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“adhering To The Gold Standard Constrained Economic Policy During The Great Depression”

A case study of the UK and the US

Date : 21/12/2016

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Sankalp

Uploaded by : Sankalp
Uploaded on : 21/12/2016
Subject : Economics

The US’ defense of gold standard parity during early 1930s has often been considered amongst the major causes of the Great Depression, as pointed out by Bemanke and James (1991). Selgin (2013) however, by defining the adherence to the gold standard as a causation of the severity and persistence of the US Great Depression as a far too simplistic view, points out how incredibly diverging views can be on the extent to which adopting gold standard parities affected economic policy in the US. Monetary policy in Britain has also regularly been under the spotlight by economists according to Wood (1983). Hodson and Mabbett (2009) underline that whilst the UK government prioritized “fiscal prudence” prior to the global financial crisis, it now opts for “unconventional monetary policies”. Considering how Arestis and Sawyer (2011) argue that, alongside monetary policy pursued by Central Banks, fiscal deficits are necessary to satisfy the level of aggregate demand, it is thus clear that the root of the macroeconomic policy debate lies in the interconnection between fiscal and monetary policy. Indeed, Wood (1983) argues that fiscal policy is used to affect monetary policy and therefore the decision process of fiscal policy is pertinent to that of monetary policy. This is precisely the reason why the existence of both fiscal and monetary policy is essential and one type of policy alone has not been successful in providing either Britain or the US with stable prices and low unemployment – two of the major goals of economic policy – throughout all of the twentieth century. Put simply, whilst empirical literature and the findings of major economists like Allen (2012) and Crafts (2011) show how gold standard adherence during the Great Depression did not allow room for aggregate demand to rise and unemployment to drop in countries like the UK, it is actually the historic contexts and scenarios which the UK and the US have undergone throughout the various phases of the Great Depression which have ultimately determined the extent to which macroeconomic policy has been successful in providing the country in question with stable prices and low unemployment. For instance, Hatton and Boyer (2005) point out how throughout the 1947-1973 period, Britain averaged a 2.1% unemployment rate, far lower than the 10.9% between 1921 and 1938. So what does the historic context of twentieth century Britain and the US – precisely during the Great Depression period – reveal about the effectiveness of fiscal and monetary policy under gold standard parities in terms of ensuring low unemployment and stable prices? As discussed by Hills, Thomas and Dimsdale (2010), it is the absence of major wars during the Victorian age which positively contributed in the stabilization of Britain’s fiscal position. However, the macroeconomic policy adopted during the Victorian age changed significantly following WWI. Crafts (2011) sheds further light on this as he claims that the 1930s Great Depression, which dominated the second half of the interwar period in Britain, radically varied macroeconomic policy between the 1920s and the 1930s. In the immediate aftermath of the First World War, as a result of the War itself, Britain had accumulated a sterlingdenominated public debt which added up to 120% of GDP, as reported by Allen (2012). Furthermore, as Hills, Thomas and Dimsdale (2010) point out, the inflationary effects of the post-war economic boom were tackled by authorities as they sharply tightened monetary and fiscal policies. Hills, Thomas and Dimsdale (2010) detail that nominal short-term interest rates were raised considerably, thus decreasing consumption – all of which whilst exports declined due to lower aggregate world demand. Soon after – as claimed by Hills, Thomas and Dimsdale (2010) – 1920s Britain suffered major deflation whilst interest rates rose to record levels. With nominal rates touching 5% in the first half of the 1920s, as underlined by Hills, Thomas and Dimsdale (2010), the primary goal of monetary policy in Britain was to restore, the gold standard at the pre-war parity according to Allen (2012). A return to a fixed exchange rate did finally occur in 1925 at the pre-war parity of $4.86 as highlighted by Crafts (2011). Overall, it is clear how monetary and fiscal policy both played active roles in controlling the initial inflationary effects which were byproducts of WWI. As the Great Depression hit Britain in 1930, Hills, Thomas and Dimsdale (2010) describe the 1930-1931 period as a year when short-term interest rates were not allowed to drop as monetary policy was fully committed to the pre-war gold standard parity of $4.86. They argue that the aforementioned strict commitment to the gold standard drove nominal interests up in 1931. It was at this point, in September 1931, that a floating exchange rate was adopted in order to fight high unemployment and increase aggregate demand by securing a recovery in prices, as argued by Allen (2012). Crafts (2011) further argues this point as he claims that a high unemployment rate during the 1930s was biting into tax revenues, thus making Britain’s budgetary position quite precarious: falling prices were harming the country’s fiscal position. Additionally, as Crafts (2011) mentions, the fiscal burden on Britain was worsened by the £2 billion 5% War Loan which the government had to pay back between 1929 and 1947. To tackle this situation, Crafts (2011) points out that fiscal policy during the early 1930s involved tax increases and expenditure cuts – mainly on unemployment benefits. As one can therefore see, fiscal policy did play a small role in reducing unemployment during the interwar period in Britain. Indeed, reductions in unemployment benefits provided the unemployed with incentives to find jobs whilst government spending on rearmament – in preparation for WWII – mildly contributed to fight the 1938 recession, according to Hills, Thomas and Dimsdale (2010). Crafts (2011) on the other hand is of the idea that government spending on rearmament represented a “significant fiscal stimulus”, approximately 3% of GDP. This divergence in view between Crafts (2011) and Hills, Thomas and Dimsdale (2010) is significant as it underlines that – despite Middleton (2010), Crafts (2011) and Hills, Thomas and Dimsdale (2010) agreeing on British fiscal policy being contractionary during the 1930s – the effectiveness of fiscal policy to fight unemployment during the Great Depression is still debatable today. Unlike in the case of fiscal policy, economists generally agree on the fact that interwar monetary policy in Britain had a significant impact on reducing unemployment and guaranteeing the country low and stable inflation. Indeed, having abandoned the gold standard in 1925, Middleton (2010) argues that deflationary fiscal measures were introduced partially as a means to maintain confidence in the British economy as individuals feared that a drastic fall in the price of sterling could result in imported inflation. Once this issue was overcome, Allen (2012) believes that monetary policy was eased to fight high 1930s unemployment whilst Crafts (2011) is of the idea this monetary measure was useful in counteracting “contractionary effects of fiscal consolidation”. As such, in 1932, the “cheap money” policy mentioned by Crafts (2011) was adopted which resulted in drops in short and long-term interest rates, ultimately allowing for a low stable inflation rate to kick in as price fluctuations typical of early 1930s no longer represented the norm. Overall, whilst adhering to the gold standard was used as a means to fight post-WWI inflationary pressures, it constrained the UK in its ability to control nominal interest rates and allow aggregate demand to rise and unemployment to drop. The extent to which economic policy was effective however, is still subject of debate today as it is affected by how one interprets the historic context of the UK. As explained by Fishback (2010), economists generally agree that the Federal Reserve committed key mistakes whilst steering monetary policy during the Great Depression years. Whilst the UK tightened monetary and fiscal policies by adopting the gold standard in 1925 in the intent to fight post-WWI inflationary pressures, the US’ monetary contraction prior to 1933 was not a result of being constrained by the gold standard, as underlined by Selgin (2013). Indeed, Selgin (2013) argues that refraining from adopting expansionary policies was a result of fear that expansion would provoke speculation attacks on the dollar causing its devaluation, mainly because the newly elected US president was unwilling to unequivocally commit to maintaining the gold standard – thus causing individuals to believe that the Fed might run out of gold reserves. Hence, on March 6, 1933, the US abandoned the gold standard as pointed out by Selgin (2013). Hsieh and Romer (2006) confirm this theory as they claim that recent scholarship has shown how US’ determination to remain on a system of fixed exchange rates immobilized it in its ability to control economic policy as it could not act to stem panics or stimulate production because expansionary policy could result in devaluation. Thus, the tension between what Fishback (2010) and Hsieh and Romer (2006) – who claim that the great depression in the gold standard view was not the result of gross policy mistakes – clearly sheds light on how it remains still unclear the extent to which adhering to the gold standard prevented aggregate demand from growing and unemployment from falling. The particular which adds credibility to the theory that aggressive Federal Reserve action could cause dollar devaluation stems from Hsieh and Romer’s (2006) paper. They claim that by 1929, the US could potentially “afford” to make substantial gold losses in open market operations as a result of the incredibly large amounts of gold reserves which it owned without threatening the US’ adherence to the gold standard. Hence, the only way the Federal Reserve could jeopardize the fixed exchange rate system was through expectations: aggressive monetary expansion may have lead individuals to doubt the US’ commitment level to the gold standard. Hence, to some degree the Fed did have its hand tied as described by Fishback (2010). Following the abandonment of the gold standard in 1933, Fishback (2010) clearly explains how the Fed was freer to control money supply as a means to affect domestic economic policy. During the gold standard period, the US economic policy mainly relied on fiscal stimulus programs as explained by Fishback (2010). Indeed, both the Hoover and Roosevelt administrations ran small deficits as they increased government spending. However, tax revenues also increased during both administrations as Fishback (2010) underlines. Hoover for instance doubled federal highway spending and increased the spending by Army Corps of Engineers on rivers, harbours and flood control by over 40%. Nominal federal expenditures, which contributed in boosting aggregated demand and lowering unemployment, rose by 52% from $3.1 billion in 1929 to $4.7 billion in 1932. A similar upward trend in annual nominal government spending occurred during the 1934-1935 period under Roosevelt. Hence, clearly the gold standard impacted the ability of monetary policy to control inflation but not of fiscal policy, whose upward trend remained unchanged throughout the Hoover and Roosevelt administrations. However, like in the UK, fiscal policy failed to lower unemployment significantly according to the Keynesian model as pointed out by Fishback (2010).Overall, all findings indicate that a country’s historical context is the ultimate determinant which impacts the effectiveness of each macroeconomic policy. Indeed, during the interwar period, by adopting a floating exchange rate, monetary policy in Britain played a key role in affecting both unemployment and inflation, far more than fiscal policy did. Indeed, throughout this period, monetary policy was eased to fight the 1930s Great Depression high unemployment, as discussed by Allen (2012). Moreover, the introduction of the “cheap money” policy mentioned by Crafts (2011) was key to offset the “contractionary effects of fiscal consolidation”, consequently lowering short and long term interest rates and accommodating a low stable rate of inflation. Fiscal policy during the 1919-1938 period mildly reduced unemployment through cuts in unemployment benefits and government spending in rearmament. Contrastingly, the Fed was indeed restricted in using monetary policy to help the country overcome the Great Depression due to the adherence to the gold standard whilst fiscal policy played a key role as small continuous fiscal deficits were run in the US throughout the Great Depression.

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