"It was a supply-side shock, not deflationary monetary and fiscal policies, which initiated depression in 1920 and contributed to the subsequent slump". Discuss.

Figure 2. A sharp rise in real wages coupled with a fall in labour productivity 

When agreeing to the reduction in the number of hours in a working week, employers had hoped to see an increase in labour productivity owing to fresher more inspired workers, with less needs for breaks, to offset the increased per hour labour factor cost. This did not materialise. Dowie seems to disagree with this, making the assumption that “the productivity offset following the hours reduction of 1919 was complete, weekly output and employer’s unit costs remaining unchanged”, although he does refer to this assumption as “extreme” and concedes that there is just ground for being “worried” about this assumption. Aldcroft disagrees with Dowie, stating that “unit labour costs rose rapidly in 1919-20, as measured by the hourly rate…[this was] not matched by productivity improvements and hence profits came under increasing pressure.”

The total effect of the aforementioned was to cause a shift in the AS curve through a negative shock.

 

Figure 3. Shift in the aggregate supply curve

The negative shift in the aggregate supply curve from AS1 to AS2 causes the price level to rise (P1 to P2), and a fall in the level of output (Y1 to Y2). As output is assumed to equal employment level, we also see that there is a fall in the level of employment.

Data for the time does not fully back this argument, however.

Table 1. Unemployment and inflation rates 1916-1932.

Figure 4. The relationship between inflation and unemployment 1914-1924.

For the AS shock argument to hold true, we would need to see a period of both high unemployment and inflation directly following the shock. However, on first inspection, the data suggests that over the period, rates of inflation and unemployment are moving in exactly opposite direction.

The working hours reform occurred, as pointed out by Bowie, at the beginning of 1919. Dowie comments that roughly 91.4% of the overall reduction in hours made over the two year period of January 1919 to December 1920, had taken place by July 1919. 

Broadberry implies a “sharp rise in unemployment during 1920-1” to emphasise his point that the supply-side shock was ultimately the cause of the depression that ensued. Glynn and Booth disagree with Broadberry and conclude that “mass unemployment was not apparent until 1921”. They argue that a lag of 2 years for unemployment to rise in response to the supply shock is too long, commenting that “the ‘supply shock’ seems to have had a very long fuse.” The data above would tend to support this argument, although other measures of unemployment around the time indicate that there may have been the beginning of a sharp increase in unemployment in 1920 rather than in late 1921 which is implied by Feinstein’s data.

Examining the trend from figure 4, I disagree with Broadberry’s argument that there was a significant rise in unemployment that began in 1920 as opposed to 1921. However, due to the variety of varying data on the period that is available I cannot confirm with utter certainty that Broadberry’s calculations were incorrect. Having established that Broadberry seems comfortable with a one year time-lag for unemployment to respond to the aggregate supply shock of early 1919, if data were to reflect a rise in unemployment earlier than my data suggests, then the corresponding rises of inflation rate and unemployment rates in 1919 and 1920 respectively may give the supply-side shock argument some credit.

 

Monetary and fiscal policy

Prior to the work done by economic historians such as Dowie, Broadberry and Aldcroft on the causes of the 1920 depression, most research pointed to aggregate demand, monetary and fiscal policies as the cause of both the post-war boom and the slump that followed.

Most writers are unanimous in attributing the post-war boom to “demand-pull” rather than “cost-push” inflation. Dimsdale attributes the increase in aggregate demand to a strong demand to rebuild stocks at home and abroad, whilst Aldcroft estimates that consumer expenditure “rose by no less than 21 per cent between 1918 and 1919”. Both Aldcroft and Broadberry refer to some sort of build up of consumer demand pressure during the last few years of WWI. They argue that as a result of few consumer goods being produced towards the end of the war, with all production focused on the war-effort, consumers were forced into saving, instigating a massive upsurge in consumption once the war had ended. This view is, however, disregarded by Glynn and Booth, who point out the lack of any empirical evidence to back this point up.

 

 

 

 

 

 

 

 

 

 

Figure 5. Interactions of aggregate demand.

An expansion in aggregate demand (AD1 to AD2), as is implied occurred in 1919 will, ceteris paribus, lead to an increase in the price level (P1 to P2) with a corresponding rise in the level of output and hence employment (fall in unemployment) (Y1 to Y2). On studying figure 5, we can see that the data in table 1 backs this almost exactly. Between 1919 and 1920 there is a 1.4% fall in the rate of unemployment and a 4.4% rise in the price level. This evidence seems to support the notion that the boom was totally demand driven. The causes of the slump are less clear-cut.

A popular argument is that tight monetary policy that was employed to try and curb spiralling inflation not only initiated the slump, but played a major part in sustaining it throughout the 1920’2 and into the 30’s. Howson estimates that by the end of 1919 “boom conditions had brought with them something like full employment”, as well as well-documented rises in output, industrial production and money income. This did, however, all come about at a cost of high inflation. Having left the gold standard in 1919, due to the unsustainable cost of pegging the pound against the dollar at an artificially high rate, Dimsdale states that “[the] immediate aims of the Bank of England and the Treasury were to check inflation … and to restore control over the domestic money market”. In April 1920, just as the economy had reached its boom peak, the Bank Rate was raised to 7%. Dimsdale goes on to suggest that this rise in interest rate caused “a fall in home demand … followed by a decline in exports.” He blames poor judgement in raising the interest rate, saying the rise came far too late to “check the boom”, and were sustained for far too long, which only served to worsen the slump. With plans afoot to rejoin the gold standard in the near future, the government were unwilling to change the money supply to try and control the slump, and stayed committed to a policy of high interest rates to curb inflation.  This restrictive monetary policy helped to improve Britain’s exchange rate position, with the pound appreciating 20.8% against the dollar between 1920 and 1922. However, Britain’s G.D.P. deflator and weekly wage rates fell by 24.9 and 23% respectively, in the same time period. Broadberry attributes the fall in price level in the 1920’s,solely on the Government’s decision to try and restore the gold standard to pre-war parity

A negative shock to aggregate demand causes the aggregate demand curve to shift to the left.(AD1 to AD3 in figure 5). This contraction in aggregate demand causes a fall in price level and an increase in unemployment. These criteria more than satisfy my data set in table 1 and so a contraction in aggregate demand does look like a more attractive explanation to the slump.

Howson and Dimsdale are in agreement that the boom was supported by mass speculation and unfounded consumer confidence in the British economy.  Alford comments “[the] speculative nature of the boom in the latter half of 1919 began to raise doubts in the minds of even the most optimistic businessmen, and it is therefore possible that business confidence was already beginning to wane before the government decided to reverse its policy stance”. Therefore, the speculative nature of the boom, that shifted the aggregate demand curve outwards during the boom, could have meant that aggregate demand was forced to quickly contract (shift left) and fall below pre-boom levels, once the speculative bubble burst. This would explain the speed at which the peak of a boom became a severe depression.

Pigou argues that the volatility of the boom-bust cycle of 1919-1922 may have arisen because of the type of goods that were being consumed directly after WWI. Pigou makes a case that there was an increase in demand for consumer durables that did not need frequent replacement, and a mass of what he calls “once-for-all” consumption. He argues, in line with Broadberry’s views, that consumers had a build up of consumption potential in the post –war years and simply chose to buy big ticket consumer durables once the war ended. This would explain sudden and explosive nature of both the boom and the slump that followed it. This is a view that is generally accepted.

Reasons for the sustained slump

What was remarkable about the post-war recession was how long some of its effects, most notably unemployment, lasted. Unemployment remained high throughout the 1920’s and the 1930’s, not falling below 6.8% until 1939.

   

   

1914-1918

1919-1923

1920-1932

Figure 6. Phillips curves for the U.K. 1914-1918, 1919-1923 & 1920-1932

From Phillips curve analysis on the three time periods 1914-1918, 1919-1923, and 1920-1932 (as shown above), I have derived the non-accelerating inflation rate of unemployment (NAIRU) figures for the time period, with very interesting results.

The NAIRU figure is a way of looking at the natural rate of unemployment within an economy and shows the level at which unemployment should be to keep inflation constant. It’s value, will therefore occur where the change in the inflation rate is equal to zero.

The NAIRU figures that I have calculated using the equations given as the line of best- fit trend lines for my input data are:

Table 2. NAIRU calculations

The natural rate of unemployment is, by definition, the unemployment rate at which the actual inflation rate is equal to expected inflation rate.

Above, I defined the aggregate supply relation as:

P = Pe(1+)F(ut,z)

Be redefining F(ut,z) as (1 - ut + z)  you get:

Pt = Pte(1+)(1 - ut + z)

The relationship (1 - ut + z) implies that the higher the unemployment rate, the lower the wage rate, and the higher z, the higher the wage. The parameter  captures the strength of the effect of the unemployment on wage- the larger the  value, the larger the effect that unemployment will have on wage rate.

By manipulating the above equation we can get:

t = te + ( + z) - ut

where  is equal to inflation.

If we now make actual inflation equal to expected inflation to solve for the natural rate of unemployment, we get

un =  - z

         

This relationship implies that as employer markup and/or the catchall variable increase, so does the natural rate of unemployment.

The rising levels of the natural rate of employment throughout the 1920’s and 30’s serve as evidence enough that supply-side factors contributed heavily in keeping the post-war British economy depressed for such a long period of time, as only supply-side factors could have influenced the natural rate of unemployment, which in turn kept unemployment at such a high rate.

Conclusion

Having examined both supply and demand side arguments as to the cause of the depression in 1920, the more empirical evidence has pointed towards a heavier relevance of demand-side factors rather than supply-side shocks. This is not to say that I am discrediting any supply-side theories, only that I have not yet been able to satisfactorily prove them. I am certain that the initial boom, that may have in itself caused the depression that followed it, was stimulated by demand side factors, and encourage the train of thought that it was probably a failure in the interaction of aggregate supply and demand that ultimately caused the slump – again without proof. Economic historians have criticised the government of the time for its poor policy choice, in tightening monetary policy by increasing interest rates to try and curb inflation. The interest rate rise was both poorly timed to curb the boom, and left in place for too long, lengthening out the duration of the forthcoming depressed period. What I have been able to satisfactorily prove, is that supply-side shocks played a crucial role in sustaining the British economies depressed stated throughout the 1920’s and 1930’s. Although I cannot attribute the start of the depression to supply side shocks, I am confident and certain that it was those very supply-side shocks that made the time period one of such heightened depression.

Bibliography

Broadberry, S.N. (1986) ‘Aggregate supply in interwar Britain’, Economic Journal, 96 (2) pp. 467-81

Broadberry, S.N. (1990) ‘The emergence of mass unemployment: explaining macroeconomic trends in Britain during the trans-World War I period’, Economic History Review, 2nd ser. 43 (2), pp. 271-82

Broadberry, S.N. (1992) ‘The emergence of mass unemployment: a reply’, Economic History Review, 45 (4), pp. 739-42

Dimsdale, N. (1981) ‘British monetary policy and the exchange rate, 1920-1938’, Oxford Economic Papers, n.s. 33 (2, Supplement), pp. 306-49.

Dowie, J.A (1975) ‘1919 is in need of attention’, Economic History Review, 2nd ser. 28 (3), pp. 429-50

Glynn, S and Booth, A.E. (1992) ‘The emergence of mass unemployment: some questions of precision’, Economic History Review, 45 (4), pp. 731-8

Howson, S.K. (1974) ‘The origins of dear money, 1919-20’, Economic History Review, 2nd ser. 27 (1), pp. 88-107

Pigou, A.C. (1947) Aspects of British Economic History, 1918-1925. London: Macmillan.

Twigger, R. (1999) ‘Inflation: the Value of the Pound 1750-1998’, House of Commons Research Paper 99/20.

Aldcroft, D. (1986) The British Economy, Volume 1, The Years of Turmoil 1920-1951. Sussex: Wheatsheaf

Feinstein, C.H. (1972) National Income Expenditure and Output of the United Kingdom, 1855-1965. Cambridge.

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