The conventional narrative describing the Great Depression goes something like this. The US Stock Market crashed in October 1929. De-leveraging from the colossal debt bubble of the late 1920s, combined with falling agricultural prices, led to a bank panic. The Federal Reserve allowed banks to go under rather than jeopardize its own credit worth, the foundation of its adherence to the gold standard. The Treasury department was just as complicit, seeking to balance its budget in an attempt to reassure creditors of the US government’s fiscal rectitude. In its view, the system needed purging anyway: “Liquidate labour, liquidate stocks, liquidate the farmers, liquidate real estate” was the soothing policy prescription of Treasury Secretary Andrew Mellon.
Interesting details have resonance today. The world economy initially cushioned the US downturn, with US net exports posting strong gains a year after the stock market collapse. Yet this was quickly reversed as America’s recession became the world’s.1/ US net exports fell 64% between mid-1931 and mid-1932. There was no global ‘cushion’ left. US policymakers made matters worse by allowing a second round of banking panic to proceed unhindered. The US money supply fell by a third between 1929 and 1933 as savers withdrew from banks. Prices plummeted in the face of eviscerated demand. Falling prices meant falling incomes. In “real” (price-adjusted) terms, that’s fine. The problem is that debts are contracted in nominal terms. That means a drop in prices, and incomes, leaves debt burdens ballooning.
From this came the famous “Debt (and) deflation theory of great depressions”, by Irving Fisher in 1933. People today use the term debt deflation differently than Fisher. He referred to “Debt (and) Deflation”. There isn’t such a thing happening in America today. Debt exists, but not yet deflation. Might that change? Some signs are not encouraging. On the front lines are central banks, still resolved to fight yesterday’s demon: inflation. They should be slashing interest rates down to 1 or 2%. But the real story is households: how they view paper money holds the balance between hyperinflation and deflation.
And that’s a key difference between the Great Depression and now. Money in the 1930s was not really fiat money.2/ Despite almost worldwide suspension of de jure gold convertibility at the central bank in a period spanning Britain’s September 1931 gold suspension, policymakers everywhere sought to maintain the value of their currencies with respect to gold – in price, quantity, or both. Indeed, the USA was on a gold standard throughout this period. The economy deflated in part because people trusted dollars. That’s because money supply and velocity both contracted, meaning that the money supply multiplier contracts too.
This is the story of the 1930s. People desired and held dollars more than gold. In fact, the dollar was better than gold, in Mundell’s words. The USA simply wasn’t willing to run international deficits; it wasn’t providing dollars to the world, so the dollar was more precious than gold — America made goods that people needed, and you needed dollars to get hold of them. Gold was merely an inconvenient intermediary. (And, from 1934, its exchange at the promised 35 dollars per ounce was available only to official institutions, and only then for an approved subset of them.)
Fast forward eighty years. The US has run an international deficit for so long that dollars are in abundance.3/ The dollar is no longer “as good as” gold and certainly not “better than” gold. As Andy Xie, formerly of Morgan Stanley, points out, whatever the merits of the current Treasury plan, it amounts to a shell game. The US government buys the household sector’s non-performing obligations, but issues its own obligations to pay for it. The economy remains highly leveraged.
Markets are buying US public debt for its perceived safety and liquidity, but why?3/ That debt must be serviced and repaid out of US fiscal streams. Is the medium-term US fiscal profile compatible with its prospective debt level and price stability? Note the qualifier. No one doubts that the bonds will be serviced. But the last refuge of an insolvent state is the printing press. The inflation tax is a tax when no other fiscal compact is workable. And if you think that’s the ultimate escape clause for the US government, why would you want to hold dollars?
If you suspect this outcome later, your incentive is to get out sooner. Because any whiff of this outcome should depress money demand. And when money demand falls, velocity rises. People try to get out of money as quickly as they come into possession of it. Rising velocity goes hand in hand with high inflation. The higher the inflation, the weaker the money demand, the higher the velocity, the higher the inflation.
What’s really needed is equity investment from abroad. Those best equipped to provide it are China and the Gulf states – but, all too often, neither is deemed an ‘acceptable’ owner. As Xie notes, America is the world’s largest debtor but behaves like its largest creditor. He worries that Americans may need much more hardship to change their attitude.
Which explains the rush into gold. Rightly or wrongly, I regard myself as a minor expert on the monetisation of gold. Much in keeping with modern views on the subject, I am no fan of the ‘gold standard’. I do not exactly see its restoration in the form we’ve ever known it, but that does not rule out its monetary use altogether. Indeed, the one constant in the gold standard through time is its adaptation. Nobody from the 19th century would have considered the Bretton Woods system a gold standard; but anybody today can see the resemblance.
I will elaborate further on gold in an upcoming piece. In the meantime, I reproduce here the concluding text of my January 2008 article on the topic:
If OECD central bank independence is called into doubt … gold’s future as a monetary asset should be taken seriously. This is not because it would be advisable, but because gold has a force of inertia that demands respect: its monetisation goes back 2500 years, its abeyance 37.
With that in mind, consider the following. Despite prefacing his statement with the caveat that central bank independence is sacrosanct, a prominent UK politician yesterday called for its suspension:
What is required is for the chancellor to write to the governor saying that on a temporary emergency basis the committee should assume a central role in countering the crisis with a large cut in interest rates. A big cut – conceivably as much as two percentage points – would have a big psychological impact on consumer and business confidence when it is most needed.
1/ Culpability for transmission of the Great Depression from the US to the world economy is thought to lay squarely at the door of the gold standard – probably rightly so. And yet, we can see today a deeply cross-border nature of a credit ailment quite independent of the currency regime.
2/ Fiat money is actually harder to define than you might think. A passable definition is that fiat money is not legally backed by a finite commodity, e.g. gold.
3/ Imagine what the latest developments in the US financial services industry do for the dark matter hypothesis. I had a lot of time for this view.
4/ “Liquidity services” is the only explanation for continuing worth in US official assets, and so ‘dark matter’ lives on!