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I do not claim in this paper that the international gold standard was a principal cause of the Great Depression. Instead, I explore the events that allowed the world to slip deeper into depression despite the gold standard. The volan'lity of international short-term capital jlows surely conm'buted greatly to the Depression. I argue that this volatility was exacerbated-rather than ameliorated-by the international gold standard. The reason is that despite governments' legal assurances that they are committed to a gold standard, speculators never perceive the terms of gold parity as immutable. This statement holds with increasing force when one observes the precarious status of government debts and internarional finance during the 1920s. This realq renders a gold standard vulnerable to precisely the type of volatility in international capital markets that made the 1931 downturn more severe.


Between 1926 and 1931, the world's major economies adhered to a gold standard with fixed exchange rates. Some may argue that if the rules of the gold standard were followed, no opportunity for seriously mismanaging monetary policy should ever have arisen. Deflationary events in any one country are supposed to induce an inflow of gold, which helps stabilize that country's money supply and price level. The actual experience, of course, was that the world tumbled into one of the worst depressions i history despite n the international gold standard. This paper explores the possibility that the institutional structure of the gold standard in fact contributed greatly to the downturn.

*Department of Economics, University of Virginia, Charlottesville. I am indebted to Jonathan Eaton, Barry Eichengreen, Charles Engel, June Flanders, Marjorie Flavin, Charles Kindleberger, Ron Michener, Anna Schwartz, and participants in the University of Virginia Macroeconomics Workshop for helpful comments on earlier drafts of this paper. The version here is a revision of one presented at the 62nd Annual Western Economic Association International Conference, Vancouver, B.C., July 1987, i a n session organized by Michael D. Bordo, University of South Carolina, Columbia.

67 Contemporary Policy Issues Vol. VI, April 1988



My arguments starting point was articulated quite eloquently by Keynes (1930, p. 199):
It is claimed for gold that it keeps slovenly currency systems up to the mark. . . .So long as a country continues to adhere to the gold standard, there i force i this. But experience-an experience s n covering much ground and subject to scarcely any exceptionsshows that, when severe stress comes, the gold standard is usually suspended. There is little evidence to support the view that authorities who cannot be trusted to run a nationally managed standard, can be trusted to run an international standard.

Since Keynes wrote those words, the international gold standard has been abandoned, arguably reimplemented under Bretton Woods, and abandoned again. Indeed, no country in the world currently is on a gold standard. If nothing else, this must remind us that as a practical matter, a gold standard is not the permanent and immutable institutional commitment that its advocates envision. It seems inconceivable that speculators are unaware of this in choosing their optimal portfolios. For this reason, in any gold standard, speculators necessarily will continuously reappraise the profit opportunities arising from any potential change in gold parity. Any new conditions warranting a reassessment of the probabilities can cause a speculative run against the defending currency. Both the run and the governments response to it can be seriously destabilizing forces. This papers central thesis is that this phenomenon indeed was an important factor in propagating the Great Depression. I am not referring to destabilizing speculation arising from transactions in which both parties are acting out of rational pursuit of personal profit. I believe that Friedmans (1953, p. 175) essential insight-that speculation under such circumstances could be destabilizing only to the extent that people bought high and sold low-is basically correct. If speculators expect to make a profit from their actions, it is difficult to close the model with a rational expectations equilibrium in which some other rational private party is willing to surrender these real resources and transfer them to the speculators. I n the case of the gold standard, however, the situation is quite different since one clearly can identify the party whose loss accounts for the speculators gain. This party is, of course, the host government. The host governments promise to honor gold conversions at the historical parity may be inconsistent with the fundamental gold
1. I am not suggesting that Keynes would have endorsed the thesis of this study. Instead, I use this quote to establish that Keynes recognized this important dimension to the practical operation of the gold standard. See Bordo (1984) for a more detailed discussion on the history of the views of Keynes and others regarding the gold standard.



value-or, in Flood and Garbers 1984 terminology, the shadow price-of the currency. In this case, a speculative attack on the currency could well profit speculators at the expense of the government. Salant and Henderson (1978), Krugman (1!n9), Salant (1983) and Flood and Garber (1984) have provided detailed theoretical analyses of exactly how this can occur under a fractional reserve gold standard.2 Lauck (1907, pp. 119-122) and Garber and Grilli (1986) have developed the thesis that fears of the gold standards being suspended contributed greatly to the panic of 1893. Wigmore (1985, pp. 444-451; 1987) argued quite convincingly that a connection existed between the U.S. banking panics of March 1933 and perceptions of President Roosevelts impending devaluation. Friedman and Schwartz (1963, p. 332) and Ely (forthcoming, pp. 71-72) also discuss this interpretation of events in 1933. In this analysis, I emphasize almost exclusively the potential profit opportunities available to private speculators rather than the particular policy objectives of central banks, even though central banks were instrumental in many of the capital movements in which we are interested. This emphasis has two motivations. First, I believe that preserving portfolio capital during this era was a more important motivation of central banks than is commonly assumed. In particular, central banks aggressive moves to convert foreign reserves into gold would seem very questionable if it really were true that everyone perceived the exchange rates between currencies and gold as incapable of changing. That central banks perceived the possibility of change and acted on that perception is the only satisfying paradigm for interpreting these flows. Second, and more important, private speculators potential profit opportunities should be regarded as an irresistible force in international finance, and any central bank policy that leaves open such opportunities is doomed to failure. In this paper, the focus is exclusively on profit opportunities from currency speculation, and the paper adopts the Flood and Garber model as the organizing theme for analysis.

According to Flood and Garber, the most important element in the success of any national gold standard is the publics confidence 2. Comments in this paper do not apply to a 100 percent reserve system-that is, one i which the total stock of Federal Reserve notes outstanding is exceeded n by the par value of the governments gold holdings and in which any privately issued demand deposits are backed 100 percent by bank reserves. Separate issues of feasibility are associated with a 100 percent reserve system arising from making the initial conversion to the standard and regulating the circulation of alternative currency substitutes. But these issues are not discussed in this paper.



that the governments fiscal soundness and political imperatives will enable it to pursue indefinitely a monetary policy consistent with long-term price stability and continuous convertibility. By this criterion, returning to the international gold standard during the mid-1920s could not have come at a worse time or for poorer reasons. Clearly, the gold standard was reinstated precisely because the fiscal and political chaos since 1914 had made it impossible for many governments to reform their monetary policies in the absence of a gold standard. Besides the physical damage to the theaters of combat wrought by World War I, the wounds to the infrastructure of world finance and world trade proved quite profound and enduring. The burden of international debts accumulated during the war was critical. France emerged owing $4 billion to the U.S. and $3 billion to Britain. The latter, in turn, owed another $4.7 billion to the U.S.3 Britain would repay the U.S. so long as Britain was repaid by France, which in turn was counting on reparations owed by Germany. In April 1921, the Reparations Commission set the total assessment against Germany at $32 billion (Eichengreen, 1985, p. 148). There seemingly would have been little possibility that Germany actually would pay such a sum. Thus, because of the interdependence of the rest of the debt structure, the resolution was mired in considerable doubt throughout the 1920s. Eichengreen (1985, pp. 147-148) observed further that this precarious balance of international finance aggravated-and was itself exacerbated by-the deteriorating political climate for world trade, in an apparent negative feedback loop:
[Flinancial instability impeded efforts to liberalize international trade. Since the major belligerents had all imposed trade controls in the course of the war, they had in place the administrative machinery needed to administer import licensing and quota schemes. While some such as Britain rapidly moved to dismantle wartime controls, others such as France, which initially emulated the British example, turned back to tariff protection once their currencies began to depreciate. Trade with central Europe was further depressed b y the slow recovery of these economies. Together with the embargo o n Russian trade, the prospects for an export-led recovery appeared dim.

3. Data and analysis are from Kindleberger (1986, p. 24). Putting these numbers into modern perspective, nominal GNP for the U.S. has increased from around $90 billion in 1920 (U.S. Department of Commerce, Hisrorical StarirricS of the United Stares, Colonial Times to 1970, U.S. Government Printing Office, Washington, D.C., 1975, part 1, p. 224) to more than $3,600 billion in 1 9 8 4 4 40-fold increase. Thus, multiplying the numbers in the text by 40 gives a contemporary yardstick of the orders of magnitude involved.



Trade policies proved an important aggravating influence throughout the 1920s and 1930s. The immediate postwar financial turmoil was worsened by the unusually sharp and severe global recession of 1920-1921 as the U.S. Federal Reserve and the Bank of England tried reversing the war-related price level increases. Others have stressed the structural imbalances associated with interwar shifts from declining sectors (see, e.g., Svennilson, 1954). The severe economic conditions of the early 1920s put enormous political pressures on central European governments to try alleviating the problems through government spending and transfer programs. Honoring the outstanding international debts was quite unfeasible-both economically and politically. Under the circumstances, the central European governments resorted to issuing paper currency to finance their ballooning deficits. Cagan (1956) has described the resulting spectacular hyperinflations of Germany, Austria, Hungary, and Poland, among other countries. Yeager (1981) and Sargent (1986a) have explored the common thread behind the resolution of such hyperinflations. These researchers noted that in each of the above cases, the hyperinflation was halted by (I) fiscal reform calling for dramatic budget cuts, tax increases, and often new loans from abroad, and (2) clear institutional separation between the borrowing needs of the fiscal authority and the monetary responsibilities of the central bank. The ultimate goal for the latter typically was reestablishing gold convertibility. The periodic large bursts of inflation and currency depreciation in France during 1923-1926 were less spectacular than the hyperinflations of central Europe. However, the former also seem attributable to the fiscal chaos and the recumng doubts about Frances ability to maintain monetary stability in the face of large and uncertain government indebtedness (Yeager, 1981; Sargent, 1986b). Again, the resolution involved fiscal and monetary reform (Sargent, 1986b; Makinen and Woodward, 1985) and de fact0 stabilization of the francs gold price beginning in 1926.4 According to Flood and Garber, a gold standard will work only if the public has faith in the governments long-term commitment to fiscal soundness and monetary stability. The world returned to an international gold standard in 1926 precisely because of the utter chaos that had characterized many national fiscal and monetary policies in its absence. Under such circumstances, one should take

4. The effective dollar-franc exchange rate essentially was constant from December 1926 to March 1933 (Board of Governors of the Federal Reserve System, 1976, p. 670), even though Frances fixed exchange rate policy was not made official until 1928.



quite seriously Herbert Hoovers suggestion that gold and short-term credit acted like a loose cannon on the deck of the world in a tempest-tossed era (Kindleberger, 1986, p. 148). The reforms of the mid-1920s, important as they were, did not completely remove the ultimate sources of these fiscal and monetary difficulties. The Dawes Plan of 1924 restructured the war debts, but even the new sums were not paid. And the Dawes Plan did not remove the political difficulty of resolving the simultaneous nature of the war debts. Further, the political environment for world trade only worsened. The Economist (February 18, 1928, p. 327) cited a new French customs tariff as a factor in the 11 percent decline in British exports to France between 1925 and 1927, and observed further that Frances own textile exports were seriously affected by tariffs abroad (Economist, July 6, 1929, p. 18). Beginning in July 1929, Germany required 40 percent of milled wheat to be of German origin and raised certain other tariffs (Economist, July 6, 1929, pp. 18-19). The U.S.s Smoot-Hawley tariff was the most devastating and most well-known, however. Passed in June 1930, it triggered a wave of retaliatory measures by other countries (Kindleberger, 1986, pp. 124-125). As stressed by Saint-Etienne (1984) and Eichengreen (1987), these developments could only aggravate any uncertainty regarding the resolution of international debts and governments ability to adhere to the gold standard. Indeed, Chandler (1971, p. 164) noted that the list of countries abandoning the gold standard prior to Britains doing so in September 1931 is dominated by those most vulnerable to depressed raw materials prices. 5


Britain and the U.S. held two-thirds of all long-term international debt-excluding war debt-in 1938 (Eichengreen and Portes, 1986, p. 601). The death blow to the international gold standard, and the knockout punch to the U.S. economy as well, was the speculative attacks on the currencies of these two world finance centers during summer and fall 1931. Regarding the flight from the British pound, much has been made of the claim that the British pound was overvalued ever since Britain returned to gold in 1925. One must ask at the outset: overvalued relative to what?

5. These countries were Australia, New Zealand, Brazil, Chile, Paraguay, Uruguay, Venezuela, and Peru. In addition, Canada, Austria, Hungary, and Germany imposed various controls on foreign exchange. Of course, raw materials prices began to plunge well before Smoot-Hawley, and no one suggests that the trade wars were the sole factor.



Keynes answer: overvalued relative to British money wages. But it is a mystery why British money wages could not fall an additional 10 percent after 1925, considering that they had already fallen some 35 percent between 1921 and 1924. (See the data cited by Keynes, 1930, p. 178.) Liberalized unemployment benefits may have played a role in wages resistance to further declines. But surely the hypothesis that the attack on the pound in 1931 resulted from a disequilibrium that had persisted since 1925 should not be the first one investigated. Others have focused on the relation of the pound not to British money wages but to wages and prices in France and the U.S. That is because these were the countries receiving most of Britains exports of gold. Indeed, one can point to events clearly accounting for an increase in the demand for French francs between 1926 and 1930. The most important was a restored confidence in Poincares political reforms (Eichengreen, 1986). Moreover, note that the dramatic flow of gold to France could well be described as resulting from the fiscal uncertainty of the times. At the time, a rational speculator would have recognized the significant probability that Frances de jure stabilization in 1928 would revalue the franc above its level of the de fmto stabilization begun in 1926 (see Kindleberger, 1986, pp. 34-35). Again, this makes possible profitable speculation against the government maintaining the convertibility. In this case, the potential profit would derive from surrendering gold or pounds in exchange for French francs in 1926, anticipating that the latter might subsequently appreciate. Then the francs could be exchanged back for gold at a profit. The U.S. deflation and contractionary monetary policy during 1928-1930 certainly were additional exogenous events exacerbating the outflow of gold from Britain before 1931. (See Friedman and Schwartz, 1963; Chandler, 1971; Hamilton, 1987.) These developments undoubtedly were important in setting the background for Britains departure from gold. But explaining July 1931 in terms of events of 1925-1930 ultimately suffers from a fundamentally misplaced emphasis. If it were true that some development in 1926 caused the departure from gold in 1931, why were people foolish enough to hold on to pounds for so long rather than attempt to profit from the incipient devaluation? If we view speculators as rationally pursuing the greatest profit and assume that they are as adept as the historian at identifying opportunities for such profit, we must look for events much more closely associated with the devaluation for the proximate cause. Little ambiguity exists as to what these events were. The failure of Austrias most important bank, the Credit-Anstalt, in June 1931 was followed by runs on banks in Hungary, Czechoslovakia, Romania,



Poland, and Germany. The continental banking crisis froze some short-term assets of the Bank of England and called into doubt the soundness of Britains international long-term loans. These developments were significant not only because of their effects on Britains abiZiry to honor gold convertibility (Cairncross and Eichengreen, 1983) but also because of their effects on investors confidence that the pounds panty with gold would be maintained. What specific events by the government persuaded speculators that devaluation was possible? One could point to internal government communications of late 1930 and early 1931 or to the Macmillan report of July 1931. These at least recognized that devaluation was possible, if only by detailing the steps needed to avoid it and the consequences of failing to take such steps (Cairncross and Eichengreen, 1983). But perhaps the most persuasive argument is the simple ex post observation that anyone who bet against the pound during summer 1931 profited handsomely from doing so. The historian observes that (I) large sums suddenly were converted from pounds into gold and other currencies, and that (2) traders who made such exchanges quickly secured large profits. Surely a strong theoretical presumption exists that traders made their profits by rational calculation and were quite accurate in assessing the probabilities. Of course, such speculation against the pound was profitable partly because of the magnitude and virulence of the speculation itself: Conceivably, f the British government would not have been forced o f gold had a speculative run not occurred. But this does not attest to any irrationality of speculators.

Speculation against the pound soon spilled over against the dollar. Between September 16 and October 28, 1931, Federal Reserve holdings of gold fell from $4.729 billion to $4.002 billion (Board of Governors of the Federal Reserve System, 1976, p. 386). This was about a 15 percent decrease in little more than a month. The outflow occurred even though the discount rate charged by the Federal Reserve Bank of New York increased from 11/2 to 3l/2 percent during this same brief interval (Board of Governors of the Federal Reserve System, 1976, p. 441). Perhaps it is worthwhile to discuss where this gold was going. Table 1 presents data for the four countries whose central banks experienced the largest change in gold holdings between August 1931 and October 1931. One should view the increase in gold holdings by the Bank of France primarily as accelerating a trend that began in 1926. The gold flows into Belgium and Switzerland, by contrast,



TABLE 1 Change in Gold Holdings of Central Banks Between August 1931 and October 1931 (in millions of dollars and as a percentage of holdings as of August 1931)
Countrv Change in Gold Holdings Millions of Dollars Percentage

Belgium France Switzerland World Total


+ 136.1
+238.5 +193.5 -154.6

-15.7 +61.6 +10.4 +84.0 -1.4

Source: Board of Governors of the Federal Reserve System, 1976, p. 544.

are dramatically different from the previous pattern and constitute substantial increases over the earlier base in percentage terms. Table 1 also reports that central banks gold holdings fell worldwide by $154.6 million during this two-month period. One can put this latter number into perspective by noting another pair of statistics. (1) Between December 1921 and December 1931, the world total of central bank gold holdings increased by $328 million per year, an average of $55 million per two-month period (Board of Governors of the Federal Reserve System, 1976, p. 544). (2) Between 1921 and 1931, world production of gold averaged $387 million per year, an average of $65 million per two-month period (Board of Governors of the Federal Reserve System, 1976, p. 542). Thus, one might add $55-$65 million to the $154.6 million drop i central bank n gold holdings to infer a $210-$220 million increase in private gold holdings during this two-month period. Of the $727 million decrease in gold holdings by the U.S. Federal Reserve between August and October 1931, roughly equal proportions may have gone to the central banks of France, Switzerland, and Belgium and to private hoarding. Of course, it is also possible that this $210-$220 million represents gold that central banks deliberately concealed from the official balance sheets. It is difficult to attribute these sudden gold flows to deliberate contractionary measures of the countries receiving the gold. The central banks of Belgium, France, and Switzerland all were charging a discount rate of 3l/2 percent in January 1930. The rate declined monotonically during 1930 in all three countries. It reached 2l/2



percent in Belgium and 2 percent in France and Switzerland by February 1931. The central bank discount rates held steady at these lower levels throughout the currency crises of 1931. Such discount rates were not raised in Belgium until February 1932, in France until November 1931, and in Switzerland until June 1935 (Board of Governors of the Federal Reserve System, 1976, p. 656). Thus, the flow of gold to these countries between August and October 1931 was not caused by changes in the central bank discount rates in the countries receiving the gold flows. In principle, the gold flows out of the U.S. could have resulted from a perceived increased riskiness of U.S. assets and from the precarious status of banking and U.S. corporate debt service, which prompted a move into foreign securities. However, the behavior of short-term U.S. Treasury notes and certificates depicts clearly that more must have been involved. (See figure 1. These data, taken from Board of Governors of the Federal Reserve System, 1976, p. 460, represent monthly averages of daily rates on three- to six-month Treasury notes and certificates, quoted in percentage per annum.) If the only factor had been concern over the creditworthiness of U.S. debtors, this should have been associated with increased demand for risk-free U.S. assets. Accordingly, the U.S. Treasury bill (T-bill) rate should have fallen. In fact, it increased dramatically. The risk6 associated with T-bills is that of currency devaluation and price level inflation-not corporate bankruptcies. The behavior of U.S. T-bill rates illustrates the importance of the former in the minds of investors during fall 193L7 Comparing the behavior of short-term U.S. Treasury yields with private discount rates in the countries receiving the gold is also informative (figure 2; data from Board of Governors of the Federal Reserve System, 1976, p. 656). The rise in interest rates on low-risk assets during summer and fall 1931 was somewhat of a worldwide phenomenon, with two important qualifications. First, interest rates in Europe rose before Britain left gold i September while those n in the U.S. increased afterward. In other words, initially a flight info dollars occurred in response to Europes banking difficulties during summer 1931. (This was associated with the perception that the U.S. was the safe haven for capital.) The second important 6. I am not using risk in the conventional finance sense of variance of return. By risk, I mean that the perceived possibility of devaluation reduced the expected real return associated with holding T-bills relative to what one would have calculated had one assumed no possibility of devaluation. 7. An interesting pattern related to corporate risk as opposed to currency risk is evident i the behavior of low-grade bonds, whose rates rose i foreign countries n n throughout 1929 and reached dramatic highs by the end of 1930. By contrast, the U.S. rate on Baa-rated corporate bonds held relatively flat until December 1930 (Kindleberger, 1986, pp. 120-122).




3% 2% 1%


Second bank ?

Britain leaves gold






July I93 1


July 1929


July 1930






July 1932

FIGURE 1 Yields on three- to six-month Treasury notes and certificates


I--, I --/I

Britain leaves gold



2% 1%


July 1929


July 1930


July 1931


July 1932

FIGURE 2 Private discount rates in Belgium, France, and Switzerland



TABLE 2 Differences Between Yield on Three- to Six-Month U.S. Treasury Notes and Certificates and Foreign Private Discount Rates During 1931
_ _ _ _ _ ~

Yield on Short-Term Date Securities

0.55 0.42 2.41

US. Rate Minus French Discount Rate

U S Rate .. U S Rate .. Minus Belgian Minus Swiss Discount Rate Discount Rate

June 1931 August 1931 December 1931

-0.51 -1.08 +0.66

-1.58 -1.99 -0.03

-0.57 -1.56 +0.66

Source: Board of Governors of the Federal Reserve System, 1976, pp. 460, 656.

difference between the patterns of figures 1 and 2 is that the magnitudes of increase in the risk-free interest rates of Belgium, France, and Switzerland were much less than that realized subsequently in the U.S. Thus, the worldwide rise in interest rates during the second half of 1931 was accompanied by large temporary swings in the spreads among risk-free rates in different countries. Table 2 summarizes these dramatic spread changes. In June 1931, investors were accepting a return on U.S. Treasury bills that was 50 basis points lower than that available on the private discount markets in France or Switzerland and 150 basis points lower than that in Belgium. By August 1931, in the wake of the continental banking crisis and immediately before the attack on the dollar, the premium required on foreign assets had widened by 50-100 basis points. By the end of the year, however, the situation had reversed dramatically. Investors were insisting that their return on U.S. Treasury bills be more than 50 basis points higher than the private discount rates in France or Switzerland and on a par with that in Belgium. Between August and December 1931, this represented a swing of about 200 basis points in the premium on low-risk assets in the U.S. relative to those in Europe. One might attribute the increase in low-risk U.S. interest rates to the decrease in U.S. money supply. Standard IS-LM (investment-saving/money demand-money supply) analysis predicts that as MI contracted, agents would have tried restoring money balances by selling interestearning assets and thus driving up domestic interest rates. To the extent that domestic and foreign assets are imperfect substitutes, some inflow of capital would have occurred in response to these higher interest rates-but not enough to prevent domestic interest rates from rising above foreign rates. One piece



of evidence incompatible with this account is the dramatic gold flows: One would have predicted an inflow of gold to the U.S.-not an outflow from the U.S.-if the spread between U.S. and foreign interest rates had been caused by a contraction in the U.S. money supply. Some additional event must have accounted for the spread between U.S. and foreign risk-free rates. The most obvious interpretation is that because U.S. Treasury bill yields were denominated in dollars, they were not perceived as truly risk free (see note 6).


One should view the speculative attack on the dollar as a cause of-not a response to-US. monetary policy during the second half of 1931. It is informative to explore further the dramatic declie in U.S. M1 after Britain departed from gold. This decline certainly did not result from open market operations: The Fed was a net buyer-not a net seller-of T-bills during this period, as its holdings of Treasury securities increased by $184 million between June and December 1931 (Board of Governors of the Federal Reserve System, 1976, pp. 385-386). The main contractionary step that the Federal Reserve took at this time was sharply increasing its discount rate and its bankers acceptance rates. In the absence of other factors, these increases would have caused system reserves to decrease by discouraging borrowing from the Fed. In theory, then, they could have accounted for a decrease in MI. In actuality, however, bills discounted by the Fed increased by $810 million between June and December 1931 while acceptances grew by $221 million (Board of Governors of the Federal Reserve System, 1976, pp. 385-386). The U.S. banking system was scrambling for reserves, and the Feds higher discount rate and higher acceptance rates did not discourage such activity. Indeed, the increases in borrowed reserves more than made up for the outflow of gold. As a result, the U.S. monetary base actually increased by $433 million between June and December 1931 despite the contractionary influences of the gold flows and of changes in the Fed discount rate and acceptance rates (Friedman and Schwartz, 1963, table B-3, column 1). Thus, attributing the contraction in M1 to Federal Reserve policy is difficult by any of the conventional accounts of how monetary policy controls the supply of domestic credit. Arithmetically, the fall in M1 was due entirely to a decrease in the money multiplier-i.e., the ratio of MI to the monetary base-which overwhelmed the effects of the net increase in the monetary base. I believe that Friedman and Schwartz correctly attributed this reduced multiplier to decreased confidence in the U.S. banking



system and to the publics desire to convert demand deposits into safer assets. I would add only that international events-the banking panic in Europe and the rapid flows of international capital in response to currency concerns-also played a prominent role in accounting for the publics disquietude. I conclude that attributing changes in the spread between U.S. and foreign interest rates solely to U.S. monetary conditions simply does not fit the facts, The monetary contraction certainly contributed to the depth of the problem in the U.S., but it is equally clear that international capital flows contributed greatly to the events of 1931. Moreover, these capital flows are difficult to understand unless one acknowledges that speculators and central banks were concerned over possible changes in exchange rates and in terms of gold parity. (Wigmore, 1985, pp. 215-216, took a similar view. He attributed the 1931 speculation against the dollar to concerns over fiscal recklessness and rumors of devaluation.) A dramatic change occurred in the premium on U.S. versus foreign assets during the second half of 1931. Meanwhile, an increase in most risk-free interest rates was experienced worldwide during the currency crises. This is explained partly by the last row of table 1: Net speculation against all currencies-i.e., a flight by private investors into gold-occurred during this period, as measured by the worldwide decline in central banks gold holdings. This phenomenon indeed was unique to the currency crises of 1931. At no other time during the Depression did a comparable global accumulation of gold by private speculators occur (Board of Governors of the Federal Reserve System, 1976, p. 544). This observation helps us understand another important issue regarding how these capital flows contributed to the global depression. If all that had occurred was that gold flowed from the U.S. to foreign countries, the resulting decrease. in the U.S. monetary base indeed would have been contractionary in this country. But the increases in Belgium, France, and Switzerland should have been expansionary in those countries. I would suggest instead that it was the voZufiZify of the flows, rather than the realized changes in base money, that introduced added uncertainty into international credit conditions. (By volatility of the flows, I mean the population variance of the stochastic process that one might use to characterize the gold flows and exchange rate uncertainty.) Increasing the variance of the money supply, prices, and interest rates exacerbated the flight to liquidity, gold, and safe currencies-and aggravated borrowers precarious financial conditions. Moreover, central banks policy responses to the gold flows actually we re addit ion a1 destabilizing influence s.



I n other words, there was risk in holding almost any countrys currency instead of gold. This resulted in increasing the ratio of gold to the worldwide supply of currency plus checkable deposits that both central banks and the public wanted to hold. In the absence of an increase in the gold supply, a decrease in the worldwide level of currency plus checkable deposits effected this increase in the ratio. This resulted in the money multipliers collapsing on a global scale. Whether the U.S. Federal Reserve was justified in sharply increasing the discount rate and bankers acceptance rates in trying to stem the outflow of gold is a separate issue. Even after the large outflow of gold in fall 1931, the U.S. still possessed significant free gold holdings, i.e., gold in excess of the statutory ratio to Federal Reserve liabilities. This led subsequent reviewers to argue that a more enlightened Fed policy would not have increased the discount rate nor tried arresting the dramatic outflow of gold. However, we need not evaluate the merits of this argument to conclude that the speculative run forced the Federal Reserve to make a difficult judgment and doubtless was the proximate cause of the monetary contraction that followed. Chandler (1971, p. 186) wrote, Whether or not they should have been, directors and officers of the Reserve Banks were deeply concerned about their free-gold positions and stated this concern several times in the latter part of 1931 and early 1932. Wickers (1966, pp. 169-170) analysis downplayed the specific concern over free gold per se. Rather, he emphasized that [tlhe Federal Reserves failure to act was owing more to consideration of the impact of [open market] purchases on European confidence in the dollar and indirectly on domestic hoarding propensities-precisely the view I advocate here. Epstein and Ferguson (1984) also stressed that Federal Reserve options were severely constrained by the desire to preserve gold convertibility. Whether one emphasizes the flight from the dollar or the Feds response to this flight as the more serious problem, the events of fall 1931 clearly were far more serious in their consequences for domestic credit than were the domestic banking panics preceding them. The most dramatic evidence supporting this proposition is the yield on short-term Treasury securities, as portrayed in figure 1. This rate underwent a prolonged and dramatic slide from 4.55 percent in July 1929 to 0.41 percent in July 1931. Only minor and brief perturbations from this trend appear associated with either of the first two banking crises identified by Friedman and Schwartz. This contrasts with a dramatic increase of 200 basis points during the last half of 1931.



In contrast to the monotonic decline in the Treasury bill rate during 1929-1931, the rate on Baa-rated covorate bonds began rising well before the currency crises of 1931. And this upward trend accelerated dramatically during September 1931. Between June 1929 and July 1931, the total increase in the Baa rate amounted to 113 basis points. This contrasts with the increase of 334 basis points realized between July and December 1931 (Board of Governors of the Federal Reserve System, 1976, p. 469). The same conclusion seemingly emerges from most other important macroeconomic aggregates. M1, for example, had decreased at a 5.7 ercent (annual logarithmic) rate between July 1929 and July H) 1931 but experienced a 10.1 percent decline during the last six months of 1931-a 20.2 percent annual rate of decline. Industrial production and the consumer price index recorded 20.3 and 6.0 percent (annual logarithmic) decreases between July 1929 and July 1931, as compared with 35.7 and 10.5 percent decreases between July 1931 and July 1932, respectively. If one claims that the effects of the fist two banking crises were comparable in magnitude with those of the Feds defense of the dollar during fall 1931, then one is not basing such a conclusion on the observed behavior of interest rates, money supply, prices, and output. Previous researchers have not discounted the economic importance of the monetary response to the gold drain relative to other events at the time. Friedman and Schwartz (1963, p. 317-318) described the October 1931 increase in the discount rate as the sharpest rise within so brief a period in the whole history of the System, before or since. They noted that the rate of decline of MI between August 1931 and January 1932 was larger than for any other comparable span in the 53 years for which we have monthly data-except perhaps the 1933 banking holiday. Even so, Kindleberger (1986, p. 166) felt that Friedman and Schwartz did not go far enough:
Friedman and Schwartz maintain that the pressure on the U.S. gold supply following British suspension of the gold standard was not critical in U.S. economic life, which continued to decline consistently from March 1931 t o mid-1932. I t is difficult to accept this verdict. Not only the money supply, but commodity prices, security prices, imports and, to a lesser extent, industrial production declined faster after [Britains] devaluation than before.
8. Calculated as (1/Z)log(Mlf/Mlf-2), with M1 the sum of currency held by the public plus demand deposits of commercial banks. Data are from Friedman and Schwartz (1963, table A-1, column 7). 9. Calculated as in note 8. Data represent the unadjusted index of industrial production (Federal Reserve Board Annual Reporr, 1932, p. 171) and the index of the cost of goods purchased by wage earners and lower-salaried workers in large cities (MonrMy Labor Review, August 1940, p. 392). Note that the latter data represent June values rather than July values.



The speculative attack on the dollar in September 1931 and the Federal Reserves response surely were critical in the deteriorating economic situation. Were speculators and foreign central banks wrong to participate in these runs in the first place? As events turned out, those who bet against the British pound were richly rewarded while those who bet against the U.S. dollar lost only the transactions and storage costs and the foregone interest from converting dollars into gold. Moreover, such traders eventually were also proven right in 1933, when Roosevelt finally took the U.S. o f gold and f the dollar fell 40-60 percent relative to major European currencies. A n interesting parallel exists i the behavior of the U.S. commodity n futures market. A futures contract is an agreement negotiated today to purchase or sell the commodity at some date in the future. One may view the price of such future exchange as recording investors expectations today about the level at which commodity spot prices likely will be at the future date of settlement. Tables 3 and 4 (reproduced from Hamilton, 1987) record the implicit expected rates of change, and the subsequent actual rates of change, i individual n commodities prices inferred from U.S. commodity futures prices for cotton, wheat, corn, and oats. During July 1931, speculators anticipated a +13.4 percent annual logarithmic inflation rate in cotton prices for the six-month period ended January 1932. In actuality, cotton prices fell at a -95.9 percent annual logarithmic rate. Similarly, in December 1931, speculators anticipated +13.8, +29.0, and +20.3 percent annual logarithmic inflation rates for wheat, corn, and oats, respectively, for the five-month period ended May 1932. In actuality, wheat experienced a +8.4 percent increase but corn dropped at a -65.9 percent rate and oats at a -26.3 percent rate. Thus, the evidence from the commodity futures markets is consistent with the foreign exchange market interpretation advanced above: Many speculators perceived gold and commodities as superior to dollars as a store of value, and they obviously were surprised by the Federal Reserves virulent defense of the dollar and subsequent deflation. Wigmore (1985, p. 217) pointed to the 35 percent increase in U.S. stock prices and the near doubling in wheat prices between October 5 and November 9, 1931, as evidence that monetary policy was loose and was contributing little to the rapidly deteriorating economic conditions at the time. I agree that these statistics are dramatic and important, but I interpret them in nearly the opposite direction. I believe that these numbers suggest a surge in inflationary expectations associated with fear of devaluation. According to my view, the numbers reflect a cause-not a consequence-of the Federal Reserves decision to tighten credit. The implications for the economy were devastating.



TABLE 3 Expected and Actual Inflation Rates Over Six-Month Intervals (annualized rates) in Cotton Prices from Futures Market

January 1922 July 1922 January 1923 July 1923 January 1924 July 1924 January 1925 July 1925 January 1926 July 1926 January 1927 July 1927 January 1928 July 1928 January 1929 July 1929 January 1930 July 1930 January 1931 July 1931 January 1932 July 1932 January 1933 July 1933 January 1934 July 1934 January 1935 July 1935 January 1936 July 1936 January 1937 July 1937

Expected Inflation +19.9

Actual Inflation

+97.2 +24.1 +40.6 +4.5 +51.6 -37.0 -35.2 -4.1


-5.0 -0.2 -26.2 -1.9 -37.6 +6.8


-18.0 -72.8 +58.1 +29.4 +28.7 -22.4 -22.5 -10.9 -45.9

-10.6 -21.2

+5.7 +0.9 -1.9


+7.8 +8.2 -1.2 +15.2 +13.4 +13.1 +13.8 +9.8 +9.3 +9.3 +7.3 +3.8

+11.9 -95.9 -24.8 +12.1 +106.6 -1.0 +37.5 +6.5 -12.1

-10.0 -11.8 -3.9





TABLE 3 (Continued)
January 1938 July 1938 January 1939 July 1939

Expected Inflation

Actual Inflation

+4.5 +1.5

-70.6 +13.3




Average Value,
January 1930-July 1932

Source: Hamilton (1987). Nore: The entry for Ex ected Inflation of January 1929 is based on the difference between the naturaf logarithms of (a) the futures price of January cotton quoted at the beginning of July 1928 and (b) the futures price of July cotton at the beginning of July 1928. The entry for Actual Inflation of January based on the difference between the natural logarithms of (a) the futures price of January cotton quoted at the beginning of January 1929 and (b) the futures price of July cotton quoted at the beginning of July 1928. Entries for July 1929 also were calculated from 1) the difference between (a) the January 1929 price of July cotton and (b) the anuary 1929 price of January cotton, and (2) the difference between (a) the July 1929 price of July cotton and (b) the January 1929 price of January cotton. Raw price data are from the issue of Barons closest to the beginning of the listed month, i.e., the Monday falling on the first through the fourth da s of the month or on one of the last three days of the preceding month. All Jfferences were converted to annual percentage rates by multiplying by 200.


I should point out, however, that in terms of the commodity futures data, the phenomenon described above is by no means unique to September 1931. Indeed, tables 3 and 4 indicate that throughout the Depression, speculators consistently bet on big increases in commodity prices and persistently got burned by the subsequent tremendous deflations. The commodity futures data provide a background portrait of investors perceptions during the Depression that is consistent with this account. However, such evidence fails to provide a dramatic coincidence in terms of timing with the specific currency speculations of summer and fall 1931. A final interesting parallel between the commodities futures data and the foreign currency markets deserves mention. Eventually, the commodity market bulls-like the currency speculators in the run on the dollar-were proven right in light of the dramatic inflation registered for the periods ending May and July 1933. Such inflation



TABLE 4 Expected and Actual Inflation Rates Over Five-Month Intervals (annualized rates) in Wheat, Corn, and Oats Prices from Futures Market
Wheat Expected Actual Inflation Inflation Corn Expected Actual Inflation Inflation Oats Expected Actual Inflation Inflation

May 1922 May 1923 May 1924 May 1925 May 1926 May 1927

+7.1 -4.6 +12.6 +12.9 -6.9 +5.9 +12.0 +15.0 +19.9 +15.2 +13.8 +23.1 +8.3 -0.6 -1.2 -4.3

+52.6 +9.7 -1.2 +8.4


+52.7 +27.3 +12.4 -16.9

+35.1 -1.4 +10.9 +26.0 +28.8 +27.6 +14.2 +5.7 +21.5 +20.1 +20.3 +34.0 +19.1 -5.1 +12.5

+20.7 +7.6 +18.1 -52.1 +14.5 +25.7 +66.6 +0.6 -28.6

+4.9 +15.8 +19.4 +29.3

+65.6 -9.2 -53.8 +21.5 +8.4 +117.7 -7.9 -0.9

+2.1 +50.8 +13.8 -24.6 -72.8 -65.9 +87.3 +6.2 -9.3 +20.5 +52.3 +20.9

May 1928
M a y 1929 May 1930 May 1931 May 1932 May 1933 May 1934 May 1935 May 1936 May 1937

+16.4 +20.5 +12.8 +29.0 +40.5 +36.2

-26.3 +105.5 -29.1 -19.1 -1.2 +23.2

+24.5 -31.9 +42.9


-13.9 +12.5 +18.8 +20.8

+11.4 +20.6

May 1938
May 1939 Average,


+44.5 -40.3

1936-1932 +16.3


Source: Hamilton (1987). Nore: The entry for Expected Inflation of May 1929 is based on the difference between the natural lo arithms of (a the futures price of May wheat quoted at the futures price of December wheat the beginning of Decemger 1928 and at the beginnin of December 1928. The entry for Actual Inflation of May based on the ifference between the natural logarithms of a) the futures price of I ( the futures price of May wheat quoted at the beginning of May 1929 and $ December wheat quoted at the beginning of December 1928. Raw price data are from the issue of Burrons closest to the beginning of the listed month, i.e., the Monday falling on the first through the fourth da s of the month or on one of the last three days of the preceding month. All ifferences were converted to annual percentage rates by multiplying by 1,200/5.


Stis te ed



resulted from devaluation of the dollar and New Deal price policies. This tremendous increase in uncertainty over the domestic price level, and this perception that prices more likely would rise than fall during 1931, surely deserves further study as an independent propagating mechanism for the Great Depression.

It simply is not correct to view a gold standard as a system under which the dollar is as good as gold. Rather, the dollar is as good as the credibility of the governments promise to maintain convertibility with gold. This is a critically important distinction. It sometimes is asserted that a gold standard introduces discipline into the conduct of monetary and fiscal policy where none existed before. Indeed, this was the primary reason that the world returned to an international gold standard during the 1920s. I cannot think of a more naive and more dangerous notion. A government lacking discipline in monetary and fiscal policy in the absence of a gold standard likely also lacks the discipline and credibility necessary for successfully adhering to a gold standard. Substantial uncertainty about the future inevitably will result as speculators anticipate changes in the terms of gold convertibility. This institutionalizes a system susceptible to large and sudden inflows or outflows of capital and to destabilizing monetary policy if authorities must resort to great extremes to reestablish credibility. Such a system requires individuals to adapt their behavior to the contingencies of rapid and dramatic changes in interest rates, credit availability, and price levels. This characterizes the events of 1931 most accurately. Surely, it contributed to propagating the Great Depression. Perhaps the relevance of all this for present policy discussions is all too clear. To draw parallels between the 1920s and the 1980s is tempting. A mountain of international debt is outstanding today, and much of this will not be repaid. This, along with losses on energy and farm loans and banks reliance on uninsured largedenomination deposits for short-term capital needs, leaves the U.S. banking system more vulnerable now than it has been at any time since the Great Depression. The future prospects for U.S. budget deficits remain highly uncertain. Double-digit growth in the monetary aggregates has not yet shown up in comparable inflation rates, perhaps because of favorable supply shocks and increased demand for transactions balances arising from banking deregulation and lower interest rates. How long this good luck will continue is unclear. The prospects for a dramatic resurgence of inflation and serious financial instability are far from negligible. Should these



return, the voices calling for a return to the discipline of the gold standard surely will return with them. Unfortunately, a gold standard can do little good for this kind of situation. What is needed is not an institutional palliative but rather fundamental reform in fiscal and monetary policy. Washington cannot deliver more government services than the public is willing to pay for with taxes, and monetary policy must not lose sight of its primary mission of promoting stability of prices and financial health of the banking system. We can ask no more than this of policy. I we ask any less, no gold standard can help us. f

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