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Ever heard of 1920-21 Financial Crisis –the post war depression that crippled the U.S. Economy and the eccentric approach followed by President Harding to fight the crisis? Everything about the crisis defined unconventionality: the power of a free market,the crisis itself and the consequent roaring twenties.
Depression is a national crisis which occurs when the country is already going through prolonged recession and its GDP has contracted by an absolute value of 10%.
The question arises :What significance do the events of 1920-21 Financial Crisis hold in present times? The answer lies in the fact that : The 1920-21 financial crisis was not only the last demonstration of how the price mechanism works but also the last depression that the government didn’t attempt to treat with fiscal intervention. President Harding’s unconventional laissez-faire economic policies during the 1920–21 depression were in direct contrast to Keynesian Economics which advocates fiscal intervention.
The crisis is a classic example of working of a business trade cycle: inceptive boom during World War I, post war recession and the consequent roaring twenties.
The root cause of 1920-21 depression was the boom that came before it- when money supply was abundant and production peaked during World War I. To combat the high inflation during World War I, the US government cut its spending from $18.5 billion to $ 6.4 billion. Federal Reserve increased the interest rates from 4.5% in 1919 to 7% in 1920. All this led to a high cost of borrowing and a deflationary trend in the economy.
Another reason which led to this depression was the shift from a war-time to a peacetime economy. The World War I brought with itself a huge economic boom for the manufacturing and the agricultural industry. The end of the war not only put an end to the economic boom but also brought in a surge of war soldiers into the labor market increasing the labor force by 1.6 million people, (or 4.1% of the labour force), in 1920. All this led to a vicious cycle in which, reduced wages made the factory goods unaffordable and hence, left factories with unsold goods.
The recession of 1920–21 was characterized by extreme deflation: reaching 18% . Real output fell by 9% and unemployment reached as high as 19%—the statistics were twice as bad as the Recession of 2007-09.The drop in wholesale prices was even more severe, falling by 36.8% which is worse than any year during the Great Depression. Stocks fell dramatically during the recession. It was a terrible climate for businesses.
Source: Spurious Volatility in Historical Unemployment Data
So what led to a quick recovery? It was definitely President Harding’s Laissez-Faire Policies.
According to Keynesian Economics, during a recession, governments should increase their fiscal intervention by giving financial aid in the form of bailouts and increasing budget spending. This however was not President Harding’s approach. He realized that the best thing the government can do is cut its own budget and downsize the government.
The results? The recovery was swift and by the end of July 1921 the unemployment rate had dropped to 6.7% from 11.7%.
Why did Harding let the market function on its own?What was the rationale behind his unconventional laissez-faire policies? The answer lies in the fact that, as there were massive disturbances in the markets due to high demand of war related goods during World War I, an equally massive correction was needed to adjust investment and consumption with the new peace-time economic environment. And, letting the markets make this correction on their own proved to be a better approach as compared to the imposition of innumerable policies by the government.
Hence, the quick recovery showed the power and strength of a free market and exemplified that if markets are left alone and undisturbed they can heal the worst of recessions and bring back economic prosperity!
By Deepti Mahajan and Sushant Sohey for D-Street.