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What caused the recession of 1937-38?
Vox ^ | 11 September 2011 | Douglas Irwin

Posted on 09/13/2011 3:07:14 AM PDT by 1010RD

The swift policy response to the recent financial crisis helped the world economy avoid a replay of the Great Depression of 1929-32. But can we avoid a replay of 1937-38? With the world economy weakening once again, this column addresses the question with a renewed urgency and comes up with an oft-overlooked explanation – the Treasury Department's decision to sterilise all gold inflows starting in December 1936.

The recession of 1937-38 is sometimes called “the recession within the Depression.” It came at a time when the recovery from the Great Depression was far from complete and the unemployment rate was still very high. In fact, it was a disastrous setback to the recovery. Real GDP fell 11% and industrial production fell 32%, making it the third-worst US recession in the 20th century (after 1929-32 and 1920-21).

The recession is often attributed to a tightening of fiscal and monetary policy. Christina Romer (2009) and others have argued that it is relevant to today’s situation because it illustrates the dangers of a premature withdrawal of stimulus when the economy is still weak.

But the recession remains somewhat of a mystery because the two most frequently mentioned causes – the reduction in the fiscal deficit and the Federal Reserve’s decision to double reserve requirements – do not appear to have been powerful enough to generate a recession of the magnitude seen. For example, Romer (1992) herself has argued that “it would be very difficult” to attribute much of the decline in output to changes in fiscal policy.1 And most studies of the Fed’s doubling of reserve requirements – most recently, Calomiris et al (2011) – have concluded that it had little impact on banks because they held abundant excess reserves, which they did not seek to rebuild after the new requirements took effect.

If fiscal retrenchment and higher reserve requirements cannot fully explain the recession, then what can? There is no doubt that there was a severe monetary shock. As Figure 1 shows, the money supply (M2) grew at a consistent rate of about 12% a year from 1934 to 1936, but then suddenly stopped growing in early 1937 and even fell later in the year. The monetary shock, however, was not the Federal Reserve’s decision to increase reserve requirements, but the often overlooked Treasury Department decision to sterilise all gold inflows starting in December 1936.

Figure 1. US money supply (M2), 1934-39

When the dollar was re-pegged to gold at $35 per oz. in January 1934, the US essentially went back on a gold standard. Gold reserves constituted 85% of the monetary base and changes in those reserves accounted for most of the changes in the monetary base. Because the US received large gold inflows in the mid-1930s, monetary policy was expansionary. This was the primary reason for the economic recovery (Romer 1992).

But when the Roosevelt administration began to worry about the potential for higher inflation, the Treasury Department decided to sterilise all gold inflows starting in December 1936. In essence, its new gold holdings were held in an inactive account rather than with the Federal Reserve, where it would have become part of the monetary base and money supply. Thus, instead of allowing the monetary base to grow with the inflow of gold, the monetary base was essentially frozen at its existing level.

The economy faltered in the spring of 1937 and tanked in the autumn of 1937. In February 1938, having realised its error, the Treasury ended its policy. In April 1938, the Treasury implemented its exit strategy and began desterilising its inactive gold holdings. The economy began to recover in June 1938.

The effect of the gold sterilisation policy on the monetary base is shown in Figure 2. The gold stock and monetary base grew consistently from 1934 to 1936. Although gold stocks continued to grow in 1937, the monetary base flatlined because of the sterilisation. The non-sterilised gold stock is flat until the Treasury began desterilising its gold holdings in April 1938.

Figure 2. US monetary base and gold stock, 1934-39

The impact of gold sterilisation and higher reserve requirements on the money supply can be separated by noting that gold sterilisation affects the monetary base while reserve requirements affect the money multiplier. In a recent paper (Irwin 2012), I find that changes in the monetary base were much more important than changes in the money multiplier in explaining the abrupt end to the growth of the money supply in 1937.

Notice also that gold inflows into the US essentially ceased in late 1937 until mid-1938. The sudden halt to gold inflows was due in part to fears that the Roosevelt administration would respond to the recession by devaluing the dollar, just as it had done in response to the Great Depression in early 1933. (Fool me once, shame on you, fool me twice, shame on me, seems to have been the view of financial markets.) However, gold began surging back into the US in September 1938 when Hitler’s territorial demands on Czechoslovakia (the Munich crisis) set off fears of a European war.

If we are to avoid the mistakes of the past, it is important to have an accurate assessment of what those past mistakes were. The severity of the Recession of 1937-38 was not due to contractionary fiscal policy or higher reserve requirements. By contrast, the policy tightening associated with gold sterilisation was not modest – it did not simply reduce the growth of the monetary base by a few percentage points, it stopped its growth altogether. While the Federal Reserve is often blamed for its poor policy choices during the Great Depression, the Treasury Department was responsible for this particular policy error.

The recession of 1937-38 occurred long ago, but it does have policy lessons for today. It suggests that, in a weak recovery, a pre-emptive monetary strike against inflation (which was very low at the time, as it is today) is capable of producing a devastating recession.


TOPICS:
KEYWORDS: 1937; 1938; depression; gold; goldbugs; hardmoneymyths; history; recession; silver
Key Points:

1. the reduction in the fiscal deficit and the Federal Reserve’s decision to double reserve requirements – do not appear to have been powerful enough to generate a recession of the magnitude seen.

2. 'It suggests that, in a weak recovery, a pre-emptive monetary strike against inflation (which was very low at the time, as it is today) is capable of producing a devastating recession.'

3. It indicates that the policy of 'repatriation of profits' being held overseas by transnationals can have a very stimulative effect on the US economy in the same way that gold inflows did during the Depression.

1 posted on 09/13/2011 3:07:15 AM PDT by 1010RD
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To: 1010RD
What caused the recession of 1937-38?

FDR and the Communists in his administration.

2 posted on 09/13/2011 3:29:50 AM PDT by SkyPilot
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To: 1010RD

I tend to agree that the gold-sterilization policy was the primary cause of the recession within a depression. Secondary causes were the passage of the National Labor Relations Act in 1935 and Roosevelt’s threats to tax corporate retained earnings.

The former set off a firestorm of strikes and violent union organization. The latter, designed to get business to invest, served only to reinforce fears and led business to cling to its capital more fiercely.

In the end, FDR’s patrician disdain for common merchants (capitalists) caused him to implement scores of policies which worked against what he claimed to promote. It’s interesting to re-live those times now.


3 posted on 09/13/2011 3:35:04 AM PDT by BfloGuy (Keynesians take the stand that the best way to sober up is more booze.)
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To: 1010RD

Bush’s fault.


4 posted on 09/13/2011 3:38:22 AM PDT by lowbridge (Rep. Dingell: "Its taken a long time.....to control the people.")
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To: 1010RD
Interesting article. Thanks for posting it.

Some have suggested that we have little inflation despite an expansionist monetary policy because of excess supplies of both capital and labor and because of a lack of velocity. People and companies that have money are saving it or using it to reduce debt, rather than spending it. For example, many people are refinancing their mortgages not primarily to reduce their monthly payments but to reduce the term of the debt and the total interest they will pay over time. They are moving to 15 year and even 10 year mortgages.

Perhaps people (and companies) are choosing this conservative path because they believe that the risks of using their capital in more agressive ways are not justified by the potential returns. If so, the challenge for policy makers at all levels is to find ways to reduce the risks and increase the potential return associated with the deployment of capital. The threat of higher taxes and the actual imposition of an expanded regulatory regime by the Obama administration would seem to be exact of oppositie of what we need in that regard.

5 posted on 09/13/2011 3:38:39 AM PDT by p. henry
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To: p. henry

I would strongly recommend a reading of The Forgotten Man (2007). It lays out the 1920s, and how things fell apart, and how the prolonged depression just kept going. Excellent reading and worth the effort.


6 posted on 09/13/2011 4:06:31 AM PDT by pepsionice
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To: p. henry
That's a very good point. It would seem to suggest that high capital gains taxes -- or fears of higher capital gains taxes -- are driving behavior among many investors right now. Capital gains taxes are not high these days (from a historical perspective), so the latter would clearly be the case.

Interestingly, we may now be seeing one of the negative impacts of the "Bush tax cuts" of the early 2000s. The reduction in the tax rate on qualified corporate dividends has reduced (or eliminated) the gap between the tax rate on capital gains and the tax rate on corporate dividends. Without that preferential tax treatment for capital gains, many investors have simply decided that earning current income is a far better proposition than investing for the future.

"A bird in the hand is worth two in the bush," as they say.

7 posted on 09/13/2011 4:07:31 AM PDT by Alberta's Child ("If you touch my junk, I'm gonna have you arrested.")
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To: 1010RD

the key domino was smoot-hawley....and the sudden contraction of the money supply...


8 posted on 09/13/2011 4:07:36 AM PDT by joe fonebone (Project Gunwalker, this will make watergate look like the warm up band......)
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To: BfloGuy
FDR’s patrician disdain for common merchants

Outstanding and correct. Patrician, here meaning arrogant, is completely accurate and describes liberals to a T. Their desire for elitism causes them to disdain all others as unsuited to the task. That's Obama & Co.

FDR's antisemitism was also a cause and is repeated by Obama.

9 posted on 09/13/2011 4:16:47 AM PDT by 1010RD (First, Do No Harm)
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To: 1010RD
I think the substantial rise in income tax rates for higher-end incomes that started with the 1936 tax year had a LOT to do with why the US economy nosedived again.

This is why we should seriously look at going to the Steve Forbes no-loophole 17% flat-rate income tax with its generous initial earned income exemptions as the minimum for a massive income tax reform that will hyper-stimulate the economy.

10 posted on 09/13/2011 4:35:58 AM PDT by RayChuang88 (FairTax: America's economic cure)
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To: 1010RD

Can/did Obama time-travel?!?


11 posted on 09/13/2011 4:48:31 AM PDT by Caipirabob ( Communists... Socialists... Democrats...Traitors... Who can tell the difference?)
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To: SkyPilot
Exactly, read The Forgotten Man by Amity Shlaes. FDR was the most destructive thing that ever happened to the USA including the Civil War. It is likely we will never fully recover the republic we had before FDR.
12 posted on 09/13/2011 5:47:42 AM PDT by muir_redwoods (Somewhere in Kenya, a village is missing an idiot)
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To: pepsionice; p. henry
This is propaganda.

Damned effective, too. What Obama is up to (stand by for blinding glimpse of painfully obvious) is building a re-election case based upon the "need" for more spending to "keep the recovery going." Cleverly offering that $250 a week forever to the 20% of the work force who remain unemployed is the key. The "Infrastructure jobs," with its retro-emotion of the WPA is also a wonderful ploy. (This also reinforces the latino vote, because every, i.e. EVERY infrastructure job I have seen is staffed by Mexicans!)

The recession of '37-39 gradually ended, not because of any government action, but because the British Empire was at war and transferred a major portion of its very considerable wealth to the US in payment for war materiél. Employment picked up and finally took off when the Japs and Hitler declared war in 1941.

Team Obama might be out looking for a war right now. The difference is that even with Roosevelt and his marxist-dominated administrations, the government was nowhere near the the vast economic sinkhole it is nowadays. That means we would risk collapse supporting the government and a war.

The government(s) is simply consuming too much of the country's wealth. IMHO, about 25% too much. How the hell do you end that?

13 posted on 09/13/2011 6:28:17 AM PDT by Kenny Bunk (Team Obama will not shrink from violence to remain in power. Be ready.)
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To: Kenny Bunk
How the hell do you end that?

At this point, I don't think "we" can end it. It's going to have to fall apart for us to have a chance of rebuilding it now, as it seems to have gained a life of it's own.

14 posted on 09/13/2011 6:42:28 AM PDT by Avalon Hussar
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To: muir_redwoods
FDR was the most destructive thing that ever happened to the USA including the Civil War. It is likely we will never fully recover the republic we had before FDR. Actually I would argue that FDR just continued the policies of Woody Wilson and TR but there has not been an administration that was able to dismantle the monster created as Coolidge did with the Wilsonian power grab.However, I believe the 16th and 17th amendments (allowing the IRS to dossier each American citizen and removing the ability of the individual states to limit federal power) along with the globalism of the League of Nations / UN have been the most destructive forces in American history.

The argument could be made though that FDR was able to use what Woody left him to do the damage that he caused.

15 posted on 09/13/2011 6:55:46 AM PDT by Cowman (How can the IRS seize property without a warrant if the 4th amendment still stands?)
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Comment #16 Removed by Moderator

To: Yosemitest

Excellent and worth its own thread. Harding suffered from a terrible administration and cronyism. He isn’t the worst President in history, but liberals do all the picking so they skip their heroes. Harding’s death gave us Coolidge and Coolidge’s son’s death gave us Hoover.

From Wikipedia: Coolidge had been reluctant to choose Hoover as his successor; on one occasion he remarked that “for six years that man has given me unsolicited advice—all of it bad.”

http://en.wikipedia.org/wiki/Calvin_Coolidge#1924_election

Hoover gave us FDR and a line of socialist refuse running right to the current occupant of the WH.


17 posted on 09/13/2011 7:35:43 AM PDT by 1010RD (First, Do No Harm)
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To: 1010RD
Click on this.
18 posted on 09/13/2011 7:39:17 AM PDT by Yosemitest (It's simple, fight or die.)
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To: 1010RD

On a related note, contrary to popular belief, the depression wasn’t caused by the stock market collapse. The economy was limping along after the crash until Hoover decided to put the recovery on the backs of the rich in the form of absurd tax hikes for the “rich”. It was at that point the economy slipped speedily into a depression.

They just never learn, & those that don’t learn form history are doomed to repeat it.


19 posted on 09/13/2011 8:11:48 AM PDT by Confab
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To: Yosemitest

Excellent and worth its own thread. Harding suffered from a terrible administration and cronyism. He isn’t the worst President in history, but liberals do all the picking so they skip their heroes. Harding’s death gave us Coolidge and Coolidge’s son’s death gave us Hoover.

From Wikipedia: Coolidge had been reluctant to choose Hoover as his successor; on one occasion he remarked that “for six years that man has given me unsolicited advice—all of it bad.”

http://en.wikipedia.org/wiki/Calvin_Coolidge#1924_election

Hoover gave us FDR and a line of socialist refuse running right to the current occupant of the WH.


20 posted on 09/13/2011 8:31:41 AM PDT by 1010RD (First, Do No Harm)
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To: joe fonebone

“the key domino was smoot-hawley....and the sudden contraction of the money supply...”

Smoot-Hawley’s role in the Depression is vastly overrated. International trade accounted for less than 5% of GNP at that time. America was a virtually self contained economy.

But the money supply collapse over the years 1930-33 was a huge factor. A full one third of American banks failed in that span and 30% of the money supply evaporated. There was no FDIC in that era and depositors were wiped out.


21 posted on 09/15/2011 9:41:51 PM PDT by Pelham (Islam. The original Evil Empire)
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To: Pelham

smoot-hawley started a trade war with the world....the first domino was the farmers, who exported 30% of their crops...I do not know of a business that could survive that..as the farmers failed, so did the banks they did business with...the suppliers of seed and fertilizer and farm equipment suddenly lost their customer base...they failed, and so did the banks they did business with... these businesses laid off all employees, and these employees could no longer buy anything..manufacturers of household goods started to fail, and so did the banks they did business with..

example #2 is the garment industry...the price of cotton and wool rags, used to make the thread that makes the cloth to make the garments, doubled...the manufacturers could not afford to buy the rags, and because of the wage freeze in effect, could not lower wages....they failed, and so did the banks they did business with...

tungsten for the steel industry was imported..the price quadrupled..the steel industy failed, and so did the banks they did business with..

That only 5% that you speak of were the critical components necessary for our industry and farmers at the time... smoot hawley started a trade war that could only result in our own destruction..


22 posted on 09/16/2011 4:52:41 AM PDT by joe fonebone (Project Gunwalker, this will make watergate look like the warm up band......)
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To: joe fonebone

While it was very popular for farmers to blame Smoot Hawley for their troubles the claim doesn’t fit the evidence.

American farmers had enjoyed a bubble during World War I when demand from Europe was very high and European farmers were out of business. This bubble popped after the war ended and European ag revived. American farmers were caught like homebuyers in 2007, with too much debt and falling prices. A depression in American farming was already underway in the mid 1920s well before Smoot Hawley was even proposed.

In fact Herbert Hoover ran on a tariff during the 1928 campaign because of the depression that was already going on in farming, before the stock market crash or Smoot Hawley.

Your example #2 of the rag business and wage freezes.... has what to do with Smoot Hawley? Rags were collected in this country. And wage freezes have nothing to do with a tariff.

Tungsten- metals were subject to a 33.95% tariff under the 1922 Fordney-McCumber tariff act. Smoot Hawley raised it a whopping 1.13%, to 35.08%.

http://eh.net/encyclopedia/article/obrien.hawley-smoot.tariff

An increase that small is alleged to be the cause of a quadrupling in steel prices?

“That only 5% that you speak of were the critical components necessary for our industry and farmers at the time..”

I don’t know where you can find support for the ‘critical components’ claim. Most imports of that day were popular ag products that didn’t grow here, coffee and bananas plus Canadian lumber. Farmers wouldn’t have been importing anything, other than perhaps guano and I’ve never seen a tariff on bird poop.


23 posted on 09/16/2011 9:48:44 PM PDT by Pelham (Islam. The original Evil Empire)
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