The current market consensus has the world economy continuing to grow, with modest inflation brought under control by a modest further increase in interest rates, and the worst case scenario being a mild downturn like those of 1990-91 (outside Britain, where it was severe) and 2001-02. Anything worse is thought to be unlikely; central banks are believed to have mastered the techniques of delivering stable economic growth without triggering either deep recession or inflation. Needless to say, this view is Panglossian in its optimism.

The business cycle has produced more economic myths than almost any other aspect of the dismal science. Before 1800, it did not exist. While there are signs of credit cycles in such phenomena as the Dutch tulip bulb mania and the South Sea Bubble, the principal drivers of changes in economic activity were wars and poor harvests.

Wars damaged particular regions but with 18th Century military technology did not devastate them (even the Thirty Years’ War, the most damaging before 1914, left much of Germany more or less untouched.). More important, they caused credit crunches by drying up sources of finance for governments, maybe causing a wealth-destroying default.

Agricultural fluctuations produced economic cycles but they were random; a run of bad harvests could certainly produce economic downturn or even starvation but there was no way of forecasting it, and conditions in the rest of the economy had very little effect on it.

Only after 1800, when the industrial sector, fueled by credit, became an important part of the economy did the business cycle emerge. The first such cycle of significance was the boom/bust cycle of 1820-30, which culminated in a stock market and emerging markets boom in 1825, followed by a collapse of several major banks and economic recession for the rest of the decade. As mentioned in this column a few weeks ago, the Prime Minister of the time, Robert, Lord Liverpool, was notable in denouncing the 1825 wave of speculation while it was in progress; he appears to have foreseen the first major cyclical downturn with considerably more clarity than later politicians with experience of previous such events. Unlike free markets, children and animals, politicians never seem to learn from experience!

Under the 1819-1914 Gold Standard monetary system, cyclical downturns were severe but generally short lived. Typical were the cycles of 1873, which led to agricultural depression in Britain but a rapid resumption of growth in the United States, and 1893-96, severe in the United States due to a gold-shortage deflation, but already well on the road to recovery by the time of the 1896 election. Occasionally, bad policy made a cycle worse; this happened in 1837, when Andrew Jackson’s battle against the Second Bank of the United States had deprived the country of a usable common currency, leading to severe monetary uncertainty, bankruptcies by even solid states such as Pennsylvania and an economic downturn that lasted half a decade.

Following the 1913 formation of the Federal Reserve System and the abandonment of the Gold Standard in 1914, cycle management initially became significantly worse. The 1920 postwar downturn was severe but brief, but the 1923-29 upswing was accompanied in the United States by a great deal of chest-beating about how the Fed had improved monetary management, and expansion, fed by lax Fed policy, continued significantly longer than it would have under the pure pre-1914 Gold Standard.

Needless to say, what followed wasn’t pretty. It was made worse by policy errors in the political sphere, notably the Smoot-Hawley Tariff of 1930 and the tax increase and public spending binge of 1931-32, but the initial mistake, omitting to reflate the money supply when mass bank failures hit after the Bank of the United States failed in December 1930, was the Fed’s. 1937-38 brought another unpleasant recession, without the prior consolation of a preceding boom; the fault appears again to have been excessive Fed tightening, combined with the 1934 Glass-Steagall Act’s effect in devastating the U.S. capital market.

For the quarter century after World War II, the business cycle did indeed appear to have been conquered, with downturns such as that of 1957-58 being far shallower than in the 19th century, and an overall rapid upward trend in output, productivity and living standards that far exceeded any comparable period before or since. A great deal of intellectual energy was accordingly spent on “proving” that the combination of expansionary monetary policy and Keynesian government finance was a panacea through which deep recessions could be avoided through adroit “fine tuning.”

The recessions of 1973-75 and 1980-82, in both Britain and the United States, changed all that. While 364 economists signed an open letter to the London Times in 1981 begging for a return to pre-1973 policies, it was already clear that those polices had failed and that recessions nastier than any since World War II could not be wholly avoided. In terms of productivity gains, the 1973-82 period was a lost decade in the United States, and it was only the institution of tighter government spending control and very tight control of money supply by President Ronald Reagan and Fed chairman Paul Volcker in 1981-82 that conquered inflation (at least temporarily) and returned the U.S. economy to something close to its historic growth track.

The caution of the 1980s was thrown away in the 1990s. Monetarism, which had worked so well in 1979-82, was abandoned in 1993, and M3 money supply was increased at a rate close to 9% per annum, that by no stretch of the imagination could be said to be consistent with stable prices. After the U.S. Federal budget was balanced in the late 1990s, restraints on spending were abandoned with the defenestration of Newt Gingrich as Speaker of the House of Representatives at the end of 1998. Inflation data was fudged, first by the mechanism of “hedonic prices” in 1996, then by ignoring the huge rise in housing costs in the second reflation of 2001-05. Money supply creation continued after 2000 at a frantic pace worldwide, and sharp and prolonged rises in the prices of oil, gold and other commodities were ignored.

Three explanations are usually trotted out as to why “it’s different this time.” First, bulls point out the subdued nature of reported inflation until very recently, and suggest that traditional monetarist rules about money creation have been proved false by inflation’s mild behavior. Second, bulls propound the theory that a “productivity miracle” has occurred in the U.S. economy, allowing it to move onto a track of faster growth, higher asset prices and lower inflation than would have been possible a generation ago. Third, bulls point to “globalization” and how an unparalleled level of integration between the world’s economies, and of migration of both people and business between countries, has allowed prices to enter a virtuous cycle of decline in which new sources of labor are forever entering the traded market and bringing ever cheaper goods to the consumer.

As discussed here the other week, the subdued behavior of inflation in the last decade is due, not to the repealing of traditional laws of economics, but to the one-off effect of the communications revolution, which enabled a level of outsourcing that had not previously been possible. A similar effect was seen in the 1873-96 period, with the opening of Midwest and Argentine agriculture to the world market, and the consequent decline in world food prices. Only the discovery of new gold deposits in South Africa and the Yukon in the late 1890s ended the deflation that this caused; since money supply was at that time fixed the deflation resulted in declining stock and real estate prices, not escalating ones. Like the communications revolution, the 1873-96 deflation confused economists at the time.

When productivity figures are examined critically, there has been no U.S. productivity miracle; in fact productivity has increased rather more slowly since 1995 than in 1948-73. The principal effect of the claimed productivity miracle, due partly to the change in U.S. price indices in 1996, has been to provide an excuse to policymakers why an asset overvaluation even more extreme than in the late 1920s need have no baleful effect.

Beyond the communications revolution, globalization, in the sense of lower tariffs and increased migration, has been no more extreme since 1990 than it was in 1870-1914. Its effect has been similar – it has reduced prices, and hugely benefited capitalists, but at the expense of reducing the real incomes of a huge segment of the population whose jobs it has placed at risk. Just as sweatshops and refrigerated transportation in the 19th century threatened the livelihoods of the lower-skilled rural and urban population so today illegal immigration and outsourcing threaten the livelihoods of their descendents. Just as John D. Rockefeller in 1900 was far richer than Cornelius Vanderbilt in 1860, so Bill Gates in 2006 is far richer than John Paul Getty in 1966. The increase in wealth of the richest and immiseration of the economically immobile poor is not due to economic growth, but to globalization, and its resulting deflation and polarization of economic rewards.

The economic polarization of the late 19th century had important political effects; it resulted in the rise of unionization and government regulation, and in a racism and nativism that produced a resurgence of the Ku Klux Klan and eventually resulted in the Immigration Act of 1924. For entirely valid reasons the political results of the current globalization are likely to be similar. The popular support for immigration restriction and anger at President George W. Bush’s amnesty proposals are likely to intensify rather than diminish – it has huge economic momentum behind it. Protectionism, too, is the wave of the future as it was in the late 19th century – inhabitants of rich countries are happy to assist the development of the Third World, but not at the expense of their own livelihoods. The Bill Gates of the world will object, as did the wealthy in 1900-20, but in a democracy there aren’t very many of them. It is to be hoped, however that we can this time be spared yet another revival of the Ku Klux Klan.

Wall Street, the Fed and the Bush administration want desperately to believe that they have succeeded in repealing the business cycle, just as did their predecessors in the “permanent plateau of prosperity” of 1929 or in the lengthy and apparently inflation-free upswing of the 1960s. Like Herbert Hoover and Lyndon Johnson, they will be disappointed. By fiddling the figures, ignoring the price effects of the communications revolution and shilling for an asset price bubble greater and longer lasting than any in world history, they have postponed the downswing but they cannot avoid it. This time, since asset prices reached unprecedented heights for an unprecedented period of time, the liquidation of values must inevitably be exceptionally severe.

Economically and politically, there are grim times ahead.

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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.)

This article originally appeared on United Press International.