Published by

AMERICAN INSTITUTEfor ECONOMIC RESEARCH

RESEARCHREPORTS

Great Barrington, Massachusetts 01230 Vol. LXI No. 7 April 4, 1994

Did the Gold Standard Causethe Great Depression?*

by Richard M. Salsman

Prevailing economic folklore has it thatthe Great Depression was a failure of freemarkets, especially its foremost feature,the gold standard. Keynesians and mon-etarists alike share a distaste for goldmoney and say it played a key role intriggering and deepening the depression.While Keynesians declare gold a "barba-rous relic" that impedes economic growth,monetarists say it is like any other com-modity, but too costly and cumbersometo serve as money. Both defend centralbanking and insist that governments canmanage our affairs best when free of thegolden albatross.

If this notion is correct, we shouldnever again have gold money or free mar-kets, for they will only wreak havoc yetagain. If it is myth, however, it should beexposed as such. A recent book by Berke-ley professor Barry Eichengreen, GoldenFetters: The Gold Standard and the GreatDepression, 1919-1939 (New York: Ox-ford University Press, 1992), helps us de-cide which is the case. The book analyzesthe connection between the gold standardand our worst economic contraction.Laden with data and charts, Golden Fet-ters contains penetrating and scholarlyinsight. The work has received high praisefrom those who pay close attention to theGreat Depression and may become a stan-dard reference for years to come.

1 At root,

* This article is a review of Golden Fetters: TheGold Standard and the Great Depression, 1919-1939, by Barry Eichengreen (New York: OxfordUniversity Press, 1992). Numbers in brackets re-fer to pages in the book.

The reviewer, Richard M. Salsman, is a VicePresident at H.C. Wainwright & Co. Economics,Inc., an economic consulting firm in Boston. Mr.Salsman is author of'Breaking the Banks: CentralBanking Problems and Free Banking Solutions,"our Economic Education Bulletin for June 1990.

1 See Richard N. Cooper, "Fettered to Gold? Eco-nomic Policy in the Interwar Period," Journal of

Economic Literature, December 1992, pp. 2120-2128 and Ben S. Bernanke, "The World on a Crossof Gold: A Review of 'Golden Fetters: The GoldStandard and the Great Depression, 1919-1939,"'

Eichengreen sides with the prevailing folk-lore. However, the facts he presents tendto exonerate the gold standard.

The Gold Standard's Shortcomings

The overriding theme of Golden Fet-ters is that the gold standard shackled theinternational monetary system to an arbi-trary commodity, thereby underminingeconomic stability. As Eichengreen putsit: "the gold standard is conventionallyportrayed as synonymous with financialstability," but "a central message of thisbook is that precisely the opposite wastrue. Far from being synonymous with sta-bility, the gold standard itself was the prin-cipal threat to financial stability and eco-nomic prosperity between the wars."[4]Eichengreen argues that gold money is animpediment to economic growth, that itssupply cannot keep pace with the overallgrowth in output. A gold-based monetarysystem thus is prone to price deflation andultimately, unemployment, since wagesdo not fall with prices. As employmentdeclines, so does economic output, anddepression results.

Eichengreen also derides the gold stan-dard for shackling government policymakers who would otherwise be free tomanage money and ensure full employ-ment. He endorses central banking andfiat paper money, because they permitgovernments to break free of these goldenfetters. The book's dust-jacket is most suc-cinct on this point: "The gold standardfundamentally constrained the economicpolicies that government pursued. It waslargely responsible for creating an unstableeconomic environment. The gold standardof the 1920s set the stage for the depres-sion by heightening the fragility of theinternational financial system and was themechanism transmitting destabilizing im-pulses from the U.S. to the rest of theworld. It was the constraint preventing

Journal of Monetary Economics, April 1993, pp.251-267.

37

policy makers from averting the failure ofbanks and containing the spread of finan-cial panic. Recovery proved possible, forthese same reasons, only after abandon-ing the gold standard."

The Gold Standard's Role

in the Great Depression

Precisely how did the gold standardbring on the contraction of the 1930s?Eichengreen's chronology begins in 1919,when most countries were issuing incon-vertible paper monies, as they had begunto do during World War I. In the 35 yearsprior to the war, 45 countries had been onthe gold standard. The sharp recession of1920-21 convinced many to seek a returnto the prewar stability that had prevailedunder the gold standard. That was the con-clusion of an international monetary con-ference in Genoa in 1922.

But Eichengreen regards this eagernessto return to gold-convertible currencies asa main source of the contraction in the1930s. The key event, he argues, wasBritain's return to the gold standard in1925 at the exchange rate that prevailedbefore World War I, before the fivefoldexpansion of pound notes to finance thewar effort. By returning the pound to goldat an artificially high exchange rate, Brit-ain set the stage for a deflation. Eitherpound notes and prices had to decline, orgold would be lost and convertibilitythreatened. Thus, Eichengreen states "thedepression was not simply a misfortunearising in 1929 for reasons unrelated tothe gold standard's operation. The prioroperation of the gold standard had playeda central role in the coming of the depres-sion."[392]

Meanwhile, a boom-bust scenario wasplaying out in the United States, whichEichengreen also attributes to the goldstandard. To help Britain return to gold atthe pre-World War I exchange rate, theFederal Reserve pushed down interestrates in 1924 and 1927. The goal was topreserve the Bank of England's gold stockand prevent it from flowing to the UnitedStates. But the Fed's artificially low in-terest rates set off a speculative boom. By1929, the Fed was reversing its policy,raising interest rates to check the boomand rebuild its gold reserves. Britain al-

ready had suffered economic contractionand unemployment, regardless of theFed's help. The United States was aboutto experience the same. Soon the wholeworld was contracting.

Why? According to Eichengreen, be-cause it was clinging to the ancient notionthat money should be tied to gold. "Theproblem was the inadequate liquidity re-sulting from slavish adherence to the goldstandard."! 11] In short, Eichengreen tellsus the gold standard deprived the econ-omy of fuel, enslaved central banks, andthereby brought on the contraction.

Surprisingly, Eichengreen barely men-tions other factors known to have contrib-uted to the Great Depression. In the UnitedStates, the protectionist Smoot-HawleyAct of 1930 set off retaliatory measuresworldwide, and income tax rates weredoubled between 1932 and 1936. In thefew times Eichengreen does refer to theseburdens on commerce, he attributes themto the gold standard. Why? Protectionismaimed at a buildup of net exports and goldreserves and higher taxes were imposedto prevent government budget deficits andcentral bank monetization, which threat-ened the gold standard. Without the goldstandard, neither policy would have beentried. Other factors may lu ve contributedto the contraction, but they all relate some-how to the gold standard.

Prosperity to Those

Who Abandoned Gold

Eichengreen also blames the gold stan-dard for prolonging the contraction. Para-lyzed by a dilemma, "Governments wereslow to respond to the Great Depression.""The dilemma was whether to sacrificethe gold standard in order to reflate, anoption most policy makers continued tooppose, or to forswear all measures thatmight stabilize the economy in order todefend the gold standard."! 16-17] "Whydidn't policy makers intervene to head offthe collapse?" he asks. "Because the goldstandard posed an insurmountable ob-stacle.... Containing bank runs requiredpolicy makers to inject liquidity into thebanking system, but this was inconsistentwith the gold standard rules." In short,"far from being a bulwark of financial sta-bility, the gold standard was the main im-pediment to its maintenance."! 18-19]

Eichengreen believes this "dilemma"was effectively resolved by defaulting onthe gold standard. Countries that aban-doned gold earliest, he says, also recov-ered earliest. As he puts it, "depreciationwas the key to economic growth.... Cur-rency depreciation stimulated economicrecovery. Prices were stabilized in coun-tries that went off gold. Output, employ-ment, investment and exports rose more

quickly than in countries that clung togold Only when principles of ortho-dox finance were abandoned did recov-ery follow."[21] "In the absence of goldstandard restraints, international coopera-tion was no longer essential... permittingmore expansionary monetary and fiscalpolicies all around."[22] The gold stan-dard was abandoned first by Britain in1931 and the title, Golden Fetters, echoesthe words of Keynes, who wrote at thetime:

The great advantages to British tradeand industry of our ceasing artificial ef-forts to maintain our currency above itsreal value were quickly realized. There

are few Englishman who do not rejoice

at the breaking of our gold fetters. Wefeel that we have at last a free hand todo what is sensible. The romantic phaseis over, and we can begin to discussrealistically what policy is for thebest.... The competitive disadvantagewill be concentrated on those few coun-tries which remain on the gold standard.On these will fall the curse of Midas.2

Haunted by the "Ethos" of Gold

Although Eichengreen believes "theU.S. devaluation ignited a successful eco-nomic recovery,"[3 84] his evidence issketchy. Industrial production actually wasstarting to turn up in the United States in1932, a year before devaluation, and in1937-38 it suffered another, though milderdepression. Eichengreen himself recountshow U.S. industrial production fell 12 per-cent at the time.[387] The unemploymentrate was 19 percent in 1938, higher than ithad been in 1931. In fact, most of worldremained mired in recession until afterWorld War II. Contrary to Keynes's opti-mism, Britain never regained its prewareconomic stature. None of this was alle-viated by resorting to inconvertible papermoney, as Eichengreen suggests.

Policymakers who questioned the ef-ficacy of devaluation, says Eichengreen,were mired in the "ethos" of the gold stan-dard. They stubbornly refused to inflatetheir paper currencies, even though thegolden fetters were removed. "Policy mak-ers feared that abandoning the gold stan-dard courted a replay" of inflations in the1920s, he notes, because "the gold stan-dard was a symbol of financial stabil-ity."[288] But instead of crediting goldfor its favorable reputation, he says it isundeserved. "Recovery required discard-ing not just the gold standard statutes butalso the gold standard ethos," he con-tends.[393] Eichengreen, with Keynes,apparently believes in "the curse of

Midas." He tells us, in effect, that the goldstandard haunted us even from the grave.

Success of the Classical

Gold Standard

Eichengreen's harsh judgment aboutthe effects of the gold standard after WorldWar I contrasts sharply with his praise ofthe prewar classical gold standard: "Therecan be no question that the developmentof the international gold standard in thesecond half of the 19th century and theenormous growth of international trade andinvestment which took place are no merecoincidences." "The hallmark of the pre-war gold standard was precisely its abilityto accommodate disturbances to financialmarkets without causing severe businesscycle fiuctuations."[29] "For more than aquarter of a century before WWI, the goldstandard provided the framework for do-mestic and international monetary rela-tions. Currencies were convertible intogold on demand and linked internation-ally at fixed exchange rates. Gold ship-ments were the ultimate means of balanceof payments settlement. The gold standardhad been a remarkably efficient mecha-nism for organizing financial affairs. Noglobal crisis comparable to the one thatbegan in 1929 had disrupted the operationof the financial markets. No economicslump comparable to that of the 1930s hadso depressed output and employment."[3]

This ringing endorsement of the clas-sical gold standard is shared by historiansof other persuasions. According to MichaelBordo, a monetarist, "the period from 1880to 1914, known as the heyday of the goldstandard, was a remarkable period in worldeconomic history. It was characterized byrapid economic growth, the free flow oflabor and capital across political borders,virtually free trade and, in general, worldpeace.... In several respects, economicperformance in the U.S. and the U.K. wassuperior under the classical gold standardto that of subsequent periods of managedfiduciary money. In particular, both theprice level and real economic activity weremore stable in the pre-World War I goldstandard era than in the subsequent six-and-one-half decades."

3

Eichengreen fails to name some im-portant reasons for this success. The clas-sical gold standard was a product of mar-ket choice, not government command. Asmoney evolved over 25 centuries, it be-came defined as a certain weight in goldand other precious metals. Gold coins cir-culated alongside private bank currency,which held its value because it was con-

2 John Maynard Keynes, "The End of the GoldStandard," September 27, 1931, reprinted in Es-says in Persuasion (New York: Harcourt Braceand Company, 1932), p. 288, 292.

38

3 Michael David Bordo, "The Classical Gold Stan-dard: Some Lessons for Today," Federal ReserveBank of St. Louis, Review, May 1981, pp. 2-17.

vertible. For more than a century in theUnited States, Canada, and Australia, thegold standard operated smoothly withoutcentral banks. Elsewhere in the world,central banks mostly kept hands off thegold standard.

4 This private, gold-based

monetary system was certainly no impedi-ment to the unprecedented economicgrowth of the 19th century.

The laissez-faire context of the 19thcentury also contributed to the success ofthe classical gold standard. Eichengreenignores this key point, but others have not.Economist Leland Yeager has written that"by and large, people in countries thathappened to be on the gold standard werefreer from government control than in anyage before or since — freer to transactbusiness, freer to make investments, totransfer funds, to travel.... The civility andinternationally prevalent during the ageof the (classical) gold standard have sucha charm for us nowadays that it seemsalmost sacrilege to ask whether these ben-efits resulted from the gold standard, orinstead, coexisted with it by mere coinci-dence."

5 In fact, the classical gold stan-

dard was an integral part of the free mar-ket environment prevailing at the time.

If Eichengreen is correct that the goldstandard caused the ills of the 1920s and1930s, how does he explain why it workedso well before World War I? He creditscentral banks for its prewar success. "Thestability of the prewar gold standard," hewrites, was the result of central bank cred-ibility, "the confidence invested by thepublic in the government's commitmentto a policy." "In the prewar period therewas little doubt that the authorities ulti-mately would take whatever steps wererequired to defend the central bank's re-serves and maintain the convertibility ofthe currency into gold."[5] These stepsincluded lending to one another when therewere gold losses, adjusting interest rates toaccommodate each other in times of stress.In effect, central bank actions were gearedto assisting the gold standard instead ofoverriding it. Importantly, "rather thanadvocating active monetary managementto stabilize the economy, the majority ofobservers advised a passive and thereforemore predictable monetary stance."[6] Hadcentral banks not cooperated, Eichengreensays, the gold standard would have brokendown. When international cooperationbroke down during the war, that is pre-

4 Arthur Bloomfield, Monetary Policy Under theInternational Gold Standard (New York: FederalReserve Bank of New York, 1959).5 Leland Yeager, "The Image of the Gold Stan-dard," in A Retrospective on the Classical GoldStandard, 1821-1931, Michael D. Bordo and AnnaJ. Schwartz (Chicago: University of ChicagoPress, 1984, p. 663).

cisely what happened. But the classical goldstandard, epitome of a laissez-faire age,could not survive without central banknurturing. So Eichengreen tells us.

What is a Gold Standard?

This seeming conflict in Eichengreen'saccount stems from his lack of a clear defi-nition of the gold standard, a major short-coming in a book that credits it with suchdisastrous consequences. Only by under-standing the fundamental characteristicsof the gold standard can one accuratelyinterpret its role in economic history.

Basically, the gold standard is a systemin which gold is money and private cur-rency and checking deposits are convert-ible into a fixed weight of gold. This fixedweight is a unit of account, called a dollaror some other name. The standard is simi-lar to a yardstick, whose units of measure-ment neither expand nor contract. Just asthe yard evolved over time to specify threefeet, the dollar evolved as a specific weightof gold. Over the centuries, after dispens-ing with other forms of money, peopleconverged on gold money and adopted thegold standard by choice. They did so be-cause such a monetary standard facilitatedeconomic activity, much as a yardstickfacilitates the construction of buildings. Ifthe standard instead were arbitrary or proneto fluctuation, economic activity (andbuildings) would be undermined.

A well-functioning gold standard is notmaintained by some predetermined sup-ply of gold, any more than the integrity ofthe yard as a unit of measure is deter-mined by the supply of yardsticks. Thesupply of gold-based money adjusts auto-matically to the demand for it, which isdetermined by the level of economic ac-tivity. As one writer has described it, "agold standard doesn't limit the money sup-ply any more than a yardstick standardlimits the number of yardsticks. The ar-gument that there is 'too little gold' isirrelevant."

6 A gold standard also requires

no government management or interven-tion. As Bordo has written, "under a strictgold standard, there is no need for a cen-tral bank."

7 At most, it requires only that

government uphold contracts in accor-dance with a market-generated system ofweights and measures. Such a role is pro-vided for in the U.S. Constitution.

The Interwar

Gold Exchange Standard

Knowing the main characteristics of thegold standard helps explain the breakdownof the monetary system between the two

6 Jude Wanniski, "A Supply-side Case for a GoldStandard," Business Week, December 7, 1981, p.23.7 Bordo, op. cit., p. 5.

39

world wars. While Golden Fetters focuseson this period, it does so while mistakingthe system for a genuine gold standard.Gold's place in the monetary systemchanged drastically during and after WorldWar I. Before the war, most gold was heldas coin in private hands, currencies werefully convertible into gold, and the centralbanks that did exist refrained from activeintervention. During and after the war, goldcame under the control of governments.Convertibility was suspended. Gold coinwas removed from private hands, turnedinto bullion to discourage demand, andreplaced with paper money.

As Eichengreen tells it, "a gold reservewas necessary to maintain confidence inthe financial system, the authorities be-lieved, more so where the confidence-in-spiring gold standard statutes had beensuspended for the duration of the war.Appealing to patriotism, governmentsurged citizens to deposit any gold theypossessed with the authorities. Of wartimeexperience, contemporaries said more goldwas mined out of the pockets of the peoplethan out of the mines of the earth."[86]Governments hoarded gold and immobi-lized it by establishing minimum gold re-serve requirements for central bank cur-rency. Central banks used foreign ex-change in place of gold as an active re-serve. They monetized government debtsand devalued currencies. In the UnitedStates, a new central bank was establishedand did many of these same things.

Eichengreen attributes these drasticchanges to the exigencies of war. Con-vertibility was suspended to prevent ad-versaries from gaining a financial advan-tage. Gold was removed from privatehands and hoarded as a show of financialstrength. Unwilling to have taxpayers fi-nance war efforts, governments resortedto deficit spending, and had no one butcentral banks to monetize their debt. Thatis, they instructed central banks to printmoney without regard to their gold hold-ings. During and after the war, "the pre-eminent concern of government officialswas debt management," Eichengreen ex-plains. "So long as problems of debt man-agement remained unresolved, govern-ments were hesitant to restore to centralbanks the independence they had tradi-tionally enjoyed. Central banks were pres-sured to keep discount rates low to mini-mize debt service costs and facilitate theplacement of treasury issues."[105]

When central banks held each other'scurrencies as reserves, they created a pyra-mid of paper claims upon other paperclaims. This system is called the gold ex-change standard, even though gold playeda far lesser role in its operation than did

foreign exchange. The gold exchange stan-dard was not a product of the free market.Eichengreen admits that "the special struc-ture of the inter-war gold standard height-ened the vulnerability of national finan-cial systems. Central banks were autho-rized to hold, in addition to gold, a por-tion of the backing for domestic liabilitiesin the form of convertible foreign ex-change," and "by the late 1920s the shareof foreign exchange in international re-serves was at least 50% above prewar lev-els." The trouble was, "as exchange re-serves grew large relative to monetarygold, the capacity of the reserve countriesto maintain gold convertibility (U.S.,France, Britain) was cast into doubt."[20]

Doubts were hardly removed whencentral banks blocked gold exports and de-valued currencies whenever it proved ex-pedient. Central banks "intervened sys-tematically in the relationship betweenspecie reserves and credit conditions,"[34]Eichengreen says, and "although licens-ing or prohibiting gold exports was incon-sistent with laissez-faire principles, thewar had taught officials to view such mat-ters in a more pragmatic light."[103] Inthe parlance of the day, the gold exchangestandard was adopted to "economize" onlimited supplies of gold. But gold was"limited" only in the sense that the war-time inflation had created an excess ofgovernment debt and paper money claimsat prewar exchange rates. The gold ex-change standard did not serve as a "fet-ter" — it subordinated gold to the insa-tiable financial needs of rapidly expand-ing governments.

There was ample evidence at the timethat expedience and intervention wouldprove destabilizing. According to Eichen-green, "central bankers ... were wellaware that market interest rates exceededofficial discount rates, providing banks anincentive to rediscount paper at the cen-tral banks and to expand the supply ofcredit."[lll] For example, "the exces-sively accommodating policies of the Fed-eral Reserve System around the middle ofthe decade" created "liberal supplies ofcredit" and "fueled speculation in finan-cial markets...."[301] Could this beblamed on the gold standard? Eichengreenconcedes that "the gold standard also ex-isted in the 19th century, of course, with-out exercising such debilitating effects.The explanation for the contrast lies in thedisintegration during and after WWI of thepolitical and economic foundations of thepre-war gold standard system.... Duringand after WWI, disputes over income dis-tribution and the proper role for the statebecame increasingly contentious ... quar-rels over war debts and reparations souredthe prospects for cooperation. Economics

and politics combined to challenge andultimately compromise the independenceof central bankers...."[xi] Eichengreenfinds that "credibility and cooperationwere central to the smooth operation ofthe classical gold standard" and that "thescope of both declined abruptly with theintervention of World War I."[12] "Theinter-war gold standard, despite resem-bling its prewar predecessor, shared fewof these virtues" and "led a short and brut-ish life of barely six years (1925-1931)."[29] Yet Golden Fetters insists onblaming gold for the interwar breakdown.

In Eichengreen's view, the postwargold exchange standard was destabilizingnot because it involved larger doses ofgovernment intervention, but because it re-tained minor vestiges of gold. The prob-lem was not government-managed money,but that gold was the money governmentssought to manage. The gold exchangestandard was doomed, not because gov-ernment was incapable of central planning,but because the planning was tethered togold. Government was fettered, its mon-etary planning partial instead of total. Onlyfiat paper money could prove beneficial.

The "Shortage" of Gold

Eichengreen refers repeatedly to goldshortages and gold "famines" that plaguedthe world in the 1930s and blames thedeflation of the Great Depression on thegold standard. Why? "The world supplyof monetary gold is fixed at a moment intime," he writes, and central banks had toengage in "desperate efforts to acquiregold from one another.... For the groupas a whole, there was only so much goldto go around."[291] In the United Statesparticularly, "to defend the gold standard,the Fed refrained from engaging in ex-pansionary open market operations ... [so]the American money supply spiraleddownward."[289]

In fact, there was no shortage of goldin purely physical terms. For decades thetotal stock of gold in the world had grownincrementally with new production, about1-2 percent per year, even during WorldWar I. Evidence in Golden Fetters itselfconfirms this point, although its authornever explains it. One chart shows howthe annual production of gold was manymillions of ounces every year, adding asteady increment to the world's stock,even during the contraction years.[199]Considering the stock of gold alone, therewas certainly neither deflation nor infla-tion to speak of. So where was the prob-lem? Were central banks running short ofgold? No, the gold reserves of centralbanks actually increased by more than 40percent from 1927 to 1935, as anotherchart in the book clearly shows.[ 192] How

40

can gold be held responsible for the dollardeflation that occurred?

In the 1930s, far from a gold famine,the world was suffering from a papermoney glut, and from a shortage of cred-ibility in ever more powerful central banks.They had printed many more claims to goldduring and after the war. There was amaldistribution of gold stock among cen-tral banks. Gold flowed to more financiallystable countries, such as the United Statesand France, away from Germany and Brit-ain. Those that inflated their currenciesmost lost the most gold. Those that inflatedleast gained gold. But the United Statesand France not only obtained gold due tofinancial prudence, they hoarded it inamounts far in excess of what the goldexchange standard required. For example,just when the U.S. economy was undergo-ing a massive deflation, the Fed's goldreserve ratio was nearly twice the 40 per-cent minimum requirement. Not only didthe Fed systematically transfer gold fromthe private sector, it then immobilizednearly 80 percent of it while the privatesector was dying of thirst.

8 When the gold

content of the dollar was reduced 41 per-cent in March of 1933, the Federal Re-serve was sitting atop a massive hoard ofthe "barbarous relic." Ogden Mills, whohad been Hoover's Secretary of the Trea-sury, remarked that "for a great centralbanking system to stand by with a 70%gold reserve without taking any activesteps in such a situation was almost incon-ceivable and almost unforgivable. The re-sources of the System should be put towork on a scale commensurate with theexisting emergency."

9

For government finances to underminethe private sector was nothing new. A simi-lar situation had occurred in the decadesafter the Civil War, when private bankswere forced to back their currency withFederal debt. As that debt was retired andthe demand for private currency grew withthe expansion of trade, currency shortagesdeveloped. After World War I, privatebanks found themselves stripped of goldreserves, forced to rely instead on govern-ment paper money, which was unreliabledespite the Fed's gold hoard. In both cases,government policy fostered the currencyinstability, while the private sector tookthe blame. When the financial system wasrelatively free of intervention, it survived

* For a detailed account of this irresponsible policy,see Richard H. Timberlake, Monetary Policy inthe United States: An Intellectual and InstitutionalHistory (Chicago: University of Chicago Press,1993), pp. 269-273.9 Quoted in Milton Friedman and Anna Schwartz,A Monetary History of the U.S., 1867-1960(Princeton: Princeton University Press, 1963), p.385.

the government's policies. During the Civil

War government issued fiat paper "green-

backs" that depreciated greatly in purchas-

ing power, but with no central bank at the

time, private banks were not forced to use

them as reserves. They survived on a foun-

dation of gold. That alternative became

illegal after World War I.

Breaking the Rules

The smooth operation of the classical

gold standard embraced the customs, stan-

dards, and rules that markets had gener-

ated over the centuries. These rules were

widely respected, fostered credibility, and

lent stability to the monetary system. Such

arrangements crumbled with the advent

of central banking and government inter-

vention in money, especially at the turn

of the century, In 1925, John Maynard

Keynes derisively referred to the market's

long-standing "rules of the game,"10 a

phrase that subsequently evolved to refer

to the various ways in which central banks

should "manage" the gold standard.

As it turned out, of course, central

banks actively interfered with gold flows,

turned coin into bullion, discouraged con-

vertibility, hoarded gold, then added to

the confusion by raising and lowering in-

terest rates at will, above and below mar-

ket rates, to manipulate trade flows and

the domestic business cycle. In short, they

broke all the rules. Eichengreen seems

aware of this. For example, he discusses

Ragnar Nurske's famous study of the

1922-1938 period, which shows how

much the central banks of the world inter-

fered with the gold exchange standard. In

effect, they sabotaged it.

Eichengreen also observes how "issues

that had previously remained outside the

political sphere, such as the determina-

tion of the level of wages and employ-

ment, suddenly became politicized" and

how "doubt was cast over the credibility

of the commitment [to gold convertibil-

ity]. No longer did capital necessarily flow

in stabilizing directions."[9] In better days,

"convertibility provided a visible signal

that a government's financial house was

in order, and the gold standard inspired

confidence on the part of domestic savers

and foreign investors." But after the war,

"in an effort to maintain confidence, gov-

ernments sought to disguise the extent of

currency depreciation. They maintained

convertibility de jure even when suspend-

ing it de facto."[231] In other words, gov-

ernments pursued a contradictory policy

of maintaining confidence by cheating.

Nevertheless, Eichengreen does not criti-

10 John Maynard Keynes, "The Economic Conse-quences of Mr. Churchill," 1925, reprinted in Es-says in Persuasion (New York: Harcourt Brace,1932), p. 259.

cize central banks for breaking the rules

and violating standards. He argues against

monetary rules and standards as such.

Did Devaluation

Actually Foster Recovery?

As mentioned, Eichengreen's claim

that economic recovery came quickest to

those countries that abandoned gold-based

money soonest lacks supporting evidence.

There is a good reason for this. When Brit-

ain abandoned the gold standard in 1931,

the pound still was a reserve currency for

most of the world's other central banks.

As the foreign exchange value of the

pound plummeted, other central banks that

held pounds suffered reserve losses and

initiated further contractions of their own

currencies. That development was unre-

lated to gold. Rather, it was the inevitable

result of pyramiding paper upon paper.

Markets valued gold more than pounds,

and later, more than dollars. By early 1933,

George Harrison, head of the Federal Re-

serve Bank of New York, witnessed an

accelerating demand for gold coin from

his bank and observed that "this movement

represents something more than a hoard-

ing of currency, which reflects a distrust

of banks; it represents in addition a dis-

trust of the currency itself and it is inspired

by the talk of devaluation of the dollar and

inflation of the currency."11 Instead of in-

spiring confidence in the Federal Reserve

dollar, Harrison tried to discourage gold

coin conversions and urged banks not to

provide storage facilities for customers.

Who could expect economic recovery

amidst such uncertainty? Others correctly

saw devaluation as the problem, not the

solution. French Prime Minister Edouard

Daladier asked "How are we to restore

the circulation of goods if the measure of

value continues to depend on hazard or

chance?" The French Foreign Minister,

Georges Bonnet, asked "Who would be

prepared to lend with the fear of being

repaid in depreciating currency always

before his eyes?"[335] Former U.S. Trea-

sury Secretary Ogden Mills remarked in

1935 that "it was not the maintenance of

the gold standard that caused the banking

panic of 1933 and the outflow of gold ... it

was the definite and growing fear that the

new administration meant to do what they

ultimately did — that is abandon the gold

standard."[327] Even Keynes admitted

that arguments such as Eichengreen's "are

not arguments against the gold standard

as such.... They are arguments against

having restored gold under conditions

which required a substantial readjustment

of all our money values."12

11 Friedman and Schwartz, op. cit., p. 350, n. 60.12 Keynes, op. cit., p. 248.

41

Eichengreen denies that currency de-

valuation prolonged depression by spread-

ing uncertainty. "The failure to pursue

more expansionary policies, and not cur-

rency depreciation itself, was responsible

for the sluggishness of the recovery."[22]

Yet he concedes that "a public that fears

that abandoning the gold standard will pro-

voke an inflationary crisis is likely to sell

its financial assets if that event occurs,

rendering such fears self-fulfilling."[26]

He recounts how in March 1933 confi-

dence plummeted when "fears that

Roosevelt might devalue the dollar in-

duced depositors to withdraw their bal-

ances even from U.S. banks that were fun-

damentally strong in order to redeem their

Federal Reserve notes."[326] And when

"FDR finally opted for a devaluation in

mid-April 1933 ... the situation deterio-

rated abruptly."[331] Yet Eichengreen is

unsure why things got worse. He claims

"there was no reason for the dollar to de-

cline," since "the gold standard had not

been abolished" but only suspended as a

"transitory expedient."[329] Instead of

seeing a devaluation of government

money as an impediment to the private

sector that had been forced to use it,

Eichengreen insists the problem was gov-

ernment money tied to gold "as an alba-

tross around the necks of American and

British policy makers."[335]

The scant evidence Eichengreen does

offer for economic recovery in the 1930s

has nothing to do with currency devalua-

tions. History shows that markets function

best under stable money, a medium of

exchange that holds a relatively constant

purchasing power. That is precisely why

people converged on gold money over the

years. Government currencies have been

another matter entirely. Generally they

have not met the market's need for stabil-

ity. They have been prone to inflation or

deflation. The German hyperinflation of

1922-23 and the worldwide deflation of

1932-33 were only extreme examples of

a broader pattern. When governments is-

sue unstable money, the market's demand

for gold and other "hard" currencies in-

tensifies. Once major inflations and defla-

tions cease, markets generally improve.

Rather than marking any "success" of fiat

paper money, it is simply this latter phe-

nomenon that Eichengreen observes.

Guardians of the Gold Standard

— or Saboteurs?

Despite pages of evidence to the con-

trary, Eichengreen speaks of central banks

as "the traditional guardians of the gold

standard."[xi] He credits "the stability of

the prewar gold standard" to "effective

management by its leading member, the

Bank of England."[4] Without evidence,

he asserts that "one rationale for creating

the Federal Reserve System in December

1913 was to manage the American gold

standard more effectively."[31] But he

admits that "the arrival of the Fed on the

international scene was a significant de-

parture from the prewar era," that "the new

institution was unpredictable,"[ 12] and that

"the establishment of a central bank with

discretionary powers contributed to the

politicization of monetary policymaking

in the U.S."[9] In Europe at the turn of the

century, "the decisions of central bankers,

long regarded as obscure, became grist for

the political mill . . . Unable to balance gov-

ernment budgets, politicians enlisted the

central bank's monetary printing presses

to finance their deficits ... resulting in epi-

sodes of inflationary chaos and economic

turmoil.. ."[9J Are unpredictability,politi-

cization, irflafion, and turmoil compatible

with the smooth operation of a gold stan-

dard? Eichengreen suggests they are. His-

tory says otherwise.

How is it that central banks can be seen

as guardians of the gold standard and re-

sponsible for its smooth operation in the

prewar era, while the breakdown of the

postwar era is blamed on gold? The con-

tradiction is never reconciled, for Eichen-

green does not question the legitimacy of

central banking. He believes its "discre-

tionary powers" are remedial, not harm-

ful. But far from being the "guardians" of

the gold standard, central banks have been

the proverbial foxes guarding the hen

houses. Even Eichengreen concedes that

"what was inadequately appreciated was

that by creating a central bank ... the U.S.

government might exacerbate the cyclical

instability of the domestic economy."[64]

Nationalism and the Gold Standard

are Incompatible

While Eichengreen's account of the in-

terwar period is illuminating, it does not

support his main thesis. The gold standard

cannot be held accountable for the Great

Depression. A more likely culprit was the

strain of government interventionism that

was running rampant at the turn of the

century, and has not diminished much

since. As the late Melchior Paly i once wrote

in his own account of the "twilight of gold,"

the problem was "an age of monetary and

commercial nationalism, with the central

banks at the mercy of political forces," and

"the welfare state's determination to by-

pass 'automatism,'" which "resulted in

making the gold standard nearly unwork-

able."13 Palyi's book remains the defini-

tive account of the connection between the

gold standard and the Great Depression.

"Melchior Palyi, The Twilight of Gold, 1914-1936, Myths and Realities (Chicago: HenryRegnery, 1972), pp. 159-160,104.

Not only did nationalism manifest it-

self in war, but also in the vast expansion

of government into hitherto private eco-

nomic affairs. The spread of mercantilist

and protectionist trade policies, progres-

sive taxation, and central banking at the

turn of the century were all part of the

nationalist wave that broke over the inter-

national free market economy that had

evolved up until that time. All of these

developments were stoked by intellectu-

als such as John Maynard Keynes. 'The

mercantilists were under no illusions as

to the nationalistic character of their poli-

cies," he once wrote, "but intellectually

their realism is much preferable to the con-

fused thinking of contemporary advocates

of an international fixed gold standard and

laissez-faire, who believe that it is pre-

cisely these policies which will best pro-

mote peace."14 Keynes sided with the na-

tionalists and gave them ammunition.

Such ideas, far from "saving" capitalism

and the gold standard, undermined them

both. Far from offering a remedy for the

contraction, as Eichengreen claims, the

economic and monetary nationalism of

Keynes and others made it possible.

The Cost of Misinterpreting History

Just as history helps us formulate theo-

ries, theory shapes the way we look at

history. False theories must render false

histories. Eichengreen's underlying theory

is that free markets fail while governments

fix them. In Golden Fetters, he blurs the

distinction between free markets and gov-

ernment intervention. While examining

many problems that arise, in fact, from

intervention, he blames them on free mar-

kets. The world is only recently learning

the error of this approach.

The empirical record cited in Golden

Fetters is the same one that indicts central

banking and fiat paper money, the same

one that exonerates free banking and the

gold standard. By clinging to myths such

as the inherent instability of capitalism,

the slavery of the gold standard, and the

benign influence of deficit spending and

central banking, Eichengreen is unable to

read the record straight. He ignores not

only the context within which his drama

14 See Keynes, The General Theory of Employ-ment, Interest, and Money (New York: HarcourtBrace and Company, 1936), p. 348.

plays but also the contrary evidence that

resides outside of this brief episode in

monetary history. Any interpretation of

the 1919-39 period should be consistent

with what is known to have occurred be-

fore and after. The interwar period was a

mixture of laissez-faire and intervention-

ism. Before World War I, governments

and central banks were relatively limited,

major countries had no central banks, the

gold standard worked well, and econo-

mies prospered. In the decades since 1939,

central banks have grown more beholden

to governments that have grown more in-

terventionist. Economic instability, infla-

tion, financial crises, and currency pro-

tectionism are commonplace today. While

the superiority of the results of the pre-

World War I era to those of the post-World

War II era seems quite clear, Eichen-

green's theme suggests that the opposite

should have maintained.

If Eichengreen's account in Golden

Fetters gains credence, it will be unfortu-

nate. Prevailing views of history often di-

rectly influence policy. So long as our un-

derstanding of the gold standard is ob-

scured and gold is made a scapegoat for

governments that brought us the Great De-

pression, as in this book, a gold standard

is not likely to be adopted. Indeed, this cur-

rent view contributed in part to the failure

of the U.S. Gold Commission in 1982 to

recommend a reintroduction of gold into

the U.S. monetary system. And the recent

breakdown of the European Currency

Mechanism, instead of being blamed on

government fiat currency, has been blamed

on pale vestiges of the gold standard.15 The

inspiration for this bizarre notion report-

edly was none other than Golden Fetters.

At bottom, this book is directed not

against monetary "slavery" (the alleged

fetters imposed by the gold standard), but

against virtually any limits to government.

It is a book that favors unmitigated power

for the central banks that finance it. As

such, it is a dangerous guide to future

policy. Golden Fetters cannot warn us

against repeating the financial and eco-

nomic disasters of history, for these are

but symptoms of government intervention

and central banking, both of which its au-

thor endorses warmly.

15 See "The Gold Standard Revisited," The Econo-mist, March 6, 1993, p. 79.

Final fixing in London

PRICE OF GOLD

1992 1993

Apr. 2 Apr. 1

$340.50 $336.35

1994Mar. 24

$390.40

Mar. 31

$389.80

Research Reports (ISSN 0034-5407) (USPS 311-190) is published twice a month at Great Barrington,Massachusetts 01230 by American Institute for Economic Research, a nonprofit, scientific, educational,and charitable organization. Second class postage paid at Great Barrington, Massachusetts 01230.Sustaining memberships: $16 per quarter or $59 per year. POSTMASTER: Send address changes toResearch Reports, American Institute for Economic Research, Great Barrington, Massachusetts 01230.

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