Europe in 1931

I was at a conference at the Cato Institute two weeks ago discussing some research by Dartmouth Professor Doug Irwin on the role of the gold standard in the Great Depression of 1929-1933. If you’re interested, you can see a written version of my comments, the slides from my presentation, or a video of the session (my comments begin a little more than half way in). Here I’d like to relate some of the discussion of what happened in Europe in 1931, and comment on some of the parallels with what is going on today.

Some people think of the Great Depression as beginning or even caused by a stock market crash in October 1929. But Robert Shiller’s data indicate a broad market decline that month of 26%, not a whole lot worse than the 20% decline we saw in September 2008. From September 1929 to March 1931, the total stock market decline was 44%, which was milder than the 49% decline from September 2007 to March 2009. The Federal Reserve Board’s index of industrial production fell 28% from September 1929 to March 1931, somewhat more severe than the 17% drop recorded in the most recent recession. But if the U.S. economy had turned around in early 1931, we would be talking about that period as just another bad recession. The reason we instead call it the Great Depression is that the stock market went on to fall an additional 61% and industrial production an additional 27% from the levels of March of 1931.

What happened in 1931 to turn a bad economic downturn into the Great Depression? Dramatic events in Europe included failure of Credit-Anstalt, Austria’s biggest bank, in May of 1931. That was followed by bank runs in Hungary, Czechoslovakia, Romania, Poland, and Germany. As is often the case historically, the financial problems were a combination of a banking crisis– I’m not sure the bank will give me back my marks– and a currency crisis– I’m not sure that, if I get my marks out of the account, they will still be worth as much. I’d rather have gold than marks in an account with some shaky German bank.



Anxious depositors outside a Berlin bank, 1931. Source: Andrew and Joshua.
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The top panel in the graph below plots gold holdings of the Bank of England during 1931. Initially gold flowed into the Bank of England, despite the fact that the Bank dropped its discount rate, in a flight to safety. However, concerns grew that some of the Bank of England’s own assets on the continent might themselves be frozen. The country saw a rapid outflow of gold that summer, the end result of which was that Britain abandoned the gold standard on September 19, 1931.



Top panel: Gold reserves of Bank of England, in millions of U.S. dollars, January to December 1931, end-of-month values. Data source: Banking and Monetary Statistics, p. 551. Bottom panel: Bank of England discount rate, in percent, January to December 1931, end-of-month values. Data source: Global Financial Data. Figure reproduced from Hamilton (2012).
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Attention then turned to the United States. In the first half of the year, the U.S., like Britain, had experienced gold inflows despite a lower discount rate. But after Britain devalued relative to gold, the U.S. then experienced rapid gold outflows as people wondered if the U.S. might be next to suspend convertibility of the dollar into gold. The U.S. had started with a larger gold buffer, and with a sharp increase in interest rates was able to stem the loss of gold. But of course a sharp hike in interest rates at that phase of the cycle proved to be disastrous by any criterion other than maintaining a gold standard.



Top panel: Gold reserves of Federal Reserve, in millions of U.S. dollars, weekly January 7 to December 30, 1931. Data source: Banking and Monetary Statistics, p. 386. Bottom panel: discount rate of Federal Reserve Bank of New York, in percent, weekly January 7 to December 30, 1931. Data source: Banking and Monetary Statistics, p. 441. Figure reproduced from Hamilton (2012).
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In 1931, countries faced doubts about whether they would stay on the gold standard, and had a choice of either to abandon gold or else to inflict further domestic economic damage in the form of monetary contraction and price deflation. Those doubts and their damage ended up bouncing across countries like a ping pong ball. In 2012, countries face doubts about whether they will remain in the European monetary union, and have a choice of either to abandon (or be forced out of) the euro or else to inflict further domestic economic damage in the form of more fiscal contraction. We’re watching those fears and their consequences today move from country to country in real time.

However, one big difference is that in 1931, a preference for gold over bank deposits did not create any more of the yellow metal. The result instead was that the price of gold relative to produced goods was bid up, meaning any country that stayed on the gold standard was forced into deflation of the price of produced goods. By contrast, in the present situation, a preference for euro deposits in Germany over euro-denominated sovereign debt of periphery countries can be infinitely elastically accommodated by the ECB.

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38 thoughts on “Europe in 1931

  1. AS

    Milton Friedman mentions in his book, “Capitalism & Freedom”, that on December 11, 1930 the Bank of the United States failed, which was in his words “critical” due to the bank’s size and name. He also mentions that “from July 1929 to March 1933, the money stock in the United States fell by one-third, and over two-thirds of the decline came after England’s departure from the gold standard”

  2. Greg Ransom

    Didn’t the problems really start in 1925, with Britain attempting to set up an unsustainable false gold standard at the pre-war parity with a inadequate stock of circulating domestic gold, a ‘gold exchange standard’ that required support from the US and France, support which was unsustainable?
    Britain was in a slump with an unemployment problem prior to America’s problems in 1929.
    Germany had borrowed and spent more than it could afford in the period after the war (see Niall Ferguson, _The Pity of War_), attempting to bankroll and then liquidate these obligations.
    Austria tried to hide debt problems and to sustain special interests via bank take-overs by the Credit-Anstalt, an unsustainable attempt to sweep debt and insolvency under the rug.
    So many of these problems flow from pathological public finance and attempts to sustain and unsustainable fake a gold standard that it is odd that people attempt to put blame on a yellow metal and a ‘standard’ that involved national fiat currency reserves and circulating fiat currency as much as metallic reserves or circulating metallic currency.

  3. W.C. Varones

    The result instead was that the price of gold relative to produced goods was bid up, meaning any country that stayed on the gold standard was forced into deflation of the price of produced goods. By contrast, in the present situation, a preference for euro deposits in Germany over euro-denominated sovereign debt of periphery countries can be infinitely elastically accommodated by the ECB.
    … which will lead to a preference to hold gold over infinitely printable Euros (and dollars) of course.

  4. gman

    Enough talking! Print Euros already (by buying euro bond)..BTW Keynes and Friedman agree!

  5. dwb

    the world is so desperate for more monetary easing that the Fed doing more sends European stock markets up (surely you did not think it was a G20 statement where Germany agreed to the “principle of action”).

  6. Johannes

    the treaty of versailles was the root cause …
    anyway, james, thanks for your post. appreciate you do not forget the european theater. might be important in the future, November 2012 coming soon.

  7. Philip George

    1931=2012
    Big Crash Coming.
    Both Depressions can be attributed to the same reason: the wiping out of savings because of the collapse of financial asset markets followed by the collapse of banks as I’ve explained in my book “The General Theory of Money”.

  8. Jehu

    You are taking cause for effect. Money dried up because commodity circulation fell, not the other way around. What made the Great Depression great was the industrial crisis, not the desire to hold gold. Holding gold was only a symptom of a fall in the rate of profit, and lack of adequate investment opportunities for capital.

  9. Ricardo

    Professor,
    Thank you so much for this topic. This is a period that I have the greatest of interest. You probably will not be surprised that I hold many opinions contrary to the accepted views on this period of time. My views are much closer to those who were writing contemporaneously to the period rather than the more modern revisionist history.
    You wrote:
    Initially gold flowed into the Bank of England, despite the fact that the Bank dropped its discount rate, in a flight to safety. However, concerns grew that some of the Bank of England’s own assets on the continent might themselves be frozen. The country saw a rapid outflow of gold that summer, the end result of which was that Britain abandoned the gold standard on September 19, 1931.
    Here your implication is that Britain abandoned the gold standard because of the outflow of gold. Why couldn’t the outflow of gold have been because of the expectation that Britain would abandon gold? The cause and effect here is just the opposite of your implication.
    The countries of Europe were on the “gold exchange standard” not a gold standard. The difference has a very significant impact on the events that transpired. The Netherlands and France had most of their reserves not in gold, as would be the case on a gold standard, but in Pounds Sterling.
    At the Genoa Conference of 1922 the UK convinced the world that the pound was “as good as gold.” By the 1930s France and the Netherlands had accumulated large holdings of pounds and were uncomfortable. The UK had not managed the pound well, but because other countries were holding pounds as reserves the UK was sliding by without having to honor its gold commitments.
    In the 1930s France began to demand gold from the UK. The day before the UK abandoned gold the Finance Minister of the Netherlands asked Montague Norman point blank if the UK was going to abandon gold and he was told no. The next day the Netherlands saw the value of their foreign exchange fall by over 50%. The UK defaulted on their commitments. They determined to keep their gold reserves, though their reserves rightfully belonged to those countries holding pounds. Savvy investors saw the betrayal coming and moved their gold to safer havens.
    The UK abandoned gold because they botched their management of the pound. They were essentially stealing value from the rest of Europe with the gold exchange standard from 1922 until the mask came off in 1931.
    In the first half of the year [1931], the U.S., like Britain, had experienced gold inflows despite a lower discount rate. But after Britain devalued relative to gold, the U.S. then experienced rapid gold outflows as people wondered if the U.S. might be next to suspend convertibility of the dollar into gold. The U.S. had started with a larger gold buffer, and with a sharp increase in interest rates was able to stem the loss of gold. But of course a sharp hike in interest rates at that phase of the cycle proved to be disastrous by any criterion other than maintaining a gold standard.
    At this time the US held most of the gold in the world. All through the 1920s Benjamin Strong had manipulated interest rates to bail out Montague Norman and the UK pound. It was only just before Strong died in 1928 that he finally broke with Norman and stopped manipulating the US gold supply to help the UK.
    But after Norman died and with Hoover as president, the US made all the wrong moves. Gold begin to flow out of the US to the rest of the world, but on a gold standard this is what should have happened. The US held the excessive reserves of gold. But because all the countries of the world had mismanaged their currencies, the gold flowed to France because the French were managing the franc well. The accumulation of gold in France was not because of an error the French made as so many theorize, but because the rest of the world had over-extended their creation of paper money. Gold flowed exactly where it the gold standard says it would flow.
    But it is false to talk of a gold standard after WWI. The Genoa Conference and the Federal Reserve, under the influence of Benjamin Strong, were managing the currency in an attempt to accomplish goals that a currency can never accomplish. A gold standard is not a managed currency in the sense of stimulating the economy but is a system to maintain stable purchasing power of the unit of exchange. Monetary conditions after WWI were a disaster worldwide because of governments attempting to manage and manipulate currencies. The solution would have been a return to the gold standard but currencies had been manipulated for so long no decision makers knew what a real gold standard was and those who did know were ignored.
    I want to spend more time on the CATO Conference and your comments so I expect to add more later.

  10. spencer

    To place this in perspective one needs to look at the overall supply of gold and its distribution.
    At the official price, the supply of gold had not grown enough to finance the growth in world output.
    Moreover, the supply was poorly distributed with the US & France have too large a share of the world’s supply relative to the size of their economies.
    This is the argument Mundell makes for gold being the driving force behind the depression.
    I think it makes a lot of sense.
    Bernanke blames the Fed for the depression, but the Fed was just following the rules of the road imposed by the gold standard.
    Remember, the old gold standard era ( 1870-1930)
    was not a free market. Rather, the gold price was artificially supported by the Bank of England offer to buy all gold tendered to it at $21.
    In the early years this was above the market clearing price as evidence by the Bank’s gold holding growing. If it had been below the market clearing price their gold holding would have fallen.

  11. ppcm

    Should parallels be established between now and 1930, let us make sure the lines do not cross each other, when unfortunately they do. The USA in 1930 is a net exporter of capital, enjoys surplus in current accounts. There is a time lag in the spread out of the great depression USA,UK and then within one two years, the rest of the world. Enough gold in the coffers of the Federal Reserve, but not enough first grade paper to issue new bills, the parallel may start at this point. Noticeable is a recurrent deviation of the credit and loans to GDP growth, Friedman is warning and wondering about the persistence of governments deficits crowding out the private sector (B Friedman the direction in the relationship between the public sector and private debt). T Philippon The Evolution of the US Financial Industry from 1860 to 2007: Theory and Evidence P37 chart Fig 1 evidences the outgrowth of the financial sector as a share of GDP where each peak delivers its crisis. Those are recurrent phenomena under gold standard or not. The leit motiv from policy makers, the financial markets deviation to trend in pricing is acknowledged, but the monetary policy is not an arbitrageur of financial bubbles. The parallel can be extended to 1980 to 2012
    B Friedman NEW DIRECTIONS IN THE RELATIONSHIP BETWEEN PUBLIC AND PRIVATE DEBT
    “This unusual set of developments raises scientific questions as well as questions of public policy. The most widely discussed issue at the policy level has been the concern that so large a federal deficit, persisting even a near—full employment, is impairing the economy’s long—run growth and competitiveness by absorbing so much saving as to “crowd out” investment in productive new plant and equipment”

  12. acerimusdux

    @ W.C.

    “… which will lead to a preference to hold gold over infinitely printable Euros (and dollars) of course.”

    No doubt. But with no major currencies tied to gold, this no longer seems to have much effect on price levels. So the price of gold in itself is no longer as significant a macroeconomic variable.

    For example, all the gold in the world today is worth about $8.5 trillion, or just over half as much as household real estate in the U.S. alone. Or just over 5% of all financial assets in the U.S economy (all sectors). It’s still an important asset class, but one of many important asset classes.

  13. The Rage

    The original gold standard was a British scam. Just like current “gold” proponents want to try and make it a American scam.
    All finance is scam.

  14. Ricardo

    Again a correction. I was at work writing from memory in my first post. I looked it up and it was the Dutch central bank governor who was told by the British only a few days before the UK default that their reserves were safe. All of the Dutch reserves were in pounds and all were lost.
    Additionally, to support my postion that gold was flowing out of the UK because savvy investors knew that the UK was planning to default, in July of 1931 Keynes wrote that it was certain that the UK would leave the gold standard.
    The crisis was not caused because people took gold out of the UK. People took gold out of the UK because of the crisis. If is much like Europe today. The problem in Europe was not a monetary problem but a fiscal problem, mismanagement of economies and taking too much debt on the sovereign governments.

  15. Ricardo

    JDH wrote:
    In the first half of the year [1931], the U.S., like Britain, had experienced gold inflows despite a lower discount rate. But after Britain devalued relative to gold, the U.S. then experienced rapid gold outflows as people wondered if the U.S. might be next to suspend convertibility of the dollar into gold. The U.S. had started with a larger gold buffer, and with a sharp increase in interest rates was able to stem the loss of gold. But of course a sharp hike in interest rates at that phase of the cycle proved to be disastrous by any criterion other than maintaining a gold standard.
    Professor,
    Another comment on your passage above, most of the gold that left the US after the UK default was taken not by individuals but by sovereign states and large banks. This was actually driven by the UK default. Other European banks saw their reserves suddenly collapse. Their only option was to pull in their deposits and draw on their lines of credit in other banks. Because the US held most of the world’s gold most of the withdrawals hit US banks.
    Even though it was anticipated the shock of the UK breaking its commitment to honor the pound reverberated throughout all of Europe and was probably the most significant action to drive the world into a continued slide as you point out. For almost 200 years the world had learned to trust the Pound Sterling. Even since Sir Issac Newton had created the gold standard the pound was the world currency standard. Confidence in the stability of the pound was so hight that the UK acutally issued consols in 1751, perpetual bonds. Can you imagine the laughter if the US tried to issue a perpetual bond? Today the only perpetual bonds issued are between banks and are callable after 5 years for protection.
    The UK had left the gold anchor in the past (the Napoleonic Wars) but had returne to parity and restored the purchasing power of the pound. Their mismanagement during the 1920s was considered an exception, but turned out to be disastrous for those who had trusted British monetary wisdom. The dollar did not replace the pound as the world reserve currency because of its soundness. The pound threw away all its reputation and good will.

  16. Bryce

    The problem in both cases, 1931 & 2012, is that credit was created [unsupported by real, voluntary savings], resulting in huge unpayable debts. Abandoning the gold-exchange standard & abandoning the Euro & printing Euro without restraint all amount to a pretty similar event: defaulting on the unpayable debts.
    Honest, above board default produces more honest prices, in my opinion, & thus a better economic outcome. Masking deflation isn’t unlike censorship of free speech. But the real problem is the central-bank-enabled creation of credit leading up to 1929 & 2009. There is no avoiding pain from that malinvestment.

  17. Ricardo

    Greg Ransom,
    I appreciate your comments.
    One thing, the problem started long before 1925. Actually if you check you will find that when the UK returned to a gold anchor in 1925 their gold flows stabilized for about 2 years. So their monetary management was better for those two years. But then they returned to the printing presses and the gold once again began to flow out of the country. The gold flows were giving them plenty of notice that they were mismanaging their monetary system but politically no one had the courage to stem the tide.

  18. keefer

    I agree with Jehu, the reason for the great crash was the state of the world economy not the money supply.
    The major economies were already slowing up in 28-29 if not before. The wrong policies on credit/money supply/gold standard served to exacerbate the crisis but were not the causes.
    The UK may have had a stable money supply in the mid-1920s but its economy was wracked by the largest strike in history, mass unemployment and a collapse in demand. Germany had sanctions against it and a currency that was non-convertible. There were significant problems in Italy, Spain and US agriculture. Russia was separated from the world market because of the Revolution.
    Here’s my history of it http://tinyurl.com/bvxuo6o

  19. Barkley Rosser

    Ricardo,
    It is useful for you to note the special role of the pound sterling and that in effect the gold standard was really a kind of cover for a pound sterling standard. As it is, many have focused on the role of so many major nations attempting to “play by the rules of the gold standard,” with Kindleberger and Eichengreen among the more important of close observers not mentioned so far. I think that arguing that it was “mismanaging currencies” within this system that was the source of the problem (and praising the conduct of France who aggressively played by the rules) is a distraction. The mismanagement in 1925 was UK attempting to repeg gold at its old rate, no longer sustainable given relative British economic decline compared especially to the US.
    That Keynes and others were forecasting UK would withdraw from gold standard in July 1931 curiously leaves out obvious international reasons for this, most notably the suspension by Germany of letting UK get deposits back when the crisis spreading from Austria after the failure of the Kreditanstalt hit that country. It was not just some arbitrary decision by UK to drop from gold, but long-building pressure that was triggered by the international crisis.
    Just reread the relevant portions of Friedman and Schwartz, perhaps inspired by just learning of her death, and they seem to pinpoint the ultimate failure of the Fed to be its lame response to the UK leaving the gold standard in Sept. 1931. The greatest rate of bank failures and associated decline of the US money supply occurred during this period, and here are F&S on p. 318: “Why should the gold drain and the subsequent rise in discount rates have intensified the domestic financial difficulties so greatly? They would not have done so, if they had been accompanied by extensive open market purchases designed to offseet the effect of the external gold drain on high-powered money, and the internal currency drain on bank reserves. Unfortunately, purchases were not made. The Reserve System’s holding of government securities were actually reduced by $15 million in the six-week period from mid-September to the end of October, and then kept unchanged until mid-December.”
    BTW, maybe you made these points, Jim, but I did not read your longer account, sorry. Otherwise in general agreement with your summarizing presentation here, as far as it went.

  20. JFK

    @Hamilton
    You end the article with:
    “By contrast, in the present situation, a preference for euro deposits in Germany over euro-denominated sovereign debt of periphery countries can be infinitely elastically accommodated by the ECB.”
    I read that; read the link too; and throughout it all the refrain, “…get your money for nothing and your chicks for free.” ran through my head.
    At the risk of sounding pedantic, will the accommodation by the ECB be truly “infinitely elastic” if the peripheral countries start defaulting on their sovereign debt?

  21. Jim Glass

    I agree with Jehu, the reason for the great crash was the state of the world economy not the money supply.
    As if the latter doesn’t affect the former?
    The UK may have had a stable money supply in the mid-1920s but its economy was wracked by the largest strike in history, mass unemployment and a collapse in demand.
    Because the pound had been set to gold at the wrong parity, making real wages too high to be sustained, forcing “internal devaluation” because currency devaluation was impossible due to the gold standard’s fixed exchange rate. Just as with the Greece and the Euro today. A classic result of toxic money policy, being repeated today.

  22. acerimusdux

    @ Bryce

    “The problem in both cases, 1931 & 2012, is that credit was created [unsupported by real, voluntary savings]”

    On the contrary, it seems to me that in both cases credit expansion occurred alongside record accumulations of wealth. I don’t think those accumulations of wealth were involuntary. In both cases, there was far more money available to borrow than there were willing and creditworthy borrowers or spenders. If it were the other way around, and there were excessive borrowing and a lack of savings, then interest rates would have been high, not at record lows. Likewise, if monetary policy had been loose and inflationary, then long term interest rates would have been high.

    @ Ricardo

    “Actually if you check you will find that when the UK returned to a gold anchor in 1925 their gold flows stabilized for about 2 years. So their monetary management was better for those two years.”

    And their GDP flattened out in mid 1925, and then took a drop in 1926. As JDH says for the Fed hikes in 1931, I’m not sure that’s a success by “any criterion other than maintaining a gold standard.”

    If you want currencies to be managed for soundness only, without regard for economic growth, then you need to be willing to turn to fiscal policy instead for maintaining economic growth.

    If you oppose deficit financing as well as monetary policy, then the only choices for reducing excessive wealth accumulations and restoring demand are to tax that wealth directly in order to support fiscal stimulus, or to simply sit back and allow massive recessions to occur and wait for that excessive wealth to be destroyed through the falling asset prices which will eventually result.

    This time, once again, it appears that the world’s policy makers have chosen the later course. In which case, Phillip George’s forecast above seems spot on.

  23. AS

    Maybe some of the expert readers can comment on Milton Friedman’s conclusions. In “Capitalism & Freedom” he says, “ I know of no severe depression in any country or any time that was not accompanied by a sharp decline in the stock of money and equally of no sharp decline in the stock of money that was not accompanied by a severe depression”.

  24. Ricardo

    Professor,
    I have tried to get through your paper but I am sorry it seems to be seriously flawed. I will try to continue it but here are a couple of comments right from the start of your paper.
    You use P for your price level then R for the price of gold and then create a fomula. The you express P in dollars. Doesn’t that mean you need another expression for dollars? Price is the ratio of exchange of two goods. Expressing P as the ratio of dollars and potatoes gives you are price of the dollar in potatoes and of potatoes in dollars. Expressing R as the ratio of potatoes to gold gives you the price of potatoes in gold and the price of gold in potatoes, but this doesn’t give you the price of gold in dollars.
    You totally discount the relative quantities. Let us assume you have a ratio of dollars for potatoes and a ratio of dollars for gold. You can express your econoomy in dollars a common unit of account. But suppose the quantity of potatoes changes. The ratio changes. You may be able to draw some conclusions if you assume that the ration of potatoes to dollars and the ratio of potatoes to gold remains the same at the new quantity, so let’s say that is true. What happens when the quantity of both potatoes and dollars changes? Now you have a totally different set of ratios and your original analysis of potatoes and gold in dollars is no longer valid. The ratio of potatoes to dollars and the ratio of gold to dollars has changed as well as the ratio potatoes to gold. There are three variables in your example not just two.
    Then you make the statement “both countries [the US and France] desired to increase their gold holdings at the same time.” Professor this is not a gold standard but mercantilism and every critic of mercantilism in the early 19th Century debunked just this kind of thinking. You equate a gold standard to mercantilism when they are far from being comparable. Keynes is the one who embraced mercantilism, not those who supported a gold standard. A gold standard is not an accumulation of gold but a standard by which money substitutes can be valued and money substitute quantities be optimized.
    Perhaps more later.

  25. JDH

    Ricardo: P refers to the price of a potato. When you go to the grocery store you will see a price listed there, and that is what I am calling P. You might find, to take an example that keeps the math very simple, that a potato costs two dollars. That price is quoted in units of dollars per potato, that is, P = 2 $/potato. Suppose the price of gold in dollars is fixed at 20 dollars per ounce of gold.

    One can also think about how many potatoes you would need to buy one ounce of gold. That number I am calling R. It is measured in units of potatoes per ounce of gold. I am claiming that if the dollar price of gold is 20 $/ounce, and if the dollar price of a potato is 2 $/potato, then the real price of gold R is 10 potatoes per ounce. Your 10 potatoes are worth $20, and $20 is worth one ounce of gold. That is why 10 potatoes are worth one ounce of gold and R = 10 potatoes/ounce.

    The equation relating the magnitudes P and R is 20 $/ounce = P $/potato x R potatoes/ounce, or 20 = 2 x 10. As long as the dollar price of gold is fixed at $20 an ounce, then P times R will have to equal 20.

  26. Ricardo

    Below is an analysis I did October 16, 2010 of a paper Irwin published September 2, 2010 entitled Did France Cause the Great Depression?
    …let me critique Douglas Irwin’s paper…. To be fair Irwin does correct some of the misleading implications of his paper in his podcast [on Econtalk], but using his paper allows me to cite page numbers, an easier way to check my references than tick numbers on the podcast.
    IRWIN’S CONCLUSION
    I will begin my criticism of Irwin’s paper by jumping to the end citing observations from his conclusion:
    Quote:

    Hence, simply avoiding deflation during this period would likely have changed the course of world history. One shudders to think of the historical ramification of the policies pursued at the time.

    But in the sentence immediately preceding this summary of his conclusion Irwin states:
    Quote:

    Of course, declining prices do not necessarily imply declining output…”

    This is an extremely important observation that is normally not even considered by modern researchers of the Great Depression and the gold standard. Prices under the gold standard will almost always decline, but consider:
    1) is this deflation? One of the primary reasons prices decline under a gold standard is that technological and scientific methods improve and find methods of producing at a lower cost. Was the decline in computer prices in the 20th Century due to deflation? And,
    2) even if falling prices under the gold standard are deflation is that a bad thing, does it cause economic decline? Prices are signals to traders of the efficiency of the allocation of resources. While price declines can signal increased inventories possibly caused by a decline in demand (the Keynesian’s primary concern) price declines that are due to deflation simply revalue the relative prices of goods and at the worst require the producer to adjust his calculations to the new value. But the historical change in prices under a gold standard (see Jastrum) has never been significant enough by itself to create monetary problems and has always returned to an equilibrium point.
    Irwin would have been more accurate removing the word “necessarily” because declining prices and declining output are totally different.
    THE CONTROVERSY ABOUT FRANCE’S MONETARY POLICY, 1928-1932
    “One of the main worries,” Irwin notes on page 8, was cited by economist Gustav Cassel (the economist most cited by Irwin) at the 1922 Genoa conference that there would be insufficient gold production leading to a shortage of gold and deflation. Irwin puts this concern to rest:
    Quote:

    As it happened, the forecasts of declining gold production were off the mark. As Figure 1 shows, the supply of gold reserves continued to grow through the late 1920’s and into the 1930s. In fact, world gold reserves increased 19 percent between 1928 and 1933.

    What is important about this is that Cassel could not have known he was wrong and so his analysis would have been based on this assumption at least into the 1930. Cassel’s analysis through the 1920s would have been biased based on his assumption. The myth should be put to rest. There was no shortage of gold before or during the Great Depression.
    On page 10 Irwin observes:
    Quote:

    Between 1923 and 1926, France’s share of gold reserves was stable, and about the same as Britain’s. However, after the de facto stabilization of the franc occurred in 1926 (codified in 1928), France’s share of world gold reserves took off.

    It must be noted that the pre-WWI value of the franc was about 4:1 to the dollar. In the spring of 1924 at the time of the Dawes plan it had fallen to 25:1. It recovered to 18:1 when a new Minister of Finance, Joseph Caillaux was selected, but scandal in the French government caused the ratio to fall such that by June of 1924 it was around 22:1. Now we must note that during this time France was the only major country not on the gold standard. According to today’s interpretation of the gold standard of the Great Depression France should have had a booming economy. Instead the franc and French output continued to fall. Caillaux attempted to get the bank to return to sound money but the regents of the Banque of France wanted to force the government to essentially declare bankruptcy. Caillaux was removed.
    In 1926 the government once again attempted to have the Banque back the franc with gold but again the regents refused. The franc was in freefall. Finally, in June Caillaux was returned as Minister and the head of the Banque was fired and replaced by Emile Moreau. The franc had fallen to a low of 37:1. In July a new Prime Minister, Raymond Poincaré took office with the franc at 50:1.
    Faith was restored with the new “hard currency” leadership and the franc began to recover. In December 1926 the franc had recovered to 25:1 and Moreau began to sell francs and buy foreign currency to stabilize the franc at this level. At this point the economy of France surged and gold began to flow into the country. To maintain the franc Moreau began to purchase foreign currency. By the end of May 1927 France had $700 million in foreign exchange, half being in pounds. For those who understand the gold standard this mix of currencies was not a signal that the franc was undervalued but that the pound was overvalued by a significant amount. Even though the UK was on the gold standard Montagu Norman refused to reduce the supply of pounds. Instead since the Genoa conference Britain had pushed the pound on the rest of the world under the “gold bullion standard” refusing to institute monetary discipline.
    At the end of his paragraph on page 10 Irwin states:
    Quote:
    blockquote>The Bank of France promoted this accumulation [of gold] by selling off its foreign exchange reserves and purchasing gold. By liquidating its holding of British pounds, France put pressure on the Bank of England’s gold reserves and hence on British monetary policy.
    But let’s explore why France sold British pounds. Was the intention to accumulate gold? In February 1927 Moreau approached the British to renegotiate the terms of a 1916 loan France had secured from Britain, secured with French gold, but Norman stood in the way preventing the resolution of the negotiation. Finally, frustrated with the lack of negotiation in May Moreau announced that France would simply pay off the loan and take back the $90 million in gold reserves. Then in June the Banque of France issued instructions that $100 million in pounds be converted to gold which would have significantly depleting British gold reserves. This action forced Norman to the negotiating table. Again we see that the supposed problem with the French accumulation of reserves was actually a British problem not a French problem. The British had been the monetary rulers of the world, but they did not understand that this honor had been won not ordained. Suddenly, the British learned they could no longer arrogantly dictate terms.
    It should be noted that as he approached the end of his life Benjamin Strong lost patience with Norman and sided with the French on monetary policy. He regreted supporting England in establishing the “gold bullion standard” because it allowed the Bank of England to manipulate European central banks while avoiding the hard decisions of a sound monetary policy. On his last trip to Europe in May of 1928, he intentionally avoided England sailing directly to France. Norman rushed to France to see him but the meeting was very difficult as Strong was very blunt with his old friend. The Banque of France held over $1 billion in pounds. Strong understood that it was not the French who blew up the gold standard by its sound monetary policy but Norman and the British.
    So what of the claim that the French were intentionally accumulating gold? On pages 14-15 Irwin writes:
    Quote:

    French officials such as Rist (1931) argued that the inflows represented confidence in their economic policies and that they were doing nothing to encourage the gold movement. Sicsic (1993) notes that capital inflows arose from the repatriation of capital by French residents after the stabilization became credible.

    He continues on page 15:
    Quote:

    In fact, a closer look at the balance sheet of the Bank of France indicates that it was not sterilizing in the classic sense of reducing domestic assets to offset an increase in foreign assets…its foreign asset holdings grew.

    France was not only not sterilizing gold it was accumulating vast amounts of foreign exchange with about half being pounds. If anything the French were assisting the British by accumulating pounds rather than redeeming them at the Bank of England for gold, yet Norman and the British were working to undermine the influence of France. The French were conducting sound monetary policy while the British played politics.
    There are many other such references in the paper demonstrating that the French were not manipulating the gold standard (especially see the footnote on page 17) but let me close this section with a quote from a footnote on page 20.
    Quote:

    Mouré(2002, 191) finds that “Bank of France records reveal no direct political motives at work….”

    GOLD AND PRICES, RESERVES AND COVER RATIOS: A COUNTERFACTUAL ASSESSMENT
    Irwin begins his assessment of the impact of US and French monetary policy by making this statement about three studies contemporary to the Great Depression on page 20:
    Quote:

    All [three papers] emphasized the same result: that monetary stock of gold would have to increase about 3 percent per year to maintain stable world prices.

    But is the gold standard about maintaining stable world prices? Not at all. The gold standard is about maintaining the exchange value of the currency. Prices should change in order to send signals to economic actors. Efforts to keep prices stable actually distort the price signals. So right from the start Irwin’s analysis is subject.
    On page 21 Irwin develops a formula to determine the effect of gold on prices. Then on page 25 he makes the observation:
    Quote:

    “For some reason, the world’s monetary gold stock was not being translated into world prices.”

    Irwin’s comment begs an answer, why. But rather than address the why, in the next sentence Irwin makes a leap of faith.
    Quote:

    The likely reason for this was the increased demand for gold by France and the sterilization of gold by France and the United States.

    This is astounding given that in the previous 20 pages he has repeatedly quoted from those giving reasons that France was not sterilizing gold holdings. Those of us familiar with Jude Wanniski’s writing would immediately ask, “What about Smoot-Hawley?”
    Then he repeats the question on page 28 in reference to a quote by Cassel:
    Quote:

    In other words, the question was why a deflationary shock suddenly appeared in mid-1929 and why it hit so powerfully – and unrelentingly – over the next three years.

    This question is answered completely by Dr. Tom Rustici in his book Lessons from the Great Depression, Smoot-Hawley.
    But in relation to the gold standard a much more important question is why was everything stable under a gold standard, but fell apart as countries began to consider leaving the gold standard.
    Irwin continues his analysis on page 29 by writing:
    Quote:

    The impact of the French and American monetary policies starting in 1928 can be assessed by calculating how much gold was sitting “inactive” in the vaults of the Federal Reserve and the Bank of France.

    This is an interesting observation given the huge excess reserves of cash sitting in Federal Reserve accounts today. Could it be that the reason is similar to why today any monetary expansion simply sends money to sit “inactive” in the vaults. The recent discussions we have had on leverage/deleverage and deflation/contraction issues shed great light on this issue.
    Then on page 30 he makes the observation:
    Quote:

    By this time, however, the gold standard had begun to disintegrate with Britain and a host of other countries allowing their currencies to depreciate in late 1931. The link between gold and prices was increasingly being severed.

    But, as Irwin notes, this severing of the link between gold and prices rested with Britain and the other countries of the commonwealth that relied on the soundness of the pound, not on the policies of the gold standard nations.
    Then on page 31 Irwin quotes Hume but it is actually out of context.
    Quote:

    In his 1752 essay “Of Money,” David Hume remarked: “If the coin be locked up in chests, it is the same thing with regard to prices, as if it were annihilated.” This analogy seems to apply to the American and French accumulation of gold during this period.

    What Irwin totally ignores is the role of money substitutes in the 1920s versus Hume’s observation about real money. The gold was stored in vaults because transactions were facilitated with francs and dollars, money substitutes. Had Hume lived in a time of money substitutes he would have obviously included them in his observation about money.
    Then on page 21 Irwin abruptly changes his characterization of US and French “sterilization” to US and French “hoarding”:
    Quote:

    In 1930, the United States and France increased the amount of gold that they were hoarding by 5 percentage points (11.4-6.4). This implies that prices in 1931 should fall 7.6 percent (5X1.5), while in fact they fell 15.5 percent.

    What this illustrates is that Irwin’s formula to determine what is “implied” does not work in the real world and he needs to change his methodology. Over and over calculations of price based on the price of gold after World War I simply do not work. Honest analysis would lead one to search for the reason why the two are disconnected after World War I but seem connected before. But no other alternative reason for the price declines is considered.
    My conclusion is that this paper and analysis is deeply flawed and incomplete and that it is accepted more because it satisfies the predominate academic view blaming the gold standard for the Great Depression than because it sheds any new light.

  27. Ricardo

    Barkley wrote:
    It is useful for you to note the special role of the pound sterling and that in effect the gold standard was really a kind of cover for a pound sterling standard.
    Barkley,
    You are absolutely correct but you are not describing a gold standard. You are describing a gold bullion or gold exchange standard as created in the Genoa Accord. Please reread what I have written. Eichengreen and others consistently get this wrong.

  28. Ricardo

    Jim Glass,
    If you hold that the UK returned to gold at the wrong parity in the 1920s then you have to explain how the UK could do the same thing after the Napoleonic Wars and not experience a Great Depression. The truth is it was not the exchange rate that caused the UK problems but their mismanagement of the country. Their taxes were too high and they supported excessive wages for unions while attempting to inflate them away. What they actually didi is “inflate” away their gold.

  29. Ricardo

    JDH wrote:
    If The equation relating the magnitudes P and R is 20 $/ounce = P $/potato x R potatoes/ounce, or 20 = 2 x 10. As long as the dollar price of gold is fixed at $20 an ounce, then P times R will have to equal 20.
    Professor,
    That is exactly my point. Your equation requires you to fix quantities at a point in time and then assume they never change while you ignore the dollar as a good. I don’t doubt your calculation but it is misleading. A change in the supply of potatoes and dollars will change the relationsip of potatoes to gold.
    This is easy to see with a change in potatoes. If the supply of potatoes declines 50% we will see potatoes exchange at $4/potato, but only 5 will exchange for a unit of gold. Because here we are assuming that the monetary system is properly managed P * R will still equal $20 and gold is at $20 per unit. This is how it should work and the increased price of potatoes brings greater profits to potato producers and will signal producers to grow more potatoes, or shift from growing another crop into growing potatoes, or importers will import potatoes.
    But if the quantity of potatoes remains the same but the dollar is mismanaged so that the quantity doubles each potato will now exchange for $4 but gold will still exchanges for 10 pototoes. Now P * R will equal $40 not $20. With the price of gold still set at $20 I will exchange one unit of gold for 10 potatoes then sell the 10 potatoes for $40. Then I will exchange the $40 for 2 units of gold, a classic arbitrage. I will receive a windfall profit and the monetary authority will lose units of gold because they mismanaged the supply of dollars.
    You are dealing with the relationship of the quantity and supply of all three goods not just two.
    Of course in the real world the QTM is not strict mathematically, these numbers would vary depending on when in the cycle the transactions happened and the shifting demand of consumers, but for simplicity this is the mechanism.

  30. Ricardo

    acerimusdux,
    Until you understand that money is not magical you will not understand monetary policy. More money does not create more wealth and less money does not cause wealth to decline of itself. If you understand that money is a unit of exchange and nothing else you will begin to connect the dots.
    Any change in the money supply either an increase or a decrease that is not justified by monetary demand will reduce the efficacy of money as a medium of exchange. But in a sense that begs the question, How do you know when to adjust the money supply due to monetary demand? This is the importance of gold and why centuries of evidence show that gold is the best indicator.
    In an economy goods exchange for goods. You do not eat money, live in money, nor wear money. You use money to exchange for goods. It that money value declines from the time you receive it in exchange for either your labor or your goods then you experience a windfall loss that has nothing to do with your production. It is all due to monetary error.
    So bottom line is yes, production is from the fiscal economy with the monetary economy simply being the vehicle to lubricate exchange.
    So burn your monetary amulets and talismans and pull down your monetary totem polls. Money is simply a tool and no amount of superstition from Keynesians or monetarists or even Austrians will make it anything else.

  31. JDH

    Ricardo: No, the price of gold will be exactly, not approximately, $20 an ounce as long as the government guarantees that the public can freely exchange dollars for gold at a rate of 20 to 1. Then P times R will be exactly, not approximately, equal to 20. When R goes up, P must go down.

    P is the aggregate price level. I call it the price of a potato just to help people see what is going on. P going down means aggregate deflation. My point is that an increase in R can, and in the experience of 1929-1933, did cause aggregate deflation.

    If the real value of gold R is stable, then a gold standard will result in a stable value for the aggregate price level P. But when the real value of gold R is unstable, as it was 1929-1933, then a gold standard will result in an unstable value for the aggregate price level P, as it did in 1929-1933.

  32. Ricardo

    Professor,
    Once again you make my point. Shifting from potatoes, something tangible, to an aggregate price level, you ignore dollars in your equation because you assume that talking aggregates, P and R are independent of money substitutes.
    My mechanism above explains why you cannot ignore dollars in your equation. This mechanism is exactly what forces gold flows on a gold standard system. Countries did not accumulate gold by force of their will. Gold flowed from those countries who mismanaged their monetary systems to those countries who did not. Contrary to modern revisionsit monetary history, on a gold standard the best indicator of how well a country is managing its money is the direction of the flow of gold.
    I never said that the dollar price of gold was approximately $20. I used exactly $20 in my example. But you made a subtle shift in definition. In your example R was not defined in dollars but in potatoes. Then, assuming a two dimensional world, you inferred a general price level in dollars. This is how you could make the statement, “If the real value of gold R is stable, then a gold standard will result in a stable value for the aggregate price level P.” But when you introduce the dollar into the equation the supply of dollars can not be assumed away.
    You discount the impact of money substitutes. You assume that gold is the only money in your aggregate. In the Fisher identity MV=PT the aggregate, M, equals all money not just gold. If you are on a 100% gold standard (an impossibility by the way) then you are right but if gold by definition exchanges for a fixed amount of dollars, when the quantity of money substitutes – dollars – increases P will increase. And not only will P increase but gold will flow out of the vaults.
    This is exactly the dynamic you describe in your paper as actually happening prior to countries abandoning gold, the general price level increases and gold flows out of those countries. It is exactly what we see in the UK through the 1920s prior to their default.
    Gold can be defined in dollars and the quantity of gold held constant but if the number of dollars increases then M will increase, and P will increase.
    It was monetary mismanagement that caused the UK to abandon gold in the 1930s and it was monetary mismanagement of money substitutes that caused the US to abandon gold in the 1970s blowing up Bretton Woods. And even when not on the gold standard, it was monetary mismanagement that caused the chronic inflation of the 1970s and it has been monetary mismanagement that has caused gold and oil to sky rocket in price since 2000.

  33. Ricardo

    Professor,
    Another issue with your paper. You wrote:
    Although the U.S and France managed to stay on the gold standard, the deflation they experienced was highly disruptive. One important source of support for this cleam is the observation that for most countries, the economic recovery began when the country went off gold and therby stopped the decline in domestic price level P.
    Here a bad definition of deflation creates a problem. Deflation is not when prices decrease but when the purchasing power of money increases. After a huge run up in prices as France experienced after WWI and as the US real estate market experienced in 2008, a decline in prices, what in recent times has been referred to as deleveraging, must happen to bring prices back to a level when consumers can afford the goods. This is not a bad thing but a good thing. It lays the foundation for recovery. But think logically. What happens if prices are too high for consumption but the government does not allow them to decline? This exactly what Hoover did.
    On the second part we have already been through that. The evidence is extremely weak for this assumption.

  34. Ricardo

    Professor,
    Let me say that I totally agree with your statement below.
    “One of the main lessons I draw from this episode is that it is a mistake to believe that a gold standard is an institutional arrangement that can by itself correct for an earlier lack of monetary and fiscal discipline.”
    But we do need to understand that by definition a gold standard is monetary discipline. If there is a lack of monetary discipline there is no gold standard.

  35. Ricardo

    JDH wrote:
    Irwin’s paper provides us with a good reminder of why an attempt to return to an international gold standard in 2013 would only be the beginning of our problems.
    One last statement. Returning to a gold standard would be the most significant thing we could do to restore free markets and honest trading. As I have demonstrated Irwin’s paper is flawed, but my statement about the gold standard is over and above Irwin’s paper.
    There was a reason that in the past, before they were outlawed in the US, gold clauses were contained in contracts. When traders enter into a contract the terms must be as clear and concrete as possible for the trade to be the most efficient and honest for both parties. In our regime of floating currencies traders never know what the value of their contract will be tomorrow much less 30 years into the future (recall the British Consols). With unstable currencies traders are forced to hedge their trades. This creates additional cost in transacting commerce by forcing the forecasting of possible currency debasement and the commitment of additional resources to a trade as insurance. It also makes traders hesitant to enter into long-term contracts.
    Money does not magically stimulate an economy as Keynesians and monetarists incantations imply. We know understand this intuitively even as little children, so it requires years of brainwashing to “teach” us to accept what we know is illogical. Those who oppose the gold standard always inject their magical thinking into their criticism, but the gold standard is not based on a magic formula. The gold standard is very simple and effective in removing most of the need of traders to hedge to prevent windfall losses.
    A gold clause in a contract was very simple. A trader can either take payment in a currency or in gold. If the currency becomes debased exchange in gold keeps the contract honest. These clauses were outlawed because sovereign countries knew that they were going to debase the currency to obtain windfall profits and such clauses would hinder this but additionally such clauses would expose their intransigence.
    Money is a medium of exchange; it is not magic. Money simply lubricates transactions. So for money to be as useful as possible in fulfilling this role, its purchasing power should be as stable as possible. For over 2,000 years traders have used gold to stablize the purchasing power of the medium of exchange. A return to the gold standard would not fix our immigration problem, or stop congress from abusing its power, but it would make our money as good as gold and that woudl be a good start on recovery.

  36. Ricardo

    JDH wrote:
    One important source of support for this cleam is the observation that for most countries, the economic recovery began when the country went off gold….
    Sorry, but I lay awake last night thinking about this canard and simply had to purge myself of the demon.
    First, if we are to make a claim of cause and effect the cause must always lead to the effect. If it does not we must discover why. Initially, when Barry Eichengreen made this claim it was offered as an undisputed truth, but others taking some of Eichengreen’s own data and correcting other demonstrated that total correlation between cause and effect did not exist. The professor supports this in his quote above – “most countries.” This should have turned economists toward a reinvestigation of the fallacy but it reinforced a desired myth and so, weak as it was, it was taken as proof.
    But, if we engage in a little critical thinking we discover a much more likely cause and effect.
    Consider you are part of an economic community where there is an interrelationship of loans and debts. This relationship is highly effective because a high degree of mutual trust between traders supports efficient trade.
    Now assume that in our community one trader over-extends. Capitalizing on the community of trust built in the community over centuries, he convinces the other members of the community to take on some of his debt to help him over a “rough spot.”
    Then comes the kick in the face. Our trader’s dark side emerges as he repudiates this debt he has convinced others to take on.
    This was the condition in 1931 when the UK defrauded those holding the pound sterling trusting the promise of gold convertibility. This was not just an off-had promise easily broken but a written pledge made before the whole world at the Genoa Convention.
    So, what will happen to the economic condition of our trader now turned swindler? Suddenly the he has a massive amount of unencumbered wealth that can be turned to other uses. By all appearances his breach of faith has led our swindler to recovery.
    But what of the traders that have been fleeced? Their capital seriously degraded assets being used as collateral are suddenly worthless. A few traders attempt to maintain the system of trust, but others determine their only way to survive is to “do unto others before they do unto them.” One after another traders default dumping their debt on those struggling to maintain a system of trust.
    One by one members of the community abandon their highly effective system of honor and trust for a system of betrayal and mistrust. Each trader becomes isolated scrambling to exist alone. And as with any pyramid scheme those entering early gain at the expense of those later in the process. The debts repudiated by the swindler have been forced down the chain and the Great Depression roars.
    This discovery of Barry Eichengreen is no magical road to recovery but simply the loot of the ill-gotten gains of the hustler.

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