Roosevelt Recession

Roosevelt Recession Causes

The Roosevelt Recession occurred during the recovery from the Great Depression. Before 1937, there had been a large recovery due in part to the policies of the New Deal. However, during the Roosevelt Recession of 1937-38, there was another steep decline before recovery continued.

There was a complex set of causes of the Roosevelt Recession. Let's first look at the initial recovery before considering the Roosevelt Recession's causes.

Recovery from the Great Depression Before the Roosevelt Recession of 1937-38

At the start of 1937, things mostly appeared rosy. The country had climbed out of the bottom of the Great Depression in 1933. Gross National Product (GNP) had risen shapely in 1934 and 1935 and grew by an even sharper 14% in 1936. Between May 1935 and April 1937, unemployment had declined by one third.¹ It appeared the country had rounded the corner.

In fact, in Roosevelt's State of the Union address in January 1937, he seemed to suggest the depression was over. Still, in it and his second inaugural address the same month, he acknowledged that there were still economic issues and disparities to be addressed. However, he and most policymakers failed to realize they were on the verge of another drastic decline.

Economists today still debate the causes of the Roosevelt Recession of 1937-38, and this decline and recovery are understudied compared to the 1929 crash and full recovery. However, those that have studied it agree there was a combination of causes.

Fig 2 - Stock prices with the declines starting in 1929, temperorary recovery and new drop in 1937.

Monetary Policy

Many of the economists who have studied the Roosevelt Recession's causes blame a shift in monetary policy. Believing the country was on track to recovery, a less expansionary monetary policy was adopted. The Federal Reserve and Roosevelt both worried that inflation was rising.

Fearing banks would be quick to loan money back out and add to inflation, they opted to increase reserve requirements, forcing banks to keep more cash on hand. However, the effect was larger than expected as many banks, hoping to prevent the type of runs that had characterized the crash in 1929, chose to keep excess reserves on top of the limits.

Therefore, banks extended less credit and made fewer loans. This had a similar effect to the decline in available money that the crash of 1929 had provoked, stalling the recovery and contributing to a new decline. This view has been one of the most dominant among economists, as argued by Milton Friedman and Anna Schwartz.

Other economists have contended that the policy did not necessarily restrict the availability of credit. However, by signaling that the government was worried about inflation, they encouraged pessimism and less spending. In other words, the policy created a sort of self-fulfilling prophecy.

Treasury Department's "Sterilization" of Gold

This period had also seen a large inflow of gold from Europe into the US banking and monetary system. Banks bought gold from European banks, and then they could resell certificates or bonds based on its value. This had helped boost the overall economy by increasing the money supply. However, it was also another potential cause of inflation, and the Treasury Department attempted to offset it by "sterilizing" the gold.

What this means is that the Treasury Department bought gold but did not then sell certificates or bonds based on its value, in essence reducing the amount of total dollars available and preventing the value of this gold from being injected into the economy.

Part of the problem is that the Federal Reserve and Treasury did not work together, but both adopted policies meant to resolve the same problem. In doing so, they basically over-fixed it, stopping the expansion of the money supply that had helped the recovery up to that point and overcorrecting for the feared inflation.

Had only one or the other been done, the retraction might not have been severe, but combined they basically cut off the expansionary spigot that had been fueling recovery, going so far as to have a contractionary effect.

Fig 3 - A young mother and migrant worker in March 1937.

Reduction of Deficit Spending

Another compounding factor for the Roosevelt Recession's causes was a return to more austerity.

Large deficit spending, or the government spending more money than it collected, had been an important part of the New Deal and the Keynesian Economics that informed it. The deficit in 1936 was the largest in the country's history.

Worried about this, government spending was reduced over the second half of 1936 and first half of 1937. At the same time, the new Social Security tax went into effect in 1937.

This meant that not only was the money in circulation reduced by the monetary policies of the Fed and Treasury, but the federal government was also spending less while collecting more. In short, spending across the entire economy decreased, adding to the deflationary momentum.

Fig 4 - People wait for relief checks in California in March 1937.

Increased Costs

Foreign and domestic factors also contributed to reduced profits for businesses. In Europe, the Spanish Civil War was underway, and most countries had begun rearming in prelude to World War II. This meant the cost of materials for many manufactured goods went up.

At home, workers and organized labor had achieved more power in the early New Deal. The number of strikes had risen, and increased bargaining power meant higher wages for workers, which meant higher labor costs for companies in addition to the increased cost of materials.

Roosevelt Recession's Impact

Economists still debate about which of these four different causes of the Roosevelt Recession of 1937-38 were most important.

However, it seems clear that they worked together to make the decline worse than it may have been. Essentially, there was less money available, less money being spent, prices were going down, and production costs were going up, leading to overall less investment and production.

What this meant in terms of the Roosevelt Recession's impact was that many of the gains of the recovery up to that point were quickly rolled back. As noted above, the Roosevelt Recession was the third largest in the 20th century history of the United States.

Real Gross Domestic Product (GDP) fell by 10%. Unemployment surged again to nearly 20%. Industrial production fell by nearly one-third.²

Fig 5 - US unemployment showing the peak in 1933 and the surge during the Roosevelt Recession of 1937-38.

Recovery from the Roosevelt Recession

Fortunately, the Roosevelt Recession's impact failed to reach the depths of the Great Depression. Policymakers reacted fairly quickly once it began, paving the way for a recovery.

The Fed reversed the increased reserve requirements, and the Treasury "de-sterilized" all the gold it had kept out of circulation. Meanwhile, the administration returned to a fiscal policy of deficit spending.

Between 1938 and 1942, economic output grew by 49%. Part of this was fueled by the defense buildup once the US entered World War II, but also by the return to expansionary monetary and fiscal policies.

Fig 6 - US manufacturing output showing the declines after 1929 and during the Roosevelt Recession before full recovery after 1939.

Roosevelt Recession Significance

It's easy to look at the Roosevelt Recession as a hiccup on the road to recovery from the Great Depression. In fact, it's often overlooked as just part of the overall recovery from 1933-1942.

To some extent, that's true, although looking at it that way no doubt fails to recognize the Roosevelt Recession's significance for the people who lost jobs or suffered from lower wages.

The Roosevelt Recession's significance from a historical perspective today is more of a warning that ending policies that promote economic recovery too early can lead to the end of the recovery and even a new decline. The fine line between stimulus and overheating the economy is one they will surely continue to debate. Policymakers and economists, no doubt will continue to debate the correct approach to economic crises, based in part on the Roosevelt Recession's causes and impact.