From his 1999 Nobel speech, supply-side guru Robert Mundell outlines his view of the Depression:
World War I made gold unstable. The instability began when deficit spending pushed the European belligerents off the gold standard, and gold came to the United States, where the newly-created Federal Reserve System monetized it, doubling the dollar price level and halving the real value of gold. The instability continued when, after the war, the Federal Reserve engineered a dramatic deflation in the recession of 1920-21, bringing the dollar (and gold) price level 60 percent of the way back toward the prewar equilibrium, a level at which the Federal Reserve kept it until 1929.
It was in this milieu that the rest of the world, led by Germany, Britain and France, returned to the gold standard. The problem was that, with world (dollar) prices still 40 percent above their prewar equilibrium, the real value of gold reserves and supplies was proportionately smaller. At the same time monetary gold was badly distributed, with half of it in the United States. In addition, uncertainty over exchange rates and reparations (which were fixed in gold) increased the demand for reserves. In the face of this situation would not the increased demand for gold brought about by a return to the gold standard bring on a deflation? A few economists, like Charles Rist of France, Ludwig von Mises of Austria and Gustav Cassel of Sweden, thought it would….
Rist, Mises and Cassel proved to be right. Deflation was already in the air in the late 1920's with the fall in prices of agricultural products and raw materials. The Wall Street crash in 1929 was another symptom, and generalized deflation began in 1930. That the deflation was generalized if uneven can be seen from the percentage loss of wholesale prices in various countries from the high in 1929 to September 1931 (the month that Britain left the gold standard): Japan, 40.5; Netherlands, 38.1; Belgium, 31.3; Italy 31.0; United States, 29.5; United Kingdom, 29.2; Canada, 28.9; France, 28.3; Germany, 22.0.
The dollar price level hit bottom in 1932 and 1933….
For decades economists have wrestled with the problem of what caused the deflation and depression of the 1930's. The massive literature on the subject has brought on more heat than light. One source of controversy has been whether the depression was caused by a shift of aggregate demand or a fall in the money supply. Surely the answer is both! But none of the theories—monetarist or Keynesian—would have been able to predict the fall in the money supply or aggregate demand in advance. They were rooted in short-run closed-economy models which could not pick up the gold standard effects during and after World War I. By contrast, the theory that the deflation was caused by the return to the gold standard was not only predictable, but was actually, as we have noted above, predicted.
The gold exchange standard was already on the ropes with the onset of deflation. It moved into its crisis phase with the failure, in the spring of 1931, of the Viennese Creditanstalt, the biggest bank in Central Europe, bringing into play a chain reaction that spread to Germany, where it was met by deflationary monetary policies and a reimposition of controls, and to Britain, where, on September 21, 1931, the pound was taken off gold. Several countries, however, had preceded Britain in going off gold: Australia, Brazil, Chile, New Zealand, Paraguay, Peru, Uruguay and Venezuela, while Austria, Canada, Germany and Hungary had imposed controls. A large number of other countries followed Britain off gold.
Meanwhile, the United States hung onto to the gold standard for dear life. After making much of its sensible shift to a monetary policy that sets as its goal price stability rather than maintenance of the gold standard, it reverted back to the latter at the very time it mattered most, in the early 1930's.
Instead of pumping liquidity into the system, it chose to defend the gold standard. Hard on the heels of the British departure from gold, in October 1931, the Federal Reserve raised the rediscount rate in two steps from 1_ to 3_ percent dragging the economy deeper into the mire of deflation and depression and aggravating the banking crisis. As we have seen, wholesale prices fell 35 percent between 1929 and 1933.
Monetary deflation was transformed into depression by fiscal shocks. The Smoot-Hawley tariff, which led to retaliation abroad, was the first: between 1929 and 1933 imports fell by 30 percent and, significantly, exports fell even more, by almost 40 percent. On June 6, 1932, the Democratic Congress passed, and President Herbert Hoover signed, in a fit of balanced-budget mania, one of its most ill-advised acts, the Revenue Act of 1932, a bill which provided the largest percentage tax increase ever enacted in American peacetime history. Unemployment rose to a high of 24.9 percent of the labor force in 1933, and GDP fell by 57 percent at current prices and 22 percent in real terms.
The banking crisis was now in full swing. Failures had soared from an average of about 500 per year in the 1920's, to 1,350 in 1930, 2,293 in 1931, and 1,453 in 1932. Franklin D. Roosevelt, in one of his first actions on assuming the presidency in March 1933, put an embargo on gold exports. After April 20, the dollar was allowed to float downward.
The deflation of the 1930's was the mirror image of the wartime rise in the price level that had not been reversed in the 1920-21 recession. When countries go off the gold standard, gold falls in real value and the price level in gold countries rise. When countries go onto the gold standard, gold rises in real value and the price level falls. The appreciation of gold in the 1930's was the mirror image of the depreciation of gold in World War I. The dollar price level in 1934 was the same as the dollar price level in 1914. The deflation of the 1930's has to be seen, not as a unique "crisis of capitalism,” as the Marxists were prone to say, but as a continuation of a pattern that had appeared with considerable predictability before—whenever countries shift onto or return to a monetary standard. The deflation in the 1930's has its precedents in the 1780's, the 1820's and the 1870's.
What verdict can be passed on this third of the century? One is that the Federal Reserve System was fatally guilt of inconsistency at critical times. It held onto the gold standard between 1914 and 1921 when gold had become unstable. It shifted over to a policy of price stability in the 1920's that was successful. But it shifted back to the gold standard at the worst time imaginable, when gold had again become unstable. The unfortunate fact was that the least experienced of the important central banks—the new boy on the block—had the awesome power to make or break the system by itself.
The European economies were by no means blameless in this episode. They were the countries that changed the status quo and moved onto the gold standard without weighing the consequences. They failed to heed the lessons of history—that a concerted movement off, or onto, any metallic standard brings in its wake, respectively, inflation or deflation. After a great war, in which inflation has occurred in the monetary leader and gold has become correspondingly undervalued, a return to the gold standard is only consistent with price stability if the price of gold is increased. Failing that possibility, countries would have fared better had they heeded Keynes' advice to sacrifice the benefits of fixed exchange rates under the gold standard and instead stabilize commodity prices rather than the price of gold.
Had the price of gold been raised in the late 1920's, or, alternatively, had the major central banks pursued policies of price stability instead of adhering to the gold standard, there would have been no Great Depression, no Nazi revolution and no World War II….
In April 1934, after a year of flexible exchange rates, the United States went back to gold after a devaluation of the dollar. This decreased the gold value of the dollar by 40.94 percent, raising the official price of gold 69.33 percent to $35 an ounce. How history would have been changed had President Herbert Hoover devalued the dollar, three years earlier!
France held onto its gold parity until 1936, when it devalued the franc. Two other far-reaching events occurred in that year. One was the publication of Keynes' General Theory; the other signing of the Tripartite Accord among the United States, Britain and France. One ushered in a new theory of policy management for a closed economy; the other, a precursor of the Bretton Woods agreement, established some rules for exchange rate management in the new international monetary system.
The contradiction between the two could hardly be more ironic. At a time when Keynesian policies of national economic management were becoming increasingly accepted by economists, the world economy had adopted a new fixed exchange rate system that was incompatible with those policies.