The central thesis of this book is that the gold standard, “far from being synonymous with stability, [was] itself … the principal threat to financial stability and economic prosperity between the wars.” Paradoxically, the prevailing conventional wisdom at the time was that the opposite was true: only gold could achieve stability and growth. UC Berkeley economist Barry Eichengreen, one of the world’s leading authorities on the subject, tackles three related questions in pursuit of his thesis.
First, why did the prewar gold standard work so well while the interwar experience was so poor?
Primarily because the credibility and cooperation that was required for the gold standard to work was not present after World War I, he argues. At the turn of the century, there was limited appreciation for the connection between monetary and fiscal policy and domestic employment, and even if there were, the groups most impacted by the decisions were political marginalized. Therefore, governments were given a virtual free hand to take whatever policy course necessary to defend the nation’s convertibility to gold, which made it “credible.” “Credibility,” he writes, “is the confidence invested by the public in the government’s commitment to a policy.” The guarantee of gold convertibility was so credible it was hardly ever challenged.
Meanwhile, that credibility was further reinforced by relatively “strings-free” international cooperation and support from the fledging national banks of the most developed economies in Europe. The Bank of England played a key role in this system, but by no means essential one, according to the author, who explicitly rejects Kindleberger’s classic “hegemonic stability theory.” The gold standard, Eichengreen claims, was “a political as well as economic system,” and it was the immense political impacts of World War I that destroyed the necessary credibility (no longer was it taken as a given that a government would raise interest rates, raise taxes and/or cut federal spending in order to defend the gold convertibility rate) and cooperation (conflicts over reparation payments, war debt, along with fundamental philosophical differences) required for the system to work.
Second, what was the connection between the gold standard and the Great Depression?
Eichengreen argues he is making a novel argument in “Golden Fetters” by suggesting that the extreme shift in the international balance of payments equilibrium after World War I made the defense of the gold standard contingent upon steady and significant financing of European international obligations. In the summer of 1928, as the US Federal Reserve raised interest rates to dampen speculation in the red hot stock market, the European economies were threatened as their limited gold reserves began to flow across the Atlantic in search of higher returns (Note: the author says that there is no evidence that loose US monetary policy played a significant role in the bull market of the 1920s). Because of the gold standard and the central role of US gold in propping it up via generous lending, American domestic policy decisions necessarily and directly impacted international policy decisions. That is, an increase in the US interest rate triggered defensive fiscal and monetary actions by the leading European economies, all in an aggressively contractionary direction (i.e. increasing of interest rates and taxes, while cutting domestic spending). Acting alone was impossible if the gold standard was to be defended. The type of cooperation required was politically impossible by the 1930s, the author writes, mainly because minority interest groups held a disproportionate influence over domestic politics in most western nations at the time.
What really triggered the Great Depression though was the epidemic and unchecked string of bank failures that generated panic and a downward spiral in liquidity. The central reserve banks refused to lower interest rates out of fear on the pressure it would put on their precious gold reserves, while consumers hoarded cash for fear that their banks would go under. Under the prevailing system, Eichengreen says, the US Fed, for instance, had no choice by sit idly by while the domestic banking system crumbled. “Shattering confidence, discouraging lending, freezing deposits, and immobilizing wealth, they amplified the initial contraction,” the author concludes.
Third, did the removal of the gold standard in the 1930s establish the preconditions necessary for recovery from the Great Depression?
After the Bank of England went off of gold in 1931 the celebrated economist John Maynard Keynes famously quipped: “There are few Englishmen who do not rejoice at the breaking of the golden fetters.” Indeed, Eichengreen maintains that currency depreciation was the key to economic growth, mainly because it freed up monetary and fiscal policies. That said, depreciation was a necessary but not in-and-of-itself sufficient to promote broad scale macroeconomic recovery. “Only when the principles of orthodox finance were rejected [i.e. running extreme budget deficits] did recovery follow.” And this is where most countries fell short according to the author. “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.” For instance, some key countries, such as Germany and France, were “obsessed with inflation because it was symptomatic of deeper social divisions.” Different national motivations and experiences led to a haphazard approach in the way nations went off gold. Most then failed to bolster that critical monetary move with aggressive expansionary fiscal policies that exacerbated the so-called “beggar-thy-neighbor” impacts on the international balance of payments. In other words, countries were capitalizing on short-term advantages in currency exchange rates to bolster exports in a way that was neither sustainable nor advantageous to the domestic economy long term. Again, it was “the failure to pursue more expansionary policies, and not currency depreciation itself,” the author claims what “was responsible for the sluggishness of recovery.”
In closing, Eichengreen makes his points with a blizzard of economic data and hammers home his central argument relentlessly: “Far from being a bulwark of financial stability, the gold standard was the main impediment to its maintenance.” It is a Keynesian argument top-to-bottom and convincingly delivered.
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