James Grant has a new book, The Forgotten Depression, and he wants us all to know that letting the business cycle run its course is in everyone’s best interest. The subtitle says as much… 1921: The Crash That Cured Itself.
The book’s premise is that a hands-off policy leads to shorter recessions and robust recoveries. Intervention by a central bank, by contrast, is destined to make things worse. But this ignores why central banks were invented in the first place — laissez–faire became unbearable when the economy slipped over to the dark side. The experiment in doing nothing, or close to nothing, was allowed to prevail in various forms through the 19th century up to the early 1930s, when the country had had enough and decided that it should do more than simply sit back and wait for the fever to pass. But now Grant informs us that it was all a mistake. The search for a silver-bullet solution that rejects decades of learning may be emotionally satisfying, not to mention entertaining. But there are several problems with embracing Grant’s proposition in terms of uncovering deep wisdom for dealing with the mother of all known and recurring risk factors.
But let’s be fair and recognize that sometimes Grant’s prescription may be valid. Quite often, however, it’s not and so his thesis, however tempting, falls far short of a universal truth. The devil really is in the details on this subject, and so it’s no surprise that the editor of Grant’s Interest Rate Observer has cherry picked one downturn—“the story of America’s last governmentally unmedicated depression”–to make his case.
Trying to draw policy insights from one slump is akin to focusing on one year of stock market activity to model equity risk. It’s convenient and dispenses vivid results, but it’s not all that practical for trying to wrap our heads around the nature of the beast.
It’s hard to know where to begin with critiquing the book’s working assumption. Let’s begin by taking issue with labeling the recession under scrutiny as the last unmanaged downturn. One can reasonably argue that the debacle in the 1930s was also a direct consequence of government inaction, namely: allowing banks to fail and passively adhering to a gold standard for several years before pulling the plug on this deflation-creating policy.
(The gold standard, by the way, is often promoted as an alternative to manipulating interest rates via Fed policy. But basing a monetary system on gold is no less manipulative of supply and demand factors, albeit in other areas. In particular, the gold standard is first and foremost a system designed so that the periodic demand for liquidity at certain times — during a financial crisis — will remain unsatisfied. In turn, that manipulation inevitably and unnecessarily leads to falling prices as the appetite for cash rises above the available supply of safe assets. Why would you engineer such an outcome? For circular reasons, according to gold bugs. The supply of gold is sacrosanct. Why is it sacrosanct? Because its gold.)
But let’s return to 1921, which in fact was a recession that was longer than the book’s title implies. According to National Bureau of Economic Research, the first downturn of the 1920s in the US ran 18 months, through July 1921 – matching the length (peak to trough) of the Great Recession of 2008-2009. So, right off the bat, let’s dispense with the notion that the 1921 affair was brief or that it was contained in one calendar year.
But that’s nitpicking. The challenges to the book’s central idea are more substantial. One could start by recognizing that the end of the 1920-21 recession was soon followed by another slump, a 14-month affair during 1923-24, followed by the 1926-27 recession, and then the Great Depression in the 1930s. Arguing that the 1920-21 decline revived the prospects for sustained growth by ushering in a period of relative calm conflicts the historical record.
The heart of the matter, however, is the policy instrument that Grant admires—the gold standard, which is no innocent bystander in looking for causes that created the 1920-21 recession in the first place. A review of Grant’s book by The Economist provides the historical context:
The boom caused prices to double between 1914 and 1920. America was still on the gold standard and orthodoxy held that deflation must follow inflation. Benjamin Strong, who as head of the New York Federal Reserve Bank was the Fed’s de facto chief, set out to make it happen. “This period will be accompanied by a considerable degree of unemployment,” he confided to one correspondent, but this would be necessary to restore “the world to normal and livable conditions”. The Fed began to raise interest rates and in short order industrial production and prices started to plunge. The monetary squeeze was severe: thanks to falling prices, real interest rates exceeded 15%. Fiscal policy was equally austere. Warren Harding, elected president in 1920, wanted the budget balanced, and vetoed a veterans’ bonus because it would add to the national debt and “undermine…confidence” in America’s credit.
The idea that ill-conceived monetary policy is a critical factor for the business cycle is, of course, widely recognized at this late date, or at least it should be. It’s also essential to recall that the gold-standard-driven slump of 1920-21 was quite harsh, as Milton Friedman and Anna Schwartz’s A Monetary History of the United States, 1867-1960 explains:
From the last week in October 1920 to the end of 1921, weekly reporting member banks cut their loans (unadjusted for seasonal) by one-sixth. The reduction in Federal Reserve credit was offset in part by gold inflows that began in the second quarter of 1920 but, even so, total high-powered money fell some 11 percent from September 1920 to the cyclical trough in July 1921.
Also, according to Friedman and Schwartz:
The monetary contraction brought in its train a sharp increase in bank failures from 63 in 1919 to 155 in 1920 to 506 in 1921.
The hands-off policy of macro management in the early twenties looks like a precursor for the 1930s, which is to say that the Fed made the same mistakes, albeit with far more painful consequences. Policymakers subsequently drew the proper conclusions in later years, but monetary enlightenment had yet to resonate in the early thirties, even as the rate of bank failures broke all previous records.
Tightening money supply amid escalating bank failures — more than 500 in 1921 alone! – may strike some as a healthy purging of economic excess, but it’s rightly seen as flirting with financial disaster by others. Clearly, there is a price to pay for letting the business cycle run its course with little or no intervention on the monetary policy front. Indeed, policy in the early 1920s was instrumental in making the slump deeper than it had to be.
The lesson for central banks in the here and now seems clear, at least to some. The main point is that ignoring periodic surges in liquidity demand is the central banking equivalent of overlooking a brush fire and hoping for the best. For anyone who disagrees, a sober review of history is recommended. On the short list of readings is Yale Professor Gary Gorton’s slim but persuasive analysis from 2012: Misunderstanding Financial Crises: Why We Don’t See Them Coming, which posits that bank runs of one form or another are the dark force that creates havoc for the real economy. Citing more than a century of hard data, which he meticulously reassembles, Gorton explains:
Banks and bank debt were at the root of every one of the 124 systemic crises around the world from 1970 to 2007 (some also involved currency crises in which the value of the domestic currency decline precipitously). Indeed, there cannot be systemic crises without bank debt. But bank debt is needed for conducting transactions and is necessary for an economy to function.
Not every financial crisis leads to a recession, but most recessions are linked with these events. History speaks loud and clear on this point. Unfortunately, not everyone is listening. Why? Some folks have drawn the wrong conclusions from the Great Recession of 2008-2009. The most conspicuous example of recent vintage: the 2011 decision to raise interest rates in Europe under the guidance of Jean-Claude Trichet, the European Central Bank president. Like austerians before him, Trichet was focused on containing inflation, when in fact the big risk factor was deflation.
There’s been a lot of criticism of macroeconomics in recent years, and justifiably so. But one of the rare slices of genuine progress can be found in the advances of monetary policy as it relates to the real economy. It’s been a long time coming. Indeed, this is an area of study that begins with David Hume’s seminal 1752 essay “Of Money.” In the 21st century, economist Chris Sims, who won the Nobel Prize for the dismal science in 2011, cites monetary policy as one of the few areas of advancement in macro matters. He writes that “the evolution since around 1950 of our understanding of how monetary policy is determined and what its effects are” constitutes “real scientific progress in economics.”
Dispensing with this progress on the basis of analyzing one event in history—and drawing dubious conclusions at best—amounts to throwing away decades of empirical evidence and research. There’s a reason why the US created a central bank in 1913 and refined the bank’s role through time. The pre-1913 strategy of letting the economy find equilibrium on its own was correctly labeled a failure, as even Wall Street at the time recognized. The last straw was the 1907 panic, which again compelled J.P. Morgan to stitch together a monetary solution at the 11th hour, as he had done several times before, and in the process acting as an informal central bank.
The lessons of 1907 are many (still), including the need for a central bank to act decisively in times of sudden increases in liquidity demand. Indeed, it’s hard to reach any other conclusion after reading The Panic of 1907: Lessons Learned from the Market’s Perfect Storm. Unfortunately, monetary history is too often forgotten (ignored?) when it comes to the truly salient lessons.
Could political agendas be mucking up what should be an objective econometric analysis of cause and effect? Maybe. In any case, It’s all cut and dry from the vantage of 2014, or at least it should be. That’s not to say that the Fed did everything correctly in the last crisis. But given what we know about financial crises and economic recessions, it’s clear that the central bank’s actions since 2008 have been instrumental in preventing the previous explosion in liquidity demand from metastasizing into a downturn a la the 1930s. True, the growth in recent years has been modest, but it could have easily been a lot worse if the Fed had taken a hands-off approach.
The alternative view, we’re told, rests on the experience of 1921 and its outcome, but that’s a thin reed. We know what happened when the Fed was largely passive the last time a major financial crisis hit. Not surprisingly, the advocates for letting the economy find its own level don’t usually find a friendly narrative in the events of 1930s. But that’s where the relevant history resides for interpreting the last six years. Analyzing 1921, by contrast, is an artful dodge.