More on the Depression of 1921

I sure have been talking about monetary topics exclusively for a long time now. It will be nice to talk about something else someday. But, it is apparent that there is still quite a bit more work to do regarding the Interwar Period. First, I will do a little background work — today, that means a little closer look at the “Depression” (anyway, a sharp recession) of 1920-21, now informed by Jim Grant’s rather excellent book on the topic.

February 23, 2017: James Grant Explains How A Crash In 1921 “Cured Itself” — With The Help Of Good Policy

We also looked at this earlier here:

March 25, 2012: The U.S. Dollar During WWI and the Recession of 1920

December 16, 2012: The Federal Reserve in the 1920s 3: Balance Sheet and Base Money


Here is some of the relevant data:

Here’s what it looks like when we continue the series into 1940. This data is from the St. Louis Fed:

We see that there is a big increase in the monetary base. This appears to have been initially driven by war-related demand — probably a combination of domestic demand (uncertainty makes people prefer cash over bank deposits, and banks hold larger reserves) and also demand from outside the U.S., for a circulating currency of some reliability, compared to the floating fiat currencies of wartime Europe. This demand drove up the value of the dollar, resulting in gold inflows. After the U.S. entry into the war in April 1917, the Federal Reserve, under pressure from the Treasury, started to print money for wartime financing needs. At first, this money-printing met existing demand expansion. Gold inflows cease, but there are no outflows. However, eventually the aggressive Federal Reserve expansion overwhelmed expanding demand, resulting in gold outflows. The response was a gold embargo, which effectively rendered the dollar a floating currency. When the embargo was lifted in 1919, gold flowed out, reflecting the sagging dollar value vs. gold.

Here’s a graph of U.S. gold imports and exports. Negative denotes an export.

The source for all these is the Fed’s Banking and Monetary Statistics, conveniently available at the St. Louis Fed FRASER archive.

The change in the story I want to point to here is this: it is easy to assume that the reduction in the monetary base 1920-1921 corresponded to the period in which the value of the dollar was raised back to its gold parity. But, now I don’t think this was the case. I think the dollar was rising in value in 1919, even though the monetary base was expanding slightly. The dollar probably reached its $20.67/oz. parity around the beginning of 1920, which is when gold outflows stopped. This makes sense, timing-wise. The economy entered recession around the beginning of 1920, which allows for a bit of lag between the rising dollar and the domestic effects. Usually, you see some lag in these things. The reduction in the monetary base in 1920-1921 was likely a response to reduced domestic demand for money, during the recession. However, the value of the dollar was likely maintained at the $20.67/oz. parity during this time. Indeed, there were substantial gold inflows, which certainly does not suggest a dollar value sagging beneath its parity.

This is a chart of the British pound vs. the dollar. It is marked in gold but it is really the foreign exchange rate. As we can see, the pound sank vs. the dollar during 1919, which fits our timing exactly. The dollar did not rise vs. the pound during 1920-21, despite the reduction in the monetary base.

However, there may have been something funny going on as early as the start of 1916 or so. We see the value of the dollar collapsing vs. noncombatants like Spain and a number of other currencies. The dollar might have been falling during this time. There is an adjustment in 1918, which returns the peseta/dollar exchange rate to its prewar level. Then, in early 1919, the peseta takes a dive against the dollar, which suggests again that the dollar was rising around that time. This dive ends at the beginning of 1920, which is exactly when gold outflows cease, indicating that the dollar has returned to its official parity value.

We can see that the dollar/pound exchange rate flatlines in 1916, which suggests wartime capital controls, and likely included capital controls on gold. Also, there is a funny flatline in U.S. gold reserves at the same time. This suggests that the increase in U.S. gold reserves after 1916 did not necessarily have anything to do with the normal operation of the gold standard, and might have been something else. And, commodities prices take off right at the beginning of 1916. In other words, there is some evidence that the effective date of the beginning of the suspension of the gold standard and the effective decline in the value of the dollar was from around the beginning of 1916. (Neither Friedman or Meltzer, in their monetary histories, have much to say about this hypothesis.)

The beginning of the U.S. wartime inflation is not too important — whether 1916 or 1917, the outcome was the same. But, it appears to me that the dollar effectively returned to its prewar gold parity around the beginning of 1920, rather than the beginning of 1922, as is suggested by the monetary base data.