OverviewAs the financial crisis continues to deepen, many people are deeply concerned that collapsing credit availability will lead to powerful monetary deflation, much like it did during the US Great Depression of the 1930s. Yet, the United States did break out of the deflationary cycle, as illustrated in the graph above. After rapidly plunging for about 30 months, with the CPI seemingly in free fall and not able to find a floor – there was an abrupt turnaround.
The Great Inflation was the defining macroeconomic event of the second half of the twentieth century. Over the nearly two decades it lasted, the global monetary system established during World War II was abandoned, there were four economic recessions, two severe energy shortages, and the unprecedented peacetime implementation of wage and price controls. The Shadow of the Great Depression and the Inflation of the 1970s. The inflation of the 1970s was a time when uncertainty about prices made every business decision a speculation on monetary policy. During that decade, the annual U.S. Inflation rate rose in the 5-10% range, compared to a 0-3% range typical of peacetime America.
Not only was a floor found, but an immediate cycle of inflation replaced the seemingly unstoppable deflation. The nation turned essentially “on a dime”, from unstoppable deflation to inflation instead.
A cycle of inflation that has continued until this day.What happened? March 9, 1993President Franklin D.
Roosevelt was inaugurated on March 4, 1933. He came into office with a mandate and agenda to stop the Depression, and that meant breaking the back of the deflationary spiral. His actions were swift, beginning with a mandatory four day bank holiday imposed the day after his inauguration. Five days after Roosevelt took office, on March 9 th, the Emergency Banking Relief Act was passed by Congress. This was the first in a series of executive orders and bills that would take place over the following weeks and year, and would cumulatively take the United States government off the gold standard – and would also effectively confiscate all investment gold from US citizens at a 41% mandatory discount.From 1900 to 1933, the US government had been on a gold standard, and had issued gold certificates. In a matter of days in March of 1933, there would be a radical change, a veritable 180 degree turn, that would not only repeal the gold standard, but effectively make the use of gold as money illegal in the United States. Fallacy One: Confusing Apples & OrangesThere is a common simplification that people make when they look at money over time.
They think that a dollar is a dollar, even if the purchasing power has changed a bit. This is a quite understandable mistake, particularly if your profession does not involve the study of money.When we look back over history – nothing could be further from the truth.
This assumption instead reflects an elementary logical error, that may be quite dangerous for your personal future standard of living, if it leads to your drawing the wrong conclusions. The term “dollar” is only a name (the same holds true for the “pound”, “franc”, “peso”, “mark”, and all other currencies).
What matters is not the name, but the set of rules – or collateral – that back the value of the currency, during a particular historical period. When we look back over long-term history, then sometimes it is gold, sometimes it is silver, sometimes it is both, and sometimes it is something else altogether. (As a creature of politics, money has always been of a complex and quite variable nature, given enough time.)So when we say history “proves” something about a currency, we need to be very, very careful that we are talking apples and apples, rather than apples and oranges. For instance, when we look at precious metals backed currencies, the deflation of 1929 to 1933 when the US was on the gold standard was nothing new.
It was just the latest development in the ongoing cycle of inflation and deflation that characterizes this type of currency. Indeed, there were four major deflations during the century before Roosevelt ended the domestic gold standard, and the deflations of 1839-1843 and 1869-1896 were each much larger than the deflation of 1929-1933, with the dollar deflating roughly 40% in each of those earlier major deflations.
This deflationary history does not, however, reflect the value of the “dollar” (as we currently know it) bouncing up and down, but rather the value of the tangible assets securing the dollar bouncing up and down around a long term average.Going off the gold standard was nothing new either. Many nations have gone through periods, particularly during wars, when more money is needed than there is gold or silver to back it up.
Life During The Great Depression
So, they issued symbolic (fiat) currencies that were backed only by the authority of the government, or debased the metals content of the coins. These fiat currencies almost always turned out badly.
Instead of cycling up and down in value over time, they tended to go straight down and never come back up. While global monetary history is complex and long, it is highly, highly unusual for a symbolic currency to experience major and sustained deflation at the levels that are the norm with precious metals backed currencies.It is this quite understandable but wrong belief that a “dollar” is a “dollar” that creates the ironic situation of many millions of people believing that the deflation of the US Great Depression proves the case for deflationary dangers in the current crisis. Not at all – what we have instead is the elemental logical fallacy of mixing up apples and oranges. Yes, the US experienced powerful monetary and price deflation during the early years of the Great Depression, but that was with a dollar that was backed by gold.
Was There Inflation Or Deflation During The Great Depression
A currency in other words, that has almost nothing to do with today’s dollar, other than the name. A currency type whose long term history is radically different than fiat currencies – such as the dollar today. Fallacy Two: Reversing The Historical LessonLet’s revisit the sequence of events and what actually happened. The United States was stuck in a powerful deflationary spiral with a gold-backed currency, that seemed unstoppable. A currency that had little to do with what we call the dollar today, other than sharing the name.So, the government changed the rules, and replaced the old dollar with a new dollar, whose value was not based on gold. A dollar much like we have today (albeit not quite the same as there was still a gold backing on an international basis). And what happened?In the depths of depression, at the height of a deflationary spiral, the government successfully broke the back of deflation within one week.
In the midst of deflationary pressures far greater than we are seeing today, the government not only stopped the deflation, but replaced it with inflation. Indeed, by May of 1933, only two months after the currency rules changed, the monthly rate of inflation hit an annualized rate of 10%, and even hit a 40%+ plus (annualized) monthly rate by June of 1933.
If you’re concerned about a new US depression leading to unstoppable price or monetary deflation because of what happened in the 1930s, let me suggest that you study and remember the graph above. When you get worried about monetary deflation – take another look at March of 1933. Remember as well the one near universal lesson from the long and convoluted history of money: every time the rules governing a currency lead to a problem that causes too much pain for a government to bear – the government just changes the rules. (The graph above may look like it starts at 95 cents, but it doesn’t, it starts at $1.00. The fall in the value of the dollar in 1933 once the gold standard was abandoned was so fast it can’t be seen with a 75 year scale and monthly increments.)A 76 year old man or woman born in the 19 th or 18 th centuries would have seen the value of their currency go both up and down over their lifetimes, and there is a pretty good chance that at age 76, the dollar (or pound) would be worth the same or more than it was when they were born.
When the US Government fundamentally changed the nature of money in 1933, it created an entirely different pattern – all down, and no up, so that for a 76 year old person today, a dollar will only buy what 6 cents did at the time they born.So as we try to decide whether the danger ahead is inflation or deflation today, what is the monetary lesson for us from the US Great Depression?The common belief is to say the Great Depression proves the awesome power of deflation, that the government can have a great deal of difficulty in fighting it, and may not be able to fight it at all. This is an extraordinary misunderstanding, and constitutes the second of our logical and historical fallacies.What the Great Depression showed was that if you have a tangible asset backed currency, such as gold or silver, and you enter a depression, then history has shown time and again that you're likely to have a period of substantial deflation.