The Two Markets

how we got the Great Depression

Originally, central banks like the Bank of England (the pioneer in this regard) acted as bankers to the government. They would lend money to the government in exchange for privileges like a monopoly of note issue. During the 19th century, as the gold standard became the norm, they began to act as reserve banks, with regular banks lodging their gold holdings there. With gold holdings centralized, central banks (or analogous institutions: in the USA, it was the big New York banks led by J.P. Morgan that fulfilled this role) began controlling the overall supply of gold, with an eye to controlling the money supply.

Prior to the First World War, these interventions were rather small-scale, and were geared toward keeping exchange rates within more or less broad bandwidths vis-à-vis the price of gold.[1] It was in the interwar period that things changed and central banks became more interventionist, and the main culprit here was the United States. As James Harvey Rogers, in his very instructive America Weighs Her Gold, noted at the time, the combination of huge debt and reparations payments, on the one hand, and tariff walls on the other, made it extremely difficult for European debtors to repay the USA. “The simple fact remains,” wrote Rogers, “that, by our high and increasing customs duties, we have made payments to us from abroad extremely and increasingly difficult.” The only alternative, under the gold standard, was to make payments in gold: “Whatever disequilibrium in the balance of payments is not taken care of by changes in some other of the items is automatically corrected by flows of gold.” Normally this would lead to “a considerable general rise in prices,” but this did not materialize. Why not? “The inflowing gold went instead to the Federal Reserve Banks in payment of member bank borrowings.” In other words, the Federal Reserve took this gold from the banks which were the original recipients of gold payments from abroad. This expanded banks’ credit capacity greatly, but did not feed into the ordinary market (the real economy). Instead, the effects were felt on the financial market. “Member banks, as their indebtedness at the Federal Reserve Banks became gradually reduced, felt  much more inclined to expand credits. New funds falling into the hands of institutions without such indebtedness were naturally used immediately in the money or investment markets. Thus a situation of general monetary ease and plenty soon prevailed.” But with this gold removed from circulation, gold shortages were cropping up in other countries, putting great strains on their monetary systems and economies. [2]

“Under such circumstances,” wrote Rogers, “New York’s money and investment markets gained rapidly in importance.” The dollar was far more credibly linked to gold than were most other currencies, and borrowing rates and costs of flotations were lower in New York. This bolstered New York’s prestige as the world’s leading financial center, attracting additional funds from abroad. And the financial market began to overshadow the ordinary market. “Under such conditions in our money and investment markets, lending of all sorts – long- and short-term, foreign and domestic – increased greatly.” Corporations began borrowing long-term at much greater levels than normal, freeing them from dependency upon banks for credit facilities. The banks, in turn, turned their attention to speculation: “The great resources of the banks were thus largely freed for the use of speculators and of others operating with money market funds; in addition, many of the normal customers of the banks became actual competitors for the speculators’ credit demands.” In this manner, the way was prepared for the great stock market boom of the late 1920s: “The high cash position of the corporations made an extremely favorable impression in their statements, while their excess funds loaned to the market provided a great share of the credit needs of the speculators.”[3] A simplified view of the process is provided in Figure 7.

Figure 7:  Short-Circuiting Gold Flows
Figure 7:  Sterilizing Gold Flows

Here the exporting country is in the position of the USA, with exports exceeding imports. The importing country represents the countries in deficit to the USA, with the trade deficit represented as a smaller arrow. Since trade barriers stand in the way of their exports, they have to cover the deficit with gold payments. These gold payments go to US banks; but from there they are detoured to the Federal Reserve Banks. In return, the banks get liquidity, which they provide to the financial market. So this excess liquidity finds its way into the financial market, driving up prices and yields there, while leaving the real economy relatively untouched, and the imbalance in the balance of trade unalleviated.

As we all know, this led to a stock-market bubble which eventually burst, mainly under the influence of Federal Reserve rate hikes, which, noticing the bubble forming on the stock market, tightened money market conditions dramatically. The tightened conditions eventually worked their way through to the stock market, precipitating the collapse. Since a good deal of the money inflows into the financial market were based on debt – debt which proved unrecoverable because of the collapse in equity prices – the collapse on the financial market redounded onto the ordinary market, both at households and businesses. The result was a massive round of debt deflation[4] and the final collapse of the gold standard, as country after country abandoned it.

[1] Matthias Morys, Monetary Policy under the Classical Gold Standard (1870s-1914), CHERRY Discussion Paper 2010/01 (Centre for Historical Economics at the University of York). Accessed at

[2] Rogers, America Weighs Her Gold (New Haven: Yale University Press, 1931), p. 96-98.

[3] Rogers, America Weighs Her Gold, pp. 98-100.

[4] Irving Fisher, “The Debt-Deflation Theory of Great Depressions,” Econometrica: Journal of the Econometric Society, vol. 1, no. 4 (October 1933), pp 337-357. Available at