When you hear the word "depression," you probably think of the Great Depression of the 1930s. What many people don't know is that a decade earlier, a severe depression occurred that didn't make it into most history books. While World War I brought a victory for the Allies, it left the U. S. with the burden of $23 billion in additional debt. (For related reading, check out What Caused The Great Depression?)

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Between 1918-1920, inflation touched 20% and the post-war economy looked grim. In response, by June, 1920, the New York Federal Reserve Bank had increased the discount rate to a record 7%. When Warren Harding became president in March 1921, unemployment had tripled to 12%. Gross National Product (GNP) had plummeted 17% and Harding found himself under tremendous pressure to initiate massive government intervention to stave off a financial collapse. Some of that pressure was coming from his Secretary of Commerce (and future president), Herbert Hoover. (Find out more about GNP in Don't Be Misled By Gross National Product.)

History's Lessons
Historical perspective is often resurrected when a new crisis develops, and the 2008 financial meltdown is no different. It's interesting to note, however, that the history that is now being cited is what was done by the Roosevelt administration to combat the Great Depression. The subject of the "lost depression" of 1920-21 has rarely been mentioned.

In fact, the actions taken by Roosevelt and Harding were polar opposites. Roosevelt followed the conventional wisdom of Keynesian economists that significant government intervention in the form of fiscal and monetary stimulus is the only way to secure recovery from an economic downturn. Even if this is done at the expense of huge borrowing and staggering deficits, so the theory goes, it will all work out in the long-term as the economy recovers.

It's no secret that U.S. Federal Reserve Chairman Ben Bernanke is a disciple of Keynesian theories. Bernanke, a self-professed student of the Great Depression, has injected massive amounts of fiscal stimulus into the system to prop up the U. S. economy. Would Bernanke have done anything differently had he been a student of the lost depression? (Find out more about Keynes and his ideas in Giants Of Finance: John Maynard Keynes.)

Harding Takes Bold Action
Defying conventional wisdom, Harding slashed taxes and cut federal spending in half. Rather than propping up failing businesses and policies, he forced credit and financial markets to restructure to current conditions, encouraged businesses to reduce production costs and relied on the free markets to reset asset values and investment allocations. Without government intervention, the economy responded quickly and began to rally during the summer of 1921. A year later the unemployment rate had retraced to 6.7% and dropped to 2.4% by 1923.

In the process, the national debt was reduced by a third while the Federal Reserve watched from the sidelines. Contrary to what is being done today, the Fed did not fight the contraction by pumping up the money supply. Harding resisted all the Keynesian economists who advocated running huge deficits to prime the pump. As a result, he was ridiculed as being old-fashioned since he believed in balanced budgets and low taxes. What was barely noticed is that a sustainable recovery was now on the horizon.

Why It Worked
Turning contemporary economic theory upside-down, Harding instituted policies that produced quick results. Companies in trouble did not receive emergency loans since that would only perpetuate failed business models, and the money supply was not increased. Instead, capital was redistributed to entrepreneurs that understood consumer needs and the reality of current conditions. Loans were directed at sound businesses that were prepared to expand production and hire more workers. (Learn more about the moral hazards involved in bailouts in The Whens And Whys Of Fed Intervention.)

By cutting government spending, valuable resources reverted to the private sector where they could be used to realign the capital structure. Markets rapidly adjusted and two consecutive years of price deflation occurred in 1921-1922. This stimulated consumer demand and business investment.

Quick Recovery
Many who subscribe to Keynesian theory are at a loss to explain or even acknowledge the dramatic recovery engineered by President Harding. Shunning all the macroeconomic tools that were later omnipresent during the New Deal, Harding avoided spiraling deficits, public works projects and the inflationary monetary policy now being advocated by most world governments.

He didn't view the depression as capitalism gone wrong, but only a normal business cycle whereby the economy reorients itself to new realities and prevailing conditions. Rather than fight that reality through federal intervention, he let the adjustment take place naturally in the free markets. What followed was a decade of powerful economic growth, otherwise known as the "Roaring Twenties".

Bottom Line
While not noted as a great orator, Harding said it best in his own way on the occasion of his inauguration in 1921:

"We must face the grim necessity, with full knowledge that the task is to be solved, and we must proceed with a full realization that no statute enacted by man can repeal the inexorable laws of nature. Our most dangerous tendency is to expect too much of government, and at the same time do for it too little. We contemplate the immediate task of putting our public household in order. We need a rigid and yet sane economy, combined with fiscal justice, and it must be attended by individual prudence and thrift, which are so essential to this trying hour and reassuring for the future."

Catch up on the latest financial news, read Water Cooler Finance: Shocking Court Rulings, Sinking Markets.

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