The US Great Depression lasted from 1929
until 1945, but the deflationary phase of the Depression effectively ended in
1932. Regardless of whether you define deflation and inflation in terms of
money supply or prices, there was almost continuous inflation in the US after
1932. The inflation was, however, briefly interrupted during 1937-1938, when
a leveling-off in the money supply and a sudden economic downturn led to
sharp declines in equity and commodity prices. The 1937-1938 downturn is sometimes called the "mistake of
1937" by those who believe that it only occurred because the Fed
tightened monetary policy prematurely. According to the believers in this
theory, the US economy would have continued to recover from the collapse of
1929-1932 if not for the Fed's premature tightening. Significantly, Ben
Bernanke is one of the believers.
Believers in the theory that the
collapse of 1937-1938 was caused by the Fed's premature tightening of
monetary conditions are partially right in that modest Fed tightening during
the second half of 1936 and the first half of 1937
was probably the catalyst for the collapse. The question that this theory
fails to address is: if a genuine economic recovery had got underway in 1933,
then why did the recovery fall apart so rapidly and so completely following
only a minor tweaking of monetary conditions? The answer is that the recovery
wasn't real; it was an illusion based on increasing money supply. When
economic growth is mainly the result of increasing money supply then
stopping, or even just slowing, the rate of money-supply growth will likely
bring about a collapse.
(As an aside, the recovery's flimsy
monetary underpinning is part of the reason why, like the recovery that began
in mid 2009, it was essentially "jobless"
(the unemployment rate remained very high throughout the 1933-1937 rebound).
However, there was more to the relentlessly high unemployment of the 1930s
than the Fed's counter-productive monetary machinations. Actions taken by the
Hoover and Roosevelt administrations to raise the price of labour can also be given a lot of credit for keeping
people out of work.)
This prompts the question: shouldn't
the Fed have continued to 'support' the economy with a constant flow of new
money until a real recovery was able to take hold?
The above question ignores the fact
that the flow of new money (monetary inflation) leads to more mal-investment
and thus not only gets in the way of a real recovery, but also further weakens
the economic structure. Had the Fed continued to provide monetary support for
an additional year then the collapse would have commenced in mid 1938 rather than mid 1937.
Also, it would have been even more devastating thanks to an additional year
of mal-investment. As Ludwig von Mises pointed out long ago: "There is
no means of avoiding the final collapse of a boom brought about by credit
expansion. The alternative is only whether the crisis should come sooner as
the result of voluntary abandonment of further credit expansion, or later as
a final and total catastrophe of the currency system involved."
The above question also ignores the
fact that in real time the central bank finds itself between the proverbial
rock and a hard place. Even when the economy is subject to natural
deflationary forces, as it was in the mid-1930s, the unnatural creation of
new money by the central bank will eventually cause evidence of an inflation
problem -- in the form of rising prices for important commodities and some goods
and services -- to emerge. After a while, the pressure on the central bank to
curtail the inflation problem can become greater than the pressure on the
central bank to 'support' the economy with a continuing flow of new money.
By the third quarter of 1936 the
pressure on the Fed to curtail the inflation problem had become dominant, but
if the Fed had ignored this pressure and instead persisted with its
price-boosting policies -- the path that Monday-morning Keynesians
now say should have been taken -- then the end result would have been an even
more severe economic downturn once monetary conditions were eventually
tightened. Alternatively, the Fed could have chosen to rapidly inflate the
money supply indefinitely, in which case the end result would have been total
catastrophe for both the US dollar and the US economy.
A picture of what happened during
1937-1938 is displayed below. On the chart the 1937-1938 downturn looks minor
in comparison to the 1929-1932 downturn, but it was substantial nonetheless.
The Dow Industrials Index lost more than half of its value, but perhaps of
greater significance was the quick one-third decline in manufacturing output.
Considering the relative importance of manufacturing in those days, this
effectively means that the economy quickly shrunk by one-third.
The chart also shows that the Fed
made no attempt to tighten via a higher official interest rate. As explained
in Note (1) below, the Fed used other means to restrict the flow of new
That many of today's most influential
policymakers and economists believe that a severe downturn could have been
avoided during the late-1930s if only the Fed had maintained its ultra-easy
monetary stance means that the wrong lesson has been learned from history.
This, in turn, almost certainly means that the Fed will stay loose for longer
in the face of blatant evidence of an inflation problem this time around, and
that the Fed will be quicker than ever to engineer a money-supply boost in
reaction to the next bout of economic weakness.
 The Fed started tightening the monetary reins in
August of 1936. It never went as far as hiking the official interest rate
(the "Discount Rate"), but it did increase bank reserve
requirements and took actions to prevent gold in-flows to the US Treasury
from boosting the Monetary Base. The result was a leveling-off in the money
supply during the 2-year period beginning in late-1936.
 A Monday-morning Keynesian is an economist who always
knows, with the benefit of hindsight, how much 'stimulus' should have been
provided to the economy to bring about a sustainable recovery. Since these
economists begin with the premise that monetary and/or fiscal stimulus helps
the economy, if an economy tanks despite the concerted application of
stimulus measures they inevitably conclude that the stimulus was
insufficient. They never seriously question the correctness of the underlying