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

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. 2

What kind of stability during the gold standard? 3

4

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. 5

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 Aspects (cf. Figures): the stock market, production, employment, farm prics, debt deflation 6

Figure 1: the US stock market 7

Fig 2:US annual GDP from 1910 to 1960, volume 8

Fig.3: Unemployment in the USA 9

Fig. 4: Soup kitchen in Chicago in 1931 (opened by Al Capone) 10

Fig. 5: US Farm Prices during the Great Depression 11

Fig. 6: The deflationary process 12

Deflation and depression raised the debt ratio 13

Fig. 6: Deflation causes bank failues 14

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. 15

16

Real income per capita in the interwar period 17

GDP developments in selected countries 18

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 19

Legacy of the Depression 20

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. 21

Development of narrow money supply in the US in

Broad money supply in the US 23

US interest rates were low in nominal terms in the 1930s, but they were extremely high in real terms 24

UK inflation was negative (real interest high) during many years 25

US public debt increased but mainly as a consequence of the depression rather than as a consequence of expansionary fiscal policy 26

WPA employed 2-3 million workers 27

Central banks almost always hate inflation 28