• The Invisible Hand

The Biggest Economic Crisis You've Never Heard Of

No it's not the 2008 recession or the 1929 depression; the biggest recession of the past 200 years happened in 1920 when GDP fell by -10% in one year alone.


Coming out of World War One economists were optimistic about Britain's economic future. Britain had been relatively unscathed by the war and in many cases it helped to eliminate inefficiencies. However, the post-war boom would be short-lived since in spring 1920 one of the worst economic shocks Britain has ever experienced occurred where unemployment plummeted by 20%. This article looks at what caused this economic catastrophes and what were the long-term persistent impacts.

In 1919, the Cunliffe Committee committed the UK to rejoining the gold standard at pre-1913 level of parity. This would set the UK on a fixed exchange rate of $4.86 per £. Before WW1 the gold standard was seen as a key instrument in our prosperity. It kept the economy and exchange rate stable which encouraged international trade and led to the first wave of globalisation. It also means lower borrowing costs since the value of debt is more certain; this would be cruical for Britain since they had heavy debts to the United States. However, while the gold standard may have served the late-Victorian economy well, it was not suited for the interwar period where the productivity of the UK was greatly diminished in relation to the US. Interest rates would have to be much higher to appreciate the pound to the $4.86 level so in April 1920 interest rates were raised to 7%. When deflation occurred shortly after this massively increased the real interest rate. A higher real interest rate massively reduces the number of viable investment projects since expected returns must exceed real interest rates. Therefore, investment demand plummets and economic growth contracts. the government remained committed to the Gold Standard and eventually joined in 1925, therefore monetary policy had a persistent negative effect.


In wartime, government spending increases massively so inevitably when a war ends there must be a major fiscal shock. Demand for armaments vanished and iron and steel were no longer as highly sought after for tank production which became more significant as the war came to an end. However, it is not inevitable that a demand shock will occur as a war finishes. The economy boomed after WW2 which had a much greater economic toll. If resources directed to war efforts are quickly transferred to the private sector a recession can be avoided. Indeed the demobilisation of soldiers to normal employment was achieved fairly swiftly and smoothly. The rise in civilian employment offset the fall in the armed forces, so this did not cause a significant demand shock.

The most significant demand shock came from the cuts in overall government spending and major increases in taxation. After WW1, national debt was over 100% of GDP and the Liberal government was committed to reducing this debt. Therefore, they moved from deficit spending to massive surpluses. Interest payments of 7% of GDP meant that cuts to other parts of government spending had to be even greater. Overall, government spending halved between 1918-1920 from 46% to 23%. Tax revenue also rose to over 30% of GDP from 10% where it had been before WW1. Economists estimate the size of the multiplier was about 2.0, therefore changes in taxation and government spending would have a big impact on GDP. This is the best demand-side explanation of the recession since it was a significant chunk of GDP.


It is also a realist interpretation of the persistent economic stagnation of the 1920s since the budget surplus always remained over 5% of GDP. The tragedy of these surpluses is that they did nothing to reduce national debt as a percentage of GDP since GDP fell significantly and deflation reduced tax receipts. National debt rose to 180% of GDP and did not begin to fall until 1934.


On the supply-side negative shocks can be characterised as having labour market origins or arising from fundamental structural change. The hours shock of 1919 is often seen as an important supply-side shock. Between 1918-19, approximately 7 million workers took cuts to their hours averaging 6.5- 7 hours a week for no cut in overall wages. This massively increased wages per hour and therefore costs of production for firms. An increase in costs means firms supply less since it is less profitable and they also increase prices to cover these additional costs. There was also a labour force shock from the deaths of 745,000 deaths of soldiers who were mostly healthy, young men and 1.7 million civilian injuries. This has a similar effect as the hours shock since if the labour force is smaller, real wages should rise.


However, the presence of deflation suggests that supply-side shocks were less significant since supply-side shocks are usually associated with inflation. Also, a cut in hours can have some effect on increasing hourly productivity, which would have lessened the costs to firms. It seems reasons to suggest the labour market would adapt overtime and absorb these changes. Therefore, an hours shock cannot explain the persistence of poor economic outcomes.


The product life cycle argument of the recession suggests that after WW1 the UK saw a major loss of comparative advantage in traditional industries. This was part of a long-term industrial decline but it had been delayed by WW1. Before 1914 the UK was heavily reliant on the four key export industries of coal, iron and steel, cotton and shipbuilding therefore changes in any of these industries could have significant implications for GDP.


Three main reasons contribute to the loss of comparative advantage. First, because of the interruption of UK exports in WW1 many countries have learnt to become more independent so by the time the war ended domestic production in other countries had caught up to the UK. Second, although Britain had leapt forward in the 19th century from innovation, by 1918 product development reached the end of its lifecycle and innovation had been widely distributed. Therefore, British industry could be imitated easily and improved upon. An increase in global supply means a lower global price so lower revenue for these key industries. Third, the appreciation of the exchange rate due to contractionary monetary policy made the UK more expensive. UK exporters struggled to remain competitive on global. In iron and steel total factor productivity was approximately equivalent in 1920-21, but US real wages were much lower. In cotton, both the UK and the US lost out to Japan. However, this decline took place over many years so cannot explain the sudden shock to GDP.


Overall, the origins of the 1920-21 recession lie largely in the demand-side of the economy. There was a sudden change in both monetary and fiscal policy in 1920. Despite poor economic performance these policies remained in place which suggests they were important persistence channels. The largely supply side impact was on traditional exporting industries. They suffered from global trends in production after WW1 and a severely overvalued exchange rate. Therefore, this recession was largely a government stimulated one.



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