Most countries still adhered to the gold standard, and with few exceptions most economists and statesmen reverenced gold with a mystical devotion that resembled religious faith. Gold underlay the most sacred token of national sovereignty: money. It guaranteed the value of money; more to the point, it guaranteed the value of a nation's currency beyond its own frontiers. Gold was therefore considered indispensable to the international trade and financial system. Nations issued their currencies in amounts fixed by the ratio of money in circulation to gold reserves. In theory, incoming gold was supposed to expand the monetary base, increase the amount of money in circulation, and thereby inflate prices and lower interest rates. Outflowing gold supposedly had the inverse effect: shrinking the monetary base, contracting the money supply, deflating prices, and raising interest rates. According to the rules of the gold-standard game, a country losing gold was expected to deflate its economyto lower prices so as to stimulate exports, and to raise interest rates so as to reverse the outflow of capital. Indeed, these effects were assumed to happen virtually automatically.
In actual practice, the gold-standard system was less systematic, less rule-bound, and more asymmetrical than the theory allowed. Nor did it necessarily work automatically. Countries losing gold were indeed under strong pressure to tighten credit or risk defaulting on their exchange-rate commitments. The latter option was thought to be prohibitively costly; events soon proved it was not. And creditor countries were under no like obligation to inflate when gold flowed in. They could simply "sterilize" surplus gold and carry on as before, leaving gold-losing countries to fend for themselves. By tying the world's economy together, the gold standard theoretically ensured that economic fluctuations in one country would be transmitted to others. It was in fact that very transmission that was supposed to dampen erratic movements and keep the global system in equilibrium.
In fair economic weather, the gold standard was thought to operate more or less mechanically as a kind of benign hydraulic pump that kept prices and interest rates stable, or fluctuating only within narrow bands, throughout the world trading system. In the foul economic weather of 1931, however, huge surges emanating from the national economic crises in Austria and Germany threatened to swamp other countries, and the international plumbing broke down. What Hoover called "refugee gold" and "flight capital" began to course wildly to and fro through the conduits of the gold-standard pumping system. Hoover likened the panicky and lurching movements of gold and credit, "constantly driven by fear hither and yon over the world," to "a loose cannon on the deck of the world in a tempest-tossed sea."10 Nations with already depressed economies proved to have little stomach for suffering further deflation through the loss of gold. To protect themselves, they raised tariff barriers and slapped controls on the export of capital. Almost all of them eventually jettisoned the gold standard itself. Frightened and battered, reefed and battened, virtually every ship of state thus set cowering and solitary course for safe haven. When the storm at last abated, it left the world forever transformed. The pre-1931 gold standard, which had been the Ark of the Covenant of the international economic order for more than a century, would never again be fully restored to the tabernacle of global commerce. Britain took the fateful step on September 21, 1931. Drained of gold by jumpy European creditors and politically unwilling to take the deflationary steps to bid gold back to English shores, Britain defaulted on further gold payments to foreigners.11 More than two dozen other countries quickly followed suit. John Maynard Keynes, already tinkering with heretical theories about "managed currency," rejoiced at "the breaking of our gold fetters."12 But most observers, including Hoover, regarded the British abandonment of the gold standard as an unmitigated catastrophe.
In an apt metaphor, Hoover likened the British situation to that of a failing bank, faced with depositors' demands but unable to turn its assets into cash, and thus forced to bar its doors. The difference was that Britain was not a piddling country bank but a central pillar of the global financial structure. When it suspended payments, world commerce shivered to a stop. The moratorium, the standstill agreement, and the British departure from gold meant that a vast volume of the world's financial assetsanything that constituted a claim on Austrian, German, or British banks, or those of any of the other countries that repudiated goldwere now frozen. The United States had already helped to clog the arteries of world trade by erecting high tariff barriers and by constricting its capital outflows after the Wall Street crash.
Now, as the world's financial lifeblood congealed, the international economy slowed to an arctic stillness. Germany would soon declare policies of national self-sufficiency. Britain in the Ottawa Agreements of 1932 effectively created a closed trading blocthe so-called Imperial Preference Systemsealing off the British empire from the commerce of other nations. The volume of global business shrank from some $36 billion of traffic in 1929 to about $12 billion by 1932. The blow to American foreign trade was a harmful consequence of Britain's departure from gold, but hardly a fatal one. The United States at this time simply did not depend on foreign trade to the degree that other nations did, a fact to which the high protective tariffs of 1922 and 1930 testified.
More directly hurtful was the punishment that the German panic and the British abandonment of gold inflicted on the already crippled American financial system, still shuddering from the rash of bank failures in the final weeks of 1930. American banks held on the asset side of their ledgers some $1.5 billion in German and Austrian obligations, which were for the moment effectively worthless. Worse, the psychology of fear was rapidly overflowing international frontiers, running dark and swift from central Europe to Britain. It now washed over the United States. Foreign investors began withdrawing gold and capital from the American banking system. Domestic depositors, once bitten, twice shy, renewed with a vengeance their runs on banks, precipitating a liquidity crisis that dwarfed the panic in the final weeks of 1930.
That earlier crisis thus served both as rehearsal and foundation for the full-blown catastrophe that hit in 1931. Five hundred twenty-two banks failed in the single month following Britain's farewell to gold. By year's end, 2,294 American banks had suspended operations, nearly twice as many as in 1930 and an all-time American record.13 American banks now bled profusely from two wounds: one inflicted by domestic runs on deposits and the other by foreign withdrawals of capital. Unfortunately, the rules of the gold-standard game, as Hoover and most American bankers understood them, dictated that the latter problem take precedence over the former. In theory, American central banking authorities should now undertake deflationary measures; in practice, they did. This forced deflation in the context of an already deflated economy was the perverse logic of the gold standard against which Keynes was railing. To stanch the outflow of gold, the Federal Reserve System raised its rediscount rate, as gold-standard doctrine dictated that it should. In fact, the Fed moved with unprecedented muscularity, bumping the rate by a full percentage point in just one week's time.
What the banking system as a whole needed, however, was not tighter money but easier money, as Marriner Eccles and other bankers knew, so that it might meet the demands of panicky depositors. The starkly deflationary discipline of the gold standard now stood nakedly revealed to Americans as it had to Britons just weeks earlier. Britain had slipped that discipline by breaking loose from gold, freeing it to advance down a path toward at least a modest economic recovery in 1932. Within a year and a half, Franklin Roosevelt would do the same for the United States, creating a wholly new context for the exercise of monetary and fiscal policy. For the moment, however, Hoover chose to struggle within the gold standard's severely constraining framework