Lessons From the 1937-38 Recession For the Fed

How fast should the Federal Reserve tighten monetary policy? Should it tighten at all? I recently wrote about these issues but didn't have the space to explore a fascinating aspect of the debate: the mostly forgotten 1937-38 recession. To many, it's a cautionary tale against adopting tighter policies too soon. The latest to sound the alarm is Ray Dalio, the respected founder of Bridgewater Associates, a huge hedge fund group. His recent memo to clients inspired a Page 1 story in the Financial Times, headlined "Dalio warns Fed of 1937-style rate risk."

At the time, it was called the "Roosevelt recession." It "came as a surprise to most Americans," writes historian Alan Brinkley in "The End of Reform: New Deal Liberalism in Recession and War." Until the summer of 1937, the economy was growing briskly, and "many New Dealers were boasting that the Depression was over." Although civilian unemployment was still high (10 percent in 1936), it was much lower than the peak (23 percent in 1932) and was declining rapidly.

Signs of economic revival abounded. In 1935, the steel industry was operating at 47 percent of capacity; by 1937, that was 80 percent. "Railroads put on extra trains" for July 4, wrote Business Week. "Mountain and seashore hotels packed them in."

And then the recession hit. It was a doozy. At its low point, the economy's output had dropped by 18 percent. Industrial production was down by 32 percent, and unemployment reached a peak of 20 percent, according to economist Allan Meltzer's history of the Fed.

With hindsight, there's widespread agreement that this stunning reversal was caused by government policies - though there's disagreement over which ones.

An early villain was fiscal (a.k.a. budget) policy. Encouraged by the economy's recovery and fearful of inflation - wholesale prices were rising, though not retail - Roosevelt decided that 1937 was a good year to redeem his promise to balance the budget. Although he failed, the budget deficit declined, driven down by the start of Social Security taxes (without offsetting benefit payments, which hadn't yet begun) and the absence of a veterans' bonus that had been paid in 1936.

On the facts, poor fiscal policy seems guilty, but some modern economists reject that verdict. By itself, the budget shift was too small to explain the economy's dramatic change, they say.

Another culprit is the Federal Reserve, which between August 1936 and May 1937 doubled the amount of banks' required reserves. (Reserves are funds that banks keep to meet depositors' withdrawals.) This, it's said, squeezed banks' lending and money-creation. Again, modern scholarship objects. Banks already held high levels of reserves, so the new requirement had little impact, concludes an influential study by economists Charles Calomiris, Joseph Mason and David Wheelock.

A final explanation involves gold. Since 1934, the United States had been receiving large gold inflows - reflecting fears of political instability or war in Europe - that stimulated economic expansion. The reason was simple. When the gold arrived here, it had to be sold to the government for dollars. Those dollars were then spent or lent, giving the economy a boost. But in late 1936, the Treasury - again, to quash incipient inflation - decided to offset this boost by draining money from the economy. In economic jargon, the gold flows were "sterilized."

This turned out to be a massive miscalculation. The sterilization created a "pronounced monetary shock," argues a paper by Dartmouth economist Douglas Irwin. Growth in the money supply, which had been rapid, halted. Stock prices fell, and interest rates rose. After the Treasury reversed its policy on sterilization in 1938, the economy recovered.

Exactly what government policies caused the 1937-38 slump remains unclear. Perhaps all of them. It almost certainly was some mix. With hindsight, the recession seems to have been preventable. This is a lesson that ought to weigh heavily on the Fed as it ponders what to do next. Though tighter policies are inevitable, a fragile economy is vulnerable to too much or too soon.