The gold standard has been gaining a great deal of attention recently, largely from Rep. Ron Paul who has main a return to gold-backed currency a major theme of his campaign. While I am hardly an advocate of the gold standard, it is unfortunate that much of the discussion of the gold standard has been riddled with inaccuracies and false causation.
Most recently, David Frum decided to tackle the issue:
Since permanently abandoning gold convertibility in 1933, the US economy has experienced far less economic volatility. Recessions are fewer and shallower (if sometimes longer).
Frum mentions the Great Depression as a byproduct of the gold standard. While this is somewhat correct, it is entirely misleading. It is not the gold standard in and of itself that led to the depression, but rather a mismanagement of the gold standard that created a deflationary bias (for a much more detailed analysis, see Bernanke and James).
This deflationary bias was created by two major factors:
1.) Asymmetrical monetary responsiveness to changes in gold flows. Under the rules of the gold standard, when one experiences an inflow of gold they are to increase the money supply accordingly and when one experiences outflows, they are to decrease the money supply accordingly. During the interwar period, those countries experiencing gold outflows were following suit by reducing the money supply. However, the United States and France, the two countries with the greatest inflow of gold, had little incentive to avoid gold accumulation (relative to currency). Prior to this period, everything had centered around the Bank of England, which had no incentive to accumulate gold and thus ensured convertibility. This lack of incentive for the United States and Franc during the interwar period, however, led to a deflationary bias.
2.) Weak central banks. During this time period, central banks had limited power over the money supply. This was largely as a result large restrictions on open market operations (the simplest way to increase the money supply). This was done following the first World War to prevent monetization of deficits by central banks. However, this limitation led to a deflationary bias.
With the major gold inflow into France, one would have expected the French to inflate their currency. However, due in large part to the strong restrictions on open market operations, France did not follow suit and actually experienced double digit deflation.
Meanwhile, in the United States, the Federal Reserve was keen on limiting stock market speculation and thus tightened monetary policy (Hamilton), despite the inflow of gold. This led to deflationary pressure and the eventual decline of the overall price level in 1929.
While this post is in no way an attempt to justify or defend the gold standard, it is especially important to note is that the gold standard is not directly the cause of the Great Depression. As Bernanke and James note, the was a “self-inflicted wound.” The central banks had little or no reason to avoid gold accumulation relative to the domestic currency and their weak powers coupled with policies that ran counter to the rules of the gold standard created the deflationary pressure that created the depression. In other words, the two countries that experienced the most pronounced inflows of gold had central banks who either chose not to adhere to the rules of the gold standard because of other policy objectives or were ill-equipped to handle such inflows due to heavy restrictions on their powers.