I got a very good question from saifedean, and thought my answer might be worth a separate post. He asked:
I am, however, surprised that you, of all people, think that Harding’s handling of the 1921 depression was good. According to your Monetarist rule-book, shouldn’t Harding have expanded the money supply to fight the depression? Yet he didn’t. And there was a fast recovery.
Doesn’t that make you doubt the veracity of the monetarist view? Doesn’t that support more the Austrian deflationist liquidationist view?
This is a very good question. And although I can and will answer the question, my answer will raise deeper questions that may undercut part of my Great Depression story. But that will be for you guys to decide. Your views may influence how I revise my Depression manuscript.
Start with a few stylized facts. The price level fluctuated around a fairly stable trend line under the gold standard. Call that trend line 100. During WWI gold demand fell sharply as European countries sold off their gold stocks to pay for the war. Even in the US prices doubled as the purchasing power of gold fell in world markets. In 1920-21 the price level fell back from roughly 200 to 150, in other words halfway back to the “natural” pre-war level. A good argument could be made that more declines were inevitable as the European countries continued to rebuild their gold stocks. This problem was recognized and countries were encouraged to economize on gold holdings to prevent further costly deflation. The idea was to have central banks hold other forms of international reserves such as dollars and British pounds.
The quick answer to saifedean is that I am OK with Harding’s actions (or the Fed’s) because the gold standard was accepted dogma at that point, and some deflation was necessary unless we were to devalue. Even though the 1920-21 depression was much milder than the Great Depression, it was still bad, and in a perfect world inflation targeting would have been even better. But that was not an option. What were the options going forward?
1. Currency devaluation right after WWI, to make the new price level permanent. This was done in some countries, but wasn’t politically acceptable in the US or UK.
2. Allow gradual deflation during the 1920s. (The Austrian view.)
3. Keep fine-tuning the economy to insure roughly stable prices during the 1920s (which was what Fed Governor Strong actually did.) Thus if Britain needed to rebuild its gold stock in the late 1920s, the US would run an easy money policy to insure that gold flowed from the US to Britain. The monetarists and Keynesians both argued that it would have been better if this policy had continued into the 1930s.
4. Adopt fiat money and start targeting inflation at 2%.
Which would have been best? I’d say number 4, but that wasn’t an option. What about among the first three? I think they all have problems, but what I would most like to emphasize is that any one of these options would have been far better than what actually happened.
You might be puzzled here. Didn’t we adopt number 3? No. We adopted number 3 from 1921-29, and then shifted to number 2, but in a very clumsy way. As a result, the price level (which had been stable at around 150 during the 1920s), fell to about 100 by 1933. We were back to the pre-war gold standard price level, but it happened in about the worst way possible. The 1929-33 deflation represented a sudden change from the Strong regime, and thus was largely unexpected. Unexpected, rapid, and long lasting deflation causes more damage than any other kind. The deflation of 1929-33 literally could not have been worse. It would have been much better if it had happened immediately after WWI. Or if prices had fallen at a slow rate during the 1920s. Or if we had devalued after WWI. Or if we had continued to prop up prices with Strong’s policies after 1929. Even fiat money would have been much better.
What we had in the 1920s was the illusion of control. Or to borrow the name of Jim Jarmusch’s new film, the limits of control. We led people to believe that we were in a new era where scientific management of money would lead to unending prosperity. And for a few years we delivered on that promise. Then we reverted to the crudest form of gold standard, where each central bank madly scrambled for gold like hysterical depositors lined up outside a failing bank.
Does this remind you of anything in my previous history post? It’s exactly the same argument I applied to Wilson and WWII. If we stay out of WWI, Germany doesn’t get humiliated and some sort of rough equilibrium is achieved. If we go in and make sure the strongest country loses, we’d better make sure we hang around to assure the new balance of power is stable. (Say through a post WWI NATO-type system.) The worst possible scenario would be to go in and create an artificial equilibrium through heavy intervention, but then revert to a very passive (isolationist) policy after WWI.
You may have noticed that in this account Wilson essentially plays the role of Gov. Strong in the 1920s. Someone who reshaped the world equilibrium (price level or balance of power) but wasn’t powerful enough to ensure that that new equilibrium outlasted him. Why then do I have a much more favorable view of Strong than Wilson? I don’t know if I have any good reasons, but I’ll try.
1. Wilson’s policies were very destructive to US lives even when he was in office. Strong’s produced good times.
2. Wilson could not even implement his vision while in office. Strong’s policy was much more plausibly long-lasting. Indeed as late as the summer of 1929 (one year after his death) stock investors thought his policies would continue. And the political obstacles to maintaining them were much less than what Wilson faced. With continued international cooperation we could have finessed the undervaluation of gold problem with a very mild deflation in the 1930s.
Both the Great Depression and World War II were partly a natural reflection of these unstable equilibria, but also a product of a virtual “perfect storm” of bad luck (too complicated to get into here.)
Just to be clear, one of my points is that all of the theories of the Great Depression are partly right:
1. The Mundell/Johnson gold undervaluation problem.
2. The Austrian claim that prices were artificially held too high in the 1920s.
3. The Keynesian/monetarist claim that prices should have been held up in the 1930s as well.
Where they differ is on relevant counterfactuals. What were the other options? What else could we have plausibly done? Could the good times have gone on forever as I (and monetarists and Keynesians) argue, or was tragedy an inevitable product of the 1920s policies, as the Austrians (and to a lesser degree the Mundellians) argue? In my manuscript I take an “efficient markets” perspective on causality. Causal factors are events that surprise markets. If markets thought prosperity could continue, then it was bad luck or bad policy that caused the Depression. On the other hand the Austrians have the advantage of arguing that the very thing they worried about actually happened.
On or about December 1910, the human character changed. — Virginia Woolf.
I guess when this quotation is discussed people usually think about radical changes in art, culture, science, etc, that occurred around this time. But the “modern era” also had a profound effect on politics and economics. Laissez-faire and isolationism were out, and interventionism and statism were in. The thing that is so fascinating, and tragic, about this sudden change is that our power raced ahead of our good judgment. We started treating society like a machine that could be controlled, without really knowing how complex the problems were, and how fragile were the new equilibria being created.
[BTW, something vaguely analogous had occurred when the gradual spread of liberal ideas after the Renaissance led to an explosion of technological progress that within a few hundred years made Europe the master of the world. Unfortunately, although the liberal revolution did gradually improve moral values, it improved power much more rapidly. Many indigenous people suffered as the West rampaged all over the world spreading disease and slavery and stealing land.]
I used to think that WWI changed everything. But maybe what really happened is everything changed and that caused WWI. After all, we have a dizzying series of “progressive” (i.e. statist) initiatives right on the eve of WWI, the income tax (1913), the Fed (1913), the War on Drugs (1914), and so on. I’m not trying to blame the progressives for WWI; just suggesting that a sudden cultural change occurred, which somehow led to the perception that the state should be made much more powerful. Any radical change along those lines is likely to have some rather unpleasant side effects. Today some of these progressive ideas (like an alliance of democracies (NATO) and central banks) actually work pretty well, but we had to learn some very painful lessons to get here.
What does this tell us about our current problems? I’m actually not as worried about global warming as most people (although I have no reason to doubt the science.) It’s the things that catch us unaware that worry me the most. A natural or genetically engineered disease that is fatal and easily spread, or even something as mundane as a solar flare, which Robin Hanson claims could easily plunge us into a dystopian world out of a Cormac McCarthy novel. (At least the articles he links to suggest that.) We’ve built this incredibly complex electrical distribution system, without thinking about what would happen if it all failed at once. I’ve wandered so far from the original topic that perhaps I should stop this late night dorm room monologue before I start scaring small children. Anyway, is there an answer to your question in there anywhere, saifedean?