The Gold Standard Mentality and the Great Depression

It is a common argument that the gold standard was one of the reasons of the Great Depression. The Federal Reserve, it is argued, was unable to follow an optimal monetary policy, with its hands tied with the gold standard regime. However, as Timberlake (2008, p. 304) argues, the gold standard “ended forever at the time the United States became belligerent in World War I.” A gold standard and a managed gold standard are two different systems. A gold standard governed by the market does not require management.

Nonetheless, the idea that the gold standard played a major role in causing the Great Depression still persists. The argument constructs on the line that even if the rules of the gold standard were not in place, the mentality of the gold standard was till dominant. Thus, it was not the gold standard, but the gold standard mentality that led monetary policy astray. Eichengreen and Temin (2002, p. 185), for instance, argue in this way. Their argument is that “the mentality of the gold standard was integral to the ideology of those segments of society that controlled economic policies, including central bankers and national politicians in Europe and the United States. This mentality […] shaped their interpretation of the Depression and led them to maintain policies that intensified the economic slump.”

If gold standard was not in place, then it is hard to see how one of the major reasons of the Great Depression can be attached to a monetary regime that in fact had been out of practice for quite a few years. Furthermore, the gold standard as a monetary institution presupposes peaceful interaction between individuals. The gold standard, like the market, is not prepared to work efficiently in the context of a world war. But, what about the presence of the ‘gold standard mentality’ as cause of the Great Depression? Was it true, in fact, that that was the case, or that monetary policy was conducted differently due to the ‘gold standard mentality’? It is not so clear, either, that that was the case in the years leading up to the Great Depression.

Anderson (1949, pp. 133-134) compares the 1920s with the World War I period. Between 1922 and 1928 deposits increased by $13,500,000,000 and loans and investments of the same banks by $14,500,000,000. The deposits and loans and investment during World War I were $5,835,000,000 and $7,056,000,000 respectively. It is hard to argue that such difference between the 1920’s and the World War I period was just market needs, and there was no excess of money supply. However, if money supply was growing too much, why was there an inflow of gold to the United States during this period rather than a loss of gold through adverse clearing?

There are different factors that affect the stock of gold in a country: (1) exports of gold, (2) imports of gold, (3) gold production, (4) industrial use and (5) net clearing with other central banks. Not all changes in the stock of gold respond to the relationship between banks (for example, changes in the production of gold). Even though some gold inflow from debtors to the United States was expected for this period, Gresham’s Law was a main driver for the gold movement to the United States during the 1920s. Most of the European countries had to restrict gold convertibility during the World War I and expand their monetary supply to finance the cost of war. Gold was taken to the United States, rather than saved in European banks, because the convertibility in the former country was still fixed and known, while in European countries the expectation was that one will have to suffer a monetary loss. Individuals would not use gold to pay their debts in England or France, but use the banknotes printed by European central banks. Gold was safer in the United State, where it could be redeemed in the future at face value without, as was the case with European banknotes, suffering a discount.

Gold was piling up for reasons other than the gold standard correction mechanisms of adverse clearing. This excess of gold in the United States would have been corrected if other major economies returned to the gold standard. According to Anderson (1949, p. 143), there were two peaks of gold, one in 1924 and the second one in 1927. In between, the Dowes Plan resulted in outflow of gold.

The gold stock in the United States in the 1920s, then, can be divided into two large groups: gold stock for monetary uses; and, gold being held for safe-keeping in the United States due to the breakdown of the gold standard in other countries. Had a gold standard mentality in fact been in place, then these two stocks of gold would not have been merged in domestic monetary policy in the first place. Certainly, to get a precise distinction of how much gold belongs to one group and how much to the other is difficult. But one can go on to ignore the difference and use the excess of gold stock to expand money supply.

The monetary policy during the 1920s was in fact in opposition to a ‘gold standard mentality.’ If the gold standard mentality was present and as strong as sometimes is suggested, then the monetary policy of this period should have been much more conservative by trying to differentiate the two gold stocks: gold stock for monetary purposes, and gold stock due to the effects of Gresham’s Law. But if there was no gold standard mentality during the 1920s, then it is hard to imagine a sudden conversion to gold standard mentality in during the Great Depression.

Nicolas Cachanosky is a doctoral student in economics at Suffolk University, as well as a previous Sound Money Essay Contest winner.

Anderson, B. M. (1949). Economics And The Public Welfare (1980th ed.). Indianapolis: Liberty Fund.

Eichengreen, B., & Temin, P. (2000). The Gold Standard and the Great Depression. Contemporary European History, 9(2), 183-207.

Timberlake, R. H. (2008). The Federal Reserve’s Role in the Great Contraction and the Subprime Crisis. Cato Journal, 28(2), 303-312.

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