“The nation of which [Warren G.] Harding became president was not happy, and forces were underway which seemed likely, unless arrested, to bring more serious unhappiness.”

— journalist Mark Sullivan, 1935

As Harding took office in March 1921, Americans were in a funk, disillusioned by World War I and fearful of alleged radicals. But the main source of anguish and anger was the unstable economy, which in the span of three years had gone from an inflationary boom to a deflationary bust.

The wartime boom and easy credit had created full employment. From 1918 to 1919, General Motors’ payrolls swelled from 49,118 to 85,980. But the boom also stoked inflation, which averaged 16 percent annually from 1917 to 1919. Prices raced ahead of wages, triggering massive strikes of coal miners, steelworkers, longshoremen, garment workers and others. In 1919, one in five workers was a striker, the largest share ever. Meanwhile, high prices helped farmers, who fed a war-ravaged Europe. Their 1919 harvest was triple the value of its prewar predecessors.

Then came the bust. As Europe recovered and credit tightened, industrial America ground to a halt. GM’s sales were averaging 52,000 a month; by January 1921, they were 6,150. As companies sold bloated inventories, production, prices and wages declined; layoffs increased. A 1921 survey found 4.3 million jobless Americans out of a non-farm labor force of 28 million, indicating an unemployment rate of 15.3 percent. Farmers who borrowed to buy more land — assuming prices would remain high — couldn’t repay their debts. In the second half of 1920, the average price for 10 leading crops dropped 57 percent.

All this is interesting. But what’s it got to do with us?

Just this: It may help explain the halting recovery from the 2007-2009 Great Recession.

This disappointing recovery, you see, contrasts sharply with the 1920s experience, when the economy rebounded strongly. Depleted inventories had to be replenished; production restarted. Lower prices for building materials encouraged a housing boom. What explains the rapid recovery and why wasn’t it repeated a decade later in the Great Depression?

James Grant thinks he has answers. Grant has written an elegant history of the 1920-1921 depression from which my brief description is drawn. The lesson, Grant argues, is that if left alone, the economy generates powerful recuperative forces. He writes:

“The hero of my narrative is the price mechanism. . . . In a market economy, prices coordinate human effort. They channel investment, saving and work. ... The depression of 1920-1921 was marked by plunging prices, the malignity we call deflation. But prices and wages fell only so far. They stopped falling when they became low enough to entice consumers into shopping, investors into committing capital and employers into hiring. Through . . . falling prices and wages, the American economy righted itself.”

Grant is a respected financial commentator. He publishes a regular newsletter (“Grant’s Interest Rate Observer”) and has written seven other books. He’s also an unrepentant and unromantic champion of markets — unrepentant because he thinks they stimulate creativity and unromantic because he acknowledges they often make huge mistakes (but have the virtue of being self-correcting).

The proposition at the core of his book — “The Forgotten Depression” — is counterintuitive. It is that modern economic policies and norms, by attempting to prop up the economy, may impede recovery.

Grant argues, for example, that the downward rigidity of wages in the 1930s prolonged and deepened the Great Depression, contrasting unfavorably with the 1920-1921 depression. He concedes that his laissez-faire approach might result in harsher recessions but also suggests that it would produce stronger recoveries. Grant disputes the conventional wisdom that falling wages and prices would doom the economy to a prolonged collapse by reducing incomes and making debts harder to repay. To the contrary: Lower prices might encourage spending and lower wages might encourage hiring.

Until recently, Grant’s critique could be easily rebutted. With the exception of the inflationary 1970s, the post-World War II economy seemed to outperform its prewar predecessor. Recessions generally occurred less frequently and were milder. As to the Great Depression, the dominant explanation remains that the gold standard was the main villain. The legal requirement that money be backed by gold forced countries into restrictive policies until gold was gradually abandoned.

Still, it’s no longer possible to be so dismissive. The recent financial crisis and the (unpredicted) weak recovery have exposed economists’ fragile grasp of reality. There has been a massive destruction of intellectual capital: Old ideas of how the economy functions and can be improved have been found wanting. Since the Great Depression, governments are expected to react to economic slumps with countercyclical policies that reverse the downturn and relieve personal suffering. These understandable impulses may compromise the economy’s recuperative rhythms. That’s a troubling possibility that echoes from the 1920s.

Read more from Robert Samuelson’s archive.