The Home of American Intellectual Conservatism — First Principles

December 17, 2017

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Warren Harding and the Forgotten Depression of 1920
Thomas E. Woods, Jr. (from IR 44:2, Fall 2009) - 10/20/09

This phenomenon has preceded all of the major booms and busts in American history, including the 2007 bust and the contraction in 1920–21. The years preceding 1920 were characterized by a massive increase in the supply of money via the banking system, with reserve requirements having been halved by the Federal Reserve Act of 1913 and then with considerable credit expansion by the banks themselves. Total bank deposits more than doubled between January 1914, when the Fed opened its doors, and January 1920. Such artificial credit creation sets the boom-bust cycle in motion. The Fed also kept its discount rate (the rate at which it lends directly to banks) low throughout the First World War (1914–18) and for a brief period thereafter. The Fed began to tighten its stance in late 1919. Economist Gene Smiley, author of The American Economy in the Twentieth Century, observes that “the most common view is that the Fed’s monetary policy was the main determinant of the end of the expansion and inflation and the beginning of the subsequent contraction and severe deflation.”12 Once credit began to tighten, market actors suddenly began to realize that the structure of production had to be rearranged and that lines of production dependent on easy credit had been erroneously begun and needed to be liquidated.

We are now in a position to evaluate such perennially fashionable proposals as “fiscal stimulus” and its various cousins. Think about the condition of the economy following an artificial boom. It is saddled with imbalances. Too many resources have been employed in higher order stages of production and too few in lower-order stages. These imbalances must be corrected by entrepreneurs who, enticed by higher rates of profit in the lower-order stages, bid resources away from stages that have expanded too much and allocate them toward lower-order stages where they are more in demand. The absolute freedom of prices and wages to fluctuate is essential to the accomplishment of this task, since wages and prices are indispensable ingredients of entrepreneurial appraisal.

In light of this description of the post boom economy, we can see how unhelpful, even irrelevant, are efforts at fiscal stimulus. The government’s mere act of spending money on arbitrarily chosen projects does nothing to rectify the imbalances that led to the crisis. It is not a decline in “spending” per se that has caused the problem. It is the mismatch between the kind of production the capital structure has been misled into undertaking on the one hand, and the pattern of consumer demand, which cannot sustain the structure of production as it is, on the other.

And it is not unfair to refer to the recipients of fiscal stimulus as arbitrary projects. Since government lacks a profit-and-loss mechanism and can acquire additional resources through outright expropriation of the public, it has no way of knowing whether it is actually satisfying consumer demand (if it is concerned about this at all) or whether its use of resources is grotesquely wasteful. Popular rhetoric notwithstanding, government cannot be run like a business.13

Monetary stimulus is no help either. To the contrary, it only intensifies the problem. In Human Action, Mises compared an economy under the influence of artificial credit expansion to a master builder commissioned to construct a house that (unbeknownst to him) he lacks sufficient bricks to complete. The sooner he discovers his error the better. The longer he persists in this unsustainable project, the more resources and labor time he will irretrievably squander. Monetary stimulus merely encourages entrepreneurs to continue along their unsustainable production trajectories; it is as if, instead of alerting the master builder to his error, we merely intoxicated him in order to delay his discovery of the truth. But such measures make the eventual bust no less inevitable— merely more painful.

If the Austrian view is correct—and I believe the theoretical and empirical evidence strongly indicates that it is—then the best approach to recovery would be close to the opposite of these Keynesian strategies. The government budget should be cut, not increased, thereby releasing resources that private actors can use to realign the capital structure. The money supply should not be increased. Bailouts merely freeze entrepreneurial error in place, instead of allowing the redistribution of resources into the hands of parties better able to provide for consumer demands in light of entrepreneurs’ new understanding of real conditions. Emergency lending to troubled firms perpetuates the misallocation of resources and extends favoritism to firms engaged in unsustainable activities at the expense of sound firms prepared to put those resources to more appropriate use.

This recipe of government austerity is precisely what Harding called for in his 1921 inaugural address:

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