Roosevelt's Recession: A Historical and Econometric Examination of the Roots of the 1937 Recession

Having been witness to the unprecedented number of bank failures that took place only months earlier, banks strengthened their reserves at the onset of the second crisis. With more urgency than before, banks shored up their reserves by liquidating assets, while depositors converted deposits to currency. Between February and August 1931, total commercial bank deposits declined at a value greater than the total decline experienced in the eighteen months before February. From August 1931 to January 1932, 1,860 banks, with combined deposits of $1.45 billion, closed their doors.25

In addition to the internal drain that banks faced from customer withdrawals, they also faced external pressures. In September 1931, Britain’s departure from the gold standard fueled fears that the United States would follow. In fear of American departure from the gold standard, foreign central banks and international investors started converting dollar assets to gold. The Federal Reserve, in turn, sharply increased the rediscount rate.

The events outlined above placed a large downward pressure on the money supply. According to Friedman, the decline in money supply could have been avoided if the Federal Reserve initiated large-scale purchases of government securities. In April 1932, after heavy political pressure from Congress, the Federal Reserve commenced on a $1 billion purchase of government securities. However, the financial sector looked down upon the Federal Reserve’s operations because many considered the purchases to be inflationary.26

The purchases temporarily stabilized the financial system. By late 1932, conditions had improved in the banking sector. The value of currency held by the public peaked in July and declined through the end of the year, meaning that the public hoarded less cash. Total demand deposits, which had been declining for over a year, reached a minimum in July and increased until the end of 1932. Similarly, total time deposits reached their minimum in September and increased through the end of the year.27 The positive banking sector developments, during the latter half of 1932, broke what was a yearlong downward trend. Once again, recovery seemed to be on the horizon; however, trouble brewed.

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In the last quarter of 1932, a series of banks failed in the West and Midwest. Yet again, fear flourished, and the public’s demand for currency increased; the banking crisis of 1933 was underway. The 1933 crisis was unlike those that preceded it, and its impact was felt across the entire country.

On the eve of President Roosevelt’s inauguration, Friday, March 3, thirty-two states had closed all their banks, six states had closed most of their banks, and ten states had placed restrictions on withdrawals.28 On the third day of his Presidency, Monday, March 6, President Roosevelt declared a nationwide banking holiday between March 6 and March 9.29 On March 9, the President indefinitely extended the banking holiday until otherwise declared in a subsequent proclamation; the undefined holiday lasted until March 13.30

It’s important to note that President Roosevelt’s bank holiday proclamations held the power of law due to his administration’s unique interpretation of executive emergency powers. The White House more broadly interpreted the definition of national emergency outlined in the 1917 Trading with the Enemy Act. Intended for use during war, the Act failed to make war a prerequisite for the declaration of national emergency and the assumption of executive emergency powers. President Roosevelt’s use of emergency powers created a controversial precedent for future Presidents.31

On March 12, on the eve of the conclusion of the final banking holiday, President Roosevelt addressed the nation in his first fireside chat and called on the country to “unite in banishing fear.”32 The public’s positive response to President Roosevelt’s first fireside chat was unprecedented.

The Depression-era bank runs were atypical not only due to their severity, but also due to the banking sector’s response. Unlike those crises that preceded them, the 1930’s banking crises occurred under the watch of the Federal Reserve. Prior to the establishment of the Federal Reserve in 1913, banks typically responded to such conditions by restricting the conversion of deposits into currency. Without fear of failure due to currency withdrawals, banks were able to stay open long enough to build their liquidity positions.

During the Depression, privately organized efforts to shore up the banking system were very limited because the banking sector generally assumed that it was no longer necessary to organize and adopt wide-scale conversion restrictions. Friedman contends, “the very existence of the Reserve System concerted [conversion] restriction” due the Federal Reserve’s role as lender of last resort.33 He believes that stronger banks had less of an incentive to utilize conversion restriction as a tool because they had a new escape mechanism that didn’t exist before 1913: discounting.34 This new system rested on the assumption that the Federal Reserve would actively intervene in times of crisis. However, the intervention, or lack thereof, did not necessarily contribute to recovery.

Although Friedman and Schwartz unwaveringly argue that monetary policy caused the Depression, one cannot ignore the other unwavering argument put forward by John Maynard Keynes. Keynes and his followers argue that the lack of fiscal policy leadership, in other words the lack of government stimulus spending, transformed what could have been a small economic downturn into a full-blown depression. Alive decades before Friedman, Keynes actually lived through the Depression. Rooted in the study of economic downturns, Keynes’ theories fundamentally changed macroeconomics and shaped government policy for nearly a century.

Early during the Depression, Keynes advocated for government spending to stimulate the economy. His lonely voice stood in contrast to prevailing wisdom of the time. Almost universally, economists and politicians agreed that balanced budgets were a prerequisite for recovery. Eric John Hobsbawm, a British historian of industrial capitalism, colorfully summarized the state of economic thought in the early 1930’s:

The economists… nailed their flag to the mast of Say’s Law which proved that [economic] slumps could not actually occur at all. Never did a ship founder with a captain and crew more ignorant of the reasons for its misfortune or more impotent to do anything about it.35 36

Although Hobsawm’s was concerned with British economists and politicians, the situation in the United States, Britain’s cultural and social counterpart, mirrored Britain.

Keynes frequently contributed to magazines and newspapers that catered to the mass public. One year after the Stock Market Crash, Keynes introduced a two-part article, titled “The Great Slump of 1930,” by solemnly noting, “The world has been slow to realize that we are living this year in the shadow of one of the greatest economic catastrophes of modern history.”37 Keynes understood that the events unfolding were unprecedented and inexplicable under existing economic theory. However, at the time, common wisdom viewed economic downturns as events based in morality. It was believed that long-lasting booms were the natural products of risky investor and business behavior.

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Through this lens, recessions were cyclical periods that brought about needed restraint. As the Pulitzer-Prize nominated journalist Sylvia Nasar puts it, “Recessions, in this view, were regrettable but necessary correctives, like a detox program for a drunk.”38 This view was so commonplace that even President Roosevelt conveyed similar beliefs during his candidacy for President. In 1932, during his nomination speech at the Democratic National Convention, FDR declared that gains from the 1920’s boom were wasted frivolously:

Enormous corporate surpluses piled up-- the most stupendous in history. Where, under the spell of delirious speculation, did those surpluses go? Let us talk economics that the figures prove and that we can understand. Why, they went chiefly in two directions: first, into new and unnecessary plants which now stand stark and idle; and second, into the call-money market of Wall Street.39

In the same address, FDR shared views that a contemporary reader may not expect of the President, views that would eventually spearhead the nation’s largest public works spending program; he underscored the need for continued government frugality and restraint during the Depression:

For three long years I have been going up and down this country preaching that Government - Federal and State and local - costs too much. I shall not stop that preaching. As an immediate program of action we must abolish useless offices… We must merge, we must consolidate subdivisions of Government, and, like the private citizen, give up luxuries which we can no longer afford.40

Although he made a clear case for lower taxes and smaller government, FDR’s traditionalist views were somewhat offset by his call for relief at the federal level. He stated that while the “primary responsibility for relief rests with localities now… the Federal Government has always had and still has a continuing responsibility for the broader public welfare.”41 Even though the severity of the Depression was clear by 1932, FDR’s belief that Federal Government had a role in promoting public welfare remained controversial within segments of American society. Contributing to the country’s inability to view relief the role of Government were long-standing notions about the poor, notions that had their roots in Britain.

In industrializing eighteenth century Britain, economists, rooted in the classical assumption of perfectly free markets, faced difficulty in explaining the persistence of poverty and unemployment despite rapid industrial expansion. Various theories were put forward, but only the simplest idea gained widespread traction across British society: prolonged poverty was theoretically inexplicable, and thus, inexcusable. Continued unemployment, excluding that caused by misfortune, was assumed to be simply the byproduct of character ills. Through this lens, poverty became the domain of charity, not economics.42 This simplistic outlook on poverty was widely accepted due to the ease with which the idea conformed to higher-class political goals and culture. Unfortunately, the burgeoning social Darwinist movement of the mid-nineteenth century set in stone, for decades, the notion that poverty was caused by personal shortcomings. It was not until the onset of the Progressive Era that these views changed.

In the last two decades of the nineteenth century until the onset of the First World War, technological progress, newfound wealth, prolonged peace, and political activism came together and set the stage for a unique populist idealism aimed at societal reform and betterment. The developments of the Progressive Era seeded in public consciousness the idea that government can be a force for good. Without this movement as a historical backdrop, FDR’s New Deal would have likely been culturally and politically unfathomable.

During the Progressive Era, Edwin R.A. Seligman served as a key reformer in the realm of economic policy. Seligman, a founding member of the American Economic Association and the American Association of University Professors, transformed the field of economics by leading a professionalization of the discipline. He also shook the field of public finance by advocating for a move away from regressive indirect taxes to a progressive centralized tax collection system. Seligman and his reform-minded contemporaries understood that powerful ideas did not easily transform to power through the force of law; a barrier existed between economists and their theories and the political process. They realized that their role required active participation in policymaking.

The Progressive-Era economists acted on that realization, and due to their success, they set a precedent for the involvement of economists in political advocacy. In 1913, years of engagement with policymakers culminated into two historic reforms: the Income Tax (16th) Amendment and the creation of the Federal Reserve System.43 However, in 1914, the First World War brought to a halt the idealism and hopefulness that defined the Progressive Era. Having successfully swung through the field of public finance, the pendulum of reform now stood still for nearly a decade. It took an economic disaster for a weary and disillusioned post-war society to again develop an interest in reform.

Conservative economic policies were long considered common wisdom before the Depression, and to an extent, during the downturn. Public figures, from mainstream economists to political candidates, were expected and assumed to support balanced budgets. Straying from the wisdom of a balanced budget ensured a future of political irrelevancy. However, during the early years of economic turmoil, Keynes led a small, vocal, minority of economists that advocated for government spending programs. As his predictions were proven to be accurate, and as his theories became more reliable, Keynes’ influence quickly soared at an international level.

Months before the idea gained traction among other economists, Keynes confidently declared in December 1930 that the world faced a downturn more serious than a common recession. Recessions were then considered cyclical economic corrections that necessarily followed prolonged periods of unsustainable growth. In his December op-ed, Keynes pondered whether man was “now awakening from a pleasant dream [the 1920s boom] to face the darkness of facts? Or dropping off into a nightmare which will pass away?”44 Keynes, of course, had a response to the question he posed. He asserted that the gains realized during the preceding decade were not deceitful byproducts of speculation, but productive, fruitful output.

With that single assertion, Keynes discounted the traditionalist view that the downturn was a corrective mechanism. Although he flatly rejected cyclical correction as a causal factor, Keynes provided no alternative explanation for the downturn. Almost a year after the Stock Market Crash, he concluded that existing theoretical knowledge could not be adequately applied to the present glut. He noted, “Today we have involved ourselves in a colossal muddle, having blundered in the control of a delicate machine, the workings of which we do not understand.” In one of his most famous metaphors, Keynes compared the current state of the economy to that of an automobile with an elusive technical malfunction. He wrote, the machine is “jammed as the result of a muddle. But because we have magneto trouble, we need not assume that we shall soon be back in a rumbling wagon and that motoring is over.”45 The wheels of commerce needed to roll once again. For that to occur, Keynes believed joint action was required from both London and Washington to restore confidence, revive enterprise, and restore prices.46Continued on Next Page »