How Markets Self-Corrected during the 1819 and 1919–21 Recessions
As the first signs of an economic tempest move through the United States—an alarming increase in bank failures, a surge in unemployment claims, and a troubling decline in retail sales—we find ourselves perched on the edge of a deep recession. Staring into this uncertain abyss, the self-designated guardians of our financial destiny, the Federal Reserve and the US government, are confronted with a monumental task. When the recession bells toll, how will they respond?
Will the Federal Reserve and the Biden administration again disrupt the market’s natural rhythms through rapid interest rate cuts, quantitative easing (QE), and excessive government spending? These interventionist measures, though designed to cushion economic downturns, distort market signals, leading to resource misallocation and the perpetuation of unsustainable structures. This approach hinders the market’s self-corrective mechanisms, preventing a return to natural equilibrium. Permitting recessions to run their course enables an organic recovery.
The noninterventionist approach, acknowledging short-term pain as a necessary component of long-term economic health, respects the market’s self-correcting ability. It understands that the short-term pain of businesses, firms, and banks facing failure is a necessary component of long-term economic health and sustainability. In our quest for economic stability, we must turn our gaze to the inherent self-corrective mechanisms at the heart of the market. The annals of economic history are filled with instances where allowing these natural healing processes to unfold has catalyzed a return to prosperity, such as the recessions of 1819 and 1919–21.
The noninterventionist approach is a nuanced, constrained approach, one that demands patience and faith in the market’s innate capacity to rebalance and recover. The path from a recession to a strong recovery passes through deflation of artificially inflated asset prices and liquidation of bad investments, which free up capital to be utilized in profitable sectors, starting the recovery.
This idea is not without its critics, however. Keynesian and monetarist economists, who push a policy of extended QE, increased spending, and reduced interest rates, often argue that liquidation could exacerbate a recession by further reducing demand and creating unemployment. According to John Maynard Keynes in his 1936 The General Theory of Employment, Interest and Money, “The remedy for the boom is not a higher rate of interest but a lower rate of interest!” His theory suggests that stimulating demand through lower interest rates and government spending would allow for a more gradual correction of malinvestments.
Monetarists, such as Milton Friedman, also argue against liquidation. In his 1962 Capitalism and Freedom, Friedman states, “We believe that the Federal Reserve System . . . should aim to mitigate, and, ideally, to prevent, severe changes in the total amount of money.” This perspective suggests that maintaining stability in the money supply can prevent severe recessions and are a better cure for them than the potentially destructive liquidation process. These measures, however, risk prolonging the adjustment process and creating greater economic instability down the line.
The Recessions of 1819 and 1919–21
The 1919–21 recession, also known as the depression of 1920–21, was a significant period in the history of the United States economy. It is of greater significance because it has been completely ignored by most of the academic community, as it doesn’t fit the Keynesian narrative of stickiness in prices, as James Grant’s seminal work The Forgotten Depression: 1921: The Crash That Cured Itself demonstrates.
Liquidation refers to businesses’ closing operations, selling assets, and using the proceeds to pay off debts. When a business cannot meet its financial obligations or is insolvent, liquidation becomes inevitable. During the 1919–21 recession, the high rate of business liquidations contributed to the severity and length of the economic downturn.
Grant especially scrutinizes the role of the Federal Reserve’s monetary policy. The Federal Reserve, established in 1913, was relatively new during the 1919–21 recession. Grant argues that the Fed’s tight monetary policy of high interest rates and contraction of the money supply contributed significantly to the severity of the recession and the high rate of business liquidations.
The Federal Reserve raised interest rates in late 1919 to combat the inflationary pressures that had built up during and after World War I. As documented by the Federal Reserve’s data, the discount rate rose from 4 percent in 1919 to 7 percent by 1920. This contraction, while initially causing economic hardship, led to the liquidation of malinvestments.
This policy led to a contraction in credit, which made it more expensive for businesses to borrow money. As a result, businesses that were highly leveraged or had weak cash flows were pushed into insolvency, leading to a surge in liquidations. The Consumer Price Index (CPI) fell by 10.8 percent in 1921, the largest single-year drop in the index’s history. This deflation reflected the widespread liquidation of malinvestments, which lowered the prices of overvalued capital and freed it to be used in profitable and stable ventures, and the economy’s adjustment to postwar conditions. The liquidation process also facilitated the reallocation of labor. Unemployment spiked to 11.7 percent in 1921 from 3.0 percent in 1919.
Despite these harsh conditions, the economy recovered remarkably quickly. By 1922, unemployment had fallen to 6.7 percent, and by 1923, it was down to 2.4 percent. Gross domestic product, which had contracted by 2.4 percent in 1921, grew by 3.8 percent in 1922 and 4.7 percent in 1923.
This incredible recovery, Grant notes, was brought about by a curious turn of fate which stopped the US government and the young insecure Federal Reserve from intervening. The one crucial role the federal government played in the 1920–21 recession was allowing the liquidation to occur. Grant cites Secretary of the Treasury Andrew Mellon, who advocated for a hands-off approach: “Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate.” By 1922, just three years after the onset of the recession, the economy was growing again, marking a relatively swift recovery.
The Panic of 1819
The Panic of 1819 was the first major peacetime economic crisis in the United States. As Murray Rothbard shows in his 1962 The Panic of 1819: Reactions and Policies, this downturn was precipitated by a sharp collapse in commodity prices and a significant contraction in the money supply. Following the War of 1812, the Second Bank of the United States attempted to curb inflation by calling in loans, leading to a sharp contraction in credit. A wave of bankruptcies across businesses and financial institutions ensued. Despite these severe conditions, the economy naturally adjusted, without any significant governmental intervention.
A pivotal mechanism facilitating this self-correction was deflation. The money supply reduction led to a substantial decrease in prices, lowering the cost of goods and sparking a revival in demand. According to Rothbard, the prices of cotton, for instance, dropped from thirty-two cents per pound in early 1819 to just fourteen cents by the end of the year, stimulating cotton exports and helping to restore balance in the economy.
Rothbard notes that this contraction led to widespread foreclosures and bankruptcies, which resulted in a significant liquidation of malinvestments. Unfortunately, this process was not completed. He writes, “It was unfortunate that the liquidation of inflated land values was not allowed to run its beneficial course.”
Still, the downturn was relatively brief, with the economy starting to recover by 1821. The government’s laissez-faire approach, as Rothbard suggests, allowed for this liquidation process to occur, and despite the initial hardship, the economy began to rebound. The liquidation allowed capital and labor to be reallocated to more productive uses, facilitating economic recovery.
The cases of the 1819 and 1919–21 recessions underline the value of patience and understanding the market’s capacity to rebalance and recover. The path to a strong recovery, as witnessed in these periods, often passes through the painful but necessary processes of deflation and liquidation of malinvestments. These processes, although tough in the short run, free up capital for more profitable ventures, thereby initiating an organic, self-driven recovery.
These historical episodes serve as reminders of the profound resilience of markets. They underscore the need for economic policies that resist the temptation to overintervene and instead allow the invisible hand of the market to orchestrate recovery. In the long run, this policy leads to a more robust, resilient, and sustainable economic framework that is better prepared to weather future economic storms.