The Fed Is Repeating A 1937 Mistake

(but not the one you think)

A principal cause of the global nature of the Great Depression, and 1937 recession was the sterilization of gold in-flows into the United States. The United States found itself as the destination of flight to quality, as a bastion of stability whilst the politics of the Europe produced Lenin, Stalin, Mussolini and Hitler. Simultaneously, the United States’ trade surplus grew from roughly flat to over a billion (nominal) dollars annually.

At the same time, the Treasury sterilized the gold in-flows. I will let Douglas A. Irwin (2012) explain:

How did the sterilization policy work? The Treasury Department purchased all gold inflows at $35 per ounce with drafts from its balance at the Federal Reserve. Normally, it would print gold certificates for the equivalent amount and deposit them in a Federal Reserve account to replenish its balance. The certificate would then become part of the monetary base and could be used to increase bank reserves. However, with sterilization, instead of replacing its withdrawn balance with a gold certificate in equal amount, the Treasury kept the certificates in an ‘inactive’ account where they could not be used for the expansion of credit. It paid for the gold out of its general fund, reducing its balances at the Federal Reserve, which would then have to be replenished by issuing new debt or raising tax revenue (Johnson 1939).

The proceeds of gold in-flows should have gone to the domestic economy. Instead, somewhat perversely, it actually served as a domestic fiscal drain, causing money supply, which had been growing 12% annually between 1934–1936, to contract:

With a culprit being the Treasury sterilization:

(Both of these images are taken from Irwin A. Douglas (2012), which is linked to above.)

The failure of in-flows to expand monetary aggregates didn’t just hurt the domestic economy. It also served to hoard gold domestically, and consequently reduce the liquidity for trade — ergo imports from our trading partners, who then suffered higher unemployment rates.

Thankfully, today, we have Merkel, Renzi, and Cameron instead of Hitler, Mussolini, and Chamberlain. But the perception of the global economy outside the United States is grim. The United States, with its diversified and dynamic economy, and still-growing (albeit slowly) working-aged population, is enjoying perhaps the best economy of any developed nation post-Great Financial Crisis. While the economies of the European Union fall apart due to inadequate fiscal policy transfers and severely divergent needs from the monetary policy they share, the United States now has unemployment below 5%, and Core CPI above 2%.

In fact, using just a 1% natural real Fed Funds rate assumption, a neutral Fed Funds rate would be around 100bps higher than it is today. The Fed, however, has suppressed the Fed Funds rate on account of the weakness in the foreign sector.

At the same time, the output gap has been consistently contracting between 0.5–2% per year:

The Fed thinks it has cover from the recent fall in oil and the global economy. History contends that this is a very temporary condition:

What’s the harm in keeping rates below the natural rate, you ask?

The most obvious answer is that it is regressive. Yes, the rich have the most cash, but they also have a higher proportion of their assets in securities with yield, and securities that either explicitly or typically move up with inflation. At the same time, the corporate sector uses these lower rates to refinance their fixed liabilities to suck interest income, largely out of pension funds and the household sector, whilst simultaneously funding buybacks to concentrate the windfall from liability repricing to the narrowing base of equity owners.

But the less obvious answer is that too loose a monetary policy reduces real consumption growth (the prime contributor to GDP), while simultaneously preventing our trading partners from adjustments necessary to fix their economies. The mechanism is simple: when the Fed keeps rates below the natural real rate, it puts a negative pressure on the value of the dollar. The Fed is essentially fighting the inflows from rest of the world, which serve to bid up the dollar. Yes, the dollar is up quite a bit since the bottom in 2011 — but how much more would it be up were the Fed not holding their finger on the rate scale? You don’t need to go any farther than comparing Real Median Weekly Earnings with dollar to see how real income and consumption are potently affected by the value of the dollar:

The higher the dollar, the higher the real earning power of our median earner. Were real rates be allowed to normalize in this country, the dollar would be even higher, and the buying power of our median earner would be higher. At the same time, this makes foreign labour cheaper, allowing employment levels internationally to improve and close on the superior US employment levels, and the US households consume the international surplus.

Instead, the Fed is holding rates — and the dollar by consequence — as low as they can, which serves to suppress domestic consumption and foreign employment. In other words, the same mistake the Fed made into the Great Depression, and then again in 1937. Yes, it should seem like a self-defeating strategy — it is.

A strong currency indicates a strong country. It indicates that other countries have too much output to consume domestically, and they are willing to sell it to us cheaply. A policy which pursues lower interest and exchange rates isn’t good for our trading partners, who are willing to trade their surplus output on the cheap, our corporations, who would buy international capital goods on the cheap, or our households, who would would consume the international surplus, and the additional output from capital services produced by international capital goods purchases.

There are conditions in which making monetary policy trade-offs are appropriate: when there is a large or growing domestic output gap, and incremental reductions to interest rates reduce the cost of capital, thereby promoting more fixed investment. We are not in those conditions. The domestic economy should be freed to purchase the international surplus at whatever discounted price they want to sell to us at.