Friday, November 9, 2018

Lessons from the Great Depression: What Really Started the Great Depression? (Part 2 of 3)

Click here to read the original Cautious Optimism Facebook post with comments

10 MIN READ - The Cautious Optimism Correspondent for Economic Affairs and Other Egghead Stuff continues with his analysis of what really started the Great Depression. Or what he modestly refers to as "the most important chapter in the world history of money."

In Part 1 we outlined the rules governing the international classical gold standard up to 1914 and foreshadowed the means by which bad monetary policy led to its demise while setting the stage for the beginning of the Great Depression. We continue now with the end of the classical gold standard and the sham paperized “gold-exchange” standard that replaced it in the 1920’s.


The outbreak of World War I ended the idyllic global classical gold standard arrangement. As with all large-scale wars, the belligerent governments went off the gold standard and freed their central banks to inflate aggressively as a means to finance war expenditures without the level of taxation that would otherwise be required. The only participant country that remained on gold was the United States, in part because it entered the war later. But even the U.S. government imposed a ban on international gold exports, so for all practical purposes the U.S. was on an exclusively domestic gold standard.

As the war dragged on, European governments inflated profusely and the value of their currencies plummeted. By the time of the Treaty of Versailles so much unbacked paper money had been manufactured that the British pound had lost 35% of its prewar value. But that loss was nothing compared to the French franc (-64%), Belgian franc (-62%), Italian lira (-71%), and German mark which had depreciated by 96% even before the Weimar hyperinflation.

Given the enormous increase in paper money and demand deposit balances in Europe, it was practically impossible for most nations to return to the gold standard at their prewar pars for that would require a sharp deflationary contraction of prices. Also many had gone heavily into debt to the United States (Great Britain being a major debtor) and to Great Britain (most European allies) meaning that there would be large gold drains to come. Soon-to-be depleted gold reserves could simply not support the inflated money supply if each unit of money was to serve as a claim on the prewar gold weight.

So European countries took the only option available to them: they returned their currencies to gold but at a sharply lower unit weight definition (ie. devaluation). Permanent devaluation was the formal nail in the coffin that consummated the inflationary tax imposed on European citizens to pay for the Great War, but there was really no other option other than going off gold completely.

The two exceptions were Great Britain and of course the United States (we’ll overlook Canada from the discussion as it was a unique case). The United States, despite inflating heavily itself to finance wartime expenditures, still had sufficient gold reserves to redeem at 1/20th of an ounce to the dollar throughout. Great Britain was a more complex problem and chose an ill-advised workaround solution that would sow the seeds for what would become the Great Depression.


Great Britain was determined to return the pound sterling to gold at the prewar par in an attempt to recapture her status as the world’s financial center from New York. But given such an inflated money supply she faced a difficult choice. Her two options were:

-Maintain the current money supply by returning to gold at a devalued par, but blemish the pound’s international reputation.

-Return to gold at the more prestigious prewar par and accept painful deflation back to the prewar money supply.

Devaluation would certainly compromise Britain’s attempts to leapfrog New York as the world’s financial capital and was quickly ruled out. But could she return to gold at the prewar par and endure the accompanying deflation and likely recession?

Yes. After the Napoleonic Wars Great Britain returned to gold at the 1797 par and the result was a contraction of the money supply as commercial banks and the Bank of England were forced to contract credit to realign paper claims with actual gold reserves. The contraction produced a painful recession followed by a long period of stable expansion. The United States had taken the same medicine after the War of 1812, the Civil War, and even the deflationary Depression of 1920-21.

But the British political landscape was notably changed by the 1920’s. Trade unions, emboldened by Labour policies, resisted falling wages even if the overall price level fell accordingly and resulted in no real change. National unemployment insurance now empowered workers to ride out prolonged joblessness and thus refuse to accept jobs with lower nominal but unchanged real wages.

And a new generation of economists berated the evils of deflation and espoused the virtues of inflation—among them Ralph Hawtrey and John Maynard Keynes—both products of Cambridge (ironically neither Hawtrey nor Keynes ever earned an economics degree). In the eyes of British policymakers a solution had to be found that allowed Britain to return to gold at the old $4.86 par, but without accepting the politically problematic deflation.

It was Hawtrey and Keynes who would devise, foster, and successfully effectuate the solution.

First, Britain would return not to the traditional gold-coin standard, whereby holders of banknotes and demand deposits could redeem their pounds in small denomination coins. Rather, the British government would mandate that all gold be centralized at the Bank of England, melted down into large gold bars of at least 400 ounces weight, and that gold redemptions must convert to a minimum amount of one bar of gold bullion. Hence, the gold-coin standard, the product of the previously more laissez-faire system, was replaced with a gold-bullion standard.

The desired effect of the gold-bullion standard was clear: The overwhelming bulk of British citizens were simply not wealthy enough to afford gold redemptions of that size. 400 ounces was the equivalent of 1,549 pounds in the 1920’s, an astronomical sum at the time. To put it into perspective, today a 400 ounce bar of gold bullion is worth approximately $500,000 in U.S. currency. Thus the number of American citizens who have the spare cash lying around to convert a minimum of $500,000 to gold is completely negligible from a policy standpoint—which was the whole objective of adopting bullion over coin: to disqualify the bulk of the populous from ever redeeming.

Therefore under gold bullion, the Bank of England would not have to devalue and in fact could continue with a policy of inflating even more pound banknotes and credit atop the same insufficient reserves of gold. For, as the thinking went, gold reserves would no longer be insufficient given that nearly all British citizens would be unable to exercise their legal rights and the central bank’s gold would go mostly unclaimed.

By 1925 the fa├žade was ended completely and British citizens were legally prohibited from redeeming their money into gold at all, freeing the Bank of England completely from a huge disciplinary obstacle that had kept it in check during the classical gold standard era.

Now Britain’s only remaining concern was overseas holders of pound sterling liabilities—the greatest of whom were central banks.

For that problem, Hawtrey and Keynes recommended another rule-skirting solution: Britain would replace the old classical gold standard—where overseas holders of paper pound sterling notes or demand deposit balances could convert those liabilities into gold—with a new “gold-exchange” standard.

The gold-exchange standard was a cunning ruse designed to circumvent the discipline of the classical gold standard by replacing gold reserves with paper pound sterling reserves. Under this new system the Bank of England would inflate pound banknote and demand deposit balances atop its centralized gold reserves.

Unsurprisingly the resulting price inflation would continue to induce more imports than exports and British pounds would still flow overseas. But instead of its trading partners redeeming their accumulated sterling balances to the Bank of England for gold, the countries of continental Europe would be pressured to accept pounds sterling as “equal to gold” and use the paper liabilities as a pseudo-gold base to inflate their own paper currencies.

Although European central banks could technically redeem their sterling balances for gold, the gold-exchange standard allowed their governments to augment their own depleted gold reserves with a paper substitute and pursue their own inflation. This way Britain could have its inflationary cake and eat it too, printing more pounds without losing gold overseas—effectively “exporting” its inflation and short-circuiting the Hume price-specie-flow market mechanism (see part 1 to review David Hume’s price-specie-flow system).

Hard money opponents of the scheme quipped that a gold-bullion-exchange system that substituted paper reserves for gold ones was really no gold standard at all. But they were swiftly brushed aside by the plan’s architects including Keynes who had long argued that...
“A preference for a tangible reserve currency is… …a relic of a time when governments were less trustworthy in these matters than they are now.”
-Keynes, Indian Currency and Finance

In the third and final chapter of this article we will review the consequences of the British pound-sterling-bullion-international-gold-exchange standard when European central banks all ran for the exits in 1931.

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