Christina Romer: The lessons of 1937
[Christina Romer is the chairwoman of Barack Obama's Council of Economic Advisers and a scholar of the Depression].
AT A recent congressional hearing I cautiously noted some “glimmers of hope” that the economy could stabilise and perhaps start to rebound later in the year. I was asked if this meant that we should cancel much of the remaining spending in the $787 billion American Recovery and Reinvestment Act. I responded that the expected recovery was both months away and predicated on Recovery Act spending ramping up greatly. Only later did it hit me that I should have told the story of 1937.
The recovery from the Depression is often described as slow because America did not return to full employment until after the outbreak of the second world war. But the truth is the recovery in the four years after Franklin Roosevelt took office in 1933 was incredibly rapid. Annual real GDP growth averaged over 9%. Unemployment fell from 25% to 14%. The second world war aside, the United States has never experienced such sustained, rapid growth.
However, that growth was halted by a second severe downturn in 1937-38, when unemployment surged again to 19% (see chart). The fundamental cause of this second recession was an unfortunate, and largely inadvertent, switch to contractionary fiscal and monetary policy. One source of the growth in 1936 was that Congress had overridden Mr Roosevelt’s veto and passed a large bonus for veterans of the first world war. In 1937, this fiscal stimulus disappeared. In addition, social-security taxes were collected for the first time. These factors reduced the deficit by roughly 2.5% of GDP, exerting significant contractionary pressure.
Also important was an accidental switch to contractionary monetary policy. In 1936 the Federal Reserve began to worry about its “exit strategy”. After several years of relatively loose monetary policy, American banks were holding large quantities of reserves in excess of their legislated requirements. Monetary policymakers feared these excess reserves would make it difficult to tighten if inflation developed or if “speculative excess” began again on Wall Street. In July 1936 the Fed’s board of governors stated that existing excess reserves could “create an injurious credit expansion” and that it had “decided to lock up” those excess reserves “as a measure of prevention”. The Fed then doubled reserve requirements in a series of steps. Unfortunately it turned out that banks, still nervous after the financial panics of the early 1930s, wanted to hold excess reserves as a cushion. When that excess was legislated away, they scrambled to replace it by reducing lending. According to a classic study of the Depression by Milton Friedman and Anna Schwartz, the resulting monetary contraction was a central cause of the 1937-38 recession....
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AT A recent congressional hearing I cautiously noted some “glimmers of hope” that the economy could stabilise and perhaps start to rebound later in the year. I was asked if this meant that we should cancel much of the remaining spending in the $787 billion American Recovery and Reinvestment Act. I responded that the expected recovery was both months away and predicated on Recovery Act spending ramping up greatly. Only later did it hit me that I should have told the story of 1937.
The recovery from the Depression is often described as slow because America did not return to full employment until after the outbreak of the second world war. But the truth is the recovery in the four years after Franklin Roosevelt took office in 1933 was incredibly rapid. Annual real GDP growth averaged over 9%. Unemployment fell from 25% to 14%. The second world war aside, the United States has never experienced such sustained, rapid growth.
However, that growth was halted by a second severe downturn in 1937-38, when unemployment surged again to 19% (see chart). The fundamental cause of this second recession was an unfortunate, and largely inadvertent, switch to contractionary fiscal and monetary policy. One source of the growth in 1936 was that Congress had overridden Mr Roosevelt’s veto and passed a large bonus for veterans of the first world war. In 1937, this fiscal stimulus disappeared. In addition, social-security taxes were collected for the first time. These factors reduced the deficit by roughly 2.5% of GDP, exerting significant contractionary pressure.
Also important was an accidental switch to contractionary monetary policy. In 1936 the Federal Reserve began to worry about its “exit strategy”. After several years of relatively loose monetary policy, American banks were holding large quantities of reserves in excess of their legislated requirements. Monetary policymakers feared these excess reserves would make it difficult to tighten if inflation developed or if “speculative excess” began again on Wall Street. In July 1936 the Fed’s board of governors stated that existing excess reserves could “create an injurious credit expansion” and that it had “decided to lock up” those excess reserves “as a measure of prevention”. The Fed then doubled reserve requirements in a series of steps. Unfortunately it turned out that banks, still nervous after the financial panics of the early 1930s, wanted to hold excess reserves as a cushion. When that excess was legislated away, they scrambled to replace it by reducing lending. According to a classic study of the Depression by Milton Friedman and Anna Schwartz, the resulting monetary contraction was a central cause of the 1937-38 recession....