The Postwar Recession

The immediate effect of the Armistice was a slowdown in the economy. Prices remained roughly level for some months. Then, in 1919, a vigorous boom began, and prices began to rise rapidly. Monetary policy added to the boom. The Federal Reserve continued to follow a policy of keeping its discount rate (lending rate) below market rates. The Federal Reserve realized that this policy was adding to inflationary pressures: Banks were finding it profitable to borrow from the Federal Reserve and then expand their own lending. The Federal Reserve, however, was reluctant to raise its rates. One reason was that higher interest rates might have depressed the values of the large amount of government war loans in the market.

Finally, the Federal Reserve acted possibly because its own reserves of gold were being depleted. In late 1919 and early 1920, the Federal Reserve raised its discount rate. The increase in January 1920 from 4.75 percent to 6 percent was the sharpest single increase in the short history of the system. On June 1, the discount rate was raised again, to 7 percent. These increases sent a strong signal to the market that credit would soon be tight. In addition, agricultural prices fell as European production recovered. As a result, the economy went into a severe recession. From 1920 to 1921, nominal net national product fell 18 percent, and real net national product fell 4 percent. But the recession was also brief: It resembled what has come to be called a “V-shaped” recession, straight down and straight back up again. One reason, perhaps, is that even though the number of bank failures rose substantially, there was no financial panic. As we shall see, the sharp contraction in 1929-1930, which appeared at first to be a repeat of 1920-1921, produced a financial panic that drove the economy far deeper into depression. After the economy recovered from the recession of 1920-1921, it entered a long period of economic expansion. This expansion was so vigorous that many people came to believe that a new age of continuous prosperity had arrived. The “roaring twenties” are the subject of chapter 22.