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.
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