When Barack Obama urged passage of his so-called stimulus measure in February, he claimed that only bold government action would prevent the economy from slipping into a deep depression. In making that argument, he was only repeating the conventional wisdom, according to which markets are not self-correcting—except in the very long run—and state intervention is necessary to revive economic activity.

Economic theory can tell us why these claims are incorrect and why, in fact, even the appearance of prosperity that those measures can produce causes still greater damage and leads to a more severe correction in the long run. But we can also refer to the testimony of history. In particular, the depression of 1920-21, which most people have never heard of, is an example of the resumption of prosperity in the absence of government stimulus, indeed in the face of its very opposite. If economies cannot turn around without these interventions, then what happened in this instance should not have been possible. But it was.

During and after World War I, the Federal Reserve inflated the money supply substantially. Once the Fed finally began to raise the discount rate—the rate at which it lends to banks—the economy slowed as it started readjusting to reality. By the middle of 1920, the downturn had become severe, with production falling by 21 percent over the next 12 months. The number of unemployed people jumped from 2.1 million in 1920 to 4.9 million in 1921.

From 1929 onward, Herbert Hoover and then Franklin Roosevelt tried to fight an economic depression by making labor costlier to hire. Warren G. Harding, on the other hand, said in the 1920 acceptance speech he delivered upon receiving the Republican nomination, “I would be blind to the responsibilities that mark this fateful hour if I did not caution the wage-earners of America that mounting wages and decreased production can lead only to industrial and economic ruin.” Harding elsewhere explained that wages, like prices, would need to come down to reflect post-bubble economic realities.

Few American presidents are less in fashion among historians than Harding, who is routinely portrayed as a bumbling fool who stumbled into the presidency. Yet whatever his intellectual shortcomings—and they have been grotesquely exaggerated, as recent scholars have admitted—and whatever the moral foibles that afflicted him, he understood the fundamentals of boom, bust, and recovery better than any 20th-century president.

Harding likewise condemned inflation: “Gross expansion of currency and credit have depreciated the dollar just as expansion and inflation have discredited the coins of the world. We inflated in haste, we must deflate in deliberation. We debased the dollar in reckless finance, we must restore in honesty.”

And instead of promising to blow unprecedented sums, he called for cutting back:

We will attempt intelligent and courageous deflation, and strike at government borrowing which enlarges the evil, and we will attack high cost of government with every energy and facility which attend Republican capacity. We promise that relief which will attend the halting of waste and extravagance, and the renewal of the practice of public economy, not alone because it will relieve tax burdens but because it will be an example to stimulate thrift and economy in private life.

The economy, Harding explained in his Inaugural Address the following year, had “suffered the shocks and jars incident to abnormal demands, credit inflations, and price upheavals.” Now the country was enduring the inevitable adjustment. No shortcuts were possible:

All the penalties will not be light, nor evenly distributed. There is no way of making them so. There is no instant step from disorder to order. We must face a condition of grim reality, charge off our losses and start afresh. It is the oldest lesson of civilization. … No altered system will work a miracle. Any wild experiment will only add to the confusion. Our best assurance lies in efficient administration of our proven system.

Harding was true to his word, carrying on budget cuts that had begun under a debilitated Woodrow Wilson. Federal spending declined from $6.3 billion in 1920 to $5 billion in 1921 and $3.3 billion in 1922. Tax rates, meanwhile, were slashed—for every income group. And over the course of the 1920s, the national debt was reduced by one third.

In contrast to Japan, which engaged in massive government intervention in 1920 that paralyzed its economy and contributed to a severe banking crisis seven years later, the U.S. allowed its economy to readjust. “In 1920-21,” says economist Benjamin Anderson,

we took our losses, we readjusted our financial structure, we endured our depression, and in August 1921 we started up again. … The rally in business production and employment that started in August 1921 was soundly based on a drastic cleaning up of credit weakness, a drastic reduction in the costs of production, and on the free play of private enterprise. It was not based on governmental policy designed to make business good.

That is not supposed to happen, or at least not nearly so quickly, in the absence of fiscal or monetary stimulus. But who are you going to believe, Paul Krugman or your own eyes?

Naturally, some modern economists who have looked into the matter have been stumped as to how economic recovery could have occurred in the absence of their cherished proposals. Robert Gordon, a Keynesian, admits, “government policy to moderate the depression and speed recovery was minimal. The Federal Reserve authorities were largely passive. … Despite the absence of a stimulative government policy, however, recovery was not long delayed.” Kenneth Weiher, an economic historian, notes, “despite the severity of the contraction, the Fed did not move to use its powers to turn the money supply around and fight the contraction.” He then briskly concedes that “the economy rebounded quickly from the 1920-1921 depression and entered a period of quite vigorous growth,” but (as with most such historians) he chooses not to dwell on this development or learn anything from it.

Weiher, in fact, notes with some condescension that “this was 1921, long before the concept of countercyclical policy was accepted or even understood.” Er, yes, and lacking those indispensable tools, the American economy rebounded all the same.

The reader has probably noticed that Harding’s advice and course of action are basically the exact opposite of the conventional wisdom in political and media circles today. The government has to do something, we’re told. Barack Obama has said that economic downturns degenerate into long-term depressions because governments fail to act with sufficient vigor to head them off.

It is not mere coincidence that the economy returned to health relatively quickly following the downturn of 1920, while on the other hand depression conditions persisted throughout the 1930s, a decade of government activism. It is precisely because monetary and fiscal stimulus measures were avoided that sound economic progress was possible.

The very ideas of fiscal and monetary stimulus stem from a misdiagnosis of the causes of economic depressions and then apply exactly the wrong remedies. The problem is not with an inadequate level of spending, but that in the wake of a central bank-induced boom, the capital structure is out of conformity with consumer demand. The recession is the period in which this mismatch is rectified through the reallocation of capital into more appropriate channels. Fiscal and monetary stimulus only interferes with and delays this purgative process.

Harding, unlike our political class today, actually understood this. The 20th-century president we’re most taught to hate saw the United States through an even worse downturn than the one we’re experiencing now by simply allowing the free market to make the necessary adjustments. And Harding, as his remarks indicate, pursued the policies he did not out of inertia or because he was incapable of conceiving of alternative approaches. This despised figure was in fact a far better economist than most of the geniuses who presume to instruct us now.

Today we have a president urging us to learn the lessons of history, and there are indeed lessons to be learned. But to the state and its purchased intellectuals, history is an instrument to be placed at the service of the propaganda demands of the moment, not an impartial source of wisdom or instruction.

That’s why watching events unfold in our own time is like watching a slow-motion train wreck. We know it has to end in disaster, and we’re helpless to stop it. We know politicians won’t learn whatever lessons history has to teach. But if they won’t learn them, we must, if only to prepare ourselves for the disaster that is coming.  
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Thomas E. Woods Jr. is the author of nine books, most recently the New York Times bestseller Meltdown.

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