Rethinkingthe

Great Depression

ECO 473 – Money & BankingDr. D. Foster

Myth vs. Reality of the Great Depression

The myths:•Capitalism failed.•Markets failed.•Government intervention was necessary.•The New Deal saved capitalism.•Growth in the 1920s was illusory.•Herbert Hoover was a do-nothing President.

The reality:

Myth vs. Reality of the Great Depression

What happened in the 1920s?:•Increased auto ownership.•The country became increasingly electrified.•Increased income.•Stock market boom.

Myth vs. Reality of the Great Depression

What happened in the 1920s?:•Increased auto ownership.•The country became increasingly electrified.•Increased income.•Stock market boom.

What precipitated the Great Depression?•Failure to maintain the gold standard.•Collapse of sound monetary policy.

Problem areas:

wheat, coal

The Gold Standard$20.67 = 1 oz. 1 oz. = £4.25 1 oz. = £4.25

$4.86 = £1

• American firms export goods to England … tractors. Value = $50 m.• British firms export goods to U.S. … fish & chips. Value = £10.29 m.• At exchange rate of $4.86 = £1, the £ earned by U.S. firms will just trade for the $ earned by the British firms.• Suppose that British exports fall by 23% and that there is only £8 mill available in foreign exchange market (to buy $).

£10.29mill.

$50 mill.

The Gold Standard$20.67 = 1 oz. 1 oz. = £4.25

£8 mill.$50 mill.

1 oz. = £4.25

$4.86 = £1

• Now, American exporters can’t exchange all of their £10.29 mill. for $.• They can only exchange £8 mill. at the going exchange rate.

. . . receiving $38,880,000. But, they aren’t going to lose here…• They would cash the rest out in gold: £2.29 mill. = 538,823 oz.• They would redeem in U.S. for dollars: 538,823 oz. = $11,120,000• Total value received = $50,000,000

The Gold Standard$20.67 = 1 oz. 1 oz. = £4.25

$50 mill. £10.29 mill.

1 oz. = £4.25

$4.86 = £1

• The flow of gold from England to U.S. won’t persist over time.

gold = MS MS = Pinflation

M•V=P•Y gold = MS MS = Pdeflation

• U.S. exports fall, British exports rise; trade flows balanced.

Confounding The Gold Standard

In England, deflation means an In England, deflation means an economic slowdown and a economic slowdown and a (hopefully) mild recession (hopefully) mild recession

((unemployment).unemployment).M•V=P•Y

To counteract these effects, the Bank of England can raise interest rates. This will attract foreign investment (capital inflows) that will offset the trade imbalance and end the outflow of gold.

• If it persists, higher interest rates will cause a recession.

Confounding The Gold Standard

In the U.S., expanding the In the U.S., expanding the money supply means money supply means

inflation and falling exports.inflation and falling exports.M•V=P•Y

To counteract these effects, the Federal Reserve can “sterilize” gold inflows by acquiring the gold (buy with taxes or sell securities). This prevents

inflation and protects exporting firms.

• This counteracts what the British are trying to do . . .

Stress on the Gold Standard

WWI - Combatant countries go off gold standard to spending.Gold rushes into the U.S. as countries buy war material.

Post-WWI, gold stocks insufficient for existing price levels.Worldwide deflation (i.e., depression) is required.Victors can ease burden by acquiring gold stocks.Burden on losers is unsustainable.Eventually, U.S. lends gold to Germany.

Stress on the Gold StandardThe Gold Exchange The Gold Exchange

Standard:Standard:U.S. & U.K. hold goldU.S. & U.K. hold gold

Other countries hold gold, $, Other countries hold gold, $, ££U.K. recession restores gold value by 1925.France devalues currency; gold inflows.

1927 - France redeems pounds; more gold inflows.Fed lowers i; gold flows from U.S.; burden on U.K. lessened.1927 - 9% of world’s gold; 1929 - 17%; 1931 - 22%Gold inflows sterilized and MS in France was constant.

The Gold Standard Collapses

U.S. monetary policy is erratic:U.S. monetary policy is erratic:1927 - lowers i (3.5%) and gold flows out.1928 - raises i to stop gold outflows.By Sept. 1929, i up to 6%; gold inflows

1929/1930.After crash, i lowered; down to 1.5% in April

1931.Gold outflows 1931; raised i to 3.5%.March 1932 Fed begins OMO which stops

deflation.OMO stop in July 1932.Devaluation concerns drive gold outflow Jan-Mar

1933.

Why did the depression last until 1932?

Herbert Hoover•Commerce Secretary in the 1920s.•Rallied business leaders in 1922.•Believed solution was to maintain wages & prices.

How a Depression becomes “Great”How a Depression becomes “Great”•Smoot-Hawley tariffs kick off trade war (1930).•Congress increases taxes to cover deficits (1932).•Hoover’s policy erodes business profits and raises unemployment.•Banks fail en masse in 1931-1932.

Why Why didn’t didn’t it end?it end?

Rethinkingthe

Great Depression

ECO 473 – Money & BankingDr. D. Foster