An Austere Recovery: The Swift Recovery from the 1920’s U.S. Recession

by | Jun 2, 2012 | History, Money & Banking

How "austerity" measures lead the United States' rapid recovery from the deep recession into which it sank in the last half of 1920.

In the course the BBC/LSE “Hayek versus Keynes” debate the Keynesian side made some claims to which I had no opportunity to respond. My earlier post addressed some of them, but left another alone. This was Lord Skidelsky’s claim, aimed at Great Britain’s current riot-provoking austerity campaign, that no government has ever achieved a speedy recovery from a recession by clamping down on its spending or reducing its indebtedness.

But there is at least one instance of economic recovery–and hardly a trivial one–that contradicts, or at least very much appears to contradict, Lord Skidelsky’s claim. This is the United States’ rapid recovery from the deep recession into which it sank in the last half of 1920.

In many respects the boom-bust cycle that started in April 1919 was typically “Hayekian”: during the boom year ending in April 1920 the Fed held its rediscount rate at 4 percent despite rising money market rates. Commercial banks took advantage of the low rate–as they’d actually been encouraged to do by the Fed–by borrowing from the Fed in order to re-lend at a profit, causing bank loans and investments to increase by just over 25 percent. General prices, and prices of commodities and land and other factors of production especially, in turn rose more rapidly than they had since the Civil War, exacerbating a gold drain that had begun with the armistice. Under the circumstances a reversal was only a matter of time.

When it came, the reversal was both sudden and sharp. Commodity prices tumbled from an index value of 248 in May 1920 to one of just 141 the following August, while consumer prices witnessed their greatest rate of deflation ever. Businesses were unable to pay their bills, industrial production fell by an unheard of 30 percent, and almost 5 millions workers lost their jobs, bringing the unemployment rate, which had been less than 2 percent, to just below 12 percent. Yet by August 1921 recovery was well underway. What’s more, it was so swift that by the spring of 1923 unemployment had given way to a pronounced labor shortage, while industrial production reached a new peak.

Did the U.S. government hasten the recovery by means of deficit spending and other “stimulus” programs? Not in the least. Instead, it stuck to conducting business as usual which, in those naive days before Keynes revealed that prudence and thrift were shopworn Victorian shibboleths, meant reverting to its prewar budget and retiring its wartime debt. In other words, it followed what would today be called an “austerity” policy, and did so to a degree that makes recent austerity measures in Great Britain and the U.S. seem downright profligate. Instead of spending more than it had been, the Harding administration steadily cut expenditures, exclusive of debt retirement, from just over $6.4 billion in fiscal 1920 to just under $3.3 billion in fiscal 1923–a whopping 45 percent! As a percentage of GNP, Randy Holcombe shows, Federal outlays fell from just over 7 percent to well under 4 percent.* And although its revenues also declined over the same period, from about $6.7 billion to about $4 billion, the government nevertheless devoted a large share–almost $1 billion–to reducing its indebtedness. As Benjamin Anderson, who was at the time an economist employed by Chase National Bank, observes in Economics and the Public Welfare (1949),

The idea that an unbalanced 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 United States 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.*

Turning to monetary policy, although easy money did contribute somewhat to the recovery, the contribution was minor and largely unintended. Thus while the Fed banks gradually lowered their discount rate from 7 to 4 percent between 1921 and 1922, 4 percent was not especially low in light of the rapid deflation then in progress. And despite the rate lowering commercial bank rediscounts declined, as banks preferred reducing their indebtedness to the Fed to taking advantage (as they regretted having done earlier) of opportunities to re-lend borrowed funds at a profit. The Fed also made what was at the time an unusually large open-market purchase of government securities. But this only served to further reduce commercial bank rediscounts, and was moreover done, not with any intent of stimulating recovery, but solely so that the Fed could earn enough revenue to cover its expenses and pay promised dividends to its commercial-bank shareholders.

Proponents of Keynesian pump-priming often berate the Hoover administration for its “liquidationist” strategy for dealing with the outbreak of the Great Depression–forgetting that it was Hoover himself who caricatured Andrew Mellon, his Secretary of the Treasury, as someone who wished to “liquidate” the stock market, farmers, real estate, and so forth, and who took pride in not having followed his advice. But Mellon was also Harding’s Secretary of the Treasury; and Harding, unlike Hoover, trusted him. It is one of the greater ironies of economic history that “liquidationist” policies, including government austerity, are blamed for prolonging a depression for which those policies were set aside, while being denied credit for perhaps helping to end one in which they really were put into practice.

Originally appeared in

George Selgin is a Professor of Economics at the University of Georgia's Terry College of Business. He is a senior fellow at the Cato Institute. His writings also appear on His research covers a broad range of topics within the field of monetary economics, including monetary history, macroeconomic theory, and the history of monetary thought. He is the author of The Theory of Free Banking, Bank Deregulation and Monetary Order, and several other books. He holds a B.A. in economics and zoology from Drew University, and a Ph.D. in economics from New York University.

The views expressed above represent those of the author and do not necessarily represent the views of the editors and publishers of Capitalism Magazine. Capitalism Magazine sometimes publishes articles we disagree with because we think the article provides information, or a contrasting point of view, that may be of value to our readers.

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