Working Paper: NBER ID: w3488
Authors: Ben Bernanke; Harold James
Abstract: Recent research has provided strong circumstantial evidence for the proposition that sustained deflation -- the result of a mismanaged international gold standard -- was a major cause of the Great Depression of the 1930s. Less clear is the mechanism by which deflation led to depression. In this paper we consider several channels, including effects operating through real wages and through interest rates. Our focus, however, is on the disruptive effect of deflation on the financial system, particularly the banking system. Theory suggests that falling prices, by reducing the net worth of banks and borrowers, can affect flows of credit and thus real activity. Using annual data for twenty-four countries, we confirm that countries which (for historical or institutional reasons) were more vulnerable to severe banking panics also suffered much worse depressions, as did countries which remained on the gold standard. We also find that there may have been a feedback loop through which banking panics, particularly those in the United States, intensified the worldwide deflation.
Keywords: Gold Standard; Deflation; Great Depression; Financial Crisis; Banking Panics
JEL Codes: E32; E52; N10
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| mismanaged international gold standard (F33) | deflation (E31) |
| deflation (E31) | Great Depression (G01) |
| deflation (E31) | reduced net worth of banks and borrowers (G21) |
| reduced net worth of banks and borrowers (G21) | affects credit flows (F65) |
| affects credit flows (F65) | affects real activity (E44) |
| banking panics (F65) | more severe depressions (E71) |
| banking panics (F65) | exacerbate deflation (E31) |
| debt-deflation mechanism (E31) | borrower insolvency (G33) |
| debt-deflation mechanism (E31) | distorts incentives (H31) |
| distorts incentives (H31) | hinders new credit extension (G21) |