CROSS … Government should butt out of recessions.

History shows less government intervention during recessions equals more growth

Not surprisingly after seven years of watching governments furiously pull every policy lever at their disposal without restoring healthy growth, analysts are questioning their efficacy. The latest example is The Forgotten Depression, by legendary bond market guru James Grant. It recounts how U.S. policymakers cured a severe depression in 1920 by doing nothing, making it “America’s last governmentally unmediated depression.” Actually there was a muted policy response, but it involved the polar opposite of what today’s conventional economic wisdom would prescribe: Government balanced the budget, raised interest rates and then patiently waited for business confidence to be restored. As Grant wryly observes, “here is a history of instructive inaction.”

There were some important differences between the economy of 1920 and today’s. Most obviously, there was no such thing as “the economy” in public debates and political parties did not run on how it was best managed. The Federal Reserve Board had just been created, followed by the adoption of income tax to help finance the war. There was not the daily dribble of data that analysts today pore over to divine where the economy is headed. The 1920 depression did lead the U.S. government to launch the Survey of Current Business (a statistics-based review of the economy) and the National Bureau of Economic Research (which famously declares when recessions begin and end), thereby setting in motion the creation of today’s gigantic statistical-media complex that futilely attributes meaning to the economy’s every gyration.

U.S. policymaking also was paralyzed by a crippled President (literally, after Woodrow Wilson suffered a severe stroke) and deadlock between a Democratic President and a Republican Congress so severe that the British ambassador lamented that “the U.S. has no government.” The recently created Federal Reserve Board felt it had done its part by assuring there were no bank failures during the depression, keeping interest rates at punishing levels even as prices declined.

So how did the economy pull itself out of depression and deflation so quickly, setting up the boom that became known as the Roaring Twenties? In Grant’s telling, the hero is “the price mechanism, Adam Smith’s invisible hand.” With minimal government interference and regulation, prices and wages were free to adjust to the drastic turn in business conditions. Maximum flexibility in wages and prices meant the instability transmitted to output and employment was minimized.

In contrast, the Federal Reserve Board during the 1920s began to target price stability as its goal; more specifically, it focused on consumer prices, as the Fed ignored the growing bubble in asset prices such as the stock market. The result of the fixation on price stability, according to Grant, was the unprecedented instability of output and jobs in the 1930s, made worse by the interventionist policies of Herbert Hoover, who effectively launched the First New Deal, and then Franklin Roosevelt. Both encouraged employers to not cut wages, forcing employment to absorb all the reduction in labour costs as firms vainly tried to protect their profit margins.

Grant is far from the first person to point an accusatory finger at government’s role in the Great Depression of the 1930s. Amity Shales in The Forgotten Man concluded that “from Hoover to Roosevelt, government intervention helped to make the Depression Great.” Milton Friedman decades ago showed that the refusal of the Fed to prevent bank failures from contracting the money supply turned a routine recession into a catastrophe. Ben Bernanke, then a governor of the Federal Reserve Board, famously declared at Friedman’s 90th birthday in 2002 that “You’re right, we did it. We’re sorry. But thanks to you, we won’t do it again.”

For all our self-proclaimed sophistication about economics, it’s not clear how much our understanding of the economy has improved over the last century. Bank runs were supposed to be impossible, until 2008 proved they could still occur outside of retail banking. In some areas, we may even have regressed; in 1920, people accepted the existence of the business cycle as easily as the changing seasons. Gary Gorton, the leading scholar of banking crises, argues that we exaggerate the importance of stability in our “history-less” and risk-averse society.

Between 1870 and 1900, the U.S. experienced eight recessions, and spent as much time contracting as expanding. Yet the expansions were glorious, with the U.S. experiencing transformative growth that lifted it past Britain as the world’s leading industrial nation. More recently, Asian economies that suffered financial crises in 1997-1998 such as Thailand and South Korea nevertheless have outperformed countries like India that emphasize stability.

What is novel and important about Grant’s book is that it highlights how the exact opposite of today’s hyperactive policies worked in 1920. Lower prices, which have spooked economists and the public because of their association with the “Dirty Thirties,” in fact were the key to helping, not hindering, the recovery. The ability to create and innovate trumps stability over the long haul, despite the inevitable instability these processes generate in the short-term.

The exact opposite of today’s hyperactive policies worked in 1920