The Gold Standard, Federal Reserve, and the Great Depression

 

    

    The Great Depression has loomed over the United States as the greatest financial crisis in the nation’s history. Not only was the financial crisis severe and sustained, but due to the interconnectedness of the US economy with the rest of the world, it became a global depression. Whenever financial downturns and panics have hit the United States in the years since the Great Depression, the causes and path back to financial stability and economic growth have been re-evaluated and analyzed in an effort to apply the lessons of the past to current economic woes. However, the Great Depression brought more than an economic crisis to the United States, it was a political crisis as well. The Hoover administration which was at the helm when the crisis began was heavily criticized for not reacting soon enough. Hoover, like the presidents before him, had a laissez-faire approach toward the economy. Fearing that decisive action on the part of the American government would not only deepen the nation’s debt but would also put people permanently on the dole. The subsequent Roosevelt administration ushered in the New Deal as a means to rescue the United States from the depths of the Depression. While much of the discussion of the Depression centers on the merits of the New Deal programs, less attention has focused on the role of the Federal Reserve at the time. The Federal Reserve and successful monetary policy could have mitigated the severity of the Great Depression and reversed the downward spiral. Furthermore, the gold standard which was suspended at the start of WWI was resumed at the war’s conclusion. This mismanaged interwar return to the gold standard was partially responsible for the economic depression that would grip much of the world’s economy.
    On the eve of the Depression, America was globally connected as the world’s leading international lender. Through international trade, the United States was tied to the international network as the world’s leading exporter and second-leading importer. The intertwining of the global economy in general and the post-war network of intergovernmental indebtedness specifically was a primary cause of the severity of the crisis. It eventually encompassed 28 countries, with Germany the most heavily in debt and the United States owed 40% of total receipts.
    The Federal Reserve was a new and relatively untested central bank when the Great Depression hit. At the end of the 1920s the Federal Reserve, in an effort for securities market speculation, began to raise interest rates. This rise triggered a global recession as the international gold standard linked both interest rates and monetary policy of the 47 countries in the gold-standard club which transmitted deflation abroad which then reflected back to the US. The gold standard was a key factor in forcing economies to deflate during a period of intense economic downturn and the departure from the gold standard was a necessity for long-term recovery.
    One of the primary functions of the Fed was to act as a lender of last resort yet in this case the Federal Reserve failed to act in face of massive bank closures. One reason for this failure was the crippling decision-making structure that existed within the Fed. The leaders disagreed on what, if any, actions should be taken and as a result, no action was taken which plunged the US deeper into the recession. Moreover, the dedication to preserving the gold standard and the contractionary bias made the Federal Reserve less receptive to policy alternatives.
    Deflation could have been prevented with an expansion of the monetary base or by the propping up of the banking system. The shrinking of the money supply intensified the economic recession and led to the Depression. The Federal Reserve, failing to recognize the impact of money hoarding that was going on, did not respond with timely and appropriate corrective action. They essentially allowed the money supply to collapse and price levels to fall leading to an overall contraction of the economy. When the Federal Reserve did eventually move to resurrect the financial system and end deflation it was too little too late.
    While the Federal Reserve did not cause the initial recession, its general inability to respond to the first signs of trouble helped plunge the United States into a deep depression. The interconnectedness of the global economy and commitment to the gold standard amplified the economic downturn into a worldwide depression. The Great Depression taught the United States many economic lessons. New legislation passed under the New Deal gave the Board of Governors more power. The experiences of the Great Depression stressed the importance of timely responses by the central bank to financial crises that threaten the macroeconomy and that price stability must be the primary objective for monetary policy due to the harm that deflation and inflation can do to the real economy.

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