A Fine Theorem

The gold standard has long been invoked (by Friedman/Schwartz and Eichengreen, among others) as a cause of the great depression (depending on how you define “cause”; since this is a history paper and not something more philosophical, we’ll leave discussion of the tenuous link between counterfactual and causality for another day). Gold, in the usual story, came in to the US in the late 1920s for a variety of reasons, but the Fed sterilized that gold so that inflation did not increase. The gold standard then transmitted that tight monetary shock worldwide and massive deflation hit many countries. It is a story that makes intuitive sense since those countries who left the post-war gold standard quickly tended to suffer milder negative effects.

In a new paper, Douglas Irwin notes that France implicitly pursued a similar policy to the US. France’s share of world gold reserves rose from 7 to 27 percent from 1926 to 1932. Their cover ratio, the ratio of gold to money supply, rose from 40% to 80%, meaning that by the early 1930s France was nearly able to cover all outstanding domestic liabilities using gold from the vault. Irwin considers the following counterfactual. First, let the US and France maintain the same cover ratio as they had in 1928 and calculate how much “excess gold” – to be defined shortly – each country held as a share of the world stock. Use the standard estimate early in the century that increasing commercial transactions meant that a 3% increase in the world gold stock annually was required to keep prices constant. Then estimate, with a regression on the period after 1870, the “multiplier” of gold on prices through 1932 when countries begin leaving the gold standard in earnest, breaking the gold-price link. This is clearly back-of-the-envelope: surely the 3% growth in natural gold demand is too large during the massive contraction of 1930. Nonetheless, it gives a rough estimate of how large the effects of US and French policy might have been.

In 1929, for instance, the US and France together “removed” 6.4% of the world gold supply from circulation. The multiplier estimate of gold supply on prices – a multiplier exists at all because currencies were not 100% backed – means that a 6.4% drop in gold leads to a 15% drop in world prices in 1930, which is roughly what was seen. By 1931, France represented nearly 100% of the “missing gold”; the sum of estimates for each year imply that this missing gold can explain between one half and all of the 40% world deflation in this period.

Two quick caveats, though. First, France was not “actively” sterilizing gold inflows. Indeed, they were printing francs at a rate consistent with the inflows. What changed was the French money multiplier. Essentially, French banks were not translating higher reserves into more economic activity. The Bank of France was limited, by law, in what they could make the French banks do even if they wanted more activity, and given France’s high external debt and high early 1920s inflation, it’s doubtful the bankers had any willingness to spend political capital bending the rules. But this is strange, then: A seemingly minor policy decision by France’s central bank, and not any type of widespread sterilization like what was done at the US Fed, can explain a 40% worldwide deflation? Why, then, didn’t we commonly see such radical deflation in the era of specie-backed currency?

Second, even if you accept that French policy is responsible for the Great Deflation, this doesn’t make them responsible for the Great Depression. Explaining the link between deflation – a nominal phenomenon – and the massive decline in industrial production – a real phenomenon, particularly a link far more severe for the worldwide economy than any seen previously, is critical for explaining the Depression. That strong link probably has nothing to do with the choices of Raymond Poincaré and his ministers. Surely “Did France Cause the Great Depression?” is an attractive title, but it’s not really what this paper is about, is it?

http://www.dartmouth.edu/~dirwin/Did%20France%20Cause%20the%20Great%20Depression.pdf (NBER Working Paper – November 2010 draft)