Tuesday, November 12, 2013

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

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.


  1. Let's imagine that in the 1930s, there had been no gold sterilization- would stocks have been able to rise forever? Presumably at some point consumers have to get enough money coming around to them to sustain a recovery. Things can get started by firms investing and building up inventory but if nothing gets sold at the end of it, a crash is unavoidable. I wonder whether "expectations" merely set the precise timing of the crash not the inevitability of the crash. What finally fixed the economy was the massive redistribution of financial power that came from WWII -its tragic that it took such an terrible event with all of the associated waste and suffering to put things back on track.

    Marriner Eccles perhaps got it right when in the 1930s he quoted:

    “It is utterly impossible, as this country has demonstrated again and again, for the rich to save as much as they have been trying to save, and save anything that is worth saving. They can save idle factories and useless railroad coaches, they can save empty office buildings and closed banks, they can save paper evidences of foreign loans, but as a class they cannot save anything that is worth saving, above and beyond the amount that is made profitable by the increase of consumer buying.
    It is for the interests of the well to do – to protect them from the results of their own folly – that we should take from them a sufficient amount of their surplus to enable consumers to consume and business to operate at a profit. This is not “soaking the rich”, it is saving the rich. Incidentally, it is the only way to assure them the serenity and security which they do not have at the present moment.”

    1. "Let's imagine that in the 1930s, there had been no gold sterilization- would stocks have been able to rise forever? "

      Well, if you believe in some sort of "plucking model", then yes. I'm not entirely sure what to think about the plucking model.

    2. I'm still trying to get my head around this. Back in the 1930s, did the people selling gold to the Treasury view the bank deposits they got in return as being very insecure? Am I right in thinking that bank collapses with loss of customer deposits had happened in the 1930s? So perhaps before sterilization, there was a shortage of treasuries and so the lack of a safe refuge helped to create a hot potato effect just like QE is hoped to do now. Perhaps the whole effect rested on bank deposits not being fully insured? Perhaps if government protection of bank deposits was as extensive and credible as that of treasuries, then no "hot potato" effect would come from unsterilized gold purchase (in 1930s) or QE today????

    3. "Back in the 1930s, did the people selling gold to the Treasury view the bank deposits they got in return as being very insecure?"

      I'm not sure. Could be. I recall reading that there were worries about devaluation in 1937.

      The hot potato effect I'm talking about in this post doesn't have much to do with things like deposit insurance. Base money is special -- it is both limited in supply and used to settle payments in the government's monopoly clearinghouse. By manipulating expected rarity of the base, a central bank creates a hot potato effect. Even if the base is not rare in the present, QE may be able to affect distant expectations about rarity, thus setting off a hot potato in the present.

    4. I'm still puzzled. If someone was directed by distant expectations about rarity then why would holding treasuries, that were going to mature in say a year, act any differently than someone holding bank deposits????

      Might the clue about the apparent affect of gold sterilization be where they say that sterilization entailed the treasury purchasing the gold with funds obtained by bond sales OR TAXATION. Perhaps it all boils down to that "or taxation" way of sterilizing. Perhaps it was nothing to do with monetary policy effects (substitution of treasuries for reserves) and all to do with a fiscal change with more taxation/ less government spending so as to get the funds to pay for the gold purchases without selling more debt. Perhaps the recovery before gold sterilization was driven by government deficits and it would have been immaterial whether those deficits were in the form of accumulating stocks of reserves or accumulating stocks of treasuries (given that interest rates were effectively at the zero bound anyway). Before sterilization, the government deficits due to treasury gold purchase passed through to be collected as profits and when sterilization was funded by increased taxation/reduced spending profits collapsed????

    5. "If someone was directed by distant expectations about rarity then why would holding treasuries, that were going to mature in say a year, act any differently than someone holding bank deposits????"

      Not bank deposits -- my whole conversation has been couched in terms of base money.

      Why do base and treasuries differ? Base money is typically more liquid than treasuries. A central bank will keep the supply of base rare in order to create a very large marginal convenience yield (or opportunity cost as JKH calls it). The convenience yield on treasuries will almost always be smaller than that of the base. Second, shopkeepers keep prices in terms of base money, not treasuries. Put differently, the $ unit-of-account is defined by Federal Reserve-issued liabilities, not treasury-issued liabilities. So while a change in the base's convenience yield will directly cause prices to change, a change in Treasury's convenience yield will not. Does that make sense? You're using four question marks, so I can only assume that I'm not properly explaining myself to you.

      I'm sure there were fiscal reasons for 1937, I chose not to get into those.

    6. JP Koning, your meaning is very clearly put -thanks. Sorry if the question marks gave a bad impression. I was only trying to convey that although I followed what your were clearly saying I was struggling to tally that with my own comprehension of plausible causes and effects.
      Although you say that this is about base money, non-banks will be left holding bank deposits rather than bank reserves won't they? Only banks can hold bank reserves so if say a car exporter sold cars to France in 1936, and the gold from that sale was then sold to the US treasury, then the consequence would be that the car exporter would be holding bank deposits that mirrored the bank reserves that his bank had got from the gold sale. It seems much the same as how JKH points out that today QE vastly increases bank deposits because the vast bulk of the treasuries that get bought by the Fed are owned by non-banks who then get primary dealers to sell them on to the Fed. Although the Fed pays with bank reserves, what the (non-bank) person/institution who was owning the treasury actually gets is bank deposits.

      About convenience yield- I can see that when the availability of base money is a binding constraint, then that pushes up interest rates by way of the convenience yield and when it becomes an extreme binding constraint then it can cause a full on deflationary crisis (that is never allowed to occur nowadays and is what central banks were set up to prevent). However, when there is plenty of base money then I fail to comprehend how adding more can increase prices. Obviously if you were to spread wealth around then that would increase demand but exchanging treasuries for base money seems to me entirely neutral when things are at the zero bound as they are now and were in the 1930s. The fact that the gold sterilization etc failed to raise interest rates much seem consistent with the idea that monetary base had minimal convenience yield at that time. If say a factory needed to be bought and lots of base money was needed for that transaction then it could be readily obtained in exchange for treasuries -which is just another way of saying treasury interest rates were low?

    7. "About convenience yield- I can see that when the availability of base money is a binding constraint, then that pushes up interest rates by way of the convenience yield and when it becomes an extreme binding constraint then it can cause a full on deflationary crisis... However, when there is plenty of base money then I fail to comprehend how adding more can increase prices.... exchanging treasuries for base money seems to me entirely neutral when things are at the zero bound as they are now and were in the 1930s."

      I was hoping you'd make that point. You're right that we currently have oodles of base money and are effectively at at the zero lower bound. The current convenience yield is 0, nada.

      However, the market also has expectations about future convenience yields going out 1-week to 1-year to 10-years etc. Although the current, or 24-hour yield is at 0, it doesn't necessarily follow that convenience yields further out along the curve are at 0. As long as distant convenience yields can be reduced by more QE now, then a central banker can still increase prices by a bit more. This process of pushing future convenience yields to 0 will at some point lose its effectiveness, as I pointed out in my post, since the discounted value of hitting a 0 convenience yield twenty years from now is piddling. Anyways, this post describes the convenience yield curve.

    8. I had a similar question as stone @5:45 AM.
      Sterilized gold purchases is fiscal tightening. There is no tightening of the base it is just not growing, and Irwin's article says reserves were plentiful. So is this really a story of the base? The situation (not sterilizing) seems to be like the SNB actions to put a floor on EURCHF; sure the base is expanding but the real story is exchange rates. As the BoC says: monetary policy is affected through interest rates and the exchange rate. The 1930s example may just be a story of fiscal policy rather than base?

    9. Not sure exactly what you mean with your SNB analogy. 1933 seems more like the SNB case to me than 1937, since in 1933 the dollar was redefined as a smaller amount of gold, just as the franc was devalued vis a vis the euro. In 1937 the dollar remained fixed at 13.71 grains of gold.

      "There is no tightening of the base it is just not growing..."

      If an announcement is made that the base will stop growing whereas everyone expected it to grow prior to that, then that sounds an awful lot like tightening to me.

      "Sterilized gold purchases is fiscal tightening."

      I thought Stone's point was that sterilization would only have amounted to a fiscal tightening if taxes and not bonds are used to sterilize.

      You guys really want to talk about the fiscal side. Must admit, that's not my expertise but I'm open to being taught.

    10. JPKoning, I totally agree when you say, "I thought Stone's point was that sterilization would only have amounted to a fiscal tightening if taxes and not bonds are used to sterilize." I just checked http://www.treasurydirect.gov/govt/reports/pd/histdebt/histdebt_histo3.htm
      Getting my calculator out it looks as though the deficits were
      To me that makes it look as though the gold sterilization WAS conducted by using taxes/spending cuts and not bonds to gather the funds to sterilize.The "recovery" was simply government deficits passing through to be captured as profits and the gold sterilization program crunched those deficits down by a big amount, profits collapsed and the stock crash and recession were simply a manifestation of that.
      Basically it looks to me as though it could well have been entirely immaterial whether those deficits were leading to an increased stock of treasuries or an increased stock of monetary base. We perhaps have no reason to try and explain how further increases to an already excessive stock of monetary base might shift expectations -perhaps there isn't evidence from this that they do?
      It seems like how they describe things in these links:

      I do wonder though whether a vast stock of monetary base MAY shift expectations because it may make it subsequently impossible for the central bank to raise rates once the central bank has a very large balance sheet of assets that pay very low rates.

    11. Perhaps it is all obvious old hat stuff but this seems a relavent quote from that link
      "Government expenditures add to business sector revenue both directly through
      government purchases of goods and services and indirectly by increasing the income of households, which then buy from business. Flows to the government either increase business expenses or reduce business revenue. If the government sector saves (spends less than it receives), the subtractions from profits will more than offset the additions to profits; a government surplus is a negative source of profits.Conversely, a government deficit is a positive source of profits because more money flows from the government sector to become business revenue than government takes away from business."

    12. "Not sure exactly what you mean with your SNB analogy."
      Sorry, my remark was muddled. I meant, the base is a side effect of some other action. With the SNB, increasing base was a side effect of targeting FX. In the 1936 case, the halt in base growth was a side effect of cutting fiscal stimulus.
      BTW really enjoyed this post; have had a long fascination with the economic history of this period since high school. Recently read, Lords of Finance (good) and The Forgotten Man (not so good). Do you have a favorite reading list for the GD?

    13. "BTW really enjoyed this post" -me too

    14. Glad you guys liked it.

      "Do you have a favorite reading list for the GD?"

      My favorite Great Depression book is Grapes of Wrath, but I really liked Lords of Finance. Right now I'm reading the Battle of Bretton Woods.

      "-perhaps there isn't evidence from this that they do?"

      Evidence would have to come in the form of a decline in the distant fed funds rate, say a fall in the 2-5 year fed funds futures market immediately after the sterilization announcement.

    15. It is hard to imagine stupider economics than what Eccles says here. The rich are plenty able to consume a ton of stuff: just look at the budget of any 22-year-old pro athlete that just signed a multi-million-dollar contract. Marx and Engels roundly mocked this idea, noting that busts come when workers wages are at their HIGHEST, not at their lowest. Please, let's not take such rubbish seriously!

  2. Yellen's comment is frightening... given Bernanke and the rest of the FED had no clue they were in the 'great recession' a full 6 months into it, how will they know when the right time to reduce excess reserves will be?.... they cant spot bubbles either... so how will they know they are not blowing one? ... given their total lack of historical ability to know exactly where they were in the cycle, how can we have any confidence in their ability to time it just right?

    1. "how can we have any confidence in their ability to time it just right?"

      Good point. We can't, I suppose. All the more reason to trust less in bureaucratic judgment and adopt a well-defined target?

  3. Perhaps this is a good test of your "memory-of-crashes" effect you've discussed previously (http://jpkoning.blogspot.com/2013/10/fama-vs-shiller-on-1987-stock-market.html)?

    1. That same thought crossed my mind when I posted the charts. Let's hope it doesn't come to that!