In what follows, I will briefly elaborate on Peter Temin’s book from 1973 “Did monetary forces cause the Great Depression”. His analysis of the events that occurred during the 1930s is mainly an attempt to debunk the more popular version proposed by Friedman and Schwartz who asserted in their book “A monetary History of the U.S.” that the Great Depression was mostly a monetary phenomonenon. Friedman and Schwartz’s account of the 1930s has to some extent become the mainstream view in macroeconomics. They claim that the Great Depression can be attributed to a number of policy failures by the Federal Reserve. The roaring 1920s saw a booming U.S. economy. Rapid credit expansion supported higher valuations of particular assets, such as housing and stocks. By the end of the 1920s, the Fed became increasingly worried about high stock market valuations and hiked interest rates in the summer of 1929 in order to pop the financial bubble. Tighter financial conditions led to a stock market crash, which in turn caused an economic slowdown. Because of the working of the international gold standard, tight financial conditions in the U.S. were also exported to European nations, which were struggling with problems on their own. Some countries like Germany had become increasingly reliant on capital imports from the U.S., which dried up as the U.S. economy started to slow down. By 1931, the economic contraction started to affect the U.S. banking system. Deflation in the double digits and the collapse of asset prices led to the failure of more than 10.000 banks nationwide. The U.S. banking system was characterized by what is known as unit-banking: Banks were not allowed to branch out across states or sometimes even within states, meaning that banks were holding extremely undiversified portfolios. Furthermore, deposit insurance did not exist yet, making financial institutions very prone to bank runs. Last but not least, the Fed did not assume its function as lender of last resort. The U.S. banking system was thus quite risky in nature. The money supply fell even further as thousands of banks collapsed in 1931 when depositors withdrew their deposits from financial instituions on the verge of collapse. These events exacerbated the monetary contraction first initiated by the Fed. According to the version suggested by Friedman and Schwartz, the Great Depression was a monetary phenomenon and can thus mainly be blamed on the failure of the Fed to conduct appropriate monetary policy. The Fed first initiated a tightening of financial conditions, which led to a stock market crash and an economic downturn. Subsequently, it failed to act as a lender of last resort for the banking system and nationwide bank failures exacerbated the economic downturn.
Peter Temin suggests an alternative account of the Great Depression. According to him, the monetary view suggested by Friedman and Schwartz is not satisfactory in explaining the severity of the downturn. First and foremost, it is equally plausible that the decline in income led to declines in the money stock, and not the other way around. Income and money are both determined endoegenously, thus suggesting a role for bidriectional causality. Second, Temin emphasizes that the bank failures in the U.S. were a result of plunging asset prices and declining income levels. The failure of the financial system was thus not so much a cause but rather a result of the economic downturn. Last but not least, Friedman and Schwartz account of the Great Depression is extremely U.S. centric and based on a misunderstanding on how the international gold standard actually worked. Canada did not experience a single banking panic during the Great Depression but suffered just as much from the downturn and global deflationary forces.
Temin emphasizes that a more global approach is needed to explain the Great Depression. Nevertheless, the biggest part of his book is devoted to the U.S. in an attempt to debunk the monetary view. Comparing the Great Depression to the U.S. recessions in 1920/21 and 1937/38, Temin shows that the Great Depression at first did not stand out so much. Many economic and financial variables behaved in a very similar fashion to earlier downturns. Furthermore, contemporary newspaper articles did not indicate in any way that people expected the Depression to last as long and to become as severe as it actually did.
Temin’s view is that the big economic contraction and the deflationary forces can be explained by an autonomous drop in consumption and investment. Especially after the real estate boom during the 1920s housing investment dropped significantly. Temin thus argues vehemently that the Friedmanite position is wrong. The drop in the money stock cannot tell us whether monetary forces are behind the Great Depression because real money balances are determined simultaneously by demand and supply. Furthermore, the contraction of credit can also be traced back to declining levels of income. Of course, while Temin’s view might be correct, it is not quite satisfactory to say that the Great Depression was caused by an exogenous decline in investment and consumption behavior because it only begs the question why this autonomous decline occurred in the first place. As to this question, however, Temin is unable to offer a satisfactory answer. Keynesian animal spirits are one potential explanation. One could imagine, for example, that the stock market crash combined with the tightening of financial conditions led to a change in expectations about future economic conditions, which depressed investment and consumption. It is plausible to assume that economic fundamentals are a to some extent a function of expectations.
Regardless, it is quite astonishing that both Friedman and Schwartz as well as Temin do not mention what should be regarded as the correct interpretation of the Great Depression.
Friedman and Schwartz’s exposition relied on an incorrect interpretation on how the international gold standard actually worked: The price-specie flow mechanism suggested by David Hume. According to Hume, the gold standard would tend to equilibrate the balance of payments between countries in the long run. Consequently, a country with a current account surplus attracts inflows of gold, which in turn would lead to an expansion of the domestic money supply and thus to higher inflation. Higher domestic prices would reduce the country’s competitiveness in world markets and the current account surplus would be reduced over time. Conversely, a country with a current account deficit can only pay for its net imports with gold outflows, which would lower the domestic money supply as well as the domestic price level. Conseuqently, the country would become more competitive and the current account deficit would disappear. According to this analysis, a balance of payments disequilibrium should only be temporary phenomenon. Gold should flow from deficit to suprlus countries and the domestic money supply and thus the price level is dependent on the gold reserves held by the Central Bank.
This analysis, however, rests on a misunderstanding on how the gold standard actually worked. It is very surprising that neither Friedman and Schwartz nor Peter Temin discuss the work of the two most prominent economists in the early 20th century, Ralph Hawtrey and Gustav Cassel, who both explained corectly the functioning of the gold standard and predicted that adherence to the system could lead to a global economic downturn.
The Swedish economist Gustav Cassel worried about a global economic downturn because he feared that the supply of gold would be inadequate for a growing world economy. Indeed, during the era of the gold standard the domestic price level would be tied down by the global demand and supply for gold. As such, the world experienced rising levels of inflation after large gold discoveries were made in the California and the Australia in the middle of the 19th century. The rising supply of gold spread thorugh the global economy and backed up a greater stock of money, which led to a surge in prices. Conversely, the world experienced periods of deflation during periods when godl supply failed to keep up with gold demand. It is exactly such a scenario that Hawtrey and Cassel were worried about during the 1920s. Both economists were concerned that gold mines would eventually be depleted and that gold production would turn out to be insufficient for a growing world economy. As it turned out, gold supply would have been inadeuqate was it not for the insane behavior of the Federal Reserve and the Banque de France. Both Central Banks, especially the Banque de France, started to accumulate a larger and larger amount of gold reserves during the late 1920s, increasing their gold reserves to about 60% of total world gold reserves in 1932. Furthermore, both countries decided to sterilize their gold inflows, meaning that they did not feed back into a higher domestic money supply and thus did not impact the domestic price level. This insane accumulation of gold imposed a large deflationary shock on the wolrd economy and it is this shock that is the true cause of the global deflationary forces that riddled the world economy and led to the Great Depression.
Countries escaped the Great Depression by abandoning the gold standard and adopting flexible exchange rates. The countries that were the first to do so were also the first to recover from the economic downturn. Abandoning the gold standard was a true regime change and led to a large devaluation of the currency vs. countries that remained on gold for the time being. A change in expectations and anticiaption of price increases led to a surge in demand. After years of deflation and depression industrial production increased by more than 50% in the 6 months after Roosevelt decided to let the dollar float. The gold standard broke down in 1933 when France was the last country to abandon its peg to gold after suffering from years of economic stagnation.