In my book entitled "The Midas Paradox", I did a very extensive
empirical study of this question. The price of German war debt bonds
suddenly become highly correlated with US stock indices in mid-1931
(when Germany got into financial trouble), and this continued through
1932. Fears of German default were triggering a loss of confidence in
the international gold standard. That loss of confidence was justified,
as Germany adopted exchange controls in July 1931 and the UK devalued
in September 1931. At that point people started worrying about a US
devaluation, and gold hoarding rose sharply.
Because the supply of newly mined gold doesn't change very much from
year to year, big changes in the value of gold are primarily caused by
shifts in gold
demand. But once the US began devaluing the
dollar in April 1933, increases in gold demand no longer had a
significant deflationary impact on the US. Gold kept getting more
valuable, but now the dollar was losing value. (Recall that price
deflation means that money is getting more valuable.)
Back in 1932, the vast majority of serious people rejected my "tight
money" explanation of the Depression. It was "obviously" caused by
financial turmoil, both domestic and international. Falling NGDP was
seen as a symptom. Only a few lonely exceptions like Irving Fisher and
George Warren took a "market monetarist" perspective, urging a shift
toward expansionary monetary policy. Because we were near the zero
bound, they recommended a depreciation of the dollar against gold. In
1933, FDR adopted their suggestion, and it worked just as Warren and
Fisher predicted---prices and output immediately began rising sharply.
The policy would have been even more effective if not offset by the
NIRA, which sharply reduced aggregate supply.
And there is lots more evidence for the tight money--->falling
NGDP---> financial distress chain of causation. After the dollar
started depreciating against gold in April 1933, domestic bank failures
ceased almost immediately.
Some people claim that tight money did not cause the Great Recession,
because there was no alternative monetary policy at the zero bound of
interest rates. But something similar occurred in the 1980s, when we
were not at the zero bound. Between 1934 and 1980, there was a period
of calm in the banking system. Some people wrongly attribute that to
regulation, but in fact it was caused by higher rates of inflation and
NGDP growth during 1934-80, which made it easier for debts to be repaid.
As soon as the Fed adopted a tight money policy in 1981, and NGDP
growth began slowing sharply, we experienced a bout of bank failures
(mostly S&Ls). The causation in this case clearly went from tight
money to sharply slower NGDP growth to banking distress, as we were not
even close to the zero lower bound on interest rates.
To summarize, the question of whether tight money or financial distress
causes deep slumps might seem almost unsolvable, if you simply focus on
the Great Recession. But those with a deep knowledge of economic
history know that causation clearly runs from tight money to falling
NGDP to financial distress. Unfortunately, economic history is no
longer widely taught in our graduate programs, so we now have an entire
generation of economists who are ignorant of this subject, and who keep
developing business cycle models that are easily refuted by the
historical record."
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