Shades of 1935 In the FOMC's 'Tapering'?

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The volume of scholarship dedicated to solving the economic riddle of the Great Depression is simply astounding. There has been so much academic and intellectual energy devoted to the economic circumstances of the decade of the 1930's that it easily surpasses even the hold the era still has on the popular imagination even eight decades on. I have mentioned before that this focus is somewhat misguided, kind of like diagnosing only the symptoms without paying much attention to the underlying causes. In this respect, there really should be more scholarship of the 1920's and the revolution in modern finance and global monetary exchange.

Setting that aside, however, there is in fact too much generalization in saying that the attention of economic historians was placed on the entire decade of the thirties. In reality, almost all study was limited to the first four years of that decade. There really is no mystery surrounding why that is; that was where all the action took place. People do love drama.

Largely forgotten now, but there was a fair amount of drama and despair in 1937. The re-depression in the middle of the 1930's seems a minor episode now, owing in no small measure to the lack of comparable theatrics. There was the great crash in 1929, and the wave of bank failures in 1930 and 1931. The following year had devastating deflation, followed by the foundations of the domestic welfare state. The year 1937 was just a depression.

What should make 1937's collapse all the more interesting in the framework of economic understanding is that it ran exactly counter to modern monetary expectations. The Bank for International Settlements in its 1938 Annual Report noted that:

"It is human to look backwards at past disasters in the hope of avoiding them in the future. But it might prove as dangerous to be led by fear of a deflation that may not come as it has been dangerous, in some cases, to be led by fear of an inflation that was not imminent. And if fear of deflation be identified with a fear for international monetary stability, this may so hinder economic recovery as to force deflation on a world gorged with gold."

The conventional, mainstream concept of deflation is tied with the grating theory of "aggregate demand." In his now infamous November 2002 speech in which he jokingly invoked the ability of the government to simply "print money," then Fed Governor Ben Bernanke laid out this assumed dynamic:

"The sources of deflation are not a mystery. Deflation is in almost all cases a side effect of a collapse of aggregate demand--a drop in spending so severe that producers must cut prices on an ongoing basis in order to find buyers."

The rest of Bernanke's speech was dedicated to the proposition that deflation was not an inevitable outcome even in the face of falling "aggregate demand" (however that might be defined). He gave two primary factors in favor of winning a battle against a deflationary episode: the resilient American economy and the Federal Reserve. This was before 2007, after all.

No doubt that the latter of those "bulwarks" against deflation was so cemented in his mind due to just the volume of scholarship I alluded to at the outset. Deflation can be successfully countered by, if all else fails, the printing press. This appeal to artificial, monetary inflation informs the basis of every "emergency" policy put in place since September 2007.

That, then, makes the BIS statement from 1938 all the more palpable in its obvious opposition. If deflation can be successfully defeated with monetary expansion, then how did the US, gorged on gold in the middle 1930's reflation, experience just that?

By the trough of the collapse in early 1933, the official monetary stock of gold was about $4 billion. By early 1937, it was up to nearly $10 billion. The devaluation of the dollar at the beginning of 1934 (coming only months after the mandated confiscation of private gold) played a substantial role in the "gorging." The volume of gold in official stocks almost doubled just on devaluation alone in early 1934.

Without a private outlet for gold into the US economy after Executive Order 6102, the increase in official gold was simply transformed into bank reserves. Bank deposits at Federal Reserve Banks in 1933 were about $2 billion, growing almost dollar for dollar with gold inflows to about $8 billion by 1937. This unofficial and exogenous balance sheet expansion fueled exactly the kind of "money printing" to which Governor Bernanke was alluding.

Wholesale prices and deflation halted in 1933, rising just under 50% in the four years from the 1933 economic trough to the 1937 economic peak. The recorded money stock moved in conjunction, growing about 53%, or about 11% per year.

So the monetary effects of countering deflation are left intact, but it raises a myriad of other problems. Inflation of that kind in an environment of such labor and economic slack is, at the very least, troubling. There was clearly economic improvement accompanying this increase in prices, industrial production more than doubled from 1933 to 1937 and unemployment fell, but all of these growth rates were enlarged simply by the comparison to the collapse. Despite these rapid accelerations, they were still below the peak levels achieved at the 1929 top.

The increasing stock of money was largely idled in not only bank reserves but also liquidity preferences. Bond yields were low by historical standards throughout the decade, actually and persistently declining in an indication of such monetary imbalance and against historical experience (recoveries were always accompanied by rising interest rates across the credit spectrum). But where that was taken for "loose monetary" policy, it suggests the very real limitations of monetary responses to such structural adjustments. In Bernanke's parlance, there was not a sufficient response in aggregate demand owing to monetary price inflation (it should be noted that price inflation was not solely monetary, the various New Deal programs like NIRA codes influenced prices, but were just as artificial in nature).

The government itself paid much attention to this imbalance between price changes and resource "slack", but it only mitigated into a partial recovery. Net private investment remained negative all the way until 1936. Private construction, for example, in early 1937 was only one third of levels seen at the previous peak. When business investment finally turned positive, it was almost uniformly directed at inventory stocks.

At the December 17-18, 1935, meeting of the FOMC, the governors (then including all the heads of the regional banks, before the board was reconstituted by legislation the next year) voted 7-5 against a measure to increase the reserve requirement on the banking system, a new control lever ceded to the Fed in the new regulatory arrangements of the New Deal age. The measure was voted down not because the FOMC was against "tightening", but because there was no full consensus on the means through which to accomplish it.

In regard to that last factor, the Fed chair introduced a revised resolution that passed 8-4 certifying the board's stance that monetary inflation was in need of attention, only that the manner of attention was in doubt (some members preferred to use open market operations).

The justifications for these efforts were varied, but included the board's opinion that banks were disproportionately investing in government bond securities at prices that may not have been sustainable beyond a record low rate environment. The Fed also felt that such excess in reserves might lead to "over borrowing" in such close proximity to the over-indebtedness (Irving Fisher's term) of the previous collapse. They also paid attention to a seemingly partially formed theory that the condition of reserves signaled to foreign investors that the US was "ripe for speculation", and thus causing gold to flow into the US - the very root of the reserve "imbalance" in the first place.

Whatever the inflationary concerns of the FOMC, it acted in July 1936 by raising the level of required reserves. Not to be satisfied with that, the committee also instituted two other reserve changes in early 1937, as well as coordinating with the Treasury Department as it began sterilizing gold inflows in much the same manner as in the late 1920's. In its August 1936 Annual Report, the Federal Reserve noted, "the Board's action was in the nature of a precautionary measure to prevent an uncontrollable expansion of credit in the future."

Almost immediately, banks responded in a manner wholly unanticipated by the FOMC. Rather than suffer a decline in their liquidity buffer, banks busily endeavored to reinstitute their level of excess reserves. The pace of buying credit securities halted immediately, and by December 1936 banks were outright selling corporate and government bonds. Between the first reserve requirement change and the end of the year, new corporate bond issues declined by almost 50% in number - collapsing still further into 1937.

From the onset of Treasury's gold sterilization, corporate bond yields in what we now would call "junk" jumped from about 4.5% to 6% by the end of 1937. Even investment grade corporate debt rates spiked, from about 4% to 5.25% (these are large moves in credit markets of the time).

Industrial production peaked in December 1936, then fell slightly until September 1937 when the economy collapsed again. From the peak, industrial production fell more than 37% in just a few months. Factory employment dropped 25%, while department store sales (the primary retail outlet) declined 16% - the disproportionate declines in production owed to the excess of inventory from business investments in 1936 and early 1937.

In short, 1937 and into the trough in mid-1938 was a depression within a depression. We have never seen such close proximity of depressionary episodes, nearly back-to-back, in history. And it occurred without the backdrop of monetary and banking panic. There was no appreciable increase in bank failures, and certainly nowhere near what was seen in the over-covered part of the 1930's.

Wholesale prices declined about 15% over the year and a half between the cyclical peak in mid-1937 and the renewal of activity toward the end of 1938. So to a smaller degree there existed an amount of what Bernanke might call deflation, but still an outright deflationary depression. And it occurred against the backdrop of a banking system saturated with reserves, the domestic system "gorged with gold".

The FOMC at the time, along with some modern interpretations, insist that monetary measures had no real or lasting relation to the 1937 depression. Instead, particularly in the Keynesian interpretation, it was government and fiscal measures that "caused" the collapse (particularly the Revenue Act of 1936 and its surtax on "undistributed profits"). Setting aside the blame, what is most relevant to current circumstances is this occurrence of re-depression inside the umbrella of a massively expanded money stock. The existence of exogenous money, so we have been told, should have been enough to prevent the deflationary collapse, regardless of the cause.

But 1937 stands in stark contrast to such expectations. The reasons, for those that are inclined to move outside ideological canon, are rather simple and intuitive. First, a theme which forms the basis of my own analytical assumptions for nearly every economic parameter post-2007, is that money stock is far less important than money flow. As we know all too well in our own experience with the current banking composition, trillions in excess reserves do not necessarily translate into direct economic activity - money stock is not directly related to GDP no matter how much such a relation is insistently incorporated mathematically in official calculations and models. The means for circulation in some respects is far more important toward the inevitable and eventual resolution of the critical state.

Second, and very much related to the first, is that the recovery from these depressionary collapses were, in large part, artificial themselves, and thus very susceptible to reversal. The key is the overabundance of money that aggregates in economically inefficient or useless outlets, demonstrated by persistently low rates on credit. The disproportionate preference for government bonds, for example, and the liquidity preference of bank portfolios was not just a reflection of banking attitudes toward credit production and flow; it was in no small way due to the very real lack of demand for credit money. Jobs and earned income were in short supply.

Business investment was low not because businesses were short of credit opportunities (as modern monetary economics obsesses with) but because businesses were dealing with structural economic changes that were not apace prices. The growth in economic activity created by monetary imbalances in the 1920's was wholly unsustainable, and it was not realistic to expect an easy return to those artificial levels. Thus, businesses were not going to keep up with the exogenous money growth expressed in prices because prices were not reflecting real levels of what rightfully should be called organic demand (not aggregate demand; activity cannot be conjured by printing money or any monetary means).

That is what made the 1937 relapse so sharp and severe. In the context of monetary adjustments, the severe collapse in prices (deflation) after 1929 simply re-adjusted the economy toward a more sustainable foundation of economic activity and growth. No doubt it was a cascading correction that was utterly violent, chaotic and messy, but phase shifts always are. Certainly, there might have been more done to contain the damage, but the depression was inevitable; though its initial severity was not.

The second collapse in 1937 was nearly identical in nature, except absent the multiplier effect of money collapse. The stock of money, through gold, prevented the return of such collateral damage through the bank panics. In other words, Bernanke was correct in asserting that the "printing press" or some process very much like it can stave off banking destruction, but that is as far as it goes and a very real limitation to the efficacy of monetary intervention. The real economy is a separate and distinct system from banks and finance, intersecting in vital ways to be sure, but " money" and debt are not the primary factors in determining recession or depression.

That should be the primary lesson learned from that re-depression. Through no real intentions of its own, the Fed allowed the system to "gorge" with gold and reflated through money expansion, but all that did was prevent another financial collapse. It did not, as Bernanke suggested in 2002, preclude another depressionary episode. Far from it. The 1937 collapse was among the worst in our history, "bested" only by 1930-32 and 1920-21.

As the FOMC echoes shades of 1935 impulses in its current flirtation with "tapering," it would do well to at least reconcile this vast discrepancy between theory and empirical history. If eight decade-old history is not convincing enough, they need only look across the Atlantic at the pathetic state of economic affairs there, or even revisit the housing bubble through this perspective. Depression is itself an economic concept, not especially subject to monetary dictations.

Jeffrey Snider is the Chief Investment Strategist of Alhambra Investment Partners, a registered investment advisor. 

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