value is in serving as a medium of exchange of other goods and services.
As such, it makes no sense that governments should create money through “quasi-private” central banks, or at the very least impose legal tender laws that prevent others from doing so. If there is consumer demand for facilitating the exchange of goods and services, then there will arise through the spontaneous order of the free market a system of competing providers of currencies. Presumably, those who produce money that will retain its value will drive out of the market those incompetent or unscrupulous competitors producing depreciating money. This is because money that retains its value over time will make the exchange of products easier because businesses will be able to make better calculations in exchange, and because as with any product, a premium will be placed on maintenance of value over depreciation.
One could speak to a host of problems with government currency: that inflation of the money supply unfairly benefits debtors at the expense of creditors and serves as an outright tax on all; that a constantly debased currency allows the government to fund unjustifiable wars in addition to all sorts of social programs and other means of unjust and unconstitutional wealth redistribution; that government naturally will mismanage the money supply just as they do all programs from a purely economic standpoint; that it is absurd that the government should have the power to outlaw monopolies yet grant itself a monopoly on a commodity like money that serves a specific special interest of the banking sector; and finally that government’s record in management of the money supply has been horrendous, with central banks creating a perpetual boom-bust cycle and constantly devaluing the people’s money. Concentrating the monopoly power over the money supply in the hands of a select group of bureaucrats is an asinine, irrational and furthermore dangerous policy.
But without going into these sometimes arcane economic phenomena, the most important thing to understand is that at its core, money supply is just like the supply of any other good or service except to the extent that its value is derived from its use as a commodity in exchange, rather than from the utility we gain in consuming a traditional good or service. If the market can provide other goods and services in the proper quantities and qualities to meet the demands of society, then surely it too can provide the proper quantity and quality of money. To believe that somehow, government provision of money is any more sacred or preferable to government provision of any other good or service is pure folly.
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.
Every day we see signs of waning confidence. The politicians pontificate and the markets plunge. Talking heads rile the trading floors. People are panicking, but are unsure as to what drives the panic. Lying behind this turmoil is the fundamental flaw in our economy: our money. The antidote is gold.
Over the last few months we have seen gold rally up to $1000. Suddenly it is being heralded as the investment (if you held it since 2001, you’d really be laughing at this), and rightfully so. Even mindless stock jockeys speak to the fact that in times of uncertainty, gold is the place where people should park their cash. It is the asset of last resort. Yet if this is considered the only safe place to put our money when times are hard, then why not just make this our currency? Why do we have a paper dollar whose intrinsic worth is equivalent to that of paper and ink, or alternatively your faith in Nancy Pelosi?
As the always pithy Daily Reckoning notes, over the last 2,500 years, an ounce of gold has maintained a value roughly equivalent to 350 loaves of bread. Seems like a pretty safe store of wealth to me. Alternatively, the value of the dollar has dropped over 95% since the government (under the auspices of the Federal Reserve) took control of our money less than one hundred years ago. You have to ask yourself, would you rather have your government constrained in the money it creates by a tangible asset that has always held its value, or a government that holds its heavy hand on the cranks of the printing press?
This brings into question another issue. The government does not control the bread supply, the iPod supply or the Kudlow supply. But when it comes to money, a good exchangeable for these other goods and services, we give the government free rein. Sure, one might argue that the central bank is technically private, but this is just the deceitful nature in which the government bends the rules of its Constitution. It is akin to Fannie and Freddie being “quasi-public” entities. But why should the government grant itself a monopoly on this product, while subjecting all private firms to its anti-trust laws?
And how does the government maintain this monopoly on money? Why, legal tender laws of course. There was a time when money was coined privately, but those days are long gone. The question is, why shouldn’t the government allow a little friendly competition for the paper that it prints? The answer is that the power to control the money supply is great. Mainly, it allows the government to plunder the people. Here are a few politicians on the matter:
“Of all the contrivances for cheating the laboring classes of mankind, none has been more effective than that which deludes them with paper money.”
Daniel Webster’s disdain is matched by that of Thomas Jefferson:
“The evils of this deluge of paper money are not to be removed until our citizens are generally and radically instructed in their cause and consequences, and silence by their authority the interested clamors and sophistry of speculating, shaving, and banking institutions. Till then, we must be content to return quoad hoc to the savage state, to recur to barter in the exchange of our property for want of a stable common measure of value, that now in use being less fixed than the beads and wampum of the Indian, and to deliver up our citizens, their property and their labor, passive victims to the swindling tricks of bankers and mountebankers.”
On the other hand, he asserts,
“Specie is the most perfect medium because it will preserve its own level; because, having intrinsic and universal value, it can never die in our hands, and it is the surest resource of reliance in time of war.”
“Specie is the most perfect medium because it will preserve its own level; because, having intrinsic and universal value, it can never die in our hands, and it is the surest resource of reliance in time of war.”
What of Woodrow Wilson, the man who signed the Fed into existence?
“I am a most unhappy man. I have unwittingly ruined my country. A great industrial nation is controlled by its system of credit. Our system of credit is concentrated. The growth of the nation, therefore, and all our activities are in the hands of a few men. We have come to be one of the worst ruled, one of the most completely controlled and dominated Governments in the civilized world no longer a Government by free opinion, no longer a Government by conviction and the vote of the majority, but a Government by the opinion and duress of a small group of dominant men.”
How about an economist for good measure? Perhaps our old friend Mr. Keynes:
“The best way to destroy the capitalist system is to debauch the currency. By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens.”
Thanks for that one, Johnny.
If paper money through inflation impoverishes the citizenry and destroys capitalism, then one has to wonder why the people continue to allow this system to hold sway across all nations. Further, the historical track record of paper monies shows that every single one has failed. But we continue to entrust our money to our politicians. To be sure it is great for some — for the bankers, the war-profiteers and the debtors, inflation is a boon. Not to mention the fact that it allows the government to do whatever it wishes — to run up unlimited debts, fight endless battles and further extend its largesse to its favored sons. This is an immoral process and one that undermines the integrity of our nation.
As we see the flood of people to gold as the only safe asset, in a time without price inflation no less, it behooves us to question the paper money through which our politicians pilfer. Restore power to the rightful hands of the people to produce their own currencies, and we can give the central bankers a run for their money. Our liberty depends upon it.