Similar, but different?
When the dollar was re-pegged to gold at $35 per oz. in January 1934, the US essentially went back on a gold standard. Gold reserves constituted 85% of the monetary base and changes in those reserves accounted for most of the changes in the monetary base. Because the US received large gold inflows in the mid-1930s, monetary policy was expansionary. This was the primary reason for the economic recovery (Romer 1992).
But when the Roosevelt administration began to worry about the potential for higher inflation, the Treasury Department decided to sterilise all gold inflows starting in December 1936. In essence, its new gold holdings were held in an inactive account rather than with the Federal Reserve, where it would have become part of the monetary base and money supply. Thus, instead of allowing the monetary base to grow with the inflow of gold, the monetary base was essentially frozen at its existing level.
The economy faltered in the spring of 1937 and tanked in the autumn of 1937. In February 1938, having realised its error, the Treasury ended its policy. In April 1938, the Treasury implemented its exit strategy and began desterilising its inactive gold holdings. The economy began to recover in June 1938.
The effect of the gold sterilisation policy on the monetary base is shown in Figure 2. The gold stock and monetary base grew consistently from 1934 to 1936. Although gold stocks continued to grow in 1937, the monetary base flatlined because of the sterilisation. The non-sterilised gold stock is flat until the Treasury began desterilising its gold holdings in April 1938.
The impact of gold sterilisation and higher reserve requirements on the money supply can be separated by noting that gold sterilisation affects the monetary base while reserve requirements affect the money multiplier. In a recent paper (Irwin 2012), I find that changes in the monetary base were much more important than changes in the money multiplier in explaining the abrupt end to the growth of the money supply in 1937.
Notice also that gold inflows into the US essentially ceased in late 1937 until mid-1938. The sudden halt to gold inflows was due in part to fears that the Roosevelt administration would respond to the recession by devaluing the dollar, just as it had done in response to the Great Depression in early 1933. (Fool me once, shame on you, fool me twice, shame on me, seems to have been the view of financial markets.) However, gold began surging back into the US in September 1938 when Hitler’s territorial demands on Czechoslovakia (the Munich crisis) set off fears of a European war.
If we are to avoid the mistakes of the past, it is important to have an accurate assessment of what those past mistakes were. The severity of the Recession of 1937-38 was not due to contractionary fiscal policy or higher reserve requirements. By contrast, the policy tightening associated with gold sterilisation was not modest – it did not simply reduce the growth of the monetary base by a few percentage points, it stopped its growth altogether. While the Federal Reserve is often blamed for its poor policy choices during the Great Depression, the Treasury Department was responsible for this particular policy error.
The recession of 1937-38 occurred long ago, but it does have policy lessons for today. It suggests that, in a weak recovery, a pre-emptive monetary strike against inflation (which was very low at the time, as it is today) is capable of producing a devastating recession.
