The gold standard and the great depression.

Eichengreen, Barry J.

The Depression of the 1930s remains the ultimate testing ground for theories of macroeconomic fluctuation, while the operation of the gold standard is the ultimate measuring rod for alternative international monetary systems. Yet neither the cause of the Great Depression nor the workings of the gold standard are understood adequately. (1) One reason, my research suggests, is that they tend to be analyzed in isolation from one another when, in fact, the gold standard provides the key to understanding the Depression, and the Depression illuminates how the gold standard workes. (2)

How the Gold Standard Worked

The dominant explanation for the stability of the prewar gold standard emphasizes adept management by the Bank of England. The Bank is said to have stabilized the gold standard system by acting as international lender of last resort. In an influential book, Charles Kindleberger contrasted the pre-World War I situation with the interwar period, when Britain was not sufficiently powerful to stabilize the system, and the United States was not prepared to do so. (3) In an application of what has come to be known as the "theory of hegemonic stability," Kindleberger concluded that the requisite stabilizing influence was supplied adequately only when there existed a dominant power ready and able to provide it. (4)

My research challenges this view. It suggests that the interwar period was hardly exceptional for the absence of a hegemon. Neither was there a country that single-handedly managed international monetary affairs prior to World War I. The prewar gold standard was a decentralized, multipolar system whose smooth operation was not attributable to stabilizing intervention by a dominant power.

The stability of the prewar gold standard was attributable rather to two very different factors: credibility and cooperation. (5) The credibility of the gold standard derived from the priority attached by governments to balance-of-payments equilibrium. In the core countries--Britain, France, and Germany--there was little doubt that the authorities would take whatever steps were required to defend the central bank's gold reserves and to maintain the convertibility of the currency into gold. If one such central bank lost gold reserves and its exchange rate weakened, then funds would flow in from abroad in anticipation of the capital gains that investors in domestic assets would reap once the authorities adopted the measures needed to stem reserve losses and strengthen the exchange rate. Because there was no question about the commitment to the existing parity, stabilizing capital flows responded quickly and in considerable volume. The exchange rate strengthened of its own accord. Stabilizing capital flows thereby minimized the need for government intervention. (6)

What rendered the commitment to gold credible? In part, there was little perception that policies required for external balance were inconsistent with domestic prosperity. There was no well-articulated theory of how supplies of money and credit could be manipulated to stabilize production or reduce joblessness. The working classes, possessing limited political power, were unable to challenge the prevailing state of affairs. In many countries, the extent of the franchise was still limited. Those who might have objected that restrictive monetary policy created unemployment were in no position to influence its formulation.

Nor was there a belief that budget deficits or changes in the level of public spending could be used to establize the economy. Since governments followed a balanced-budget rule, changes in revenues dictated changes in public spending. Countries rarely found themselves confronted with the need to eliminate large budget deficits in order to stem gold outflows.

Ultimately, however, the credibility of the prewar gold standard rested on international cooperation. Minor problems could be dispatched by tacit cooperation, generally achieved without open communication among the parties involved. When global credit conditions were overly restrictive and a loosening was required, for example, the requisite adjustment had to be undertaken simultaneously by several central banks. Unilateral action was risky; if one central bank reduced its discount rate but others failed to follow, that bank would suffer reserve losses and would be forced to defend the convertibility of its currency. Under such circumstances, the most prominent central bank, the Bank of England, signaled the need for coordinated action. When it lowered its discount rate, other central banks responded in kind. In effect, the Bank of England provided a focal point for the harmonization of national monetary policies.

Major crises, in contrast, required different responses in different countries. The country losing gold and threatened with a convertibility crisis had to raise interest rates to attract funds from abroad; other countries had to loosen domestic credit conditions to make funds available to the central bank that was experiencing difficulties. The follow-the-leader approach did not suffice, especially when it was the leader, the Bank of England, whose reserves were under attack. Instead, such crises were contained through overt, conscious cooperation. Other central banks and governments discounted bills on behalf of the weak-currency country, or loaned gold to its central bank. Consequently, the resources upon which any one country could draw when its gold parity was under attack far exceeded its own reserves.

Both the credibility of the commitment to gold and the extent of international cooperation were eroded by World War I. The credibility was challenged by political and economic changes that shattered the particular constellation of political power upon which policy decisions had been predicated before 1913. Issues that had previously remained outside the political sphere, such as the determination of wages and employment, suddenly became politicized. Extension of the franchise and the growth of political parties dominated by the working classes intensified the pressure to adapt policy toward employment targets. When employment and balance-of-payments goals clashed, it was no longer clear which would dominate. Doubt was cast over the credibility of the commitment to gold. No longer did capital flow only in stabilizing directions. It might do the opposite, intensifying the pressure on countries experiencing a loss of reserves.

The decisions of central bankers, long regarded as obscure, became grist for the political mill. Monetary policymakers consequently lost much of the insulation they once had enjoyed. Those responsible for fiscal policy generally enjoyed still less insulation from political pressures. The war shattered the understandings regarding the distribution of the fiscal burden that had existed before 1913. The level and composition of taxes were altered. Incomes were redistributed. The question became whether to retain the new distribution of fiscal burdens or to restore the old order. Economic interests fought a fiscal war of attrition, resisting any increasing in the taxes they paid and any reduction in the transfers they received. Each faction held out in the hope that the others would give in first. (7) Even in countries where central bankers retained sufficient independence from political pressures that they could be counted on to defend gold convertibility, fiscal policy became highly politicized. Absent a consensus on fiscal incidence, there was no guarantee that taxes would be raised or government spending would be cut when required to defend the gold standard. Credibility was the casualty.

With the erosion of credibility, international cooperation became still more important than before the war. Yet the requisite level of cooperation was not forthcoming. Three obstacles blocked the way: domestic political constraints; international political disputes; and incompatible conceptual framework. Domestic interest groups with the most to lose were able to stave off adjustments in economic policy that would have facilitated international cooperation. The international dispute over war debts and reparations hung like a dark cloud over international negotiations, contaminating efforts to redesign and cooperatively manage the gold standard system. The competing conceptual frameworks employed in different countries prevented policymakers from reaching a common understanding of their economic problem, much less from agreeing on a solution.

The agrument, then, is that credibility and cooperation were central to the smooth operation of the pre-war gold standard. The scope for both declined abruptly after World War I. The instability of the interwar gold standard was the result.

The Causes of the Great Depression

Given this explanation for the instability of the interwar gold standard, it remains to link the gold standard to the Great Depression. That link stretches back to the changes in the pattern of balance-of-payments position of the United States and weakened that of the other nations. (8) In the mid-1920s, the external accounts of other countries remained tenuously balanced on long-term capital outflows from the United States. But if U.S. lending was interrupted for any reason, the underlying weakness of other countries' external position suddenly would be revealed. As they lost gold and foreign exchange reserves, the convertibility of their currencies into gold would be threatened. Their central banks would be forced to restrict credit, their fiscal authorities to compress public spending, even if doing so threatened to plunge their economies into recession.

This is what happened when U.S. lending was curtailed in the summer of 1928 as a result of increasingly stringent Federal Reserve monetary policies. Superimposed on already weak foreign balances of payments, this policy shift provoked a greatly magnified monetary contraction abroad. In addition, it provoked a contractionary shift in fiscal policies in parts of Europe and much of Latin America. This shift in policy worldwide, and not merely the relatively modest shift in policy in the United States, provided the contractionary impulse that set the stage for the 1929 downturn.

Policies in other countries were linked to policy in the United States by the international gold standard. Given the preexisting pattern of international settlements, a modest shift in U.S. policy could have a dramatic impact on the payments positions of other countries and hence could provoke a greatly magnified adjustment in the stance of their economic policies. Monetary authorities outside the United States were forced to respond vigorously to the decline in capital inflows if they wished to stay on the gold standard. Fiscal authorities were forced to retrench to compress domestic spending and limit the demand for imported goods.

It is hard to see what else officials in individual countries could have done, given their commitment to gold. Unilateral monetary expansion or increased public expenditure moved the balance of payments into deficit, threatening the gold standard. So long as they remained unwilling to devalue, governments hazarding expansionary initiatives were forced to draw back. Britain learned this lesson in 1930, the United States in 1931-3, Belgium in 1934, and France in 1934-5. (9)

The dilemma was whether to sacrifice the gold standard in order to reflate, an option most policymakers opposed, or to forswear all measures that might stabilize the economy in order to defend the gold standard. Finessing this choice required international cooperation. Had policymakers in different countries been able to agree on an internationally coordinated package of expansionary initiatives, the decline in spending might have been moderated or reversed without creating balance-of-payments problems for any one country. Reflation at home would have reversed the decline in spending; reflation abroad would have prevented the stimulus to domestic demand from producing trade deficits and capital flight. Under the gold standard, reflation required cooperation.

A separate question is what amplified the destabilizing impulse to the point that it became the great economic contraction of modern times. There is widespread agreement that the answer lies in the spread of financial instability starting in the second half of 1930--in the bank failures and financial chaos that led to the liquidation of bank deposits and disrupted the provision of financial services. The role of banking crises in the propagation of the Great Depression is widely accepted for the United States. (10) But bank failures played an important role in other countries as well. (11) When allowed to spread, bank runs disrupted the functioning of financial markets. Shattering confidence, disrupting lending, freezing deposits, and immobilizing wealth, they amplified the initial contractionary shock.

This answer to the question of what amplified the destabilizing impulse only suggests another question: why did policymakers fail to intervene to head off the collapse of their domestic financial systems? They failed to do so because the gold standard posed an insurmountable obstacle to unilateral action. Containing bank runs required them to inject liquidity into the banking system. But doing so could be inconsistent with the gold standard rules. Defending the gold parity might require the authorities to sit idly by as the banking system crumbled, as did the Federal Reserve System at the end of 1931 and again at the beginning of 1933.

Even when central bankers risked gold convertibility by intervening domestically as lenders of last resort, the operation of the gold standard could render their initiatives counterproductive. The provision of liquidity on a significant scale signaled that the authorities attached as much weight to domestic financial stability as to the gold standard. Realizing that convertibility might be compromised and that with devaluation they might incur capital losses on domestic assets, investors rushed to get their money out of the country. Additional funds injected into the banking system leaked back out as depositors liquidated their balances. Perversely, the banking crisis was intensified.

Once again, escaping this dilemma required international cooperation. Loans from other gold standard countries could have replenished the reserves of central banks confronted with banking crises. But the longer creditor countries vacillated, the larger the necessary loans became. Ultimately, the requisite loans could only be provided collectively. Once again a variety of obstacles--reparations, diplomatic disputes, and doctrinal disagreements among them--thwarted cooperation.

The End of the Gold Standard

and the End of the Depression

If the gold standard contributed to the severity of the slump, then did its collapse set the stage for recovery? The currency depreciation made possible by abandonment of the gold standard, according to the conventional wisdom, failed to ameliorate conditions in countries that left gold while exacerbating the Depression in countries that remained. My research shows that nothing could be more contrary to the evidence. (12) Depreciation was the key to economic recovery. Prices were stabilized in countries that abandoned the gold standard. Output, employment, ivnestment, and exports rose more quickly than in countries that clung to it instead.

The advantage of currency depreciation was that it freed up monetary and fiscal policies. No longer was it necessary to restrict domestic credit in order to defend convertibility. No longer was it necessary to cut public spending on countries where expenditure was already in a tailspin.

Yet there was surprisingly little tendency, upon suspending gold controvertibility, to initiate reflationary action. Six months to a year had to pass before officials took steps to expand the money supply. The interlude was required to convince the public and policymakers that abandoning gold did not pose an inflationary threat. Only then did governments initiate the policies that finally launched their economies down the road to recovery. Herein lies the explanation for why currency depreciation did not unleash a more rapid return to full employment.

Ultimately, the question is why countries stayed wedded to gold for so long, and why countries that abandoned the gold standard failed to pursue expansionary policies more aggressively. In part, different decisions across countries reflected differences in the balance of political power, between creditors who benefited from deflation and debtors who suffered, or between producers of internationally traded goods who benefited fron devaluation and producers of domestic goods who were likely to be hurt. In addition, however, policy decisions reflected the influence of historical experience. A central determinant of the willingness of governments to dispense with the gold standard in the 1930s was the ease with which it had been restored in the 1920s. Where the battle was difficult, countries had endured costly and socially divisive inflations. In such extreme cases as Germany, Austria, Hungary, and Poland, price instability had exploded into hyperinflation. In Frnnce, Belgium, and Italy, although inflation did not reach comparable heights, the legacy was the same. Policymakers and the public continued to regard the gold standard and price stability as synonymous. They continued to adhere to this view long after the 1929-31 collapse of prices had provided ample evidence to the contrary.

Countries such as Britain, Sweden, and the United States had not experienced runaway inflation in the 1920s. The gold standard and price stability were still clearly distinguished. Policymakers worried less that devaluation would lead inevitably to monetary instability, social turmoil, and political chaos. Elected officials in these countries were able to pursue policies designed to raise prices.

Politicians in counties such as Germany and France were obsessed with inflation because it was symptomatic of deeper social divisions. It reflected the disintegration of the prewar consensus regarding the distribution of incomes and financial burdens. World War I had transformed the distribution of tax obligations. It had destroyed long-standing conventions governing income distribution. A bitter dispute erupted over whether to restore the status quo or to maintain the new fiscal system. So long as this dispute raged, postwar governments were incapable of agreeing on a package of tax increases and public expenditure reductions sufficient to balance their budgets.

Inflation had been symptomatic of this fiscal war of attrition. The longer budget deficits persisted, the less willing investors grew to absorb government bonds, and the more the fiscal authorities were forced to rely on the central bank's printing press. Only when inflation had risen to intolerable heights had an accommodation been reached. The gold standard was emblematic of the compromise. To abandon it threatened to reopen the dispute and ignite another debilitating inflationary spiral.

The war of attrition had been most intractable, and therefore exerted the most inhibiting influence on policy in the Depression, in those countries where the prewar settlement had been most seriously challenged--where fiscal institutions had been most dramatically altered, where property had been most heavily destroyed, where income had been most radically redistributed. In addition, the war of attrition was most intractable where political institutions handicapped those wishing to compromise. In countries with proportional-representation electoral systems, it was easy for small minorities to obtain parliamentary seats. The sensible strategy for political candidates was to cater to a narrow interest group. Political parties proliferated. Every group that might suffer from the imposition of a tax had an elected representative to block its adoption. Government was by coalition. When a coalition government attempted to redress the fiscal problem, adversely affected parties withdrew their support and the administration collapsed.

In countries with majority-representation electoral systems, in contrast, fringe parties enjoyed less political influence. Under majority representation, the party whose candidate receives a majority or plurality of votes cast in a district is the only one represented. Better prospects for securing a legislative majority gave political parties incentive to moderate their positions in order to appeal to a large fraction of the electorate. A government of the majority was in a better position to raise taxes, reduce transfers, or take other steps to contain the fiscal crisis.

Countries that suffered inflationary crises in the 1920s tended to have proportional-representation electoral systems. Since their institutions lent themselves least easily to political stability, they had particular reason to fear inflation and hence experienced the greatest difficulty in formulating a concerted response to the Great Depression. These connections among electoral systems, governmental stability, and economic policy outcomes form an important topic for future research.

(1) Previous NBER books have made important contributions to the literatures on both subjects. See, for example, M. Friedman and A. J. Schwartz, A Monetary History of the United States, 1867-1960, NBER Studies in Business Cycles No. 12, Princeton, NJ: Princeton University Press, 1963, and W. A. Brown, Jr., The International Gold Standard Reinterpreted, 1914-1934, NBER General Series No. 37, Ann Arbor, Ml: University Microfilms, 1940.

(2) This article summarizes the argument developed in my forthcoming NBER book, Golden Fetters: The Gold Standard and the Great Depression, 1919-1939, New York: Oxford University Press.

(3) C. Kindleberger, The World in Depression, 1929-1939, Berkeley: University of California Press, 1973.

(4) B. J. Eichengreen, "Hegemonic Stability Theories of the International Monetary System," NBER Reprint No. 1271, September 1989.

(5) B. J. Eichengreen, "The Gold Standard since Alec Ford," NBER Working Paper No. 3122, September 1989.

(6) The argument draws on the recent literature on exchange rate target zones. See P. R. Krugman, "Target Zones and Exchange Rate Dynamics," NBER Working Paper No. 2481, January 1988.

(7) This process is modeled by A. Alesina and A. Drazen, "Why Are Stabilizations Delayed?" NBER Working Paper No. 3053, August 1989. See also B. J. Eichengreen, "The Capital Levy in Theory and Practice," NBER Working Paper No. 3096, September 1989.

(8) B. J. Eichengreen, "'Til Debt Do Us Part: The U.S. Capital Market and Foreign Lending, 1920-55," NBER Repring No. 1148, March 1989.

(9) B. J. Eichengreen, "Relaxing the External Constraint: Europe in the 1930s, "NBER Working Paper No. 3410, August 1990.

(10) B. S.Bernanke, "Nonmonetary Effects of Financial Crises in the Propagation of the Great Depression," American Economic Review 73, pp. 257-276.

(11) B. J. Eichengreen, "International Monetary Instability between the Wars: Structural Flaws or Misguided Policies?" NBER Reprint No. 1486, January 1990, and B. S. Bernanke and H. James, "The Gold Standard, Deflation, and Financial Crisis in the Great Depression: An International Comparison," NBER Working Paper No. 3488, October 1990.

(12) B. J. Eichengreen and J. D. Sachs, "Exchange Rates and Economic Recovery in the 1920s," Journal of Economic History 65, pp. 924-946.