James Grant Explains How A Crash In 1921 “Cured Itself” — With The Help Of Good Policy

(This item originally appeared at Forbes.com on February 23, 2017.)


James Grant’s The Forgotten Depression (2014) is a splendid account of an important period in U.S. economic history — the sharp but brief “depression” of 1921 — that is easily overshadowed by the Great Depression a few years later. It seemed to be, as Grant’s subtitle says: “The crash that cured itself.” This stands in contrast with the Great Depression, which remained uncured throughout the 1930’s even after enormous government intervention; or our own experience, milder but equally prolonged, since 2008.

I group it with Lawrence Kudlow and Brian Domitrovic’s JFK and the Reagan Revolution (2016) as an example of a new sort of hybrid – a readable history book by economic sophisticates. As the publisher of Grant’s Interest Rate Observer, Grant has spent the last few decades immersed in discussion of markets and economies with some of the most sophisticated investors on Earth. Larry Kudlow brought similar expertise to JFK, with similarly superb results. Books by historians tend to become compilations of newspaper headlines, spiced with individual anecdotes; books by academics tend to be unreadable, and for those that persist nevertheless, compromised by fallacy and dogma born of academic isolation. Although Grant’s book is brief, enjoyable, and beautifully written, he cites the help of four research assistants, plus three other research contributors.

World War I caused a U.S. economic boom powered by European wartime demand and U.S. government military spending. In addition, the newly-created Federal Reserve was engaging in aggressive money-creation to allow huge U.S. deficits to be financed at attractive rates. A gold embargo in 1917 effectively suspended the gold standard and allowed inflation. When the gold embargo was lifted in 1919, the Federal Reserve had to reverse some of its wartime money-creation to raise the value of the dollar back to its prewar parity and halt gold conversion outflows. At the same time, the federal government’s spending collapsed back to peacetime levels. Spending of $18.493 billion in the fiscal year ended June 1919 tumbled to $6.358 billion in 1920, $3.289 billion in 1922, and $2.908 billion in 1924. In 1921, the heart of the downturn, the Federal government ran a surplus of $509 million.

Commodity prices and wages had soared due both to wartime demand and Federal Reserve money-printing. With the war over, shrinking government spending, military demobilization and a return to gold standard discipline, these high prices and wages were unsustainable. In the ensuing adjustment, 1920-1921, prices and wages fell dramatically. And then, it was over: in mid-1921, the wonderful economic boom of the “Roaring ’20s” began.

The government’s response was the opposite of the interventionist nostrums that the economic manipulators have pushed for most of the last century. There was no government deficit spending and “easy money.” Exactly the opposite. And the result, after the intense but short-lived discomfort, was one of the best expansions of the twentieth century.

While Grant’s subtitle suggests a passive approach, the evidence that Grant expertly unfolds in the body of the book illustrates a little different narrative.

The government was not “doing nothing.” Certainly, some of the cause of the recession was monetary: both the inflationary expansion by the Federal Reserve during the war, and the deflationary return to the gold standard, at the pre-war parity, in 1919. On fiscal policy, some very important changes were happening. President Woodrow Wilson suffered a stroke in September 1919 that effectively incapacitated his administration. The demands of wartime had led to all manner of economic intervention, including price controls and the nationalization or centralized control of industry. Many in his administration were committed socialists, even borderline communists, who wanted to retain both the wartime industrial controls and also the high income tax rates, with a top rate that had soared to 77%. Government control of coal mining, railroads, and telephone and telegraphs, even after the war’s end, led to endless problems. The Wilsonians argued that these difficulties required that the controls remain, and still further controls imposed.

The threat of continued leadership in this vein, under Democratic presidential candidate James Cox, was neutralized with the election of Warren Harding in 1920. Harding ran on a platform of a “return to normalcy.” This apparently vague feel-good phrase had several important connotations: a major reduction in tax rates (the top prewar rate was 7%), low levels of Federal spending (which would in turn facilitate budget surpluses and tax rate reductions), and the elimination of all war-related controls on industry. It amounted to a major change in the direction of economic policy.

But, better yet, Harding brought on Andrew Mellon as Treasury Secretary. Mellon was the kind of giant figure that America rarely seems to produce today. He combined the financial savvy of Warren Buffet, the managerial skills of Jack Welch, the public policy sophistication of Steve Forbes and the Constitutional principles of Ron Paul in one coherent mind. He understood American business because he had built much of the American business landscape with his own hands. After a career of establishing a series of huge industrial and financial concerns – much of it with his own capital – he sat on the boards of 60 corporations. In today’s money, he was worth about $25 billion.

Mellon saw the advantages of major tax reform, which he later laid out in his brilliant 1924 book Taxation: The People’s Business, and then implemented as Calvin Coolidge’s Treasury Secretary. In 1921 he was able to enact a tax reform that brought the top rate down to 50%, and promised more to come. Mellon wanted to cut it to 40%, but was blocked – plus ça change – by the era’s deficit hawks, or maybe I should say: inadequate-surplus hawks. In 1925, the top income tax rate was 25%, and the surplus was on its way to $1,155 million in 1927. If the deflationary return to the gold standard in 1919 was part of the cause of the downturn, it was also part of the cure. The Federal Reserve brushed off arguments by John Maynard Keynes or Irving Fischer that the dollar should remain, in effect, a floating currency. While Europe’s currencies would float for several more years, and some would descend into hyperinflation, the U.S. dollar was once again “as good as gold.” Businessmen looked into the future and saw what I call the Magic Formula: Low Taxes and Stable Money.

It was, indeed, rather similar to the strong dollar/tax cut strategy that Ronald Reagan implemented in 1981-1983, and which generally does not get the label of “benign neglect.” While the self-healing properties of the free market economy were at the core of Harding’s economic strategy, the economy had quite a bit of help healing itself.

Britain’s policy to return the pound to its prewar gold parity in 1925 was actually rather similar to what the Federal Reserve did in 1919. The main difference was fiscal policy: Britain’s tax rates also soared during wartime, but they were not reduced afterwards. Instead, a series of new taxes were imposed, to pay for new welfare programs. The new taxes created more unemployment; and the new public dole made the unemployment more persistent. People blamed the gold standard.

Whether you characterize Harding’s economic strategy as “active” or “passive,” Grant’s careful exposition shows that free-market principles are not just vague ideals, but practical tools for producing prosperity and bounty. If these principles – low taxes, stable money, business-friendly regulation, restrained spending – are unpopular today, then let us at least remember them for the future. We might need them again.