This section tries to provide evidences for the claim that the mismanagement of the Interwar Gold Standard and the constraints on central bank policies imposedby it were the responsible for the deflation of the late 1920s and early 1930s.
1. Asymmetric response to gold flows between surplus and deficit countries
The monetary policies dictated bythe interwar gold standard’s “rule of the game” are appointed as the factor that made international deflation almost inevitable. Under the gold standard’s “rule of the game” central banks of countriesexperiencing gold inflows (surplus countries) were supposed to expand money supply and inflate, while countries facing gold outflows (deficit countries) should contract money supply and deflate.Nevertheless, the deficit countries being constraint by losses of gold reserves complied with this rule and deflate in order to maintain fixed parities, while by contrast the surplus countries having noincentive to adjust their money supply and price levels upward continued accumulating gold reserves.
These gold imbalances were magnified by fractional reserves requirement imposed on many centralbanks, which returned to the gold standard, after the First World War. As the monetary based was no longer required to be fully backed by gold (cover ratio was typically less than one) the deflationresulting from gold outflows in a country was not being balanced by inflation elsewhere. Indeed, the USA had a cover ratio equal to 40% and the USA wasn’t expanding its money supply even though thecountry was experiencing gold inflows as result the USA was imposing a monetary contraction in the country from which gold was flowing out of 2,5 times larger than the gold loss, therefore the USA wasimposing deflation in the country experiencing the gold outflow that was not being balance by inflation in the USA.
2. The pyramid of reserves
The interwar gold standard was a monetary regime...