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The Gold Standard and the Great Depression:

a Dynamic General Equilibrium Model

L. Pensieroso and R. Restout

Discussion Paper 2018-16

TheGoldStandar dandthe Great

Depression:aDynamicGeneral

EquilibriumModel

LucaPensieroso

RomainRestout

December3, 2018

Abstract

WastheGoldStandard amajordeterminant oftheonset andthe protractedcharacterofthe theGreat Depressionof the1930sin the UnitedStatesand Worldwide? Inthispaper ,wemodeltheÔGold- StandardhypothesisÕinadynamic generalequilibriumframework. Weshowthatencompassingthe internationalandmonetary dimen- sionsofthe GreatDepr essionis importanttounderstandwhathap- penedinthe 1930s,especiallyoutside theUnitedStates. Contrary towhatis oftenmaintained intheliteratur e,ourr esultssuggestthat thevagueof successivenominalexchange ratedevaluations coupled withthemonetary policyimplemented intheUnited Statesdidnot actasa relief.On thecontrary ,theymadetheDepression worse. Keywords:GoldStandar d,GreatDepression,DynamicGeneralEqui- librium

JELClassiÞcation:N10,E13, N01

York,attheASSET2016 conferencein Thessaloniki,atthe WorkshopinMacroeconomics on atthe2015 Macro-DynamicsWorkshopinBilbao.W ethankparticipants tothesemeetings, aswellas participantsto seminarsatthe UniversitiesofLouvainandStrasbourg fortheir feedback.Charlottede MontpellierandGiulio Nicolettimadeinter estingremarks onan earlierversion.The usualdisclaimersapply .Restoutthanks theRegionof Lorrainefor researchsupport(GrantAAP-009-020). IRES,Universit"ecatholique deLouvain.Email: luca.pensieroso@uclouvain.be Universit"edeLorraine, Universit"edeStrasbour g,CNRS,BET A,54000,Nancyand IRES,Universit"ecatholique deLouvain.Email: romain.restout@univ-lorraine.fr 1

1Introduction

Inthisarticle, weintroduce atwo-country ,two-gooddynamic general equilibriummodel tostudywhether theGoldStandar dwasa majorcon- comitantcausefor theonset andthelong durationofthe GreatDepr ession ofthe1930s. SinceKeynesÕsGeneralTheory,theGr eatDepression hasbeenonthe frontierofresearch inmacroeconomics. Yet,theliteratureisstillincon- clusiveaboutthe causesofthe Depression,wi thmacroeconomists and economichistorians strugglingto provideaconsensualexplanation ofthis exceptionalevent. thestory goes,are chronicallysubject todepressionsdueto possiblede- Þcienciesinaggr egatedemand.This callsforsystematicGovernmentin- terventionin theformof publicexpenditur esandexpansionary monetary policy. Thealternativeview runsunder thebannersof Monetarism.This viewwasput tothe foreby FriedmanandSchwartz (1963)andfurther elaboratedbyMishkin (1978).Accor dingtothe Monetaristexplanation, theGreat Depressionwasnotamarket failure,butactuallyaState failure. TheÞngersar epointedto theFederalReserve(Fed),who failedtoact aslenderof lastresort. Theconsequentlack ofliquidityin themarket causedbankingpanics anddebt-deßation, therebypr omptingtheworst

DepressionofAmericanhistory.

Economichistorianshave blendedthetwo theoreticalappr oachesand widenedthescope ofthe analysisfrom theUnitedStates tother estof theW orld.TheÞrstremarkableanalysis wasthatby Kindleberger(1973), ofthemonetary systemofthe time,theGold Standard,due toalack of lenderoflast resortat theinternationallevel ,withtheBankofEngland notcapableto exertthis roleanymor e,andtheFednotyet ready toaccept thehandover. Takingthereasoningone stepfurther,Eichengreen(1992) arguesthatnotonlythe GoldStandard didnotwork wellbecauseof alack ofhegemonicpower ,butthe GoldStandarditselfwasat theheartof the trouble.TheGoldStandard hypothesiswas mostnotablysupported by thework ofBernanke(1995), BernankeandCar ey(1996),Eichengr eenand Irwin(2010),Eichengr eenand Sachs(1985),Eichengreenand Temin(2000) andTemin (1989),amongothers. Attheend ofthe1990s, anewstrand ofmacroeconomic literatureon 2 theGreat Depressionsawthelightof theday. 1

Usingdynamicgeneral

equilibrium(DGE)models, theseauthorscollectively claimthatthe De- pressionwasaÔnormalÕ businesscycle worsenedbybad policydecisions. Theirmodelsar eequilibriummodels ofthebusinesscycle,in thesense ofLucas(1980). Theypointto aStatefailur e,butthey includeKeynesian ColeandOhanian (1999),Coleand Ohanian(2004),W eder(2006). Theemergence ofDGEmodelsofthe GreatDep ressionwas amajor breakthrough. 2 Inparticular, itallowedar eformulationofthe Keynesian andMonetaristviews oftheDepr essioninterms offormaleconomic mod- elsgear edtowardsaquantitative assessmentoftheirrelevance.Still,this researchagendaraisesasmanyquestions asitanswers, asrecalled byPen- sieroso(2011b)andTemin (2008).Oneobvious concernisits mainfocus 3 As basedonidiosyncratic shockshittingdi !erentcountriesatthesame time arehardlycompelling.Mor eover,noneofthemodel producedso farin theliterature canhelpustoassesswhether theGoldStandar dhypothesis puttothe foreby thehistorianshold good. Inthispaper ,wepr ovidetheÞrstconsistentDGE modelofthe Gold

StandardandtheGreat Depressioni ntheliteratur e.

4

Webuildatwo-

country,two-goodDGEmodel,in whichthe UnitedStatestrade ingoods withtheRest oftheW orld.Themodel isspeciÞedin monetaryterms, withmoneysupply linkedtothe goldreserves ofthecountry ,while gold ßowsensures theequilibriumofthebalanceof payments.Monetarynon- ofan exogenousmoneymultiplier ensuresthe modelcancatch, atleast inreduced form,theÞnancialdimensionof theDepression. Themodelis calibratedon historicaldatafor theUnitedStates andabunch ofWestern countriesr egroupedundertheÔRestoftheWorldÕ label.It featuresa series ofreal andmonetaryshocks,properlycalibrated fromthe historicaldata 1 Seethe articlesinthecollectedvolume byKehoeand Prescott(2007), andPensieroso (2007)fora criticalsurvey. 2

SeeDeV roeyand Pensieroso(2006).

3 Closed-economyanalyses includeBeaudryand Portier(2002)for France,Coleand Ohanian(1999)for theUnitedStates, ColeandOhanian (2002)forthe UnitedKingdom, FisherandHornstein (2002)forGermany ,Pensieroso (2011a)forBelgium. 4 Inanindependent work,Chen andWar d(2018)estimate aNewKeynesian modelfor thepre-1913 GoldStandard.Theyargue thatpriceßex ibility,duethelarge predominance ofagriculturalpr oductsamong tradeablegoods,explainswhyadjustmentsof current accountimbalanceswer etypicallynot accompaniedbysigniÞcantoutputlossesin the pre-WWIGoldStandardsystem. 3 aswell.The modelhasa goodÞtting,for itiscapable tomatchmost ofthe statisticalmomentsof thedata.Res ultsfrom numericalsimulationsand counterfactualanalysis showhowimportant itisto encompassapr oper internationaldimensionin themodel,in orderto betterunderstandwhat happenedduring the1930s.Indeed, monetaryshockslinked totheGold Standardhelpstoaccountfor theactualdata, particularlyin theRest oftheW orld.TheGold Standarddidprovidea powerfultransmission mechanismofmonetary shocksfrom theUnitedStates tother estofthe World,asclaimedbythe historicalliterature.However,contrarytowhatis tothe 1929GoldStandar dby1932, withnoadditional monetaryshock,the Depressionwouldhavebeen milder,especially inther estofthe World. Thisisin accordancewith Kindleberger(1973), whoviewedtheseriesof successivedevaluations ofthe1930s asessentiallybeggar -thy-neighbour. Thoughtheaim ofthiswork istocontribute tothemacr oeconomic literatureontheGr eatDepression, byassessingthe qualitativeadequacy andquantitativer elevanceof theGoldStandardhypothesis,the scopeof ouranalysisactually extendsbeyondthe realmof history,and toucheson currentevents.Ithasbeen arguedthat theEuro zonepresents important analogieswiththe GoldStandard. Inparticular, Eichengreenand Temin (2010)havear guedthatthe Europeansarechainedby fettersofpaper today,liketheWorld waschainedby fettersofgold duringtheGreatDe- pression,withtheimplicit conclusionthatexiting theEurowouldhelp the recovery.AssessingwhethertheGoldStandard wasal ikelyculpritfor the Depression,andwhetherexitingthe GoldStandard wastherefor ethe way outofthe Depressionmight haveimportantindir ectpolicyimplications. narrativeon theworkingof theGold Standardand itspossibler oleduring theGreat Depression.InSection3,we presentourmodel.We proceed tocalibrateand simulateitin Section4,wher ewealso showthe impulse responsefunctionsofthemodel andprovide ourcounterfactualanalysis.

Section5 concludes.

4

2TheGold Standard

2.1Theworking oftheGold Standard

Theclassicalexposition ofthew orkingofthe GoldStandard istobe found inHume(1752). 5

Itsmechanicsis basedonthr eepillars,money supply,

thetradebalance andgoldßows. Moneysupplyis linkedtogold through thepriceof gold,theunits ofcurrency thatmustbe giveninexchange foraunit ofgold.This priceisÞxed bythe monetaryauthority. When twocountriesboth abidebythe GoldStandard, thenominalexchange rate betweentheir currenciesis Þxedandequaltothe relativeprice ofgoldin thetwocountries. Inotherwor ds,theGold Standardis aÞxedexchange rateregime, inwhichrelativegoldparity regulatesthe nominalexchange rate.Inth iscontext,when thetradebalanceinthe domesticeconomyis in deÞcit,thedomestic currencycannot devaluate.Accordingly ,thequantity ofgoldmust adjusttor estorethe equilibriumofthe tradebalance.The countryindeÞcit willthenexperience agoldoutßow ,andconsequently a deßationof monetaryprices.By thesametoken, thecountryin surplus willexperiencean increase ingoldr eserves,which,giventhegoldcontent ofthecurr ency,implies anincreaseinmoneysupplyand therefor ein monetaryprices. Deßationinthe domesticeconomyand inßationinthe foreigneconomywillpushthe termsoftrade infavourof theforeign economy.Hence,thelatterwill startimportingmor efrom, andexporting lesstothe domesticeconomy, therebycorr ectingtheinitial disequilibrium inthetrade balance.Thismechanism willworkuntil thetradebalance is inequilibrium. Ifthisis thebackboneof theGoldStandar dsystem,its actualwork- ingmight bemore complex,oncewe takeintoaccountthepresence of banksand theÞnancialsystem. Asaptlynoted bytheCunli !eCommittee (1918), 6 capitalmovements(i.e. internationallen dingandb orrowing)add additionalspeciÞcfeat uresto thesystem.IfthetradebalanceisindeÞcit, thecentralbank ofthedeÞcit countrycanraise thediscountrate toattract lending.Inthis way,the trade-balancedeÞcitmight becompensatedby capitalinßows (i.e.debt),with noorless goldoutßows.This possibil- ityintroduces anelementofarbitrarinessin theworkingof anotherwise automaticmechanism.It followsthat crediblecommitment totheGold Standardandcentralbankcooperation becomescentralfeatur esofthe system.Notice thatcapitalmovements donotcorr ectthedisequilibrium 5

Reprintedin Eichengreen,ed (1985).

6

ReprintedinEichengr een,ed(1985).

5 ofthetrade balance,perse.Indeed,the inßowsofcapital, tobesustainable, cannotbeper ennial,whilecapital mobilitywilltendtoequalise interest ratesacross countries.Therefore,eventually thereal exchangeratemust adjusttor estore equilibrium.Again,inaÞxedexchangeratecontext,it isther elativepriceindex thatmustbearthebrunt ofadjustment.The higherinterest rateinthedeÞcitcountrywill discourageinvestments, loweraggregate demandandtherefore exertadeßationary pressure. The consequentdepr eciationoftherealexchange ratewillfavour exportsand depressimports,thereby contributingto restoretheequilibriumofthe tradebalance.Notice thepossible trade-o!betweenthelong-r unobjective ofbalance-of-paymentsstabilisation andtheshort-r unobjectiveof coun- tercyclicalmonetarypolicy, atraitalr eadyhighlightedbyKeynes(1923), mostnotably.

2.2The GoldStandardand theGreatDepression

Themostcomplete accountofthe GoldStandard hypothesisforthe Great Depressionistobefound inEichengreen (1992).Like Friedmanand Schwartz(1963), Eichengreenattributes theonsetoftheGreat Depression tother estrictivemonetary policyimplementedbytheFedin 1927-1928, intheattempt toavoidthe burstingofa speculativebubble.However , di!erentlyfromFriedmanand Schwartz(1963),Eichengreenlooks atthis Statesimpliedless lendingfrom theUnited Statestothe restoftheW orld. Thiswasa problemfor manycountries,and inparticularfortheEuropean countries,whower estillr ecoveringfromWorldW arI,and witnessed heavycurrent accountdeÞcits.AbsentAmericanlending, therest ofthe Worldwasforcedto recurto restrictiveÞscalandmonetarypolicy inorder tokeepgold parityandpr eventgoldoutßows. Ifbadmonetary policy inthe UnitedStateswas theimpulsemechanism determiningtheonset of theGreat Depression,thetransmissionmechanism frommoneytother eal worldpassedthr oughwage andpricerigidityintheUnited Statesand elsewhere,andthroughthe lackofinternational cooperation.Eichengreen attributesthe strongnon-neutrality ofmoneynecessarytoexplainwhy monetarypolicyhad suchdevastatinge !ectsonr ealoutput andemploy- menttonominal stickiness,includingwages, rentsand mortgages.Infact, theevidence suggeststhatr ealwages wereincr easingmoreforcountries belongingto theGoldStandar d.Moreover ,theystarted todecreasealmost 7

Intheinternational

7

SeeBernanke(1995) andEichengr eenandSachs (1985).

6 context,monetarytensions wereworsened byissueslike warrepayments andwardebts, whichled tofreeze anycoordinated actionbythe main centralbanksto provide liquiditytothe economywithoutincurringin lossesofgold. TheDepression wasfurtherworsened becauseofthe Þ- nancialcrises thathitthe UnitedStatesand othercountries(Austria and Germany,mostnotably).Eichengr eenpointsto thetrade-o!betweenÞ- nancialstabilityand nominalexchangerate pegging.Incase ofliquidity increasetheperceivedrisk ofcurr encydevaluation,therebyincreasing de- positwithdrawalsand inducingcapital(and gold)outßows.Accor dingto Eichengreen,farfrom actingasa stabiliser,theGoldStandard wasactually fosteringÞnancialinstability andbankingcrises. Thesedramaticevents unfoldedinwhat wastobecome theworsteco- nomiccrisisin thehistory ofmoderncapitalism, untiloneby onecountries startedexitingthe GoldStandard, orimposingstrict capitalcontrols. This is,according toEichengreen,themainpolicy decisiondrivingthe World economyoutof theDepression. Indeed,theevidence showsthatcountries exitingtheGo ldStandar dearlier,recovered earlierandfaster. 8

Absent

theexternalconstraint onthenominal exchangerate,Þscal andmonetary expansionbecamepossible. However, theDepression lingeredforquite sometime,and itwaseventually sweptawayonly bytheoutbr eakof

WorldWarII.

3Themodel

3.1Keyfeatures andnotation

Thetheoretical reasoningunderpinningtheliteratur eontheGoldStan- dardandtheGreat Depressionis basedonmany elements:exchange ratepegging,mon etaryand realshocks,moneynon-neutralityinduced bynominalrigidities, Þnancialinstability andbankingcrises, tradeand capitalmovements. Ourmodelfeatur esmostof thoseelements.Weshallhav eexchange ratepegging,monetary andreal shocks,nominalwage rigidityandinter - nationaltrade.Capitalmovementsar enotincludedasdeemedtobeminor inthe1930s. 9

Wedonotmodelthe useof reservecurr encybecausethe

8 SeeChoudhriand Kochin(1980) andEichengreen andSachs(1985). 9 AccordingtoEichengreen (1992),capitaloutßows fromEuropetothe UnitedStates attheend ofthe1920s arethe transmissionmechanismof themonetaryshock from the UnitedStatesto theRest oftheW orld,asthey forcedthe Europeancentral banksto 7 issueisirr elevantina two-countrymodel.Financialsectorandbanking crisesare includedinreducedform. 10 Themodelfeatur estwosymmetric countries,theUnitedStates(US) andtheÔRest oftheW orldÕ(RW).Each countryproduces inperfect com- petitiononecountry-speciÞc good,thatcan beconsumedand invested domestically,andtradedinternationally atnotcost. Weassume thatboth labourandphysical capitalare notmobileinternationally .Populationis assumedto beconstantin bothcountries.Agents haveperfectfor esight. 11 Akeyingr edientofthis modelisthepresenceof moneyin thesense ofcashbalances whosequantityis linkedtothe quantityofgold andto monetarypolicy. Nominalwagesar eassumedto witnesssomedegreeofri gidityinboth countries. Beforeproceedingtoillustrate themodel,someexplanationabout no- tationis inorder ,forthe modelfeaturestwocountries,twogoods,two currenciesandfourprice indices,allof whichmakesnotation quitecum- bersome. Variablesreferringto theRestoftheWorld aredenoted byaÔstar Õ, X .Variables referringtotheU nitedStatesbearnosuperscript.Nominal variablesinlocal currencyar edenotedby ansuperscriptÔtildeÕ,

X.Real

variablesbearno superscriptifde ßatedbythe consumptionpriceindex.

Theyare insteaddenotedbyasuperscript ÔhatÕ,

X,ifthey arephysical

quantitiesofgood. Lower-casevariables standforper -capita,i.e.aggre- gatevariablesdivided bythepopulation, NandN fortheUnited States andtheRest oftheW orld,respectively .We denotebyntheratioN /N.A USorRWsuperscriptdenotesthe originof thegood(i.e. wherethe good hasbeenpr oduced). Toeasethetaskfor thereader ,notationis reportedin Table1. Inwhat followswewillfocustheexposition ontheUnited States. increasetheirpolicyrates, inorder toavoidmajor outßowsofgold. Inthemodel, absent capitalmobility, wewilltreatmonetaryshocks inthe Restofthe Worldasexogenous,but itmust beunderstoodby thereader thatthoseshocks arelinked totheGold Standard, andweshall considerthemas such. 10

Wediscusstheissue atlengthin Section3.6.

11 Whilethis isacommon assumptioninthe literature,ther eislittle consensusover thecorrect wayofmodelingexpectationsinthe analysisofthe GreatDepr ession.See KehoeandPr escott(2008)for adiscussionaboutrationalexpectationsvsperfectforesight intheanalysis oftheGr eatDepression. Eggertsson(2008) providesa modelhighlighting therole ofexpectationsindrivingtheAmerican economyoutof theGreat Depression ofthe1930s. AguilarGarc `õaandPensier oso(2018)ar ecurrentlyfurtherexploring the expectationshypothesis, byintroducingadaptivelearningin aDGEmodel oftheU.S.

GreatDepression.

8

U.S.variables

Cnominalconsumption(in dollars)

C" C/P c realconsumption(deßatedbyCPI) c"C/Nrealconsumptionpercapita US

U.S.real per-capitaconsumptionofU.S.good

RW

U.S.real per-capitaconsumptionofRW good

RWvariables

C nominalconsumption(in RWcurr ency) C C /P c! realconsumption(deßatedbyCPI) c "C /N realconsumptionpercapita US!

RWrealper-capita consumptionofU.S.good

RW!

RWrealper-capita consumptionofRWgood

Table1:Notation:U.S.and RWvariables

Giventhesymmetry betweenthetwo countries,themodel fortheRest of theWorl disanalogous.Wewillspellout theequations fortheRestofthe

3.2TheU.S. aggregateconsumption

Realper-capita aggregateconsumptioninthe UnitedStates,c,ismade of consumptionofboth thedomesticand theforeign good.Asstandar din theinternationaltrade literature,we shallusea CESaggregator,where !>0standsfor theelasticity ofsubstitutionbetween thetwogoods, and "#(0,1)indicatesthe relativepr eferencefor theU.S.good. c t 1 US t !$1 +(1$") 1 RW t !$1 !$1 ,(1) Inviewof theimportance attributedto theHawley-SmootAct of1931 weallowfor thepresence oftari!sonU.S. imports.T ari!sonthe dollar valueofimports aredenoted by#.CallingP thepricein foreigncurr ency RW ,andethenominalexchange rateexpressed astheamountofdollars for1unit ofinternationalcurr ency, expenditureminimizationbyther epresentativehousehold gives: US t P t P c t c t ,(2) 9 RW t =(1$") (1+# t )e t P t P c t c t ,(3) P c t "P 1$! t +(1$") (1+# t )e t P t 1$! *1 1$! ,(4) whereP c istheCPI impliedbymodel.quotesdbs_dbs15.pdfusesText_21

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