Today we bring you Part VI of “A Brief Monetary History of the United States” from the Ron Paul Monetary Policy Anthology. The full series can be found at the following links:
The Great Depression
The Federal Reserve’s monetary inflation throughout the mid- to late-1920s resulted, not surprisingly, in the Great Depression. As with any credit-induced economic boom, the newly created credit caused a distortion in the allocation of resources. Instead of economic growth resulting from increased real savings and investment, the boom of the 1920s was caused by an artificial increase of credit in the banking system by the Federal Reserve.
Whereas savings-induced growth aligns consumers’ present and future preferences, credit-induced growth does not. An artificial increase in credit allows banks to make more loans to businesses, and these increased loans signal to businesses that consumers are saving more in the present in order to consume more in the future. Businesses begin to undertake longer-term, more capital-intensive projects which, once they are finished, they find to be unsustainable because consumers either do not actually want them or cannot afford them because they have not saved enough money to purchase the goods. These resources have been malinvested, or invested badly, into sectors of the economy that do not actually serve the needs and wants of consumers. And it is not just one or two businesses which find themselves in such straits, but a whole slew of businesses, often across many different sectors of the economy.
The way out of a crisis had traditionally been to allow these malinvested resources to liquidate. Bad debts had to be liquidated so that prices could fall in order for markets to clear. In doing so, resources that were malinvested would be shifted to be used productively in other sectors. This was what was done during the Depression of 1920-21, in which President Harding refused to allow any sort of intervention by the federal government to alleviate the crisis. As we have seen, that crisis, although quite sharp, came to a quick end as the economy rebounded and returned to normal.
The federal government’s response during the Great Depression was completely the reverse of its behavior during 1920-21. President Hoover was determined not to allow bad debts to liquidate, and intervened into the economy on a scale never before seen in American history. In the aftermath of the stock market crash of 1929, Hoover called a series of conferences with industrial leaders and induced them not to reduce wage rates; he introduced a series of farm subsidies to keep the prices of various agricultural commodities artificially high; and he began a series of public works projects. The Federal Reserve increased its purchases of government securities, increased the amount of credit available to the banking system, and lowered its discount rate, keeping poorly-run banks from going under.
Not surprisingly, none of Hoover’s or the Fed’s policies alleviated the Depression; in fact, they made it worse. Unemployment continued to rise and economic production continued to fall. Passage of the Smoot-Hawley Tariff Act put a damper on international trade and helped to contribute to the economic problems facing Europe. And while private spending continued to decrease, tax rates increased and government spending rose significantly as a percentage of total economic output. Contrary to popular belief, government interventions of the New Deal type originated not with President Franklin Delano Roosevelt, but with Hoover. FDR merely enlarged and expanded upon Hoover’s intervention through the programs which came to be known as the New Deal. These programs, too, failed to achieve their intended aim, and the burdens they placed on American taxpayers and American businesses only prolonged the duration of the Depression.
The worsening economic situation led to a fall in confidence in the dollar, as Americans pulled their money out of banks in droves. In response, state governments began to institute bank holidays, forcibly closing banks in order to keep depositors from withdrawing their money. Just after taking office in 1933, President Roosevelt pushed through Congress the Emergency Banking Act of 1933, which ordered a federal bank holiday and also granted the Secretary of the Treasury the authority to order any individual or corporation to turn over any gold under their control to the Treasury.
Less than a month after the bank holiday, Roosevelt issued Executive Order 6102, ostensibly to prevent the hoarding of gold coin and gold bullion. This order made it illegal for any individual, partnership, or corporation to hold gold coins, gold bullion, or gold certificates, with limited exceptions. All gold coin, gold bullion, and gold certificates were to be turned over to the Federal Reserve or to member banks of the Federal Reserve System. From this point on, the United States was no longer on the gold standard. Citizens could no longer redeem their notes for gold, only for silver coins or other notes. It was not until 1975 that gold ownership was once again legalized in the United States.
In 1934, Congress enacted the Gold Reserve Act, which transferred all title of Federal Reserve-held gold to the U.S. Treasury. Almost immediately the government redefined the value of the dollar from $20.67 per ounce to $35 per ounce, massively increasing the amount of dollars the government could issue while devaluing the purchasing power of the citizenry’s dollar holdings.
The Gold Standard vs. The Gold-Exchange Standard
In some circles, the existence of the gold standard is blamed for exacerbating the Great Depression. Yet since World War I the world had not been on the same international gold standard as existed during the century preceding the war. Instead, there existed a system called the gold-exchange standard, in which international balance of payment settlements were settled with gold-backed national currencies (in particular the British pound sterling) rather than actual gold.
The primary force behind the adoption of the gold-exchange standard after World War I was the United Kingdom. The U.K. had decided to return to the gold standard at the pre-war level of parity. Before the war the pound had been defined as a weight of gold that made it worth roughly $4.86. Inflation during the war drove down the pound to where it was only worth around $3.50. Despite the fact that the currency had been devalued, the British government was determined to return to the gold standard at the pre-war exchange rate.
In order to do so, the British government had to convince other governments to return their currencies to their pre-war rates as well, while at the same time discouraging gold redemption of pounds because the British government did not have enough gold to back up all the new money that had been created during the war. And by also making British notes redeemable only in gold bullion rather than gold coin, the British government ensured that the only conversion of notes into gold would come from foreign governments and not from individuals. Furthermore, the British government would also redeem its pounds in dollars, and in fact preferred to do so in order to conserve its gold balances. Other countries were willing to accept dollars because they knew that the dollar was entirely backed by gold. This led to an international monetary system in which the dollar joined the pound as one of the premier currencies of international exchange because the dollar was “as good as gold.”
As long as no other countries sought to redeem their pounds for gold, the system functioned more or less smoothly. Unfortunately, once the British government was freed from the discipline of having to redeem its pounds for gold, it began to inflate its currency yet again. Eventually the system broke down as the worsening banking crisis in Europe in 1931 caused the U.K.’s international creditors to seek to redeem their pounds for gold, resulting in the U.K. leaving the gold standard for good.
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