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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’: