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s and 1940s: the Great Depression and its aftermath

The Great Depression was an unprecedented event that began in the United States (US) and spread to both developed and developing countries globally. Although serious crises had occurred previously, the Great Depression changed the way in which policy makers around the world responded to a flagging economy and notably ended permanently the gold standard, which had been used in varying capacities for decades. Countercyclical fiscal policy was first used on a grand scale in the US, after insufferable months of cyclical budget tightening in which economic grievances caused great social unrest.


Financial crises prior to the Great Depression occurred consistently around the world throughout the nineteenth century, as well as in the beginning of the twentieth century. Some of these crises were similar in nature to crises that came later (for example, caused by excessive foreign lending, as in 1826). The crisis of 1873 in the US, which lasted more than 20 years, is sometimes seen as even more devastating than the Great Depression of 1929 (Kindleberger 1986). In the nineteenth century, the largest national banks in Europe and Canada led the way out of crises. In the US, bankers coordinated at a regional level to suspend convertibility and establish rules for interbank clearing of transactions over this period (Calomiris and Gorton 1991).

The crises of the twentieth century brought about significant banking regulation at a national level in the US (Calomiris and Gorton 1991). Unlike some European countries, whose central banks provided monetary and financial stability for decades, even centuries,1 the US lacked a central bank, which had dissolved in 1836. The US crisis of 1907, significantly, gave rise to the Federal Reserve and highlighted the instability of US banks and markets in a crisis compared to the relative stability found elsewhere in the world. During the crisis of 1907, New York banker J.P. Morgan pledged his own funds to assist the financial system (Bruner and Carr 2007). In the aftermath of the crisis, and soon after the death of J.P. Morgan in 1913, legislation was passed to revive a central bank.

When World War I began in 1914, the US was strongly isolationist, but nevertheless the economy was affected by the war. Stock markets the world over declined and the price of gold soared, reflecting a rush of uncertainty in the global economy (Sobel 1968). In time, American securities appeared safer than European securities. Trade for both American and European merchants was at risk as freight ships were attacked on the seas. However, trade continued and increased for US munitions producers, with demand for weapons and other war materials on the rise. Even after the US declaration of war in 1917, on the whole, wealth was lost in Europe and much was transferred to the US.

Europe suffered greatly from World War I as a result of losing many of its youth and experiencing destruction of its lands. The United Kingdom’s future had been compromised to guarantee its victory in the war (Sobel 1968). France was deeply scarred. Germany was made to pay reparations to the opposing nations, the Allies, for its instigating role in the Great War. The payments were forced despite the great opposition of John Maynard Keynes, at the time an advisor to the British government (Keynes 1920). Keynes’s views in this regard were later upheld.

The Dawes Plan of 1924 was drawn up by Allied nations, and sought to collect German war reparations more effectively, demanding 1 billion Marks in the first year of the plan, rising to 2.5 billion Marks over a period of four years (Columbia Electronic Encyclopedia 2001). Within a short period of time, the Dawes Plan was largely recognized as excessively onerous. The Young Plan of 1929 brought together a group of experts in Paris to discuss German reparations, and was negotiated, rather than imposed upon Germany (Bergmann 1930).

Since there was at the time no other commodity or currency that was considered outside money, save for gold, Europe and the US returned to the gold standard in 1925 under the Gold Standard Act of 1925 enacted in Britain. Small countries favored the gold standard for its stabilizing properties, while larger countries wanted stability in exchange rates for foreign trade (Kindleberger 1986). After the Great Depression, the return to the gold standard was for the most part regarded as an error, which we discuss below. France in particular struggled to regain monetary stability, suffering speculative attacks on the franc and large depreciations under political chaos, between 1924 and 1926. The franc was finally stabilized under the strong leadership of Raymond Poincare (Eichengreen 1992).

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