A New, Eclectic View of the Depression: Part III- Examining the data on recovery influences

23 Jul

Leaving Gold and Recovery

            If it is indeed the case that the gold standard contributed to the global decline in output and prices during the 1930s, then one would expect that those countries not on gold at the time and those countries first to leave gold would experience the most rapid recoveries.  The evidence to support such a hypothesis is remarkable.  Kochin and Choudhri (1980), Eichengreen and Sachs (1985), and Bernanke and James (1991) each contribute to the evidence.

IN a landmark study of the Great Depression and exchange rate regimes, Kochin and Choudhri (1980) examine the efficacy of floating exchange rates in insulating economies from exogenous shocks.  To do this, look at output and prices of three different sets countries during the Great Depression, with each set then being compared to the United States and each other in regression analysis.  The authors examined (1) Spain, which had a fully floating exchange rate regime at the time, (2) the Netherlands, Belgium, Italy, and Poland; which were on gold throughout the Depression until 1935, and (3) the Scandinavian countries of Denmark, Finland, and Norway, which left gold in 1931.  The US left gold in 1933.

The authors find that US output and prices had no statistically significant impact on Spanish output and prices.  Indeed, the Spanish economy was astonishingly resilient to exogenous shocks from the US, with prices and output hardly falling during the Depression.  When looking at the data on the Scandinavian countries, the US did influence their output and prices, but to a much lesser extant than the countries of the Netherlands, Belgium, and Italy, and Poland.  For the eight sampled countries, the authors conclude that the severity of the Depression experienced by the individual country was “strongly related to the contraction…in the United states.”  The Scandinavian countries enjoyed greater insulation after leaving gold, and Spain was the only country which appeared essentially unaffected by the Depression.

Eichengreen and Sachs (1985) add to Choudhri and Kohin’s (1980) analysis of exchange rates by examining the way different exchange rate devaluations affected both the domestic and foreign economy.  The authors identify four different types of exchange rate devaluations, and find that while every from of devaluation certainly had a positive effect on domestic output, but that the “devaluation cycle” that occurred in the late 1920s and throughout the duration of the Depression indeed had a beggar-thy-neighbor effect.  However, this was merely because various countries devalued unilaterally, but had they each engaged in bilateral, cooperative devaluations, the authors predict that the beggar-thy-neighbor effect would have been subdued, and world interest rates would have been reduced to the point where investment was stimulated on a global scale.

The authors identify several mechanisms by which devaluation would increase domestic output.  On the supply side  there are two primary effects.  First, devaluation would make domestic goods more attractive on the foreign market and would also have the effect making foreign goods less attractive to domestic consumers.  The combination of these two would bid up the price of domestic goods, stimulating production.  Secondly , by bidding up domestic goods prices, real wages decline, which also stimulates output.  The authors show that those countries which devalued the most, relative to France, experience the largest reductions in real wages and the largest increases in real output.  Both Denmark and Sweden depreciated the most, and they also achieved the largest changes in real wages and the largest change in industrial production.  Another mechanism the authors identify is that by depreciation, the country could, and often did, expand its domestic money supply, thus lowered domestic rates and stimulating investment.  The regression, which looks at the discount rate and the extent of depreciation verifies such a relationship.  Additionally, the authors find that the direction of gold flows following devaluation is indicative of whether or not it was beggar-thy-neighbor, under the particular circumstance where a country devalues and accommodates their money supply enough to induce gold outflows and stimulate demand via declining foreign interest rates.  However their regression analysis indicates that depreciating countries largely experienced gold inflows, thus making their devaluations beggar-thy-neighbor.  In their view, the, the uncoordinated devaluation cycle contributed to the declines in global output, but had devaluations been strategically employed, they could have lowered world interest rates, accelerating the recovery process.

Bernanke and James (1991) look at prices, money supplies, and industrial production form a sample of 24 different countries.  The countries in the data set are subdivided into one of four categories, depending on adherence to and date at which the gold standard was abandoned.  When looking at the log-differences of the wholesale price index between countries from 1920-1936, the trend is apparent that gold standard countries experienced deflation of prices to a far greater extend than those which abandoned the standard.  Indeed, Spain, Australia, and New Zealand all experienced only minor deflations up to 1933, and then slight inflation from 1934 to 1936.  Those countries which abandoned the standard in 1931 encountered deflation of about 13% from 1930 until abandonment, after which time inflation is characteristic of these countries.  In contrast, those countries latest to abandon still experienced average deflation of 4 and 5% in 1935 and 1936., respectively.  The US experienced deflation of 10, 17, and 12% from 1930-1933, and upon abandoning the gold standard in 1933, experienced rates of inflation of 2, 13, 7, and 1% from 1933-1936.  In stark contrast, those countries still on gold as of 1936 experienced deflation of prices on average of 5% to as late as 1935, with France experiencing deflation as high as 11% in 1935.  In 1936, after these countries abandoned gold, each of them turned inflationary.  Thus, the authors conclude, “the link between deflation and adherence to the gold standard…seems quite clear.”

To compliment the data on the price index, the authors also examine data on money supplies, with the same breakdown of countries as before.  It would be assumed that leaving gold would be correlated with more aggressive growth in the aggregates, although, as Bernanke notes, the correlation is “less than anticipated.”  For instance, in 1932, countries on gold experienced an average of 13% deflation, yet comparisons of average monetary growth rates between gold and non-gold countries during that year reveal a difference of less than 1%.  Despite this, after 1933 the expected correlation is obvious, with the average differences between rates of growth in the monetary aggregates between gold and non-gold standard countries being about 5% in 1933, 3% in 194, and 8.6% in 1935.  I suspect this is merely due to lag, as money makes its way through the economy and people adjust to new expectations.  Thus, from 1933 on, it appears that remaining on the gold standard restricted a central bank’s ability to engage in quantitative easing.

The authors also look at industrial production with the same sample, and the finding support the view that the global deflation precipitated by the inter-war gold standard had substantial real effects on the economy.  When looking at the period from 1932-1935, it is evident that countries not on gold experienced, on average, nearly 7% greater industrial output than the gold-bound countries.  Bernanke notes this as “a very substantial effect.”

Bernanke and James interpret their findings as evidence to suggest that adherence to the gold standard lengthened both the deflation and declines in output that countries experienced during the Depression, as well as suggesting, though with less certainty, that monetary policy effectiveness was restricted by a country’s decision to remain on gold.


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