Lessons from the Great Depression: What Really Started the Great Depression? (Part 1 of 3)

No, it wasn't income inequality which was just a symptom of the real cause: bad monetary policy—this time with urging from Great Britain.

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10 MIN READ - The Cautious Optimism Correspondent for Economic Affairs and other Egghead Stuff continues his series on the Great Depression addressing the pesky and poorly understood question of what started the whole sorry affair.

I.  NEW YORK CITY: JULY 1, 1927

Meeting in the New York Federal Reserve Building, the heads of the world’s four largest central banks convened to discuss a major policy change in the new era of international monetary cooperation. Attending were:

Benjamin Strong—Governor of the New York Federal Reserve

Montagu Norman—Governor of the Bank of England

Hjalmar Schacht—Governor of the German Reichsbank

Charles Rist—Deputy Governor of the Bank of France

The American governor Strong and his British counterpart Norman surprised their French and German opposite numbers with a startling announcement: the Federal Reserve would launch an aggressive asset purchase and quantitative easing campaign, effectively bolstering U.S. inflation in an effort to curtail Great Britain’s chronic trade deficits with the United States.

The meeting itself was a fait accompli, a mere formality since the decision had long since been agreed upon between Strong and Norman—close working associates and personal friends. Germany’s Schacht and France’s Rist, hard-money advocates who preferred adherence to the traditional workings of the pre-WWI classical gold standard with minimal state interference, were shaken by the development which they viewed as potentially destabilizing to the international monetary system. But powerless to do anything about it they reluctantly agreed—at which point Strong turned to Rist and excitedly proclaimed:

 “I’m going to give a little coup de whiskey to the [U.S.] stock market!”

Strong kept his word. In the eighteen months that ensued the Federal Reserve expanded its balance sheet from $1.175 billion to $1.824 billion—an increase of 55%—and the U.S. money supply ballooned at its fastest rate of the entire 1920’s decade.

Newly created money and bank credit quickly spilled over into asset markets and fueled speculation as the Dow Jones Industrial Average advanced from an alltime high of 175.35 in early July 1927 to 386.10 in September 1929, a stunning advance of over 120% in just 26 months. Real estate speculation pushed commercial and particularly residential property prices into record territory. Cheap credit spawned irrational business investment projects such as factory overexpansion and competitive groundbreakings for “world’s tallest building” in New York City.

And the rich (who by definition own assets) got a lot richer while the poor (who by definition don’t own assets) saw only meager gains. Thus wealth inequality—which today’s progressives are so obsessed with and claim in and of itself causes recessions—widened due to the central bank induced inflow of money. The climax of the Roaring Twenties was underway.

Oddly enough, since most of the new money flooded into asset speculation the wholesale and consumer price indexes signaled subdued inflation. Fooled by what appeared to be only moderate price pressures, America’s greatest contemporary economist Irving Fisher concluded that the U.S. economy had entered a new era of prosperity, famously declaring in the New York Times that “Stock prices have reached what looks like a permanently high plateau” on October 21, 1929—six days before the Black Tuesday crash.

Misled by holes in his own Quantity Theory of Money, it was a mistake that Irving’s Monetarist successors would go on to make decades later, including the great Milton Friedman himself who saw no  inflation problems in 2005 and declared "The stability of our economy is greater than it has ever been in our history. We really are in remarkable shape.”

But back to the 1920’s. Benjamin Strong, who had always suffered from poor health, died from tuberculosis in October of 1928 leaving it to his successor George L. Harrison to wind up the Fed’s easing campaign at the end of the year, tightening credit and raising interest rates in 1929. Starved of plentiful new money to fuel the credit boom the economy began to sink into recession by the summer of 1929, and dangerously overvalued asset market bubbles began to burst, culminating with the famous stock market crash in October.

The 1927 secret meeting is only known to us because Charles Rist wrote of it in his personal diaries. And the Fed as policy culprit rings with depressing familiarity of other such episodes in economic history. But the story behind the 1927 Fed QE decision is truly unique among history’s credit-induced tragedies. Its origins ultimately laid the groundwork that dragged two continents into a cataclysmic monetary collapse that transformed what should have been just another credit-fueled recession (in the tradition of 1819, 1825, 1837, 1857, 1873, 1893, 1907, and 1921) into the Great Depression.

And the ill-fated joint decision by the Federal Reserve and Bank of England would prove so fatal that it would force the world off the centuries-long venerable gold standard only a few short years later—ironically because Strong and Norman attempted to “cheat” with policies that the traditional gold standard would never have allowed.

This column tells that story, because it’s impossible to truly understand what started the Great Depression and particularly why its severity and duration were so unprecedented without grasping its unique monetary policy origins.

II.  BEFORE THE ROARING TWENTIES: THE INTERNATIONAL CLASSICAL GOLD STANDARD

To understand why Great Britain asked for inflationary assistance from the Federal Reserve in 1927 it’s essential to revisit the global economy before 1914 when the industrialized world operated under the 19th century classical gold standard (roughly 1870-1914 with Britain first to adopt it de jure in 1816 and the United States last in 1879).

Under the classical gold standard, every country’s currency was defined as a unit weight of gold. For example, the U.S. dollar was not a piece of paper but rather the dollar was literally about 1/20th an ounce of gold—or 23.22 grains of gold to be exact. The British pound sterling was defined as approximately 1/4th an ounce of gold or 113.00 grains. Francs, marks, lira, etc… were also literally unit weights of gold. Paper banknotes and demand deposit balances were simply claims on dollars, pounds, francs, etc… hence why old banknotes of the 19th century bore the promise “Will pay the bearer on demand five dollars.”

Because both the dollar and the pound were defined as unit weights of gold, the “exchange rate” between the two was fixed. And since one pound sterling contained 4.86 times more gold than one dollar, the pound sterling equaled $4.86—an exchange rate that had been unchanged since the U.S. Coinage Act of 1834.

Another important attribute of the classical gold standard was that any institution that issued paper banknotes or demand deposit balances (usually created when that institution loaned money) was obligated to convert those notes or deposits on demand in gold coin. In the U.S. that commonly meant gold eagle coins equal to $20 in gold, or in Britain the gold sovereign containing one pound sterling equivalent in gold. Other countries’ currencies followed the same rules.

The constant threat of on-demand redemption by all holders of paper liabilities was critical as it kept issuing institutions “honest.” That is, whether they were commercial banks—as was the case in the USA and Canada—or central banks such as the Bank of England, the threat of redemption served as a natural check against overissuance or overexpansion of credit.

The handful of pre-WWI examples of irresponsible overexpansion by banks were virtually always the consequence of government intervention overturning private redemption contracts such as legally suspending gold convertibility (Great Britain during the Napoleonic Wars 1797-1825, USA during the War of 1812 from 1812-1815) or attempts to substitute government paper for gold (USA: “Greenback” paper money during the Civil War). But in the relatively free and undisturbed periods of money and banking, institutions were kept in check by market forces that prevented inflationary overexpansion.

The same rules applied to entire nations. If one country’s commercial banks or central bank printed too many banknotes or created too much demand deposit checkbook money (ie. inflation), prices would rise in that country and, given fixed exchange rates, competing imported products became cheaper. Consumers in the inflating country would buy more imports, sending their currency (say in this case, British pounds) overseas. The receiving country (say, France) had little use for pounds and would submit them for redemption to the Bank of England and gold would flow across the Channel.

With its gold reserves diminishing, the British banking system would be forced to end its overexpansion or even contract, and prices would fall back into line. Conversely, with French gold reserves rising the resulting increase the money supply would make French products more expensive leading to higher British imports and an equilibrium would ensue.

Scottish philosopher David Hume observed this phenomenon and wrote about it in the 1750’s. The tendency for freely moving international commerce to put a check on overexpansion of money and credit vis-à-vis a country’s gold reserves has been known since as the Hume price-specie-flow mechanism. And under this self-regulating international monetary system—even with occasional destabilizing interventions by governments—the world saw an explosion in wealth creation and international trade. For example worldwide foreign investment rose from 7% of GDP in 1870 to 18% of GDP in 1914 (NBER: Estevadeordal, Frantz, Taylor). That’s a near tripling not of foreign investment, but of its share of world GDP. Since world GDP rose by approximately 147% during the same period (A. Madison), total foreign investment rose by 530% in just 44 years.

The same is true of total world trade. From 1870 to 1914 global trade rose from 10% of GDP to 21%, or in absolute terms an increase of 419%. And these gains were accompanied by a dramatic decline in major European wars during the latter half of the 19th century and early 20th century.

So understanding what made the classical gold standard work so well in the late 19th century is also essential to identifying what went wrong in the 1920’s, a tragic story that we will visit in Part 2 of this series…