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Sunday, January 27, 2013



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

2.5 Regression Results

In this section we present empirical results based on our panel data set. The

principal question of interest is the relative importance of various transmission
mechanisms of deflation to output. We also address the question, so far not
discussed, of whether banking crises could have intensified the deflation process
The basic set of results is contained in table 2.9, which relates the logdifferences
in industrial production for our set of countries to various combinations
of explanatory variables. The definitions of the right-hand-side variables
are as follows:
DlnPW: log-difference of the wholesale price index;
DlnEX: log-difference of nominal exports;
DlnW: log-difference of nominal wage;
DISC: central bank discount rate, measured relative to its 1929 value (a
government bond rate is used for Canada; since no 1929 interest rate
could be found for New Zealand, that country is excluded in regressions
including DISC);
PANIC: a dummy variable, set equal to the number of months during the
year that the country experienced serious banking problems (see below);
AlnMO: log-difference of money and notes in circulation.
Exports are included to control for trade effects on growth, including the
benefits of competitive devaluation discussed by Eichengreen and Sachs
(1986); and the wage is included to test for the real wage channel of transmission
from deflation to depression. Of course, theory says that both of these   variables should enter in real rather than in nominal terms; unfortunately, in  practice the theoretically suggested deflator is not always available (as we  noted in our discussion of the real wage above). 

We resolve this problem by  supposing that the true equation is, for example,
(1) Dln/P = Be (DlnEX - DlnPe,) + Bw (DlnW - DlnPw )+ error
where Pe and Pw, the optimal deflators, are not available. Let the projections
of log-changes in the unobserved deflators on the log-change in the wholesale
price deflator be given by
(2) DlnPi, = ψDlnPW + ui     i=e,w
where the ui are uncorrelated with DlnPW and presumably the ψ, are positive.
Then (1) becomes
(3) ΔlnΙP = - ( βeψe + βwψw)ΔlnPW + βeΔlnEX + βwΔlnW + new error
This suggests allowing ΔlnPW and the nominal growth rates of exports and
wages to enter the equation separately, which is how we proceed.18 Putting
ΔlnPW in the equation separately has the added advantage of allowing us to
account for any additional effect of deflation (such as debt deflation) not explicitly
captured by the other independent variables.
The discount rate DISC is included to allow for the interest rate channel and
as an additional proxy for monetary policy. Since ΔlnPW is included in every
equation, inclusion of the nominal interest rate DISC is equivalent to including
the actual ex post real interest rate, that is, we are effectively assuming
that deflation was fully anticipated; this should give the real interest rate hypothesis
its best chance.
In an attempt to control for fiscal policy, we also included measures of central
government expenditure in our first estimated equations. Since the estimated
coefficients were always negative (the wrong sign), small, and statistically
insignificant, the government expenditure variable is excluded from the
results reported here.
Construction of the dummy variable PANIC required us to make a judgment
about which countries' banking crises were most serious, which we did from
our reading of primary and secondary sources. We dated periods of crisis as
starting from the first severe banking problems; if there was some clear demarcation
point (such as the U.S. bank holiday of 1933), we used that as the
ending date of the crisis; otherwise we arbitrarily assumed that the effects of
the crisis would last for one year after its most intense point. The banking
crises included in the dummy are as follows (see also table 2.7):

1. Austria (May 1931-January 1933): from the Creditanstalt crisis to the
date of official settlement of the Creditanstalt's foreign debt.
2. Belgium (May 1931-April 1932; March 1934-February 1935): for one
year after the initial Belgian crisis, following Creditanstalt, and for one  
year after the failure of the Banque Beige de Travail led to a general
3. Estonia (September 1931-August 1932): for one year after the general
banking crisis.
4. France (November 1930-October 1932): for one year following each of
the two peaks of the French banking crises, in November 1930 and October
1931 (see Bouvier 1984).
5. Germany (May 1931-December 1932): from the beginning of the major
German banking crisis until the creation of state institutes for the liquidation
of bad bank debts.
6. Hungary (July 1931-June 1932): for one year following the runs in Budapest
and the bank holiday.
7. Italy (April 1931-December 1932): from the onset of the banking panic
until the takeover of bank assets by a massive new state holding company,
the Istituto por le Riconstruzione Industriale (IRI).
8. Latvia (July 1931-June 1932): for one year following the onset of the
banking crisis.
9. Poland (June 1931-May 1932): for one year following the onset of the
banking crisis.
10. Rumania (July 1931-September 1932): from the onset of the crisis until
one year after its peak in October 1931.
11. United States (December 1930-March 1933): from the failure of the
Bank of the United States until the bank holiday.

The inclusion of Austria, Belgium, Estonia, Germany, Hungary, Latvia,
Poland, Rumania, or the United States in the above list cannot be controversial;
each of these countries suffered serious panics. (One might quibble on
the margin about the exact dating given—for example, Temin [1989] and others
have argued that the U.S. banking crisis did not really begin until mid
1931—but we doubt very much that changes of a few months on these dates
would affect the results.) The inclusion of France and Italy is more controversial.
For example, Bouvier (1984) argues that the French banking crisis was
not as serious as some others, since although there were runs and many banks
failed, the very biggest banks survived; also, according to Bouvier, French
banks were not as closely tied to industry as other banking systems on the
Continent. For Italy, as we have noted, early and massive government intervention
reduced the incidence of panic (see Ciocca and Toniolo 1984); however,
the banks were in very poor condition and (as noted above) eventually
signed over most of their industrial assets to the IRI.
To check the sensitivity of our results, we reestimated the key equations
omitting first the French crisis from the PANIC variable, then the French and
Italian crises. Leaving out France had a minor effect (lowering the coefficient
on PANIC and its f-statistic about 5% in a typical equation); the additional
exclusion of the Italian crisis has essentially no effect.19
As a further check, we also reestimated our key equations omitting, in
separate runs, (i) the United States; (ii) Germany and Austria; and (iii) all
eastern European countries. In none of these equations were our basic results
substantially weakened, which indicates that no single country or small group
of countries is driving our findings.
The first seven equations in table 2.9 are not derived from any single model,
but instead attempt to nest various suggested explanations of the link between
deflation and depression. Estimation was by OLS, which opens up the possibility
of simultaneity bias; however, given our maintained view that the deflation
was imposed by exogenous monetary forces, a case can be made for treating
the right-hand-side variables as exogenous or predetermined.

Note: For variable definitions, see text. The sample period is 1930-36. The panel consists of
twenty-four countries except that, due to missing wage data, Finland, Greece, and Spain are
excluded from equations (5)-(8). Estimates of country-specific dummies are not reported. Standard
errors are in parentheses.
*Export growth is measured in real terms in equation (8).

The principal inferences to be drawn from the first seven rows of table 2.9
are as follows:20
1. Export growth consistently enters the equation for output growth
strongly, with a plausible coefficient and a high level of statistical significance.
2. When wage growth is included in the output equation along with only
wholesale price and export growth (row 5), it enters with the wrong sign.

Only when the PANIC variable is included does nominal wage growth have
the correct (negative) sign (rows 6 and 7). In the equation encompassing all
the various channels (row 7), the estimated coefficient on wage growth is of
the right sign and a reasonable magnitude, but it is not statistically significant.
3. The discount rate enters the encompassing equation (row 7) with the
right sign and a high significance level. A 100-basis-point increase in the discount
rate is estimated to reduce the growth rate of industrial production by
3.6 percentage points.
4. The effect of banking panics on output is large (a year of panic is estimated
in equation (7) to reduce output growth by 12 X .0138, or more than
16 percentage points) and highly statistically significant (f-statistics of 4.0 or
better). The measured effect of the PANIC variable does not seem to depend
much on what other variables are included in the equation.
5. There may be some residual effect of deflation on output not accounted
for by any of these effects. To see this, note that in principle the coefficient on
DlnPW in equation (7) of table 2.9 should be equal to and opposite the
weighted sum of the coefficients on DlnEX, DlnW, and DISC (where the
weights are the projection coefficients of the respective "true" deflators on
DlnPW). Suppose for the sake of illustration that each of the projection coefficients
equals one (that is, the wholesale price index is the correct deflator).
Then the expected value of the coefficient on DlnPW should be approximately
.052; the actual value is .296, with a standard error of .123. Thus there may
be channels relating deflation to depression other than the ones explicitly accounted
for here. One possibility is that we are simply picking up the effects
of a simultaneity bias (a reverse causation from output to prices). Alternatively,
it is possible that an additional factor, such as debt deflation, should be
As an alternative to the procedure of nesting alternative channels in a single
equation, in equation (8) of table 2.9 we report the results of estimating the
reduced form of a simple aggregate demand-aggregate supply (AD-AS) system.
Under conventional assumptions, in an AD-AS model output growth
should depend on money growth and autonomous spending growth (represented
here by growth in real exports21), which shift the AD curve; and on
nominal wage growth, which shifts the AS curve. In addition, we allow
PANIC to enter the system, since banking panics could in principle affect both
aggregate demand and aggregate supply. The results indicate large and statistically
significant effects on output growth for real export growth, money
growth, and banking panics. Nominal wage growth enters with the correct
sign, but the coefficient is very small and statistically insignificant.
We have so far focused on the effects of banking panics (and other variables)
on output. There is an additional issue that warrants some discussion
here; namely, the possibility that banking panics might have themselves worsened
the deflationary process.
Some care must be taken with this argument. Banking panics undoubtedly
had large effects on the composition of national money supplies, money multipliers,
and money demand. Nevertheless, as has been stressed by Temin
(1989), under a gold standard, small country price levels are determined by
international monetary conditions, to which domestic money supplies and demands
must ultimately adjust. Thus banking panics cannot intensify deflation
in a small country.22 Indeed, a regression (not reported) of changes in wholesale
prices against the PANIC variable and time dummies (in order to isolate
purely cross-sectional effects) confirms that there is very little relationship
between the two variables.
The proposition that bank panics should not affect the price level does not
necessarily hold for a large country, however. In econometric language, under
a gold standard the price level of a large country must be cointegrated with
world prices; but while this means that domestic prices must eventually adjust
to shocks emanating from abroad, it also allows for the possibility that domestic
shocks will influence the world price level. Notice that if banking panics
led to deflationary shocks in a large country and these shocks were transmitted
around the world by the gold standard, a cross-sectional comparison would
find no link between panics and the price level.
The discussion of the gold standard and deflation in section 2.2 cited Hamilton's
(1987) view that the initial deflationary impulses in 1928-29 came
from France and the United States—both "big" countries, in terms of economic
importance and because of their large gold reserves. This early deflation
obviously cannot be blamed on banking panics, since these did not begin
until at least the end of 1930. But it would not be in any way inconsistent with
the theory of the gold standard to hypothesize that banking panics in France
and the United States contributed to world deflation during 1931-32.23
Empirical evidence bearing on this question is presented in table 2.10. We
estimated equations for wholesale price inflation in the United States and
France, using monthly data for the five-year period 1928-32. We included an
error-correction term in both equations to allow for cointegration between the
U.S. and French price levels, as would be implied by the gold standard. This
error-correction term is the difference between the \og-levels of U.S. and
French wholesale prices in period t — 1; if U.S. and French prices are in fact
cointegrated, then the growth rate of U.S. prices should respond negatively to
the difference between the U.S. price and the French price, and the French
growth rate of prices should respond positively. Also included in the equations
are lagged inflation rates (to capture transitory price dynamics), current and
lagged base money growth, and current and lagged values of the deposits of
failing banks (for the United States only, due to data availability).
The results are interesting. First, there is evidence for cointegration: The
error-correction terms have the right signs and reasonable magnitudes, although
only the U.S. term is statistically significant. Thus we may infer that
shocks hitting either French or U.S. prices ultimately affected both price levels.
Second, both U.S. base money growth and bank failures are important

Note: Deposits of failing banks are from the Federal Reserve Bulletin. USAWPI and FRAWPI are
wholesale price indexes for the United States and France, respectively. Monthly data from 1928
to 1932 are used.

determinants of the U.S. (and by extension, the French) deflation rates; these
two variables enter the U.S. price equation with the right sign and marginal
significance levels of .0005.
With respect to the effect of banking panics on the price level, then, the
appropriate conclusion appears to be that countries with banking panics did
not suffer worse deflation than those without panics;24 however, it is possible
that U.S. banking panics in particular were an important source of world deflation
during 1931-32, and thus, by extension, of world depression.
2.6 Conclusion
Monetary and financial arrangements in the interwar period were badly
flawed and were a major source of the fall in real output. Banking panics were
one mechanism through which deflation had its effects on real output, and
panics in the United States may have contributed to the severity of the world
In this empirical study, we have focused on the effects of severe banking
panics. We believe it likely, however, that the effects of deflation on the financial
system were not confined to these more extreme episodes. Even in countries
without panics, banks were financially weakened and contracted their  
operations. Domestic debt deflation was probably a factor, to a greater or
lesser degree, in every country. And we have not addressed at all the effect of
deflation on the burden of external debt, which was important for a number of
countries. As we have already suggested, more careful study of these issues is
clearly desirable.


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


17. Causality could run in both directions. For example, Wigmore (1987) argues

that the U.S. banking panic in 1933 was in part created by a run on the dollar.
18. It has been pointed out to us that if nominal wages were literally rigid, then this
approach would find no effect for wages even though changes in the real wage might
be an important channel for the effects of deflation. The reply to this is that, if nominal
wages are completely rigid, the hypothesis that real wages are important can never be
distinguished from an alternative which proposes that deflation has its effects in some
other way.
19. In another sensitivity check, we also tried multiplying PANIC times the change
in the deposit-currency ratio, to allow for differential severity of panics. The results
exhibited an outlier problem. When Rumania (which had a change in the depositcurrency
ratio of — .76 in 1931) was excluded, the results were similar to those obtained
using the PANIC variable alone. However, inclusion of Rumania weakened both
the magnitude and statistical significance of the effect of panics on output. The "reason"
for this is that, despite its massive deposit contraction, Rumania experienced a
5% growth of industrial production in 1931. Whether this is a strong contradiction of
the view that panics affect real output is not clear, however, since according to the
League of Nations the peak of the Rumania crisis did not occur until September or
October, and industrial production in the subsequent year fell by 14%. Another reason
to downplay these results is that the change in the deposit-currency ratio may not be a
good indicator of the severity of the banking crisis, as the Italian case indicates.
20. Results were unchanged when lagged industrial production growth was added
to the equations. The coefficient on lagged production was typically small and statistically
21. Deflation is by the wholesale price index.
22. A possible exception to this proposition for a small country might be a situation
in which there are fears that the country will devalue or abandon gold; in this case the
country's price level might drop below the world level without causing inflows of reserves.
An example may be Poland in 1932. A member of the Gold Bloc, Poland's
wholesale price level closely tracked that of France until mid 1931, when Poland experienced
severe banking problems and withdrawals of foreign deposits, which threatened
convertibility. From that point on, even though both countries remained on the
gold standard, money supplies and prices in Poland and France began to diverge. From
the time of the Polish crisis in June 1931 until the end of 1932, money and notes and
circulation dropped by 9.1% in Poland (compared to a gain of 10.5% in France); Polish
commercial bank deposits fell 24.5% (compared to a 4.1% decline in France); and
Polish wholesale prices declined 35.2% (compared to a decline of 18.3% in France).
Despite its greater deflation, Poland lost about a sixth of its gold reserves in 1932,
while France gained gold.
23. This hypothesis does not bear on Temin's claim that there was little that central
banks could do about banking crises under the gold standard; rather, the argument is
that if, fortuitously, French and U.S. banking panics had not occurred, world deflation
in 1931-32 would have been less severe.
24. Indeed, if banking panics induced countries to abandon gold, they may have
indirectly contributed to an eventual rise in price levels.

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B)Why the U.S. Has Launched a New Financial World War -- and How the Rest of the World Will Fight Back

By August 1971, war spending in Vietnam and other foreign countries forced the United States to suspend gold convertibility of the dollar through sales via the London Gold Pool. But largely by inertia, central banks continued to settle their payments balances in U.S. Treasury securities. After all, there was no other asset in sufficient supply to form the basis for central bank monetary reserves. But replacing gold – a pure asset – with dollar-denominated U.S. Treasury debt transformed the global financial system. It became debt-based, not asset-based. And geopolitically, the Treasury-bill standard made the United States immune from the traditional balance-of-payments and financial constraints, enabling its capital markets to become more highly debt-leveraged and “innovative.” It also enabled the U.S. Government to wage foreign policy and military campaigns without much regard for the balance of payments.
The problem is that the supply of dollar credit has become potentially infinite. The “dollar glut” has grown in proportion to the U.S. payments deficit. Growth in central bank reserves and sovereign-country funds has taken the form of recycling of dollar inflows into new purchases of U.S. Treasury securities – thereby making foreign central banks (and taxpayers) responsible for financing most of the U.S. federal budget deficit. The fact that this deficit is largely military in nature – for purposes that many foreign voters oppose – makes this lock-in particularly galling. So it hardly is surprising that foreign countries are seeking an alternative.
Contrary to most public media posturing, the U.S. payments deficit – and hence, other countries’ payments surpluses – is not primarily a trade deficit. Foreign military spending has accelerated despite the Cold War ending with dissolution of the Soviet Union in 1991. Even more important has been rising capital outflows from the United States. Banks lent to foreign governments from Third World countries, to other deficit countries to cover their national payments deficits, to private borrowers to buy the foreign infrastructure being privatized, foreign stocks and bonds, and to arbitrageurs to borrow at a low interest rate to buy higher-yielding securities abroad.
The corollary is that other countries’ balance-of-payments surpluses do not stem primarily from trade relations, but from financial speculation and a spillover of U.S. global military spending. Under these conditions the maneuvering for quick returns by banks and their arbitrage customers is distorting exchange rates for international trade. U.S. “quantitative easing” is coming to be perceived as a euphemism for a predatory financial attack on the rest of the world. Trade and currency stability are part of the “collateral damage” being caused by the Federal Reserve and Treasury flooding the economy with liquidity in their attempt to re-inflate U.S. asset prices. Faced with U.S. quantitative easing flooding the economy with reserves to “save the banks” from negative equity, all countries are obliged to act as “currency manipulators.” So much money is made by purely financial speculation that “real” economies are being destroyed.
The coming capital controls
The global financial system is being broken up as U.S. monetary officials change the rules they laid down nearly half a century ago. Prior to the United States going off gold in 1971, nobody dreamed that an economy – especially the United States – would create unlimited credit on computer keyboards and not see its currency plunge. But that is what happens under the Treasury-bill standard of international finance. Under this condition, foreign countries can prevent their currencies from rising against the dollar (thereby pricing their labor and exports out of foreign markets) only by (1) recycling dollar inflows into U.S. Treasury securities, (2) by imposing capital controls, or (3) by avoiding use of the dollar or other currencies used by financial speculators in economies promoting “quantitative easing.”
Malaysia successfully used capital controls during the 1997 Asian Crisis to prevent short-sellers from covering their bets. This confronted speculators with a short squeeze that George Soros says made him lose money on the attempted raid. Other countries are now reviewing how to impose capital controls to protect themselves from the tsunami of credit from flowing into their currencies and buying up their assets – along with gold and other commodities that are turning into vehicles for speculation rather than actual use in production. Brazil took a modest step along this path by using tax policy rather than outright capital controls when it taxed foreign buyers of its bonds last week.
If other nations take this route, it will reverse the policy of open and unprotected capital markets adopted after World War II. This trend threatens to lead to the kind of international monetary practice found from the 1930s into the ‘50s: dual exchange rates, one for financial movements and another for trade. It probably would mean replacing the IMF, World Bank and WTO with a new set of institutions, isolating U.S., British and Eurozone representation.
To defend itself, the IMF is proposing to act as a “central bank” creating what was called “paper gold” in the late 1960s – artificial credit in the form of Special Drawing Rights (SDRs). However, other countries already have complained that voting control remains dominated by the major promoters of arbitrage speculation – the United States, Britain and Eurozone. And the IMF’s Articles of Agreement prevent countries from protecting themselves, characterizing this as “interfering” with “open capital markets.” So the impasse reached this weekend appears to be permanent. As one report summarized matters: “‘There is only one obstacle, which is the agreement of the members,’ said a frustrated  Kahn .”
Paul Martin, the former Canadian prime minister who helped create the G20 after the 1997-1998 Asian financial crisis, said “said the big powers were largely immune to being named andshamed.” And in a Financial Times interview Mohamed El Erian, a former senior IMF official and now chief executive of Pimco  said, “You have a burst pipe behind the wall and the water is coming out. You have to fix the pipe, not just patch the wall.”
The BRIC countries are simply creating their own parallel system. In September, China  supported a Russian proposal to start direct trading between the yuan and the ruble. It has brokered a similar deal with Brazil. And on the eve of the IMF meetings in Washington on Friday, October 8, Chinese Premier Wen stopped off in Istanbul to reach agreement with Turkish Prime Minister Erdogan to use their own currencies in tripling Turkish-Chinese trade to $50 billion over the next five years, effectively excluding the U.S. dollar. “We are forming an economic strategic partnership … In all of our relations, we have agreed to use the lira and yuan,” Mr. Erdogan said.
On the deepest economic lane, the present global financial breakdown is part of the price to be paid for the Federal Reserve and U.S. Treasury refusing to accept a prime axiom of banking: Debts that cannot be paid, won’t be. They tried to “save” the banking system from debt write-downs in 2008 by keeping the debt overhead in place. The resulting repayment burden continues to shrink the U.S. economy, while the Fed’s way to help the banks “earn their way out of negative equity” has been to fuel a flood of international financial speculation. Faced with normalizing world trade or providing opportunities for predatory finance, the U.S. and Britain have thrown their weigh behind the latter. Targeted economies understandably seeking alternative arrangements.
Michael Hudson is a former Wall Street economist. A Distinguished Research Professor at University of Missouri, Kansas City (UMKC), he is the author of many books, including Super Imperialism: The Economic Strategy of American Empire (new ed., Pluto Press, 2002) and Trade, Development and Foreign Debt: A History of Theories of Polarization v. Convergence in the World Economy . He can be reached via his website,mh@michael-hudson.com



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