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Essays on the Great Depression
Ben S. Bernanke

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COPYRIGHT NOTICE: Published by Princeton University Press and copyrighted, © 2000, by Princeton University Press. All rights reserved. No part of this book may be reproduced in any form by any electronic or mechanical means (including photocopying, recording, or information storage and retrieval) without permission in writing from the publisher, except for reading and browsing via the World Wide Web. Users are not permitted to mount this file on any network servers. Follow links for Class Use and other Permissions. For more information, send e-mail to

Chapter 1


A Comparative Approach

To understand the Great Depression is the Holy Grail of macroeconomics. Not only did the Depression give birth to macroeconomics as a distinct field of study, but also—to an extent that is not always fully appreciated—the experience of the 1930s continues to influence macroeconomists' beliefs, policy recommendations, and research agendas. And, practicalities aside, finding an explanation for the worldwide economic collapse of the 1930s remains a fascinating intellectual challenge.

    We do not yet have our hands on the Grail by any means, but during the past fifteen years or so substantial progress toward the goal of understanding the Depression has been made. This progress has a number of sources, including improvements in our theoretical framework and painstaking historical analysis. To my mind, however, the most significant recent development has been a change in the focus of Depression research, from a traditional emphasis on events in the United States to a more comparative approach that examines the experiences of many countries simultaneously. This broadening of focus is important for two reasons: First, though in the end we may agree with Romer (1993) that shocks to the domestic U.S. economy were a primary cause of both the American and world depressions, no account of the Great Depression would be complete without an explanation of the worldwide nature of the event, and of the channels through which deflationary forces spread among countries. Second, by effectively expanding the data set from one observation to twenty, thirty, or more, the shift to a comparative perspective substantially improves out ability to identify—in the strict econometric sense—the forces responsible for the world depression. Because of its potential to bring the profession toward agreement on the causes of the Depression—and perhaps, in consequence, to greater consensus on the central issues of contemporary macroeconomics—I consider the improved identification provided by comparative analysis to be a particularly important benefit of that approach.

    In this lecture I provide a selective survey of our current understanding of the Great Depression, with emphasis on insights drawn from comparative research (by both myself and others). For reasons of space, and because I am a macroeconomist rather than a historian, my focus will be on broad economic issues rather than historical details. For readers wishing to delve into those details, Eichengreen (1992) provides a recent, authoritative treatment of the monetary and economic history of the interwar period. I have drawn heavily on Eichengreen's book (and his earlier work) in preparing this lecture, particularly in section 1 below.

    To review the state of knowledge about the Depression, it is convenient to make the textbook distinction between factors affecting aggregate demand and those affecting aggregate supply. I argue in section 1 that the factors that depressed aggregate demand around the world in the 1930s are now well understood, at least in broad terms. In particular, the evidence that monetary shocks played a major role in the Great Contraction, and that these shocks were transmitted around the world primarily through the working of the gold standard, is quite compelling.

    Of course, the conclusion that monetary shocks were an important source of the Depression raises a central question in macroeconomica, which is why nominal shocks should have real effects. Section 2 of this lecture discusses what we know about the impacts of falling money supplies and price levels on interwar economies. I consider two principal channels of effect: (1) deflation-induced financial crisis and (2) increases in real wages above market-clearing levels, brought about by the incomplete adjustment of nominal wages to price changes. Empirical evidence drawn from a range of countries seems to provide support for both of these mechanisms. However, it seems that, of the two channels, slow nominal-wage adjustment (in the face of massive unemployment) is especially difficult to reconcile with the postulate of economic rationality. We cannot claim to understand the Depression until we can provide a rationale for this paradoxical behavior of wages. I conclude the paper with some thoughts on how the comparative approach may help us make progress on this important remaining issue.

1. Aggregate Demand: The Gold Standard and World Money Supplies

During the Depression years, changes in output and in the price level exhibited a strong positive correlation in almost every country, suggesting an important role for aggregate demand shocks. Although there is no doubt that many factors affected aggregate demand in various countries at various times, my focus here will be on the crucial role played by monetary shocks.

    For many years, the principal debate about the causes of the Great Depression in the United States was over the importance to be ascribed to monetary factors. It was easily observed that the money supply, output, and prices all fell precipitously in the contraction and rose rapidly in the recovery; the difficulty lay in establishing the causal links among these variables. In their classic study of U.S. monetary history, Friedman and Schwartz (1963) presented a monetarist interpretation of these observations, arguing that the main lines of causation ran from monetary contraction—the result of poor policy-making and continuing crisis in the banking system—to declining prices and output. Opposing Friedman and Schwartz, Temin (1976) contended that much of the monetary contraction in fact reflected a passive response of money to output; and that the main sources of the Depression lay on the real side of the economy (for example, the famous autonomous drop in consumption in 1930).

    To some extent the proponents of these two views argued past each other, with monetarists stressing the monetary sources of the latter stages of the Great Contraction (from late 1930 or early 1931 until 1933), and antimonetarists emphasizing the likely importance of nonmonetary factors in the initial downturn. A reasonable compromise position, adopted by many economists, was that both monetary and nonmonetary forces were operative at various stages (Gordon and Wilcox 1981). Nevertheless, conclusive resolution of the importance of money in the Depression was hampered by the heavy concentration of the disputants on the U.S. case—on one data point, as it were.

    Since the early 1980s, however, a new body of research on the Depression has emerged which focuses on the operation of the international gold standard during the interwar period (Choudhri and Kochin 1980; Eichengreen 1984; Eichengreen and Sachs 1985; Hamilton 1988; Temin 1989; Bernanke and James 1991; Eichengreen 1992). Methodologically, as a natural consequence of their concern with international factors, authors working in this area brought a strong comparative perspective into research on the Depression; as I suggested in the introduction, I consider this development to be a major contribution, with implications that extend beyond the question of the role of the gold standard. Substantively—in marked contrast to the inconclusive state of affairs that prevailed in the late 1970s—the new gold-standard research allows us to assert with considerable confidence that monetary factors played an important causal role, both in the worldwide decline in prices and output and in their eventual recovery. Two well-documented observations support this conclusion.

    First, exhaustive analysis of the operation of the interwar gold standard has shown that much of the worldwide monetary contraction of the early 1930s was not a passive response to declining output, but instead the largely unintended result of an interaction of poorly designed institutions, shortsighted policy-making, and unfavorable political and economic preconditions. Hence the correlation of money and price declines with output declines that was observed in almost every country is most reasonably interpreted as reflecting primarily the influence of money on the real economy, rather than vice versa.

    Second, for reasons that were largely historical, political, and philosophical rather than purely economic, some governments responded to the crises of the early 1930s by quickly abandoning the gold standard, while others chose to remain on gold despite adverse conditions. Countries that left gold were able to reflate their money supplies and price levels, and did so after some delay; countries remaining on gold were forced into further deflation. To an overwhelming degree, the evidence shows that countries that left the gold standard recovered from the Depression more quickly than countries that remained on gold. Indeed, no country exhibited significant economic recovery while remaining on the gold standard. The strong dependence of the rate of recovery on the choice of exchange-rate regime is further, powerful evidence for the importance of monetary factors.

    Section 1.1 briefly discusses the first of these two observations, and section 1.2 considers the second.

1.1. The Sources of Monetary Contraction: Multiple Monetary Equilibria?

Despite the focus of the earlier monetarist debate on the U.S. monetary contraction of the early 1930s, this country was hardly unique in that respect: The same phenomenon occurred in most market-oriented industrialized countries, and in many developing nations as well. As the recent research has emphasized, what most countries experiencing monetary contraction had in common was adherence to the international gold standard.

    Suspended at the beginning of World War I, the gold standard had been laboriously reconstructed after the war: The United Kingdom returned to gold at the prewar parity in 1925, France completed its return by 1928, and by 1929 the gold standard was virtually universal among market economies. (The short list of exceptions included Spain, whose internal political turmoil prevented a return to gold, and some Latin American and Asian countries on the silver standard.) The reconstruction of the gold standard was hailed as a major diplomatic achievement, an essential step toward restoring monetary and financial conditions—which were turbulent during the 1920s—to the relative tranquility that characterized the classical (1870-1913) gold-standard period. Unfortunately, the hoped-for benefits of gold did not materialize: Instead of a new era of stability, by 1931 financial panics and exchange-rate crises were rampant, and a majority of countries left gold in that year. A complete collapse of the system occurred in 1936, when France and the other remaining "Gold Bloc" countries devalued or otherwise abandoned the strict gold standard.

    As noted, a striking aspect of the short-lived interwar gold standard was the tendency of the nations that adhered to it to suffer sharp declines in inside money stocks. To understand in general terms why these declines happened, it is useful to consider a simple identity that relates the inside money stock (say, M1) of a country on the gold standard to its reserves of monetary gold:

M1 = (M1/BASE) x (BASE/RES) x (RES/GOLD) x PGOLD x QGOLD (1)


M1 = M1 money supply (money and notes in circulation plus commercial bank deposits),

BASE = monetary base (money and notes in circulation plus reserves of commercial banks),

RES = international reserves of the central bank (foreign assets plus gold reserves), valued in domestic currency,

GOLD = gold reserves of the central bank, valued in domestic currency = PGOLD x QGOLD,

PGOLD = the official domestic-currency price of gold, and

QGOLD = the physical quantity (for example, in metric tons) of gold reserves.

Equation (1) makes the familiar points that, under the gold standard, a country's money supply is affected both by its physical quantity of gold reserves (QGOLD) and the price at which its central bank stands ready to buy and sell gold (PGOLD). In particular, ceteris paribus, an inflow of gold (an increase in QGOLD) or a devaluation (a rise in PGOLD) raises the money supply. However, equation (1) also indicates three additional determinants of the inside money supply under the gold standard:

    (1) The "money multiplier," M1/BASE. In fractional-reserve banking systems, the total money supply (including bank deposits) is larger than the monetary base. As is familiar from textbook treatments, the so-called money multiplier, M1/BASE, is a decreasing function of the currency-deposit ratio chosen by the public and the reserve-deposit ratio chosen by commercial banks. At the beginning of the 1930s, M1/BASE was relatively low (not much above one) in countries in which banking was less developed, or in which people retained a preference for currency in transactions. In contrast, in the financially well-developed United States this ratio was close to four in 1929.

    (2) The inverse of the gold backing ratio, BASE/RES. Because central banks were typically allowed to hold domestic assets as well as international reserves, the ratio BASE/RES—the inverse of the gold backing ratio (also called the coverage ratio)—exceeded one. Statutory requirements usually set a minimum backing ratio (such as the Federal Reserve's 40 percent requirement), implying a maximum value for BASE/RES (for example, 2.5 in the United States). However, there was typically no statutory minimum for BASE/RES, an important asymmetry. In particular, sterilization of gold inflows by surplus countries reduced average values of BASE/RES.

    (3) The ratio of international reserves to gold, RES/GOLD. Under the gold-exchange standard of the interwar period, foreign exchange convertible into gold could be counted as international reserves, on a one-to-one basis with gold itself) Hence, except for a few "reserve currency" countries, the ratio RES/GOLD also usually exceeded one.

    Because the ratio of inside money to monetary base, the ratio of base to reserves, and the ratio of reserves to monetary gold were all typically greater than one, the money supplies of gold-standard countries—far from equalling the value of monetary gold, as might be suggested by a naive view of the gold standard—were often large multiples of the value of gold reserves. Total stocks of monetary gold continued to grow through the 1930s; hence, the observed sharp declines in inside money supplies must be attributed entirely to contractions in the average money-gold ratio.

    Why did the world money-gold ratio decline? In the early part of the Depression period, prior to 1931, the consciously chosen policies of some major central banks played an important role (see, for example, Hamilton 1987). For example, it is now rather widely accepted that Federal Reserve policy turned contractionary in 1928, in an attempt to curb stock market speculation. In terms of quantities defined in equation (1), the ratio of the U.S. monetary base to U.S. reserves (BASE/RES) fell from 1.871 in June 1928, to 1.759 in June 1929, to 1.626 in June 1930, reflecting both conscious monetary tightening and sterilization of induced gold inflows. Because of this decline, the U.S. monetary base fell about 6 percent between June 1928 and June 1930, despite a more-than-10 percent increase in U.S. gold reserves during the same period. This flow of gold into the United States, like a similarly large inflow into France following the Poincare' stabilization, drained the reserves of other gold-standard countries and forced them into parallel tight-money policies.

    However, in 1931 and subsequently, the large declines in the money-gold ratio that occurred around the world did not reflect anyone's consciously chosen policy. The proximate causes of these declines were the waves of banking panics and exchange-rate crises that followed the failure of the Kreditanstalt, the largest bank in Austria, in May 1931. These developments affected each of the components of the money-gold ratio: First, by leading to rises in aggregate currency-deposit and bank reserve-deposit ratios, banking panics typically led to sharp declines in the money multiplier, M1/BASE (Friedman and Schwartz 1963; Bernanke and James 1991). Second, exchange-rate crises and the associated fears of devaluation led central banks to substitute gold for foreign exchange reserves; this flight from foreign-exchange reserves reduced the ratio of total reserves to gold, RES/ GOLD. Finally, in the wake of these crises, central banks attempted to increase gold reserves and coverage ratios as security against future attacks on their currencies; in many countries, the resulting "scramble for gold" induced continuing declines in the ratio BASE/RES.

    A particularly destabilizing aspect of this process was the tendency of fears about the soundness of banks and expectations of exchange-rate devaluation to reinforce each other (Bernanke and James 1991; Temin 1993). An element that the two types of crises had in common was the so-called "hot money," short-term deposits held by foreigners in domestic banks. On one hand, expectations of devaluation induced outflows of the hot-money deposits (as well as flight by domestic depositors), which threatened to trigger general bank runs. On the other hand, a fall in confidence in a domestic banking system (arising, for example, from the failure of a major bank) often led to a flight of short-term capital from the country, draining international reserves and threatening convertibility. Other than abandoning the parity altogether, central banks could do little in the face of combined banking and exchange-rate crises, as the former seemed to demand easy money policies while the latter required monetary tightening.

    From a theoretical perspective, the sharp declines in the money-gold ratio during the early 1930s have an interesting implication: namely, that under the gold standard as it operated during this period, there appeared to be multiple potential equilibrium values of the money supply. Broadly speaking, when financial investors and other members of the public were "optimistic," believing that the banking system would remain stable and gold parities would be defended, the money-gold ratio and hence the money stock itself remained "high." More precisely, confidence in the banks allowed the ratio of inside money to base to remain high, while confidence in the exchange rate made central banks willing to hold foreign exchange reserves and to keep relatively low coverage ratios. In contrast, when investors and the general public became "pessimistic," anticipating bank runs and devaluation, these expectations were to some degree self-confirming and resulted in "low" values of the money-gold ratio and the money stock. In its vulnerability to self-confirming expectations, the gold standard appears to have borne a strong analogy to a fractional-reserve banking system in the absence of deposit insurance: For example, Diamond and Dybvig (1983) have shown that in such a system there may be two Nash equilibria, one in which depositor confidence ensures that there will be no run on the bank, the other in which the fears of a run (and the resulting liquidation of the bank) are self-confirming.

    An interpretation of the monetary collapse of the interwar period as a jump from one expectational equilibrium to another one fits neatly with Eichengreen's (1992) comparison of the classical and interwar gold-standard periods [see also Eichengreen (forthcoming)]. According to Eichengreen, in the classical period, high levels of central bank credibility and international cooperation generated stabilizing expectations, for example, speculators' activities tended to reverse rather than exacerbate movements of currency values away from official exchange rates. In contrast, Eichengreen argues, in the interwar period central banks' credibility was significantly reduced by the lack of effective international cooperation (the result of lingering animosities and the lack of effective leadership) and by changing domestic political equilibria—notably, the growing power of the labor movement, which reduced the perceived likelihood that the exchange rate would be defended at the cost of higher unemployment. Banking conditions also changed significantly between the earlier and later periods, as war, reconstruction, and the financial and economic problems of the 1920s left the banks of many countries in a much weaker financial condition, and thus more crisis-prone. For these reasons, destabilizing expectations and a resulting low-level equilibrium for the money supply seemed much more likely in the interwar environment.

    Table 1 illustrates equation (1) with data from six representative countries. The first three countries in the table were members of the Gold Bloc, who remained on the gold standard until relatively late in the Depression (France and Poland left gold in 1936, Belgium in 1935). The remaining three countries in the table abandoned gold earlier: the United Kingdom and Sweden in 1931, the United States in 1933. [Throughout this lecture I follow Bernanke and James (1991) in treating any major departure from gold-standard rules, including devaluation or the imposition of exchange controls, as "leaving gold."] Of course, the gold leavers gained autonomy for their domestic monetary policies; but as these countries continued to hold gold reserves and set an official gold price, the components of equation (1) could still be calculated for those countries.

    Several useful points may be gleaned from Table 1: First, observe the strong correspondence between gold-standard membership and falling M1 money supplies (a minor exception is Poland, which managed a small growth in nominal M1 between 1932 and 1936). Second, note the sharp declines in M1/BASE and RES/GOLD, reflecting (respectively) the banking crises and exchange crises (both of which peaked in 1931). Third, the table shows the tendency of gold-surplus countries to sterilize (that is, BASE/RES tends to fall in countries experiencing increases in gold stocks, QGOLD).

    A striking case shown in Table 1 is that of Belgium: Although that country was the beneficiary of large gold inflows early in the Depression, the combination of declines in M1/BASE (reflecting banking panics), RES/ GOLD (reflecting liquidation of foreign-exchange reserves), and BASE/RES (the result of conscious sterilization early in the period, and of attempts to defend the exchange rate against speculative attack later in the period) induced sharp declines in the Belgian money stock. Similarly, because of falls in M1/BASE and RES/GOLD, France experienced almost no nominal growth in M1 between 1930 and 1934, despite a more than 50 percent increase in gold reserves. The other Gold Bloc country in the table, Poland, experienced monetary contraction principally because of loss of gold reserves.

    Another interesting phenomenon shown in Table 1 is the tendency of countries devaluing or leaving the gold standard to attract gold away from countries still on the gold standard. In the table, the United Kingdom, Sweden, and the United States all experienced significant gold inflows starting in 1933. This seemingly perverse result reflected the greater confidence of speculators in already depreciated currencies, relative to the clearly overvalued currencies of the Gold Bloc. This flow of gold away from some important Gold Bloc countries was the final nail in the gold standard's coffin.

Copyright © 2000 Princeton University Press. All rights reserved.

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