4 Ways to Turn a Recession Into a Depression

Hoo, boy. Wall Street, as well as America's Investor Class, ought to find the following statement reassuring. Here is Senate Majority Leader Harry Reid on the credit crisis, "No one knows what to do. We are in new territory here." Well, my first piece of advice would be to do nothing. Punish Wall Street? The market is already doing that. Crack down on super risky home loans? The market is already doing that, too.

Moving forward, however, Washington might want to crack open some history books and examine just how bad policy from Washington turned an economic downturn into the Great Depression. Here are handy tips for what not to do:

1) Close the banks. This is the biggie—not letting the financial system disintegrate. Thank goodness it is already being handled by de facto copresidents Hank Paulson and Ben Bernanke. (In the end, though, the American taxpayer may well have to provide M.O.A.B.—the Mother of All Bailouts.) Indeed, Bernanke is a student of the Great Depression and understands well the key role of the Federal Reserve in such a crisis. In fact, he has explicitly blamed bad Fed policy for turning a 1920s downturn into a 1930s economic catastrophe.

2) Raise taxes. Another classic. The Revenue Act of 1932 was at the time the largest peacetime tax increase in American history. The top rate, for instance, went from 25 percent to 63 percent. Economists agree this is one of the dumbest things Herbert Hoover did. Alas, it is a mistake we might be getting ready to repeat.

3) Unnerve business. With the economy shaky, the last thing you want to do is to raise uncertainty about government policy as it affects business. And there is a lot of that going on right now. Will the Bush tax cuts be extended? Will government nationalize healthcare? Will carbon emissions be taxed? The same was true during FDR's administration. Recall the anticompetitive National Recovery Administration, for instance, with its myriad business rules and regulations. As economic historian Amity Shlaes noted in this interview earlier this year: "Both the Hoover and Roosevelt administrations (but especially the Roosevelt administration) were so unpredictable. That hurt the economy very much, and when I went back and saw the extent, I was astounded.... During the Depression, you heard the phrase "bold, persistent experimentation" all the time. We've been taught that was good. Somebody had to do something, was what we learned. But what I saw was this enormous cost, especially during the second half of the 1930s."

4) Start a trade war. The raising of tariffs always gets plenty of blame for the Great Depression. And while most economists have learned the lesson of Smoot-Hawley, politicians have not. There are sorts of anti-China bills floating around Congress that seek to penalize that nation for its weak currency, blamed by some for our huge trade deficit with that nation. A weak economy in 2009 might provide more momentum for protectionists on Capitol Hill.

So how to improve the economy? Cutting taxes and avoiding hastily prepared new regulations are good starts. Reforming our entitlement system would also go a long way to restoring the faith of international investors in our economy and government.