1990 NBER paper by Ben Bernanke and Harold James studying the transmission channels linking deflation and depression. The "mismanaged interwar gold standard" inevitably caused both deflation and depression, their major contribution is the analysis of the role of major banking panics.

1. The Gold Standard, Deflation, and
Financial Crisis in the Great Depression:
An International Comparison
Ben Bernanke and Harold James
American University
ECON-630
Achim Braunsteffer
December 2nd, 2015

2. Ben Bernanke Harold James
• PhD in History, Cambridge
University, 1982
• Professor of History and
International Affairs, Princeton
University, since 1986
• Helmut Schmidt Prize for
Economic History, 2004
• PhD in Economics, MIT, 1979
• Professor of Economics and
Public Affairs, Princeton
University, 1985-2002
• Chairman of the Federal Reserve
Board, 2006-2014
• Distinguished Fellow in
Residence, Brookings Institution,
since 2014

3. The Interwar Gold Standard
• Gold-exchange standard adopted in Genoa in 1922
• Monetary origin of prolonged deflation during 1920s and 1930s
• Close correspondence between deflation and nations‘ adherence to gold
standard
• High correlation between deflation and depression
• “Mismanaged interwar gold standard”
• What was the source of this massive monetary non-neutrality?

4. Gold Standard Comparison
• Classical gold standard functioned for more than thirty years
• Interwar gold standard substantially broken down by 1931 and
disappeared by 1936
• Fundamental economic problems complicating trade and monetary
adjustment
• Legacy of the war included political borders without economic rationale,
overcapacity/undercapacity in some sectors and fiscal burdens
• Kindleberger points out the inexperience of the new potential hegemon
(the US) and ineffective cooperation among central banks

5. Technical Problems
1. Asymmetry between surplus and deficit countries in the required
monetary response to gold flows
• Most important structural flaw according to Temin (1989)
• Potential deflationary bias because surplus countries can accumulate reserves
indefinitely without sterilizing gold inflows
2. Pyramiding of reserves
• Convertible foreign exchange reserves as partial substitute for gold
• Only fractionally backed by gold, lowering the total domestic money supply
3. Insufficient powers of central banks
• Weak control over money supply because of discount policy

6. Deflation and Depression
• Monetary contraction began in the US and France and propagated
throughout the world
 Countries abandoning gold standard avoided much of the deflationary pressure

7. Transmission Channels
Channels linking deflation and depression:
1. Real wages
 Correlation of real wage increases and depression not particularly strong
2. Real interest rates
 Monetary contraction depresses output, r ↑, I ↓
3. Financial crisis
 Disruptive effect of deflation on the financial system
 Source of monetary nonneutrality: debt instruments set in money terms
 Weakening position of borrowers, nonfinancial firms, financial intermediaries

8. Interwar Banking and Financial Crises
• Significant banking problems reached sharp peak between spring and fall
of 1931 following the intensification of banking problems in Germany
• Most major banking crises were associated with sharp drops in the
deposit-currency ratio
• Banking panics were an endogenous response to deflation and
operations of the gold standard regime
• Idiosyncratic factors include (i) Banking structure, (ii) Reliance of banks
on short-term foreign liabilities, (iii) Financial and economic experience
of the 1920s

9. Real Effects of Deflation
• Deflation and constraints on central bank policy important causes of
banking panics
• Banking panics interfere with normal flows of credit and, therefore,
affect the performance of the real economy
• Debt deflation (Fisher 1933, Bernanke 1983)
• Deflation creates an environment of financial distress in which the
incentives of borrowers are distorted and a credit crunch occurs

10. Banking Panics and Depressions
• Significantly worse
depressions in countries
with banking panics
• Real wage channel of
transmission can be
rejected
• DISC allows for interest
rate channel
• Negative feedback loop of
PANIC?

11. Critique
• Influential paper and great read
• Bernanke & James study mechanisms of financial crises and bank panics
• Lacking objective indicators of seriousness of financial problems
• No direct evidence of debt-deflation mechanism due to data problems
• Effect of deflation on burden of external debt not addressed
More careful study of these issues is clearly desirable.