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The recent consensus view that the gold standard was the leading cause of the worldwide Great Depression 1929–1933 stems from the two propositions: (1) Under the gold standard, deflationary shocks were transmitted between countries and, (2) for most countries, continued adherence to gold prevented monetary authorities from offsetting banking panics and blocked their recoveries. In this article we contend that the second proposition applies only to small open economies with limited gold reserves. This was not the case for the United States, the largest country in the world, holding massive gold reserves. The United States was not constrained from using expansionary policy to offset banking panics, deflation, and declining economic activity. Simulations, based on a model of a large open economy, indicate that expansionary open market operations by the Federal Reserve at two critical junctures (October 1930 to February 1931; September 1931 through January 1932) would have been successful in averting the banking panics that occurred, without endangering convertibility. Indeed had expansionary open market purchases been conducted in 1930, the contraction would not have led to the international crises that followed.

A much-debated hypothesis about the Great Depression is Friedman and Schwartz’s (1963) contention that a severe but not unusual U.S. recession turned into the greatest contraction of all times because the Federal Reserve failed to undertake expansionary open-market operations. Controversy about the role of monetary factors in causing the Great Depression in the United States was a feature of the earlier literature, but the consensus of current literature is that monetary shocks (produced largely by a series of banking crises) played a major role in prolonging and deepening the Great Depression.1 International aspects of the Great Depression have also been the focus of attention in recent studies. Research on international experience shows conclusively that the countries that left the gold standard early suffered a less severe Depression than those that stayed on.2 The international transmission of the Great Depression occurred for two key reasons. First, fixed exchange rates under the gold standard transmitted adverse shocks from one country to another. Second, commitment to the gold standard deterred countries from pursuing expansionary monetary policies to counteract these shocks.3 This view of the transmission mechanism is supportive of the Friedman–Schwartz hypothesis insofar as it helps explain how banking panics in the United States could have produced a worldwide depression. However, this view also suggests that gold standard constraints might have prevented the Federal Reserve from increasing high-powered money sufficiently to offset decreases in the money stock induced by banking crises. A policy of expanding domestic credit to stabilize the stock of money might have aroused doubts about U.S. commitment to the gold standard and led to a loss of gold reserves. Eichengreen (1992) argues that the loss would have been sufficiently large to force the United States off the gold standard. His argument points to the imperatives of the international gold standard rather than ineptness of the Federal Reserve as primarily responsible for not averting the Great Depression. For Friedman and Schwartz (1963), however, the Federal Reserve held so large a stock of gold that even had such a loss occurred, it would not have posed a serious threat to the U.S. commitment to the gold standard. Although there is considerable interest in this issue, little empirical work exists on estimating the loss of gold reserves that might have resulted, had the Federal Reserve undertaken expansionary monetary policy to offset the banking panicsduring the Great Depression. The main purpose of this article is to undertake such an exercise. Section 2 of the article briefly reviews the history of the interwar gold standard, discusses key developments before and during the Great Depression, and focuses on the international crises from 1931 to 1933. Section 3 then develops a model that identifies key determinants of gold flows from the United States. The model can be used to simulate the behavior of gold reserves had monetary policy been expansionary during banking panics. In view of the large size of the U.S. economy, the model explicitly takes into account the interaction between the United States and the rest of the world. Even in the special case of perfect capital mobility (which represents the most severe constraint for U.S. policy), the model shows that the expansion of U.S. domestic credit would have been only partially offset by gold flows and it would have been technically possible for the Federal Reserve to counter a decline in the stock of money. Section 4 empirically implements the article’s model using monthly data for four major countries, France, Germany, the United Kingdom, and the United States. We consider two hypothetical scenarios of expansionary monetary policy, one initiated after the first banking panic in October 1930, and the second, after the crises associated with sterling’s devaluation in September 1931. We account for possible speculative attacks suggested by the recent literature. We simulate the time path of U.S. gold reserves (as well as that of the gold-reserve ratio) under the two hypothetical scenarios up to February 1933. In the first simulation, we show that a $1 billion open market purchase over the period October 1930–February 1931 could have prevented the banking panics that followed by providing the banking system with additional reserves, and it would not have led to a gold drain in 1931–1933 sufficient to deplete U.S. gold reserves. In the second simulation, which omits the first hypothetical open market purchase, we assume that after the British devaluation the Federal Reserve would have increased domestic credit by $1 billion from September 1931 through January 1932. We show that U.S. gold reserves would have declined significantly but not sufficiently to reduce the gold ratio below the statutory minimum requirement. The reason for the hypothetical large gold outflows in this simulation is that the British devaluation could have shaken the market’s confidence in the U.S. commitment to gold parity at a time when France was converting its dollar claims into gold.

The recent consensus view is that the gold standard is the key cause of the Great Depression. This view has merit, first in the sense that deflationary shocks were transmitted by the gold standard and, second, in the sense that for most countries continued adherence to gold blocked their recoveries. These were small, open economies, with limited gold reserves. This was not, however, the case for the United States. The United States had the largest economy in the world, held massive gold reserves, and hence was not constrained from using expansionary policy to offset banking panics. Indeed, under Benjamin Strong, the Federal Reserve had demonstrated its understanding of the need to pursue such policies. This conclusion holds even in the face of perfect international capital flows. Dollar claims against the United States were minor relative to the size of its gold reserves in contrast to the situation today. Emerging countries that recently experienced crises hold outstanding international liabilities far in excess of their international reserves. This made it hard for them to alleviate domestic banking difficulties using domestic monetary policy. The simulations we constructed, based on a model of a large open economy, indicate that expansionary open market operations at two critical junctures of the Great Depression would have been successful in every scenario in averting the banking panics without endangering convertibility. Indeed, had expansionary open market purchases been conducted in 1930, the Depression would not have led to the international crises that followed.