In his paper A Critique of the Austrian School Interpretation of the 1920-21 Depression, Daniel Kuehn claims to have refuted the Austrian School analysis of the 1920 depression. Instead, he unintentionally demonstrates the veracity of the long held Rothbardian/libertarian explanation of that depression and even the Great Depression. Further, he helps demonstrate that there is no factual or theoretical basis for the Keynesian explanation of either the 1920 and/or the later Great Depression. Or of virtually anything Keynesian for that matter. The market did not fail. The market does not fail. Price distortions were caused by the Fed, not the market.
Kuehn first demonstrates that it was the Fed's funding of WWI that caused an artificial boom and inflation. The problem was not caused by any failure of "the free market".
2. The austerity depression of 1920–21
During World War I federal expenditures ballooned and although the new income tax was able to partially finance the war effort, most of the financing was done through federal borrowing and by the highly accommodating monetary policy of the Federal Reserve. The role of the Federal Reserve at this time was expressed unambiguously by the New York Federal Reserve Bank Governor Benjamin Strong, who told a Congressional committee in 1921 that ‘I feel that I, or the bank at least, was their [the Treasury’s] agent and servant in those matters’ and further added that the wartime inflation caused by the low interest rates maintained by the bank were ‘inevitable, unescapable, and necessary’ for prosecuting the war (Strong, 1930) [emphasis added}
This is the pure Rothbardian explanation. Wars are funded with fiat money which robs average people of purchasing power without the victims understanding exactly what is being done to them and without any due process of law. If the citizens had to make an immediate sacrifice in the form of a forced contribution of tax money to fund wars on a pay-as-you-go format, there would be far fewer wars. Kuehn then notes that the inflation encountered by the populace had been caused by the “expansionary policy of the Federal Reserve” and thus not any alleged “market failure”. After the war, such policy was “sharply curtailed” as was government spending leading to the predictable bust:
However, after the war ended the deficit spending of the Wilson administration and the expansionary policy of the Federal Reserve were sharply curtailed to bring a halt to the inflation. By November 1919 the Wilson administration balanced the federal budget, slashing monthly expenditures by almost 75% in a matter of months.4 The New York Federal Reserve Bank raised the discount rate by 244 basis points over the course of eight months, with other Reserve System banks following suit. Shortly after these austerity measures were taken, the 1920–21 depression was under way. Postwar industrial production in the USA peaked in January 1920 as the economy moved into a major depression, with production levels dropping by 32.5% by March 1921.5 This loss in output is second only to the Great Depression in American economic history (Romer, 1999), although its duration was considerably shorter. Declines in output were matched by precipitous drops in employment and the price level. The proximate cause of the 1920–21 depression was a deliberate fiscal and monetary retrenchment following World War I.
Even with this horrible distortion of the price, investment and capital structure caused by the government, free people were able quite quickly to re-establish prosperity without any significant government involvement. Indeed, it was the lack of such involvement that allowed prosperity to return. This horrible historical chapter inflicted upon the public was caused by "progressive" interference in society and was cured without significant governmental assistance. This is why the episode is virtually unknown to public school graduates and people who get their news from the mainstream media.
Note that it is simply outrageous the way Kuehn and the Keynesians refer to the process of ending the criminal and immoral government programs which facilitate war and theft of purchasing power as “austerity”. To a statist Keynesian, when you are successful in keeping your own money out of the hands of the fascist state, such a state of affairs is inherently “austerity”. The way they distort and mangle common words and ideas is almost……Orwellian.
UPDATE SEPTEMBER 21, 2014. Note that Krugman long ago gave his approval to Mr. Kuehn's paper. Further, Mr. Kuehn conceded that his paper was consistent with the Rothbardian narrative.
What is amazing about Krugman’s reaction to Kuehn's paper is that it was a short Tom Woods article from around that time published in “The American Conservative” which spawned Kuehn’s paper because the short TAC article did not mention Wilson. Thus, we have the spectacle of Kuehn and Krugman chortling that Austrians do not understand the timeline for the event because they allegedy failed to realize that the most important events regarding the 1920 depression occurred under Wilson. Such insight.
UPDATE NOVEMBER 15, 2016. Progressive interventionist warmonger Woodrow Wilson had a stroke soon after the end of WWI and was unable to interfere in the ongoing slashing of government spending. Richard Vedder has referred to this as the “stroke of luck”.
From 2009, Tom Woods mentions the “Stroke of Luck” in jest at the 2:25 minute mark of this youtube video:
Factory employment from the beginning of 1920 to the trough in the third quarter of 1921 fell slightly more than 30 percent on a seasonally adjusted basis, a sharp drop by any standard. Similarly, industrial production fell by a like proportion. An even steeper decline occurred with respect to wholesale prices. Between the second quarter of 1920, when they peaked, to the third quarter of 1921, a period of slightly over one year, wholesale prices fell nearly 44 percent, one of the steepest decreases recorded in American history.
The substantial fall in prices greatly exceeded the drop in money wages, so real wages rose markedly until the third quarter of 1921. It would be an overstatement, however, to characterize money wages as rigid. After all, they did fall over 19 percent from the summer of 1920 to the end of 1921. It is more accurate to say that wages proved less flexible than prices.
All of that repricing and repair happened without a government program. So much for the alleged problem of "sticky" prices and wages. It is clear that the market did not fail here (as it never does) but that the market quickly repaired a horrendous crisis caused by government, its wars, its violent interventions and its central bank funny money. Further, the distortions that existed prior to the quick repairing of the problem by the market were far worse than anything one would ever find in a free market. This is why this event is and must be suppressed by the statists.