Fed, Banking Regulations, Capital Flow, Crisis, Part 4

The forgotten depression of 1920-21 is a very important chapter in our history. Prices dropped by 18% in 1920-21, compared to 2.5% in 1929-30. Unemployment rate reached 11.75% in 1921. The drop in wholesale prices was 36.8%. Industrial productivity was decreased by 29.4%. Stocks fell by 47%. The failure of businesses climbed from 37 to 120 per 10,000. These figures are fairly comparable to 1929 Great Depression. Some are even worse than 1929. But, the depression of 1920 lasted only 18 months, while Great Depression of 1929 lasted 132 months. Why? What is the difference? Can we learn any lessons from these highly comparable examples in our own history? Do they teach the correct strategy to deal with economic downturns? Can this comparison finally end the debate between different points of view in our politics, media, economics and finance?

The most basic and critical difference that we see between 1920 and 1929 depressions is the role of government. In 1929 we see the Roosevelt’s “New Deal”, a massive expansion in the size and authority of government. We see that government gives birth to new regulatory authorities and legislates a number of laws. It is actively interfering into, and enforcing the new rules on markets. Large amounts of tax payer’s dollars and printed money are blown into the economy. Government is picking winners and losers. It is deciding which sectors of economy should take priority over the others. A whole new wave of public projects is generated.

On the other hand, we see that Warren Harding takes a very classical stance, in 1920-21. He knows that the post war markets need serious adjustments. Excessive government intervention during World War 1 caused the problem and more intervention will just make it worse. He really believed in freedom of markets. So, mostly, he just let the market forces play their role. He let the hidden hand play its part. So, he lets the prices fall down. Does not do any significant debt financing.

Results were amazing. The depression lasted only for 18 months. It started in January 1920, and by July 1921 the depression was gone. So, what actually happened here? Without government being pumping in, the tax payers’ money, printed fiat money and borrowed debt money, and rising unemployment, reduced the demand for goods and services, a lot. This caused a serious drop in prices. The drop in prices suddenly raised the value of Dollar. People started realizing that they can buy a lot more with their money, and even after buying what they want and need, they have sufficient money available to save and invest.

Due to the reduced prices, cost of living and cost of doing business was already down. Saving accounts started to fill up with saved money and investment portfolios started to grow rapidly. These new investments and savings helped certain revolutionary inventions to take place and reach the markets. These included automobile and a wide expansion in the supply and availability of electricity. Automobile industry pumped up several other industries including tires, paint, body, parts, repair and road construction. It also increased the people’s mobility to a great extant. These industries raised the demand for labor to a level never known before.

On the other hand investments in electricity were bringing on a new revolution. Inventions like radio, washing machine and vacuum cleaners were rapidly becoming an integral part of everyday life. Electricity and automobiles also helped to raise the production and distribution of movies. All this amounted to an enormous increase and demand for labor, increase in wages, reduction in unemployment and rise in standards of living. Roaring twenties were on. It was the party time. There was plenty of everything and life was moving at a much faster pace. Productivity reached new levels which also contributed to higher wages. Roaring twenties were the times to be happy.

This happened because markets were allowed to make their own natural adjustments. There were no bailout for big corporations, in the name of “for your own good” or “to save the economy” or “to prevent the disaster”. There was no trickle up economy of tax payers’ money being awarded to campaign financiers in big corporations and banks. There was no interference in or distortion of markets. There was no printing of trillions of dollars for big banks at the expense of an average Joe. There was minimal manipulation of interest rates. There were no armies of people, hired with tax payers’ Dollars for “public works”.
There was no picking of winners and losers by government. No displacement of money from genuine and profitable investments to ridiculous and dead projects picked by government. There were no tax increases in the name of “more taxes for rich” or “to provide healthcare to everyone”. There was no creation of new federal government departments and agencies at the expense of tax payers, to “fix the economy”. Economy just fixed it by itself, as it should be, and fixed itself quickly, and effectively, resulting into ‘roaring twenties’. American dream was alive and well for everyone, again.
The cause of the 1920 depression was World War 1. Taxes were raised. The number of people employed by military was increased to 2.9 million, at the end of war in 1918. After the war by 1920 it dropped down to a little over 300,000. 1.6 million people were released into private labor force in 1920, only. This increased the private labor force by 4.1% during that year. This massively increased supply of labor caused a sharp decline in wages. Spending power was reduced and so were the standards of living and demand for goods and services. This resulted into increasing unemployment and a spiral causing stock market crisis and depression.
So, the government manipulation of markets in World War 1 caused depression and in spite of its severity, it got fixed quickly because government stayed out of crisis fixing. So, what do we learn from it? Our recent recession in 2008 was caused by government manipulation of housing and banking markets. Slogans like; “Home ownership is American Dream”, “No one should be denied for a mortgage”, became extremely popular. Government agencies like Freddie Mac and Fannie Mae started landing recklessly to everyone, forcing private banks to do the same. A bubble was created just like a bubble was created by World War 1 spending in 1918.
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