James Grant’s excellent new book, The Forgotten Depression: 1921: The Crash That Cured Itself, tells the story of “America’s last governmentally untreated depression.”

Just prior to the Roaring Twenties, the U.S. went into a deep economic slump but soon recovered—despite no active government stimulus policies. That sort of government inaction, of course, is very different from what we find in all subsequent economic downturns.

Grant’s book, consequently, has received sharp criticism from some economists eager to reject the notion an economy can recover without massive government intervention.

These critiques miss the mark for several reasons. First, most of the criticism counters arguments that Grant doesn’t even make. Additionally, one of the more serious critiques gets bogged down in the age-old fallacy that lower interest rates always reflect easy monetary policy.

George Selgin’s recent response does an excellent job of refuting both of these bogus criticisms. This column is meant to complement George’s post.

The main theme of Grant’s book is that there was a major inflation, followed by a severe deflation, and the economy rebounded with virtually no government intervention. During this period, there was nothing remotely like a fiscal stimulus package, a TARP program, or even a QE policy designed to prevent economic collapse.

In fact, because there was a previous (war-induced) inflation, people accepted that prices had to fall back to their “normal” levels. In econ-speak, prices had to fall back to their natural equilibrium levels.

Failure – or perhaps refusal – to accept this equilibrium story is one key source of the recent criticism of Grant’s book. Grant now stands accused of advocating for a policy of deflation, but he actually does no such thing.

Specifically, Grant does not claim a policy of deflation, simply for the sake of forcing prices downward, cured the 1920 slump. He does, however, argue that deflation helped to cure the slump because prices had previously been inflated well above their equilibrium values.

In other words, a major recovery took place in the U.S. – even though there was a major deflation – because the government allowed the price mechanism to work.

That sort of hands-off policy is the complete opposite of what we’ve seen in every subsequent downturn. In these more “modern” times, the government bends over backwards to prop up prices (including wages) no matter what.

But, as Grant points out, the very concept of “the economy” was only beginning to take shape in 1920. As this concept developed, of course, more people began clamoring for specific types of government intervention to fix the supposedly broken free market.

Grant points out that, in 1923, Keynes argued “It is obvious that an individualist society left to itself does not work well or even tolerably….The more troublous the times, the worse does a laissez-faire system work.”

Keynes further argued – much like Irving Fisher – that the main source of these troubles was “the instability of the standard of value.” Many people now take for granted that we need some kind of government agency to actively stabilize prices, but this concept was brand new in 1920.

To be sure, the level of intolerability in the U.S. during the 1920-21 incident was subjective, but the voting public certainly did not reject the status quo. When President Harding died in 1923, Calvin Coolidge took over. Coolidge was then overwhelmingly elected in 1924, with roughly three times the votes of the Progressive PGR -1.28% candidate, Robert LaFollette, and approximately twice those of the Democratic candidate, John Davis.

Regardless, there simply was no massive government intervention to “boost” the economy out of the 1920 Depression. It is true that the Fed was operating at this time, though, and critics are completely wrong to accuse Grant of pretending that the “the Fed barely even existed then.”

Throughout the book Grant makes many references to – and provides detailed explanations of – Federal Reserve policies during this period. And it’s not simply to disparage the Fed. For example, Grant states:

"Public policy made one signal contribution, at least, to the improvement in American finances. This was in the all-important matter of interest rates. It was welcome news when the Federal Reserve Bank of Boston cut its main discount rate to 6 percent from 7 percent, effective April 15. It was the first easing move by any Federal Reserve bank since the previous spring. The Federal Reserve Bank of New York followed on May 4 with a reduction to 6.5 percent from 7 percent. This move the market correctly interpreted as the beginning of the end of the era of ultrahigh interest rates (high enough in nominal terms, extra lofty when adjusted for the declines in prices and wages). Bond yields, which had been gently falling since May 1920, now began to nosedive."

If anything, Grant gives too much credit to the Fed. As Selgin discusses, this lowering of the discount rates did not indicate expansionary monetary policy. (Charts 21 and 24 from Friedman and Schwartz further support Selgin’s stats.)

There’s also detailed evidence presented throughout Grant’s book showing that the recovery worked because prices adjusted back to their equilibrium levels. Prices had become inflated and, though painful for a time, the fact that they were allowed to seek their lower equilibrium levels did not prevent a robust recovery.

The process wasn’t painless, and Grant doesn’t shy away from that fact. For example, he notes:

"Plunging prices were bane and blessing, all at once. They made American exports more competitive and American investments more alluring (certainly, more value laden). They made the governors of the Federal Reserve Board more amenable to considering a reduction in interest rates. They delivered relief to the inflation-wary shoppers, at least to those who still held jobs."

But the U.S. did recover and prosper. And there’s also some evidence that the U.S. recovered more quickly because markets were allowed to clear – a sharp contrast to Great Britain’s experience.

While a forced return to the gold standard was a popular explanation for Britain’s economic problems, Grant points out that there was another view.

Sir Josiah Stamp, “banker, economist, and industrialist,” blamed the British government’s refusal to let the price mechanism work. Stamp concluded: “Instead of allowing economic forces to operate freely, the tendency, since the War, has everywhere been in the opposite direction.”

For the most part, the rest of the world’s governments soon followed suit. Standard post WWII central banking policy, for instance, is to prevent prices from falling. Deflation has become synonymous with depression, even though the empirical evidence suggests otherwise.

Today, the Fed is viewed as an economic stabilizer extraordinaire because it finally “tamed” inflation. Yet its reputation is actually much better than its track record.

Evidence suggests, for example, that the average length of recessions, as well as the average time to recover from recessions, has been slightly longer in the post-WWII era than in the pre-Fed era.

This finding holds even though we’re ignoring the Depression era. The Fed was up and running then too, of course.

 - Norbert J. Michel is a research fellow specializing in financial regulation for The Heritage Foundation’s Thomas A. Roe Institute for Economic Policy Studies.