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.
March 26, 2015
March 25, 2015
Based on the [quantity theory of money equation MV = PQ] holding the money velocity constant, if the money supply (M) increases at a faster rate than real economic output (Q), the price level (P) must increase to make up the difference. According to this view, inflation in the U.S. should have been about 31 percent per year between 2008 and 2013, when the money supply grew at an average pace of 33 percent per year and output grew at an average pace just below 2 percent. Why, then, has inflation remained persistently low (below 2 percent) during this period? …
During the first and second quarters of 2014, the velocity of the monetary base2 was at 4.4, its slowest pace on record. This means that every dollar in the monetary base was spent only 4.4 times in the economy during the past year, down from 17.2 just prior to the recession. This implies that the unprecedented monetary base increase driven by the Fed’s large money injections through its large-scale asset purchase programs has failed to cause at least a one-for-one proportional increase in nominal GDP. Thus, it is precisely the sharp decline in velocity that has offset the sharp increase in money supply, leading to the almost no change in nominal GDP (either P or Q).
So why did the monetary base increase not cause a proportionate increase in either the general price level or GDP? The answer lies in the private sector’s dramatic increase in their willingness to hoard money instead of spend it. Such an unprecedented increase in money demand has slowed down the velocity of Money …
And why then would people suddenly decide to hoard money instead of spend it? A possible answer lies in the combination of two issues:
•A glooming economy after the financial crisis
•The dramatic decrease in interest rates that has forced investors to readjust their portfolios toward liquid money and away from interest-bearing assets such as government bonds.
October 8, 2014
The trial challenging the government’s rescue of American International Group is in full swing this week. Ben Bernanke, Hank Paulson, and Tim Geithner are making appearances. AIG’s former CEO-through his charitable foundation, which is a large AIG shareholder-has sued the government for its allegedly punitive bailout of AIG during the financial crisis. The government officials who bailed out the company may find it hard to run from their prior statements.
Over the same weekend that Lehman failed, AIG was also on the precipice of failure. Not only were collateral demands from counterparties of its notorious Financial Products division draining the company’s liquid assets, but its securities lending operations were also emptying company coffers and threatening the viability of some of the company’s insurance subsidiaries.
The company and its regulators concocted a number of plans for non-governmental rescues, but each of these fell through. A consortium of big banks took a deep look at AIG and concluded that it wasn’t worth saving. Forthcoming demands for cash from the company exceeded the value of the company’s assets, so there was no point in pouring good money in after bad. As insurance expert David Merkel puts it, “AIG was broke.”
The government, not deterred by the thought that it might be rescuing an insolvent company, jumped right in with an $85 billion loan. AIG was in such bad shape that the initial loan was followed by more government money and a loosening of the loan terms. Wrapped in the government’s protective mantle, AIG survived.
Now Hank Greenberg, AIG’s long-time CEO, is challenging the tough terms under which the government rescued his former company from trouble that probably would not have happened under his watch. His lawsuit alleges that the federal government withheld help from AIG, such as discount window access and loan guarantees, that it extended to other companies. When the government finally coughed up assistance for AIG, the lawsuit alleges, “the terms demanded by the Government were grossly disproportionate to the Government’s interest in protecting the interests of taxpayers.” In addition to securing the loan with all of the company’s assets, the government took a 79.9 percent equity stake in the company-an unconstitutional taking of private property according to Greenberg’s suit.
The government could credibly argue that AIG was in so much trouble that even such a large stake in the company was not of any value. That is what the private sector would-be lenders concluded. AIG’s problems ran through the company and were not just isolated to its Financial Products unit. But that sort of defense would raise new questions about why the government rescued AIG at all. The government is not supposed to loan money to insolvent companies, but only those that have good collateral to secure the loan.
Accordingly, in defending the rescue in the past, government officials have argued that AIG-in contrast to Lehman-was very valuable when it was rescued. Former Federal Reserve Chairman Ben Bernanke, for example, insisted that AIG “had lots and lots of perfectly good assets. And as a result, it had collateral which it could offer to the Fed to allow us to make a loan to provide the liquidity needed to stay afloat.” Statements like that make it awfully hard to argue in the context of this lawsuit that actually AIG was not chock full of good collateral, but was so desperate for help that the government was justified in taking a big equity stake.
Bolstered by the government’s own insistence that AIG was a really valuable company with a temporary liquidity problem, Greenberg might succeed in convincing the court that the government took private property without just compensation. Although not the right result, at least it would strike a blow to too-big-to-fail by adding to the bailout calculus the specter of subsequent courtroom payouts to allegedly aggrieved shareholders.
Hester Peirce is a senior research fellow at the Mercatus Center at George Mason University.
March 28, 2013
The Cyprus resolution is taking shape as it looks like accounts with balances greater than €100,000 will be subject to a 30% hit to go toward meeting the requirements of the bailout. This news seemed to have visible impacts on iShares Italy (EWI) and iShares Spain (EWP) which were both down more than 4% yesterday.
If this true, the Europe crisis is just warming up.
December 13, 2012
It would seem that some are questioning whether the market will trade higher on the back of QE infinity or unemployment 6.5%.
Get a grip. With the Federal Reserve pouring in new money to offset any monetary contraction still occurring from defaults, or expanding the money supply in aggregate, financial markets will move higher.
To benefit however is not an overnight operation, nor will it be easy. There will be the inevitable shakeouts etc. These are opportunities to trade around the position, where money can be made. It comes down to timing and your methodology [trading system] to take advantage of those fluctuations.
My newsletter has two components: [i] weekly system based on COT reports and [ii] my longer term methodology.
The COT report methodology, like any short-term system requires far greater accuracy than a longer term system. The longer term system by comparison is very easy.
Either way, with QE infinity, you need to be long the market. It will trade higher, the question is when.
November 13, 2012
Greece. Who, apart from the Greeks themselves, currently really give a damn. The saga just goes on and on.
Question: Is the goal still to get Greece’s debt to 120%?
Juncker: The fact is that the target of 120% will remain, but the target as far as the time frame is concerned has been postponed to 2022.
[Laughter in the room]
Juncker: That was not a joke!
August 19, 2012
There’s a story by Reuters citing the latest edition of German magazine Der Spiegel, which is reporting that the ECB is considering setting an explicit top yield threshold for peripheral nation borrowing costs at its meeting in September.
In other words, ECB chief Mario Draghi would come out and say something like: “Italy’s 2-year borrowing costs shall not be more than 300 basis points above Germany’s 2-year borrowing costs, and if it rises above that level, the ECB will come in and press it down via bond purchases.”
It would be an incredible game changer for traders to know that the ECB was sitting there on the bid at a certain level, standing ready to buy sovereign debt.
That the ECB would eventually do something like this has been buzzed about for a long time, but speculation really started heating up in late July, when Mario Draghi came out and said that high peripheral borrowing costs were impeding the transmission of monetary policy, and thus came under the purview of the ECB.
He further hinted at something like this at the August meeting, when he talked about making purchases at the short end of the yield curve, offering the market a very clear idea that more action was on the way.
So Europe goes full bore inflation, or QE.