“Gold Standard during the Great Depression”

December 28, 2016 Sankalp V

– a case study of the UK and the US

The US’ defense of gold standard parity during early 1930s has often been

considered amongst the major causes of the Great Depression, as pointed out by

Bemanke and James (1991). Selgin (2013) however, by defining the adherence to

the gold standard as a causation of the severity and persistence of the US Great

Depression as a far too simplistic view, points out how incredibly diverging

views can be on the extent to which adopting gold standard parities affected

economic policy in the US. Monetary policy in Britain has also regularly been

under the spotlight by economists according to Wood (1983). Hodson and

Mabbett (2009) underline that whilst the UK government prioritized “fiscal

prudence” prior to the global financial crisis, it now opts for “unconventional

monetary policies”. Considering how Arestis and Sawyer (2011) argue that,

alongside monetary policy pursued by Central Banks, fiscal deficits are necessary

to satisfy the level of aggregate demand, it is thus clear that the root of the

macroeconomic policy debate lies in the interconnection between fiscal and

monetary policy. Indeed, Wood (1983) argues that fiscal policy is used to affect

monetary policy and therefore the decision process of fiscal policy is pertinent to

that of monetary policy. This is precisely the reason why the existence of both

fiscal and monetary policy is essential and one type of policy alone has not been

successful in providing either Britain or the US with stable prices and low

unemployment – two of the major goals of economic policy – throughout all of

the twentieth century. Put simply, whilst empirical literature and the findings of

major economists like Allen (2012) and Crafts (2011) show how gold standard

adherence during the Great Depression did not allow room for aggregate

demand to rise and unemployment to drop in countries like the UK, it is actually

the historic contexts and scenarios which the UK and the US have undergone

throughout the various phases of the Great Depression which have ultimately

determined the extent to which macroeconomic policy has been successful in

providing the country in question with stable prices and low unemployment. For

instance, Hatton and Boyer (2005) point out how throughout the 1947-1973

period, Britain averaged a 2.1% unemployment rate, far lower than the 10.9%

between 1921 and 1938. So what does the historic context of twentieth century

Britain and the US – precisely during the Great Depression period – reveal about

the effectiveness of fiscal and monetary policy under gold standard parities in

terms of ensuring low unemployment and stable prices?

As discussed by Hills, Thomas and Dimsdale (2010), it is the absence of major

wars during the Victorian age which positively contributed in the stabilization of

Britain’s fiscal position. However, the macroeconomic policy adopted during the

Victorian age changed significantly following WWI. Crafts (2011) sheds further

light on this as he claims that the 1930s Great Depression, which dominated the

second half of the interwar period in Britain, radically varied macroeconomic

policy between the 1920s and the 1930s. In the immediate aftermath of the First

World War, as a result of the War itself, Britain had accumulated a sterlingdenominated

public debt which added up to 120% of GDP, as reported by Allen

(2012). Furthermore, as Hills, Thomas and Dimsdale (2010) point out, the

inflationary effects of the post-war economic boom were tackled by authorities

as they sharply tightened monetary and fiscal policies. Hills, Thomas and

Dimsdale (2010) detail that nominal short-term interest rates were raised

considerably, thus decreasing consumption – all of which whilst exports declined

due to lower aggregate world demand. Soon after – as claimed by Hills, Thomas

and Dimsdale (2010) – 1920s Britain suffered major deflation whilst interest

rates rose to record levels. With nominal rates touching 5% in the first half of the

1920s, as underlined by Hills, Thomas and Dimsdale (2010), the primary goal of

monetary policy in Britain was to restore, the gold standard at the pre-war parity

according to Allen (2012). A return to a fixed exchange rate did finally occur in

1925 at the pre-war parity of $4.86 as highlighted by Crafts (2011). Overall, it is

clear how monetary and fiscal policy both played active roles in controlling the

initial inflationary effects which were byproducts of WWI. As the Great

Depression hit Britain in 1930, Hills, Thomas and Dimsdale (2010) describe the

1930-1931 period as a year when short-term interest rates were not allowed to

drop as monetary policy was fully committed to the pre-war gold standard parity

of $4.86. They argue that the aforementioned strict commitment to the gold

standard drove nominal interests up in 1931. It was at this point, in September

1931, that a floating exchange rate was adopted in order to fight high

unemployment and increase aggregate demand by securing a recovery in prices,

as argued by Allen (2012). Crafts (2011) further argues this point as he claims

that a high unemployment rate during the 1930s was biting into tax revenues,

thus making Britain’s budgetary position quite precarious: falling prices were

harming the country’s fiscal position. Additionally, as Crafts (2011) mentions, the

fiscal burden on Britain was worsened by the £2 billion 5% War Loan which the

government had to pay back between 1929 and 1947. To tackle this situation,

Crafts (2011) points out that fiscal policy during the early 1930s involved tax

increases and expenditure cuts – mainly on unemployment benefits. As one can

therefore see, fiscal policy did play a small role in reducing unemployment

during the interwar period in Britain. Indeed, reductions in unemployment

benefits provided the unemployed with incentives to find jobs whilst

government spending on rearmament – in preparation for WWII – mildly

contributed to fight the 1938 recession, according to Hills, Thomas and Dimsdale

(2010). Crafts (2011) on the other hand is of the idea that government spending

on rearmament represented a “significant fiscal stimulus”, approximately 3% of

GDP. This divergence in view between Crafts (2011) and Hills, Thomas and

Dimsdale (2010) is significant as it underlines that – despite Middleton (2010),

Crafts (2011) and Hills, Thomas and Dimsdale (2010) agreeing on British fiscal

policy being contractionary during the 1930s – the effectiveness of fiscal policy

to fight unemployment during the Great Depression is still debatable today.

Unlike in the case of fiscal policy, economists generally agree on the fact that

interwar monetary policy in Britain had a significant impact on reducing

unemployment and guaranteeing the country low and stable inflation. Indeed,

having abandoned the gold standard in 1925, Middleton (2010) argues that

deflationary fiscal measures were introduced partially as a means to maintain

confidence in the British economy as individuals feared that a drastic fall in the

price of sterling could result in imported inflation. Once this issue was overcome,

Allen (2012) believes that monetary policy was eased to fight high 1930s

unemployment whilst Crafts (2011) is of the idea this monetary measure was

useful in counteracting “contractionary effects of fiscal consolidation”. As such, in

1932, the “cheap money” policy mentioned by Crafts (2011) was adopted which

resulted in drops in short and long-term interest rates, ultimately allowing for a

low stable inflation rate to kick in as price fluctuations typical of early 1930s no

longer represented the norm. Overall, whilst adhering to the gold standard was

used as a means to fight post-WWI inflationary pressures, it constrained the UK

in its ability to control nominal interest rates and allow aggregate demand to rise

and unemployment to drop. The extent to which economic policy was effective

however, is still subject of debate today as it is affected by how one interprets the

historic context of the UK.

As explained by Fishback (2010), economists generally agree that the Federal

Reserve committed key mistakes whilst steering monetary policy during the

Great Depression years. Whilst the UK tightened monetary and fiscal policies by

adopting the gold standard in 1925 in the intent to fight post-WWI inflationary

pressures, the US’ monetary contraction prior to 1933 was not a result of being

constrained by the gold standard, as underlined by Selgin (2013). Indeed, Selgin

(2013) argues that refraining from adopting expansionary policies was a result

of fear that expansion would provoke speculation attacks on the dollar causing

its devaluation, mainly because the newly elected US president was unwilling to

unequivocally commit to maintaining the gold standard – thus causing

individuals to believe that the Fed might run out of gold reserves. Hence, on

March 6, 1933, the US abandoned the gold standard as pointed out by Selgin

(2013). Hsieh and Romer (2006) confirm this theory as they claim that recent

scholarship has shown how US’ determination to remain on a system of fixed

exchange rates immobilized it in its ability to control economic policy as it could

not act to stem panics or stimulate production because expansionary policy

could result in devaluation. Thus, the tension between what Fishback (2010) and

Hsieh and Romer (2006) – who claim that the great depression in the gold

standard view was not the result of gross policy mistakes – clearly sheds light on

how it remains still unclear the extent to which adhering to the gold standard

prevented aggregate demand from growing and unemployment from falling. The

particular which adds credibility to the theory that aggressive Federal Reserve

action could cause dollar devaluation stems from Hsieh and Romer’s (2006)

paper. They claim that by 1929, the US could potentially “afford” to make

substantial gold losses in open market operations as a result of the incredibly

large amounts of gold reserves which it owned without threatening the US’

adherence to the gold standard. Hence, the only way the Federal Reserve could

jeopardize the fixed exchange rate system was through expectations: aggressive

monetary expansion may have lead individuals to doubt the US’ commitment

level to the gold standard. Hence, to some degree the Fed did have its hand tied

as described by Fishback (2010). Following the abandonment of the gold

standard in 1933, Fishback (2010) clearly explains how the Fed was freer to

control money supply as a means to affect domestic economic policy. During the

gold standard period, the US economic policy mainly relied on fiscal stimulus

programs as explained by Fishback (2010). Indeed, both the Hoover and

Roosevelt administrations ran small deficits as they increased government

spending. However, tax revenues also increased during both administrations as

Fishback (2010) underlines. Hoover for instance doubled federal highway

spending and increased the spending by Army Corps of Engineers on rivers,

harbours and flood control by over 40%. Nominal federal expenditures, which

contributed in boosting aggregated demand and lowering unemployment, rose

by 52% from $3.1 billion in 1929 to $4.7 billion in 1932. A similar upward trend

in annual nominal government spending occurred during the 1934-1935 period

under Roosevelt. Hence, clearly the gold standard impacted the ability of

monetary policy to control inflation but not of fiscal policy, whose upward trend

remained unchanged throughout the Hoover and Roosevelt administrations.

However, like in the UK, fiscal policy failed to lower unemployment significantly

according to the Keynesian model as pointed out by Fishback (2010).

Overall, all findings indicate that a country’s historical context is the ultimate

determinant which impacts the effectiveness of each macroeconomic policy.

Indeed, during the interwar period, by adopting a floating exchange rate,

monetary policy in Britain played a key role in affecting both unemployment and

inflation, far more than fiscal policy did. Indeed, throughout this period,

monetary policy was eased to fight the 1930s Great Depression high

unemployment, as discussed by Allen (2012). Moreover, the introduction of the

“cheap money” policy mentioned by Crafts (2011) was key to offset the

“contractionary effects of fiscal consolidation”, consequently lowering short and

long term interest rates and accommodating a low stable rate of inflation. Fiscal

policy during the 1919-1938 period mildly reduced unemployment through cuts

in unemployment benefits and government spending in rearmament.

Contrastingly, the Fed was indeed restricted in using monetary policy to help the

country overcome the Great Depression due to the adherence to the gold

standard whilst fiscal policy played a key role as small continuous fiscal deficits

were run in the US throughout the Great Depression.


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