golden fetters

Preface
The gold standard and the Great Depression might appear to
be two very different topics requiring two entirely separate
books. The attempt to combine them here reflects my
conviction that the gold standard is the key to understanding
the Depression. The gold standard of the 1920s set the stage
for the Depression of the 1930s by heightening the fragility of
the international financial system. The gold standard was the
mechanism transmitting the destabilizing impulse from the
United States to the rest of the world. The gold standard
magnified that initial destabilizing shock. It was the principal
obstacle to offsetting action. It was the binding constraint
preventing policymakers from averting the failure of banks
and containing the spread of financial panic. For all these
reasons, the international gold standard was a central factor
in the worldwide Depression. Recovery proved possible, for
these same reasons, only after abandoning the gold standard.
The gold standard also existed in the nineteenth century, of
course, without exercising such debilitating effects. The
explanation for the contrast lies in the disintegration during
and after World War I of the political and economic
foundations of the prewar gold standard system. The dual
bases for the prewar system were the credibility of the official
commitment to gold and international cooperation. Credibility
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(p.xi) Preface
Page 2 of 6
induced financial capital to flow in stabilizing directions,
buttressing economic stability. Cooperation signalled that
support for the gold standard in times of crisis transcended
the resources any one country could bring to bear. Both the
credibility and the cooperation were eroded by the economic
and political consequences of the Great War. The decline in
credibility rendered cooperation all the more vital. When it
was not forthcoming, economic crisis was inevitable.
This decline in credibility and cooperation during and after
World War I reflected a confluence of political, economic, and
intellectual changes. In the sphere of domestic politics,
disputes over income distribution and the proper role for the
state became increasingly contentious. In the international
political realm, quarrels over war debts and reparations
soured the prospects for cooperation. Economics and politics
combined to challenge and ultimately to compromise the
independence of central bankers, the traditional guardians of
the gold standard system. Doctrinal disagreements led
countries to diagnose their economic ills in different ways,
thereby impeding their efforts to cooperate with one another
in administering a common remedy. Placed against the
background of far‐reaching economic changes that heightened
the fragility of domestic and international financial
institutions, this was a prescription for disaster.
This book attempts to fit these elements together into a
coherent portrait of economic policy and performance
between the wars. My goal is to show how the policies
pursued, in conjunction with economic imbalances created by
World War I, (p.xii) gave rise to the catastrophe that was the
Great Depression. My argument is that the gold standard
fundamentally constrained economic policies, and that it was
largely responsible for creating the unstable economic
environment on which they acted.
I like to pretend that these are the final words I will write on
the world economy between the wars. I recall some who
questioned at the outset whether a study of a period through
which they themselves had lived was properly regarded as
history. “So you're an economic historian,” one of my future
colleagues in the Harvard economics department greeted me
(p.xi) Preface
Page 3 of 6
when I arrived to interview for my first academic job. “Surely
you don't think that the interwar period qualifies as history.”
The passage of time, if nothing else, has helped to convince
skeptics that the subject of this volume qualifies as history. It
is up to me, I suppose, to convince them that its treatment
qualifies as economics.
The process of writing a book such as this serves as a pleasant
reminder of what it means to belong to a community of
scholars. It was Jeff Sachs who first suggested that I write this
book rather than the less tractable volume I initially
envisaged. He will detect here the influence of a series of
conversations begun nearly ten years ago. I also received
valuable encouragement, both written and verbal, from
innumerable other friends and colleagues. Without
denigrating the gratitude I feel to any of those individuals who
devoted their scarce time to reviewing drafts of the
manuscript and who provided other forms of valuable
assistance, I must single out three with whom I had very
extended conversations. Peter Temin's thoughtful comments
were especially important for shaping the book's final form.
My initial impulse, as always, was to resist Peter's challenges
to what I regarded as my impeccable logic. I should know by
now that however much I am inclined to resist them, I will feel
compelled in the end to address Peter's points as best I can.
That his comments were accompanied by lox, bagels, and
strong coffee made them go down easier. Jeff Frieden, who
critiqued the political aspects of the argument, has all the
good instincts of an economist plus the good sense not to be
one. Conversations with Michael Bordo, who is the product of
a different intellectual tradition than I, continue to
demonstrate that doctrine need be no barrier to the search for
understanding in history and economics.
The author of a work of synthesis risks offending specialists.
Instead of protecting their turf, experts on aspects of
international finance, international relations, and economic
history that I had not broached before encouraged me to stray
onto unfamiliar turf, graciously pointing out errors of fact and
interpretation that I threatened to commit along the way. I can
vividly remember opening a fifteen‐page single‐spaced letter
from Peter Kenen and making a mental note to call my editor
(p.xi) Preface
Page 4 of 6
and announce that the manuscript would be delayed. Others
who responded with great care, and to whom I am deeply
grateful, include Alberto Alesina, Ben Bernanke, Charles
Calomiris, Marcello de Cecco, Brad DeLong, Trevor Dick,
Stanley Engerman, Charles Feinstein, Peter Hall, Gary Hawke,
Carl‐Ludwig Holtfrerich, Susan Howson, Toru Iwami, Harold
James, Lars Jonung, Charles Kindleberger, Adam Klug, Robert
Keohane, Diane Kunz, Maurice Levy‐Leboyer, Peter Lindert,
Charles Maier, Donald Moggridge, Douglass North, John
O'Dell, Ronald Rogowski, Christina Romer, Anna Schwartz,
Mark Thomas, Gianni Toniolo, Eugene White, and Elmus
Wicker. Where we continue to differ, I hope that they (p.xiii)
will see that I have done my best to indicate clearly my
rationale for advancing interpretations and analyses with
which they disagree. In addition to providing general
reactions, Ian McLean and Steve Webb graciously responded
to data questions. Gerald Feldman shared portions of his as
yet unpublished study of the German hyperinflation, which
helped me to clarify aspects of Chapter 5. Theo Balderston's
unpublished manuscript similarly helped to clarify portions of
Chapters 8 and 9. I thank them as well for comments on the
manuscript.
The final version of the manuscript is considerably changed—I
like to think improved—from the version read by and reacted
to by all those persons mentioned above. This is my unsubtle
plea that they read this version before dispatching their
devastating reviews.
In what is intended as a work of synthesis, I have tried to keep
to a minimum references to unpublished sources. Inevitably I
have been forced back to the archives, however, where the
secondary literature is contradictory or incomplete. For
permission to cite materials in their possession, I am grateful
to the Federal Reserve Bank of New York (Strong Papers and
related documents), Columbia University's Butler Library
(Harrison Papers), Harvard University's Baker Library
(Lamont Papers), the League of Nations Archives at the United
Nations in Geneva, the French Ministry of Finance, the Bank
of France, and the British Public Record Office.
(p.xi) Preface
Page 5 of 6
Similarly, I have tried to keep as unobtrusive as possible the
jargon and mathematical apparatus characteristic of research
in economics. Recent developments in economics, I am
convinced, help to clarify our understanding of several
disputed aspects of the gold standard and the Great
Depression. Work on the time consistency of economic policy,
game theoretic treatments of international policy coordination,
and stochastic models of exchange‐rate target zones are three
examples of literatures that bear directly on the issues this
book is concerned with and that lend structure to its
arguments and interpretations. Theoretical formulations and
statistical relationships inevitably inform all analyses of this
kind. But I have tried to state them nontechnically and keep
them from interrupting the narrative. For formal statements of
the models and econometric tests, readers may refer to
journal articles cited in the notes. I thank my editor at Oxford,
Herb Addison, for guiding my quest to bag the elusive general
reader.

Abstract and Keywords
The gold standard is conventionally portrayed as synonymous
with financial stability, and its downfall, starting in 1929, is
implicated in the global financial crisis and the worldwide
depression. A central message of this book is that precisely
the opposite was true: far from being synonymous with
stability, the gold standard itself was the principal threat to
financial stability and economic prosperity between the World
Wars I and II. To understand why, it is necessary first to
appreciate why the interwar gold standard worked so poorly
when its prewar predecessor had worked so well, next, to
identify the connections between the gold standard and the
Great Depression, and finally, to show that the removal of the
gold standard in the 1930s established the preconditions for
recovery from the Depression. These are the three tasks
undertaken in the book (which is arranged chronologically),
and they are summarized in the sections of this introductory
chapter.
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Oxford Scholarship Online
Introduction
Page 2 of 43
Keywords: economic instability, economic stability, financial instability,
financial stability, gold standard, Great Depression, interwar period, World War
I, World War II
“Finance is the nervous system of capitalism,” observed
Ramsay MacDonald, intermittently Britain's prime minister
between 1924 and 1935. If so, then the capitalist system in
MacDonald's years suffered from a chronic neurological
disorder. The 1929 Wall Street crash was followed by the
collapse of financial institutions and an implosion of activity on
financial markets. The subsequent downturn became the Great
Depression—the great economic catastrophe of modern times.
That catastrophe was a global phenomenon. Contrary to the
impression conveyed by much of the literature, which focuses
on the United States, the Great Depression was so severe
precisely because so many countries were affected
simultaneously. No national economy was immune. All
suffered financial difficulties and many experienced
debilitating financial crises. It is therefore logical to seek the
key that unlocks the puzzle of the Depression in the
institutions linking the financial markets of different countries.
Here the gold standard enters the story. For more than a
quarter of a century before World War I, the gold standard
provided the framework for domestic and international
monetary relations. Currencies were convertible into gold on
demand and linked internationally at fixed rates of exchange.
Gold shipments were the ultimate means of balance‐ofpayments
settlement. The gold standard had been a
remarkably efficient mechanism for organizing financial
affairs. No global crisis comparable to the one that began in
1929 had disrupted the operation of financial markets. No
economic slump comparable to that of the 1930s had so
depressed output and employment.1
The central elements of this system were shattered by the
outbreak of World War I. More than a decade was required to
complete their reconstruction. Quickly it became evident that
the reconstructed gold standard was less resilient than its
prewar predecessor. As early as 1929 the new international
monetary system began to crumble. Rapid deflation forced
countries producing primary commodities to suspend gold
Introduction
Page 3 of 43
convertibility and depreciate their currencies. Payments
problems spread next to the industrialized world. In the
summer of 1931 Austria and Germany suffered banking panics
and imposed exchange controls, suspending the convertibility
of their currencies into gold. Britain, along with the United
States and France, one of the countries at the center of the
international monetary system, was (p.4) next to experience a
crisis, abandoning the gold standard in the autumn of 1931.
Some two dozen countries followed suit. The United States
dropped the gold standard in 1933; France hung on until the
bitter end, which came in 1936.
The collapse of the international monetary system is
commonly indicted for triggering the financial crisis that
transformed a modest economic downturn into an
unprecedented slump. So long as the gold standard was
maintained, it is argued, the post‐1929 recession remained
just another cyclical contraction. But the collapse of the gold
standard destroyed confidence in financial stability, prompting
capital flight which undermined the solvency of financial
institutions. The financial crisis leapfrogged from country to
country, dragging down economic activity in its wake.
Removing the gold standard, the argument continues, further
intensified the crisis. Having suspended gold convertibility,
policymakers manipulated currencies, engaging in beggar‐thyneighbor
depreciations that purportedly did nothing to
stimulate economic recovery at home while only worsening the
Depression abroad. The world of finance was splintered into
competing currency areas, disrupting international trade,
discouraging foreign investment, and generally impeding
recovery.
The gold standard, then, is conventionally portrayed as
synonymous with financial stability. Its downfall starting in
1929 is implicated in the global financial crisis and the
worldwide depression. A central message of this book is that
precisely the opposite was true. Far from being synonymous
with stability, the gold standard itself was the principal threat
to financial stability and economic prosperity between the
wars.
Introduction
Page 4 of 43
To understand why, we must first appreciate why the interwar
gold standard worked so poorly when its prewar predecessor
had worked so well. Next, we must identify the connections
between the gold standard and the Great Depression. Finally,
to clinch the argument we must show that removal of the gold
standard in the 1930s established the preconditions for
recovery from the Depression. These are the three tasks
undertaken in this book. The remainder of this chapter
describes the connections between them and summarizes the
evidence presented.
How the Gold Standard Worked
Considerable agreement exists on the reasons for the contrast
between the stability of the classical gold standard and the
instability of its interwar counterpart. The dominant
explanation is expressed most clearly in the work of Charles
Kindleberger. Kindleberger argues that the stability of the
prewar gold standard resulted from effective management by
its leading member, Great Britain, and her agent, the Bank of
England. The British capital market is said to have increased
its foreign lending whenever economic activity turned down,
damping rather than aggravating the international business
cycle. The Bank of England is said to have stabilized the gold
standard system by acting as international lender of last
resort. Kindleberger contrasts the prewar situation with the
interwar period, when Britain was too weak to stabilize the
system and the United States was not prepared to do so. In an
application of what has come to be known as the theory of
hegemonic stability, Kindleberger concludes that the requisite
stabilizing influence was adequately supplied (p.5) only when
there existed a dominant economic power, or hegemon, ready
and able to provide it.2
Chapter 2 challenges this argument. It suggests that the
interwar period was hardly exceptional for the absence of a
hegemon. Nor was there a country that singlehandedly
managed international monetary affairs prior to World War I.
London may have been the leading international financial
center, but it had significant rivals, notably Paris and Berlin.
The prewar gold standard was a decentralized, multipolar
Introduction
Page 5 of 43
system. Its smooth operation was not attributable to
stabilizing intervention by one dominant power.3
The stability of the prewar gold standard was instead the
result of two very different factors: credibility and
cooperation.4 Credibility is the confidence invested by the
public in the government's commitment to a policy. The
credibility of the gold standard derived from the priority
attached by governments to the maintenance of balance‐ofpayments
equilibrium. In the core countries—Britain, France,
and Germany—there was little doubt that the authorities
ultimately would take whatever steps were required to defend
the central bank's gold reserves and maintain the
convertibility of the currency into gold. If one of these central
banks lost gold reserves and its exchange rate weakened,
funds would flow in from abroad in anticipation of the capital
gains investors in domestic assets would reap once the
authorities adopted measures to stem reserve losses and
strengthen the exchange rate. Because there was no question
about the commitment to the existing parity, capital flowed in
quickly and in considerable volume. The exchange rate
consequently strengthened on its own, and stabilizing capital
flows minimized the need for government intervention. The
very credibility of the official commitment to gold meant that
this commitment was rarely tested.5
(p.6) What rendered the commitment to gold credible? In
part, there was little perception that policies required for
external balance were inconsistent with domestic prosperity.
There was scant awareness that defense of the gold standard
and the reduction of unemployment might be at odds.
Unemployment emerged as a coherent social and economic
problem only around the turn of the century. In Victorian
Britain, social commentators referred not to unemployment
but to pauperism, vagrancy, and destitution. In the United
States such persons were referred to as out of work, idle, or
loafing but rarely as unemployed. In France and Sweden the
authorities referred not to unemployment but to vagrancy and
vagabondism. These terms betray a tendency to ascribe
unemployment to individual failings and a lack of
comprehension of how aggregate fluctuations, referred to by
Introduction
Page 6 of 43
contemporaries as the trade cycle, affected employment
prospects.6
Even observers who connected unemployment to the state of
trade rarely related aggregate fluctuations to interest rates or
monetary conditions. They had limited appreciation of how
central bank policy affected the economy. There was no wellarticulated
theory of how supplies of money and credit could
be manipulated to stabilize production or reduce joblessness,
like the theories developed by Keynes and others after World
War I. Those who focused on changes in money and credit,
such as Ralph Hawtrey, argued that these perversely amplified
the trade cycle.7 Rather than advocating active monetary
management to stabilize the economy, the majority of
observers advised a passive and therefore predictable
monetary stance.
The working classes, possessing limited political power, were
unable to challenge this state of affairs. In many countries, the
extent of the franchise was still limited. Labor parties, where
they existed, rarely exercised significant influence. Those who
might have objected that restrictive monetary policy created
unemployment were in no position to influence it. Domestic
political pressures did not undermine the credibility of the
commitment to gold.
The point should not be exaggerated. By the first decade of
the twentieth century, unemployment had become a
prominent social issue. The spread of unionism and extension
of the franchise had enhanced the political influence of those
most vulnerable to loss of work. There was a growing
consensus that high interest rates discouraged investment and
depressed trade. Central bankers were not insensitive to these
considerations. Still, when forced to choose between external
and internal targets, they did not hesitate.
Nor did policymakers believe that budget deficits or increased
public spending could be used to stabilize the economy. Since
governments followed a balanced‐budget (p.7) rule, changes
in revenues dictated changes in the level of public spending.
Countries rarely found themselves confronted with the need to
eliminate large budget deficits in order to stem gold outflows.
Introduction
Page 7 of 43
Firmly established norms existed concerning the distribution
of the fiscal burden. For revenues, central governments relied
primarily on import duties; taxes on income or domestic
activity were still costly to collect. The individuals required to
pay import duties, often purchasers of imported foodstuffs and
other consumer goods, tended to be wage earners with
relatively little political say. When revenue needs fluctuated,
import duties could be adjusted accordingly. The need to
eliminate a budget deficit did not automatically open up a
contentious debate over taxation. Governments could credibly
promise to direct fiscal as well as monetary instruments
toward balance‐of‐payments targets.
Thus, a particular constellation of political power, reinforced
by prevailing political institutions, and a particular view of the
operation of the economy provided the foundation for the
classical gold standard system. This combination of factors—
political institutions and influence on the one hand, the
prevailing conceptual framework on the other—was the basis
for the system's credibility.8
Ultimately, however, the credibility of the prewar gold
standard rested on international cooperation. When stabilizing
speculation and domestic intervention proved incapable of
accommodating a disturbance, the system was stabilized
through cooperation among governments and central banks.9
Minor problems could be solved by tacit cooperation,
generally achieved without open communication among the
parties involved. When global credit conditions were overly
(p.8) restrictive and a loosening was required, for example,
the requisite adjustment had to be undertaken simultaneously
by several central banks. Unilateral action was risky; if one
central bank reduced its discount rate but others failed to
follow, that bank would suffer reserve losses and might be
forced to reverse course to defend the convertibility of its
currency. Under such circumstances, the most prominent
central bank, the Bank of England, signaled the need for
coordinated action. When it lowered its discount rate, other
central banks usually responded in kind. In effect, the Bank of
England provided a focal point for the harmonization of
national monetary policies. By playing follow the leader, the
Introduction
Page 8 of 43
central banks of different countries coordinated the necessary
adjustments.10
Major crises, in contrast, typically required different
responses from different countries. The country losing gold
and threatened by a convertibility crisis had to raise interest
rates to attract funds from abroad; other countries had to
loosen domestic credit conditions to make funds available to
the central bank experiencing difficulties. The follow‐theleader
approach did not suffice, especially when it was the
leader, the Bank of England, whose reserves were under
attack. Such crises were instead contained through overt,
conscious cooperation among central banks and governments.
Central banks and governments discounted bills on behalf of
the weak‐currency country or lent gold to its central bank.
Consequently, the resources any one country could draw on
when its gold parity was under attack far exceeded its own
reserves; they included the resources of the other gold
standard countries. This provided countries with additional
ammunition for defending their gold parities.
What rendered the commitment to the gold standard credible,
then, was that the commitment was international, not merely
national. That commitment was activated through
international cooperation.
This theme of cooperative management is different from the
conventional focus in the gold standard literature, which
emphasizes the Bank of England's hegemonic role. The
incompatibility of the two views need not be overstated,
however. One way of reconciling them is to observe that their
relative importance varied with time and circumstances. In
relatively tranquil periods, the Bank of England's tacit
leadership provided the organizing framework for
international cooperation. In times of crisis, in contrast,
international cooperation was key. The Bank of England lost
her leadership status. During crises she became no more than
one of several central banks whose collective intervention was
needed to stabilize the gold standard system. At worst, she
lost even her capacity to contribute to international support
operations. During the most serious crises, notably in 1890
and 1907, the critical stabilizing role was exercised by other
Introduction
Page 9 of 43
central banks. The Bank of England herself became a hostage
to international cooperation. Far from international lender of
last resort, she was international borrower of last resort,
reduced to dependence on the assistance of the Bank of
France, the German Reichsbank, and other European central
banks.
(p.9) In the decade leading up to World War I, such
international cooperation became increasingly frequent and
regularized. The leading role of the Bank of England was
challenged, and international cooperation became increasingly
prevalent. It is commonplace to assert that the gold standard
was a managed system; the point here, which is a departure
from the existing literature, is that much of that management,
especially in times of crisis, was undertaken collectively by
several countries. Though it is important to acknowledge that
Bank of England leadership as well as international
cooperation figured in the functioning of the prewar system, to
concentrate on the leadership and neglect the cooperation is
to fundamentally misunderstand its operation.
The two linchpins—credibility and cooperation—that had held
the prewar gold standard in place were eroded by World War
I. Credibility was challenged by an array of political and
economic changes that shattered the particular constellation
of political power upon which policy decisions had been
predicated before 1913. Adopting the corporatist strategy for
securing labor peace, wartime governments encouraged the
spread of unionism. Issues that had previously remained
outside the political sphere, such as the determination of
levels of wages and employment, suddenly became politicized.
Extension of the franchise and the growth of political parties
dominated by the working classes intensified the pressure to
adapt policy toward employment targets.11 When employment
and balance‐of‐payments goals clashed, it was no longer clear
which would dominate. Doubt was cast over the credibility of
the commitment to gold. No longer did capital necessarily flow
in stabilizing directions. It might do the opposite, intensifying
the pressure on countries that were losing reserves. The
erosion of credibility rendered the interwar system
increasingly vulnerable to destabilizing shocks.
Introduction
Page 10 of 43
The decisions of central bankers, long regarded as obscure,
became grist for the political mill. The monetary authorities
were attacked from the left for upholding outdated monetary
doctrines and from the right for pandering to the demands of
the masses. They consequently lost much of the insulation
they once enjoyed.
Where the independence of monetary policymakers was most
seriously compromised, explosive inflations ensued. Unable to
balance government budgets, politicians enlisted the central
bank's monetary printing presses to finance their deficits. In
some countries the resulting episode of inflationary chaos and
economic turmoil lasted until 1926. The lesson drawn was the
need to insulate central banks from political pressures. In
France, Germany, and other countries, steps were taken to
bolster the independence of the monetary authorities. The new
statutes sometimes tied the central bankers' hands so firmly
that they were prevented from extending a helping hand to
foreign banks in need. Legislative reform designed to enhance
the credibility of the gold standard thus had the perverse
effect of thwarting cooperation.
(p.10) Those responsible for fiscal policy generally enjoyed
even less insulation from political pressures than their
counterparts in central banks. The war shattered the
understandings regarding the distribution of the fiscal burden
that existed before 1913. The level and composition of taxes
were radically altered. Incomes were redistributed wholesale.
The question was whether to retain the new distribution of
fiscal burdens or to restore the old order. Economic interests
fought a fiscal war of attrition, resisting any increase in the
taxes they paid and any reduction in the transfers they
received. Each faction held out in the hope that the others
would give in first.12 Even in countries where central bankers
retained sufficient independence from political pressures that
they could be counted on to defend gold convertibility, fiscal
policy became politicized. Absent a consensus on the
distribution of fiscal burdens, there was no guarantee that
taxes would be raised or government spending cut when
required to defend the gold standard. Credibility was the
casualty.
Introduction
Page 11 of 43
The connection between domestic politics and international
economics is at the center of this book. The gold standard, I
argue, must be analyzed as a political as well as an economic
system. The stability of the prewar gold standard was
attributable to a particular constellation of political as well as
economic forces. Similarly, the instability of the interwar gold
standard is explicable in terms of political as well as economic
changes. Politics enters at two levels. First, domestic political
pressures influence governments' choice of international
economic policies. Second, domestic political pressures
influence the credibility of governments' commitment to
policies and hence their economic effects.
With the erosion of credibility, international cooperation
became even more important than before the war. Yet the
requisite level of cooperation was not forth‐coming. Three
obstacles blocked the way: domestic political constraints,
international political disputes, and incompatible conceptual
frameworks. Domestic interest groups with the most to lose
were able to stave off adjustments in economic policy that
would have facilitated international cooperation. The
international dispute over war debts and reparations hung like
a dark cloud over all international negotiations, contaminating
efforts to redesign and manage the gold standard system
cooperatively. The competing conceptual frameworks
employed in different countries prevented policymakers from
reaching a common understanding of their economic problem,
much less from agreeing on a solution.
The nature of these conceptual frameworks can be explained
in terms of the historical experiences of the nations
concerned. Different experiences with inflation created
different views of the connections between finance and the
economy and of the role for monetary management. In
countries like France that suffered persistent inflation,
discretionary monetary management came to be seen as the
source of financial instability rather than the solution. In
countries like Britain that had avoided persistent inflation and
restored their prewar parities, the increasingly multipolar
nature of the world economy and the growing prominence of
foreign exchange reserves heightened the importance
attached to intervention and cooperation. In the eyes of the
Introduction
Page 12 of 43
French, excessive credit creation in violation of the gold
(p.11) standard constraints, which had been circumvented by
international cooperation, had set the stage for the economic
collapse that started in 1929. In the eyes of the British, the
problem instead was inadequate liquidity resulting from
slavish adherence to the gold standard. Policymakers found it
hard to agree on a diagnosis of the problem, much less a
remedy. Hence they found it impossible to cooperate in
stabilizing the gold standard and countering the economic
slump.13
It is not entirely accurate to characterize these conceptual
frameworks in such monolithic terms. Doctrinal divisions
existed within countries as well. In the United States, which
finally established a central bank in 1914, officials of the
Federal Reserve Bank of New York, the seat of international
finance, were better attuned to the advantages of international
cooperation than their counterparts on the Board of Governors
in Washington, D.C. The arrival of the Fed on the international
scene was a significant departure from the prewar era.
Disputes between New York and Washington rendered the
new institution unpredictable. Until the Banking Act of 1935
consolidated power, considerable influence was wielded by
reserve city bankers from the interior of the country with little
exposure to or sympathy for international considerations.14
The brash newcomer disrupted the clubby atmosphere in
which European central bankers had managed the prewar
system. Prior to World War I, cooperation among the few
important national participants in international markets could
be arranged on an ad hoc basis. But with the addition of new
participants, ad hoc agreements proved increasingly difficult
to reach.
A formal venue might have helped. In the 1920s international
institutions embodying every important function of the
organizations established at Bretton Woods in 1944 were
proposed by economists and other experts both in and out of
government.15 Governments sent delegates to international
conferences at Brussels in 1920 and Genoa in 1922 in the
hope of designing an institutional basis for cooperation.
Incompatible conceptual frameworks and the dispute over war
debts and reparations frustrated their efforts. The single most
Introduction
Page 13 of 43
notable attempt to institutionalize international economic
cooperation, founding the Bank for International Settlements
(B.I.S.) in 1930, was of no consequence. Ongoing international
political disputes, still connected mainly with war debts and
reparations, prevented the B.I.S. from serving as a significant
venue for international monetary cooperation. The initial
responsibilities of the B.I.S. focused on German reparations;
given the linkage between the reparations owed by Germany
and the war debts owed to the United States, the U.S.
Congress refused to permit the Fed to join.
It was still possible for central bankers to meet informally and
for governments to consult. But international political disputes
could be equally disruptive of ad hoc efforts to cooperate, as in
attempts to arrange French, British, and American loans to
Austria and Germany in 1931. The Austrian loan foundered
over French insistence (p.12) that the supplicant renounce its
prospective customs union with Germany. The German loan
negotiations were disrupted by the dispute over reparations.
Moreover, when contemplating policy trades that might
enhance the welfare of all the nations involved, policymakers
were hamstrung by domestic political opposition motivated on
other grounds. A concession by domestic policymakers that
elicited a matching concession abroad, even if it rendered both
nations better off, still might be opposed by entrenched
minorities within both countries. For example, an international
agreement for reducing interest rates in order to stimulate
output and employment in both countries might be opposed by
lenders and other beneficiaries of high interest rates.
Minorities in a strategic political position succeeded
repeatedly in blocking cooperative agreements.
The argument, in a nutshell, is that credibility and cooperation
were central to the smooth operation of the classical gold
standard. The scope for both declined abruptly with the
intervention of World War I. The instability of the interwar
gold standard was the inevitable result.
The Causes of the Great Depression
Given this explanation for the instability of the interwar gold
standard, it remains to link the gold standard to the Great
Introduction
Page 14 of 43
Depression. That link stretches back to the changes in the
pattern of balance‐of‐payments settlements bequeathed by
World War I. The war greatly strengthened the balance‐ofpayments
position of the United States and weakened that of
other nations. In the mid‐1920s, the external accounts of other
countries remained tenuously balanced courtesy of long‐term
capital outflows from the United States. But if U.S. lending
was interrupted, the underlying weakness of other countries'
external positions suddenly would be revealed. As they lost
gold and foreign exchange reserves, the convertibility of their
currencies into gold would be threatened. Their central banks
would be forced to restrict domestic credit, their fiscal
authorities to compress public spending, even if doing so
threatened to plunge their economies into recession.
This is what happened when U.S. lending was curtailed in the
summer of 1928 as a result of increasingly stringent Federal
Reserve monetary policy. Inauspiciously, the monetary
contraction in the United States coincided with a massive flow
of gold to France, where monetary policy was tight for
independent reasons.16 Thus, gold and financial capital were
drained by the United States and France from other parts of
the world. Superimposed on already weak foreign balances of
payments, these events provoked a greatly magnified
monetary contraction abroad. In addition they caused a
tightening of fiscal policies in parts of Europe and much of
(p.13) Latin America. This shift in policy worldwide, and not
merely the relatively modest shift in the United States,
provided the contractionary impulse that set the stage for the
1929 downturn. The minor shift in American policy had such
dramatic effects because of the foreign reaction it provoked
through its interaction with existing imbalances in the pattern
of international settlements and with the gold standard
constraints.
This explanation for the onset of the Depression, which
emphasizes concurrent shifts in economic policy in the United
States and abroad, the gold standard as the connection
between them, and the combined impact of U.S. and foreign
economic policies on the level of activity, has not previously
appeared in the literature. Its elements are familiar, but they
Introduction
Page 15 of 43
have not been fit together into a coherent account of the
causes of the 1929 downturn.17
To understand how those elements coalesce, it is necessary to
return to the economic effects of World War I. The war
strengthened the competitive position of American producers
in international markets for manufactured goods. This,
together with an exceptionally productive agricultural sector,
pushed the U.S. trade balance into surplus. Capital
transactions reinforced these trends. After the war,
reparations began to flow westward from Germany to the
victorious Allies and from there, in repayment of war debts, to
the United States. American lending to Central Europe was
needed to recycle these westward flows. Imported capital was
required by Latin American countries seeking to adjust to the
slump in primary commodity prices and by Western European
nations rebuilding their war‐torn economies. American loans
were essential for both processes. So long as American
lending continued, the gold standard remained viable and did
not pose a threat to prosperity. But when U.S. capital exports
were curtailed, the gold standard was at risk. The policies
required to defend it proved inconsistent with economic
stability.
At first, the process worked smoothly. Generous U.S. lending
enabled the nations of Western Europe to repair their
devastated economies. Germany and the new nations of
Eastern Europe, rewarded for their adoption of austerity
measures by a surge of foreign loans, were able to halt their
postwar hyperinflations without plunging their economies into
extended recessions. Inflows of capital and gold enabled
countries like Britain to restore the prewar gold standard
parity at relatively low cost. Each of these achievements was
facilitated by low interest rates and expansionary monetary
policy in the United States. Low domestic interest rates
encouraged (p.14) abundant U.S. financial capital to seek
more remunerative employment overseas. The expansion of
domestic credit minimized U.S. acquisition of gold and in some
periods, like the second half of 1927, encouraged American
gold to flow abroad.
Introduction
Page 16 of 43
Accommodating U.S. monetary policy between 1924 and 1927
is not usually cast in this favorable light. More commonly, it is
blamed for igniting the Wall Street boom, thereby setting the
stage for the crash that would initiate the Depression. In fact,
there is no evidence that monetary policy played a significant
role in the great bull market of the 1920s.18 It is more
plausible to argue that the Wall Street boom influenced
monetary policy rather than the other way around. Starting in
1928, Federal Reserve officials concluded that an orgy of
financial speculation was diverting money from productive
uses. They began tightening monetary policy, increasing the
likelihood that the economy would fall prey to recession.
Steadily rising domestic interest rates curtailed U.S. foreign
lending. The debtor nations, heavily reliant on capital imports,
felt the effects starting in the summer of 1928. As their
payments positions weakened, they were forced to adopt
increasingly stringent monetary and fiscal policies to defend
their gold parities and maintain service on their external
debts. Sometimes even the most draconian measures did not
suffice. The debtors were forced off the gold standard, one
after another, starting in 1929.
Debt service was maintained in the hope of renewed access to
foreign capital following the Wall Street boom. But the Great
Crash was followed by the Great Depression and the collapse
of U.S. lending. World trade imploded. Protectionism in the
United States and other industrial countries intensified the
primary producers' balance‐of‐payments problems. Continued
difficulties led to default in Latin America in 1931, in Central
Europe in 1932, and in Germany in 1933. Default was a rude
shock to the creditors. For countries like Britain, heavily
dependent on interest earnings from abroad, it contributed to
the deterioration in the balance of payments, setting the stage
for the 1931 sterling crisis. Thus, the same recycling
mechanism that underpinned the pattern of international
settlements in the 1920s undercut its stability in the 1930s.
The initial downturn in the United States enters this tale as
something of a deus ex machina, lowered from the rafters to
explain the severity and persistence of difficulties in other
parts of the world. To some extent this is inevitable, for there
Introduction
Page 17 of 43
is no consensus about the causes of the downturn in the
United States. The tightening of Federal Reserve policy in
1928–29 seems too modest to explain a drop in U.S. GNP
between 1929 and 1930 at a rate twice as fast as typical for
the first year of a recession. Hence the search for other
domestic factors that might have contributed to the severity of
the downturn, such as structural imbalances in American
industry, (p.15) an autonomous decline in U.S. consumption
spending, and the impact of the Wall Street crash on wealth
and confidence.19
The debate over the role of such factors remains far from
resolution. This is not surprising, since by focusing exclusively
on events internal to the United States the literature misses a
critical facet of the story. It is not possible to understand the
causes of the American slump so long as they continue to be
considered in isolation from events in other parts of the world.
The downturn that began in the United States in the late
summer or early autumn of 1929 was already evident
elsewhere, and had been so for as long as 12 months.
Consequently, U.S. exports peaked before U.S. industrial
production. When domestic demand in the United States
weakened, it reinforced the previous decline in export
demand. American producers did not have the option of
sustaining their profits by diverting sales from domestic to
foreign markets—they had no choice but to curtail
production.20 Hence the initial downturn in the United States
was unusually severe.
Thus, the debilitating downturn of 1929–30 was not simply the
product of a contractionary shift in U.S. monetary policy but of
a restrictive shift in policy worldwide. Policies in other
countries were linked to policy in the U.S. by the international
gold standard. Given the pattern of international settlements,
a modest shift in U.S. policy could have a dramatic impact on
the payments positions of other countries, provoking a greatly
magnified adjustment in their economic policies. Monetary
authorities outside the United States were forced to respond
vigorously to the decline in capital inflows if they wished to
stay on the gold standard. Fiscal authorities had to retrench to
compress domestic spending and limit the demand for
merchandise imports.
Introduction
Page 18 of 43
American policymakers, in contrast, were not required to react
to the improvement in the U.S. balance of payments by
loosening the economic reins. So long as the Wall Street boom
persisted, the Fed continued to raise interest rates instead of
allowing them to fall. Rather than being cushioned by a
decline in U.S. interest rates, the rise in rates in Europe and
Latin American was thereby reinforced. With the Fed's failure
to repel capital inflows, other countries were forced to
redouble their restrictive efforts. The asymmetry in the gold
standard system under which countries in surplus can shift the
burden of adjustment to countries in deficit, forcing them to
deflate, was the last thing needed in 1928–29.
However devastating this initial disturbance, one would think
that at this point the self‐equilibrating tendencies of the
market would have come into play. Wages (p.16) and other
costs should have fallen along with prices to limit the rise in
unemployment and the decline in sales. They did so only
modestly. The explanation lies in the “stickiness,” in money
terms, of other important variables. Mortgages were fixed in
nominal terms and ran for years to maturity. Rents also were
fixed in nominal terms for extended periods. Bonds paid
coupons that were fixed in nominal terms. Claimants to these
sources of income—rentiers, capitalists, and workers—each
would have accepted a reduction in their incomes had they
been assured that others were prepared to do the same.
Without a mechanism to coordinate their actions, no one
group was prepared to be the first to offer concessions.21
None of this explains why governments were so slow to
respond as the Depression deepened. If wages failed to fall,
officials could have used monetary policy to raise prices.22 If
private spending collapsed, they could have used public
spending to offset it. Yet monetary policy in the United States,
France, and Britain remained largely passive. Fiscal policy
turned contractionary, as governments raised taxes and
reduced public spending. Policy thereby reinforced rather
than offset the decline in demand.
The response may have been perverse, but it was not
paradoxical. It is hard to see what else officials in these
countries could have done individually given their commitment
Introduction
Page 19 of 43
to gold. Unilateral monetary expansion or increased public
expenditure moved the balance of payments into deficit,
threatening the gold standard.23 So long as they remained
unwilling to devalue, governments hazarding expansionary
initiatives were forced to draw back. Britain learned this
lesson in 1930, the United States in 1931–33, Belgium in 1934,
France in 1934–35. Thus, not even the (p.17) leading
proprietors of gold, the United States and France, escaped the
external constraint.24
The dilemma was whether to sacrifice the gold standard in
order to reflate, an option most policymakers continued to
oppose, or to forswear all measures that might stabilize the
economy in order to defend the gold standard. Finessing this
choice required international cooperation. Had policymakers
in different countries been able to agree on an internationally
coordinated package of expansionary initiatives, the decline in
spending might have been moderated or reversed without
creating balance‐of‐payments problems for any one country.
Reflation at home would have reversed the decline in
spending; reflation abroad would have prevented the stimulus
to domestic demand from producing trade deficits and capital
flight. Under the gold standard, reflation required
cooperation. Without cooperation, reflation was impossible.
This lesson was learned the hard way. Repeatedly, domestic
political pressures compelled governments to attempt
reflationary policies. Quickly the gold standard was
threatened, and they were forced to draw back. Large as well
as small countries were constrained. This is clearly evident in
the French experiment with reflationary initiatives under
Flandin and Laval in 1934–35. Not even the United States
could reflate unilaterally, as the open market purchases and
reserve losses of the spring and summer of 1932 would reveal.
The problem was not a lack of U.S. leadership, since effective
leadership was impossible. It was the failure of cooperation.
The one significant opportunity to coordinate reflationary
initiatives, the 1933 London Economic Conference, was an
utter failure. All the obstacles to cooperation that had
disrupted the operation of the gold standard were thrown up
again. The question of war debts, still unresolved, continued to
Introduction
Page 20 of 43
complicate negotiations. Minority interests blocked
international policy trades that would have benefited each of
the participating nations. Policymakers in different countries
continued to diagnose the crisis in different ways. The British,
having endured high interest rates since 1925, perceived the
Depression as a consequence of excessively restrictive
monetary policies. The French, having suffered double‐digit
inflation as recently as 1926, blamed the Depression on overly
expansive policies that had provoked an unsustainable boom, a
devastating crash, and a lingering slump. The American
position resembled that of France while Herbert Hoover was
president before gravitating toward that of Britain once
Franklin Roosevelt took office. Different diagnoses of the
problem led to different prescriptions of the appropriate
monetary remedy and to an inability to agree on a coordinated
response.
So far we have an explanation for the destabilizing impulse
and its propagation. The impulse was the restrictive monetary
policy pursued by the Federal Reserve for (p.18) domestic
reasons, in conjunction with the restrictive policies induced
abroad by the operation of the gold standard. It failed to die
out quickly because decentralized markets were unable to
coordinate an immediate adjustment of money wages and
prices, and because the gold standard constraints prevented
governments from pursuing a reflationary monetary response.
But what amplified this destabilizing impulse to the point that
a modest monetary correction in 1928–29 gave rise to the
great economic contraction of modern times? The answer lies
in the spread of financial instability starting in the second half
of 1930—the bank failures and financial chaos that led to the
liquidation of bank deposits and disrupted the provision of
financial services. The role of banking crises in the Great
Depression is widely accepted for the United States, although
the channels through which they affected the economy remain
in dispute. But bank failures played an important role in other
countries as well.25 Commercial banks around the world
pursued strategies of aggressive expansion that heightened
their vulnerability when the Depression struck. If allowed to
spread, bank runs threatened to disrupt the functioning of
financial markets. Shattering confidence, discouraging
Introduction
Page 21 of 43
lending, freezing deposits, and immobilizing wealth, they
amplified the initial contraction.
This answer to the question of what amplified the destabilizing
impulse only suggests another question: Why didn't
policymakers intervene to head off the collapse of their
domestic financial systems? They failed to do so because the
gold standard posed an insurmountable obstacle to unilateral
action. Containing bank runs required policymakers to inject
liquidity into the banking system, but this could be
inconsistent with the gold standard rules. Defending the gold
parity might require the authorities to sit idly by as the
banking system crumbled, as the Federal Reserve System did
at the end of 1931 and again at the beginning of 1933.
Even when central bankers risked gold convertibility by
intervening domestically as lenders of last resort, the
operation of the gold standard could render their initiatives
counterproductive. The provision of liquidity on a significant
scale signaled that the authorities attached as much weight to
domestic financial stability as to the gold standard. Realizing
that convertibility might be compromised and that devaluation
might cause capital losses on domestic assets, investors
rushed to get their money out of the country. Additional funds
injected into the banking system leaked back out as depositors
liquidated their balances. Perversely, the banking crisis was
intensified. International reserves were depleted as domestic
currency was sold for foreign exchange, forcing the authorities
to intervene in support of the exchange rate. Once the balloon
was punctured, blowing in additional air only widened the tear
and left the central bank gasping for breath.
These destabilizing linkages between domestic and
international financial systems operated most powerfully
where foreign deposits were most prevalent. Europe's banking
systems were interconnected by a network of foreign deposits.
(p.19) German banks and companies maintained deposits in
Vienna. Austrian banks and companies held deposits in Berlin.
By their nature, these balances were the most mobile
internationally. Disturbing revelations about the condition of a
national banking system might cause foreign depositors to
repatriate their funds. The capital account of the balance of
Introduction
Page 22 of 43
payments would weaken and the banking crisis would lead to
a convertibility crisis. Equally, disturbing news about the
balance of payments could spill over into an attack on the
banking system. Anticipating devaluation, foreigners
converted their bank deposits into currency and requested the
authorities to convert that currency into gold. The simultaneity
of banking panics and convertibility crises was systematic, not
coincidental.
Germany provides a classic illustration of these mechanisms at
work. Under the gold standard, the Reichsbank was required
to maintain a gold cover (essentially, the ratio of gold reserves
to notes and coin it issued) of at least 40 percent.26 Due to the
weakness of Germany's balance of payments, the cover ratio
was uncomfortably close to that minimum even before the
financial crisis of 1931. The banking crisis in neighboring
Austria was merely the straw that broke the camel's back.
German deposits in Vienna were frozen. The banking crisis
spread quickly to Hungary and other parts of Central Europe.
Disturbing revelations about the state of the German banking
system led investors to pessimistically revise their assessment
of the condition of German banks. French and British deposits
were withdrawn. The Reichsbank began to provide liquidity to
the banking system, but capital flight only accelerated. The
gold cover quickly fell to its legal minimum. To reduce it
further threatened to rekindle inflationary fears and
antagonize the reparations creditors, who had written into the
1930 Hague Treaty a provision requiring Germany to secure
permission from the Bank for International Settlements or the
Young Plan Arbitral Tribunal before modifying its gold
standard law. The Reichsbank was forced to draw back and let
the banking crisis run its course.27
Analogous forces came into play in the United States in 1933
and in Belgium in 1934, to cite only two examples. In contrast,
countries already off the gold standard had more freedom to
act. In Denmark and Sweden, which left gold in September
1931, officials were able to use their room for maneuver to
contain incipient banking crises, in Denmark in the final
months of 1931 and in Sweden in early 1932. Far from being a
bulwark of financial stability, the gold standard was the main
impediment to its maintenance.
Introduction
Page 23 of 43
Once again, escaping this dilemma required international
cooperation. Loans from other gold standard countries could
have replenished the reserves of central (p.20) banks
confronted with banking crises. The longer creditor countries
vacillated, the larger the requisite loans became. The loan
requested by the Reichsbank in the summer of 1931 would
have all but exhausted the free gold possessed by the United
States. Clearly, any such loan had to be provided collectively.
But again a variety of obstacles—reparations, diplomatic
disputes, and doctrinal disagreements among them—thwarted
cooperation.
The special structure of the interwar gold standard heightened
the vulnerability of national financial systems. The interwar
system was a gold‐exchange standard with multiple reserve
currencies. Central banks were authorized to hold, in addition
to gold, a portion of the backing for domestic liabilities in the
form of convertible foreign exchange. They held primarily U.S.
dollars, French francs, and British pounds. Altering the foreign
exchange portfolio entailed negligible costs. Central banks had
every incentive to hedge their bets—to sell a weak currency as
soon as the country of issue experienced difficulties. A minor
deterioration in the external position could be amplified
quickly if foreign central banks chose to alter the composition
of their foreign reserves.
Supplementing gold with foreign exchange was no recent
innovation. In response to postwar fears of inadequate
liquidity, however, the practice was generalized and extended.
By the late 1920s the share of foreign exchange in
international reserves was at least 50 percent above prewar
levels.28 As exchange reserves grew large relative to monetary
gold, the capacity of the reserve countries to maintain gold
convertibility was cast into doubt. Avoiding deflation required
continual growth of international reserves. Given the
inelasticity of gold supplies, this implied the growth of foreign
currency balances. The problem emphasized by Robert Triffin
after World War II—the dynamic instability of a system
predicated on gold convertibility but dependent on foreign
exchange for incremental liquidity—also arose in the 1920s.29
If anything, it was more vexing in the 1920s because of the
multiplicity of reserve currencies. In Triffin's era, central
Introduction
Page 24 of 43
banks held mainly dollars with the option of converting them
into gold. In the 1920s they were not forced to choose
between interest earnings and security; they could simply
convert one reserve currency into another.
This discussion of mutually reinforcing threats to the gold
standard and domestic banking systems is an example of one
of the methodological themes of this book: the need to treat
the gold standard as one of a range of factors contributing to
the Great Depression and to relate those factors to one
another. Some authors have analyzed the role of the gold
standard in the Depression, others the role of domestic
banking panics. The point here is that domestic and
international finance were intimately (p.21) connected.
Problems in one sphere cannot be understood in isolation from
problems in the other.
The End of the Gold Standard and the End of the
Depression
If the gold standard contributed to the severity of the slump,
did its collapse free the world from Depression's thrall?
According to the conventional wisdom, the currency
depreciation made possible by abandoning the gold standard
failed to ameliorate conditions in countries that left gold and
exacerbated the Depression in those that remained.30 Nothing
could be more contrary to the evidence. Depreciation was the
key to economic growth. Almost everywhere it was tried,
currency depreciation stimulated economic recovery. Prices
were stabilized in countries that went off gold. Output,
employment, investment, and exports rose more quickly than
in countries that clung to their gold parities.
The advantage of currency depreciation was that it freed up
monetary and fiscal policies. No longer was it necessary to
restrict domestic credit to defend convertibility. No longer was
it necessary to cut public spending in countries where
expenditure was already in a tailspin. “There are few
Englishmen who do not rejoice at the breaking of our gold
fetters,” as Keynes put it when Britain was forced to devalue
in September 1931.31
Introduction
Page 25 of 43
It was not only the gold standard as a set of institutions that
posed an obstacle to economic recovery, however, but also the
gold standard as an ethos. Though abandoning gold
convertibility was necessary for adopting reflationary policies,
it was not sufficient. A financial crisis might force a country to
abandon gold convertibility, but it did not cause it to abandon
financial orthodoxy. Only when the principles of orthodox
finance were also rejected did recovery follow.
Where devaluation was seen as an opportunity to expand
domestic credit, as in Belgium, recovery was propelled by
domestic spending. Output and employment responded quickly
to demand. Since credit expansion drove up domestic prices,
little change occurred in the real exchange rate (the cost of
foreign goods expressed in domestic currency, relative to the
cost of their domestic counterparts). There was little
improvement in international competitiveness. Exports rose
slowly if at all, and the trade balance strengthened marginally
at best.
Where currency depreciation did not occasion an expansion of
domestic credit, as in Czechoslovakia, exports played a larger
role. Recovery was still possible, since devaluation raised the
price of foreign goods relative to those produced at home,
switching demand to the latter. But less domestic credit
expansion meant less inflation. By making exports more
competitive, depreciation therefore strengthened the balance
of payments. The increased demand for credit that
accompanied recovery was accommodated by gold imports.
But with less domestic demand, output and (p.22)
employment were slow to recover. Some countries, like
Britain, followed a course midway between these extremes.
Others, like France, once they finally depreciated their
currencies perversely adopted measures that neutralized the
benefits.
Most countries were slower to abandon the gold standard's
ethos than its institutions. There was little tendency, after
suspending gold convertibility, to initiate reflationary action.
Six months to a year had to pass before officials took steps to
expand the money supply. The interlude was necessary to
convince the public and policymakers alike that abandoning
Introduction
Page 26 of 43
gold did not pose an inflationary threat, which was a
necessary precondition for questioning financial orthodoxy.
Only then did governments initiate policies that finally
launched their economies on the road to recovery. This
explains why currency depreciation did not prompt a more
rapid return to full employment.
Thus, the failure to pursue more expansionary policies, and
not currency depreciation itself, was responsible for the
sluggishness of recovery. This emphasis on the salutary effects
of depreciation is very different from the negative assessment
that pervades the literature. In at least one respect, however,
the revisionist view presented here is compatible with
previous accounts. Prior authors have emphasized the
damaging foreign repercussions of competitive depreciation—
the notorious “beggar‐thy‐neighbor” effects. Those effects did
operate. Depreciation stimulated recovery in the initiating
country partly by altering relative prices and switching
demand from foreign to domestic goods. At the same time that
it increased demand for domestic products, it exacerbated
competitive difficulties abroad. The magnitude of the beggarthy‐
neighbor effects depended on the nature of the policies
that accompanied devaluation. The more the depreciating
country expanded domestic credit, the greater the level of
domestic spending on imports as well as other goods. The
more it expanded domestic credit, the smaller the capital
inflow following devaluation. Countries still on the gold
standard suffered smaller reserve losses and were not forced
to contract their money supplies to the same extent.32
Foreign countries may have suffered, but the choice was
theirs. Indeed, they had the capacity to avoid the damaging
repercussions entirely. They too could have chosen to go off
gold and reflate. It did not follow that the beneficial effects
were eliminated if every country devalued. Every country,
once off the gold standard, could initiate expansionary
monetary and fiscal measures. In the absence of gold standard
constraints, international cooperation was no longer essential.
Even if the devaluation cycle, once complete, left exchange
rates between currencies at their initial levels, it permitted
more expansionary monetary and fiscal policies all around.33
Introduction
Page 27 of 43
Admittedly, the haphazard manner in which devaluation took
place amplified its beggar‐thy‐neighbor effects. Countries still
on gold responded to their loss of competitiveness by raising
tariffs and tightening quotas. Frequently these measures
(p.23) were justified as retaliation against devaluation abroad.
Though the aggregate effects were not large, protectionism
was a further impediment to cooperation. Once entrenched
behind protective barriers, domestic producers went to great
lengths to prevent them from being dismantled. The strength
of protectionist sentiment in countries like France posed a
major obstacle to the negotiation of an internationally
coordinated response to the Depression.
Unpredictable exchange‐rate fluctuations also encouraged
liquidation of foreign exchange reserves. As central banks
scrambled to substitute gold for foreign exchange, pressure on
the reserves of the remaining gold standard countries
intensified. A more orderly devaluation, like that negotiated by
France in 1936, could have minimized the uncertainty and
subdued the deflationary scramble for gold. But such
negotiations were inconceivable so long as countries remained
wedded to the gold standard.
Ultimately, the question is why countries stayed wedded to
gold for so long, and why those that abandoned the gold
standard failed to pursue expansionary policies more
aggressively. Why were some more inclined than others to
release their gold fetters? The question brings us back full
circle to the issues that began our discussion—to the
importance of domestic politics for international economics
and the enduring legacy of economic events in the early 1920s
for economic outcomes in the 1930s. In part, different
decisions across countries reflected differences in the balance
of political power, between creditors who benefited from
deflation and debtors who suffered, or between producers of
internationally traded goods who benefited from devaluation
and producers of domestic goods who were likely to be hurt.34
Farmers, who were both debtors and producers of traded
goods, were usually in the vanguard of those pressing for
devaluation or, in the case of countries like Germany, for
exchange control. Labor was ambivalent: workers moved
freely between sectors producing traded and nontraded goods
Introduction
Page 28 of 43
and doubted the efficacy of measures like devaluation that
promised to reduce unemployment only by cutting the living
standards of the employed. The traditional opposition of
financial interests to tampering with the monetary standard
was defused once the gold standard was revealed as
inconsistent with the stability of banking systems.
Policy decisions reflected, in addition to shifting political
coalitions, the influence of historical experience. A central
determinant of the willingness of governments to dispense
with the gold standard in the 1930s was the ease with which it
had been restored in the 1920s. Where the battle was difficult,
countries had endured costly and socially divisive inflations. In
extreme cases like Germany, Austria, Hungary, and Poland,
price instability had degenerated into hyperinflation. In
France, Belgium, and Italy, though inflation did not reach
comparable heights, the legacy was still the same.
Policymakers and the public continued to regard the gold
standard and price stability as synonymous. And they
continued to adhere to this view long after the 1929–31
collapse of prices had provided ample evidence to the
contrary. “Depreciation” and “inflation” were still used
interchangeably without awareness that their meaning was
not precisely the same. The suspension of convertibility
(p.24) raised the specter of an explosive rise in prices. As
Heinrich Brüning, Reich Chancellor in 1930–32, explained the
problem to British Prime Minister Ramsay MacDonald in June
1931, “One must either go along with deflation or devalue the
currency. For us only the first could be considered, since, six
years after experiencing unparalleled inflation, new inflation,
even in careful doses, is not possible.”35
There is no little irony in the fact that inflation was the
dominant fear in the depths of the Great Depression, when
deflation was the real and present danger. Precisely because
this fear seems so misplaced, its pervasiveness cannot be overemphasized.
Countries like Britain, Sweden, and the United States had not
experienced run‐away inflation in the 1920s. The gold
standard and price stability were still clearly distinguished.
Though policymakers harbored fears of inflation, those fears
Introduction
Page 29 of 43
did not reach phobic levels. There was less trepidation that
devaluation would lead inevitably to monetary instability,
social turmoil, and political chaos. Elected officials in these
three countries were eventually able to pursue policies
designed to raise prices, at least until they had been restored
to pre‐Depression levels.
Politicians in countries like Germany and France were
obsessed with inflation because it was symptomatic of deeper
social divisions. It reflected the disintegration of the prewar
settlement—specifically, the prewar consensus regarding the
distribution of incomes and fiscal burdens. World War I
transformed the distribution of incomes and tax obligations
and destroyed long‐standing conventions governing
distribution. A bitter dispute erupted over whether to restore
the status quo ante or to maintain the new fiscal system. So
long as this dispute raged, postwar coalition governments
were incapable of agreeing on a package of tax increases and
public expenditure reductions sufficient to balance their
budgets.
Inflation was symptomatic of this fiscal war of attrition. The
longer budget deficits persisted, the less willing investors
grew to absorb government bonds, and the more the fiscal
authorities were forced to rely on the central bank's printing
press. In the 1920s, only when inflation had risen to
intolerable heights had an accommodation been reached. The
gold standard was emblematic of the compromise. To abandon
it threatened to reopen the dispute and ignite another
debilitating inflationary spiral.
Thus, the failure in countries like Germany and France to
clearly distinguish depreciation from inflation was not mere
intellectual carelessness. The strong association of the two
concepts derived from the common set of political pressures
that had generated both phenomena in the aftermath of the
war.
The war of attrition had been most destructive, and therefore
exerted the most inhibiting influence on policy in the
Depression, in those countries where the prewar settlement
had been most seriously challenged—where fiscal institutions
Introduction
Page 30 of 43
were most dramatically altered, where property had been
most heavily destroyed, where income was most radically
redistributed. Still, virtually every European country
experienced these effects to some extent. Additional
considerations are therefore required to explain why they
reacted in such different ways.
(p.25) Among the most important considerations was the
structure of domestic political institutions. The war of attrition
was most intractable where political institutions handicapped
those who wished to compromise. In countries where
proportional representation electoral systems prevailed, it was
relatively easy for small minorities to obtain parliamentary
seats. The sensible strategy for political candidates was to
cater to a narrow interest group. Political parties proliferated.
Every group that might suffer from the imposition of a tax had
an elected representative to block its adoption. Government
necessarily was by coalition. Either a formal coalition was
formed of parties that together possessed a parliamentary
majority, or a minority government was formed with the
support of other parties. When the government attempted to
redress the fiscal problem, adversely affected parties
withdrew their support and the administration collapsed.
In countries with majority representation, in contrast, fringe
parties were more likely to be denied legislative voice. In this
electoral system, the party whose candidate receives a
majority or plurality of votes cast in a district is the only one
represented. Better prospects for securing a legislative
majority gave political parties an incentive to moderate their
positions in order to appeal to a large fraction of the
electorate. A government of the majority was better able to
raise taxes—not uncommonly, those paid by a minority. It was
in a better position to reduce transfers—usually those received
by a minority.36
A suggestive correlation exists between countries that
suffered inflationary crises in the 1920s and those with
proportional representation. The outbreak of World War I was
popularly ascribed to suppressed nationalism and the
mistreatment of minorities. The architects of the postwar
political order therefore created several separate nations out
Introduction
Page 31 of 43
of what had previously been the Austro‐Hungarian Empire and
encouraged the adoption of proportional representation to
give voice to minorities. Weimar Germany adopted a
proportional system. France reformed her electoral system to
incorporate a strong element of proportionality. Belgium
eliminated the right of electors to cast multiple votes, thereby
enhancing the proportionality of her electoral system. These
were among the countries hardest hit by the inflationary
crisis. In contrast, countries like the United Kingdom and the
United States whose electoral systems were based on majority
representation did not suffer comparable inflation.37 It is no
coincidence that, in the 1930s, France, Belgium, Poland, Italy,
(p.26) and Germany, who all had employed forms of
proportional representation and suffered inflation in the
1920s, remained on the gold standard or imposed exchange
control, with the same stifling effects, long after other
countries had gone off gold.
Countries whose institutions lent themselves least easily to
political stability thus had particular reason to fear inflation
and hence experienced the greatest difficulty in formulating a
concerted response to the Great Depression. But even in
countries like France, in which the political system was
reformed late in the 1920s to moderate its emphasis on
proportionality, fears lingered that abandoning gold would
ignite another round of inflationary chaos. Even where no
longer appropriate, views were still conditioned by the
experience of the previous decade. Historical memory
provided the framework through which economic events were
ordered and interpreted.
Other authors have noted the tendency for policymakers to
continue using history as a frame of reference even when
conditions have changed fundamentally.38 The point here is
different. The public also continues to use history in this
fashion. This provides even rational policymakers incentive to
err in the same direction. A public that fears that abandoning
the gold standard will provoke an inflationary crisis is likely to
sell its financial assets if that event occurs, rendering such
fears self‐fulfilling. Policymakers have good reason to proceed
cautiously when contemplating such actions.
Introduction
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Policy in general, and policy toward the gold standard in
particular, played a pivotal role in the Great Depression. It
was central to the Depression's onset. It was the key to
recovery. But policy was not formulated in a vacuum.
Policymakers resided in a particular time and place. Historical
experience—first with the classical gold standard, then with
the first world war, finally with inflation in the 1920s—molded
their perceptions and conditioned their actions, with profound
implications for the course of economic events.
The Structure of This Book
Developing these arguments is not straightforward, for three
reasons frequently stated but rarely taken to heart. First, the
Great Depression was a multifaceted event. Monocasual
explanations are certain to be partial and misleading. For this
reason, the gold standard is treated here as only one of
several factors contributing to the Depression. Throughout, I
attempt to relate the gold standard to these other factors and
to analyze their interaction.
Second, the Great Depression did not begin in 1929. The
chickens that came home to roost following the Wall Street
crash had been hatching for many years. An adequate analysis
must place the post‐1929 Depression in the context of the
economic developments preceding it. Another goal of this book
is to show the insight that can be gleaned from treating the
Great Depression as only one stage in a sequence of events
than began unfolding in 1914.
Third, the Great Depression was a global phenomenon. The
disturbances that (p.27) initiated it were not limited to the
United States. The Depression's severity was due not simply to
the magnitude of the errors committed by American
policymakers, although these played a considerable part.
Rather, it resulted from the interaction of destabilizing
impulses in the United States and other countries. A goal of
this book is to show how national histories can be knitted
together into a coherent analysis of the international economic
crisis.
The material used to develop these themes is organized
chronologically to convey a sense of how events appeared to
Introduction
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those who made the critical decisions. Chapter 2 begins with
the prewar gold standard. Besides documenting the role of
credibility and cooperation in the operation of this system, it
highlights differences in the functioning of the gold standard
at the center and the periphery. I show that the smooth
operation of the prewar system hinged on a particular
conjuncture of economic and political forces—forces that were
in decline even before the outbreak of World War I. I explain
why interwar observers failed to appreciate the tenuous basis
of the prewar system.
The war transformed the international economic and political
environment. Chapter 3 analyzes the major changes in
domestic and international finance and their implications for
the economic balance of power. It also describes the changes
in domestic political institutions that channeled the pressures
felt by policymakers. The postwar boom and slump, covered in
Chapter 4, provided a first indication of how radically the
environment had changed, although contemporaries
inadequately appreciated its lessons. The next two chapters
describe the fiscal war of attrition that fueled inflation in the
1920s. That war proved most intractable in Germany, where it
was fought internationally as well as on the domestic front.
The German hyperinflation that resulted from this deadlock is
the subject of Chapter 5. Chapter 6, which contrasts
inflationary chaos elsewhere in Europe with the experience of
countries that repelled the inflationary threat, shows that the
same forces also operated in other countries.
The next three chapters consider the operation of the
reconstructed gold standard system. Chapter 7 documents the
decline in credibility and cooperation compared to the prewar
era. Chapter 8 analyzes the role of the gold standard in the
onset of the Great Depression and shows how in turn the
slump undercut the foundations of the gold standard system.
Chapter 9 describes the desperate attempts of policymakers to
defend the gold standard and analyzes their role in
aggravating the Depression. At the same time it suggests that
the system's collapse provided new opportunities for
constructive action. The Chinese character for “crisis”
combines the symbols for “danger” and “opportunity.”39 My
Introduction
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point in this chapter entitled “Crisis and Opportunity” is much
the same.
Chapter 10 traces the consequences of the disintegration of
the gold standard system, contrasting economic recovery in
countries that jettisoned gold with continued depression in
countries that retained it. I attempt to account for their
respective policy decisions. The U.S. case emerges as
something of an anomaly. Chapter 11 therefore analyzes the
critical period in the spring of 1933 when American policy was
reversed and the dollar devalued. Roosevelt's abandonment of
gold coincided (p.28) with the London Economic Conference,
a last attempt to respond cooperatively to the economic crisis.
I trace the connections between the dollar's depreciation and
the London Conference and explain why the latter failed.
By 1934 it was impossible to ignore the contrast between the
persistence of depression in gold standard countries and the
acceleration of recovery in the rest of the world. The
continued allegiance to gold by several European countries,
led by France, has consequently been regarded as an enigma.
Chapter 12 shows how domestic politics combined with
collective memory of inflationary chaos in the 1920s to sustain
resistance to currency depreciation. Indeed, inflation anxiety
in the gold bloc was not entirely unfounded; sometimes it
proved self‐fulfilling. When currency depreciation finally came
to France in 1936, it was accompanied by inflation and social
turmoil but not by the beneficial effects evident in other
countries. Here, as in the rest of the book, historical and
political factors, not just economics, bear the burden of
explanation.
The legacy of the gold standard and the Great Depression
continued to influence both the economic behavior of
individuals and the policies of governments through the
remainder of the interwar years. That influence persisted into
World War II, into the postwar period, indeed right down to
the present day. The concluding chapter describes some
implications of that persistence for the postwar international
economic order.