Recessions of '37 & '48
Jude Wanniski
December 7, 2001


To: SSU Students
From: Jude Wanniski
Re: Answering the Monetarists

In our lesson last week differentiating between a "contraction" and a "deflation," we covered my argument that the Great Depression that began in 1929 was caused by fiscal policy and can in no way be considered a monetary event. In other words, the "gold standard" bears no responsibility for the Crash of 1929 or the great economic contraction that followed the higher tariffs and taxes imposed by the Hoover administration. I promised this week I would follow-up with a discussion of the recessions of 1937-38, the so-called "recession within the Depression," and the post-war recession of 1948-49. In addition, I said I would add an interesting discussion of the Depression by Ludwig von Mises, which he wrote in 1934 as a preface to the English edition of his Theory of Money and Credit. I've trimmed it a bit, but it is still several pages. It is important because it is written after the Crash and just into the Depression. Von Mises exonerates gold in a way other Austrians and monetarists do not. He would understand today's deflation immediately.

The discussion of the two recessions was inspired by an e-mail from an old friend, Howard Segermark, one of the earliest supply-siders, at the time the economic advisor to Jesse Helms, and the inspiration for the Gold Commission. Howard picked up on a comment I'd written to another supply-sider and copied to him, which led to this exchange on November 27:

SEGERMARK: Jude, one question about your comments: If we were on a gold standard, the Fed would have to buy or sell assets to meet market demand for liquidity at the dollar/gold exchange rate, and not worry about the "money supply." In a floating regime, as we are now, the velocity of money changes constantly, as it does not do under a fixed gold regime. Isn't it true that under any monetary regime, the demand for money may change? Say, for example, we had a gold standard and a Reaganesque shift of economic incentives (big marginal tax cuts) and people found it more desirable to have large cash balances. Wouldn't that be a shift in demand for money? Of course, under a gold standard, the response would be automatic as you point out. We care not about how many dollars; just their value. (I recall Friedman and other monetarists in '82-'83 predicting catastrophe because of rapid increases in M2, and later when no hyperinflation came, calling the money expansion a one-time 'stochastic shock.' They had to, because in their world, the velocity of money is constant.)

Am I wrong to think it more logical to talk about demand for money rather than velocity? It is also logical, as you pointed out, that under a fiat system, market participants must constantly make predictions about the future value of their money; the wisdom of cash balances and fiat-currency-denominated assets. Demand/velocity is inherently unstable.

WANNISKI: Funny you mention this, Howard. I've been thinking about it for the last two days, since I read a column by Robert Samuelson in The Washington Post, which pooh-poohs the idea of there being a deflation underway. After I read it, I dug out my copy of the late Herb Stein's book, The Fiscal Revolution in America, which Herb gave me when we were still on speaking terms in 1970, before I met Laffer. Here is Samuelson, a columnist who has been sniggering at supply-siders for 20 years without making the slightest attempt to investigate:

What does history teach? Just this: Deflation's dangers seem greater in theory than practice. "We've had a couple of recent recessions with deflation: one in 1937-38 and another in 1948-49. We recovered from those quite nicely," says economist Allan Meltzer of Carnegie Mellon University. In both cases, says Meltzer, the Federal Reserve prevented a deflationary spiral by easing money and credit. Even before the Fed's creation in 1913, deflation wasn't fatal if it was mild. Prices drifted down slowly in the late 19th century (about 2.5 percent annually from 1865 to 1880) without crippling industrialization. Railroads, steel companies and meatpackers all expanded rapidly. However, falling crop prices hurt farmers, who were often big debtors.

The scary counterexample is the Great Depression. From 1929 to 1933, consumer prices fell almost 205 percent, unemployment rose from 3 percent to 25 percent and 10,797 banks failed. This was a classic deflationary spiral. Meltzer blames the Federal Reserve for not stopping it with easier credit.

Notice Howard, not one of the "deflations" Meltzer mentions were monetary deflations. All occurred while the U.S. was on a gold standard. The 1937-38 recession was the result of the increase in the capital gains tax in 1937. It ended in June 1938 when the Democratic Congress, according to the Stein account on pages 114-115, cut the tax back to where it had been a year earlier. Dixiecrats joined the GOP in passing the tax cut, which FDR let pass into law without his signature. having earlier threatened a veto. Meltzer, a dyed-in-the-wool monetarist, only sees the monetary aggregates falling in 1937 and expanding in 1938. This was the recession within the Depression, a "contraction," as I would put it, not a "deflation." The 1948-49 recession ended when the Congress, which twice had a tax cut vetoed by President Truman, finally passed one over his veto in 1948, its provisions taking effect on January 1, 1949. Again, Meltzer sees the money supply contracting in the recession and expanding as the gold standard automatically supplies the expanding economy with the money it demands.

Of course Meltzer and the Friedmanites will never give up on their idea that the Depression that began with the Crash of 1929 had anything to do with the Smoot-Hawley Tariff Act or the Hoover tax increases. The demand for money crashed, but the monetarists think it could have been offset by pushing reserves into the banking system, although when they did, all that happened was that gold flowed out of Treasury's hoard. So yes, Howard, I would much rather talk about the demand for money under a gold standard. But when you have a fiat system as we have now, we are in a monetarist world, and they like velocity, although they hate to have to explain it as the source of their forecasting failures. There is plenty of cash in the economy right now, with negative velocity, but bank reserves are about where they were five years ago. There was a spike at Y2K that was meaningless, although Art Laffer uses it to explain the stock market expansion and its collapse. And there was a brief spike at 9/11. But over the five years, adjusted bank reserves have been flat.

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The outward guise assumed by the questions with which banking and currency policy is concerned changes from month to month and from year to year. Amid this flux, the theoretical apparatus which enables us to deal with these questions remains unaltered. In fact, the value of economics lies in its enabling us to recognize the true significance of problems, divested of their accidental trimmings. No very deep knowledge of economics is usually needed for grasping the immediate effects of a measure; but the task of economics is to foretell the remoter effects, and so to allow us to avoid such acts as attempt to remedy a present ill by sowing the seeds of a much greater ill for the future.

Ten years have elapsed since the second German edition of the present book was published. During this period the external appearance of the currency and banking problems of the world has completely altered. But closer examination reveals that the same fundamental issues are being contested now as then. Then, England was on the way to raising the gold value of the pound once more to its prewar level. It was overlooked that prices and wages had adapted themselves to the lower value and that the reestablishment of the pound at the prewar parity was bound to lead to a fall in prices which would make the position of the entrepreneur more difficult and so increase the disproportion between actual wages and the wages that would have been paid in a free market. Of course, there were some reasons for attempting to reestablish the old parity, even despite the indubitable drawbacks of such a proceeding. The decision should have been made after due consideration of the pros and cons of such a policy. The fact that the step was taken without the public having been sufficiently informed beforehand of its inevitable drawbacks, extraordinarily strengthened the opposition to the gold standard. And yet the evils that were complained of were not due to the resumption of the gold standard, as such, but solely to the gold value of the pound having been stabilized at a higher level than corresponded to the level of prices and wages in the United Kingdom.

From 1926 to 1929 the attention of the world was chiefly focused upon the question of American prosperity. As in all previous booms brought about by expansion of credit, it was then believed that the prosperity would last forever, and the warnings of the economists were disregarded. The turn of the tide in 1929 and the subsequent severe economic crisis were not a surprise for economists; they had foreseen them, even if they had not been able to predict the exact date of their occurrence.

The remarkable thing in the present situation is not the fact that we have just passed through a period of credit expansion that has been followed by a period of depression, but the way in which governments have been and are reacting to these circumstances. The universal endeavor has been made, in the midst of the general fall of prices, to ward off the fall in money wages, and to employ public resources on the one hand to bolster up undertakings that would otherwise have succumbed to the crisis, and on the other hand to give an artificial stimulus to economic life by public works schemes. This has had the consequence of eliminating just those forces which in previous times of depression have eventually effected the adjustment of prices and wages to the existing circumstances and so paved the way for recovery. The unwelcome truth has been ignored that stabilization of wages must mean increasing unemployment and the perpetuation of the disproportion between prices and costs and between outputs and sales which is the symptom of a crisis.

This attitude was dictated by purely political considerations. Governments did not want to cause unrest among the masses of their wage-earning subjects. They did not dare to oppose the doctrine that regards high wages as the most important economic ideal and believes that trade-union policy and government intervention can maintain the level of wages during a period of falling prices. And governments have therefore done everything to lessen or remove entirely the pressure exerted by circumstances upon the level of wages. In order to prevent the underbidding of trade-union wages, they have given unemployment benefits to the growing masses of those out of work and they have prevented the central banks from raising the rate of interest and restricting credit and so giving free play to the purging process of the crisis.

When governments do not feel strong enough to procure by taxation or borrowing the resources to meet what they regard as irreducible expenditure, or, alternatively, so to restrict their expenditure that they are able to make do with the revenue that they have, recourse on their part to the issue of inconvertible notes and a consequent fall in the value of money are something that has occurred more than once in European and American history. But the motive for recent experiments in depreciation has been by no means fiscal. The gold content of the monetary unit has been reduced in order to maintain the domestic wage level and price level, and in order to secure advantages for home industry against its competitors in international trade. Demands for such action are no new thing either in Europe or in America. But in all previous cases, with a few significant exceptions, those who have made these demands have not had the power to secure their fulfillment. In this case, however, Great Britain began by abandoning the old gold content of the pound. Instead of preserving its gold value by employing the customary and never-failing remedy of raising the bank rate, the government and parliament of the United Kingdom, with bank rate at four and one-half percent, preferred to stop the redemption of notes at the old legal parity and so to cause a considerable fall in the value of sterling. The object was to prevent a further fall of prices in England and above all, apparently, to avoid a situation in which reductions of wages would be necessary.

The example of Great Britain was followed by other countries, notably by the United States. President Roosevelt reduced the gold content of the dollar because he wished to prevent a fall in wages and to restore the price level of the prosperous period between 1926 and 1929....Today, in every country in the world, no question is so eagerly debated as that of whether the purchasing power of the monetary unit shall be maintained or reduced. It is true that the universal assertion is that all that is wanted is the reduction of purchasing power to its previous level, or even the prevention of a rise above its present level. But if this is all that is wanted, it is very difficult to see why the 1926-29 level should always be aimed at, and not, say, that of 1913.

If it should be thought that index numbers offer us an instrument for providing currency policy with a solid foundation and making it independent of the changing economic programs of governments and political parties, perhaps I may be permitted to refer to what I have said in the present work on the impossibility of singling out any particular method of calculating index numbers as the sole scientifically correct one and calling all the others scientifically wrong. There are many ways of calculating purchasing power by means of index numbers, and every single one of them is right, from certain tenable points of view; but every single one of them is also wrong, from just as many equally tenable points of view. Since each method of calculation will yield results that are different from those of every other method, and since each result, if it is made the basis of practical measures, will further certain interests and injure others, it is obvious that each group of persons will declare for those methods that will best serve its own interests.

At the very moment when the manipulation of purchasing power is declared to be a legitimate concern of currency policy, the question of the level at which this purchasing power is to be fixed will attain the highest political significance. Under the gold standard, the determination of the value of money is dependent upon the profitability of gold production. To some, this may appear a disadvantage; and it is certain that it introduces an incalculable factor into economic activity. Nevertheless, it does not lay the prices of commodities open to violent and sudden changes from the monetary side. The biggest variations in the value of money that we have experienced during the last century have originated not in the circumstances of gold production, but in the policies of governments and banks-of-issue. Dependence of the value of money on the production of gold does at least mean its independence of the politics of the hour. The dissociation of the currencies from a definitive and unchangeable gold parity has made the value of money a plaything of politics. Today we see considerations of the value of money driving all other considerations into the background in both domestic and international economic policy. We are not very far now from a state of affairs in which "economic policy" is primarily understood to mean the question of influencing the purchasing power of money. Are we to maintain the present gold content of the currency unit, or are we to go over to a lower gold content? That is the question that forms the principal issue nowadays in the economic policies of all European and American countries. Perhaps we are already in the midst of a race to reduce the gold content of the currency unit with the object of obtaining transitory advantages (which, moreover, are based on self-deception) in the commercial war which the nations of the civilized world have been waging for decades with increasing acrimony, and with disastrous effects upon the welfare of their subjects.

It is an unsatisfactory designation of this state of affairs to call it an emancipation from gold. None of the countries that have "abandoned the gold standard" during the last few years has been able to affect the significance of gold as a medium of exchange either at home or in the world at large. What has occurred has not been a departure from gold, but a departure from the old legal gold parity of the currency unit and, above all, a reduction of the burden of the debtor at the cost of the creditor, even though the principal aim of the measures may have been to secure the greatest possible stability of nominal wages, and sometimes of prices also.

Besides the countries that have debased the gold value of their currencies for the reasons described, there is another group of countries that refuse to acknowledge the depreciation of their money in terms of gold that has followed upon an excessive expansion of the domestic note circulation, and maintain the fiction that their currency units still possess their legal gold value, or at least a gold value in excess of its real level. In order to support this fiction they have issued foreign-exchange regulations which usually require exporters to sell foreign exchange at its legal gold value, that is, at a considerable loss. The fact that the amount of foreign money that is sold to the central banks in such circumstances is greatly diminished can hardly require further elucidation. In this way a "shortage of foreign exchange" (Devisennot) arises in these countries. Foreign exchange is in fact unobtainable at the prescribed price, and the central bank is debarred from recourse to the illicit market in which foreign exchange is dealt in at its proper price because it refuses to pay this price. This "shortage" is then made the excuse for talk about transfer difficulties and for prohibitions of interest and amortization payments to foreign countries. And this has practically brought international credit to a standstill. Interest and amortization are paid on old debts either very unsatisfactorily or not at all, and, as might be expected, new international credit transactions hardly continue to be a subject of serious consideration. We are no longer far removed from a situation in which it will be impossible to lend money abroad because the principle has gradually become accepted that any government is justified in forbidding debt payments to foreign countries at any time on grounds of "foreign-exchange policy." The real meaning of this foreign-exchange policy is exhaustively discussed in the present book. Here let it merely be pointed out that this policy has much more seriously injured international economic relations during the last three years than protectionism did during the whole of the preceding fifty or sixty years, the measures that were taken during the world war included. This throttling of international credit can hardly be remedied otherwise than by setting aside the principle that it lies within the discretion of every government, by invoking the shortage of foreign exchange that has been caused by its own actions, to stop paying interest to foreign countries and also to prohibit interest and amortization payments on the part of its subjects. The only way in which this can be achieved will be by removing international credit transactions from the influence of national legislatures and creating a special international code for it, guaranteed and really enforced by the League of Nations. Unless these conditions are created, the granting of new international credit will hardly be possible. Since all nations have an equal interest in the restoration of international credit, it may probably be expected that attempts will be made in this direction during the next few years, provided that Europe does not sink any lower through war and revolution. But the monetary system that will constitute the foundation of such future agreements must necessarily be one that is based upon gold.

Gold is not an ideal basis for a monetary system. Like all human creations, the gold standard is not free from shortcomings; but in the existing circumstances there is no other way of emancipating the monetary system from the changing influences of party politics and government interference, either in the present or, so far as can be foreseen, in the future. And no monetary system that is not free from these influences will be able to form the basis of credit transactions. Those who blame the gold standard should not forget that it was the gold standard that enabled the civilization of the nineteenth century to spread beyond the old capitalistic countries of Western Europe, and made the wealth of these countries available for the development of the rest of the world. The savings of the few advanced capitalistic countries of a small part of Europe have called into being the modern productive equipment of the whole world. If the debtor countries refuse to pay their existing debts, they certainly ameliorate their immediate situation. But it is very questionable whether they do not at the same time greatly damage their future prospects. It consequently seems misleading in discussions of the currency question to talk of an opposition between the interests of creditor and debtor nations, of those which are well supplied with capital and those which are ill supplied. It is the interests of the poorer countries, who are dependent upon the importation of foreign capital for developing their productive resources, that make the throttling of international credit seem so extremely dangerous.

The dislocation of the monetary and credit system that is nowadays going on everywhere is not due—the fact cannot be repeated too often—to any inadequacy of the gold standard. The thing for which the monetary system of our time is chiefly blamed, the fall in prices during the last five years, is not the fault of the gold standard, but the inevitable and ineluctable consequence of the expansion of credit, which was bound to lead eventually to a collapse. And the thing which is chiefly advocated as a remedy is nothing but another expansion of credit, such as certainly might lead to a transitory boom, but would be bound to end in a correspondingly severer crisis.

The difficulties of the monetary and credit system are only a part of the great economic difficulties under which the world is at present suffering. It is not only the monetary and credit system that is out of gear, but the whole economic system. For years past, the economic policy of all countries has been in conflict with the principles on which the nineteenth century built up the welfare of the nations. International division of labor is now regarded as an evil, and there is a demand for a return to the autarky of remote antiquity. Every importation of foreign goods is heralded as a misfortune, to be averted at all costs. With prodigious ardour, mighty political parties proclaim the gospel that peace on earth is undesirable and that war alone means progress. They do not content themselves with describing war as a reasonable form of international intercourse, but recommend the employment of force of arms for the suppression of opponents even in the solution of questions of domestic politics. Whereas liberal economic policy took pains to avoid putting obstacles in the way of developments that allotted every branch of production to the locality in which it secured the greatest productivity to labor, nowadays the endeavor to establish enterprises in places where the conditions of production are unfavorable is regarded as a patriotic action that deserves government support. To demand of the monetary and credit system that it should do away with the consequences of such perverse economic policy, is to demand something that is a little unfair.

All proposals that aim to do away with the consequences of perverse economic and financial policy, merely by reforming the monetary and banking system, are fundamentally misconceived. Money is nothing but a medium of exchange and it completely fulfills its function when the exchange of goods and services is carried on more easily with its help than would be possible by means of barter. Attempts to carry out economic reforms from the monetary side can never amount to anything but an artificial stimulation of economic activity by an expansion of the circulation, and this, as must constantly be emphasized, must necessarily lead to crisis and depression. Recurring economic crises are nothing but the consequence of attempts, despite all the teachings of experience and all the warnings of the economists, to stimulate economic activity by means of additional credit.

This point of view is sometimes called the "orthodox" because it is related to the doctrines of the Classical economists who are Great Britain's imperishable glory; and it is contrasted with the "modern" point of view which is expressed in doctrines that correspond to the ideas of the Mercantilists of the sixteenth and seventeenth centuries. I cannot believe that there is really anything to be ashamed of in orthodoxy. The important thing is not whether a doctrine is orthodox or the latest fashion, but whether it is true or false. And although the conclusion to which my investigations lead, that expansion of credit cannot form a substitute for capital, may well be a conclusion that some may find uncomfortable, yet I do not believe that any logical disproof of it can be brought forward.

June 1934