Golden fetters and paper chains

In various posts over the years I’ve mentioned how countries finally got out of the Great Depression.  Generally that involved breaking the link between their respective currencies and gold and then being able to adopt more-expansionary macroeconomic policies.  That was relatively easy to do as a purely technical matter, but it took a long time for countries to get there (a handful of significant countries not until 1936).  I’ve worried aloud that given how low the starting point for nominal interest rates was going to be that in the next serious downturn the refusal of central banks –  and it is simply a refusal –  to take policy rates deeply negative would end up as much the same sort of fetter as gold once was.

The definitive book-length treatment of this angle on the Great Depression is Berkeley professor Barry Eichengreen’s  Golden Fetters.  It was published in 1992 – decades ago now – and going by the marks in the margin of my copy I seem to have read it once a crisis since then.  It is one of those books that repays rereading, partly because the contemporary context against which one reads it is different each time.  I read it again last week.

What follows is informed by Eichengreen, although refracted through my lenses.  There are places where Eichengreen’s argument isn’t fully persuasive (and he has one or two facts wrong about New Zealand).

Much of the book is scene-setting for the experience of the Great Depression.  That includes a perspective on the pre-War Gold Standard, which tied together most of the major (and many of the minor) economies of the time, with a leadership role played in particular by the Bank of England.    In many of the core countries –  UK, France, Germany notably –  central banks played an important role, but in other countries operating on a gold standard there was no central bank at all (most importantly, the United States, but also countries like New Zealand and Canada-  all three of whom were net capital importers).    Price levels didn’t change much over time (the British price level was about the same in 1914 as it had been in 1834), capital flowed freely, trade (and migration) was extensive, and if there were periodic crises or threats to the system, central banks worked together to maintain stability.

World War One greatly disrupted the picture.  Some countries formally went off gold, others didn’t formally but there were enough interventions that the pre-war parities didn’t act as any sort of constraint on price levels.  Huge debts –  internal and external – were run-up in the process, and the US moved from being a net borrower to being a net lender to the rest of the world.  And in the aftermath of the war there were reparations obligations established, huge distributional fights (inside countries) as to who should cover what portion of the accumulated costs, and some countries collapsed into hyperinflation sooner (Austria) or later (Germany).   All manner of other countries had much higher price levels than pre-war, and in some –  notably France –  high inflation remained an issue well into the mid-1920s.

Against that backdrop, in many quarters a return to a money convertible to gold was seen as partly as a key confidence-building commitment, and partly as a return to something like normality.  It took a long time –  in one case, Japan, it din’t actually happen until early 1930 – and for good reason.  There were debates about which rate to restore parity at –  the UK eventually, perhaps unnecessarily, chose to re-peg at the pre-war parity, which implied several more years of moderate deflation.  For France, having had so much inflation, the pre-war peg quickly became unrealistic and they stabilised at a considerably devalued exchange rate to gold.  For Germany, of course, hyperinflation made a nonsense of the pre-war parity.

There hadn’t much gold mined in the previous few years, and yet global price levels were much higher than they had been.  That in itself posed some challenges.  But international cooperation and trust wasn’t what it had been pre-war either.  And particular policy choices made by the US and France meant that those two countries’ central banks accumulated an increasing share of the world’s gold are were unwilling and/or unable to let those inflows flow into much looser domestic monetary conditions (France, for example, having just stabilised was understandably averse to a fresh wave of inflation).  The UK –  still operating as a major global financial centre, significant source of long-term foreign lending –  operated with low gold reserves.  Germany, with a populace only too conscious of hyper-inflation just a few years previously, had high minimum gold cover requirements, but those buffers couldn’t be cut into.  Higher interest rates in the US – as in 1928/29 – forced both the UK and Germany to adopt tighter domestic monetary policy.   And so on.

The Depression itself got underway in a variety of countries influenced by various factors, domestic and international.    The 1929 sharemarket “crash” wasn’t particularly important, except perhaps in shaping the mindset of various US policymakers (including at the Fed) who were uneasy about much looser monetary policy because they reckoned the excesses of speculation needed to be purged.    Some countries were affected worse than others early on –  Australia for example on the worse side, and France on the more positive side.

Generally, however, monetary conditions did ease as the respective economic conditions deteriorated.  But the fixed exchange rate system, underpinned by convertibility to gold, severely limited what could be done with either fiscal or monetary policy –  and that was true even in the countries with large gold holdings, the US and France.

The financial crisis aspects really intensified in mid-1931, in Austria and Germany (where there were significant domestic banking system issues) initially, and then spilling over to the UK, where the economic slump itself had been relatively mild –  relative being the word –  but the pressure eventually told on gold parity.   The re-formed National government –  still led by former Labour Prime Minister Ramsay McDonald –  decided not to impose further pain on the domestic economy (which might have been insufficient anyway) and went off gold.    The break in the parity was initially envisaged as temporary, and it was some months before domestic policy itself became much more expansionary.  But the consequence of the lower exchange rate –  although many smaller countries moved to peg to sterling, giving rise to the “sterling area” which persisteed for several decades) and easier domestic monetary conditions meant that the UK was the first significant economy to recover from the Depression.

The US held on to the old gold parity until April 1933, and while that old parity held it acted as a real and binding constraint on the ability of domestic authorities –  including the Fed – to run much easier policy.   Fear of devaluation sparked capital (and gold) outflows.   But as Eichengreen records, many of the senior Fed officials were not that keen on much easier policy anyway, and some saw the roots of the Depression primarily in past speculative excesses.  Even in the US, concern about possible inflation risks – in the depths of a deflation –  were heard, and were evidently sincere.  The US later returned to a gold parity (while prohibiting for decades citizens from holding gold) but at a much-devalued exchange rate.

Those inflation concerns were all the greater on the Continent.  Germany never abandoned the old gold parity, but just rendered it non-binding with an increasing complex of exchange controls and other payments restrictions.   But for the remaining gold countries –  most notably France, Belgium, Netherlands and Switzerland –  the tensions grew between the desire to maintain the parity –  whether as symbol of normality or (more strongly in the French cases) ran increasingly up against the losses of competitiveness producers in those countries faced as other countries devalued, and the market recogmition of those pressures (thus capital flight).  It wasn’t until 1936 that those parities were finally abandoned.

As Eichengreen notes, at the end of it all, by the late 1930s, real exchange rates among the major economies had not changed that much at all.  Some countries had got the initial advantage of moving earlier (the UK notably) but in the longer-term the beneficial effect was not breaking the gold parity and getting a lower exchange rate, but breaking the constraints (domestic and international) on domestic macro policy (fiscal and monetary).  As he also notes, it wasn’t enough just to break from gold, since countries also had to be willing to break with the Gold Standard ethos, and allow/adopt looser macro policies.  One obstacle to that had been the fear of inflation.  That fear might look unreasonable –  whether from this standpoint, or contemplating a country with a deep deflation in the early 1930s –  but the hyperinflationary and high inflation experiences really weren’t that far in the past, and had been utterly destructive for many.

Eichengreen has a nice table late in the book illustrating how industrial production –  the main macro variable at the time, before quarterly national accounts were a thing –  responded in different groups of countries.

eichengreenLook at the last two columns and you can readily see the difference of experience in the countries that went off gold/devalued (sterling area and the “other depreciated currencies” lines) with the experience in the gold bloc countries, where even by 1935 industrial production was still 20 per cent lower than in 1939.

It need not have been.  It wasn’t as if the 1920s and 1930s were a period of underlying economic stagnation.  The US –  by then the world’s leading edge economy – experienced really strong total factor productivity growth in both the 1920s and the 1930s.  I’m sure some economic ups and downs were inevitable, but nothing on the scale and duration of what actually happened in the 1930s was in any way inevitable –  it was largely the consequence of a succession of choices, of almost entirely well-intentioned people, working against the backdrop of presuppositions, presumptions about normality, and the backdrop of some deeply unsettling experiences, that led to those savage and prolonged losses.   When countries broke the golden fetters –  and for many it was regretted initially or felt to be hugely risky – economies started to recover, and the gains in an increasing number supporetd a sustained global recovery in demand.

(You might be wondering where New Zealand fits in all this.  That is mostly another post.  We had no central bank.  We went off gold in 1914.  That left our banks issuing their own currency, in practice loosely pegged to sterling (but not legally so), with banks managing domestic credit based on their holdings of London funds.  Our exchange rate – managed by the banks – was allowed to depreciate a bit, but the big movements were in September 1931 when the UK went off gold and their exchange rate depreciated against the rest of the world and so, thus, did ours, and –  more importantly –  then in January 1933 when the government initiated a formal devaluation against sterling (still not having a central bank) over the objections – and resignation –  of the Minister of Finance (and with not a little domestic unease and debate).  In 1931 and 1932 even after the UK went off gold our economic policy options were very very few, and our devaluation was much more of a turning point (probably helping that it was followed a couple of months later by the beginnings of the US reflation).  I have an old post on New Zealand and the Great Depression.)

Of course, the point of the post is to draw some loose comparisons between the golden fetters of the early 1930s, which proved so costly in the specific circumstances of the time, and what I’ve taken to calling the paper chains, the refusal of the world’s central banks now to do anything about taking official interest rates deeply negative, even though standard macroeconomic prescriptions –  such as the Taylor rule –  suggest that is exactly what should be done.

I’m not suggesting it is some sort of allegory for our age, in which every detail of the 1930s can be mapped to something now.  It can’t.  It is really just about a single point: that self-imposed constraints, which can seem very very important to preserve at the time, can actually in some circumstances prove incredibly costly, and in those circumstances the sooner they are jettisoned the better.

One area in which the parallels certainly aren’t exact is around fiscal policy.  Most countries in the 1930s had very little freedom of fiscal action initally, precisely because of the monetary/gold parity constraints  –  increase your fiscal deficit and the resulting increase in demand will also result in increased current account outflows (of gold).    In some cases – New Zealand –  there was just no effective borrowing capacity at all –  thus, Keynes’s advice to Downie Stewart that I’ve quoted here previously (“if I were you I’d try to borrow; if I were your bankers I would not lend to you).  We have nothing like those sorts of technical constraints.  But that doesn’t mean there are no limits in practice –  as we saw after 2008/09, public tolerance of continued very large ongoing fiscal stimulus, even in badly affected countries, was really quite limited.  In the real world, fiscal policy isn’t any sort of fully adequate substitute for monetary policymakers choosing to sit on the sidelines –  dealing, perhaps, with market liquidity issues, but not doing much about the overall stance of monetary policy, even as deflationary risks mount (thus, real retail interest rates have not fallen at all in New Zealand and Australia this year, despite the huge economic slump).

There is a, perhaps understandable, sense in some quarters that there wasn’t too much wrong with economies last December.  Perhaps, but things have now changed, and if one strand of macro policy – typically the most important for cyclical purposes, and easiest to adjust –  is allowed to sit on the sidelines doing nothing –  and elected ministers have the power to change thatg –  there is risks that this economic downturn ends up much more severe and protracted than it needs to be.  All because central bankers won’t break free of their paper chains and their old mindsets (aggravated in New Zealand’s case by the stunning negligence of a Reserve Bank that talked modestly negative interest rates for some time but did nothing at all to ensure there were no technical/systems obstacles): we pay the price for both lack of preparation and the reluctance/refusal to break the paper chains and put in place quickly the sorts of rules and practices that could allow official rates to be taken deeply negative for a time, in turn supporting demand (directly and via the exchange rate) and supporting medium-term expectations about the economy and inflation.




21 thoughts on “Golden fetters and paper chains

  1. two points
    Uneasy money written by David Glasner is THE definitive blog on how the Gold standard affected the great Depression.
    The second is a mere technical point. The exchange rate is devalued in a fixed exchange. The currency only depreciates under a floating exchange rate.

    both Keynes and Hawtrey were in agreement about the value of large devauations. It boosted inflation which was necessary.

    As for Kiwiland. not much significant change in unemployment as far as I can determine until 1936 with both a change in Government and policy however I am no expert on your country.


  2. Yes, Glasner is good value.

    Re depreciation/devaluation yes I agree (altho, say, the NZ experience early in the Depression involved an exchange not really fixed.

    On the NZ experience, even for full year 1935 considerable ground had been regained. You are right that 1936 is another step up, but the change of govt here was not until Dec 1935, so much of 1936 outcomes were already “baked in”, between the global recovery and the gains – incl on policy – already in play domestically.

    For unemployment, the biggest one year drops were in 1937 and 1938 – altho then we ended 1938 with a severe foreign exchange crisis and new stringent exchange controls (so excessively loose macro policy over that particular period),


    • good to know.

      There can be other explanations for reductions in unemployment than mere fiscal policy of course.


  3. I guess this is a case where you see one of Keyenes’ famous quotes as being relevant – “The difficulty lies not so much in developing new ideas as in escaping from old ones.”?

    And I see that this morning Westpac put out that it is expecting a negative OCR (-50bpts) later in the year.


  4. Maybe the time has come to abandon the OCR and move to exchange rate targeting ?

    What we need now is weaker monetary conditions, and that can only be achieved via a weaker currency. I’ve been telling my clients for over a month we will see 50bp or rate cuts by year end and have ridden the front end down all the way, but 50bp of cuts in the wholesale market won’t necessarily be passed through to mortgage rates and the cost of capital, and from an MCI standpoint – and aside from the operational difficulties of using an MCI (which I wouldn’t advocate) – a 50bp move would be equivalent of only 2pp on the TWI. Which by the way, if you use the latest Breugal estimates of the REER which captures all countries, remains expensive.


  5. I’ve always wondered: when the classical gold standard began, who determined or how were the initial parity levels set?


      • …yes but the de facto fixed exchange rates: i had in my mind they were set to enable roughly balanced trade? so was wondering how the initial, say, $5 = £ (or whatever the rate) was determined? must of had a rough idea of productivity?


    • I guess that all depends on what you mean out of the depression.
      Here in OZ we merely went to being a recession.
      My understanding is only Germany got to full employment.
      They by the way went off the gold standard but did not devalue.


      • Yes, thanks for the correction re Germany.

        Re full employment, NZ by 1938 had about 5000 people registerd as unemployed (on this measure 53000 in 1933) from a population of 1.6m – excess demand from v stimulatory mon/fiscal policy, which ran us into crisis and controls (similar remedy, as it happens, to the German one, even if not rearmament focused here).


      • in 1934 Tozze has Germany in an exchange rate crisis which could be solved by a devaluation . however Hitler feared the political consequences of higher inflation!


      • Yep, exactly the sort of thing that bothered Bruning etc!

        In NZ, one of the sources of opposition to devaluation in 1933 was the trade union movement – despite the savage unemployment the worry was rising costs of basic (tradables).


  6. Hello Michael
    A couple of comments
    (a) For JMK; the central US-UK exchange rate ($4.8665 for the pound) was determined by the relative amount of gold in the two countries’ currencies: essentially by the relative amount of gold in a sovereign and a $20 gold eagle coin. Gold was regularly shipped between financial centres to ensure the exchange rates for paper currency never deviated too far from gold parity rates.

    (b) How deeply negative do you want real interest rates to be? In the future it is clearly possible that the central bank could issue legal tender debit cards and/or accounts instead of legal tender paper currency, in which case it will be possible to offer negative nominal and real interest rates. In the present, nominal interest rates below -1 percent look impractical. But I am not sure how happy i would be making it easy for a government via a central bank to be able to offer negative nominal interest rates, as it would make it rather easy for them to say ‘For the sake of the country, to reduce unemployment, we must punish you if you do not spend your money immediately.’ The rewards for saving via the accumulation of bank deposits are already fairly thin (in part because of the taxation of the inflation component of interest income); if you make it easy to impose negative nominal and real interest rates, people who save in this manner (typically less sophisticated investors) will be even worse off and the benefits of saving by accumulating equity stakes in companies and property rather than by lending money will be further enhanced.

    In flexible price commodity markets, where real own-interest rates are negative whenever the spot rate is lower than the forward rate (or, more precisely whenever S(1+r)/F is less than 1, where S is the spot rate, F is the rate for forward delivery, and r is the money interest rate), negative real rates normally mean there is a temporary decline in spot prices when there is a shortfall of demand . The lower spot rates help clear the market by rewarding people who purchase immediately. If you want negative real rates on money because prices are not temporarily falling, then you are trying to encourage immediate spending by punishing delayed spending. It is not clear that this will have the same effect as trying to encourage immediate spending via a temporary price cut. There are quite different distributional effects as well. A temporary 10% price cut is a benefit to purchasers but worn by producers (who do get to increase sales). A temporary 10 percentage decline in the GST rate (another possibility to stimulate sales via temporarily reduced prices) is a a benefit to purchasers but would be worn by the Government and passed around via increased taxes to different groups of citizens at another time. However, to the extent that negative nominal and real interest rates increase immediate sales, the benefit goes to those who borrow to make purchases and the cost is worn by lenders who choose not to increase their spending. If prices are inflexible, it is most often the case that producers choose not to cut their prices, because individually they find it better to reduce sales than cut prices. Yes, this has clear macroeconomic consequences, but it is not obvious to me why it appropriate to punish those who lend for the price inflexibility of producers . Or am I missing something or several things?


    • Hi Andrew

      Thanks, as always, for the thoughtful comments.

      I disagree on the technical feasibility of a deeply negative OCR now – people like Buiter and Miles Kimball have articulated various options, and here I’ve argued for simply capping the physical currency issue (say 20% above current level) and auctioning any further tranches of net currency sales from RB to the banks. The big risk is not Mum and Dad converting to physical currency, but large investment funds etc.

      There were Taylor-rule based estimates for the US in 2008/09 which reckoned as Fed Funds rate of perhaps -5% would have been desirable (in other words a 10 percentage point cut). Anywhere between that and, say, the 575 basis point cut the RBNZ put in place then looks like a reasonable jumping off point – as opposed to the 75bps of cuts so far, or even the 150bps of cuts Westpac now expects, Given the margin between retail and wholesale rate, an OCR of -5 per cent, even mostly passed through – which I think is quite likely – would mean term deposit rates of perhaps -2 or -3 and retail lending rates at perhaps -1 or -2.

      I guess the framework I have in mind is really where some hypothetical free market might take real interest rates in the current climate, with investment demand v low and private savings preferences probably rising. In that climate, reasonably significantly negative risk-free short-term rates seem like the sort of outcome one might expect.

      I agree that the effects of a temporary GST cut and a cut in interest rates aren’t identical, but they both work in the direction of drawing forward demand. I’d prefer interest rate action, partly because that also draws demand towards NZ producers from abroad.

      On your final point re price stickiness, I guess my response is along the lines of “yes, but we’ve made that choice decades ago – the choice to have discretionary monetary policy as the way of minimising unemployment/output gaps, presumably having concluded that adjustment to shocks is typically easier that way”. I’m still comfortable with that – and in fact think it is most relevant in really severe shocks (even if we are seeing an interesting degree of downward wage adjustment at present).


      • How would we explain to young 10 year old Tabatha the life choices of saving, who deposits $1 per week of her pocket money in a savings account currently getting 0.01% on her savings account. What would happen to her account. Bang goes all our parenting advice


      • It is a more complex discussion – about buffers etc – but not necessarily more so than, say, when I was young and inflation was averaging 15% and returns on savings accounts were much lower than that.


      • I have drawn from my unused bank overdraft facility and put $100k into a savings account for my 10 year old. In these uncertain times better to have cash available rather than unused bank overdraft facility.


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