Bernanke Gold Standard Hypothesis on the Causes of the Great Depression

 

There have been several theories explaining how the Great Depression began. Milton Friedman and Anna Schwartz argue the Great Depression was caused by the failure of the Federal Reserve to moderate monetary policy, leading to a contraction in money supply.[1] Peter Temin argues it was not the “money hypothesis,” as he terms Friedman and Schwartz’s theory, that led to the Great Depression but the “spending hypothesis” caused by contractions in consumption.[2] Others argue that some mix of monetary and nonmonetary factors that led to the Great Depression.[3]

"Great Depression Food Line" Courtesy Creative Commons

More recently, Ben Bernanke and others theorize the Great Depression was due to monetary shocks that were transmitted globally through countries utilizing the gold standard.[4] Bernanke shows data from several countries in order to provide a comparative view that two factors contributed to the Great Depression. First, monetary contraction in the early 1930s was not due to inaction by the government to declining output, but “an interaction of poorly designed institutions, shortsighted policy-making, and unfavorable political and economic preconditions.” The second factor was the reliance on the gold standard; those countries that abandoned the standard fared better and recovered more quickly than those that stayed with the standard.[5] In theory, then, if more countries left the gold standard, their economic recoveries would have been faster and ended the Great Depression.

"Crowne-Cold-Silver-Bullion" Courtesy Creative Commons

Bernanke’s hypothesis convincingly leads to this conclusion. Using data across countries on and off the gold standard, Bernanke notes those countries that adhered to the gold standard suffered sharp declines in their money supply. As for the decline in the global money-gold ratio, he cites a number of policy and non-policy reasons, including conscious monetary tightening that caused a decline in monetary bases. Banking panics, declines in domestic money multipliers, and unfavorable exchange rates and devaluation of currency all had the knock-on effect of causing large declines in the money-gold ratio. Many countries scrambled for gold in an effort to mitigate these effects, which further caused a decline in the money-gold ratio.[6]

In contrast, those countries that left the gold standard fared better by “effectively removed the external constraint on monetary reflation,” which allowed them to have earlier and stronger economic recoveries. This effect was also noted by Ehsan Choudhri and Levis Kochin in their study. They observed money supply in Spain and eight Scandinavian countries during the Great Depression and conclude those countries that maintained flexible exchange rate systems fared better than countries on fixed exchange rates.[7] Bernanke’s work confirms the work by Choudri and Kochin by looking at an additional twenty-six countries.[8] Barry Eichengreen and Jeffrey Sachs conclude similarly, observing that deliberate government action to devalue currency actually benefited such countries in navigating monetary shocks. They note that fixed exchange rates based on gold gave these countries less flexibility.[9]

Ultimately, it is unknown whether Bernanke’s gold-standard theory would have cured the economic woes of the Great Depression. As Larry Schweikart explains, while usually war is an enemy of business by reducing the consumer base and constraining consumption, World War II created an unprecedented economic revival because President Roosevelt encouraged businesses to produce weapons, which ensured full employment. This and forced savings led to a post-war consumer boom, fully bringing the Great Depression to an end.[10]

"Construction" Courtesy Creative Commons

In sum, several theories have been put forth by economists since the Great Depression on its causes. However, Bernanke’s gold-standard hypothesis carries a great deal of currency in that he uses an expanded data set on gold-standard and non-gold standard countries to show correlation that flexible exchange rates allow countries to weather shocks better and recover faster than those countries on the gold standard. However, it was ultimately World War II that ended the Great Depression; we will never know if the elimination of the gold standard across the globe would have cured the economic downturn of the 1930s.

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[1] Milton Friedman and Anna J. Schwartz, A Monetary History of the United States, 1867-1960 (Princeton: Princeton University Press, 1963), 300–301.

[2] Peter Temin, Did Monetary Forces Cause the Great Depression? (New York: Norton, 1976), 7; Ben S. Bernanke, “The Macroeconomics of the Great Depression: A Comparative Approach,” Journal of Money, Credit and Banking 27, no. 1 (1995): 3, https://doi.org/10.2307/2077848.

[3]  Ben S. Bernanke, “Nonmonetary Effects of the Financial Crisis in the Propagation of the Great Depression,” The American Economic Review 73, no. 3 (1983): 257–76, showing a reduction in intermediation services by the financial sector and subsequent credit squeeze on aggregate demand was a contributing factor to the Depression. Robert Higgs, “Crisis, Bigger Government, and Ideological Change: Two Hypotheses on the Ratchet Phenomenon,” Explorations in Economic History 22, no. 1 (1985): 1–28, https://doi.org/10.1016/0014-4983(85)90019-1, on showing the rachet phenomenon creating permanently bigger government. Eugene N. White, “The Stock Market Boom and Crash of 1929 Revisited,” The Journal of Economic Perspectives 4, no. 2 (1990): 67–83, in which the stock market bubble that led to panic selling at the beginning of an economic recession. This in turn led to economic policies that pushed the economy further into recession. Price Fishback, “The Newest on the New Deal,” Essays in Economic & Business History 36, no. 1 (June 13, 2018): 1–22, looking at the spending and lending programs of the federal government, leading to changes in labor supply and demand as well as the implicit wage minimum, which in turn disrupted aggregate employment.

[4] Bernanke, “The Macroeconomics of the Great Depression,” 3.

[5] Bernanke, “The Macroeconomics of the Great Depression,” 4.

[6] Bernanke, “The Macroeconomics of the Great Depression,” 6–7.

[7] Ehsan U. Choudhri and Levis A. Kochin, “The Exchange Rate and the International Transmission of Business Cycle Disturbances: Some Evidence from the Great Depression,” Journal of Money, Credit and Banking 12, no. 4 (1980): 573, https://doi.org/10.2307/1991882.

[8] Bernanke, “The Macroeconomics of the Great Depression,” 12.

[9] Barry Eichengreen and Jeffrey Sachs, “Exchange Rates and Economic Recovery in the 1930s,” The Journal of Economic History 45, no. 4 (1985): 926.

[10] Larry Schweikart, The Economic Impact of War on Business (Lynchburg, VA), accessed November 5, 2020, https://libertyuniversity.instructure.com/courses/48886/pages/watch-the-economic-impact-of-war-on-business?module_item_id=5099951.