Announcement! I’ll be hosting a fascinating conversation with Dan Rasmussen and Michael Batnick on Wednesday September 21st @ 12PM EST. Our wide-ranging discussion will cover:
- Market areas that have historically outperformed during periods of inflation and recessions
- A cycle-driven approach to asset allocation
- The bull and bear case for U.S. large cap
- The state of private assets and whether they are attractive on a go ahead basis
The Great Depression is sooooooo mainstream.
We’ve all heard and studied how terrible the 1929 Crash and ensuing Great Depression was for America’s economy, but far less people know about the other 1920s economic downturn: the “forgotten depression” of 1920-1921. While technically a recession, the economic slump of 1920 certainly felt like a depression, but more on that in a moment.
First, I want to highlight how the recession of 1920-21 and our current recession in 1922 marks yet another milestone in our “is this the 1920s?” timeline. While we do not have an equivalent world war in today’s timeline, the progression of large scale events in the 1920s and today are eerily similar:
While there are obviously countless differences between the two eras, it is interesting that some of these major events are unfolding in similar fashion. Thus, we can only hope that our recession will similarly precede a notoriously prosperous decade like the Roaring 1920s. Now, back to the 1920-21 Recession.
WHAT WAS THE 1920-1921 RECESSION?
The forgotten recession of 1920-21 was a short – but severe – economic crisis that lasted 18 months post-World War I. This excerpt from an article in 1922 summarizes the brief economic boom post-armistice, which was then followed by a severe recession.
However, this “tremendous upswing in business activity” was followed by the 1920-21 recession.
The author of this 1922 article provided a graph portraying the severity of this downturn:
The statistics for this recession shown below are equally sobering:
WHAT CAUSED THE RECESSION?
There were many causes for this recession, but the main culprits were monetary policy and the end of wartime demand.
During World War I, agricultural demand and production boomed to fulfill demand for wartime commodities like cotton, and replacing European production of things like wheat. Farmers took out mortgages and loans to expand their operations to meet this demand, and when prices fell, farmers could not meet their payments, which had knock-on effects to other parts of the supply chain. Southern banks with heavy exposure to commodity prices via loans to farmers were also impacted.
The drop in cotton prices was especially brutal, particularly for southern states. In 1910, the U.S. produced a staggering 54% of the world’s cotton supply, and just five states produced 25% of global cotton (Alabama, Florida, Georgia, Louisiana, Mississippi).
As the chart below shows, the price of cotton rose from a wartime low of $0.07 to a record high price of $0.42 in 1920. Yet, as wartime demand ended and the realities of over-production appeared, prices plummeted 71% in 1921 to just $0.12.
Collapsing cotton prices ravaged the economies of southern states. As this chart from 1923 demonstrates, financing cotton was an interconnected process with many different institutions and players. Many of the loans on banks’ balance sheets were either collateralized by cotton itself, or assets tied to the production of cotton. Thus, a dramatic fall in cotton could severely threaten the regional financial system as banks faced mounting losses on cotton related loans that could not be repaid.
As the Federal Reserve Bank of Atlanta put it:
“Agriculture relied increasingly on cotton; cotton finance relied on fragile local banks; and local banks and other credit providers relied on the liquidity of cotton-backed securities in distant financial markets.”
Fed Policy & Inflation
Like today, inflation was a major problem facing America’s economy after World War I ended. The Consumer Price Index rose 109% between 1913 – 1920. The Atlanta Fed Governor at the time, Maximillian Wellborn, explained:
“A short while after the armistice the public which had denied itself many luxuries during the war, turned around,” giving rise to a period of “imprudent and unusual extravagance. Money was easily made, and was therefore easily spent. Those who had prospered on war contracts felt no restraint, and bought to the fullest extent… and naturally prices rose to unprecedented figures.” (Atlanta Fed)
The Federal Reserve itself was also culpable, as the central bank had kept rates unusually low after the war. This decision was borne out of fears that raising rates would severely damage commercial banks that had accumulated substantial amounts of liberty bonds during World War I. However, the consequence of keeping rates low in order to avoid substantial losses on liberty bonds was rising inflation.
Eventually, however, inflation became a problem that had to be dealt with, and quickly.
THE FED RESPONSE
In January of 1920 the Federal Reserve and its member banks raised the discount rate to 6%, and then quickly raised it again to 7%. Yet, this action coincided with a downturn in business activity and the collapse in cotton prices covered earlier.
“As the business cycle had just turned downward in January 1920, this action was probably excessive and Friedman and Schwartz comment ‘The rise in the discount rates in January was not only too late but also probably too much’, turning a mild recession into a dramatic one.” (White)
The problem of rising inflation then turned into a problem of rapid deflation. After rising 109% between 1913-1920, prices then fell 22% between 1920-1922. Bank suspensions (failures) soared.
There were widespread calls in the summer of 1920 for Fed officials to slash rates, as the economy was clearly suffering from higher discount rates. Yet, the Fed maintained it’s position. Benjamin Strong, Governor of the Federal Reserve Bank of New York, stated:
“I believe that this period will be accompanied by a considerable degree of unemployment, but not for very long, and that after a year or two of discomfort, embarrassment, some losses, some disorders caused by unemployment, we will emerge with an almost invincible banking position [and] with prices more nearly at competitive levels with other nations…”
In other words, the Fed fully understood the consequences of keeping rates at elevated levels, but believed it was necessary in order to restore order to the economy / financial system.
The cost of such a plan was a severe 18 month recession, but the economy began to quickly recover, and gave way to the famously “roaring” 1920s, a decade of economic prosperity like few others.
Time will tell if the recession we’re currently experiencing will also give way to a decade of unprecedented prosperity, but one can hope that the timeline we’re on continues to resemble that of the 1920s.
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