Roosevelt’s Depression of 1937

The “Great Depression” is a thoroughly-studied event in the economic history of the United States.  The reasons for the Crash of 1929 are heavily debated on amongst economic scholars of varying schools of thoughts.  However, it is accepted that the economy “bottomed out” in 1933 and then began a modest recovery.  The reasons for that recovery are just as debated on as the reasons for the crash—some believe that the recovery was relevant to President Franklin Roosevelt’s New Deal; others believe that a recovery of some sort was inevitable since the economy had already bottomed out by the time he took office in 1933.  These arguments are also well documented.  A less studied section of the Great Depression was the so-called “depression within a depression”, or “Roosevelt’s depression”.  This was another dramatic downturn in the economy in 1937—generally, the Keynesian outlook was that Roosevelt decided to balance the budget by cutting government spending, leading to a massive decrease in gross domestic product.  The monetarist theory is that the Federal Reserve ended its credit stimulus too early, or too abruptly, causing a decline in government and consumer spending.  This latter argument is probably the more correct argument. However, their conclusions are generally incorrect (the principle conclusion being that the Federal Reserve can learn from the mistake and undertake a much smoother credit expansion and contraction).  Nevertheless, monetary expansion during the first Roosevelt administration goes a long way in explaining why there was a modest recovery in the economy and why there was a sudden crash in 1937.

Although I do not purport to analyze the New Deal and the economic recovery of 1933–36, the events which took place in these three years were exactly the causes of the crash of 1937.  As I am still in the infant stages of my research on the topic, my objective is not to provide an exhaustive analysis on the credit expansion of 1933–36 and the resultant bust of 1937–38, but instead show some of the research that I have collected lately in an effort to stir collaboration and healthy debate.  This topic is very relevant in today’s era of uncertainty, given that President Obama’s fiscal stimulus is bound to create some artificial and temporary upsurge—at least to a minor degree—in the economy.  Studying the reasons for the 1937 crash may offer important details on the future of the current world economy and may unveil some new expectations of future events.

To fully understand the thesis I am presenting I will quote Spanish economist Jesús Huerta de Soto, from his book Money, Bank Credit and Economic Cycles (Second Edition):

…[The] strategy of increasing credit expansion in order to postpone the crisis cannot be indefinitely pursued, and sooner or later the crisis will be provoked by any of the following three factors, which will also give rise to the recession:

(a)      The rate at which credit expansion accelerates either slows down or stops, due to the fear, experienced by bankers and economic authorities, that a crisis will erupt and that the subsequent depression may be even more acute if inflation continues to mount.  The moment credit expansion ceases to increase at a growing rate, begins to increase at a steady rate, or is completely halted, the six microeconomic processes which lead to the crisis and the readjustment of the productive structure are set in motion (pp. 401–402).

The thesis is that this is exactly what occurred in 1937.  The graph to the right shows the increase in the monetary stock between 1933–36 (taken from data provided by Friedman and Schwartz in Monetary History).  In The Federal Reserve Policy and the Recession of 1937–1938, Kenneth Roose argues that:

Assisted by gold imports, member banks adjusted their reserve position so easily that by December 1936, excess reserves had risen to 2,200 million dollars.  To prevent further gold imports from being made the basis for deposit expansion, the Treasury inaugurated its sterilization program on December 21, 1936.  With additions to reserves from this area stopped, the Board of Governors of the Federal Reserve System then announced a second increase in reserve requirements f 33 1/3 percent for the spring of 1937.  This action exhausted the Board’s power to increase reserve requirements, and was taken again to prevent a possible injurious credit expansion from developing.

Given information on the growth of the money supply during President Roosevelt’s first administration, and the reasoning behind the Federal Reserve’s decision to end its credit expansion in late 1936 and early 1937, the most likely reason for the 1937 depression is that of Huerta de Soto.

In 1933, the economy bottomed out, making a recovery of some sort inevitable.  Although Roosevelt’s New Deal was a restraint on true recovery, the Federal Reserve’s credit expansion (which began during the Hoover administration—as early as November 1929) caused a temporary credit boom, similar to the events which took place between 1924–29, which catalyzed a temporary stimulus to the economy.  The Federal Reserve tightened its open market operations in late 1936, causing another credit contraction and another period of market clearing—that is, the market forced the liquidate of malinvestments made during the “boom” years of 1933–36.  This leads to two conclusions.  First, the “recovery” made during the first administration of the Roosevelt presidency was artificial and did not represent a recovery of real wealth.  Second, the principle cause of the “depression within a depression” was a restoration of the market after it had been distorted by the prior credit boom of the mid-1930s.

There were likely other factors, including increased employment costs and increased taxes.  Clearly, however, it was credit expansion which catalyzed the inevitable boon.  Of course, the topic requires further investigation and exhaustive research would be paramount for a strong argument—but, from information already presented, the case is strong for the Austrian School of Thought to make their argument against further fiscal stimulation of our current economy.  Of course, first our economy will have to bottom out.  The main point of contention should be that the causes for the 1937 crash are not solvable—that is, there is nothing the Federal Reserve can do to correct its mistakes, other than avoid credit expansion (which would make the Federal Reserve obsolete).  Ultimately, the real argument is that it is impossible for the Federal Reserve’s leadership to calculate exactly how much money is necessary to stimulate an economy and when it should end credit expansion.  The reasoning is two-fold.  First, all credit expansion necessarily leads to the distortion of the markets, which catalyzes a credit contraction.  Second, there is no method of calculating how much money is truly necessary, even if credit expansion really did stimulate recovery in the long-run.  Studying the depression of 1937–38 leads to important lessons which still must be learnt by those driving our current fiscal program.