“The central irony of financial crisis is that while it is caused by too much confidence, too much lending and too much spending, it can only be resolved with more confidence, more lending and more spending.” This post-crisis advice from Larry Summers – a former U.S. Treasury secretary, presidential economic advisor and president of Harvard – represents the conventional wisdom of the economic policymaking elite. This is the same elite, you may recall, that failed to see the global meltdown coming in the first place. Could it be that they’ve got things wrong yet again?
James Grant, an experienced chronicler of Wall Street’s deeds and misdeeds past and present, believes so. In his latest book, “The Forgotten Depression” – subtitled “1921: The Crash that Cured Itself” – Grant relates the story of the U.S. economic boom which appeared after the Great War ended and the very severe bust that followed in its wake. The 1921 downturn was not softened by fiscal or monetary policy. It was, in Grant’s words, “America’s last governmentally unmedicated depression.” And if most people have forgotten this depression, as the book’s title suggests, it’s because the downturn was brief and any lingering, grim memories were soon effaced by the economic high of the Roaring Twenties.
In its general characteristics, the frenzied post-war prosperity resembles many more recent booms. It was marked by rising leverage in the banking system; incautious lending to emerging markets – National City Bank, the corporate forebear of today’s Citigroup, lost money lending to Cuban sugar planters; a growing taste for high living – the comptroller of the Currency announced at a Federal Reserve Board meeting that he was “very much disgusted” to discover that his chauffeur had acquired three silks shirts; and widespread business profligacy. Alfred Sloan, who later headed General Motors to great acclaim, recalled this era as a time when “overruns on capital investment had become the rule.” Some of the Detroit carmaker’s money was spent on constructing the world’s largest office building.
While the features of this boom may be familiar to us, the economic downturn, which commenced in early 1920, belongs to a different age. For a start, it was savage in its intensity. National income fell, in nominal terms, by nearly a quarter. The stock market was sawed in half, while corporate profits sunk by more than 90 percent. At the high estimate, nearly one in five eligible workers was unemployed. Deflation, the economic bogeyman of our time, clocked in at 15 percent. The Kansas City haberdashery store of future President Harry Truman was one among thousands of business failures.
Even stranger to comprehend was the response of the authorities to this economic catastrophe. As unemployment soared, the Fed hiked interest rates up to 7 percent and kept them there. Factoring in the general decline in the price levels, real rates topped 20 percent. Deflation was embraced. “Where there has been inflation,” opined Adolph Miller, a Berkeley professor and the only economist on the board of the Fed, “there must follow deflation, as a necessary condition to the restoration of economic health.” The Fed chief, William Harding, resisted calls for extraordinary monetary experiments, “especially if those new plans and methods are fundamentally unsound.”
Nor did the newly installed administration of Warren Harding (no relation to the Fed’s Harding) apply Larry Summers’ advice. Rather, Treasury secretary Andrew Mellon slashed government borrowing and spending. President Harding even rejected a Senate-sponsored veterans’ bonus bill. Throughout the downturn, the federal government maintained a large surplus. “There is no instant step from disorder to order,” the Republican president observed in his inaugural address. “We must face a condition of grim reality, charge off our losses and start afresh. It is the oldest lesson of civilization.” An old lesson perhaps, but one no longer apparently taught at Harvard, or observed in practice in Washington.
America’s business leaders responded to the economic contraction by slashing inventories and paying down debts. The president of a leading truck maker told his stockholders that the downturn “afforded an opportunity to put into effect many of the economies of manufacture and selling, the importance of which had long been appreciated but the adoption of which had been precluded by the necessities of peak production.” To bring costs down in line with revenues, wages were slashed. By August 1921, the Wisconsin Steel Works of the International Harvester Group had cut workers’ pay by a total of 44 percent.
Throughout the depression, the American dollar remained convertible into gold. By the summer of 1921, the worst was over. Grant notes that “inventories were low, gold was plentiful, and asset values were cheap.” The economic recovery which started around that time was as abrupt as the preceding decline. Corporate America fortified by its recent cold bath emerged in rude health. In 1922, manufacturing output per person rose by 20 percent – the largest ever recorded increase. Strong productivity gains continued throughout the Roaring Twenties.
“The Forgotten Depression” is a loving tribute to laissez-faire, a “history of instructive inaction” in the author’s words. Grant pens his tale with a wry humor reminiscent of John Kenneth Galbraith in “The Great Crash.” Whereas Galbraith belonged to the Keynesian fold, Grant is more sympathetic to the Austrian school of Friedrich Hayek and economic historian Murray Rothbard. Grant repeats Rothbard’s claim that what distinguished the Great Depression from the brief economic contraction of 1921 was the “whirlwind of intervention” from President Herbert Hoover, in particular his successful attempt to prevent wages from falling in the face of deflation. The price mechanism, writes Grant, worked more freely in 1920 to 1921 than it was allowed to do in 1929 to 1933.
The global financial crisis of 2008 has been followed by even more intervention from policymakers than Hoover mustered. Summers’ prescription of “more spending and more lending” has been adhered to around the globe. Yet six years after the collapse of Lehman Brothers, the economies of the developed nations remain weak and productivity growth has been almost non-existent. “The Forgotten Depression” is a timely reminder that our forebears knew of other, more efficacious, remedies to cure financial hangovers than the hair of the dog.