Did the Gold Standard Cause the Great Depression?

Let me make a confession, I am not a gold-bug, but my original introduction to economics was by someone who stressed the virtues of 'honest money' and I wrote an op-ed as a youngster advocating a return to a true gold-standard.  Now, I would simply argue that we should move toward a system of free banking.  My "market prediction" as opposed to theoretical necessity would be that some form of commodity-backed currency would emerge in the competition as the most 'trusted' money.  But it need not.

Still, as I read the various discussions about the Gold-Standard inspired by Ron Paul's political campaign, I am struck by the unwarranted attacks.  I know the arguments that people like Barry Eichengreen have made about the gold-standard and GD, but it is my understanding that the historical record is a bit more complicated.  Eichengreen is no doubt a first-rate economic historian, but the gold-standard that existed at the time he is talking about is not the historical gold-standard that advocates push for.  Eichengreen does for the gold-standard, what Stiglitz does for 'shock therapy' in East and Central Europe, or what Rodrik does for the 'Washington consensus' in the developing world.  Free market shock therapy didn't take place in the transition economies, it was a government administered and regulated 'market' economy that was instituted.  And similarly the developing world did not follow a path of fiscal and monetary responsibility, free trade, and low taxes and minimal regulation.  The transition has been slowest and the development the least in those countries that have failed to move toward a free market system.  It is government policies of regulation, taxation and restrictions on trade that cause the problems.  To give one example, when Argentina had its recent woes, the problems often got blamed on the currency board system it was operating under, but it wasn't the currency board that caused the problems, but the fiscal policies that eventually destroyed the currency board that caused the problems.

I really think the issue of understanding cause and consequence (and not confusing them) are critical in all these discussions.

I might be wrong on the Gold Standard and the Great Depression, but nothing I have read to date has convinced me on that.  The Great Depression was a consequence of (a) credit expansion to pay off war debts from WWI during the 1920s, (b) monetary contraction during the 1930s, (c) government microeconomic policies which completely curtailed the ability of market forces to adjust to the changing circumstances, and (d) government policies which eliminated the ability of individuals to realize gains from trade.  None of this is about the gold-standard.

The gold-standard is a serious check on government debasement of the currency.  This should be viewed as a GOOD THING to have done in the realm of public policy.  I am not saying it is the best way to do this, but that is its main strength as far as I am concerned.  Like the lock system on my car raises the costs of the car thief, a gold-standard raises the cost to government thievery of our wealth.  Unfortunately, it alone doesn't prevent government stealing anymore than door locks prevent car theft.  But we would have more theft if we left our doors open and our keys in the ignition.  Fiat currency is analogous to leaving the keys in the ignition with the door unlocked.

Does it make one a suspect economist to argue that government debasement of the currency is a problem?  Not any more than arguing that socialism doesn't work or macroeconomic policies will be counter-productive.  Perhaps you might be referred to as a 'market fundamentalist' in economics, but all that means is that you understand the basic principles of economics and BELIEVE them to be true based on logic and evidence.  As the old joke used to go, at Harvard we read the same books in economics that you guys read at Chicago, we just don't believe them.  Well, the market fundamentalist believes there are good reasons to believe them if you tell the complete story.

Of course, Austrians have some important nuanced points to make about dynamic adjustment, time, ignorance, uncertainty, and mutual dependence.  And these are extremely important points to insist on in the scientific and policy discussion, but at the moment there are even more basic issues that are missed and thus the discussion is confused.

As Jim Buchanan always stressed to his students ... "it takes varied reiterations to force alien concepts upon reluctant minds."  Those of us who understand and believe in 'basic economics' (the wonderful phrase that Bruce Caldwell uses to describe Hayek's economics in Hayek's Challenge) have our work cut out for us to educate our students, the public, and to a considerable extent our peers who fall prey to Romantic notions of politics and scientistic notions of economics.  The alliance between statism and scientism is what Hayek had to fight against in his career, and the current manifestation of that alliance is what we must continue to fight against.  In our contemporary context it has shown itself in the scoffing at the 'old fashion' ideas of Ron Paul and the contempt of anyone who would be silly enough to believe in the old-wisdoms of the classical economists.

Comments

[John V]

Funny thing on the contraction, Dr. Boettke,

I read Amity Schlaes's book, The Forgotten Man, and in it, she actually says how a huge influx of gold into during the early thirties (a lot of it from Germany as citizens wanted to get their wealth out of the country before Hitler got to it) would actually allowed for a expansion of money in the face of the huge contraction that happening and that Hoover and FDR refused to do it.

It's been a few months since I read it and the details are a little hazy but what you wrote reminded me of that.

[Josh Hendrickson]

The gold standard was not the cause of the Great Depression. However, the mismanagement of the gold standard played a substantial role. Gold was flowing into the United States and France (so much so that something like 70 percent of the world's gold was located in those two countries). Unfortunately, the central banks in each country were pursuing contractionary monetary policy despite the gold inflows. In the United States, this was largely to curb the excess investment that was taking place in the stock market. Naturally, this caused deflation which made it harder for individuals to pay back loans, etc.

Had the U.S. and France simply followed the gold standard rather than pursuing their own interests, the world would likely have avoided the problems that resulted from deflation. Unfortunately, due to the abandonment of the gold standard during the first World War, there would have been a market correction eventually as a results of the malinvestment created by the monetary expansion during the war.

The consensus among macroeconomists of all stripes seems to be that the Great Depression was largely the result of monetary contraction and an overall mismanagement of the gold standard.

[Peter Boettke]

Josh,

Can you give me some dates? It is my understanding that the 1920s are defined by credit expansion. See Bejamin Anderson's work. The contraction takes place in the 1930s. See Friedman and Schwartz's classic A Monetary History.

When are the dates for the influx of gold you are talking about?

I am influenced in my interpretation of the events by Rothbard, Friedman, Greenfield, Selgin, Horwitz and Garrison, and especially Higgs. I find Selgin's argument for a declining price level during a growing economy to be persuasive. I think Greenfield's argument for the negative consequences of deflation in some circumstances (caused by not matching money supply and demand). And I am EXTREMELY influenced by Robert Higgs's work on the length and severity of the GD due to MICROECONOMIC regulations and restrictions which completely distorted and ultimately constrained the exchange order.

Pete

[G]

You know what I never hear mentioned often enough? Eisenhower's Research-Industrial Complex.

[Josh Hendrickson]

Pete,

According to Hamilton, the contraction of monetary policy began in 1928 during which time the Fed sold a large majority of its security holdings in order to deplete bank reserves and therefore curb the gold flow to France as well as stock market speculation. Initially, this wasn't all that successful because banks simply chose to borrow at the discount window. However, over time, this contractionary policy did take hold.

The inflow of gold in the U.S. was modest compared to that of France. France was likely the main culprit of deflation on the world stage because their central bank had limited powers and thus as gold flowed into the country, they did not inflate their currency as expected.

I suppose that it is a stretch to say that contractionary monetary policy was the cause of the depression. However, it was certainly the spark that started the fire. To revise my previous statement, perhaps I should state that the GD was of monetary origin. After all, you are correct in your assertion that microeconomic regulations and restrictions distorted exchange. Hamilton points to trade restrictions as distorting not only market activity, but also the price-specie mechanism. Bernanke and James also point to the banking crisis.

Thus, to sum up, I would say the the GD has a monetary origin, but was exacerbated by the regulations and restrictions that followed.

[Bogdan Enache]

According to the French economist Jacques Rueff the new post WW1 gold exchange standard allowed central banks in Europe to hold reserves not only in gold, but also in foreign currency such as dollars and punds.

Consequently, the reserves of central banks in European countries and in France in particular consisted to a large extent of US dollar notes. Because the gold exchange standard disassociated the gold movement form the note issuing and holding, this meant that its net effect was to create inflation and export it to foreign countries. In other words, for the gold stored in the Fed which was supposed to back the dollars held in reserve by the French central bank (and other European central banks), the Federal Reserved continued to issue dollar notes in the domestic market. This way the supply of dollar bills was increased twofolds relative to gold stock, first by sending dollars in the coffers of European central banks and then by printing dollars for the US market.

So, when the bust came the European central bancks naturally wanted to redeem their dollars in Federal Rserve gold. But there was not enough gold because the dollar notes supply was twice the gold supply that was supposed to back it.

Consequently, when the deflation set in the US it triggered a deflation in France. Maybe that's the positive side of the fact that one can find quit a number of French historians and economist who will tell you that US exported the Great Depression to France, and Europe.

[Mark Koyama]

Barry Eichengreen seems to have recently adopted the Austrian view that a credit expansion in the 1920s was partly responsible for the slump that followed though he does not seem to directly cite any Austrian economists (See for instance http://papers.ssrn.com/sol3/papers.cfm?abstract_id=959644).

The standard view taught most economic historians I have spoken to seems to be a combination of Friedman's views on the collaspe in the money supply in 1931 and the views of Peter Temin in his 1989 book and Eichengreen in his 1992 book that the mismanaged post WW1 gold standard was responsible both the monetary disequilibrium that occurred between Britain, the US and France that Josh refers to, and for acting as an international transmission mechanism spreading the depression across the world and thus causing a secondard aggregate demand shock to the US via falling exports.

This standard view does not strike me as necessarily wrong but it is certainly incomplete and I think it could be usefully integrated with the Austrian view of the 1920s.

[Peter Boettke]

How much is the standard economic historian view influenced by classical monetary theory and how much is it influenced by some version of Keynesianism?

I am somewhat suspicious of any macro-variable imbalance explanation. What are the microeconomic foundations of that story? I could easily be persuaded that a mismanagement story of the money supply is at the root, but I would like to see the causal mechanism being explicated to grasp how a nominal variable can have real effects. The language that most economists use in these discussions still seem to me to be focused on the interaction of aggregate variables, rather than the impact on choices that individuals make.

STEVE --- feel free to jump in here and straighten me out.

Pete

[Mark Koyama]

Pete -

As far as I understand it there was a Keynesian verses Monetarist battle in economic history over the Great Depression in the 1970s and 1980s in which Temin claimed that there had been an autonomous fall in demand in 1929 which then induced the contraction of the money supply in 1931. But I think that Temin effectively conceded defeat and acknowledged the responsibility of the Fed for this in his 1989 book.

The recent literature focuses on the international aspect of the great depression. I am most familiar with what happened in Britain in the 1920s where the government returned to gold at the pre-war parity. Given what had happened since 1914 (in terms of world gold supplies and inflation during the war etc.) this meant that the pound was overvalued. Unions and government policy then prevented prices and wages from adjusting downwards creating unemployment. In other words this was a mechanism that makes made money non-neutral.

Keynes effectively assumed that price and wage flexibility could never be achieved because of the strength of organized labour and therefore advocated inflation in order to make exports competitive. This problem was aggravated by the policies of French and American central banks which as noted above sterilized some of the gold inflows thus preventing price levels from rising in America and France.

In order to work the gold standard required governments to “play by the rules” and it also required cooperation between central banks. In the 1920s, governments and central banks broke those rules and the gold standard that resulted seems to have contributed and even exacerbated problems caused either by WW1 or by subsequent government intervention.

[Mark Koyama]

Apologises the link I posted earlier was actually

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=959644.

[Bill Woolsey]

Could the Federal Reserve have increased base money enough to keep the money supply from falling in the face of bank runs, while maintaining gold convertability without devaluation?

We don't really know, because the Fed didn't try.

If they had tried and approached a depletion of gold reserves, then the options are devaluation or suspension. Both have occured in the context of a gold standard, though each time such a thing is done, the less is the point of having a gold standard.

Or, of course, they could have maintained the gold standard and allowed the drop in the money supply and hence the deflation.

But, again, we didn't get that far.

The Fed pegged a low discount rate and let the money supply collapse and gold flowed into the U.S. and the Fed increased its gold reserve.

And so, those of us taking the monetary disequilibrium approach can blame the Fed, but we just don't know if sensible policy by the Fed would have prvented the defelation and allowed the maintenance of the gold standard.

And, of course, we didn't get to find out how much structural unemployment and excess capacity would result from shortening the structure of production created by the "excess" money creation in the twenties.

Personally, the episode troubles me because what I take to be a "hard money" policy by France made world deflation inevitable. The only solution I can see is either adjust to the new, lower price level, or else devalue. Or what? Go to war with France over their monetary policy?

Speaking of war, if U.S. had a free banking system and gold standard and remained neutral in WWI, wouldn't the U.S. suffer inflation because as the Europeans inflated their currencies, the gold flow to the U.S. would generate inflation in the U.S.? (And, of course, when the Europeans decided to return to the gold standard during the twenties and accumulate gold reserves, the reverse.

[John David Galt]

I hold to the theory in Davidson and Rees-Mogg's Blood in the Streets: The end of the gold standard, both World Wars, and the Depression were all just symptoms of the fact that Great Britain could no longer afford to dominate the world economy because it no longer enjoyed a big advantage in weapons technology over the other would-be dominant countries. This trend actually began in the mid 19th century.

The US similarly began losing its advantage in the mid 1960s, and Vietnam was our WW1. (The "closing of the gold window" is even a parallel with the earlier British loss of advantage.) As in the earlier cycle, the world economy will continue to be in the "doldrums" for a while until some new power -- probably China -- decides the time is ripe to try for dominant-power status by starting the next World War. I expect that any day now, and certainly before 2020.

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