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

The Great Debate: Monetary or Fiscal Policy?

Similar to their treatment of the causes of the Great Depression, Friedman and Schwartz attribute the Recession to the Federal Reserve’s increase of reserve requirements in August 1936, March 1937, and May 1937. They believe that the nine-month, three-step doubling of reserve requirements, reaching the maximum level permitted, was the main cause of the Recession because it led to a contraction in the money supply, due to less bank lending.156

Friedman and Schwartz begin their analysis of the 1937 time period by examining what role the discount rate played in decisions and outcomes that would later follow. They argue that the discount rate during the years leading up to the Recession, although low in absolute terms, was high relative to market rates, leading banks to view discounting as an expensive way to meet temporary liquidity needs. Therefore, banks relied on alternative sources for liquidity, like accumulating unusually large reserves. However, Friedman and Schwartz do not believe that the discount rate was a mistaken policy decision, “but only that it cannot be regarded as having contributed to monetary ‘ease.’”157

According to their analysis, the singular mistake made by the Federal Reserve was one of interpretation. The Federal Reserve mistakenly interpreted the accumulation of excess reserves as a choice to hoard by risk-averse banks, not as a useful accumulation of reserves to be utilized as an alternative to discounting. Based on analysis of memoranda and statements among Federal Reserve officials, Friedman and Schwartz conclude that the prevailing view within the institution was “that excess reserves were idle funds servicing little economic function and reflecting simply absence of demand for loans.”158 The same memorandum outlines five major concerns arising over the size of excess reserves, like banking sector over-investment in government bonds, rapid over-borrowing by individuals and organizations due to the amount of money available for use, and possible inflationary pressures.159 Clearly, excess reserves were viewed as a problem that required a solution.

To counter the perceived negative effects of excess accumulation, the Federal Reserve had three tools available: open market operations, the act of selling or purchasing government bonds on the open market, adjusting the discount rate, and adjusting the reserve requirement. In an internal memorandum dated December 13, 1935, the Federal Reserve deemed open market operations inefficient due to the size of the excess reserves. Additionally, they ruled discount rate adjustments ineffective, given the public’s low demand for loans. Therefore, the tool of choice was increasing reserve requirements to immobilize the accumulated reserves from being used.160 Their hypothesis regarding the cause of the Recession links the increase in reserve requirements to a reduction in the money supply, due to the banking sector’s desire to hold excess reserves.

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Friedman and Schwartz’s monumental volume brought the role of monetary policy into the spotlight, but their work of economic history largely lacks quantitative analysisand relies heavily on casual arguments. To further examine claims made by Friedman and Schwartz, specifically those related to 1937, a paper from 1992 is examined: Christina Romer’s “What Ended the Great Depression?” Although Romer builds on the foundation laid by Friedman and Schwartz, her paper is primarily concerned with the onset of recovery. She notes that Friedman and Schwartz “appear to have been more interested in the role that Federal Reserve inaction played in causing and prolonging the Great Depression than they were in quantifying the importance of monetary expansion in generating recovery."161 Her paper concludes that, primarily, the expansion of the money supply led to recovery. This conclusion is a mirror image of Friedman and Schwartz’s view that a decline in the money supply led to the 1937 downturn.

Early in her paper, Romer criticized contemporary Depression-related research for blindly adhering to assumptions off conclusions reached by leading economists from previous decades, like E. Cary Brown and Friedman. She says, “The emphasis that these early studies placed on policy inaction and ineffectiveness may have led the authors of more recent studies to assume that conventional aggregate-demand stimulus could not have influenced recovery”162

Romer’s critique hints that contemporary economists may have misinterpreted relevant causes of recovery due to their preexisting assumptions. To aid her critique, Romer pointed to a paper by Bernanke and Parkinson. The two authors were surprised by the strength of overall recovery in the 1930’s, but having preemptively assumed the ineffectiveness of New Deal policy and not being interested in examining this assumption due to the narrow scope of their paper, the authors concluded that recovery came about naturally. Romer also discounts a specific assumption made by many contemporary economists. Whereas it is often assumed that recovery from the Depression was slow until the start of World War II, Romer bases her study on the assumption that recovery was strong. She contends that the decade-long recovery process was to be expected given the unprecedented magnitude of the early 1930’s and 1937 contraction.163 Romer concludes that without aggregate demand stimulus, which in her view took the form mainly of monetary expansion, “the economy would have remained depressed far longer and far more deeply than it actually did.”164

Much of the literature regarding the 1937 Recession points to monetary policy decisions as the cause. Perhaps due to increasing ideological divisions or perhaps due to the continued taboo around fiscal stimulus, it is sometimes assumed that the support of monetary policy as a causal factor is equivalent to the discounting of the role that was or could have been played by fiscal policy. In an address in 2009, as a member of the White House’s Council of Economic Advisers, Romer clarified this point when she flatly stated:

I wrote a paper in 1992 that said that fiscal policy was not the key engine of recovery in the Depression. From this, some have concluded that I do not believe fiscal policy can work today or could have worked in the 1930s. Nothing could be farther than the truth. 165

Although monetary policy may have been the direct contributing factor that caused the 1937 Recession, it’s important to contextualize this cause in the absence of fiscal policy. Monetary policy decisions affected the economy at a time when the government pulled back spending. If one assumes that monetary policy was the only cause of the Recession, the next question to be asked is the following: would monetary policy decisions have had an impact if government spending had been maintained at early New Deal levels?

E. Cary Brown, an economist who taught at MIT for nearly sixty years, made a fundamental contribution to the study of the Recession by examining the question posed above. In his seminal 1956 paper, Brown argued that “fiscal policy seems to have been an unsuccessful recovery device,” but he added the caveat "not because it did not work, but because it was not tried.”166 Romer declared in her 2009 speech that the "crucial lesson from the 1930s is that a small fiscal expansion has only small effects."167She reiterated Brown’s famous conclusion: “The key fact is that while Roosevelt's fiscal actions were a bold break from the past, they were nevertheless small relative to the size of the problem.” To contextualize her argument, Romer presented her audience with two figures: when Roosevelt took office in 1933, GDP was 30% below trend and one year later, in 1934, deficit spending rose only by 1.5% of GDP.168

To consider the validity of Brown’s and Romer's statements, it must first be asked whether fiscal policy had an impact on the economy in 1937. Disregarding papers on both extremes of the spectrum, the consensus in the middle is that both monetary and fiscal policy factors had an impact on the 1937 downturn. In a paper about the Recession, Velde used a VAR model and concluded "monetary and fiscal factors account fairly well for the pattern of industrial production and, in particular, for the depth of the recession.”169

Velde was concerned primarily with the hypothesized causes the Recession. His brief but targeted analysis shed light on this little-studied downturn by reaching a conclusion that shows both monetary and fiscal policy factors played contributing roles. However, one of the most important contributions provided by his study is not his conclusion, but instead his treatment of the monetary policy question. In regards to the impact that reserve requirement increases had on the money supply, Velde tried to resolve arguments put forward on one end by Friedman and Romer and on the other Telser.

Whereas Friedman argued that reserve requirements had a direct impact on the money supply through decreased lending, Telser examined both sides of the banking sector’s balance sheet and argued that banks responded to the reserve requirement increases not by decreasing lending, but instead by liquidating other assets to fulfill their desire for cushioned reserves. If Telser’s argument is assumed to be true, then lending did not decrease, and the reserve requirement increases had no impact on the money supply; therefore, the Recession could have only been caused by other hypothesized factors, of which only fiscal policy changes and wage increases remain. Friedman’s and Telser’s views are mutually exclusive, and they must be reconciled prior to a quantitative analysis, so that a fitting money supply variable, should one exist, can be compiled.

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Velde’s findings are partially in agreement with Telser’s conclusion and partially in agreement with Friedman’s. Velde finds that banks did not respond to the increases by decreasing private lending for some time. In agreement with Telser, Velde said, "Looking at interest rates confirms that the impact of reserve requirements manifested itself on tradable securities rather than loans.” Velde continued to note that even after the first increase in August 1936, interest "rates charged by banks on loans were little affected.”170 Although his study so far has been in agreement with Telser, Velde went farther and examined even more deeply the possible mechanism by which the reserve ratio increases could have had a downward pressure on the money supply. He found that after the second increasein March 1937,the U.S. bond market, which had remained relatively stable, saw a spike in yield rates. The spike in the bond market took Morgenthau by surprise. According to Velde, the spike prompted Morgenthau to telephone and complain to Eccles, the Chairman of the Federal Reserve, that the Federal Reserve “bungled the increase in reserve requirements.”171

Based on Velde’s analysis, Friedman was wrong in assuming a direct mechanism of impact on the money supply. Furthermore, Telser’s analysis was valid, but he was wrong to fully discount the role of reserve requirement increases without examining the other possible mechanisms of action. Velde concluded that given the bond rate increases and the sharp decline in corporate issues, the banking sector's demand for corporate and government liabilities had declined. The decreased demand likely was the indirect mechanism through which the reserve requirement increases impacted the economy. Velde noted, "The fall in lending translated into higher interest rates and a lower volume of issues.”172

A 2006 paper published by economists Thomas Cargill and Thomas Mayer further discounts Telser’s conclusion. Cargill and Mayer examined more closely the effect of reserve requirement increases on the money supply. Given Telser’s surprising finding that conflicted with long-standing assumptions put forward by Friedman, Cargill and Mayer examined more closely the possible impact, if any, that the increased required reserves had on the money supply. They studied whether banks held reserves due to a lack of profitable lending opportunities, or whether banks hoarded reserves as a reactionary and precautionary measure. Because no reliable measurement of loan demand was available for the time period in question, Cargill and Mayer compared the reserve accumulation behavior of Federal Reserve member banks to that of non-member banks, which were not subject to Federal Reserve mandates:

If member banks increased their total reserve ratios because of a decline in the demand for bank credit, then on the reasonable assumption that there was no concurrent change in the relative volume of credit demand from member and nonmember banks, the total reserve and loan ratios of member banks and nonmember banks should have behaved in the same way when member bank reserve requirements where raised.173

The authors utilized a regression analysis that examined the difference between member and non-member banks response behaviors to the increased reserve requirementsthat affected only the member banks. The overwhelmingly significant results are reported in Table 2 of their paper.174

They concluded that banks did not respond “to the changes in reserve requirements essentially by changing theirexcess reserves.” Instead, Cargill and Mayer found that “member banks met a substantial part of their increased reserve requirements by reducing their earning assets.”175 Member banks, in response to the increased reserve requirements, liquidated assets in order to maintain a buffer of excess reserves similar to that which they had prior to the increases. Although the mechanism of action is in question, most of the recent literature is in agreement: the reserve requirement increases affected the money supply. Therefore, a money supply variable focused on the role of reserve requirement increases is necessary for a quantitative analysis.

Having pointed to studies that underscore the likely impact of fiscal policy and having argued that no matter the mechanism of action considered, reserve requirement increases likely had an impact on the money supply, focus will be turned in the next section to synthesizing the arguments put forward in an econometric study of only the 1937 Recession. The vast literature concerned with the debate over the role of monetary and fiscal policy is of little use to this study because the literature is primarily concerned with the time period as a whole (1929-1939) or the post-1939 war spending. Given the unique factors leading to the 1937 Recession, studies of the broader time period contribute little to an understanding of only this recession. These studies gloss over the 1937 Recession by treating the recovery period through WWII as one continuous progression. However, as shown earlier in Figure 2, the economy had reached an acceptable level of recovery by 1936, when industrial production matched its 1929 peak. Although unemployment was still high and the economy still in a delicate state, the country was inching towards full recovery until the Recession hit. The consolidation of the time period as one group is a questionable practice. Studies of the Depression should consider the 1929-1936, 1937-1938, and 1939-1945 time periods as distinct points of recovery given the unique factors affecting society within each period.Continued on Next Page »