“Massive jolts of New Deal spending had stopped the economic slide, [but the economy crashed again when] over two years, FDR slashed government spending 17 percent.” (From a 2011 NPR presentation.)

In the last installment of this series, I discussed the hypothesis that the 1937 collapse resulted from an ill-conceived tightening of monetary policy to which both the Fed and the Treasury contributed.

While authorities differ in the degree of responsibility they assign to each, there’s widespread agreement that, between them, instead of merely extinguishing a boom, as they intended to do, both Fed and Treasury officials helped bring about a crash that undid much of the post-1933 recovery.

But monetary explanations are far from the only ones that have been offered for the 1937 downturn. As I’ve said, there seems to be no end of potential culprits in that calamity. Here I consider some others, starting with the claim that the downturn was the result, not of monetary developments, but of a return to fiscal austerity.

Austerity, New Deal Style

Worries about over-speculation and looming inflation that led the Fed and the Treasury in 1936 to take up the cudgels against overly-easy monetary policy had their fiscal counterpart in the fear that the federal debt was reaching unsustainable levels. The result was a renewed attempt to clamp-down on deficits by reining-in federal expenditures and collecting new taxes.

Although Treasury Secretary Henry Morganthau was this effort’s prime mover, FDR was solidly behind it. “People complain to me,” the president told a gathering at New York’s Democratic Club that April:

about the current costs of rebuilding America, about the burden on future generations. I tell them that whereas the deficit, of the federal government this year is about $3,000,000,000, the national income of the people of the United States has risen from $35,000,000,000 in the year 1932 to $65,000,000,000 in the year 1936, and I tell them further that the only burden we need to fear is the burden our children would have to bear if we failed to take these measures today.

In fact the difference between fiscal 1936 receipts and revenues turned out to be almost twice Roosevelt’s $3,000,000,000 estimate, making for the largest peacetime deficit in the nation’s history, which, together with deficits run in each of the preceding five years, would raise the total federal debt to $34.5 billion.

So the government tightened the reins. Between September 1936 and October 1937, cuts reduced government spending by a quarter of a billion inflation-adjusted dollars, while an increased tax burden, due mainly to the Social Security tax first collected in January 1937, but also to the undistributed profits tax introduced in mid-1936, reduced private earnings. The Federal government’s net contribution to total earnings fell accordingly.

Fed officials were, not surprisingly, among those who tried to pin the blame for the ’37 downturn on the government’s decision to turn off its fiscal tap. Marriner Eccles, for example, attributed it to a “too rapid withdrawal of the government’s stimulus.” Eccles drew on a report on “Causes of the Recession” prepared by economist Lauchlin Currie, his personal assistant. “From 1934 to 1936,” Currie wrote, “the largest single factor in the steady recovery movement was the excess of Federal activity-creating expenditures over activity-decreasing receipts.” During 1936, those net outlays averaged to $335 million per month. In contrast, from September through March 1937, the average was just $60 million a month. From this and other evidence, and after briefly examining other possible explanations, Currie concluded that the “withdrawal of the Government’s contribution” to overall spending was to blame for the recession.

Fiscal Policy: Mole Hill or Mountain?

The claim that, by withdrawing most of its fiscal stimulus, the government slowed economic activity, seems beyond dispute. But Currie’s further claim that fiscal retrenchment alone accounts for the severe 1937 downturn won’t stand close scrutiny. For one thing, by comparing net government outlays between March and September 1937 to those for 1936, he exaggerates the extent of the retrenchment. Thanks to the veteran’s Bonus Act passed (over FDR’s veto) in 1936, which ultimately added $1.7 billion to government expenditures, the government’s net contribution for 1936 was an exceptionally high $4.1 billion, as compared to $3.2 billion and $3.1 billion for 1934 and 1935, respectively. The period from March to September 1937, in contrast, was a low water mark for net government expenditures: the government’s monthly contribution was still $264 million that January, and by mid-1938 it had bounced back to about $300 million per month—a value exceeding the averages for 1934 and 1935, and only slightly below the exceptionally high monthly average of $335 million for 1936.

Even so, the cutback was substantial. But timing is another problem for Currie’s thesis. As Kenneth Roose, who was then teaching at UCLA, observed in a 1951 article, and as the chart reproduced from it below shows, there’s a lag of more than six months between the beginning of the start of the decline in net government spending in December 1936 and the start of the decline in total income, and it wasn’t until January 1938 that monthly income fell below its high 1936 average. Yet a large proportion of government spending in the 1930s, including relief payments, became income with no lag at all; and contemporary estimates put the income lag for government payments of all sorts at just one month.

But the biggest problem with Currie’s thesis is his assumption that until 1937 “the largest single factor in the steady recovery movement was the excess of Federal activity-creating expenditures over activity-decreasing receipts.” That assumption turns out to be crucial, for if expansionary fiscal policy wasn’t an important driver of the pre-1937 recovery, so long as the government’s contribution remained positive, a decline in that contribution, however substantial, couldn’t possibly have been the main, let alone the sole, cause of the 1937 crisis.

In fact, as I pointed out in an earlier part of this series, fiscal policy didn’t contribute much to the 1933–37 recovery. To recall E. Cary Brown’s summing-up of his seminal findings, since confirmed by Christina Romer and others, far from driving that recovery, as a means for achieving recovery fiscal stimulus simply “wasn’t tried”: although the federal government’s net contribution to spending was certainly lower in 1937 than it had been in 1934 or 1935, it was no greater in those years than it had been in 1929! 1936 alone witnessed an exceptional fiscal contribution, thanks to the veteran’s bonus; but that bonus, which only began mid-way through the year, at best accounts for a small part only of the overall increase in income between April 1933 and May 1937. So while the post-1936 decline in net government spending probably contributed to the Roosevelt Recession, it can hardly be held solely responsible for it.

Finally, Currie’s attempt to deny that monetary policy contributed to the downturn is itself unsatisfactory. He notes that, from their nadir at the start of the bank holiday, demand (“checkable”) deposits grew by some $10 billion by the middle of 1936, and that this growth went hand-in-hand with growth in spending on consumer durables. So far so good. But Currie then claims that the build-up in deposits can only have been due to the government’s deficit spending; and that claim is neither logically sound nor consistent with the evidence. As I explained in yet another post for this series, and as the next chart shows, by adding to the nation’s gold reserves (blue line), gold imports contributed a lot more to demand deposits (red) than net government spending (green) did.

Parceling Out Blame

In a 2015 study Jonian Rafti, then a senior at Bard College, tried to weight the respective fiscal and monetary contributions to the ’37 crash econometrically. He concluded that each was responsible for about half of the overall decline in income. But because he assumed a fiscal multiplier of 1.4, meaning that every $1 reduction in net government spending reduces total income by that amount plus 40 cents, Rafti’s estimate of the fiscal contribution is probably on the high side of the truth. At the other extreme, Romer, using statistical evidence of the effects of the 1936 veteran’s bonus, found a fiscal multiplier of just .233 (in contrast to her monetary multiplier estimate of 0.823), implying a much smaller fiscal contribution. Most other estimates of the government spending multiplier place it somewhere between Rafti’s and Romer’s estimates. So it’s likely that the cutback in net government spending was to blame for less, if not much less, than half of the ’37 downturn.

To be clear: this conclusion does not mean that a sufficiently expansionary fiscal policy couldn’t have prevented the Roosevelt Recession. However small the fiscal multiplier, a big enough boost in net government spending might in principle have made up for any decline in spending of other sorts. But saying this isn’t the same as saying that the recession was mainly brought about by the Roosevelt administration’s cutbacks and new taxes.

Striking it Poor

Because serious recessions generally involve correspondingly severe reductions in overall spending, it’s not surprising that economists seeking the cause of the ’37 collapse should seek its cause in either monetary or fiscal tightening. But adverse supply shocks can also cause, or at least aggravate, downturns, as happened when OPEC restricted its oil exports starting in 1973, and when the coronavirus struck last year. According to some experts, it happened in 1937 as well; and here again, the New Deal had something to do with it.

Several developments sent shock waves through the U.S. economy in 1937, striking the automobile industry especially hard. One was an increase in the cost of labor and raw materials. Thanks mainly to European rearmament, the materials needed to make a small car, which would have cost G.M., Ford, or Chrysler less than ninety dollars in the summer of 1936, cost almost 106 dollars a year later; and thanks mainly to more aggressive union tactics, labor costs rose even more.

Quite apart from their role in securing higher wage rates, some of those union tactics were themselves “shocking.” They took the form of numerous strikes, including many production-paralyzing “sit-down” strikes. The BLS recorded 4740 strikes in all for 1937—an all-time record, and more than twice the number in 1936. These led to the loss of almost 28.5 million man-hours of work, itself a record.

Sit-down strikes, the main cause of lost work hours, had been rare before the depression, and became common only after members of the United Auto Workers took over two Flint, Michigan auto body plants on December 30, 1936. Between then and late February 1939, when the Supreme Court decided (in National Labor Relations Board (NLRB) v. Fansteel Metallurgical Corporation) that the NLRB lacked authority to order employers to reinstate workers fired after sit-down strikes) there were some 600 such strikes, thanks to which the automobile industry alone ultimately ended up losing about 4.5 million man-hours.

Strikes and the Wagner Act

The burst of strikes, and of sit-down strikes especially, is often attributed to the July 1935 passage of the National Labor Relations Act (NLRA), better known as the Wagner Act (after New York Senator Robert Wagner, who sponsored it). Harold Cole and Lee Ohanian, for example, claim that, by giving “even more bargaining power to workers than the NIRA,” the Wagner Act led to a significant increase in strike activity “particularly after the Supreme Court upheld its constitutionality in 1937.”

But the Wagner Act’s bearing on strike activity wasn’t so straightforward. For one thing, the timing is off: although FDR signed the act on July 5th, 1935, the total number of strikes, and the number of major sit-down strikes, didn’t rise considerably until the last weeks of 1936. Nor does Cole and Ohanian’s claim that the number of strikes rose “after the Supreme Court upheld [the NLRB’s] constitutionality in 1937” wash: in fact that number reached its zenith in March 1937, a month before the Supreme Court rendered its decision.

And while it’s certainly true that the NLRA strengthened workers’ collective-bargaining rights, it and other “little Wagner Acts” passed by state governments also established boards to adjudicate disputes over those rights. The whole point of those boards was to make it unnecessary for unions to resort to militant tactics. Consequently, as John Spielmans observes in a 1941 JPE article, as tempting as it may be to connect the strike wave to the New Deal’s “promise…to lend support to labor in its struggle,” treating that wave as “as proof of the unhappy effects of the Wagner Act” would be “rash.”

The more subtle truth is that the Wagner Act encouraged strikes, not by granting workers more rights, but by failing to adequately clarify those rights. By upholding workers’ right to organize under “majority rule,” it sought to rule-out employer-dominated “company” unions. But it left federal law regarding the legality of “closed shops,” meaning unions that compelled all workers to join them and take-part in their tactics, unsettled. The National Labor Relations Board was therefore in no position to adjudicate disagreements between unions seeking to establish closed shops and employers bent on stopping them. Frustrated by what they considered the Wagner Act’s failure to deliver on its promises, and encouraged by FDR’s reelection in November 1936, union organizers decided to force the issue. The Flint strike was their big gamble; and that strike’s surprising success quickly led to hundreds of others like it.[1]

A Cost-Push Recession?

Between them, strikes, however encouraged, and the Wagner Act’s general strengthening of workers’ bargaining power, boosted firms’ labor costs. Benjamin Anderson considered this “[a] main factor on the industrial side in bringing the revival of 1935–1937 to a close.” So did Kenneth Roose. “In a free enterprise economy,” Roose observed in a 1948 article, “given sufficiently low profits, an increase in costs…can lead to an almost complete cessation in investment.” And that, he said, was what happened when input costs, “of which labor costs were the most important,” began rising during the first quarter of 1937. Cole and Ohanian also claim that union activity “significantly reduced firm profitability” both by temporarily shutting-down plants and by boosting the cost of labor.

Could increased union activity really have boosted labor costs enough to throttle business investment? According to Chris Hanes, that seems to have been the case. In a paper published in the December, 2020 Journal of Economic History, he estimates what he calls “projected average hourly earnings (AHE) inflation rates” for 1929–1939 using coefficients from a regression of AHE inflation for 1891–1914 and 1955–67 on the current and lagged unemployment rate, plus a dummy variable for the pre-WWI years. He also does the same thing using industrial production instead of unemployment, with almost identical results. Comparing his projected values with actual depression-era AHE inflation, he finds that the actual series rose well above the projections in 1933–1935 and again in 1937–1938. A chart from Hanes’ paper comparing the two series, with error bands surrounding his AHE projections, suggests a kneeling Bactrian camel, complete with GI tract:

Hanes goes on to consider possible explanations for the camel’s humps, ruling them all out save for New Deal labor policies. He finds that the first hump coincides with the dates of the NRA codes, and that the second coincides precisely “with a wave of strikes associated with unionization supported by New Deal labor policies.” Employers, Hanes says, “raised wages and overtime premiums as they entered into agreements with unions or attempted to forestall union threats.” And those wage hikes “were large,” especially compared to firms’ still-depressed profits. Hanes shows as well that a regression of his estimated AHE anomaly against the number of manufacturing workers involved in strikes and a small set of control variables fits the data extremely well, reproducing “not only the rise of anomalous [wage] inflation in 1933 but also the diminution of anomalous inflation in 1936 and the second round of anomalous inflation in late 1936–1937.”

In a somewhat earlier, complementary study, Joshua Hauseman shows that the real consequences of labor supply shocks, and shocks to the auto industry especially, were also large. Automobile production, he notes, made up a substantially larger share (3.5 percent) of U.S. GDP in 1937 than it does today. Most car production inputs were also supplied domestically back then. Using a statistical model that fits pre-1937 auto sales to fiscal, monetary, and other economic determinants, Hauseman finds that, had it not been for adverse auto-industry supply shocks, the Roosevelt-Recession might only have been two-thirds as deep as it was in fact.

***

In “Murder on the Orient Express,” Hercule Poirot discovers that, except for the victim, the passengers on that train are all members or servants of the same family; and that, while some played bigger parts in the murder than the rest, all took part in it. As for what killed the 1933–37 economic recovery, one might say much the same thing: all of the suspect policies were guilty to at least some extent; and all were kith and kin of the New Deal.

Continue Reading The New Deal and Recovery:

• Intro
• Part 1: The Record
• Part 2: Inventing the New Deal
• Part 3: The Fiscal Stimulus Myth
• Part 4: FDR’s Fed
• Part 5: The Banking Crises
• Part 6: The National Banking Holiday
• Part 7: FDR and Gold
• Part 8: The NRA
• Part 8 (Supplement): The Brookings Report
• Part 9: The AAA
• Part 10: The Roosevelt Recession
• Part 11: The Roosevelt Recession, Continued

_______________________

[1] The Wagner Act ultimately failed to secure not only unions’ right to establish closed shops, but their right to resort to sit-down strikes for any purpose. Although, with its April 12, 1937 NLRB v. Jones & Laughlin Steel Corp. decision, the Supreme Court declared the NLRA itself constitutional, not quite two years later, in NLRB v. Fansteel Metallurgical Corp., it held that the NLRA lacked the authority to compel employers to reinstate workers fired for taking part in sit-down strikes. Finally, the NLRA’s lack of clarity regarding the legality of closed shops was corrected by the 1947 Taft-Hartley Act, which made them illegal, while also prohibiting mass picketing, “wildcat” (or “quickie”) strikes, and various other former union tactics.

[Cross-posted from Alt‑M.org]

By the start of 1937, things were looking up for the U.S. economy. Although the Supreme Court had struck down both the NIRA and the AAA—the chief pillars of the original New Deal’s recovery plan—some time earlier, like a glider released by its tow plane, the recovery itself kept going.

Indeed, the glider analogy doesn’t quite work, because instead of gradually declining, economic activity started rising faster than ever: whereas in 1934 and 1935 real GNP grew by 7.7 and 8.1 percent, respectively, in 1936 it grew by a whopping 14.1 percent. Between May 1935, when the NIRA was struck down, and April 1937, unemployment fell by a third—as compared to a 28 percent decline while the NRA codes were in effect. Bank lending, long stagnant, also started to revive. And the stock market, which bounced around but otherwise made little headway while the NRA did its thing, rose by a hefty 70 percent.[1]

Nor was this improvement at all mysterious. As I explained in an earlier post, instead of promoting recovery as it was supposed to, the NRA codes held it back. It’s therefore not surprising that, by sweeping them off the books in May 1935, and thereby allowing the U.S. economy to make better use of the gold inflows from Europe that were really nursing it to health, the Supreme Court actually did more to promote recovery than the NRA itself had done.

A False Dawn

Things were so good, in fact, that many believed the long-awaited recovery to be just around the corner. FDR must have thought so, or else he wouldn’t have reminded Congress that January that “Your task and mine is not ending with the end of the depression.”

But such optimism didn’t last long. In May, according to the NBER’s business cycle chronology, the economy started shrinking again. Expenditures fell; inventories accumulated; and profits dwindled. Soon it was obvious to all that the U.S. was in the throes of yet another severe recession. By the time it was over, in June 1938, real U.S. GNP had fallen by 18.2 percent. That was less than the 26.6 percent decline suffered in the early years of the depression. But as is clear from the chart below, it happened much more quickly, and was in that respect even more stunning. The setback was also severe enough to undo a substantial part of the gains achieved since FDR took office.

Bad as the quarterly GNP numbers look, they still don’t accurately convey the extreme nature of the 1937 downturn. Because that downturn was so steep and short-lived, quarterly data can’t do it full justice. To come closer we need to look at industrial production. Although it tracks the nominal output of manufacturing firms, mines, and utilities only—a small portion of the U.S. economy taken as a whole—that statistic has the advantage of being measured every month. Between May 1937 and June 1938, industrial production fell by almost one third—a truly stupendous drop.

What came to be known as the “Roosevelt Recession,” especially among FDR’s detractors, has posed a challenge to economic historians. But unlike the challenge of explaining the 1929 downturn, the problem in this case consists not of a lack but of a surfeit of plausible culprits—a very different sort of whodunit.

Fear of ‘Flating

Most accounts of the 1937 crash blame it on demand-side shocks, and particularly on a sudden switch to less expansionary, if not contractionary, monetary and fiscal policies. The switch was partly informed by the belief that full recovery was in sight, and the fact that the markets for stocks and some commodities were already booming. But it was also a reaction to banks’ large holdings of excess reserves. Together these developments suggested to many that, unless steps were taken to prevent it, the United States was headed straight for what Federal Reserve Chairman Marriner Eccles called a “dangerous inflation.” Eccles’ worries were shared by many administration officials, including FDR. “I am concerned—we are all concerned,” he told the press that April, “over the price rise in certain materials.”

Dangerous inflation? In retrospect at least, officials’ fear seems tragi-comic. Far from being something to be dreaded, inflation sufficient to get prices back to their 1926 level had long been one of FDR’s main objectives. One could even say that he regarded its achievement as the sum and substance of a complete recovery. But in the late spring of 1937 the Consumer Price Index was still about 20 percent below its level in mid-1926. And if that wasn’t proof enough that the recovery was far from complete—that the country still had a way to go before “reflation” gave way to inflation proper—there was the fact that the conventionally-measured unemployment rate, which counted those working in government relief programs as “unemployed,” was still in the double-digits. Upon hearing that American officials had begun to worry about inflation, Keynes is supposed to have quipped that they “professed to fear that for which they dared not hope.”

Alas, those officials were in earnest; and their fears soon led to action. What particularly concerned them was the reserve stockpile banks had accumulated since the bank holiday, a large part of which consisted of “excess” reserves, meaning reserves beyond banks’ mandatory requirements. Fed officials feared that, as the recovery continued, a revived demand for credit would lead first to a rapid expansion of bank lending and the money stock, and thence to the “dangerous inflation” Eccles warned about. That European gold—“hot money”—was now flowing into the U.S. faster than ever, and that the Fed’s limited security holdings would prevent it from using open-market sales to keep that inflow from adding to banks’ superfluous reserves, only made the need for other action seem that much more acute.[2]

Although the Fed’s open-market powers were limited, thanks to the Banking Act of 1935 it had another trick up its sleeve: the power to as much as double its member banks’ minimum reserve requirements. Fed officials now chose to put that power to use. On Bastille Day, 1936, a divided Board of Governors voted to raise member bank reserve requirements by 50 percent effective August 15th. Because rates didn’t budge, and gold kept pouring into the country, sentiment grew in favor of further increases. Finally, at the end of January 1937, the Board elected to raise the requirements by another third—the maximum level allowed—this time in two half steps to be taken on March 6th and May 1st, respectively. The vertical lines in the following chart, showing the behavior of total and excess bank reserves between 1931 and 1942, mark the dates of the three increases.

A Doubling Debacle

While the Fed’s first two reserve-requirement increases seemed to do little harm, the third almost perfectly coincided with the start of the ’37 downturn. According to many experts, this was no coincidence. So far as they’re concerned, instead of merely serving to head-off inflation, the Fed’s decision to double reserve requirements was one of the chief causes, if not the cause, of the 1937 collapse.

How so? In essence, the argument—which owes its popularity to Milton Friedman and Anna Schwartz’ development of it in their Monetary History of the United States—is that while Fed officials viewed excess reserves as “redundant” reserves, the banks themselves didn’t see them so. Instead, having been traumatized by runs in the early years of the depression, they accumulated excess reserves deliberately, for safety’s sake: unlike required reserves, excess reserves could be used to meet runs without risk of legal penalties. Thanks to low interest rates, this precaution, besides being prudent, was also cheap.[3]

So when the Fed increased banks’ required reserves, and especially when it did so for the third time, instead of doing nothing the banks sought to rebuild their excess reserve cushions. With only so many reserves in the system, this meant limiting their required reserves by shrinking the non-reserve components of their balance sheets: loans, investments, and deposits. The resulting decline in bank credit and the money stock helped bring about the 1937–8 recession, just as the Great Monetary Contraction of 1929–33 led (once again, according to Friedman and Schwartz) to the first Great Depression downturn.

Reserve-ations

Popular as it is, the theory that the Fed triggered the ’37 collapse by raising banks’ reserve requirements has never lacked critics. Unsurprisingly, those Fed officials who argued for the policy, including Lauchlin Currie, the Board’s chief economic advisor, denied that it restricted the supply of credit, or otherwise contributed to the recession. Nor were they alone among their contemporaries in taking that view. According to Benjamin Anderson, who served as Chase National Bank’s chief economist during the depression,

Reducing the [banks’] excess reserves could not reduce the volume of business unless real differences were made thereby in interest rates, and unless restrictions were imposed thereby upon the use of money and credit. Now the evidence is overwhelming that nothing of this sort occurred.

Several more recent writings have drawn renewed attention to and supplemented the evidence Anderson had in mind. In a 2001 article L.G. Telser showed that, instead of lending less, Fed member banks met their increased reserve requirements by selling government securities, ruling out the possibility that the Fed’s actions triggered a credit crunch. A decade later, upon examining data for individual Fed member banks, Charles Calomiris, Joseph Mason, and David Wheelock (2011) found that, even after they’d been doubled, the Fed’s “reserve requirements were not binding on bank reserve demand in 1936 and 1937, and therefore could not have produced a significant contraction in the money multiplier.” Instead, they conclude that, contrary to the Friedman and Schwartz hypothesis, such increases in reserve demand as took place from June 1936 to June 1937 “reflected predictable influences related to the structure of the banks, and not increases in reserve requirements imposed by the Fed.” Finally, Haelim Park and Patrick Van Horn (2014) also find that Fed’s reserve requirement changes didn’t lead member banks to reduce their lending. They therefore conclude that “the actions of the Federal Reserve…cannot be blamed for instigating the economic downturn of 1937–38.”

And a Rejoinder

But Friedman and Schwartz’ critics may not have the last word. Instead, their arguments have been questioned in turn by Gauti Eggertsson and Benjamin Pugsley (2006), who claim that the Fed’s doubling of reserve requirements contributed to the 1937 downturn even though it didn’t lead to any substantial decline in bank lending or the money stock, or to any substantial or lasting increase in short-term interest rates. In their view, the Fed’s decision mattered not because it led to an immediate tightening of credit but because it was the first important sign that the government was reversing its stance on inflation: having long promised to get prices back to their pre-depression levels, and despite not having yet reached that goal, government officials now seemed determined to put a lid on inflation.

Eggertsson and Pugsley consider this official about-face “one of the most peculiar policy mistakes in U.S. economic history.” But they regard it so not because it led to any immediate clamping-down on credit, but because it “created pessimistic expectations of future growth and price inflation that fed into both an expected and an actual deflation.” Nominal rigidities, finally, caused the collapse in prices to be accompanied by an equally severe contraction of output.

Using a dynamic stochastic general equilibrium (DSGE) model, Eggertsson and Pugsley show that, far from depending on any increase in current short-term interest rates (as opposed to expectations of future rate increases), such an expectations-driven downturn can be “particularly damaging at zero interest rates.” Because it’s immune to the objection that monetary policy can only matter if it leads to immediate changes in bank lending, money growth, and short-term rates, the Eggertsson and Pugsley thesis gives “monetary” explanations of the 1937 downturn a new lease on life.

Rebirth Control

The Fed’s doubling of reserve requirements was but one of two monetary policy changes that may have contributed to the Roosevelt Recession, whether through an expectations channel or otherwise. The other, which some consider more important, and which was also part of the government’s effort to forestall inflation, was the Treasury’s decision to “sterilize” gold inflows.

In fact, Friedman and Schwartz themselves viewed the Treasury’s gold sterilization program as being just as important a cause of the contraction of ’37 as the Fed’s reserve requirement increases. The Treasury had nevertheless been cast in most accounts since as the Fed’s less important accomplice. But in a 2012 paper Dartmouth economic historian Doug Irwin makes a strong case for giving the Treasury pride of place.

As we’ve seen, after 1933 gold fleeing Europe for the U.S. was the chief cause of overall demand growth and, starting in 1935, of concerns that the U.S. was headed toward unwanted inflation. The Fed could do nothing to prevent the gold inflow from adding to banks’ reserves; but it could and it did force banks to hold on to those extra reserves. The Treasury, on the other hand, could sever the link between increases in the total U.S. gold stock and increases in the monetary gold stock, where the last alone contributed to bank reserves. Normally, after drawing on its Fed balance to pay to buy gold at the official price of $35 an ounce, the Treasury would replenish its account by depositing an equivalent sum in gold certificates. The monetary gold stock and monetary base would then grow in step with the total gold stock. To sever the link, and thereby “sterilize” the gold inflows, the Treasury had merely to quit printing and depositing a like value of gold certificates for every ounce of gold it purchased.

And from December 1936 until February 1938, excepting a one-time “desterilization” of $300 million in September 1937, the Treasury did just that, with the express aim of “halt[ing] the inflationary potentialities” of incoming gold. As the next FRED chart shows, because the Fed itself extended very little credit during the sterilization period, the Treasury’s policy slammed the brakes on the monetary base growth that had been promoting recovery, to the extent that other New Deal policies allowed it to, since 1934. The chart also makes clear the close coincidence, allowing for a short lag, between the start and finish of the Treasury’s policy and the beginning and end of the 1937–8 recession as reflected in Ayres’ Business Activity index.

According to Irwin, the Treasury’s sterilization policy was far more contractionary than the Fed’s reserve-requirement increases, partly owing to the fact that reserve requirements were less binding than Friedman and Schwartz and others have supposed, but also because the change in the growth rate of the monetary base, from an average annualized rate of 17 percent between 1934 and 1936 to zero, was far greater than the concurrent change in the money multiplier. For this and other reasons, including its timing, Irwin concludes that the Treasury’s policy played the more important role in the 1937–8 recession.[4]

But it was, after all, the combined effects of the Fed and Treasury actions, rather than the relative importance of each, that really matters. And here it’s worth noting that each player acted rather as if it didn’t know, or didn’t care, what the other was up to! While both Marriner Eccles and Treasury Secretary Henry Morgenthau saw a need to clamp down on money growth to head-off inflation, Eccles favored doing so by raising the Fed’s reserve requirements, while Morgenthau tried to convince him that sterilizing gold inflows was the better policy. Instead of coming to an agreement, or otherwise coordinating their policies, Eccles went ahead with the Fed’s first reserve requirement increase without bothering to tell Morgenthau, let alone gain his approval. When that increase seemed to make little difference, Morgenthau proceeded with his sterilization program, after securing Eccles’ last minute and grudging endorsement. Then, despite Morgenthau’s expressed reservations, Eccles in turn went ahead with Fed’s further reserve requirement increases. It is as though two doctors, sharing the same overanxious patient, each insisted on administering a strong sedative, whether the other did so or not, and ended up rendering her unconscious.

But here again, my analogy falls short, because it’s far from obvious that the U.S. economy needed a sedative at all. It fails in another respect as well. For instead of just getting a double-dose of sedatives, the U.S. economy got several. Just what those other sedatives were, and how they contributed to the economic collapse, will be the subjects of my next installment.

Continue Reading The New Deal and Recovery:

• Intro
• Part 1: The Record
• Part 2: Inventing the New Deal
• Part 3: The Fiscal Stimulus Myth
• Part 4: FDR’s Fed
• Part 5: The Banking Crises
• Part 6: The National Banking Holiday
• Part 7: FDR and Gold
• Part 8: The NRA
• Part 8 (Supplement): The Brookings Report
• Part 9: The AAA
• Part 10: The Roosevelt Recession

___________________

[1] For more on the slow and erratic progress of recovery while the first New Deal was in effect see Garfield Cox (1936, p. 2). Referring to that progress as measured by Leonard Ayres’ index of American Business Activity (which closely follows the more frequently cited index of industrial production), Cox notes that whereas “all previous recoveries, once started, have brought [that index] back to normal rather quickly,” with the longest delay taking just 14 months, “this time after 33 months this index is still substantially below trend.” Furthermore, “no previous recovery from depression has been punctuated by reversals so extensive as those which have interrupted the current expansion.” Cox also notes (ibid., p. 3) that “in no recovery in eighty years have iron and steel and durable goods in general lagged as they have from 1933 to 1935.” These were, of course, among the sectors most influenced by NRA codes.

[2] Several factors contributed to the Fed’s limited capacity to offset gold-based reserve growth through open market sales. One was that by mid-1936, member bank excess reserves exceeded the Fed’s government securities of just over $2.4 billion. Another was that the Fed relied upon income generated by those securities to pay its operating expenses.

[3] For further developments of the argument that banks’ had a genuine demand for excess reserves see Frost 1971 and Wilcox 1984.

[4] Concerning Eggertsson and Pugsley’s claim that the bearing of the Fed’s reserve requirement changes on expectations made those changes much more potent than they might have been otherwise, Irwin observes (p. 250n7) that “[i]t seems implausible to think that ‘animal spirits’ could sink the economy as much as occurred during 1937–8 in the absence of some tangible change in government policy or some real shock.” This seems rather unfair to Eggertsson and Pugsley, who never suggest otherwise. Instead they claim only that expectation effects further magnified the consequences of “tangible” policy changes, including both the Fed’s reserve requirement increases and the Treasury’s sterilization policy.




[Cross-posted from Alt‑M.org]

Having devoted the last two posts in my New Deal series to the NRA, I may have given readers the impression that I had nothing to say about the consequences of the Agricultural Adjustment Act (AAA) passed more than a month before the National Recovery Act. As this series is about the New Deal’s contribution to economic recovery, you perhaps assumed that I skipped the AAA because it was a farm relief and reform measure only, and not an important part of FDR’s recovery strategy.

If so, you were mistaken, for I realize that FDR saw the AAA and NRA as twin pillars of his recovery plan. The NRA was supposed to boost manufacturers’ revenues by ending cutthroat competition, while enhancing their workers’ purchasing power by raising their wage rates. The AAA was, in the meantime, supposed to raise farm product prices, and thereby boost farmers’ purchasing power, by getting farmers to cut their output. Indeed, if FDR can be said to have considered either program more crucial to recovery than the other, it was to the AAA that he assigned top priority. I took up the NRA first, not because I considered the AAA less important, but because the NRA’s tendency to reduce the real gains from gold-based demand growth made it seem natural to turn to it immediately after discussing New Deal gold policies.

Despite its name, the NRA ended up hampering “national recovery” instead of promoting it. In contrast, many experts believe that the less ambitiously-named AAA did promote recovery. In today’s installment to my New Deal series, I discuss the AAA’s origins, how it was supposed to help end the depression, the extent to which it succeeded, and its long-run repercussions. To anticipate: although the AAA may have aided recovery, its contribution was probably very modest, while its long-run consequences have been so negative that one may well conclude that it ultimately did more harm than good.

U.S. Agriculture in War and Peace

To understand the importance FDR and others assigned to helping farmers during the depression, one must bear in mind the much larger role farmers and farming played in the U.S. economy then compared to today. In 1930 farm families made up a quarter of the total U.S. population, with farm employment accounting for almost as large a share (22 percent) of total employment, and farm output making up about 8 percent of GDP. Those figures are roughly ten times their current counterparts. Apart from their direct importance, farms supported larger rural populations comprising 44 percent of all Americans, as well as a large food processing industry. So it wasn’t just farmers who suffered when crop and livestock prices fell.

And those prices fell dramatically at the start of the 1920s, after rising almost as dramatically during and immediately following the First World War. At its peak, in May, 1920, an index of wholesale prices of farm products stood at almost 2.5 times its average between 1910 and the war’s outbreak. But between May and December 1920 the same index fell to half that level. As can be seen from the FRED chart below, the rise and consequent decline in crop prices was especially severe. The chart also shows that general prices rose less sharply during the war and immediate postwar period, and stayed well above their prewar levels after the ’20-’21 bust. Consequently, although the 1920s may have “roared” for some, farmers found themselves considerably worse off then than they’d been before the war.

During the boom, those farmers, encouraged both by it and by a government-guaranteed wheat price and other wartime government policies deliberately aimed at boosting farm output, invested heavily in new farmland. As Robert Sobel notes in his biography of Coolidge (p. 247), “Wheat acreage rose from forty-eight million acres to more than seventy-five million between 1914 and 1919. Iowa farmland that sold for $82 an acre in 1910 went for $200 in 1920.”

Farmers typically paid for new land, and for the resources they needed to cultivate it, by signing mortgages with the sellers or arranging mortgage loans with commercial banks. By 1925, gross U.S. mortgage debt had risen to $9.4 billion, or nearly three times its level in 1910. After farm product prices collapsed, farm foreclosure rates in turn rose to record levels: from an average of just 3.2 foreclosures per 1000 farms for 1913–1920, they climbed to 17.4 by 1926, and ultimately to a 1933 peak of 38.8 foreclosures per thousand farms.

As I noted in my segment on the banking crisis, the souring of farm mortgages was a major cause of bank failures both during the 20s and during the first years of the depression. According to a recent study by Matt Jaremski and David Wheelock, rising crop prices encouraged not just more borrowing but the formation of many new banks to accommodate it. Because they tended to be especially aggressive lenders, these banks failed in disproportionate numbers when farm prices tumbled. According to economic historian Lee Alston, the overall damage done by farmers’ defaults was such that, had it not been for it, “the country at large would have been far less receptive to a New Deal.”

Hoover’s Farm Problem

Long before the New Deal, while he was still Harding’s Secretary of Commerce, Herbert Hoover recognized the farm problem as one of overproduction. “The fundamental need,” he told a gathering of dairy farmers, “is the balancing of our home production to our home demand.” Although he encouraged voluntary cutbacks, Hoover was opposed to any government scheme that would compel farmers to produce less. The main role he favored for government was its support of the formation of national farm marketing cooperatives, which he hoped might, together with generally rising prosperity, eventually raise farmers’ profits enough to end their plight.

But farmers weren’t keen on either national cooperatives or voluntarily cutting production. They wanted higher prices for the output they were already generating; and they wanted them not “eventually” but right away. Only direct government support could grant them that wish; and Hoover opposed such support. In particular, both as Secretary of Commerce under Harding and Coolidge and once he became President, Hoover successfully opposed the McNary-Haugen farm relief bill, which would have had a government-funded “export corporation” restore the prices of various farm products to their pre-WWI “parity” levels by purchasing “surplus” output at those parity prices and disposing of it abroad. Farmers responsible for surpluses on which the corporation lost money would be taxed to make up for those losses, while those responsible for crops sold abroad at a profit would receive a corresponding dividend.

Hoover objected to the McNary-Haugen proposal not just because it called for unprecedented “socialistic” government intervention in agriculture, but because he believed that propping-up farm product prices would only result in still larger farm surpluses, and that the export corporation’s efforts to dispose of surplus crops abroad would violate the era’s anti-dumping laws. Hoover was hardly alone in holding these views, which were shared by many economists, including Chase National Bank’s Benjamin (“Mac”) Anderson. When the McNary-Haugen bill was first taken up by Congress in 1924, Anderson observed, correctly and somewhat presciently, that it couldn’t work unless “Government had power to exercise control over the production of agricultural com­modities and allocate to each individual farmer the permissible acreage of given commodities and to hold the farmers down to the acreage allowed them.”

Once elected president Hoover continued to favor voluntary efforts to reduce farm output, which he attempted to assist through the establishment of a Federal Farm Bureau. But as Joan Hoff Wilson notes, Hoover’s voluntary scheme struck farmers as both too “complex” and too long term. They therefore continued to press for “an immediate price-lifting solution guaranteed by the government” of the sort “McNary-Haugenism” promised. When the depression began, the Hoover administration took the further step of using loans and grants to enhance both foreign and domestic demand for farm products; but that extra support hardly sufficed to make up for the depression’s further toll on crop and livestock prices, let alone achieve a pre-WWI “parity” of relative farm product prices. It fell to FDR to grant farmers the sort of immediate and substantial aid they’d been pining for for a decade.

From Agricultural Reform to National Recovery

With the coming of the depression, farmers’ plight went from bad to worse, both in absolute and in relative terms. The average, absolute price of farm products fell below its prewar level, while their price relative to goods and services in general fell to what was then a record low.

While farm legislation had previously been aimed solely at giving farmers their “fair share” of national income, once the depression broke out its proponents began to emphasize its potential contribution to a general recovery. This tack was taken by FDR himself during his presidential campaign, and particularly in his September, 1932, Topeka campaign speech. Yet despite this, as a comprehensive Brookings Institute study of the AAA observes (p. 12), so far as actual policies were concerned neither the Democratic platform nor FDR himself went much beyond the official Republican party position, “if indeed they went that far.”

FDR did, however, express his support for aspects of the so-called “domestic allotment” plan, albeit without naming it, having been encouraged to do so by both Raymond Moley and Rex Tugwell. By 1932 that plan, first proposed by agricultural economist W.J. Spillman, and then taken up and popularized by another agricultural economist, Harvard’s John D. Black, was generally seen as the most promising alternative to McNary-Haugenism. The basic thinking behind it was that, while tariffs on farm products alone had proven ineffective in raising farmers’ earnings, they could become effective if farmers limited their output to levels consistent with domestic needs. The plan’s “essential principle,” Black told the House Agriculture Committee in 1929,

is paying a free-trade price plus the tariff duty for the part of [farmers’] crop which is consumed in the United States and this price without the tariff duty for the part of it that is exported, this to be arranged through a system of allotments to individual producers of rights to sell the domestic part of the crop in the domestic market.

A version of Black’s plan, which had many progressive Republican supporters, including future Agriculture Secretary Henry Wallace, was taken up by Congress twice during 1932. But the “Jones Bill,” named after Congressman Marvin Jones (D‑Texas), who became chair of the House Agriculture Committee when the Democrats gained control of Congress that year, was rejected by the Senate both times, and would certainly have been vetoed by Hoover had it not been.

Once in office, FDR, who had encouraged Jones’s efforts,[1] asked him to assist Wallace in revising a draft bill also based on the domestic allotment idea. The revised measure differed from Jones’s earlier efforts mainly by replacing transferable allotment rights with direct payments made to farmers in return for their agreeing to limit output to allotted amounts, to be financed by taxes on food processors. The resulting Agricultural Adjustment Act, promising to “relieve the existing national economic emergency by increasing agricultural purchasing power,” flew through the House on March 22, 1933, gained the Senate’s approval five weeks later, and was signed by FDR on May 12th.

The Theory

By creating a government agency—the Agricultural Adjustment Administration—expressly charged with restoring farmers’ purchasing power to levels last seen in the years just before World War I, the new law broke new and untested ground. Whether its combination of direct benefit payments and reduced farm output would suffice to achieve its immediate goal was doubtful enough. But even if it succeeded, just how were farmers’ higher earnings supposed to translate into improved all-around prosperity? Direct benefits to farmers were funded by taxes on food processors, which ultimately tended to be passed on to consumers. Crop reduction programs likewise benefited farmers only by making food less abundant and more costly for everyone. Surely Robbing Peter to pay Paul couldn’t possibly make both Peter and Paul better off. Or could it?

Actually, it could—in theory at least. For it to do so, it sufficed for farmers taken as a whole to have a higher “marginal propensity to consume” than those, apart from farmers themselves, who bore the brunt of higher food prices. That, at least, is how economists might put it today. During the first years of the depression, before the General Theory had taken the economics profession by storm, the same idea was stated more prosaically, if also more awkwardly. According to the Brookings study, by initially shifting “purchasing power” to farmers from others, the AAA intended to “exert a significant influence toward accelerating the release of [that] purchasing power into the general market.”

FDR understood that, taken as a means for improving overall prosperity, the AAA was a gamble. In his message transmitting the bill to Congress, he admitted that it took the government down “a new and untrod path.” But he considered the gamble worth taking, while promising that if it failed to “produce the hoped-for results, I shall be the first to acknowledge it and advise you.”

Qui Buono?

Did the AAA actually “produce the hoped-for results”? FDR, for his part, never suggested otherwise; and all experts agree that the AAA boosted overall farm earnings. Brookings’ painstaking report concludes that, taken as a whole, its programs enhanced gross farm earnings by as much as $2 billion, about a quarter of which took the form of direct Treasury payments. Allowing that farm families themselves bore some burden from increased food prices still left them with net gains of between $1.5 and $1.9 billion, which, at a time when total U.S. GNP was around $58 billion, was no small sum. Although AAA officials themselves claimed much bigger gains, they tended to credit the AAA both for its genuine contributions to farm earnings and for concurrent improvements in those earnings for which other factors were responsible.

To call the AAA’s contributions gains to “farmers” is nevertheless misleading, because they mostly ended up going to landlords, rather than to their tenants or to actual farm workers. When AAA benefits went to cash-paying tenants, they tended to be fully offset by higher rents. When, instead, they were meant to be divided between sharecroppers and their landlords, as in the cotton-growing South, the landlords often prevented sharecroppers from being paid directly, while dispensing with those they no longer needed. As a result, hundreds of thousands of tenant farmers and their family members found themselves homeless, with no means of survival save those offered by other New Deal relief programs. A Cornell agricultural economist estimated that, all told, the AAA added roughly 2 million former farm tenants and workers to the ranks of the unemployed.[2]

But so far as we’re concerned, the relevant question is whether the AAA helped to lift the U.S. economy as a whole from the depths of the Great Depression. Did it serve in practice to boost aggregate demand, as it was supposed to do in theory?

According to two of Brookings’ three experts, it did, both because farmers were more inclined to spend extra resources that came their way than the groups from which those resources were diverted, and because AAA programs often “advanced” purchasing power to farmers before they deprived food processors of it by taxing them. “On the whole,” they write, “we believe that the AAA was a quickening rather than a retarding factor in industrial activity”:

With confidence renewed that he was to be enabled to keep his farm and continue supplying the market under more favorable commercial conditions, the farmer expanded his purchases of consumption goods and farm supplies up to the limit made possible by enhanced prices, better credit, and direct benefit payments. This expansion of orders…improved the financial position and the business confidence of certain classes of manufacturers and in turn enlarged their purchases of raw materials and equipment. This reacted favorably on employment, payrolls, and urban buying. Ultimately…there was a larger flow of national income from which to divert the larger share that went to the farmer.

The same experts concluded that there was no reason to doubt the AAA’s claim that increased rural demand accounted for two-fifths of the rise in factory employment between the spring of 1933 and the fall of 1935, although AAA programs themselves only accounted for part of this, the rest having been due to “relief, public works, the Farm Credit Administration, and the drought.”

Where Credit is Due

For some, even Brookings’ tempered conclusion gave the AAA too much credit. These included Joseph S. Davis, the third author of its in-depth study. That conclusion, he observes in a footnote to that study, “conveys a materially exaggerated impression of the extent of the AAA’s recovery contribution.” In Davis’s opinion, that contribution, if it was positive at all, was minor. “[I]n this important sense,” he says, “the ‘recovery argument’ of its [the AAA’s] advocates was unsound.”

Although Davis’s footnote doesn’t supply his reasons for doubting that the AAA promoted recovery, he offered some of them two years earlier, when the AAA had been in business for 19 months, in an article for the Journal of Farm Economics. “On the basis of reasoning and experience to date,” Davis wrote then, the AAA’s contribution to recovery “has been minor, not major.” While Davis didn’t deny that AAA programs added to the money earnings of certain groups of farmers, he believed that most of the observed increase in both farmers’ earnings and their demand for non-farm goods and services was “due to other factors than the AAA.” Those other factors included the Great Plains drought, “[h]uge outpourings of public funds other than through the AAA,” and the dollar’s depreciation. Although Davis was unable to determine just “what influence the AAA might have had” in the absence of these other factors, his best guess was “that as a force in general recovery…it quite failed to fulfill” its advocates’ promises, “and may even have retarded aggregate business recovery.”

A recent AER paper lends support to Davis’s perspective, by showing that devaluation was a major source of both farmers’ increased earnings and the revival of rural demand for non-agricultural goods and services. In “Recovery from the Great Depression: The Farm Channel in Spring 1933,” Joshua Hausman, Paul Rhode, and Johannes Wieland argue that, thanks to farmers’ relatively high marginal propensity to consume, a redistribution of income favoring farmers did indeed contribute substantially to recovery during the spring of 1933. However, on the basis of a careful assessment of the evidence, in which they do their best to “control for the possible confounding effects of the drought and the AAA,” Hausman et al. assign most of the credit for that redistribution, not to AAA programs, but to the devaluation of the dollar, which caused farm product prices, and traded crop prices especially, to rise both absolutely and relative to the CPI. Contemporary press accounts, they note, also attributed the spring, 1933 rise in farm commodity prices to the FDR’s April 19th decision to suspend gold exports and allow the dollar to depreciate. And no wonder: within three months of that decision, the dollar had lost between 30 and 36 percent against gold and gold-backed currencies!

The other economists who shared Davis’s pessimistic view of the AAA’s contribution to recovery included T. W. Schultz, the future Nobel Memorial Prize winner, who in commenting on Davis’s assessment said not only that he found it reasonable, but that he doubted “if anyone would claim that the AAA has been a mighty or even a significant force in improving economic activity generally.” Schultz, who on the whole favored the AAA, regretted that Davis chose to harp on its failure to promote recovery, rather than on its contribution to agricultural reform. But since Davis’s concern, like ours, was the “AAA as a Force in Recovery,” Schultz’s complaint is mostly beside the point.

The AAA is Dead; Long Live the AAA

“Mostly.” Except that any full account of the AAA’s merits as a recovery measure must consider both its immediate and its longer-run costs and benefits.

The AAA was sold to the public as an emergency measure, which, if proven successful, would end once “the national economic emergency in relation to agriculture has been ended.” But as we’ve seen, its roots lay in proposals that pre-dated the depression. Moreover, the agency was expected not just to re-establish but “to maintain” agricultural commodity prices at their (relatively high) pre-WWI levels—something it could hardly do once it ceased to exist.

So it isn’t surprising that many of those who took part in creating and overseeing it, including FDR himself, looked forward all along to making agricultural “adjustments” a permanent feature of U.S. agricultural policy.

It was never the idea of men who framed the act,” FDR said in an October, 1935 statement, “that the Agricultural Adjustment Administration should be either a mere emergency operation or a static agency. It was their intention—as it is mine—to pass from the purely emergency phases necessitated by a grave national crisis to a long-time more permanent plan for American agriculture.

And that is indeed what the AAA became. Despite the Supreme Court’s ruling of January 6, 1936, striking down the original act as unconstitutional on the grounds that by using taxes levied on food processors to benefit farmers the federal government had encroached upon states’ rights, the AAA would survive, in name, until 1953; and after that, as Bill Ganzel observes, “the basic policy of the federal government has remained to keep prices up by keeping production down. And this is a very real way in which the Great Depression continues to affect those of us growing up and living today.”

As the aforementioned Brookings study notes (p. 2), instead of being “swept from the boards by this Supreme Court decision, as the NRA had been some seven months before,” the AAA was merely “diverted into new channels under modified procedures.” Less than two months after the court’s decision, the AAA’s crop-reduction component was reconstituted as part of the Soil Conservation and Domestic Allotment Act. Under that arrangement farmers, instead of being paid simply for refraining from growing certain crops, were paid for “conserving” former cropland, either by growing grass or nitrogen-fixing legumes on it instead, or by otherwise modifying it to limit soil erosion.

Two years later, a brand new Agricultural Adjustment Act, guaranteeing minimum prices for cotton, corn, and wheat. and otherwise supporting various other farm products, rose, phoenix-like, from its predecessor’s ashes. To steer clear of the Supreme Court’s 1936 ruling, instead of being funded by a tax on food processors, the new AAA relied upon appropriations from the Treasury’s general fund. In 1940 the new AAA, which like its predecessor was originally to expire after two years, was made permanent; and in 1942, in Wickard v. Filburn, the Supreme Court declared it constitutional.

Because FDR and other proponents of the original AAA had always had a permanent arrangement in mind, it seems only reasonable to take both the original and the revived AAA’s consequences into account in assessing the original plans’ overall net benefits. Addressing those consequences a half-century after the original law’s passage, agricultural economist Don Paarlberg concludes that the program’s tendency to benefit a minority of relatively large farmers, present from the start, only grew worse over time. While producers of certain “basic” crops, which by 1983 accounted for only 20 percent of agricultural output, received 75 percent of the program’s benefits, farmers of hundreds of other crops got no help from it at all; and 21 percent of the benefits paid went to just 1 percent of all participating farmers, who were generally far better off than the consumers and taxpayers who paid the bill for this largesse.[3]

And that largesse has grown considerably since the 1930s, both absolutely and as a share of total farm earnings. Here is a chart (from a webinar bearing the happy title, “Straining the Alphabet Soup,” by University of Illinois agricultural economists Joe Janzen and Nick Paulson) showing how direct government payments to farmers have evolved since 1933:

And here is another, from the folks at Agricultural Economic Insights, showing the change in the government-provided shares of total net farm income. It shows how, when Paarlberg wrote, that share had risen to almost 70 percent!

Nor have matters improved since Paarlberg wrote. Although direct farm payments declined as a share to total farm for most of the period after the mid-1980s, they were still substantial—and still overwhelmingly aimed at large-scale farmers who were better off than most of their fellow citizens. “If the intent of commodity support programs is to assist low-income households,” the President’s Economic Report for 2005 observed, “then these programs are failing in this task today because the bulk of payments go to farm households with incomes above the U.S. nonfarm average.”

At last, in 2014, Congress did away with direct farm subsidies by passing a new Farm Act. But while that measure did reduce the flow of direct aid to farmers, it did so by substituting almost equally generous crop insurance subsidies along with other offsetting benefits. Consequently, although insurance companies now received a bigger slice of the subsidy pie, large-scale farmers suffered little if at all.[4]

And thanks to the first Coronavirus Food Assistance Program (CFAP), and despite the 2014 reform, those farmers raked-in more direct government aid in 2020 than ever before. Here again, as has been the case generally, the largest 1 percent of farms received one-fifth of all direct CFAP payments to farmers, amounting to almost $1.1 billion. While many people found themselves in desperate economic straights in 2020, thanks to the CFAP large-scale farmers earned more than they had in any year since 2013. Because the second COVID-19 relief package includes a similar amount of direct aid to farmers, mostly aimed at the usual set of favored farm commodities, 2021 is likely to turn out to be another banner year for them.

Nor has the harm done by post-New Deal farm policies been limited to regressive income redistribution. By encouraging for intensive farming methods, including heavy applications of chemical fertilizers and pesticides, those policies have also had substantial, adverse environmental consequences. “To the extent then that agricultural assistance stimulates crop and livestock production,” Jan Lewandrowski, James Tobey, and Zena Cook observed in the August, 1997 issue of Land Economics, “and to the extent that such increases in output impose unintended and unaccounted for environmental costs on society, those environmental costs can be seen as a form of government ‘policy failure’.”

***

Just how should one weigh the AAA’s supposedly positive, if modest, contribution to economic recovery in the 1930s against its regressive and environmentally damaging long-run legacy? There may be no generally-acceptable way of doing so scientifically. But I daresay that few plausible social welfare functions would suggest a net balance in the program’s favor, let alone a substantial one. On the contrary: I believe most would suggest that, as a means for promoting general prosperity, the farm support gambit was a game not worth the candle.

Continue Reading The New Deal and Recovery:

• Intro
• Part 1: The Record
• Part 2: Inventing the New Deal
• Part 3: The Fiscal Stimulus Myth
• Part 4: FDR’s Fed
• Part 5: The Banking Crises
• Part 6: The National Banking Holiday
• Part 7: FDR and Gold
• Part 8: The NRA
• Part 8 (Supplement): The Brookings Report
• Part 9: The AAA

_____________________

[1] According to Eric Rauchway (Winter War, p. 78), Roosevelt had also “indicated to Hoover the importance of a farm bill, telling the president at their White House meeting on November 22 that if a law incorporating his [and progressing Republicans’] ideas about farm relief could be passed in the lame-duck sitting, then he might be able to avoid calling Congress into a special session on March 4, because the nation’s most pressing economic need would already have been addressed.” This was, of course, long before anyone had any inkling of the banking crisis that would erupt in the weeks leading to Roosevelt’s inauguration.

[2] James E. Boyle, “The AAA: An Epitaph.” The Atlantic Monthly 157 (February, 1936). (Unavailable online.)

[3] For more on the skewed distribution of farm program benefits up to 1983 see Johnson and Short (1983).

[4] For a detailed, critical account of the various farm subsidies in effect as of 2018, see this Downsizing Government entry by my colleague, Chris Edwards.

[Cross-posted from Alt‑M.org]

The answer depends on what you mean. Succeeded at what?

With the US dollar price of Bitcoin reaching an all-time high above $23,000 this month, and its market cap reaching an all-time high above $400 billion, there has been much celebration among Bitcoin holders about their success at investing. The run-up has accompanied the announcements by large institutional investors Grayscale, MicroStrategy, and MassMutual that they are acquiring hundreds of millions of dollars in Bitcoin for their investment portfolios. There isn’t much doubt that the Bitcoin project has succeeded remarkably at creating a new type of asset.

The developers of bitcoin, particularly Satoshi Nakamoto and the Bitcoin Foundation, however, have said that they want to develop a widely used private alternative to government fiat money. They have not yet succeeded in achieving that goal. Bitcoin is not a commonly accepted medium of exchange.[1] It has even lost one niche where it was the leading medium of exchange, namely in cryptoasset markets. Bitcoin’s use in buying and selling the “altcoins” that constitute the other 35 percent of the total cryptoasset market has actually receded in recent years. That role has been taken over by Tether and other US dollar stablecoins.[2]

Commentators have long confused success as an asset with success as a commonly accepted medium of exchange. In November 2013, economic commentator Edward Hadas offered “A Prediction: Bitcoin is Doomed to Fail.” He followed it up two months later with an article entitled “An early obituary for bitcoin.” These essays have understandably been ridiculed by Bitcoin enthusiasts. But they are worth re-examining because many of their claims are still heard today.

Starting from an (overstated) argument, to the effect that Bitcoin would not become a commonly accepted medium of exchange, Hadas leapt to the prediction that Bitcoin would have zero use and zero market value. Bitcoin today in fact occupies an intermediate position: it is an uncommon or niche medium of exchange. It is better than other media for making some payments that, even if for legitimate purposes, might be censored if routed through payment systems controlled by national governments and central banks. Human rights activist Alex Gladstein recently tweeted an annotated list of Bitcoin use cases, beginning with: “BYSOL, a grassroots Belarusian human rights org, has moved more than $500k of value peer-to-peer to striking workers inside Belarus, in a way the regime can’t stop. Activists or protestors normally get their bank accounts frozen.” His other examples include fundraising by activists in Nigeria, Hong Kong, and Russia; savings expatriation by people fleeing Venezuela; remittances into Iran; and peer-to-peer transfers within China among people seeking to avoid state financial surveillance. Such uses (together with forecasts of wider future use) are enough to sustain Bitcoin’s positive market value.

On the other hand, Bitcoin is far from being a commonly accepted medium of exchange in everyday use. It is not on one side of many transactions for goods and services. Coindesk columnist Jill Carlson has recently noted that, apart from people holding Bitcoin for speculation:

Real use of cryptocurrency products and applications remains limited. … Only about 2,500 merchants accept bitcoin in the United States. Adoption is trending the right direction, but it is still early.

In the United States and in other economies as a whole, then, Bitcoin has not achieved widespread acceptance as a medium of exchange. In a recently published paper, Peter K. Hazlett and William J. Luther put the point another way, observing that there exists only “a small corner of the internet where transactions are routinely conducted with bitcoin serving as the medium of exchange.”

I say that Hadas’ argument was overstated not only because he overlooked the possibility of a niche transactions demand for Bitcoin, but because in the first-listed piece he wrote:

The developers of bitcoin are trying to show that money can be successfully privatized. They will fail, because money that is not issued by governments is always doomed to failure. Money is inevitably a tool of the state.

Misconceptions permeate these sentences. Nobody needs to show today that money can be privately issued, because history is replete with examples. Private gold mints had a successful track record in the United States. In most developed countries, redeemable paper currency was mostly privately issued before the First World War. In the US, private banknotes continued in parallel with Federal Reserve notes until the government abrogated the banks’ right to issue. In Scotland, Northern Ireland, and Hong Kong, private banknotes continue to this day. In the US today, most money is issued by commercial banks, in the form of checking account balances (currently 66% of the narrow M1 measure of the US money stock), rather than by government.

Whether or not Bitcoin or another cryptoasset succeeds at gaining wider monetary use as a medium of exchange, privately issued money is not limited to that form. Money not issued by governments but by private banks, in the form of silver- and gold-redeemable checkable accounts and banknotes, spread across the globe over the centuries after 1200 AD and so cannot be “doomed to failure.” Money cannot be “inevitably a tool of the state” when privately issued money has historically so often succeeded. Money has evolved from private payment innovators striving to serve the convenience of merchants and households, not from the efforts of a mythical entrepreneurial state. Bitcoin and its competitors continue to evolve.

Like some other critics, Hadas apparently wanted Bitcoin to fail because it exemplifies a free-market ideology that he does not favor. But that is not a good reason for thinking that it must fail, either as a portfolio asset or as a commonly accepted medium of exchange. He wrote: “Bitcoin exemplifies some of the problems of private money. Its value is uncertain, its legal status is unclear, and it could easily become valueless if users lose faith.” It should be noted that uncertainty of value (highly volatile purchasing power), and the possibility of a loss of value due to a loss of faith, are problems shared by many government-issued fiat monies. They are not shared historically by private commodity monies. Any unclarity of Bitcoin’s legal status is the fault of legislation and bureaucratic rule-making, not of Bitcoin, and the responsibility for removing it lies with government.

Hadas continued: “Besides, if bitcoin ever really started to take off, governments would either ban it or take over the system.” That vulnerability is a problem, but it is odd to consider it a fault of private money, rather than a problem due to inadequate limits on government power.

At the end of his 2013 piece, Hadas derided Bitcoin users as criminals, geeks, and speculators. But then (and again in his 2014 piece), despite having predicted Bitcoin’s failure in both senses, he recognized another motive that gives Bitcoin a future: “People can be excused for thinking that governments, including central banks, have run the money system so poorly that non-governmental money might be better … Bitcoin appeals because governments are not fully living up to the responsibility that comes with state-sponsored money. Bitcoin, or something like it, will thrive until the authorities do better.”

Revisiting Bitcoin in 2017 after its price topped $10,000, Hadas conceded: “For now, bitcoin is working out well for speculators, if not for society.”

People can indeed be excused for thinking that central banks have done poorly at preserving the purchasing power of money, and at preserving financial privacy. And people can be excused for thinking that Bitcoin is potentially a more viable money than a non-governmental commodity standard in a world where governments have been allowed to suppress commodity-money payment systems. Bitcoin is vulnerable to government surveillance and prohibitions that could quash crypto exchanges and drive trades underground. But it arguably could survive underground better than could a banking system based on commodity redeemability that must be openly accessible to be trustworthy. If Bitcoin will continue to thrive as an investment and medium-of-exchange-in-waiting “until the authorities do better” at managing fiat money (and at allowing financial privacy), then Bitcoin may thrive for a long time to come.

********

[1] A “medium of exchange” is an asset acquired in one trade for the purpose of trading it away for something else. Anything that serves as a “commonly accepted medium of exchange” is a money in standard economics usage, although some textbooks confuse matters by giving equal billing to two subsidiary roles: “unit of account,” which derives from the CAMOE role, and “store of value,” which fails to differentiate money from bonds or real estate or any other asset. To avoid definitional disputes over “money” here, I focus on which roles Bitcoin has and has not achieved.

[2]The cryptoasset exchange Binance reports that 91% of its trades are currently conducted in USD Tether, only 4% in BTC.

[Cross-posted from Alt‑M.org]

[This is the last half of a two-part critique of Douglas Diamond and Philip Dybvig’s highly influential paper purporting to show that fractional reserve banking systems are inherently unstable. Part I can be found here.]

Sauce for the Goose…

Half a century after the fact, the “aggregate uncertainty” version of the Diamond-Dybvig model appeared at long last to offer solid proof of the inherent instability of ordinary banks, together with an equally solid foundation for government deposit insurance. But no sooner had the inspectors started poking their flashlights around that supposedly solid structure than its serious weaknesses became evident.

The first casualty of that inspection was Diamond and Dybvig’s case for deposit insurance. That case depends on their model’s “sequential service” constraint, which calls upon their bank to meet its depositors’ demands on a first-come-first-served basis. The constraint matters because, if it could instead delay paying its customers until it has received all of their requests, a Diamond-Dybvig (“D‑D”) type bank could make its period‑1 payments contingent on total period 1 withdrawals, thereby ruling-out runs despite aggregate uncertainly, by achieving the same structure of expected returns it might achieve using the threat of suspension in the aggregate certainly-sequential service case.

The problem with Diamond and Dybvig’s case for deposit insurance is that it implicitly and illogically exempts government authorities from the sequential service constraint imposed on the D‑D bank. In order for the deposit insurance solution to work, the government must itself accumulate all period‑1 payment requests, and then present those making such requests with their (optimal) tax bills before they actually withdraw funds, lest unwanted withdrawals should cut into period‑2 returns by interrupting the production process. There must, in other words, be no “first-come-first-taxed” constraint on the government corresponding to the bank’s “first-come-first-served” constraint. Although Diamond and Dybvig recognize that their case for deposit insurance rests upon this “asymmetry” in their treatment of the sequential service constraint, they never bother to justify it. They therefore opened themselves to the charge, leveled at them by Neil Wallace, of not taking their model’s sequential service constraint “seriously.”

That charge in turn suggests two obvious alternatives. One—imposing the sequential service constraint on government and bank alike—would rule out Diamond and Dybvig’s scheme. But the other—exempting government and bank alike—would serve their ends no better, because it would make a private-market, contractual solution feasible despite aggregate uncertainty. As Hu McCulloch and Min-Teh Yu explain, because the “tax” involved in Diamond and Dybvig’s insurance scheme is really just a “redistribution between period 1 withdrawers and nonwithdrawers,” once the Diamond-Dybvig bank is itself freed of the sequential service constraint, it can arrange to contractually implement the same “tax” itself.

As fatal as McCulloch and Yu’s observation is to Diamond and Dybvig’s argument for deposit insurance, in merely suggesting that insurance can do no better than voluntary contracts might, it understates the weakness of that argument, which rests upon Diamond and Dybvig’s assumption of a single, riskless production technology. As Diamond and Dybvig themselves recognize, because it “abstracts from the choice of bank loan portfolio risk,” the assumption of a single, riskless production technology sidesteps the notorious problem of moral hazard.

As Denise Hazlett has shown, allowing a Diamond-Dybvig bank to invest in either riskless or risky assets can easily sway the balance in favor of laissez-faire. Hazlett makes the point neatly by abstracting from aggregate uncertainty. Doing that makes the Diamond-Dybvig insurance scheme feasible even with a generalized sequential service requirement. But as we’ve seen, it also makes suspension of convertibility a first-best solution to the problem of runs. Insurance, on the other hand, isn’t such a good solution, because although it discourages runs, it also encourages excessive risk taking. Although Hazlett shows how certain regulations can limit the moral hazard problem, these also tend to make insurance less effective in discouraging runs.

Capitalists to the Rescue

That Diamond and Dybvig’s argument for deposit insurance isn’t tenable doesn’t itself dispose of their main finding, which is that private arrangements can guarantee a first-best banking outcome when there is aggregate uncertainty and withdrawals are granted on a first-come-first-served basis. But this finding depends crucially on several odd features of their “bank.”

One of these odd features is the Diamond-Dybvig bank’s “demand deposit” contract. As Kevin Dowd points out, that contract differs from actual bank deposit contracts in treating patient, type‑2 depositors as residual claimants even when they don’t panic. Yet the Diamond-Dybvig bank also doesn’t make use of equity financing as that’s normally understood. Instead, its liabilities are debt-equity “hybrids.” The “bank” itself is therefore something of a cross between a real-world bank and a mutual fund.

This difference between a Diamond-Dybvig bank and an actual bank turns out to be more than a mere technical shortcut. For the substantive question is whether real-world banks, and not just the hybrid and entirely imaginary institutions found in Diamond and Dybvig’s paper and most subsequent studies based on it, are inherently failure-prone; and it turns out that real-world banks, with their reliance upon both debt and equity financing instead of a hybrid of the two, are less likely to exhibit the “bad” equilibrium of Diamond-Dybvig style banking, and might never exhibit it at all.

To see why, it suffices, as Dowd demonstrates elsewhere, to assume that, besides type‑1 and type‑2 consumers, the world is inhabited by others—let’s call them “capitalists”—who are sufficiently well-endowed to be able to invest K units of capital without the least risk of wishing to consume them at T = 1. Suppose they do so by buying shares in a “bank” that’s otherwise the same as the one modeled by Diamond and Dybvig. Dowd shows that such a bank, with its distinct set of “pure” residual claimants, could prove attractive to capitalists. More importantly, it would certainly be more attractive to depositors than an ordinary D‑D bank, because it would make runs both less likely and less harmful to them if they ever occurred.

The possibility of a run on a D‑D bank arises, Dowd observes, because type‑2 depositors know they might suffer losses if too many other depositors withdraw in period 1. But if K is big enough—specifically, if K ≥ (r₁ – 1)[1]—type 2s would have absolutely no reason to fear losses and withdraw early. In short, capitalists can do what neither deposit insurance nor suspension of payments is capable of doing: they can guarantee a “good” equilibrium despite the presence of aggregate uncertainty.

Allowing for Bank-Issued Money

Another peculiarity of Diamond-Dybvig style “banks” is that, unlike real-world banks, they don’t offer payment services. Indeed, as Gary Gorton and Andrew Winton note, there are no distinct means of payment or exchange of any kind in the Diamond-Dybvig model and most variations upon it. In particular, “[t]here is no purchase of consumption goods using bank liabilities as money. In the model, the bank is, in effect, also the store.” In the real world, in contrast,

consumers buy goods with bank liabilities without any need to return to the bank to withdraw. This is the essence of a medium of exchange. And that is how bank notes and bank deposits work. While consumption smoothing, and the demand for consumption insurance, are likely important features of reality, it is not clear that consumption smoothing is really a meaningful sense in which bank liabilities are a medium of exchange.

Here once again, the peculiarity of the Diamond-Dybvig bank isn’t innocuous. It’s only thanks to it that suspension of payments can’t be relied upon to achieve a first-best banking outcome in the face of aggregate uncertainty.

The trouble with suspension in the aggregate-uncertainty version of the Diamond-Dybvig model is that it can frustrate the consumption plans of type‑1 consumers: if the bank underestimates t, the bank will suspend payments even when there’s no run, leaving some impatient customers out in the cold: because the bank is their only source of “corn,” they’re forced to go without. “A suspension of payments in the D‑D model,” I note elsewhere, “has the same effect that closing all retail outlets for real goods would have in an actual economy.”

In contrast, a real-world bank suspension doesn’t necessarily prevent bank customers from acquiring consumption goods. In reality, goods are sold by separate producers and merchants. Banks, for their part, use savings entrusted with them to finance those merchants and producers, but don’t produce or sell goods themselves. However, their liabilities can be used to purchase goods, and not merely to reclaim deposited funds. They serve, in other words, as means of payment. It follows that, when a real-world bank suspends payments, although it prevents holders of its IOUs from cashing them, it doesn’t necessarily prevent them from going shopping. So long as merchants remain willing to receive suspended bank IOUs at face value in payments, a real-world bank suspension can thwart a run without limiting impatient depositors’ ability to consume their savings.

To illustrate this point, some years ago I constructed an alternative version of the standard D‑D model designed to allow a role for a non-bank exchange medium, which I call “gold.” To make gold useful, I assume that the economy’s N consumers have no corn endowment in period 0, but are instead endowed with one ounce of gold each. I then add “corn merchants” to the economy, endowing them with an inventory of at least N bushels of corn, but no gold. Consumers and their bank must purchase corn from corn merchants, who are assumed to sell it at a given “world” price of one gold ounce per bushel. Finally, I assume that corn merchants, like type 2 bank depositors, are “patient” consumers.

I then consider two cases. In the first, a “gold only” payments technology prevails. In the second, “transactable” bank liabilities can serve in place of gold. I then show that, in the gold only case, all the results of the original D‑D model are replicated, including the finding that, with aggregate uncertainty, suspension can harm type‑1 consumers. The difference is that this result is due, not to “the fact that all ‘goods’ are locked-away in bank vaults,” but to the fact that type 1 agents can’t trade their bank deposit credits directly for available corn. The difference, I note, makes my version “more consistent with the ‘stylized facts’ of historical banking crises, which typically have involved shortages of money but not shortages of consumption goods.” The national bank “holiday” of 1933 was a notorious instance of this.

The second case I consider differs from the first only in allowing bank deposits to be directly traded for corn. Impatient consumers can then offer to exchange their bank deposits directly for merchants’ corn, with the merchants then joining ranks with other type‑2 depositors. I show that this modified model also replicates the results of Diamond and Dybvig’s original, but with one crucial difference: suspension no longer harms type‑1 consumers, who can go on trading their deposits for corn just as they might if suspension weren’t resorted to. Merchants’ own “patience” suffices to guarantee this outcome, because it makes them as willing as type‑2 depositors are to hold suspended bank deposits, so that they have no reason to refuse payments that take the form of such deposits.

While the consequences of the 1933 bank holiday resemble those of suspension in the “gold only” version of my modified D‑D model, earlier payment “restrictions” overseen by private bank clearinghouses came closer to the benign suspension of the version with transactable bank money. This was so because the private clearinghouses and their member banks continued to process checks, and also because banks and clearinghouses both issued low-powered paper substitutes for gold and high-powered paper money. During the 1933 holiday, in contrast, banks were closed altogether, and clearinghouses were prevented from issuing “emergency” currency. It appears, in other words, that, instead of illustrating the inherent shortcomings of suspension in the presence of aggregate uncertainty, the harm done by the bank holiday instead illustrates the potential disadvantages of a government-mandated suspension of payments compared to the sort of suspensions that are likely to be resorted to on a voluntary basis.

An Untestable Theory

That the predictions of the Diamond-Dybvig model should seem most consistent with what happened in the U.S. in late February and early March, 1933, than what transpired elsewhere during that decade, or in the U.S. at other times, is no surprise. As I noted at the onset, Diamond and Dybvig almost certainly drew inspiration from that singular U.S. episode.

It doesn’t follow, however, that D‑D model’s implications are inconsistent with other episodes, including those of Scotland, Canada, and other nations where for significant periods the lack of either deposit insurance or a lender of last resort went hand-in-hand with an almost equally complete lack of bank runs and panics. This is so for the simple reason that the D‑D model is empirically vacuous: according to it, panics are random events. Indeed, as Andrew Postlewaite and Xavier Vives have pointed out, they have got to be random events, for no one would put money (or “corn”) in a D‑D bank knowing that a panic was due.

It follows that, although panics are possible, they need never occur. The difference between the U.S. and, say, Canadian banking experience during the 1930s therefore poses no problem: Canada just happened to get lucky. (So, apparently, did Czechoslovakia, Denmark, Lithuania, the Netherlands, and Sweden, among other places.) “Luck,” or its absence, accounts for differing outcomes that might otherwise have to be traced to differences in macroeconomic conditions, the industrial organization of banking, bank investment fundamentals, prudential and other regulations, and a host of other potentially-relevant factors. And since but one cause, bad luck, is to blame for panics everywhere, the same solution or small set of solutions—deposit insurance or an alert last-resort lender or narrow banking—are the only conceivable remedies to any actual or potential banking crisis.

Because it’s consistent with any observed pattern of runs and panics, the D‑D theory of banking instability is untestable and, therefore, unfalsifiable. This might sound like a good thing. But it isn’t. For one thing, it makes the theory incapable of accounting for “the stylized facts” of banking history. As Gorton and Wintrop point out, anyone conversant with those facts will find it “straightforward to observe that banks are not fundamentally flawed institutions. …Panics simply are not a feature of most economies that have banks. The world is more complicated.”

In other words, factors other than sheer “luck” appear to matter. As we’ll see, one of those factors consists of laws that limit banks’ freedom to manage their affairs as they see fit.

A Not So Holy Grail

Practically all of the models that build upon Diamond and Dybvig’s pioneering effort retain that effort’s mechanism-design framework, with its peculiar assumption that, whatever else it does, a good bank model has to be able to show that banks and banking systems are inherently vulnerable to runs. “Some researchers believe,” Gorton and Winton observe (with Diamond and Dybvig and their adherents in mind), “that a theoretical model of the existence of financial intermediaries must simultaneously be a model of panics; banks and panics are inherently intertwined and models should reflect this.”

For many economists, in other words, the “inherent instability” claim is not just one hypothesis among many to be explored and tested, but an axiom no theory worth taking seriously can contradict. The unshakeable aim of the “substantial economic literature” launched by Diamond and Dybvig’s paper, Huberto Ennis and Todd Keister observe, has been “to identify the essential components” of a laissez-faire banking system that would justify the opinion “that banks…are inherently fragile, in the sense of being susceptible to a self-fulfilling run by their depositors.” More bluntly: a plausible theory of banking consistent with the idée fixe that banks are inherently unstable has long been the Holy Grail of economists studying the subject.

In his excellent survey of post Diamond and Dybvig research up to 2010, Ricardo Cavalcanti also acknowledges this Holy Grail approach. Noting that the models he covers “seem so distant from monetary theory,” he says this was unavoidable, for other approaches would have yielded “controversial…conclusions about fragility.” That is, they were bound to be even less capable of demonstrating banks’ inherent instability than ones that followed Diamond and Dybvig’s “mechanism design” approach in which the modeler starts by treating a bank run as one of several objectives his or her bank must accomplish, and works backward from there. Economists, Calvalcanti says, had

to give serious consideration to the possibility that financial fragility is an intrinsic consequence of trying to extend to individuals the best liquidity arrangements possible. This favors mechanism design over general equilibrium theory.

Indeed it does. But after yet another decade of toying with such models, with ever-diminishing returns, might it be that they’ve received as much serious consideration as they deserve? Might it be time to consider the possibility that, in seeking the causes of banking crises in the very nature of banking itself, economists have been barking up the wrong tree? Might an alternative approach prove more fruitful?

One such alternative turns the Diamond-Dybvig strategy on its head, by starting with the assumption that an unregulated bank is a robust institution, and then asking what sort of regulatory interventions can make it less so. Among other insights that can be gleaned from it, the Diamond-Dybvig literature shows that modeling a robust banking system, meaning one with contracts that rule-out “bad,” panic-based equilibrium, is relatively easy. So why not start with such a model—the more realistic the better—and then consider whether, and how, various regulatory restrictions can undermine the good equilibrium, either by ruling it out altogether or by introducing an alternative, “bad” equilibrium? In fact, there’s no need to start such an alternative research program. It has already been started, for at least some of the “bad” outcomes in extant Diamond-Dybvig models are readily interpreted as consequences, not of laissez faire, but of unnecessary legal restrictions

Whereas empirical (as opposed to mythical) support for the “inherent instability” hypothesis is scarce, there’s no shortage of evidence favoring this alternative “legal restrictions” theory of banking crises. For starters, there’s the fact that some of the world’s least heavily-regulated banking systems have also been remarkably crises free. There is the fact that voluntary contracts allowing bankers to suspend convertibility of their liabilities—the most obvious private-market device for preventing runs—have frequently been outlawed. Finally, there are piles of evidence concerning the (often crucial) role other misconceived regulations have played in past banking crises—so much evidence, indeed, that it’s hard to discover any past banking calamity in which misguided regulations played no part. Besides the works just linked, skeptical readers are encouraged to consult Fragile by Design, Charles Calomiris and Stephen Haber’s excellent 2014 survey which, thick though it is, is but the tip of a very large iceberg.

***

In his essay, “Monetary Theory and History: An Attempt at Perspective,” Sir John Hicks observed that “Monetary theory is less abstract than most economic theory; it cannot avoid a relation to reality, which in other economic theory is sometimes missing. It belongs to monetary history, in a way that economic theory does not always belong to economic history.”

What Sir John said of monetary theory necessarily goes for its subdisciplines. It follows that the theory of banking also “belongs” to monetary history, and therefore can’t avoid a relation to reality. The trouble with Diamond and Dybvig’s model is that its relation to reality is so very distant that the two might as well be perfect strangers.

_______________

[1] This condition, Dowd notes, “is a sufficient condition to rule out runs, but it is not a necessary one… While depositors would obviously prefer as much reassurance as possible, other things being equal, a higher capital base means a lower return on bank equity, other things again equal, and a lower return on bank equity makes the equity itself harder to attract. …[T]he optimal level of capital will trade off the reassurance it provides the depositors with the cost of the capital itself.”


[Cross-posted from Alt‑M.org]

Has any theoretical work on banking been more influential than Douglas Diamond and Phillip Dybvig’s 1983 JPE article, “Bank Runs, Deposit Insurance, and Liquidity”? If so, I can’t think of it. With well over 12,000 Google citations and counting, it’s certainly among the most cited academic papers in economics, let alone in the sub-discipline of monetary economics.

Nor has that paper’s influence been merely academic. Far from it: it is routinely cited by policymakers as supplying a rationale for government intervention in banking, and for explicit national deposit insurance schemes in particular. That the number of countries that adopted such schemes more than quadrupled during the two decades immediately following the article’s appearance—from just 20 to 87—almost certainly owes something to Diamond and Dybvig’s influential publication, which is bound to have informed the thinking of experts at the IMF and other international agencies who recommended deposit insurance as the best cure for banking crises.[1] Alas for Diamond and Dybvig and the citizens of the countries that followed those experts’ advice, its practical results can’t be said to have been universally benign.

That the Diamond-Dybvig model should have become so popular in policy circles isn’t hard to fathom. So far as many policymakers (and more than a few economists) are concerned, it shows, “rigorously,” that ordinary (that is, fractional-reserve) banking systems are inherently unstable, and that deposit insurance or an alert and efficient lender of last resort or some other form of intervention, like narrow banking, is needed to stabilize them. Ask an expert who advocates any of these solutions for proof that it’s necessary, and chances are he or she will eventually get around to saying, in essence, “See Diamond and Dybvig (1983).” Q.E.D.

There’s just one problem. It’s that Diamond and Dybig (1983) demonstrate no such thing.

Although I plan to criticize rather than praise the Diamond-Dybvig model, I have no desire to bury it. I completely agree with Ricardo Cavalcanti when he writes that it

was a significant conceptual and methodological advance in studying banking arrangements. Its methodological contribution was the use of mechanism-design theory rather than the old strategy, still prevalent in textbooks and some of macro, of tacking a banking sector onto a model of market exchange.

Indeed. Diamond and Dybvig’s model is cited so often in part because it has been criticized and refined so often, with each criticism and refinement adding, if only a teeny bit, to our understanding of the true causes of systemic banking crises.[2] So my beef isn’t with Diamond and Dybvig per se. It’s with those who assume that their model supplies adequate grounds for government intervention in banking. As experts have long understood, it does nothing of the sort. Here I review some reasons why.

When the Legend Becomes Fact…

In “The Man Who Shot Liberty Valence,” John Ford’s 1962 Western, Jimmy Stewart plays distinguished U.S. Senator Ranse Stoddard, who has just returned to the frontier town he left 25 years earlier. Maxwell Scott, who edits the town newspaper, wants his story. Stoddard regales him with his many accomplishments since he left; but Scott, in the meantime, hears the rumor that young Stoddard killed the town villain in a shootout. The rumor turns out to be false (John Wayne did it). But that doesn’t stop Scott from deciding that it makes for better copy than Stoddard’s real accomplishments. “This is the West, sir,” he tells the crestfallen Senator after tearing up his notes. “When the legend becomes fact, print the legend.”

Banking, too, has its legends. And in the U.S., at least, those legends have more in common with John Ford’s movies than one might expect. For they, too, are at least partly legends of the old West, which besides its gunslingers and regular shootouts had its fly-by-night “wildcat” banks and worthless shinplasters.

Or so we’re told. But just as shootouts were actually rare, even in Dodge City, so (as numerous studies have now shown) was wildcat banking. That’s not to say that there were no bank runs or bank failures: there were plenty. But that wasn’t because antebellum bank liabilities weren’t insured, or because their issuers only held fractional reserves, or because, after 1836, there was no central bank, or (despite misleadingly named “free banking” statutes) because banks weren’t otherwise regulated. On the contrary: it was because most of the banks that failed were regulated, irresponsibly, especially by being prevented from branching and by being compelled to invest in doubtful securities as a condition for issuing currency.

Yet the myth that banks failed in droves before the Civil War because they weren’t regulated enough persists. As I observed in a previous essay, this is partly because many naively assume that if government authorities call something “free banking” it must be so, and also because a story about banks running “wild”

makes for more titillating reading than ones about the mass of less colorful, if no less unfortunate, free-bank failures. Wildcat banking is to the history of banking what the O.K. Corral and Wild Bill Hickok are to the history of the far west.

If people still subscribe to the wildcat banking myth today, it wouldn’t be at all surprising to learn that Diamond and Dybvig subscribed to it in 1983, when its exposure by economic historians was still not widely appreciated, even among economists. However, it’s more likely that their assumption that banks as inherently failure-prone was informed by a different myth: that concerning the bank runs and failures of the early 1930s, and especially the systemic banking crisis that took place during late February and early March 1933.[3]

As I’ve also addressed this “Great American Banking Myth” elsewhere on this site, I’ll only observe here that, just as Hugh Rockoff, Arthur Rolnick, and Warren Weber began to demolish the myth of antebellum wildcat banking starting in the mid 1970s, others, including Barry Wigmore and Elmus Wicker, took a hard look at banking crises of the 1930s, and found that self-fulfilling fears of bank insolvency played a much more limited part in them than others had supposed. Wigmore, in particular, has argued quite persuasively that the 1933 run was “a run on the dollar,” meaning that, instead of imagining that all the banks still standing were about to go belly-up, people worried that, once he became president, FDR would devalue the dollar. That made it perfectly reasonable for them to run on banks they considered perfectly sound, so they could acquire gold by staging a run on the Federal Reserve banks, and ultimately on the Federal Reserve Bank of New York, which held most of the system’s gold. It was because the New York Fed was running short of gold that it ultimately urged the government to declare a nationwide bank holiday.

Alas, the theoretical literature on banking panics, including Diamond and Dybvig’s seminal article, appears to owe more to tenacious myths about banking in the U.S. than to any well-informed survey of U.S. banking experience, let alone experience elsewhere. “It does not seem to be an exaggeration, Gary Gorton and Andrew Winton observe, in their chapter on “Financial Intermediation” for Elsevier’s Handbook on the Economics of Finance, “to say that most of the theoretical work on panics has been motivated by the U.S. experience, which has then been incorrectly generalized. Panics simply are not a feature of most economies that have banks.”

In short, when Diamond and Dybvig set out to write their famous paper, U.S. banking legends were quickly giving way to facts. But like Maxwell Scott, though unwittingly, Diamond and Dybvig printed the legend. That is, they modeled the legend, and the JPE printed it.

The Baseline Diamond-Dybvig Model

Not that modeling the legend was easy. On the contrary: coming up with a reasonably tractable model economy in which a “bank” performed some essential function, yet was almost certain to eventually fail, was anything but. (Not for nothing did their paper make it into the JPE!) Indeed, the real lesson the Diamond-Dybvig exercise teaches couldn’t be further removed from the one many draw from it, particularly if they aren’t familiar with the many follow-up studies it inspired.[3] The lesson is that, while it’s possible to come up with a model bank that succumbs easily to panic, making one that also resembles real-world banks is well-nigh impossible.

To see why, we must first come to grips with the Diamond-Dybvig (or D‑D, for short) model itself. Having done my best to explain that model elsewhere, I can’t do much better than repeat that effort here. “The D‑D economy,” I wrote,

begins with N consumers endowed with equal quantities of the economy’s single consumption good, e.g., … a bushel of corn. There are three periods, 0, 1, 2—a “planting” period, an “intermediate” period, and a “harvest” period. A bushel of corn planted in period 0 yields R > 1 bushels in period 2, but only one bushel in period 1. Because consumers may meet with emergencies in period 1, investment in corn production is risky. Unlucky “type 1” consumers will have to liquidate their corn investments prematurely, realizing a net return of zero. In contrast, lucky “type 2” consumers can afford to delay consumption until the harvest, enjoying a positive return. All consumers feel vulnerable as of period 0, however, because they do not learn their types until period 1.

According to Diamond and Dybvig, a bank is a device that allows optimal risk sharing by pooling investments and dividing anticipated returns among type 1 and type 2 consumers. Assuming that the fraction, t, of type 1 consumers is less than one, risk sharing takes the form of (nontransactable) deposit contracts entitling depositors to a preset payoff of r₁ bushels of corn per bushel deposited in period 0 for period 1 withdrawals (R > r₁ > 1) and to a residual payoff of r₂ (< R) bushels of corn per bushel deposited in period 0 for period 2 withdrawals, where r₂ represents a pro rata share of corn harvested in period 2. A “good” banking equilibrium with optimal risk sharing occurs when deposit contracts are taken advantage of and type 2 consumers behave like type 2 consumers, delaying their withdrawals until the harvest.

Unfortunately, Diamond and Dybvig demonstrate that such a “good” equilibrium is only one of two possibilities. A “bad” equilibrium may also occur in which type 2 agents panic and join type 1s in withdrawing their deposits prematurely. Because the D‑D model assumes a single bank, such panic-based withdrawals are the equivalent of systemwide panic in a multibank system. A panic spoils the risk-sharing arrangement because, with r₁> 1, the value of the bank’s assets in period 1 (= N bushels of com) falls short of the promised period 1 redemption value of bank deposits (= Nr₁). Assuming… a “sequential [first-come, first-served] service constraint” is in effect, depositors who recover their initial deposits plus interest in period 1 leave the rest with less than their initial deposits. It follows that “anything that causes [type 2 consumers] to anticipate a run will lead to a run,” including intrinsically irrelevant random events such as sunspots.

At first blush, the Diamond-Dybvig model seems to answer all the requirements of a rigorous model of banking panics. It starts with an economy in which uncertain consumption needs to coexist with a production technology that calls for illiquid investment. In that environment, a “bank” can make everyone better off by allowing consumers to pool their investments to share the risk of having to consume early. But the insurance banks offer makes them vulnerable to panic-based runs. When panic strikes, the insurance arrangement breaks down, and instead of being better off, some depositors—those who take too long to cash-in their deposits—lose out, earning less than they would have by fending for themselves.

But there’s a hitch. In the simple or “baseline” version just described, the D‑D model suggests a straightforward, contractual remedy to the problem of bank runs: provided it knows the value of t—the fraction of impatient, type‑1 depositors—instead of allowing unlimited deposit withdrawals, the bank can include clauses in its deposit agreements allowing it to “suspend” period one payments as soon as the share of withdrawn deposits reaches t . By assuring patient, type‑2 depositors that they will always receive their promised return, the option of suspending payments eliminates their incentive to panic, ruling out the bad, bank run equilibrium. Because the option to suspend makes everyone better off, it constitutes a free-market solution to the problem of bank panics. So the baseline Diamond-Dybvig bank turns out not to be inherently unstable after all.

“Aggregate Uncertainty” and the Case for Intervention

But Diamond and Dybvig show that a minor and perfectly plausible tweak to their baseline model suffices to make the suspension solution less than optimal. If, instead of being known with certainty, the fraction of type‑1 depositors is a random variable, the bank has to estimate t. If it underestimates it, the bank will suspend payments even when no type 2s are panicking, but before all of its type‑1 depositors cash out. The left-out type 1s then suffer a welfare loss compared to the case of a “good” equilibrium without suspension. It follows that in a situation of “aggregate uncertainty” (that is, where the value of aggregate type‑1 withdrawals is uncertain), deposit agreements that allow for suspension may not be attractive enough to make them a viable, free-market solution to the problem of panics.

The government, on the other hand, can do something to stop panics—or so Diamond and Dybvig claim. “Government deposit insurance,” they write, “can improve on the best allocations that private markets provide” by guaranteeing “that the promised return will be paid to all who withdraw.” By taking advantage of its power to tax by committing to tax bank customers who withdraw their deposits in period 1, at a rate based on the realized value of total withdrawals, it can reduce the post-tax return type 2s can look forward to if they panic. Insurance can thus achieve the same run-preventing structure of returns in a situation of aggregate uncertainty as suspension contracts are able to achieve only when the share of type 1 depositors is known.

This isn’t to say that deposit insurance is the only possible solution. Diamond and Dybvig claim that appropriate central bank action can also rule-out runs. The Fed, for example, might “provide a service similar to deposit insurance” by using its last-resort lending facilities to “buy bank assets … for prices greater than their liquidating value. If the taxes and transfers were set to be identical to that of the optimal deposit insurance, it would have the same effect.”

***

So much for Diamond and Dybvig’s model and the claims they and others make with reference to it. In the second half of this essay, I’ll explain why their model actually says very little about how real world banks work, and even less about how we can get them to work better.

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[1] A rising incidence of financial crises abroad undoubtedly played their part as well. However it’s worth noting that the period’s international crises were primarily currency crises, involving speculative attacks on pegged foreign exchange rates, rather than banking crises in the strict sense. While deposit insurance can rule out ordinary bank runs, it generally can’t prevent runs on banks by persons seeking to acquire domestic currency for the sake of converting it into foreign exchange.

[2] Space and time prevent me from mentioning, let alone doing justice to, most of these Diamond-Dybvig inspired writings: while some of the strictures I make here against Diamond and Dybvig’s original effort pertain to many of these other works, it’s far from being the case that all of my criticisms apply to all of them. This is most obviously so for those articles that themselves underscore problems with Diamond and Dybvig’s analysis, even as they retain and build upon many of its features.

[3] By way of motivating their article, Diamond and Dybvig themselves mention runs on Hartford Federal Savings and Loan (February 1982) and the Abilene National Bank of Texas (July 1982) along with the large losses suffered by uninsured depositors upon the failure of Oklahoma’s Penn Square Bank (July 1982). That Penn Square failed because it made all sorts of bad loans is notorious. Abilene National Bank was one of Penn Square’s major correspondents, which suffered a run when word got out that it had suffered major loan losses. Hartford Federal, finally, endured a run after the Hartford Current reported, accurately, that it “lost a record $7.3 million in 1981 and is now taking drastic steps to stay afloat.” Sheer panic played no obvious part in any of these episodes, while deposit insurance failed, in the last of them, to keep insured depositors from running. In short, while Diamond and Dybvig may well have been inspired by these episodes, their contribution can hardly be said to help us understand them.




[Cross-posted from Alt‑M.org]