Recession of 1920–1921

The Event: Economic downturn characterized by severe deflation

Date: January 1920 to July 1921

Only the second recession to hit the United States following the creation of the Federal Reserve in 1913, the economic downturn of the early 1920s saw the federal government playing a more central role in dealing with the financial crisis. The efforts of the Federal Reserve and, to a lesser extent, the President’s Conference on Unemployment set the stage for the federal government to take greater responsibility for dealing with the impact of economic downturns.

Although often characterized as a period of economic growth and prosperity, the 1920s started as they ended: with a recession. Less famous than the 1929 recession, later known as the Great Depression, the recession of 1920–1921 stands out more for its large drop in prices, or deflation, than for its drop in output. As with most recessions, experts generally agree about its impact on employment, output, and prices, but disagree about its causes.

In common usage, a recession is said to have occurred if a country’s total output, or real gross domestic product (GDP), has declined for two or more consecutive quarters (six months or more). However, the National Bureau of Economic Research (NBER) uses a more sophisticated definition, identifying a recession as having occurred if there is a “significant decline in economic activity,” with economic activity being defined by broad economic measures such as real output, income, and employment.

Using their definition, the NBER has identified the 1920 recession as having begun in January 1920 and ended in July 1921. This means that economic activity reached a peak in January of 1920 and a trough in July of 1921, at which point the economy began to grow again. From its peak, real output has been estimated to have dropped by roughly 3 percent or more, while unemployment increased from 5.2 percent to between 8.7 and 11.7 percent.

What distinguishes the 1920–1921 recession from other severe recessions is its sharp drop in prices. An economic slowdown creates downward pressure on prices as businesses try to reduce their inventories and generate sales in order to employ idle resources. From a high in May 1920, wholesale prices dropped by 45 percent by June 1921, while consumer prices dropped by more than 10 percent. The falling prices hit the agricultural sector particularly hard.

Causes

Recessions are generally caused by a sudden reduction in the demand for output. The trigger for that change in demand is important to know in order to avoid recessions in the future. While it is not a universally accepted theory, many economists name the Federal Reserve as a primary cause of the severity of the 1920–1921 recession. Created in 1913, the Federal Reserve is the central bank of the United States, in which capacity it influences the country’s money supply and interest rates. Lowering interest rates makes it cheaper to borrow money, so businesses tend to increase their demand for capital goods such as equipment and machinery, and consumers tend to increase their demand for goods typically purchased on credit, such as new homes. This increase in demand causes the economy to expand. Increasing interest rates—an action normally taken to head off inflation—has the opposite effect of lowering demand, causing the economy to grow more slowly or even to shrink.

Starting in November 1919, in response to postwar inflation, the Federal Reserve began raising the discount rate, which is the interest rate it charges on the money it lends to banks. By June 1920, the discount rate had increased from 4 percent to 7 percent. This in turn resulted in higher interest rates charged to businesses and consumers, thereby causing a reduction in their purchases.

While the Federal Reserve may have played a role in the severity of the recession, its main cause was likely global economic adjustments following the end of World War I. As a result of the disappearance of war-related expenditures, the federal government went from having a deficit to having a surplus, which meant that less money was in the hands of businesses and consumers, leading to reduced demand. At the same time, other factors allowed for an increase in supply or output in the economy, which put further downward pressure on prices. As the economies of other countries rebuilt, this resulted in a decline in U.S. exports, and the demobilization of U.S. troops and rising immigration rates meant an increase in the labor supply. All of these factors created the expectation of lower prices in the future, which further decreased demand and depressed economic activity.

Impact

Although painful in its severity, the 1920–1921 recession did not last very long, and the U.S. economy quickly recovered. By 1922, real output had returned to its prerecession level, and the unemployment rate had also declined. However, this turnaround was not yet evident in September 1921, when President Warren G. Harding’s secretary of commerce, Herbert Hoover, convened the President’s Conference on Unemployment. This move was a first step toward the government taking on a larger role in mitigating the pain of unemployment that accompanies recessions.

Bibliography

Eichengreen, Barry. GoldenFetters: The Gold Standard and the Great Depression, 1919–1939. New York: Oxford University Press, 1992. Contains a discussion of the 1920–1921 recession and Federal Reserve policy in the context of the return to the gold standard following World War I.

Friedman, Milton, and Anna J. Schwartz. A Monetary History of the United States, 1867–1960. Princeton, N.J.: Princeton University Press, 1963. Presents details of the 1920–1921 recession in the context of a study of the post–Civil War U.S. economy, including the role the Federal Reserve may have played in the crisis.

Garraty, John A. Unemployment in History: Economic Thought and Public Policy. New York: Harper & Row, 1978. Provides a brief discussion of the President’s Conference on Unemployment and the economic conditions that led to it.

Kindleberger, Charles P., and Robert Aliber. Manias, Panics, and Crashes: A History of Financial Crises. 5th ed. Hoboken, N.J.: John Wiley, 2005. Puts the 1920–1921 recession into historical perspective within the context of other economic crises, along with lessons learned.

Knoop, Todd A. Recessions and Depressions: Understanding Business Cycles. Santa Barbara, Calif.: Praeger, 2010. An overview of recessions and the factors that lead to them.