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.

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.

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.

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."