How did the World-Wide Economic Crisis of the 1930s Propagate?
The global economic crisis of the 1930s – the Great Depression – was propagated by inappropriate monetary policy, which amplified vulnerabilities in banking and debt. Examining this historic period is important for understanding the appropriateness of exchange rate regimes and the responsibilities of central banks.
In Parts I and II of this essay, I will examine how coordination failure between central banks allowed the Gold Exchange Standard to transmit the recession globally. Then, in Parts III and IV, I will investigate the consequences of this transmission on banking systems and war debt, which contributed towards the severity of the crisis.
PART 1: Coordination Failure
It is hardly surprising that the First World War undermined the trust and cooperation between governments and central banks. Still, the United States (US), as the new leading economy, played a central role in destabilizing the post-war global economy and the Gold Exchange Standard.
Previously, the United Kingdom had ensured global cohesion throughout the Classical Gold Standard Era (1880-1914). It promoted free trade and adhesion to the rules of the game. This latter concept refers to the price-specie-flow, which necessitated that a central bank, faced with gold inflows, also increases the national currency base (and vice-versa for gold outflows). Through this mechanism, central banks allowed international prices to equilibrate. [1] Eichengreen emphasizes the Bank of England’s role as a ‘leader by example’, ensuring solidarity by lending to central banks with limited gold reserves. [2]
Following the First World War, the United States (US) took over leadership of the world economy from the United Kingdom (UK). Britain had been weakened during the war, having to sell assets and engage in inflationary defense spending. Geographical distance and lesser involvement in the war allowed the US to recover rapidly, resulting in the optimism-driven boom of the Roaring 20s. [3]
The US and the Federal Reserve (FED) led by different principles than the British. The US implemented protectionist policies, [4] and, crucially, failed to play by the rules of the game. The FED blocked the price-specie-flow, allowing the US to hoard gold reserves. It did this by expanding the monetary base by a lesser amount than gold inflows (increasing the gold cover ratio). [5] In 1928, the FED tightened its monetary policy, hoping to curb volatile speculation on Wall Street. [6] Higher interest rates attracted foreign investors, causing even more gold inflows. Soaking up gold reserves allowed US exports to remain competitive. Additionally, France also engaged in the ‘sterilization’ of gold inflows, accumulating 27% of world gold reserves by 1932. [7]
A failure to play by the ‘rules of the game’ underpinned a failure of international cooperation. A ‘scramble for gold’ occurred amongst gold-deficient countries. Central banks raised interest rates and decreased their monetary base – effectively engineering a recession. [8] In the US and otherwise, output declined, unemployment rose and prices fell (by 28.3% on average between 1929 and 1933). From 1929 to 1933, world trade fell by 65%. [9] Tariffs and quotas were implemented in the hopes of earning gold inflows through exports. [10] Eichengreen noted that this scramble could have been avoided if the United States and France had provided ‘support for weak currencies and international loans of reserves’. [11] Instead, central banks resorted to seeking individual gold parity, instead of a collective commitment, as in the Classical Gold Standard Era. [12]
PART II: The Gold Exchange Standard
This failure of international cooperation allowed the Gold Exchange Standard to act as a transmission mechanism for the Great Depression. A deep-rooted flaw of the standard was thus revealed, best illustrated using the ‘macroeconomic policy trilemma’:
According to the trilemma, only two of three policy objectives are mutually consistent with one another. The gold standard – allowing stable exchange rates and free capital flows – thus necessitated that monetary and fiscal policy was dedicated to defending it, and not to tackling domestic issues. Had gold-deficient countries used expansionary policy, they would have been inconsistent with this principle, as it would have encouraged further gold outflows. In turn, speculators might believe the currency to be overvalued in terms of gold, prompting speculative attacks.
Effectively, the more committed countries were to the gold standard, the closer they followed US monetary policy into recession. Eichengreen and Sachs showed that countries which left the standard earlier (e.g. the United Kingdom and the Scandinavian countries), allowing for expansionary monetary policy, recovered more swiftly than those that did not: [14]
Note that after leaving the Gold Standard in 1931, Germany maintained high interest rates, extending its depression – perhaps fearing inflationary pressures alike to the hyperinflation of 1921-1923. [15] [16]
PART III: Banking Crises
The Gold Exchange Standard was a necessary, but not a sufficient, condition for the propagation of the crisis. Economic contractions brought about losses in asset value, threatening bank solvency. The Wall Street Crash of 1929 and the European Banking Crisis of 1931 contributed towards a global credit crunch, depressing investment and consumption further. The gravity of consequences can be attributed to the failure of central banks in preventing and impeding them.
Monetarists Friedman and Schwartz criticized the FED for failing to act as a lender of last resort. ‘Unit banks’ – localized banks with limited resources – were notably affected by the downturn due to farm mortgage defaults. Tight monetary policy had affected agriculture especially adversely, experiencing a 65% fall in income. [17] However, the Federal Reserve System did not recognize unit banks due to their size, on top of adhering to ‘liquidationist’ thesis (hoping for weak banks to ‘weed’ themselves out). [18] Consequently, the crisis spread and a third of all banks in the US collapsed, the bank money multiplier decreased and the slump was exacerbated[19]. The US banking crisis caused a credit crunch, which spread from New York to London. Governments and firms resorted to sourcing loans from continental banks.
However, soon the European Banking Crisis would begin through the collapse of over-leveraged banks in Austria and Germany, spreading across Europe. Again, both the Österreichische Nationalbank and the Reichsbank failed to ensure adequate liquidity reserves. (p.72). [20] Following the May 1931 collapse of the Austrian giant, the Creditanstalt, other banks followed. [21] Speculative attacks forced Germany and Austria off the gold standard mid-1931.
British merchant banks had significant exposure to central European markets, and acted as guarantors to debt by German and Austrian clients. [22] Finally, regulators caved under the deepening contraction and growing budget deficit (-2.2% of GDP in 1931), and devalued the Sterling. [23] Speculative attacks forced Britain off the gold standard in September 1931.
PART IV: War Debt
Germany played a unique role in propagating the crisis in Europe, lying at the centre of a complex web of short-term war debts to the US. Germany’s reparations payments were used by countries such as Britain and France to meet debt obligations. From 1924 to 1929, they received nearly 2 billion dollars in reparations from Germany. [24] Thus, a shock weakening Germany may ripple out amongst European countries, as they struggle to meet their payment obligations. Indeed, directly through the German crisis or indirectly through increased uncertainty, banking crises erupted globally in the early 1930s:
Unfortunately, Germany was in a particularly vulnerable position. All indebted European countries were dependent on low US interest rates and capital exports in order to service their debts – though Germany also received high-interest loans from the US under the 1924 Dawes Plan (1930 the Young Plan) to meet its reparations payments. Monetary tightening by the FED marked the end of cheap credit. US foreign lending halted in the second half of 1928, [26] virtually ceasing in 1931. [27] Thus, indebted countries were forced to focus their fiscal expenditures on balancing the budget. Germany faced one of the most severe crises in Europe, with industrial production falling to 61% of its 1929 level in 1932 [28] and unemployment rising to a peak of 31.5% in 1931. [29]
CONCLUSION
The introduction of the Gold Exchange Standard post-1925 was meant to be a return to the normality of the Classic Gold Standard Era. Instead, the United States and France, two major economies, played against the rules of the game, leading to an international scramble for gold. The closer a country adhered to the standard, the closer it followed the US’ disastrous tight monetary policy. Simultaneously, a banking crisis – barely mitigated by central banks – swept across the globe, exacerbating the depression. The interconnectedness of the crisis was furthered by a web of war debts to the US, at the center of which lied Germany’s reparation payments. Higher interest rates led to an even deeper focus of countries on debt, than on domestic issues. Recovery could only be stimulated by leaving the gold exchange standard, and engaging in expansionary monetary policy – and yet, the repercussions of the depression were felt for years to come.
Footnotes:
[1] Michael D. Bordo “Gold Standard.” Econlib, June 27, 2018. [2] Eichengreen, Barry J. “Golden Fetters: The Gold Standard and the Great Depression 1919-1939 .” p.8 [3] Eichengreen, Barry J. “Globalizing Capital.” ProQuest, 2008, p.48 [4] Alejandro, C. D. “Latin America in the 1930s: The Role of Periphery in the Crisis .” Kortext reader. Macmillian, 2018. p.5 [5] Jonathan Hazell ‘Great Depression & Bank Runs’ EC1B1 Macroeconomics Lecture, Lent Term 2023, Slides 24-25 [6] Nicholas Crafts and Peter Fearson. “The Great Depression of the 1930s: Lessons for Today.” Academic.oup.com, February 2013, p.10 [7] Irwin, Douglas A. “The French Gold Sink and the Great Deflation of 1929–32.” Cato Institute, 2012. p.11 [8] (Jonathan Hazell – EC1B1 Macroeconomics Lecture ‘Great Depression & Bank Runs’ Lent Term 2023, Slide 26) [9] Nicholas Crafts and Peter Fearson. “The Great Depression of the 1930s: Lessons for Today.” Academic.oup.com, February 2013, p.21 [10] Nicholas Crafts and Peter Fearson. “The Great Depression of the 1930s: Lessons for Today.” Academic.oup.com, February 2013, p.2 [11] Eichengreen, Barry J. “Golden Fetters: The Gold Standard and the Great Depression 1919-1939 .” p.190 [12] Nicholas Crafts and Peter Fearson. “The Great Depression of the 1930s: Lessons for Today.” Academic.oup.com, February 2013, p.79 [13] Nicholas Crafts and Peter Fearson. “The Great Depression of the 1930s: Lessons for Today.” Academic.oup.com, February 2013, p.78 [14] Barry J Eichengreen and Jeffrey Sachs. “Exchange Rates and Economic Recovery in the 1930s.” Journal of Economic History, V ol. XL V, No. 4, December 1985, p.936 [15] Roselli, Alessandro. “Hyperinflation, Depression, and the Rise of Adolf Hitler.” University of Buckingham. Economic Affairs, 2021. [16] Nicholas Crafts and Peter Fearson. “The Great Depression of the 1930s: Lessons for Today.” Academic.oup.com, February 2013, p.18 [17] Nicholas Crafts and Peter Fearson. “The Great Depression of the 1930s: Lessons for Today.” Academic.oup.com, February 2013, p.22 [18] Bernanke, Ben. “ Remarks by Governor Ben S. Bernanke At the Conference to Honor Milton Friedman, University of Chicago, Chicago, Illinois November 8, 2002.” Federal Reserve Board, November 8, 2002. [19] Jonathan Hazell – EC1B1 Macroeconomics Lecture ‘Great Depression & Bank Runs’ Lent Term 2023, Slides 31 [20] James, Harold. “The Causes of the German Banking Crisis of 1931.” The Economic History Review , Feb., 1984, Vol. 37, No. 1 (Feb., 1984), pp. 68-87 [21] Schubert, Aurel. “The Creditanstalt Crisis of 1931.” Google Books. Google, 1991. P.69 [22] Accominotti, Olivier. “London Merchant Banks, the Central European Panic, and the Sterling Crisis of 1931: The Journal of Economic History.” Cambridge Core. Cambridge University Press, March 12, 2012. [23] Nicholas Crafts and Peter Fearson. “The Great Depression of the 1930s: Lessons for Today.” Academic.oup.com, February 2013, p.16,18 [24] Eichengreen, Barry J. “Globalizing Capital.” ProQuest, 2008, p.68 [25] Nicholas Crafts and Peter Fearson. “The Great Depression of the 1930s: Lessons for Today.” Academic.oup.com, February 2013, p.21 [26] Eichengreen, Barry J. “Globalizing Capital.” ProQuest, 2008, p.70 [27] Nicholas Crafts and Peter Fearson. “The Great Depression of the 1930s: Lessons for Today.” Academic.oup.com, February 2013, p.15 [28] James, Harold. “The Causes of the German Banking Crisis of 1931.” The Economic History Review , Feb., 1984, Vol. 37, No. 1 (Feb., 1984), pp. 68-87 [29] Nicholas Crafts and Peter Fearson. “The Great Depression of the 1930s: Lessons for Today.” Academic.oup.com, February 2013, p.2