The Economic Superbowl: 1920-1921 versus 1930-1931

It’s been said there’s no such thing as a controlled experiment in the social sciences, including economics. But we had something close to a laboratory experiment back in 1920-1921 and 1930-1931.

In each of these periods there was a depression. Unemployment was high – for a while — it briefly was higher in the 1920s than in the 1930s. Prices fell in both periods. 

In the 1920-21 depression, the Federal Reserve Bank of New York crashed the monetary base, thereby reducing the money stock, and jacked interest rates to record highs. In the 1930-1931 depression, however, the federal reserve gradually increased the monetary base and lowered the interest rate. 

In the 1920-21 period the government slashed spending and allowed nominal wages to fall. In the 1930-31 depression the government increased spending and deficits while pressuring industrial leaders to maintain wage rates.

Tax Policies

Coming out of World War I the highest marginal income tax rate was 77 percent. First President Warren G. Harding, then President Calvin Coolidge (following Treasury secretary Andrew Mellon’s advice) lowered tax rates steadily in the early 1920s. By 1925 the highest tax rate was around 25 percent. Tax receipts began to climb, as people stopped playing defense and looked for ways to grow their income. As incomes increased, so did tax revenue despite the lower rates. 

In 1932, President Herbert Hoover pushed through one of the highest peacetime tax increases in U.S. history. A person making above a million dollars in 1931 could keep 75 cents on the dollar; a year later the amount plunged to 37 cents. In the lowest bracket, rates more than doubled. Along with this were countless taxes on items that had never been taxed. From 1931 – 1933, revenue from the individual income tax dropped by more than half. By 1933, the economy was at the depth of the Depression.

President Franklin D. Roosevelt went further. The top income tax rate had spiked from 24 to 63 percent under Hoover, and then to 78 percent in 1935 under FDR. Capital gains taxes more than doubled, going from 12.5 percent during the 1920s and early 1930s to 32 percent by 1934-1935. 

In 1936, the New Dealers decided to tax corporate savings, imposing a severe penalty on businesses that depended on profits to expand operations. Called the Undistributed Profits Tax, it entrenched the bigger firms by keeping their smaller competitors from expanding. It also pressured firms to use debt instead of equity to finance expansion.

Throughout the 1920s, the Coolidge administration ran a budget surplus every year. Throughout the 1930s, first Hoover, then Roosevelt ran budget deficits every year.

Keynesians such as Christina Romer tell us that the deficits were not big enough. It took the huge deficits of World War II to break the back of the Depression, they claim. Whether fighting the war overseas or on the home front, however, Americans were anything but prosperous during this period.

Monetarists such as Milton Friedman tell us the Fed didn’t inflate enough after the Crash to offset the fall in the money supply. People were pulling their money out of the banks, and the Fed failed to offset the deflationary effect this was creating. 

As Robert Murphy writes:

If Friedman is right that the Federal Reserve’s inaction caused the Great Depression, then why didn’t the U.S. experience even worse catastrophes before 1913, when the Fed didn’t even exist?

Gold takes the blame

Both Keynesians and Monetarists blame the gold standard for restricting policy options. When FDR confiscated the people’s gold in 1933 and outlawed contracts denominated in gold, the Fed went on a printing spree and the government stepped up its spending. From 1933-1936, unemployment declined steadily while GDP increased.

But the gold standard in some form had existed for centuries prior to the 1930s. Why did it suddenly cause a massive depression? It existed during the depression of 1920-21, yet that crisis was over in two years and was followed by one of the most prosperous periods in U.S. history.

And if the gold standard of 1929 did cause the depression, why didn’t going off gold end it? Fed monetary inflation and government spending improved the statistics somewhat, but the economy remained in a depressed state throughout the 1930s and beyond. 

Critics of gold rarely mention that the gold standard that failed was not the classical gold standard of the 19th century. European governments ordered their banks to stop redeeming gold in 1914 so they could use the printing press to pay for the carnage of the Great War. The “gold standard” abandoned in the 1930s had been erected in 1922 at a conference attended by 34 countries in Genoa, Italy. Called the gold exchange standard, its purpose was to keep gold “in the vaults” by redeeming currencies not in coins but in large bars. 

Most European citizens were thereby disarmed of their means for keeping government spending under control. U.S. citizens could still legally redeem bank notes for gold coins, but in practice it was rare. The gold exchange standard collapsed in 1931 when England went off gold completely because it couldn’t redeem France’s sterling holdings.

The Monetaristsslam-dunk: The double-dip of 1937-1938

According to monetarists, the Fed interrupted the New Deal’s recovery in 1936-1937 when it doubled the reserve requirements of its member banks, thus contracting the money stock and producing a double-dip or a “depression within a depression” in 1937-1938. Unemployment spiked and GDP fell off.

Let’s take a closer look at this period and the years preceding it. Following passage of the Gold Reserve Act of 1934, the U.S. Treasury was under a legal mandate to purchase all the gold offered to it at the rate of $35 an ounce, a 69 percent increase over the classical rate of $20.67. The Treasury was in effect mimicking the Fed’s inflationary open market operations by freely purchasing demonetized gold instead of government securities. Gold flowed into the U.S. from abroad, increasing bank reserves and inflating the money supply by over 10 percent annually from 1934-1936.

When in 1937 the Treasury began sterilizing their purchases (i.e., selling securities to pay for the gold instead of printing money) it slowed the growth of the money supply. Doubling the reserve requirements brought interest rates up a notch but they were still very low. Cheap loans were still available for businesses that wanted them. 

So, what caused the plunging economic indicators? As Joseph Salerno points out, money wages shot up 13.7 percent in the first three quarters of 1937. The Supreme Court had recently upheld the National Labor Relations Act of 1935, and unions were cashing in. With labor productivity remaining constant, unemployment began to rise. 

As business profits were squeezed by the run-up of labor costs and the economy slipped into recession, banks prudently began to contract their loans and pile up liquid reserves to protect themselves against prospective loan defaults and bank runs. To offset this uncontrolled decline of the money supply, beginning in mid-1938 the Fed (and the Treasury) once again resorted to an inflationary policy, reversing the reserve requirement increase and allowing gold inflows, once again pumping up bank reserves.

Between June 30, 1937, and June 30, 1938, the money supply did in fact decrease, but this was a result, rather than a cause, of the recession, Salerno concludes.

And the winners? Experts from the leading schools of economics today – the Keynesian and monetarist – tell us the Great Depression could’ve been avoided. They know the depression of 1920-21 was followed by the Roaring Twenties. They know the depression of 1930-31 turned into the Great Depression and is one of the reasons the world went to war in the 1940s. So, do these experts take the government/Fed response to the 1920-21 depression as their model?

Perhaps because it would put them out of work, their answer is a resounding No. That these same experts never see a crisis on the horizon should not dissuade us from ever trusting them.


The Politically Incorrect Guide to the Great Depression and the New Deal, Robert M. Murphy

America’s Great Depression, Murray N. Rothbard

The Forgotten Depression: 1921, The Crash That Cured Itself, James Grant

Money and Gold in the 1920s and 1930s: An Austrian View, Joesph Salerno

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