The potential swine flu pandemic has emphasized once again the vulnerability of the global economy to being knocked off an even course by unexpected events, not all of which are as obviously based in past economic policy as the US housing finance disaster. Wars, epidemics, serious terrorist attacks and doubtless in the future ecological crises are all capable of devastating the finely tuned modern economic system. The government panic and misguided activity of the last six months have however made on thing abundantly clear: the world urgently needs a better designed paradigm for producing recovery.

Ordinary recessions, a product of a predictable business cycle, don’t seem to be much of a problem, and nor do stock market crashes taken by themselves. The last 30 years are full of examples of such events, during which governments either did nothing or confined themselves to moderate monetary and/or fiscal stimulus. In 1987, for example, monetary authorities in both Britain and the United States loosened policy after a stock market crash, preventing it from spreading. Likewise in 2001 both countries loosened monetary policy in face of a stock market crash, though in that case US policymakers kept rates too loose for too long.

The problem is that those remedies, both of which are generally popular with business and the public at large, are only effective when used in moderate doses against moderate, conventionally-caused recessions. In 1987, the stock market crash took prices down to reasonable levels, and policy prior to the boom had not been over-expansionary, so stimulus worked well. Likewise in 2001-03, the US budget was close to balance and so the moderate fiscal stimulus of the early Bush years did its job, particularly as it was accompanied by a modest supply-side effect from the 2001 tax rate cuts and a much larger one from the 2003 partial removal of dividend double taxation.

However loose monetary policy in the US and the UK in 1970-73 led to much higher inflation without producing much economic recovery. Similarly Britain’s mid-1970s fiscal stimulus under Harold Wilson produced a sterling crisis but did not cause the economy to recover. Fiscal and monetary stimuli are thus the equivalent of aspirin, effective in small doses against mild illnesses, but ineffectual against major maladies and dangerous if taken in excessive quantities. One need not be a pessimist, as I am, about their efficacy in the current crisis; one need only look at the huge fiscal and monetary stimulus employed in 1990s Japan to realize that fiscal and monetary aspirin can kill the patient if used against a serious disease.

Policymakers therefore need a recipe against serious economic traumas, which prevents them from turning into the Great Depression or Japan’s miserable post-1990 trajectory. It is reasonable to suppose that exogenous shocks to the economic system are more likely in a world of globalization, rapid communication and high population density than in the slow-communications, lower-population less integrated world of the 19th and early 20th century. One way or another, we can confidently expect at least one major economic crisis per generation, generally from a cause that is either non-economic or wholly unexpected beforehand, and we had better learn how to deal with them.

The first point to note in dealing with these serious crises is that the policy aspirins effective against lesser economic ills are positively harmful in these cases. This time round, the Bush “stimulus” of 2008 was not only ineffective, it dangerously increased the government’s borrowing requirements, reducing financial flexibility and increasing the capital starvation caused by the flight to quality in late 2008, Monetary stimulus used after 2001 to counter the effects of the stock market downturn produced the much more dangerous and widespread housing bubble.

The huge additional monetary and fiscal stimuli implemented since September have not yet imposed their costs but may be beginning to do so. The first quarter Gross Domestic Product deflator came in contrary to expectations of deflation at a 2.9% rise, while 10-year Treasury bond yields have now broken decisively above 3%. Both inflation and interest rates can be expected to push sharply higher in the months ahead.

To determine the policy response to a serious economic crisis, it is first necessary to consider what you are attempting to achieve: an economy in rapid recovery, generating large numbers of jobs at good pay rates, with capital formation and entrepreneurship active, inflation low or even negative and government reined in, so that the budget is either in balance or moving rapidly back towards it. The best recoveries from economic catastrophe have all taken this form – you can consider the British 1820s recovery from the Napoleonic Wars and postwar depression, the US 1920s recovery from World War I and postwar depression, the US 1945-60 recovery from the Great Depression, the German and Japanese 1950s recoveries from World War II and many others. Even in the Great Depression itself Britain, which followed these policies, fared much better than the US and Germany, which didn’t.

Attempted recoveries from catastrophe that have not taken this form have not worked. The German money printing of 1919-23 led to the Weimar hyperinflation and the impoverishment of the middle class. The British attempt to recover from World War II through Keynesian government spending and economic planning never got off the ground and lagged similar efforts in France and Germany, let alone Japan. Notoriously, Japan’s attempt to achieve prosperity through public sector infrastructure in the 1990s didn’t work. Russia’s post-Communist attempt in the 1990s to achieve prosperity through dodgy privatization and cheap money failed catastrophically. In each of these cases, other excuses can be made for failure, but the overall picture is clear; only the hard money, high savings, balanced budget approach can be relied upon to recover from a real crisis.

These policies have succeeded in the past centuries against wars and major economic collapse, but there is no reason to believe they will not work against other types of catastrophe, such as major epidemics or ecological disaster (which does not include only global warming; economic catastrophe could also result from uncontrollable pollution or a “nuclear winter” period of famine and disruption resulting from volcanic activity.) In each case, there would be special factors to be dealt with, such as a catastrophic loss of population, the abandonment of some central economic activity that had caused the pollution problem or relocation of much of the planet’s agriculture or industry to take account of new conditions. Nevertheless, there is no reason why the same central economic objectives should not hold true, whatever the cause of the initial disaster.

If a high saving, low-inflation, reined-in government environment is the necessary state for economic recovery from disaster, then the correct policies to pursue become obvious.
* Interest rates should be increased to provide adequate returns for savers and rebuild the capital stock.
* Public spending should be reined in sharply, in order to get closer to budget balance without having to increase taxes, which inevitably dampens activity.
* Economic losers should be starved of capital and liquidated, in order to free up resources for the new industries that need to arise.
* Inflation should be treated as a leper because of its erosion of savings, while a moderate amount of deflation should be welcomed, as it will increase the value of capital and thereby produce more and better new businesses.
* Trade should be freed up, in order that new business opportunities appear and Joseph Schumpeter’s “creative destruction” can work its magic.
* Labor laws should be eliminated as far as possible so that wages and employment can re-set to market levels, while labor mobility within the domestic economy should be encouraged. (However international labor mobility in a recession depresses living standards in the higher-wage economy, allowing unscrupulous employers to drive wages down to Malthusian levels.)

Against a major economic collapse, only these policies will work. They were employed by Lord Liverpool in 1815-25 Britain, by Andrew Mellon in the 1920s US, by Dwight Eisenhower and William McChesney Martin in the US after 1951-52 (when the US savings rate was over 10%, far higher than today), by Konrad Adenauer and Ludwig Erhard in Germany from 1948 through 1963, by Shigeru Yoshida and Hayato Ikeda in Japan from 1949 through 1964 and by Neville Chamberlain in 1931-37 Britain.

Maynard Keynes would grind his teeth in thwarted academic fury at the policies proposed. He disliked Chamberlain, disdained Mellon and Liverpool and would have hated the others. Yet they not he were true architects of economic recoveries and their policies not his failed nostrums should be adopted today.

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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)