The US economy: a lesson from the twenties?

By Gerry Jackson
web posted July 31, 2000

"The economy has entered a new era", wrote one financial journalist while another exclaimed that a "new epoch in economics" had arrived. These Pollyanna statements are not isolated headlines designed to grab readers' attention but the result of an inability to understand what is happening to the American economy.

Unfortunately, in this respect these journalist are only parroting sentiments that seem to dominate the economics profession, at least until the next recession. Yet there is nothing new here. The great American boom of the 1920s was also hailed as a "New Era", one, so it was thought, that heralded permanent prosperity for the American people. A stable price level and booming output convinced the likes of Keynes and Professor Fisher that a New Era had indeed arrived, with Keynes describing Federal Reserve Board's monetary management as a "triumph" — a triumph whose economic and political denouement was the Great Depression. (Though Fisher was later ridiculed for his optimism, Keynes was praised for his 'wisdom'.)

Investment in the capital structure of about 6.4 per cent a year caused manufacturing productivity per worker to rise by 43 per cent while prices remained relatively stable. By 1929 America was producing virtually as many cars as in 1953, the sale of electrical products tripled, spending on radios rose from about $10.7 million dollars in 1920 to more than $411 million by 1929, a prolonged building boom provided millions of Americans with their first house. That the period was marked by rapidly rising consumption was not disputed. There was, however, a dark side to this success story. Despite the rise in productivity many workers found it difficult to maintain their purchasing power. The increasing movement of married women into the workforce at this time tends to lend support to this view.

Though the 1920s is considered by some to be the greatest boom period in US history the greatly neglected boom of 1896-1903 exceeded it, certainly in terms of physical production though not in financial folly. Statistics show that nearly half of the rise in productivity during the '20s took place from 1921 to 1923. US Bureau of Labor Statistics reveal that average real wages (excluding agriculture) rose by just over 6 per cent from 1921 to 1929. Needless to say, this average concealed considerable differences in pay rates.

What happened was that the attempt at price stabilisation skewed consumption and created an imbalance in production. (What the Austrian school would call misdirected production or malinvestments.) The rapid progress in productivity should have seen the price level gently decline. Convinced by the likes of Fisher, Gustav Cassel and Ralph Hawtrey that allowing prices to fall was a bad thing, the Federal Reserve engaged upon massive credit expansion by forcing down the discount rate. The result was that though the number of dollar bills remained comparatively stable ($3.68 billion in 1920 compared with $3.64 billion in 1929) credit grew from $45.3 billion in June 1921 to $73 billion in July 1929, a 61 per cent rise. It was this rapid expansion that fuelled the stock market frenzy and created malinvestments by discoordinating the market process. However, by the end of 1928 the inflation was over. Total money supply stood at $73 billion on December 31, 1928 and $73.26 billion on the 29 June 1929. The result was inevitable.

One argument advanced in support of the price stabilisation doctrine is based on the fallacy that any general fall in prices is by definition deflationary and will thus depress business activity and raise unemployment. This view makes no distinction between a money induced fall in prices caused by a monetary contraction and falling prices caused by rising productivity. Nonetheless, The Australian Financial Review could seriously argue (14/9/98, p. 38) that the period 1870-90 was a deflationary one in the US and that it was "excess capacity" that drove prices down while "production boomed" [!] It evidently did not occur to the author that booming output is incompatible with 'excess capacity.' Moreover, he admitted that falling prices were caused not by a monetary contraction, i.e., genuine deflation, but by increasing investment — thus demonstrating how rife confusion is on this subject.

What is obviously not understood is that falling prices due to increased productivity benefits everyone by spreading the fruits of increased investment. Attempts to stabilise purchasing power of the monetary unit blocks this process, denying to many rises in real income they would have otherwise enjoyed. And this is precisely what happened during the 1920s boom. Credit expansion caused wage rates in the capital goods industries to significantly outstrip those in the consumer goods industries. By expanding credit capitalists were encouraged to invest in lengthier and more complex stages of production causing them to bid up wage rates at the expense of those in the consumer goods industries. In addition, because the means (capital goods, i.e., savings) were not available to finish these stages [1] they eventually revealed themselves as malinvestments, misnamed 'excess capacity'.

Put another way, labour employed in the capital goods industries had the value of its services inflated by credit expansion, which in turn allowed it to bid more goods away from other workers. It should also be clear that the credit expansion imposed forced savings which kept real wages below the level that a genuine free-market saving/consumption ratio would have dictated. And all for the sake of stable prices. No wonder Phillips, McManus and Nelson were driven to charge that "the end-result of what was probably the greatest price stabilisation experiment in history proved to be, simply, the greatest depression" (Banking and the Business Cycle)

Unfortunately it was the stock market frenzy that marked out the 1920s and became the culprit for the depression instead of credit expansion. It is also in the current stock market boom that we see shadows lurking from the financial follies of the Roaring Twenties. By 1929 the average stock had tripled its value in only 7 years. Alarmed at the apparent inexorable rise of the market and the accompanying reckless speculation, Roger Babson, a Boston financial adviser, was warning investors in September 1929 of an imminent crash. (Babson was far from being a lone voice. Sound money men like Benjamin M. Anderson and E. C. Harwood also warned that a crash was inevitable.

In early 1929 Hayek published a number of articles in the monthly reports of the Austrian Institute of Economic Research, of which he was director, arguing that the boom only had months to run. Felix Somary, another economist in the Austrian school and Swiss banker, even warned Keynes against buying stock and predicted an impending crash. Keynes replied: "There will be no more crashes in our lifetime." Convinced that the price level proved that there was no inflation, Irving Fisher argued that "stock prices have reached what looks like a permanently high plateau." In his paper Is There Inflation in the United States?, 1 September 1928, Keynes endorsed Fisher's optimism, only to admit in 1930 that he had been mistaken about inflation.

Yet we are hearing basically the same thing today. Given that the price level in the '20s remained stable, I suppose many can be forgiven for thinking that inflation was absent. But how anyone can claim the US is basically inflation free when the CPI is still rising beats me. As we can see, even stable prices can conceal considerable inflation if we define inflation, as we should, as a monetary expansion. It follows that economic observers should be looking at money supply figures for guidance and not price indexes. In this respect the signs are not good with the money supply rising sharply. During the past three years, for example, growth in M3 has greatly exceeded the Fed's monetary target.

Even though the stock market is down growing GDP, rising incomes and falling unemployment seem to belie any gloomy predictions. So what is happening? As I explained rather briefly, cheap money policies created the 1920s boom that resulted in the Great Depression. However, though the cessation of monetary growth in December 1928 brought the boom to an end, Austrians point out that even if monetary growth did not cease the boom would have terminated itself. Cheap money misleads capitalists into thinking that the social rate of time preference (ratio of consumption to savings) has fallen thus releasing more resources for investment.

Eventually the additional spending raises consumers' nominal incomes; as their rate of time preference remains unchanged their spending on consumer goods will rise causing consumer prices to rise relative to commodities and producer goods. This means that production costs rise and profits begin to fall. As this process makes itself felt employment growth begins to slow and then goes into reverse. Pressure on consumer prices is already intensifying and profits are slowing. The question is whether the Fed will apply the breaks before the boom self-destructs. Another sign that the boom may be closing has been the increasing use of high-priced stock to pay for mergers that may not make economic sense. Precisely the same thing happened during 1899 to 1902, 1924 to 1929 and the later 1980s.

When the boom breaks the Fed and Washington should stand aside and allow the malinvestments to be liquidated as quickly as possible. Interfering with the process will only deepen and prolong the agony, as happened in the 1930s. The great advantage of the US is its flexible labor markets. Standing aside will see the economy rapidly recover and unemployment turn down again. The 1920-21 crisis is a graphic example of how quickly the market can adjust if left alone to do its work. From May 1920 to August 1921 [2] wholesale prices fell from 248 to 141, a 43 per cent drop, average wage rates fell by about 11 per cent and unemployment leapt from 1.3 per cent to 11.2 per cent. But unemployment and production quickly began to recover in 1921 and by 1922 unemployment had fallen to 6.8 per cent; by Spring 1923 the economy had fully recovered, employment stood at 1.7 per cent and labor shortages were emerging.

One particularly bleak spot is America's poor savings rate. Savings fuel an economy and entrepreneurship drives it. America has proved time and time again that it has the entrepreneurs, despite the obstacles Washington has placed in their path. What is lacking is the fuel. This is Keynes' dreadful legacy, one that I fear will have the most awful long-run consequences.

[1] Some have argued that because the economic landscape was not dotted with unfinished factories, this falsifies Austrian theory. This argument only demonstrates that the author has not understood Austrian capital theory as well as the Austrian explanation for depressions. There is absolutely no need for factories to be incomplete; only that overinvestment has taken place in higher stages of production relative to lower stages. In other words, the capital structure has been distorted.

[2] This plunge in wholesale prices and the speed at which it happened was unprecedented in American history and certainly surpassed the rate at which prices fell during the beginning of the Great Depression.

Gerard Jackson is the editor in chief of the peerless The New Australian. Reprinted with kind permission.

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