The Utter Failure and Stupidity of the Gold and Silver Standards: Part 4
I ended my previous economics post with the merciful end of the deflationary ratchet in 1933. Today, I must turn to the abject failure that was the reassertion of the international gold standard before and during the horror of World War II.
The Curious Cases
I’ve written before about the post-Battle of the Bulge “demobilization” recession:
Recessions can and do occur during wartime. The last twelve years have been a prime example. But the same was true of Vietnam—the stagflation first hit in 1970. Or the 1945 recession during World War II. Wait, what?
The American economy ran into a wall in 1945, GDP crashing by 11%. Every account I have read about the 1945 recession blames postwar demobilization—the loss of aggregate demand from the abrupt ending of wartime production levels and/or returning soldiers displacing working women are the two factors most often cited to explain the downturn. There’s a major issue with these assumption. The “demobilization” recession officially started in February 1945 and lasted until October. Am I the only one who sees a problem here?
The postwar recession started before V-E day (and ended a mere month after V-J day). Growth in the United States peaked in December 1944, during the Battle of the Bulge. The battles for Iwo Jima and Okinawa (the amphibious assault on the latter island was larger than Operation Overlord on June 6, 1944) had not yet occurred. So, how did this constitute demobilization? Short answer—it didn’t.
I termed this strange case to be the Enigma of 1945—what on Earth caused such a dramatic drop in wartime output? In May 2013 I postulated one possible cause might have been preparations for Operation Downfall:
Operation Downfall, the planned invasion of the Japanese Home Islands in late 1945, would have been the most violent American military operation in history. As a study by Secretary of War Henry Stimson’s staff calculated a loss of 1.7-4,000,000 American casualties including 400,000-800,000 KIA (killed in action–for perspective 521,915 American servicemen lost their lives in both World Wars) in the invasion of Japan, the military ordered the manufacture of 500,000 Purple Hearts. The nearly 70 year-old stockpile of medals still numbered in excess of 100,000 in 2003 and is currently being distributed to casualties in Afghanistan today. Until Hirohito’s surrender message, Downfall still loomed menacingly. Could the “guns and butter” economic calculation run so far toward the guns side that economic output actually began to drop?
In National Product in Wartime Kuznets noted that national income accountants must make definite assumptions about “the purpose, value, and scope of economic activity.” He observed that “a major war magnifies these conceptual difficulties, raising questions concerning the ends economic activity is made to pursue; and “the distinction between intermediate and final products.” Moreover, “war and peace type products . . . cannot be added into a national product total until the differences in the valuation due to differences in the institutional mechanisms that determine their respective market prices are corrected for.” During the war Kuznets constructed several alternative series, one of which appears in Table 2, column 4. Its values for 1942 and 1943 are substantially lower than those in columns 1, 2, and 3, in part because Kuznets used preliminary nominal data as well as different deflators for expenditure on munitions.11
After the war Kuznets refined his estimates, producing a series (Table 2, column 5) that differs substantially from the standard series “partly because of the allowance for overpricing of certain types of war production, partly because of the exclusion of nondurable war output (essentially pay and subsistence of armed forces).” Contrasting his estimate and that of the Commerce Department, he found the latter “difficult to accept” because it made too little correction for actual inflation during the war years and did not deal satisfactorily with the decline in the relative prices of munitions during the war.12 Kuznets’s refined estimates follow a completely different profile for the 1940s. Most notable is that whereas the Commerce Department’s latest estimate of real GNP drops precipitously in 1946 and remains at that low level for the rest of the decade, Kuznets’s estimate increases in 1946 by about 8 percent, then rises slightly higher during the next three years.
Table 2. REAL GROSS NATIONAL PRODUCT, 1939-1949
(index numbers, 1939 = 100)
Commerce Kuznets Year Estimate of
Kendrick Wartime Revised Variant III GNP* 1939 100.0 100.0 100.0 100.0 100.0 100.0 100.0 1940 108.5 107.9 109.7 109.3 109.0 109.0 108.7 1941 125.9 126.9 128.7 125.9 121.8 121.7 119.4 1942 142.2 150.8 145.5 131.9 126.5 118.2 108.4 1943 161.0 178.1 160.6 148.6 132.5 117.6 102.2 1944 172.5 192.7 172.4 135.8 122.1 105.4 1945 169.6 189.1 171.3 139.4 125.6 114.3 1946 149.3 153.1 156.7 151.0 146.5 144.8 1947 148.0 148.9 153.4 154.5 148.0 147.3 1948 154.6 154.7 160.0 155.5 153.1 152.3 1949 154.8 154.8 156.9 152.6 148.5 147.5
Sources: Column 1 was computed from data in U.S. Bureau of the Census, Historical Statistics, p. 224 (series F-3); column 2 from data in U. S. Council of Economic Advisers, Annual Report, p. 296; column 3 from data in Kendrick, Productivity Trends, pp. 291-92 (national security variant); column 4 from data in Kuznets, National Product in Wartime, p. 89 (Variant a); column 5 from data in Kuznets, “Long-Term Changes,” p. 40; and column 6 from data in Kuznets, Capital, p. 487. GNP* is equal to Kuznets’s variant III minus gross war construction and durable munitions and was computed form data in Kendrick, Productivity Trends, pp. 291-92.
In my defense, I also identified another possible culprit for the Enigma:
So, is there any other plausible explanation for the enigma that is the 1945 recession? I have a theory—Bretton Woods. The conference occurred in 1944, reestablishing part of the fixed-exchange system that had collapsed when the full gold standard was abandoned during the 1930s. When the gold standard had been reintroduced in 1920 it merely triggered the second worst recession in American history; what’s the worst that could happen?
Turns out I was wrong: the U.S. never abandoned the gold standard in the 1910s or ‘20s; but the postwar Depression was nevertheless horrific:
This context highlights the importance of the 1920–1921 depression. Here the government and Fed did the exact opposite of what the experts now recommend. We have just about the closest thing to a controlled experiment in macroeconomics that one could desire. To repeat, it’s not that the government boosted the budget at a slower rate, or that the Fed provided a tad less liquidity. On the contrary, the government slashed its budget tremendously, and the Fed hiked rates to record highs. We thus have a fairly clear-cut experiment to test the efficacy of the Keynesian and monetarist remedies.
At the conclusion of World War I, U.S. officials found themselves in a bleak position. The federal debt had exploded because of wartime expenditures, and annual consumer price inflation rates had jumped well above 20 percent by the end of the war.
To restore fiscal and price sanity, the authorities implemented what today strikes us as incredibly “merciless” policies. From FY 1919 to 1920, federal spending was slashed from $18.5 billion to $6.4 billion—a 65 percent reduction in one year. The budget was pushed down the next two years as well, to $3.3 billion in FY 1922.
On the monetary side, the New York Fed raised its discount rate to a record high 7 percent by June 1920. Now the reader might think that this nominal rate was actually “looser” than the 1.5 percent discount rate charged in 1931 because of the changes in inflation rates. But on the contrary, the price deflation of the 1920–1921 depression was more severe. From its peak in June 1920 the Consumer Price Index fell 15.8 percent over the next 12 months. In contrast, year-over-year price deflation never even reached 11 percent at any point during the Great Depression. Whether we look at nominal interest rates or “real” (inflation-adjusted) interest rates, the Fed was very “tight” during the 1920–1921 depression and very “loose” during the onset of the Great Depression.
But the Depression of 1921 was in itself another enigma:
Now some modern economists will point out that our story leaves out an important element. Even though the Fed slashed its discount rate to record lows during the onset of the Great Depression, the total stock of money held by the public collapsed by roughly a third from 1929 to 1933. This is why Milton Friedman blamed the Fed for not doing enough to avert the Great Depression. By flooding the banking system with newly created reserves (part of the “monetary base”), the Fed could have offset the massive cash withdrawals of the panicked public and kept the overall money stock constant.
But even this nuanced argument fails to demonstrate why the 1929–1933 downturn should have been more severe than the 1920–1921 depression. The collapse in the monetary base (directly controlled by the Fed) during 1920–1921 was the largest in U.S. history, and it dwarfed the fall during the early Hoover years. So we hit the same problem: The standard monetarist explanation for the Great Depression applies all the more so to the 1920–1921 depression.
If the Keynesians are right about the Great Depression, then the depression of 1920–1921 should have been far worse. The same holds for the monetarists; things should have been awful in the 1920s if their theory of the 1930s is correct.
To be sure, the 1920–1921 depression was painful. The unemployment rate peaked at 11.7 percent in 1921. But it had dropped to 6.7 percent by the following year, and was down to 2.4 percent by 1923. After the depression the United States proceeded to enjoy the “Roaring Twenties,” arguably the most prosperous decade in the country’s history. Some of this prosperity was illusory—itself the result of subsequent Fed inflation—but nonetheless the 1920–1921 depression “purged the rottenness out of the system” and provided a solid framework for sustainable growth.
Right…the 1920s were supposedly more prosperous than the 1960s, the second longest economic expansion in American history (the 1990s were #1). During the twenties, the gathering of economic data was pretty sparse compared to the post-World War II era to today. But the data collected does show that deflation is incredibly destructive:
The “purge of rottenness” that Murphy speaks of is the gold standard’s deflation ratchet, the “mean reverting” horror that demanded that the American price level in 1920 return to the price level of 1837. By 1926 the U.S. was experiencing sustained deflation, as the deflationary ratchet cranked ever tighter. Perhaps the Great Depression was worse considering the British price level too was “required” to be dropped back to 1717 levels when the UK resumed the gold standard in 1925?
Not to mention the “Roaring Twenties” did not last very long…
|DURATION IN MONTHS|
are in parentheses
December 2007 (IV)
|December 1854 (IV)
December 1858 (IV)
June 1861 (III)
December 1867 (I)
December 1870 (IV)
March 1879 (I)
May 1885 (II)
April 1888 (I)
May 1891 (II)
June 1894 (II)
June 1897 (II)
December 1900 (IV)
August 1904 (III)
June 1908 (II)
January 1912 (IV)
December 1914 (IV)
March 1919 (I)
July 1921 (III)
July 1924 (III)
November 1927 (IV)
March 1933 (I)
June 1938 (II)
October 1945 (IV)
October 1949 (IV)
May 1954 (II)
April 1958 (II)
February 1961 (I)
November 1970 (IV)
March 1975 (I)
July 1980 (III)
November 1982 (IV)
November 2001 (IV)
June 2009 (II)
…the U.S. in the 1920s managing at best a 27-month expansion amidst three contractions that averaged 15 months apiece–all prior to the Great Depression’s 43-month 1929-33 initial contraction. The dreaded 1960s and 1990s expansions managed…106 and 120 months each. Do we need any more evidence that the gold standard’s deflation ratchet was a profoundly misguided policy?
Bretton Woods Blunder
In discussing the disaster that was the gold standard, I strangely find myself having to turn to the Ludwig von Mises Institute. I love the tagline—Advancing Austrian Economics, Liberty and Peace. I’ll dispense with Austrian peace, thank you very much. But Murray N. Rothbard was an American, not Austrian national:
The new international monetary order was conceived and then driven through by the United States at an international monetary conference at Bretton Woods, New Hampshire, in mid-1944, and ratified by the Congress in July, 1945. While the Bretton Woods system worked far better than the disaster of the 1930’s, it worked only as another inflationary recrudescence of the gold-exchange standard of the 1920s and–like the 1920s–the system lived only on borrowed time.
The new system was essentially the gold-exchange standard of the 1920s but with the dollar rudely displacing the British pound as one of the “key currencies.” Now the dollar, valued at 1/35 of a gold ounce, was to be the only key currency. The other difference from the 1920s was that the dollar was no longer redeemable in gold to American citizens; instead, the 1930’s system was continued, with the dollar redeemable in gold only to foreign governments and their central banks. No private individuals, only governments, were to be allowed the privilege of redeeming dollars in the world gold currency.
Anyone see the issue?
|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)
The negotiators at Bretton Woods made a fatal error—the price controls were never adjusted for inflation. First World Wartime inflation wasn’t reflected in the commodities market; Second World Wartime inflation less so.
Worse, the negotiators settled on $35 per troy ounce of gold, a Depression-era revaluation made to account for a century of wartime inflation. There was no recognition that 1933 price levels were not at all appropriate during the 1940s:
Under the gold standard, the insane “mean reversion” requirement almost immediately brought out the deflation ratchet and triggered recessions (if not full-on depressions). Bretton Woods had reestablished the international gold standard in 1944; should I be surprised the U.S. sank into an economic contraction in February of the following year?
Cold War Gold
History unfolding this way does lead to a new question—why didn’t the 1948-49 recession hit as hard as 1920-21? That answer is quite easy—conflict in Korea forbid the contraction to continue. The deflation ratchet had begun to crank painfully at the end of the 1940s, but was interrupted by the onset of the Korean War.
I turned to the Mises Institute in the first place due to the fact that John Paul Koning’s research contradicts his fellow Austrian School writers. Murray Rothbard almost accuses Bretton Woods of locking private individuals out of the gold markets. That was not the case in 1958:
The US government tried to prevent gold from leaving by twisting the arms of foreign central banks to keep their dollars, and, later, setting travel limits on American tourists overseas and US private investment in Europe. By 1958, London gold was trading closer to its $35.18 upper limit rather than the bottom limit at $34.82, which it touched in 1957. Participants in the London market — increasingly dominated by throngs of private investors and speculators — were ever more certain that the United States’ plunging gold reserves would force it to dramatically devalue the dollar.
I have to ask–what’s with American ethnocentrism in Austrian economics? Market access was an issue exclusive to the U.S., a product not of Bretton Woods but from 1933 gold revaluation legislation (wouldn’t a better policy have been floating the dollar amidst the Great Depression instead?)
More to the point, what exactly was transpiring during the 1950s to throw the London gold market into turmoil?
[G]old charts show a flat line through the Bretton Woods era of the 1940s, ’50s, and ’60s at $35.
The problem with these flat lines is that they imply that monetary authorities were able to keep the actual gold price fixed at the precise level they specified, and conversely, that the purchasing power of the dollar remained constant. This was not the case, as the market price for gold often differed from the official $35 price, sometimes quite significantly, and the dollar actually lost value against most goods, even though it was officially fixed versus gold.
When doing research for a gold chart project of my own, I spent several weeks nosing through old papers and magazines for market data from the era of $35 gold. I hope to bring back into public memory the divergence of gold’s market price from the official price, a data set that has been forgotten.
Our chart begins in 1954 with the reopening of the London gold market, which, prior to being closed at the outbreak of World War II, had been the world’s largest venue for trading the metal. Through the 1950s the London price fluctuated between $34.85 and $35.17. These upper and lower limits were set by arbitrage and the threat thereof. Foreign central banks, as stipulated in Bretton Woods, could go to the Federal Reserve in New York and convert their dollars into gold or gold into dollars at $35 plus 8.75¢ commission. The cost of shipping and insuring gold from New York to London and vice versa was 8¢ to 10¢ per ounce.
Thus, when the London price traded down to $34.82 or so, it made sense for central banks to buy gold in London, ship it to New York for 8¢, then sell it to the US Treasury at the $35 official price less 8.75¢ commission, earning arbitrage profits of around 1¢ an ounce. Conversely when gold rose to $35.18 in London, it made sense to buy gold from the US Treasury at $35.0875, ship it to London for 8¢, sell it at $35.18, and earn arbitrage profits of 1¢.
Gold spikes in 1954, 1958 and 1960–during the first three American recessions after the the end of the Korean War. Coincidence, or were all three related to the gold standard?
This leads to a follow-up question: gold wasn’t revalued in the 1950s or 1960s…
|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)
…and by inflation indications the deflation ratchet did not recur after the completion of the Korean demobilization…
…so what was different about the Cold War gold standard?