Friday, October 31, 2014

The “Depression” of 1920–1921: The Libertarian Myth that Won’t Die

Yes, there was a recession from 1920–1921, but its history and significance are badly misrepresented by libertarians and Austrian economists, and the following talk by James Grant is a case in point. Grant even has a forthcoming book on the recession called The Forgotten Depression: 1921: The Crash That Cured Itself (2014).

What are the problems here?

They are as follows:
(1) the downturn of 1920–1921 was not a depression, if “depression” is defined as a contraction in the business cycle where real output fell by 10% or more.

The two best estimates of the depth of the downturn of 1920–1921 are Romer (1989) and Balke and Gordon (1989: 84–85).

Romer (1989) provided a new estimate for GNP declines from 1920 to 1921, as follows:
Year | GNP* | Growth Rate
1914 | $414.599
1915 | $443.048 | 6.86%
1916 | $476.498 | 7.54%
1917 | $473.896 | -0.54%
1918 | $498.458 | 5.18%
1919 | $503.873 | 1.08%
1920 | $498.132 | -1.13%
1921 | $486.377 | -2.35%

1922 | $514.949 | 5.87%
1923 | $583.105 | 13.23%
* Billions of 1982 dollars
(Romer 1989: 23).
These estimates show a GNP contraction of only 3.47% from 1919 to 1921, a mild to moderate recession.

By contrast, Balke and Gordon (1989: 84–85) estimate a GNP decline of 5.58% from 1920–1921, a moderately bad recession.

On either of these estimates, however, the downturn of 1920 to 1921 was nothing like the Great Depression, and, as we will see below, was an anomaly in other ways.

(2) Even the idea that the recession of 1920 to 1921 was some remarkably short recession is untrue. The recession lasted from January 1920 to July 1921: a period of 18 months. But a recession lasting 18 months is in fact quite a long one by the standards of the post-1945 US business cycle. The average duration of US recessions in the post-1945 era of classic Keynesian demand management (1945–1980) and the neoliberal era (1980–2010) has been about 11 months (Carbaugh 2010: 248; Knoop 2010: 13). So far from being some remarkably quick recession that was shorter than post-1945 recessions, it was about 7 months longer than the post-1945 average.

(3) At 12.29–12.33, Grant says that the recession of 1920 to 1921 was “the last governmentally unmediated major business cycle downturn.” This is untrue. Why? Because the Federal Reserve existed, and engaged in both open market operations and interest rate reductions as a deliberate strategy to stimulate recovery. In particular, by April and May 1921, the Federal Reserve member banks dropped their rates to 6.5% or 6%. In November 1921, there were further falls in discount rates: rates fell to 4.5% in the Boston, Philadelphia, New York, and to 5% or 5.5% in other reserve banks (D’Arista 1994: 62).

From the perspective of libertarian ideologues, it was worse than this, because other government interventions occurred as follows:
(1) a proto-form of quantitative easing by the Federal Reserve in which there were open market operations in late 1921–1922 to aid recovery, and in which the Federal Reserve bought government bonds from November 1921 to June 1922 and tripled its holdings from $193 million in October 1921 to $603 million by May 1922 (a fact even noted by Rothbard 2000: 133).

(2) direct credit allocation by the government “War Finance Corporation” and the “Federal Land Bank system” from early 1921, in which loans were granted to distressed farm cooperatives and other agricultural businesses. In August 1921, the War Finance Corporation corporation even became a rediscount agency for agricultural and livestock producers.

(3) there was even some limited deficit-financed public works, in the form of municipal bonds.
What should be particularly embarrassing for libertarians and Austrians is that all these interventions were known to described by Rothbard (see Rothbard 2000: 137–138, 191–193).

(4) Running through the talk is the bizarre background assumption that Keynesian economics says that economies can never recovery from recessions without government intervention. But that is not what Keynes or Keynesians think. What Keynes thought was that there is no universal, consistent, and reliable tendency for market economies to converge to full employment equilibrium. This does not mean that market economies can sometimes recover relatively rapidly from recessions, under the right circumstances.

(5) There were a number of reasons why the recession of 1920–1921 was unusual and indeed anomalous, and why it did not become very severe and protracted:
(1) the deflation was caused to some great extent, not by demand shocks, but a positive supply shocks in commodities due to the resumption of shipping and production after WWI (Romer 1988: 110; Vernon 1991).

(2) The recession of 1920–1921 also had no serious financial crisis, and no mass bank runs and collapses;

(3) the level of private debt was considerably lower in 1920 than in 1929, and the real value of debt had been reduced considerably by the large WWI and 1919 inflation, so that debt deflationary forces did not become severe.
In short, 1920 to 1921 was an anomalous recession, it was not especially short, it did have monetary interventions that aided recovery, and it is absurd to think that you can make sweeping generalisations from it about how government interventions are never needed to stabilise economies.

Further Reading
“The US Recession of 1920–1921: Some Austrian Myths,” October 23, 2010.

“There was no US Recovery in 1921 under Austrian Trade Cycle Theory!,” June 25, 2011.

“The Depression of 1920–1921: An Austrian Myth,” December 9, 2011.

“A Video on the US Recession of 1920-1921: Debunking the Libertarian Narrative,” February 5, 2012.

“More Fake History of the Great Depression,” September 28, 2012.

“The Recovery from the US Recession of 1920–1921 and Open Market Operations,” October 4, 2012.

“Rothbard on the Recession of 1920–1921,” October 6, 2012.

“The Recession of 1920–1921 versus the Depression of 1929–1933,” February 2, 2014.

“Debt Deflation: 1920–1921 versus 1929–1933,” February 3, 2014.

“US Wages in 1920–1921,” February 10, 2014.

“The Causes of the Recession of 1920–1921,” February 11, 2014.

Balke, N. S., and R. J. Gordon, 1989. “The Estimation of Prewar Gross National Product: Methodology and New Evidence,” Journal of Political Economy 97.1: 38–92.

Carbaugh, R. J. 2010. Contemporary Economics: An Application Approach. M.E. Sharpe, Armonk, New York.

D’Arista, J. W. 1994. The Evolution of U.S. Finance, Volume 1: Federal Reserve Monetary Policy: 1915–1935. M. E. Sharpe, Armonk, New York.

Grant, James. 2014. The Forgotten Depression: 1921: The Crash That Cured Itself. Simon & Schuster.

Knoop, T. A. 2010. Recessions and Depressions: Understanding Business Cycles (2nd edn). Praeger, Santa Barbara, Calif.

O’Brien, Anthony Patrick. 1997. “Depression of 1920–1921,” in D. Glasner and T. F. Cooley (eds), Business Cycles and Depressions: An Encyclopedia. Garland Pub., New York. 151–154.

Rothbard, Murray N. 2000. America’s Great Depression (5th edn.). Ludwig von Mises Institute, Auburn, Alabama.

Romer, C. D. 1988. “World War I and the Postwar Depression: A Reinterpretation based on Alternative Estimates of GNP,” Journal of Monetary Economics 22.1: 91–115.

Romer, C. D. 1989. “The Prewar Business Cycle Reconsidered: New Estimates of Gross National Product, 1869–1908,” Journal of Political Economy 97.1: 1–37.

Vernon, J. R. 1991. “The 1920–21 Deflation: The Role of Aggregate Supply,” Economic Inquiry 29: 572–580.

Tuesday, October 28, 2014

Hayek on Costs and Pricing

This comment that Hayek makes occurs in a discussion of Keynes’ General Theory, which I first quote merely for context:
“Now if there is a well-established fact which dominates economic life, it is the incessant, even hourly, variation in the prices of most of the important raw materials and of the wholesale prices of nearly all foodstuffs. But the reader of Mr. Keynes’ theory is left with the impression that these fluctuations of prices are entirely unmotivated and irrelevant, except towards the end of a boom, when the fact of scarcity is readmitted into the analysis, as an apparent exception, under the designation of ‘bottlenecks’. And not only are the factors which determine the relative prices of the various commodities systematically disregarded; it is even explicitly argued that, apart from the purely monetary factors which are supposed to be the sole determinants of the rate of interest, the prices of the majority of goods would be indeterminate. Although this is expressly stated only for capital assets in the special narrow sense in which Mr. Keynes uses this term, that is, for durable goods and securities, the same reasoning would apply to all factors of production. In so far as ‘assets’ in general are concerned the whole argument of the General Theory rests on the assumption that their yield only is determined by real factors (i.e. that it is determined by the given prices of their products), and that their price can be determined only by capitalising this yield at a given rate of interest determined solely by monetary factors. This argument, if it were correct, would clearly have to be extended to the prices of all factors of production the price of which is not arbitrarily fixed by monopolists, for their prices would have to be equal to the value of their contribution to the product less interest for the interval for which the factors remained invested. That is, the difference between costs and prices would not be a source of the demand for capital but would be unilaterally determined by a rate of interest which was entirely dependent on monetary influences. (Hayek 2009 [1941]: 374–375).
But the crucial passage is here:
“The reason why Mr. Keynes does not draw this conclusion, and the general explanation of his peculiar attitude towards the problem of the determination of relative prices, is presumably that under the influence of the ‘real cost’ doctrine which to the present day plays such a large role in the Cambridge tradition, he assumes that the prices of all goods except the more durable ones are even in the short run determined by costs. But whatever one may think about the usefulness of a cost explanation of relative prices in equilibrium analysis, it should be clear that it is altogether useless in any discussion of problems of the short period.” (Hayek 2009 [1941]: 375, n. 3).
Of course, the idea here seems to be that, in the long run, prices move towards marginal cost, so it is not modern mark-up pricing theory per se.

Nevertheless, Hayek is utterly wrong that many, even most prices, are not determined by costs of production in the short run. On the contrary, we now know, after many decades of empirical study, that most prices are cost-based or mark-up prices and are determined by total average unit costs plus a profit mark-up, not only in the long run but also in the short run. Therefore an economic theory that assumes this is how most prices are set is entirely realistic and correct, and it is marginalist pricing theory that is severely flawed and wrong.

Hayek, F. A. 2009 [1941]. The Pure Theory of Capital. Ludwig von Mises Institute, Auburn, Ala.