Rethinking the Great Depression ECO 473 – Money & Banking Dr. D. Foster

Myth vs. Reality of the Great Depression The myths: Capitalism failed. Markets failed. Government intervention was necessary. The New Deal saved capitalism. Growth in the 1920s was illusory. Herbert Hoover was a do-nothing President. The reality:

Myth vs. Reality of the Great Depression What happened in the 1920s?: Increased auto ownership. The country became increasingly electrified. Increased income. Stock market boom.

Myth vs. Reality of the Great Depression What happened in the 1920s?: Increased auto ownership. The country became increasingly electrified. Increased income. Stock market boom. What precipitated the Great Depression? Failure to maintain the gold standard. Collapse of sound monetary policy. Problem areas: wheat, coal

How the Gold Standard works $20.67 = 1 oz.1 oz. = £4.25 $4.86 = £1 American firms export goods to England … tractors. Value = $50 m. British firms export goods to U.S. … fish & chips. Value = £10.29 m. At exchange rate of $4.86 = £1, the £ earned by U.S. firms will just trade for the $ earned by the British firms. Suppose that British exports fall by 23% and that there is only £8 mill available in foreign exchange market (to buy $). £10.29 mill. $50 mill. A gold standard implies that we have “fixed” exchange rates between currencies.

Now, American exporters can’t exchange all of their £10.29 mill. for $. They can only exchange £8 mill. at the going exchange rate.... receiving $38,880,000. But, they aren’t going to lose here… They would cash the rest out in gold: £2.29 mill. = 538,823 oz. They would redeem in U.S. for dollars: 538,823 oz. = $11,120,000 Total value received = $50,000,000 $20.67 = 1 oz.1 oz. = £4.25 $4.86 = £1 £8 mill. $50 mill. How the Gold Standard works

The flow of gold from England to U.S. won’t persist over time.  gold =  MS  MS =  P inflation  gold =  MS  MS =  P deflation U.S. exports fall and British exports rise until trade flows balance. $20.67 = 1 oz.1 oz. = £4.25 $4.86 = £1 £8 mill. 538,823 ounces $50 mill. How the Gold Standard works MV=PY

In England, the outflow of gold will lead to price deflation and probably a recession (or a depression). So, the Bank of England raises interest rates. This attracts foreign investment (capital inflows) which ends outflow of gold. Confounding the Gold Standard In the U.S., expanding the money supply means inflation and falling exports. The Fed can buy this gold by selling Treasury securities, so not allowing the money supply to increase. But, this will also raise U.S. interest rates which works against British policy and encourages more gold inflows!

Stress on the Gold Standard WWI - Combatant countries go off gold standard to  spending. Gold rushes into the U.S. as countries buy war material. Post-WWI, gold stocks insufficient for existing price levels. Worldwide deflation (i.e., depression) is required. Victors can ease burden by acquiring  gold stocks. Burden on losers is unsustainable. Eventually, U.S. lends gold to Germany.

Stress on the Gold Standard The Gold Exchange Standard: U.S. & U.K. hold gold Other countries hold gold, $, £ U.K. recession restores gold value by France devalues currency; gold inflows France redeems pounds; more gold inflows. Fed lowers i; gold flows from U.S.; burden on U.K. lessened % of world’s gold; %; % Gold inflows sterilized and MS in France was constant.

The Gold Standard Collapses U.S. monetary policy is erratic: lowers i (3.5%) and gold flows out raises i to stop gold outflows. By Sept. 1929, i up to 6%; gold inflows 1929/1930. After crash, i lowered; down to 1.5% in April Gold outflows 1931; raised i to 3.5%. March 1932 Fed begins OMO which stops deflation. OMO stop in July Devaluation concerns drive gold outflow Jan-Mar 1933.

Why did the depression last until 1932? Herbert Hoover Commerce Secretary in the 1920s. Rallied business leaders in Believed solution was to maintain wages & prices. How a Depression becomes “Great” Smoot-Hawley tariffs kick off trade war (1930). Congress increases taxes to cover deficits (1932). Hoover’s policy erodes business profits and raises unemployment. Banks fail en masse in Why didn’t it end?

Rethinking the Great Depression ECO 473 – Money & Banking Dr. D. Foster