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.
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.
FDR and the Communists in his administration.
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.
Bush’s fault.
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.
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.
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.
the key domino was smoot-hawley....and the sudden contraction of the money supply...
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.
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.
Can/did Obama time-travel?!?
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?
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.
The argument could be made though that FDR was able to use what Woody left him to do the damage that he caused.
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.
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.
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.
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