Myth 7: The Gold Standard was Responsible for the Deflation that Ushered in the Great Depression

Modern scholarship regards the Depression as an international phenomenon, rather than as something that affected different countries in isolation. The thread that bound countries together in the economic collapse was the gold standard. Barry Eichengreen’s 1992 bookGolden Fetters is most commonly associated with the view that the gold standard was the key factor in the origins and transmission of the Great Depression around the world.

The most often cited piece of evidence cited for this view (p 3) is “[t]he fact that countries not on the gold standard managed to avoid the Great Depression, while countries on the gold standard did not begin to recover until they left it.”

In this section I address the “factor in the origins” charge.  Below I address “transmission” charge.

James D. Hamilton (2012) argues that “between 1929 and 1933, the U.S. and much of the rest of the worldwere on a gold standard. That did not prevent (indeed, I have argued it was an important cause of) a big increase in the real value of gold over that period. Because the price of gold was fixed at a dollar price of $20/ounce, the increase in the real value of gold required a huge drop in U.S. nominal wages over those years.”  Because wages were sticky downward, the requirement for a huge drop in nominal wages created massive disemployment.

To set the stage for the deflation of 1930-32, we need to review the deflation of the interwar period as a whole.  And to understand the interwar deflation as a whole, we need to review the monetary events of the First World War.  During the war the major combatant nations went off of the gold standard in order to print money for war finance.  At war’s end they were left with price levels in local currency much higher than before, and much higher than postwar price levels measured in gold units.  As Robert Mundell (1999) noted in his Nobel lecture, large volumes of European gold flowed to the United States, which alone continuously remained on gold (though the federal government embargoed gold exports in 1917-19).  The gold inflow substantially raised the dollar price level during the war.  Despite a major correction in 1920-21, “the dollar (and gold) price level” remained 40 percent above “the prewar equilibrium, a level at which the Federal Reserve kept it until 1929.” For the US, this meant that the price level would eventually have to fall. …

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