“Adhering to the Gold Standard constrained economic policy during the Great Depression”


The US’ defense of gold standard parity during early 1930s has often been
considered amongst the major causes of the Great Depression, as pointed out by
Bemanke and James (1991). Selgin (2013) however, by defining the adherence to
the gold standard as a causation of the severity and persistence of the US Great
Depression as a far too simplistic view, points out how incredibly diverging
views can be on the extent to which adopting gold standard parities affected
economic policy in the US. Monetary policy in Britain has also regularly been
under the spotlight by economists according to Wood (1983). Hodson and
Mabbett (2009) underline that whilst the UK government prioritized “fiscal
prudence” prior to the global financial crisis, it now opts for “unconventional
monetary policies”. Considering how Arestis and Sawyer (2011) argue that,
alongside monetary policy pursued by Central Banks, fiscal deficits are necessary
to satisfy the level of aggregate demand, it is thus clear that the root of the
macroeconomic policy debate lies in the interconnection between fiscal and
monetary policy. Indeed, Wood (1983) argues that fiscal policy is used to affect
monetary policy and therefore the decision process of fiscal policy is pertinent to
that of monetary policy. This is precisely the reason why the existence of both
fiscal and monetary policy is essential and one type of policy alone has not been
successful in providing either Britain or the US with stable prices and low
unemployment – two of the major goals of economic policy – throughout all of
the twentieth century. Put simply, whilst empirical literature and the findings of
major economists like Allen (2012) and Crafts (2011) show how gold standard
adherence during the Great Depression did not allow room for aggregate
demand to rise and unemployment to drop in countries like the UK, it is actually
the historic contexts and scenarios which the UK and the US have undergone
throughout the various phases of the Great Depression which have ultimately
determined the extent to which macroeconomic policy has been successful in
providing the country in question with stable prices and low unemployment. For
instance, Hatton and Boyer (2005) point out how throughout the 1947-1973
period, Britain averaged a 2.1% unemployment rate, far lower than the 10.9%
between 1921 and 1938. So what does the historic context of twentieth century
Britain and the US – precisely during the Great Depression period – reveal about
the effectiveness of fiscal and monetary policy under gold standard parities in
terms of ensuring low unemployment and stable prices?
As discussed by Hills, Thomas and Dimsdale (2010), it is the absence of major
wars during the Victorian age which positively contributed in the stabilization of
Britain’s fiscal position. However, the macroeconomic policy adopted during the
Victorian age changed significantly following WWI. Crafts (2011) sheds further
light on this as he claims that the 1930s Great Depression, which dominated the
second half of the interwar period in Britain, radically varied macroeconomic
policy between the 1920s and the 1930s. In the immediate aftermath of the First
World War, as a result of the War itself, Britain had accumulated a sterlingdenominated
public debt which added up to 120% of GDP, as reported by Allen
(2012). Furthermore, as Hills, Thomas and Dimsdale (2010) point out, the
inflationary effects of the post-war economic boom were tackled by authorities
as they sharply tightened monetary and fiscal policies. Hills, Thomas and
Dimsdale (2010) detail that nominal short-term interest rates were raised
considerably, thus decreasing consumption – all of which whilst exports declined due to lower aggregate world demand. Soon after – as claimed by Hills, Thomas
and Dimsdale (2010) – 1920s Britain suffered major deflation whilst interest
rates rose to record levels. With nominal rates touching 5% in the first half of the
1920s, as underlined by Hills, Thomas and Dimsdale (2010), the primary goal of
monetary policy in Britain was to restore, the gold standard at the pre-war parity
according to Allen (2012). A return to a fixed exchange rate did finally occur in
1925 at the pre-war parity of $4.86 as highlighted by Crafts (2011). Overall, it is
clear how monetary and fiscal policy both played active roles in controlling the
initial inflationary effects which were byproducts of WWI. As the Great
Depression hit Britain in 1930, Hills, Thomas and Dimsdale (2010) describe the
1930-1931 period as a year when short-term interest rates were not allowed to
drop as monetary policy was fully committed to the pre-war gold standard parity
of $4.86. They argue that the aforementioned strict commitment to the gold
standard drove nominal interests up in 1931. It was at this point, in September
1931, that a floating exchange rate was adopted in order to fight high
unemployment and increase aggregate demand by securing a recovery in prices,
as argued by Allen (2012). Crafts (2011) further argues this point as he claims
that a high unemployment rate during the 1930s was biting into tax revenues,
thus making Britain’s budgetary position quite precarious: falling prices were
harming the country’s fiscal position. Additionally, as Crafts (2011) mentions, the
fiscal burden on Britain was worsened by the £2 billion 5% War Loan which the
government had to pay back between 1929 and 1947. To tackle this situation,
Crafts (2011) points out that fiscal policy during the early 1930s involved tax
increases and expenditure cuts – mainly on unemployment benefits. As one can
therefore see, fiscal policy did play a small role in reducing unemployment
during the interwar period in Britain. Indeed, reductions in unemployment
benefits provided the unemployed with incentives to find jobs whilst
government spending on rearmament – in preparation for WWII – mildly
contributed to fight the 1938 recession, according to Hills, Thomas and Dimsdale
(2010). Crafts (2011) on the other hand is of the idea that government spending
on rearmament represented a “significant fiscal stimulus”, approximately 3% of
GDP. This divergence in view between Crafts (2011) and Hills, Thomas and
Dimsdale (2010) is significant as it underlines that – despite Middleton (2010),
Crafts (2011) and Hills, Thomas and Dimsdale (2010) agreeing on British fiscal
policy being contractionary during the 1930s – the effectiveness of fiscal policy
to fight unemployment during the Great Depression is still debatable today.
Unlike in the case of fiscal policy, economists generally agree on the fact that
interwar monetary policy in Britain had a significant impact on reducing
unemployment and guaranteeing the country low and stable inflation. Indeed,
having abandoned the gold standard in 1925, Middleton (2010) argues that
deflationary fiscal measures were introduced partially as a means to maintain
confidence in the British economy as individuals feared that a drastic fall in the
price of sterling could result in imported inflation. Once this issue was overcome,
Allen (2012) believes that monetary policy was eased to fight high 1930s
unemployment whilst Crafts (2011) is of the idea this monetary measure was
useful in counteracting “contractionary effects of fiscal consolidation”. As such, in
1932, the “cheap money” policy mentioned by Crafts (2011) was adopted which
resulted in drops in short and long-term interest rates, ultimately allowing for a
low stable inflation rate to kick in as price fluctuations typical of early 1930s no longer represented the norm. Overall, whilst adhering to the gold standard was
used as a means to fight post-WWI inflationary pressures, it constrained the UK
in its ability to control nominal interest rates and allow aggregate demand to rise
and unemployment to drop. The extent to which economic policy was effective
however, is still subject of debate today as it is affected by how one interprets the
historic context of the UK.
As explained by Fishback (2010), economists generally agree that the Federal
Reserve committed key mistakes whilst steering monetary policy during the
Great Depression years. Whilst the UK tightened monetary and fiscal policies by
adopting the gold standard in 1925 in the intent to fight post-WWI inflationary
pressures, the US’ monetary contraction prior to 1933 was not a result of being
constrained by the gold standard, as underlined by Selgin (2013). Indeed, Selgin
(2013) argues that refraining from adopting expansionary policies was a result
of fear that expansion would provoke speculation attacks on the dollar causing
its devaluation, mainly because the newly elected US president was unwilling to
unequivocally commit to maintaining the gold standard – thus causing
individuals to believe that the Fed might run out of gold reserves. Hence, on
March 6, 1933, the US abandoned the gold standard as pointed out by Selgin
(2013). Hsieh and Romer (2006) confirm this theory as they claim that recent
scholarship has shown how US’ determination to remain on a system of fixed
exchange rates immobilized it in its ability to control economic policy as it could
not act to stem panics or stimulate production because expansionary policy
could result in devaluation. Thus, the tension between what Fishback (2010) and
Hsieh and Romer (2006) – who claim that the great depression in the gold
standard view was not the result of gross policy mistakes – clearly sheds light on
how it remains still unclear the extent to which adhering to the gold standard
prevented aggregate demand from growing and unemployment from falling. The
particular which adds credibility to the theory that aggressive Federal Reserve
action could cause dollar devaluation stems from Hsieh and Romer’s (2006)
paper. They claim that by 1929, the US could potentially “afford” to make
substantial gold losses in open market operations as a result of the incredibly
large amounts of gold reserves which it owned without threatening the US’
adherence to the gold standard. Hence, the only way the Federal Reserve could
jeopardize the fixed exchange rate system was through expectations: aggressive
monetary expansion may have lead individuals to doubt the US’ commitment
level to the gold standard. Hence, to some degree the Fed did have its hand tied
as described by Fishback (2010). Following the abandonment of the gold
standard in 1933, Fishback (2010) clearly explains how the Fed was freer to
control money supply as a means to affect domestic economic policy. During the
gold standard period, the US economic policy mainly relied on fiscal stimulus
programs as explained by Fishback (2010). Indeed, both the Hoover and
Roosevelt administrations ran small deficits as they increased government
spending. However, tax revenues also increased during both administrations as
Fishback (2010) underlines. Hoover for instance doubled federal highway
spending and increased the spending by Army Corps of Engineers on rivers,
harbours and flood control by over 40%. Nominal federal expenditures, which
contributed in boosting aggregated demand and lowering unemployment, rose
by 52% from $3.1 billion in 1929 to $4.7 billion in 1932. A similar upward trend in annual nominal government spending occurred during the 1934-1935 period
under Roosevelt. Hence, clearly the gold standard impacted the ability of
monetary policy to control inflation but not of fiscal policy, whose upward trend
remained unchanged throughout the Hoover and Roosevelt administrations.
However, like in the UK, fiscal policy failed to lower unemployment significantly
according to the Keynesian model as pointed out by Fishback (2010).
Overall, all findings indicate that a country’s historical context is the ultimate
determinant which impacts the effectiveness of each macroeconomic policy.
Indeed, during the interwar period, by adopting a floating exchange rate,
monetary policy in Britain played a key role in affecting both unemployment and
inflation, far more than fiscal policy did. Indeed, throughout this period,
monetary policy was eased to fight the 1930s Great Depression high
unemployment, as discussed by Allen (2012). Moreover, the introduction of the
“cheap money” policy mentioned by Crafts (2011) was key to offset the
“contractionary effects of fiscal consolidation”, consequently lowering short and
long term interest rates and accommodating a low stable rate of inflation. Fiscal
policy during the 1919-1938 period mildly reduced unemployment through cuts
in unemployment benefits and government spending in rearmament.
Contrastingly, the Fed was indeed restricted in using monetary policy to help the
country overcome the Great Depression due to the adherence to the gold
standard whilst fiscal policy played a key role as small continuous fiscal deficits
were run in the US throughout the Great Depression.

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Name: Sankalp
Uploaded Date: Dec 29,2016

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University of Warwick 2015 graduate in Bsc (Hons) Economics. Entering a Global Msc in Management at LSE in September 2017. Previously an Investment Banker in London.