The “Mistake of 1937”

Below is an excerpt from a commentary originally posted at www.speculative-investor.com on 19th April 2012.

The US Great Depression lasted from 1929 until 1945, but the deflationary phase of the Depression effectively ended in 1932. Regardless of whether you define deflation and inflation in terms of money supply or prices, there was almost continuous inflation in the US after 1932. The inflation was, however, briefly interrupted during 1937-1938, when a leveling-off in the money supply and a sudden economic downturn led to sharp declines in equity and commodity prices. The 1937-1938 downturn is sometimes called the “mistake of 1937” by those who believe that it only occurred because the Fed tightened monetary policy prematurely. According to the believers in this theory, the US economy would have continued to recover from the collapse of 1929-1932 if not for the Fed’s premature tightening. Significantly, Ben Bernanke is one of the believers.

Believers in the theory that the collapse of 1937-1938 was caused by the Fed’s premature tightening of monetary conditions are partially right in that modest Fed tightening during the second half of 1936 and the first half of 1937(1) was probably the catalyst for the collapse. The question that this theory fails to address is: if a genuine economic recovery had got underway in 1933, then why did the recovery fall apart so rapidly and so completely following only a minor tweaking of monetary conditions? The answer is that the recovery wasn’t real; it was an illusion based on increasing money supply. When economic growth is mainly the result of increasing money supply then stopping, or even just slowing, the rate of money-supply growth will likely bring about a collapse.

(As an aside, the recovery’s flimsy monetary underpinning is part of the reason why, like the recovery that began in mid 2009, it was essentially “jobless” (the unemployment rate remained very high throughout the 1933-1937 rebound). However, there was more to the relentlessly high unemployment of the 1930s than the Fed’s counter-productive monetary machinations. Actions taken by the Hoover and Roosevelt administrations to raise the price of labour can also be given a lot of credit for keeping people out of work.)

This prompts the question: shouldn’t the Fed have continued to ‘support’ the economy with a constant flow of new money until a real recovery was able to take hold?

The above question ignores the fact that the flow of new money (monetary inflation) leads to more mal-investment and thus not only gets in the way of a real recovery, but also further weakens the economic structure. Had the Fed continued to provide monetary support for an additional year then the collapse would have commenced in mid 1938 rather than mid 1937. Also, it would have been even more devastating thanks to an additional year of mal-investment. As Ludwig von Mises pointed out long ago: “There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.”

The above question also ignores the fact that in real time the central bank finds itself between the proverbial rock and a hard place. Even when the economy is subject to natural deflationary forces, as it was in the mid-1930s, the unnatural creation of new money by the central bank will eventually cause evidence of an inflation problem — in the form of rising prices for important commodities and some goods and services — to emerge. After a while, the pressure on the central bank to curtail the inflation problem can become greater than the pressure on the central bank to ‘support’ the economy with a continuing flow of new money.

By the third quarter of 1936 the pressure on the Fed to curtail the inflation problem had become dominant, but if the Fed had ignored this pressure and instead persisted with its price-boosting policies — the path that Monday-morning Keynesians(2) now say should have been taken — then the end result would have been an even more severe economic downturn once monetary conditions were eventually tightened. Alternatively, the Fed could have chosen to rapidly inflate the money supply indefinitely, in which case the end result would have been total catastrophe for both the US dollar and the US economy.

A picture of what happened during 1937-1938 is displayed below. On the chart the 1937-1938 downturn looks minor in comparison to the 1929-1932 downturn, but it was substantial nonetheless. The Dow Industrials Index lost more than half of its value, but perhaps of greater significance was the quick one-third decline in manufacturing output. Considering the relative importance of manufacturing in those days, this effectively means that the economy quickly shrunk by one-third.

The chart also shows that the Fed made no attempt to tighten via a higher official interest rate. As explained in Note (1) below, the Fed used other means to restrict the flow of new money.

(1) The Fed started tightening the monetary reins in August of 1936. It never went as far as hiking the official interest rate (the “Discount Rate”), but it did increase bank reserve requirements and took actions to prevent gold in-flows to the US Treasury from boosting the Monetary Base. The result was a leveling-off in the money supply during the 2-year period beginning in late-1936.

(2) A Monday-morning Keynesian is an economist who always knows, with the benefit of hindsight, how much ‘stimulus’ should have been provided to the economy to bring about a sustainable recovery. Since these economists begin with the premise that monetary and/or fiscal stimulus helps the economy, if an economy tanks despite the concerted application of stimulus measures they inevitably conclude that the stimulus was insufficient. They never seriously question the correctness of the underlying premise.