Economics / History

Aggregate Demand Dominance: The Deflation Ratchet and the Great Depression

The Utter Failure and Stupidity of the Gold and Silver Standards: Part 3

In a previous posting, I described the tendency for the gold standard to be “mean reverting” as the primary enforcement mechanism of the fixed-exchange system that prevailed for over two centuries prior to the Great Depression. This tendency is easily recognizable in the aftermath of major wars, as deflation sets in to return the gold price to par—Britain adopted the gold standard de jure in 1821 after wringing the Napoleonic War inflation out of its economy and triggering an economic depression in the process.

The economics profession seems to overlook this tendency, as even Keynesian economists argue that during the late nineteenth century deflation was much more sustainable than during the present day. I beg to differ:

Year British Official Price
(British pounds per fine ounce
end of year)
U.S. Official Price
(U.S. dollars per fine ounce
end of year)
New York Market Price
(U.S. dollars per fine ounce)
London Market Price
(British £ [1718-1949] or
U.S. $ [1950-Present] per fine ounce)
1861 4.25 20.67 20.67 £ 4.24
1862 4.25 20.67 23.42 £ 4.24
1863 4.25 20.67 30.02 £ 4.24
1864 4.25 20.67 42.03 £ 4.24
1865 4.25 20.67 32.52 £ 4.24
1866 4.25 20.67 29.13 £ 4.24
1867 4.25 20.67 28.57 £ 4.24
1868 4.25 20.67 28.88 £ 4.24
1869 4.25 20.67 27.49 £ 4.24
1870 4.25 20.67 23.75 £ 4.24
1871 4.25 20.67 23.09 £ 4.24
1872 4.25 20.67 23.24 £ 4.24
1873 4.25 20.67 23.52 £ 4.24
1874 4.25 20.67 22.99 £ 4.24
1875 4.25 20.67 23.75 £ 4.24
1876 4.25 20.67 23.05 £ 4.24
1877 4.25 20.67 21.66 £ 4.24
1878 4.25 20.67 20.84 £ 4.24
1879 4.25 20.67 20.67 £ 4.24
1880 4.25 20.67 20.67 £ 4.24

The deflation during the Long Depression wasn’t natural or sustainable—wringing the Civil War inflation out of the American economy required wholesale economy-wide price decreases for the market rate for gold to resume the $20.67 per troy ounce price control that had been set during the Panic of 1837. This ill-advised policy choice begun in 1873 and continued uninterrupted for 35 years after the birth to the international gold standard in 1879, which used deflation as a ratchet to maintain gold at £4.25 per troy ounce; the standard that had prevailed since Master of the Royal Mint Isaac Newton put the price control in place during 1717. The system functioned minimally amidst the vast changes ushered in by the Industrial Revolution until 1918, when the deflationary ratchet became unbelievably destructive.

Twisted Twenties…

After the First World War armistice, the idiotic prewar gold price controls were reasserted. Amidst the German hyperinflation, in October 1923 the newly-issued rentenmark was tied to gold at the same prewar ratio of 2,790 goldmarks per kilogram of gold that had prevailed before 4 August 1914 (the papiermark had replaced the goldmark on that date, coinciding with the German invasion of Belgium). Across the North Sea, the £4.25 millstone was again hung around the British economy’s neck. Gold returned to par in 1926…

Year British Official Price
(British pounds per fine ounce
end of year)
London Market Price
(British £ [1718-1949] or
U.S. $ [1950-Present] per fine ounce)
1914 4.25 £ 4.24
1915 4.25 £ 4.24
1916 4.25 £ 4.24
1917 4.25 £ 4.24
1918 4.25 £ 4.24
1919 4.25 £ 4.50
1920 4.25 £ 5.65
1921 4.25 £ 5.35
1922 4.25 £ 4.67
1923 4.25 £ 4.51
1924 4.25 £ 4.69
1925 4.25 £ 4.27
1926 4.25 £ 4.25

 …the year after Britain resumed the gold standard. The pain was just beginning—the price level had risen 600% from 1914 levels in Britain by that time, and the “mean reverting” nature of the gold standard would punch the British economy viciously:

1925 0.30%  
1926 -0.80%  
1927 -2.40%  
1928 -0.30%  
1929 -0.90%  
1930 -2.80%  
1931 -4.30%  
1932 -2.60%  
1933 -2.10%  

 Historians centuries or millennia from now might be confused why contemporary histories describe the Great Depression as commencing in October 1929. A tsunami of deflation struck America as well beginning in 1926…

Historical Data Chart

…indicating the Roaring Twenties were a deflationary expansion economically. I have found no evidence of any other sustained deflationary economic expansions in U.S. history, but considering the cataclysm which followed, thankfully the late-1920s were an outlier.

…Terrible Thirties…

The gold standard’s myriad defenders are fond of arguing Franklin Delano Roosevelt and the Democratically-controlled Congress of the 1930s perpetuated the Great Depression, especially after “taking the American economy off gold in 1933.” The argument is backwards. Deflation ceased after 1933…

British Inflation Rates

1933 -2.10%  
1934 0.00%  
1935 0.70%  
1936 0.70%  
1937 3.40%  
1938 1.60%  
1939 2.80%  
1940 16.80%  
1941 10.80%  

 Historical Data Chart

…only reappearing for any significant period of time afterwards during the brutal 1937 recession (and only in the U.S.) Self-described “deflationistas” try mightily to make the statement “deflation is destructive” common wisdom in contrast to horrid screams about hyperinflation around the corner; yet the powerful “inflationista” mindset tries to argue deflation historically is not dangerous. The history of the Great Depression seems to indicate otherwise.

The federal government in 1933 unleashed the New Deal to counteract the massive economic damage of the previous decade, but the most noticeable mechanism was revaluing the price control on gold:

Year British Official Price
(British pounds per fine ounce
end of year)
U.S. Official Price
(U.S. dollars per fine ounce
end of year)
New York Market Price
(U.S. dollars per fine ounce)
London Market Price
(British £ [1718-1949] or
U.S. $ [1950-Present] per fine ounce)
1931 4.25 20.67 20.67 £ 4.63
1932 4.25 20.67 20.67 £ 5.90
1933 4.25 20.67 24.44 £ 6.24
1934 4.25 35.00 34.94 £ 6.88
1935 4.25 35.00 35.00 £ 7.11
1936 4.25 35.00 35.00 £ 7.01
1937 4.25 35.00 35.00 £ 7.04
1938 4.25 35.00 35.00 £ 7.13
1939 4.25 35.00 35.00 £ 7.72
1940 4.25 35.00 35.00 £ 8.40
1941 4.25 35.00 35.00 £ 8.40
1942 4.25 35.00 35.00 £ 8.40
1943 4.25 35.00 35.00 £ 8.40
1944 4.25 35.00 35.00 £ 8.40
1945 4.25 35.00 35.00 £ 8.40

Increasing the controlled price for the first time in almost a century (more than two centuries in Britain’s case) removed the deflationary ratchet. The American ceiling rose almost 70% while the British valuation rose more than 97%.

It is important to note that 1933 wasn’t a foray into a floating-exchange currency regime. Domestically, the U.S. had essentially switched back to the silver standard, which explains how sustained inflation was tolerated in the peacetime American economy for the first time:

https://i0.wp.com/www.kitco.com/LFgif/ag792-999D.gif

Congress had set the price of silver at $1.293 per troy ounce with the Coinage Act of 1792, imposing that price control on the silver market until the outbreak of the Civil War. Silver had steadily eroded in value after the Crime of ’73, sinking to its lowest ever recorded value of $0.254 in 1932. Silver never rose to 50% of its statutory ceiling before the outbreak of the Second World War, finally rising to $1.293 thirty years after gold’s revaluation.

…the Overlooked Cause

Arguing what caused the Great Depression is a fool’s errand—too much information abounds and emotions and tempers flare on both sides of the political and economic divide to come to an undisputed conclusion.

However, the question of what sustained the Great Depression—perhaps this piece has proved beyond any doubt that after deflation set in during 1926, the gold standard’s deflation ratchet cranked incessantly against the economy’s neck during the 43 month continuous economic contraction between 1929 and 1933.

Removing the deflationary ratchet was an unmitigated act of mercy, releasing the American economy from the gold standard’s manipulation…until the Enigma of 1945.

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2 thoughts on “Aggregate Demand Dominance: The Deflation Ratchet and the Great Depression

  1. Pingback: Aggregate Demand Dominance: The Enigma of 1945 | In The Corner, Mumbling and Drooling

  2. Pingback: Aggregate Demand Dominance: MIC and the Death of the Deflation Ratchet | In The Corner, Mumbling and Drooling

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