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.