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The Great Depression

The 1937-38 Recession: A Depression Within the Depression

Pomegra Learn

What Caused the 1937-38 Recession and Why Does It Still Matter?

By early 1937, the Great Depression appeared to be ending. GDP had grown by approximately 50 percent from its 1933 trough; unemployment had fallen from 25 percent to approximately 14 percent; industrial production had nearly recovered to 1929 levels; the Dow Jones Industrial Average had risen from 41 to approximately 185. Policy makers concluded that the private economy had recovered sufficiently to sustain growth without continued government support. They were catastrophically wrong. Within months of the decision to tighten fiscal and monetary policy, the economy collapsed: unemployment rose from 14 to nearly 20 percent; industrial production fell sharply; the Dow fell approximately 40 percent. The 1937-38 recession became the canonical example of premature policy tightening during incomplete recovery—and its lessons have shaped the management of every major recession since.

Quick definition: The 1937-38 recession refers to the sharp economic contraction within the already-depressed Great Depression economy, caused by the simultaneous tightening of fiscal policy (reduction of WPA spending and movement toward budget balance) and monetary policy (the Federal Reserve's doubling of bank reserve requirements in 1936-37), which revealed that the recovery was government-stimulus-dependent and produced a severe setback that delayed full recovery until World War II.

Key takeaways​

  • The 1937-38 recession was caused by deliberate policy tightening: the Federal Reserve doubled reserve requirements; the Roosevelt administration reduced WPA spending and moved toward fiscal balance.
  • The contraction was rapid and severe: GDP fell approximately 10 percent from the 1937 peak to the 1938 trough; unemployment rose from approximately 14 percent to nearly 20 percent.
  • The recession proved that the 1933-1937 recovery had been government-stimulus-dependent—private sector investment and consumption had not recovered sufficiently to maintain growth without support.
  • Policy was reversed quickly once the mistake was recognized; the Fed reversed reserve requirements and fiscal stimulus was resumed, allowing recovery by late 1938.
  • The 1937-38 episode has been cited in the policy debate surrounding virtually every subsequent major recession as the canonical lesson against premature tightening.
  • The episode directly shaped post-WWII fiscal policy thinking and was a key reference point in the 2008-2009 recession's policy response design.

The rationale for tightening in 1937​

Understanding the 1937 tightening requires understanding the policy perspective of its architects—it was not mindless error but reasoned (if ultimately wrong) judgment.

By 1937, the economy had been growing strongly for four years. The unemployment rate of 14 percent, while still historically high, was dramatically lower than the 25 percent peak of 1933. Prices had been rising—the CPI rose approximately 3.5 percent in 1937—and policy makers feared the beginning of inflation if stimulus continued. The federal deficit, which had funded the recovery programs, was seen by many as fiscally unsustainable.

Treasury Secretary Henry Morgenthau, who was Roosevelt's closest economic advisor, was deeply committed to the balanced-budget norm. He argued repeatedly that the deficit was undermining business confidence—that private investment would not recover as long as the government ran large deficits—and that fiscal consolidation was needed to restore that confidence. Roosevelt was sympathetic to this view.

The Federal Reserve's rationale for raising reserve requirements was different. Banks had accumulated large excess reserves (reserves above the required minimum) during the Depression; the Fed feared that banks might suddenly deploy these excess reserves in an inflationary credit expansion. The reserve requirement increases were designed to immobilize the excess reserves, preventing future inflation.

The mechanism of the 1937 recession​

The tightening operated through two channels simultaneously, which compounded its effect.

The fiscal channel: The Works Progress Administration's employment was reduced; Treasury moved toward fiscal balance through spending cuts. This directly reduced income for WPA workers and their suppliers, reducing consumer spending, reducing business revenues, and producing layoffs. The fiscal multiplier operated in reverse: a dollar of reduced government spending reduced total output by more than a dollar as the reduction cascaded through the economy.

The monetary channel: The Federal Reserve's reserve requirement increases—implemented in three steps in August 1936, March 1937, and May 1937—doubled reserve requirements. Banks responded by reducing loans and investments to build up their reserve positions. The credit available to businesses and consumers fell; investment projects that had been viable became unfinanceable; the economic activity that credit had been supporting declined.

The combination of fiscal and monetary tightening was more than twice as damaging as either alone—the two channels reinforced each other. Reduced government spending reduced demand; reduced credit reduced investment; falling activity reduced tax revenues; falling activity reduced bank profitability, making banks more conservative; the cycle was vicious.

The speed of the collapse​

The economy's response to the 1937 tightening was faster than the tightening's architects had anticipated. The recession began in the third quarter of 1937—within months of the policy changes. By the end of 1937, it was clear that a severe contraction was underway; by mid-1938, with unemployment approaching 20 percent, the mistake was undeniable.

The speed of the collapse was itself informative about the recovery's nature. If the private economy had been genuinely self-sustaining—if private investment and consumer spending had fully recovered—the withdrawal of government stimulus would have produced only modest slowing, quickly offset by the private sector's own momentum. The dramatic and rapid response to tightening demonstrated that the private sector had not recovered: it had been running on government-provided demand, and when that demand was withdrawn, the underlying weakness was immediately exposed.

The speed also demonstrated something about policy transmission: the announcement effect of policy changes can operate quickly. Businesses that anticipated the tightening—observing the Fed's reserve requirement announcements and the Treasury's budget-balancing statements—began cutting investment before the full tightening had been deployed. Expectations channel transmission accelerated the real effects.

Policy recognition and reversal​

Roosevelt recognized the mistake relatively quickly. By early 1938, as unemployment rose toward 20 percent and the stock market fell dramatically, the White House acknowledged that the recession required policy response. Hopkins and other New Dealers argued for reversal; Morgenthau resisted.

Roosevelt ultimately sided with the expansionists. In April 1938, he submitted a $3.75 billion emergency spending bill to Congress, primarily for WPA expansion. The Federal Reserve reversed its reserve requirement changes. The policy reversal halted the contraction; recovery resumed by late 1938. But the damage had been done—the partial recovery of 1933-1937 had been partially reversed, and full employment remained beyond reach until the war.

The analytical impact: stimulus dependency recognized​

The 1937-38 recession provided the most direct evidence for what critics had suspected and advocates had hoped: the New Deal's recovery was real but insufficient, dependent on continued government support rather than self-sustaining.

This recognition had several implications:

For Keynesian economics (the General Theory was published in 1936), the 1937 recession provided empirical support for Keynes's argument that economies could remain trapped below full employment without sustained government intervention, and that premature withdrawal of fiscal support would abort recovery.

For fiscal policy, it established that the balanced-budget norm was inappropriate during incomplete recovery. The lesson—maintain stimulus until the private sector can sustain growth independently—has shaped fiscal policy responses to every subsequent major recession.

For monetary policy, it established that tightening during incomplete recovery can be catastrophically counterproductive. The Fed's post-WWII evolution toward greater flexibility in managing the cycle reflects the 1937 lesson.

Real-world examples​

The 1937-38 recession is cited in almost every policy debate about fiscal stimulus withdrawal timing. Three specific modern applications:

2010-2013 eurozone austerity: The eurozone's move toward fiscal austerity beginning in 2010, despite unemployment remaining high across southern European countries, drew explicit comparisons to 1937. The result—prolonged stagnation and elevated unemployment in austerity countries—confirmed the parallel.

2013 US fiscal cliff and sequester: The US budget sequester of 2013, reducing federal spending during incomplete recovery from the 2008 recession, was criticized using the 1937 precedent. Many economists argued it delayed recovery; the evidence on its economic impact is more mixed than the eurozone case but consistent with some growth drag.

2021-2022 stimulus debate: The debate about whether COVID-era stimulus was too large and extended too long drew the reverse of the 1937 lesson: some argued the 1937 mistake was withdrawing too early, but others argued (and subsequent inflation outcomes suggested) that the 2021-2022 fiscal expansion was too large and too sustained. The 1937 lesson argues against premature withdrawal; it does not argue for unlimited duration.

Common mistakes​

Treating the 1937 recession as inevitable. The 1937 contraction resulted from deliberate policy choices that were recognized as mistakes and reversed within months. It was not an inevitable consequence of the Depression's structure but a policy-induced setback. This is both the lesson's point and its limitation: subsequent policy makers need to make correct judgment calls about when stimulus is no longer needed, with the 1937 precedent warning against premature withdrawal.

Treating the 1937 lesson as "never tighten." The lesson is about premature tightening in incomplete recovery, not about the impossibility of successful policy normalization. The eventual successful transition from wartime stimulus to peacetime economy without renewed depression demonstrates that policy normalization can succeed when recovery is genuinely complete.

Applying the 1937 lesson mechanically to different contexts. The 1937 policy tightened during 14 percent unemployment with no private sector recovery momentum. Applying the same lesson to tightening from 4 percent unemployment misapplies the lesson—the context determines whether tightening is premature.

FAQ​

Did Roosevelt ever acknowledge the 1937 mistake?​

Roosevelt did not explicitly acknowledge the mistake in terms that would have been politically damaging, but his April 1938 emergency spending message to Congress implicitly acknowledged that recovery required renewed fiscal support. His economic advisors' private communications and subsequent memoirs more directly acknowledged that the 1937 tightening had been an error.

How did the 1937 recession affect the political coalition for the New Deal?​

The 1937 recession damaged Roosevelt politically—Republicans gained 71 seats in the House in the 1938 midterms, the largest midterm loss of any president since 1934. The recession reinvigorated criticism of New Deal economic management and reduced Roosevelt's congressional majority for the remainder of his second term. The political damage from the recession was a concrete demonstration that premature tightening has political as well as economic costs.

How does the 1937 recession inform modern central bank policy?​

The 1937 reserve requirement increases—which immobilized bank excess reserves but contracted credit by doing so—directly influenced subsequent Federal Reserve thinking about the interaction between reserve requirements and credit availability. Modern central bank communication about the timing of policy normalization—"forward guidance"—is explicitly designed to avoid the 1937-type situation where policy changes produced faster and more severe tightening than anticipated because of expectations effects.

Summary​

The 1937-38 recession—caused by deliberate fiscal tightening (WPA spending cuts) and monetary tightening (Federal Reserve doubling reserve requirements)—was the Depression's single most important policy lesson. It proved that the 1933-1937 recovery had been government-stimulus-dependent by demonstrating that withdrawal of that support immediately produced recession: GDP fell approximately 10 percent and unemployment rose from 14 to nearly 20 percent within months of the policy changes. Policy was reversed in 1938, allowing recovery to resume, but the setback delayed full employment until World War II mobilization. The 1937-38 episode established the principle of not withdrawing stimulus prematurely during incomplete recovery, a principle cited in virtually every subsequent major recession's policy debate and that explicitly shaped the 2008-2009 crisis response.

Next​

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