Can a Crash Cure Itself?

How much do you know about the inflationary financing, in which the then-new Federal Reserve led the parade, that backed America’s participation in World War I? How about the high-inflation postwar aftermath? How about the steep and painful, although brief, depression (that’s depression, not recession) of 1920-21? The report of a congressional joint commission of the day concluded that “the debacle of 1920-21 was without parallel”—without parallel but now forgotten. Most importantly, how much do you know about the general lack of government interventions in that depression, but the rapid recovery and renewed growth that followed it?

If you are an average American, namely somebody who has never entered the instructive realms of financial history, your answer to all of these questions is probably, “I know nothing about any of this.”

Luckily, James Grant’s new book, The Forgotten Depression—1921: The Crash That Cured Itself gives you the chance to improve your historical perspective, while also enjoying Grant’s trademark witty, trenchant, and appropriately sardonic observations on human financial frailties. These frailties include the inability, then as now, of the Federal Reserve to know what the effects of its own actions will be.

The book gives you the opportunity to consider what lessons this unknown history may supply. Grant qualifies 1920-21 as the “the last governmentally untreated business depression in America.” But nonetheless, or possibly because of that, “by late 1921, a powerful jobs-filled recovery was under way.” He contrasts this with the usual lessons drawn from the 1930s about the need for big government interference, pointing out that the big interventions began in 1929 with Hoover, a resolute planner, not with Franklin Roosevelt.

In 1920-21, wages fell along with prices. In 1929, Hoover set out to keep income from falling, and orchestrated a “grand, depression-defying bargain” with large companies to this effect. As described that year by a prominent economist, “the President of the United States is organizing the economic forces of the country to check the threatened decline.”

“What we can observe,” says Grant, “is that the price mechanism worked more freely in 1921-22 than it was allowed to do in 1929-33.”

In the turn of the 1920-21 depression into boom in 1922, Grant sees a provocative contrast with the extended slump of the 1930s. He implies that we should take a skeptical look at the hyperactive central banking and regulation of our own time, five years after the end of the crisis of 2007 through 2009.

Grant exercises his notable talent for finding outlandish quotes from prominent personages of the day. Here is Woodrow Wilson in the summer of 1919: “I am perfectly sure that the state has got to control everything that everybody needs and uses.” A remarkable thing to be perfectly sure of!

Wilson’s pronouncement reflected the high postwar inflation and escalating cost of living. Consistent with this approach, his Attorney General added a memorable idea of how to deal with the rising price of food:

The Department of Justice will use all its agents throughout the nation to hunt down the hoarders and the profiteers in food.

During the American participation in the First World War, the Wilsonian theory was applied. Robert Brookings, the founder of the Brookings Institution, was then the chairman of the National Price Fixing Committee. This title may sound strange to us, but we still have a national price-fixing committee today. It is called the Federal Reserve and is accorded great deference. Grant relates that Brookings had this to say:

I would rather pay a dollar a pound for [gun]powder for the United States in a state of war if there was no profit in it, than pay the DuPont Company 50 cents a pound if they had 10 cents profit in it.

The Republican victory in the election of 1920 put into office men with views opposite to all these, so the non-price controllers (Harding and Coolidge) were in charge for the post-inflation bust and the subsequent boom.

One of the book’s many examples of the severity of the 1920-21 depression is the experience of the DuPont Company whose war profits Brookings so resented. DuPont’s “net sales dropped to $55 million from $94 million in 1920 (and from $329 million in 1918).” In 1921, “DuPont eliminated its bank debt and sacked more than half its employees. It wrote down the value of its inventories to $25 million from $52 million.”

Some observers believed in 1921 that a collapse was coming that would rival the downfall of the Roman Empire. But following that frightening period was the rapid recovery of 1922. “From 1921 to 1922,” Grant relates, “industrial production jumped by 25.9% and residential construction by 57.9%. Real income per capita rose to $553 from $522, a gain of 5.9%.” In 1921, aggregate corporate net profits were “$458 million, which was down from $5.9 billion in 1920. In 1922, such profits rebounded to $4.8 billion. In 1921, Detroit produced 1.5 million cars and trucks. In 1922, it turned out 2.4 million, a leap of 63%.” And so on.

Amidst all this, what was the role of the Federal Reserve, our national monetary price-fixing committee? Everybody agrees they contributed to the downturn by pushing interest rates up in 1920, intending to help a deflation, but certainly not intending a depression. The Fed of the 1920s obviously was not, just as today’s Fed is not, one bit more successful at economic predictions than everybody else.

As Grant explains, the Fed’s original goals were much less grandiose than they have subsequently become. About the newly formed Fed, he writes,

Notable was what the new creation would have nothing to do with. [They thought!] Missing from the Reserve banks’ original remit was an obligation to stabilize the price level, promote full employment, iron out the business cycle, buy up Treasury bonds or pull an oar for economic growth.

All of these difficult or impossible assignments were added later. They represent a repeatedly disappointed, but dogged, faith in the foresight of the Fed.

Returning to the contrast between 1921-22 and the 1930s: we learn that the great economist Irving Fisher wrote in May, 1930 that “It seems manifest that thus far the difference between the present comparatively mild business recession and the severe depression of 1920-21 is like that between a thunder-shower and a tornado.”

As Grant says, “Fisher had it backwards.” Grant proceeds to the prediction of the December, 1929 Survey of Business Conditions: “While it may be too early to say that the utilization of business data had entirely eliminated the business cycle”—perhaps a little too early, indeed—“the wider use of facts will mitigate in a large degree many of the disastrous effects of the one-time recurrent business cycle.” It hadn’t, and hasn’t, needless to say.

All in all, James Grant has produced a thought-provoking, entertaining, and informative book. It does not constitute a proof of an economic theory, and in economics such proofs do not exist in any case. But it should make us doubt or at least reconsider the theories derived from common interpretations of the 1930s, by setting forth a vivid and very well told counter-example.