23 Apr 2009

Did Abandoning the Gold Standard Get Us Out of the Depression?

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Greg Mankiw has come out of his shell lately on his blog. Whenever I visited in the past, I would quickly move on because he would offer links with at most a sentence of commentary. Unfortunately, now he is devoting his writing skills to pushing the benefits of massive inflation.

Last week Mankiw wrote an op ed for the NYT saying the Fed should promise large inflation in the future, in order to push the “real” (inflation-adjusted) interest rate into negative territory. Apparently many readers were upset–imagine that!–and Mankiw has been defending his flank ever since. In his most recent defense he writes:

As to the Fed announcing a commitment to a moderate amount of inflation, let me point out that according to many macroeconomic historians, the abandonment of the gold standard was the most useful thing that the federal government did to get the country out of the Great Depression. A commitment to producing a moderate amount of inflation would be the modern equivalent of that act.

As I argue in my new book, The Politically Incorrect Guide to the Great Depression and the New Deal, this hostility to the gold standard is misplaced. Before we delve into the economic theory, just consider the brute historical facts: In prior US depressions (or “panics”), when the US dollar was tied to gold, the country began to recover typically within about two years. In contrast, it wasn’t until the governments of the world all abandoned gold, that the entire world was mired in the worst downturn in history, and for a decade to boot!

Let me dispatch with an obvious response. Mankiw could say, “Well sure, the gold standard tied the hands of central bankers, but it had an irrational aura of inviolability, and so it’s not surprising that it took the worst downturn ever to finally get the Fed to drop the barbarous relic. The US economy turned around on a dime the moment FDR severed the tie to gold.”

But no, that doesn’t quite work either. If it were really true that it was the gold standard holding the US in Depression, then surely, say, five years after FDR severed the link, the economy should have been humming, right? But the official unemployment statistics (and note these BLS figures don’t count people receiving WPA checks as having a real job) record that in 1938–five years into the New Deal–the unemployment rate averaged 19%. So when people tout how great things were for the US economy once we ditched gold, keep that in mind. Yes, 19% is lower than 25% (the rate in 1933), but to repeat, in all prior US history, a depression would have been long gone five years after the trough.

But now let’s use economic theory to make sense of these undeniable historical facts. I argue in the book that the one thing that set the Great Depression apart from its earlier peers was that Herbert Hoover subscribed to an underconsumptionist theory of the business cycle. After the stock market crash in 1929, Hoover called all the big business leaders to Washington and told them not to cut wage rates, because (he thought) to do so would simply reduce incomes and hence would exacerbate the downturn in spending on business.

So what happened is that workers’ paychecks fell much more slowly than prices in general, during the 1929-1933 period. In fact, workers’ “real” wages (i.e. actual dollar amount adjusted for falling prices) rose more quickly during this period than they had during the Roaring Twenties! So it’s no wonder that unemployment rates skyrocketed, because the relative price of labor kept rising even amidst horrible business losses.

In this context, running the printing press could provide at least short term relief, and I believe that is the explanation for Brad DeLong’s favorite chart. If the government (in concert with unions) is enforcing very severe nominal wage rigidity, then the normal price deflation during a depression will be catastrophic. By freeing central banks of their obligations to redeem currency for gold, they were given the ability to run the printing press and push prices back up, easing the massive surplus in the labor market.

But it would be very queer to describe the high unemployment of the early 1930s as the fault of the gold standard. No, the blame rests squarely on government policies (and support for unions) that kept wage rates above their free market levels. In the 1920-1921 depression, for example, prices in the US fell much more quickly than they did during any single year of the 1930s, but unemployment spiked at 11.7% and then was down to 2.4% by 1923.

The reason? Wages fell even more quickly than prices; they dropped 20% in a single year. At the time Herbert Hoover (Harding’s Commerce Secretary) was horrified, but it was a much better outcome than what his “compassionate” policies would unleash on workers a decade later.

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