The German Crisis of 1931 (Pt. 1 of 4)

This is the first part of chapter 5, which discusses 1931.  First I’d like to make a few comments on this amusing video.  My favorite line is when Joe Biden prays to God.   I didn’t know that politicians talk to God in the same dishonest way they talk to voters.  Bloggers on the right and on the left who think the other party is a bunch of lying weasels are half right.  They are a bunch of lying weasels.  But so is their own party, which they somehow overlook.  Above the fray independents have the right attitude toward most politicians of both parties—contempt.

BTW, in my view Bush was right and the Dems were wrong in 2005, and Obama is right and the GOP is wrong today.   The filibuster makes no sense.  Indeed I’d like to see a parliamentary system in this country, where something like the German Free Democrats was in the center, determining what got done.  Some people seem to believe the filibuster favors small government, but I find that unlikely.  Size of government is just as likely to shrink as to grow, otherwise government would head toward 100% of the economy in the long run.  So in the steady state there will be equal number of proposals to shrink government as to expand government.

When 59 people disagree with 41, the 59 are more likely to be right.  If they were more likely to be wrong, we ought not have democracy at all.

OK, enough political nonsense.  On to 1931:

Chapter 5: The German Crisis of 1931

The first three months of 1931 was a period of relative calm, with no banking panics (to cause currency hoarding), no devaluation fears (to cause private gold hoarding.)  Even growth in the world gold reserve ratio slowed somewhat.  Thus far things looked a lot like 1920-21, with industrial production falling 31%, and then beginning to rise.  If the Fed had not continued to increase its gold reserve ratio then a vigorous recovery might have occurred.  Even without help from the Fed, industrial production rose 3.2 percent between January and April and there were numerous signs that the Depression might be ending.  Then, between mid-1931 and mid-1932 an extraordinary series of events turned a major recession into the Great Contraction.

The renewed downturn was accompanied by some fundamental changes in the nature of the international gold standard.  Contrary to popular belief, 1931 did not mark the end of the international gold standard; if it had, the Depression might have ended much more quickly.  Instead, it marked the end of a stable international gold standard.  For the remainder of the 1930s a hobbled gold standard did far more damage than would have been possible from either a pure gold standard or a pure fiat money regime.  It was the worst of both worlds; the gold standard continued to constrain monetary policymakers in many countries, including the US, but the panicky search for liquidity increased the demand for gold and took away its greatest virtue, its stability of value.

In the next two chapters we will take a detailed look at how political and economic shocks impacted the international gold market, financial markets, and the overall economy during 1931-32.  We begin with a brief discussion of how the gold market approach to aggregate demand can provide framework for the subsequent narrative.

5.a  Gold Hoarding and Aggregate Demand During 1931

In chapters 3 and 4 we saw how a 9.6 percent increase in the world gold reserve ratio sharply output and prices after October 1929.  With the onset of banking crises in late 1930, however, increases in real currency demand (or alternatively lower currency velocity) also became major factor in the ongoing worldwide deflation.   In fact, tables 3.1 and 3.4, suggest that currency hoarding can explain nearly all of the deflation after October 1930.  Nominal currency demand actually rose by about 5 percent between October 1930 and the end of 1932, despite a 25 percent drop in the world price level.  This means that real currency demand soared by roughly 30 percent over that 26 month period.  Even with no change in gold stocks or gold reserve ratios, such an increase in real currency demand would have had a severe deflationary impact.

As if this weren’t bad enough, private and central bank gold hoarding also put strong downward pressure on the world price level during the crucial period of June 1931 to June 1932.  Private gold demand, which had averaged about xxx million during 1926-30, soared by xxx million in the 12 months between June 1931 and June 1932.  There was also an increase in the world’s gold reserve ratio, mostly due to hoarding by European central banks.

The effect of gold hoarding may have been even greater than suggested by the data in chapters 2 and 3.  In the decomposition of changes in the world price level in tables 3.1 and 3.4, increases in real currency demand were essentially a residual, which picked up all factors other than private gold hoarding or central bank deviations from the “rules of the game.”  But the increase in currency hoarding was itself a response to the Depression, particularly low interest rates and fear of bank failures.  In addition, Wicker (1996) found evidence that two of banking panics might have been aggravated by runs on the dollar, which were at least partly attributable to worries over the sufficiency of monetary gold reserves.[1] Thus gold hoarding by both private citizens and foreign central banks may have indirectly contributed to currency hoarding during the early 1930s.  If so, then the impact of private and central bank gold hoarding on the price level would have been even larger than the estimates in tables 3.1 and 3.4.

Growth in the world monetary gold stock slowed only slightly after October 1930, from an annual rate of 4.3 percent between December 1926 to October 1930, to an annual rate of 4.2 percent between October 1930 and December 1932.[2] How then could private gold hoarding have played a role in the severe deflation of the latter period?  If we look at shorter time periods, we see a much more complex pattern.  During the first year of the Depression growth in the world monetary gold stock actually accelerated to a rate of 5.2 percent.  After the first banking panics began in late 1930, growth accelerated further to an annual rate of 5.9 percent between October 1930 and June 1931.

[1]See also Wigmore (1987.)

[2]  Bernanke (1995) and Sumner (1991) both argued that the continued growth in the world monetary gold stock after 1929 meant that the deflation must have come from other (demand-side) factors.

The initial acceleration in the growth rate of the world monetary gold stock is exactly what one would expect during a period of deflation.  Recall that under a gold standard regime deflation raises the real price of gold.  Unless the deflation was caused by a leftward shift in the supply gold (clearly not the case in the 1930s) one would expect an increase in the quantity of newly-mined gold.  In addition, a higher real price of gold might be expected to reduce the industrial demand for the metal (assuming that the ongoing deflation was not caused by increased industrial demand for the metal.)  And the fall in real incomes during the 1930s might have been expected to further reduce demand for a metal often used in luxury goods.  It is also possible that a higher real price of gold could lead to some reduction in private demand for gold as an investment.  In fact, there was an increase in the supply of newly mined gold during the early 1930s, and there was also massive gold dishoarding from India after mid-1931,[1] which added several percentage points to the growth rate of the world monetary gold stock.

Between the growth in newly mined gold and the dishoarding from India, one might have normally expected the growth of monetary gold stocks to have accelerated to a rate well above 5.9 percent after mid-1931. Instead, after the German reichsmark came under attack growth in the world monetary gold stock came to an abrupt halt, rising just 0.7 percent over the following 12 months.  Rapid growth in world gold stocks briefly resumed after July 1932, although there was renewed hoarding in early 1933.  Coincidently, it was in July 1932 that U.S. industrial production (and the Dow) reached its lowest point of the Great Depression.  And there is some evidence that investors may have been counting on the stabilizing properties of the gold standard.  When the gold was not forthcoming, the NYT noted that during previous depressions “increase in the world’s gold supplies had a definite influence in bringing recovery” and then wondered “Why did not this process affect prices and prosperity” in 1932?[2]

To summarize, gold standard models suggest that the supply and demand for gold tends to adjust to shocks in a way that ensures rough stability in the long run value of gold (and hence price level.)  To be sure, this process may take decades, and was certainly too slow to prevent the Depression, but one would at least have expected some response in the supply of monetary gold to the ongoing deflation.  And during the first stage of the Depression that response seemed to be occurring.  It is in that context that the temporary cessation of growth in the world monetary gold stock during 1931-32 takes on such importance.  Investors may have anticipated (and the world economy certainly needed) continued acceleration in the growth rate of the world monetary gold stock.  As we will see, the financial markets reacted extremely negatively to signs that that growth might be disrupted.

At first glance, the data in table 3.4 also seems to suggest that the world gold reserve ratio played only a modest role during the second stage of the Depression. The ratio actually fell slightly after October 1930, and even though it rose after mid-1931, the total increase between October 1930 and December 1932 was only about 4.2 percent.  Once again, however, a closer look at the data shows that the gold reserve ratio played a significant deflationary role during 1931 and 1932.

[1] The NYT (1/03/1933, p. 25) noted that “Last year [1932] the high premium paid for gold in England’s depreciated currency drew out an estimated $50,000,000 from sale to the banks of British gold ornaments and hoarded coin, and had the much more remarkable effect of turning India, hitherto an immense absorbent of the world’s new gold, into a huge exporter.  Estimates vary as to the amount thus released, but they range from $300,000,000 to $400,000,000.”

[2] NYT, 1/3/1933, p. 25.

In chapter 3 I defined the “rules of the game” as a stable gold reserve ratio, and used adherence to this rules as a benchmark for a neutral monetary policy.  But it is not clear that a stable gold reserve ratio should be viewed as the baseline policy.  If, for instance, Bagehot’s maxim that central banks should lend freely in response to internal drains is regarded as standard operating procedure under a gold standard regime, then gold reserve ratios should have fallen during banking panics.  In that case, the assumption that a stable gold reserve ratio represented a neutral policy would lead one to overestimate the importance of currency hoarding, and underestimate the failure of central bank monetary policies.

Consider, for example, the response of the Fed to the extensive currency hoarding which occurred in the U.S. after the banking panics.  A policy of maintaining a stable gold reserve ratio would have forced the Fed to accumulate massive quantities of gold during 1931-32.  Instead, they partially accommodated the currency hoarding by sharply lowering the U.S. gold reserve ratio.  In fact, the decrease in the U.S. gold reserve ratio was large enough, by itself, to reduce the world gold reserve ratio by roughly 11 percent between October 1930 and December 1932.  Given that the U.S. held almost 40 percent of world monetary gold stocks, how could the world gold reserve ratio have risen by 4.2 percent during the same period?  As we will see, the answer is that after mid-1931 there was massive gold hoarding by central banks in the so-called “gold bloc,” especially France.[1]

In the next few sections we will see evidence that the financial markets were adversely affected by signs that central banks and private individuals intended to hoard gold.  But the policy implications of this were not as obvious as one might imagine.  An expansionary policy that reduced the gold reserve ratio could trigger devaluation fears, which could then lead to more private gold hoarding.  Was the way out of this policy dilemma, then, to abandon the gold standard and inflate?  Perhaps, but actual devaluations in one country often triggered devaluation fears in other countries, again leading to more gold hoarding.  The interconnections are obviously quite complex and difficult to disentangle, but the proximate causes of the second stage of the Depression appear to have been:[2]

1. 1.  Currency hoarding.  (Primarily in the U.S.)
2. 2.  Central bank gold hoarding (primarily in the gold bloc.)
3. 3.  Private gold hoarding (especially between mid-1931 and mid-1932.)
   

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[1]This is not to exonerate the Fed, most of the world’s currency hoarding occurred in the U.S., and with its massive gold stocks the Fed arguably had both the ability and duty to be much more accommodative of the increased currency demand.

[2] Hamilton (1988, p. 81) also emphasizes the deflationary impact of private and central bank gold hoarding during 1931-32. Appendix 5a presents evidence that increased private and central bank gold hoarding tended to be correlated with declines in aggregate demand.

5.b  The problem of the “maldistribution” of gold.

          As prices continued to fall during 1931, there was increasing concern that the demand for gold was outstripping the supply.  There was little explicit discussion of the world gold reserve ratio; instead many commentators saw the problem as being caused by a maldistribution of gold among the major central banks.  At the time France returned (defacto) to the gold standard in December 1926, they held less than 8 percent of the world’s monetary gold stock.  After 4 years of steady gold inflows, France began 1931 with nearly 20 percent of the world monetary gold stock.  Although the U.S. share dipped slightly over this period, it still held almost 39 percent of the world total at the beginning of 1931.

Eichengreen argued that the maldistribution of gold was symptomatic of a lack of policy coordination among the major central banks.  Temin(p. 87) countered that “the only kindof cooperation possible was under the gold-standard orthodoxy.  More of this kind of cooperation would have been dysfunctional”.  No doubt Temin is right that a joint devaluation in 1931 would have been preferable to continued adherence to the gold standard, but there is also evidence that, given the political impossibility of devaluation in American and France, some sort of coordinated move to reduce central bank gold hoarding would have been welcomed by the financial markets.

In the last two months of 1930 the British gold stock had resumed its decline and the pound was under renewed pressure.  Not surprisingly, much of the criticism of U.S. and French gold policies came from Britain.  The French and British met in Paris on January 2^nd, 1931, to develop a plan to curb the persistent flow of gold from London to Paris.  The same day the Dow opened the year up 3.2 percent.  On the 3^rd, the Bank of France cut its discount rate by a half point, and the following day’s NYT (p. N11) cited this move as one reason for an additional 1.3 percent increase in the Dow.

During the early months of 1931 there were encouraging signs that the gold agreement was having some success.  Beginning in late January 1931 the French monetary gold stock leveled off for a period of 4 months, during which time the British were able to add to their gold stocks.  Of course gold flows mean little in and of themselves, but in this case gold was being redirected toward countries with lower gold reserve ratios than France, and thus the net impact of this accord was to lower the world’s gold reserve ratio.  On February 10, 1931 the NYT was able to report that Europe was becoming more optimistic as the pound strengthened in value, and by February 23^rd (p. 26) they were reporting that confidence was returning to Europe.  The very next day, the Dow hit its 1931 high, up 18.1 percent from the beginning of the year.  Stocks then moved sideways for the next four weeks, before beginning a decline that would continue over the following 15 months.

Although we now know that early 1931 was merely a pause in the Great Contraction, there are a number of reasons why investors might have felt optimistic during early 1931.  The British-French monetary accord had improved international monetary conditions and worldwide commodity price deflation had moderated.  In Germany, the Nazi party seemed to have been marginalized by the government.  And in the U.S., the banking situation was improving after the wave of failures during late 1930.  Between July 1929 and July 1932 there was only one period where monthly industrial production figures increased, January to April 1931.  During this period, many financial commentators expressed the view that the Depression had bottomed out and a recovery was already underway.

Unfortunately, the Fed began hoarding gold again during early 1931.  On May 7^ththe Fed cut the discount rate in an attempt to stem the gold inflow, andthe next day investors responded enthusiastically with a 4.0 percent increase in the Dow.  But this move would prove to be too little, too late, as increasing financial instability in Europe made American investments seem relatively attractive.  The U.S. gold stock continued to increase right up until September 1931, when Britain departed from the gold standard.  Indeed the US gold stock during this period grew faster than the world stock, which meant that countries in a precarious reserve position were forced to adopt contractionary monetary policies.

5.c  The Price of Young Plan Bonds and the U.S. Stock Market

During the early 1930s the U.S. financial press paid far more attention to international monetary and financial news than do post-war American newspapers. Of course this change in emphasis might have merely reflected stylistic differences, perhaps due to a change in readership.  Of even greater significance, however, was the extraordinary extent to which movements in the U.S. stock market paralleled those news headlines.  We have already seen evidence that the German election of 1930 had a modest impact on the U.S. stock market.  Now we will see that, beginning in mid-1931, the Dow was heavily influenced by German financial and monetary news.  And this influence appears to have been far stronger than what could plausibly result from “real” channels such as the U.S.-German trade relationship.

It was during mid-1931 that the international monetary system began to unravel, and Germany was at the center of the crisis.  The price of the German war reparations bonds, dubbed “Young Plan bonds” (YPBs), were a good indicator of political turmoil in Germany during late 1930, and will prove to be an even better indicator during 1931 and 1932.  The bonds had been originally issued in June 1930 at a price of 90, began 1931 trading at 69.25 and remained in the 68-84 range throughout the first five months of the year. One indication of the severity of the German economic crisis is that by yearend their price had fallen to 23.5.

Table 5.1 shows the correlation between the price of YPBs and the Dow for selected periods during 1930, 1931, and 1932.  Perhaps the most striking finding is that whereas there was little or no correlation between the first difference of the log of the Dow (DLDOW) and the first difference of the log of the price of YPBs (DLYPB) during the first half of 1931, the two variables were highly correlated during the final six months of the year, and also the first half of 1932.  To make sense out of these correlations we need to take a closer look at the economic and political developments that influenced markets during 1931.

Table 5.1  The Relationship Between Variations in the Dow Jones Industrial Average (DLDOW), and the Price of Young Plan Bonds (DLYPB), Sept. 1930 – Dec. 1931, Selected Periods, Daily.

Dependent Variable – DLDJIA

Sample                       Number of     Coefficient                       Adjusted     Durban-

Period                      Observations    on DLYPB   T-Statistic   R-squared   Watson 

1.   9/14/30 – 9/30/30        14             .5492            2.18           .225          2.69

2.   12/31/30 – 3/20/31      65             .1202            0.71          .000          2.19

3.   3/20/31 – 5/1/31          35             .5714             2.12          .094           2.59

4.   5/1/31 – 6/19/31          41            -.1084           -0.54          .000          1.94

5.   6/19/31 – 7/30/31        34             .4559             5.05          .426           1.96

6.   7/30/31 – 9/17/31        40             .3554            3.78           .254           2.39

7.   9/17/31 – 11/6/31        41              .2888            3.85          .257           2.40

8.   11/6/31 – 12/30/31      43             .2801            3.72          .234           2.33

9.   12/30/31 – 3/31/32      75              .2617            4.03          .171          1.80

10.  3/31/32 – 6/30/32       77             .3152             3.75          .147           2.30

11.  6/30/32 – 9/30/32       76             .0799             0.66          .000           1.92

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