COVID-19 Crisis: More Like the 1920-1921 Recession

The Fed increased interest rate in 1920 to bring down inflation and attract gold inflows to restore the gold standard. The hike started in January 1920 and caused severe contraction of industrial production, consumption, and investment. Combined with government spending cuts due to WWI defense spending demobilization, the interest rate hike was high enough to cause the unemployment rate to go up from 2.3% in 1919 to 11.3 in 1921 and nonfarm unemployment rate rose up to 16%. With the economy in a deep recession and unemployment high, prices declined in the biggest deflation of the American economy in the last 120 years.

Then as the high interest rate attracted gold inflows and the price level significantly declined, the Federal Reserve started cutting interest rate in mid-1921. Soon enough the economy recovered through spending booms of debt-driven consumption and residential investment. Usually, the recovery out of recession takes long, hence the argument for government intervention. But as Keynes explained in the General Theory, under extraordinary circumstances that “could only be accomplished by administrative decree and is scarcely practical politics under a system of free wage-bargaining.”

When there is an anchor of expectations that raise the expectation of higher income, then recovery of spending can follow swiftly. During the early 1920s recession, we could argue, this anchor was the Federal Reserve monetary policy. The Fed’s interest rate cut raised expectations of higher future income and an end to the monetary-tightening caused recession. Furthermore, as I argue in a forthcoming paper, the increase in demand was also facilitated by a jump in private spending that was pent-up due to WW-I rationing and the subsequent recession.

As the management of the economy was still in the era of laissez-faire, the high unemployment rate was tolerable and forced as a fair price to purge the economy of inflation. Benjamin Strong, the chairman of New York Federal Reserve refused to cut of interest rates before wages had gone down as much as prices. In the post New Deal era, a high unemployment rate around 10% is less tolerable.

Government spending expansion when social-distancing measures are enforced and when relaxed would help us avoid a drastic depression as it would ensure sustained demand during the recovery. Furthermore, public deficit driven recovery would enable us to avoid risky private debt-driven rebound which characterized the era of the Roaring Twenties and contributed to the severity of the Great Depression.

Any concerns about expanding the debt are unjustified. The US debt to income ratio is currently less than half that of Japan which is capable of borrowing at extremely low cost while it has a smaller economy and lesser role in global financial markets compared to that of the US. If the Japanese experience proves anything it is that we have ample room for more debt to fund expansionary fiscal policy and avoid a depression. There is no reason to repeat the policy mistake done with the American Taxpayer Relief Act of 2012 which cut discretionary government spending when the unemployment rate was 8%. More generous European economic fiscal and monetary reactions to the current crisis prove the capacity of advanced economies governments in relieving its citizens of economic hardship. One hopes these responses would bring the order of mythological fiscal scarcity to an end.