The 1937-1938 contraction

A few months ago I was surprised to see this paper by Chris Calomiris, Joseph Mason, and David Wheelock:

In 1936-37, the Federal Reserve doubled the reserve requirements imposed on member banks. Ever since, the question of whether the doubling of reserve requirements increased reserve demand and produced a contraction of money and credit, and thereby helped to cause the recession of 1937-1938, has been a matter of controversy. Using microeconomic data to gauge the fundamental reserve demands of Fed member banks, we find that despite being doubled, reserve requirements were not binding on bank reserve demand in 1936 and 1937, and therefore could not have produced a significant contraction in the money multiplier. To the extent that increases in reserve demand occurred from 1935 to 1937, they reflected fundamental changes in the determinants of reserve demand and not changes in reserve requirements.

My view had traditionally been that of Friedman and Schwartz, Eggertsson (and here), and Krugman, but if you wish to read the other side of the story there it is.  In any case I do not see any good argument for monetary contraction today, no matter how one reads the 1937 story.  We await clarification from Scott Sumner.



Then lets all chant "QE3!, QE3!, QE3!"

You're late. Many economists have been doing that for some time --they believe in the power and magic of chanting, especially when they don't have good arguments and don't have time to re-write history. Hope they are not close to the stage of insulting Uncle Ben, although earlier today --after the release of the employment data-- I could hear a few chanting for QE4 and QE5 and more important QE-November 2012.

And on hearing the QE shouting, more people bought bitcoin and gold and also helped inflate more bubbles.

It seems to me that there are very few, if any, serious economists arguing for monetary contraction at the moment. Why then is there a groundswell of support for cutting govt. spending to the bone, raising interest rates to fight (weak) inflation, etc...

Since I am a student, who is still learning the complexities of macro, perhaps there is a possibility that I am somehow missing the larger point. Otherwise, how can such a harmful economic fallacy become the conventional wisdom in todays age? I am perplexed.

Dear Perplexed,

So am I.

As to why "such a harmful economic fallacy become the conventional wisdom in todays age?" You have to separate politics from economics and then you'll understand. Just as the democrats added some stimulus programs to get what they wanted during the crash, some republicans want to get what they want with the yearly debt limit increase. But, politics aside, you and most everyone knows what makes sense and what doesn't. We'll survive this period of posturing.

Thanks for the reply. It can be frustrating at times to see so much disinformation being taken seriously by people whom you are suppossed to revere (i.e. congress).

We're supposed to "revere" Congress? Jesus, you fucking need help. I hope to God your education is not being paid for by taxpayers.

Ever so slightly over the top

revere: regard as worthy of great honor...

Using a word accurately in a sentence used to be a sign of intelligence. Apparently if the reader disagrees with your statement, he can question your education. This is truly sad.

It seems to me that there are very few, if any, serious economists arguing for monetary contraction at the moment. Why then is there a groundswell of support for cutting govt. spending to the bone, raising interest rates to fight (weak) inflation, etc…

I have a sort of poetic description which might apply, but it was longer than I wanted to post here. I hope you'll look at it and preferably comment.

I wouldn't call it cutting federal spending "to the bone". I would call it modest decreases in the rate of increase of government spending to avert catastrophe.

Then I would say you are both posturing political positions.

I personally see it as 2 groups of people with little desire to understand economics and a lot of desire to push political ideologies. I definitely have personal political positions, but I can't even approve of the current conversations. Political conversations abuse cultural norms and I read this forum in hopes that Tyler, Alex, and the majority of commenters recognize and accept that.

Some economists are worried about a repetition of the mistake of 1937 when monetary (and fiscal?) policy would have triggered the recession (the old MF&AS position). In the paper quoted by Tyler the authors attempt to show that the increase in reserve requirements on bank deposits did not cause a monetary contraction and claim that a large increase in the demand for bank reserves caused the increase in reserves and then the Fed increased the requirements. Both positions are based on the classical, but mistaken, multiplier approach to money supply.

This approach assumes that the monetary base (= currency in circulation + bank reserves) is controlled by the central bank and that the demand for it comes from people (currency) and banks (reserves on their deposits, including both required and excess reserves). Although many monetary economists may still rely on it, the approach is nonsense. First, the central bank does not control the monetary base because it's committed to a standard (= the price of gold or any good or service), or to financing the government (forget about the myth of an independent central bank) or the banking system (the central bank is responsible for its soundness and liquidity), or to some rule derived from a magic model (or proposed by a magician armed with a model) but implemented by a discretionary bureaucrat to achieve some ultimate or intermediate or early or whatever objective or target (in the 1960s, Brunner and Meltzer expanded the multiplier approach by changing the rhetoric of monetary policy and after writing my Ph.D. thesis on their contribution I got crazy). Second, it ignores the fundamental fact that central banks hold assets to back up the monetary base (their liability) and for a long time, even during the gold standard, central banks didn't back up the base with gold. Actually, in some countries, most of the assets are simple accounting entries of disbursements to governments that will never pay back them. Thus, an increase in bank reserves that change only the composition of the monetary base is not indicative of a monetary contraction --it often means that government can finance its deficits or refinance its debts at a nominal interest rate lower than the market rate. Third, there is a penalty rate for failing to comply with reserve requirements and depending on the relation between this rate and market interest rates banks may comply or not with the requirements.

To make matters worse, the multiplier approach assumes a stable multiplier between the monetary base and all definitions of money (following Friedman's practice most monetarists change the definition to accommodate the situation they want to explain). The purpose of economic analysis is to find stable relationships among variables (the quantity demanded of x depends on its relative price and income) but it is hard to find them and too many shortcuts are taken. It would take a long paper to review the thousands of empirical studies of the demand for "money" and its "components", but my impression is that we can claim only stable patterns of payments (using currency and demand deposits) although in the past 50 years they have been changing because of tech developments and much greater reliance on two or more currencies for large transactions.

In sum, I believe that you can say anything you want about monetary policy because the theory underlying the multiplier approach as well as other approaches that assume that "money" (rather than the monetary base) is exogenous (that is, controlled by a central bank) has yet to be authenticated (despite the large number of empirical studies in the past 50 years). Indeed, we don't need that theory to explain hyperinflation --as Gordon Tullock, Philip Cagan and others showed decades ago it is the direct consequence of increasing the supply of currency at a high rate per day.

So, the 37-38 recession was caused by the austerity budgeting which cut Federal spending to reduce the deficit.

year gdp$2005 fed-deficit$2005 fed-spend$2005
1936 .... 977.9 .... 46.55 .... 106.95
1937 .... 1028 .... 29.15 .... 98.52
1938 .... 992.6 .... 14.10 .... 97.40
1939 .... 1072.8 .... 24.92 .... 107.69

year nom-gdp$ nom-fed-deficit$ fed-spend$2005
1936 .... 83.8 .... 3.99 .... 9.17
1937 .... 91.9 .... 2.61 .... 8.81
1938 .... 86.1 .... 1.22 .... 8.45
1939 .... 92.2 .... 2.14 .... 9.26

number in $B from

Note, taxes had been hiked in 1932, 34, and 35 by more than in 1936, and taxes were not cut, but instead hiked in 1940 after the recession had ended. The tax hikes were needed to increase spending - no one was willing to borrow to spend without the expectation of revenue paying for the higher spending.

I guess today's Republicans are trying to create a new recession and extend the Great Recession to block Obama's reelection.

What are you trying to show with these tables? That cutting spending in '37 and '38 increased GDP in '39?Or that decreased spending in '37 led to increased GDP in '37? I can't tell.

You're not supposed to discern any point with Bill. He's a noxious partisan who is only mouthing what he thinks to be the Democratic Party Line.

You didn't read Eggertsson-Pugsley paper carefully enough. His paper does not claim that the doubling of reserve requirements matter, except in-so-far as it contributed to a change in expectations regarding the policy path. In fact, he specifically argues and cites evidence against the Friedman-Schwartz reserve requirement story. Read the ending paragraph on page 24 through the end of page 25 of the Eggertsson paper you linked too. He doesn't think raising the reserve requirements had any direct affect, except its affect on expectations of future policy.

"In any case I do not see any good argument for monetary contraction today, no matter how one reads the 1937 story."

Debt problems in Europe driving up demand for dollars combined with no prospects of further monetary easing sounds like monetary contraction to me.

Let's remember Ben Bernanke's press conference a little over a month ago where he said "tradeoffs between QE and inflation are becoming less attractive at this point." How's that looking right now? Anyone still worried about inflation? And he hasn't said anything since then to imply a more dovish stance.

Not "binding"? If this merely means (as it is usually taken to mean) that the banks ended up holding even more than the new requirements--that is, that they held so much as to again end up with substantial excess reserves, the argument proves absolutely nothing: for the standard story is precisely that banks had good reason to wish to hold lots of excess reserves (excess relative to the required levels, of course), so that, when the requirements were doubled, banks contracted lending so as to make themselves as liquid, in excess reserve terms, as before.

So the question is, what do the authors means when they say that the doubled minimum reserve ratios weren't binding? Do they really mean that the doubling didn't have any influence on bank lending? The M2 figures certainly suggest otherwise.

It probably isn't correct to suggest the the Fed's actions were entirely responsible for the '37-8 downturn. But to suggest that they had no bearing on it seems too clever by a half.

Here's what the Romers wrote about the 1937 recession in 2004:

1) (page 133)
"Friedman and Schwartz (1963) argue forcefully that the rise in reserve requirements
was the key cause of the recession that began in May 1937. As Eccles realized
shortly after the March 1937 increase, “banks have been accustomed . . . to an
extremely large amount of excess reserves . . . and . . . it would take the banks some
time to accustom themselves to operating with a smaller amount of excess, as
evidenced by the fact that they had sold earning assets rather than reduce their
balances with correspondents” (Minutes, 4/3/37, p. 7). Bank lending declined and
the money supply fell sharply in the wake of the increases in reserve requirements.
Figure 1 shows the behavior of the unemployment rate starting in January 1934;
Figure 2 shows the behavior of the inflation rate. Unemployment rose dramatically
in 1938, and prices switched from rising slowly to falling."

2) (page 135)
"Figure 3 shows estimates of the expected (or ex ante) real interest rate, which
is arguably the most fundamental indicator of the stance of monetary policy. The
derivation of this series is discussed in the Appendix. The real interest rate was
substantially negative during most of the mid-1930s, as gold inflows expanded the
money supply greatly and generated expectations of inflation. However, it rose
markedly in the third quarter of 1937 (to roughly zero) and was high and positive
through most of the 1937–1938 recession. The Federal Reserve clearly did not
undertake the kind of aggressive monetary expansion that might have reversed
expectations of deflation and lowered real rates. The failure to try to bring the real
rate down from its high level is particularly striking when one considers that
unemployment reached 20 percent in 1938. This inaction, however, is consistent
with policymakers’ fatalistic beliefs at the time."

My impression is that the Romers are in aggreement with F&S. Moreover I think this supports what George Selgin is saying.

In my view gold hoarding was the primary cause of the sharp contraction of late 1937, however the increase in reserve requirements sure didn't help.

I also see no good reason for tight money today, but obviously the Fed feels differently. Perhaps they know something we don't--it would be interesting to find out why they believe more AD would not be helpful.

Do you mean the contraction in the early 30's? In 1937 it was already illegal for US citizens to own gold.

The Fed can use bank reserves (1) to finance the Treasury or private banks or firms and (2) to buy gold or other assets. You are saying that in 1936-38 they were (mainly?) used to buy gold, but you don't say what happen with the supply of currency --in other words, did the monetary base increase? or was there only a change in composition and the change was accompanied by a change in the composition of assets backing the monetary base? I want only to make the point of how difficult it is to pass judgement on the idea of a monetary contraction.
Today there has been a large increase in bank reserves but I have not studied the details to know why. Most likely the new reserves have been used to finance the Treasury (either the deficit or its outstanding debt, each with different economic effects). Since the Fed has to continue to finance the Treasury I don't see how it can allow bank reserves to decrease. Most likely the concern is how to increase bank reserves to finance the Treasury. At least we don't have to worry about gold hoarding, although some proposals for new QEs may imply to buy "non-traditional" real assets. My point is "forget about money, focus on how the Treasury is financed" (yes, it's the Argentine approach to central banking).

Sorry this was a comment on Scott's comment.

I'll put on my Sumnerian hat and point out the transmission mechanism for monetary policy includes expectations: therefore, if increasing reserve requirements signaled that the 1937 Fed was more hawkish than expected, its contractionary effect would not be exerted by the "direct" transmission mechanism but by the worsening of expectations.

To quote Krugman in the column linked above: "[A]s I said, we have already repeated a version of the mistake of 1937, withdrawing fiscal support much too early and perpetuating high unemployment."
Friedman and Schwartz -- as well as many others -- attribute the 37-38 recession to a contraction in the money supply. Krugman lays the blame on the reduction in stimulus fiscal policy.
I would also add that the Roosevelt Administration responded with some idiot idea about business monopolies being the source of the problem. And so you can imagine what happened to business confidence.

I think is very wrong to claim that Krugman lays all the blame on fiscal contraction. The article you quote begins with:

"Earlier this week, the Federal Reserve Bank of New York published a blog post about the “mistake of 1937,” the premature fiscal and monetary pullback that aborted an ongoing economic recovery and prolonged the Great Depression."

When discussing the causes of the 1937-38 contraction Krugman usually cites the research of the Romers. And although the Romers in 1990 argued that F&S' claim that it was the increase in the reserve requirement was less than conclusive (e.g. see here):

I think it's clear in reading their more recent research (2004) they make it clear they think monetary policy was still primarily to blame (see here);

Moreover, elsewhere the Romer's have stated that "monetary developments were a crucial source of the recovery" from the Great Depression (9.5% average real GDP growth in 1934-37) and that in contrast fiscal policy "contributed almost nothing". If fiscal stimulus contributed almost nothing to the recovery how could fiscal contraction be its primary cause of the contraction of 1937-38?

If the BOG raised the average reserve ratios on member bank deposits, the VOLUME of required, or legal reserves would increase (like RRs raised in 1936 & in 1937).

Similarily, if the BOG raised the remuneration rate on excess, & required reserves (vis a’ vis other competitive financial investments), the VOLUME of IBDDs would likewise increase.

However from the standpoint of the entire economy these actions are very different. IOeRs induce dis-intermediation from the non-banks at a faster rate than just increasing RRs does.

The source of time/savings deposits to the CB system is demand deposits, either via the currency route, the bank's undivided profit's account, or now IOeRs. The CB's (sactioned by professional economists), have decided to pay for what they already own (i.e. the elimination of REG Q ceilings). But the non-banks have not ever, and do not now, compete with the CBs. The non-banks are the customer's of the CBs. Money flowing to the non-banks never leaves the CB system (as anyone who has ever applied double-entry booking on a national scale would know). However the CBs can and currently do induce dis-intermediation among the non-banks, shadow banks, or formally 82% of the lending market.

Butt-plug say what?

asshole fucker said what?

From a layman's point of view, when sailing, a question sometimes arises, when to reef the sails. The simple answer is, whenever you think to ask the question, it is time to reef. The same response might be applied to spending money on consumption or when not to spend money. There was a recent article on the German system of handling employment during contractions. Hours are cut, wages supplemented, workers remain employed. Contractions are an inconvenience. Unemployed US workers either find another job within a safety-net time frame or they are liquidated. It appears the contraction of 1938 produced a dramatic up tick in unemployment, depending on sources, it was the equivalent of 10 million jobs today and perhaps double that amount if the Romer paper is consulted. This was the second scare for workers and being liquidated a second time was not on their wish list, so it is entirely possible that there was a real reason that demand plummeted unrelated to monetary policy. If you read Keynes' private letter to FDR, he says as much, prosperity and employment must be restored with government involvement, immediately, if lacking cooperation from the business sector. He also notes that the housing debacle had not much improved. We could say the same today. The German system appears to mitigate contraction shocks while we continue to pursue a policy of worker liquidation with the resulting natural response of financial risk avoidance and pocketbook closure, a topic much written about in the not so distant past and demonstrated recently with the unexpected increase in the price of gasoline.

This shows which they last very much lengthier and thus saving you income which could otherwise are actually utilized to purchase new ones.

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