The Cause of the Great Depression: The Decision to Resume the Gold Standard on Prewar Terms.

• Author: Mazumder, Sandeep

Economists disagree about the cause(s) of the Great Depression, but most studies attribute it to the unfortunate coincidence of a variety of shocks (e.g., Schumpeter 1939, 161-74; R. A. Gordon 1952, 405-7; Estey 1956,113-20; R. J. Gordon and Wilcox 1981; Hall and Ferguson 1998; Meltzer 2003,390). Paul Samuelson maintains that "the origins of the Depression lie in a series of historical accidents." (1) The Great Depression was also special. Robert Lucas observes that the "Great Depression dealt a serious blow to the idea of the business cycle as a repeated occurrence of the 'same' event, and ... continues, in some respects, to defy explanation by existing economic analysis" (1980, 706). "Our attention," Lucas says, "is drawn to the evidence Friedman and Schwartz and others have assembled associating monetary contractions with depressions in real activity, not because this evidence documents an independent 'causal' role for money, but because these real movements appear to be too large to be induced" by the shocks observed and "propagation mechanisms" assumed (1987, 71). Furthermore, the initial demand-shock explanations of the Depression are weak. Consumption as a proportion of gross national product actually rose throughout the period, and the initial decline in investment was less than at the beginnings of other downturns (Friedman 1957, 117; Temin 1976, 4, 63). The changes in consumption and investment seem more effects than causes; that is, postwar weaknesses seem effects of the misalignments of governments' exchange-rate choices.

"Because of [the Great Depression's] exceptional character," Michel DeVroey and Luca Pensieroso write, "an explanation of the Great Depression was" considered "beyond the grasp of the equilibrium approach to the business cycle" (2006,1) and is comparable, according to Ben Bemanke, to the search for the Holy Grail (2000,11). "I do not have a theory," Thomas Sargent told an interviewer, "nor do I know anybody else's theory that constitutes a satisfactory explanation of the Great Depression" (in Klamer 1984, 69).

Resumption of the gold standard as the primary cause of the Great Depression was suggested by some European economists at the time (see Cassel 1922, 1932; Rist 1940), but this explanation soon took a back seat (amounting to virtually complete suppression, particularly in the textbooks (2)) to Keynesian (exogenous demand) and monetarist (exogenous money) explanations. This paper argues that the Great Depression was indeed special but that it is also susceptible to a straightforward explanation: the post-World War I decision to resume the gold standard on prewar terms.

The Swedish economist Gustav Cassel was on the mark when he wrote, "The present crisis must be treated as a new phenomenon and cannot be explained as a particular phase of a cyclical movement of business assumed to be inherent in the capitalist system. The War and the collapse of the whole monetary system of the world represent disturbances of the first order in the average uniformity of normal economic development" (1932, vii).

He was writing of the attempted restoration of the pre -1914 gold standard after its suspension during World War I (1914-18). This suggests that a complete explanation of the Great Depression must date at least from 1914 and include the resumptions and deflations of the 1920s. (3) "The Great Depression is typically thought to have started in August 1929, when industrial production in the United States began to fall, or in October, the month of the Wall Street crash," Barry Eichengreen writes. "But well before that summer, economic activity was already in decline over significant parts of the globe"--for example, Australia and the Netherlands East Indies at the end of 1927, Germany and Brazil in 1928, and Argentina, Canada, and Poland in the first half of 1929 (1992, 222). He could have added much of the rest of Europe and Latin America, in particular those countries that resumed conversion of their currencies to gold at their prewar levels in the mid-1920s. Prices in the United States had declined from mid-1925.

Eichengreen's book Golden Fetters (1992) suggests that the gold standard exacerbated the Great Depression by its constraints on policies. Central banks hesitated to expand money in a world of deflation and overvalued exchange rates for fear of depleting their gold reserves. Peter Temin also argues "that unsuitable macroeconomic policies caused the Depression. In particular, adherence to the gold standard mandated deflation in circumstances where it was the worst of all policies" (1989, 89). (For supporting arguments, see also Mundell 1993; Johnson 1997; Irwin 2012; and Sumner 2015.)

The present paper extends this work by suggesting that the attempted resumptions of the gold standard on prewar terms after the massive wartime inflation brought deflation that lasted until prices resumed prewar levels or currencies were devalued or the gold standard was suspended. So the gold standard operated as should have been expected. Resumption of convertibility of currencies to gold at prewar values might be a complete explanation like the other war-and-peace, suspension-and-resumption experiences depicted in figure 1, which illustrates those episodes associated with (1) the French wars (for Great Britain) and the War of 1812 (for the United States), (2) the American Civil War, and (3) World War I for Great Britain and the United States (although the United States did not suspend in this case). The lower dotted lines indicate gold production (Mazumder and Wood 2013).

Countercyclical policies were ineffective as long as the resumption of prewar exchange rates remained a goal. As Cassel wrote in the early 1920s, (4)

If the War and all it brought in its train turned the world's monetary system upside down, that is no reason for trying to restore the monetary conditions prevailing before the War. They have nothing of an essential character in them. The essential factor was the high degree of stability attained at that time, and it is this stability we should now endeavor to restore. This is ... the only practicable and wise object we can for the present set before us in our exchange policy, [specifically] as soon as possible and with the least possible friction, restore stability not only in internal values of the various currencies, but also in their international exchange rates. The level at which the value of money is then fixed is, relatively speaking, a matter of secondary importance. As was predicted, the process of deflation has proved extremely harmful ... particularly [as] the burden of the public debts becomes heavier than the community can bear. (1922, 254-57) In 1925, John Maynard Keynes warned of the consequences of the British government's decision to resume the pound's gold convertibility at the prewar rate of $4.86 after it had floated below $4 before the Bank of England began its tight-money policy in 1923, even though the United Kingdom had experienced greater wartime inflation than the United States (table 1). Keynes wrote,

These arguments are not ... against the gold standard as such.... They are arguments against having restored gold in conditions which required a substantial readjustment of all our money values. If Mr. Churchill [the chancellor of the Exchequer] had restored gold by fixing the parity lower than the pre-war figure, or if he had waited until our money values were adjusted to the pre-war parity, then these particular arguments would have no force. But in doing what he did ..., he was just asking for trouble. For he was committing himself to force down money wages and all money values, without any idea how it was to be done. ([1925] 1932, 212) An understanding of the Cassel-Keynes criticisms and the course of events require an appreciation of the workings of the classical gold standard as set forth in the next section, which is followed by a section discussing how that standard, shocked by the wartime inflations/suspensions and postwar resumptions, imposed significant deflations and falls in output. Our method is a union of previous research, including their correspondences between resumptions, deflations, regime changes, expectations, and falls in output.

The Gold Standard

Our method is a straightforward application of the prewar gold standard, whose specifications begin with units of account defined in terms of quantities of gold. For example, the Gold Standard Act of 1900 declared that the U.S. "dollar consisting of 0.048375 ounces of gold ... shall be the standard unit of value, and all forms of money issued or coined by the United States shall be maintained at a parity of value with this standard, and it shall be the duty of the Secretary of the Treasury to maintain such parity" (preamble). The Coinage Act of 1870 defined the British pound as 0.23542 ounces of gold, so in markets with free exchange between gold and currencies, 1[pounds sterling] equaled 0.23542/0.048375, or $4.866. (5)

Nassau Senior explained that the

value of money ... does not depend permanently on the quantity of it possessed by a given community, or on the rapidity of its circulation, or on the prevalence of exchanges, or on the use of barter or credit, or, in short, on any cause whatever, excepting the cost of its production.... As long as precisely 17 grains of gold can be obtained by a day's labour, every thing else produced by equal labour will, in the absence of any natural or artificial monopoly, sell for 17 grains of gold; whether all the money of the country change hands every day, or once in four days, ... whether such exchanges are effected by barter or credit, or by the actual intervention of money...