Submitted by Stephen Lewis of admisi [16]
The 1937 Recession
The US Federal Reserve terminated its latest programme of bond purchases at the end of last month. Though Fed officials have been at pains to point out that this did not represent a tightening in monetary policy, but at most a halt in the supply of monetary stimulus, financial market participants are not wholly convinced. They fear the shift in Fed policy is occurring before US economic growth is firmly established. They worry that the US economy will slip back into recession from lack of adequate monetary support. Some of them cite the example of 1937-38 when the US suffered a severe downturn in business activity four years into its recovery from the Great Depression. This they attribute to an untimely tightening in the Fed’s policy-stance. They argue that Ms Yellen and her colleagues could be repeating the mistake of their predecessors eighty years ago.
Nowadays, events in the US economy in the 1930s are seen primarily through the prism of ‘A Monetary History of the United States, 1867-1960’ by Milton Friedman and Anna Schwartz. This is certainly a work that greatly influenced Mr Bernanke in his responses to the policy challenges he faced after 2008. The financial markets largely accept the Friedman/Schwartz view that the troubles of the Great Depression and its aftermath were the consequence of faulty monetary policies. However, we should remember that the Friedman/Schwartz work was not entirely objective; it was produced in support of their thesis that monetary variables are the key to short-term economic fluctuations. It is not surprising, then, that their account of the 1930s experience points to that conclusion. It attaches overwhelming weight to central bank monetary policy in generating and dampening these fluctuations, while overlooking what may be other significant influences. When, in 2008, the global economy plunged into a crisis widely acknowledged as the most dangerous since the 1930s, the Friedman/Schwartz analysis naturally gained influence, as a text relevant to such situations, and with that came the current assumption that central bank monetary policy sufficiently determines whether or not an economy will achieve sustained growth with stable prices. It also seems to many observers, especially in the financial markets where historical analyses are received second-hand, that central banks ought to be on guard to avoid repeating errors they are believed to have committed all those years ago. This is why there is now a strong focus on the Fed’s supposed contribution in precipitating the severe recession of 1937/38.
The setback to US economic activity in 1937-38 was no small matter. The unemployment rate rose from 14.3% to 19.0%, as manufacturing output suffered a peak-to-trough fall of 37% and personal incomes declined by 15%. By comparison, during the Great Depression in the USA, unemployment had risen from 3% to 21%, industrial production had dropped by 45% and personal incomes by 44%. (It is worth noting that the post-2008 downturn did not generate statistics anything like the order of magnitude of those relating to either of these episodes, except that labour-shedding was on roughly the same scale as in 1937-38). The monetarist analysis sees the 1937 downturn as a consequence of premature tightening in US central bank policy, starting in August 1936. In the previous year, the reserves held by banks had built up to more than twice the legal requirement, a circumstance that unsettled Marriner Eccles, then Fed Chairman. His concern and that of other Fed and US Treasury officials was that the reserves overhang could prove inflationary or result in asset bubbles, as it gave banks massive scope to step up their lending. Consequently, the Fed decided, over three stages, to double the level of the reserve requirements. This is the action that, according to the monetarist account, triggered the 1937-38 recession. To be sure, there was the appropriate temporal relationship between the Fed’s move and the economic downturn, with the former coming before the latter. However, while the data is scanty, it does not appear that the tightening of reserve requirements was the decisive factor, since the lending behaviour of member banks after the policy-move was similar to that of unaffected non-member banks. If higher reserve requirements had made a substantial difference to banks’ lending behaviour, member banks should have been more constrained than non-member banks. The monetarist account of these events is not all that persuasive.
We should bear in mind that the financial structure in the mid-1930s was, in important respects, different from today’s. One important difference lay in the relative importance of gold to the monetary system. The USA went off the gold standard in 1933 but under the Gold Reserve Act in January 1934, the Roosevelt Administration withdrew gold coin from circulation and fixed the US dollar price of gold at $35/oz. At that price, gold flooded into the USA from the increasingly troubled states of Europe, thereby increasing the US money supply. The rising liquidity in US capital markets boosted asset prices and encouraged speculative activity. As a result, there was widespread misallocation of capital. Belatedly, the US Treasury moved to sterilise the monetary effects of these inflows of gold. As the flow of liquidity to the markets was cut off, the unproductive character of much of the financial investment during the recovery years was made manifest. The economy thereupon peaked and went into a slide.
This Austrian School interpretation of events fits the facts rather better than the monetarist account. The lesson for policymakers today is uncomfortable. For, on this view, if there is a parallel with the 1930s, the damage has already been done. It was done when the Fed allowed funds available for investment in capital markets to balloon, not this time through unsterilized gold inflows but through its QE experiment.
There are, indeed, other factors that may have led to the 1937-38 recession. Contrary to popular belief, the Roosevelt fiscal policy up to 1937 was aimed at balance; only in response to the recession did the Administration resort to Keynesian pump-priming. Fiscal policy was far looser in the aftermath of the 2008 debacle than it was from 1933 onwards. This should warn us against assuming too close a parallel between the two periods.
