Why the Gold Standard is Bad During a Depression

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In 1931, the Fed raised the discount rate from 1.5% to 3.5% during the teeth of the Depression because gold was flowing out of the economy. Raising interest rates during a contraction is the exact opposite of what should be done, and helped prolong the Great Depression.

1. Monetary policy. Any country that loosens monetary policy, and lowers interest rates, will tend to create a larger deficit on the capital account of the balance of payments. Now, under flexible exchange rates, this will cause a depreciation of the exchange rate. The lower interest rate increases demand, and so does the lower exchange rate. These encourage countries to loosen monetary policy in a recession. But in the 1930's, under the Gold Standard, the increased capital account deficit would cause a loss of gold reserves, and the danger of running out of reserves completely.

In a global recession, you want a global loosening of monetary policy. It is individually rational today to loosen monetary policy. It was not always individually rational to loosen monetary policy in the 1930's.

2. Fiscal Policy. Holding interest rates constant, and holding exchange rates constant, a country which loosens fiscal policy in a recession will see increased output, income, and imports. This increase in imports will tend to create a larger current account deficit. Now, under flexible exchange rates, this will cause a depreciation of the exchange rate, which partially or fully offsets the drop in net exports. But in the 1930's, under the Gold Standard, the larger current account deficit would cause a loss in gold reserves, and the danger of running out of reserves completely.

In a global recession, you want a global loosening of fiscal policy. It is individually rational today to loosen fiscal policy. It was not always individually rational to loosen fiscal policy in the 1930's.

3. Deflation. Under the Gold Standard, there is an incentive for an individual country to lower its levels of prices and wages. This would depreciate its real exchange rate, increase net exports, and increase demand for its goods. But these gains in one country's net exports came at the expense of other countries' net exports. At the global level, world deflation had one good effect, in that it increased the real value of the global stock of reserve currency, namely gold. But it had adverse effects as well, probably larger. The first adverse effect is to increase the real value of debts, as in Irving Fisher's debt-deflation theory. The second adverse effect is to create expected deflation, which increases real interest rates and reduces demand for goods. Now, under flexible exchange rates, there is less incentive for countries to encourage deflation to increase net exports. The exchange rate would adjust to offset an increase in net exports.

In a global recession, you do not want deflation. It is individually rational today to avoid deflation. It was not always individually rational to avoid deflation in the 1930's.

4. Protectionism. Some argue today that it is individually rational for a country today to adopt protectionism, to try to divert demand away from other countries and increase net exports. Others, like me, argue that it is not individually rational, mainly because exchange rates will adjust to offset the effects. Regardless of who is right today, the incentives for an individual country to adopt protectionism were stronger under the Gold Standard, for two reasons. First, because exchange rates could not adjust to offset the effects of protectionism. Second, because a country which did succeed in using protectionism to increase net exports would not only gain by diverting demand for goods away from other countries, it would also gain gold reserves.

In a global recession, you do not want protectionism. The incentives for countries to adopt protectionism today are weaker than in the 1930's.

Worthwhile Canadian Initiative: At least we don't have the Gold Standard to worry about

 

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