Best Do Nothing

What can we learn from the economic consequences of the First World War?

The Comptroller of the Currency was dismayed to find his chauffeur buying three silk shirts. He should have been saving up, so his passenger thought, not wasting his substance on riotous shirting. This was how people behaved in a bubble. It would burst. It did.

We still have soap in our eyes from the bubble that burst half a dozen years ago, and we know the feeling. The comptroller’s successors have been busy ever since, on both sides of the Atlantic, printing money, rescuing banks and nailing interest rates to the floor. They have made sluggish progress. In The Forgotten Depression  (Simon & Schuster, $28), James Grant, Wall Street’s historian, tells the story of an earlier bubble’s bursting, when the damage was left to look after itself. It did. 

A century ago, war had set every combatant government to borrow as much as it could, and as cheaply. Late into action, the United States hurried to catch up. Credit was plentiful, prices took off, and an activist President, Woodrow Wilson, vainly sought to hold them down by fiat, blaming profiteers and impounding their stocks of eggs. Silk shirts were good business for a later President, Harry Truman — until everything changed and his shop had to shut.

The change came suddenly. Farm prices, share prices, staple prices all crumbled. Millions of Americans were thrown out of work, and the big steel companies kept their plants open — or some of them — by cutting wages. The big banks turned out to have been behaving badly — punting in the market and financing the punts of others — and had suffered for it. Does that sound familiar? 

Faced with a full-scale depression, what was an activist President to do? Woodrow Wilson could do nothing. Campaigning by rail across the country, needing to carry the terms of peace he had brought back from Europe, he had suffered a stroke and was paralysed. His incapacity was covered up, but his party drifted to defeat at the election. His successor, Warren Harding, was a genial senator whose slogan had been “Back to normalcy.” He believed in sound finance and balanced budgets, but was more of an inactivist. 

Depression and deflation ran their course for about a year and a half. By then, costs and prices were so much reduced that the survivors in business could afford to rebuild their stocks — and their workforce, too. Wage costs had fallen far enough to make industry profitable. The optimists, says Grant, began hiring first. The realists had to follow and to pay the market rate. The stage had been set for America’s Roaring Twenties. 

What had caused the depression? Inflation, says Grant. It ended when prices became low enough to entice consumers into shopping, investors into committing capital and employers into hiring. What it shows is the price mechanism at work: Adam Smith’s “invisible hand”. These remedies are no longer prescribed.

The modern treatment was set out by Larry Summers, Harvard sage and sometime Secretary of the Treasury: “Financial crisis is caused by too much confidence, too much lending and too much spending — but can only be cured with more confidence, more lending and more spending.” This requires overruling the price mechanism and manipulating the market, on what is now an unprecedented scale. 

Like other medical treatments, this one runs the risk of being more addictive and less effective in equal proportions. It is easier to start than to stop and harder still to reverse. Grant’s lively history shows us what constructive inaction can do.

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