Could the Great Depression Happen Again?

CAMBRIDGE: With the remarkable financial turbulence of recent months, many people are asking whether the world could somehow blunder into global recession or even global depression. Could the world-wide financial crisis of 1929-33 happen again? A year ago, the question itself would have seemed preposterous. Now that financial crisis has spread from East Asia to much of Latin America, parts of Africa, and Russia, and it has rattled the stock markets of the advanced economies. The question now deserves a very considered response.

The right starting point is to understand the Great Depression itself, since the 1929-1933 economic crash was a once-in-a-century event. Looking back with the benefit of nearly 70 years, we can see the financial roots of the worldwide crisis. World War I, during 1914-1918, had destroyed the pre-war Gold Standard. Wartime finance had led to high inflation in much of Europe, the U.S., and Asia. After the war, the world spent 10 years attempting to get back on to the gold standard. This attempt, ironically, set the stage for the ensuing collapse.

At the most basic level, there were not enough gold reserves around to back the monetary needs of a growing world economy, especially since the prices of goods had risen sharply as a result of wartime money printing. Thus, the major currencies could be only partly backed by gold reserves. Investors knew that if everybody tried to convert a national currency into gold, there would not be enough gold reserves to go around. This was true not only one country at a time, but also for all countries together that were trying to re-establish the gold standard.

The result was a heightened risk of instability. Central Banks around the world promised that their respective domestic currencies (British pounds, U.S. dollars, French Francs, etc.) could be converted into gold at a fixed exchange rate, even though they did not have enough gold to guarantee the commitment fully. As long as investors were content to hold money rather than gold, the partial gold backing of the money supply was not a major problem. If investors, en masse, attempted to convert their money into gold, however, the system would necessarily break down.