Rev Austrian Econ (2011) 24:273291 DOI 10.

1007/s11138-010-0131-3

A critique of Powell, Woods, and Murphy on the 19201921 depression

Daniel Kuehn

Published online: 28 October 2010 # Springer Science+Business Media, LLC 2010

Abstract A series of recent reviews of the depression of 19201921 by Austrian School and libertarian economists have argued that the downturn demonstrates the poverty of Keynesian policy recommendations. However, these writers misrepresent important characteristics of the 19201921 downturn, understating the actions of the Federal Reserve and overestimating the relevance of the Harding administrations fiscal policy. They also engage a caricatured version of Keynesian theory and policy, which ignores Keyness views on the efficacy of nominal wage reductions and the preconditions for monetary and fiscal intervention. This paper argues that the governments response to the 19201921 depression was consistent with Keynesian recommendations. It offers suggestions for when Austrian School and Keynesian economics share common ground and argues that the two schools come into conflict primarily in downturns where nominal interest rates are low and demand is depressed. Neither of these conditions held true in the 19201921 depression. Keywords Macroeconomics . Economic history . Keynesianism . Austrian School . Monetary policy . Fiscal policy JEL Codes B53 . E12 . E31 . E32 . E58 . E62 . N12

1 Introduction Since the beginning of the Great Recession in 2008 and the renewal of the heated debate over the efficacy of fiscal and monetary stimulus, several articles have argued

D. Kuehn (*) The Urban Institute, Center on Labor, Human Services, and Population, 2100 M St. NW, Washington DC 20037, USA e-mail: dkuehn@urban.org

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that the events surrounding the 19201921 depression vindicate the Austrian School and decisively invalidate Keynesianism (Powell 2009; Woods 2009; Murphy 2009).1 These authors contend that the speedy recovery of the economy in 1921 and 1922 in the absence of fiscal intervention demonstrates that government inaction, or even austerity, is the ideal remedy for a downturn. The apparent success of the rapid liquidation of malinvestments that were made during the inflationary prologue to the depression is furnished as empirical support for the Austrian Schools contentions. There is a genuine prospect that these recent reviews will emerge as the canonical Austrian interpretation of the 19201921 depression, because few other Austrian economists have engaged or commented on that downturn. Hayek (1925) and Rothbard (2002) only mention the downturn casually, instead focusing on monetary policy immediately after the 19201921 depression as a precursor to the Great Depression. Mises does not appear to cover the American downturn of this period at all. This paper argues that the broad acceptance of the Powell (2009), Woods (2009), and Murphy (2009) interpretation would be problematic for two primary reasons. First, the position of Powell (2009) and Woods (2009) is based on a fundamental misunderstanding of the American monetary and fiscal policy response to the postwar inflation and the subsequent deflationary depression. Contrary to the case laid out by Woods (2009), the Federal Reserve played an active role in this period. Powell (2009) and Woods (2009) also overemphasize the relevance of the Harding administration to the recovery. The second misconception shared by all three articles is their framing of traditional Keynesian fiscal policy recommendations, which are not applicable to the post-World War I downturn. Keynes (1936) specifically considers the implications of a downturn at a time of low nominal interest rates and deficient demand, which he argues requires demand augmentation; these conditions did not materialize during the 19201921 depression. However, Keynes provides a clear policy prescription for the appropriate fiscal and monetary response to the conditions that were in force for the United States in the early 1920s. These recommendations were largely consistent with the actions taken by the Federal Reserve at the time. Austrian scholars need to address these misconceptions in the recent reviews of the 19201921 downturn and provide a more rigorous account of the episode from an Austrian perspective. The depression of 19201921 verifies essential elements of the Austrian Schools perspective, and this needs to be highlighted. However, it also offers support to those who advocate an active role for central banks in guaranteeing stability during a crisis. To the extent that advocates of a central bank are buttressed by this episode, free banking theorists should also respond.2 Finally, rather than invalidating Keynesian policy prescriptions, the depression of 19201921 is unable to provide a verdict on traditional Keynesian deficit spending, because the preconditions for fiscal stimulus were not apparent in

Each author presents a slightly different perspective on the 19201921 depression, although they have a broad enough similarity to be considered together here as an emerging Austrian and libertarian narrative. The citation of certain authors on specific points below is deliberate and reflects the somewhat different argument of each. 2 Why was a Federal Reserve brake necessary? Why did private banks not staunch the monetary expansion in 1919? What does this imply about how a system of free banking would have fared?

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the United States in the early 1920s. Keynesians and Austrians alike need to acknowledge this when they consider how the 19201921 depression informs arbitration between different macroeconomic policies.

2 War finance, inflation, and the depression of 19201921 The depression of 19201921 was preceded by a significant inflationary episode propelled by gold inflows from allies and government borrowing during World War I. When the armistice was signed in Compigne in 1918, net American interest bearing debt stood at $18.4 billion. Almost a year later, when the Allies signed the Treaty of Versailles with the new Weimar Republic, American debt had increased by over 25%, to $24.9 billion. At the time, the Federal Reserve was unambiguous about its role in war finance. Speaking of the relationship between the Federal Reserve and the Treasury Department in response to a 1921 inquiry by Senator Lenroot,3 New York Federal Reserve Bank Governor Benjamin Strong insisted that I feel that I, or the bank at least, was their [the Treasurys] agent and servant in those matters (Strong 1930). Strongs conviction that the Federal Reserve was the agent and servant of the Treasury was maintained in full recognition that inflation induced by the war borrowing was inevitable, unescapable, and necessary (Strong 1930). After the armistice, federal borrowing began to recede, although it remained considerable. Strong explained to Sen. Lenroot during his Joint Commission testimony that while the war was over in actual combat, in finance it was far from over (Strong 1930). More specifically, the Federal Reserve still faced the task of facilitating the sale of the Victory Loan, which followed the series of Liberty Loans as the final bond-drive of the war effort. At that time, Strong expressed concerns about the mounting inflation but did not consider himself at liberty to gainsay the policy of Wilsons Treasury Department with a dramatic shift in monetary policy in early 1919 (Strong 1930). By the time that the Victory Loan was issued in April of 1919, consumer prices were 65% higher than they were when war broke out in Europe. Data from the National Industrial Conference Board (Beney 1936) suggest that most of the inflation in consumer prices was driven by clothing and food prices. Fuel, a product that contributes a great deal of volatility to modern consumer prices, did not react as violently. Housing prices, which played a major role in the onset of the Great Depression and the Great Recession, were also relatively stable during this period, as were other assets. The rise in the price level that was set off by inflationary and deficit financing of the war reached its peak in June 1920,

Senator Irvine Lenroot, a Republican from Wisconsin, was the preferred Vice Presidential candidate of Warren Harding in 1920, though he lost to Coolidge (Associated Press 1920). Much of Governor Strongs understanding of monetary policy during the 19201921 depression will be drawn from his testimony before the Joint Commission of Agricultural Inquiry (August 211, 1921), in which Sen. Lenroot played a prominent role. The Joint Commission was organized in response to public outrage over agricultural price deflation, and provides a comprehensive review of Strongs understanding of monetary policy during this period.

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roughly a year after the issuance of the Victory Loan, and a year and a half after the armistice was signed. It was in this inflationary environment that Strong, finally freed from the war financing demands of the Treasury, began to chart the Federal Reserves next steps. Simultaneously, the contours of post-war fiscal policy were being publicly debated in the ongoing presidential race between the Republican candidate, Warren Harding, and the Democratic candidate, James Cox. 2.1 Monetary policy and deflation One of the most problematic claims of some of the recent Austrian work on the depression is the assertion that the Federal Reserves actions in the early 1920s were hardly noticeable (Woods 2009). On the contrary, the discount rate policy of the Federal Reserve can be credited not only with deliberately engineering the 1920 1921 depression but also with implementing the steps leading to a swift recovery. While later writers, primarily monetarists (Chandler 1959; Friedman and Schwartz 1963; Meltzer 2003), criticize the Federal Reserve for failing to respond to the 1920 1921 depression with a sufficiently expansionary policy, the Reserves inconsistency with late twentieth century monetarist prescriptions should not be confused with inaction. In fact, monetary policy before and for the duration of the downturn was far more insightful and self-aware than it is often given credit for. Governor Strong was as adamant about the need to rein in inflation as soon as it became feasible as he was that the inflation itself was inevitable, unescapable, and necessary for the war effort. To this end, Strong used the discount rate (the interest rate charged to banks borrowing directly from the Federal Reserve) as the primary policy tool for restoring price stability. The New York Federal Reserve began raising the discount rate in January, 1920, from 4.56% to 7% by June 1920. Rate increases at other branch banks tracked the New York branch rates closely, tightening credit across the Federal Reserve System in the first two quarters of 1920. In response to the inquiries of Sen. Lenroot, Strong explained this decision to raise discount rates as a resistance to expansion (Strong 1930). The discount rate played a considerably more potent role in the operations of the Federal Reserve in the first decade of its existence than it has since, which may explain some of the confusion of Woods (2009) about the extent of monetary policy activism during the 19201921 depression. For most of the Reserves history, the discount rate has been less prominent than the effective federal funds rate (the interest rate that banks charge each other for short-term loans of their surplus reserves). Today, borrowing at the discount window is considered a last resort, because it can be interpreted as a sign of financial distress. However, in the early years of the Federal Reserve, the discount window was not limited to the lender of last resort function. During his Joint Commission testimony, Strong explained his understanding of the use of the discount rate, noting that if a bank has a deficient reserve as the result of its days business, it borrows more from us to make its reserve good (Strong 1930). In other words, at that time, reserve maintenance was primarily achieved by borrowing directly from the Federal Reserve rather than by todays practice of lending between banks. The decision in January 1920 to begin raising the discount rate was therefore an unequivocally contractionary policy.

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2.2 Fiscal policy and deflation As Woods (2009) points out, President Harding agreed with the Federal Reserve on the need for intelligent and courageous deflation (Harding 1920). However, the Harding administrations role in the facilitation of price deflation was marginal at best. By the time Harding called for intelligent and courageous deflation, the New York branch of the Federal Reserve had already raised the discount rate to the 7% plateau that would be maintained for the ensuing year. Hardings election in November of 1920 roughly coincided with the halfway point in Strongs high discount rate policy. The trough in industrial production was in March 1921, the month that Harding was inaugurated. Thus, despite his forceful campaign rhetoric, Harding did not play a significant role in the painful, but necessary, deflation of 19201921. The emphasis that Powell (2009) and Woods (2009) place on Hardings role in liquidating malinvestments with a contractionary fiscal policy is therefore consistent with Hardings personal outlook on economic policy, but it is historically inaccurate. Instead, the impact of the Harding administration during this time period must be assessed by examining his fiscal policy during the recovery, rather than the initial deflation. While active monetary policy seems to have had the most decisive influence on the 19201921 deflation, the fiscal policy of the Wilson administration should also be taken into account. Wilsons most important contribution to the deflation was to balance the federal budget. The 3-month moving average of the difference between federal expenditures and federal tax receipts turned and remained positive (indicating a budget surplus) in November 1919. Thus, net federal borrowing ceased 7 months before Harding vowed to strike at government borrowing, 12 months before he was elected to office, and 24 months before Harding passed his first budget. Although modern Keynesians place greater emphasis on the federal deficit than on federal spending, an almost identical narrative is provided by spending data; the Wilson administration cut expenditures dramatically before the 19201921 depression and before Harding took office. The claim of Woods (2009) that instead of fiscal stimulus, Harding cut the governments budget nearly in half between 1920 and 1922 obscures the fact that federal spending was falling precipitously over the course of 1919 and 1920. When Harding took office in March of 1921, the Wilson administration had already reduced monthly federal spending to 17% of its war-time high. The bulk of this reduction was achieved by the end of 1919. While it is certainly true that the Harding administration would reduce spending further, the cuts were not as substantial as the cuts made by the Wilson administration immediately prior to the downturn. The use of annual data of Woods (2009) instead of monthly data is misleading because spending was still being winnowed down over the course of the 1920 fiscal year. It gives the false impression that most of the adjustment to federal spending occurred during the depression, when in fact most occurred well before the downturn began. Wilsons balanced budget and spending reductions may have contributed to the deflation of 1920 in two ways. First, they ended the most forceful source of growth in the money supply. Second, they marked a reduced level of government demand for goods and services. The balanced budget can, therefore, at least be credited with

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removing some of the inflationary pressures, although it is disputed whether it impacted the subsequent deflation (Temin 1998). 2.3 Keynes and deflation Much of the analyses of Powell (2009), Woods (2009), and Murphy (2009) of the implications of the 19201921 depression for Keynesian economics hinges on the implicit assumption that Keynes was an ardent foe of deflation. This interpretation is defensible if it is qualified but can easily be overstated. Throughout his career, Keynes was a consistent advocate of price stability and, at most, can be said to have preferred low inflation to deflation as the lesser of two evils. In his 1923 book A Tract on Monetary Reform (Keynes 1923), Keynes wrote that both [deflation and inflation] are unjust and disappoint reasonable expectation. But whereas Inflation, by easing the burden of national debt and stimulating enterprise, has a little to throw into the other side of the balance, Deflation has nothing. His General Theory (Keynes 1936) also suggests that inflation could be a more efficient way of reducing real wages than nominal wage reductions, but expressly states that no essential point of principle is involved in that evaluation. Earlier in his discussion of changes in nominal wages, Keynes writes that wage reductions, as a method of securing full employment, are also subject to the same limitations as the method of increasing the quantity of money (266). Therefore, Keynes is best understood as (1) opposing both inflation and deflation, (2) being analytically indifferent to the tradeoff between real wage reductions through nominal wage adjustments or through price level adjustments, while (3) recognizing limited ancillary social benefits and practical advantages4 of low inflation as an adjustment mechanism, rather than fluctuating nominal wages. This more nuanced perspective is hardly the inflationist attitude that is often attributed to Keynes by his detractors and occasionally by some of his proponents. Considering the American case in particular, one of the greatest concerns that Keynes (1923) had about the newly created Federal Reserve was not that it would be unnecessarily deflationary but that it was still liable to be overwhelmed by the impetuosity of a cheap money campaign (175). Hayek was adamant that had he lived to see the inflation of the 1970s Keynes would have become one of the great fighters against inflation (Rosten 1983). Any understanding of a Keynesian response to the depression of 19201921 that is dependent on the view that Keynes was an inflationist, therefore, has the potential to be quite misleading. There is no need to speculate about Keyness thoughts on the post-war downturn considered by Powell (2009), Woods (2009), and Murphy (2009). His A Tract on Monetary Reform (Keynes 1923) was an explicit response to the sharp price and currency fluctuations following World War I, not only in Great Britain and the United States but in much of the rest of the world. The primary thesis of the Tract
4

In his discussion of the practical advantages of inflation over nominal wage adjustments, Keynes makes the point that nominal wage adjustments are inherently going to meet with varying degrees of success across industries due to differences in bargaining power and other factors. For this reason, relying exclusively on nominal wage adjustments could actually exacerbate distortions in the market. A change in the price level, on the other hand, should fall far more equally across all workers (Keynes 1936).

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was twofold: that the traditional gold standard was inappropriate for modern economies, despite the stability it had provided in the past, and that central banks should give primacy to stabilizing the internal price level, rather than stabilizing their foreign exchange. These positions formed the foundation of Keyness forays into public policy for much of the 1920s in Britain. The case put forward by several modern Austrian economists and libertarians is that Keynesians would have abhorred the inaction of the Federal Reserve and the Harding administration in the face of the steep deflation of 19201921. At the time, Keynes himself did not see American policy as being in sharp contrast with his own views. Instead, he argues that the responses of the United States to the post-war downturn half consciously and half unconsciously are mainly on the lines I advocate. In practice, the Federal Reserve Board often ignores the proportion of its gold reserve to its liabilities and is influenced, in determining its discount policy, by the object of maintaining stability in prices, trade, and employment (197). This American approach contrasted starkly with the outlook of many European central bankers who placed greater emphasis on maintaining a stable foreign exchange (Wicker 1966). In the early 1920s, these exchange rate concerns led some to advocate a return to and maintenance of the pre-war parities. Keynes recognized that this would require severe deflation in both Britain and the United States, and dismissed whatever benefits the gold standard may have offered in the past as being inadequate compensation for the austerity that would be necessary for its return, a return which he opposed in any event as being inconsistent with internal price stability. In this way, Keynes was closely in line with the views of Governor Strong and the Federal Reserve, at least in terms of their perceptions of the proper role of a central bank. However, Keyness outspoken opposition to the ultimate goal of returning to pre-war parities does contrast with the position of President Harding, who cited the restoration of the 100-cent dollar5 as the goal of the deflation (a goal never emphasized by Strong). Does it follow, then, that Keynes opposed any effort at deflation following the war (the apparent implicit assumption of Powell (2009), Woods (2009), and Murphy (2009))? Despite his prominent concerns about a declining price level, he held an equal disdain for the corrosive effects of dramatic inflation, and he explicitly advocated a deflationary monetary policy to counteract such instances of inflation. This facet of Keynesian monetary policy is neglected in the recent work of Powell (2009), Woods (2009), and Murphy (2009). In his discussion in the Tract of the relationship between forward markets and banking policy, Keynes writes: Dear moneythat is to say, high interest rates for shortperiod loanshas two effects. The one is indirect and gradualnamely, in diminishing the volume of credit quoted by the banks. This effect is much the same now as it always was. It is desirable to produce it when prices are rising and

It is plausible, of course, that Harding himself was never genuinely dedicated to the restoration of prewar parities, and that his campaign rhetoric on the subject was simply that. If this were the case, then Harding, Strong, and Keynes would have indeed shared the same general outlook on the need for a corrective deflation, without any pious adherence to the value of the dollar before the war.

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business is trying to expand faster than the supply of real capital and effective demand can permit in the long run. It is undesirable when prices are falling and trade is depressed. (p. 136137) A deliberate, contractionary monetary policy is, therefore, well within the purview of Keynesian policy recommendations, and Keyness requirement that prices are rising and business is trying to expand faster than the supply of real capital and effective demand can permit in the long run can certainly be said to apply to the United States in 1919 and early 1920. Keynes also approved of the policy lever used by the Federal Reserve to achieve this goal. He observes favorably that the bank rate is now employed, however incompletely and experimentally, to regulate the expansion and deflation of credit in the interests of business stability and the steadiness of prices (172). Thus, contrary to Powell (2009), Woods (2009), and Murphy (2009), the evidence suggests that while Keynes would not have fetishized the 100-cent dollar in the way that Harding did during his campaign, his views were quite consistent on a theoretical level with those of the Federal Reserve in the early 1920s, and on a practical level, they were even in line with Hardings perspective on the need for a deflation of the credit bubble. Any disapproval of American policy by Keynes (or for that matter, modern Keynesians) would have been directed towards the extent of the contractionary monetary policy. The Tract argues that on balance, deflation was more destructive than inflation and that deflation in an already depressed economy could be especially destructive but that it was justified to normalize prices after an inflationary episode. He writes that the time to deflate the supply of cash is when real balances are falling, i.e., when prices are rising out of proportion to the increase, if any, in the volume of cash, and that the time to inflate the supply of cash is when real balances are rising. However, no detailed guidance is given on when the rise in real balances would be sufficient to refrain from a deliberate deflation. In both the Tract and The General Theory, Keynes repeatedly emphasizes that a single economic policy would not be appropriate for all economies and that policymakers must proceed cautiously and empirically, aware of the idiosyncrasies of the situation in which they find themselves. It should, therefore, not be surprising that a detailed treatment of the appropriate duration for such a deflation is not provided. By the time A Tract on Monetary Reform was written, the Federal Reserve had already completed its strategy of deliberate deflation, followed by monetary easing and a robust recovery. If Keynes had any concerns about the duration of Governor Strongs 7% discount rate policy, he had ample opportunity to criticize it in the Tract, but instead, he insists that Reserve policies were mainly on the lines I advocate (197). Keyness rebuke was reserved for the Bank of England, which was moving forward with a policy of still further deflation to achieve pre-war gold parity at a time when the economy was already deeply depressed. This extended contractionary monetary policy stands in stark contrast to American policy, which was not aimed at achieving any sort of pre-war parity for the dollar, but was focused on deflating the post-war credit bubble and stabilizing the price level. A closer inspection of the events of 1919 and 1920 suggests that Woods (2009) understates the activism of the Federal Reserve and that Powell (2009) and

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Woods (2009) overstate the role of President Harding in a deliberate deflation of the post-war expansion.6 In a matter of months, the Reserve increased the discount rate by over 50%, from 4.56% to 7%. After a standard lag of 6 months (Cagan and Gandolfi, 1969), the price level began to decline and the economy began to cool just as the presidential campaign of 1920 was heating up with Hardings call for intelligent and courageous deflation. However, an even greater oversight by Powell (2009), Woods (2009), and Murphy (2009) has been the misrepresentation of the Keynesian perspective on the deflation. While Keynes was generally opposed to deflation, he repeatedly advocated contractionary monetary policy as a response to a major inflationary episode. Keyness goal was to impress upon central banks that internal price stability should take primacy over foreign exchange or the maintenance of gold reserves, issues on which he was very closely aligned with the Federal Reserve in the early 1920s, and which he maintained through the 1930s (Moggridge and Howson 1974). From this perspective, the deflation of 1920 was a result of Federal Reserve policy activism, which itself was fully consistent with Keynesian policy recommendations. 2.4 Deflation and recovery The monetary and fiscal policies contributing to the deflation discussed above occurred in relatively close proximity (Table 1). The Wilson administration balanced the federal budget after several months of drastic spending cuts in November, 1919, and the Federal Reserve began to raise the discount rate in January, 1920. This coordination is unsurprising, since the expansionary policy of the Reserve before 1920 was almost exclusively directed towards easing the burden of federal borrowing. Consumer prices peaked in June 1920, when they were 8.3% higher than in January of that year, and 66.8% higher than when the United States entered the war 3 years earlier.7 The fall in the general price level after the Federal Reserve began increasing the discount rate was equally dramatic. In January 1921, a year after the rate increase began, prices had already fallen by 23.7% to a level last seen in November 1918. Consumer prices reached their trough 1 year later, in January 1922, 34.5% lower than when the discount rate increase began. After that point, consumer prices rose gradually for the rest of the decade. Price declines were sharpest in the sectors that had previously experienced the most severe inflation, particularly food and clothing (Beney, 1936). The credit contraction hit farmers especially hard (Link 1946), prompting even President Harding to consider methods of deflating industrial values without serious injury to the agricultural interests (New York Times, 1921). Sharp wage and output declines occurred in tandem with the price declines. The NBER index of average weekly earnings across twelve manufacturing industries declined by 34% from June 1920 to its lowest point in January 1922, a considerably
6

Murphy (2009) explicitly recognizes the policy activism of the Federal Reserve, avoiding Woodss mistaken characterization of the Reserve as hardly noticeable. 7 Substantial government borrowing and demand pressure from the Allied powers began to influence the price level before the United States formally entered the conflict in April 1917, but inflation began in earnest only after the declaration of war.

282 Table 1 Timeline of Economic Performance, Monetary Policy, and Fiscal Policy: 19191922

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Industrial production/ consumer pricesa Mar. 1919 Apr. May. Jun. Jul. Aug. Sep. Oct. Nov. Dec. Jan. 1920 Feb. Mar. Apr. May. Jun. Jul. Aug. Sep. Oct. Nov. Dec. Jan. 1921 Feb. Mar. Apr. May. Jun. Jul. Aug. Sep. Oct. Nov. Dec. Jan. 1922 Feb. 80.4/85.0 81.8/86.5 82.3/87.6 87.6/87.6 92.8/90.2 94.3/91.7 92.3/92.2 91.4/93.8 90.0/95.9 91.4/97.9 100.0 (peak)/100.0 100.0/101.0 98.1/102.1 92.8/105.2 95.2/106.7 96.2/108.3 (peak) 93.8/107.8 94.3/105.2 90.9/103.6 87.1/1031. 79.9/102.6 75.1/100.5 70.8/98.4 69.4/95.3 67.5 (trough)/94.8 67.5/93.8 69.4/91.7 68.9/91.2 68.4/91.7 70.8/91.7 71.3/90.7 75.6/90.7 74.6/90.2 74.2/89.6 77.0/87.6 80.4/87.6

Monetary policyb

Fiscal policy

Victory Loan

Wilson balances the budget Discount Rate Rise Begins

Discount Rate Peaks at 7%

Harding elected President

Harding inaugurated Discount Rate Fall Begins

Strongs 1921 Testimony

Revenue Act of 1921 Discount Rate Stable at 4.5%

The 19201921 recession, as defined by the NBER, is highlighted in gray. Source: St. Louis Federal Reserve and the National Bureau of Economic Research Index of industrial production and consumer prices, Jan. 1920=100; peaks and troughs are parenthetically noted
b a

Monetary policy events are based on New York federal reserve bank policies

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steeper drop than the decline of 19% recorded in the BLSs consumer price index over the same period. Other wage indices showed a more measured decline, such as the New York Federal Reserves Composite Wage Index, which fell by only 12%. Wilford King (1923), who provides some of the most detailed wage information available on the downturn, records a drop in wages of 8.9% from the fourth quarter of 1920 to the first quarter of 1922. King (1923) reports that factory wages declined by 14.5% over the same period, with wages in Metals and Metal Products falling 20.5%.8 Whatever measure is used, the decline in wages was considerable, ameliorating much of the shock to real labor costs that would have accompanied deflation in an environment of more rigid nominal wage rates. The 19201921 depression was accompanied by a fall in output as well as a precipitous deflation. The NBERs industrial production index peaked earlier than prices in January of 1920, falling 32% by July 1921, after which it began to recover. However, Romer (1988) points out that this production index likely overstates the decline in output. She compares the widely cited Commerce Department GNP series, which shows a sharp drop in output (similar to the industrial production index), to the revised 1961 Kendrick series, which shows a GNP decline that is considerably smaller.9 Romer (1988) concludes that the Kendrick series is far more reliable, and therefore suggests that the wage and price declines were much sharper than the shock to output in the 19201921 depression. Most economists commenting on the 19201921 depression after Romers (1988) work on the GNP estimates cite her findings to highlight the importance of aggregate supply shocks, rather than aggregate demand disruptions, in the 19201921 depression (Vernon 1991; Temin 1998). Others have used the same approach for explaining British deflation in the early 1920s, highlighting the importance of aggregate supply factors (Broadberry 1986). Unfortunately, Powell (2009), Woods (2009), and Murphy (2009) cite no economists who wrote about the 19201921 downturn after the work of Romer (1988) on the various pre-war GNP series, nor do they discuss anyone who notes that aggregate supply factors played a greater role in the downturn than aggregate demand factors. By focusing on the older scholarship, they paint 19201921 as an aggregate demand driven episode, or at least attribute this perspective to Keynesians more broadly.10 This omission has important implications for the conclusions that the recent Austrian School reviews draw about the relevance of the 19201921 depression for Keynesian fiscal policy, because Keynesians advocate different interventions in demand driven recessions than they do in recessions characterized by supply shocks. The American economic recovery began in the first half of 1921. The Federal Reserves monthly industrial production index troughed in March of that year, the
The quarterly wage data of King (1923) is not directly comparable to the monthly wage indices, which can reach lower monthly troughs that would be averaged out in the quarterly data. 9 The Commerce series shows a GNP decline of 15% between 1919 and 1921, compared to a 3% decline in the Kendrick series. These are annual figures and, therefore, are not directly comparable to the monthly industrial production figures cited above. 10 The failure of Woods (2009) to mention the work of these more modern Keynesians and their finding that the 19201921 depression was not caused by a demand deficiency is especially egregious, since his article makes a point of highlighting the alleged negligence of modern Keynesians with respect to this episode.
8

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month that President Harding took the oath of office. Deflation began to moderate at this point as well, although the consumer price decline would be completely arrested about a year later, settling in the spring of 1922 at 80% of the June 1920 peak. King (1923) suggests that the nominal wage decline stabilized earlier, in the third quarter of 1921, soon after industrial production began to improve. Thus, Harding entered office as the contours of the new normalcy were emerging. The balance of the decade would be characterized by robust growth and stable producer and consumer prices, albeit with inflating asset prices lurking just below the surface. 2.5 Monetary policy and recovery The contribution of the Federal Reserve to the economic recovery follows unambiguously from comprehension of its contribution to the onset of the depression. In 1920, Benjamin Strong of the New York Federal Reserve initiated a steady but dramatic increase in the discount rate to rein in the credit expansion that undergirded the Wilson administrations war financing efforts. In May, 1921, New York reduced its rate to 6.5% (following the Boston branchs lead) as a prelude to a steady decline to 4% by July 1922. Governor Strong described the rate reduction in 1921 as a reaction to internal credit conditions rather than a concern with the reserve ratio or foreign exchange. During his testimony he argued that cheaper credit was coming into competition with the more expensive credit obtainable at the Federal Reserve Bank, and as soon as those conditions developed then we were justified in rate reductions, and I dont think we were justified in rate reductions until then (Strong 1930). As with the initial rate increase, prices began to respond with a slackening of the deflation about half a year after the reduction began. The discount rate had proven itself to be an extremely potent policy lever in the post-war period. Wielding the rate in an austere crusade against his own engineered inflation, Governor Strong initiated one of the sharpest price deflations ever experienced in the United States. Goodfriend (2003) describes the Federal Reserve as being traumatized by the sheer force of its first contractionary use of the discount rate. This trauma led to the adoption of open market operations as an alternative monetary policy mechanism for the Reserve in the mid-1920s, a transition that Strong himself would spearhead.11 2.6 Fiscal policy and recovery Powell (2009) and Woods (2009) suggest that the Harding administrations decision to cut income taxes was instrumental to the recovery which began in 1921 and continued in earnest the following year. This is a misleading account of the Harding administrations tax policy. The Harding administration did cut tax rates for higher income families in 1922 (the highest brackets rates were reduced from 73% to 58%) and implemented an across the board rate reduction in 1923 (from 58% to 43.5% for the highest bracket and from 4% to 3% for the lowest bracket). However, these rate cuts were accompanied by a considerable expansion of the income taxable at any given rate (Internal Revenue Service 2010). For example, while the top brackets rate
11

See Hayek (1925) for a discussion of this adjustment in monetary policy.

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was reduced by 15% points from 1921 to 1922 in Hardings Revenue Act of 1921, the income taxable at that rate was expanded from all income over $1,000,000 to all income over $200,000. Therefore, while the tax rates were lowered, the amount of income that these tax rates were assessed against was considerably increased by the Harding administration. The net effect was that from 1921 to 1922, the period of the initial Harding tax cut, the percent of individual income collected as revenue through the income tax actually increased from 3.67% to 3.95% (Internal Revenue Service 2010). While this expansion of the tax burden under Harding is not particularly large, it belies claims by Powell (2009) about a tax cut during the economic recovery. After 1922, further rate cuts assessed on the same income brackets did result in a decline in the tax burden from 1922 to 1923. The early Harding administration saw increasing income tax burdens for a variety of reasons, not the least of which being the restored economic growth, which pushed more families into higher tax brackets. However, the statutory expansion of these tax brackets in Hardings Revenue Act of 1921 represented a deliberate, though modest, tax increase in the interest of maintaining a balanced federal budget. While the brief decline in the tax burden that occurred in 1923 came too late to be considered as a factor in the recovery from the 19201921 downturn, the sea-change in government borrowing under the Wilson administration came far too early to be considered an important factor in the recovery. The persistence of the Wilson administrations borrowing well past the end of the war was noted earlier. However, these deficits were effectively eliminated by November, 1919, when the 3-month moving average of the federal budget surplus became and remained positive (indicating a federal surplus).12 Industrial production first declined from its peak in March of 1920, 5 months after the Wilson administration balanced the federal budget. Balancing the budget preceded the recovery in industrial production by 22 months, and the recovery in prices by 30 months, rendering the claim that the end to federal borrowing ushered in a recovery completely untenable. Powell (2009) and Woods (2009) propose a strange account of the causes of recovery, indeed: they credit the reduction in federal spending and borrowing with orchestrating a recovery from a depression which itself began after the purported recovery efforts went into effect. 2.7 Keynes and recovery Despite his general aversion to deflation, Keynes makes clear at several points that the primacy he places on price stability may necessitate a contractionary monetary policy, particularly in the aftermath of an inflationary episode. In this sense, American monetary and fiscal policy through 1920 was entirely consistent with Keynesianism. However, the Keynesian prescription for orchestrating a recovery is somewhat more complicated than the Keynesian prescription for an unsustainable, inflationary boom. The traditional view outlined in Keynes magnum opus, The General Theory of Employment, Interest, and Money (Keynes
12

A moving average is necessary because tax receipts and government expenditures fluctuated considerably from month to month. Moving averages of greater breadth than 3 months offered no additional smoothing.

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1936), would seem to embrace monetary and fiscal stimulus, with a measured skepticism about the limitations of monetary policy as a recovery tool. However, these prescriptions were intended to address a very specific diagnosis, most notably the economic conditions of the 1930s. Keynesian theory does not dictate fiscal stimulus as a remedy for all recessions.13 In the discussion of Lawrence Klein (1966) of the extent to which Keynes presents an economics of a depression situation, he cautions that: It is wrong to think that Keynes system fails if it cannot predict pessimistic results. The pessimism is not inherent in this system; instead the determinants behind the system make it operate either pessimistically or optimistically, depending on the current state of affairs in economic and non-economic life. (Klein 1966, emphasis mine) Before assessing whether the recovery from the 19201921 depression was Keynesian, we need to consider how the conditions of that depression would have responded to fiscal and monetary stimulus in the Keynesian framework. Keynes believed the primary tool for encouraging depressed investment was the interest rate. The General Theory (Keynes 1936) even suggests that adjustment of the interest rate might be the only policy necessary to induce a recovery, speculating that it may turn out that the propensity to consume will be so easily strengthened by the effects of a falling rate of interest, that full employment can be reached with a rate of accumulation little greater than at present (377). The 7% discount rate plateau maintained for most of 1920 and early 1921 furnished the Federal Reserve with considerable latitude for rate reductions in line with Keynesian recommendations. The Federal Reserve instituted precisely this policy in May 1921. Of course, Keynes is better known for advocating public works and government spending to augment output to a level consistent with full employment. While, Woods (2009) and Murphy (2009) do mention monetary accommodation, it is this expansionary fiscal policy that they seem to have in mind when they attempt to contrast the recovery from the 19201921 depression with Keynesianism. However, output augmentation through fiscal stimulus was only ever intended as a supplement in conditions where nominal wage adjustments and monetary policy could not achieve full employment.
An anonymous referee raises the concern that Keyness position substantially changed between the early 1920s and the General Theory, rendering simultaneous reference to the Tract and the General Theory tenuous. The concern is based on statements attributed to Keynes by Hayek about the shift in his views between 1930 and 1936, and Hayeks unwillingness to respond to a book (the General Theory) that might be abandoned by its author within a couple years. Hayeks criticism obscures the fundamental continuities in Keyness thought, at least with regard to the topics discussed in this paper. As Caldwell (1998), Howson (2001), and Butos (2003) point out, Hayek furnished several different reasons for not responding to the General Theory over the course of his life. His latest justification, the fear that Keynes would change his mind again, is perhaps a way of distancing himself from earlier justifications that were subsequently discredited (such as Hayeks 1966 statement of his view in the 1930s that the General Theory was simply a tract of the times). Howson (1973) and Moggridge and Howson (1974) demonstrate that Keyness views on monetary policy and fiscal policy remained consistent between 1910 and 1946, and that apparent variations in his perspective can be traced not to a substantial difference in his position (although his theoretical framework had matured during this time), but to the circumstances under which certain policies would be appropriate and efficacious. When the facts changed, Keynes changed his mind on the ideal policy response. That is the fundamental conclusion of this paper as well.
13

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Keyness discussion of nominal wage (or money wage) adjustments in Chapter 19 of the General Theory (Keynes 1936) suggests that he would not have advocated public works or any further socialization of investment in the United States in 1920 and 1921. Keyness thoughts on money wages are often mischaracterized by detractors and proponents alike as a rejection of the prospect and efficacy of nominal wage adjustments. In actuality, Chapter 19 outlines no less than seven factors that influence the ultimate impact that nominal wage reductions will have on employment and the price level. Some of these factors contribute to the success of nominal wage cuts in bolstering output and employment, and some imply that wage cuts will be less successful. No blanket rejection of nominal wage adjustments is offered, although Keynes does express serious doubts about such a course under certain conditions. It is only when these conditions are binding that Keynes advocates fiscal intervention. These conditions were not binding in 1920 and 1921. One of Keyness concerns was that nominal wage reductions that lead to the expectation of additional future wage cuts would reduce the marginal efficiency of capital and introduce a negative aggregate demand shock. However, if wages are not expected to fall further in the future, Keynes notes that it will increase the marginal efficiency of capital; whilst for the same reason it may be favourable to consumption (263). In 1920 and 1921, nominal wage reductions and deflation generally were attributed by workers and employers alike to the reduction in public borrowing and the tight money policy of the Federal Reserve. Although the wage reductions were vehemently opposed in certain quarters, their transitory nature was unambiguous. Since the public was well aware that wage reductions were simply a symptom of the popped credit bubble, and that they would shortly be arrested, the appropriate Keynesian response derived from Chapter 19 is that the nominal wage cuts would be effective in guaranteeing recovery. This is in contrast to the situation of the 1930s (or the late 1920s in Britain) with which Keynes primarily concerns himself in the General Theory (1936), when the public expected that nominal wage reductions would lead to additional nominal wage reductions. During the Great Depression there was no expectation of a return to normalcy in the way that there was after World War I.14 Another reason why Keynes suggests that nominal wage reductions could induce recovery is that such reductions would lower interest rates. He notes that this mechanism becomes weaker as interest rates become lower and demand for money becomes more elastic, a phenomenon which has become known as the liquidity trap.15 But the early 1920s, in contrast with the 1930s,
14

These differential expectations and the different source of the downturn in the 1930s and in 1920 account for the response in consumer confidence. With no permanent supply shock and no demand deficiency to speak of, there was no reason to expect that consumers or investors would undergo a serious crisis of confidence. 15 A great deal of ink has been spilled over the question of whether a liquidity trap is determined by a 0% interest rate, or some low, positive rate; whether liquidity traps are best diagnosed with long-term or short-term rates; whether liquidity traps are a symptom of conditions in the loanable funds market or money supply and demand conditions; and whether or not monetary policy is ineffective in a liquidity trap (Boianovsky 2004). Regardless of these points of disagreement, Keynes is at least clear that the effectiveness of nominal wage and interest rate reductions becomes less effective at lower interest rates. Whatever disagreements exist over what Keynesians should advocate in a liquidity trap, Keynesians are in relative agreement about what to do when interest rates are high and a recovery is desirable: allow nominal wages to fall naturally, thereby lowering interest rates.

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were characterized by high interest rates. Keynes suggests that nominal wage reductions and interest rate reductions maintain their efficacy under such conditions. Keynes also notes that wage reductions will induce investment if the reduction of money-wages is a reduction relatively to money-wages abroad when both are reduced to a common unit (262). Rothbard (2002) highlights that this was the case in 1920 and 1921, when American wage reductions were not matched by wage reductions in Britain. In addition to noting psychological benefits of wage reductions for business, Keynes finally notes that lower nominal wages will reduce the need for businesses to hold cash, a reduction in the degree of liquidity preference that can be so destructive in the Keynesian system (263). What emerges from even a casual reading of the General Theorys (Keynes 1936), chapter on wages is that Keynes acknowledges both beneficial and detrimental effects of nominal wage reductions, but that almost all of his reservations about wage cuts revolve around conditions of low interest rates and an expectation of the extension of wage reductions into the future. Neither of these circumstances were apparent during the 19201921 depression, so the Keynesian position is that nominal wage reductions (in addition to nominal interest rate reductions) should be effective in achieving a recovery without recourse to fiscal policy.

3 Conclusion: The 19201921 depression, the Austrian school, and Keynesian economics Austrians and Keynesians have been engaged in an extended feud, clashing even before Keynesian economics had fully matured in the General Theory. The original disagreements were relatively mild. In Hayeks piece on American monetary policy after the 1920 deflation, the only critique of Keyness recent book, A Tract on Monetary Reform, was that Keynes was too sanguine about the United States success in sterilizing its gold reserves. Keyness review of Mises (Keynes 1914) and Misess review of Keynes (Mises 1927) are both notoriously curt and combative. Nevertheless, these skirmishes were only a prelude to the disagreements that would emerge after 1936. At least in part, these disagreements seem grounded in a misunderstanding of fundamental positions on both sides. An example of such misunderstanding is the common assumption that Keynes and Keynesians are inflationists, that they never countenance a contractionary monetary policy, and that they consider nominal wage reductions to be ineffective. Such assumptions lead to erroneous conclusions about Keynesian policy prescriptions, such as the assertion of Powell (2009), Woods (2009), and Murphy (2009) that the response to the 19201921 depression was non-Keynesian or even that it disproved Keynes. The reality is that Keynes and the Austrian School are not diametrically opposed to each other on all questions16 and that both bodies of theory seem to be consistent with the events of 1920 and 1921. Keynes clearly suggests in the Tract that the inflation of the money supply can have a more than proportionate effect on the price level (82) and that the appropriate policy in such a situation is to apply
16

This is certainly evident in the work of Sir John Hicks and Edmund Phelps, who claim inspiration from both the Austrian school and from Keynes.

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contractionary monetary policy. This view is not entirely inconsistent with the Austrian view of the credit cycle; it affirms the importance of the credit dynamics that Austrians highlight. Nominal wage adjustments, which are assumed to clear the labor market naturally in Austrian economics, are also effective in the Keynesian system under these normal conditions. The General Theory provides a detailed treatment of when nominal wage adjustments are and are not efficacious, and the greatest doubts that Keynes furnishes on such adjustments are only applicable at low interest rates or when there are expectations of continued deflation. While this paper has critiqued the treatment of Powell (2009), Woods (2009), and Murphy (2009) of the 19201921 depression as pieces that engage a caricature of Keynesianism, Keynesian economists could also benefit from a more conciliatory approach to the Austrian School. DeLong (1990) presents an example that other Keynesians should follow on what he calls the liquidationist theory of the Great Depression, which he attributes to Hayek and other Austrians. While DeLong (1990) is often criticized in Austrian circles for his perceived hostility towards Hayek, he also presents a sympathetic interpretation of credit cycle theories as an explanation of downturns before the Great Depression.17 It is unlikely that the two schools will ever agree on the Great Depression itself, but not every downturn is a Great Depression, and Keynesians can certainly embrace the validity of the credit cycle as an important, if not exclusive, determinant of recessions. Murphy (2009) calls the 19201921 depression just about the closest thing to a controlled experiment in macroeconomics that one could desire. This paper demonstrates that nothing could be further from the truth. First and foremost, deep depression was deliberately courted by the Federal Reserve to address other more pressing concerns, such as the post-war inflation. Nevertheless, even after the depression took hold, macroeconomic conditions in the early 1920s were such that fiscal stimulus was not appropriate by Keyness standards and the standards of modern Keynesians. The economy experienced an aggregate supply shock rather than an aggregate demand shock, a fact obscured by the failure of any of these authors to cite any of the research following Romer (1988). Interest rates were high, and wage declines were known to be temporary and sharper than wage cuts abroad. All of these factors are highlighted in the General Theory as conditions rendering the market reasonably self-correcting. The great experiment pitting Keynesianism definitively against Austrianism is, therefore, a mirage. But the project of an Austrian interpretation of the 19201921 downturn has a considerable amount of material to work with, tracing the buildup of the malinvestments and capital market distortions during the war years, as well as their unraveling (the nature of these malinvestments remains something of a black box in the articles treated here). It also
I find much to agree with in the critique of White (2008) of DeLongs accusations. The label liquidationist is almost certainly too harsh, although as White (2008) himself suggests, neither Hayek nor Robbins made an effort to push for a more accommodating monetary policy during the Depression. However, I would argue in response to White (2008) that Hayeks refutation of the Real Bills Doctrine (as described by White (2008) himself) implicitly suggests an opposition to an accommodating interest rate policy. Why would Hayek, in criticizing banking policy that does not let the interest rate rise with investment demand (relying instead on an expansion of credit), propose expanding the supply of credit even more when the previous problematic expansion begins to crest and collapse? The presentation of White (2008) of Hayeks critique of the Real Bills Doctrine does not seem consistent with the presentation of White (2008) of Hayek as a theoretical proponent of accommodating monetary policy.
17

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faces stimulating challenges, such as the need to explain the efficacy of the central bank response to the crisis. Such an endeavor should be an important priority for Austrian economists.
Acknowledgements I would like to thank Wayne Vroman, Tom Woods, Jeffrey Herbener, and two anonymous referees for their helpful comments. I am also grateful to Steve Horwitz for the insights he provided on how to frame this research so that it would be useful for the community of Austrian economists. The standard disclaimer applies.

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