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Tuesday, June 19, 2012

THINKING IN THE BOX (A)


A)The Gold Standard, Deflation, and Financial Crisis  in the Great Depression:

 An International Comparison


2.1 Introduction

Recent research on the causes of the Great Depression has laid much of the

blame for that catastrophe on the doorstep of the international gold standard.




In his new book, Temin (1989) argues that structural flaws of the interwar gold


standard, in conjunction with policy responses dictated by the gold standard's

"rules of the game," made an international monetary contraction and deflation

almost inevitable. Eichengreen and Sachs (1985) have presented evidence that

countries which abandoned the gold standard and the associated contractionary

monetary policies recovered from the Depression more quickly than countries

that remained on gold. Research by Hamilton (1987, 1988) supports the

propositions that contractionary monetary policies in France and the United

States initiated the Great Slide, and that the defense of gold standard parities

added to the deflationary pressure.1

The gold standard-based explanation of the Depression (which we will  



elaborate in section 2.2) is in most respects compelling. The length and depth


of the deflation during the late 1920s and early 1930s strongly suggest a monetary

origin, and the close correspondence (across both space and time) between

deflation and nations' adherence to the gold standard shows the power

of that system to transmit contractionary monetary shocks. There is also a

high correlation in the data between deflation (falling prices) and depression

(falling output), as the previous authors have noted and as we will demonstrate

again below.

If the argument as it has been made so far has a weak link, however, it is
probably the explanation of how the deflation induced by the malfunctioning
gold standard caused depression; that is, what was the source of this massive
monetary non-neutrality?2
The goal of our paper is to try to understand better
the mechanisms by which deflation may have induced depression in the
1930s. We consider several channels suggested by earlier work, in particular
effects operating through real wages and through interest rates. Our focus,
however, is on a channel of transmission that has been largely ignored by the
recent gold standard literature; namely, the disruptive effect of deflation on the
financial system.
Deflation (and the constraints on central bank policy imposed by the gold
standard) was an important cause of banking panics, which occurred in a
number of countries in the early 1930s. As discussed for the case of the United
States by Bernanke (1983), to the extent that bank panics interfere with normal
flows of credit, they may affect the performance of the real economy;
indeed, it is possible that economic performance may be affected even without
major panics, if the banking system is sufficiently weakened. Because severe
banking panics are the form of financial crisis most easily identified empirically,
we will focus on their effects in this paper. However, we do not want to
lose sight of a second potential effect of falling prices on the financial sector,
which is "debt deflation" (Fisher 1933; Bernanke 1983; Bernanke and Gertler
1990). By increasing the real value of nominal debts and promoting insolvency
of borrowers, deflation creates an environment of financial distress in
which the incentives of borrowers are distorted and in which it is difficult to
extend new credit. Again, this provides a means by which falling prices can
have real effects.
To examine these links between deflation and depression, we take a comparative
approach (as did Eichengreen and Sachs). Using an annual data set
covering twenty-four countries, we try to measure (for example) the differences
between countries on and off the gold standard, or between countries
experiencing banking panics and those that did not. A weakness of our approach
is that, lacking objective indicators of the seriousness of financial
problems, we are forced to rely on dummy variables to indicate periods of
crisis. Despite this problem, we generally do find an important role for financial
crises—particularly banking panics—in explaining the link between falling
prices and falling output. Countries in which, for institutional or historical
reasons, deflation led to panics or other severe banking problems had significantly
worse depressions than countries in which banking was more stable. In
addition, there may have been a feedback loop through which banking panics,
particularly those in the United States, intensified the severity of the worldwide
deflation. Because of data problems, we do not provide direct evidence
of the debt-deflation mechanism; however, we do find that much of the apparent
impact of deflation on output is unaccounted for by the mechanisms we

explicitly consider, leaving open the possibility that debt deflation was important.

The rest of the paper is organized as follows. Section 2.2 briefly recapitulates

the basic case against the interwar gold standard, showing it to have been

a source of deflation and depression, and provides some new evidence consistent

with this view. Section 2.3 takes a preliminary look at some mechanisms

by which deflation may have been transmitted to depression. In section

2.4, we provide an overview of the financial crises that occurred during the

interwar period. Section 2.5 presents and discusses our main empirical results

on the effects of financial crisis in the 1930s, and section 2.6 concludes.

2.2 The Gold Standard and Deflation
In this section we discuss, and provide some new evidence for, the claim

that a mismanaged interwar gold standard was responsible for the worldwide

deflation of the late 1920s and early 1930s.

The gold standard—generally viewed at the time as an essential source of

the relative prosperity of the late nineteenth and early twentieth centuries—

was suspended at the outbreak of World War I. Wartime suspension of the gold

standard was not in itself unusual; indeed, Bordo and Kydland (1990) have

argued that wartime suspension, followed by a return to gold at prewar parities

as soon as possible, should be considered part of the gold standard's normal

operation. Bordo and Kydland pointed out that a reputation for returning

to gold at the prewar parity, and thus at something close to the prewar price

level, would have made it easier for a government to sell nominal bonds and

would have increased attainable seignorage. A credible commitment to the

gold standard thus would have had the effect of allowing war spending to be

financed at a lower total cost.

Possibly for these reputational reasons, and certainly because of widespread

unhappiness with the chaotic monetary and financial conditions that

followed the war (there were hyperinflations in central Europe and more moderate

but still serious inflations elsewhere), the desire to return to gold in the

early 1920s was strong. Of much concern however was the perception that

there was not enough gold available to satisfy world money demands without

deflation. The 1922 Economic and Monetary Conference at Genoa addressed

this issue by recommending the adoption of a gold exchange standard, in

which convertible foreign exchange reserves (principally dollars and pounds)

as well as gold would be used to back national money supplies, thus "economizing"

on gold. Although "key currencies" had been used as reserves before

the war, the Genoa recommendations led to a more widespread and officially

sanctioned use of this practice (Lindert 1969; Eichengreen 1987).

During the 1920s the vast majority of the major countries succeeded in returning

to gold. (The first column of table 2.1 gives the dates of return for the

countries in our data set.) Britain returned at the prewar parity in 1925, despite

Keynes's argument that at the old parity the pound would be overvalued. By

the end of 1925, out of a list of 48 currencies given by the League of Nations

(1926), 28 had been pegged to gold. France returned to gold gradually, following

the Poincare stabilization, although at a new parity widely believed to

undervalue the franc. By the end of 1928, except for China and a few small

countries on the silver standard, only Spain, Portugal, Rumania, and Japan

had not been brought back into the gold standard system. Rumania went back

on gold in 1929, Portugal did so in practice also in 1929 (although not officially

until 1931), and Japan in December 1930. In the same month the Bank

for International Settlements gave Spain a stabilization loan, but the operation

was frustrated by a revolution in April 1931, carried out by republicans who,

as one of the most attractive features of their program, opposed the foreign

stabilization credits. Spain thus did not join the otherwise nearly universal

membership of the gold standard club.

The classical gold standard of the prewar period functioned reasonably

smoothly and without a major convertibility crisis for more than thirty years.

In contrast, the interwar gold standard, established between 1925 and 1928,

had substantially broken down by 1931 and disappeared by 1936. An extensive

literature has analyzed the differences between the classical and interwar

gold standards. This literature has focused, with varying degrees of emphasis,

both on fundamental economic problems that complicated trade and monetary

adjustment in the interwar period and on technical problems of the interwar

gold standard itself.

In terms of "fundamentals," Temin (1989) has emphasized the effects of the

Great War, arguing that, ultimately, the war itself was the shock that initiated

the Depression. The legacy of the war included—besides physical destruction,

which was relatively quickly repaired—new political borders drawn apparently

without economic rationale; substantial overcapacity in some sectors

(such as agriculture and heavy industry) and undercapacity in others, relative

to long-run equilibrium; and reparations claims and international war debts

that generated fiscal burdens and fiscal uncertainty. Some writers (notably

Charles Kindleberger) have also pointed to the fact that the prewar gold standards

was a hegemonic system, with Great Britain the unquestioned center. In

contrast, in the interwar period the relative decline of Britain, the inexperience

and insularity of the new potential hegemon (the United States), and ineffective

cooperation among central banks left no one able to take responsibility

for the system as a whole.

The technical problems of the interwar gold standard included the following

three:

1.The asymmetry between surplus and deficit countries in the required

monetary response to gold flows.


Temin suggests, correctly we believe, that

this was the most important structural flaw of the gold standard. In theory,

under the "rules of the game," central banks of countries experiencing gold   

inflows were supposed to assist the price-specie flow mechanism by expanding



domestic money supplies and inflating, while deficit countries were supposed
to reduce money supplies and deflate. In practice, the need to avoid a
complete loss of reserves and an end to convertibility forced deficit countries
to comply with this rule; but, in contrast, no sanction prevented surplus countries
from sterilizing gold inflows and accumulating reserves indefinitely, if
domestic objectives made that desirable. Thus there was a potential deflationary
bias in the gold standard's operation.
This asymmetry between surplus and deficit countries also existed in the
prewar period, but with the important difference that the prewar gold standard
centered around the operations of the Bank of England. The Bank of England
of course had to hold enough gold to ensure convertibility, but as a profitmaking
institution it also had a strong incentive not to hold large stocks of
barren gold (as opposed to interest-paying assets). Thus the Bank managed
the gold standard (with the assistance of other central banks) so as to avoid 
both sustained inflows and sustained outflows of gold; and, indeed, it helped
ensure continuous convertibility with a surprisingly low level of gold reserves.
In contrast, the two major gold surplus countries of the interwar period,
the United States and France, had central banks with little or no incentive
to avoid accumulation of gold.

The deflationary bias of the asymmetry in required adjustments was magnified
by statutory fractional reserve requirements imposed on many central
banks, especially the new central banks, after the war. While Britain, Norway,
Finland, and Sweden had a fiduciary issue—a fixed note supply backed only
by domestic government securities, above which 100% gold backing was required—
most countries required instead that minimum gold holdings equal a
fixed fraction (usually close to the Federal Reserve's 40%) of central bank
liabilities. These rules had two potentially harmful effects.
First, just as required "reserves" for modern commercial banks are not
really available for use as true reserves, a large portion of central bank gold
holdings were immobilized by the reserve requirements and could not be used
to settle temporary payments imbalances. For example, in 1929, according to
the League of Nations, for 41 countries with a total gold reserve of $9,378
million, only $2,178 million were "surplus" reserves, with the rest required
as cover (League of Nations 1944, 12). In fact, this overstates the quantity of
truly free reserves, because markets and central banks became very worried
when reserves fell within 10% of the minimum. The upshot of this is that
deficit countries could lose very little gold before being forced to reduce their
domestic money supplies; while, as we have noted, the absence of any maximum
reserve limit allowed surplus countries to accept gold inflows without
inflating.
The second and related effect of the fractional reserve requirement has to do
with the relationship between gold outflows and domestic monetary contraction.
With fractional reserves, the relationship between gold outflow and the
reduction in the money supply was not one for one; with a 40% reserve requirement,
for example, the impact on the money supply of a gold outflow
was 2.5 times the external loss. So again, loss of gold could lead to an immediate
and sharp deflationary impact, not balanced by inflation elsewhere.

2.The pyramiding of reserves.

As we have noted, under the interwar goldexchange
standard, countries other than those with reserve currencies were
encouraged to hold convertible foreign exchange reserves as a partial (or in
some cases, as a nearly complete) substitute for gold. But these convertible
reserves were in turn usually only fractionally backed by gold. Thus, just as a
shift by the public from fractionally backed deposits to currency would lower
the total domestic money supply, the gold-exchange system opened up the

possibility that a shift of central banks from foreign exchange reserves to gold

might lower the world money supply, adding another deflationary bias to the

system. Central banks did abandon foreign exchange reserves en masse in the

early 1930s, when the threat of devaluation made foreign exchange assets

quite risky. According to Eichengreen (1987), however, the statistical evidence

is not very clear on whether central banks after selling their foreign

exchange simply lowered their cover ratios, which would have had no direct

effect on money supplies, or shifted into gold, which would have been contractionary.

Even if the central banks responded only by lowering cover ratios,

however, this would have increased the sensitivity of their money supplies to

any subsequent outflow of reserves.

3.Insufficient powers of central banks.

An important institutional feature of

the interwar gold standard is that, for a majority of the important continental

European central banks, open market operations were not permitted or were

severely restricted. This limitation on central bank powers was usually the

result of the stabilization programs of the early and mid 1920s. By prohibiting

central banks from holding or dealing in significant quantities of government

securities, and thus making monetization of deficits more difficult, the architects

of the stabilizations hoped to prevent future inflation. This forced the

central banks to rely on discount policy (the terms at which they would make

loans to commercial banks) as the principal means of affecting the domestic

money supply. However, in a number of countries the major commercial

banks borrowed very infrequently from the central banks, implying that except

in crisis periods the central bank's control over the money supply might

be quite weak.

The loosening of the link between the domestic money supply and central

bank reserves may have been beneficial in some cases during the 1930s, if it

moderated the monetary effect of reserve outflows. However, in at least one

very important case the inability of a central bank to conduct open market

operations may have been quite destabilizing. As discussed by Eichengreen

(1986), the Bank of France, which was the recipient of massive gold inflows

until 1932, was one of the banks that was prohibited from conducting open

market operations. This severely limited the ability of the Bank to translate its

gold inflows into monetary expansion, as should have been done in obedience

to the rules of the game. The failure of France to inflate meant that it continued

to attract reserves, thus imposing deflation on the rest of the world.3

Given both the fundamental economic problems of the international economy

and the structural flaws of the gold standard system, even a relatively

minor deflationary impulse might have had significant repercussions. As it

happened, both of the two major gold surplus countries—France and the

United States, who at the time together held close to 60% of the world's monetary

gold—took deflationary paths in 1928-29 (Hamilton 1987).

In the French case, as we have already noted, the deflationary shock took

the form of a largely sterilized gold inflow. For several reasons—including a
successful stabilization with attendant high real interest rates, a possibly

undervalued franc, the lifting of exchange controls, and the perception that

France was a "safe haven" for capital—beginning in early 1928 gold flooded

into that country, an inflow that was to last until 1932. In 1928, France controlled

about 15% of the total monetary gold held by the twenty-four countries

in our data set (Board of Governors 1943); this share, already disproportionate

to France's economic importance, increased to 18% in 1929, 22% in 1930,

28% in 1931, and 32% in 1932. Since the U.S. share of monetary gold remained

stable at something greater than 40% of the total, the inflow to France

implied significant losses of gold by countries such as Germany, Japan, and

the United Kingdom.































(TO BE CONTINUED)

Author: Ben Bemanke, Harold JamesConference Date: March 22-24,1990






Ben Bemanke is professor of economics and public affairs at Princeton University and a research


associate of the National Bureau of Economic Research. Harold James is assistant professor

of history at Princeton University.

The authors thank David Fernandez, Mark Griffiths, and Holger Wolf for invaluable research

assistance. Support was provided by the National Bureau of Economic Research and the National

Science Foundation.


Notes

1. The original diagnosis of the Depression as a monetary phenomenon was of

course made in Friedman and Schwartz (1963). We find the more recent work, though

focusing to a greater degree on international aspects of the problem, to be essentially

complementary to the Friedman-Schwartz analysis.

2. Eichengreen and Sachs (1985) discuss several mechanisms and provide some

cross-country evidence, but their approach is somewhat informal and they do not consider

the relative importance of the different effects.

3. To be clear, gold inflows to France did increase the French monetary base directly,

one for one; however, in the absence of supplementary open market purchases,

this implied a rising ratio of French gold reserves to monetary base. Together with the

very low value of the French money multiplier, this rising cover ratio meant that the

monetary expansion induced by gold flowing into France was far less significant than

the monetary contractions that this inflow induced elsewhere.


SOURCE   The National  U.S.A. Bureau of Economic Research,chapter parts  from the book
Financial Markets and Financial Crises

B)

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