A few days ago, I posted a comment on austerity measures as a complement to supply-side measures. One of the economist that I quoted, Daniel Kuehn, has replied in earnest about the 1920-21 recession:
I still wished I had explained the supply shock argument a little better (i.e. – reproduce with ample citation Romer’s excellent treatment and share a few other things on agriculture at the time that I dug up). The tight money policy was an aggregate demand shock, and the tight money policy did really put the economy into a nose-dive, so you have to be careful in talking about it as a supply-side downturn. And there was a good reason why they did that: to bring the price level back in line. The reason why it doesn’t really give us much guidance about fiscal policy is that monetary policy had a ridiculous amount of maneuvering room (which it took advantage of even before Harding came into office), and their was no demand shock to speak of except for the one that Benjamin Strong was already in the process of removing.
It seems that, indeed, I might over-emphasized the role of the drop in aggregate supply in Kuehn’s excellent paper in the Cambridge Journal of Economics. However, I am not convinced that monetary policy had much to do with that recession, the recovery was still “supply-side-led” (if that word exist, I am coining it…) and the austerity measures acted as “credible commitments”.
When one looks at the United States relative to other countries like Canada, we can see how supply-side constraints and shocks led the economy to nose-dive. For example, Canada announced in early 1919 that all price controls would be released and that some taxes would be cut down. The government of Canada also commited itself to austerity and debt reduction via the curtailment of public expenditures. Meanwhile, the Wilson administration announced that it would keep many price controls and actually announced a month after Canada that a Post-War Price Board would be kept to continue price controls. As much as inflation played a role after the war in the US, price controls created shortages and industrial shutdowns (combined with industrial transformation back to peacetime industry) that probably fuelled strikes and lockouts. Moreover, during the war there was – as Albrecht Ristchl pointed out – the Clayton Act which allowed collective bargaining on a large scale (hence more union power that could collaborate with businesses to hike real wages and reduce employment). It was only after the Clayton Act was invalidated in court and that the Harding and Coolidge Administrations began to eliminate constraints on supply that growth took off. Here, I believe that Kuehn and me agree. So the recession was mostly a supply-side contraction and the recovery was the increase in aggregate demand (and a part of monetary policy).
However, my point is that austerity is not a measure for short term recovery. It is a measure for sustaining growth rates. Most of the spending cuts occured indeed in the Wilson years, but were mostly linked with returning troops being “laid off” and military spending returning to pre-war levels. However, the Wilson “cuts” returned spending to a higher steady path than prior to the war. Economic actors saw this and their expectations were negatively affected (see 1920: The Year of the Six Presidents for a discussion of the events and people of the time). The austerity measures of Harding combined with tax cuts provided what we can call “a credible commitment” to an institutional setting in which actors could steadily form expectations, invest and expand their activities.
The reason is that I don’t think individuals in the US at the time lived via Ricardian Equivalence. They had expected the government to return to prior size and commit to reduce the debt by not using higher taxes. The Harding-Coolidge commitment was believed and the “return to normalcy” was seen as credible. In a sense, “austerity measures” had an impact on expectations.
P.S. : My friend John Gent of the LSE made a similar point with regards to William Pitt’s sinking fund and the return to the gold standard as a credible commitment after the Napoleonic Wars to reassure financial actors.