From the 20th to the 21st century, we have observed significant growth in government intervention in the economy, particularly during times when markets attempted to self-correct. There are two main schools of thought regarding the extent of government intervention in these situations. The Keynesian theory advocates for massive fiscal stimulus to prevent economic collapse. In contrast, Friedman and other small-government monetarists argue that increasing the money supply can prevent a recession from evolving into a depression. Both sides agree that allowing free markets to correct themselves without government intervention would lead to disaster. However, the two approaches to addressing economic downturns in the 20th century have often clashed, and ultimately, a combination of free-market principles and government austerity prevailed.
From 1920 to 1921, the United States entered a lesser-known depression. This downturn began due to government expansion during World War I, which resulted in a significant federal deficit. By the war’s conclusion, consumer price inflation exceeded 20%. Additionally, while unemployment was just 1.4% and productivity had surged due to the war effort, the return of 1.6 million soldiers—equating to a 4.1% growth in the civilian workforce—led to an increase in unemployment as the economy began to weaken. The influx of workers also diminished union power, resulting in lower wages and heightening the risk of an economic slump.
Between 1920 and 1921, production plummeted by 32.5% compared to the previous year, prices fell by 15%, and unemployment surged to 12%, surpassing levels seen at the onset of the Great Depression. Many businesses failed, and those that survived experienced drastic revenue drops, while the stock market—specifically the Dow Jones Industrial Average—declined by 47%, causing widespread anxiety among the public. During this period, the monetary base collapsed, marking the most substantial decline in U.S. history, even greater than during the initial stages of the Great Depression. Yet, the government chose not to intervene. Presidents Wilson and Harding reduced government size by 65%, cutting federal spending from $18.5 billion to $6.5 billion between 1919 and 1920. Then, in the fiscal year of 1922, they further cut the budget from an additional $2.2 billion to $3.3 billion. At the same time, the New York Fed raised interest rates to 7% for its discount rate, resulting in a federal budget surplus of $509 million in 1921 and a $736 million surplus in 1922, which helped pay down World War I debt. What followed was an unprecedented economic boom characterized by annual budget surpluses and prosperity for many, especially those who were prudent with their investments.
During this initial depression, Herbert Hoover served as Secretary of Commerce and advised both Presidents Wilson and Harding to increase government spending through deficit financing and to lower interest rates. However, they rejected Hoover’s counsel. Ironically, when Hoover became President at the onset of the Great Depression, he adopted the very strategies he had earlier proposed.
Between 1929 and 1930, the United States faced the Great Depression, a severe financial decline. The stock market crashed in October 1929, resulting in billions of dollars in losses, and the total money supply shrank by one-third by 1933. While Hoover reduced income taxes by 1%, he was inherently Keynesian and later raised taxes. During his term from 1930 to 1933, government spending increased by 42%, leading to unprecedented federal deficits during peacetime. He also initiated public works projects, such as the Hoover Dam, and established the Reconstruction Finance Corporation, which injected over $1 billion into failing banks. However, Hoover’s tax cut for 1929 was short-lived, as he raised taxes again by 1932. The top tax bracket for 1933 reached 63%, up from 25% in 1932, yet federal revenue only increased by 3.8% between 1932 and 1933, while the federal budget deficit stood at 4.5% of GDP.
Additionally, during this period, the New York Fed reduced interest rates to 1.5% to stimulate borrowing and help prevent the failure of struggling firms. This approach was a stark contrast to the earlier strategy of increasing the discount rate, which was intended to save solvent firms lacking liquid capital while forcing insolvent firms to close. Economist Lionel Robbins remarked,
“In the present depression we have changed all that. We eschew the sharp purge. We prefer the lingering disease. Everywhere, in the money market, in the commodity markets and in the broad field of company finance and public indebtedness, the efforts of Central Banks and governments have been directed to propping up bad business positions.” (Murphy)
However, all the government intervention in the economy during the 1930s did little to improve the economic situation. Instead, it contributed to one of the least prosperous decades in U.S. history. It was only the onset of World War II that pulled us out of that depression. Despite implementing price controls, rationing, and increased productivity to support the war effort, we still faced a mild recession after World War II due to decreased wartime spending and the transition back to a peacetime economy. Therefore, the effects of the Keynesian experiment, which promoted increased government intervention in the economy, are complex, especially considering the impact of World War II.
Regrettably, the circumstances of the Great Depression established an economic model that continues to influence policy today. Since then, we have experienced 13 recessions, and the effects of Keynesian economics have become more evident. The most recent example occurred during the 2007-2008 financial crisis, when the collapse of Lehman Brothers and the housing market triggered a global recession. Additionally, during the COVID-19 pandemic in 2020, the government injected massive sums of money into the economy in an effort to prevent a depression or recession. However, this led to increased debt and higher taxes, leaving us with no clear solution for our escalating national debt.
Regrettably, we now have a bloated national government with an ever-expanding bureaucracy that is hampering the innovation of the American people and the economic change we need to return our country to its great status. So what can we do about this? We can continue to demand the contraction of government (austerity), which appears to be what the current President wants to do. It will be economically painful initially if the government decreases, but eventually, it will be better for the country to return to balanced trade, budgets, and economic prosperity. When more money is returned to the people, innovation, and prosperity are secured, and the failing businesses are forced to close rather than being propped up, leading to financially stable businesses being created or expanded to meet the demand. It does no one nor a country any good if we prop up failing businesses in favor of businesses or individuals that can and will succeed.
Murphy, Robert P. 2009. “The Depression You’ve Never Heard Of: 1920-1921 | Robert P. Murphy.” Fee.org. Foundation for Economic Education. November 18, 2009. https://fee.org/articles/the-depression-youve-never-heard-of-1920-1921/.
Roundtree, Devin. 2014. “1920 Depression v. Great Depression | AIER.” Aier.org. August 11, 2014. https://aier.org/article/1920-depression-v-great-depression/.
staff, B. E. R. 2021. “In the Shadow of the Slump: The Depression of 1920-1921.” Berkeley Economic Review. March 18, 2021. https://econreview.studentorg.berkeley.edu/in-the-shadow-of-the-slump-the-depression-of-1920-1921/.
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