Download Viewpoint: Understanding the Great Depression

Viewpoint: Understanding the Great Depression
Author(s): Barry Eichengreen
Source: The Canadian Journal of Economics / Revue canadienne d'Economique, Vol. 37, No. 1
(Feb., 2004), pp. 1-27
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Viewpoint:Understandingthe Great
Depression
Barry Eichengreen
University of California, Berkeley
If there is a feature of modern scholarship on the Great Depression that distinguishes it from its antecedents, it is the tendency of recent contributions to frame
that event as a global phenomenon (see, e.g., Eichengreen 1992; Johnson 1998;
Bernanke 2000; and James 2001). It is now commonplace to view the Depression
from an internationalperspectiveand to test causal hypotheses by comparing the
experiences of countries that endured more and less severe cyclical downturns.
This is in contrast with the earlier generation of scholarship, notably the influential work of Friedman and Schwartz (1963) and Temin (1976), which viewed the
Depression as centred in the United States and focused on shocks and policies in
that country. Specific hypotheses associated with the global perspectivecontinue
to be disputed, but there seems little question that the internationalview serves as
a point of departure for a growing portion of recent scholarship.
Whether this new research has produced a scholarly consensus is another
matter. In this paper I ask whether it is possible to arrive at such a consensus by
synthesizing the old and new literatures.I describe a perspective that views the
Great Depression as a global phenomenon, emphasizinglinkages among countries
and the destabilizinginfluence of the internationalmonetary and financial system,
but that at the same time acknowledgesthe uniquely importantcharacterof events
and policies in the United States. I therebysuggest that the opposition between the
'old' and 'new' (or 'U.S.-centric'and 'global') views of the Great Depression may
ultimately prove artificial.The task for macroeconomic and historical scholarship
going forward is to reconcilethese previouslycompeting strands of thought.
This is a revisionof the 2002 MackintoshLecture,deliveredat Queen'sUniversity.I am
gratefulto MugeAdaletfor able researchassistanceand to RobertGordon,ChrisMeissner,
Kris Mitchener,and two anonymousrefereesof thisjournalfor commentsand assortedforms
of help. Email:[email protected]
Canadian Journal of Economics / Revue canadienne d'Economique, Vol. 37, No. 1
February / fevrier 2004. Printed in Canada / Imprime au Canada
0008-4085/ 04 / 1-27 / ? CanadianEconomicsAssociation
2 B. Eichengreen
1. The onset of the GreatDepression
The most difficultchallengefor any analysisof money and output, and hence
for the monetaryinterpretationof the onset of the Great Depression,is the
identificationproblem.Tobin (1965)famouslymade this point in his admiring
review of Friedman and Schwartz's Monetary History of the United States
(1963).Temin(1976)elaboratedit when he observedthat a negativeshock to
output (his favouredcandidatebeing an autonomousfall in consumptionin
1929)could in principlehave led to the fall in money, ratherthan a negative
shock to money causingthe fall in output.
From this point of view, it is the depthand breadthof historicaldetail that
renderFriedmanand Schwartz'saccount so compelling.In their Monetary
Historythey used historicaldetail to make the case that the monetaryshock
was autonomousand the fall in outputwas induced- that causalityeffectively
ran frommoneyto output.They documentedthe Fed's concernwith excessive
financialspeculation.They showed how this led the centralbank to raise the
discountraterepeatedly,especiallyfollowingthe deathof BenjaminStrongand
the ascent of Adolph Miller,a diehardbelieverin the dangersof speculative
excesses.The implicationwas that moneywas not tightenedin responseto the
evolutionof output.Rather,it was tightenedfor unrelatedfinancialreasons.
Friedmanand Schwartznext arguedthat the untimelydeath of Strongand
disputesamongregionalreservebanksand betweenthe reservebanksand the
Federal Reserve Board preventedpolicy from respondingin its customary
stabilizingfashion to the decline in industrialproduction.An inexperienced
FederalReserveBoard had neverencounteredan analogouspeacetimerecession. Misinterpreting
the real-billsdoctrine,predisposedto a perverseand selffulfillingliquidationalistview of the businesscycle, and preoccupiedby the
belief that monetaryease might reignitespeculation,it saw inaction as the
appropriatepolicy response (DeLong 1990; Calomirisand Wheelock 1998;
Meltzer2002). Thus, monetarypolicy was slow to loosen as output declined.
theoperaThis,then,wasevidenceof an autonomousmonetaryshock,reflecting
the
in turnencourages
tionof a uniquesetof historical
circumstances.
Thisargument
beliefthatmonetaryfactorsplayedan importantrolein theonsetof theDepression.
But there are problemswith this U.S.-centredmonetaryinterpretationof
the slump. While the tighteningof monetarypolicy through the summerof
1929 was not particularlydramatic,the subsequentdecline in activity was.1
1 Ritschl and Woitek (2000) document this in a forecasting framework. Their time series analysis
suggests that the effects of the Fed's discount policy remained 'far too small to explain the
collapse in output after 1929' (11). To put these changes in perspective, the Fed has typically
(since 1951) raised the discount rate by 425 basis points between the trough and the peak of the
business cycle (as dated by the NBER). By comparison, the tightening in 1928-9 was 350 basis
points, hardly out of the ordinary. (This comparison assumes, of course, that the 1926-7
slowdown was a business cycle trough, a characterization that would not be universally
accepted.) The implication in the text only follows, of course, if one agrees that the 'direct action'
part of the Fed's initiative ultimately had little effect (which is my view).
Understandingthe Great Depression 3
Recall that the Fed attempted to use 'direct action' to deny Wall Street credit
for use in speculative activities. Rather than simply relying on the classic device
of a higher discount rate to reduce the volume of credit for use in financing
brokers' loans (making it more expensive for banks to obtain credit from the
Fed and thereby forcing them to pass through that cost to their customers), it
applied moral suasion to the banks. It hesitated to make more active use of the
conventional instruments. Essentially, this is another way of saying that the
Fed did not tighten particularly aggressively.2Thus, the first problem, to put it
in the form of a question, is: How could this modest monetary tightening
produce such a sharp contraction in the United States?
If the Fed's modest monetary tightening was not obviously sufficient to
explain the unusually sharp downturn in U.S. economic activity, then it was
even less sufficient to explain the unusually sharp downturn in the rest of the
world. The Institut fur Konjunkturforschung's index of world industrial production fell by 10% between 1929 and 1930, while the League of Nations'
index of mining and manufacturing fell by 12%.3This is the second problem: it
is not clear how modest monetary tightening in one country could have been
responsible for a depression that engulfed the entire world.
The third problem is related: a number of other countries - Canada,
Germany, Poland, Argentina, Brazil, and Australia among them - turned
down before the United States.4 The model of international transmission in
traditional accounts - inspired by the IS-LM model with low capital mobility
that was the workhorse for multi-country macroeconomic thought experiments
in the 1960s and 1970s - is that the Fed's tightening led to a deceleration in
growth in the United States, which in turn led the United States to import less,
transmitting the slowdown to other countries. Clearly, the actual sequence of
events is wrong for this story.5
The gold standard - and the fact that capital mobility was anything but low
in the 1920s - helps to resolve all three paradoxes. Because capital was mobile
and exchange rates were fixed, higher interest rates in the United States meant
higher interest rates in the rest of the world as a result of interest arbitrage. If
market interest rates rose in the United States, they also had to rise in other
countries, as capital flowed toward the country or at least flowed out at a
slower rate. If foreign central banks failed to follow the Fed in raising discount
2 Note that the sameproblemarisesin the immediatepost-crashperiod.The Fed loosened
significantlyfollowingthe stock marketcrash,whichmakesit all the more surprisingthat the
economycontractedas rapidlyas it did - althoughone can certainlyargue,with benefitof
hindsight,that it did not loosen far or fast enough.
3 By comparison,the largestfall since 1971in the IMF's indexof worldrealGDP was 1.5%in
1982.
4 In Germany,for example,recentnationalproductestimatesshow that the peakwas reachedin
1928.Constructionpeakedin the summerof 1927,and the productionof consumergoods
peakedin February1928.See Ritschl(1997, 1999).
5 U.S. merchandiseimportspeakin the firsthalf of 1929,not in the firsthalf of 1928.Whilethere
is anotherupwardspikein U.S. importsin October1929,this appearsto be a seasonaleffect.
4
B. Eichengreen
rates, they would suffer reserve losses, jeopardizing the stability of their
currencies. Because Europe and Latin America had relatively weak balances
of payments, reflecting the strengthened competitive position in international
markets for manufacturing exports acquired by the United States during and
after World War I and the weakness of agricultural and primary product prices
in the 1920s, their central banks could ill afford reserve losses. Because their
commitment to the gold standard was uncertain, reflecting the expansion of
the franchise and the inability of populist governments to subordinate other
goals of policy to the overarching imperative of exchange rate stabilization, the
tendency for capital flows to reverse direction and now flow not from but to
the United States raised doubts about the stability of currencies elsewhere.6
Central banks thus had to respond by raising rates even more sharply to calm
skittish investors.
Consequently, the restrictive turn in monetary policy in the United States
provoked an even more restrictive turn in monetary policy elsewhere. The
deceleration in the rate of money growth in 1928 was even faster in Latin
America and Europe than in the United States. The same was again true in
1929. The only region where this was not the case was East Asia, not surprisingly, since Australia had already begun to tinker with its gold standard and
Japan was not on the gold standard at all, except for a few months in 1930-1.
Now consider again our three paradoxes. That the shock was a global
monetary contraction, not just a U.S. monetary contraction, helps to explain
why the U.S. economy turned down so sharply. Exports were the first component of aggregate demand to begin falling, indicative of the impact of the
contraction in the rest of the world on the United States. That foreign central
banks had to respond sharply helps to explain why foreign cycles peaked even
earlier. The one factor that insulated U.S. economic activity from the effects of
higher Federal Reserve discount rates, namely, the reversal of U.S. capital
exports, further explains why other countries began to contract before the
United States. It is revealing that countries whose business cycle peaks preceded that of the U.S. had been capital importers in the 1920s. And a global
monetary shock works better than a U.S. monetary shock in explaining a
global recession.
Of course, other factors besides Federal Reserve policy set the stage for the
Great Depression. Even if one focuses on rising interest rates and tightening
monetary conditions as precipitating factors, interest rates in other countries
could have risen for unrelated reasons; the tightening of monetary policy
elsewhere, it could be argued, did not simply result from the international
transmission by the gold standard of tighter money in the United States. There
are at least some national cases where this objection has validity. For example, the
6 Obstfeld and Taylor (2002) invoke this connection between gold standard credibility and popular
politics and provide supportive data for the interwar years. Flandreau, Le Cacheaux, and Zumer
(1998) challenge the applicability of the thesis to the period before 1913, but that is a different
question.
Understandingthe Great Depression 5
operation of additional factors was clearly evident in France.7 The Poincare
stabilization raised French real interest rates in the second half of 1926, as
inflation came down but nominal interest rates remained stuck in positive
territory. Higher real interest rates made France a more attractive place for
portfolio capital; hence, funds flowed to Paris from other financial centres. But
high real interest rates also made consumption and investment less attractive,
strengthening the French current account. Lower nominal rates, for their part,
stimulated the demand for money, which could be met only by running a
payments surplus and attracting gold from the rest of the world, given the
reluctance of the Bank of France to expand domestic credit.8 For its own
reasons, then, France became an independent source of monetary deflation in
the second half of the 1920s.
Germany is another other important country for which this case can be made
(Balderston 1993; Ritschl 1999). The president of the Reichsbank, Hjalmar
Horace Greeley Schacht, became convinced of the dangers of a speculative
bubble in the spring of 1927, even before similar fears infected the members of
the Federal Reserve Board, leading the German central bank to tighten credit
(Voth 2002).9 Schacht too resorted to a policy of direct pressure, meeting with
the directors of the big Berlin banks to express his concerns. Tighter money
and credit succeeded in pushing down the German stock market, as Schacht
intended, but they also pushed down the German economy, which was presumably not his intention.10 Here too, then, we see policies of monetary
tightening implemented for reasons largely unrelated to the decisions of the
Federal Reserve.
The other objection to the gold standard story is that it was not monetary
policy but other shocks and imbalances that caused the slump. This returns us
to the debate between Friedman and Schwartz and Temin; indeed, it returns us
7 As emphasizedin Eichengreen(1992)and Johnson(1998).
8 Whilethe Frenchcentralbank'srevisedstatutelimitedthe scopefor conventionalexpansionary
open marketoperations,it still could haveexpandeddomesticcreditby unconventionalmeans
suchas purchasingforeignexchangeon the open market.Preoccupiedwith inflationto the
point of phobia,however,it hesitatedto do so. If this referenceto the needto use
unconventionalmeansand to the centralbank'sneuroticpreoccupationwith inflationreminds
readersof the Bankof Japanin the 1990s,my wordingwill have accomplishedits goal.
9 Schachtwasalsoconcernedaboutthe highlevelof foreignborrowing;
he sawthe stockmarket
boomin Berlinandexpansionin Germanyin generalas beingfuelledby unsustainable
capital
externalobligations,therebysetting
inflows,whichaddedto the country'salreadyunsustainable
theeconomyup for an evenmorepainfulfuturefall.Thedilemma,then,was the sameas that
facinganycentralbankerconfrontinga problemof capitalinflows:higherinterestratesmight
eventuallyprickthe stockmarketbubble,butin themeantimetheywouldonlyencouragefurther
capitalinflows(as theydid,in the Germancase,untilthe Fedrespondedin 1928withfurther
increasesin its discountrate).Schacht'spreferredsolution,whichis themedicinenowadays
recommended
for countriesexperiencing
difficult-to-manage
capitalinflows,wasfiscalrestraint,
or Reich
but thiswasnot somethinghe couldforceon free-spending
municipalgovernments
authoritiesfeelingpressurefroma varietyof specialinterestgroups.
10 This line of argumentalso addressesa problemnoted by Temin(1971),that the German
economystartedturningdown even beforecapitaloutflowsfromthe UnitedStateswere
curtailed.
6 B. Eichengreen
to what was the debate in the 1930s.After experiencingthe 1990s,observers
are perhapsless inclinedto find explanationsfor the downturnin an autonomous fall in consumptionspendingand more likely to considera role for the
creditboom, the stock marketbubble,realestatespeculation,excessiveoptimism about the commercialpotential of information and communications
technologies(in the 1920s, radio; in the 1990s, the Internet),and the naive
belief that recessionshad become a thing of the past. The culpritcould have
beentechnologicalchangecreatingstructuralimbalancesthat left the economy
vulnerableto destabilizingshocks.Many old industrieswerefinanciallyfragile,
and new ones like radio were not yet profitable.Thus, even a minor shock,
whateverits source, could create financial stress. This is the story told by
Bernstein(1987) and elaboratedby Szostak (1995). Alternatively,the culprit
could have been overinvestmentin property,which left financialinstitutions
exposed and bequeatheda legacy of inappropriatelysubdividedtracts that
depressedproductivitywell into the 1930s(Field 1992).
The problemwith these interpretationsis that they tend to be sector and
countryspecific.Theyfocus on sectorssuchas radio,electricity,and residential
constructionand on a particularcountry,typicallythe United States.It is not
clear how sector-specificfactors could have produced such a pronounced
economy-wideslump or how country-specificfactors could have produced
such a sharp global downturn.And as an explanationfor global macroeconomic developments,they are weakened by the absence of a propagation
mechanism.
One way of attemptingto knit these stories together is by applying 'the
Bank for InternationalSettlementsview' (BIS) of the 1990s (e.g., Borio,
Fufine, and Lowe 2001; Borio and Lowe 2002; Vila 2002) to the 1920s.The
BIS view is that pronouncedcredit booms set the stage for sharp economic
downturns,often accompaniedby severefinancialdistress."Thereis, first, an
upswing in activity, at least partially grounded in fundamentals.Whether
becausethe exchangerate is pegged or for other reasons, such as a positive
supplyshock,upwardpressureon wholesaleand retailpricesremainssubdued.
Consequently,money and credit conditions remain accommodating.Ample
supplies of liquidity animate financial markets, driving up asset prices. As
lending by commercialbanks expands, increasinglyspeculativeinvestments
are underwritten,and the quality of bank loans declines. Higher property
and securitiespricesencourageinvestmentactivity,especiallyin interest-ratesensitiveactivitieslike construction.Here too, as the volume of investment
activityrises, the averagequalityof projectsdeteriorates.
11 The BISviewhas at leasttwo significantprecursorsin the literatureon the interwarperiod:the
Austrianinterpretation
of the Depression,and the view that attributesthe Depressionto the
stockmarketboomandcrash.TheAustrianviewtracesto the workof Mises(1924)andHayek
(1925);see Robbins(1935)and Rothbarth(1975).Theroleof the GreatCrashis emphasizedby
Galbraith(1972)and Kindleberger
(1973).
Understandingthe Great Depression 7
Duringthis upswing,the demandfor speculativeinvestmentsriseswith the
supply, since, in the prevailingenvironmentof stable prices,nominalinterest
ratesand thereforeyields on safe assets are too low to be attractive.In search
of yield, investorsdabbleincreasinglyin risky investments.Their appetitefor
speculativeinvestmentsis strongerstill to the extentthat these trendscoincide
with the developmentof new technologies,networktechnologiesof promising
but uncertaincommercialpotential in particular.Eventually,central banks
begin tightening,the financialbubbleis pricked,and asset pricesdecline.The
economy is then left with an overhangof ill-designed,non-viableinvestment
projects,distressedbanks, and heavily indebtedhouseholdsand firms, all of
which aggravatethe subsequentdownturn.
This tale from the 1990shas obviousappealfor historiansof the 1920s.The
1920swas a decadeof cyclicalexpansion,reflectingrecoveryfromWorldWar
I, new informationand communicationstechnologieslike radio, and new
processeslike the productionof motor vehiclesusing assembly-linemethods.
It was accompaniedby accommodatingmoney and credit conditionsin the
United States, reflectingthe ample gold reservesaccumulatedby the country
duringWorldWar I and financialinnovationsrangingfrom the development
of the moderninvestmenttrust to consumercredit tied to purchasesof bigticketdurablegoods like the automobile.Ample suppliesof money and credit
fueleda realestateboom in Floridain 1925,a Wall Streetboom in 1928-9,and
a consumerdurablesspendingspreein the secondhalf of the 1920s.That these
booms developedunderthe fixed exchangerates of the gold standardmeant
that they generatedlittle inflationarypressureat home but also that their
effects were transmittedto the rest of the world. The ready availabilityof
moneyand creditproduceda visibledeteriorationin the qualityof projects- as
in the Florida land boom of the mid-1920s- and a growing prevalenceof
malfeasanceand graft, evident in the activitiesof CharlesPonzi in Florida,
ClarenceHatry in London,and Ivar Kreugerin Stockholm.Thesechangesin
turnheightenedthe concernof centralbanksaboutthe broadereffectsof assetprice inflation, leading them eventuallyto tighten. The not uncontroversial
implicationis that the Fed should have preventedthe developmentof speculative excesses by maintaininga tighter policy stance, specificallybetween
1925 and 1927, despite the absence of wholesale and retail price inflation.
Doing so might have obviated the need to tighten so sharply starting in
1928, by which time the financialposition of banks, firms, and households
had weakenedsignificantly.It might have avoided precipitatinga downturn
that banks,firms,and ultimatelythe economy,burdenedby excessesaccumulated in the RoaringTwenties,werein no position to withstand.
Borio and Lowe (2002)developindicatorsof this creditboom phenomenon
- constructedas a weightedaverageof the rate of growthof bankcredit,stock
marketvaluations,and the investmentratio - and show that recessionsand
crises are most likely to follow when these indicatorsrise relativeto trend.
Togetherwith Kris Mitchener,I have constructedanalogousindicatorsfor the
8 B. Eichengreen
1920s.12 The idea of this composite is to capture not just the availability of
credit to the private sector but also its transmission to asset prices and economic activity. The motivation is that the same increase in credit may have
different effects depending on the structure of the economy that amplifies or
muffles its impact. The composite indicator thus seeks to capture both the
impulse and its amplification by measuring not only the growth of credit but
also its impact on asset prices and aggregate demand.
Figure 1 shows the unweighted average of the composite indicators for 16
countries for which the necessary data are available.13 As shown there, the
composite indicator rises relative to trend after 1927, signalling turbulence
ahead. Figure 2 shows that the larger the credit boom circa 1928 (i.e., the
greater the rise in the actual value of the composite indicator, plotted on the
horizontal axis), the larger the subsequent fall in per capita GDP (plotted on
the vertical axis).14 We also see from the figure that the credit-boom - subsequent-depression relationship is above all a U.S. story. This is consistent with
the older literature on the United States, emphasizing the downward shock to
consumption and investment emanating from the collapse of the stock market
and from overbuilding in the 1920s. But a number of other countries also
experienced pronounced credit booms in the late 1920s - Canada, France, and
Italy among them - and suffered the consequences subsequently.
Credit booms had littered the nineteenth-century financial landscape, of
course. Typically, a combination of lax domestic credit conditions and capital
inflows fuelled a railway- or public-utility-related construction boom, investment in which was encouraged by government guarantees. Such stories feature
prominently in Sprague's (1910) history of U.S. financial crises, and other
countries, like Argentina in the 1880s, similarly displayed all the classic symptoms. Why, then, did none of these late-nineteenth-century episodes produce a
slump as deep, long, and widespread as that of the 1930s?
12 While Borio and Lowe use measures of domestic credit to the private sector, comparable
data are not available for the interwar years. We therefore use M2. Equity prices are measured
as the ratio of a broad stock market index to the consumer price index, while investment is
expressed as a share of GDP. The three ratios were then detrended by fitting a linear trend
through 1930. The composite index is constructed by weighting the three ratios by their
respective signal-to-noise ratios - that is, by the ratio of the share of subsequent crises
successfully predicted by data through 1928 to the share of false positives, where the signalling
threshold is set to maximize this ratio. When this is done separately for currency and banking
crises, it yields slightly different composite indicators for the two cases, although the prevalence
of twin crises in the 1930s dictates that the differences in the two variants are small. Unweighted
averages of the three components of the composite yield essentially identical results in the
forecasting exercises described below.
13 The countries are Argentina, Australia, Belgium, Canada, Denmark, Finland, France,
Germany, Italy, Japan, the Netherlands, Norway, Spain, Sweden, the United Kingdom and the
United States.
14 Multiple regressions, including controls for other country characteristics influencing their
susceptibility to the international slump (e.g., the size of the current account deficit in 1928), do
not weaken this relationship. The typical t-statistic on the value of the composite indicator in
1928 in such a multiple regression is consistent with statistical significance at the 95% but not
the 99% confidence level.
Understandingthe Great Depression 9
10-
5X
a)
'ID
c
a)
Q)
0
0-
E
0
0
-5-
-10I
1920
1925
1a CompositeIndicatorfor BankingCrises
1930
1935
date
10-
x
0V
0-
._
o
Q.
E
0
) -10-
-20I
I
I
I
920
1920
1925
1930
1935
1935
date
1b CompositeIndicatorforCurrencyCrises
FIGURE 1 Composite Indicator for Currency Crises
10 B. Eichengreen
20-
FRANCE
y = 1.2676+ 0.8864 x
t-stat:(0.31)
(2.05)
UNITED STATES CANADA
AUENTIN
ARGENTINA
co
CL
0CD
10-
C:
UNITED
NORWAY
oo3
Cu
0-
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BELGIUM
DENMARK
-10-
~~I
-5
JAPAN
~I
i
0
I
I
I
1
15
1
10
5
1928 Composite Indicator
30-
UNITED STATES
Y= 3.6974 + 0.9696 x
t-stat: (0.80)
(1.96)
CANADA
FRANCE
CO
a)
20-
ARGENTINAGERMANY
a.
(3
0)
NETHERLAND
AUSTRALIA
o
10-
SWEDEN
ol,
JAPAN
FINLAND
i\
SPAIN
KINGDOM
0-
~I
-5
ITALY
BELGIUM
NORWAY
DENMARK
I~
i
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5
I
I
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15
1928 Composite Indicator
FIGURE 2
The competing answers focus, predictably,on U.S. and foreign policies. Before
1913 Treasury operations were capable of some monetary fine tuning, but there
was no central bank to behave in strongly destabilizingfashion. The prewar gold
standard imposed automatic limits on the extent of credit fluctuations. In the
Understandingthe Great Depression 11
1920s, however, an additional element of discretionwas introduced.The Fed kept
interest rates too low for too long, allowing the credit boom to develop, before
ratchetingthem up sharply.The key mistake in this view was at least as much that
monetary policy was too loose before 1927 as that it was too tight later. The
problem was not merely the gold standard, in other words; it was gold standard
management.
The limitation of this U.S.-centric story, once again, is that it does not
explain why other countries responded in like fashion. It can explain the
U.S. credit boom but not the global credit boom, unless we are prepared to
assume that low interest rates in a country accounting for only a quarter of
global output and 15% of world exports can explain financial developments
throughout the world.
Thus, foreign policies must also have been to blame insofar as other central
banks similarly allowed interest rates to remain too low for too long. Countries
like Britain were already suffering double-digit unemployment, and raising
interest rates would have only added to the problems of a politically challenged
Conservative government. Part of what the governor of the Bank of England,
Montagu Norman, meant when he described the Bank as continuously 'under
the harrow' was the political pressure he felt not to raise interest rates even
when doing so was dictated by gold standard considerations.15 Germany, for
its part, had a moral hazard problem: tighter credit that strengthened the
balance of payments undermined the argument that the country was incapable
of meeting its reparations obligations. The problem, in this view, was not so
much misguided policy in the United States as the politicization of policy in
other countries.
Central banks' ill-conceived efforts to cooperate may have contributed to
this situation. Benjamin Strong understood that his foreign counterparts, in
particular Norman, were under pressure not to raise interest rates. If they
failed to act, this might raise questions about the credibility of Britain's
commitment to the gold standard. This was the motivation for the secret
meeting of central bankers on Long Island in May 1927 - the 1920s analogue
of 'the committee to save the world.' Rather than forcing the Bank of England
to raise its discount rate, as dictated by the 'rules of the game,' the Fed agreed
to lower its rate as a result of that meeting It was at this point, it is sometimes
15 For those who recall textbook accounts in which the instability of the 1920s was a result of
misaligned exchange rates - and specifically of Winston Churchill's decision to restore sterling's
pre-war parity in 1925 - this is where these factors enter the story. Sterling's overvaluation
compounded the problem of British unemployment and balance-of-payments weakness. More
generally, the failure of central banks to force prices back down to pre-war levels before
restoring convertibility at the pre-war rate of exchange forced the interwar system to operate on
a narrower gold basis - the real value of existing gold stocks would have been higher had price
levels been lower - leaving less margin for error. The resulting global gold shortage continues to
be emphasized by authors writing in the tradition of Cassel (1936); see, for example, Johnson
(1998) and Mundell (2000).
12 B. Eichengreen
alleged,that the creditboom and the Wall Streetbubblebegan to get out of
hand.
This bringsus to the role of centralbankcooperation.Flandreau(1997)and
Moure(2002)have criticizedthe argument(associatedwith Eichengreen1992)
that the inadequacyof centralbank cooperationin the 1920scontributedto
the collapseof the interwargold standardand ultimatelyto the severityof the
Great Depression.They suggest that such cooperationwas never especially
prevalentbefore 1913,makingit hardto arguethat its failurein the 1920scan
explainthe inferiorperformanceof the gold-exchangestandardreconstructed
afterWorldWarI, and that to the extentthat cooperationactuallyoccurredin
the 1920sit was partof the problem,not part of the solution.Not surprisingly,
I remainunconvinced.For one thing, the criticsexaggeratethe role of internationalfactorsin explainingthe Fed's interestrate cut in 1927.The Fed was
respondingto the slowdown in industrialproduction(as Henry Ford shut
down his assemblylines to retool for the Model A) and to distressin the
agriculturalmidwestdue to depressedfarm prices.Therewas a large element
of unilateralismand self-interest,in otherwords,in the Fed's 1927interestrate
cut, as opposedto internationalmotives.This is anotherreminderof the need
to distinguishbetweenU.S. and internationalfactors.
In addition,when analysingthe pre-1913gold standard,my emphasiswas
on the importanceof 'regime-preserving
cooperation.'The argumentwas not
that centralbankshad cooperatedcontinuouslywhensettinginterestrates,but
that the leadingcentral banks and governmentshad supportedone another
with emergencyassistancein timesof crisis.This preventedthe collapseof any
one currencyfrom jeopardizingthe entire system. It preventedpressureson
particularcurrenciesfromprovokingsystemiccrisesof the sort that eruptedin
the 1930s.It was this regime-preserving
cooperationthat was missingin 1931,
when the Bankof Francehesitatedto assistits Austrianand Germancounterpartsand the BIS was preventedfrom doing so for a time by the disputeover
reparations,Germany'sprogram of building pocket battle ships, and the
proposal for a Austro-Germancustoms union in contraventionof the VersaillesTreaty.Thereis no contradictionbetweenthe argumentthat the absence
of regime-preserving
cooperationwas part of the problemin the 1930s, but
that misguidedcooperationof a differentsort was equallyproblematicin the
1920s.
2. The downwardspiral
As output and asset pricesbegan to fall, banks experiencedfinancialdistress.
Since borrowers'obligationswere fixed in nominalterms,the fall in incomes
led to a rise in non-performingloans. Growingconcernsover the stabilityof
the gold standardthen led investors to substitutegold for financial assets
where doing so was permittedand central banks to liquidate their foreign
Understandingthe Great Depression 13
exchange reserves to avoid suffering capital losses in the event that reserve
currencies were devalued.
Under these circumstances, the gold standard became an engine of deflation. Money supplies were a multiple of the international reserve backing of
central banks and governments. This backing contracted as central banks,
fearful for the stability of the gold standard, liquidated their foreign exchange
reserves. Central banks whose obligations were reserve currencies, suffering
corresponding reserve losses, raised their discount rates to stem capital outflows.16 Higher interest rates heightened the distress experienced by commercial banks with maturity mismatches on their balance sheets. They
consequently sought to rebuild their liquidity and reserves by calling in loans.
Depositors, with fears about the liquidity of the banks, fled into currency.
Bernanke and Mihov (2000) decompose this process by writing the money
stock (M1) as follows:
M1 = (M1/BASE)*(BASE/INTRES)*(INTRES/GOLD)*GOLD,
where BASE is currency in circulation plus the reserves of commercial
banks, INTRES is the country's international reserves (gold plus foreign
exchange), and GOLD is the value of gold reserves denominated in domestic
currency. We can take the second term as fixed in the short run by the backing
rules under which the gold standard operated and the fourth term as slow to
change, given the lagged response of the gold-mining industry. Thus, most of
the action in this product should have come from the first and third terms. The
first term, the money multiplier, will fall as the worsening prospects of financial
institutions lead depositors to flee into cash and banks to call in their loans.
The third term, the international reserve multiplier (total international reserves
relative to gold), will fall as central banks liquidate their foreign currency
assets.
How important were these components in producing the observed decline in
money stocks? The INTRES/GOLD ratio fell from 1.27 at the end of 1929 to
1.25 at the end of 1930 and 1.12 at the end of 1931 in 26 countries (the 24
countries considered in Nurkse 1944, appendix II, plus the United States and
16 As the Fed did, for example, in September-October 1931 following Britain's abandonment of
the gold standard - see below. Say that the National Bank of Belgium sought to liquidate its
holdings of British treasury bills and to replace them with gold in order to avoid suffering
capital losses on the former. It would sell those bills on the British market for sterling and
present that sterling to the Bank of England for conversion into gold. The Bank of England,
experiencing gold losses, would then have to raise interest rates to limit the deterioration of its
position. The National Bank of Belgium, to minimize its own reserve losses, would presumably
respond in kind. The net effect would be a decline in reserve backing (since foreign exchange
reserves had declined but the amount of gold in the international system was fixed) and higher
interest rates all around - two indications of deflationary pressure. In fact, the Belgian case is an
interesting one. The British authorities lobbied the National Bank to hold onto its sterling, as a
result of which the Belgian authorities suffered extensive capital losses when sterling was
ultimately devalued.
14 B. Eichengreen
the United Kingdom). Other things being equal, this implies a 12% fall in
global money supplies centred in 1931. If we exclude the United States and the
United Kingdom, the principal reserve-currency countries (the ratio being
fixed at unity in reserve-currencycountries that issued rather than held foreign
exchange reserves), then INTRES/GOLD falls from 1.60 at the end of 1929 to
1.53 at the end of 1930 and 1.23 at the end of 1931. In other words, for
countries other than the reserve centres, the corresponding fall in money
supplies was 23%.
While the INTRES/GOLD ratio fell across the board (except in the United
States and the United Kingdom for the aforementioned institutional reasons),
the direction of the change in M1/BASE varied across countries. Bernanke
(1995) analyses data for six countries, of which the largest fall was in the
United States (25%), but in two of which (the United Kingdom and Sweden)
the ratio instead rose between the end of 1929 and the end of 1931.17 The
weighted average for Bernanke's six countries (weighted by 1929 money supplies expressed in U.S. dollars) declined by 21%. The weighted average,
excluding the U.S., was 11%. I undertook a broader comparison for a total
of 31 countries; in this larger sample, the weighted average decline, excluding
the United States (30 countries), was 10%.18
Evidently, then, the liquidation of foreign exchange reserves played a more
important role than the liquidation of bank deposits in the monetary contraction outside the United States. The United States was unusual in that the
percentage fall in the M1/BASE ratio was larger than the percentage fall in
the INTRES/GOLD ratio.19 (Recall that as the issuer of a reserve currency,
the Fed, like the Bank of England, held no foreign-exchange reserves.) It is
tempting to say that for the rest of the world the collapse of the gold-exchange
standard mattered more than the collapse of the banking system, while the
opposite was true for the United States. It is not surprising, from this point of
view, that the literature on the global depression focuses on the gold standard,
while that on the United States concentrates on the banking crisis.
One should be cautious here, since banking and currency crises were related.
Currency crises in other countries were one factor forcing the Fed to ratchet up
interest rates in the final months of 1931 (both devaluation and higher interest
17 Of course,theseweretwo of the countriesthat went off the gold standardtowardsthe end of
1931.But the othertwo countriesconsidered,Polandand Belgium,did not experiencedeclines
in the M1/BASEratioapproachingthat of the UnitedStates.
18 The 30 countrieswereBelgium,Bolivia,Brazil,Bulgaria,Canada,Chile,Colombia,
Czechoslovakia,Denmark,Estonia,Ecuador,Finland,France,Germany,Hungary,Italy,
Japan,Latvia,Lithuania,Mexico,Netherlands,Norway,Poland,Portugal,Romania,Spain,
Sweden,Switzerland,the UnitedKingdom,and Uruguay.Again,I took the weightedaverage
by convertingM1 and the base into dollarsat marketexchangerates.
19 In the United Kingdom, in contrast, the M1/BASE ratio rose slightly between the end of 1929
and the end of 1930and fell slightlybetweenthe end of 1930and the end of 1931,hence
remainingessentiallyunchangedover the period.This stabilityreflectsthe absenceof serious
banking-sector
problemsin Britain,an issue to whichI returnbelow.
Understandingthe Great Depression 15
rates abroad increased the perceived likelihood that the dollar might have to be
devalued, forcing the Fed to raise interest rates to stem capital outflows).
Those higher interest rates surely contributed to the difficulties of the U.S.
banking sector. In other countries, the banking crisis worsened the liquidity
crisis. All of the banking-crisis episodes identified by Bernanke and James
(1991) begin before the corresponding currency crises in the same countries.
Note that the same pattern - banking crises first, currency crises second - is
typical of twin crises today (Kaminsky and Reinhart 1998). When deposits
hemorrhage out of the banking system, governments and central banks find
themselves between a rock and a hard place. In the 1930s providing large
amounts of liquidity to the banking system almost certainly would have
violated gold-standard statutes; doing so would have raised questions about
whether the authorities attached priority to the maintenance of the exchange
rate peg relative to other economic and social goals. But not doing so might
have allowed the banking system to come crashing down, with even more
disruptive effects on economic activity. Except in the United States, where
they remained strangely unperturbed, the authorities generally took steps to
prevent the collapse of banking systems. But adding liquidity to the financial
system undermined confidence in the stability of the currency, provoking
capital flight and encouraging the continued conversion of foreign exchange
reserves into gold, thereby accelerating the fall of the gold-reserve multiplier.
Again, it follows that the main engine of deflation was the banking crisis in the
United States and the currency crisis in other countries.
A conventional critique of the literature on twin crises is that timing does
not prove causality.20That a banking crisis becomes evident before a currency
crisis does not prove that the former caused the latter. It could be that
anticipations of a subsequent currency crisis led savers to liquidate domesticcurrency-denominated deposits and flee into foreign exchange in order to
avoid capital losses due to the eventual devaluation. This of course was the
dynamic evident in Argentina in the final months of 2001, although deposit
withdrawals were not enough to provoke a full-blown banking crisis prior to
the actual devaluation. Ferguson and Temin (2001) show that Germany was
running chronic budget deficits in the first half of 1931 and reason that
expectations that these would be monetized, leading to a currency crisis,
provoked the deposit withdrawals of May and June.21Wigmore (1984) argues
that anticipations of Roosevelt's decision to take the dollar off gold led to the
run on U.S. banks in the interregnum between FDR's election and assumption
20 Recall that this is the same critique of timing evidence on money and output alluded to in the
preceding discussion of Friedman and Schwartz's (1963) examination of monetary factors in the
onset of the Depression.
21 The authors argue that Bruening's references to a reparations moratorium worked in the same
direction. Of course, there is a sense in which the reparations tangle and German budget deficits
were two sides of the same coin; strengthening the budget would have weakened the argument
that Germany could not pay.
16 B. Eichengreen
of office. Thejudiciousconclusion,then as now, is that the causalitybetween
bankingand currencycriseswas bidirectional.
If expectationsof depreciationcould destabilizea bankingsystem,then the
fact of depreciationcould be broadlystabilizing.Going off the gold standard
freed up monetarypolicy. It allowed the central bank to cut interestrates,
relieving banking sector distress. Grossman (1994) contrasts a number of
explanationsfor why some countriessucceededin avertingbankingcrises in
the 1930s.The singlemost importantfactor, he finds, was whethera country
had abandonedthe gold standard,allowingthe centralbank to engage more
freelyin lender-of-last-resort
operationsand to jump-startthe recovery.This
seems to have been the case in capital-importingand capital-exportingeconomies and industrialand developingcountriesalike.
This situationis in contrastto the experienceof the 1990s, when capitalimportingemergingmarketssaw theirfinancialsystemsand economiesdestabilized by depreciation.Why didn't depreciationin the 1930s have similarly
destabilizingeffects?One can think of severalpotentialexplanations.
* Foreign deposits were widespread but foreign-currency-denominated
deposits were less. This was at least one favourablelegacy of the gold
standard,insofar as a history of fixed rates made it seem less imperative
for foreigndepositorsto avoid currencyrisk.
* Foreign-currency
denominatedloansto the banks'domesticclientsweresimilarlyless prevalent.Hence,depreciationdid not destroythe balancesheetsof
loans.
the corporatesectorand aggravatethe problemof non-performing
* Not a few countrieswith foreignobligationsrespondedto exchangemarket
pressuresby slappingon currencyand exchangecontrols - in effect, they
respondedlike Malaysiain 1998.This allowedthe authoritiesto injectcredit
into the bankingsystemwithout precipitatingthe uncontrolledcollapse of
the currency.Decouplingfrom internationalfinancialmarketsmade more
sensein the 1930sthan the 1990sbecausethe marketfor new foreignissues
was effectivelyshut down.
* Finally, a number of countries substitutedclear and coherent monetary
policy operatingstrategiesfor the gold-standardanchor. Swedenadopted
a priceleveltargetnot dissimilarfromthe inflationtargetingregimethat has
becomea popularapproachto anchoringfloatingexchangeratesin recent
years. Britainadopted a dirty float consistentwith an exchangerate that
remainedstable over the intermediaterun. The Commonwealthand many
of Britain'stradingpartnersadopteda policy of followingthe pound, albeit
more loosely than before,formingwhat came to be known as the Sterling
Area.Thus,fearsthat abandoningthe gold standardwouldunleashanother
round of uncontrolledinflation were quickly dispatched.This helped to
reviveconfidencein bankingsystems.
All this assumesthat the gold standardwas a bindingconstrainton stabilizing
interventionand that its abandonmentwas a preconditionfor the adoption
Understandingthe Great Depression 17
of reflationary policies. Any attempt to reduce interest rates or to engage in
expansionary open market operations unilaterally would have precipitated
capital outflows and reserve losses that endangered the exchange rate peg.
Here was where the absence of international cooperation was an issue. A
unilateral interest rate reduction would cause capital to flow towards other,
higher interest rate markets, endangering the exchange rate of the initiating
country, but there was no reason why simultaneous reductions by several
countries would weaken any one currency relative to another.
The United States was the one country arguably not prevented from taking
unilateral monetary action. Controversy here centres on the open market
purchases of April-August 1932 and whether they were abandoned as a result
of fears that continued security purchases would lead to further reserve losses,
to the point where the dollar would be attacked.22 Bordo, Choudhri, and
Schwartz (1999) simulate a calibrated price-specie flow model and conclude
that further increases in domestic credit, undertaken in either October 1930 February 1931 or September 1931 - January 1932, would not have exhausted
the Fed's gold reserves. Their analysis assumes a linear relationship between
domestic credit creation and reserve losses of a sort that will be familiar to
readers from the monetary approach to the balance of payments. The authors
raise but rule out the possibility of a speculative attack, which, in balance-ofpayments crisis models like Krugman (1979), produces a sharp non-linearity
when reserves fall to a lower threshold. In effect, they rule out a priori the
central problem of concern to those who see fears for the stability of the dollar
as constraining the Fed.
Hsieh and Romer (2001) argue that there was little perception, in either the
markets or the corridors of the Fed, that a speculative attack was looming.
They support this conclusion with Einzig's (1937) data on forward foreign
exchange rates; they show that the forward discount on the dollar against the
French franc implied a maximum probability of 11% of a major U.S. devaluation in the summer of 1932.23They show that the forward discount displayed
no significant correlation with the magnitude of open market operations and
that the behaviour of forward rates implies that expectations of a major dollar
devaluation actually dropped during the latter part of the Fed's expansionary
program. Sceptics will want more evidence on the volume of activity in the
forward market and on how Einzig's forward quotations were constructed.
22 Thereis less disputeover the two otherperiodswherethe gold standardallegedlyinhibitedthe
pursuitof moreexpansionarypolicies.The firsttime was in 1931,followingBritain's
devaluation,whenthe Fed had to hold gold to backnot just its own liabilitiesbut also
governmentsecuritiesin its portfolio;thiswas the problemof freegold eliminatedby the GlassSteagallAct of February1932.No one to my knowledgehas disputedthat the Fed neededto
raiseratesin the wake of Britain'sdevaluationin orderto maintainconfidencein the dollar.
The secondtimewas in January-February
1933,whenexcessreservesfell to zero, and thereis
no questionthat the gold standardbound.
23 Theyobtainbasicallythe sameresultwhetheror not theyadjustthe observedforwarddiscount
for meanreversion,in the mannerof the modem exchangeratetargetzone literature.
18 B. Eichengreen
There is also the question of whether the Fed aborted its program for fear of
destabilizing the dollar even before a larger discount was allowed to emerge,
and whether expectations of this action were what caused the discount to
narrow in July. Hsieh and Romer's qualitative discussion speaks to this question; they focus on the Harrison Papers, which do not suggest significant
concern within the Fed about the danger to the dollar. But Sumner (1997)
provides qualitative evidence that points in the opposite direction.
This controversy is one more sign that the United States was different. It is
another indication that the gold standard mattered less while banking crises
mattered more for the United States in this, the second stage of the Great
Contraction.
3. The recovery
This perspective implicating monetary blunders and constraints in the onset of
the slump suggests a role for corrective monetary action in the recovery. Just as
the gold standard prevented central banks from unilaterally pursuing expansionary monetary policies, abandoning the gold standard could have allowed
them to impart an expansionary monetary impulse. Fiscal policy played a
negligible role in recovery, even in countries like the United States, the United
Kingdom, and Sweden, where the Keynesian revolution received the most
intellectual play.24 Monetary policy did the hard lifting. In some cases, like
the United States, the monetary authorities simply cut interest rates and
allowed the exchange rate to decline; they accommodated the increase in the
demand for money and credit by passively discounting or leaving capital
inflows unsterilized. The U.S. case probably overstates the typical degree of
monetary stimulus from devaluation, since the country was also on the receiving end of capital flight from Europe once war clouds began to darken. On the
other hand, devaluation probably helped less insofar as the United States was a
large open economy (for smaller economies, there would have been no offsetting negative impact on the rest of the world and hence on export demand).
In other cases, the authorities actively expanded domestic credit but did so
cautiously, given memories of high inflation in the 1920s, the last time the gold
standard had been abeyance. This reluctance to expand more aggressively,
while understandable in the circumstances, is one reason why the recovery
was not more robust.
But wasn't monetary policy rendered impotent by the liquidity trap? In the
1930s nominal interest rates fell to low levels, especially the United States.
With rates so low, it hardly made sense for banks to lend, as opposed to
24 See Romer (1992) on the United States and Jonung (1981) on Sweden. The same was also true of
emergingmarkets (see Della Paolera and Taylor 1998). The main exceptions were Germany and
Japan, in which recoverywas stimulatedby public expenditureon rearmament.Towards the end of
the 1930s,as militaryconflict loomed, stimulus from rearmamentbecame general(see, e.g., Thomas
1983 on Britain).But this occurredafter the period of principalconcern here.
Understandingthe Great Depression 19
holding excess reserves. Expansionary open market operations that created
additional Federal Reserve obligations to the private sector might simply go
into additional bank reserves and, given where the banks held their reserves,
back into the Fed. Buying bonds 'would simply increase the reserves of the
banking system by the amount of government bonds which were purchased
with currency. The currency would go out.. .but [it] would immediately go into
the banks and from the banks into the federal Reserve Banks' (U.S. Congress
1935, quoted in Wilcox (1984), 1).
In the 1930s, as in the 1990s, whether the supply or the demand for bank
loans was the binding constraint mattered greatly for effectiveness of policy. If
the problem was less that no one was willing to lend, given the low-interest-rate
environment, than that no one was willing to borrow, given deflationary
expectations and demoralized business conditions, then a monetary shock
could transform the situation. A sharp change in the exchange rate was an
obvious way of transforming expectations of future prices and policies.25
Allowing the exchange rate to depreciate by, say, 25% (the magnitude of a
typical devaluation) implied a substantial rise in import prices and ultimately
in the domestic price level. In the short run, before prices had completed their
adjustment, the change in the exchange rate also had the effect of shifting
demand from foreign to domestic goods. If the authorities wished to prevent
the currency from rebounding too strongly from its initial drop, they could
undertake unsterilized intervention (Britain's approach following the establishment of the Exchange Equalisation Fund), engage in expansionary open
market operations, or re-peg the currency to gold at its new lower level (as
the United States did in January 1934), allowing the now higher demand
for money and credit to be met by capital and gold inflows.26 In this case,
the fall in the exchange rate was an unequivocal signal that future prices
would be higher than current prices; by transforming deflationary expectations, it pushed down the real interest rate and stimulated borrowing for
investment.
Temin and Wigmore (1984) show how devaluation of the dollar led to a
sharp rise in activity in capital-goods-producing industries in a matter of
months, just as if such a transformation of expectations had taken place. The
literature on Britain's devaluation and recovery points in a similar direction; it
25 Similarly,this is the conclusionof the modem literatureon the liquiditytrap.Evenif the
interest-ratechannelfor monetarypolicyis immobilizedby the lowerboundon the nominal
rate,a reflationarystrategyof pushingdownthe exchangerateandcommittingto a futurepath
for the foreignexchangevalueof the currencycan still help an open economyto escapethe
liquiditytrap(Svensson2000;McCallum2001).
26 Svensson(2000)observesthat peggingthe exchangeratein an environmentof deflationary
expectations(whenit is, if anything,expectedto appreciate)may requirearbitrarilylarge
foreignexchangemarketinterventions.Peggingto gold thus may requirearbitrarilylarge
purchasesof gold. In practice,it was throughdaily purchasesof gold at progressivelyhigher
prices(setby FDR and his 'kitchencabinet'overthe president'sbreakfast)thatthe dollar'srate
of exchangewas drivendown to lowerlevelsafterApril 1933.
20 B. Eichengreen
emphasizesthe recoveryof residentialconstruction(the housing boom), and
what is residentialconstructionif not an investmentactivity?Nominal interest
rates declined still furtherstartingin 1932, but this did not prevent British
banks from lending. Rather, the fall in real interestrates as expectationsof
deflationwere eliminatedstimulatedthe demandfor bank credit. Both cases
thus suggestthat the failureof the demandfor bank loans, not any liquiditytrap-relatedobstacle to their supply, was the problem in the Depression.27
Similarargumentscan be madefor othercountries;for example,Della Paolera
and Taylor(1998)show that abandonmentof the gold standardled to a sharp
changein expectationsin Argentina,again consistentwith the effectivenessof
monetary-cum-exchange-rate
policy. All these cases suggestthat this problem
could be solved by a devaluationthat convincinglytransformedexpectations
of future prices and monetarypolicies and gave the authoritiesthe leeway
neededto validatethose expectations.
Once devaluationtransformedexpectationsand freedup monetarypolicy,
prices began to rise, or at least they stopped falling. Eichengreenand Sachs
(1985) identifieda numberof channelsthrough which the effects were felt.
Raisingimportand exportpricesstimulatednet exports.Increasedprofitability and sales, futureas well as current,raisedthe value of productivecapacity
relative to its replacementcost, encouraginginvestment- which, as noted,
tended to lead the recovery in countries pursuing this policy. Stabilizing
outputpricesmade productionmore profitableand stimulatedlabor demand.
Bernankeand Carey(1996)focus on this aspectof the response.They observe,
on the assumptionthat differencesin economic performanceas of the mid1930sweredue to differencesin aggregatedemandflowingfromgold standard
policiesand that producerswerecontinuouslyon theirlabourdemandcurves,
that the cross-sectionrelationshipbetweenrealwagesand productionidentifies
a componentof the aggregatesupply relation. If the main thing happening
in the 1930swas shocks to demandcoming from domesticand international
monetarypolicies, in other words, then the resultingshifts in the aggregate
demandscheduleenable us to trace out the aggregatesupplycurve.That real
wagesfluctuatedcountercyclically(in contrastto the periodsbeforeand since,
when their cyclical propertiesare more ambiguous)is consistent with the
premise,common to these studies, that the Great Depressionwas mainly a
demand-inducedphenomenon, with aggregate demand shocks driving the
economyup and down along its aggregatesupplycurve.
These conclusions have not gone unchallenged.Figure 3, adapted from
Cole, Ohanian,and Leung (2002), shows that the cross-sectionrelationship
betweenthe changein real wages and the changein output over the 1929-33
period is relativelydiffuse. Superimposedon the scatterplot is their labour
27 Of course,factorsotherthan the liquiditytrap(adversebalance-sheeteffectsdue to deflation,
the destructionof informationdue to bankfailures,the eliminationof thicknessexternalities)
could havedisruptedthe supplyof financial-intermediation
services,as emphasizedby
Bernanke(1983)and furtheranalysedbelow.
Understandingthe Great Depression 21
o
0.2-0- -
o_0
o0O
-
tzerland....
0.0-. ..........Sw
...
i
-
++
.....
...........
+
0.0
0.6....
0.2
.
0-0.2. {). .....................+
LRWCH
3 The real wage-output relationshi,
FIGURE
-J o
0.6
... ..... ........
Netherlands
0.4
France
i
,=
+ ...............
?
o0.
2
US:
-0.6
-0.2
0.0
0.2
0.4
0.6
Proportional
ChangeinRealWages,1929-33
LRWCH
1929-33
FIGURE3 Therealwage-output
relationship,
demand schedule, derived on the assumption of a Cobb-Douglas production
function with a labour share of two-thirds. (The schedule goes through the
origin and has an elasticity of negative one-half, such that labour's share is
constant.) In some countries, notably the United States, the fall in output is
larger than the rise in real wages would lead one to predict. In others, notably
France, Holland, and Switzerland, it is smaller. Indeed, assuming, as we have
done so far, that the Great Depression resulted from demand-side factors
alone, it is hard to imagine any plausible production function that would be
consistent with the fact that output fell so much more in some countries than in
others experiencing roughly comparable increases in real wages. The implication would seem to be that the observed real-wage/employment relationship
was simultaneously perturbed by supply-side disturbances.
This interpretation is attractive if it is possible to identify plausible supply
shocks in the countries concerned. As noted, four countries in Cole, Ohanian,
and Leung's 17-country sample lie especially far from the predicted real-wage/
employment relationship. The United States lies far below, while France, the
Netherlands and Switzerland lie far above. For the United States, the obvious
factor disrupting aggregate supply was the financial crisis.28This emphasis on
28 Conceivably supplemented by the tendency for New Deal policies to restrict competition and
push up production costs, although the comparison of 1933 with 1929 is a bit early for the latter
set of effects plausibly to have made themselves felt.
22 B. Eichengreen
the collapse of financialintermediationas a supply shifteris consistentwith
Bernanke'semphasison the non-monetaryeffectsof the financialcrisisand on
the impactof increasesin the cost of creditintermediation.Earlyanalysestreat
bankfailuresmainlyas a determinantof aggregatedemand,operatingthrough
the monetarychannel.The presentperspective,in contrast,suggeststhat the
bankingcrisis had an impact on both blades of the aggregate-supply/aggregate-demandscissors.
As noted, France,the Netherlands,and Switzerlanddid better,in termsof
the change in output, than the rise in their labour costs would lead one to
predict.As membersof the gold bloc, they wereon the receivingend of capital
inflows once the gold-standardparitiesof other countriesbegan to crumble.
This renderedtheir financialsystemsmore liquid and creditconditionsmore
accommodatingthan would have been the case otherwise.29This, then, could
have amountedto a positivesupplyshock - a mirrorimage of the U.S. case.
Thatsaid,noneof thesecountriesentirelyescapedfinancialsectorproblems.In
France,a majordepositbank,theBanqueNationalede Credit,collapsedin 1932.30
In Switzerland,
the BanquePopulairehad to be restructured
in November1933.
Thatmost of theseeventsoccurredrelativelylate in the 1929-33periodsuggests
that the longerthesecountriesstayedon the gold standard,the morefragiletheir
financialsystemsand economiesbecame.An implicationis thatthesethreemembersof the goldblocwouldnot haveperformedso unusuallywellin a longer-term
comparison,whilethe UnitedStates,now off the gold standardandableto put its
banking-sector
problemsbehindit, would not have performedso exceptionally
This
poorly.
predictionis borneout for the UnitedStates,as shownin figure4,
whichis the equivalentof figure3, exceptthat 1929is comparedwith 1935rather
than1933.U.S. outputis now 30%belowpredictedlevels,ratherthanfully45%,a
considerable
injust two years.Bordo,Erceg,and Evans(1997)note
improvement
that standardmodelsof monetary-induced
inflationand deflation,togetherwith
stickiness
due
to
contracts,cannotexplainwhythe UnitedStates
wage
overlapping
recoveredas quicklyas it didafter1933,giventhattherewasno significantdecline
in realwages.Thespeedof recoverybecomeseasierto understandonceone admits
a role for the restorationof financialstabilityand reintermediation
due to the
loosercreditconditionsbroughtaboutby capitalinflows.
France,the Netherlands,and Switzerland,on the other hand, remainpositive outliersby about the same extent in 1935 as in 1933. But by 1935 these
countrieswere no longer on the receivingend of gold and capitalinflows, as
worries mounted about the sustainabilityof their gold standardpegs. This
suggests that there must have been additional factors behind the fact that
output in the gold bloc countriesdid not collapse more dramatically.Cole,
29 Cooperand Ejarque(1995)providea modelin whichcapitalflows like thesecan affectthe
but, as theynote, their
supplyside,owingto thicknessexternalitiesin financialintermediation,
modelcan reproduceonly some of the macroeconomicfluctuationsof the period.
30 Therewerealso threebankfailuresand runson provincialbanksin 1930,althoughBouvier
(1984)questionswhethertheseeventsconstituteda bankingcrisis
Understandingthe Great Depression 23
0 .2 .
0.2
Q)
A ........... .
^..... .....................--.......|
-
0.0-- .
+
\
.....
.....
>ic
\
.r?~~~
SwitzeFland -
i
+
+
~Netherlands
.....................
+.....
-0.2-
+
+
......
\
0
U
a.
-0.4
-0.2
+
0
France
+
\
0.2
0.4
0.6
ProportionalChange in Real Wages, 1929-35
LRWCH35
FIGURE 4 The real wage-output relationship, 1929-35
Ohanian, and Leung encourage one to search for additional positive supply
shocks to these countries. Finding them is not easy, especially in France. In
early 1935 the newly formed Flandin Government, inspired by Roosevelt's
New Deal, encouraged the adoption of legislation to cartelize French industry.
The subsequent year was one of growing political tension, culminating in the
electoral victory of a leftist government, the adoption of statutes mandating a
reduction in weekly hours, and sharp increases in unit labour costs. It is hard
to believe that there was a sharply positive aggregate supply shock lurking
behind these adverse developments.
The other way of interpreting figures 3 and 4 is that firms were thrown off
the notional demand curves for labour to which Cole, Ohanian, and Leung
assume that they clung faithfully and continuously throughout the period.
Whereas the New Classical analysis of these authors assumes that a reduction
in real wages would have led firms to hire additional workers, since the
reduction in costs would have made it profitable to produce and sell more
output, disequilibrium analysis in the tradition of Barro and Grossman (1976)
suggests that even if firms had produced more, they might have found themselves unable to sell it. In this view, countries lay to the left or the right of the
neoclassical labour demand curve plotted in figure 3 not because of adverse
and favourable aggregate supply shocks, but because producers were pushed
off their notional labour demand curves by different degrees of effective
demand failure in different countries. In the United States, where the policy
failure and therefore the demand failure were greatest, the lingering impact on
employment was still evident in 1935. In contrast, in France, where the Flandin
24 B. Eichengreen
governmentpursuedexpansionaryfiscal initiativesto head off politicalopposition on the left and a high level of reservesenabledthe Bank of Franceto
maintaininterestrate at artificiallylow levels, the consequenceswere least.
Ultimately,then, evidencelike that in figures 3 and 4 does not permitus to
determineonce and for all whetherthe GreatDepressionis entirelya story of
demandfailure, or whetherthere also were importantcompoundingsupplyside factors associatedwith the collapse of the financialsystem. More likely
than not, the answeris not either/or,but both.
4. Conclusion
One way of characterizingrecent researchon the Great Depression is as
'normalscience.'There is now a steady streamof publicationsadding incrementallyto existingknowledge.The onset of the Depressionremainsthe stage
about whichthereis probablyleast agreement,perhapsunavoidablygiven the
limited ability of macroeconomiststo explain turning points. The debate
continuesto revolvearoundthe relativeimportanceof inappropriatenational
policiesversusan unstableinternationalsystem.If thereis anythingresembling
a consensus,it is a syntheticview, which admits a role both for monetary
policy blundersin the United States, Germany,and France but also for the
unstable internationalmonetary and financial system in amplifying these
negativeimpulsesand transmittingthem to the rest of the world. It explains
the speedand extentof the subsequentoutputdeclinein termsof both banking
crisesand the collapseof the gold exchangestandard.It explainsthe eventual
recoveryin termsof the abandonmentof the gold standard,which facilitated
the pursuitof stabilizingmonetarypolicies,but also in termsof the restoration
of stabilityto bankingand financialsystems.
The challengefor proponentsof this consensusview is that differentelements dominatedin the United States and other countries.In the case of the
United States,thereis no denyingthe role of policymistakesin the onset of the
Depression,whereasfor other countriesinternationaltransmissionvia capital
and gold flows playedthe moreimportantpart.Whereasthe bankingcrisiswas
the main motor for the downwardspiralin the United States,in other countries the disintegrationof the gold-exchangestandardhad more profound
effects. For most countries,the movement of wages and prices can largely
explain the course of slump and recovery,but industrialproductionin the
United States fell more rapidlythan the behaviourof real wages would lead
one to predict,and it remaineddepressedrelativeto the internationalnormfor
severalyearsfollowingdevaluationof the dollar.
One explanationfor the disputesthat characterizethe literatureis thus that
Americanistscontinue to export the conclusions of researchon the United
Statesto the restof the world,whileothercountryspecialistscontinueto do the
opposite. The challengefor those seekingconsensusis thereforeto recognize
Understandingthe Great Depression 25
that national experiences differed while at the same time not abandoning
the effort to place individual country experiences in a broader framework. In
this paper I have sought to demonstrate that this effort to reconcile these
heretofore competing strands of thought may not be in vain.
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