9. THE GREAT DEPRESSION AND THE GOLD STANDARD The interwar period was a prolonged period of political and economic instability. The gold standard had in the 19 th century been seen as an admiral automatic mechanism for monetary and price stability. This was not the case for the interwar period. In that period the gold standard functioned as a mechanism that transmitted the depressive impulse from the US to the rest of the world. In fact, the gold standard magnified the original instability, it prevented offsetting action in all countries on the gold standard, and it acted as a constraint preventing authorities from containing financial panic and bank failures. 1
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9. THE GREAT DEPRESSION AND THE GOLD STANDARD
The interwar period was a prolonged period of political and economic instability.
The gold standard had in the 19th century been seen as an admiral automatic mechanism for monetary and price stability.
This was not the case for the interwar period. In that period the gold standard functioned as a mechanism that transmitted the depressive impulse from the US to the rest of the world.
In fact, the gold standard magnified the original instability, it prevented offsetting action in all countries on the gold standard, and it acted as a constraint preventing authorities from containing financial panic and bank failures.
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The gold standard before and after WWI
All countries (with partial exception for the US) were forced to abandon the gold standard during WWI. Given the monetary financing of large budget deficits, there was a period of very rapid inflation during and immediately after the war.The bilateral exchange rates during the gold standard would be fixed and equal to the ratio of their gold parities. The basic purpose of the gold standard was that money supply would be regulated by the balance of payments in such a way as to keep the price level stable at the level that ensured external balance or trade balance (section 7). There were also other equilibrating mechanisms at work than the trade balance such as:
- stabilizing capital flows caused by exchange rate expectations- gold arbitrage- central banks raising interest rates if need be (to attract capital inflows)- lending of gold/foreign exchange as between monetary authorities.
This worked fine before WWI: there was a constellation of factors – including the distribution of power in society, the prevailing economic doctrine and the capacity for international cooperation – which explains the long-standing stability of the gold standard.After the war the power of labor had increased, the doctrine was less influential and international cooperation more or less broke down.
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What kind of stability during the gold standard?
Table x: Inflation and output growth in the UK and the US
United Kingdom United States
1870-1913 1946-1979 1870-1913 1946-1979
Rate of inflation - 0.7 5.6 0.1 2.8 (wholesale prices)
Standard deviation 4.6 6.2 5.4 4.8
Annual growth rate 1.4 2.4 1.9 2.1 of GDP per capita
Coefficient of variation 2.5 1.4 3.5 1.6
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What kind of stability during the gold standard?
Table: Levels of wholesale prices in selected countries 1816-1913 (1913=100)
United States United Kingdom Germany France
1816 150 147 94 143
1849 82 86 67 94
1873 137 130 114 122
1896 64 72 69 69
1913 100 100 100 100
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The Great Depression
In mid 1920s most European countries went back to the gold standard (which the US had largely remained on during the war). However, the political changes served to undermine the credibility of the gold standard regime. In the new circumstances it was not clear that exchange rate deviations from parity would induce the kind of stabilizing capital flows that had taken place before the war.
Also, given higher unionization rates and increased political power of parties associate with labor, it was less clear that wages would adjust flexibly to correct trade balances. In many countries economic policy issues and notably fiscal policy became the subject of intense political conflict.
Finally, there was not the same readiness to international cooperation between governments and central banks with a view to deal with payment difficulties.
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The Great Depression (cont.)
• Originated in the US (’Black Thursday on 29 October 1929, cause or symptom?)
• Continued for many years, notably in the US until WWII
• Its causes are still to some extent a matter of debate, but tight or passive monetary policy in the US is a key aspect
• Was transmitted world wide through the mechanisms of the gold standard
Fig. 4: Soup kitchen in Chicago in 1931 (opened by Al Capone)
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Fig. 5: US Farm Prices during the Great Depression
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Fig. 6: The deflationary process
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Deflation and depression raised the debt ratio
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Fig. 6: Deflation causes bank failues
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Great Depression: developments in Europe
• Developments in Europe were similar but less severe (developing countries were also seriously affected by falling commodity prices and the fall in capital imports)
• Output levels and GDP per capita declined + undemplyoment increased + large-scale banking panics (notably in Austria and Germany) and wide-spread bank failures, introduction of foreign exchange controls de facto suspending convertibility into gold.
• Britain was forced to leave the gold standard early, in 1931, and was soon followed by a number of countries (including Finland), which then pegged their currencies to Britain, their most important trading partner.
• It is a remarkable testimony to the role of the gold standard that those countries recovered first that left the gold standard earliest (table and fig). The gold standard functioned as a straightjacket preventing action to combat the crisis and to avert the bank failures.
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Table: GDP per capita (PPP) 1929-1939
USA WEU GBR GER FRA FIN
1929 100 100 100 100 100 100
1930 90 98 99 98 96 98
1931 82 92 93 90 90 95
1932 71 89 94 83 84 94
1933 69 92 96 88 90 99
1934 74 95 102 95 89 110
1935 79 97 105 102 87 114
1936 90 99 110 110 90 121
1937 93 104 113 116 95 126
1938 89 106 114 123 95 132
1939 95 111 114 133 102 125
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Real income per capita in the interwar period
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GDP developments in selected countries
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Japan was never on the gold standard, Britain (and a number of other countries including Finland) left gold in 1931, Germany and the US later and
France held out the longest
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Legacy of the Depression
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The role of economic policies
It is still an issue for debate whether the Great Depression should be seen as a failure of free markets or of mistakes made by authorities, notably central bankers. The decline in money supply in the US (fig) has been much emphasized (Milton Friedman and Anna Schwartz); it is partly endogenous but could have been prevented by a more active monetary policy by the US Fed. Nominal interest were low, but real interest rates (presumably also expected real interest rates) were extremely high. The Fed, to a large extent, took a position close to ‘liquidationism’. Public debt in the US increased as a share of GDP in the early phase of the depression, but this was due more to the decline in GDP than to any expansionary action. President Franklin D. Roosevelt later tried, inter alia, public works and farm subsidies, but these actions were too cautious to have any significant economic effects. He never gave up the ambition that the federal budget should balance and public debt remained at a low and rather stable level relative to GDP.
Passive economic policies did little if anything to try to stop the depression. This was due to the constraints on policies imposed by the gold standard but also because the established doctrine suggested that there was no useful role for active policies.
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Development of narrow money supply in the US in 1926-40
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Broad money supply in the US
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US interest rates were low in nominal terms in the 1930s, but they were extremely high in real terms
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UK inflation was negative (real interest high) during many years
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US public debt increased but mainly as a consequence of the depression rather than as a consequence of expansionary fiscal policy
