Federal Reserve Policy and the Recession of 1937-38: A Note

Abstract

N the May I950 issue of this REVIEW, Professor Roose concludes that Federal Reserve policy had an important responsibility in precipitating the I937-38 recession, because (i) the second raise in reserve requirements in the spring of I937 pinched central reserve city banks, forcing them to unload large amounts of government securities with a resultant fall in bond prices in March and April I937, and (2) thisfall in bond, and subsequently stock, prices in turn dampened the market for new security issues.' Professor Roose argues that the peak in new security issues in June I937, the fifth month after the announcement of the increase in reserve requirements and the second month after bond prices had reached a low point, was the result of special circumstances and, in fact, hid weaknesses of the capital market at that time. There is no doubt that the 3313 per cent increase in reserve requirements, half of which took effect on March I and half on May I, forced some banks to sell government securities, although they did so at a profit. Total member-bank holdings declined by $856 million, or about seven per cent, during the first six months of I937; the effect of about one eighth of these sales on the bond market was nullified by open-market operations of Federal Reserve Banks in March and April.2 But for the Board of Governors to be at fault, it must be proved that the decline in bond prices, which was arrested by May I, was effective in diminishing new investment through the capital issues market, for bank loans continued to increase through June I937 SO that investment was not hindered through a blocking of this source.3 Professor Roose adopts three pieces of evidence to show that there was a worsening of conditions on the capital market in the spring of I937 in spite of the peak in new security issues in June, and argues that the high cost of borrowing as a result of declining bond and stock prices was the cause of this deterioration. But his evidence is based on two unusual months, December I936 and June I937; when the fourth quarter of I936 is compared with the second quarter of I937, there is no clear-cut indication that the capital market was in a shaky position. Roose's evidence is: (i) There was a substantial shift from stocks to bonds, 54 per cent of the new capital issues being comprised of bonds in December I936 and 70 per cent of new issues being bonds in June I937. But actually there was no such marked shift even into the third quarter of I937; bonds comprised 6i per cent of new issues in the fourth quarter of I936, 67 per cent in the first quarter of I937, 65 per cent in the second quarter, and 65 per cent in the third quarter.4 (2) The peak in new securities in June I937 resulted from an affluence of special, highgrade issues during that month. This is true, but there were no such high-grade issues in May. Of the II companies floating bonds for new financing that month which had a Moody's rating on existing issues, only two had a minimum rating of Aaa (Cincinnati, New Orleans and Texas Pacific Railroad, and Central Illinois Light Company), two had A, one had Baa, one had Ba, two had B, and three had some form of C rating. None of the stockissuing firms had a high rating.5 (3) The number of stock issues for new and untested companies in June I937 was considerably smaller than in December 1936. But the number of new issuances of common stock representing new financing during the period was as follows: October I936 (20), November (I4), December (32 ), January I937 (IO),