Expert Commentary

The Deflation and Depression You've Never Heard Of. And Why...

Government and central bank stimulus are the only way out of depression, right? Wrong. Here's a depression the Fed don't want you to know about.

100 years ago, after the Spanish Flu had swept across the world, killing more people than the First World War, there was a deep depression in the United States. Just as Covid-19 is not the cause of today's economic turmoil, nor was the Spanish Flu the cause of the U.S. depression that started in 1920. The cause, as with all economic cycles, was the trend in social mood. And this example shows that social mood, not government intervention, was also the cause of the recovery.

The New York Stock Exchange closed for four months at the outbreak of war in 1914 but reopened in November of that year. The Dow Jones Industrial Average advanced by 125% from December 1914 to November 1919. It then crashed by 47% into a low in August 1921. Gross National Product declined by 17% and Industrial Production by 30%. The unemployment rate is estimated to have risen from around 2% in 1919 to 11% in 1921. The deflation of consumer prices occurred at an annualized rate of nearly 16% between 1920 and 1921.

Dow Jones Industrial Average

Given this severe deflationary depression, modern interventionist economics would prescribe huge government and central bank stimulus. But that didn't happen. Under President Harding, spending was reduced (not increased) and taxes were cut (not raised), reducing the U.S. national debt by a third. The Fed, meanwhile, did not loosen monetary policy at all.

By late 1921, signs of recovery were already coming through. In 1922, unemployment was reduced and by 1923 it was less than 3%. The Dow Jones Industrial Average quintupled from 1921 to 1929. The economy had recovered naturally and quickly, without any government or Fed stimulus. Indeed, some economists might say the strong recovery occurred because there was no government or Fed intervention.

We can look at the Dow Jones Industrial Average priced in the honest money of Gold. When there had been no government or Fed intervention it had taken just 6 years to surpass its 1919 high-water mark. Now contrast that with the recovery when government and central bank stimulus are applied. In the Great Depression, the Fed ran a looser monetary policy than during the 1920-21 depression and President Hoover's New Deal provided fiscal stimulus. Yet the Dow priced in Gold took 30 years to surpass its 1929 peak.

The Dow / Gold ratio topped out in 1999 as the economy peaked. Since then, U.S. Federal government debt as a percentage of Gross Domestic Product has exploded from 54% to 106% and rising, the Fed Funds interest rate has declined from 5% to effectively zero, and the Fed has created trillions of dollars out of thin air. Despite all of that, as of April 2020, the Dow Jones Industrial Average priced in Gold still remains nearly 70% below its 1999 peak.

Dow Real Money

Governments and central banks don't want you to know about the deflationary depression of 1920-21 because it shows that by not intervening, by doing the exact opposite of what is thought best today, an economy can recover quickly and strongly. Indeed, they don't want to entertain any notion that they are not only powerless in causing a recovery, but they might, actually, make things worse.

It's social mood that drives economic cycles and social mood exhibits a natural cycle according to Elliott's Wave Principle.