Who can doubt it? The desperate defense of the gold standard led directly to the Great Depression, as economist Barry Eichengreen of the University of California shows in a brilliant new book.* In turn, it is conceivable-though not certain-that World War II would not have occurred without the Depression, which abetted the rise of Hitler. Beyond that, we’re still living with one legacy of the demise of the gold standard: perpetual inflation.

Paradoxically, the gold standard’s virtues and vices were intertwined. Its rigidity fostered the Great Depression while also checking inflation. The promise of governments to pay gold for paper currency limited their ability to create endless amounts of money. With this discipline gone, pervasive inflation has afflicted virtually all industrial democracies. Countries that cope well (like Germany) limit it to 2 percent to 4 percent, and countries that don’t (like Brazil) have as much as 3,000 percent.

To say a nation was on the gold standard meant different things at different times. By the early 20th century, though, there were no pure gold standards in the sense that all a country’s money consisted of gold coin. Governments typically committed themselves to sell gold for paper money and made the commitment credible by maintaining gold reserves equal to a minimum proportion of the paper money. In 1930, the Federal Reserve was required to have gold stocks worth 40 percent of outstanding paper dollars (Federal Reserve notes). Gold was valued at $20.67 an ounce.

Gold backing inspired public confidence in money’s value, and it is hard for us today to appreciate how important this guarantee was considered. When President Franklin Roosevelt effectively abandoned gold in 1933, even some of his top advisers had huge misgivings. “This is the end of Western civilization,” one said privately. What ended, of course, was not civilization but a narrow concept of governmental economic responsibility.

The gold standard relegated government to the largely passive economic role of safeguarding a nation’s gold stocks. Massive unemployment (it averaged 18 percent in the United States in the 1930s) and great suffering made this unacceptable. People everywhere expected their government to engineer prosperity and protect the disadvantaged. But to attribute the triumph of social-welfare politics to the Depression-which is obvious-begs the basic question: why was there a Great Depression?

Some sort of slump was likely after the 1920s’ long prosperity. But few economists believe that the stock-market crash of 1929 transformed a routine downturn into a calamity. What did, as Eichengreen argues, was the gold standard. Governments were immobilized, because they were pulled in opposite directions: falling production required forceful action to ease credit and lower interest rates; but easing too much risked a flight of capital that would deplete their gold stocks.

Countries were especially hostage to huge bank deposits by foreigners (businesses, individuals and governments). These deposits were $2 billion in Britain and $1.2 billion in Germany, for example. Even a hint that gold convertibility might be suspended could frighten these depositors into converting their currency to gold. Aggressive actions by governments to fight the Depression-lowering interest rates too much or expanding the money supply-“might cast doubt over the official commitment to gold,” as Eichengreen writes.

With most governments initially clinging to gold, the slump fed on itself through bank failures and a collapse in world trade. Every major country ultimately changed its mind or was forced off gold by capital flight. Germany and Austria went in mid-1931. Huge gold losses made Britain leave in September. Because Britain was the citadel of financial orthodoxy, its capitulation led many countries to follow. The United States vainly stayed with gold another 18 months, as its Depression worsened and bank failure spread. France didn’t jettison gold until 1936. Once countries left gold, their economies generally improved.

The pleasures of history start with a better understanding of the past. The Depression has long been a bit of a mystery. In 1963, economists Milton Friedman and Anna Schwartz blamed it on the Federal Reserve’s restrictive policies. But beyond sheer incompetence, they never convincingly explained why the Fed blundered. A decade later, economist Charles Kindleberger argued that the Depression was so severe because it was worldwide in nature. Countries’ distress reinforced each other. But he, too, didn’t offer a convincing theory of why. Eichengreen bridges the gap: the slump was global because governments everywhere, adhering to the gold standard, made similar mistakes.

It’s always tempting to draw lessons from history. We should be cautious. Those who grimly prophesize a devastating economic collapse in the 1990s routinely compare the 1980s to the 1920s. Both (it’s said) were eras of prosperity, excessive speculation and too much debt. The day of reckoning must be at hand. The parallels are strained, because the 1920s’ prosperity didn’t cause the Depression.

What might give us pause are looser parallels. In part, the Depression was an outgrowth of World War I. It left a power vacuum: Britain couldn’t lead, as Kindleberger puts it, and the United States wouldn’t. This limited international cooperation to check the Depression. The end of the cold war could create a similar situation. Old power relationships are breaking down. American influence is waning. Ideas that once worked (like the gold standard) may no longer. What we have to fear most is not what we know–but what we don’t.

  • “Golden Fetters: The Gold Standard and the Great Depression, 1919-1939,” to he published by Oxford University in early 1992.