A New, Eclectic View of the Great Depression- Part I: breaking the rules and debt-deflation

17 Jul

Bank run sketch of customers demanding deposits “en masse.”

The Pre-War Gold Standard

In order to understand that interwar gold standard, it is first to contrast it to the better, more efficient pre-war gold standard.  Eichengreen (1992) argues that the pre-war gold standard operated so efficiently for over 25 years preceding World War I because it functioned under two critical tenants of credibility and cooperation.  The three countries at the heart of the system were Britain, France, and Germany, and each one had a strong commitment to operating under the “rules of the game” as dictated by the price-specie-flow mechanism, where debtor countries drawing down reserves were supported by increased interest rates domestically and decreased interest rates abroad, channeling reserves to the debtor country at sufficient speed.  Eichengreen that the reason this commitment was so rigidly maintained was because, prior to the turn of the century, central bankers were given little authority and thought to influencing unemployment.  That is, central bankers focused on external, rather than internal balance.  Thus, “the commitment was international;” other central banks followed the discount rate policy of the Bank of England during “tranquil” times, and in times of crisis, each central bank explicitly cooperated with one another.

With the outbreak of WWI, the system was alerted significantly, and ultimately broke down.  With the rearrangement of war debt and fiscal burdens, each country had alternative views on how to cope, and instead of relying on import duties as taxes as they had in the past, countries adopted no unified system.  Additionally, the influence of unions and special interest groups strengthened during the war years, which increased pressure on central banking authorities to consider employment targets.  Each country had its own ideology and view on the proper role of central banks in dealing with theses issues, which depended upon the particular political atmosphere at the time and the countrys’ past experiences with inflation.  Thus, there was a conflict of visions, as the external focus of the pre-war era shifted inward, the old system broke down.

The Inter-War gold Standard

Bernanke and James (1991) identify three technical problems associated with the interwar gold standard; an asymmetry of monetary response by deficit and surplus countries, the pyramiding of reserves, and a lack of central bank authority.  Each of these factors assisted in creating global deflation.

The “rules of the game” dictated that in order for the price-specie-flow mechanism to operate smoothly, countries receiving an inflow of gold must expand their money supplies, while those experiencing an outflow were to contract.  Theoretically, this would serve to maintain the world ratio of m1/base.  With the inter-war gold standard, there existed a statutory minimum on the coverage ratio of 40%, thus making it mandatory that deficit countries contract as gold drained from their central banks.  However, no such minimum existed for the base/reserves ratio, so surplus countries could sterilize inflows if the central bank authorities deemed it necessary or prudent.  Consequently, this asymmetry made the interwar system biased towards deflationary pressure.

However, this was not the tendency toward deflation the interwar gold standard possessed.  Bernanke notes that factionary reserve requirements amplified the deflationary bias in the system via two mechanisms.  First, because central banks held a 40% minimum amount of gold as reserves, they were effectively tied up and could not be used to pay liabilities.  Thus, a portion of all the gold reserves was immobilized.  Bernanke sites League of Nations data, which shows that of the total amount of gold reserves held by 41 countries, only about 23% was available as surplus to be used for the payment of debts.  The second mechanism by which fractional reserve requirements created a deflationary bias is because the ratio of monetary contraction to gold outflows was not one-to-one.  Under the fractional reserve system, whenever the domestic money supply was contracted, gold flowed out of the country at some multiple of the contraction.  For instance, under the 40% reserve requirement for the interwar gold standard, the multiple loss of gold was 2.5.

The second technical flaw, addressed by Bernanke, has to do with the fact that under the system, foreign exchange reserves were a near equal substitute for gold.  IN the 1930s, when the threat of exchange rate crises and devaluation loomed, central banks fled from foreign exchange “en masse,” leading to declines in the reserves/gold ratio.   Then, in order to insulate their economies from currency attacks, countries increased their coverage ratio in a “scramble for gold,” causing the base/reserves ratio to fall.  Thus, this  “pyramiding of reserves” was yet another technical impediment, resulting in further deflationary bias in the system.

Bernanke points out a third flaw, and it is a conspicuous lack of policy tools available to central banks during the interwar period.  Most notabley, he points to the Bank of France, who between the United States and itself possessed approximately 60% of the world’s gold supply.  During the 1920s, in order to prevent the monetization of deficits, the Bank of France was restricted of its authority to engage in open market operations, thus leaving only the discount rate as a tool to effect policy.  However, European commercial banks seldom borrowed from the bank of France, thus enervating the Bank of France’s ability to affect the domestic money supply.  Form the period 1928-1932, France’s holdings of gold increased over 100%, peaking at an amount equal to 32% of the world’s gold supply.  This entailed a substantial drain on reserves from deficit nations.  Yet, with France unable to expand, the price-specie-flow mechanism was disrupted, resulting in deflationary pressure transmitted internally.  The US, fearing inflation and potential asset bubbles, began sterilizing and become concretionary in 1928.  This combined contraction by the US and out of France led to a drastic decline in the world money multiplier, and set the stage for the global deflation that characterized the 1930s.


The specific transmission mechanism by which deflationary pressure leads to depression is an important consideration.  IN the spirit of Irving Fisher’s 1933 work, Bernanke and Gertler (1990) stress debt-deflation as a principal cause for the declines in output, whereby the borrower’s real debt burden is increased with deflation (i.e. every penny they owe is now costs more than before).  Borrower reactions to this “financial distress” impose a negative externality, which results in a deadweight loss to others.  For instance, in order to repay his new, higher real debt, he may make cutbacks and lay off workers, who in turn make cutbacks in spending on their own.  These create significant nominal shocks, particularly to consumer and investment spending, and precipitous decline in prices and aggregate demand ensue.

Bernanke and James (1991) emphasize that the banking panics—which peaked in 1931 not just in the US, but in several another countries as well, ranging from Hungary, to Japan, to Sweden—were a direct result of the deflation by the disrupted interwar gold standard, and served as a primary conduit linking nominal shocks of declining prices to the real side of the economy, namely aggregate output.  According to this view, the banking sector, whose assets (deposits) are set in strictly nominal terms but whose liabilities (debt and equity) are real, were squeezed by any fall in prices, as this caused their assets to decline in value.  This is similar to Fisherian debt-deflation.  As already noted, under the gold standard central banks could not engage in quantitative easing at will due to cover ratio statutes in already in place.

The authors (Bernanke and James) run regression analysis on several variables to determine the effect of banking panics on output and find that banking panics reduced output by 16%, which is statistically significant.    IN addition to the regression, Bernanke offers an alternative analysis using the standard AD-AS/IS-LM framework, and again finds that banking panics have statistically significant effects on output.

Also addressed is the scenario in which banking panics initiated by the gold standard deflation could set of a further deflationary contagion transmitted again via the gold standard.  Theoretically, banking panics in small, debtor countries on gold could not affect world prices, because their money supplies must ultimately respond to those of their creditors.  This theory is supported by regression analysis again by Bernanke and James (1991), where they find no significant link between banking panics in small countries and deflation.  However, such is not the case for large creditor countries, where domestic shocks to the price level will be transmitted via the gold standard to the smaller countries, whose prices must adjust.  Indeed, Bernanke offers empirical evidence on wholesale prices and money growth in the United States and France to support this view.  He finds that there is, in fact, “cointegration,” which means that shocks to the prices level in large countries under the interwar gold standard will be transmitted to smaller countries on gold.  Thus, the banking panics in the US and France exacerbated the global deflation and declines in output during 1931 and 1932 (Bernanke and James, 1991).

 Part II will be up soon, in which I’ll discuss some non-monetary contributing factors, and the workings of Eichengreen’s “golden fetters” model.

Copyright Nelson R Hoffman


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