Money, Gold, and the Great Depression

Like Parker Willis, I was a professor myself before coming to the Federal Reserve Board. One topic of particular interest to me as a researcher was the performance of the Federal Reserve in its early days, particularly the part played by the young U.S. central bank in the Great Depression of the 1930s.¹ In honor of Willis's important contribution to the design and creation of the Federal Reserve, I will speak today about the role of the Federal Reserve and of monetary factors more generally in the origin and propagation of the Great Depression. Let me offer two caveats before I begin: First, as I mentioned, H. Parker Willis resigned from the Fed in 1922, to take a post at Columbia University; thus, he is not implicated in any of the mistakes that the Federal Reserve made in the late 1920s and early 1930s. Second, the views I will express today are my own and are not necessarily those of my colleagues in the Federal Reserve System.

The number of people with personal memory of the Great Depression is fast shrinking with the years, and to most of us the Depression is conveyed by grainy, black-and-white images of men in hats and long coats standing in bread lines. However, although the Depression was long ago--October this year will mark the seventy-fifth anniversary of the famous 1929 stock market crash--its influence is still very much with us. In particular, the experience of the Depression helped forge a consensus that the government bears the important responsibility of trying to stabilize the economy and the financial system, as well as of assisting people affected by economic downturns. Dozens of our most important government agencies and programs, ranging from social security (to assist the elderly and disabled) to federal deposit insurance (to eliminate banking panics) to the Securities and Exchange Commission (to regulate financial activities) were created in the 1930s, each a legacy of the Depression.

Although passed over somewhat lightly by Bernanke, everything I've read suggests in some manner that one of the core issues related to frequency of period economic depressions is the "living memory" of the people who suffered most at the hands of the event.  Thus, as long as there are people around who can say "Don't do that because..." the odds of replaying the same kind of outcome are relatively reduced.  However, given a world which no longer remembers its past, the odds of replaying history in some ways is increased. 

The impact that the experience of the Depression has had on views about the role of the government in the economy is easily understood when we recall the sheer magnitude of that economic downturn. During the major contraction phase of the Depression, between 1929 and 1933, real output in the United States fell nearly 30 percent. During the same period, according to retrospective studies, the unemployment rate rose from about 3 percent to nearly 25 percent, and many of those lucky enough to have a job were able to work only part-time. For comparison, between 1973 and 1975, in what was perhaps the most severe U.S. recession of the World War II era, real output fell 3.4 percent and the unemployment rate rose from about 4 percent to about 9 percent.

We note with interest, non-monetary interest, that is, that Mr. Bernanke does not reference more recent unemployment levels.  Yet, when we look at alternative measures of unemployment, we see that present levels exceed 9% and are likely to soar higher this year as the exodus of American jobs to foreign countries continues to accelerate.

Other features of the 1929-33 decline included a sharp deflation--prices fell at a rate of nearly 10 percent per year during the early 1930s--as well as a plummeting stock market, widespread bank failures, and a rash of defaults and bankruptcies by businesses and households. The economy improved after Franklin D. Roosevelt's inauguration in March 1933, but unemployment remained in the double digits for the rest of the decade, full recovery arriving only with the advent of World War II. Moreover, as I will discuss later, the Depression was international in scope, affecting most countries around the world not only the United States.

Just as the Depression was international in scope, we expect the Greater Depression to be international in scope as well.

What caused the Depression? This question is a difficult one, but answering it is important if we are to draw the right lessons from the experience for economic policy. Solving the puzzle of the Depression is also crucial to the field of economics itself because of the light the solution would shed on our basic understanding of how the economy works.

During the Depression years and for many decades afterward, economists disagreed sharply on the sources of the economic and financial collapse of the 1930s. In contrast, during the past twenty years or so economic historians have come to a broad consensus about the causes of the Depression.

Although Professor Bernanke is right about the development of a consensus of opinion, there are two key points he does not mention.  First, that much of the so-called consensus was achieved through pressures within academia in general and the arrogance of economists in general to ascribe all economic outcomes as being caused by economic events.  Secondly, the development of a consensus does not necessarily mean the consensus is correct.  For example, we note that a broad consensus existed in the 1300's that the world was flat.  Just as the present consensus among economists is pervasive, so too was the worldview in pre-1492 Europe.  The consensus viewpoint may be shown convincingly in correct in ,geography, physics, politics, and for economists to believe their consensus is the One Best Way is in my view the height of folly.

A widening of the geographic focus of Depression research deserves much of the credit for this breakthrough.(

Breakthrough?  If Bernanke refers to looking at the last Depression from the global corporatist perspective and feeling smug, I can only suggest that this is quite likely wrong.

Before the 1980s, research on the causes of the Depression had considered primarily the experience of the United States. This attention to the U.S. case was appropriate to some degree, as the U.S. economy was then, as it is today, the world's largest; the decline in output and employment in the United States during the 1930s was especially severe; and many economists have argued that, to an important extent, the worldwide Depression began in the United States, spreading from here to other countries (Romer, 1993). However, in much the same way that a medical researcher cannot reliably infer the causes of an illness by studying one patient, diagnosing the causes of the Depression is easier when we have more patients (in this case, more national economies) to study. To explain the current consensus on the causes of the Depression, I will first describe the debate as it existed before 1980, and then discuss how the recent focus on international aspects of the Depression and the comparative analysis of the experiences of different countries have helped to resolve that debate.

I have already mentioned the sharp deflation of the price level that occurred during the contraction phase of the Depression, by far the most severe episode of deflation experienced in the United States before or since. Deflation, like inflation, tends to be closely linked to changes in the national money supply, defined as the sum of currency and bank deposits outstanding, and such was the case in the Depression. Like real output and prices, the U.S. money supply fell about one-third between 1929 and 1933, rising in subsequent years as output and prices rose.

While the fact that money, prices, and output all declined rapidly in the early years of the Depression is undeniable, the interpretation of that fact has been the subject of much controversy. Indeed, historically, much of the debate on the causes of the Great Depression has centered on the role of monetary factors, including both monetary policy and other influences on the national money supply, such as the condition of the banking system. Views have changed over time. During the Depression itself, and in several decades following, most economists argued that monetary factors were not an important cause of the Depression. For example, many observers pointed to the fact that nominal interest rates were close to zero during much of the Depression, concluding that monetary policy had been about as easy as possible yet had produced no tangible benefits to the economy. The attempt to use monetary policy to extricate an economy from a deep depression was often compared to "pushing on a string."

During the first decades after the Depression, most economists looked to developments on the real side of the economy for explanations, rather than to monetary factors. Some argued, for example, that overinvestment and overbuilding had taken place during the ebullient 1920s, leading to a crash when the returns on those investments proved to be less than expected. Another once-popular theory was that a chronic problem of "under-consumption"--the inability of households to purchase enough goods and services to utilize the economy's productive capacity--had precipitated the slump.

However, in 1963, Milton Friedman and Anna J. Schwartz transformed the debate about the Great Depression. That year saw the publication of their now-classic book, A Monetary History of the United States, 1867-1960. The Monetary History, the name by which the book is instantly recognized by any macroeconomist, examined in great detail the relationship between changes in the national money stock--whether determined by conscious policy or by more impersonal forces such as changes in the banking system--and changes in national income and prices. The broader objective of the book was to understand how monetary forces had influenced the U.S. economy over a nearly a century. In the process of pursuing this general objective, however, Friedman and Schwartz offered important new evidence and arguments about the role of monetary factors in the Great Depression. In contradiction to the prevalent view of the time, that money and monetary policy played at most a purely passive role in the Depression, Friedman and Schwartz argued that "the [economic] contraction is in fact a tragic testimonial to the importance of monetary forces" (Friedman and Schwartz, 1963, p. 300).

To support their view that monetary forces caused the Great Depression, Friedman and Schwartz revisited the historical record and identified a series of errors--errors of both commission and omission--made by the Federal Reserve in the late 1920s and early 1930s. According to Friedman and Schwartz, each of these policy mistakes led to an undesirable tightening of monetary policy, as reflected in sharp declines in the money supply. Drawing on their historical evidence about the effects of money on the economy, Friedman and Schwartz argued that the declines in the money stock generated by Fed actions--or inactions--could account for the drops in prices and output that subsequently occurred.²

That Friedman and Schwartz did great work cannot be argued.  However I propose that it is a mistake to take Friedman & Schwarz as the "right" point of view.  It may be the prevailing paradigm, yet it is horribly flawed.  The analysis of the "real" economy deserves more attention.  As Northwestern University7 Econ Chair Robert Ely wrote in the classic "real economy" book, :Hard Times: The Way in, the Way Out", the real causative factors of the Great Depression were at their core not economic as the current consensus holds.  The arrogance of the "economists" is that they hold that huge innovations in the everyday operation of the country was secondary to monetary issues. 

Ely points out, for example, that there was a huge economic displacement caused by the sudden obsolescence of horses.  Upwards of 7-million acres of land had been devoted to raising horses throughout the early 1920's.  As the automobile and tractor caused displacement, the farmers who were previously engaged in rearing horses were forced to change their product mix from equestrian to pure agrarian. The cash output from the land stopped being horses and started being grains.  That led to over-production of grains and a collapse of pricing power, which drove down prices in a deflationary manner.

Further, on the "real" side of the economy, the fallout from Henry Ford's mass production revolution was getting underway.  Where goods had been individually produced previously, millionaires grew plentiful in the early 1920's as thousands of consumer goods hit new-fangled "production lines" and again, drove down unit costs and reduced labor demand.

Indeed, as J.P. Waters writes in "Technological Change in the Great Depression" the role of industrial displacement was measurable and demonstrably replicatable.

Last, but not least, we have the huge parallel between  between Radio of the 1920's and the Internet of the 1999-2000 bubble top.  In both cases excessive growth was projected based on a popular myth of markets - that they can expand forever.  Sadly, they can't and they don't.  Markets for all goods and services follow S-curves of growth (after Marchetti).  As bacteria describe S-curves growth as they populate a Petri dish, so too productions expands in the early stages of SDLC (that's system development life cycle for marketers like me, not the other SDLC, synchronous data link control for IT people -if there are any left in America...)

It's a widely understood fact that stock prices have an analog to SDLC.  As the SDLC cycle begins, there is a "pop" in stocks which have new technology.  As the product comes to market and is accepted and sales grow, there is markup in stock prices.  As the company operates profitably and safely, the stock underlying the company undergoes accumulation, and as the outlook for the underlying product begins to decline, the stock market responds by marking down prices, in a process called distribution.

Bernanke's embrace of the monetarist view while simple, doesn't fully explain the phenomena of the next Greater Depression which I propose is developing.  The macroeconomic forces today are different from horses versus tractors, craftsmen versus production lines, and radio versus existing publishing enterprises.

This time around the macro forces are global competing currencies versus an international standard, the end of cheap energy and the developing scarcity of oil and gas, coupled with the end of a resilient environment, which is beginning to bite us all with effects like increasingly large weather anomalies and disappearing glaciers that will at some point inundate whole countries. If I could effectively short Dutch real estate over 20-years, I'd do it.

But now let's continue with Bernanke's analysis of how policy-makers of the 1930's made mistakes - and I'll point out how we may be echoing those errors today.

Friedman and Schwartz emphasized at least four major errors by U.S. monetary policymakers. The Fed's first grave mistake, in their view, was the tightening of monetary policy that began in the spring of 1928 and continued until the stock market crash of October 1929 (see Hamilton, 1987, or Bernanke, 2002a, for further discussion). This tightening of monetary policy in 1928 did not seem particularly justified by the macroeconomic environment: The economy was only just emerging from a recession, commodity prices were declining sharply, and there was little hint of inflation. Why then did the Federal Reserve raise interest rates in 1928? The principal reason was the Fed's ongoing concern about speculation on Wall Street. Fed policymakers drew a sharp distinction between "productive" (that is, good) and "speculative" (bad) uses of credit, and they were concerned that bank lending to brokers and investors was fueling a speculative wave in the stock market. When the Fed's attempts to persuade banks not to lend for speculative purposes proved ineffective, Fed officials decided to dissuade lending directly by raising the policy interest rate.

The market crash of October 1929 showed, if anyone doubted it, that a concerted effort by the Fed can bring down stock prices. But the cost of this "victory" was very high. According to Friedman and Schwartz, the Fed's tight-money policies led to the onset of a recession in August 1929, according to the official dating by the National Bureau of Economic Research. The slowdown in economic activity, together with high interest rates, was in all likelihood the most important source of the stock market crash that followed in October. In other words, the market crash, rather than being the cause of the Depression, as popular legend has it, was in fact largely the result of an economic slowdown and the inappropriate monetary policies that preceded it. Of course, the stock market crash only worsened the economic situation, hurting consumer and business confidence and contributing to a still deeper downturn in 1930.

Just as the Fed make a mistake in tightening monetary policy in 1928, I believe the present day Fed is at a similar juncture today. The Fed will have to raise rates in the not-too-distant future because Japan is running out of money to intervene on behalf of the dollar.  When their intervention stops, rates will go up because as the Chairman has noted, the combined demands of corporate obligations (bonds) and demands of Social Security, coupled with the deficit and current account demands (speech below) will force rates up.  So while it's nice to recount the sins of the past, I'd suggest that like the present-day Fed, the actions were all reasonable at the time, and just like the previous Fed, the current Fed will need to raise rates.

The second monetary policy action identified by Friedman and Schwartz occurred in September and October of 1931. At the time, as I will discuss in more detail later, the United States and the great majority of other nations were on the gold standard, a system in which the value of each currency is expressed in terms of ounces of gold. Under the gold standard, central banks stood ready to maintain the fixed values of their currencies by offering to trade gold for money at the legally determined rate of exchange.

The fact that, under the gold standard, the value of each currency was fixed in terms of gold implied that the rate of exchange between any two currencies within the gold standard system was likewise fixed. As with any system of fixed exchange rates, the gold standard was subject to speculative attack if investors doubted the ability of a country to maintain the value of its currency at the legally specified parity. In September 1931, following a period of financial upheaval in Europe that created concerns about British investments on the Continent, speculators attacked the British pound, presenting pounds to the Bank of England and demanding gold in return. Faced with the heavy demands of speculators for gold and a widespread loss of confidence in the pound, the Bank of England quickly depleted its gold reserves. Unable to continue supporting the pound at its official value, Great Britain was forced to leave the gold standard, allowing the pound to float freely, its value determined by market forces.

With the collapse of the pound, speculators turned their attention to the U.S. dollar, which (given the economic difficulties the United States was experiencing in the fall of 1931) looked to many to be the next currency in line for devaluation. Central banks as well as private investors converted a substantial quantity of dollar assets to gold in September and October of 1931, reducing the Federal Reserve's gold reserves. The speculative attack on the dollar also helped to create a panic in the U.S. banking system. Fearing imminent devaluation of the dollar, many foreign and domestic depositors withdrew their funds from U.S. banks in order to convert them into gold or other assets. The worsening economic situation also made depositors increasingly distrustful of banks as a place to keep their savings. During this period, deposit insurance was virtually nonexistent, so that the failure of a bank might cause depositors to lose all or most of their savings. Thus, depositors who feared that a bank might fail rushed to withdraw their funds. Banking panics, if severe enough, could become self-confirming prophecies. During the 1930s, thousands of U.S. banks experienced runs by depositors and subsequently failed.

Long-established central banking practice required that the Fed respond both to the speculative attack on the dollar and to the domestic banking panics. However, the Fed decided to ignore the plight of the banking system and to focus only on stopping the loss of gold reserves to protect the dollar. To stabilize the dollar, the Fed once again raised interest rates sharply, on the view that currency speculators would be less willing to liquidate dollar assets if they could earn a higher rate of return on them. The Fed's strategy worked, in that the attack on the dollar subsided and the U.S. commitment to the gold standard was successfully defended, at least for the moment. However, once again the Fed had chosen to tighten monetary policy despite the fact that macroeconomic conditions--including an accelerating decline in output, prices, and the money supply--seemed to demand policy ease.

Again, while it's interesting to single out gold's behavior in the 1930's, Bernanke misses the point that in the present difficulty ahead, we are likely to see all hard assets such as paid up real estate, paid for autos, and virtually all paid for hard goods, will appreciate in value.  The reason is simply this:  Absent a gold standard, the world will go through a huge round of competitive devaluations designed to give each country a relative trading advantage.  Thus when the US dollar goes down, the Euro will come down in order for the European block to maintain competitiveness with the US.  Moreover, while I expect gold and silver to appreciate like crazy as the public debt is monetized (which is the only way out of the mess) owning the means of production will return to its former glory.  Gold can't buy you food if there's none to be had at any price because of energy issues, can it?  Thus, along with gold and silver, a piece of land where you can raise crops becomes extremely attractive.  If not today, at least over the next 10-years for certain.

The third policy action highlighted by Friedman and Schwartz occurred in 1932. By the spring of that year, the Depression was well advanced, and Congress began to place considerable pressure on the Federal Reserve to ease monetary policy. The Board was quite reluctant to comply, but in response to the ongoing pressure the Board conducted open-market operations between April and June of 1932 designed to increase the national money supply and thus ease policy. These policy actions reduced interest rates on government bonds and corporate debt and appeared to arrest the decline in prices and economic activity. However, Fed officials remained ambivalent about their policy of monetary expansion. Some viewed the Depression as the necessary purging of financial excesses built up during the 1920s; in this view, slowing the economic collapse by easing monetary policy only delayed the inevitable adjustment. Other officials, noting among other indicators the very low level of nominal interest rates, concluded that monetary policy was in fact already quite easy and that no more should be done. These policymakers did not appear to appreciate that, even though nominal interest rates were very low, the ongoing deflation meant that the real cost of borrowing was very high because any loans would have to be repaid in dollars of much greater value (Meltzer, 2003). Thus monetary policy was not in fact easy at all, despite the very low level of nominal interest rates. In any event, Fed officials convinced themselves that the policy ease advocated by the Congress was not appropriate, and so when the Congress adjourned in July 1932, the Fed reversed the policy. By the latter part of the year, the economy had relapsed dramatically.

Mr. Bernanke himself in earlier remarks has opened the discussion of running the printing press 24-7 if necessary to pump liquidity.  I take his review of the sins of the 30's here as confirmation that he might do the same thing as the Depression unfolds.

The fourth and final policy mistake emphasized by Friedman and Schwartz was the Fed's ongoing neglect of problems in the U.S. banking sector. As I have already described, the banking sector faced enormous pressure during the early 1930s. As depositor fears about the health of banks grew, runs on banks became increasingly common. A series of banking panics spread across the country, often affecting all the banks in a major city or even an entire region of the country. Between December 1930 and March 1933, when President Roosevelt declared a "banking holiday" that shut down the entire U.S. banking system, about half of U.S. banks either closed or merged with other banks. Surviving banks, rather than expanding their deposits and loans to replace those of the banks lost to panics, retrenched sharply.

The banking crisis had highly detrimental effects on the broader economy. Friedman and Schwartz emphasized the effects of bank failures on the money supply. Because bank deposits are a form of money, the closing of many banks greatly exacerbated the decline in the money supply. Moreover, afraid to leave their funds in banks, people hoarded cash, for example by burying their savings in coffee cans in the back yard. Hoarding effectively removed money from circulation, adding further to the deflationary pressures. Moreover, as I emphasized in early research of my own (Bernanke, 1983), the virtual shutting down of the U.S. banking system also deprived the economy of an important source of credit and other services normally provided by banks.

The Federal Reserve had the power at least to ameliorate the problems of the banks. For example, the Fed could have been more aggressive in lending cash to banks (taking their loans and other investments as collateral), or it could have simply put more cash in circulation. Either action would have made it easier for banks to obtain the cash necessary to pay off depositors, which might have stopped bank runs before they resulted in bank closings and failures. Indeed, a central element of the Federal Reserve's original mission had been to provide just this type of assistance to the banking system. The Fed's failure to fulfill its mission was, again, largely the result of the economic theories held by the Federal Reserve leadership. Many Fed officials appeared to subscribe to the infamous "liquidationist" thesis of Treasury Secretary Andrew Mellon, who argued that weeding out "weak" banks was a harsh but necessary prerequisite to the recovery of the banking system. Moreover, most of the failing banks were relatively small and not members of the Federal Reserve System, making their fate of less interest to the policymakers. In the end, Fed officials decided not to intervene in the banking crisis, contributing once again to the precipitous fall in the money supply.

The modern Fed over the past several years has gone right back into the same mold as the 1930's fed through the following actions:  1) allowing banks to open on weekends.  2) Allowing securities firms to operate as banks. 3) promoting the irresponsible use of mortgages to pump up domestic consumption for purely political reasons thereby encouraging people to part with their underlying assets.

The present Fed has, in my view, ignored the danger signs available from Tobin's Q (the ration of financial assets to goods producing assets of a country).  We're wildly reclassifying burger makers into "industrial workers" and deluding ourselves into believing that those new "manufacturing jobs" will somehow prevent the natural outcome of a shopkeeper economy.

Friedman and Schwartz discuss other episodes and policy actions as well, such as the Federal Reserve's misguided tightening of policy in 1937-38 which contributed to a new recession in those years. However, the four episodes I have described capture the gist of the Friedman and Schwartz argument that, for a variety of reasons, monetary policy was unnecessarily tight, both before the Depression began and during its most dramatic downward phase. As I have mentioned, Friedman and Schwartz had produced evidence from other historical periods that suggested that contractionary monetary policies can lead to declining prices and output. Friedman and Schwartz concluded therefore that they had found the smoking gun, evidence that much of the severity of the Great Depression could be attributed to monetary forces.

Friedman and Schwartz's arguments were highly influential but not universally accepted. For several decades after the Monetary History was published, a debate raged about the importance of monetary factors in the Depression. Opponents made several objections to the Friedman and Schwartz thesis that are worth highlighting here.

First, critics wondered whether the tightening of monetary policy during 1928 and 1929, though perhaps ill advised, was large enough to have led to such calamitous consequences.³ If the tightening of monetary policy before the stock market crash was not sufficient to account for the violence of the economic downturn, then other, possibly nonmonetary, factors may need to be considered as well.

Again, economists argue about the darnedest things. There's a paucity of work in fundamentals.  Try to find a work that explores what would have happened had "radio" been regulated in 1925 instead of 1933 after the Crash.  Similarly, where are the regulations of GM food today ahead of Crash II?  What about regulation of the Internet prior to Crash II?  What about regulation on the export of goods producing jobs in advance of Crash II?

There's a myopia to economists.  They seem to universally hold that economics is causative. I'd propose that economics follows human activity and if you want to get ahead of the curve, study fundamental changes in how a society works, consumes, and migrates.

A second question is whether the large decline in the money supply seen during the 1930s was primarily a cause or an effect of falling output and prices. As we have seen, Friedman and Schwartz argued that the decline in the money supply was causal. Suppose, though, for the sake of argument, that the Depression was the result primarily of nonmonetary factors, such as overspending and overinvestment during the 1920s. As incomes and spending decline, people need less money to carry out daily transactions. In this scenario, critics pointed out, the Fed would be justified in allowing the money supply to fall, because it would only be accommodating a decline in the amount of money that people want to hold. The decline in the money supply in this case would be a response to, not a cause of, the decline in output and prices. To put the question simply, we know that both the economy and the money stock contracted rapidly during the early 1930s, but was the monetary dog wagging the economic tail, or vice versa?

The focus of Friedman and Schwartz on the U.S. experience (by design, of course) raised other questions about their monetary explanation of the Depression. As I have mentioned, the Great Depression was a worldwide phenomenon, not confined to the United States. Indeed, some economies, such as that of Germany, began to decline before 1929. Although few countries escaped the Depression entirely, the severity of the episode varied widely across countries. The timing of recovery also varied considerably, with some countries beginning their recovery as early as 1931 or 1932, whereas others remained in the depths of depression as late as 1935 or 1936. How does Friedman and Schwartz's monetary thesis explain the worldwide nature of the onset of the Depression, and the differences in severity and timing observed in different countries?

That is where the debate stood around 1980. About that time, however, economic historians began to broaden their focus, shifting from a heavy emphasis on events in the United States during the 1930s to an increased attention to developments around the world. Moreover, rather than studying countries individually, this new scholarship took a comparative approach, asking specifically why some countries fared better than others in the 1930s. As I will explain, this research uncovered an important role for international monetary forces, as well as domestic monetary policies, in explaining the Depression. Specifically, the new research found that a complete understanding of the Depression requires attention to the operation of the international gold standard, the international monetary system of the time.⁴

Pay attention now, as this is the part where the Fed heir-apparent begins to take on gold and peddles his "banker view" that gold was "bad".

As I have already mentioned, the gold standard is a monetary system in which each participating country defines its monetary unit in terms of a certain amount of gold. The setting of each currency's value in terms of gold defines a system of fixed exchange rates, in which the relative value of (say) the U.S. dollar and the British pound are fixed at a rate determined by the relative gold content of each currency. To maintain the gold standard, central banks had to promise to exchange actual gold for their paper currencies at the legal rate.

The gold standard appeared to be highly successful from about 1870 to the beginning of World War I in 1914. During the so-called "classical" gold standard period, international trade and capital flows expanded markedly, and central banks experienced relatively few problems ensuring that their currencies retained their legal value. The gold standard was suspended during World War I, however, because of disruptions to trade and international capital flows and because countries needed more financial flexibility to finance their war efforts. (The United States remained technically on the gold standard throughout the war, but with many restrictions.)

After 1918, when the war ended, nations around the world made extensive efforts to reconstitute the gold standard, believing that it would be a key element in the return to normal functioning of the international economic system. Great Britain was among the first of the major countries to return to the gold standard, in 1925, and by 1929 the great majority of the world's nations had done so.

Unlike the gold standard before World War I, however, the gold standard as reconstituted in the 1920s proved to be both unstable and destabilizing. Economic historians have identified a number of reasons why the reconstituted gold standard was so much less successful than its prewar counterpart. First, the war had left behind enormous economic destruction and dislocation. Major financial problems also remained, including both large government debts from the war and banking systems whose solvency had been deeply compromised by the war and by the periods of hyperinflation that followed in a number of countries. These underlying problems created stresses for the gold standard that had not existed to the same degree before the war.

Second, the new system lacked effective international leadership. During the classical period, the Bank of England, in operation since 1694, provided sophisticated management of the international system, with the cooperation of other major central banks. This leadership helped the system adjust to imbalances and strains; for example, a consortium of central banks might lend gold to one of their number that was experiencing a shortage of reserves. After the war, with Great Britain economically and financially depleted and the United States in ascendance, leadership of the international system shifted by default to the Federal Reserve. Unfortunately, the fledgling Federal Reserve, with its decentralized structure and its inexperienced and domestically focused leadership, did not prove up to the task of managing the international gold standard, a task that lingering hatreds and disputes from the war would have made difficult for even the most-sophisticated institution. With the lack of effective international leadership, most central banks of the 1920s and 1930s devoted little effort to supporting the overall stability of the international system and focused instead on conditions within their own countries.

Finally, the reconstituted gold standard lacked the credibility of its prewar counterpart. Before the war, the ideology of the gold standard was dominant, to the point that financial investors had no doubt that central banks would find a way to maintain the gold values of their currencies no matter what the circumstances. Because this conviction was so firm, speculators had little incentive to attack a major currency. After the war, in contrast, both economic views and the political balance of power had shifted in ways that reduced the influence of the gold standard ideology. For example, new labor-dominated political parties were skeptical about the utility of maintaining the gold standard if doing so increased unemployment. Ironically, reduced political and ideological support for the gold standard made it more difficult for central banks to maintain the gold values of their currencies, as speculators understood that the underlying commitment to adhere to the gold standard at all costs had been weakened significantly. Thus, speculative attacks became much more likely to succeed and hence more likely to occur.

With an international focus, and with particular attention to the role of the gold standard in the world economy, scholars have now been able to answer the questions regarding the monetary interpretation of the Depression that I raised earlier.

First, the existence of the gold standard helps to explain why the world economic decline was both deep and broadly international.

Yeah, don't blame revolutionary changes in production causing dislocation - blame gold!

Under the gold standard, the need to maintain a fixed exchange rate among currencies forces countries to adopt similar monetary policies. In particular, a central bank with limited gold reserves has no option but to raise its own interest rates when interest rates are being raised abroad; if it did not do so, it would quickly lose gold reserves as financial investors transferred their funds to countries where returns were higher. Hence, when the Federal Reserve raised interest rates in 1928 to fight stock market speculation, it inadvertently forced tightening of monetary policy in many other countries as well. This tightening abroad weakened the global economy, with effects that fed back to the U.S. economy and financial system.

Other countries' policies also contributed to a global monetary tightening during 1928 and 1929. For example, after France returned to the gold standard in 1928, it built up its gold reserves significantly, at the expense of other countries. The outflows of gold to France forced other countries to reduce their money supplies and to raise interest rates. Speculative attacks on currencies also became frequent as the Depression worsened, leading central banks to raise interest rates, much like the Federal Reserve did in 1931. Leadership from the Federal Reserve might possibly have produced better international cooperation and a more appropriate set of monetary policies. However, in the absence of that leadership, the worldwide monetary contraction proceeded apace. The result was a global economic decline that reinforced the effects of tight monetary policies in individual countries.

The transmission of monetary tightening through the gold standard also addresses the question of whether changes in the money supply helped cause the Depression or were simply a passive response to the declines in income and prices. Countries on the gold standard were often forced to contract their money supplies because of policy developments in other countries, not because of domestic events. The fact that these contractions in money supplies were invariably followed by declines in output and prices suggests that money was more a cause than an effect of the economic collapse in those countries.

It's evident here that Bernanke doesn't see the transmission of tightening or loosening through competitive currency devaluations as the modern analog.  Yet I'll propose that absent gold, the way is clear for bankers such as Mssrs. Bernanke and Greenspan to simply print away our current day problems.

Perhaps the most fascinating discovery arising from researchers' broader international focus is that the extent to which a country adhered to the gold standard and the severity of its depression were closely linked. In particular, the longer that a country remained committed to gold, the deeper its depression and the later its recovery (Choudhri and Kochin, 1980; Eichengreen and Sachs, 1985).

The willingness or ability of countries to remain on the gold standard despite the adverse developments of the 1930s varied quite a bit. A few countries did not join the gold standard system at all; these included Spain (which was embroiled in domestic political upheaval, eventually leading to civil war) and China (which used a silver monetary standard rather than a gold standard). A number of countries adopted the gold standard in the 1920s but left or were forced off gold relatively early, typically in 1931. Countries in this category included Great Britain, Japan, and several Scandinavian countries. Some countries, such as Italy and the United States, remained on the gold standard into 1932 or 1933. And a few diehards, notably the so-called gold bloc, led by France and including Poland, Belgium, and Switzerland, remained on gold into 1935 or 1936.

Once again, the wrong cause is identified.  Let's look at the countries and what was going on at the production level and in politics. To ascribe conditions to gold is to ignore the political control mechanisms of the countries involved.  Kingdoms recovered before democracies, too, so does that mean the Kingdoms are more depression resistant than democracies?  (yes...) 

Do you see what I mean about this monetarists myopia? 

If declines in the money supply induced by adherence to the gold standard were a principal reason for economic depression, then countries leaving gold earlier should have been able to avoid the worst of the Depression and begin an earlier process of recovery. The evidence strongly supports this implication. For example, Great Britain and Scandinavia, which left the gold standard in 1931, recovered much earlier than France and Belgium, which stubbornly remained on gold. As Friedman and Schwartz noted in their book, countries such as China--which used a silver standard rather than a gold standard--avoided the Depression almost entirely.

Oh oh, problem.  If one precious metal is bad, Ben, like gold, how can another be good?

The finding that the time at which a country left the gold standard is the key determinant of the severity of its depression and the timing of its recovery has been shown to hold for literally dozens of countries, including developing countries. This intriguing result not only provides additional evidence for the importance of monetary factors in the Depression, it also explains why the timing of recovery from the Depression differed across countries.

We could note with equal or greater validity that countries that recovered first were those not participating in international banking systems, too.

The finding that leaving the gold standard was the key to recovery from the Great Depression was certainly confirmed by the U.S. experience.

Contrary to what Bernanke would have you believe, what finally got the US out of the Depression was WW II.  Not the abandoning of the gold standard.  In fact, if abandoning the gold standard was a cure all, the secondary depression of 1937-38 should never have happened, right?

One of the first actions of President Roosevelt was to eliminate the constraint on U.S. monetary policy created by the gold standard, first by allowing the dollar to float and then by resetting its value at a significantly lower level. The new President also addressed another major source of monetary contraction, the ongoing banking crisis. Within days of his inauguration, Roosevelt declared a "bank holiday," shutting down all the banks in the country. Banks were allowed to reopen only when certified to be in sound financial condition. Roosevelt pursued other measures to stabilize the banking system as well, such as the creation of a deposit insurance program. With the gold standard constraint removed and the banking system stabilized, the money supply and the price level began to rise. Between Roosevelt's coming to power in 1933 and the recession of 1937-38, the economy grew strongly.

I have only scratched the surface of the fascinating literature on the causes of the Great Depression, but it is time that I conclude. Economists have made a great deal of progress in understanding the Great Depression. Milton Friedman and Anna Schwartz deserve enormous credit for bringing the role of monetary factors to the fore in their Monetary History. However, expanding the research focus to include the experiences of a wide range of countries has both provided additional support for the role of monetary factors (including the international gold standard) and enriched our understanding of the causes of the Depression.

Alas, the remarks have only served to put us on notice that Bernanke doesn't like gold, but then what central banker does?

Some important lessons emerge from the story. One lesson is that ideas are critical. The gold standard orthodoxy, the adherence of some Federal Reserve policymakers to the liquidationist thesis, and the incorrect view that low nominal interest rates necessarily signaled monetary ease, all led policymakers astray, with disastrous consequences.

Not so.  The decisions made were all rational within the context of the times and no amount of historical revisionism can remove the fact that the captains of the Depression were reasonable men acting reasonably in a chaotic world. 

It can also not hide the fact that the rate of recovery from the Depression was proportionate to the involvement of the big banking families.  Those countries without a banker elite recovered first.

We should not underestimate the need for careful research and analysis in guiding policy. Another lesson is that central banks and other governmental agencies have an important responsibility to maintain financial stability.

We note that Bernanke's allegiance is to stability not a sound currency which retains purchasing power over time.  That's where the gulf opens up.  Bankers today don't care about maintaining purchasing power.  They care only about stability and predictability of theft of working people's wealth through inflation.

That Bernanke should choose to put gold in a bad light only confirms this allegation.

The banking crises of the 1930s, both in the United States and abroad, were a significant source of output declines, both through their effects on money supplies and on credit supplies.

The reason for output declines was market saturation and the accompanying delation as pricing power eroded.  Just like it's eroding today due to jobjacking (outsourcing).

Finally, perhaps the most important lesson of all is that price stability should be a key objective of monetary policy.

Aha!  Stability above honesty of the currency.  You got it from the horse's mouth right there.

By allowing persistent declines in the money supply and in the price level, the Federal Reserve of the late 1920s and 1930s greatly destabilized the U.S. economy and, through the workings of the gold standard, the economies of many other nations as well.

The sad corollary is that this time around as we stand today at the start of the Greater Depression, the Fed will not hesitate to run the presses full speed and will resist any linkage of paper money to hard assets because it would prevent the planned theft of an entire generation's hard work through a killer round of inflation coupled with reneging on the social contract to provide even basis Social Security benefits for this generation. 

I have no intention today of discussing the foreign exchange policy of the United States. That is the province of the Secretary of the Treasury. Nor do I intend to project exchange rates. My experience is that exchange markets have become so efficient that virtually all relevant information is embedded almost instantaneously in exchange rates to the point that anticipating movements in major currencies is rarely possible. The exceptions to this conclusion are those few cases of successful speculation in which governments have tried and failed to support a particular exchange rate.

Nonetheless, despite extensive efforts on the part of analysts, to my knowledge, no model projecting directional movements in exchange rates is significantly superior to tossing a coin. I am aware that of the thousands who try, some are quite successful. So are winners of coin-tossing contests. The seeming ability of a number of banking organizations to make consistent profits from foreign exchange trading likely derives not from their insight into future rate changes but from market making.

This may seem a rather surprising conclusion, given that so many commentators apparently believe that they know the real value of the dollar must decline further because of the record current account deficit of the United States. It should be sobering to recall that three years ago --February 2001-- to be exact for similar reasons a vast majority of a large panel of forecasters were projecting a lower dollar against the euro. In the subsequent twelve months, the dollar rose nearly 6 percent against the euro.

Rather than engage in exchange rate forecasting, today I will discuss certain developments in foreign exchange markets, and in the international financial system in general, which bear on the ultimate outcome of our current account adjustment process. Before raising the broader issues of adjustment, I should like to address the actions of certain of the players in the exchange market that are likely to delay the adjustment process, but only for a time.

I refer to the heavy degree of intervention by East Asian monetary authorities, especially in Japan and China, and the apparent stepped up hedging of currency movements by exporters, especially in Europe. As all of you who follow these markets are aware, since the start of 2002, the extraordinary purchases by Asian central banks and governments of dollar assets, largely those by Japan and China, have totaled almost $240 billion, all in an apparent attempt to prevent their currencies from rising against the dollar. In particular, total foreign exchange reserves for China reached $420 billion in November of last year and for Japan more than $650 billion in December.

The awesome size of Japan's accumulation results from persistent intervention to suppress what Japanese authorities have judged is a dollar-yen exchange rate that is out of line with fundamentals. One factor boosting the yen is a significant yen bias on the part of Japanese investors. This propensity, in my judgment, runs far beyond the normal tendency of investors worldwide to buy familiar domestic assets and eschew foreign-exchange risk.

Nowhere else in the world will investors voluntarily purchase ten-year government obligations at an interest rate of 1 percent or less, especially given a rate of increase in the outstanding supply of government debt that has generally been running at 9 percent over the past year. Not surprisingly, very few Japanese government bonds (JGBs) are held outside of Japan.

Aside from the holdings of the Bank of Japan, almost all JGBs are held by Japanese households, banks, insurance companies and the postal saving system. And none of them holds significant amounts of foreign assets; 99 percent of household assets are in yen, and, including the postal saving system, about 91 percent of the assets of financial institutions are in yen. Japanese nonfinancial corporations do hold a larger share of foreign assets in their securities' portfolios, but the absolute amounts are small. The Japanese have made significant foreign direct investments, especially in the United States, and the Ministry of Finance does, of course, hold large dollar balances as a consequence of exchange rate intervention. But the Japanese private sector, by and large, has exhibited limited interest in accumulating dollar or other foreign assets, removing what in other large trading economies would be a significant segment of demand for foreign assets.

The degree of domestic currency bias in Japan, which far exceeds that of its trading partners, may thus have contributed to a foreign exchange rate for the yen that appears to be elevated relative to the dollar and possibly other internationally traded currencies as well.¹ Of course, this preference for yen assets, while a persistent influence on the value of the yen, has at times been overwhelmed by other factors.

Granted the level of intervention pursued by the Japanese monetary authorities has influenced the market value of the yen, but the size of the impact is difficult to judge. In any event, it must be presumed that the rate of accumulation of dollar assets by the Japanese government will have to slow at some point and eventually cease. For now, partially unsterilized intervention is perceived as a means of expanding the monetary base of Japan, a basic element of monetary policy. (The same effect, of course, is available through the purchase of domestic assets.) In time, however, as the present deflationary situation abates, the monetary consequences of continued intervention could become problematic. The current performance of the Japanese economy suggests that we are getting closer to the point where continued intervention at the present scale will no longer meet the monetary policy needs of Japan.

China is a similar story. In order to maintain the tight relationship with the dollar initiated in the 1990s, the Chinese central bank has chosen to purchase large quantities of U.S. Treasury securities with renminbi. What is not clear is how much of the current upward pressure on the currency results from underlying market forces, how much from capital inflows owing to speculation on potential revaluation, and how much from capital controls that suppress the demand of Chinese residents for dollars and other currencies.

No one truly knows whether easing or ending capital controls would lessen pressure on the currency and, in the process, also eliminate inflows from speculation on a revaluation. Many in China, however, fear that an immediate ending of controls could induce capital outflows large enough to destabilize the nation's improving, but still fragile, banking system. Others believe that decontrol, but at a gradual pace, could conceivably avoid such an outcome.

Chinese central bank purchases of dollars, unless offset, threaten an excess of so-called high-powered money expansion and a consequent overheating of the Chinese economy. The Chinese central bank last year offset --that is, sterilized-- much of its heavy dollar purchases by reducing its loans to commercial banks, by selling bonds, and by increasing reserve requirements.

But the ratio of the money supply to the monetary base in China has been rising steadily for a number of years as financial efficiency improves. Thus the modest rise that has occurred in currency and commercial bank reserves has been enough to support a twelve-month growth of the M2 money supply in the neighborhood of 20 percent through 2003 and a bit less so far this year. Should this pattern continue, the central bank will be confronted with the choice of curtailing its purchases of dollar assets or facing an overheated economy with the associated economic instabilities. Lesser dollar purchases presumably would allow the renminbi, at least temporarily, to appreciate against the dollar.

Other East Asian monetary authorities, in an endeavor to hold their currencies at a par with the yen and the renminbi, accumulated about $120 billion in reserves in 2003 and appear to have continued that rate of intervention since.

* * *

There is a general view that this heavy intervention places upward pressure on the euro. It is assumed that the dollar's trade-weighted exchange rate reflects its worldwide fundamentals, and therefore if the Asian currencies are being suppressed, the euro and other non-Asian currencies need to appreciate as an offset.

But a more likely possibility is that Asian currency intervention has had little effect on other currencies and that the trade-weighted average of the dollar is, thus, somewhat elevated relative to the rate that would have prevailed absent intervention. When Asian authorities intervene to ease their currencies against the dollar, they purchase dollar-denominated assets from private sector portfolios. With fewer dollar assets in private hands, the natural inclination to rebalance portfolios will tend to buoy the dollar even against currencies that are not used in intervention operations, including the euro. These transactions raise the dollar against, for example, the yen, lower the yen against the euro, and lower the euro against the dollar. The strength of the euro against the dollar thus appears to be the consequence of forces unrelated to Asian intervention. As I will explain later, this does not mean that when Asian intervention ceases the dollar will automatically fall because other influences on the dollar cannot be foreseen.

Some have argued that purchases of U.S. Treasuries by Asian officials are holding down interest rates on these instruments, and therefore U.S. interest rates are likely to rise as intervention by Asian monetary authorities slows, ceases, or even turns to net sales. While there are obvious reasons to be concerned about such an outcome, the effect of a reduction in the scale of intervention, or even net sales, on U.S. financial markets would likely be small. The reason is that central bank reserves are heavily concentrated in short-term maturities; moreover, the overall market in short-term dollar assets, combining both public and private instruments, is huge relative to the size of asset holdings of Asian monetary authorities. And because these issues are short-term and hence capable of only limited price change, realized capital losses, if any, would be small. Accordingly, any incentive for monetary authorities to sell dollars, in order to preserve market value, would be muted.

* * *

A different issue arises with the apparent level of hedging by exporters in Europe and elsewhere. The effect, however, is the same as Asian official intervention: It slows the process of adjustment.

Against a broad basket of currencies of our trading partners, the foreign exchange value of the U.S. dollar has declined about 12 percent from its peak in early 2002. Ordinarily, currency depreciation is accompanied by a rise in the dollar prices of our imported goods and services, because foreign exporters seek to avoid price declines in their own currencies, which would otherwise result from the fall in the foreign exchange value of the dollar.

Reflecting the swing from dollar appreciation to dollar depreciation, the dollar prices of goods and services imported into the United States have begun to rise after declining on balance for several years. But the turnaround to date has been moderate and far short of that implied by the exchange rate change. Apparently, foreign exporters have been willing to absorb some of the price decline measured in their own currencies and the consequent squeeze on profit margins it entails in order to hold market share. In fact, given that the nearly 9 percent rise in dollar prices of goods imported from western Europe since the start of 2002 has been far short of the rise in the euro, profit margins of euro-area exporters to the United States may well have turned negative.

Nonetheless, euro-area exports to the United States, when expressed in euros, have slowed only modestly. A possible reason is that European exporters' incentives to sell to the United States were diminished significantly less than indicated by the dollar price and exchange rate movements owing to accelerated short forward positions against the dollar in foreign exchange markets. A marked increase in foreign exchange derivative trading, especially in dollar-euro, according to the Bank for International Settlements, is consistent with increased hedging of exports to the United States and to other markets that use currencies tied to the U.S. dollar.²

However, most contracts are short-term because long-term hedging is expensive. Thus, although hedging may delay, and perhaps even smooth out, the adjustment, it cannot eliminate, without prohibitive cost, the consequences of exchange rate change. Accordingly, the currency depreciation that we have experienced of late should eventually help to contain our current account deficit as foreign producers export less to the United States. On the other side of the ledger, the current account should improve as U.S. firms find the export market more receptive. But in the process, dollar prices of imports will surely rise.

* * *

When the temporary forestalling of the U.S. balance of payments adjustment process comes to an end, does that suggest a steepening of the decline in the dollar's exchange rate?

As I pointed out in the beginning, the most sophisticated analytical techniques have been unable to profitably project the exchange rates of major currencies. Yet, most commentators argue that because the current account deficit must eventually narrow, the price-adjusted value of the dollar must accordingly decline. But how can exchange rates and the current account be systematically related, if exchange rates are inherently unpredictable? The answer is that the point at which the U.S. current account deficit will be forced to narrow is itself inherently difficult to predict. The current account reflects the myriad forces that bring our transactions with foreign economies into balance at our borders, of which exchange rates are only one. But those forces that, in the end, are reflected in a current account surplus or deficit are both domestic and foreign. Indeed, our current account balance can be shown to be exactly equal to the difference between domestic saving and domestic investment. In fact, it is often instructive in longer-term analysis to view our current account in terms of its domestic counterparts.

As I pointed out in a speech last November,³ virtually all of our trading partners share our inclination to invest a disproportionate percentage of domestic savings in domestic capital assets, irrespective of their differential rates of return. People seem to prefer to invest in familiar local businesses even where currency and country risks do not exist. For the United States, studies have shown that individual investors and even professional money managers have a slight preference for investments in their own communities and states. Trust, so crucial an aspect of investing, is most likely to be fostered by the familiarity of local communities.

As a consequence, "home bias" will likely continue to constrain the movement of world savings into its optimum use as capital investment, thus limiting the internationalization of financial intermediation and hence the growth of external assets and liabilities and the dispersion of world current account balances that such growth implies.

Nonetheless, during the past decade, home bias has apparently declined significantly. For most of the earlier post World War II era, the correlation between domestic saving rates and domestic investment rates across the world's major economies, a conventional measure of home bias, was exceptionally high.⁴ For the member countries of the Organization for Economic Cooperation and Development (OECD) , the GDP-weighted correlation coefficient was 0.97 in 1970. However, it fell from 0.96 in 1992 to less than 0.8 in 2002. For OECD countries excluding the United States, the recent decline is even more pronounced. These declines, not surprisingly, mirror the rise in the differences between saving and investment or, equivalently, of the dispersion of current account balances over the same years.

The decline in home bias probably reflects an increased international tendency for financial systems to be more transparent, open, and supportive of strong investor protection.⁵ Moreover, vast improvements in information and communication technologies have broadened investors' vision to the point that foreign investment appears less exotic and risky. Accordingly, the trend of declining home bias and expanding international financial intermediation will likely continue. This process has enabled the United States to incur and finance a much larger current account deficit than would have been feasible in earlier decades. It is quite difficult to contemplate foreign savings in an amount equivalent to 5 percent of U.S. GDP being transferred to the United States two or three decades ago.

* * *

It is unclear whether the burden of servicing our growing external liabilities or the rising weight of U.S. assets in global portfolios will impose the greater restraint on current account dispersion over the longer term. Either way, when that point arrives, will the process of reining in our current account deficit be benign to the economies of the United States and the world?

According to a Federal Reserve staff study, current account deficits that emerged among developed countries since 1980 have risen as high as double-digit percentages of GDP before markets enforced a reversal.⁶ The median high has been about 5 percent of GDP.

Complicating the evaluation of the timing of a turnaround is that deficit countries, both developed and emerging, borrow in international markets largely in dollars rather than in their domestic currency. The United States has been rare in its ability to finance its external deficit in a reserve currency. This ability has presumably enlarged the capability of the United States relative to most of our trading partners to incur foreign debt.

Besides experiences with the current account deficits of other countries, there are few useful guideposts of how high our country's net foreign liabilities can mount. The foreign accumulation of U.S. assets would likely slow if dollar assets, irrespective of their competitive return, came to occupy too large a share of the world's portfolio of store of value assets. In these circumstances, investors would seek greater diversification in non-dollar assets. At the end of 2002, U.S. dollars accounted for about 65 percent of the foreign exchange reserves of foreign monetary authorities, with the euro second at 19 percent. Approximately half of private cross-border holdings were denominated in dollars, with one-third in euros.

* * *

More important than the way that the adjustment of the U.S. current account deficit will be initiated is the effect of the adjustment on both our economy and the economies of our trading partners. The history of such adjustments has been mixed. According to the aforementioned Federal Reserve study of current account corrections in developed countries, although the large majority of episodes were characterized by some significant slowing of economic growth, most economies managed the adjustment without crisis. The institutional strengths of many of these developed economies --rule of law, transparency, and investor and property protection-- likely helped to minimize disruptions associated with current account adjustments. The United Kingdom, however, had significant adjustment difficulties in its early postwar years, as did, more recently, Mexico, Thailand, Korea, Russia, Brazil, and Argentina, to name just a few.

Can market forces incrementally defuse a worrisome buildup in a nation's current account deficit and net external debt before a crisis more abruptly does so? The answer seems to lie with the degree of flexibility in both domestic and international markets. In domestic economies that approach full flexibility, imbalances are likely to be adjusted well before they become potentially destabilizing. In a similarly flexible world economy, as debt projections rise, product and equity prices, interest rates, and exchange rates could change, presumably to reestablish global balance.

The experience over the past two centuries of trade and finance among the individual states that make up the United States comes close to that paradigm of flexibility even though exchange rates among the states have been fixed. Although we have scant data on cross-border transactions among the separate states, anecdotal evidence suggests that over the decades significant apparent imbalances have been resolved without precipitating interstate balance of payments crises. The dispersion of unemployment rates among the states, one measure of imbalances, spikes during periods of economic stress but rapidly returns to modest levels, reflecting a high degree of adjustment flexibility. That flexibility is even more apparent in regional money markets, where interest rates that presumably reflect differential imbalances in states' current accounts and hence cross-border borrowing requirements have, in recent years, exhibited very little interstate dispersion. This observation suggests either negligible cross-state-border imbalances, an unlikely occurrence given the pattern of state unemployment dispersion, or more likely very rapid financial adjustments.

* * *

We may not be able to usefully determine at what point foreign accumulation of net claims on the United States will slow or even reverse, but it is evident that the greater the degree of international flexibility, the less the risk of a crisis.⁷ The experience of the United States over the past three years is illustrative. The apparent ability of our economy to withstand a number of severe shocks since mid 2000, with only a small decline in real GDP, attests to the marked increase in our economy's flexibility over the past quarter century.⁸

* * *

In evaluating the nature of the adjustment process, we need to ask whether there is something special in the dollar being the world's primary reserve currency. With so few historical examples of dominant world reserve currencies, we are understandably inclined to look to the experiences of the dollar's immediate predecessor. At the height of sterling's role as the world's currency more than a century ago, Great Britain had net external assets amounting to some 150 percent of its annual GDP, most of which were lost in World Wars I and II. Britain in the early post World War II period was hobbled with periodic sterling crises when much of the remnants of Empire endeavored to disengage themselves from heavy reliance on holding sterling assets as central bank reserves and private stores of value. The experience of Britain's then extensively regulated economy, harboring many wartime controls well beyond the end of hostilities, provides testimony to the costs of structural rigidity in times of crisis.

* * *

Should globalization be allowed to proceed and thereby create an ever more flexible international financial system, history suggests that the odds are favorable that current imbalances will be defused with little disruption to the economy or financial markets.

But there are other outcomes that are less benign, and we must endeavor to limit the likelihood of these outcomes. One avenue by which to lessen the risk of a more difficult adjustment is for us to restore fiscal discipline. The rise in national saving that would accompany a reduction in the federal budget deficit will alleviate some of the burden of adjustment that would otherwise be required of the private sector through movements in asset prices.

Even more worrisome than the lack of fiscal restraint are the clouds of emerging protectionism that have become increasingly visible on today's horizon. Over the years, protected interests have often endeavored to stop in its tracks the process of unsettling economic change. Pitted against the powerful forces of market competition, virtually all such efforts have failed. The costs of any new such protectionist initiatives, in the context of wide current account imbalances, could significantly erode the flexibility of the global economy. Consequently, it is imperative that creeping protectionism be thwarted and reversed.

Footnotes

1. The yen bias certainly existed in earlier decades, but it has become more evident as Japanese growth slowed.  Return to text

2. That many exports even from Europe are priced in dollars is a trading convention. It does not affect the costs in domestic currencies that exporters incur.  Return to text

3. Alan Greenspan, speech at the 21st Annual Monetary Conference, cosponsored by the Cato Institute and the Economist, Washington, D.C., November 20, 2003.  Return to text

4. See Martin Feldstein and Charles Horioka, "Domestic Saving and International Capital Flows," The Economic Journal, June 1980, 314-29.  Return to text

5. Research indicates that home bias in investment toward a foreign country is likely to be diminished to the extent that the country's financial system offers transparency, accessibility, and investor safeguards. See Alan Ahearne, William Griever, and Frank Warnock, "Information Costs and Home Bias: An Analysis of U.S. Holdings of Foreign Equities," Journal of International Economics, March 2004, pages 313 36.  Return to text

6. Caroline Freund, "Current Account Adjustment in Industrialized Countries," Board of Governors of the Federal Reserve System, International Finance Discussion Paper No. 692, December 2000.  Return to text

7. Although increased flexibility apparently promotes resolution of current account imbalances without significant disruption, it may also allow larger deficits to emerge before markets are required to address them.  Return to text

8. See Alan Greenspan, remarks before a symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming, August 30, 2002.  Return to text