Did the Gold Standard Cause the Great Depression?

Did the Gold Standard Cause the Great Depression?
April 4, 2012

(This item originally appeared at Forbes.com on April 1, 2012.)


Whenever I talk about the gold standard, usually there is someone who stands up and says “what about the Great Depression?” — like that is some kind of remark that trumps all possible replies.

Well, what about it?

The Great Depression was, undoubtedly, the time period when the conventional wisdom migrated from a Classical viewpoint, emphasizing money that is stable in value, to a Mercantilist viewpoint, emphasizing money that can be manipulated to cause short-term economic effects.

The main economic problem that they wanted to deal with was unemployment. So, they looked for a way to deal with unemployment via currency manipulation. Seems kind of silly when you put it in those terms, doesn’t it?

I think it is important to recognize that this was something of a political tide. Governments around the world had already fully embraced currency devaluation by the time that Keynes’ book The General Theory of Employment, Interest and Money came out in 1936. The title alone tells you where Keynes intends to get his employment from, which is good because the book itself is basically unreadable.

Actually, governments had already gotten rather tired of the “beggar thy neighbor” devaluation game by 1934, and refrained from any more developments there. The U.S. maintained the value of the dollar at $35/oz. of gold from 1934 to 1971.

People at the time, for the most part, didn’t have the idea that the gold standard system caused the Great Depression. They just wanted to be able to devalue their currencies, and the gold standard system prevented that.

The notion that the gold standard (or anyway, the monetary conditions of the time) was a cause of the Great Depression really came about in the 1960s. I see it mostly as a swipe at the Federal Reserve. The Federal Reserve has been unpopular among libertarian types since it was founded in 1913. So, if you don’t like Federal Reserve, then blame the Great Depression on it. I’m not sure there’s that much more to it than that.

The Fed actually did its job of serving as a “lender of last resort,” as the phrase was understood at the time. This is evidenced by the low and stable short-term interbank lending rates throughout the time period. This is exactly what the Fed was created to do, and it did it.

I looked at the 1914-1930 period in considerable detail in the past, and found nothing of any great importance. Currencies were pegged to gold. Thus, the only way for a gold standard to have caused an event of this sort would have been for gold’s value to change suddenly and by a very large degree – something which is historically unprecedented – and for this change to go unnoticed by people at the time.

And what supposedly caused this dramatic change in value? Some people have tried to blame France, which I find rather laughable if you look at the historical data. France didn’t do anything of any great importance. (One thing I’ve noticed is that almost nobody actually looks at the data, although it is available free online at the St. Louis Fed’s FRASER database.)

We know a few things about the Great Depression. We know that there was a dramatic, worldwide trade war, in retaliation for the U.S.’s Smoot-Hawley Tariff, which raised tariffs on over 20,000 products. Smoot-Hawley put a tariff of 60% on 3,200 items, many of which were not even manufactured in the U.S. This alone was enough to cause a worldwide recession.
As governments’ tax revenue faltered in the initial recession, and demands for welfare services and public works spending increased, very large domestic tax increases were implemented around the world according to the conservative conventional wisdom of the time, especially in Britain, Germany and the U.S. (France and especially Japan were much less aggressive here).

In the U.S., the big tax hike took place in 1932. The top income tax rate rose from 25% to 63%, and an explosion of excise taxes (in effect a national sales tax) were imposed. In Britain and Germany, this took place in 1930-33. Does this sound like today’s “austerity,” as Europe is experiencing, but multiplied several times? Just like today, it didn’t work then either.

In the midst of this, with unemployment exploding higher (much as it has exploded higher in Greece and Spain in response to “austerity” recently), governments began to devalue their currencies as a last-resort option. This happened as something of an accident in Germany in 1931, in the midst of a bank panic. Britain followed with an intentional devaluation in September 1931, and Japan in December 1931. The U.S. followed in 1933, and France in 1936.

The effect of these devaluations was just as you might imagine. Industry became more “competitive,” and debts became easier to repay because they could be paid in a devalued currency. The economies of the devaluers seemed to improve a little bit, and unemployment declined.

What about those countries that didn’t devalue, like the U.S. and France? They were worse off, because of the artificial “competitive advantage” enjoyed by the devaluers. Now their own industries were rendered artificially “uncompetitive,” while they were flooded by cheap imports. Thus it was called “beggar thy neighbor,” because whatever advantage gained was at the cost of economic deterioration in the non-devaluing countries.

Actually, the devaluers weren’t all that well off, because of course the “competitive advantage” ultimately came about because wages had been devalued, and bondholders suffered what amounted to a partial default. You can’t devalue yourself to prosperity, then or now, which is why this devaluation game was soon abandoned. All this currency devaluation introduced a new layer of financial chaos and uncertainly to an already rather grim picture. Having learned to their satisfaction just how much (and how little) you can really accomplish just by jiggering the unit of account, the world soon settled back into the gold standard system, which was formalized in 1944 as the Bretton Woods Agreement.

For the rest of the decade, governments mostly went back and forth between “stimulus” (wasting a lot of government money and running big deficits) and “austerity” (raising taxes), with much the same results as Europe or Japan today, with the same strategy.

And that, in short, was the Great Depression. What did it have to do with the gold standard system? The purpose of a gold standard system, then as now, was to produce a currency of stable value. I think it did this properly, just as it has done so for centuries.

Governments touched off a recession due to their tariff wars. Then, they made the problem worse with “austerity” and “stimulus” (deficit spending and tax hikes). Then, they made the problem even worse with currency chaos, although this did seem to help in the short term.

Of course it did. That’s why governments have been playing around with currency devaluation for over two thousand years. Do you think it is because it is politically unpleasant?

I say the proper response to the Great Depression was not currency devaluation. It was to deal with the problems directly. Undo the tariff wars, as Roosevelt’s Secretary of State Cordell Hull attempted valiantly. Don’t raise taxes – that only makes things worse. Spend on welfare programs to alleviate the distress, but don’t spend boatloads of taxpayer money in hopes of some “multiplier effect” that never seems to pan out.

You could even cut taxes, or better yet have a comprehensive tax reform like the flat tax plan that Russia implemented, in the depths of disaster in 2000.
The recession of 1921 is often cited as an example of what can happen if you “do nothing,” and let the economy recover. The downturn was almost as intense as the initial stages of the Great Depression, but the recovery was quick and the rest of the 1920s were boom years, especially in the U.S.

But the U.S. government didn’t “do nothing” in 1921. Republican Warren Harding won the presidential election in 1920, replacing Democrat Woodrow Wilson. Harding promised to reduce income tax rates dramatically, and he did. The top income tax rate fell from 73% in 1920 to 46% in 1924, and additional corporate taxes were reduced. Calvin Coolidge promised to reduce income tax rates still further in the 1924 election, with the top rate falling to 25%. He won, and delivered on his promise immediately afterwards.

Supposedly the Keynesians are great students of the Great Depression. What are they doing today? In Europe, it is “stimulus” and bloated government spending, “austerity” and higher taxes, and, following the predictable failure of this approach, various calls for individual countries like Greece or Spain to withdraw from the euro and devalue. This is exactly what governments did during the Great Depression, and it is having similar results today. Nobody learns nothing.