The Gold Standard and the Great Depression: Echoes

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In September 1931, Britain abandoned the gold standard, at least for the next six months. This followed Germany’s decision in mid-July of that year to establish strict exchange controls, a response to serious foreign-account liquidations and demands for gold shipments in early summer.

What was this gold standard and why was it under pressure in 1931?

The idea was that gold reserves represented a foundation for a nation’s currency and securities, allowing government notes to be exchanged for gold at any time at fixed rates. Exchange rates were stable among nations maintaining the gold standard. If a state began spending beyond its means and running deficits, those holding its notes would start converting them to gold, worrying that inflation would devalue the dollar, pound or franc. Conversions could exhaust a country’s gold reserves, punishing the government and the economy. Reserve levels determined how much currency nations could issue, and hence the money supply.

During the Depression, as revenues fell, governments trying to provide services ran growing budget deficits. This unnerved banks and wealthy investors, domestic and foreign, spurring waves of cash-outs (“Here’s your paper money; give me my gold!”). Banks and individuals then hoarded the gold, rather than using it for making loans or new investments.

The result was a continuing spiral of contraction. Credit was throttled, prices and wages fell (there wasn't enough money moving to sustain them), debtors were hammered (their payments were fixed as their incomes shrank), and ultimately there were widespread defaults on economic commitments (bankruptcies, inability to pay interest due, abandonment of loans, expanding layoffs).

Gold withdrawals gutted the German financial system in the summer of 1931. When the state stopped shipments through exchange controls, the virus spread to Britain. As money evaporated from the banking system, economic activity floundered. Governments had two main options: Defend the exchange value of their currency to prevent inflation, at the price of further slowing the economy, or let the currency devalue to whatever level markets would determine, undermining exchange rates and purchasing power, in the hope that money "rightly priced" would begin circulating more fluidly.

Germany held the mark at a fixed rate, which turned out to be the wrong strategy. Britain let the pound float, at the mercy of the market. Initially the pound fell from $4.85 to less than $4.00. Then it rose to $4.22 before dropping again to $3.91 in early 1932. Bonds denominated in pounds had lost between 15 and 20 percent of their exchange value, but British products suddenly were 15 to 20 percent cheaper to sell abroad. Such tradeoffs punished investors but advantaged exporters. More than a dozen other nations soon followed Britain in abandoning the gold standard.

But France and the U.S. didn't -- with harsh implications before long.

(Philip Scranton is a Board of Governors Professor of the History of Industry and Technology at the University of Rutgers at Camden and the editor-in-chief of Enterprise and Society. He writes "This Week in the Great Depression" for the Echoes blog. The opinions expressed are his own.)

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