Europe in 1931
I was at a conference at the Cato Institute two weeks ago discussing some research by Dartmouth Professor Doug Irwin on the role of the gold standard in the Great Depression of 1929-1933. If you're interested, you can see a written version of my comments, the slides from my presentation, or a video of the session (my comments begin a little more than half way in). Here I'd like to relate some of the discussion of what happened in Europe in 1931, and comment on some of the parallels with what is going on today.
Some people think of the Great Depression as beginning or even caused by a stock market crash in October 1929. But Robert Shiller's data indicate a broad market decline that month of 26%, not a whole lot worse than the 20% decline we saw in September 2008. From September 1929 to March 1931, the total stock market decline was 44%, which was milder than the 49% decline from September 2007 to March 2009. The Federal Reserve Board's index of industrial production fell 28% from September 1929 to March 1931, somewhat more severe than the 17% drop recorded in the most recent recession. But if the U.S. economy had turned around in early 1931, we would be talking about that period as just another bad recession. The reason we instead call it the Great Depression is that the stock market went on to fall an additional 61% and industrial production an additional 27% from the levels of March of 1931.
What happened in 1931 to turn a bad economic downturn into the Great Depression? Dramatic events in Europe included failure of Credit-Anstalt, Austria's biggest bank, in May of 1931. That was followed by bank runs in Hungary, Czechoslovakia, Romania, Poland, and Germany. As is often the case historically, the financial problems were a combination of a banking crisis-- I'm not sure the bank will give me back my marks-- and a currency crisis-- I'm not sure that, if I get my marks out of the account, they will still be worth as much. I'd rather have gold than marks in an account with some shaky German bank.
Anxious depositors outside a Berlin bank, 1931. Source: Andrew and Joshua.
The top panel in the graph below plots gold holdings of the Bank of England during 1931. Initially gold flowed into the Bank of England, despite the fact that the Bank dropped its discount rate, in a flight to safety. However, concerns grew that some of the Bank of England’s own assets on the continent might themselves be frozen. The country saw a rapid outflow of gold that summer, the end result of which was that Britain abandoned the gold standard on September 19, 1931.
Top panel: Gold reserves of Bank of England, in millions of U.S. dollars, January to December 1931, end-of-month values. Data source: Banking and Monetary Statistics, p. 551. Bottom panel: Bank of England discount rate, in percent, January to December 1931, end-of-month values. Data source: Global Financial Data. Figure reproduced from Hamilton (2012).
Attention then turned to the United States. In the first half of the year, the U.S., like Britain, had experienced gold inflows despite a lower discount rate. But after Britain devalued relative to gold, the U.S. then experienced rapid gold outflows as people wondered if the U.S. might be next to suspend convertibility of the dollar into gold. The U.S. had started with a larger gold buffer, and with a sharp increase in interest rates was able to stem the loss of gold. But of course a sharp hike in interest rates at that phase of the cycle proved to be disastrous by any criterion other than maintaining a gold standard.
Top panel: Gold reserves of Federal Reserve, in millions of U.S. dollars, weekly January 7 to December 30, 1931. Data source: Banking and Monetary Statistics, p. 386. Bottom panel: discount rate of Federal Reserve Bank of New York, in percent, weekly January 7 to December 30, 1931. Data source: Banking and Monetary Statistics, p. 441. Figure reproduced from Hamilton (2012).
In 1931, countries faced doubts about whether they would stay on the gold standard, and had a choice of either to abandon gold or else to inflict further domestic economic damage in the form of monetary contraction and price deflation. Those doubts and their damage ended up bouncing across countries like a ping pong ball. In 2012, countries face doubts about whether they will remain in the European monetary union, and have a choice of either to abandon (or be forced out of) the euro or else to inflict further domestic economic damage in the form of more fiscal contraction. We're watching those fears and their consequences today move from country to country in real time.
However, one big difference is that in 1931, a preference for gold over bank deposits did not create any more of the yellow metal. The result instead was that the price of gold relative to produced goods was bid up, meaning any country that stayed on the gold standard was forced into deflation of the price of produced goods. By contrast, in the present situation, a preference for euro deposits in Germany over euro-denominated sovereign debt of periphery countries can be infinitely elastically accommodated by the ECB.