What caused the prosperity of the 1920s in the USA?

Historians of the 1920s and economists have been apt to disagree on the development of 1920s prosperity. This has been because economists have focussed on the monetary policies and implications of the period whereas historians have looked to the supply-side, or to Keynesian analyses based around employment and demand. The two professions have therefore, until recently, formed radically different perspectives on the period.

To an historian, the 1920s were a period when Gross National Product rose by some $25 billion; the number of ‘radio-owning households’ rose over sixteen times, from 60000 to ten million; income tax millionaires rose eightfold, and the number of people who used airlines rose twentyfold. This speaks to a massive increase in demand, which can be associated with the growth of jobs in motor manufacturing, and in the associated industries such as tyre-making and steelworks. The automobile industry alone was by 1929 responsible for 7 % of all United States industrial workers and 9% of wages. In addition, the period was one in which the development of earlier infrastructure projects, such as New York or California bridges, fed into architecture and construction. In that regard, Al Smith’s Empire State Building has become something of a symbol of the era.

One key development, to the non-economist’s eye, might be productivity growth. Again, this was most pronounced in the motor industry, which was able to massively reduce the average price of cars to $300 by the mid-1920s. This reflected an increase in purchasing power of the dollar, and also some of the benefits of Henry Ford’s production lines and Frederick Winslow Taylor’s time and motion efficiency studies. 26 million cars were produced over the decade—1 for each $1000 increase in GNP, and this led in part to another $1 billion in road spending. The motor industry gained this pre-eminence in part from capital investment, which rose seven times over the period. It contributed both to urban growth, (especially in Detroit) but also to other industries, to savings, and to the model of large, oligopolistic industries working with government to minimise regulation that characterised Herbert Hoover’s ‘associationalist’ policies as Secretary of Commerce between 1921 and 1928.

The growth of ‘Big Auto’ has been quite useful for historians of the period as an anchor for discussions of Labour movement policies, or the over-supply of the market, or the cultural impact of the ‘shadow finance’ and housing collateral that paid for working- and middle-class men to buy automobiles. However, economists have generally argued that such a focus belies the true reason for 1920s prosperity in a monetary bubble that can be traced to the expansion of the Federal Reserve’s powers during 1917.

The Federal Reserve, as established in 1913, was a response to the crisis of 1907. It had no power to issue bonds, no power to print money, no discounting ability, and was there to coordinate 12 confederations of major local banks in such a way that they maintained liquidity in the whole banking system. They were empowered to do this via the issue of short term commercial paper in return for cash.

In 1917, however, the Federal Reserve acquired powers under legislation encouraged by the Treasury Secretary, William Gibbs McAdoo and the Federal Reserve Board Chairman Benjamin Strong. These powers allowed the ‘Fed’ to lend money and issue bonds at discounted rates. Four Liberty Loans to fund the federal government’s war efforts followed. These were preceded by ‘certificates of anticipation’ and ‘certificates of indebtedness’ which allowed the Fed to lend the money to its constituent banks for the liberty loans before the liberty loans were made. In essence, the Federal Reserve started the process of getting Americans to monetise their wealth by lending itself the money to encourage them to do so.

The banks then essentially created facilities, such as part payment, or collateralised loans, which they extended to companies and individuals to buy the liberty bonds. The liberty bonds were thus guaranteed cash-flow, and because they were issued at a lower interest rate than treasury bonds, the banks could use the initial collateral (the pre- payment guarantees) to buy treasury bonds at a higher rate of interest and then profit from the difference. Banks then placed these monies with corporations for investment, helping to explain the vast and suspicious ‘over investment’ in capital of large companies. In turn, large companies found that cheap borrowing and productivity growth improved their profits, which allowed for apparent rises in share prices.

The rise in share prices was more apparent than real for two reasons. Firstly, the increase in the money supply was properly speaking an increase in balances at banks. This meant that there had been an expansion of cash, which is not money but just representative of money.

It would be acceptable to argue that, because the money came initially from the government in a wartime emergency, and made its way to armaments and grain exports which increased GDP by well over $45 billion, that this was a financial trick that actually resulted in real growth and not a bubble. Further, such an argument would go, it was then paid for by ordinary people collateralising their wealth or betting against their income. However, America was at the time on a gold standard. The growth in money exceeded the growth in gold, so that by 1918 there was an excess of some $2.6 billion paper to metal, which meant that the money was inflated compared to 1916.

This inflation, or debasement (same thing) continued into the 1920s, when the Federal Reserve held its central lending rate at 3%, which was enough to keep the dollar down on international markets. This was lower than it should have been because European gold was flooding into America, making dollars more valuable again, as a result of the need from 1919 on to fund reparations and to buy American exports. One of the main reasons that the dollar was kept down was that the Federal Reserve did not wish to assume monetary leadership of the world, but only to achieve the benefits and privileges thereof. So, an interest rate that kept the dollar low relative to the pound, but in which America provided most of the loans, held the gold, and was the market for the global community, was guaranteed to enhance the US economy, to speed up British outflows of gold to America, and to turn the attentions of Europeans seeking finance to American surpluses. By the same token, the British would be consigned to cuts in spending, including armaments, and attached to American policy.

The effect on the American economy, however, was inflationist. From 1917 to 1929, with two very short exceptions in 1923-4 and 1927, the Federal Reserve kept interest rates low, and kept the expansion of finance, based on money that was progressively worth less than it seemed to be, going.  The effect was to provide too much capital for investment, leading to absurd exploitation of economies of scale, apparent share increases, and apparent productivity growth. The reality was that, to continue, the system had to encourage individuals to monetise their wealth and their income by taking on debt. Those who had done ‘well out of the war’—the steel manufacturers and commodity production companies, and new industries backed by existing capital or in relationships with local banks, had a head start because the low interest rates particularly favoured them. The system also encouraged the global lending that led to British weakness and to European imbalance.

These facts are generally known to economists. Some, like Murray Rothbard, argue that they were a bad thing, whereas others, like Ben Bernanke, suggest that they provided a template for how to avoid deflation. Both sides agree that the slowdown and then crash of 1928-9 was, in such circumstances, inevitable, though they disagree that this inevitably led to 1931 and to the Great Depression. They argue instead that quantitative easing and even more federal money creation, plus an earlier moratorium on debt and suspension of the gold system, would have seen recovery by 1930-1, without an European banking crisis.

The parallax view, however, leads to distortions. Most historians will have looked at the question of 1920s growth and asked, ‘what other than motor manufacturing would have created such demand?’ Most economists would now ask ‘why just look at the 1920s?’ A few would go further, and perhaps suggest that the growth of the period represented a confluence of Kondratiev and Kuznets waves—a peak of exploitation of one set of technologies, such as steel, the railroad, the radio and the internal combustion engine—before a collapse caused by over-supply.

However, since economists and historians are both rightly sceptical of vague cyclical arguments for the recurrence of economic growth and decline, such ‘Schompeterian’ or even ‘Spenglerian’ analyses are possibly best left out of this answer. The one thing that cannot be said to have caused the boom, though it did not get in the way, is the general policy of the Harding, Coolidge and Hoover Administrations. The one man who links them all, Herbert Hoover, was an associationalist. He believed in working with industry, and occasionally in encouraging regulations, such as traffic codes or rules about radios. He was an expansive Secretary of Commerce who encouraged people to buy their own cars and homes with credit, and who sat in a government that manipulated tariffs and cut taxes. 

Congressional policies also catch the eye in these debates. The Fordney-McCumber Tariff Act, for instance, prevented true European competition, should such a thing ever have arisen, from reaching American shores just as much as the low dollar policy coupled with loans to Europe encouraged exports. Revenue Acts, encouraged by administrations, reduced surtax from 50% to 20% over the period, although these were accompanied by corporate, inheritance and capital gains taxes which grew or stayed stable over the period. The Federal Trade Commission, heavily influenced by the atmosphere created by Hoover, cut regulations substantially, and unions were suppressed, leading to low wage growth.

Bizarrely, however, these actions were foam on the surface of what was, really, a monetary sea. Economic historians should not look to the government, but to the Federal Reserve, for explanations of the period.

To summarise; Motor manufacturing was representative of 1920s growth and had some second-order and not insignificant multiplier effects. Government had too. In truth, however, ‘it was the Fed what done it’, and not necessarily with the best of consequences.