Having seen it mentioned several times in the past year at various blogs that I follow, I finally read a journal article by an econ PhD student (and Keynesian) on the depression of 1921. The author’s goal is to show that the fiscal and monetary measures taken at the time were consistent with Keynesian recommendations, contrary to those who cite the episode as a rebuke of the theory.
First, to set the stage, many sympathizers of Austrian and Libertarian thought (including Jim Grant) mention this depression as an example where the powers that be sat on their hands, the markets cleared, and the economy was off to the races again within short order. Well, the author contests that depiction, noting primarily that the problem was a supply shock, rather than one of demand, so concerted efforts at running deficits and lowering interest rates in response would not have been appropriate.
The depression came on the heels of World War I, when government borrowing had been significant and inflation meaningful. This reality was, in part, a function of war financing activities that continued long after the actual conflict had ceased. Thus, in 1920, New York Fed Governor Benjamin Strong started raising rates to try and stem the tide of inflation. So, at least as to the claim that the government did nothing, the depression was in many ways a conscious choice by the Fed. Such maneuvers were supplemented by Woodrow Wilson who began to cut federal spending in 1919, and followed up by Warren Harding who implemented his own policies towards a balanced budget once in office.
This brings us to the standard characterization of what J.M. Keynes thought about deflation, versus what he actually wrote – as his views on the subject operate at the core of why many use the 1921 downturn as a rejection of his ideas. The author suggests that Keynes was actually indifferent between inflation and deflation – that he was theoretically in favor of deflating the money supply when prices were rising at a higher rate than the supply of cash. As such, given the circumstances at the time, Keynes was supportive of the policies of Strong and Wilson in order to deflate a post-war credit bubble and stabilize prices.
In addition, the author points out that the depression was largely tied to supply shocks (i.e., declines in output following the war) rather than in demand. And for that reason, monetary policy was a more potent tool (as opposed to calling for fiscal intervention, which is how critics try to contrast the response with what is happening now).
But, here is where the author’s argument starts to go off the rails in my opinion. Basically he argues that you could reduce wages in 1921 (and balance budgets) because everyone understood that these actions were a function of decreased public borrowing and therefore would be temporary. By contrast, in the 1930s, people thought wage decreases would beget more wage decreases and there was no sense that the economic downturn would pass in short order, so fiscal intervention was appropriate.
Huh?
That’s a pretty convenient explanation. Look, I’m happy to acknowledge that 1921 was more supply shock than anything else. I can also go along with the idea that Keynes was not an inflationist always and at all times. However, this emphasis on a very subtle and arguably expedient caveat regarding how long wage reductions would last, sorry, but I’m calling bullshit. Everything else lines up with the Austrian story, then, lo and behold, we emphasize a notion of expectations that is hardly verifiable (I would point out that the author is happy to footnote sources that confirm his other contentions in the article – in this case, nothing). And the article’s alternative interpretation largely hinges on this idea of expectations about wage reductions.
Another important point – the author does present Keynes’ views in a way that suggests that deflation can be an appropriate tool. But, what the man thought then is not necessarily how the religion is practiced now. Fiscal intervention in its current forms is never temporary. Reminded of Minsky, the current wizards are always pushing for do-overs and bailouts. They are encouraging instability and defaulting to inflation as the preferred solution. So, maybe Keynes stands up reasonably against the Austrian tale of 1921, but today’s practitioners of his cult don’t do as well.
I think, as with most things in economics, that no one has a monopoly on the right answer. Such is the case with efforts to turn the 1921 depression into a slam dunk for one school of thought over another. The author certainly pokes some holes in other renditions of this tale, but he hasn’t discredited the basic implications that follow from the fact that there was a credit bubble and that fiscal intervention was not needed – his gyrations about expectations are just not convincing.
