1937, the Fed, the stock market, and the Treasury

Sitting on cash when people want cash drives up interest rates. High interest rates discourage investment. They discourage investment even more when investors are already predisposed against expanding operations to provide for future demand that they're uncertain about. They discourage investment even more if there are arithmetic barriers to relief on interest rates (like a nominal price floor and weak inflation).

As far as the economy is concerned, it doesn't matter who does it: households increasing savings, businesses demanding and retaining higher profits, central bankers mandating higher reserves, or fiscal authorities sitting on money. As far as history is concerned, of course, sometimes one entity is more to blame than another.

Paul Krugman recently wrote a post on the "recession within a depression" of 1937, which he says eerily parallels the discourse we see today. He says (citing Friedman and Schwartz) that in 1936-1937 the Federal Reserve started getting concerned about the inflationary potential of the large growth in excess reserves. These concerns are not unlike those we are hearing today. They responded by raising reserve requirements, a decision which Friedman and Schwartz consider to be the source of the 1937 downturn. Krugman raises doubts about how important this policy really was, citing the Romers. Recent research looking at Federal Reserve member banks by Calamoris, Mason, and Wheelock (2011) confirms Krugman and the Romers' suspicion that Friedman and Schwartz were too quick to blame the Fed. They demonstrate that the reserve requirement rules were non-binding. This is all in the spirit of Krugman's own mentor, James Tobin, who said of the 1936-37 Fed policy that "raising reserve requirements may have been a mistake but it was probably a relatively harmless one."

Jonathan Catalan presents a response that ties Krugman to Friedman and Schwartz (which seems a little odd to me). Aside from the question of what Krugman thinks fo the Friedman and Schwartz argument, Jonathan does identify the common thread between the three economists, that "the point Krugman is trying to make is that tight monetary policy will definitely set a recovery back". Jonathan, of course, disagrees - a position which he has staked out earlier in his Mises Daily article on the 1937 recession. He blames the stock market crash for the contraction of the money supply. Falling stock prices increased precautionary demand for money, leading to a contraction in the money supply.

This is a little confusing to me. As I understand it, the stock market crashed in August of 1937, the monetary base started falling at the beginning of 1937, and output started falling earlier in the spring. How does Jonathan get the causality going from the stock market to the monetary base? I don't entirely understand the argument.

So barring an explanation from Jonathan, he seems to be wrong in pointing to the stock market (and thus businesses and households) as the source of the reduction in the money supply. Friedman and Schwartz are wrong that the Fed is to blame (according to Jonathan, Krugman, Calamoris, Mason, Wheelock, Tobin, Romer, and Romer). So what happened in 1937?

Well once again we can look to Calamoris, Mason, and Wheelock (2011), who suggest that the real culprit may have been the U.S. Treasury. In 1936 the Secretary Morgenthau decided to play central banker and sterilize billions of dollars of incoming gold by stock-piling it and paying for it by selling government securities (rather than by depositing it at the Federal Reserve). This is just as contractionary as it would be if the Federal Reserve had engaged in open market sales.

Of course taxes were raised and the deficit was cut too - that doesn't help. But the gold sterilization point is interesting because you don't hear people talking about it as much.

Does this history make sense? I'm no expert on the depression, but the literature seems to point to this explanation. Perhaps Friedman and Schwartz defenders can reinvigorate the case for the impact of reserve requirements or Jonathan could explain how the stock market is causal here.