By: Ben Bernanke & Harold James

The Gold Standard, deflation and financial crisis in the great depression:an international comparison By: Ben Bernanke & Harold James

ABSTRACT • “Theory suggests that falling prices, by reducing the net worth of banks and borrowers, can affect flows of credit and thus real activity…we confirm that countries which were more vulnerable to severe banking panics also suffered much worse depressions, as did countries which remained on the gold standard.”

Introduction • Temin (1989): structural flaws of the interwar gold standard, in conjunction with policy responses dictated by the gold standard’s “rules of the game”, made an international monetary contraction and deflation almost inevitable. • Hamilton (1987-88): “the defense of gold standard parities added to the deflationary pressure.” • Deflation may have induced depression through real wage and interest rate effects, or the disruptive effect of deflation on the financial system (this being the paper’s primary focus). P down  Y down Deflation’s impact on finance: Bank Panics & Debt Deflation • Fisher (1933): “Debt-Deflation” • The more the debtor pays, the more he owes

The Gold Standard and Deflation • Mismanaged Interwar gold standard was responsible for the worldwide deflation of the late 1920’s and early 1930’s. • Gold Standard : Suspended at the outbreak of WWI. • Not itself unusual. • Bordo& Kydland (1990): Should be considered part of its normal operation. • Create reputation to return at pre-war parity. • End up returning somewhere near that parity. • Would make it easier for Gov’t to sell bonds at low nominal rates and allow the war to be financed at a lower total cost.

The Gold Standard and Deflation • Desire to return to gold standard at pre-war pars was strong in early 1920’s . • However there was the perception that there was not enough gold available to satisfy world money demands without deflation  Gold-Exchange Stnd. Note: • Industry (debtor) vs. Finance (creditor) • The City’s interest: A strong pound  London as the world financial center

The Gold Standard and Deflation • Interwar Standard Est. 1925-28 and had substantially broken down by 1931 and disappeared by 1936. • Temin (1989): “the war itself was the shock that initiated the Depression • arbitrary borders disrupted trade • reparations claims and international war debts  fiscal burdens and fiscal uncertainty • Ineffective cooperation among central banks  no one to take responsibility for system as a whole. “The British couldn’t, the U.S. wouldn’t” Kindleberger

The Gold Standard and Deflation • Asymmetry between surplus and deficit countries in the required monetary response to gold flows. • “Rules of the Game” forced on debtor countries • No sanction prevented surplus countries from sterilizing gold inflows and accumulating reserves indefinitely. • France and U.S. at one point held 60% of world’s gold.  a deflationary bias in the gold standard’s operation.

The Gold Standard and Deflation • Pyramiding of reserves in Gold-Exchange System: • Convertible reserves only partially backed by gold. • A shift by the public from fractionally backed deposits to currency lowers the domestic money supply. • A shift by Central Banks from foreign exchange reserves to gold might lower the world money supply.  Another deflationary bias to the system. • Central banks did abandon foreign exchange en masse in early 1930’s when threat of devaluation made foreign exchange assets too risky.

The Gold Standard and Deflation • Insufficient powers of Central Banks • Open mkt. operations were not permitted or were severely restricted for European C.B.’s. • Stabilization policies of early and mid 1920’s following hyperinflations • C.B.’s control over money supply quite weak except in period of crisis • Bank of France prohibited by law from engaging in open market operations France could not inflate while it sucked gold from others Deficit countries forced to deflate  Global deflation • But laws can be changed

The Gold Standard and Deflation:The Villans • France and U.S. had surplus gold inflows • Both end up deflating. • France: • Economic growth: increased demand for francs exceeded the sterilized inflow of reserves  price deflation of ~ 11% from Jan. 1929- Jan. 1930. • United States: • Monetary tightening in 1928 to slow stock market speculation. • Price level falls 4%. • Business cycle peak reached in August ’29 • Stock mkt. crashes Oct. ‘29

The Gold Standard and Deflation • Temin: “once these destabilizing policy measures had been taken, little could be done to avert deflation and depression, given the commitment of Central Banks to maintenance of the gold standard.” • Central Banks engaged in competitive deflation and a scramble for gold, hoping to protect their currencies against speculative attack. • Attempts by any individual Central Bank to reflate were met by immediate gold outflows, forcing it to raise its discount rate and deflate once again. • Monetary contraction began in U.S. and France and was propagated throughout the world by the international monetary standard.

The Gold Standard and Deflation • Spain: never restored gold standard and allowed exchange rate to float. • Avoided the declines in prices and output that effected other European countries. • Haberler (1976):Scandinavian countries along with the U.K. leave gold in 1931 and recover much more quickly than other European countries that remained on gold standard. • Don’t forget Sweden’s “stimulus program” • Countries whose currencies depreciated enjoyed faster growth of exports and production than countries that did not depreciate. • Eichengreen and Sachs (1985, 1986): Coordinated devaluation would have benefited all countries

The Gold Standard and Deflation • After 1931, sharp divergence between countries on and off the gold standard. • Price levels in countries off gold stabilized by 1933 • Gold standard countries continued to deflate, although slower than initially, until 1936 with the dissolution of the gold standard. • Countries off gold did not fully take advantage of opportunity to reflate ... Msgrowth lagged • Mdmay have fallen: fear of inflation • Gold standard mindset in absence of gold standard

Link Between Deflation and Depression • Worldwide deflation was the result of a monetary contraction transmitted through the international gold standard. • High Real wages: • lowered profitability  reduced investment • Bernanke and James report inconclusive empirical results • High Real Interest Rates: • Monetary contraction shifts LM curve left, raising real i rates, reducing spending, depressing output. • But M/P may actually have risen with price deflation • Deflationary expectations raise real interest rates  Spending decreases  IS shifts inward But was ongoing deflation anticipated? • Financial Crisis: • Deflation weakens financial positions of borrowers, both nonfinancial firms and financial intermediaries.

Debt-Deflation • “Debt-deflation”: the increase in the real value of nominal debt obligations brought about by falling prices.” • Real value of assets down • Borrower net worth down  Worsened agency problem • “Financial distress” (such as induced by debt-deflation) can in principle impose deadweight losses on an economy  Interwar period marked by financial crises. • Financial crisis intensity: bad and worse • Central banks constrained from acting as lenders of last resort • Unit banking (small US banks) v. branch banking (big Canadian banks) • Universal banking (Kreditanstalt as holding company) v. arms-length banking (UK-US short-term lending) • Foreign deposits  “hot money” • Legacy of hyperinflation and stabilization programs

Conclusion “Monetary and financial arrangements in the interwar period were badly flawed and were a major source of the fall in real output. Banking panics were one mechanism through which deflation had its effects on real output, and panics in the U.S. may have contributed to the severity of the world deflation.”

By: Ben Bernanke & Harold James