The danger of deflation was augmented by the centralization of gold reserves in the previous half century. In 1914, most of the world’s monetary gold was stored at a small number of central banks. By 1922, “the world market in gold was practically coterminous with the monetary demand of one great country” as nearly half of the world’s monetary gold resided at the Federal Reserve (Hawtrey 1947, 97). Consolidation made prices even more sensitive to changes in the demand and supply of gold. When coordination of independent central banks from the Bank of England ceased, the price of gold became unhinged, swinging wildly between 1914 and 1920 and again between 1929 and 1932.
This problem was inherent in the system. It was not a defect of the gold standard per se. It was a defect of management under a system of fixed exchange rates. Deflation must follow an unbacked expansion of the money stock by the central bank if larger players like the Bank of England and the Federal Reserve refuse to keep reserve ratios suppressed. Under a system of floating exchange rates, on the other hand, the economy probably would have adjusted to a higher price level and “the subsequent collapse would almost surely not have occurred (Friedman 1961, 68).” Of course, depression also could have been avoided by a return to the gold standard at devalued parities, but such an option was politically unpalatable. In light of political constraints, the economic instability associated with the latter decades of the gold standard was not a glitch, but rather the logical end of an international, monometallic legal tender regime.