Recent economic data have caused economic commentators to begin wondering whether the U.S. economy is heading into a “double-dip,” prolonging the period in which employment and output run far below potential. Once again, this raises parallels with the 1929 crash, which led to a Great Depression that in the United States was only ended by the onset of World War II. So this time, are we due for a decade of non-recovery, before natural forces or a second Armageddon rescue us in 2020 or so?

In the Great Depression the absolute bottom in economic activity occurred early on in 1932, but a second sharp downturn in 1937-38 led to economic misery only slightly less severe than the nadir six years earlier. This time around, the initial plunge in 2008-09 was considerably less severe, albeit worse than any post-war downturn. However economic theory in relation to such major economic traumas is poorly established. There would indeed appear no reason why a different set of misguided economic policies in such a trauma could not produce a result with a different pattern.

Make no mistake about it, while exceptionally deep economic downturns may be caused by particularly painful economic dislocations, such as the bank collapses that triggered the Panic of 1837, exceptionally prolonged economic traumas result mainly from misguided policy meddling. Keynesian theories of unforced suboptimal equilibriums that can persist for decades are very unconvincing indeed. When examined closely such disequilibria have clear policy links. For example the British 1920s economic sluggishness (which triggered Maynard Keynes’ musings) was caused by Britain’s 1925 return to the Gold Standard at an overvalued parity without having passed an Imperial Preference tariff to “level the playing field” against Britain’s protectionist competitors. (Stanley Baldwin’s feeble 1923 attempt to introduce such a tariff failed, and it was only in 1932 that Neville Chamberlain secured one through the Ottawa Agreements – after which Britain’s economic performance, absolute and relative, improved hugely.)

In the U.S. Great Depression three major policy errors caused the unprecedented downturn. The Smoot-Hawley tariff of 1930 decimated international trade. Then the Fed’s lack of response to the bank collapses that began in December 1930 kept real money supply too tight and caused an international banking meltdown beginning with the Creditanstalt crash in May 1931. Finally Herbert Hoover’s irresponsible crony capitalist slush-fund spending through the Reconstruction Finance Corporation was followed by an increase in the top rate of income tax from 25% to 63%, which caused the final lurch to the bottom in 1932.

Following the advent of the Franklin Roosevelt administration in March 1933, further policy errors aborted the exceptionally strong bounce-back that began in 1933 and 1934. First, the NRA production codes cartelized industry, keeping prices artificially high and sabotaging the initial recovery in demand. Second, the 1933 repudiation of bond issue gold clauses, backdated for existing obligations, and the break-up of the banks under Glass-Steagall brought great capital market uncertainty and sharply limited new issue capacity, so that the volume of new financings fell for several years below the levels of the 1920-21 recession and stayed there until 1940-41. Then the 1935 Wagner Act and the forced unionization of the automobile industry drove costs up to excessive levels throughout the economy, thus stymieing the market’s attempt to return to full employment. Finally the Fed, by raising reserve requirements in 1936-37, repeated its tight-money mistake of 1930-32, tipping the economy back into recession.

Without Hoover’s policy mistakes in 1930-32, the Great Depression would have become nothing like as deep as it did, producing perhaps an 8-10% real drop in GDP rather than the 25% drop that actually occurred. Without Roosevelt’s policy mistakes, even after Hoover’s errors, the U.S. economy would have bounced back much more quickly and robustly than it did, closing in on full employment and moving to a new high in real per capita GDP in 1936 or so, rather than delaying that attainment until 1940-41.

This time around, policymakers have more or less avoided all three of Hoover’s errors, but have replaced them with new errors of their own. To avoid the bank failures of 1931-33, they have not only supplied large amounts of money, avoiding the 1930-33 Fed error, but have pushed interest rates down to exorbitantly low levels and kept them there, thus rekindling inflation and particularly an out-of-control boom in global commodity prices. Then, misreading the fiscal policy mistakes of 1931-32, they have indulged themselves in over $1 trillion of worthless fiscal stimulus, mostly through federal spending on energy boondoggles and bloated union contracts, thus crowding out the small-company sector and giving the U.S. government a creditworthiness problem it completely lacked in 1931-33. Bank commercial and industrial loans, the main source of finance for the small business sector, have not recovered from the market nadir in 2009 and are still almost 25% below their 2008 level. Finally, unlike in the 1930s illegal immigration has been uncontrolled, greatly increasing the downward pressure on wages for low-skill labor and increasing domestic unemployment and underemployment.

Because policymakers avoided Hoover’s errors, the 2008-09 recession was nothing like as deep as that of 1929-33, with real GDP falling only 4.2% from the fourth quarter of 2007 to the second quarter of 2009. However the costs imposed by current policymakers’ different errors must now be paid. The government’s diversion of resources from productive industry to unproductive uses has caused GDP and workforce growth to be exceptionally sluggish in this recovery, with an emergent tendency to slide back into recession. The over-easy monetary policy may have reflated the banks in 2009, but has now produced an excessive commodity price inflation that is spreading into the overall economy, bringing the likelihood of inflation much more rapid and virulent than in the U.S.1970s.

The closest comparison to the current situation is not the U.S.1970s but the British 1970s, where money supply growth got further out of control than in the U.S., and where the election of a left-oriented Labour government in February 1974 produced a surge in public spending and the budget deficit that took it to dangerous levels over double those of the U.S. 1970s, but quite similar to those of the U.S. in 2009-12.

The good news? Britain never had a housing crash in the 1970s. With cheap money, inflation rose to 25% in 1975 and remained so high that the incipient house price decline was aborted as nominal incomes rose to meet house prices and mortgage levels were eroded by inflation. Banks, holding mostly nominal assets, were downsized in real terms like the Incredible Shrinking Man, making them completely uncompetitive when the London market was opened fully to competition in the following decade and wrecking an industry that had been the backbone of British wealth for over 200 years. However homeowners felt nothing like the pain of U.S. homeowners in 2008-11. In a similar fashion, a burst of inflation now will greatly mitigate any future pain in the U.S. housing market and assist its recovery – at the cost of creating a chronically undercapitalized banking system.

What happens now depends on what policy is pursued. At one extreme, a watertight agreement between Democrats and Republicans on sharp cuts in public spending, combined with a realization by the Fed that inflation is a major danger, requiring sharply positive real interest rates (and presumably accompanied by the forced resignation of Ben Bernanke) would in the short term produce a sharp decline in commodity prices, a major stock market crash (to a low of 4,000-5,000 on the Dow) and a deep recession, taking GDP down perhaps 6-8% from its current level. Essentially we would pay today the stored-up costs of past fiscal and monetary folly, producing a second “dip” in the economy that was somewhat more severe than the first. However that second dip would probably be far less damaging in terms of employment than the first dip; the return of sharply positive real interest rates – perhaps a Federal Funds rate of 10% if inflation was running at 6% — would cause businesses to seek ways to substitute labor for suddenly expensive capital, causing new jobs to appear even as bankruptcies removed the old ones. Once bottom had been reached, probably within 12-18 months from the decline’s start, a true economic recovery would begin that would rapidly increase demand for labor as in 1983-84, quickly reducing unemployment except for those unfortunate souls whose skills had atrophied due to the duration of their enforced leisure.

At the opposite and unfortunately more likely extreme, the two sides will fail to agree on serious budget cuts and will be panicked by signs of renewed downturn into yet more foolish and damaging public spending “stimulus.” Monetary policy will remain accommodative, and Bernanke will bring in a “QE3” program of further Fed purchases of government bonds. In that case, the initial further decline in output will be modest, or possibly hidden altogether in quarterly statistics, but inflation will race past 10% per annum and unemployment will increase more rapidly than would be expected from such a modest output decline.

In the latter case, we are indeed destined for a Great Depression, reversed temporally from the 1930s version with hyperinflation and a major crash in its latter stages towards the end of this decade. Nothing is forever, and doubtless the U.S. economy would eventually emerge from the ruins – but with very much lower living standards than it currently enjoys, as much of its output and most of its capital would have been lost to the thrifty and temperate Asians.

If we are to have a double dip, we had better hope the second down-leg is a deep one, with much higher interest rates, stern economies in government and a Dow dropping by two thirds from its current levels. The alternative, of a mild dip assuaged by an intensification of current misguided policies, is in the long run far more unpleasant.

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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.)