1,682 days and all's well

1,682 is the number of days that the Dow Jones Industrial Average has spent rising since hitting rock bottom back in March 6, 2009.

It also happens to be the number of days between the Dow's July 8, 1932 bottom and its March 10, 1937 top. From that very day the Dow would begin to decline, at first slowly, and then dramatically from August to November when it white-knuckled almost 50%, marking one of the fastest bear market declines in history.

Comparisons of our era to 1937 seems apropos. Both eras exhibit near zero interest rates, excess reserves, and a tepid economic recovery characterized by chronic unemployment. Are the same sorts of conditions that caused the 1937 downturn likely to arise 1,682 days into our current bull market?

The classic monetary explanation for 1937 can be found in Friedman & Schwartz's Monetary History. Beginning in August 1936, the Fed announced three successive reserve requirement increases, pushing requirements on checking accounts from 13% to 26% (see chart below). The economy began to decline, albeit after a lag, as banks tried vainly to restore their excess reserve position by reducing lending and selling securities. A portion of the reserve requirement increase was rolled back on April 14, 1938, too late to prevent massive damage being done to the economy. The NBER cycle low was registered in June of that year.

Friedman & Schwartz's second monetary explanation for 1937 has been fleshed out by Douglas Irwin (pdf)(RePEc). In December 1936, FDR began to sterilize foreign inflows of gold and domestic gold production (see next paragraphs for the gritty details). This effectively froze the supply of base money, which had theretofore been increasing at a rate of 15-20% or so a year. Tight money, goes the story, caused the economy to plummet, a decline mitigated by FDR's announcement on February 14, 1938 to partially desterilize (and therefore allow the base to increase again, with limits), further mitigated by an all-out cancellation of the sterilization campaign that April.

Here are the details of how sterilization worked. (If you find the plumbing of central banking tedious, you may prefer to skip to the paragraph that begins with ">>" — I'll bring the 1937 analogy back to 2013 after I'm done with the plumbing). In the 1920s, the supply of base money could be increased in several ways. First, Fed discounting could do the trick, whereby new reserves were lent out upon appropriate collateral. The Fed could also create new reserves and buy either government securities in the open market or bankers acceptances. Lastly, gold was often sold directly to the Fed in exchange for base money. After 1934, all but the last of these four avenues had been closed. Both the Fed's discount rate and its buying rate on acceptances was simply too high to be attractive to banks, and the practice of purchasing government securities on the open market had long since petered out. Only the gold avenue remained.

New legislation in 1934 meant that all domestic gold and foreign gold inflows had to be sold to the Treasury at $35/oz. The Secretary of the Treasury would write the gold seller a cheque drawn on the Treasury's account at the Fed, reducing the Treasury's balance. The Treasury would then print off a gold certificate representing the number of ounces it had purchased, deposit the certificate at the Fed, and have the Fed renew its account balance with brand-spanking new deposits. Put differently, gold certificates were monetized. As the Treasury proceeded to pay wages and other expenses out of its account during the course of business, these new deposits were injected into the banking system.

You'll notice that by 1934 the Treasury, and not the Fed, had become responsible for increasing the base money supply, a situation that may seem odd to us today. As long as the Treasury Secretary continuously bought gold and took gold certificates representing those ounces to the Fed to be monetized, the supply of base money would increase one-for-one as the Treasury drew down its account at the Fed.

The Treasury's decision to sterilize gold inflows in December 1936 meant that although it would continue to purchase gold, it would cease bringing certificates to the Fed to be monetized. The Treasury would pay for each newly mined gold ounce and incoming foreign ounces by first transferring tax revenues and/or the proceeds of bond issuance to its account at the Fed. Only then could it afford to make the payment. Whereas the depositing of gold certificates by the Treasury had resulted in the creation of new base money, neither the transfer of tax revenues nor the proceeds of bond issuance to the Treasury's account would have resulted in the creation of new base.

FDR's sterilization campaign therefore froze the base. Gold was kept "inactive" in Treasury vaults, as Friedman & Schwartz would describe it. The moment the sterilization campaign was reversed (partially in February 1938, and fully in April), certificates were once again monetized, the base began to expand again, and a rebound in stock prices and the broader economy followed not long after.

>> Let's bring this back to the present. Before 2008 the Fed typically increased the supply of base money as it defended its target for the federal funds rate. The tremendous glut of base money created since 2008 and the introduction of interest-on-reserves has given the Fed little to defend, thus shutting the traditional avenue for base money increases. Just as the gold avenue became the only way to increase the base in 1936, quantitative easing has become the only route to get base money into the banking system. With that analogy in mind, FDR's 1936 sterilization campaign very much resembles an end to QE, doesn't it? Both actions freeze of the monetary base. Likewise, last September's decision to avoid tapering is analogous to the 1938 decision to cease sterilization (or to "desterilize") —both of these decisions unfreeze the base.

Who cares if the base is frozen? After all, in 1937 and today, any pause in base creation won't change the fact that there is already a tremendous glut in reserves. A huge pile of snow remains a huge pile, even after it has stopped snowing.

One reason that desterilization and ongoing QE might be effective is because they shape expectations about future monetary policy, and these expectations are acted upon in the present. For instance, say that the market expects the glut of base money to be removed five years in the future. Only then will reserves regain their rare, or "special" status. While a sudden announcement to taper or sterilize will do little to reduce the present glut, it might encourage the market to move up the expected date of the glut's removal by a year or two. Which will only encourage investors in the present to sell assets for soon-to-be rare reserves, causing a deflationary decline in prices. On the other hand, a renewed commitment to QE or desterilization may extend glut-expectations out another few years. This promise of an extended glut period pushes the prospect that reserves might once again be special even further down the road. With the return on base money having been reduced, current holders of the base will react by trying to offload their stash now—thus causing a rise in prices in the present.

If the monetary theories about the 1937 recession are correct, it is no wonder then that 1,682 days into our current bull market investors seem to be so edgy about issues like tapering. Small changes in current purchasing policies may have larger effects on markets than we would otherwise assume thanks to the intentions they convey about future policy.

QE is effective insofar as it is capable of pushing market expectations concerning the future removal of the base money glut ever farther into the future. But once that lift-off point has been pushed so far off into the distant future (say ten years) that the discounted value of going further is trivial, more QE will have minimal impact.

If QE is nearing the end of its usefulness, what happens if we are hit by a negative shock in 2014? Typically when an exogenous shock hits the economy and lowers the expected return on capital, the Fed will quickly reduce the return on base money in order to ensure that it doesn't dominate the return on capital. If the base's return is allowed to dominate, investors will collectively race out of capital into base money, causing a crash in capital markets. The problem we face today is that returns on capital are currently very low and nominal interest rates near zero. Should some event in 2014 cause the expected return on capital to fall below zero, there is little room for the Fed to reduce the return on base money so as to prevent it from dominating the return on capital—especially with interest-on-reserves unable to fall below zero and QE approaching irrelevance. Come the next negative shock, we may be doomed to face an unusually sharp and quick crash in asset prices (like 1937) as the economy desperately tries to adapt to the superior return on base money.

So while I am still somewhat bullish on stocks 1,682 days into the current bull market, I am worried about the potential for contractionary spirals given that we are still at the zero-lower bound. I'm less worried about the Fed implementing something like a 1937-style sterilization campaign. Incoming Fed chair Janet Yellen is well aware of the 1937 event and is unlikely to follow the 1937 playbook. Writes Yellen:

If anything, I’m more concerned that we will be tempted to tighten policy too soon, thereby aborting recovery. That’s just what happened in 1936 when, following two years of robust recovery, the Fed tightened policy because it was worried about large quantities of excess reserves in the banking system. The result? In 1937, the economy plunged back into a deep recession.  -June 30, 2009 [link] 

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Other recent-ish commentary on the 1937 analogy include Paul Krugman, Francois Velde (pdf), Scott Sumner, Lars Christensen, Christina Romer, Charles Calomiris (pdf), Business Insider, and David Glasner.