that at the beginning of 1920, and given the small reduction in the workweek that occurred, hourly productivity probably did not fall at all. At the low point in factory employment in the summer of 1921, output per worker was somewhat higher than when the downturn began in early 1920. Indeed, productivity was remarkably stable during the downturn, only to rise robustly during the recovery that began in the fall of 1921.
The fall in employment and the corresponding rise in unemployment is well explained by the sharp rise in the adjusted real wage, which in turn was entirely a consequence of the price deflation. As figure 4.1 illustrates, the adjusted real wage peaked in precisely the quarter when employment reached its lowest point. Note that the adjusted real wage never returned to the level prevailing at the beginning of 1920—but neither did factory employment.
TABLE 4.3 QUARTERLY EMPLOYMENT AND LABOR MARKET INDICATORS, U.S. 1920–1923
FIGURE 4.1 EMPLOYMENT AND THE ADJUSTED REAL WAGE, QUARTERLY DATA, 1920–23
A statistical examination of data similar to that in table 4.3 reveals what the figure tells us visually, namely that there is a striking and statistically significant negative correlation between the adjusted real wage and factory employment. A model regressing wholesale prices, money wages, and productivity (output per worker) against factory employment shows an expected positive relationship between price and productivity movements and employment, and a negative relationship between money-wage changes and employment. Moreover, the relationships are statistically significant and the overall explanatory power of the model is high (R2 = .86).
As already noted, the root cause of the rising real wage and accompanying fall in employment was the acute price deflation. Changes in monetary variables fit the price history of the downturn reasonably well. According to Friedman and Schwartz, the money stock peaked in May 1920 at $30.3 billion (the same quarter in which prices peaked), falling by 8.9 percent to $27.8 billion by the third quarter of 1921, the same quarter in which prices reached a low point. Over the next year, prices increased by about 10 percent.19
At the same time, a monetarist explanation does not tell the entire story. The stock of money in the third quarter of 1920 was actually greater than in the first quarter, yet over 30 percent of the observed decline in factory employment had already occurred. Rising money wages in the first months of 1920 rather than falling prices seems to explain the initial employment downturn.
The decline in prices was so substantial-about as great as in the Great Depression that followed—that it seems difficult to attribute it solely to an 8 percent fall in the money stock. There was, by any measurement, a sharp decrease in the velocity of money. The American experience was similar to that in most other countries, and indeed the Federal Reserve Board actually attributed the American price decline to falling prices overseas.20 Certainly the Federal Reserve’s raising discount rates twice in 1920—to a record of 7 percent that stood for over half a century—contributed to the decline in borrowings from the Federal Reserve that led to a sizable decrease in the monetary base. Unlike after 1929, there was no decline in depositor confidence, as the deposit-currency ratio actually increased. This was not sufficient, however, to offset the impact of a highly contractionary monetary policy. The Federal Reserve seemed to have failed in its first peacetime attempt at monetary and price stabilization.
The fall in the income velocity of money that accompanied this monetary policy is not too surprising in light of contemporary experience. When inflationary expectations increase, as they did during World War I and 1919, the opportunity cost of holding cash balances rises and people conserve on those balances, maintaining relatively small amounts of cash (money) for any given income. When prices fall, after having risen for many years, inflationary expectations are shattered, particularly when the long-run historical trend was for prices to remain roughly stable. Accordingly, the perceived opportunity cost of holding cash falls, and people start to increase their cash balances. Since demand deposits paid interest, and since prices in any case were falling, the real rate of return on cash balances in 1920 and 1921 was actually very high—those balances were getting more valuable daily as prices fell. Thus the deflationary impact of a decline in the stock of money was furthered by the resulting fall in velocity associated with changing expectations.
EVIDENCE FROM THE IRON AND STEEL INDUSTRY
Readers of the last chapter and the discussion above might be dubious of our statistical evidence on the relationship between real wages and unemployment on the grounds that we are dealing with highly aggregative data for the whole economy. Do our findings hold if we reduce the analysis to the level of the individual industry? Is there some sort of “aggregation bias” that gives a false wage-employment relationship that falls apart when individual industry wage, price, and productivity data are used?
Fortunately, data exist to examine the relationship between factory employment and money wages, prices, and labor productivity on a quarterly basis for 1919 through the second quarter of 1923 for the iron and steel industry, one of the nation’s largest.21 That industry underwent wrenching changes in the period, with steel output in the third quarter of 1921 being two-thirds less than in the first quarter of the previous year.
The findings tend to confirm the wages hypothesis. A regression model explaining iron and steel employment in terms of metal prices (largely iron and steel), money wages in the steel industry, and output per worker in that industry, using quarterly data, works well, explaining nearly 93 percent of the variation in steel industry employment over that period. That variation was extraordinary, with employment dropping almost precisely 50 percent between the first quarter of 1920 and the third quarter of 1921. The expected positive relationship between prices, productivity, and employment is observed, statistically significant at the 1 percent level. The expected negative relationship between money wages and employment is not obtained; there is evidence, however, of multicolinearity (strong intercorrelation among the variables in the model.)
To deal with this, we eliminated one variable by using a model regressing real wages and productivity against employment; it works in the expected fashion:
where STELEMP is employment of production workers in the iron and steel industry; RLWAG is the real wage, unadjusted for productivity change; PRDTY is productivity per worker, and numbers in parentheses are standard errors; an autoregressive adjustment term is omitted. All variables are indexed with the first quarter of 1919 equal to 100.
The model works as predicted. Increases in real wages are associated with reduced employment (increased unemployment), while productivity and employment are positively related. Both variables are significant at the 1 percent level, and the model explains over four-fifths of the considerable variation in employment over the four-and-a-half-year period.
CONTEMPORARY ANALYSIS OF THE 1921 DEPRESSION
Our explanation of unemployment in 1920–22 is not new, but rather is a reaffirmation and rediscovery of what several economists observed during and shortly after that downturn. Both Paul Douglas and Alvin Hansen noted the sharp rise in real wages occurring during the period.22 Hansen attributed the rise in unemployment to the fact that wages were “much higher than the industrial situation warranted.”23 Downward wage adjustments to deal with the economic situation had
