What if the economy goes off a cliff and the government does nothing to stop it? That’s the question James Grant considers in the aftermath of the underwhelming stimulus era. And it’s no hypothetical: In 1921, the American economy was in free-fall; every important sector from automobiles to agriculture went into liquidation while wages plummeted. The Forgotten Depression narrates the Keynesian unthinkable. The crash “cured itself,” as the subtitle puts it, and segued into the greatest recovery on record.
No one is more suitable to revive this story of modern economic heresy than Grant. Publisher of Grant’s Interest Rate Observer, he has a command of economic history from the ex ante rather than the ex post point of view. His accounts are no mere look-backs, but rather 360-degree perspectives of how events unfolded. Most period pieces smell of the library, but not Grant’s, and it’s his sourcing that’s the tonic. The Forgotten Depression is a tour of a harrowing episode in American history—informed by memos, cables, speeches, transcripts, letters, periodicals, corporate communications, and the then-burgeoning field of economic statistics—that has a happy and counterintuitive ending.
By 1919, the economy was frothy on the heels of post-Great War inflation. A nice pair of shoes that had cost $3 before the war now was $10 or $12. General Motors had nearly doubled both its sales, to $510 million, and its head count, to 86,000 employees, from the year before. In 1919, GM started construction on the world’s largest office building for its new Detroit headquarters. Harry Truman and a partner opened a menswear store at a prominent location in Kansas City, with shirts that sold for $200 in today’s money. It was clear to most observers of macroeconomics (another new field) that this easy-money phase of the business cycle couldn’t last much longer. The question was: What, then, to do?
The downturn arrived in 1920, during the tail end of the Wilson administration, while the president was consumed by his crusade for the League of Nations and then incapacitated by illness. Wilson’s successor, Warren G. Harding, purposely extended the hands-off approach: He believed that prices and wages had to fall on their own, taxes had to be reduced to prewar levels, and the federal budget needed to be brought into balance. In short, he believed in the self-correcting mechanisms embedded in free-market capitalism. The 1920-21 experience, which became a full-blown depression, would put that belief system to the test.
The Harding White House was complemented by a central bank that was willing to do the unpopular work of tightening credit. As was the case with Paul Volcker at the helm 60 years later, the Federal Reserve raised interest rates dramatically to combat double-digit inflation. Benjamin Strong, governor of the all-powerful Federal Reserve Bank of New York, had a plan (as Grant puts it) “to pull the rug out from under the American economy.” Higher interest rates would lead to less borrowing, which would force firms to cut prices, sell off excess inventory, and either reduce wages or lay off workers. Once American goods and investments were priced competitively for buyers at home and abroad, the economy would rebound. It wasn’t unanimous—the first rate hike was approved by the Federal Reserve Board only after the mercurial comptroller of the currency, John Skelton Williams, changed his vote—but the plan had complete support from the board’s chairman, W. P. G. Harding (no relation to the president).
Grant makes clear that the executors of the liquidation policy did not want what today’s self-proclaimed heirs of free-market economics say they want: stable prices. Strong and Harding both believed that deflation had to follow inflation for supply to meet demand and the economy to expand, even though it meant sure pain. At a time when a quarter of the workforce made a living in farming, the average value of crops per acre fell by half from 1919 to 1921. Businesses marked down their inventories more than 25 percent in 1921. Ford cut the price of the Model T from $575 to $440; General Motors wasn’t selling many cars, either, and had to follow suit.
Like the Federal Reserve, the American public was divided on how to respond to the slump that accompanied this deflation. President Harding vetoed a popular bonus bill for veterans in order to stick to his budget plan. Grant cites different sociological accounts of unemployment at the time: Some found that it built moral fiber while others saw it bring out the worst in people. But on the whole, neither the American people nor American business threw in the towel. The corporate debt default rate hardly budged as firms dug in with anticipation of better times around the corner—although Truman’s haberdashery went bankrupt.
What was so impressive about the ensuing recovery wasn’t that the nation’s leaders had prophesied it—they had—or the suddenness of its arrival in mid-1921. It was the force that accompanied it. Corporate profits spiked from $458 million to $4.8 billion from 1921 to 1922. Residential construction grew from 110,000 buildings to 160,000. The automakers increased car production by 63 percent. Firms were healthier than they had been during the pre-bust inflation era: Their inventories were right-sized and their debts pared back. The liquidation had done its job.
Yet even while it was working before their eyes, economists on the left and right argued for a better way. John Maynard Keynes, witnessing the 1922 Genoa conference (which the United States declined to join), saw the global shift from settling payments in gold to national currencies as an advance that would let governments smooth out domestic fluctuations without having to trigger deflation. They could print their way out of international payment deficits. Yale’s Irving Fisher believed price stability to be the one true central banking goal, and the Federal Reserve followed it for the rest of the decade. A continued natural decline in prices, thanks to technology during the Roaring Twenties, was thwarted and a new bubble in investments emerged under the guise of stable consumer prices. The decade would be bookended by another crash, and, of course, the response to it would be entirely different than in 1921.
Could the liquidation approach to economic collapse have worked in 2008? Grant and David Stockman, author of The Great Deformation (2013), are the only two observers who dare suggest it today. Defenders of Keynesian orthodoxy point to the modern superstructure of wages and their stickiness. But the Volcker purge of 1979-81 came at the high noon of organized labor, and the result was equally successful. Today’s resistance to self-correcting capitalism seems to be made of the “political expediency” that President Harding decried when he vetoed the bonus bill.
The depression of 1920-21 lasted only 18 months, but it’s unimaginable that anyone in Washington would ask the American public to stick it out that long today. Yet the economy rallied then and limps along today. We’re still searching for a cure.
Rich Danker, a Washington political consultant, managed Jeffrey Bell’s 2014 Senate campaign in New Jersey.
