The gold standard and the great depression.

• Author: Eichengreen, Barry J.
• Position: The economic depression of the 1930s

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...