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The First Crash: Lessons from the South Sea Bubble

Author(s):Dale, Richard
Reviewer(s):Neal, Larry

Published by EH.NET (March 2005)

Richard Dale, The First Crash: Lessons from the South Sea Bubble. Princeton: Princeton University Press, 2004. ix + 198 pp. $29.95 (cloth), ISBN: 0-691-11971-6.

Reviewed for EH.NET by Larry Neal, Department of Economics, University of Illinois at Urbana-Champaign.

Many of us are still licking our wounds from the collapse of the “ bubble” in March 2000. The NASDAQ index, weighted by the market capitalization of all the stocks it lists, soared from a low of 333 in October 1990 to 5,048 on March 10, 2000. The electronic trading system added hundreds of new technology companies purporting to reap network economies from “new new” applications of information technology on the world-wide web and all of them tried to expand their public equity at the behest of their venture capital backers. By the end of 2000, however, the NASDAQ had lost half its value and continued to lose another half before reaching bottom in October 2002.[1] This was the latest financial crash, but it was just one of many other that have occurred since the existence of organized secondary markets in financial assets. After each crash, one can be sure that references will crop up to the South Sea Bubble of 1720, the granddaddy of them all. The explicit sub-text of these works is always, “People often act like damn fools;” or, more soberly, we are all subject to occasional bouts of irrational exuberance. The implicit sub-text, often made explicit, is that stock markets should be regulated closely and access to them limited, mainly to protect people from the consequences of these recurrent bouts of mass madness.

It is not surprising then that Richard Dale, Professor Emeritus of Finance at Southampton University, should take advantage of the opportunity to repeat this oft-repeated lesson of history and make explicit comparisons between the original stock market crash and the most recent one. What he contributes is an effort to validate the approach of behavioral finance as applied to the events of 1720, as well as to the more recent crash. Moreover, he argues that sound financial analysis of fundamentals was available and widely disseminated even in 1720, but that it was ignored by the masses who flocked to their fleecing at the behest of the charlatans in control of the South Sea Company. Throughout, he draws analogies with the analysis of the companies and the frauds perpetrated by the directors of Enron and WorldCom in the recent NASDAQ crash. As icing on the cake, he takes to task previous historians of the South Sea Bubble (including this reviewer) for overlooking the work of a sound financial analyst who disseminated his results publicly at the time, but to no avail against the forces of irrational herd-like behavior. Finally, he uses quantitative evidence also overlooked by previous historians on the erratic pricing of subscriptions to the new issues of South Sea stock issued at various times and various prices during the course of the South Sea Bubble, which he takes as direct evidence of market irrationality.

Dale builds his argument first by setting the scene for irrational exuberance in the coffee houses of London (chapter 1). There, subject to the intoxicating fumes of the exotic bean, people regularly lost their senses and fell prey to constant streams of misinformation produced by an untrammeled and unregulated press. In these coffee houses and the narrow confines of Exchange Alley abutting the Royal Exchange, where legitimate and regulated trade was carried on, a free-wheeling, unregulated stock market arose (chapter 2). It quickly was dominated by a few manipulative entrepreneurs, as aptly described by Daniel Defoe in his Anatomy of Exchange-Alley. Among them were the projectors of the South Sea Company, created in 1711 to help the government refinance much of the huge debt it had incurred over the course of the War of the Spanish Succession (1702-1713) (chapter 3). No recapitulation of the South Sea Bubble is complete without reference to the comparable scheme begun earlier in France by the expatriate Scot, John Law. Chapter 4 briefly describes the innovations in marketing expanded issues of capital stock that, according to Dale, imitated earlier South Sea innovations — installment payments on new shares, options, and interventions by Law to first run up the price of Mississippi stock and then to stabilize it. The crowd spirit incited by Law’s machinations then spilled back across the Channel to whip Londoners into comparable frenzies. Chapter 5 takes us back to the South Sea Bubble proper and lays out the mechanics of the scheme, while introducing us to Archibald Hutcheson, the one voice of reason who explained, again and again, in the clearest terms possible, why the scheme was fated to fail. Dale notes explicitly that many of the flaws in the scheme were repeated once again in the bubble of the 1990s.

The South Sea bubble, nevertheless, unfolded quickly after Parliament approved it in February 1720 and the sheer momentum of the crowd’s frenzy kept it going well into July 1720. On the timing of the bubble, Dale takes sharp issue with previous analysts of the bubble who claimed that the peak occurred just before the Company closed its books in early June to prepare the summer dividends. He dismisses explicitly my argument that a severe payments crisis had hit the European economy at this time, even though he describes the currency manipulations of John Law that caused the payments crisis in his chapter on Law. Apparently, he believes that only animal spirits flowed across the Channel then, not actual means of payment.

Dale’s focus on frenzy rather than finance at this time is consistent with that of Archibald Hutcheson as well. Hutcheson was the very archetype of the mercantilist “little Englander” later derided by the Scotsman, Adam Smith. Hutcheson’s main policy recommendation was to create perpetual annuities that were obligations of the state that could be held permanently by the British citizens. One great advantage would be that foreigners would have no claims against the state, which was proving increasingly to be the case with Dutch investors and even Scottish investors who came into London in the train of William III after the Glorious Revolution of 1689. Naturally, Hutcheson’s overall goals were anathema to the Scottish supporters of the Hanoverians, and not welcome to the directors of the Bank of England and the East India Company with their strong ties to the Dutch. As early as March 1720, Hutcheson sounded the alarm against the scheme of the South Sea directors with fiery rhetoric that they threatened the very bases of English liberties and urged his fellow Parliamentarians to take preventive action against the Company so that “our Weekly Bills of Mortality may not be filled with large Articles of unhappy People, who have hang’d, drown’d or shot themselves”! (Hutcheson, p. 8, from his March 1720 pamphlet.) It may be that Hutcheson’s analysis of the frailty of the scheme was ignored not so much due to the frenzy of his audience but more because of the excesses of his rhetoric. From the beginning of his many pamphlets on the public debt, Hutcheson made it clear that he desired nothing else than a complete repayment of the national debt, including that held by the Bank of England, the East India Company, and the South Sea Company. This implied, of course, ending those companies when their current charters expired. No wonder his counsel held little charm for the thousands of shareholders in said companies!

In his “Bubble” chapter, Dale also gives the main quantitative evidence for irrational behavior lasting through the summer of 1720. These are the highest weekly prices of the three South Sea subscriptions that had been issued by mid-June. These peak at various times but well into July, implying according to Dale that the frenzy had not yet abated. He dismisses my argument that the bubble had already been pierced with a contraction of liquidity in the mercantile payments system in early June by asserting that interest rates remained remarkably stable throughout 1720, basically close to 5 percent annually. (Usury limits of 5 percent set the maximum interest rate legally offered by any company at this time.) Dale offers proof in the East India Company’s 5 percent bonds, whose prices remained fairly stable until the last quarter of 1720 (after the Sword Blade Company, which provided banking services for the South Sea Company, had failed). These India bonds were short-term bills with expiry dates of less than a year, with rollovers occurring quarterly. As they would be redeemed at par within a year, their price could not rise above par unless they were especially useful as means of payment; and if they did fall below par it could only be because the company issuing them was suspected of not being capable of redeeming all the bills as they expired. Thomas Mortimer in his classic guide to the eighteenth century stock market, Every Man His Own Broker, tells us that sellers made out the terms of sale for the India bonds, asking the par value plus the accumulated interest and then adding the market premium or discount on the basis of a ?100 bond. This premium averaged around 2 pounds through August, when increasing concerns that the troubles of the South Sea Company might spread to the East India Company drove their bonds to ever larger discounts, reaching 6 pounds at the depths of the crash. South Sea short-term bonds were even more deeply discounted by then. As Dale notes, there was no fiat money in England, unlike the situation then being attempted in France. Neither the Bank of England, the East India Company, nor the South Sea Company could create means of payment. The best they could do was to recycle idle balances more rapidly, which they had all begun to do in May 1720. This meant that the supply of India bonds could not be expanded at will to meet scrambles for liquidity. Their prices were tightly constrained by the short term of their existence and therefore the implied interest rates also tightly confined.

Goldsmith bankers and merchant bankers operating in the City of London at the time found that short term credit was very tight in the summer of 1720, which proved to be the case throughout mercantile Europe. George Middleton, John Law’s banker in London, reported that money could only be had for 50 percent per month in June 1720, which coincidentally was when the effects of Law’s fiat devaluations and revaluations at the end of May were disrupting the mercantile payments throughout Europe (Neal, 1994). Also coincidentally, that was the forward premium I calculated from the forward prices of the South Sea stock when the transfer books were closed in June (Neal, 1990). Dale regards that figure as unrealistically high, but one of the most knowledgeable and active goldsmith bankers operating in London at the time reported that it was the case. Even earlier in 1720, Archibald Hutcheson noted that borrowers had to pay very high interest rates at the outset of the bubble. (Hutcheson, April 1720, p. 25, refers to “the borrowing of Money, at the rate of 10l. per Cent. Per Mensem; and even at 20 s. per Cent. Per Diem?”)

The issue of the appropriate interest rate comes into play again in Dale’s final chapter, “Lessons from the South Sea Bubble.” There, Dale argues that each subscription issued by the South Sea Company on an installment basis should, rationally, have been priced at the current price of a fully paid up share. To calculate this, one should take the amount already paid in and then add the discounted present value of the future calls on the subscription. Dale does this with a discount rate of 5 percent (which I argue is far too low for the customers buying the subscriptions) and finds what he regards as two anomalies. First, the calculated values of the subscriptions are consistently higher than the current price of the fully paid up shares of South Sea stock; and second, the various subscriptions, especially the third subscription, vary erratically relative to each other. The two findings together lead him to conclude that the market for South Sea stock was increasingly irrational from June 1720 to the end of 1720, by which time the entire scheme had collapsed, the King was recalled from Hanover, and Parliament, with the ever-helpful Archibald Hutcheson playing a leading role, was investigating the entire affair. The affair was wound up, as Dale describes in chapter 7, with a complete re-organization of the Company, the Directors removed and penalized with loss of the bulk of their estates judged to be ill-gotten, part of the Company’s stock was engrafted onto the capital of the Bank of England, and the remaining stock divided into half.

It was clear to investors at the time, however, as it would be for investors in the London capital market for centuries after, that the subscriptions had a greater value than the current full shares for two reasons. One reason, elaborated in chapter 4 of Thomas Mortimer’s handbook was that they enabled speculators in the stock to leverage their investments, gaining the rise in the price of the full share on a partially paid up subscription for a new share. A second reason, certainly understood by the infamous stockjobbers crowding the coffee houses of Exchange Alley, was the option value of defaulting on future installments in case the stock began to lose value in the market. Share warrants, as they were later named formally, always priced higher than the regular shares. Finally, if the option value varied among the three subscriptions, and they certainly did as the value of defaulting on future installments rose sharply with the Third Subscription, we should expect differences in the prices of the subscription shares to emerge, and more so as the regular stock began its precipitous decline in August 1720.

So, what are the lessons to be learned? A previous writer has suggested that the entire affair “appears to be a tale less about the perpetual folly of mankind and more about the continual difficulties of the adjustments of financial markets to an array of innovations.” After reading Dale’s efforts to revivify the tenets of behavioral finance to comprehend the significance of the South Sea bubble, I confess that statement seemed so reasonable an assessment that I wish I had made it. Checking Dale’s footnote, I was gratified to find that I had (Neal, 1990, p. 90)!

Note: 1. Later financial historians will wonder, as did most financial journalists and academic observers in the late 1990s, why it didn’t collapse earlier, and in October 1997, 1998, or 1999 rather than March 2000. Possible answers might be in the extraordinary steps taken by the U.S. monetary authority to expand liquidity after the Asian crises in 1997, the Russian bankruptcy in 1998, and the “Y2000″ fear in late 1999.


Daniel Defoe (1719), Anatomy of Exchange Alley, London: E. Smith.

Archibald Hutcheson (1721), A Collection of Treatises Relating to the National Debts & Funds, London.

Thomas Mortimer (1765), Everyman His Own Broker, sixth edition, London.

Larry Neal (1990), The Rise of Financial Capitalism: International Capital Markets in the Age of Reason, Cambridge: Cambridge University Press.

Larry Neal (1994) “‘For God’s Sake, Remitt Me': The Adventures of John Law’s Goldsmith-Banker in London, 1712-1729,” Business and Economic History, 23:2, pp. 27-60.

Larry Neal is past president of the Economic History Association and the Business History Conference and former editor of Explorations in Economic History.

Subject(s):Financial Markets, Financial Institutions, and Monetary History
Geographic Area(s):Europe
Time Period(s):18th Century

Evolving Financial Markets and International Capital Flows: Britain, the Americas, and Australia, 1865-1914

Author(s):Davis, Lance E.
Gallman, Robert E.
Reviewer(s):Taylor, Alan M.

Published by EH.NET (May 2002)

Lance E. Davis and Robert E. Gallman, Evolving Financial Markets and

International Capital Flows: Britain, the Americas, and Australia,

1865-1914. Cambridge: Cambridge University Press, 2001. vii + 986 pp.

$100.00 (cloth), ISBN: 0-521-55352-0.

Reviewed for EH.NET by Alan M. Taylor, Department of Economics, University of

California, Davis.

Lance Davis and the late Robert Gallman have produced a monumental book. The

authors’ aim is to understand financial markets in five countries in the late

nineteenth century, their evolution, and their interaction with the growth of

global financial markets. Why should we care? With a new era of globalization

now upon us the potential for an instructive history lesson is clear.

The authors make the locus for their study the world capital market in the

1865-1914 era and its major players. For their sample they select the one major

capital exporter, Britain, and four major capital importing countries, the four

settler economies of the United States, Canada, Australia and Argentina. The

book proceeds from an introductory chapter, laying out the major hypotheses to

a study of each country in turn, in the order noted. Some closing chapters sum

up and ponder the lessons.

Knowing the lifetime achievements of the two distinguished authors will permit

some potential readers to guess, if not the entire story, at least some of the

tools and approaches employed. Work on the United Kingdom’s capital exports

naturally draws on Davis’s prior work with Huttenback, and their databases of

capital called and securities performance in London prior to 1914, supplemented

by national income and growth data and married to a dense coverage of the

country’s financial history. On the United States, national income and growth

rest on Gallman’s seminal contributions in that field, meshing with Davis’s own

landmark works on financial development. The other settler economies represent

more of a “frontier” for the authors too, but an encyclopedic coverage of each,

born of deep digging in the primary data sources and a comprehensive sweep of

the secondary literature, leaves the reader convinced that the authors, far

from speculatively squatting in such an historical outback, have staked out a

firm claim on the relevant scholarly territory.

The central thesis, again perhaps no surprise, is that although capital

accumulation matters for economic growth (a widely held, if not uncontested,

claim, in light of the “A versus k” debate), such a process does not occur in a

vacuum. Specifically, one needs to understand the transaction costs associated

with capital mobilization to understand the process fully, for the capital

market is unlike the market for goods, and is beset by unique problems (moral

hazard, adverse selection, risk, uncertainty, asymmetric and imperfect

information, time inconsistency) whose solution depends on the design of

particular mechanisms. And, of course, those mechanisms are embedded in an

institutional structure: the financial sector itself. Thus the book largely

sidesteps questions of saving supply and investment demand, to focus on the

financial frictions that exist in systems of intermediation. Nonetheless, some

attention to supply and demand fundamentals is necessary for correct inference

from quantity and price data, so the authors have to keep that set of tools on

one side, but always at the ready. This is a big set of tasks.

Financial evolution and growth can be understood at one level by a cliometric

study of stocks, banks, deposits, leverage, financial ratios, returns, and so

on; but the Davis-Gallman thesis is that such a picture would be incomplete

without an understanding of how the system is shaped by shocks that are

exogenous (for example, wars and globalization, to pick the big ones) and

shocks that are endogenous (crises, government policy, learning, market power,

network externalities, or other sources of lock-in that might generate a “path

dependent” outcome). Hence, the book aspires to that modern marriage which

marks the very best of scholarship in economic history today. On the one hand

it is a book of quantitative rigor that seeks to document changing financial

markets. On the other hand it is a book of modern-day institutional economic

history explaining how the market outcomes shape, and are shaped by, the

broader political economy setting. Or maybe it is two books.

We can spell out in more detail the methodological structures employed in the

book. The chapters on each country proceed in a similar fashion, almost

following a template. Whilst some might see this as mechanical, it is to be

applauded as it clearly facilitates the comparative analysis for which the

authors are striving. Typically, discussion begins with a broad overview of the

economic history of the country in question, often going back decades or even

centuries, to spell out the major developments at the macroeconomic level and

the micro-level changes in the financial sector. The formal quantitative

analysis of the macroeconomy then follows, to motivate a study of the ups and

downs of the financial sector in light of growth and fluctuations in the

broader economy. The quantitative and descriptive guns then turn on the

financial sector for the rest of the chapter, seeking to document its size,

growth, performance and external linkages, and to explain the rise and fall of

the whole sector and its constituent parts, such as banks, primary and

secondary securities markets, nonbank financial intermediaries (building

societies, insurance companies) and so on. As that story unfolds, the reader is

gradually weaned off the early barrage of tables containing the data and the

hard-sought documentary evidence is gradually piled up. The approach is

balanced. It isn’t heavily “cliometric,” since the quantitative base is heavy,

but not dominant, and the methods are certainly not econometrically high-tech.

But it is not exactly an “analytic narrative” either, since formal theory is

eschewed. With its textual layers filled by a dense flow of historiographic

information the style is, perhaps, more like economic history as “thick


And at 986 pages, the description is thick indeed. The sheer size of the book

poses problems for the reader (as it no doubt did for the author and the

press). The reader has to try to keep all the balls in the air at once. The

mobilization hypothesis, though rather intractable, needs to be always in the

back of the mind. In addition, when moving between the chapters it is tricky to

keep all of the relevant quantitative detail at hand so as to make the relevant

comparisons. And even within a chapter, the connection between the early

quantitative results and the later narrative needs keen attention. In some

sense, such problems are simply the occupational hazard of anyone engaged in so

vast an enterprise, but one is always desirous of devices that can ease the

management of the tasks at hand. Sometimes, for example, very useful comparison

tables appear that link data across all the countries. (The best of these is

Table 7:3-1, which lays out major differences in the environment in each

country; it is a shame that we have to wait until p. 778 for this nugget).

Sometimes, the national narratives make connections with one another. Still,

the reader will need some reserves of energy to make it to the last page and

still have everything in order.

Overall, what is the bottom line? Invoking North (p. 753) as they start to tell

the lessons from the past, the authors quote as a dictum that “the economies of

scope, complementarities, and network externalities of an institutional matrix

make institutional change overwhelmingly incremental and path dependent” and

that since ” the static structure of economic theory ill fits us to understand

that process we need to construct a theoretical framework that models economic

change.” The authors do not claim to supply such a framework for the episode

they study (nor does anyone else, yet) but their aim is to develop a

“taxonomy,” which they think is an important first step towards developing a

theory. For this review, a sample of events in each country can illustrate the

various taxonomic forms on display, revealing the links these authors make to

other parts of the literature whilst pursuing their own unique comparative


Learning matters. In the United Kingdom, financial history is linked back to

early modern times, and the notion of “educating” the British saver is

discussed, that is, how agents learned that pieces of paper can represent real

wealth, and how the risk associated with such instruments can be evaluated,

managed, and diversified, and this despite periodic hiccups such as the South

Sea Bubble. As the Industrial Revolution happened first in England, the need

for “impersonal” capital in such ventures as the early railroads again widened

the market.

Wars matter. As Britain refined its strong fiscal state to develop and maintain

military strength in the seventeenth and eighteenth centuries, the flotation of

public debt set the foundation for future financial markets. Similarly,

Hamilton’s innovations in the United States set the stage for a later period of

“saver education” there in the nineteenth century.

Broad political choices matter. In countries like Australia, where government

managed much more of the economy (significantly, railroads) there was less need

to float private capital issues, so such markets remained thin.

The external environment matters. Even Australian public issues could be

largely floated in Britain, again denting the need to develop domestic markets,

and a similar story can be told of Argentina, which, of all the countries,

satisfied the largest share of capital formation (about two thirds) via import.

Banking regulation matters. In Canada, banks could not take demand deposits and

lend long. This, and branching, kept banks safer, but left a niche in the

market unfilled. The unique Canadian bond house sprang up to fill it. In the

U.S. branching was not permitted, so the market for commercial paper expanded

to fill the niche left by the inability of banks to intermediate between

surplus and deficit regions.

A major crash matters. Events in 1890 in Australia scarred the financial system

for over a decade and the economy sat in slump. Savers who were burned were

nervous of putting their money in the bank (or in any private enterprise) and

private financial development was slowed.

(On the impact of a crash, I would read Argentine financial history after the

Baring Crash in the same way, only as more disastrous; but the authors put a

slightly more positive spin on the Argentine case. Yet the major banks were

wiped out or suspended there, the major national bank was the only source of

growth in the system, large swathes of the pampas were no longer served after

the provincial bank collapsed and closed all its rural branches, and external

capital flows were turned off for a decade. Under the circumstances the

Argentine recovery in the late 1890s was remarkable, but it took place despite,

rather than because of, the resilience of the financial system.)

On the other hand, some institutions receive little attention, though maybe

they also mattered. For example, the settler economies had high shares of

activity in agriculture, and in many cases land was sharecropped, usually

fifty-fifty. This clearly changed investment incentives for each party, and

hence the derived demand for intermediation. Even in the Argentine case, where

the literature has argued that such problems were potentially severe, we are

still poorly placed to know how much they mattered.

It is fair to say that the book’s taxonomy is very complete. Is it too

complete? Or rather, could it be faulted for not discriminating enough among

the different shocks that are said to matter? And what does “matter” mean? This

is nothing more than the old “how big is big?” problem.

One is not necessarily, or only, asking here for a hypothesis test, for by just

listening to the siren songs of statistical significance we will surely run our

ship onto the rocks — as we are occasionally reminded. The question is really

quantitative significance, and the “big” threshold is then potentially more

subjective (personally, my rule of thumb is 15 percent; just don’t ask me why).

To take an example from the book, the very attentive reader, arriving at p.

691, will note that the Argentine insurance industry was not a “major player”

and didn’t contribute in a significant way to capital formation or the

financial markets; a key empirical fact here is that the sector “only” held 1.5

percent or less of Argentine tangible wealth. As our extremely attentive reader

will recall, this is in contrast to the British case discussed four to five

hundred pages earlier, where the insurance firms were “major players” in the

formal securities markets (p. 150); in the British case, insurance sector

assets (503 million pounds, p. 142) were about 5 percent of total British

tangible wealth (11,750 million pounds, p. 63). Now, some of the difference (5

versus 1.5) is no surprise, since financially backward Argentina’s ratio of

financial assets to GNP was about half that of Britain (even without a list of

tables, our clairvoyant reader has just sprinted forward to check Goldsmith’s

ratios on p. 770). So the ratio of insurance assets to total financial assets

in the two countries differs even less. Implicitly, in between the two ratios,

the authors have in mind a threshold for this sector to be a “major player”;

but they do not tell us what that threshold is and why it takes that value. Of

course, this is a contrived example. And it is a little unfair; as the authors’

surrounding discussion makes clear, size matters, but so does much else, such

as sectoral innovation and activity in certain markets. But I think those

caveats do not make the problem go away, they only complicate it further, and

it is an issue that hovers just under the surface throughout the book.

We strive to keep our theories parsimonious, and careful empirical work remains

our principal bulwark against kitchen-sink models. The taxonomy proposed by

Davis and Gallman leads to many hypotheses, some testable, and the empirical

challenge of substantiating these will likely keep future generations of

cliometricians quite busy. There are many hypotheses on offer in the book, and

all are plausible, and probably mattered to some degree. Although there is a

wealth of data, the book finds little space for formal empirical testing,

having much else to keep the reader occupied.

Still, there are some intriguing pieces of evidence here and there. The finding

that capital calls in the four settler economies are largely uncorrelated at an

annual frequency (p. 35) makes a powerful case for the idea that

(country-specific) investment demand shocks on the periphery were dominant, and

(common, British) savings supply shocks were unimportant in driving the

cyclical flow of capital overseas, though one might wish for a more

comprehensive model of trends and cycles in capital exports based on

“fundamentals.” The finding that risk and return were correlated for overseas

securities in the London market fits the prescriptions of finance theory, but

the data are there to test a full-blown international CAPM model, and we could

learn much from that kind of empirical exercise (p. 219 et seq.).

Future researchers have been set many challenges by this book, and they will

have plenty of hypotheses to attack. Undoubtedly they will be assisted by the

public release of the underlying data from this book. Some data originate in

the earlier Davis-Huttenback study, such as the London securities prices,

balance sheets, profit and loss data, and the capital call data. It is highly

desirable that future scholars have access via the web to a readable version of

these and other data, to sustain work on this topic. I encourage Lance Davis in

his ongoing efforts to get the timeworn tapes decoded and uploaded in a modern

workable form.

Style matters. In a book of this size, efficient design is paramount to keep

things manageable. Some technical problems do crop up, where the authors,

copyeditors, typesetters, and editors might have made different choices. The

citation style is cumbersome, and a move to author-date might have been

economical. There is no list of tables and figures. Given that the book is, in

places, just a wall of tables and figures, this may be understandable, but it

makes navigation difficult. Even the table placement is hard on the reader —

in the U.K. chapter there are sections of uninterrupted tables running twelve

pages (even, once, twenty pages) in a row, and these are not the only cases of

information overload. Perhaps the strategic use of appendices or a different

layout could have helped maintain the flow. The book really needed one more

spell check. Still, one cannot complain too much — the mere fact that a press

was willing to run a 986-page academic book should be cause for some rejoicing

in these days of hard-nosed publishing, notwithstanding the generous subsidy of

this series by the Sanwa Bank.

Moving from style to substance, the one thing I would have added to the overall

comparative study is more discussion of the role of the gold standard, a

critical macro-institution that is almost sidelined in the discussion of the

micro-financial nexus. As recent research has conclusively shown, the gold

standard (at least pre-1914) had important implications for country risk, the

spread between local government bond yields and London consol yields. It

therefore deeply affected countries’ access to the London market. Going on or

off the gold standard was a major regime change, and the constraints on

monetary policy so implied had even deeper implications for how financial

markets, especially banks, could operate. On the periphery, to take Argentina

as an example (and the lesson is still obviously relevant today), it is clear

that you cannot have a credible gold standard commitment and have

lender-of-last-resort options. The precise choice of monetary policy, note

issue laws, bank regulation, and so on, all interact with this larger regime

choice. It is impossible to understand the larger money-banking story without

that key ingredient, and policy makers and private agents obviously had this

variable in their sights.

It again seems like carping, however, to point out omissions in a book of

roughly one thousand pages, and the strengths should be recognized. The

chapters on the United Kingdom and United States offer very fine treatments of

their subjects, as one would expect, and could almost stand as books in their

own right. In the other chapters, especially a short one on Argentina (“only”

eighty pages), the material is well organized even if the interpretations are

more hedged and depend more on secondary literature. Yet the point of such a

comparative study is surely that the whole be greater than the sum of the

parts, and in this respect the book succeeds. The volume embodies the vast

human capital accumulation of its authors — and that capital, now mobilized

(at some cost) for our benefit, will be a reference for years to come.

Alan M. Taylor writes on economic history and international economics. He has

a special interest in Argentina. His recent works include Straining at the

Anchor: The Argentine Currency Board and the Search for Macroeconomic

Stability, 1880-1935 with Gerardo della Paolera (University of Chicago

Press, 2001); “A Century of Missing Trade?” (with Antoni Estevadeordal)

American Economic Review, 2002; “A Century of Purchasing Power Parity,”

Review of Economics and Statistics, 2002; and “Globalization and Capital

Markets” (with Maurice Obstfeld), in Globalization in Historical

Perspective, edited by Michael D. Bordo, Alan M. Taylor, and Jeffrey G.

Williamson (University of Chicago Press, forthcoming).

Subject(s):International and Domestic Trade and Relations
Geographic Area(s):General, International, or Comparative
Time Period(s):20th Century: Pre WWII

Rainbow’s End: The Crash of 1929

Author(s):Klein, Maury
Reviewer(s):Zevin, Robert

Published by EH.NET (February 2002)

Maury Klein, Rainbow’s End: The Crash of 1929. New York: Oxford

University Press, 2001. xx + 345 pp. $27.50 (cloth), ISBN: 0-19-513516-4.

Reviewed for EH.Net by Robert Zevin, Robert Brooke Zevin Associates,

Newburyport, MA.

In this, his twelfth book, Maury Klein, a professor of history at the

University of Rhode Island, has a lot to tell his readers about the 1920’s, the

Great Crash and its immediate aftermath. However the purpose and meaning of all

his tales is problematic. His narratives are cut and switched to a new topic

every one to four pages. Sometimes a truncated narrative is resumed later.

Sometimes not. One individual is usually the focus of each segment. These range

from Herbert Hoover and Benjamin Strong to Groucho Marx and an individual

victim of Wall Street rapaciousness whose story appears in the congressional

investigations after the Crash. Klein tells his readers about the illnesses and

disasters that afflict these people, about their feelings and about their

financial gains and losses.

However, if there is a moral to these tales or an insight into the booming

1920’s and the Great Crash, it is not explicit. Stories, facts and occasional

quantities are poured out in an undifferentiated continuum. Klein hardly pauses

to provide reasons, consequences or delineations.

After looking diligently, it may be that the clustering of tales in the first

half of Rainbow’s End is intended to suggest that the euphoria of the

1920’s was not merely associated with the economy, new technologies, new

products and the stock market. Klein suggests that euphoria was endemic to

sports, religious revivalism and every other aspect of culture and society.

(Poor farmers, the unemployed and people of color basically don’t appear in

this book.) However, if this is intended to be his opening theme, Klein remains

mute on why this transformation happened when it did or indeed why it happened

at all.

Several additional themes can be attributed to the second half of the book.

First is the familiar tale of a deadlocked Federal Reserve failing to act in

any helpful way. Klein returns to this story repeatedly, using contemporary

newspaper accounts and secondary sources as he does throughout the book.

Although Milton Friedman and Anna Jacobson Schwartz (A Monetary History of

the United States, 1867-1960, Princeton University Press, 1963) appear in

the bibliography, their masterful description of this deadlock is never

referenced by Klein. The reasons for the deadlock and the viability of various

possible actions are never discussed.

A second implicit theme can be deduced from Klein’s frequent recitations of the

magnitude of outstanding broker loans and the interest rate on overnight call

loans. The increases in these two measures are precisely the thing that Klein

implies the Federal Reserve might have done something about. And along with the

increase in the volume of stock market transactions, they also could be

indicators of a less widely familiar and accepted argument that the stock

market required increasing transactions balances and broker’s loans to the

detriment of other uses for money and credit.

Yet another recurrent theme in the tales Klein chooses to tell is the idea the

bull market was characterized from beginning to end by the systemic virtual

theft of money from the investing public by brokers, insiders, pool operators

and various people at the top. Each individual story is apparently true. It is

also true, as John Kenneth Galbraith (The Great Crash, 1929, Boston,

Houghton Mifflin, 1955) has observed, that the chicanery that lives under the

rocks of financial markets is typically exposed in the aftermath of the crash.

Of course, since none of these themes is explicitly stated, none is

convincingly established. More generally economic reasoning and quantitative

data about the economy and the stock market are astonishingly scarce and often

flawed. Only two places in the entire book present stock market data in tabular

form. A pair of tables (pp 96-97) purports to show data for the Dow Jones

Industrial and Rail Averages for 1920 through 1926. However most of the time

what are described as the high and low for these averages in one year fall

completely above or below the range for the same numbers in adjoining years.

And what are labeled the high and low values for these indices in January and

December also typically exceed the stated range for the year in both

directions. The other table (p. 183) attempts to illustrate the increasing

volatility of the market from 1920 through 1929. It shows volume — in shares

for the year although none of this is explicitly stated — and what is called

“Average Swing,” which, although again not explained, corresponds for the

earlier years to the difference between the mysteriously calculated high and

low prices of the earlier tables. Klein does not provide a clue whether the

increase in this number is due to increased price levels or truly increased


Nowhere is there a graph of stock price levels and trading volume over time.

Many pages in the closing chapters are consumed with a tedious account of the

market’s vicissitudes in 1928 and 1929, often on a day-by-day basis. Few

readers would be able to construct an overview of the market’s behavior from

this prosaic recital, which is occasionally enlivened with such meaningless

observations as “Once again, however, a small cluster of 10 to 15 stocks led

the charge” (p. 195).

Klein’s narrative style and focus on individuals might suggest using this book

as a supplement in an undergraduate course. In my view students would be better

entertained, better educated and better insulated from numerous errors by

reading abundant alternatives such as Galbraith’s The Great Crash.

Robert Zevin is president of Robert Brooke Zevin Associates, Investment

Advisors, Newburyport, MA and author of various articles in economic history

including “The Economics of Normalcy,” Journal of Economic History, Vol.

42, no. 1 (March 1982).

Subject(s):Macroeconomics and Fluctuations
Geographic Area(s):North America
Time Period(s):20th Century: Pre WWII

Western Capitalism in China: A History of the Shanghai Stock Exchange

Author(s):Thomas, W. A.
Reviewer(s):McElderry, Andrea

Published by EH.NET (December 2001)

W. A. Thomas, Western Capitalism in China: A History of the Shanghai Stock

Exchange. Aldershot: Ashgate, 2001. xii + 328 pp. $74.95 (hardback), ISBN:


Reviewed for EH.NET by Andrea McElderry, Department of History, University of


W. Arthur Thomas of the University of Liverpool has written a very

straightforward descriptive history of the securities market in Shanghai from

the late nineteenth century to the present. The study centers on securities

trading in Shanghai’s International Settlement where the listed securities

were almost exclusively those of foreign companies and organizations. Along

the way Thomas provides glimpses of life in the International Concession and

sketches of its foreign residents. In the final two chapters on Chinese stock

markets, Thomas gives a useful summary of the Chinese government bond market

until 1940, which was the main activity on the Chinese stock exchanges, and

of the ins and outs of today’s emerging markets in Shanghai and Shenzhen.

Thomas begins with a brief account of the development of foreign trade in

China and of the foreign community in Shanghai. Crucial to both was the

formation of the International Settlement in Shanghai as a result of the

Treaty of Nanking, 1842 (which ended the Opium War) and subsequent agreements

between Chinese and foreign governments. In the International Settlement,

foreign residents lived under the jurisdiction of their own courts and at

least some of them elected their own Municipal Council since “there were

strict property qualifications attached to the franchise” (p. 20). Western

banks and trading houses located in the Settlement and it quickly became a

“flourishing emporium.”

The bulk of the book is an account of securities trading centered in the

International Settlement. Thomas’s main source of information is the weekly

share list and related material published in the Settlement’s English-language

newspaper, the North China Herald. In spite of “an extensive search of

libraries and other depositories,” Thomas did not find any records of the

Shanghai Stock Exchange founded in 1904 or the earlier Shanghai Sharebrokers’

Association, formed in 1898. The first share list appeared in 1866 and by then

Shanghai’s International Settlement had developed the conditions conducive to

the emergence of a share market: several banks, a legal framework for

joint-stock companies, and an interest in diversification among the

established trading houses (although the trading houses themselves remained


The supply of securities came primarily from local companies. In the early

days, banks dominated private shares but, by 1880, only the Hong Kong and

Shanghai (the local bank, so to speak) remained. Shipping, insurance, and

docks persisted to 1940 but were overshadowed by industrial shares after the

Treaty of Shiminoseki, 1895, which permitted Japan, and by extension other

nations who had treaties with China, to establish factories in Shanghai and

other treaty ports. Rubber plantations became the staple of stock trading

beginning in the second decade of the twentieth century. Fixed securities

balanced the “risky” shares of local companies, both in terms of dividends and

capital value. Those of the Shanghai Municipal Council and local utilities,

such as the Shanghai Waterworks, enjoyed the most consistent favor.

Shanghai had no shortage of people who were willing to risk investing in local

companies. Thomas has gleaned information about the foreign investors from

reports of company meetings in the North China Herald. Individuals,

most connected in one way or another with Shanghai’s foreign trading

companies, provided the main “supply” of investors in the early days. From the

mid-1890s, with the expansion of commercial activity and the introduction of

manufacturing, “the securities of local companies became attractive trade

investments for the corporate sector” (p. 83). Information on Chinese

investors comes largely from Yen-p’ing Hao’s work on compradors and Chinese

business development in the late nineteenth century. (See, Yen-p’ing Hao,

Commercial Revolution in Nineteenth Century China: The Rise of Sino-Western

Mercantile Capitalism, University of California Press, 1986, and The

Comprador in Nineteenth Century China: Bridge between East and West,

Harvard University Press, 1970.)

What stands out in chapters 7 through 9 detailing the fluctuations of the

market is the importance of rubber. In 1909-10 investment and speculation in

rubber plantations in Southeast Asia “produced a transformation in the share

list” (p. 145). By autumn 1910, 47 rubber companies were listed on the

Shanghai exchange. Not surprisingly, the boom did not last. Thomas details the

rise and subsequent crash of rubber shares, the general outlines of which are

known to those familiar with Shanghai financial history. What is not so well

known is that rubber recovered and remained a staple of the market until the

Japanese occupation of International Settlement in December 1941 brought an

end to the Shanghai Stock Exchange. For example, “a sharp and unexpected rise

in the price of rubber produced a big increase in share business” (p. 199) in

1925 after a major strike among Chinese workers in Shanghai. Rubber prices

collapsed in early 1928 on the heels of a crisis connected to Chiang Kai-shek

consolidating control over the Chinese part of Shanghai. Perhaps, Thomas

suggests, the fall in rubber prices was responsible for the ensuing enthusiasm

for greyhound shares. Greyhound racing had arrived in Shanghai in 1928 and

the shares in companies who ran the sport were briefly “the focus of all

activity” (p. 203). However, when “the flirtation with ‘the dogs’ had ended

the market returned to its main dealing medium, rubber shares” (p. 203).

Thomas’s study is the first account of foreign stock trading in Shanghai and,

as such, will be useful to those who examine various aspects of finance and

business in Shanghai and China. The book is also an addition to literature on

the history of stock trading. It would benefit from an analytical framework

grounded either in Chinese economic history or in comparative stock market

history. The latter is more realistic since the author is clearly not a China

specialist but is quite conversant with stock markets.

The book has a sense of having been written and published in a hurry.

Footnoting is inconsistent. At times, even quotations have no citations.

Material from the Cambridge History of China, one of the main secondary

sources on China, is sometimes cited by author but mostly cited only by volume

and page. Also the book, or at least the copy I have, needs some serious

copy-editing, especially for romanized Chinese words. Understandably spell

check doesn’t recognize the Chinese words, but even Hong Kong comes out

variously as Kong Kong and Honk Kong. More serious, Chinese names of authors

cited are sometimes, but not always, misspelled. For example, the frequently

cited works of Yen-p’ing Hao are often footnoted as Hoa. Less serious is the

lack of a standardized romanization system such as on page 138 where spellings

of Kang Youwei and the Kuang-hsu emperor come from two different systems.

Admittedly, the romanization of Chinese is a slippery slope and thus its

inconsistency can be put down as a quibble from a Chinese specialist who will,

no doubt, use the book as a reference.

Andrea McElderry’s publications on Chinese business history include a study

of Chinese stock exchanges, “Shanghai Securities Exchanges: Past and Present”

(Occasional Paper Series in Asian Business History #4), Brisbane: Asian

Business History Centre, University of Queensland, 2001.

Subject(s):Financial Markets, Financial Institutions, and Monetary History
Geographic Area(s):Asia
Time Period(s):20th Century: Pre WWII

Opening America’s Market: U.S. Foreign Trade Policy Since 1776

Author(s):Eckes, Alfred E. Jr.
Reviewer(s):Khula, Bruce A.

Alfred E. Eckes, Jr. OPENING AMERICA’S MARKET: U.S. FOREIGN TRADE POLICY SINCE 1776. Chapel Hill: University of North Carolina Press, 1995. xi + 402 pp. Illustrations, tables, bibliography, and index. $34.95 (cloth); ISBN 0-8078-2213-2.

Reviewed by Bruce A. Khula, The Ohio State University, for H-BUSINESS November, 1995.

Historians of American business and foreign policy will benefit from a careful reading of Alfred E. Eckes’s newest book, OPENING AMERICA’S MARKET. As an historian at Ohio University and a former commissioner for the U.S. International Trade Commission, Eckes provides an insider’s knowledge coupled with the nuance and analysis that one expects of a seasoned historian. Although Eckes is clearly not the first to examine the economic dimensions of American foreign policy, his contribution nevertheless stands out. Much of the history written on American foreign economic policy has focused on the efforts of policymakers to open foreign markets for American goods. Eckes’s book is concerned instead with policymakers’ efforts to open the American market to foreign imports. The story Eckes tells is a fascinating one, and his conclusions necessitate a reexamination of America’s current obsession with the doctrine of free trade.

In OPENING AMERICA’S MARKET, Eckes has three principal arguments. First, he claims that American trade policy was explicitly and consciously protectionist from the early days of the Republic until the New Deal, when it underwent a dramatic shift toward free trade. Second, Eckes argues that before the New Deal, U.S. trade policy was designed to achieve domestic objectives but that, over the course of the 1930s, trade policy was ordered to fit the needs of American diplomacy. Eckes’s final, implicit argument is an observation and a warning that free trade may not be the only, or even the best, route to economic growth and national prosperity. As Eckes forcefully contends, a great deal of American economic growth came during years of high tariff barriers.

Eckes hopes his book will benefit policymakers as well as scholars. Having served on the International Trade Commission from 1981 to 1990, from 1982 to 1984 as chairman, Eckes laments the paucity of historical knowledge that American officials bring to trade negotiations. Policymakers and historians alike would do well to read this book. Eckes’s writing is smooth, his arguments are compelling, and the subject is both timely and important.

Eckes begins his analysis of American trade policy by examining its origins in the years following 1776. Early American leaders like Benjamin Franklin and Thomas Jefferson were strong proponents of free trade. Influenced by the writings of Adam Smith, these leaders believed that the peace and prosperity of the young nation depended on unrestricted access to foreign markets. If the United States was willing to offer reciprocal and open access to all nations, policymakers reasoned, American consumers would gain access to desired manufactured goods even as foreign consumers were enjoying American agricultural products. Accordingly, when the Tariff Act of 1789 was passed, it embraced universal nondiscrimination by utilizing a single-schedule tariff. Eckes notes that, although this act emphasized the American commitment to equality among nations, it also handicapped the president by depriving the executive branch of the ability to bargain during trade negotiations.

The initial free trade goals of Franklin and Jefferson fell into disrepute as the United States entered the nineteenth century. Alexander Hamilton had questioned them from the beginning. His “Report on Manufactures” was openly protectionist, endorsing a comprehensive system of tariffs and subsidies designed to enhance and protect American manufacturing. Hamilton took issue with Adam Smith’s free trade doctrine, claiming that it failed to promote the long-term interests of the nation. The strengths of Hamilton’s critique were underscored by the experiences of the War of 1812, which Eckes credits with generating “a major shift away from the idealistic policy of promoting equality and reciprocal access” (p. 18). Repeated European violations of American shipping demonstrated the economic vulnerability of the nation. Swelling nationalism provided figures like Henry Clay with a political foundation to promote a strong domestic manufacturing base. Clay’s “American System” consciously put the interests of the nation and its producers before the interests of its consumers. According to Eckes, Clay’s protectionism became the clear consensus of American policymakers until the Great Depression. They realized that free trade did not serve the interests of the young nation, and they were not afraid to erect high tariff barriers. After all, before the Civil War, American diplomats were not terribly concerned with winning access to foreign markets, and until the 1930s, “diplomacy remained an instrument of commerce” (p. 27).

In the years between the Civil War and the New Deal, the Republican Party emerged as the champion of protectionism. As pre-Civil War policymakers had, Republicans considered the short-term consumer gains promised by free trade less important than the long- term gains of increasing employment, industrial maturation, and economic diversification. Republicans dismissed State Department claims that reciprocity served American interests. If a nation lacked a consumption-oriented society, Republican politicians argued, offering that nation reciprocal access to the American market in no way secured the interests of the United States. Therefore, under Republican guidance, American trade policy established low tariffs on necessary raw materials but kept tariffs high on value-added manufactured goods.

According to Eckes, this selective tariff policy had several impressive results. It provided the national government with a steady and substantial source of revenue. In addition, American consumers were not seriously harmed by high tariff barriers; as a result of competition and the rise of big business, prices actually declined. Finally, contrary to the expectations of modern-day economists, economic growth was not retarded by protectionism but expanded during this period. Eckes asserts that his research uncovered “no significant negative relationship between high tariffs and real economic growth” (p. 55).

Clearly, the most contentious argument in this book is Eckes’s claim that the 1930 Smoot-Hawley Tariff was not the disaster that most historians consider it to have been. In a spirited attack on the conventional wisdom, Eckes attempts to prove that politicians and ideologues have “transformed a molehill into a mountain” (p. 139). Eckes dismisses claims that Smoot-Hawley raised tariffs to unprecedented levels. The highest rate on ad valorem goods applied to only about one-third of American imports, and even then it was actually lower than the rate of the 1828 “Tariff of Abominations.” Furthermore, Eckes argues that the impending tariffs of Smoot-Hawley had little to do with the 1929 Stock Market Crash, and he insists that the act was not as singularly damaging to world trade as critics suggest. Finally, Eckes demonstrates that few formal protests by foreign nations were filed against Smoot-Hawley: foreign retaliation was more mythical than real. Concluding his effort to revise the history of Smoot-Hawley, Eckes writes that Congress was looking out for American interests and in passing the tariff act was in fact acting “prudently” (p. 137)

The single most important individual in Eckes’s book is unquestionably Cordell Hull. Devoted to free trade, Hull took advantage of the Democratic Congress and used his influence as Secretary of State to engineer a “revolution in U.S. trade policy” (p. 98). Abandoning its 120-year old protectionist legacy, the United States embraced free trade. Under the auspices of the Reciprocal Trade Agreements Program (RTAP), the United States unilaterally slashed its high tariff barriers to encourage foreign nations to do the same. Hull promised to reverse the worsening pattern of global trade without injuring American producers. This “no-injury” pledge was to be policed by the State Department, which the RTAP empowered with negotiating authority. By minimizing congressional interference with tariff-making and packing the U.S. Tariff Commission with free traders, Hull advanced a series of policies that provided virtually unimpeded access to the American market for all nations. Eckes points out that U.S. officials had the power to enforce American commercial rights, but that they consciously avoided doing so. Not only did these steps fail to promote American exports, but they also demonstrated that trade policy had finally been subordinated to foreign policy. Hoping to promote peace and stability through international economic cooperation, American diplomats ignored domestic interests. The long-term negative consequences of such a policy were not immediately apparent, however, for the artificial economic environment of World War II kept both employment and production high.

As the Second World War came to a close, Hull’s vision received a new lease on life with the coming of the Cold War. Trade policy became a key component of containment. Once again subordinating domestic needs to foreign policy, American officials promoted free trade to reconstruct and integrate Western Europe while isolating the Soviet Union and its satellite states. As the Republican Party began to emerge from the political wilderness, its membership initially moved toward a traditional pro-tariff position. The Republicans were soon co-opted by President Harry Truman’s strident anti-communism, however, and they reluctantly accepted Hull’s trade revolution. One result of foreign policy preoccupation and Republican acquiescence was an emerging “pattern of tolerance for discrimination against American exports” (p. 164). Not only did the government encourage American companies to invest abroad, but it also used taxpayers’ dollars to promote importation of foreign manufactured goods. President Dwight Eisenhower contributed to the trade revolution by concluding an excessively-generous trade agreement with Japan in 1955, and his successors, presidents John Kennedy and Lyndon Johnson, made even more radical changes.

Focusing on the Kennedy Round of the General Agreements on Tariffs and Trade and the Trade Expansion Act of 1962, Eckes illustrates the shortcomings of American trade policy in the 1960s. The executive branch was granted unprecedented levels of discretionary authority, yet it failed to obtain significant foreign tariff concessions, abandoned the “no-injury” pledge, exacerbated balance-of-payments problems, and created the first American trade deficit since 1893. As Eckes sees it, Japan was the “real winner” of 1960s American trade policy. Providing minimal concessions and receiving maximum access to the American market, the Japanese received a “phenomenal deal” (p. 200). Responding to growing public suspicion of trade liberalization, President Richard Nixon and Congress initiated a shift toward protectionism in the 1970s by adopting rigorous enforcement of trade laws and congressional oversight of trade negotiations. Yet this reaction was too little, too late. Focusing on the loss of American industrial employment and the trade deficit, Eckes writes that “the Kennedy and Johnson administrations unwittingly made a series of policy decisions that contributed to the domestic economic dislocations of the 1980s and 1990s” (p. 218).

Eckes is sharply critical of American trade policy following Cordell Hull’s revolution. Not only did American officials fail to promote exports, but they also made no effort to enforce the terms of trade negotiations. Theoretically, the existence of “escape clauses” allowed the United States to absolve itself of treaty obligations if it were being treated unfairly, but in practice such clauses were empty concessions on the part of foreign governments; to minimize international conflict, the State Department refused to invoke them even in the face of blatant discrimination. Escape clauses were not actually used until the mid-1970s, but by 1985, however, they had once again fallen into disuse, victim of the Ronald Reagan administration’s zeal for free trade.

By the 1930s, American trade negotiators were also failing to prevent “dumping” and to enact effective countervailing duties. Antidumping legislation in the United States was limited in nature and provided broad executive discretion. The result, not surprisingly, was its subordination to larger foreign policy goals. Prior to the 1930s, the U.S. government employed countervailing duties to protect domestic industry against products made from industries subsidized by foreign governments. Like antidumping and the escape clause, the strategy of applying countervailing duties was set aside for foreign policy goals.

OPENING AMERICA’S MARKET is an ambitious book. In attempting to explain trade policy since 1776, Eckes has made a major contribution to the existing scholarship on American foreign economic policy. His treatment of trade policy during the Cold War suggests that historians who accuse the United States of self-aggrandizement have ignored a key piece of the puzzle. Eckes is, however, by no means uncritical of American Cold War trade policy, which he argues “imposed unnecessary burdens on U.S. producers and workers, severely harmed long-term U.S. economic performance, and circumvented the authority and will of Congress” (p.177).

For all its merits, the book is not without a few problems. As a former trade commissioner, Eckes occasionally attributes excessive importance to trade officials or tariff acts. Although Eckes explicitly backs away from asserting that trade policy was the primary stimulus for American economic growth, there are places in the text that seem to belie this distancing. One section of the book finds Eckes comparing a period of high tariffs (1890-1910) to a period with dramatically reduced barriers (1972-1992). He finds that the growth rate of Gross National Product (GNP) and per capita GNP during the high-tariff period was actually greater than that of the low-tariff period. This comparison seems fraught with problems. The second industrial revolution, the rise of big business, and the 1895-1905 merger wave make the period from 1890 to 1910 a tough act to follow. Whatever the trade policy had been during this period, these other factors would clearly have generated dynamic and substantial growth. From 1972-1992, on the other hand, American business buckled under the pressures of major corporate restructuring, an aging industrial base, and the reemergence of foreign competition. Regardless of existing trade policy, the economic growth of this period would likely have been stifled.

It would be wrong to belabor this point further, however. Eckes has not demonstrated the primacy of trade policy (and indeed he has not attempted to), but he has provided a needed corrective to historians who fixate on the firm as the source of economic growth. Along with politicians and trade negotiators, business and diplomatic historians must take Eckes’s arguments into account: his research is thorough, his knowledge of the issues impressive, and the questions he raises cannot be ignored.

Bruce A. Khula, The Ohio State University

118 Robinson Hall Harvard University Cambridge, MA 02138 –>


Subject(s):International and Domestic Trade and Relations
Geographic Area(s):North America
Time Period(s):20th Century: WWII and post-WWII

Hall of Mirrors: The Great Depression, the Great Recession, and the Uses — and Misuses — of History

Author(s):Eichengreen, Barry
Reviewer(s):Rockoff, Hugh

Published by EH.Net (February 2016)

Barry Eichengreen, Hall of Mirrors: The Great Depression, the Great Recession, and the Uses — and Misuses — of History. New York: Oxford University Press, 2015. vi + 512 pp. $30 (hardcover), ISBN: 978-0-19-939200-1.

Reviewed for EH.Net by Hugh Rockoff, Department of Economics, Rutgers University.
Barry Eichengreen knows as much or more about the financial history of the Great Depression as any living economic historian, and it shows in this splendid new book which compares the Great Recession with the Great Depression. The U.S. story, on which I will focus here, is the centerpiece, but as might be expected from Eichengreen, what happened in the rest of the world is also explored in detail. Eichengreen’s thesis is straightforward. In 2008 the United States, and with it the rest of the world, was headed for another Great Depression. Thanks to strong doses of monetary and fiscal stimulus, and lender-of-last-resort operations, especially in the United States, a second Great Depression was averted. Ideas were important: Much of the success can be attributed to John Maynard Keynes, Milton Friedman, and Anna Schwartz, and the lessons they drew from the Great Depression. But there was a downside to success. Because of the severity of the crisis in the 1930s the financial system underwent a massive reform that put it in a tough but effective straightjacket. The Great Recession was milder; politicians and lobbyists who opposed strict regulation regrouped, and the reforms were moderate at best. The Great Depression and the Great Recession were separated by eighty years, a long period of financial stability produced, according to Eichengreen, by New Deal financial reforms. But, he concludes, because the damage done by deregulation was only partly undone, “we are likely to see another such crisis in less than eighty years (p. 387).”

The analysis in the book is rigorous. Nevertheless, Eichengreen has written a book that can be read by policy makers, journalists, and the famous, and hopefully numerous, intelligent layperson. There are no charts, tables, or equations. Indeed, it would make a good textbook for an undergraduate course on the financial crisis. Eichengreen writes clearly. And he has sprinkled the text with biographical snippets that both inform and entertain. We meet William Jennings Bryan in the 1920s when he is using his oratorical skills to sell real estate in Florida; and we meet Charles Dawes, prominent banker, Vice President, Nobel Peace Prize winner (for his work on German Reparations), and composer of the melody for “It’s All in the Game.”

To make his case that the two crises were similar except for actions taken by governments, Eichengreen recounts both crises and identifies one parallel after another. The 1920s had Charles Ponzi; we had Bernie Madoff. In the 1920s the head of the Bank of England, Montagu Norman, was given, perhaps unconsciously, to “constructive ambiguity” (p. 23); we had Alan Greenspan. The 1920s witnessed the Florida land boom; we had subprime mortgages. Charles Dawes’s bank got needed assistance from the Reconstruction Finance Corporation, but the Guardian Group in Detroit was allowed to fail; we had Bear Stearns and Lehman Brothers. And this is just a taste. Eichengreen adds many, many more. Indeed, the parallels come so thick and fast that one is reminded of the phrase Albert Einstein used to describe two distant particles that were thought to be entangled: “spooky action at a distance.”

The book is divided into four parts. Part I, “The Best of Times,” consists of six chapters that cover the 1920s and the first decade of our century.  Here we learn (without attempting to be exhaustive) about real estate booms in the twenties, the attempt after World War I to reconstruct the gold standard, the repeated attempts to solve the German reparations problem, the Smoot-Hawley tariff, and the U.S. Stock market bubble. Then Eichengreen turns to our era and describes financial deregulation, the subprime mortgage boom, the expansion of the shadow banking sector, and the spread of this type of banking to Europe. Eichengreen doesn’t present new, controversial interpretations of events. Rather he presents conclusions based on careful readings of the available literature including the latest work by economic historians. What is new is the web of parallels he draws between the two crises. Others, of course, have noted the similarities, not the least Ben Bernanke as he wrestled with the crisis; but no one has created such a large catalog of parallels.

In Part II, “The Worst of Times,” nine chapters in all, we learn first about the stock market crash in 1929, the banking crises of 1930-33, and the spread of the Great Depression to Europe. Then he turns to the Great Recession: Bear Stearns, Lehman Brothers, AIG and all that, and the spread of the crisis to Europe.

In the seven chapters of Part III, “Toward Better Times,” we learn about Roosevelt’s attempts to revive the economy: the National Industrial Recovery Act, the Reconstruction Finance Corporation, Federal Reserve Policy in the 1930s, and Roosevelt’s conflicted ideas about budget deficits. European responses to the crisis are also discussed at length, and Japan’s Korekiyo Takahashi is celebrated as the finance minister who got it right. Takahashi, aided it must be said by costly Japanese military adventures, authorized a heavy dose of money-financed deficit spending and the result was the best economic performance among the industrial nations. Eichengreen then turns to our crisis: zero interest rates, quantitative easing, bailouts, and the fiscal stimulus. The argument is usually that what the government did helped, but more should have been done.

In Part IV, “Avoiding the Next Time,” Eichengreen focusses particularly on Dodd-Frank and the Euro. His main efforts are directed at explaining why so little was done to prevent another crisis. A number of potential reforms get favorable mentions: consolidation of regulatory agencies, higher capital requirements for financial institutions, and regulations that limit risk taking. But Eichengreen doesn’t rank possible reforms or explain in detail how they would work. Here I wanted Eichengreen to go on a bit, and tell us more about his ideas on what should have and presumably still can be done to prevent another crisis. His approach to Glass-Steagall is an example of his above the fray stance toward regulation. Eichengreen mentions Glass-Steagall, and the separation of commercial from investment banking many times — one chapter is titled “Shattered Glass.” He rejects the argument made mostly forcefully by Andrew Ross Sorkin (2012) — although it is one that must have occurred to many observers — that ending the separation of commercial and investment banking didn’t have much to do with causing the crisis. After all, Merrill Lynch, Bear Stearns, and Lehman brothers were not branches of commercial banks when they went off the rails. And AIG was an insurance company. Eichengreen tells us that ending Glass Steagall was “indicative of a trend” (p. 424), which it surely was, but he seems to feel that it was more than that. Here I would have liked to learn more about Eichengreen’s ideas about how ending Glass-Steagall undermined the system. Did it create moral hazard, because firms knew they could merge with a bank if they got in trouble? Or was it some other mechanism? And more urgently, I would have liked to have read more about Eichengreen’s views on how high a priority restoring Glass-Steagall should be, and where the lines should be drawn.

Comment and Conclusion

Eichengreen’s book is a synthesis. It pulls together an enormous body of studies by economic historians, policy makers, and journalists. Specialists in financial history will be familiar with many parts of the story. But I doubt there are any who will not learn a great deal from reading Eichengreen’s account. While I was persuaded by most of Eichengreen’s arguments I did have a recurring concern about how far we can go as social scientists, as opposed to policy advocates, in making assertions about what would have happened if alternative policies had been followed on the basis of two observations. It is one thing to claim that without aggressive monetary and fiscal actions and bailouts we might have ended up in another Great Depression.  And for me, as I suspect for most of us, that possibility justifies much of what was done. Even, say, a one-third chance of another Great Depression makes pulling out the stops worthwhile. But that claim is very different from the claim that we would have ended up in a Great Depression if less had been done. The truth is that we can’t be sure what path the economy would have followed if less had been done, or where we would be today.

Consider the following table which shows unemployment after four financial panics. When you compare 2008 only with 1930, it seems clear that we did a lot a better after the panic of 2008, and the things we did in 2008 “worked” at least up to a point: We avoided a Great Depression. On the other hand, we did, arguably, worse after 2008 than after the panic of 1907 when help for the economy was provided mainly through the circumscribed lender-of last-resort actions undertaken by J.P. Morgan.  And we did almost exactly the same as after the crisis of 1893, when only some limited stimulus came well after the crisis in the form of gold inflows and spending on the Spanish-American War. In fact, the 2008 and 1893 unemployment rates are so similar that it looks like another case of “spooky action at a distance.”

2008 1930 1907 1893
-1 4.6 2.9 2.5 4.3
0 5.8 8.9 3.1 6.8
1 9.3 15.7 7.5 9.3
2 9.6 22.9 5.7 8.5
3 8.9 20.9 5.9 9.3
4 8.1 16.2 7.0 8.5
5 7.4 14.4 5.9 7.8
6 6.2 10.0 5.7 5.9
7 5.3 9.2 8.5 5.0

Source: Historical Statistics of the United States, Millennial Edition: Volume 2, Work and Welfare, series Ba475 for 1893, 1907, and 1930 (pp. 2-82 and 2-83), and the standard Bureau of Labor Statistics series for 2008.

My point is not that 1893 is necessarily a better analog than 1930. One could argue the point, but I don’t think we know. Constructing a counterfactual macroeconomic history of a financial crisis and recession is essentially an exercise in forecasting, and we economists are just not very good at macroeconomic forecasting. We are in the position, I believe, of physicians in days gone by: we have some drugs that experience tells us sometimes relieve pain and suffering. But how they work and why they work in some cases and not in others, and what the long-run side effects are – we have some ideas we can discuss, or more likely debate, but the bottom line is that we don’t know.

(If we were entangled with the Depression of 1890s, we would want to know what happened in 1901 the year that corresponds to 2016. Among other things, 1901 began with a slide on the stock market of about 9%. Sound familiar?! Despite a spring rally the market finished the year off by about the same percentage. By the way, this is just an observation; I am not giving investment advice.)

Many excellent books and articles have been written about the financial crisis of 2008 and there will undoubtedly be many more. Gary Gorton’s papers and books and Ben Bernanke’s memoir immediately spring to mind, but the list of good books and articles is already a long one. There is nothing like a financial crisis to concentrate the minds of economists. However, if financial history is not your thing, and you want to read just one book about the financial crisis, you couldn’t do better than Hall of Mirrors.


Andrew Ross Sorkin, “Reinstating an Old Rule Is Not a Cure for Crisis” New York Times, May 21, 2012.

Hugh Rockoff is Distinguished Professor of Economics at Rutgers University and a Research Associate with the National Bureau of Economic Research.

Copyright (c) 2016 by EH.Net. All rights reserved. This work may be copied for non-profit educational uses if proper credit is given to the author and the list. For other permission, please contact the EH.Net Administrator ( Published by EH.Net (February 2016). All EH.Net reviews are archived at

Subject(s):Financial Markets, Financial Institutions, and Monetary History
Macroeconomics and Fluctuations
Geographic Area(s):General, International, or Comparative
North America
Time Period(s):20th Century: Pre WWII
20th Century: WWII and post-WWII

Harold Adams Innis

Robin Neill, University of Prince Edward Island

Harold Innis has been called “the first Canadian-born social scientist to achieve an international reputation” and “the father of Canadian Economic History.” He was the second president of the Economic History Association (1942-1944) and the fifty-fourth President of the American Economic Association (1951). He has been credited with joint authorship of the Staple Theory of Canadian Economic Development (W.T. Easterbrook, 967, p. 261). In a backhanded posthumous complement a Keynesian said of him that he led the Canadian economics profession down the wrong path for fifteen years.

Innis’s influence in Canadian social science was pervasive in the pre-Keynesian period. His studies of the fur trade, the cod fisheries, and the mining and forest frontiers broke new ground, and provided an economic underpinning for the Laurentian School of Canadian historians. His students, W.T. Easterbrook, Hugh G.J. Aitken, Albert Faucher, and two of the then famous four Saskatonians, Vernon C. Fowke and Kenneth A.H. Buckley, are still cited in current Canadian economic history texts. The building-of-the-Canadian-nation histories that typified the Laurentian School have lost some of their appeal. Regional and community histories are now more frequently celebrated. Close reading of Innis, and particularly of Fowke (R.F. Neill, 1999), however, shows the two to have made a greater contribution in this regard than one would surmise from reading the general texts that draw on their work.

Innis’s influence in economic history in general has been considerable. His reworking of the “vent for surplus” theory of economic development, that is the “staple,” “primary products” or “export base” theory of economic development, was extended by Douglass North in applications to regional development in the United States, and to the experience of what were then called underdeveloped countries. Subsequently it was elaborated in generalized export-base models used to describe the experience of newly industrializing countries.

Innis’s contribution to historical economics, we have to assume, was noted. His success in the profession would indicate that it was. But that sort of Old Institutional, historical theorizing fell out of fashion after the Second World War. Neither Innis’s “cyclonics” nor J.M Clark’s “non Euclidian economics” had any formal standing in the period following general acceptance of Keynesian macroeconomic theory. Nonetheless, Innis had some influence beyond economic history. His most celebrated student, Harry G. Johnson, referred back to Innis as his “greatest teacher in economics” (Johnson and Johnson, 1978, p. 234).

The studies of communication media that characterized the so-called “later Innis” were not understood by, or, better, were outside the grasp of, economists preoccupied with positivistic testing of neoclassical, neo-Keynesian, and Monetarist-New Classical hypotheses. The root of the media studies can be traced back to the work of nineteenth-century historical economists, such as J.K. Ingram, who had much to say about “the prevalent mode of thinking” that shaped the nature of economic theory in any given period (Ingram, 1888, p. 2-3). Innis’s studies of communication media were an attempt to specify one causal factor in changes in the prevalent mode of thinking. His approach gave him grounds for assessing the economics profession itself.

He was not alone in this. J.J. Spengler, whose work also emerged from 1930s discussion of the nature of economics, also adopted an “external” approach to the history of economics (Spengler, 1940). This approach has had considerable acceptance among historians of economic thought, and it has been taken up by intellectual historians in general. Indeed, it gained high fashion following Michel Foucault’s discussion of the biased information environments that he called “epistemes,” and following Jacques Derrida’s emphasis on the linguistic context of all knowledge, both of which were related to analyses of prevalent modes of thinking.

Harold Adams Innis was born on November 5, 1894, in Otterville, Ontario, the first born of William Anson and Mary (Adams) Innis. His parents worked a hundred-acre farm outside of Otterville in Oxford County. At age eleven Harold was admitted to the Otterville high school. Two years later, in the fall of 1908, he began commuting twenty miles to the Woodstock Collegiate Institute. After graduation, he taught grade school for a year and then registered at McMaster University in Hamilton at the western end of Lake Ontario. The First World War interrupted his education. Upon graduating from McMaster, in the spring of 1916, he enlisted in the Canadian Army. By Christmas his group, the 69th Battery, was on the front in France. By the end of July, Innis had been wounded and sent to England for convalescence. During his stay in England he studied for a Master’s degree through a wartime institution called Khaki College. On arrival back in Canada he passed the examination for an M.A. in Economics. Disappointment over what he had learned was a major motivation in his enrolling in the doctoral program at the University of Chicago, a Baptist institution appropriate for one raised strictly in that faith.

When Innis arrived at Chicago there was considerable dissent in the United States with respect to the tenets of neoclassical economic theory. Its fundamental assumptions were being questioned by the Institutionalist Thorstein Veblen and by his student and colleague, John R. Commons. Some of the controversy was brought to Innis’s attention by his mentors, C.W. Wright and C.S. Duncan, but his most effective contact with current economic thought was through Frank H. Knight, who was then an instructor at Chicago. Knight’s skepticism captured Innis’s imagination and drew him into a small, informal group, including Carter Goodrich, Morris Copeland, W.B. Smith, J.W. Angel, and, of course, Knight himself. Their discussions focused on the nature and implications of Veblen’s critique of received economic doctrine.

Innis returned to Canada in 1920 to take a position in the Department of Political Economy at the University of Toronto. With the exception of its redoubtable Head, James Mavor, the Department was young and aware that it had the economics of Canada still to discover. Mavor had attempted an introduction to Canadian economic history, but had left it unfinished. C.R. Fay, the economic historian, was at Toronto in those years, and was aware that there was something to be done. He and Innis became life long friends in their mutual endeavor to see that it did. V.W. Bladen, recently arrived from Oxford, was pulled into the effort by Innis who insisted that Bladen could not understand the economics of Canada unless he personally visited every part of it.

The first fifteen of Innis’s years at Toronto were a difficult but fruitful time. He was not always understood, and, at one point, he was withdrawn from teaching a course because he pursued its subject “along too radical lines.” Still, his efforts began to produce results with the 1930 publication of his own introduction to Canadian economic history, The Fur Trade of Canada. Following the 1929 stock market crash, the Canadian Political Science Association was reestablished. Innis was deeply involved. A year earlier, with the help of the Bladens, he initiated a periodical, Contributions to Canadian Economics. The publication provided a medium for the Canadian Political Science Association, and its success in that capacity was a major factor in the Association’s decision to launch the Canadian Journal of Economics and Political Science. Innis’s contributions to the literature on Canadian economic history, and his involvement in the institutionalization of economics brought public recognition. In 1934 he was elected fellow of the Royal Society of Canada. He was promoted to Full Professor rank in 1936. He was an invited member of the Nova Scotia Royal Commission of Economic Enquiry in 1933. In 1937 he was appointed Head of the Department of Political Economy at the University of Toronto, and he remained Head until his death in 1952. From 1947 until 1952 he was Dean of Graduate Studies at Toronto, and had, in the meantime been a member of a Federal Royal Commission on Transportation. These public appointments say much for his influence on the economics profession in Canada, but they are not the end of it. He took a personal interest in the politics of the Department of Economics and Political Science at the University of Saskatchewan, which was headed by his student and close friend George Britnell. Perhaps his greatest influence was exercised through Canada’s Social Science Research council of which he was Chairman in 1945-46, and Chairman of the Grants-in-Aid Committee for its first nine years. Funds then available to assist research in the social sciences were minuscule by later standards, but none were allocated without Innis’s concurrence. He met regularly with Anne Bezanson, another sometime president of the EHA, who represented the Carnegie Foundation. Together they poured over names and projects related to social science research in Canada. In recommending reorganization of the Canadian Social Science Research Council in 1968, Mabel Timlin stated that in the beginning elaborate organization was not needed because Innis knew everyone.

For all his involvement in the institutionalization of economics in Canada, Innis did not withdraw from contacts in the United States. He was involved in the founding of the Economic History Association and the launching of the Journal of Economic History. He was the Association’s second president, and was deeply involved with the Committee on Research in Economic History, sponsored by the Social Science Research Council of the United States. It was these activities that brought Innis into close contact with American economic historians, Arthur H. Cole, Anne Bezanson, Robert B. Warren, and Earl J. Hamilton. At the same time Innis continued his interest in the general debates over the nature of economics in the United States, reviving his interaction with Frank Knight and eventually leading to his presidency of the American Economics Association in 1951. Innis has been the only president of the Economic History Association or the American Economic Association never to become an American citizen.

The lines of cleavage in the 1930s American debate over the nature of economics are now being clarified (Yonay, 1998; Morgan and Rutherford, 1998). One was drawn over the extent to which the values of elites should direct government economic policy. Another was drawn over the role of values in social science in general, but, particularly, in economics. With respect to these cleavages, Innis found himself in opposition to Frank Underhill and the socialist League for Social Reconstruction, which was active at the University of Toronto. Knight opposed the interventionist economics of the New Deal “brains trust” economist Guy Rexford Tugwell. Neither Innis nor Knight was well disposed towards the rise of Keynesian macroeconomics. Innis found it to be too interventionist given what he thought to be the unreliable state of the economics on which it was based. Perhaps it was for this reason that, from 1943 to 1947, Innis had an open invitation from the University of Chicago, where other, now famous, dissenters were gathering (Kitch, 1983).

Harold Innis died November 8, 1952. He was at the peak of his career. He had been invited to give the Beit Lectures in Imperial History at Oxford in 1949. While in England he was invited to give the Cust Lecture at Nottingham, and he spoke at the University of London. His thesis was, perhaps, not clearly presented, and not well received. Still, he continued to develop it over the succeeding years, leaving behind a body of writing well ahead of its time in intellectual history, and well off from contemporary paradigms in economics.

Selected Publications of Harold Innis: Books and Collections of Articles

A History of the Canadian Pacific Railway. London: P.S. King, 1923; Toronto: University of Toronto Press, 1971.

The Fur Trade in Canada: An Introduction to Canadian Economic History. New Haven: Yale University Press, 1930.

Peter Pond: Fur Trader and Adventurer. Toronto, 1930.

Select Documents in Canadian Economic History, Volume 1 (1497-1783), Volume 2 (1783-1885), co-edited with A.R.M. Lower. Toronto: University of Toronto Press, 1929 and 1933.

Problems of Staple Production in Canada. Toronto: University of Toronto Press, 1933.

Settlement and the Mining Frontier. Toronto: University of Toronto Press, Toronto, 1936.

The Cod Fisheries: The History of an International Economy. New Haven: Yale University Press, 1940.

Political Economy and the Modern State. Toronto: University of Toronto Press, 1946.

Empire and Communications. Oxford: Clarendon Press, 1950.

The Bias of Communication. Toronto: University of Toronto Press, 1951.

Changing Concepts of Time. Toronto: University of Toronto Press, 1952.

Essays in Canadian Economic History, ( M.Q. Innis, editor). Toronto: University of Toronto Press, 1956.

The Idea File of Harold Adams Innis, (introduced and edited by William Christian). Toronto: University of Toronto Press, 1980.

Innis on Russia: The Russian Diary and Other Writings (edited with a preface by William Christian). Toronto: University of Toronto Press, 1981.

Selected Writings about Innis: Biographical, Bibliographical, and Interpretative

Barnes, T.J. “Focus: A Geographical Appreciation of Harold A. Innis.” Canadian Geographer. 37 (1993): 352-364.

Creighton, Donald. Harold Adams Innis: Portrait of a Scholar. Toronto: University of Toronto Press, 1957.

Havelock, E.A. “Harold Innis: A Man of His Times” and “Harold Innis: The Philosophical Historian.” Et cetra 38 (1981): 242-268.

Neill, Robin. A New Theory of Value: The Canadian Economics of Harold Adams Innis. Toronto: University of Toronto Press, 1972.

Neill, Robin. “Rationality and the Information Environment: A Reassessment of the Work of Harold Adams Innis.” Journal of Canadian Studies 22 (1987-88): 78-92.

Patterson, Graeme. History and Communications: Harold Innis, Marshall McLuhan, the Interpretation of History. Toronto: University of Toronto Press, 1990.

Stamps, Judith. Unthinking Modernity: Innis, McLuhan, and the Frankfurt School. Kingston and Montreal: McGill-Queen’s University Press, 1995.

Additional References: Relevant to the Presented Interpretation

Ingram, J.K. A History of Political Economy. New York: Augustus M. Kelly (1888, 1967).

Johnson, E.S. and Johnson, H.G. In the Shadow of Keynes. Oxford: Basil Blackwell, 1978.

Kitch, E.W. “Fire of Truth: A Remembrance of Law and Economics at Chicago, 1932-1970.” Journal of Law and Economics 26 (1983): 163-233.

Morgan, M.S. and Rutherford, M., editors. From Interwar Pluralism to Postwar Neoclassicism. Durham, NC: Duke University, 1998.

Neill, R.F. “Economic Historiography in the 1950s: The Saskatchewan School.” Journal of Canadian Studies 34 (1999): 243-260.

Spengler, J.J. “Sociological Presuppositions in Economic Theory.” Southern Economic Journal 7 (1940): 131-157.

Yonay, Y.P. The Struggle over the Soul of Economics. Princeton University Press, Princeton, 1998.

Citation: Neill, Robin. “Harold Adams Innis”. EH.Net Encyclopedia, edited by Robert Whaples. March 16, 2008. URL

Smoot-Hawley Tariff

Anthony O’Brien, Lehigh University

The Smoot-Hawley Tariff of 1930 was the subject of enormous controversy at the time of its passage and remains one of the most notorious pieces of legislation in the history of the United States. In the popular press and in political discussions the usual assumption is that the Smoot-Hawley Tariff was a policy disaster that significantly worsened the Great Depression. During the controversy over passage of the North American Free Trade Agreement (NAFTA) in the 1990s, Vice President Al Gore and billionaire former presidential candidate Ross Perot met in a debate on the Larry King Live program. To help make his point that Perot’s opposition to NAFTA was wrong-headed, Gore gave Perot a framed portrait of Sen. Smoot and Rep. Hawley. Gore assumed the audience would consider Smoot and Hawley to have been exemplars of a foolish protectionism. Although the popular consensus on Smoot-Hawley is clear, the verdict among scholars is more mixed, particularly with respect to the question of whether the tariff significantly worsened the Great Depression.

Background to Passage of the Tariff

The Smoot-Hawley Tariff grew out of the campaign promises of Herbert Hoover during the 1928 presidential election. Hoover, the Republican candidate, had pledged to help farmers by raising tariffs on imports of farm products. Although the 1920s were generally a period of prosperity in the United States, this was not true of agriculture; average farm incomes actually declined between 1920 and 1929. During the campaign Hoover had focused on plans to raise tariffs on farm products, but the tariff plank in the 1928 Republican Party platform had actually referred to the potential of more far-reaching increases:

[W]e realize that there are certain industries which cannot now successfully compete with foreign producers because of lower foreign wages and a lower cost of living abroad, and we pledge the next Republican Congress to an examination and where necessary a revision of these schedules to the end that American labor in the industries may again command the home market, may maintain its standard of living, and may count upon steady employment in its accustomed field.

In a longer perspective, the Republican Party had been in favor of a protective tariff since its founding in the 1850s. The party drew significant support from manufacturing interests in the Midwest and Northeast that believed they benefited from high tariff barriers against foreign imports. Although the free trade arguments dear to most economists were espoused by few American politicians during the 1920s, the Democratic Party was generally critical of high tariffs. In the 1920s the Democratic members of Congress tended to represent southern agricultural interests — which saw high tariffs as curtailing foreign markets for their exports, particularly cotton — or unskilled urban workers — who saw the tariff as driving up the cost of living.

The Republicans did well in the 1928 election, picking up 30 seats in the House — giving them a 267 to 167 majority — and seven seats in the Senate — giving them a 56 to 39 majority. Hoover easily defeated the Democratic presidential candidate, New York Governor Al Smith, capturing 58 percent of the popular vote and 444 of 531 votes in the Electoral College. Hoover took office on March 4, 1929 and immediately called a special session of Congress to convene on April 15 for the purpose of raising duties on agricultural products. Once the session began it became clear, however, that the Republican Congressional leadership had in mind much more sweeping tariff increases.

The House concluded its work relatively quickly and passed a bill on May 28 by a vote of 264 to 147. The bill faced a considerably more difficult time in the Senate. A block of Progressive Republicans, representing midwestern and western states, held the balance of power in the Senate. Some of these Senators had supported the third-party candidacy of Wisconsin Senator Robert LaFollette during the 1924 presidential election and they were much less protectionist than the Republican Party as a whole. It proved impossible to put together a majority in the Senate to pass the bill and the special session ended in November 1929 without a bill being passed.

By the time Congress reconvened the following spring the Great Depression was well underway. Economists date the onset of the Great Depression to the cyclical peak of August 1929, although the stock market crash of October 1929 is the more traditional beginning. By the spring of 1930 it was already clear that the downturn would be severe. The impact of the Depression helped to secure the final few votes necessary to put together a slim majority in the Senate in favor of passage of the bill. Final passage in the Senate took place on June 13, 1930 by a vote of 44 to 42. Final passage took place in the House the following day by a vote of 245 to 177. The vote was largely on party lines. Republicans in the House voted 230 to 27 in favor of final passage. Ten of the 27 Republicans voting no were Progressives from Wisconsin and Minnesota. Democrats voted 150 to 15 against final passage. Ten of the 15 Democrats voting for final passage were from Louisiana or Florida and represented citrus or sugar interests that received significant new protection under the bill.

President Hoover had expressed reservations about the wide-ranging nature of the bill and had privately expressed fears that the bill might provoke retaliation from America’s trading partners. He received a petition signed by more than 1,000 economists, urging him to veto the bill. Ultimately, he signed the Smoot-Hawley bill into law on June 17, 1930.

Tariff Levels under Smoot-Hawley

Calculating the extent to which Smoot-Hawley raised tariffs is not straightforward. The usual summary measure of tariff protection is the ratio of total tariff duties collected to the value of imports. This measure is misleading when applied to the early 1930s. Most of the tariffs in the Smoot-Hawley bill were specific — such as $1.125 per ton of pig iron — rather than ad valorem — or a percentage of the value of the product. During the early 1930s the prices of many products declined, causing the specific tariff to become an increasing percentage of the value of the product. The chart below shows the ratio of import duties collected to the value of dutiable imports. The increase shown for the early 1930s was partly due to declining prices and, therefore, exaggerates the effects of the Smoot-Hawley rate increases.

Source: U.S. Bureau of the Census, Historical Statistics of the United States, Colonial Times to 1970, Washington, D.C.: USGPO, 1975, Series 212.

A more accurate measure of the increase in tariff rates attributable to Smoot-Hawley can be found in a study carried out by the U.S. Tariff Commission. This study calculated the ad valorem rates that would have prevailed on actual U.S. imports in 1928, if the Smoot-Hawley rates been in effect then. These rates were compared with the rates prevailing under the Tariff Act of 1922, known as the Fordney-McCumber Tariff. The results are reproduced in Table 1 for the broad product categories used in tariff schedules and for total dutiable imports.

Table 1
Tariffs Rates under Fordney-McCumber vs. Smoot-Hawley

Equivalent ad valorem rates
Product Fordney-McCumber Smoot-Hawley
Chemicals 29.72% 36.09%
Earthenware, and Glass 48.71 53.73
Metals 33.95 35.08
Wood 24.78 11.73
Sugar 67.85 77.21
Tobacco 63.09 64.78
Agricultural Products 22.71 35.07
Spirits and Wines 38.83 47.44
Cotton Manufactures 40.27 46.42
Flax, Hemp, and Jute 18.16 19.14
Wool and Manufactures 49.54 59.83
Silk Manufactures 56.56 59.13
Rayon Manufactures 52.33 53.62
Paper and Books 24.74 26.06
Sundries 36.97 28.45
Total 38.48 41.14

Source: U.S. Tariff Commission, The Tariff Review, July 1930, Table II, p. 196.

By this measure, Smoot-Hawley raised average tariff rates by about 2 ½ percentage points from the already high rates prevailing under the Fordney-McCumber Tariff of 1922.

The Basic Macroeconomics of the Tariff

Economists are almost uniformly critical of tariffs. One of the bedrock principles of economics is that voluntary trade makes everyone involved better off. For the U.S. government to interfere with trade between Canadian lumber producers and U.S. lumber importers — as it did under Smoot-Hawley by raising the tariff on lumber imports — makes both parties to the trade worse off. In a larger sense, it also hurts the efficiency of the U.S. economy by making it rely on higher priced U.S. lumber rather than less expensive Canadian lumber.

But what is the effect of a tariff on the overall level of employment and production in an economy? The usual answer is that a tariff will leave the overall level of employment and production in an economy largely unaffected. Although the popular view is very different, most economists do not believe that tariffs either create jobs or destroy jobs in aggregate. Economists believe that the overall level of jobs and production in the economy is determined by such things as the capital stock, the population, the state of technology, and so on. These factors are not generally affected by tariffs. So, for instance, a tariff on imports of lumber might drive up housing prices and cause a reduction in the number of houses built. But economists believe that the unemployment in the housing industry will not be long-lived. Economists are somewhat divided on why this is true. Some believe that the economy automatically adjusts rapidly to reallocate labor and machinery that are displaced from one use — such as making houses — into other uses. Other economists believe that this adjustment does not take place automatically, but can be brought about through active monetary or fiscal policy. In either view, the economy is seen as ordinarily being at its so-called full-employment or potential level and deviating from that level only for brief periods of time. Tariffs have the ability to change the mix of production and the mix of jobs available in an economy, but not to change the overall level of production or the overall level of jobs. The macroeconomic impact of tariffs is therefore very limited.

In the case of the Smoot-Hawley Tariff, however, the U.S. economy was in depression in 1930. No active monetary or fiscal policies were carried out and the economy was not making much progress back to full employment. In fact, the cyclical trough was not reached until March 1933 and the economy did not return to full employment until 1941. Under these circumstances is it possible for Smoot-Hawley to have had a significant impact on the level of employment and production and would that impact have been positive or negative?

A simple view of the determination of equilibrium Gross Domestic Product (Y) holds that it is equal to the sum of aggregate expenditures. Aggregate expenditures are divided into four categories: spending by households on consumption goods (C), spending by households and firms on investment goods — such as houses, and machinery and equipment (I), spending by the government on goods and services (G), and net exports, which are the difference between spending on exports by foreign households and firms (EX) and spending on imports by domestic households and firms (IM). So, in the basic algebra of the principles of economics course, at equilibrium, Y = C + I + G + (EX – IM).

The usual story of the Great Depression is that some combination of falling consumption spending and falling investment spending had resulted in the equilibrium level of GDP being far below its full employment level. By raising tariffs on imports, Smoot-Hawley would have reduced the level of imports, but would not have had any direct effect on exports. This simple analysis seems to lead to a surprising conclusion: by reducing imports, Smoot-Hawley would have raised the level of aggregate expenditures in the economy (by increasing net exports or (EX – IM)) and, therefore, increased the level of GDP relative to what it would otherwise have been.

A potential flaw in this argument is that it assumes that Smoot-Hawley did not have a negative impact on U.S. exports. In fact, it may have had a negative impact on exports if foreign governments were led to retaliate against the passage of Smoot-Hawley by raising tariffs on imports of U.S. goods. If net exports fell as a result of Smoot-Hawley, then the tariff would have had a negative macroeconomic impact; it would have made the Depression worse. In 1934 Joseph Jones wrote a very influential book in which he argued that widespread retaliation against Smoot-Hawley had, in fact, taken place. Jones’s book helped to establish the view among the public and among scholars that the passage of Smoot-Hawley had been a policy blunder that had worsened the Great Depression.

Did Retaliation Take Place?

This is a simplified analysis and there are other ways in which Smoot-Hawley could have had a macroeconomic impact, such as by increasing the price level in the U.S. relative to foreign price levels. But in recent years there has been significant scholarly interest in the question of whether Smoot-Hawley did provoke significant retaliation and, therefore, made the Depression worse. Clearly it is possible to overstate the extent of retaliation and Jones almost certainly did. For instance, the important decision by Britain to abandon a century-long commitment to free trade and raise tariffs in 1931 was not affected to any significant extent by Smoot-Hawley.

On the other hand, the case for retaliation by Canada is fairly clear. Then, as now, Canada was easily the largest trading partner of the United States. In 1929, 18 percent of U.S. merchandise exports went to Canada and 11 percent of U.S. merchandise imports came from Canada. At the time of the passage of Smoot-Hawley the Canadian Prime Minister was William Lyon Mackenzie King of the Liberal Party. King had been in office for most of the period since 1921 and had several times reduced Canadian tariffs. He held the position that tariffs should be used to raise revenue, but should not be used for protection. In early 1929 he was contemplating pushing for further tariff reductions, but this option was foreclosed by Hoover’s call for a special session of Congress to consider tariff increases.

As Smoot-Hawley neared passage King came under intense pressure from the Canadian Conservative Party and its leader, Richard Bedford Bennett, to retaliate. In May 1930 Canada imposed so-called countervailing duties on 16 products imported from the United States. The duties on these products — which represented about 30 percent of the value of all U.S. merchandise exports to Canada — were raised to the levels charged by the United States. In a speech, King made clear the retaliatory nature of these increases:

[T]he countervailing duties ? [are] designed to give a practical illustration to the United States of the desire of Canada to trade at all times on fair and equal terms?. For the present we raise the duties on these selected commodities to the level applied against Canadian exports of the same commodities by other countries, but at the same time we tell our neighbour ? we are ready in the future ? to consider trade on a reciprocal basis?.

In the election campaign the following July, Smoot-Hawley was a key issue. Bennett, the Conservative candidate, was strongly in favor in retaliation. In one campaign speech he declared:

How many thousands of American workmen are living on Canadian money today? They’ve got the jobs and we’ve got the soup kitchens?. I will not beg of any country to buy our goods. I will make [tariffs] fight for you. I will use them to blast a way into markets that have been closed.

Bennett handily won the election and pushed through the Canadian Parliament further tariff increases.

What Was the Impact of the Tariff on the Great Depression?

If there was retaliation for Smoot-Hawley, was this enough to have made the tariff a significant contributor to the severity of the Great Depression? Most economists are skeptical because foreign trade made up a small part of the U.S. economy in 1929 and the magnitude of the decline in GDP between 1929 and 1933 was so large. Table 2 gives values for nominal GDP, for real GDP (in 1929 dollars), for nominal and real net exports, and for nominal and real exports. In real terms, net exports did decline by about $.7 billion between 1929 and 1933, but this amounts to less than one percent of 1929 real GDP and is dwarfed by the total decline in real GDP between 1929 and 1933.

Table 2
GDP and Exports, 1929-1933

Year Nominal GDP Real GDP Nominal Net Exports Real Net Exports Nominal Exports Real Exports
1929 $103.1 $103.1 $0.4 $0.3 $5.9 $5.9
1930 $90.4 $93.3 $0.3 $0.0 $4.4 $4.9
1931 $75.8 $86.1 $0.0 -$0.4 $2.9 $4.1
1932 $58.0 $74.7 $0.0 -$0.3 $2.0 $3.3
1933 $55.6 $73.2 $0.1 -$0.4 $2.0 $3.3

Source: U.S. Department of Commerce, National Income and Product Accounts of the United States, Vol. I, 1929-1958, Washington, D.C.: USGPO, 1993.

If we focus on the decline in exports, we can construct an upper bound for the negative impact of Smoot-Hawley. Between 1929 and 1931, real exports declined by an amount equal to about 1.7% of 1929 real GDP. Declines in aggregate expenditures are usually thought to have a multiplied effect on equilibrium GDP. The best estimates are that the multiplier is roughly two. In that case, real GDP would have declined by about 3.4% between 1929 and 1931 as a result of the decline in real exports. Real GDP actually declined by about 16.5% between 1929 and 1931, so the decline in real exports can account for about 21% of the total decline in real GDP. The decline in real exports, then, may well have played an important, but not crucial, role in the decline in GDP during the first two years of the Depression. Bear in mind, though, that not all — perhaps not even most — of the decline in exports can be attributed to retaliation for Smoot-Hawley. Even if Smoot-Hawley had not been passed, U.S. exports would have fallen as incomes declined in Canada, the United Kingdom, and in other U.S. trading partners and as tariff rates in some of these countries increased for reasons unconnected to Smoot-Hawley.

Hawley-Smoot or Smoot-Hawley: A Note on Usage

Congressional legislation is often referred to by the names of the member of the House of Representatives and the member of the Senate who have introduced the bill. Tariff legislation always originates in the House of Representatives and according to convention the name of its House sponsor, in this case Representative Willis Hawley of Oregon, would precede the name of its Senate sponsor, Senator Reed Smoot of Utah — hence, Hawley-Smoot. In this instance, though, Senator Smoot was far better known than Representative Hawley and so the legislation is usually referred to as the Smoot-Hawley Tariff. The more formal name of the legislation was the U.S. Tariff Act of 1930.)

Further Reading

The Republican Party platform for 1928 is reprinted as: “Republican Platform [of 1928]” in Arthur M. Schlesinger, Jr., Fred L. Israel, and William P. Hansen, editors, History of American Presidential Elections, 1789-1968, New York: Chelsea House, 1971, Vol. 3. Herbert Hoover’s views on the tariff can be found in Herbert Hoover, The Future of Our Foreign Trade, Washington, D.C.: GPO, 1926 and Herbert Hoover, The Memoirs of Herbert Hoover: The Cabinet and the Presidency, 1920-1933, New York: Macmillan, 1952, Chapter 41. Trade statistics for this period can be found in U.S. Department of Commerce, Economic Analysis of Foreign Trade of the United States in Relation to the Tariff. Washington, D.C.: GPO, 1933 and in the annual supplements to the Survey of Current Business.

A classic account of the political process that resulted in the Smoot-Hawley Tariff is given in E. E. Schattschneider, Politics, Pressures and the Tariff, New York: Prentice-Hall, 1935. The best case for the view that there was extensive foreign retaliation against Smoot-Hawley is given in Joseph Jones, Tariff Retaliation: Repercussions of the Hawley-Smoot Bill, Philadelphia: University of Pennsylvania Press, 1934. The Jones book should be used with care; his argument is generally considered to be overstated. The view that party politics was of supreme importance in passage of the tariff is well argued in Robert Pastor, Congress and the Politics of United States Foreign Economic Policy, 1929-1976, Berkeley: University of California Press, 1980.

A discussion of the potential macroeconomic impact of Smoot-Hawley appears in Rudiger Dornbusch and Stanley Fischer, “The Open Economy: Implications for Monetary and Fiscal Policy.” In The American Business Cycle: Continuity and Change, edited by Robert J. Gordon, NBER Studies in Business Cycles, Volume 25, Chicago: University of Chicago Press, 1986, pp. 466-70. See, also, the article by Barry Eichengreen listed below. An argument that Smoot-Hawley is unlikely to have had a significant macroeconomic effect is given in Peter Temin, Lessons from the Great Depression, Cambridge, MA: MIT Press, 1989, p. 46. For an argument emphasizing the importance of Smoot-Hawley in explaining the Great Depression, see Alan Meltzer, “Monetary and Other Explanations of the Start of the Great Depression,” Journal of Monetary Economics, 2 (1976): 455-71.

Recent journal articles that deal with the issues discussed in this entry are:

Callahan, Colleen, Judith A. McDonald and Anthony Patrick O’Brien. “Who Voted for Smoot-Hawley?” Journal of Economic History 54, no. 3 (1994): 683-90.

Crucini, Mario J. and James Kahn. “Tariffs and Aggregate Economic Activity: Lessons from the Great Depression.” Journal of Monetary Economics 38, no. 3 (1996): 427-67.

Eichengreen, Barry. “The Political Economy of the Smoot-Hawley Tariff.” Research in Economic History 12 (1989): 1-43.

Irwin, Douglas. “The Smoot-Hawley Tariff: A Quantitative Assessment.” Review of Economics and Statistics 80, no. 2 (1998): 326-334.

Irwin Douglas and Randall S. Kroszner. “Log-Rolling and Economic Interests in the Passage of the Smoot-Hawley Tariff.” Carnegie-Rochester Series on Public Policy 45 (1996): 173-200.

McDonald Judith, Anthony Patrick O’Brien, and Colleen Callahan. “Trade Wars: Canada’s Reaction to the Smoot-Hawley Tariff.” Journal of Economic History 57, no. 4 (1997): 802-26.

Citation: O’Brien, Anthony. “Smoot-Hawley Tariff”. EH.Net Encyclopedia, edited by Robert Whaples. August 14, 2001. URL

An Overview of the Great Depression

Randall Parker, East Carolina University

This article provides an overview of selected events and economic explanations of the interwar era. What follows is not intended to be a detailed and exhaustive review of the literature on the Great Depression, or of any one theory in particular. Rather, it will attempt to describe the “big picture” events and topics of interest. For the reader who wishes more extensive analysis and detail, references to additional materials are also included.

The 1920s

The Great Depression, and the economic catastrophe that it was, is perhaps properly scaled in reference to the decade that preceded it, the 1920s. By conventional macroeconomic measures, this was a decade of brisk economic growth in the United States. Perhaps the moniker “the roaring twenties” summarizes this period most succinctly. The disruptions and shocking nature of World War I had been survived and it was felt the United States was entering a “new era.” In January 1920, the Federal Reserve seasonally adjusted index of industrial production, a standard measure of aggregate economic activity, stood at 81 (1935–39 = 100). When the index peaked in July 1929 it was at 114, for a growth rate of 40.6 percent over this period. Similar rates of growth over the 1920–29 period equal to 47.3 percent and 42.4 percent are computed using annual real gross national product data from Balke and Gordon (1986) and Romer (1988), respectively. Further computations using the Balke and Gordon (1986) data indicate an average annual growth rate of real GNP over the 1920–29 period equal to 4.6 percent. In addition, the relative international economic strength of this country was clearly displayed by the fact that nearly one-half of world industrial output in 1925–29 was produced in the United States (Bernanke, 1983).

Consumer Durables Market

The decade of the 1920s also saw major innovations in the consumption behavior of households. The development of installment credit over this period led to substantial growth in the consumer durables market (Bernanke, 1983). Purchases of automobiles, refrigerators, radios and other such durable goods all experienced explosive growth during the 1920s as small borrowers, particularly households and unincorporated businesses, utilized their access to available credit (Persons, 1930; Bernanke, 1983; Soule, 1947).

Economic Growth in the 1920s

Economic growth during this period was mitigated only somewhat by three recessions. According to the National Bureau of Economic Research (NBER) business cycle chronology, two of these recessions were from May 1923 through July 1924 and October 1926 through November 1927. Both of these recessions were very mild and unremarkable. In contrast, the 1920s began with a recession lasting 18 months from the peak in January 1920 until the trough of July 1921. Original estimates of real GNP from the Commerce Department showed that real GNP fell 8 percent between 1919 and 1920 and another 7 percent between 1920 and 1921 (Romer, 1988). The behavior of prices contributed to the naming of this recession “the Depression of 1921,” as the implicit price deflator for GNP fell 16 percent and the Bureau of Labor Statistics wholesale price index fell 46 percent between 1920 and 1921. Although thought to be severe, Romer (1988) has argued that the so-called “postwar depression” was not as severe as once thought. While the deflation from war-time prices was substantial, revised estimates of real GNP show falls in output of only 1 percent between 1919 and 1920 and 2 percent between 1920 and 1921. Romer (1988) also argues that the behaviors of output and prices are inconsistent with the conventional explanation of the Depression of 1921 being primarily driven by a decline in aggregate demand. Rather, the deflation and the mild recession are better understood as resulting from a decline in aggregate demand together with a series of positive supply shocks, particularly in the production of agricultural goods, and significant decreases in the prices of imported primary commodities. Overall, the upshot is that the growth path of output was hardly impeded by the three minor downturns, so that the decade of the 1920s can properly be viewed economically as a very healthy period.

Fed Policies in the 1920s

Friedman and Schwartz (1963) label the 1920s “the high tide of the Reserve System.” As they explain, the Federal Reserve became increasingly confident in the tools of policy and in its knowledge of how to use them properly. The synchronous movements of economic activity and explicit policy actions by the Federal Reserve did not go unnoticed. Taking the next step and concluding there was cause and effect, the Federal Reserve in the 1920s began to use monetary policy as an implement to stabilize business cycle fluctuations. “In retrospect, we can see that this was a major step toward the assumption by government of explicit continuous responsibility for economic stability. As the decade wore on, the System took – and perhaps even more was given – credit for the generally stable conditions that prevailed, and high hopes were placed in the potency of monetary policy as then administered” (Friedman and Schwartz, 1963).

The giving/taking of credit to/by the Federal Reserve has particular value pertaining to the recession of 1920–21. Although suggesting the Federal Reserve probably tightened too much, too late, Friedman and Schwartz (1963) call this episode “the first real trial of the new system of monetary control introduced by the Federal Reserve Act.” It is clear from the history of the time that the Federal Reserve felt as though it had successfully passed this test. The data showed that the economy had quickly recovered and brisk growth followed the recession of 1920–21 for the remainder of the decade.

Questionable Lessons “Learned” by the Fed

Moreover, Eichengreen (1992) suggests that the episode of 1920–21 led the Federal Reserve System to believe that the economy could be successfully deflated or “liquidated” without paying a severe penalty in terms of reduced output. This conclusion, however, proved to be mistaken at the onset of the Depression. As argued by Eichengreen (1992), the Federal Reserve did not appreciate the extent to which the successful deflation could be attributed to the unique circumstances that prevailed during 1920–21. The European economies were still devastated after World War I, so the demand for United States’ exports remained strong many years after the War. Moreover, the gold standard was not in operation at the time. Therefore, European countries were not forced to match the deflation initiated in the United States by the Federal Reserve (explained below pertaining to the gold standard hypothesis).

The implication is that the Federal Reserve thought that deflation could be generated with little effect on real economic activity. Therefore, the Federal Reserve was not vigorous in fighting the Great Depression in its initial stages. It viewed the early years of the Depression as another opportunity to successfully liquidate the economy, especially after the perceived speculative excesses of the 1920s. However, the state of the economic world in 1929 was not a duplicate of 1920–21. By 1929, the European economies had recovered and the interwar gold standard was a vehicle for the international transmission of deflation. Deflation in 1929 would not operate as it did in 1920–21. The Federal Reserve failed to understand the economic implications of this change in the international standing of the United States’ economy. The result was that the Depression was permitted to spiral out of control and was made much worse than it otherwise would have been had the Federal Reserve not considered it to be a repeat of the 1920–21 recession.

The Beginnings of the Great Depression

In January 1928 the seeds of the Great Depression, whenever they were planted, began to germinate. For it is around this time that two of the most prominent explanations for the depth, length, and worldwide spread of the Depression first came to be manifest. Without any doubt, the economics profession would come to a firm consensus around the idea that the economic events of the Great Depression cannot be properly understood without a solid linkage to both the behavior of the supply of money together with Federal Reserve actions on the one hand and the flawed structure of the interwar gold standard on the other.

It is well documented that many public officials, such as President Herbert Hoover and members of the Federal Reserve System in the latter 1920s, were intent on ending what they perceived to be the speculative excesses that were driving the stock market boom. Moreover, as explained by Hamilton (1987), despite plentiful denials to the contrary, the Federal Reserve assumed the role of “arbiter of security prices.” Although there continues to be debate as to whether or not the stock market was overvalued at the time (White, 1990; DeLong and Schleifer, 1991), the main point is that the Federal Reserve believed there to be a speculative bubble in equity values. Hamilton (1987) describes how the Federal Reserve, intending to “pop” the bubble, embarked on a highly contractionary monetary policy in January 1928. Between December 1927 and July 1928 the Federal Reserve conducted $393 million of open market sales of securities so that only $80 million remained in the Open Market account. Buying rates on bankers’ acceptances1 were raised from 3 percent in January 1928 to 4.5 percent by July, reducing Federal Reserve holdings of such bills by $193 million, leaving a total of only $185 million of these bills on balance. Further, the discount rate was increased from 3.5 percent to 5 percent, the highest level since the recession of 1920–21. “In short, in terms of the magnitudes consciously controlled by the Fed, it would be difficult to design a more contractionary policy than that initiated in January 1928” (Hamilton, 1987).

The pressure did not stop there, however. The death of Federal Reserve Bank President Benjamin Strong and the subsequent control of policy ascribed to Adolph Miller of the Federal Reserve Board insured that the fall in the stock market was going to be made a reality. Miller believed the speculative excesses of the stock market were hurting the economy, and the Federal Reserve continued attempting to put an end to this perceived harm (Cecchetti, 1998). The amount of Federal Reserve credit that was being extended to market participants in the form of broker loans became an issue in 1929. The Federal Reserve adamantly discouraged lending that was collateralized by equities. The intentions of the Board of Governors of the Federal Reserve were made clear in a letter dated February 2, 1929 sent to Federal Reserve banks. In part the letter read:

The board has no disposition to assume authority to interfere with the loan practices of member banks so long as they do not involve the Federal reserve banks. It has, however, a grave responsibility whenever there is evidence that member banks are maintaining speculative security loans with the aid of Federal reserve credit. When such is the case the Federal reserve bank becomes either a contributing or a sustaining factor in the current volume of speculative security credit. This is not in harmony with the intent of the Federal Reserve Act, nor is it conducive to the wholesome operation of the banking and credit system of the country. (Board of Governors of the Federal Reserve 1929: 93–94, quoted from Cecchetti, 1998)

The deflationary pressure to stock prices had been applied. It was now a question of when the market would break. Although the effects were not immediate, the wait was not long.

The Economy Stumbles

The NBER business cycle chronology dates the start of the Great Depression in August 1929. For this reason many have said that the Depression started on Main Street and not Wall Street. Be that as it may, the stock market plummeted in October of 1929. The bursting of the speculative bubble had been achieved and the economy was now headed in an ominous direction. The Federal Reserve’s seasonally adjusted index of industrial production stood at 114 (1935–39 = 100) in August 1929. By October it had fallen to 110 for a decline of 3.5 percent (annualized percentage decline = 14.7 percent). After the crash, the incipient recession intensified, with the industrial production index falling from 110 in October to 100 in December 1929, or 9 percent (annualized percentage decline = 41 percent). In 1930, the index fell further from 100 in January to 79 in December, or an additional 21percent.

Links between the Crash and the Depression?

While popular history treats the crash and the Depression as one and the same event, economists know that they were not. But there is no doubt that the crash was one of the things that got the ball rolling. Several authors have offered explanations for the linkage between the crash and the recession of 1929–30. Mishkin (1978) argues that the crash and an increase in liabilities led to a deterioration in households’ balance sheets. The reduced liquidity2 led consumers to defer consumption of durable goods and housing and thus contributed to a fall in consumption. Temin (1976) suggests that the fall in stock prices had a negative wealth effect on consumption, but attributes only a minor role to this given that stocks were not a large fraction of total wealth; the stock market in 1929, although falling dramatically, remained above the value it had achieved in early 1928, and the propensity to consume from wealth was small during this period. Romer (1990) provides evidence suggesting that if the stock market were thought to be a predictor of future economic activity, then the crash can rightly be viewed as a source of increased consumer uncertainty that depressed spending on consumer durables and accelerated the decline that had begun in August 1929. Flacco and Parker (1992) confirm Romer’s findings using different data and alternative estimation techniques.

Looking back on the behavior of the economy during the year of 1930, industrial production declined 21 percent, the consumer price index fell 2.6 percent, the supply of high-powered money (that is, the liabilities of the Federal Reserve that are usable as money, consisting of currency in circulation and bank reserves; also called the monetary base) fell 2.8 percent, the nominal supply of money as measured by M1 (the product of the monetary base3 multiplied by the money multiplier4) dipped 3.5 percent and the ex post real interest rate turned out to be 11.3 percent, the highest it had been since the recession of 1920–21 (Hamilton, 1987). In spite of this, when put into historical context, there was no reason to view the downturn of 1929–30 as historically unprecedented. Its magnitude was comparable to that of many recessions that had previously occurred. Perhaps there was justifiable optimism in December 1930 that the economy might even shake off the negative movement and embark on the path to recovery, rather like what had occurred after the recession of 1920–21 (Bernanke, 1983). As we know, the bottom would not come for another 27 months.

The Economy Crumbles

Banking Failures

During 1931, there was a “change in the character of the contraction” (Friedman and Schwartz, 1963). Beginning in October 1930 and lasting until December 1930, the first of a series of banking panics now accompanied the downward spasms of the business cycle. Although bank failures had occurred throughout the 1920s, the magnitude of the failures that occurred in the early 1930s was of a different order altogether (Bernanke, 1983). The absence of any type of deposit insurance resulted in the contagion of the panics being spread to sound financial institutions and not just those on the margin.

Traditional Methods of Combating Bank Runs Not Used

Moreover, institutional arrangements that had existed in the private banking system designed to provide liquidity – to convert assets into cash – to fight bank runs before 1913 were not exercised after the creation of the Federal Reserve System. For example, during the panic of 1907, the effects of the financial upheaval had been contained through a combination of lending activities by private banks, called clearinghouses, and the suspension of deposit convertibility into currency. While not preventing bank runs and the financial panic, their economic impact was lessened to a significant extent by these countermeasures enacted by private banks, as the economy quickly recovered in 1908. The aftermath of the panic of 1907 and the desire to have a central authority to combat the contagion of financial disruptions was one of the factors that led to the establishment of the Federal Reserve System. After the creation of the Federal Reserve, clearinghouse lending and suspension of deposit convertibility by private banks were not undertaken. Believing the Federal Reserve to be the “lender of last resort,” it was apparently thought that the responsibility to fight bank runs was the domain of the central bank (Friedman and Schwartz, 1963; Bernanke, 1983). Unfortunately, when the banking panics came in waves and the financial system was collapsing, being the “lender of last resort” was a responsibility that the Federal Reserve either could not or would not assume.

Money Supply Contracts

The economic effects of the banking panics were devastating. Aside from the obvious impact of the closing of failed banks and the subsequent loss of deposits by bank customers, the money supply accelerated its downward spiral. Although the economy had flattened out after the first wave of bank failures in October–December 1930, with the industrial production index steadying from 79 in December 1930 to 80 in April 1931, the remainder of 1931 brought a series of shocks from which the economy was not to recover for some time.

Second Wave of Banking Failure

In May, the failure of Austria’s largest bank, the Kredit-anstalt, touched off financial panics in Europe. In September 1931, having had enough of the distress associated with the international transmission of economic depression, Britain abandoned its participation in the gold standard. Further, just as the United States’ economy appeared to be trying to begin recovery, the second wave of bank failures hit the financial system in June and did not abate until December. In addition, the Hoover administration in December 1931, adhering to its principles of limited government, embarked on a campaign to balance the federal budget. Tax increases resulted the following June, just as the economy was to hit the first low point of its so-called “double bottom” (Hoover, 1952).

The results of these events are now evident. Between January and December 1931 the industrial production index declined from 78 to 66, or 15.4 percent, the consumer price index fell 9.4 percent, the nominal supply of M1 dipped 5.7 percent, the ex post real interest rate5 remained at 11.3 percent, and although the supply of high-powered money6 actually increased 5.5 percent, the currency–deposit and reserve–deposit ratios began their upward ascent, and thus the money multiplier started its downward plunge (Hamilton, 1987). If the economy had flattened out in the spring of 1931, then by December output, the money supply, and the price level were all on negative growth paths that were dragging the economy deeper into depression.

Third Wave of Banking Failure

The economic difficulties were far from over. The economy displayed some evidence of recovery in late summer/early fall of 1932. However, in December 1932 the third, and largest, wave of banking panics hit the financial markets and the collapse of the economy arrived with the business cycle hitting bottom in March 1933. Industrial production between January 1932 and March 1933 fell an additional 15.6 percent. For the combined years of 1932 and 1933, the consumer price index fell a cumulative 16.2 percent, the nominal supply of M1 dropped 21.6 percent, the nominal M2 money supply fell 34.7 percent, and although the supply of high-powered money increased 8.4 percent, the currency–deposit and reserve–deposit ratios accelerated their upward ascent. Thus the money multiplier continued on a downward plunge that was not arrested until March 1933. Similar behaviors for real GDP, prices, money supplies and other key macroeconomic variables occurred in many European economies as well (Snowdon and Vane, 1999; Temin, 1989).

An examination of the macroeconomic data in August 1929 compared to March 1933 provides a stark contrast. The unemployment rate of 3 percent in August 1929 was at 25 percent in March 1933. The industrial production index of 114 in August 1929 was at 54 in March 1933, or a 52.6 percent decrease. The money supply had fallen 35 percent, prices plummeted by about 33 percent, and more than one-third of banks in the United States were either closed or taken over by other banks. The “new era” ushered in by “the roaring twenties” was over. Roosevelt took office in March 1933, a nationwide bank holiday was declared from March 6 until March 13, and the United States abandoned the international gold standard in April 1933. Recovery commenced immediately and the economy began its long path back to the pre-1929 secular growth trend.

Table 1 summarizes the drop in industrial production in the major economies of Western Europe and North America. Table 2 gives gross national product estimates for the United States from 1928 to 1941. The constant price series adjusts for inflation and deflation.

Table 1
Indices of Total Industrial Production, 1927 to 1935 (1929 = 100)

1927 1928 1929 1930 1931 1932 1933 1934 1935
Britain 95 94 100 94 86 89 95 105 114
Canada 85 94 100 91 78 68 69 82 90
France 84 94 100 99 85 74 83 79 77
Germany 95 100 100 86 72 59 68 83 96
Italy 87 99 100 93 84 77 83 85 99
Netherlands 87 94 100 109 101 90 90 93 95
Sweden 85 88 100 102 97 89 93 111 125
U.S. 85 90 100 83 69 55 63 69 79

Source: Industrial Statistics, 1900-57 (Paris, OEEC, 1958), Table 2.

Table 2
U.S. GNP at Constant (1929) and Current Prices, 1928-1941

Year GNP at constant (1929) prices (billions of $) GNP at current prices (billions of $)
1928 98.5 98.7
1929 104.4 104.6
1930 95.1 91.2
1931 89.5 78.5
1932 76.4 58.6
1933 74.2 56.1
1934 80.8 65.5
1935 91.4 76.5
1936 100.9 83.1
1937 109.1 91.2
1938 103.2 85.4
1939 111.0 91.2
1940 121.0 100.5
1941 131.7 124.7

Contemporary Explanations

The economics profession during the 1930s was at a loss to explain the Depression. The most prominent conventional explanations were of two types. First, some observers at the time firmly grounded their explanations on the two pillars of classical macroeconomic thought, Say’s Law and the belief in the self-equilibrating powers of the market. Many argued that it was simply a question of time before wages and prices adjusted fully enough for the economy to return to full employment and achieve the realization of the putative axiom that “supply creates its own demand.” Second, the Austrian school of thought argued that the Depression was the inevitable result of overinvestment during the 1920s. The best remedy for the situation was to let the Depression run its course so that the economy could be purified from the negative effects of the false expansion. Government intervention was viewed by the Austrian school as a mechanism that would simply prolong the agony and make any subsequent depression worse than it would ordinarily be (Hayek, 1966; Hayek, 1967).

Liquidationist Theory

The Hoover administration and the Federal Reserve Board also contained several so-called “liquidationists.” These individuals basically believed that economic agents should be forced to re-arrange their spending proclivities and alter their alleged profligate use of resources. If it took mass bankruptcies to produce this result and wipe the slate clean so that everyone could have a fresh start, then so be it. The liquidationists viewed the events of the Depression as an economic penance for the speculative excesses of the 1920s. Thus, the Depression was the price that was being paid for the misdeeds of the previous decade. This is perhaps best exemplified in the well-known quotation of Treasury Secretary Andrew Mellon, who advised President Hoover to “Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate.” Mellon continued, “It will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up the wrecks from less competent people” (Hoover, 1952). Hoover apparently followed this advice as the Depression wore on. He continued to reassure the public that if the principles of orthodox finance were faithfully followed, recovery would surely be the result.

The business press at the time was not immune from such liquidationist prescriptions either. The Commercial and Financial Chronicle, in an August 3, 1929 editorial entitled “Is Not Group Speculating Conspiracy, Fostering Sham Prosperity?” complained of the economy being replete with profligate spending including:

(a) The luxurious diversification of diet advantageous to dairy men … and fruit growers …; (b) luxurious dressing … more silk and rayon …; (c) free spending for automobiles and their accessories, gasoline, house furnishings and equipment, radios, travel, amusements and sports; (d) the displacement from the farms by tractors and autos of produce-consuming horses and mules to a number aggregating 3,700,000 for the period 1918–1928 … (e) the frills of education to thousands for whom places might better be reserved at bench or counter or on the farm. (Quoted from Nelson, 1991)

Persons, in a paper which appeared in the November 1930 Quarterly Journal of Economics, demonstrates that some academic economists also held similar liquidationist views.

Although certainly not universal, the descriptions above suggest that no small part of the conventional wisdom at the time believed the Depression to be a penitence for past sins. In addition, it was thought that the economy would be restored to full employment equilibrium once wages and prices adjusted sufficiently. Say’s Law will ensure the economy will return to health, and supply will create its own demand sufficient to return to prosperity, if we simply let the system work its way through. In his memoirs published in 1952, 20 years after his election defeat, Herbert Hoover continued to steadfastly maintain that if Roosevelt and the New Dealers would have stuck to the policies his administration put in place, the economy would have made a full recovery within 18 months after the election of 1932. We have to intensify our resolve to “stay the course.” All will be well in time if we just “take our medicine.” In hindsight, it challenges the imagination to think up worse policy prescriptions for the events of 1929–33.

Modern Explanations

There remains considerable debate regarding the economic explanations for the behavior of the business cycle between August 1929 and March 1933. This section describes the main hypotheses that have been presented in the literature attempting to explain the causes for the depth, protracted length, and worldwide propagation of the Great Depression.

The United States’ experience, considering the preponderance of empirical results and historical simulations contained in the economic literature, can largely be accounted for by the monetary hypothesis of Friedman and Schwartz (1963) together with the nonmonetary/financial hypotheses of Bernanke (1983) and Fisher (1933). That is, most, but not all, of the characteristic phases of the business cycle and depth to which output fell from 1929 to 1933 can be accounted for by the monetary and nonmonetary/financial hypotheses. The international experience, well documented in Choudri and Kochin (1980), Hamilton (1988), Temin (1989), Bernanke and James (1991), and Eichengreen (1992), can be properly understood as resulting from a flawed interwar gold standard. Each of these hypotheses is explained in greater detail below.

Nonmonetary/Nonfinancial Theories

It should be noted that I do not include a section covering the nonmonetary/nonfinancial theories of the Great Depression. These theories, including Temin’s (1976) focus on autonomous consumption decline, the collapse of housing construction contained in Anderson and Butkiewicz (1980), the effects of the stock market crash, the uncertainty hypothesis of Romer (1990), and the Smoot–Hawley Tariff Act of 1930, are all worthy of mention and can rightly be apportioned some of the responsibility for initiating the Depression. However, any theory of the Depression must be able to account for the protracted problems associated with the punishing deflation imposed on the United States and the world during that era. While the nonmonetary/nonfinancial theories go a long way accounting for the impetus for, and first year of the Depression, my reading of the empirical results of the economic literature indicates that they do not have the explanatory power of the three other theories mentioned above to account for the depths to which the economy plunged.

Moreover, recent research by Olney (1999) argues convincingly that the decline in consumption was not autonomous at all. Rather, the decline resulted because high consumer indebtedness threatened future consumption spending because default was expensive. Olney shows that households were shouldering an unprecedented burden of installment debt – especially for automobiles. In addition, down payments were large and contracts were short. Missed installment payments triggered repossession, reducing consumer wealth in 1930 because households lost all acquired equity. Cutting consumption was the only viable strategy in 1930 for avoiding default.

The Monetary Hypothesis

In reviewing the economic history of the Depression above, it was mentioned that the supply of money fell by 35 percent, prices dropped by about 33 percent, and one-third of all banks vanished. Milton Friedman and Anna Schwartz, in their 1963 book A Monetary History of the United States, 1867–1960, call this massive drop in the supply of money “The Great Contraction.”

Friedman and Schwartz (1963) discuss and painstakingly document the synchronous movements of the real economy with the disruptions that occurred in the financial sector. They point out that the series of bank failures that occurred beginning in October 1930 worsened economic conditions in two ways. First, bank shareholder wealth was reduced as banks failed. Second, and most importantly, the bank failures were exogenous shocks and led to the drastic decline in the money supply. The persistent deflation of the 1930s follows directly from this “great contraction.”

Criticisms of Fed Policy

However, this raises an important question: Where was the Federal Reserve while the money supply and the financial system were collapsing? If the Federal Reserve was created in 1913 primarily to be the “lender of last resort” for troubled financial institutions, it was failing miserably. Friedman and Schwartz pin the blame squarely on the Federal Reserve and the failure of monetary policy to offset the contractions in the money supply. As the money multiplier continued on its downward path, the monetary base, rather than being aggressively increased, simply progressed slightly upwards on a gently positive sloping time path. As banks were failing in waves, was the Federal Reserve attempting to contain the panics by aggressively lending to banks scrambling for liquidity? The unfortunate answer is “no.” When the panics were occurring, was there discussion of suspending deposit convertibility or suspension of the gold standard, both of which had been successfully employed in the past? Again the unfortunate answer is “no.” Did the Federal Reserve consider the fact that it had an abundant supply of free gold, and therefore that monetary expansion was feasible? Once again the unfortunate answer is “no.” The argument can be summarized by the following quotation:

At all times throughout the 1929–33 contraction, alternative policies were available to the System by which it could have kept the stock of money from falling, and indeed could have increased it at almost any desired rate. Those policies did not involve radical innovations. They involved measures of a kind the System had taken in earlier years, of a kind explicitly contemplated by the founders of the System to meet precisely the kind of banking crisis that developed in late 1930 and persisted thereafter. They involved measures that were actually proposed and very likely would have been adopted under a slightly different bureaucratic structure or distribution of power, or even if the men in power had had somewhat different personalities. Until late 1931 – and we believe not even then – the alternative policies involved no conflict with the maintenance of the gold standard. Until September 1931, the problem that recurrently troubled the System was how to keep the gold inflows under control, not the reverse. (Friedman and Schwartz, 1963)

The inescapable conclusion is that it was a failure of the policies of the Federal Reserve System in responding to the crises of the time that made the Depression as bad as it was. If monetary policy had responded differently, the economic events of 1929–33 need not have been as they occurred. This assertion is supported by the results of Fackler and Parker (1994). Using counterfactual historical simulations, they show that if the Federal Reserve had kept the M1 money supply growing along its pre-October 1929 trend of 3.3 percent annually, most of the Depression would have been averted. McCallum (1990) also reaches similar conclusions employing a monetary base feedback policy in his counterfactual simulations.

Lack of Leadership at the Fed

Friedman and Schwartz trace the seeds of these regrettable events to the death of Federal Reserve Bank of New York President Benjamin Strong in 1928. Strong’s death altered the locus of power in the Federal Reserve System and left it without effective leadership. Friedman and Schwartz maintain that Strong had the personality, confidence and reputation in the financial community to lead monetary policy and sway policy makers to his point of view. Friedman and Schwartz believe that Strong would not have permitted the financial panics and liquidity crises to persist and affect the real economy. Instead, after Governor Strong died, the conduct of open market operations changed from a five-man committee dominated by the New York Federal Reserve to that of a 12-man committee of Federal Reserve Bank governors. Decisiveness in leadership was replaced by inaction and drift. Others (Temin, 1989; Wicker, 1965) reject this point, claiming the policies of the Federal Reserve in the 1930s were not inconsistent with the policies pursued in the decade of the 1920s.

The Fed’s Failure to Distinguish between Nominal and Real Interest Rates

Meltzer (1976) also points out errors made by the Federal Reserve. His argument is that the Federal Reserve failed to distinguish between nominal and real interest rates. That is, while nominal rates were falling, the Federal Reserve did virtually nothing, since it construed this to be a sign of an “easy” credit market. However, in the face of deflation, real rates were rising and there was in fact a “tight” credit market. Failure to make this distinction led money to be a contributing factor to the initial decline of 1929.


Cecchetti (1992) and Nelson (1991) bolster the monetary hypothesis by demonstrating that the deflation during the Depression was anticipated at short horizons, once it was under way. The result, using the Fisher equation, is that high ex ante real interest rates were the transmission mechanism that led from falling prices to falling output. In addition, Cecchetti (1998) and Cecchetti and Karras (1994) argue that if the lower bound of the nominal interest rate is reached, then continued deflation renders the opportunity cost of holding money negative. In this instance the nature of money changes. Now the rate of deflation places a floor on the real return nonmoney assets must provide to make them attractive to hold. If they cannot exceed the rate on money holdings, then agents will move their assets into cash and the result will be negative net investment and a decapitalization of the economy.

Critics of the Monetary Hypothesis

The monetary hypothesis, however, is not without its detractors. Paul Samuelson observes that the monetary base did not fall during the Depression. Moreover, expecting the Federal Reserve to have aggressively increased the monetary base by whatever amount was necessary to stop the decline in the money supply is hindsight. A course of action for monetary policy such as this was beyond the scope of discussion prevailing at the time. In addition, others, like Moses Abramovitz, point out that the money supply had endogenous components that were beyond the Federal Reserve’s ability to control. Namely, the money supply may have been falling as a result of declining economic activity, or so-called “reverse causation.” Moreover the gold standard, to which the United States continued to adhere until March 1933, also tied the hands of the Federal Reserve in so far as gold outflows that occurred required the Federal Reserve to contract the supply of money. These views are also contained in Temin (1989) and Eichengreen (1992), as discussed below.

Bernanke (1983) argues that the monetary hypothesis: (i) is not a complete explanation of the link between the financial sector and aggregate output in the 1930s; (ii) does not explain how it was that decreases in the money supply caused output to keep falling over many years, especially since it is widely believed that changes in the money supply only change prices and other nominal economic values in the long run, not real economic values like output ; and (iii) is quantitatively insufficient to explain the depth of the decline in output. Bernanke (1983) not only resurrected and sharpened Fisher’s (1933) debt deflation hypothesis, but also made further contributions to what has come to be known as the nonmonetary/financial hypothesis.

The Nonmonetary/Financial Hypothesis

Bernanke (1983), building on the monetary hypothesis of Friedman and Schwartz (1963), presents an alternative interpretation of the way in which the financial crises may have affected output. The argument involves both the effects of debt deflation and the impact that bank panics had on the ability of financial markets to efficiently allocate funds from lenders to borrowers. These nonmonetary/financial theories hold that events in financial markets other than shocks to the money supply can help to account for the paths of output and prices during the Great Depression.

Fisher (1933) asserted that the dominant forces that account for “great” depressions are (nominal) over-indebtedness and deflation. Specifically, he argued that real debt burdens were substantially increased when there were dramatic declines in the price level and nominal incomes. The combination of deflation, falling nominal income and increasing real debt burdens led to debtor insolvency, lowered aggregate demand, and thereby contributed to a continuing decline in the price level and thus further increases in the real burden of debt.

The “Credit View”

Bernanke (1983), in what is now called the “credit view,” provided additional details to help explain Fisher’s debt deflation hypothesis. He argued that in normal circumstances, an initial decline in prices merely reallocates wealth from debtors to creditors, such as banks. Usually, such wealth redistributions are minor in magnitude and have no first-order impact on the economy. However, in the face of large shocks, deflation in the prices of assets forfeited to banks by debtor bankruptcies leads to a decline in the nominal value of assets on bank balance sheets. For a given value of bank liabilities, also denominated in nominal terms, this deterioration in bank assets threatens insolvency. As banks reallocate away from loans to safer government securities, some borrowers, particularly small ones, are unable to obtain funds, often at any price. Further, if this reallocation is long-lived, the shortage of credit for these borrowers helps to explain the persistence of the downturn. As the disappearance of bank financing forces lower expenditure plans, aggregate demand declines, which again contributes to the downward deflationary spiral. For debt deflation to be operative, it is necessary to demonstrate that there was a substantial build-up of debt prior to the onset of the Depression and that the deflation of the 1930s was at least partially unanticipated at medium- and long-term horizons at the time that the debt was being incurred. Both of these conditions appear to have been in place (Fackler and Parker, 2001; Hamilton, 1992; Evans and Wachtel, 1993).

The Breakdown in Credit Markets

In addition, the financial panics which occurred hindered the credit allocation mechanism. Bernanke (1983) explains that the process of credit intermediation requires substantial information gathering and non-trivial market-making activities. The financial disruptions of 1930–33 are correctly viewed as substantial impediments to the performance of these services and thus impaired the efficient allocation of credit between lenders and borrowers. That is, financial panics and debtor and business bankruptcies resulted in a increase in the real cost of credit intermediation. As the cost of credit intermediation increased, sources of credit for many borrowers (especially households, farmers and small firms) became expensive or even unobtainable at any price. This tightening of credit put downward pressure on aggregate demand and helped turn the recession of 1929–30 into the Great Depression. The empirical support for the validity of the nonmonetary/financial hypothesis during the Depression is substantial (Bernanke, 1983; Fackler and Parker, 1994, 2001; Hamilton, 1987, 1992), although support for the “credit view” for the transmission mechanism of monetary policy in post-World War II economic activity is substantially weaker. In combination, considering the preponderance of empirical results and historical simulations contained in the economic literature, the monetary hypothesis and the nonmonetary/financial hypothesis go a substantial distance toward accounting for the economic experiences of the United States during the Great Depression.

The Role of Pessimistic Expectations

To this combination, the behavior of expectations should also be added. As explained by James Tobin, there was another reason for a “change in the character of the contraction” in 1931. Although Friedman and Schwartz attribute this “change” to the bank panics that occurred, Tobin points out that change also took place because of the emergence of pessimistic expectations. If it was thought that the early stages of the Depression were symptomatic of a recession that was not different in kind from similar episodes in our economic history, and that recovery was a real possibility, the public need not have had pessimistic expectations. Instead the public may have anticipated things would get better. However, after the British left the gold standard, expectations changed in a very pessimistic way. The public may very well have believed that the business cycle downturn was not going to be reversed, but rather was going to get worse than it was. When households and business investors begin to make plans based on the economy getting worse instead of making plans based on anticipations of recovery, the depressing economic effects on consumption and investment of this switch in expectations are common knowledge in the modern macroeconomic literature. For the literature on the Great Depression, the empirical research conducted on the expectations hypothesis focuses almost exclusively on uncertainty (which is not the same thing as pessimistic/optimistic expectations) and its contribution to the onset of the Depression (Romer, 1990; Flacco and Parker, 1992). Although Keynes (1936) writes extensively about the state of expectations and their economic influence, the literature is silent regarding the empirical validity of the expectations hypothesis in 1931–33. Yet, in spite of this, the continued shocks that the United States’ economy received demonstrated that the business cycle downturn of 1931–33 was of a different kind than had previously been known. Once the public believed this to be so and made their plans accordingly, the results had to have been economically devastating. There is no formal empirical confirmation and I have not segregated the expectations hypothesis as a separate hypothesis in the overview. However, the logic of the above argument compels me to be of the opinion that the expectations hypothesis provides an impressive addition to the monetary hypothesis and the nonmonetary/financial hypothesis in accounting for the economic experiences of the United States during the Great Depression.

The Gold Standard Hypothesis

Recent research on the operation of the interwar gold standard has deepened our understanding of the Depression and its international character. The way and manner in which the interwar gold standard was structured and operated provide a convincing explanation of the international transmission of deflation and depression that occurred in the 1930s.

The story has its beginning in the 1870–1914 period. During this time the gold standard functioned as a pegged exchange rate system where certain rules were observed. Namely, it was necessary for countries to permit their money supplies to be altered in response to gold flows in order for the price-specie flow mechanism to function properly. It operated successfully because countries that were gaining gold allowed their money supply to increase and raise the domestic price level to restore equilibrium and maintain the fixed exchange rate of their currency. Countries that were losing gold were obligated to permit their money supply to decrease and generate a decline in their domestic price level to restore equilibrium and maintain the fixed exchange rate of their currency. Eichengreen (1992) discusses and extensively documents that the gold standard of this period functioned as smoothly as it did because of the international commitment countries had to the gold standard and the level of international cooperation exhibited during this time. “What rendered the commitment to the gold standard credible, then, was that the commitment was international, not merely national. That commitment was activated through international cooperation” (Eichengreen, 1992).

The gold standard was suspended when the hostilities of World War I broke out. By the end of 1928, major countries such as the United States, the United Kingdom, France and Germany had re-established ties to a functioning fixed exchange rate gold standard. However, Eichengreen (1992) points out that the world in which the gold standard functioned before World War I was not the same world in which the gold standard was being re-established. A credible commitment to the gold standard, as Hamilton (1988) explains, required that a country maintain fiscal soundness and political objectives that insured the monetary authority could pursue a monetary policy consistent with long-run price stability and continuous convertibility of the currency. Successful operation required these conditions to be in place before re-establishment of the gold standard was operational. However, many governments during the interwar period went back on the gold standard in the opposite set of circumstances. They re-established ties to the gold standard because they were incapable, due to the political chaos generated after World War I, of fiscal soundness and did not have political objectives conducive to reforming monetary policy such that it could insure long-run price stability. “By this criterion, returning to the gold standard could not have come at a worse time or for poorer reasons” (Hamilton, 1988). Kindleberger (1973) stresses the fact that the pre-World War I gold standard functioned as well as it did because of the unquestioned leadership exercised by Great Britain. After World War I and the relative decline of Britain, the United States did not exhibit the same strength of leadership Britain had shown before. The upshot is that it was an unsuitable environment in which to re-establish the gold standard after World War I and the interwar gold standard was destined to drift in a state of malperformance as no one took responsibility for its proper functioning. However, the problems did not end there.

Flaws in the Interwar International Gold Standard

Lack of Symmetry in the Response of Gold-Gaining and Gold-Losing Countries

The interwar gold standard operated with four structural/technical flaws that almost certainly doomed it to failure (Eichengreen, 1986; Temin, 1989; Bernanke and James, 1991). The first, and most damaging, was the lack of symmetry in the response of gold-gaining countries and gold-losing countries that resulted in a deflationary bias that was to drag the world deeper into deflation and depression. If a country was losing gold reserves, it was required to decrease its money supply to maintain its commitment to the gold standard. Given that a minimum gold reserve had to be maintained and that countries became concerned when the gold reserve fell within 10 percent of this minimum, little gold could be lost before the necessity of monetary contraction, and thus deflation, became a reality. Moreover, with a fractional gold reserve ratio of 40 percent, the result was a decline in the domestic money supply equal to 2.5 times the gold outflow. On the other hand, there was no such constraint on countries that experienced gold inflows. Gold reserves were accumulated without the binding requirement that the domestic money supply be expanded. Thus the price–specie flow mechanism ceased to function and the equilibrating forces of the pre-World War I gold standard were absent during the interwar period. If a country attracting gold reserves were to embark on a contractionary path, the result would be the further extraction of gold reserves from other countries on the gold standard and the imposition of deflation on their economies as well, as they were forced to contract their money supplies. “As it happened, both of the two major gold surplus countries – France and the United States, who at the time together held close to 60 percent of the world’s monetary gold – took deflationary paths in 1928–1929” (Bernanke and James, 1991).

Foreign Exchange Reserves

Second, countries that did not have reserve currencies could hold their minimum reserves in the form of both gold and convertible foreign exchange reserves. If the threat of devaluation of a reserve currency appeared likely, a country holding foreign exchange reserves could divest itself of the foreign exchange, as holding it became a more risky proposition. Further, the convertible reserves were usually only fractionally backed by gold. Thus, if countries were to prefer gold holdings as opposed to foreign exchange reserves for whatever reason, the result would be a contraction in the world money supply as reserves were destroyed in the movement to gold. This effect can be thought of as equivalent to the effect on the domestic money supply in a fractional reserve banking system of a shift in the public’s money holdings toward currency and away from bank deposits.

The Bank of France and Open Market Operations

Third, the powers of many European central banks were restricted or excluded outright. In particular, as discussed by Eichengreen (1986), the Bank of France was prohibited from engaging in open market operations, i.e. the purchase or sale of government securities. Given that France was one of the countries amassing gold reserves, this restriction largely prevented them from adhering to the rules of the gold standard. The proper response would have been to expand their supply of money and inflate so as not to continue to attract gold reserves and impose deflation on the rest of the world. This was not done. France continued to accumulate gold until 1932 and did not leave the gold standard until 1936.

Inconsistent Currency Valuations

Lastly, the gold standard was re-established at parities that were unilaterally determined by each individual country. When France returned to the gold standard in 1926, it returned at a parity rate that is believed to have undervalued the franc. When Britain returned to the gold standard in 1925, it returned at a parity rate that is believed to have overvalued the pound. In this situation, the only sustainable equilibrium required the French to inflate their economy in response to the gold inflows. However, given their legacy of inflation during the 1921–26 period, France steadfastly resisted inflation (Eichengreen, 1986). The maintenance of the gold standard and the resistance to inflation were now inconsistent policy objectives. The Bank of France’s inability to conduct open market operations only made matters worse. The accumulation of gold and the exporting of deflation to the world was the result.

The Timing of Recoveries

Taken together, the flaws described above made the interwar gold standard dysfunctional and in the end unsustainable. Looking back, we observe that the record of departure from the gold standard and subsequent recovery was different for many different countries. For some countries recovery came sooner. For some it came later. It is in this timing of departure from the gold standard that recent research has produced a remarkable empirical finding. From the work of Choudri and Kochin (1980), Eichengreen and Sachs (1985), Temin (1989), and Bernanke and James (1991), we now know that the sooner a country abandoned the gold standard, the quicker recovery commenced. Spain, which never restored its participation in the gold standard, missed the ravages of the Depression altogether. Britain left the gold standard in September 1931, and started to recover. Sweden left the gold standard at the same time as Britain, and started to recover. The United States left in March 1933, and recovery commenced. France, Holland, and Poland continued to have their economies struggle after the United States’ recovery began as they continued to adhere to the gold standard until 1936. Only after they left did recovery start; departure from the gold standard freed a country from the ravages of deflation.

The Fed and the Gold Standard: The “Midas Touch”

Temin (1989) and Eichengreen (1992) argue that it was the unbending commitment to the gold standard that generated deflation and depression worldwide. They emphasize that the gold standard required fiscal and monetary authorities around the world to submit their economies to internal adjustment and economic instability in the face of international shocks. Given how the gold standard tied countries together, if the gold parity were to be defended and devaluation was not an option, unilateral monetary actions by any one country were pointless. The end result is that Temin (1989) and Eichengreen (1992) reject Friedman and Schwartz’s (1963) claim that the Depression was caused by a series of policy failures on the part of the Federal Reserve. Actions taken in the United States, according to Temin (1989) and Eichengreen (1992), cannot be properly understood in isolation with respect to the rest of the world. If the commitment to the gold standard was to be maintained, monetary and fiscal authorities worldwide had little choice in responding to the crises of the Depression. Why did the Federal Reserve continue a policy of inaction during the banking panics? Because the commitment to the gold standard, what Temin (1989) has labeled “The Midas Touch,” gave them no choice but to let the banks fail. Monetary expansion and the injection of liquidity would lower interest rates, lead to a gold outflow, and potentially be contrary to the rules of the gold standard. Continued deflation due to gold outflows would begin to call into question the monetary authority’s commitment to the gold standard. “Defending gold parity might require the authorities to sit idly by as the banking system crumbled, as the Federal Reserve did at the end of 1931 and again at the beginning of 1933” (Eichengreen, 1992). Thus, if the adherence to the gold standard were to be maintained, the money supply was endogenous with respect to the balance of payments and beyond the influence of the Federal Reserve.

Eichengreen (1992) concludes further that what made the pre-World War I gold standard so successful was absent during the interwar period: credible commitment to the gold standard activated through international cooperation in its implementation and management. Had these important ingredients of the pre-World War I gold standard been present during the interwar period, twentieth-century economic history may have been very different.

Recovery and the New Deal

March 1933 was the rock bottom of the Depression and the inauguration of Franklin D. Roosevelt represented a sharp break with the status quo. Upon taking office, a bank holiday was declared, the United States left the interwar gold standard the following month, and the government commenced with several measures designed to resurrect the financial system. These measures included: (i) the establishment of the Reconstruction Finance Corporation which set about funneling large sums of liquidity to banks and other intermediaries; (ii) the Securities Exchange Act of 1934 which established margin requirements for bank loans used to purchase stocks and bonds and increased information requirements to potential investors; and (iii) the Glass–Steagal Act which strictly separated commercial banking and investment banking. Although delivering some immediate relief to financial markets, lenders continued to be reluctant to extend credit after the events of 1929–33, and the recovery of financial markets was slow and incomplete. Bernanke (1983) estimates that the United States’ financial system did not begin to shed the inefficiencies under which it was operating until the end of 1935.


Policies designed to promote different economic institutions were enacted as part of the New Deal. The National Industrial Recovery Act (NIRA) was passed on June 6, 1933 and was designed to raise prices and wages. In addition, the Act mandated the formation of planning boards in critical sectors of the economy. The boards were charged with setting output goals for their respective sector and the usual result was a restriction of production. In effect, the NIRA was a license for industries to form cartels and was struck down as unconstitutional in 1935. The Agricultural Adjustment Act of 1933 was similar legislation designed to reduce output and raise prices in the farming sector. It too was ruled unconstitutional in 1936.

Relief and Jobs Programs

Other policies intended to provide relief directly to people who were destitute and out of work were rapidly enacted. The Civilian Conservation Corps (CCC), the Tennessee Valley Authority (TVA), the Public Works Administration (PWA) and the Federal Emergency Relief Administration (FERA) were set up shortly after Roosevelt took office and provided jobs for the unemployed and grants to states for direct relief. The Civil Works Administration (CWA), created in 1933–34, and the Works Progress Administration (WPA), created in 1935, were also designed to provide work relief to the jobless. The Social Security Act was also passed in 1935. There surely are other programs with similar acronyms that have been left out, but the intent was the same. In the words of Roosevelt himself, addressing Congress in 1938:

Government has a final responsibility for the well-being of its citizenship. If private co-operative endeavor fails to provide work for the willing hands and relief for the unfortunate, those suffering hardship from no fault of their own have a right to call upon the Government for aid; and a government worthy of its name must make fitting response. (Quoted from Polenberg, 2000)

The Depression had shown the inaccuracies of classifying the 1920s as a “new era.” Rather, the “new era,” as summarized by Roosevelt’s words above and initiated in government’s involvement in the economy, began in March 1933.

The NBER business cycle chronology shows continuous growth from March 1933 until May 1937, at which time a 13-month recession hit the economy. The business cycle rebounded in June 1938 and continued on its upward march to and through the beginning of the United States’ involvement in World War II. The recovery that started in 1933 was impressive, with real GNP experiencing annual rates of the growth in the 10 percent range between 1933 and December 1941, excluding the recession of 1937–38 (Romer, 1993). However, as reported by Romer (1993), real GNP did not return to its pre-Depression level until 1937 and real GNP did not catch up to its pre-Depression secular trend until 1942. Indeed, the unemployment rate, peaking at 25 percent in March 1933, continued to dwell near or above the double-digit range until 1940. It is in this sense that most economists attribute the ending of the Depression to the onset of World War II. The War brought complete recovery as the unemployment rate quickly plummeted after December 1941 to its nadir during the War of below 2 percent.

Explanations for the Pace of Recovery

The question remains, however, that if the War completed the recovery, what initiated it and sustained it through the end of 1941? Should we point to the relief programs of the New Deal and the leadership of Roosevelt? Certainly, they had psychological/expectational effects on consumers and investors and helped to heal the suffering experienced during that time. However, as shown by Brown (1956), Peppers (1973), and Raynold, McMillin and Beard (1991), fiscal policy contributed little to the recovery, and certainly could have done much more.

Once again we return to the financial system for answers. The abandonment of the gold standard, the impact this had on the money supply, and the deliverance from the economic effects of deflation would have to be singled out as the most important contributor to the recovery. Romer (1993) stresses that Eichengreen and Sachs (1985) have it right; recovery did not come before the decision to abandon the old gold parity was made operational. Once this became reality, devaluation of the currency permitted expansion in the money supply and inflation which, rather than promoting a policy of beggar-thy-neighbor, allowed countries to escape the deflationary vortex of economic decline. As discussed in connection with the gold standard hypothesis, the simultaneity of leaving the gold standard and recovery is a robust empirical result that reflects more than simple temporal coincidence.

Romer (1993) reports an increase in the monetary base in the United States of 52 percent between April 1933 and April 1937. The M1 money supply virtually matched this increase in the monetary base, with 49 percent growth over the same period. The sources of this increase were two-fold. First, aside from the immediate monetary expansion permitted by devaluation, as Romer (1993) explains, monetary expansion continued into 1934 and beyond as gold flowed to the United States from Europe due to the increasing political unrest and heightened probability of hostilities that began the progression to World War II. Second, the increase in the money supply matched the increase in the monetary base and the Treasury chose not to sterilize the gold inflows. This is evidence that the monetary expansion resulted from policy decisions and not endogenous changes in the money multiplier. The new regime was freed from the constraints of the gold standard and the policy makers were intent on taking actions of a different nature than what had been done between 1929 and 1933.

Incompleteness of the Recovery before WWII

The Depression had turned a corner and the economy was emerging from the abyss in 1933. However, it still had a long way to go to reach full recovery. Friedman and Schwartz (1963) comment that “the most notable feature of the revival after 1933 was not its rapidity but its incompleteness.” They claim that monetary policy and the Federal Reserve were passive after 1933. The monetary authorities did nothing to stop the fall from 1929 to 1933 and did little to promote the recovery. The Federal Reserve made no effort to increase the stock of high-powered money through the use of either open market operations or rediscounting; Federal Reserve credit outstanding remained “almost perfectly constant from 1934 to mid-1940” (Friedman and Schwartz, 1963). As we have seen above, it was the Treasury that was generating increases in the monetary base at the time by issuing gold certificates equal to the amount of gold reserve inflow and depositing them at the Federal Reserve. When the government spent the money, the Treasury swapped the gold certificates for Federal Reserve notes and this expanded the monetary base (Romer, 1993). Monetary policy was thought to be powerless to promote recovery, and instead it was fiscal policy that became the implement of choice. The research shows that fiscal policy could have done much more to aid in recovery – ironically fiscal policy was the vehicle that was now the focus of attention. There is an easy explanation for why this is so.

The Emergences of Keynes

The economics profession as a whole was at a loss to provide cogent explanations for the events of 1929–33. In the words of Robert Gordon (1998), “economics had lost its intellectual moorings, and it was time for a new diagnosis.” There were no convincing answers regarding why the earlier theories of macroeconomic behavior failed to explain the events that were occurring, and worse, there was no set of principles that established a guide for proper actions in the future. That changed in 1936 with the publication of Keynes’s book The General Theory of Employment, Interest and Money. Perhaps there has been no other person and no other book in economics about which so much has been written. Many consider the arrival of Keynesian thought to have been a “revolution,” although this too is hotly contested (see, for example, Laidler, 1999). The debates that The General Theory generated have been many and long-lasting. There is little that can be said here to add or subtract from the massive literature devoted to the ideas promoted by Keynes, whether they be viewed right or wrong. But the influence over academic thought and economic policy that was generated by The General Theory is not in doubt.

The time was right for a set of ideas that not only explained the Depression’s course of events, but also provided a prescription for remedies that would create better economic performance in the future. Keynes and The General Theory, at the time the events were unfolding, provided just such a package. When all is said and done, we can look back in hindsight and argue endlessly about what Keynes “really meant” or what the “true” contribution of Keynesianism has been to the world of economics. At the time the Depression happened, Keynes represented a new paradigm for young scholars to latch on to. The stage was set for the nurturing of macroeconomics for the remainder of the twentieth century.

This article is a modified version of the introduction to Randall Parker, editor, Reflections on the Great Depression, Edward Elgar Publishing, 2002.


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1 Bankers’ acceptances are explained at

2 Liquidity is the ease of converting an asset into money.

3 The monetary base is measured as the sum of currency in the hands of the public plus reserves in the banking system. It is also called high-powered money since the monetary base is the quantity that gets multiplied into greater amounts of money supply as banks make loans and people spend and thereby create new bank deposits.

4 The money multiplier equals [D/R*(1 + D/C)]/(D/R + D/C + D/E), where

D = deposits, R = reserves, C = currency and E = excess reserves in the

banking system.

5 The real interest rate adjusts the observed (nominal) interest rate for inflation or deflation. Ex post refers to the real interest rate after the actual change in prices has been observed; ex ante refers to the real interest rate that is expected at the time the lending occurs.

6 See note 3.

Citation: Parker, Randall. “An Overview of the Great Depression”. EH.Net Encyclopedia, edited by Robert Whaples. March 16, 2008. URL

Gold Standard

Lawrence H. Officer, University of Illinois at Chicago

The gold standard is the most famous monetary system that ever existed. The periods in which the gold standard flourished, the groupings of countries under the gold standard, and the dates during which individual countries adhered to this standard are delineated in the first section. Then characteristics of the gold standard (what elements make for a gold standard), the various types of the standard (domestic versus international, coin versus other, legal versus effective), and implications for the money supply of a country on the standard are outlined. The longest section is devoted to the “classical” gold standard, the predominant monetary system that ended in 1914 (when World War I began), followed by a section on the “interwar” gold standard, which operated between the two World Wars (the 1920s and 1930s).

Countries and Dates on the Gold Standard

Countries on the gold standard and the periods (or beginning and ending dates) during which they were on gold are listed in Tables 1 and 2 for the classical and interwar gold standards. Types of gold standard, ambiguities of dates, and individual-country cases are considered in later sections. The country groupings reflect the importance of countries to establishment and maintenance of the standard. Center countries — Britain in the classical standard, the United Kingdom (Britain’s legal name since 1922) and the United States in the interwar period — were indispensable to the spread and functioning of the gold standard. Along with the other core countries — France and Germany, and the United States in the classical period — they attracted other countries to adopt the gold standard, in particular, British colonies and dominions, Western European countries, and Scandinavia. Other countries — and, for some purposes, also British colonies and dominions — were in the periphery: acted on, rather than actors, in the gold-standard eras, and generally not as committed to the gold standard.

Table 1Countries on Classical Gold Standard
Country Type of Gold Standard Period
Center Country
Britaina Coin 1774-1797b, 1821-1914
Other Core Countries
United Statesc Coin 1879-1917d
Francee Coin 1878-1914
Germany Coin 1871-1914
British Colonies and Dominions
Australia Coin 1852-1915
Canadaf Coin 1854-1914
Ceylon Coin 1901-1914
Indiag Exchange (British pound) 1898-1914
Western Europe
Austria-Hungaryh Coin 1892-1914
Belgiumi Coin 1878-1914
Italy Coin 1884-1894
Liechtenstein Coin 1898-1914
Netherlandsj Coin 1875-1914
Portugalk Coin 1854-1891
Switzerland Coin 1878-1914
Denmarkl Coin 1872-1914
Finland Coin 1877-1914
Norway Coin 1875-1914
Sweden Coin 1873-1914
Eastern Europe
Bulgaria Coin 1906-1914
Greece Coin 1885, 1910-1914
Montenegro Coin 1911-1914
Romania Coin 1890-1914
Russia Coin 1897-1914
Middle East
Egypt Coin 1885-1914
Turkey (Ottoman Empire) Coin 1881m-1914
Japann Coin 1897-1917
Philippines Exchange (U.S. dollar) 1903-1914
Siam Exchange (British pound) 1908-1914
Straits Settlementso Exchange (British pound) 1906-1914
Mexico and Central America
Costa Rica Coin 1896-1914
Mexico Coin 1905-1913
South America
Argentina Coin 1867-1876, 1883-1885, 1900-1914
Bolivia Coin 1908-1914
Brazil Coin 1888-1889, 1906-1914
Chile Coin 1895-1898
Ecuador Coin 1898-1914
Peru Coin 1901-1914
Uruguay Coin 1876-1914
Eritrea Exchange (Italian lira) 1890-1914
German East Africa Exchange (German mark) 1885p-1914
Italian Somaliland Exchange (Italian lira) 1889p-1914

a Including colonies (except British Honduras) and possessions without a national currency: New Zealand and certain other Oceanic colonies, South Africa, Guernsey, Jersey, Malta, Gibraltar, Cyprus, Bermuda, British West Indies, British Guiana, British Somaliland, Falkland Islands, other South and West African colonies.
b Or perhaps 1798.
c Including countries and territories with U.S. dollar as exclusive or predominant currency: British Honduras (from 1894), Cuba (from 1898), Dominican Republic (from 1901), Panama (from 1904), Puerto Rico (from 1900), Alaska, Aleutian Islands, Hawaii, Midway Islands (from 1898), Wake Island, Guam, and American Samoa.
d Except August – October 1914.
e Including Tunisia (from 1891) and all other colonies except Indochina.
f Including Newfoundland (from 1895).
g Including British East Africa, Uganda, Zanzibar, Mauritius, and Ceylon (to 1901).
h Including Montenegro (to 1911).
I Including Belgian Congo.
j Including Netherlands East Indies.
k Including colonies, except Portuguese India.
l Including Greenland and Iceland.
m Or perhaps 1883.
n Including Korea and Taiwan.
o Including Borneo.
p Approximate beginning date.

Sources: Bloomfield (1959, pp. 13, 15; 1963), Bordo and Kydland (1995), Bordo and Schwartz (1996), Brown (1940, pp.15-16), Bureau of the Mint (1929), de Cecco (1984, p. 59), Ding (1967, pp. 6- 7), Director of the Mint (1913, 1917), Ford (1985, p. 153), Gallarotti (1995, pp. 272 75), Gunasekera (1962), Hawtrey (1950, p. 361), Hershlag (1980, p. 62), Ingram (1971, p. 153), Kemmerer (1916; 1940, pp. 9-10; 1944, p. 39), Kindleberger (1984, pp. 59-60), Lampe (1986, p. 34), MacKay (1946, p. 64), MacLeod (1994, p. 13), Norman (1892, pp. 83-84), Officer (1996, chs. 3 4), Pamuk (2000, p. 217), Powell (1999, p. 14), Rifaat (1935, pp. 47, 54), Shinjo (1962, pp. 81-83), Spalding (1928), Wallich (1950, pp. 32-36), Yeager (1976, p. 298), Young (1925).

Table 2Countries on Interwar Gold Standard
Country Type ofGold Standard Ending Date
Exchange-RateStabilization CurrencyConvertibilitya
United Kingdomb 1925 1931
Coin 1922e Other Core Countries
Bullion 1928 Germany 1924 1931
Australiag 1925 1930
Exchange 1925 Canadai 1925 1929
Exchange 1925 Indiaj 1925 1931
Coin 1929k South Africa 1925 1933
Austria 1922 1931
Exchange 1926 Danzig 1925 1935
Coin 1925 Italym 1927 1934
Coin 1925 Portugalo 1929 1931
Coin 1925 Scandinavia
Bullion 1927 Finland 1925 1931
Bullion 1928 Sweden 1922 1931
Albania 1922 1939
Exchange 1927 Czechoslovakia 1923 1931
Exchange 1928 Greece 1927 1932
Exchange 1925 Latvia 1922 1931
Coin 1922 Poland 1926 1936
Exchange 1929 Yugoslavia 1925 1932
Egypt 1925 1931
Exchange 1925 Palestine 1927 1931
Exchange 1928 Asia
Coin 1930 Malayat 1925 1931
Coin 1925 Philippines 1922 1933
Exchange 1928 Mexico and Central America
Exchange 1922 Guatemala 1925 1933
Exchange 1922 Honduras 1923 1933
Coin 1925 Nicaragua 1915 1932
Coin 1920 South America
Coin 1927 Bolivia 1926 1931
Exchange 1928 Chile 1925 1931
Coin 1923 Ecuador 1927 1932
Exchange 1927 Peru 1928 1932
Exchange 1928 Venezuela 1923 1930

a And freedom of gold export and import.
b Including colonies (except British Honduras) and possessions without a national currency: Guernsey, Jersey, Malta, Gibraltar, Cyprus, Bermuda, British West Indies, British Guiana, British Somaliland, Falkland Islands, British West African and certain South African colonies, certain Oceanic colonies.
cIncluding countries and territories with U.S. dollar as exclusive or predominant currency: British Honduras, Cuba, Dominican Republic, Panama, Puerto Rico, Alaska, Aleutian Islands, Hawaii, Midway Islands, Wake Island, Guam, and American Samoa.
dNot applicable; “the United States dollar…constituted the central point of reference in the whole post-war stabilization effort and was throughout the period of stabilization at par with gold.” — Brown (1940, p. 394)
e1919 for freedom of gold export.
f Including colonies and possessions, except Indochina and Syria.
g Including Papua (New Guinea) and adjoining islands.
h Kenya, Uganda, and Tanganyika.
I Including Newfoundland.
j Including Bhutan, Nepal, British Swaziland, Mauritius, Pemba Island, and Zanzibar.
k 1925 for freedom of gold export.
l Including Luxemburg and Belgian Congo.
m Including Italian Somaliland and Tripoli.
n Including Dutch Guiana and Curacao (Netherlands Antilles).
o Including territories, except Portuguese India.
p Including Liechtenstein.
q Including Greenland and Iceland.
r Including Greater Lebanon.
s Including Korea and Taiwan.
t Including Straits Settlements, Sarawak, Labuan, and Borneo.

Sources: Bett (1957, p. 36), Brown (1940), Bureau of the Mint (1929), Ding (1967, pp. 6-7), Director of the Mint (1917), dos Santos (1996, pp. 191-92), Eichengreen (1992, p. 299), Federal Reserve Bulletin (1928, pp. 562, 847; 1929, pp. 201, 265, 549; 1930, pp. 72, 440; 1931, p. 554; 1935, p. 290; 1936, pp. 322, 760), Gunasekera (1962), Jonung (1984, p. 361), Kemmerer (1954, pp. 301 302), League of Nations (1926, pp. 7, 15; 1927, pp. 165-69; 1929, pp. 208-13; 1931, pp. 265-69; 1937/38, p. 107; 1946, p. 2), Moggridge (1989, p. 305), Officer (1996, chs. 3-4), Powell (1999, pp. 23-24), Spalding (1928), Wallich (1950, pp. 32-37), Yeager (1976, pp. 330, 344, 359); Young (1925, p. 76).

Characteristics of Gold Standards

Types of Gold Standards

Pure Coin and Mixed Standards

In theory, “domestic” gold standards — those that do not depend on interaction with other countries — are of two types: “pure coin” standard and “mixed” (meaning coin and paper, but also called simply “coin”) standard. The two systems share several properties. (1) There is a well-defined and fixed gold content of the domestic monetary unit. For example, the dollar is defined as a specified weight of pure gold. (2) Gold coin circulates as money with unlimited legal-tender power (meaning it is a compulsorily acceptable means of payment of any amount in any transaction or obligation). (3) Privately owned bullion (gold in mass, foreign coin considered as mass, or gold in the form of bars) is convertible into gold coin in unlimited amounts at the government mint or at the central bank, and at the “mint price” (of gold, the inverse of the gold content of the monetary unit). (4) Private parties have no restriction on their holding or use of gold (except possibly that privately created coined money may be prohibited); in particular, they may melt coin into bullion. The effect is as if coin were sold to the monetary authority (central bank or Treasury acting as a central bank) for bullion. It would make sense for the authority to sell gold bars directly for coin, even though not legally required, thus saving the cost of coining. Conditions (3) and (4) commit the monetary authority in effect to transact in coin and bullion in each direction such that the mint price, or gold content of the monetary unit, governs in the marketplace.

Under a pure coin standard, gold is the only money. Under a mixed standard, there are also paper currency (notes) — issued by the government, central bank, or commercial banks — and demand-deposit liabilities of banks. Government or central-bank notes (and central-bank deposit liabilities) are directly convertible into gold coin at the fixed established price on demand. Commercial-bank notes and demand deposits might be converted not directly into gold but rather into gold-convertible government or central-bank currency. This indirect convertibility of commercial-bank liabilities would apply certainly if the government or central- bank currency were legal tender but also generally even if it were not. As legal tender, gold coin is always exchangeable for paper currency or deposits at the mint price, and usually the monetary authority would provide gold bars for its coin. Again, two-way transactions in unlimited amounts fix the currency price of gold at the mint price. The credibility of the monetary-authority commitment to a fixed price of gold is the essence of a successful, ongoing gold-standard regime.

A pure coin standard did not exist in any country during the gold-standard periods. Indeed, over time, gold coin declined from about one-fifth of the world money supply in 1800 (2/3 for gold and silver coin together, as silver was then the predominant monetary standard) to 17 percent in 1885 (1/3 for gold and silver, for an eleven-major-country aggregate), 10 percent in 1913 (15 percent for gold and silver, for the major-country aggregate), and essentially zero in 1928 for the major-country aggregate (Triffin, 1964, pp. 15, 56). See Table 3. The zero figure means not that gold coin did not exist, rather that its main use was as reserves for Treasuries, central banks, and (generally to a lesser extent) commercial banks.

Table 3Structure of Money: Major-Countries Aggregatea(end of year)
1885 1928
8 50
33 0d
18 21
33 99

a Core countries: Britain, United States, France, Germany. Western Europe: Belgium, Italy, Netherlands, Switzerland. Other countries: Canada, Japan, Sweden.
b Metallic money, minor coin, paper currency, and demand deposits.
c 1885: Gold and silver coin; overestimate, as includes commercial-bank holdings that could not be isolated from coin held outside banks by the public. 1913: Gold and silver coin. 1928: Gold coin.
d Less than 0.5 percent.
e 1885 and 1913: Gold, silver, and foreign exchange. 1928: Gold and foreign exchange.
f Official gold: Gold in official reserves. Money gold: Gold-coin component of money supply.

Sources: Triffin (1964, p. 62), Sayers (1976, pp. 348, 352) for 1928 Bank of England dollar reserves (dated January 2, 1929).

An “international” gold standard, which naturally requires that more than one country be on gold, requires in addition freedom both of international gold flows (private parties are permitted to import or export gold without restriction) and of foreign-exchange transactions (an absence of exchange control). Then the fixed mint prices of any two countries on the gold standard imply a fixed exchange rate (“mint parity”) between the countries’ currencies. For example, the dollar- sterling mint parity was $4.8665635 per pound sterling (the British pound).

Gold-Bullion and Gold-Exchange Standards

In principle, a country can choose among four kinds of international gold standards — the pure coin and mixed standards, already mentioned, a gold-bullion standard, and a gold- exchange standard. Under a gold-bullion standard, gold coin neither circulates as money nor is it used as commercial-bank reserves, and the government does not coin gold. The monetary authority (Treasury or central bank) stands ready to transact with private parties, buying or selling gold bars (usable only for import or export, not as domestic currency) for its notes, and generally a minimum size of transaction is specified. For example, in 1925 1931 the Bank of England was on the bullion standard and would sell gold bars only in the minimum amount of 400 fine (pure) ounces, approximately £1699 or $8269. Finally, the monetary authority of a country on a gold-exchange standard buys and sells not gold in any form but rather gold- convertible foreign exchange, that is, the currency of a country that itself is on the gold coin or bullion standard.

Gold Points and Gold Export/Import

A fixed exchange rate (the mint parity) for two countries on the gold standard is an oversimplification that is often made but is misleading. There are costs of importing or exporting gold. These costs include freight, insurance, handling (packing and cartage), interest on money committed to the transaction, risk premium (compensation for risk), normal profit, any deviation of purchase or sale price from the mint price, possibly mint charges, and possibly abrasion (wearing out or removal of gold content of coin — should the coin be sold abroad by weight or as bullion). Expressing the exporting costs as the percent of the amount invested (or, equivalently, as percent of parity), the product of 1/100th of these costs and mint parity (the number of units of domestic currency per unit of foreign currency) is added to mint parity to obtain the gold-export point — the exchange rate at which gold is exported. To obtain the gold-import point, the product of 1/100th of the importing costs and mint parity is subtracted from mint parity.

If the exchange rate is greater than the gold-export point, private-sector “gold-point arbitrageurs” export gold, thereby obtaining foreign currency. Conversely, for the exchange rate less than the gold-import point, gold is imported and foreign currency relinquished. Usually the gold is, directly or indirectly, purchased from the monetary authority of the one country and sold to the monetary authority in the other. The domestic-currency cost of the transaction per unit of foreign currency obtained is the gold-export point. That per unit of foreign currency sold is the gold-import point. Also, foreign currency is sold, or purchased, at the exchange rate. Therefore arbitrageurs receive a profit proportional to the exchange-rate/gold-point divergence.

Gold-Point Arbitrage

However, the arbitrageurs’ supply of foreign currency eliminates profit by returning the exchange rate to below the gold-export point. Therefore perfect “gold-point arbitrage” would ensure that the exchange rate has upper limit of the gold-export point. Similarly, the arbitrageurs’ demand for foreign currency returns the exchange rate to above the gold-import point, and perfect arbitrage ensures that the exchange rate has that point as a lower limit. It is important to note what induces the private sector to engage in gold-point arbitrage: (1) the profit motive; and (2) the credibility of the commitment to (a) the fixed gold price and (b) freedom of foreign exchange and gold transactions, on the part of the monetary authorities of both countries.

Gold-Point Spread

The difference between the gold points is called the (gold-point) spread. The gold points and the spread may be expressed as percentages of parity. Estimates of gold points and spreads involving center countries are provided for the classical and interwar gold standards in Tables 4 and 5. Noteworthy is that the spread for a given country pair generally declines over time both over the classical gold standard (evidenced by the dollar-sterling figures) and for the interwar compared to the classical period.

Table 4Gold-Point Estimates: Classical Gold Standard
Countries Period Gold Pointsa(percent) Spreadd(percent) Method of Computation
Exportb Importc
U.S./Britain 1881-1890 0.6585 0.7141 1.3726 PA
U.S./Britain 1891-1900 0.6550 0.6274 1.2824 PA
U.S./Britain 1901-1910 0.4993 0.5999 1.0992 PA
U.S./Britain 1911-1914 0.5025 0.5915 1.0940 PA
France/U.S. 1877-1913 0.6888 0.6290 1.3178 MED
Germany/U.S. 1894-1913 0.4907 0.7123 1.2030 MED
France/Britain 1877-1913 0.4063 0.3964 0.8027 MED
Germany/Britain 1877-1913 0.3671 0.4405 0.8076 MED
Germany/France 1877-1913 0.4321 0.5556 0.9877 MED
Austria/Britain 1912 0.6453 0.6037 1.2490 SE
Netherlands/Britain 1912 0.5534 0.3552 0.9086 SE
Scandinaviae /Britain 1912 0.3294 0.6067 0.9361 SE

a For numerator country.
b Gold-import point for denominator country.
c Gold-export point for denominator country.
d Gold-export point plus gold-import point.
e Denmark, Sweden, and Norway.

Method of Computation: PA = period average. MED = median exchange rate form estimate of various authorities for various dates, converted to percent deviation from parity. SE = single exchange-rate- form estimate, converted to percent deviation from parity.

Sources: U.S./Britain — Officer (1996, p. 174). France/U.S., Germany/U.S., France/Britain, Germany/Britain, Germany/France — Morgenstern (1959, pp. 178-81). Austria/Britain, Netherlands/Britain, Scandinavia/Britain — Easton (1912, pp. 358-63).

Table 5Gold-Point Estimates: Interwar Gold Standard
Countries Period Gold Pointsa(percent) Spreadd(percent) Method of Computation
Exportb Importc
U.S./Britain 1925-1931 0.6287 0.4466 1.0753 PA
U.S./France 1926-1928e 0.4793 0.5067 0.9860 PA
U.S./France 1928-1933f 0.5743 0.3267 0.9010 PA
U.S./Germany 1926-1931 0.8295 0.3402 1.1697 PA
France/Britain 1926 0.2042 0.4302 0.6344 SE
France/Britain 1929-1933 0.2710 0.3216 0.5926 MED
Germany/Britain 1925-1933 0.3505 0.2676 0.6181 MED
Canada/Britain 1929 0.3521 0.3465 0.6986 SE
Netherlands/Britain 1929 0.2858 0.5146 0.8004 SE
Denmark/Britain 1926 0.4432 0.4930 0.9362 SE
Norway/Britain 1926 0.6084 0.3828 0.9912 SE
Sweden/Britain 1926 0.3881 0.3828 0.7709 SE

a For numerator country.
b Gold-import point for denominator country.
c Gold-export point for denominator country.
d Gold-export point plus gold-import point.
e To end of June 1928. French-franc exchange-rate stabilization, but absence of currency convertibility; see Table 2.
f Beginning July 1928. French-franc convertibility; see Table 2.

Method of Computation: PA = period average. MED = median exchange rate form estimate of various authorities for various dates, converted to percent deviation from parity. SE = single exchange-rate- form estimate, converted to percent deviation from parity.

Sources: U.S./Britain — Officer (1996, p. 174). U.S./France, U.S./Germany, France/Britain 1929- 1933, Germany/Britain — Morgenstern (1959, pp. 185-87). Canada/Britain, Netherlands/Britain — Einzig (1929, pp. 98-101) [Netherlands/Britain currencies’ mint parity from Spalding (1928, p. 135). France/Britain 1926, Denmark/Britain, Norway/Britain, Sweden/Britain — Spalding (1926, pp. 429-30, 436).

The effective monetary standard of a country is distinguishable from its legal standard. For example, a country legally on bimetallism usually is effectively on either a gold or silver monometallic standard, depending on whether its “mint-price ratio” (the ratio of its mint price of gold to mint price of silver) is greater or less than the world price ratio. In contrast, a country might be legally on a gold standard but its banks (and government) have “suspended specie (gold) payments” (refusing to convert their notes into gold), so that the country is in fact on a “paper standard.” The criterion adopted here is that a country is deemed on the gold standard if (1) gold is the predominant effective metallic money, or is the monetary bullion, (2) specie payments are in force, and (3) there is a limitation on the coinage and/or the legal-tender status of silver (the only practical and historical competitor to gold), thus providing institutional or legal support for the effective gold standard emanating from (1) and (2).

Implications for Money Supply

Consider first the domestic gold standard. Under a pure coin standard, the gold in circulation, monetary base, and money supply are all one. With a mixed standard, the money supply is the product of the money multiplier (dependent on the commercial-banks’ reserves/deposit and the nonbank-public’s currency/deposit ratios) and the monetary base (the actual and potential reserves of the commercial banking system, with potential reserves held by the nonbank public). The monetary authority alters the monetary base by changing its gold holdings and its loans, discounts, and securities portfolio (non gold assets, called its “domestic assets”). However, the level of its domestic assets is dependent on its gold reserves, because the authority generates demand liabilities (notes and deposits) by increasing its assets, and convertibility of these liabilities must be supported by a gold reserve, if the gold standard is to be maintained. Therefore the gold standard provides a constraint on the level (or growth) of the money supply.

The international gold standard involves balance-of-payments surpluses settled by gold imports at the gold-import point, and deficits financed by gold exports at the gold-export point. (Within the spread, there are no gold flows and the balance of payments is in equilibrium.) The change in the money supply is then the product of the money multiplier and the gold flow, providing the monetary authority does not change its domestic assets. For a country on a gold- exchange standard, holdings of “foreign exchange” (the reserve currency) take the place of gold. In general, the “international assets” of a monetary authority may consist of both gold and foreign exchange.

The Classical Gold Standard

Dates of Countries Joining the Gold Standard

Table 1 (above) lists all countries that were on the classical gold standard, the gold- standard type to which each adhered, and the period(s) on the standard. Discussion here concentrates on the four core countries. For centuries, Britain was on an effective silver standard under legal bimetallism. The country switched to an effective gold standard early in the eighteenth century, solidified by the (mistakenly) gold-overvalued mint-price ratio established by Isaac Newton, Master of the Mint, in 1717. In 1774 the legal-tender property of silver was restricted, and Britain entered the gold standard in the full sense on that date. In 1798 coining of silver was suspended, and in 1816 the gold standard was formally adopted, ironically during a paper-standard regime (the “Bank Restriction Period,” of 1797-1821), with the gold standard effectively resuming in 1821.

The United States was on an effective silver standard dating back to colonial times, legally bimetallic from 1786, and on an effective gold standard from 1834. The legal gold standard began in 1873-1874, when Acts ended silver-dollar coinage and limited legal tender of existing silver coins. Ironically, again the move from formal bimetallism to a legal gold standard occurred during a paper standard (the “greenback period,” of 1861-1878), with a dual legal and effective gold standard from 1879.

International Shift to the Gold Standard

The rush to the gold standard occurred in the 1870s, with the adherence of Germany, the Scandinavian countries, France, and other European countries. Legal bimetallism shifted from effective silver to effective gold monometallism around 1850, as gold discoveries in the United States and Australia resulted in overvalued gold at the mints. The gold/silver market situation subsequently reversed itself, and, to avoid a huge inflow of silver, many European countries suspended the coinage of silver and limited its legal-tender property. Some countries (France, Belgium, Switzerland) adopted a “limping” gold standard, in which existing former-standard silver coin retained full legal tender, permitting the monetary authority to redeem its notes in silver as well as gold.

As Table 1 shows, most countries were on a gold-coin (always meaning mixed) standard. The gold-bullion standard did not exist in the classical period (although in Britain that standard was embedded in legislation of 1819 that established a transition to restoration of the gold standard). A number of countries in the periphery were on a gold-exchange standard, usually because they were colonies or territories of a country on a gold-coin standard. In situations in which the periphery country lacked its own (even-coined) currency, the gold-exchange standard existed almost by default. Some countries — China, Persia, parts of Latin America — never joined the classical gold standard, instead retaining their silver or bimetallic standards.

Sources of Instability of the Classical Gold Standard

There were three elements making for instability of the classical gold standard. First, the use of foreign exchange as reserves increased as the gold standard progressed. Available end-of- year data indicate that, worldwide, foreign exchange in official reserves (the international assets of the monetary authority) increased by 36 percent from 1880 to 1899 and by 356 percent from 1899 to 1913. In comparison, gold in official reserves increased by 160 percent from 1880 to 1903 but only by 88 percent from 1903 to 1913. (Lindert, 1969, pp. 22, 25) While in 1913 only Germany among the center countries held any measurable amount of foreign exchange — 15 percent of total reserves excluding silver (which was of limited use) — the percentage for the rest of the world was double that for Germany (Table 6). If there were a rush to cash in foreign exchange for gold, reduction or depletion of the gold of reserve-currency countries could place the gold standard in jeopardy.

Table 6Share of Foreign Exchange in Official Reserves(end of year, percent)
Country 1928b
Excluding Silverb
0 10
0 0c
0d 51
13 16
27 32

a Official reserves: gold, silver, and foreign exchange.
b Official reserves: gold and foreign exchange.
c Less than 0.05 percent.
d Less than 0.5 percent.

Sources: 1913 — Lindert (1969, pp. 10-11). 1928 — Britain: Board of Governors of the Federal Reserve System [cited as BG] (1943, p. 551), Sayers (1976, pp. 348, 352) for Bank of England dollar reserves (dated January 2, 1929). United States: BG (1943, pp. 331, 544), foreign exchange consisting of Federal Reserve Banks holdings of foreign-currency bills. France and Germany: Nurkse (1944, p. 234). Rest of world [computed as residual]: gold, BG (1943, pp. 544-51); foreign exchange, from “total” (Triffin, 1964, p. 66), France, and Germany.

Second, Britain — the predominant reserve-currency country — was in a particularly sensitive situation. Again considering end-of 1913 data, almost half of world foreign-exchange reserves were in sterling, but the Bank of England had only three percent of world gold reserves (Tables 7-8). Defining the “reserve ratio” of the reserve-currency-country monetary authority as the ratio of (i) official reserves to (ii) liabilities to foreign monetary authorities held in financial institutions in the country, in 1913 this ratio was only 31 percent for the Bank of England, far lower than those of the monetary authorities of the other core countries (Table 9). An official run on sterling could easily force Britain off the gold standard. Because sterling was an international currency, private foreigners also held considerable liquid assets in London, and could themselves initiate a run on sterling.

Table 7Composition of World Official Foreign-Exchange Reserves(end of year, percent)
1913a British pounds 77
2 French francs }2}



a Excluding holdings for which currency unspecified.
b Primarily Dutch guilders and Scandinavian kroner.

Sources: 1913 — Lindert (1969, pp. 18-19). 1928 — Components of world total: Triffin (1964, pp. 22, 66), Sayers (1976, pp. 348, 352) for Bank of England dollar reserves (dated January 2, 1929), Board of Governors of the Federal Reserve System [cited as BG] (1943, p. 331) for Federal Reserve Banks holdings of foreign-currency bills.

Table 8Official-Reserves Components: Percent of World Total(end of year)
Country 1928
Gold Foreign Exchange
0 7 United States 27 0a
0b 13 Germany 6 4
95 36 Table 9Reserve Ratiosa of Reserve-Currency Countries

(end of year)

Country 1928c
Excluding Silverc
0.31 0.33
90.55 5.45
2.38 not available
2.11 not available

a Ratio of official reserves to official liquid liabilities (that is, liabilities to foreign governments and central banks).
b Official reserves: gold, silver, and foreign exchange.
c Official reserves: gold and foreign exchange.

Sources : 1913 — Lindert (1969, pp. 10-11, 19). Foreign-currency holdings for which currency unspecified allocated proportionately to the four currencies based on known distribution. 1928 — Gold reserves: Board of Governors of the Federal Reserve System [cited as BG] (1943, pp. 544, 551). Foreign- exchange reserves: Sayers (1976, pp. 348, 352) for Bank of England dollar reserves (dated January 2, 1929); BG (1943, p. 331) for Federal Reserve Banks holdings of foreign-currency bills. Official liquid liabilities: Triffin (1964, p. 22), Sayers (1976, pp. 348, 352).

Third, the United States, though a center country, was a great source of instability to the gold standard. Its Treasury held a high percentage of world gold reserves (more than that of the three other core countries combined in 1913), resulting in an absurdly high reserve ratio — Tables 7-9). With no central bank and a decentralized banking system, financial crises were frequent. Far from the United States assisting Britain, gold often flowed from the Bank of England to the United States to satisfy increases in U.S. demand for money. Though in economic size the United States was the largest of the core countries, in many years it was a net importer rather than exporter of capital to the rest of the world — the opposite of the other core countries. The political power of silver interests and recurrent financial panics led to imperfect credibility in the U.S. commitment to the gold standard. Runs on banks and runs on the Treasury gold reserve placed the U.S. gold standard near collapse in the early and mid-1890s. During that period, the credibility of the Treasury’s commitment to the gold standard was shaken. Indeed, the gold standard was saved in 1895 (and again in 1896) only by cooperative action of the Treasury and a bankers’ syndicate that stemmed gold exports.

Rules of the Game

According to the “rules of the [gold-standard] game,” central banks were supposed to reinforce, rather than “sterilize” (moderate or eliminate) or ignore, the effect of gold flows on the monetary supply. A gold outflow typically decreases the international assets of the central bank and thence the monetary base and money supply. The central-bank’s proper response is: (1) raise its “discount rate,” the central-bank interest rate for rediscounting securities (cashing, at a further deduction from face value, a short-term security from a financial institution that previously discounted the security), thereby inducing commercial banks to adopt a higher reserves/deposit ratio and therefore decreasing the money multiplier; and (2) decrease lending and sell securities, thereby decreasing domestic assets and thence the monetary base. On both counts the money supply is further decreased. Should the central bank rather increase its domestic assets when it loses gold, it engages in “sterilization” of the gold flow and is decidedly not following the “rules of the game.” The converse argument (involving gold inflow and increases in the money supply) also holds, with sterilization involving the central bank decreasing its domestic assets when it gains gold.

Price Specie-Flow Mechanism

A country experiencing a balance-of-payments deficit loses gold and its money supply decreases, both automatically and by policy in accordance with the “rules of the game.” Money income contracts and the price level falls, thereby increasing exports and decreasing imports. Similarly, a surplus country gains gold, the money supply increases, money income expands, the price level rises, exports decrease and imports increase. In each case, balance-of-payments equilibrium is restored via the current account. This is called the “price specie-flow mechanism.” To the extent that wages and prices are inflexible, movements of real income in the same direction as money income occur; in particular, the deficit country suffers unemployment but the payments imbalance is nevertheless corrected.

The capital account also acts to restore balance, via interest-rate increases in the deficit country inducing a net inflow of capital. The interest-rate increases also reduce real investment and thence real income and imports. Similarly, interest-rate decreases in the surplus country elicit capital outflow and increase real investment, income, and imports. This process enhances the current-account correction of the imbalance.

One problem with the “rules of the game” is that, on “global-monetarist” theoretical grounds, they were inconsequential. Under fixed exchange rates, gold flows simply adjust money supply to money demand; the money supply is not determined by policy. Also, prices, interest rates, and incomes are determined worldwide. Even core countries can influence these variables domestically only to the extent that they help determine them in the global marketplace. Therefore the price-specie-flow and like mechanisms cannot occur. Historical data support this conclusion: gold flows were too small to be suggestive of these mechanisms; and prices, incomes, and interest rates moved closely in correspondence (rather than in the opposite directions predicted by the adjustment mechanisms induced by the “rules of the game”) — at least among non-periphery countries, especially the core group.

Discount Rate Rule and the Bank of England

However, the Bank of England did, in effect, manage its discount rate (“Bank Rate”) in accordance with rule (1). The Bank’s primary objective was to maintain convertibility of its notes into gold, that is, to preserve the gold standard, and its principal policy tool was Bank Rate. When its “liquidity ratio” of gold reserves to outstanding note liabilities decreased, it would usually increase Bank Rate. The increase in Bank Rate carried with it market short-term increase rates, inducing a short-term capital inflow and thereby moving the exchange rate away from the gold-export point by increasing the exchange value of the pound. The converse also held, with a rise in the liquidity ratio involving a Bank Rate decrease, capital outflow, and movement of the exchange rate away from the gold import point. The Bank was constantly monitoring its liquidity ratio, and in response altered Bank Rate almost 200 times over 1880- 1913.

While the Reichsbank (the German central bank), like the Bank of England, generally moved its discount rate inversely to its liquidity ratio, most other central banks often violated the rule, with changes in their discount rates of inappropriate direction, or of insufficient amount or frequency. The Bank of France, in particular, kept its discount rate stable. Unlike the Bank of England, it chose to have large gold reserves (see Table 8), with payments imbalances accommodated by fluctuations in its gold rather than financed by short-term capital flows. The United States, lacking a central bank, had no discount rate to use as a policy instrument.

Sterilization Was Dominant

As for rule (2), that the central-bank’s domestic and international assets move in the same direction; in fact the opposite behavior, sterilization, was dominant, as shown in Table 10. The Bank of England followed the rule more than any other central bank, but even so violated it more often than not! How then did the classical gold standard cope with payments imbalances? Why was it a stable system?

Table 10Annual Changes in Internationala and Domesticb Assets of Central BankPercent of Changes in the Same Directionc
1880-1913d Britain 33
__ France 33
31 British Dominionse 13
32 Scandinaviag 25
33 South Americai 23

a 1880-1913: Gold, silver and foreign exchange. 1922-1936: Gold and foreign exchange.
b Domestic income-earning assets: discounts, loans, securities.
c Implying country is following “rules of the game.” Observations with zero or negligible changes in either class of assets excluded.
d Years when country is off gold standard excluded. See Tables 1 and 2.
e Australia and South Africa.
f1880-1913: Austria-Hungary, Belgium, and Netherlands. 1922-1936: Austria, Italy, Netherlands, and Switzerland.
g Denmark, Finland, Norway, and Sweden.
h1880-1913: Russia. 1922-1936: Bulgaria, Czechoslovakia, Greece, Hungary, Poland, Romania, and Yugoslavia.
I Chile, Colombia, Peru, and Uruguay.

Sources: Bloomfield (1959, p. 49), Nurkse (1944, p. 69).

The Stability of the Classical Gold Standard

The fundamental reason for the stability of the classical gold standard is that there was always absolute private-sector credibility in the commitment to the fixed domestic-currency price of gold on the part of the center country (Britain), two (France and Germany) of the three remaining core countries, and certain other European countries (Belgium, Netherlands, Switzerland, and Scandinavia). Certainly, that was true from the late-1870s onward. (For the United States, this absolute credibility applied from about 1900.) In earlier periods, that commitment had a contingency aspect: it was recognized that convertibility could be suspended in the event of dire emergency (such as war); but, after normal conditions were restored, convertibility would be re-established at the pre-existing mint price and gold contracts would again be honored. The Bank Restriction Period is an example of the proper application of the contingency, as is the greenback period (even though the United States, effectively on the gold standard, was legally on bimetallism).

Absolute Credibility Meant Zero Convertibility and Exchange Risk

The absolute credibility in countries’ commitment to convertiblity at the existing mint price implied that there was extremely low, essentially zero, convertibility risk (the probability that Treasury or central-bank notes would not be redeemed in gold at the established mint price) and exchange risk (the probability that the mint parity between two currencies would be altered, or that exchange control or prohibition of gold export would be instituted).

Reasons Why Commitment to Convertibility Was So Credible

There were many reasons why the commitment to convertibility was so credible. (1) Contracts were expressed in gold; if convertibility were abandoned, contracts would inevitably be violated — an undesirable outcome for the monetary authority. (2) Shocks to the domestic and world economies were infrequent and generally mild. There was basically international peace and domestic calm.

(3) The London capital market was the largest, most open, most diversified in the world, and its gold market was also dominant. A high proportion of world trade was financed in sterling, London was the most important reserve-currency center, and balances of payments were often settled by transferring sterling assets rather than gold. Therefore sterling was an international currency — not merely supplemental to gold but perhaps better: a boon to non- center countries, because sterling involved positive, not zero, interest return and its transfer costs were much less than those of gold. Advantages to Britain were the charges for services as an international banker, differential interest returns on its financial intermediation, and the practice of countries on a sterling (gold-exchange) standard of financing payments surpluses with Britain by piling up short-term sterling assets rather than demanding Bank of England gold.

(4) There was widespread ideology — and practice — of “orthodox metallism,” involving authorities’ commitment to an anti-inflation, balanced-budget, stable-money policy. In particular, the ideology implied low government spending and taxes and limited monetization of government debt (financing of budget deficits by printing money). Therefore it was not expected that a country’s price level or inflation would get out of line with that of other countries, with resulting pressure on the country’s adherence to the gold standard. (5) This ideology was mirrored in, and supported by, domestic politics. Gold had won over silver and paper, and stable-money interests (bankers, industrialists, manufacturers, merchants, professionals, creditors, urban groups) over inflationary interests (farmers, landowners, miners, debtors, rural groups).

(6) There was freedom from government regulation and a competitive environment, domestically and internationally. Therefore prices and wages were more flexible than in other periods of human history (before and after). The core countries had virtually no capital controls; the center country (Britain) had adopted free trade, and the other core countries had moderate tariffs. Balance-of-payments financing and adjustment could proceed without serious impediments.

(7) Internal balance (domestic macroeconomic stability, at a high level of real income and employment) was an unimportant goal of policy. Preservation of convertibility of paper currency into gold would not be superseded as the primary policy objective. While sterilization of gold flows was frequent (see above), the purpose was more “meeting the needs of trade” (passive monetary policy) than fighting unemployment (active monetary policy).

(8) The gradual establishment of mint prices over time ensured that the implied mint parities (exchange rates) were in line with relative price levels; so countries joined the gold standard with exchange rates in equilibrium. (9) Current-account and capital-account imbalances tended to be offsetting for the core countries, especially for Britain. A trade deficit induced a gold loss and a higher interest rate, attracting a capital inflow and reducing capital outflow. Indeed, the capital- exporting core countries — Britain, France, and Germany — could eliminate a gold loss simply by reducing lending abroad.

Rareness of Violations of Gold Points

Many of the above reasons not only enhanced credibility in existing mint prices and parities but also kept international-payments imbalances, and hence necessary adjustment, of small magnitude. Responding to the essentially zero convertibility and exchange risks implied by the credible commitment, private agents further reduced the need for balance-of-payments adjustment via gold-point arbitrage (discussed above) and also via a specific kind of speculation. When the exchange rate moved beyond a gold point, arbitrage acted to return it to the spread. So it is not surprising that “violations of the gold points” were rare on a monthly average basis, as demonstrated in Table 11 for the dollar, franc, and mark exchange rate versus sterling. Certainly, gold-point violations did occur; but they rarely persisted sufficiently to be counted on monthly average data. Such measured violations were generally associated with financial crises. (The number of dollar-sterling violations for 1890-1906 exceeding that for 1889-1908 is due to the results emanating from different researchers using different data. Nevertheless, the important common finding is the low percent of months encompassed by violations.)

Table 11Violations of Gold Points
Exchange Rate Time Period Number of Months Number dollar-sterling 240 0.4
1890-1906 3 dollar-sterling 76 0
1889-1908 12b mark-sterling 240 7.5

a May 1925 – August 1931: full months during which both United States and Britain on gold standard.
b Approximate number, deciphered from graph.

Sources: Dollar-sterling, 1890-1906 and 1925-1931 — Officer (1996, p. 235). All other — Giovannini (1993, pp. 130-31).

Stabilizing Speculation

The perceived extremely low convertibility and exchange risks gave private agents profitable opportunities not only outside the spread (gold-point arbitrage) but also within the spread (exchange-rate speculation). As the exchange value of a country’s currency weakened, the exchange rate approaching the gold-export point, speculators had an ever greater incentive to purchase domestic currency with foreign currency (a capital inflow); for they had good reason to believe that the exchange rate would move in the opposite direction, whereupon they would reverse their transaction at a profit. Similarly, a strengthened currency, with the exchange rate approaching the gold-import point, involved speculators selling the domestic currency for foreign currency (a capital outflow). Clearly, the exchange rate would either not go beyond the gold point (via the actions of other speculators of the same ilk) or would quickly return to the spread (via gold-point arbitrage). Also, the further the exchange rate moved toward the gold point, the greater the potential profit opportunity; for there was a decreased distance to that gold point and an increased distance from the other point.

This “stabilizing speculation” enhanced the exchange value of depreciating currencies that were about to lose gold; and thus the gold loss could be prevented. The speculation was all the more powerful, because the absence of controls on capital movements meant private capital flows were highly responsive to exchange-rate changes. Dollar-sterling data, in Table 12, show that this speculation was extremely efficient in keeping the exchange rate away from the gold points — and increasingly effective over time. Interestingly, these statements hold even for the 1890s, during which at times U.S. maintenance of currency convertibility was precarious. The average deviation of the exchange rate from the midpoint of the spread fell decade-by-decade from about 1/3 of one percent of parity in 1881-1890 (23 percent of the gold-point spread) to only 12/100th of one percent of parity in 1911-1914 (11 percent of the spread).

Table 12Average Deviation of Dollar-Sterling Exchange Rate from Gold-Point-Spread Midpoint
Percent of Parity Quarterly observations
0.32 1891-1900 19
0.15 1911-1914a 11
0.28 Monthly observations
0.24 1925-1931c 26

a Ending with second quarter of 1914.
b Third quarter 1925 – second quarter 1931: full quarters during which both United States and Britain on gold standard.
c May 1925 – August 1931: full months during which both United States and Britain on gold standard.

Source: Officer (1996, pp. 182, 191, 272).

Government Policies That Enhanced Gold-Standard Stability

Government policies also enhanced gold-standard stability. First, by the turn of the century South Africa — the main world gold producer — sold all its gold in London, either to private parties or actively to the Bank of England, with the Bank serving also as residual purchaser of the gold. Thus the Bank had the means to replenish its gold reserves. Second, the orthodox- metallism ideology and the leadership of the Bank of England — other central banks would often gear their monetary policy to that of the Bank — kept monetary policies harmonized. Monetary discipline was maintained.

Third, countries used “gold devices,” primarily the manipulation of gold points, to affect gold flows. For example, the Bank of England would foster gold imports by lowering the foreign gold-export point (number of units of foreign currency per pound, the British gold-import point) through interest-free loans to gold importers or raising its purchase price for bars and foreign coin. The Bank would discourage gold exports by lowering the foreign gold-import point (the British gold-export point) via increasing its selling prices for gold bars and foreign coin, refusing to sell bars, or redeeming its notes in underweight domestic gold coin. These policies were alternative to increasing Bank Rate.

The Bank of France and Reichsbank employed gold devices relative to discount-rate changes more than Britain did. Some additional policies included converting notes into gold only in Paris or Berlin rather than at branches elsewhere in the country, the Bank of France converting its notes in silver rather than gold (permitted under its “limping” gold standard), and the Reichsbank using moral suasion to discourage the export of gold. The U.S. Treasury followed similar policies at times. In addition to providing interest-free loans to gold importers and changing the premium at which it would sell bars (or refusing to sell bars outright), the Treasury condoned banking syndicates to put pressure on gold arbitrageurs to desist from gold export in 1895 and 1896, a time when the U.S. adherence to the gold standard was under stress.

Fourth, the monetary system was adept at conserving gold, as evidenced in Table 3. This was important, because the increased gold required for a growing world economy could be obtained only from mining or from nonmonetary hoards. While the money supply for the eleven- major-country aggregate more than tripled from 1885 to 1913, the percent of the money supply in the form of metallic money (gold and silver) more than halved. This process did not make the gold standard unstable, because gold moved into commercial-bank and central-bank (or Treasury) reserves: the ratio of gold in official reserves to official plus money gold increased from 33 to 54 percent. The relative influence of the public versus private sector in reducing the proportion of metallic money in the money supply is an issue warranting exploration by monetary historians.

Fifth, while not regular, central-bank cooperation was not generally required in the stable environment in which the gold standard operated. Yet this cooperation was forthcoming when needed, that is, during financial crises. Although Britain was the center country, the precarious liquidity position of the Bank of England meant that it was more often the recipient than the provider of financial assistance. In crises, it would obtain loans from the Bank of France (also on occasion from other central banks), and the Bank of France would sometimes purchase sterling to push up that currency’s exchange value. Assistance also went from the Bank of England to other central banks, as needed. Further, the credible commitment was so strong that private bankers did not hesitate to make loans to central banks in difficulty.

In sum, “virtuous” two-way interactions were responsible for the stability of the gold standard. The credible commitment to convertibility of paper money at the established mint price, and therefore the fixed mint parities, were both a cause and a result of (1) the stable environment in which the gold standard operated, (2) the stabilizing behavior of arbitrageurs and speculators, and (3) the responsible policies of the authorities — and (1), (2), and (3), and their individual elements, also interacted positively among themselves.

Experience of Periphery

An important reason for periphery countries to join and maintain the gold standard was the access to the capital markets of the core countries thereby fostered. Adherence to the gold standard connoted that the peripheral country would follow responsible monetary, fiscal, and debt-management policies — and, in particular, faithfully repay the interest on and principal of debt. This “good housekeeping seal of approval” (the term coined by Bordo and Rockoff, 1996), by reducing the risk premium, involved a lower interest rate on the country’s bonds sold abroad, and very likely a higher volume of borrowing. The favorable terms and greater borrowing enhanced the country’s economic development.

However, periphery countries bore the brunt of the burden of adjustment of payments imbalances with the core (and other Western European) countries, for three reasons. First, some of the periphery countries were on a gold-exchange standard. When they ran a surplus, they typically increased — and with a deficit, decreased — their liquid balances in London (or other reserve-currency country) rather than withdraw gold from the reserve-currency country. The monetary base of the periphery country would increase, or decrease, but that of the reserve-currency country would remain unchanged. This meant that such changes in domestic variables — prices, incomes, interest rates, portfolios, etc.–that occurred to correct the surplus or deficit, were primarily in the periphery country. The periphery, rather than the core, “bore the burden of adjustment.”

Second, when Bank Rate increased, London drew funds from France and Germany, that attracted funds from other Western European and Scandinavian countries, that drew capital from the periphery. Also, it was easy for a core country to correct a deficit by reducing lending to, or bringing capital home from, the periphery. Third, the periphery countries were underdeveloped; their exports were largely primary products (agriculture and mining), which inherently were extremely sensitive to world market conditions. This feature made adjustment in the periphery compared to the core take the form more of real than financial correction. This conclusion also follows from the fact that capital obtained from core countries for the purpose of economic development was subject to interruption and even reversal. While the periphery was probably better off with access to the capital than in isolation, its welfare gain was reduced by the instability of capital import.

The experience on adherence to the gold standard differed among periphery groups. The important British dominions and colonies — Australia, New Zealand, Canada, and India — successfully maintained the gold standard. They were politically stable and, of course, heavily influenced by Britain. They paid the price of serving as an economic cushion to the Bank of England’s financial situation; but, compared to the rest of the periphery, gained a relatively stable long-term capital inflow. In undeveloped Latin American and Asia, adherence to the gold standard was fragile, with lack of complete credibility in the commitment to convertibility. Many of the reasons for credible commitment that applied to the core countries were absent — for example, there were powerful inflationary interests, strong balance-of-payments shocks, and rudimentary banking sectors. For Latin America and Asia, the cost of adhering to the gold standard was very apparent: loss of the ability to depreciate the currency to counter reductions in exports. Yet the gain, in terms of a steady capital inflow from the core countries, was not as stable or reliable as for the British dominions and colonies.

The Breakdown of the Classical Gold Standard

The classical gold standard was at its height at the end of 1913, ironically just before it came to an end. The proximate cause of the breakdown of the classical gold standard was political: the advent of World War I in August 1914. However, it was the Bank of England’s precarious liquidity position and the gold-exchange standard that were the underlying cause. With the outbreak of war, a run on sterling led Britain to impose extreme exchange control — a postponement of both domestic and international payments — that made the international gold standard non-operational. Convertibility was not legally suspended; but moral suasion, legalistic action, and regulation had the same effect. Gold exports were restricted by extralegal means (and by Trading with the Enemy legislation), with the Bank of England commandeering all gold imports and applying moral suasion to bankers and bullion brokers.

Almost all other gold-standard countries undertook similar policies in 1914 and 1915. The United States entered the war and ended its gold standard late, adopting extralegal restrictions on convertibility in 1917 (although in 1914 New York banks had temporarily imposed an informal embargo on gold exports). An effect of the universal removal of currency convertibility was the ineffectiveness of mint parities and inapplicability of gold points: floating exchange rates resulted.

Interwar Gold Standard

Return to the Gold Standard

In spite of the tremendous disruption to domestic economies and the worldwide economy caused by World War I, a general return to gold took place. However, the resulting interwar gold standard differed institutionally from the classical gold standard in several respects. First, the new gold standard was led not by Britain but rather by the United States. The U.S. embargo on gold exports (imposed in 1917) was removed in 1919, and currency convertibility at the prewar mint price was restored in 1922. The gold value of the dollar rather than of the pound sterling would typically serve as the reference point around which other currencies would be aligned and stabilized. Second, it follows that the core would now have two center countries, the United Kingdom and the United States.

Third, for many countries there was a time lag between stabilizing a country’s currency in the foreign-exchange market (fixing the exchange rate or mint parity) and resuming currency convertibility. Given a lag, the former typically occurred first, currency stabilization operating via central-bank intervention in the foreign-exchange market (transacting in the domestic currency and a reserve currency, generally sterling or the dollar). Table 2 presents the dates of exchange- rate stabilization and currency convertibility resumption for the countries on the interwar gold standard. It is fair to say that the interwar gold standard was at its height at the end of 1928, after all core countries were fully on the standard and before the Great Depression began.

Fourth, the contingency aspect of convertibility conversion, that required restoration of convertibility at the mint price that existed prior to the emergency (World War I), was broken by various countries — even core countries. Some countries (including the United States, United Kingdom, Denmark, Norway, Netherlands, Sweden, Switzerland, Australia, Canada, Japan, Argentina) stabilized their currencies at the prewar mint price. However, other countries (France, Belgium, Italy, Portugal, Finland, Bulgaria, Romania, Greece, Chile) established a gold content of their currency that was a fraction of the prewar level: the currency was devalued in terms of gold, the mint price was higher than prewar. A third group of countries (Germany, Austria, Hungary) stabilized new currencies adopted after hyperinflation. A fourth group (Czechoslovakia, Danzig, Poland, Estonia, Latvia, Lithuania) consisted of countries that became independent or were created following the war and that joined the interwar gold standard. A fifth group (some Latin American countries) had been on silver or paper standards during the classical period but went on the interwar gold standard. A sixth country group (Russia) had been on the classical gold standard, but did not join the interwar gold standard. A seventh group (Spain, China, Iran) joined neither gold standard.

The fifth way in which the interwar gold standard diverged from the classical experience was the mix of gold-standard types. As Table 2 shows, the gold coin standard, dominant in the classical period, was far less prevalent in the interwar period. In particular, all four core countries had been on coin in the classical gold standard; but, of them, only the United States was on coin interwar. The gold-bullion standard, nonexistent prewar, was adopted by two core countries (United Kingdom and France) as well as by two Scandinavian countries (Denmark and Norway). Most countries were on a gold-exchange standard. The central banks of countries on the gold-exchange standard would convert their currencies not into gold but rather into “gold-exchange” currencies (currencies themselves convertible into gold), in practice often sterling, sometimes the dollar (the reserve currencies).

Instability of the Interwar Gold Standard

The features that fostered stability of the classical gold standard did not apply to the interwar standard; instead, many forces made for instability. (1) The process of establishing fixed exchange rates was piecemeal and haphazard, resulting in disequilibrium exchange rates. The United Kingdom restored convertibility at the prewar mint price without sufficient deflation, resulting in an overvalued currency of about ten percent. (Expressed in a common currency at mint parity, the British price level was ten percent higher than that of its trading partners and competitors). A depressed export sector and chronic balance-of-payments difficulties were to result. Other overvalued currencies (in terms of mint parity) were those of Denmark, Italy, and Norway. In contrast, France, Germany, and Belgium had undervalued currencies. (2) Wages and prices were less flexible than in the prewar period. In particular, powerful unions kept wages and unemployment high in British export industries, hindering balance-of-payments correction.

(3) Higher trade barriers than prewar also restrained adjustment.

(4) The gold-exchange standard economized on total world gold via the gold of reserve- currency countries backing their currencies in their reserves role for countries on that standard and also for countries on a coin or bullion standard that elected to hold part of their reserves in London or New York. (Another economizing element was continuation of the move of gold out of the money supply and into banking and official reserves that began in the classical period: for the eleven-major-country aggregate, gold declined to less than œ of one percent of the money supply in 1928, and the ratio of official gold to official-plus-money gold reached 99 percent — Table 3). The gold-exchange standard was inherently unstable, because of the conflict between (a) the expansion of sterling and dollar liabilities to foreign central banks to expand world liquidity, and (b) the resulting deterioration in the reserve ratio of the Bank of England, and U.S. Treasury and Federal Reserve Banks.

This instability was particularly severe in the interwar period, for several reasons. First, France was now a large official holder of sterling, with over half the official reserves of the Bank of France in foreign exchange in 1928, versus essentially none in 1913 (Table 6); and France was resentful that the United Kingdom had used its influence in the League of Nations to induce financially reconstructed countries in Europe to adopt the gold-exchange (sterling) standard. Second, many more countries were on the gold-exchange standard than prewar. Cooperation in restraining a run on sterling or the dollar would be difficult to achieve. Third, the gold-exchange standard, associated with colonies in the classical period, was viewed as a system inferior to a coin standard.

(5) In the classical period, London was the one dominant financial center; in the interwar period it was joined by New York and, in the late 1920s, Paris. Both private and official holdings of foreign currency could shift among the two or three centers, as interest-rate differentials and confidence levels changed.

(6) The problem with gold was not overall scarcity but rather maldistribution. In 1928, official reserve-currency liabilities were much more concentrated than in 1913: the United Kingdom accounted for 77 percent of world foreign-exchange reserves and France less than two percent (versus 47 and 30 percent in 1913 — Table 7). Yet the United Kingdom held only seven percent of world official gold and France 13 percent (Table 8). Reflecting its undervalued currency, France also possessed 39 percent of world official foreign exchange. Incredibly, the United States held 37 percent of world official gold — more than all the non-core countries together.

(7) Britain’s financial position was even more precarious than in the classical period. In 1928, the gold and dollar reserves of the Bank of England covered only one third of London’s liquid liabilities to official foreigners, a ratio hardly greater than in 1913 (and compared to a U.S. ratio of almost 5œ — Table 9). Various elements made the financial position difficult compared to prewar. First, U.K. liquid liabilities were concentrated on stronger countries (France, United States), whereas its liquid assets were predominantly in weaker countries (such as Germany). Second, there was ongoing tension with France, that resented the sterling-dominated gold- exchange standard and desired to cash in its sterling holding for gold to aid its objective of achieving first-class financial status for Paris.

(8) Internal balance was an important goal of policy, which hindered balance-of-payments adjustment, and monetary policy was affected greatly by domestic politics rather than geared to preservation of currency convertibility. (9) Especially because of (8), the credibility in authorities’ commitment to the gold standard was not absolute. Convertibility risk and exchange risk could be well above zero, and currency speculation could be destabilizing rather than stabilizing; so that when a country’s currency approached or reached its gold-export point, speculators might anticipate that currency convertibility would not be maintained and the currency devalued. Hence they would sell rather than buy the currency, which, of course, would help bring about the very outcome anticipated.

(10) The “rules of the game” were infrequently followed and, for most countries, violated even more often than in the classical gold standard — Table 10. Sterilization of gold inflows by the Bank of England can be viewed as an attempt to correct the overvalued pound by means of deflation. However, the U.S. and French sterilization of their persistent gold inflows reflected exclusive concern for the domestic economy and placed the burden of adjustment on other countries in the form of deflation.

(11) The Bank of England did not provide a leadership role in any important way, and central-bank cooperation was insufficient to establish credibility in the commitment to currency convertibility.

Breakdown of the Interwar Gold Standard

Although Canada effectively abandoned the gold standard early in 1929, this was a special case in two respects. First, the action was an early drastic reaction to high U.S. interest rates established to fight the stock-market boom but that carried the threat of unsustainable capital outflow and gold loss for other countries. Second, use of gold devices was the technique used to restrict gold exports and informally terminate the Canadian gold standard.

The beginning of the end of the interwar gold standard occurred with the Great Depression. The depression began in the periphery, with low prices for exports and debt-service requirements leading to insurmountable balance-of-payments difficulties while on the gold standard. However, U.S. monetary policy was an important catalyst. In the second half of 1927 the Federal Reserve pursued an easy-money policy, which supported foreign currencies but also fed the boom in the New York stock market. Reversing policy to fight the Wall Street boom, higher interest rates attracted monies to New York, which weakened sterling in particular. The stock market crash in October 1929, while helpful to sterling, was followed by a passive monetary policy that did not prevent the U.S. depression that started shortly thereafter and that spread to the rest of the world via declines in U.S. trade and lending. In 1929 and 1930 a number of periphery countries either formally suspended currency convertibility or restricted it so that their currencies went beyond the gold-export point.

It was destabilizing speculation, emanating from lack of confidence in authorities’ commitment to currency convertibility that ended the interwar gold standard. In May 1931 there was a run on Austria’s largest commercial bank, and the bank failed. The run spread to Germany, where an important bank also collapsed. The countries’ central banks lost substantial reserves; international financial assistance was too late; and in July 1931 Germany adopted exchange control, followed by Austria in October. These countries were definitively off the gold standard.

The Austrian and German experiences, as well as British budgetary and political difficulties, were among the factors that destroyed confidence in sterling, which occurred in mid-July 1931. Runs on sterling ensued, and the Bank of England lost much of its reserves. Loans from abroad were insufficient, and in any event taken as a sign of weakness. The gold standard was abandoned in September, and the pound quickly and sharply depreciated on the foreign- exchange market, as overvaluation of the pound would imply.

Amazingly, there were no violations of the dollar-sterling gold points on a monthly average basis to the very end of August 1931 (Table 11). In contrast, the average deviation of the dollar-sterling exchange rate from the midpoint of the gold-point spread in 1925-1931 was more than double that in 1911-1914, by either of two measures (Table 12), suggesting less- dominant stabilizing speculation compared to the prewar period. Yet the 1925-1931 average deviation was not much more (in one case, even less) than in earlier decades of the classical gold standard. The trust in the Bank of England had a long tradition, and the shock to confidence in sterling that occurred in July 1931 was unexpected by the British authorities.

Following the U.K. abandonment of the gold standard, many countries followed, some to maintain their competitiveness via currency devaluation, others in response to destabilizing capital flows. The United States held on until 1933, when both domestic and foreign demands for gold, manifested in runs on U.S. commercial banks, became intolerable. The “gold bloc” countries (France, Belgium, Netherlands, Switzerland, Italy, Poland) and Danzig lasted even longer; but, with their currencies now overvalued and susceptible to destabilizing speculation, these countries succumbed to the inevitable by the end of 1936. Albania stayed on gold until occupied by Italy in 1939. As much as a cause, the Great Depression was a consequence of the gold standard; for gold-standard countries hesitated to inflate their economies for fear of weakening the balance of payments, suffering loss of gold and foreign-exchange reserves, and being forced to abandon convertibility or the gold parity. So the gold standard involved “golden fetters” (the title of the classic work of Eichengreen, 1992) that inhibited monetary and fiscal policy to fight the depression. Therefore, some have argued, these fetters seriously exacerbated the severity of the Great Depression within countries (because expansionary policy to fight unemployment was not adopted) and fostered the international transmission of the Depression (because as a country’s output decreased, its imports fell, thus reducing exports and income of other countries).

The “international gold standard,” defined as the period of time during which all four core countries were on the gold standard, existed from 1879 to 1914 (36 years) in the classical period and from 1926 or 1928 to 1931 (four or six years) in the interwar period. The interwar gold standard was a dismal failure in longevity, as well as in its association with the greatest depression the world has known.


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Citation: Officer, Lawrence. “Gold Standard”. EH.Net Encyclopedia, edited by Robert Whaples. March 26, 2008. URL