The 1920-21 deflation: the role of aggregate supply

Economic Inquiry, July, 1991 by J.R. Vernon

I. INTRODUCTION

The 1920-21 recession in the United States was brief relative to the Great Depression of a decade later, but it included a remarkably sharp price deflation. The decline in the GNP price deflator from 1920 to 1921 is the largest one-year percentage decline in the series in the more than 120 years covered. This is true whether the Department of Commerce [1986] estimates or the recently provided Balke and Gordon [1989] or Romer [1989] estimates are used. These estimates produce one-year deflation figures of 18 percent, 13.0 percent, and 14.8 percent, respectively. The closest competitor is the 11.5 percent deflation recorded for 1931-32, the third year of the Great Depression. (1)

Annual data for wholesale prices tell a similar story. Wholesale prices declined by 36.8 percent for 1920-21, the largest one-year decline on record, going back at least to the American Revolutionary War period.

The 1920-21 deflation contains another striking feature. Not only was it sharp, it was large relative to the accompanying decline in real product. The ratio of the percentage decline in the GNP deflator for 1920-21 to the percentage decline in real GNP is 2.6 using the Department of Commerce figures, 3.7 using the Balke and Gordon data, and 6.3 using the Romer data. By contrast, during 1929-30, the first year of the Great Depression, the GNP deflator declined by 2.7 percent and real GNP by 9.4 percent, for a ratio of 0.3. The ratios of the percentage decline in GNP prices to the percentage decline in real GNP for 1930-31, 1931-32, 1932-33, and 1937-38, the other Great Depression years in which real GNP declined, were 1.0, 0.9, 1.2, and 0.3, respectively, all well below the 1920-21 figures.

This paper examines the 1920-21 deflation. It asks why the deflation was so sharp, both in itself and in relation to the decline in real product. The answer, the paper concludes, is that the deflation was produced by a sharp decline in aggregate demand combined with an increase in aggregate supply, a supply increase in which deflationary expectations played a prominent role.

II. THE 1920-1921 RECESSION

The National Bureau of Economic Research dates the 1920-21 recession from a general business peak in January 1920 to a trough in July 1921. It was mild at first. Wholesale prices continued to increase until May 1920, four months past the general business peak. By July 1920, the Federal Reserve Board's index of industrial production had declined by only 7 percent from its January peak, and factory employment had fallen 7.3 percent.

The contraction then became severe. By the year's end, industrial production had fallen 25.6 percent below its January 1920 peak and bottomed out at 32.6 percent below its January 1920 level in July 1921, the general business trough. Wholesale prices were 42.9 percent below their May 1920 peak by July 1921. Industrial production had fallen by 32.6 percent in eighteen months, wholesale prices by 42.9 percent in fourteen months. The deflation eliminated more than 70 percent of the rise in wholesale prices associated with World War I.

Civilian unemployment rose substantially during the recession. According to Lebergott [1964, 512], the unemployment rate was 1.4 percent for both 1918 and 1919, 5.2 percent for 1920, and 11.7 percent for 1921.

The 1920-21 recession was not the first following the end of World War I. The economy had slowed in 1918, at about the time of the November armistice, as the transition was made from wartime to peacetime production. Both industrial production and wholesale prices declined moderately. The National Bureau of Economic Research dates this first post-war recession as extending from August 1918 to March 1919.

The economy then turned upward and expanded, peaking in January 1920. In this period industrial production rose by 25.5 percent. Wholesale prices, after hitting bottom in February 1919, had risen by 20.7 percent by January 1920, the general business peak, and by 28.0 percent at their own May 1920 peak. (2)

III. THE DEMAND VIEW

Friedman and Schwartz [1963, 205-39] attribute the severe phase of the 1920-21 recession and its attending deflation to monetary restraint. Monetary policy was expansive throughout World War I, including the period of U.S. neutrality. Policy remained expansive during most of 1919, even though by summer an inflationary boom was underway. The Federal Reserve was pegging interest rates at a low level using its loan discount rate in order to accommodate the Treasury's funding of the war debt. The Fed also had an interest in protecting commercial bank portfolios, which contained substantial quantities of war bonds and loans secured by war bonds.

Monetary policy began to shift in December 1919, then changed markedly in January 1920. The Federal Reserve Bank of New York's discount rate, which had been pegged at 4 percent since April 1919, was raised to 4.75 percent in December 1919, to 6 percent in January 1920, and to 7 percent in June 1920. Similar discount rate increases were made at the other Federal Reserve Banks.