In what follows, I will illustrate how bad monetary policy by 2 countries, the United States and especially France, led to global deflation under the gold standard and caused the Great Depression. Just intuitively it seems highly unlikely that France is mainly responsible for the Great Depression in the 1930s, the biggest economic catastrophe of the last century. But the theory and the numbers really add up.
How does the gold standard work?
Under the gold standard, all member countries pegged their domestic currency to gold at a fixed parity. This, in turn, implied that all currencies were fixed to each other at a given rate as well. Let me illustrate: Let us say that the Bank of England promised a conversion rate of 1000£ per kg of gold and the Federal Reserve promised a conversion rate of 500$ per kg of gold, then this would imply a £/$ exchange rate of 2:1, two pounds are worth one dollar (obviously, these numbers are made up). The gold standard was thus a monetary system of fixed exchange rates.
What were the problems associated with this system?
Contrary to what some people belief, the gold standard does not imply stable prices. In fact, price fluctuations were quite common since world prices were dependent on the world quantity of gold. Consequently, the world as a whole would experience deflation if world output would grow more quickly than the supply of gold. On the other hand, the discovery of large quantities of gold could lead to worldwide inflation if the supply of gold were to outpace world output growth.
Adherence to the gold standard also implied that countries effectively gave up their monetary autonomy. A country confronted by an economic recession would not be able to use monetary policy to stimulate its economy. That is because lowering the domestic interest rate would lead to outflows of gold, which in turn would threaten the domestic conversion rate between the country’s currency and gold.
The “rules of the game” – how the adjustment mechanism in the gold standard was supposed to work
It easy to see how the adjustment mechanism was supposed to work by looking at two countries only. Let us suppose that England is a trade deficit country (net importer) and France is a trade surplus country (net exporter). The English would thus pay for their net imports with English currency. The French, having no use for English pounds, would present the English pounds they received for French goods to the Bank of England for conversion into gold. Deficit countries would thus experience outflows of gold whereas surplus countries would experience inflows of gold. The French merchants would subsequently present the gold to the Bank of France for conversion into Francs. Having more gold reserves, the Bank of France would thus be able to print more currency. French prices would rise, French goods would become less competitive and France’s trade surplus would decrease whereas Britain’s trade deficit would go down as well. The adjustment mechanism worked if surplus countries, countries receiving gold inflows, would expand their money supply. This was the so-called “rule of the game”.
The problem with this system was that deficit countries, having less gold reserves, were forced to decrease their money supply whereas surplus countries could sterilize their gold inflows: Surplus countries were not forced to increase their money supply when receiving gold inflows: They could just store the additional gold in the vaults of the Central Bank without printing more currency. We will see that these sterilization policies by France (and the U.S.) were largely responsible for the Great Depression.
How did France impose worldwide deflation?
Gustav Cassel, a famous Swedish economist, was worried in the 1920s that world gold supply would not be able to keep up with world economic growth and that this could lead to global deflation and worldwide economic depression. It turns that Cassel’s predictions were not very far off even though his worries about the supply of gold did not turn out to be true. Global reserves of gold actually increased by 18% between 1928 and 1933 (Irwin, 2010). The ultimate problem would turn out to be the monetary policies by the Federal Reserve and especially the Bank of France in the end of the 1920s. In what follows, I will describe how these two Central Banks started to accumulate a large part of the world’s gold reserves and thus imposed deflation on the rest of the world.
France faced several years of economic instability after World War I with low growth rates and high inflation rates. By 1926, the economic situation stabilized and the country decided to join the gold standard again. The chosen exchange rate by the French officials hugely undervalued the Franc and thus gave the country a competitive advantage in world markets. As a result, France became a net exporter and ran persistent Current Account surpluses for several years after 1926. These surpluses implied that the country began to receive significant inflows of gold. But instead of adhering to the “rules of the game”, the Bank of France simply sterilized the gold inflows: French officials simply stashed the gold in the vaults of the Bank of France and decided not to increase the domestic money supply, which would have led to higher prices and could have eliminated the current account surplus and the resulting inflows of gold from abroad. I describe in my Master thesis to what extent France accumulated the world’s gold reserves:
...France started to attract significant inflows of gold from 1926 onwards. The accumulation of gold by the Bank of France meant that France’s share of world gold reserves increased from 7% in 1926 to roughly 27% in 1932 (Irwin, 2010).
...the U.S. and France held more than 60% of the world’s monetary gold stock in 1932. These reserves did not correspond in any way to their combined share of world GDP. One should note that France held roughly the same amount of gold as the U.S. even though its output was only about 25% of the size of American output (Irwin, 2010).
Once the deflationary spiral started, other factors began to reinforce it. As a result of the FED’s decision to increase interest rates in 1928, for example, many European countries were forced to increase their domestic interest rates as well in order to stop massive outflows of gold. These policies of tight money led to massive monetary contractions all over the world and caused financial panics and banking failures. The financial crises, in turn, exacerbated the monetary contractions and the associated deflation even further.
Why is deflation so bad?
The previous section illustrates that the U.S. and mainly France were responsible for worldwide deflation in the 1930s by hording ridiculous amounts of gold and thereby starving the rest of the world of gold. The countries suffering the most from deflation also experienced the most severe economic downturns in terms of output loss. There are several reasons why unexpected deflation will most likely lead to big output shocks in the short-run.
1) Nominal wage rigidities:
Keynes already emphasized the importance of sticky wages. Workers are often unwilling to accept wage cuts (in nominal terms) even if prices in the economy are falling. Lower profits as a result of falling prices and higher labor costs (in real terms) imply that firms will have to fire workers. This will amplify the output shock through the multiplier effect as all the fired workers will have less money to spend on goods and services, thus decreasing consumption even further.
2) Deflation increases the real value of debt:
Irving Fisher (1933) came up with his theory of debt deflation in the 1930s. He argued that deflation has an impact on output even if wages are perfectly flexible by increasing the real value of debt. That is because debt contracts are normally issued in nominal terms. The burden of a loan thus increases under deflation because 100$, for example, are worth more in the future than today when prices are falling.
3) Deflation and falling asset prices lead to distress in the financial sector and can ultimately cause a financial crisis:
...banking panics across the globe led in turn to a disruption of credit flows in the real economy and additional decreases in the money supply. The impact of deflation on the financial sector thus seems to be one of the sources of monetary non-neutrality. Bernanke and James (1991) argue that one of the reasons why the monetary contraction had large real effects on output stems from the failing of the financial sector as a result of falling prices. The associated disruption in credit markets, also called credit crunch, affects both businesses and consumers who rely on financial intermediaries. Financial crises during the Great Depression thus had a significant negative impact on real economic activity.
With falling prices it is actually profitable to hold cash. Individuals and firms have an incentive to hoard money instead of consuming/investing. The fall in consumption and investment will obviously depress output even further.
How do we know that the Great Depression was mostly the result of poor monetary policy?
We know that the Great Depression was the result of poor monetary policy. To invoke the spirit of Milton Friedman: Deflation, just as inflation, is always a monetary phenomenon. The Great Depression provides us with a wonderful natural experiment. Two countries, Spain and China, were not on the gold standard during that time. Spain was managing a fiat currency whereas China was actually on a silver standard. As a result, those two countries were not affected by the global shortage of gold and did not suffer from deflation. The absence of falling prices, in turn, meant that both countries largely avoided a recession.
Furthermore, a large number of studies have compared the macroeconomic performance of countries that left the gold standard early with those that remained on the gold standard until its demise in 1935. The results of these studies are unambiguous:
Choudhri and Kochin (1980) realized a clear difference in economic performance between
countries that stubbornly adhered to the gold standard (Belgium, Italy, the Netherlands, and Poland) and countries that left the peg early (Denmark, Finland, and Norway), or even had a flexible exchange rate to begin with (Spain). Their study revealed that the countries that remained on the gold standard suffered from significantly sharper declines in output and prices as well as employment.
...countries that abandoned the gold standard earlier also experienced a much quicker recovery from the Great Depression than countries that remained on the peg.
What are the implications for the current crisis?
We know that the Great Depression was a monetary phenomenon. Global deflation was caused by an artificial shortage of gold. The global fall in output was the result of super tight monetary polices.
Similarly, Japan experienced a similar phenomenon after the bust of its housing and stock market bubble. The two Japanese lost decades are mainly the result of tight monetary policy as the ultra-conservative Bank of Japan (BoJ) was willing to accept years of deflation and low nominal GDP growth. In the beginning of this year, the BoJ finally decided to step up after 20 years of inactiveness and the results of “Abenomics” are very promising. The monetary expansion led to higher inflation and inflation expectations and Japan was the fastest growing G7 country over the last couple of months with annualized GDP growth of roughly 4% (growth rates the Eurozone can only dream of).
Likewise, the Eurozone continues to stagnate because of insufficient aggregate demand. 6 years into the crisis the ECB is unwilling to pursue more expansionary monetary policies even though money is extremely tight since 2007. We know that monetary policy is not expansionary enough because all the indicators are telling us that money is tight: low nominal interest rates, low nominal GDP growth (aggregate demand) and low inflation rates.
Unfortunately, the Eurozone is heading for two lost decades right now, just like Japan, the only difference being that Japanese unemployment never exceeded 6% whereas Eurozone is currently at about 12% and will remain at elevated levels for quite some time if policy makers do not change course.
· Bernanke, B., & James, H. (1991). The gold standard, deflation, and financial crisis in
the great depression: An international comparison. In R. Hubbard (Ed.), Financial
markets and financial crises (pp. 33-68). Chicago: University of Chicago Press.
· Choudhri, E. U., & Kochin, L. A. (1980). The exchange rate regime and the
international transmission of the business cycle disturbances. Money, Credit, and
Banking, 12(4), 565-574.
· Eichengreen, B. (2008). Globalizing capital: A history of the international monetary
system. (2 ed., p. 70). Princeton: Princeton University Press.
· Fisher, I. (1933). The debt-deflation theory of the great depression. Econometrica, 1(4), 337-357.
· Irwin, D. A. (2010). Did France cause the Great Depression? NBER Working Papers
16350, National Bureau of Economic Research, Inc.
This is a great Econtalk by Douglas Irwin about his research on France and the gold standard: