In the folklore of modern Austrian Business Cycle Theory, the Depression of 1920-21 occupies a special place. It is this depression that supposedly proves that all depressions are caused by government excesses and that, if left unattended, with no government fiscal or monetary stimulus, would work themselves out, without great difficulty, just as happened in 1920-21. In other words, government is the problem, not the solution, and the free market is the solution, not the problem. If only (the crypto-socialist) Herbert Hoover and (the not-so-crypto) FDR had followed the wholesome example of the great Warren G. Harding, cut spending to the bone and cut taxes, the Great Depression would have been over in 18 months or less, just as the 1920-21 Depression was. And if Bush and Obama had followed the Harding example, our own Little Depression would have surely long since have been a distant memory.
In two recent papers (“A Critique of the Austrian School Interpretation of the 1920-21 Depression“, “A note on America’s 1920-21 depression as an argument for austerity“), fellow blogger Daniel Kuehn provides some historical background and context for the 1920-21 Depression, showing that the 1920-21 Depression was the product of a deliberately deflationary fiscal and monetary policy aimed at undoing (at least in part) the very rapid inflation that occurred in the final stages and the aftermath of World War I. In that sense, the 1920-21 Depression really is very much unlike the kind of overinvestment/malinvestment episodes envisioned by the Austrian theory.
The other really big difference between the 1920-21 Depression and the Great Depression is that there was effectively no gold standard operating in 1920-21. True the US had restored convertibility between the dollar and gold by 1920, but almost no other currencies in the world were then tied to gold. The US held 40 percent of the world’s reserves of gold, so the US was determining the value of gold rather than gold determining the value of the dollar. The Federal Reserve had as much control over the US price level as any issuer of fiat currency could ever desire. By 1929, there was a world market for gold in which many other central banks were exerting — and none more than the insane Bank of France — a powerful influence, almost exclusively on the side of deflation. Thus, immediately following a wartime inflation — historically almost always a time for deflation — it was relatively easy to unwind the inflationary increases in wages and prices of the preceding few years. When the Fed signaled in 1921, by reducing its discount rate, that it was no longer aiming for deflation, the deflation quickly came to an end. But in the Great Depression, notwithstanding the characteristically exaggerated, if not delusional, Austrian rhetoric about the inflationary excesses 1920s, there was in fact no previous inflation to unwind. As long as a country remained on the gold standard, there was no escape from deflation caused by an increasing real value of gold.
On at least one occasion, no less an authority on Austrian Business Cycle theory than Murray Rothbard, himself, actually admitted that the 1920-21 Depression was indeed a purely monetary episode, in contrast to the Great Depression in which real factors played a major role. In the late 1960s, when I was an undergrad in economics at UCLA, Rothbard gave a talk at UCLA about the Great Depression. All I really remember is that he spent most of the talk berating Herbert Hoover for being just as bad as FDR. Most people were surprised to find out that Hoover was such an interventionist, though anyone who had read Ronald Coase’s classic article on the FCC would have already known that Hoover was very far from being a free market ideologue. I had just started getting interested in Austrian economics – while my contemporaries were experimenting with drugs, I was experimenting with Austrian economics; go figure! I sure hope no permanent damage was done – and was curious to hear what Rothbard had to say. But it was all about Herbert Hoover. Later, I asked Axel Leijonhufvud, who had also attended the talk, what he thought. Axel said that Rothbard was a scholar, but didn’t elaborate except to say that he had chatted with Rothbard after the talk asking Rothbard if there had ever been a purely monetary depression and that Rothbard had said that the 1920-21 Depression had been purely monetary. So there you have it, Rothbard, on at least one occasion, admitted that the 1920-21 Depression was a purely monetary phenomenon.