It has long been taught that the Great Depression spiraled out of control due to a significant contraction because of a change in the business cycle followed by an increase in uncertainty. However, what has been neglected from the high school history books is the role the gold standard played in further exacerbating the horrible economic downturn of the late 1920's and early 1930's. The reason is partially why the financial crisis of 2008 did not result in a significant depression.

To begin, the gold standard was a system in which the dollar's value was pegged to the value of gold, meaning the dollar was fixed to the price of gold. I have written a previous article here on the gold standard and its meaning. However, the main feature that stands with the gold standard is that country's are severely limited in producing and maintaining their own monetary policy especially when it comes to expansionary or inflationary policy that involves printing money. Since the dollar is fixed to the value of gold, an increase in the money supply would mean that the US would have to acquire enough gold reserves to back up that increase, or if said increase was unsustainable then it would lead to a currency crisis as there would be speculation to whether or not the dollar could maintain its convertibility to gold.

The gold standard worked for many years largely in part by cooperation between most of the nation-states involved to freely transfer gold between borders and because there were no significant adverse economic shocks that would trigger a large need for liquidity, or cash. However, the Great Depression and its subsequent downward spiral was marked by severe banking panics and crises that involved a large need for immediate cash on the part of banks. Banking runs are largely in part triggered by speculation onto the possibilities of adverse shocks on the economy affecting banks, as a result a large number of people move to withdraw their money from the banks. However, due to the nature of fractional reserve banking the bank is not able to cover the immediate deposits of everyone up front and as such there is a banking crisis of liquidity.

Influential thinkers, such as Milton Friedman and Anna Schwartz have long argued that the disaster of the Great Depression was largely in part caused by inaction by the Federal Reserve in terms of monetary policy. While this statement is accurate, it is incomplete. At the time, the Federal Reserve was inactive in monetary policy not because it wanted to refrain from giving liquidity to banks, but because it could not give liquidity to banks. The only way the Fed could have intervened is to do something similar to what it did in the 2008 crisis by pumping money into the economy via printing into solvent but illiquid banks at a high interest rate so that they could cover their deposits without worry of moral hazard. However, because of the gold standard, banks were unable to print money without calling into question the convertibility of the dollar into gold, which would trigger a separate currency crisis that would have derailed the economy further. Instead, the US chose to suspend the gold standard in order to be able to provide that liquidity later on.

The Great Depression showcases the faults of the gold standard and gives credence to the importance of the Federal Reserve and monetary policy. As such it is important to remember the function of the Federal Reserve as well as its responsibilities.