The gold standard and the Great Depression

There always seem to be voices raising the possibility that a return to a monetary gold standard could solve all our problems. Among those championing this meme this week were Chris Mayer at Daily Reckoning, Robert Blumen at Mises Economics Blog, and some of my fellow blogjammers.

Under a pure gold standard, the government would stand ready to trade dollars for gold at a fixed rate. Under such a monetary rule, it seems the dollar is "as good as gold."

Except that it really isn't-- the dollar is only as good as the government's credibility to stick with the standard. If a government can go on a gold standard, it can go off, and historically countries have done exactly that all the time. The fact that speculators know this means that any currency adhering to a gold standard (or, in more modern times, a fixed exchange rate) may be subject to a speculative attack.

After suspending gold convertibility in World War I, many countries stayed off gold and experienced chaotic fiscal and monetary policies in the early 1920's. Many observers reasoned then, just as many observers reason today, that the only way to restore fiscal and monetary responsibility would be to go back on gold, and by the end of the 1920's, most countries had returned to the gold standard.

I argued in a paper titled, "The Role of the International Gold Standard in Propagating the Great Depression," published in Contemporary Policy Issues in 1988, that counting on a gold standard to enforce monetary and fiscal discipline in an environment in which speculators had great doubts about governments' ability to adhere to that discipline was a recipe for disaster. International capital flows became more erratic, not less, as doubts were raised about whether first the pound would be devalued and then the dollar. Britain gave in to the speculative attacks and abandoned gold in 1931, whereas the U.S. toughed it out by deliberately raising interest rates in 1931 at a time when the economy was already near free fall.

Because of this uncertainty, there was a big increase in demand for gold, the one safe asset in this setting, which meant the relative price of gold must rise. If everybody is trying to hoard more gold, you're going to have to pay more potatoes to get an ounce of gold. Since the U.S. insisted on holding the dollar price of gold fixed, this meant that the dollar price of potatoes had to fall. The longer a country stayed on the gold standard, the more overall deflation it experienced. Many of us are persuaded that this deflation greatly added to the economic difficulties of those countries that insisted on sticking with a fixed value of their currency in terms of gold.

Ben Bernanke and Harold James, in a paper called "The Gold Standard, Deflation, and Financial Crisis in the Great Depression: An International Comparison" published in 1991 (NBER working paper version here), noted that 13 other countries besides the U.K. had decided to abandon their currencies' gold parity in 1931. Bernanke and James' data for the average growth rate of industrial production for these countries (plotted in the top panel above) was positive in every year from 1932 on. Countries that stayed on gold, by contrast, experienced an average output decline of 15% in 1932. The U.S. abandoned gold in 1933, after which its dramatic recovery immediately began. The same happened after Italy dropped the gold standard in 1934, and for Belgium when it went off in 1935. On the other hand, the three countries that stuck with gold through 1936 (France, Netherlands, and Poland) saw a 6% drop in industrial production in 1935, while the rest of the world was experiencing solid growth.

A gold standard only works when everybody believes in the overall fiscal and monetary responsibility of the major world governments and the relative price of gold is fairly stable. And yet a lack of such faith was the precise reason the world returned to gold in the late 1920's and the reason many argue for a return to gold today. Saying you're on a gold standard does not suddenly make you credible. But it does set you up for some ferocious problems if people still doubt whether you've set your house in order.

The depression was NOT caused by government overspending! This arguement ignores the actual reported money supply during that period of time, as documented in Anderson's book "Monetary History of the United States 1918 to 1945". The depression was caused by the misguided policies of the Federal Reserve.

Briefly, the money supply tripled from 1918 to 1926, creating an artificial boom, when the Fed started selling Federal Reserve Bonds needed by banks to make loans. The US at that time was supposedly under the gold standard, in which the total money supply was supposed to be limited by the amount of gold they held. The Fed thought it had things under control because prices were stable - mostly due to increases in productivity (e.g., manufacture of autos, pipelines carrying oil, use of electricity, rise of the factory system, etc.). But checking accounts were just becoming popular, and their impact on the money supply was not taken into account by the Fed, and so their estimates were off by over 100%. One could take the position that the US went off of the gold standard in about 1920 because the Fed actions were not properly constrained by the amount of gold in the US.

When the Fed finally figured out they had screwed up, in typical government fashion, they began to try to correct the situation without telling anyone. They began buying Federal Reserve Bonds (needed by a bank in order to make a loan) in 1926, with a goal of reducing the money supply by 1/3. It took until 1929 for the reduction in the money supply to finally bite, and the stock market tumbled. They continued to buy these bonds even as late as 1936, when FDR was trying every crazy idea his brain trust thought of to try to restart the economy.

Europeans began to send gold to the US in the early 1920s because of political instabilities, and the fact that the US stock market was starting up. This reduced the money supply of European countries, and they all went into recession. Because gold entered the US, the US was supposed to reduce interest rates so that gold could flow back to the European countries; but the Fed was trying to fix its error, so it kept the gold and did not reduce interest rates. This deepened the European recessions into their depressions, a full 2 years before the US depression; and this brought Hitler to power in Germany.

Banks failed in NY in 1929 to 1930 because they had loaned money to people to buy stocks, with low margins (i.e., banks put up 90% of the money to buy GM stock). When stocks tumbled by more than 1/3, the banks were legally bankrupt, but the Fed couldn't let all of them go down.

Meanwhile, the banks did not have the Federal Reserve Notes needed to make loans to farmers for spring planting, or to retailers to buy goods to sell, so farms and medium sized retailers went bankrupt; then the manufacturers couldn't sell enough stuff, so they laid off the workers. It was a downwards spiral, ultimately resulting in 20% unemployment.

FDR didn't help the recovery at all by changing the price of gold daily, and passing laws which completely regulated the economy, creating such uncertainty that it paralyzed the ability to make business decisions -- so firms didn't spend what was left of their capital to restart, and unemployment was over 20%.

The unemployment rate was as bad in 1940 as it was in 1932 - there was no recovery due to FDR's economic policies. It did in fact take WWII to restart the economy. And the Fed has never taken responsibility for their screwups.

...or was it after the war when all the producers returned, that true prosperity became possible.

I do believe this to be the case. The war increased industrial capacity. That is the ability to make stuff like guns and bombers. When the GI's returned home, they wanted two things; families and the stuff that families need. The same machinery and organization that makes guns and bombers can also make refrigerators, stoves, and automobiles. The only hiccup in the immediate postwar period was getting Uncle Sam's hands out of everything and letting business fill the needs of post war Americans.

America was doing well until 1965 and LBJ.

"It is my understanding that the boom of the 1920's was caused by tons of European gold coming to New York for safe storage and the depression was caused by the return of that gold to Europe."

You are correct and the bulk of that gold returned as war debt from England and indirectly from France and Germany due to e the Treaty of Versailles.

Churchill exacerbated the situation by pegging the Stirling at an artificially high rate which emptied the British Treasury of gold and filled Fort Knox to overflowing.

That increase of gold into the US Treasury fueled the 1929 speculation bubble which burst. FDR then outlawed all private ownership of gold to protect the US dollar.

Fast forward to the present. No American citizen can enter Fort Knox to physically examine the US Govt's gold holdings.

It's like Area 51.

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