What Caused The Great Depression?

After World War I, the US hoarded gold to bolster its own domestic economy. The US held 27% of the world’s supply of gold in 1913 and increased their holdings to 38% of gold supplies by 1931. Reasons for the accumulation of gold stock include conservative Fed policies (money and price levels remained unchanged from 1925 to 1929) and restrictive protective tariffs such as the 1930 Smoot-Hawley Act. During World War I, the European nations went off the gold standard to allow for deficit spending and saved their gold for the purchase wartime materials from America.

From 1914 to 1924, the US dollar was the only currency convertible in gold. In 1924, Germany went back to gold to stop hyperinflation, and England and France soon followed. These four nations created excessive demand for gold and started the deflationary process that evolved into the Great Depression. By 1931, France and America owned 60% of world gold supplies.

During this time, Britain could not maintain its balance of payments as their gold drains worsened, and by September 1931 the Bank of England could no longer maintain the convertibility of the Pound. Britain went off gold in 1931. After Britain abandoned the Gold Standard, speculation that America would get off gold led to massive foreign withdrawals from US Banks and a rapid outflow of gold. In the six weeks ending in October 28, 1931, the gold stock of the US decreased by 15%.

In an effort to combat gold outflows, the Fed raised its discount and acceptance buying rates to attract foreign capital inflows. Because of the Fed’s lack of gold reserves (they were required to maintain gold reserves equal to 40% their notes or reserves of either gold or “eligible paper”), the Fed’s failure to offset the gold and currency outflows suffered by the banks accelerated the process of money contraction. By 1933, gold and currency outflows forced Franklin D. Roosevelt to declare a Bank Holiday to suspend gold shipments. France abandoned gold in 1936.

Interestingly, in 1930 and 1931 the Fed opted to preserve their commitment to the Gold Standard over the expedient short-term benefits of suspending reserve requirements to infuse cash into the economy. These Fed members were “liquidationists” who believed that depressions and corrections were healthy for the “long term vitality of capitalistic markets.”

The inflows of gold to America from 1914 to 1929 created the credit bubble now called the Roaring Twenties. Foreign capital inflows have the same “easy money” effect that occurs when the Fed purchases securities. Bank lending averaged 16% annual growth from 1916 to 1920. As a result of the hyperinflation of asset prices caused by gold inflows, the credit bubble exploded, caused massive bank failures across the US, and started the Great Depression.

By: Zempower

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