An Inflationary Contraction

Money is stable in value on a gold standard. That’s all a gold standard does. It links a currency to gold, and that currency achieves gold’s historical stability of value. Stable value eliminates inflation and deflation. It’s why Great Britain could issue Consol bonds in the 19th century of unlimited duration at historically low and stable interest rates—set by the market without central bank manipulation. Compare interest rates during Great Britain’s gold standard with the fiat U.S. dollar after the end of Bretton Woods.

Yields on long-term government bonds: U.S. (1970-2017) and Britain (1830-1880) NATHAN LEWIS

On a gold standard, absent the negative effects of inflation or deflation, an economy will expand or contract based on fiscal policy. A gold standard eliminates money illusion (inflation/deflation), the temporary and long-term negative effects of the change in the value of a currency that benefit a few at the expense of many. The elimination of money illusion and its corresponding chaos is a matter of economic efficiency. 

We can look at fiscal policy in terms of domestic and international, political and geopolitical. Taxes, regulations, and the size and reach of a government drive domestic fiscal policy. Domestic fiscal policy is a trade-off that incentivizes the entrepreneur and producer for maximum economic growth.  It must balance the needs of society at large—national defense, law and order, a system of justice, desired public works, and support for those members of society least able to provide for themselves. There is no need to incentivize consumption. The desire to consume is unlimited. Fiscal policy that puts the producer at the center of its economic model creates a foundation for growth.

Geopolitical policy likewise drives economic growth. The only closed economy is the world economy. International cooperation in trade and diplomacy that efficiently allocates the world’s production and resources unleashes individual ingenuity and growth. International cooperation reduces hot and cold wars and creates a foundation for global economic expansion. The world experienced its greatest rates of international growth during the Classical gold standard from 1870-1914. Essentially, the whole world was on a gold standard during this period, with one international currency defined by gold’s stability of value. The free flow of international capital and trade resulted in the greatest era of growth, industrialization, rising standards of living, and overall progress the world has ever experienced. The next episode of this type of sustained world growth and rising living standards occurred under the Bretton Woods international gold standard from 1944-1971.

It is intuitive that when money remains stable in value, then fiscal policy drives economic expansion or contraction. Money is simply a standard of reference for the exchange of goods and services.  It is a measuring stick, not a magic wand.  To the extent a monetary reference remains stable in value, the exchange of goods and services is at its most efficient, and everybody benefits economically. 

A foundation that creates economic growth requires that the government first do no harm. Establish stable money.  Keep taxes, regulations, and the size of government limited and cooperate in good faith with the world. Get government out of the way, and let producers and entrepreneurs create. The desire to achieve one’s God-given talent is genetically encoded in every human’s DNA. The artificial suppression of individual liberty and creativity for the expansion of control by the political class results in economic and social decline.

The Great Depression and Economic Contraction

Four components define the basics of an economic condition—inflation, deflation, contraction, and expansion.  Economic contraction or expansion may occur with inflation or deflation as well as with stable money.  As noted, stable money eliminates inflation and deflation. On a gold standard, it is solely fiscal policy that drives economic contraction (negative growth) or expansion (growth).

The Great Depression was a lesson in errant fiscal policy creating an economic contraction. The U.S. was on a gold standard with the dollar linked to gold at $20.67/oz for 140 years leading up to the GD. (We can ignore a minor devaluation from $19.39/oz related to the gold-silver bimetallic system that occurred in 1834.) The Founders entrenched stable money defined by gold into the Constitution along with individual liberty.  The fledgling U.S. expanded rapidly to the top of the world economic pyramid. 

Smoot-Hawley legislation preceded the 1929 Wall Street crash. S-H enacted a global tariff wall that shutdown international trade and cooperation. Congress enacted the law at the behest of domestic producers who desired to gain a competitive advantage against their global competitors. Goods and services built up behind the tariff wall with a corresponding reduction in global demand. International cooperation dissipated, and the rise of nationalism in the intervening years naturally reflected every country for itself.  World War II followed a decade later.

The onset of the GD was an economic contraction. In his book, The Way the World Works, Jude Wanniski tracked the chronological timeline during the enactment of Smoot-Hawley as it worked its way toward passage in the Senate and the response in the Dow indices leading up to the market crash. The Dow tracked exactly either positively or negatively with the prospect of S-H’s enactment. The market crashed when the passage of S-H became a fait accompli.

Political and economic ignorance created the onset of the GD, and the resulting contraction required economic actors to liquidate goods and services at whatever price they could obtain. The Fed lent to solvent banks, those with collateral to back their loans, and insolvent banks failed. Unemployment soared. Monetary deflation was not a factor.

Hoover’s Treasury Secretary, Andrew Mellon, recommended liquidation:

Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate. … It will purge the rottenness out of the system. 

Short of rolling back the S-H tariff wall, liquidation was the only option.  Prices had to clear to allow a way for a V-shaped economic recovery.  What did not need to occur was additional growth-destructive errant fiscal policy. Simply alleviating the negative fiscal effect of S-H by rolling back the tariff rates or allowing the rates to lapse over time would have resulted in a recession instead of a Great Depression. Instead, In 1932 Hoover and Congress increased tax rates on top earners from 25 percent to 65 percent.  This growth-inhibiting tax hike further put a fiscal barrier on producers and deepened the economic contraction. Hoover’s tax increases combined with FDR’s destructive anti-growth socialist fiscal policy throughout the 1930s turned a temporary tariff-induced recession into the Great Depression. In addition, FDR did a one-time devaluation of the dollar in 1933 that deepened the economic decline.

Economists frame the GD as an economic debate between Mellon’s do-nothing, heartless capitalist liquidation, and FDR’s decade of “well-intentioned” socialist policy intervention. What the debate misses is the proper perspective to define the economic problem.  S-H was Congressional intervention that degraded the free flow of capital and trade. Simply ignoring the contractionary fiscal error and allowing economic conditions to work themselves out over time while business and workers got decimated is not the desired option.  Yet, it remains a better option than making things worse with growth-killing tax hikes and additional fiscal errors.  Intervention is necessary, but it must be directed toward creating a foundation for growth.  

The U.S. was on a gold standard during the onset of the GD. Despite the revisionist claims that the Fed should have devalued as a monetary palliative to alleviate the GD, it couldn’t both devalue and maintain the gold standard. A gold standard maintains the stability of the value of a currency. Had the Fed abandoned the gold standard and devalued we would have had the Great Stagflation Depression.

FDR’s devaluation in 1933 resulted in a 69.3 percent increase in the dollar price of gold. The price of gold went from $20.67/oz to $35/oz. This was not an abandonment of the U.S. gold standard. It was a one-time devaluation. The dollar remained linked to gold—the definition of a gold standard—at $35/oz until 1971. What was particularly galling about the 1933 devaluation was that FDR confiscated gold at the low price of $20.67/oz and then revalued gold to $35/oz confiscating $4 billion of wealth from U.S. citizens and transferring it onto government accounting books. The devaluation did nothing to alleviate the Great Depression, which continued for the rest of the decade. It did cause an inflationary adjustment in the price level over the next two decades. Only fiscal relief from high tariffs, increased tax rates, and destructive socialist policy could provide the growth incentives necessary to get the economy back on its feet during the Great Depression. There was no monetary palliative. 

Understanding the Great Depression in terms of stable money and errant fiscal policy provides a foundation for examining and understanding what is happening today after 50 years of unstable money. The current government-imposed shutdown contraction is occurring under unstable monetary policy, yet semi-favorable fiscal policy.


Next, An Inflationary Contraction II will observe the intervention policy effects of our current government-imposed economic contraction. 


  1. Bill Brenneman

    Moved to reread Jude Wanniski, a hero of the second Gulf war because he was one of the few willing to proclaim and prove that Saddam had no WMD.

  2. Michael Kendall (Post author)

    “A great reporter is one who does not stop asking questions until he runs out of people with answers.” JW

    The tenet for Jude’s journalistic style that guided him to jettison preconceived wisdom and instead always seek the truth–wherever it leads.


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