World War I, Gold, and the Great Depression

Nice post by Hu Mcculloch. He revisits the Great Depression and says it was Gold Standard which was primarily responsible for the deep crisis we had back then.

My own view, after pondering the problem for many decades, is that indeed the Depression was monetary in origin, but that the ultimate blame lies not with U.S. domestic monetary and financial policy during the 1920s and 30s. Rather, the massive deflation was an inevitable consequence of Europe’s departure from the gold standard during World War I —  and its bungled and abrupt attempt to return to gold in the late 1920s.

In brief, the departure of the European belligerents from gold in 1914 massively reduced the global demand for gold, leading to the inflation of prices in terms of gold — and, therefore, in terms of currencies like the U.S. dollar which were convertible to gold at a fixed parity. After the war, Europe initially postponed its return to gold, leading to a plateau of high prices during the 1920s that came to be perceived as the new normal. In the late 1920s, there was a scramble to return to the pre-war gold standard, with the inevitable consequence that commodity prices — in terms of gold, and therefore in terms of the dollar — had to return to something approaching their 1914 level.

The deflation was thus inevitable, but was made much more harmful by its postponement and then abruptness. In retrospect, the UK could have returned to its pre-war parity with far less pain by emulating the U.S. post-Civil War policy of freezing the monetary base until the price level gradually fell to its pre-war level. France should not have over-devalued the franc, and then should have monetized its gold influx rather than acting as a global gold sink. Gold reserve ratios were unnecessarily high, especially in France.

And as there was no Gold Standard during 2008 crisis, the policies should not have reacted asif we are about to face another Great Depression:

This leads to the question of whether the 2008 financial crisis would likely have spiraled into another Great Depression in the absence of the extraordinary monetary, fiscal, and financial measures that were taken. The unequivocal answer is No. In 2008, the U.S. was not on a gold standard, and the world had not just gone through the unique historical experience of World War I, so that there was absolutely no reason to expect a reprise of the Great Depression.

For several years before the 2008 crisis, the financial sector, led by the Government Sponsored Enterprises, Fannie Mae and Freddie Mac, had indulged in reckless mortgage underwriting standards, with the result that by 2008 several large firms were economically bankrupt. The simple solution would have been to wipe out the equity of the responsible firms — including Fannie, Freddie, and a few large financial holding companies — and then mark down the debt held by the creditors who carelessly enabled this lending. The flagship commercial banks whose shares were held by these financial holding companies might have had new owners, but their own operations and capital would not have been interrupted, so long as the “firewalls” promised by the 1999 Gramm-Leach-Bliley Act were actually in place. Wall Street would have been sadder, but wiser, and life would have gone on.

The panicky monetary, fiscal, and financial measures that were actually taken in response to the 2008 financial crisis therefore cannot be justified by the experience of the Great Depression.

How these debates continue to be as fascinating as ever….

One Response to “World War I, Gold, and the Great Depression”

  1. Anantha Nageswaran Says:

    Good point Hu Mcculluch makes. Thank you for highlighting that.

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