Recovery Without Bailout

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The New York Sun

Recovery without federal bailout? Impossible.

That’s what we think as we watch the Federal Reserve and the Treasury move to rescue Bear Stearns Cos., Fannie Mae and Freddie Mac, and now, American International Group Inc.

Bailout was the rule in preceding slumps as well. From the New Deal to the Chrysler bailout of 1979, to Long-Term Capital Management LP to today, bailouts are what America does.

So the only thing remaining to think about is exactly when the next bailout will come — when, say, General Motors Corp. and the other automakers will get more cash. Or whether Robert Willumstad deserves that exit package of $7 million for his three-month tenure as chief executive officer of AIG. Or if the chairman of the Federal Reserve, Ben Bernanke, struck a smart deal on behalf of the taxpayer.

In fact, recovery is possible without bailout. It happened right here in America back in the early 1920s.

In 1919, as in 2007, the country was on a roll. Unemployment was 1.4%. The Dow Jones Industrial Average hit 119, almost double what it had been in 1917. The young Fed and the Treasury had been inflating the money supply in order to pay off World War I debt.

Then the Fed began raising the discount rate. Also, gold was leaving America, another contractionary force.

The recession was sharp. Unemployment moved up to 5.2% in 1920 and 11% in 1921. The Dow lost almost half its value. Political anxiety was part of the story. A wave of strikes was hitting the country. The attorney general, Alexander Mitchell Palmer, was conducting a series of raids across the country to root out suspected radicals. There was a sense that the revolution in Russia might replicate itself here. Progressives were gaining a great following.

Companies ran into trouble, even some in forward-looking industries such as autos. One such company, Kissel Motor Car Co., had thrived during the war, when it had made trucks for the U.S. Army.

Another was GM, which in 1920 saw its stock plummet to 12 7/8 in November from 42 earlier in the year. GM’s business had been “substantially curtailed during recent weeks in view of the falling off of demand of automobiles,” the New York Times reported. Then, as now, GM was emblematic.

What to do? Herbert Hoover, then Commerce secretary, argued that employers must not cut wages and called for collective bargaining.

What about the companies? A bailout did come for GM — but not from the government. Pierre S. Du Pont and J.P. Morgan took control, buying until they held more than 51% of the company. “Deal embraces move to stabilize the nation’s entire automobile industry,” the Times wrote. Many automakers, including Kissel, weren’t as lucky.

Washington, for its part, didn’t do much bailing. Nor did it attack Wall Street, as House Speaker Pelosi, a Democrat, and, for that matter, the Republican presidential candidate, John McCain, are doing.

To Hoover’s displeasure, government didn’t manage to persuade companies to sustain wages. Wages were cut by more than 5% even “before business had reached a dangerous position,” as a scholar, Don Lescohier, has noted. At the Treasury, meanwhile, Andrew Mellon hacked away at tax rates.

Recovery arrived as suddenly as recession had. By 1923, unemployment was down again, to 2.4%. The Dow climbed back, although taking longer to do so. The economy spent the rest of the decade growing in exemplary fashion. What had been good for GM proved good for America.

Why? As always in crashes, the economy needed to readjust to its new smaller base, says W. Gene Smiley, the author of the primer “Rethinking the Great Depression.” In the early 1920s, that adjustment was the right kind. Prices came down.

Forcing the adjustment by attacking companies or getting them to share the wealth just slows the recovery, Mr. Smiley says. It’s better to allow an adjustment to the new, smaller world through prices, including wages.

A decade later Hoover, and then Franklin Roosevelt, did prop up wages and bash companies. Both men blamed Wall Street as well; Roosevelt, of course, expanded the government. Recovery eluded the country for another decade.

Mr. Smiley makes a subtle, crucial point: The sharper the downward movement — think of Wednesday’s 449-point loss in the Dow — the more people believe a bailout is necessary. But that 60% decline in the Dow of the early 1920s was a good thing, reflecting an economy able to adjust.

It is possible to write new rules that provide incentives to make investment banks act the way J.P. Morgan and Du Pont did in the GM case. One change, put forward by Charles Calomiris of Columbia University and others, would allow government bailouts. But in such instances, government would make other investment banks share the cost by bearing the first tier of losses before taxpayers.

Such a rule would discourage unnecessary bailouts, since banks would lobby against them, and therefore reduce overall taxpayer risk. Commercial banks already do so under the Federal Deposition Insurance Corp. Improvement Act of 1991.

Economic history these days is becoming news, so badly do we all desire context for the week’s events. The Democratic presidential candidate, Senator Obama, is already positioning himself as the heir to Roosevelt, ready to offer a New New Deal. And Americans tend to believe that a Rooseveltian program represents the most successful form of crash management. But as the 1920s show, there’s more than one way to get to recovery.

Miss Shlaes, a senior fellow in economic history at the Council on Foreign Relations, is a columnist of Bloomberg News.

The New York Sun

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