Weird Science

I am puzzled by Paul Krugman's effort to defend fiscal stimulus against Rush Limbaugh's criticisms by invoking pre-World War I recessions. Here's the relevant part of a recent blog post: "How fast would the economy recover in the absence of a stimulus plan and a financial rescue? ...Well, my general view is that this isn’t your father’s recession; it’s your grandfather’s recession. And the experience with pre-WWII recessions may be a useful guide. I’m not just talking about the Great Depression; some earlier experiences may in some ways be equally or more relevant. So let’s look at the NBER business cycle data. What we see is that some of those prewar slumps were really, really long: the Panic of 1873 was followed by a recession that lasted 5 1/2 years."

The US didn't have a central bank (and thus a modern monetary policy) prior to WWI. Consequently, the monetary authorities could not respond to the panic of 1873 with monetary expansion. Moreover, the monetary authorities did not wish to respond to the panic with monetary expansion. Instead, Congress implemented a wingnut monetary policy by demonetizing silver in The Crime of 1873. Congress then remonitized silver five years later. The federal government also withdrew currency notes from circulation between 1875 and 1878 in connection with the Specie Payment Resumption Act.

The shift away from bimetallism in 1873 and the 1875 Resumption Act probably reduced the money supply; it certainly failed to expand it. The Friedman and Schwartz data show money supply (M2 and M3) falling between 1875 and 1878 . Short-term interest rates (commercial paper rates) averaged slightly above 6 percent through the 1873-1878 period, which seems high given the recession (and associated price deflation). The simplest explanation for why the recession that began in 1873 lasted five and a half years, then, is really bad monetary policy.

What is true for 1873 probably is true more generally about the post Civil War 19th century. Monetary policy rarely expanded in the wake of financial panics, and often contracted. Indeed, because many panics triggered (or were triggered by) gold outflows, they necessarily reduced the stock of monetary gold. Consequently, recessions followed panics. Some recessions, like that of 1873-1878, were long. Others, like that following the 1890 panic, were short (10 months). On average, though, 19th century recessions lasted almost two years (22 months)--more than twice as long on average as those that have occurred since WWII.

One might ask whether the less frequent and substantially shorter recessions we have enjoyed since WWII result from better monetary policy--even if all we mean by this is the absence of truly perverse monetary policy. This does not mean that there is no case today for fiscal stimulus. It does mean that there is reason to doubt a claim that in the absence of fiscal stimulus we will endure a five and a half year recession like that which befell our great-great grandparents in the 1870s.