Tuesday, September 14, 2010

A Counterfactual Quesiton

Tyler Cowen sends us to an interesting paper by Doug Irwin on the gold standard and the Great Depression.  This paper shows via a counterfactual exercise that had the United States and France not sterilized their large gold inflows the price-specie-flow mechanism would have worked its magic and the world would have avoided the destructive deflations of 1929-1933.  Others have made this argument before, particularly advocates of the gold standard.  They contend that it wasn't the gold standard per se, but the failure of the U.S. and French monetary authorities to play by the "rules of the game" for the international gold standard (i.e. they should not have sterilized their gold inflows).  So let's do our own counterfactual: what if the rules of the game had been followed and, as a result, the Great Depression had been avoided across the world in the 1930s. How would the world be different today?  

There are probably a thousand different answers one could give--Peter Temin and Barry Eichengreen argue the Nazis would not have risen to power in Germany--but I want to focus on just one possibility: we could still be on the gold standard today. Had this happened what else in monetary history would be different?  Would the Great Inflation of the 1970s been avoided? If so, then Paul Volker wouldn't be the legend he is today because there would be no inflation monster for him to slay.  Presumably, under such a system the Fed would not have helped fuel a housing boom in the 2000s. With a gold standard, it also seems the Fed would be smaller and the Fed chairman wold be less important--no Greenspan Maestro.  Similarly, there would be little-to-no uncertainty over FOMC meetings since their decisions would largely be driven by the gold standard.  We wouldn't be worked up over the Senate's delay  of the President's Fed appointments since  they really wouldn't matter.  In many ways it seems that there would be more certainty in this system than what we have under current arrangements.  On the other hand,  there is no reason to believe in this counterfactual that all nations would continue to play by the rules of the game necessary for an international gold standard to work.  And it is not clear that the painful price adjustments  required in a gold standard from a money demand shock  would be politically feasible forever (of course it such price adjustments were common then maybe prices would be more flexible).  In short, one could easily construct a gold standard scenrio where things go terribly wrong again at some later date. 


  1. David, I think the great English historian EP Thompson had the best description of historical counterfactuals. He called it

    And the reason it doesn't work in this case is the gold standard was already doomed by World War I. Nobody wanted to play by the rules of the game because well they had just been bayoneting, machine gunning and gassing each other by the thousands on the banks of the Somme.

  2. In my research on the Depression I also noticed that US and French gold hoarding was the main problem in the early 1930s. But I see that as weakening the case for the gold standard. If you have to assume that all countries maintain a stable ratio of gold to money in order for the gold standard to work, then why not have fiat money? The gold standard was supposed to work even if governments were irresponsible--unlike fiat money.

  3. ECB: Interesting point that it is simply naive to expect any other outcome for the gold starndard given WWI.

    Scott: Wouldn't another strike against the gold standard be the painful price adjustments it would require from time to time? If I recall correctly, Barry Eichengreen argued something along these lines, that democracy and enfranchisement doomed the gold standadrd since the populace would never accept the required painful adjustments needed.

  4. David, I agree. Even if countries did follow the rules of the game, you might well have unstable price levels and/or NGDP.

    It's not the worst possible system, but the politics of it are pretty much impossible in the modern world. The sort of government activism required to make it work would be much better off being used for NGDP targeting.

  5. Is it of any relevance that -

    1) the depression of 1920-21 was deep but short at a time when everyone was off the gold standard due to the recently completed war, and

    2) After the '29 collapse, countries recovered from the depression in exactly the same order as they again abandoned the gold standard?


  6. The argument here sounds the same as that made in great detail by Clark Johnson in his 1997 book, Gold, France, and the Great Depression.

  7. DB: I haven't read it in a while, but I think this is the message inherent in Golden Fetters isnt it?
    The constellation of political and social factors that underpinned the classical GS was shattered by WWI. It was doomed, just waiting for the right shock to push it into oblivion.
    Think about the tensions engendered (and observed recently in Florida and NY) by a comparatively minor event like 9/11. Now multiply that a thousand-fold for a truly cataclysmic world war and you can see how international co-operation was compromised. Winston Churchill called 1914-45 the Thirty Years War (if I recall right) meaning that Versailles was simply a time-out. There was too much unfinished business for another round of slaughtering to be avoided.

  8. David
    You forgot to mention one very important "counterfactual": Maybe Keynesian economics wouldn´t have been born!

  9. Jeez Louise, am I sick of gold. What is it with the shiny yellow metal? Why not a silver standard, a diamond standard, a platinum standard or a palladium standard?

    Listen, one time my grandfather told me something I have never forgotten:

    "All gold is fool's gold."

  10. Scott:

    Richard Timberlake once said in a podcast that it is silly to think of central banking AND the gold standard for "If two men ride a horse, one necessarily rides in back."

    Proponents of the gold standard, as I understand, would like the central bank to be "riding in back" or, perhaps more clearly, non-existent.

    In any event, the point seems to be that you either have central banking OR you have a gold standard.