What the Hell Friday - The Depression of 1921

Austrian Economists and their acolytes claim that the depression of 1921, which was deep but short, (January 1920 to July 1921) refutes Keynesian economics, since the recovery occurred with no government action.   The corollary is that Government  action interferes with the economy, distorts asset allocation and other economic factors and either causes or prolongs times of economic hardship.

As is always the case with people who reason based on dogma rather than data, the 1921 depression is a cherry-picked instance.  I suspect they keep coming back to it because it is the only data point that is consistent with their view of the world.

For example, one can look at Federal spending and see that the Government did not run a deficit to recover from the 1921depression .

The blue line is receipts, the pink line is expenditures, and the yellow line is the surplus or deficit.  Sure enough, no deficit spending in 1920 or 21, following the deficits of the WW I years.

But what gets ignored is the entire economic background was different in1921 as compared to 1929.  First off, the graph indicates that in 1918 and 1919, there were sizable deficits.  In 1920, the budget ran a tiny surplus, and surpluses are slight through most of the roaring 20's.  So - the 1921 depression was preceded by two years of large deficits, the 1929 depression was preceded by several years of steady surpluses.

It is worth noting that the 1921 depression came on the heels of WW I.  Coincidentally, there was a sharp, rather short recession following WW II, as well.

Van Mises acolyte Robert Murphy recently posted this graph on his blog.

His point is that deflation couldn't have caused the lengthy 1929 depression, since the deflation in 1921was steeper and deeper, and that depression was short-lived.  Wow!  Look at that cliff-fall in CPI in 1921.  Nothing like that happened in the 30's.  OK - fair enough.  If everything else is equal.  We've already had a hint of how they weren't, but let's examine this graph a little more closely.  The years from about 1915 to 1920 were characterized by high inflation - way over 10% that entire time, and popping up above 20%, just before the crash.  On the other hand, the years leading up to 1929 were characterized by no inflation at all. 

So, deflation in 1921 is a crash from several years of high inflation, the slump starting in 1929 followed several years of no inflation.

Let's look at Fed activity.  I was not able to come up with much information, but did find some on the St. Louis Fed website.

Here is the Discount Rate during years of both depressions.  Depression times are indicated in red, non-depression times in blue.  Selected dates of Fed activity are noted.  The rate was raised to 6% on 1/24/1920, and lowered on  to 5% 11/03/1921, and again to 4.5% on 4/06/1922.  A cynic might say the interest rate hike of 1920 helped bring on the depression, while the quantitative easing of 1921-2 secured its end, but we won't go there.  Based on this graph alone, it does look as if the interest rate situation were nowhere near the 0-rate bound in 1921, and might have been approaching it in the 30's.  At any rate, the statement that the economy quickly recovered after 1920 in the absence of fed and Government activity is simply false.

One criticism leveled against the Fed from a modern perspective (but not by Austrians) is that in the 30's there was no appreciation that during deflation real interest rates are higher than nominal rates.  Rates were going down, so the contemporary understanding was that easing was taking place.  Unfortunately, real rates were rising, and the economy was effectively being choked.

 Randall Parker explains: 

The giving/taking of credit to/by the Federal Reserve has particular value pertaining to the recession of 1920–21. Although suggesting the Federal Reserve probably tightened too much, too late, Friedman and Schwartz (1963) call this episode “the first real trial of the new system of monetary control introduced by the Federal Reserve Act.” It is clear from the history of the time that the Federal Reserve felt as though it had successfully passed this test. The data showed that the economy had quickly recovered and brisk growth followed the recession of 1920–21 for the remainder of the decade.

Another reason to criticize the early Fed is that they did not have a proper understanding of the devastating effects of deflation.  Parker continues (emphasis added):

Moreover, Eichengreen (1992) suggests that the episode of 1920–21 led the Federal Reserve System to believe that the economy could be successfully deflated or “liquidated” without paying a severe penalty in terms of reduced output. This conclusion, however, proved to be mistaken at the onset of the Depression. As argued by Eichengreen (1992), the Federal Reserve did not appreciate the extent to which the successful deflation could be attributed to the unique circumstances that prevailed during 1920–21. The European economies were still devastated after World War I, so the demand for United States’ exports remained strong many years after the War. Moreover, the gold standard was not in operation at the time. Therefore, European countries were not forced to match the deflation initiated in the United States by the Federal Reserve (explained below pertaining to the gold standard hypothesis).

So, countering the effects of the depression we have strong U.S. exports.  And what's this about gold?  Because of WW I, the gold standard was abandoned by the involved countries.  Later in the 20's the U.S. and Europe went back on the gold standard, but at the time of the 1920 depression, nobody important was on it.

This is not a trivial point, when we consider he part gold played in the Great Depression of 1929.  Parker again:

Looking back, we observe that the record of departure from the gold standard and subsequent recovery was different for many different countries. For some countries recovery came sooner. For some it came later. It is in this timing of departure from the gold standard that recent research has produced a remarkable empirical finding. From the work of Choudri and Kochin (1980), Eichengreen and Sachs (1985), Temin (1989), and Bernanke and James (1991), we now know that the sooner a country abandoned the gold standard, the quicker recovery commenced. Spain, which never restored its participation in the gold standard, missed the ravages of the Depression altogether. Britain left the gold standard in September 1931, and started to recover. Sweden left the gold standard at the same time as Britain, and started to recover. The United States left in March 1933, and recovery commenced. France, Holland, and Poland continued to have their economies struggle after the United States’ recovery began as they continued to adhere to the gold standard until 1936. Only after they left did recovery start; departure from the gold standard freed a country from the ravages of deflation.

Summary:
The depressions of 1920-21 and 1929-4? (pick an number) occurred in very different circumstances.  My cursory check uncovered this list:

1920 preceded by large deficits, 1929 preceded by surpluses.
1920 preceded by inflation, 1929 preceded by no inflation.
1920 preceded by war, 1929 preceded by peace.
1920 depression possibly softened by export strength, 1929 ???
1920 evidently not near the 0-interest rate bound, 1929 probably approaching it.
1920 gold standard not in force, 1929, gold standard in force.

Every bit of this gets ignored by Austrians.  Some of this is probably more important than the rest.  I find the gold facts to be especially intriguing. There are probably more differences than can be discovered in 20 minutes of fumbling around on the intertubes.   I welcome any additional information.

UPDATE:
In comments, J points out some other relevant historical information.  In addition there is the matter of debt ratio that I spoke about in a different context recently.  In 1920-21 the ratio of debt to GDP increased from about 150 to 190% during the course of the depression.   In 1929, this ratio started at about 190%, and by 1933, had increased to 299%.

Update 2:
Rereading the second Parker quote above, I gleaned the following inference.  During the 1920-1 depression, deflation was a local U.S. phenomenon.  In the 1929 depression, deflation was a nearly world-wide phenomenon.
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