Golden Fetters

"It’s important for helping to answer the question, why was the Depression a worldwide phenomenon? Friedman and Schwartz and other studies have shown that what caused the Depression here in the US was largely domestic shocks – a terrible stock market crash and a series of uncontrolled banking crises. But if that is the case, why was the Depression so terrible in Great Britain, France and basically throughout the entire world? Golden Fetters , by my colleague Barry Eichengreen, gives a definitive explanation of the role that the gold standard played in transmitting the shocks centred in the US to lots of other countries. The basic story is that if something happened in the US that pushed up our interest rates or pushed down our prices, it would draw gold from other countries toward the US. In the Depression, other countries were worried about their gold reserves and they didn’t want gold to flow toward the US. So they basically had to have a monetary contraction as well. You saw countries deliberately pushing up interest rates to try to prevent gold from flowing out of their economies. Golden Fetters explains that because of the gold standard, a monetary shock in the US led to a worldwide monetary contraction. Eichengreen shows that a bad economic idea can have devastating consequences. The fact that policymakers throughout the world were determined to remain on the gold standard caused them to follow the US into the Great Depression. There were some who understood and warned about the downsides, but largely its flaws were realised in retrospect. The gold standard is a bit like the euro today. It worked quite well during the good times of the late 1800s and early 1900s, just as the euro worked quite well before the financial crisis. Policymakers tended to think it would always work well. Eichengreen argues that the gold standard worked well in its heyday because countries played by the rules and the Bank of England was an effective worldwide manager of the system. But after the gold standard broke down during the First World War, economists and policymakers were slow to realise when they tried to restore it that it might not work as well, especially in the face of enormous shocks in the US. Absolutely. The most important one is the notion that fiscal contractions – reducing the budget deficit immediately – can be expansionary. Some policymakers have become convinced that cutting spending and raising taxes will be so good for confidence that it will increase rather than decrease employment and growth. This is a very bad idea that is contradicted by strong empirical evidence. This mistaken belief in expansionary fiscal contractions has caught hold especially in Europe. It’s a big part of why Europe is in the mess that it’s in. Deeply troubled countries, such as Greece and Spain, have been forced to adopt severe fiscal austerity in order to receive aid from other European countries and the IMF. And other countries, such as the UK and Germany, have moved to austerity because they bought into the idea that it would be good for their growth. But the outcome has not been good. Growth has slowed throughout Europe, and the eurozone has almost certainly entered another recession. Countries such as Spain and Greece that have adopted extreme austerity measures have seen unemployment rise dramatically. This rise in unemployment makes it all the harder for them to actually get their budget deficits under control. There are much wiser policies for Europe and for the US. The fiscal problems are very real but they should be dealt with gradually. It would be far better to pass plans now, but not make the actual spending cuts and tax increases until the economies are healthier. Policies aimed at stimulating growth would be far more humane, and ultimately better for the fiscal situation. Without growth and full employment, it is very hard to ever get the budget deficit truly under control. Read Barry Eichengreen’s book. Not only is the gold standard not a cure for our current ills, it could make things much worse."