The Gold Standard, deflation and financial crisis in the great depression:an international comparison By: Ben Bernanke & Harold James
ABSTRACT • “Theory suggests that falling prices, by reducing the net worth of banks and borrowers, can affect flows of credit and thus real activity…we confirm that countries which were more vulnerable to severe banking panics also suffered much worse depressions, as did countries which remained on the gold standard.”
Introduction • Temin (1989): structural flaws of the interwar gold standard, in conjunction with policy responses dictated by the gold standard’s “rules of the game”, made an international monetary contraction and deflation almost inevitable. • Hamilton (1987-88): “the defense of gold standard parities added to the deflationary pressure.” • Deflation may have induced depression through real wage and interest rate effects, or the disruptive effect of deflation on the financial system(this being the paper’s primary focus). • Fisher (1933): “Debt-Deflation” was an important cause of banking panics which occurred in a number of countries in the early 1930’s
The Gold Standard and Deflation • Mismanaged Interwar gold standard was responsible for the worldwide deflation of the late 1920’s and early 1930’s. • Gold Standard : Suspended at the outbreak of WWI. • Not itself unusual. • Bordo& Kydland (1990): Should be considered part of its normal operation. • Create reputation to return at pre-war parity. • End up returning somewhere near that parity. • Would have made it easier for Gov’t to sell nominal bonds and effectively allow the war to be financed at a lower total cost.
The Gold Standard and Deflation • Thus, desire to return to gold standard in early 1920’s was strong. • However there was the perception that there was not enough gold available to satisfy world money demands without deflation.
The Gold Standard and Deflation • Interwar Standard Est. 1925-28 and had substantially broken down by 1931 and disappeared by 1936. • Temin (1989): “the war itself was the shock that initiated the Depression…reparations claims and international war debts generated fiscal burdens and fiscal uncertainty • Ineffective cooperation amoung C.B. > no one to take responsibility for system as a whole.
The Gold Standard and Deflation • Asymmetry between surplus and deficit countries in the required monetary response to gold flows. • “Rules of the Game” • In contrast, no sanction prevented surplus countries from sterilizing gold inflows and accumulating reserves indefinitely. France and U.S. at one point held 60% of world’s gold. • Thus, a potential deflationary bias in gold standard’s operation.
The Gold Standard and Deflation • Pyramiding of reserves: convertible reserves usually only partially backed by gold. • A shift by the public from fractionally backed deposits to currency would lower the total domestic money supply. • A shift of C.B. from foreign exchange reserves to gold might lower the world money supply. • Adds another deflationary bias to the system. • Central banks in early 1930’s did abandon foreign exhange in masse when threat of devaluation made F.E. assests too risky.
The Gold Standard and Deflation • Insufficient powers of Central Banks • Interwar Gold Standard> in European C.B.’s, open mkt. operations were not permitted or were severely restricted. • Also as result of stabilization policies of early and mid 1920’s • Architects of which were primarily hoping to prevent future inflation • Implies that C.B.’s control over money supply quite weak except in period of crisis
The Gold Standard and Deflation • France and U.S. had surplus gold inflows both end up deflating. • France: economic growth led the demand for francs to expand even more quickly than the sterilized inflow of reserves. Experiences price deflation of almost 11% from Jan. 1929- Jan. 1930. • U.S. experiences monetary tightening in 1928 to slow stock market speculation. Price level falls 4%. B.C. peak reached in August ‘29, stock mkt. crashes Oct. ‘29
The Gold Standard and Deflation • Temin: “once these destabilizing policy measures had been taken, little could be done to avert deflation and depression, given the commitment of C.B.’s to maintenance of the gold standard. • C.B.’s engaged in competitive deflation and a scramble for gold, hoping to protect their currencies against speculative attack. • Attempts by any individual C.B. to reflate were met by immediate gold outflows, forcing that C.B. to raise its discount rate and deflate once again. • Monetary contraction began in U.S. and France and was propagated throughout the world by the international monetary standard.
The Gold Standard and Deflation • Spain: never restored gold standard and allowed exchange rate to float. • Avoided the declines in prices and output that effected other European countries. • Haberler (1976):Scandinavian countries along with the U.K. leave gold in 1931 and recover much more quickly than other European countries that remained on gold standard. • Countries who’s currencies depreciated enjoyed faster growth of exports and production than countries that did not depreciate.
The Gold Standard and Deflation • After 1931, sharp divergence between countries on and off the gold standard. • Price levels in countries off gold stabilized by 1933 • Gold standard countries continued to deflate, although slower than initially, until 1936 with the dissolution of the gold standard.
Link Between Deflation and Depression • Worldwide deflation was the result of a monetary contraction transmitted through the international gold standard. • Real wages: • lowered profitability, reduced investment • Real i rates: • Monetary contraction depresses output, shifts LM curve left, raising real i rates, reducing spending. • Financial Crisis: • Deflation weakens financial positions of borrowers, both nonfinancial firms and financial intermediaries.
Debt-Deflation • “Debt-deflation”: the increase in the real value of nominal debt obligations brought about by falling prices, real value of assets down, erodes the net worth position of borrowers. • “Financial distress” (such as induced by debt-deflation) can in principle impose deadweight losses on an economy • Leads to Interwar period being marked by financial crises.
Conclusion “Monetary and financial arrangements in the interwar period were badly flawed and were a major source of the fall in real output. Banking panics were one mechanism through which deflation had its effects on real output, and panics in the U.S. may have contributed to the severity of the world deflation.”