Amity Shlaes explains in the latest issue of Forbes magazine why one point of modern economic consensus is wrong.
AT SOME POINT consensus becomes dogma. In the case of U.S. monetary policy we’ve about reached that point. Ask any authority you like and you’ll hear that loose is good and looser is better. The dogma of “loose” prevails at all stages of the business cycle, but especially if you want to reduce the damage of a recession. “The central irony of a financial crisis,” former Treasury Secretary Lawrence Summers said, “is that while it is caused by too much confidence, too much lending and too much spending, it can only be resolved with more confidence, more lending and more spending.”
This theory, which author James Grant has labeled “Summers’ Paradox,” features corollaries: Inflation is good, deflation is evil; spending is good, thrift is “dangerous.” Consumer spending matters most. Wages are and ought to be “sticky downward”: They should stay high in a downturn to stimulate spending. Income inequality hurts the rest. Evidence that suggests another view rarely appears in general history books.
All the more valuable, therefore, is The Forgotten Depression–1921: The Crash That Cured Itself (Simon & Schuster, $28), the history in which Grant mentions Summers’ Paradox. In his well-argued monograph Grant documents that tighter can be better, that stimuli are not necessary, that wages can come down and–get this–that austerity can be salvation.
Grant’s account will disorient the reader. Modern textbooks bill the 1930s as the period of the Depression. Grant shows that the downturn of the early 1920s also earned the “Depression” label: Joblessness climbed to 12%, the Dow dropped by nearly half, and the economy contracted dramatically.
An early Keynesian by the name of F. Scott Fitzgerald sketched the event as a failure of capitalism.
Second, the 1920s downturn was intentionally brought about by policymakers in both parties. “We will never be able to bring about the desired deflation until the general extravagance is curtailed,” a former comptroller of the currency said, explaining the necessity for raising interest rates. Officials deemed a postwar price rise dangerous, not a benign symptom of growth. If the government didn’t squeeze prices down, a banker noted, “it would mean that all the savings of the people which are in the form of savings bank deposits, promissory notes or life insurance are in large part, perhaps one-half, wiped out as with a sponge.” Therefore, officials doubled interest rates to 7%. They encouraged companies to lower wages and reduced federal stimulus by cutting federal spending.
These moves feel so counterintuitive today that the reader gets the sense Grant has taken him for a ride–on the wrong side of the road. Or that Grant is insisting there really is adequate oxygen for a walk on the moon. Still, the austerity policy of the early 1920s worked. Within two years the economy was booming again, averaging real and nominal growth of more than 3%. Joblessness dropped below 5%. Farmers found jobs in the cities. Its very brevity explains why the early 1920s depression was, as per Grant’s title, “forgotten.”
