By Ahmad Borazan, Fresno State (Guest blogger)
Economic commentators are struggling to find a historic precedent to the current COVID-19 caused economic crisis and the possible path of recovery. Majority of economic downturns are dominantly an aggregate demand driven phenomenon. But with the current crisis there is an imposed constriction in both supply and demand sides of the economy. Looking at the aggregate supply and demand forced contraction there is a compelling analogy between the current crisis and the Federal Reserve induced recessions such as that of 1920-1921.
Donald Trump commenting on rescuing affected workers, kept saying we will help them so they "don’t get penalized for something that’s not their fault.” As if in normal times being unemployed or working for below a living wage is usually an individual’s choice and fault; not a result of the "naturally optimal" markets and other human-made structures.
Economic commentators are struggling to find a historic precedent to the current COVID-19 caused economic crisis and the possible path of recovery. Majority of economic downturns are dominantly an aggregate demand driven phenomenon. But with the current crisis there is an imposed constriction in both supply and demand sides of the economy. Looking at the aggregate supply and demand forced contraction there is a compelling analogy between the current crisis and the Federal Reserve induced recessions such as that of 1920-1921.
During a recession caused by a Fed’s hike of interest rate both the supply and demand sides of the economy are brought to a halt. The higher cost of borrowing impedes spending resulting in a chain reaction of contracting production and spending. Similarly, social distancing measures curb spending and production as people stay home, unemployment rises, and non-essential businesses closed.
The Fed increased interest rate in 1920 to bring down inflation and attract gold inflows to restore the gold standard. The hike started in January 1920 and caused severe contraction of industrial production, consumption, and investment. Combined with government spending cuts due to WWI defense spending demobilization, the interest rate hike was high enough to cause the unemployment rate to go up from 2.3% in 1919 to 11.3 in 1921 and nonfarm unemployment rate rose up to 16%. With the economy in a deep recession and unemployment high, prices declined in the biggest deflation of the American economy in the last 120 years.
Then as the high interest rate attracted gold inflows and the price level significantly declined, the Federal Reserve started cutting interest rate in mid-1921. Soon enough the economy recovered through spending booms of debt-driven consumption and residential investment. Usually, the recovery out of recession takes long, hence the argument for government intervention. But as Keynes explained in the General Theory, under extraordinary circumstances that “could only be accomplished by administrative decree and is scarcely practical politics under a system of free wage-bargaining.”
When there is an anchor of expectations that raise the expectation of higher income, then recovery of spending can follow swiftly. During the early 1920s recession, we could argue, this anchor was the Federal Reserve monetary policy. The Fed’s interest rate cut raised expectations of higher future income and an end to the monetary-tightening caused recession. Furthermore, as I argue in a forthcoming paper, the increase in demand was also facilitated by a jump in private spending that was pent-up due to WW-I rationing and the subsequent recession.
As the management of the economy was still in the era of laissez-faire, the high unemployment rate was tolerable and forced as a fair price to purge the economy of inflation. Benjamin Strong, the chairman of New York Federal Reserve refused to cut of interest rates before wages had gone down as much as prices. In the post New Deal era, a high unemployment rate around 10% is less tolerable.
The Fed increased interest rate in 1920 to bring down inflation and attract gold inflows to restore the gold standard. The hike started in January 1920 and caused severe contraction of industrial production, consumption, and investment. Combined with government spending cuts due to WWI defense spending demobilization, the interest rate hike was high enough to cause the unemployment rate to go up from 2.3% in 1919 to 11.3 in 1921 and nonfarm unemployment rate rose up to 16%. With the economy in a deep recession and unemployment high, prices declined in the biggest deflation of the American economy in the last 120 years.
Then as the high interest rate attracted gold inflows and the price level significantly declined, the Federal Reserve started cutting interest rate in mid-1921. Soon enough the economy recovered through spending booms of debt-driven consumption and residential investment. Usually, the recovery out of recession takes long, hence the argument for government intervention. But as Keynes explained in the General Theory, under extraordinary circumstances that “could only be accomplished by administrative decree and is scarcely practical politics under a system of free wage-bargaining.”
When there is an anchor of expectations that raise the expectation of higher income, then recovery of spending can follow swiftly. During the early 1920s recession, we could argue, this anchor was the Federal Reserve monetary policy. The Fed’s interest rate cut raised expectations of higher future income and an end to the monetary-tightening caused recession. Furthermore, as I argue in a forthcoming paper, the increase in demand was also facilitated by a jump in private spending that was pent-up due to WW-I rationing and the subsequent recession.
As the management of the economy was still in the era of laissez-faire, the high unemployment rate was tolerable and forced as a fair price to purge the economy of inflation. Benjamin Strong, the chairman of New York Federal Reserve refused to cut of interest rates before wages had gone down as much as prices. In the post New Deal era, a high unemployment rate around 10% is less tolerable.
Similarly, we could argue that loosening up social-distancing measures would kick in an increase of spending though as reports from China show this will not be fast as people would still be worried about going back to pre-crisis spending level. The last few days we saw protests in multiple US cities with crowds demanding to reopen the economy. Although the drivers of these protests could vary from legitimate economic pain to partisan politics, the US government should enhance its fiscal measures to sustain households’ incomes and jobs. Paycheck protection program for workers in small businesses should be expanded and extended to workers in large enterprises, in addition to state and local governments.
Government spending expansion when social-distancing measures are enforced and when relaxed would help us avoid a drastic depression as it would ensure sustained demand during the recovery. Furthermore, public deficit driven recovery would enable us to avoid risky private debt-driven rebound which characterized the era of the Roaring Twenties and contributed to the severity of the Great Depression.
Any concerns about expanding the debt are unjustified. The US debt to income ratio is currently less than half that of Japan which is capable of borrowing at extremely low cost while it has a smaller economy and lesser role in global financial markets compared to that of the US. If the Japanese experience proves anything it is that we have ample room for more debt to fund expansionary fiscal policy and avoid a depression. There is no reason to repeat the policy mistake done with the American Taxpayer Relief Act of 2012 which cut discretionary government spending when the unemployment rate was 8%. More generous European economic fiscal and monetary reactions to the current crisis prove the capacity of advanced economies governments in relieving its citizens of economic hardship. One hopes these responses would bring the order of mythological fiscal scarcity to an end.
Government spending expansion when social-distancing measures are enforced and when relaxed would help us avoid a drastic depression as it would ensure sustained demand during the recovery. Furthermore, public deficit driven recovery would enable us to avoid risky private debt-driven rebound which characterized the era of the Roaring Twenties and contributed to the severity of the Great Depression.
Any concerns about expanding the debt are unjustified. The US debt to income ratio is currently less than half that of Japan which is capable of borrowing at extremely low cost while it has a smaller economy and lesser role in global financial markets compared to that of the US. If the Japanese experience proves anything it is that we have ample room for more debt to fund expansionary fiscal policy and avoid a depression. There is no reason to repeat the policy mistake done with the American Taxpayer Relief Act of 2012 which cut discretionary government spending when the unemployment rate was 8%. More generous European economic fiscal and monetary reactions to the current crisis prove the capacity of advanced economies governments in relieving its citizens of economic hardship. One hopes these responses would bring the order of mythological fiscal scarcity to an end.
Donald Trump commenting on rescuing affected workers, kept saying we will help them so they "don’t get penalized for something that’s not their fault.” As if in normal times being unemployed or working for below a living wage is usually an individual’s choice and fault; not a result of the "naturally optimal" markets and other human-made structures.
Yes, indeed a lot of people find similarities in this situation. Thank you for sharing your thoughts. This is valuable!
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