Constraints of the Interwar Gold Standard

The Costs of Adherence: Constraints of the Interwar Gold Standard and the Opportunities of an Alternative Policy Regime

Regard for the role of the Gold Standard as the main issue underlying the Great Depression has grown so much since its formulation around twenty years ago[1] that it is now the prevailing view in academic discourse. A central part of this discussion is the recognition that not only did the deflationary operation of the interwar Gold Standard system cause much of the economic crisis, but that the constraints it put upon economic policy prevented the adoption of a range of strategies to facilitate recovery. Once economies left the Gold Standard, however, they were able to introduce such measures to good effect. Specifically, governments could carryout expansionary monetary policy, including (1) the characteristic change in gold parity and (2) efforts to increase the money supply and to ensure that credit was both available and affordable, along with (3) expansionary fiscal policy (such as military spending or employment initiatives; as well as having the power to (4) intervene in banking or financial crises. These tools could attack the economic crisis at its roots: insufficient domestic demand, turmoil within banking and finance, and persistent balance of payment difficulties stemming from poorly aligned currency values and exacerbated by the depression-induced collapse in trade.

The examples of Britain and German together illustrate both the causes of the Great Depression and the potential solutions enabled by going off the Gold Standard, as identified here. A number of parallels were present especially in their exposure to common sources for depression. Yet each also adds unique insights by charting different pathways to recovery. A major distinction is in then method each used to reflate the domestic economy: Britain utilizing expansionary monetary policy most of all, while German was known more for its expansionary fiscal policy. Moreover, the difference in both the timing and conditions of their departures from the Gold Standard had major implications for the recovery of trade and the development of a banking crisis. The body of this paper will therefore draw primarily on the experiences of Britain and Germany to analyze the way in which the Gold Standard imposed a limited and deflationary response to the economic crisis, as well as evaluating the four different policy tools posited here as available under an alternative regime, in order to verify the claim that adherence to the Gold Standard hindered the adoption of more favourable economic policy.

Long before economists established the culpability of the Gold Standard in the poor economic performance of the period, many among both scholars and laypeople recognized the harmful effects of the severe deflation that was the trademark of the period. Deflation, as measured by the CPI, reached a height of 18% in the UK and 23% in Germany, both in 1933.[2] Yet there was no universal consensus that deflation was damaging. Instead, Gold Standard ideology advocated deflation during instances of insufficient demand or balance-of-payment deficits, two of the main reasons for the economic crisis. Moreover, the Gold Standard had great appealit's regime oversaw a long period of prosperous growth, spanning from about 1870 to 1914with average GDP growth rates over 2% for the U.S. and Western Europethe highest the world had yet seen.[3] For those who witnessed the rapid inflation and economic instability of the 1920s (which was especially strong in Germany), such a system would seem especially attractive.[4]

But the fact remains that deflation was bad. Ben Bernanke notes that 'declines in output and employment were strongly correlated with money and price declines,'[5] and furthermore finds causation in the link between deflation and depression. There are a few major explanations for this claim. Often cited is the 'sticky' nature of wages and, to a lesser extent, prices, which reduces profits and distorts labourcreating unemployment. Another major issue was the failure of central banks to reduce nominal interest rates to account for deflation, resulting in high ex post real interest rates. Finally, there was the problem of 'debt-deflation,' a phenomenon wherein deflation causes real debt burdens to significantly increase, causing financial difficulties for debtors, which consequently raises the risk for creditors, reduces demand and often reduces returnsas banks are forced to collect collateralized real assets. This, in turn, creates both banking crises and a 'credit crunch.'[6] For all of these reasons, deflation severely impaired national economies and was in dramatic need of reversal.

Under the workings of the Gold Standard, however, there was very little freedom of monetary or fiscal policy, as concerns about maintaining convertibility and the balance of payments were paramount. The situation was particularly restrictive for Britain and Germany, whoas Michael Kitson observeswere 'the two major constrained counties in the 1920s...which both emerged from the aftermath of war with severe economic problems.'[7] The Gold Standard prescription of higher interest rates to reduce credit and limit consumption therefore applied all the more stringently to Great Britain and Germany, intensifying the effects of the Depression.

The shaky position of both economies in the 1920s ultimately became unhinged in the turmoil of 1931. Barry Eichengreen writes, 'As with the fever of a flu-ridden patient, a point came where the severity of the symptoms signalled imminent recovery. The collapse of output and employment had proceeded so far that the Gold Standard could no longer be supported.'[8] In essence, he is rightthe Gold Standard was largely responsible for its own demise by creating a catastrophe so great that the system itself fell victim. It is also true that the act of devaluation embodied the pivotal moment of both crisis and recovery during the Great Depression.

Yet it is important to emphasize that the Gold Standard sewed its own destruction in absolute terms, rather than by creating condition too unpleasant to contemplate. Agents in neither Britain nor Germany chose to abandon the Gold Standard, rather it was forced on them as maintaining convertibility and the balance-of-payments became impossible. In particular, Germany, which had long been in trade deficit, introduced exchange controls in July 1931 after the Austrian banking crisis was transmitted to its own banking system, inducing a massive flight of capital and a run on the banks that overwhelmed the fragile abilities of the Reichsbank to provide liquidity.[9]

Britain's move off Gold happened under mostly similar conditions. The ability of the Bank of England to provide liquidity was curtailed due to a loss of reserves that began with the resumption of the gold parity in 1925,[10] which was compounded by a current accounts deficits beginning in 1931. When Germany imposed exchange controls and froze repayment of short-term loans, this imported the crisis to Britaincausing speculative attacks on the pound which even sharp increases in the discount rate could not defend. As a result, Britain was forced to let the pound depreciate beginning in September 1931.[11]

For most economies, the first step after suspending the 'rules of the game' was to allow the gold parity of its currency to depreciate, but Germany's choice to remain nominally on the Gold Standard through the use of exchange controls meant that only Britain enjoyed the salutary effects of this move. In fact though, Britain also failed to fully exploit the gains of devaluation by choosing not to adjust the monetary stock to reflect the higher price of gold, as did the United States in 1933.[12] Despite this, devaluation yielded serious immediate gains through two other mechanisms. First, devalued economies became what Patricia Clavin called 'sanctuaries for foreign capital,' due to perceptions of less instability and risk. For Great Britain, this resulted in the acquisition of $4 billion from abroad.[13] Secondly, devaluationespecially while other countries remained on the gold standardenhanced the competitiveness of an economy's exports by increasing the purchasing power of foreign currencies relative to one's own. Kitson suggests that the 13% fall in the value of sterling in 1931-2 generated an extra 80 million in the balance of payments, or with the money multiplier, 'a 3 per cent increase in GDP... a large part of the turning point in 1932.'[14]

Barry Eichengreen notes, however, that 'it was not so much devaluation in and of itself that mattered...but the expansionary policies whose unilateral adoption was facilitated by the abandonment of the gold standard.'[15] Expansionary monetary policy was arguably the most effective and influential road to recovery during the Great Depression. In fact, such policy was exhibited to varying degrees in almost every state following devaluation of the currencythough it was the members of the 'sterling bloc,' led by Great Britain and including the likes of Scandinavia and most of the Dominion, who were the main practitioners.[16]

One might have expected even more vigorous monetary expansion during this period, which might have been realized by employing techniques such as large-scale open-market operations or decreasing the coverage ratio of currency-to-gold,[17] but initiatives were largely limited to the so-called policy of 'cheap money,' associated with Great Britain. The principle of 'cheap money' was to assure the expansion of credit by making it affordable and widely available, most notably by reducing the discount rate extensively.[18]

In practice, this process was largely automatic. The depreciation of currency following departure from the gold standard meant that even if nominal interest rates stayed the same, real interest rates declined. While states could reduce nominal rates even further for greater effect, the main imperative was that central banks not behave as though they were still on the gold standardraising nominal interest rates in order to protect gold reserves. Whereas Germany was notoriously guilty in this respect, Britain on the other hand ultimately complemented devaluation with the reduction of nominal interest ratesmost notably lowering the bank rate from 6% to 2% in 1932, reversing monetary contraction and encouraging recovery based on domestic demand, especially in booming industries such as housing and consumer durables that were especially sensitive to interest rate changes.[19]

Germany's recovery came laterwith the rise of the Nazi government and massive public spending in 1933. Expansionary fiscal policy arrived in the form of the First Four-Year Program, centred on job creation, followed by even greater spending on rearmament. Much of this strategy necessarily involved expansionary monetary policy, as the government could not pay for schemes of such a magnitude through regular means. Instead they relied on the issue of new 'Mefo' bonds, which acted as an 'off the books' currency to fund the initiatives. But the crucial difference remained that Nazi spending was not satisfied with helping the economy rebuild itselfrather it was a much more active type of intervention that resulted in a command economy. State spending had a reached a third of the GNP by 1938, twice the level it was in 1932. [20] Moreover, unemployment was 'outlawed' while investment, income and consumption were all regulated by the state. Despite the creation of some serious structural issues associated with a planned economy, Nazi intervention was an overall success. Industrial production, fuelled especially by rearmament, was back at its pre-Depression levels by 1935, despite having fallen to 61% in 1932. By 1938, this figure had increased an additional 27% to reach comparable levels with Great Britain, despite the much milder British experience of the Depression.[21]

Though fiscal policy assumed a much smaller role in British recovery, it maintained a significantly positive impact on the economy. The introduction of major job creation programs failed, despite energetic appeals from figures such as John Maynard Keynes. Rearmament, however, assumed an important role in Britain just as in Germany (as one might expect), especially from 1937.[22] Eichengreen notes that Defence spending in the UK almost tripled between 1935 and 1938, rising from 2.7% to 7.7% of GDP. This expansionary policy, he argues, was an important factor in softening the effects of the recession that hit again in 1937, as well as a major force in job creationperhaps accounting for 1.5 million new jobs by 1938.[23]

Among the policies that abandoning the Gold Standard afforded as discussed here, the prior three functioned mainly to alleviate conditions of the Depression. However, a final opportunity made available by the movethe freedom to intervene in banking crisesacted to prevent much of the crisis for individual economies. Governments and central banks were largely unable to intervene in these crises under the Gold Standard both because they lacked the reserve to meet the liquidity crisis and because by doing so their commitment to convertibility would be called into question, evoking capital flight.[24] Therefore, states that were hit by severe banking panics and did not move off the Gold Standard immediately were forced to allow major banks to fail, as with the Darmstadter-und-Nationalbank (Danat) bank in Germany.[25] Collapses of this magnitude challenged the entire financial systemembattling the crucial need for credit and destabilizing the money supply. Bernanke shows that this had 'economically large and statistically significant effects on manufacturing production and employment...[as well as acting] to reduce both real and nominal wages, hurt competitiveness and exports, raise the ex post real interest rate and reduce real share prices.'[26] Nations such as Great Britain that abandoned the Gold Standard before banks collapsed were able to avoid much of this instability and monetary shock. Specifically, as reserves dwindled, they were able to suspend convertibility to halt bank runs and supply necessary liquidity through funs otherwise obligated to the balance of payments.[27]

During the Classical era of the Gold Standard, it seemed as though the presumably self-regulating system had worked to promote growth and stabilitymaintaining price levels and attracting capital to troubled regions in the confidence that recovery would soon take hold.[28] Yet under the less hopeful conditions of the interwar period, the Gold Standard revealed itself to be a fair-weather friend that was not at all self-regulating. The Great Depression painfully refuted the view that government intervention obstructed growth and that the mechanical operation of the Gold Standard was bestas deflation continued to plunge national economies further into decline while the balance-of-payments and convertibility requirements continued to restrict economic policy. Once nations devalued or otherwise left the Gold Standard, they consistently outperformed those who still played by the 'rules of the game.'[29] As the examples of Britain and Germany indicate, moving off the Gold Standard benefited economies because it allowed them to introduce policies that could restore domestic demand by reflating the money supply (through devaluation and expansionary fiscal and monetary policy), while also promoting financial stability (through intervention in banking crises) and providing a short-term advantage in trade (also through devaluation).


  • Bernanke, Ben. S. 'The Macroeconomics of the Great Depression: A Comparative Approach,' in Ben S. Bernanke, Essays on the Great Depression (Princeton Univ. Press: Princeton, NJ, 2000).
  • Bernanke, Ben S. and Harold James (1991), 'The Gold Standard, Deflation and Financial Crisis in the Great Depression: an International Comparison' in Ben S. Bernanke, Essays on the Great Depression (Princeton Univ. Press: Princeton, NJ, 2000).
  • Bernanke, Ben. S. and Ilian Mihov, 'Deflation and Monetary Contraction in the Great Depression: An Analysis by Simple Ratios,' in Ben S. Bernanke, Essays on the Great Depression (Princeton Univ. Press: Princeton, NJ, 2000).
  • Clavin, Patricia. The Great Depression in Europe, 1929-1939. MacMillan Press: London, 2000.
  • Crouzet, Francois. A History of the European Economy. Univ. Press of Virginia: London 2001.
  • Eichengreen, Barry. 'The British Economy Between the Wars,' in The Cambridge Economic History of Modern Britain, Vol. 2, eds. Roderick Floud and Paul Johnson (Cambridge Univ. Press: Cambridge, 2004).
  • Eichengreen, Barry Globalizing Capital. Princeton Univ. Press: Princeton, NJ, 1996.
  • Eichengreen, Barry. Golden Fetters: The Gold Standard and the Great Depression. Oxford: Oxford University Press, 1992.
  • Eichengreen, Barry and Marc Flandreau. The Gold Standard in Theory and History. Routledge: London, 1997.
  • Feinstein, Charles H., Peter Temin, and Gianni Toniolo. The European Economy Between the Wars. Oxford Univ. Press: Oxford, 1997.
  • Kitson, Michael. 'Slump and Recovery: the UK Experience,' in The World Economy and National Economies in the Interwar Slump (Palgrave: London, 2003).
  • Madison, Angus. The World Economy: A Millenial Perspective. OECD: London, 2001.
  • Temin, Peter. Lessons from the Great Depression. Cambridge, MA: MIT Press, 1989.
  1. See Barry Eichengreen and Jeffrey Sachs, "Exchange Rates and Economic Recovery in the 1930s," Journal of Economic History 45 (1985);
  2. Barry Eichengreen, Golden Fetters: The Gold Standard and the Great Depression (Oxford: Oxford University Press, 1992);
  3. Ben Bernanke and Harold James (1991), 'The Gold Standard, Deflation and Financial Crisis in the Great Depression: an International Comparison' in R. Glen Hubbard, ed., Financial Markets and Financial Crises, NBER;
  4. and Peter Temin, Lessons from the Great Depression (Cambridge, MA: MIT Press, 1989).
  5. Ben. S. Bernanke and Ilian Mihov, 'Deflation and Monetary Contraction in the Great Depression: An Analysis by Simple Ratios,' in Ben S. Bernanke, Essays on the Great Depression (Princeton Univ. Press: Princeton, NJ, 2000), 115.
  6. Francois Crouzet, A History of the European Economy (Univ. Press of Virginia: London 2001);
  7. Angus Madison, The World Economy: A Millenial Perspective (OECD: London, 2001), Appendix B, p. 28; <>
  8. Eichengreen, Golden Fetters, 152.
  9. Ben. S. Bernanke, 'The Macroeconomics of the Great Depression: A Comparative Approach,' in Ben S. Bernanke, Essays on the Great Depression (Princeton Univ. Press: Princeton, NJ, 2000), 22.
  10. Ben S. Bernanke and Harold James, 'The Gold Standard, Deflation, and Financial Crisis in the Great Depression: An International Comparison,' 84-97.
  11. Michael Kitson, 'Slump and Recovery: the UK Experience,' in The World Economy and National Economies in the Interwar Slump (Palgrave: London, 2003), 90.
  12. Barry Eichengreen, Golden Fetters, 390.
  13. Charles H. Feinstein, et. al., The European Economy Between the Wars (Oxford Univ. Press: Oxford, 1997), 108-110.
  14. Clavin, 130-1.
  15. Feinstein, et. al., 91, 110-113.
  16. Bernanke and Mihov, 151-154.
  17. Patricia Clavin, The Great Depression in Europe, 1929-1939 (MacMillan Press: London, 2000), 169.
  18. Michael Kitson, 'Slump and Recovery: the UK Experience,' 95.
  19. Eichengreen, Golden Fetters, 393.
  20. Feinstein, et. al., The European Economy Between the Wars
  21. Barry Eichengreen, Globalizing Capital (Princeton Univ. Press: Princeton, NJ, 1996), 88-91.
  22. Barry Eichengreen, 'The British Economy Between the Wars,' in The Cambridge Economic History of Modern Britain, Vol. 2, eds. Roderick Floud and Paul Johnson (Cambridge Univ. Press: Cambridge, 2004), 333-335.
  23. Eichengreen, 'The British Economy Between the Wars,' 335; Feinstein, et. al., The European Economy Between the Wars, 142.
  24. Clavin, 176.
  25. Feinstein, et. al., 173-175; Clavin, 171-179.
  26. Eichengreen, Golden Fetters, 387.
  27. Eichengreen, 'The British Economy Between the Wars,' 337.
  28. Eichengreen, Golden Fetters, 393.
  29. Feinstein, et. al., 108-110.
  30. Ben. S. Bernanke, 'The Macroeconomics of the Great Depression: A Comparative Approach,' 27.
  31. Feinstein, 110-112.
  32. Eichengreen, Globalizing Capital, 31-35;
  33. Barry Eichengreen and Marc Flandereau, Barry Eichengreen and Marc Flandreau, The Gold Standard in Theory and History (Routledge: London, 1997), pg. 107.
  34. Feinstein, et. al., 172.

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