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Dangerous Lessons of 1937

February 2, 2010

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Migrant family stalled on road, 1937Migrant family stalled on road, 1937

Many economists have already compared the years 1929–1932 to those of 2007–2009, and the current period of recovery to the time period 1933–1939. It was only a matter of time before they began to look for a comparison between the recession of 1937 and a potential "double dip" today.

The 1937 recession was preceded by a decrease in deficit spending and an increase in the reserve requirements of banks by part of the Federal Reserve. Otherwise known as "Roosevelt's recession," it is a perfect example of how a drop in government spending and tight monetary policy leads to economic disaster. Or so the official story goes.

The actual lessons of Roosevelt's Recession are much different. The 1937–1938 dip was not the product of tight fiscal and monetary policy, but of excessive government regulation and loose monetary policy. We must clear away the misconception that, without deficit spending and easy credit, the market will fail.

The official story tells of a recovery that took place upon the ascension of Franklin Delano Roosevelt to the presidency. He replaced penny-pinching Herbert Hoover, who foolishly trusted in the power of the free market to correct itself. Roosevelt immediately began to pour money into public-works projects, social-insurance programs and other types of government welfare. While the government accumulated a substantial government debt, the economy recovered at a respectable rate between the years 1933 and 1936, avoiding perpetual poverty and suffering.

In 1937, Roosevelt decided to balance the budget and drastically cut deficit spending. Nearly simultaneously, the Federal Reserve raised reserve ratio requirements for member banks, leading to a contraction of the monetary base. The economy slumped back into recession. The economy was not strong enough to support itself, and tight fiscal and monetary policy allowed a fickle market to waver in the face of what was otherwise a stable period of recovery.[1]

Christina Romer, Barack Obama's current chair of economic advisors, sums up the official history:

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%.… The fundamental cause of this second recession was an unfortunate, and largely inadvertent, switch to contractionary fiscal and monetary policy. [Spending cuts and tax hikes] reduced the deficit by roughly 2.5% of GDP, exerting significant contractionary pressure. [2]

Oftentimes, the official history turns out to be wrong. This history of the Great Depression is not an exception. The idea that Herbert Hoover was a laissez-faire president and that Roosevelt's New Deal paved the road to recovery have been refuted elsewhere.[3] Here we shall concern ourselves only with the myths of 1937.

Myth 1: Deficit Spending

That the deficit of 1937 was smaller than that of 1936 is undeniable. In 1937 the deficit stood at $2.2 billion, as compared to a deficit of $4.3 billion in 1936. However, it is also noteworthy that, while the deficit was half as much as that of the previous year, total government outlays decreased from $8.2 billion to only $7.6 billion.[4]

Interestingly, during 1935 — a year considered one of recovery — total government outlays measured $6.4 billion, less than during both 1936 and 1937. In fact, looking back to the years from 1933 to 1935, government spending peaked at $6.5 billion in 1934. It suffices to say that explaining Roosevelt's recession by pointing at a decrease in government spending is severely dishonest.

It is not much more useful to look at deficit spending. True, deficit spending in 1937 was at its lowest since 1933, but it is worth mentioning that in 1938 — the same year as the economy rebounded from the 1937 dip — total government deficit spending amounted to only $89 million.

But wait, if government spending did not decrease by much in 1937, then how did the government avoid large deficits? Government receipts — money received through taxes — increased from $3.9 to $5.4 billion between 1936 and 1937. In other words, high government spending did not result in a high annual deficit because the government collected a far greater amount of tax money that year than in all previous years of the Great Depression. It is unsurprising that in 1938, government receipts increased to $6.75 billion.

Finally, while government spending did decrease between 1936 and 1937, total expenditure in 1937 was still greater than all years prior to 1936. If a contractionary fiscal policy led to a recession in 1937, how did less spending cause recovery only a few years earlier? This inchoate theory does not hold water.

Myth 2: Tight Credit

Blaming cyclical fluctuations on tight monetary policies has been a favorite pastime ever since Milton Friedman and Anna Schwartz's extensive, albeit heavily flawed, monetary history of the Great Depression.[5] Why such a terrible depression in 1929? Restrictive monetary policy![6] Why the recession of 1937? Restrictive monetary policy, of course!

The 1937 recession came with a contraction in the money supply. The reasons for this contraction is that the Federal Reserve raised the reserve ratio in the previous months.[7] However, his explanation of the contraction is unsatisfying, because the volume of loans made and securities sold continued to rise despite the increase in the required reserve ratio. It was only after the initial fall in the stock market that bank lending began to tighten.[8]

A more plausible explanation behind the contraction of the money supply is a tightening in lending and a decrease in borrowing due to an increase in entrepreneurial uncertainty, given the drop in the stock market's value and the growing disproportion between real wages and productivity. The fall in the supply of money was a result of the 1937 recession, not vice versa.[9]

If anything, a loose monetary policy preceding the recession was more at fault than the Federal Reserve's ineffective attempt to lower excess reserves by raising the reserve ratio.

Causes of Roosevelt's Recession of 1937

If it was not tight credit or low government spending, then what caused the 1937 downturn? Three main factors stand out:

  1. An inflow of gold from Europe and an artificial increase in the dollar-gold exchange ratio caused inflation.

  2. Meanwhile, government's union and wage policies maintained high real wages in the face of stagnating productivity.

  3. Finally, heavy government regulation made the stock market extremely volatile and susceptible to otherwise minor changes.

The years 1933–1936 saw an expansionary monetary policy pushed by the Federal Reserve and the federal government.[10] Within that time period, the stock of money increased by 46% and the general price level by 31%.[11] While the Federal Reserve's rediscount rate remained at 3.5% for the majority of that time,[12] the greatest monetary inflation came as a result of the inflow of gold from Europe.

Regime uncertainty in Europe, largely as a result of the rise of Adolph Hitler in Germany, caused an influx of gold into the United States. In 1934, the government increased the price of gold from $20.67 to $35 per ounce. Banks holding this increased stock of gold were therefore keen on exchanging it for dollars, leading to a substantial increase in the money base.[13]

Ricardo Effect: the tendency for entrepreneurs to replace labor with capital-goods while the productive structure lengthens due to increases in real wages.

We know from Austrian business-cycle theory that increases in the supply of money will lead to shifts in the structure of production.[14] This means that there will be a shift toward the production of capital goods, as they seem advantageous while the interest rate — the cost to borrow capital — is low.[15] This occurs because lower interest rates imply that the share of profits made from investments in capital goods will increase, given that the cost of borrowing the necessary capital is decreased.[16]

The result is widespread malinvestment, as the decrease in the rate of interest was not preceded by a necessary increase in the volume of voluntary savings. Such was the result of the artificial increase in the price of gold in 1934. It comes as little surprise that between 1935 and 1936 there was a sudden illusionary boom in productivity.[17]

Although real wages decreased at first, by 1937 they rose by 11.6%. It is no mere coincidence that around that time the Supreme Court upheld the Social Security Act, the Wagner Act, and the National Labor Relations Act of 1935. The result of these decisions was an increase in the power of unions to coerce firms to raise wages and benefits.[18] Fringe benefits — supplements to standard wages — rose from 1.4% in 1935 to 4.2% in 1937. Accounting for the majority of the rise in cost of supplements was the required employers' contributions toward social insurance, which by 1938 rose from 25 to 71% of the total cost of the supplements.[19]

It is also important to consider Friedrich Hayek's "Ricardo Effect" theory. This is the tendency for entrepreneurs to replace labor with capital-goods while the productive structure lengthens due to increases in real wages.[20] The period between 1935 and 1936, as previously explained, saw an economic boom, a lengthening of the productive structure. But union activity largely disallowed entrepreneurs from replacing labor with capital goods, while real wages were rising astronomically.[21]

All that was necessary was a catalyst to bring about a slowing in the pace of credit expansion. This was provided by the stock market. Heavy regulation in the years leading up to 1937, including heavy taxes and legal impediments on inside trading, reduced incentives to invest in the market.

The result was a stock market in which a large proportion of shares were held by a relatively small pool of investors. This naturally "thinned" the markets, meaning that minor changes relating to buying and selling could reflect dramatically on the prices of individual stocks.[22] Regime uncertainty caused by increasing tax rates and several Supreme Court's decisions led to volatile fluctuations in the stock market, as investors moved to sell their shares.

The sudden drop in value of aggregate stock indexes led to more widespread uncertainty, causing a decrease in the volume of lending. This catalyzed a contraction in the credit markets. The widespread malinvestments which occurred in 1935 and 1936 began to reveal themselves. The 1937–1938 period, known as "Roosevelt's Recession," was therefore a necessary readjustment period after the boom of the period 1935–1936.

More roundabout methods of production, or more capital-intensive entrepreneurial activities, were found to be less profitable than was earlier believed. Moreover, marginal profitability was undercut by the high cost of wages. The predictable result was an incredible drop in productivity and a rise in unemployment.

$20 $17


It is evident that the recession of 1937 was not a product of low government deficit spending or contractionary fiscal policy on the part of the Federal Reserve. It was, instead, a product of expansionary monetary policy and heavy government regulation.

These are important lessons to learn, for we face a new period of recession and slow recovery. We should not be fooled into believing that the economy will crumble without high government spending and loose credit organization. The actual situation is far different. Indeed, high government spending and easy money will only increase malinvestments and forestall necessary readjustments, promising a decline in prosperity.

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[1] The case against the Federal Reserve's tight monetary policy was defended by Milton Friedman and Anna Schwartz in A Monetary History of the United States, pp. 493–545. Also worth reading: Roose, Kenneth D., "Federal Reserve Policy and the Recession of 1937–1938," The Review of Economics and Statistics, Vol. 32, No. 2: May 1950; p. 178.

[2] As quoted in Murphy, Robert, "Christina Romer's Faulty Depression History," Mises Daily: 6 July 2009.

[3] Rothbard, Murray, "Reliving the Crash of '29," Mises Daily: 21 December 2009. Also worth reading: Murphy, Robert, The Politically Incorrect Guide to the Depression and the New Deal, Regnery, 2009.

[4] All budgetary information (outlays and receipts) is provided by the Government Printing Office.

[5] Friedman and Schwartz (1963).

[6] For a refutation see: Rothbard, Murray, America's Great Depression, BN Publishing: 2008.

[7] Friedman and Schwartz (1963) and Roose (1950).

[8] Anderson, Benjamin M., Economics and the Public Welfare, Liberty Press, Indianapolis, Indiana: 1979; p. 432–434.

[9] Salerno, Joseph T., Money and Gold in the 1920s and 1930s: An Austrian View, The Freeman: October 1999 (Vol. 49, No. 10).

[10] Ibid.

[11] Friedman and Schwartz (1963), pp. 497–498.

[12] Ibid., p. 512.

[13] Anderson (1979), p. 346.

[14] Hayek, Friedrich A., Prices & Production and Other Works, Ludwig von Mises Institute, Auburn, Alabama: 2008; pp. 78–79.

[15] Ibid., p. 67.

[16] Huerta de Soto, Jesús, Money, Bank Credit and Economic Cycles, Ludwig von Mises Institute, Auburn, Alabama: 2009; p. 349.

[17] Higgs, Robert, Depression, War and Cold War: Challenging the Myths of Conflict and Prosperity, Independent Institute, Oakland, California: 2006; pp. 11–13.

[18] Vedder, Richard K. and Gallaway, Lowell E., Out of Work: Unemployment and Government in Twentieth-Century America, New York University Press, New York: 1993; pp. 130–131.

[19] Ibid., pp. 140–141.

[20] Huerta de Soto (2009), pp. 330–331.

[21] Salerno (1999).

[22] Anderson (1979), pp. 441–442.

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