Posted on 12/13/2005 5:45:39 AM PST by BJClinton
How the gold standard contributed to 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.
Nevertheless, I'm willing to grant Tim Iacono that the stuff is pretty.
The stuff is pretty.
It was a sas day when gold was outlawed back in 1933. Not that I was there, mind you.
The U.S. abandoned gold ....in 1933, after which its dramatic recovery immediately began.....
It is my understand that the recovery did not become sustainable till the war spending and production began in ernest.
Going off the gold standard was but one of numerous failed attempts. War finally did the trick.
My memories are of a down side of being on the gold and silver standard. Foreign powers began turning in silver and gold certificates and or dollars and demanding gold in return. Depending on how much paper a government has in outside circulation, your gold and silver would quickly end up in places other than Fort Knox.
This is a bad start; anyone who uses the word "meme" is tentatively classified as a liberal yogurt-head. Or a pseudo-intellectual poser.
Under such a monetary rule, it seems the dollar is "as good as gold."
Here he's quoting the late Jude Wanniski. Wanniski was an idiot. He has a long history of backing the right decision for all the wrong reasons.
If a government can go on a gold standard, it can go off, and historically countries have done exactly that all the time.
This is a fair point, and it's really the whole substance of his argument. There's only one problem: folks who want a gold standard usually want to do away with centralized banks. If the federal reserve doesn't exist, then the "government" has nothing to do with the basis of our currency.
...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.
The use of the word "hoard" here is a dead giveaway. If I save money, am I "hoarding" it? This guy is a Keynesian, and believes in the asinine "paradox of thrift". If people want gold more than they want potatoes, then the price of potatoes will indeed fall--but that's one of the things that is necessary to get out of a depression! Only keynesian idiots think we can get out of a depression without any decreases in any prices or wages.
The longer a country stayed on the gold standard, the more overall deflation it experienced.
And deflation is a bad thing because...? Computers are cheaper than ever--yet computer industry profits are higher than ever. I'm sure the author knows this, and realizes that he needs to prove that deflation is bad, right?
Many of us are persuaded that this deflation greatly added to the economic difficulties of those countries...
I guess I'm wrong. Instead of proving it, he lets us know that he and his friends think deflation is bad. I'm like, so impressed.
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.
Yup, this guy (1) believes in central banks, and (2) is out-and-out keynesian. He believes that holding prices stable is important. The gold standard has nothing to do with "stabilizing prices"; the point of the gold standard is to prevent artificial inflation, whereby the owner of the printing press steals money by devaluing the currency. With a gold standard, monetary hijinks are prevented because people can run to gold if the currency is inflated. In that context, however, prices will still rise and fall. Increasing overall wealth translates into decreasing prices--i.e., deflation is quite normal.
It is my understanding that the government was doing most of the spending and the private sector was doing most of the production. Does that mean that we spent ourselves into prosperity? or was it after the war when all the producers returned, that true prosperity became possible.
..Does that mean that we spent ourselves into prosperity? ......
I think it does. The capital raised for the war production produced industrial capabilities and the resulting post war prosperity.
1. What to do about silver? When the U.S. had a gold standard, post Civil War, most observers thought a policy of bimetallism was unworkable. It would require pegging the price of one metal to the other. Any time metal markets moved to higher gold, silver would drive gold out of circulation (Say's Law, I believe).
2. If you don't adopt bimetallism, political pressures will develop to do so, just as they did in the late 1800's (William Jennings Bryan). What happened was silver purchases by the Treasury -- 1890 Sherman Silver Repurchase Act -- to placate the easy money crowd. When the budget ran a deficit back then, the purchases threatened to force the government to redeem paper with silver rather than gold, effectively forcing conversion to a silver standard.
3. Conversion to a silver standard then destroys the fixed exchange rate which is one of the original purposes of a gold standard. Currencies are then revalued accordingly, depriving investors of what was originally sought, a guarantee of non-depreciation of the currency.
4. Under a gold standard, when the gov't runs a surplus, its drains gold from the economy, making it difficult for banks to keep necessary reserves on hand. The banks then have to call in loans, precipitating an economic tightening, raising interest rates, lowering prices on capital markets for stocks and bonds. Gov't deficits work in the opposite direction, with the potential inability of the gov't to redeem its currency in gold. This is why Nixon took us off finally in the 70's.
They found it was very hard to have a balanced budget back in the late 1800's, when things were much simpler than today. Would be near impossible to do so now I imagine, so surpluses and deficits would have the same harmful consequences they did in our previous experience with gold.
Can these problems, which are based on our actual experience, be overcome?
It was re-legalized back in the 80's, so you're in the clear.
Posted before commenting on the rest: excellent points all-around, thanks.
Thanks for that. As for "hoarding", you have a point. I suppose the real question is, don't I have a right to hoard? After all, my root cellar and my weapons cache are both "hoards", right?
Thanks. Nice job! Otherwise I would have had to.
Of course you have a right to hoard. But society has a need for currency to flow.
The recovery didn't really start until the war started. It started in a small way before that but wasn't much. The real reason that the recovery was so long in coming was that FDR insisted on rasing taxes when he should have lowered them. This man did deserves the largest share of the blame for the depression taking so long to rebound.
The mistake made by the Fed during the 1920s was expanding the supply of money and credit too rapidly. However, as increasing productivity prevented consumer prices from rising, the Fed was unconcerned about the inflation it was creating. Instead, the excess money and credit that spilled into financial and real estate markets caused asset prices to rise, which resulted in claims of a "new era" (sound familiar?).
The bust of 1929 led to the Great Depression of the 1930s not as a result of Fed tightening, as Bernanke claims, but due to the misguided economic policies of the Hoover and Roosevelt administrations.
By preventing market forces from efficiently correcting the imbalances created during the inflationary boom of the 1920s, the Federal Government turned what otherwise would have been a normal, though severe, cyclical recessionary bust, into what became known as The Great Depression.
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