Liberty, Prudence, Imperfection, and Law

“A Golden Trilemma,” By Gerald P. O’Driscoll Jr.

Professor Irwin accomplishes a great deal in this short book. He reexamines the dreadful episode of the Great Depression, 1929–33, indeed the entire decade of the 1930s. His particular focus is on the collapse of global trade, and he offers an alternative explanation for that collapse from the standard one. He enlarges our understanding of trade and trade policy in that era. His contribution is the more notable because he unites two fields that are typically kept separate: international trade and international finance.

His analysis relies on a trilemma articulated by Milton Friedman: “fixed exchange rates, stable internal prices, unrestricted multilateral trade; of this trio, any pair is attainable; all three are not simultaneously attainable”(35). Irwin analyzes the policies taken in the 1930s by the governments of countries caught up in the maelstrom of the Great Depression. Different countries resolved the trilemma by giving up one of these three policies, and they did so at different times.

Irwin starts with an outline of the classical gold standard, which evolved over the course of the nineteenth century and lasted until 1914. National currencies were defined as a quantity of gold. As a consequence, the exchange rate between any two currencies was fixed. The fixity of exchange rates was not a separate policy, but the consequence of each currency being so much gold. Irwin describes the classical gold standard as “a stable international monetary system that had many advantages” (3).

Strengths can also be weaknesses. The gold standard linked countries and shocks in one country were often transmitted to others. The transmission was through movements in gold reserves (or through the exchange of financial claims on reserves). Countries losing reserves were forced to contract their money supplies, which put downward pressure on prices. Countries experiencing inflows of reserves would see their domestic money supplies increase, which resulted in price increases. The adjustment in the terms of trade between countries eventually brought about an equilibrium among countries. The adjustment was automatic, or as automatic as any institution can be with the involvement of human beings.

The mechanism was first articulated by David Hume, and termed the price-specie flow mechanism. Irwin observes that it functioned well “in part because wages and prices were flexible”(5). I would suggest that wages and prices were flexible in part because there was a gold standard.

World War I brought an end to the classical gold standard, and to classical liberal institutions generally. Many countries returned to something called the gold standard after the war ended. But it deviated from the prewar or classical gold standard in important respects. Some countries adopted parities that overvalued their currencies with respect to gold, like the United Kingdom, which made them chronically short of gold reserves and created chronic deflationary pressures. The British economy stagnated throughout the 1920s with high and prolonged unemployment. That was the background to much of Keynes’s writings.

Other countries effectively undervalued their currencies, such as the United States and France. They sterilized or offset gold inflows and did not allow their domestic money supply to expand as gold inflows occurred. As Irwin observes, “in the interwar period, the price-specie flow mechanism was not allowed to work” (7). Central banks were conducting semi-independent monetary policy, which is inconsistent with the classical gold standard.[1]

All this is important because Irwin sometimes trips himself up by using one term—the gold standard—for two different monetary orders. “…The gold standard as a fixed exchange rate regime promoted the growth of world trade prior to World War I. Yet when it encountered problems in the early 1930s, the gold standard bred protectionism that inflicted great damage on world trade” (33–34). There is no conundrum to solve here. The problem is that the “it” in the quotation refers to different systems that operated differently. The prewar system did promote trade as many have noted.[2] The postwar system, as detailed by Irwin, had problems almost from the outset. It is no wonder that protectionist sentiment arose in Britain given the depressing effects of the overvalued pound sterling.

Having clarified the gold question, I proceed to Irwin’s thesis. In what follows, unless otherwise noted, references to the gold standard are to “the newly reconstructed gold standard” (6) of the postwar period.

Many believe that the Smoot-Hawley tariff, passed by Congress and signed into law by President Hoover in 1930, set off a global trade war, which deepened and prolonged the Great Depression. Irwin refutes that thesis. First, he notes that Smoot-Hawley was conceived in 1928 when the US economy was strong, and was not a response to the Depression. Second, the “tariff was a large but not a massive shock to US imports, and to world trade more generally” (15). Its passage caused problems with our trading partners and some retaliation. It did not set off a global trade war, which came later and for different reasons.

I find Irwin’s argument on Smoot-Hawley to be compelling. Those who believe Smoot-Hawley caused or worsened the Depression now have a higher bar to pass to make their case convincing. Smoot-Hawley was bad trade policy, but it did not trigger the Depression.

Things fell apart in 1931 beginning with the May failure of Credit Anstalt, Austria’s largest bank. That set off a financial panic that spread to other countries and eventually to the world. “The world trading system was brought down along with it” (20). So, it was a shock in the international financial system that spread to the international trading system. Much of the rest of the book details that spread.

By the end of 1931, countries had basically aligned into three groups in terms of their response to the financial crisis: the exchange control group (which ended gold convertibility); the sterling bloc (which ended the gold parity); and the gold bloc (which stayed on the gold standard). Prior to the 1931 crisis, governments were reluctant to devalue or abandon gold because of fear of inflation. The fear was rational given the hyperinflation episodes of the 1920s. The worse the inflation experience of the 1920s, the more reluctant was a government and its citizens to devalue or move off gold. After the financial crisis, however, all faced tough decisions. Those most committed to gold found themselves implementing trade restrictions. Recall the trilemma; it was not possible to do all three of the following: adhere to the gold standard at parity, stabilize prices, and have an open trading system. To adhere to the first two policies necessitated abandoning the third.

Irwin provides evidence that the wave of protectionist measures originated not in special interest lobbying but in response to the financial crisis. By 1931, the Depression had gone on for two years. Trade collapsed faster than income, and import penetration declined. For domestic producers, foreign competition was a declining problem.

Protectionist measures took a variety of forms: tariffs, quotas, exchange controls, etc. All were aimed at conserving gold reserves. The degree of trade distortion varied by policy, and Irwin provides analysis and data on that issue. Exchange controls were particularly damaging. They gave government the power to control exactly how much could be spent on imports.

Germany and the exchange control bloc were quickly decoupled from the global trading and financial systems. They resorted to expedients such as barter. Trade and economic growth suffered. But even they began to recover in 1933.

The United Kingdom and the sterling bloc benefited from devaluation and began their recovery in 1932. The recovery in gold bloc countries of France, Belgium, the Netherlands, Switzerland, and Poland did not begin until 1936. The recovery in the United States occurred after abandoning gold in 1933.

As far as it goes, Irwin’s account provides a compelling confirmation of the trilemma. It also appears to confirm the account of antigold historians like Barry Eichengreen and Peter Temin. But let us remind ourselves that they are analyzing a flawed variant of the classical gold standard.

The Federal Reserve, created at the end of 1913, had a dual mandate to passively respond to gold movements and to offers of real bills. That dual mandate was a fatal flaw. In Allan Meltzer’s words, “no one discussed what the System should do if the two signals gave conflicting commands, as in 1930 when gold flowed in and real bills declined. The Federal Reserve had abandoned strict adherence to the gold standard in World War I and in the 1920s. It followed the real bills guide. Policy was deflationary in 1930 when adherence to the gold standard rules called for expansion.”[3] It was not adherence to the gold standard that caused the Fed to contract rather than to expand in the first year of the Depression. It was the failure to follow the classical gold standard policy of passively responding to gold inflows by allowing the money supply to increase.

Irwin advances our understanding of the Great Depression by looking beyond monetary policy to trade policy. But monetary policy and trade policy do not exhaust the list of public policies affecting economic growth. Consider the record of the Hoover administration, which included the following statutes and policy actions:

  • Utilized the Federal Farm Board to make loans and provide subsidies in a failed attempt to prop up farm prices.
  • In September 1930 he issued an Executive Order greatly restricting immigration.
  • In the fall of 1930, Hoover convened a White House conference with top businessmen persuading them not to cut wages. With prices falling, that was equivalent to increasing real wage rates. Unemployment jumped.
  • He signed the Davis-Bacon Act of 1931 with its requirement for wages in federal contracts to be paid at the “prevailing” (above-market) level.
  • In 1932, he signed the Norris-LaGuardia Act that also favored unions.
  • He asked for and Congress passed the Revenue Act of 1932, which substantially increased individual income tax rates with a special surcharge on high incomes. It also raised corporate tax rates and placed other new taxes on income and wealth.

And, then there was the Smoot-Hawley tariff, which he signed into law in 1930.[4] All of these measures to one degree or another were contractionary in their effects. Leaving this potpourri of ill-advised policies out of the picture means that too much economic damage is being attributed to the monetary system. This point is in addition to all the caveats about the exact nature of that system.

So what is the overall assessment of Trade Policy Disaster? It is a significant contribution to our understanding of the Great Depression and particularly of the collapse in global trade. Irwin’s analysis of the interaction between trade and finance is impressive. My critical comments are on positions for which he has support among other historians. I disagree with their analysis of events and have provided support for mine. For students of the Great Depression and of economic fluctuations generally, the book is a must read.


Gerald O’Driscoll is a senior fellow at the Cato Institute and a widely quoted expert on banking and monetary policy. With Mario J. Rizzo, he coauthored The Economics of Time and Ignorance (1996). This essay was originally published in June 2013 at Liberty Fund’s Library of Law and Liberty, and it is republished here with gracious permission from that web-magazine.



[1] Allan H. Meltzer’s A History of the Federal Reserve, vol. 1: 1913–1951 (University of Chicago Press, 2003) chronicles in great detail how Federal Reserve policy deviated from that required by the classical gold standard.

[2] Money, Markets, and Sovereignty (Yale University Press, 2009) by Benn Steil and Manuel Hinds explicates the connection between gold and trade very effectively. Their book should be read in conjunction with Irwin’s to get a balanced picture of the classical gold standard.

[3] Meltzer, History, 401–2.

[4] “Herbert Hoover: Father of the New Deal,” Briefing Paper 122 (Cato Institute, 2011) by Steven Horwitz is the source for Hoover’s policies. See also Lee Ohanian, “What—or Who—Started the Great Depression?” Journal of Economic Theory 144 (2009): 2310–35; and Murray N. Rothbard, America’s Great Depression, 5th ed. (Auburn, AL: Mises Institute, 2000).

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