Sebastian Edwards on FDR, Gold, and the Great Depression

FDR’s presidency, which stretched throughout the majority of the Great Depression, had major implications for monetary policy.

Sebastian Edwards is a professor of economics at UCLA, and is a former chief economist for the World Bank. He joins the Macro Musings podcast to talk about his new book ‘American Default: The Untold Story of FDR, the Supreme Court, and A Battle over Gold.’

Read the full episode transcript:

Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected].

David Beckworth: Sebastian welcome to the show.

Sebastian Edwards: Oh, thank you David. It's a pleasure to be here.

Beckworth: Well it's great to have you on. You are a very accomplished academic. Written a lot about monetary policy, emerging markets, bounce the payment issues and you've written a very interesting book about the Great Depression and what happened to Gold Clause contracts during that time. And I'm curious what got you into it?

Edwards: Well as you mentioned David I've spent most of my career working on macro issues related to the emerging market. And in the year 2002 I was approached by a law firm in New York and the lawyers have looked at my vita and have read some of my work on balance of payment crises and the default of sovereign debt. And they asked me if I could do some work for them and write an expert's report of the origin time default of 2002. And so we agreed that I would do that. And so they handed me a big document that the Republic of Argentina it was it's a brief to the tribunal and they told me to read a particular section. And they said, "Don't read the rest."

Edwards: They're paying by the hour so they want you to focus. But I read it nonetheless. And I run into a paragraph where Argentina said more or less following. "Yes, it is true that we retro actively have changed contracts. Contracts that were written in US dollars. We have now made them into pesos and we devalued the peso. It's true we did that. But there is a legal historical precedent." Argentina said, "And that is coming from the United States in 1933 the Roosevelt administration did the same except that the contracts were in gold and then devalued the dollar." And Argentina added, "And the Supreme Court of the United States said it was okay. So if it was okay for the US in 1933, '35 it certainly is okay for us to do this because we face similar crisis situation."

Edwards: And I said, "Wow. How come I didn't know about this?" And I started asking around to my colleagues that do macro and almost no one knew anything. The economic historians did but almost no one else. And I started researching this and talking to a number of people including Milton Friedman. And I said, "Well I think that there is something to be done here. We have to retell this story because we have gone through a period of collective amnesia where we don't want to recognize that there was a time in the past not so long ago when we acted... We the United States acted like a banana republic." And that's how I got into the book.

Beckworth: Yes, very interesting. I love the term you use collective amnesia. So we have forgotten this experience. And you mentioned in the book there's not been a lot written about it. There's been some economic historians who've looked at it. There's been a few technical studies have looked at it but not a thorough history like you do in your book. Is that right?

Edwards: That is right. And that is quite surprising since in the '30s after the Supreme Court ruling in February of '35. It was considered those are there are two rulings. They were considered to be some of the most important rulings by the court. And law schools used to teach the abrogation of the Gold Clauses in their contract law courses and constitutional law. But slowly it has been moved out of the curriculum. So when I talked to lawyers sort of older members of the profession know about it vaguely because they covered it in their course. But younger lawyers do not know much about it. So I mean as I said I talked to Milton we were colleagues in the Governor Arnold Schwarzenegger's Council for economic advisors here in California just before Milton died.

Edwards: I talked to Anna Schwartz. And she was very generous and gave me copies of some notes that she had made on this particular issue. I talked to Alan Meltzer who knew a lot about it but there's very little on the case in his monumental history of the Federal Reserve. So it was surprising to me that there was an important aspect of the Great Depression that was already there on the table for someone to write a book on it and a topic that had not been covered before.

Beckworth: Yeah, this should give all our graduate students hope that there's plenty to be researched yet.

Edwards: That's true.

Beckworth: Lots of fertile fields out there for the undertaking. What's also fascinating about this experience as you get into book you the reader finds out is that this was a big deal when it happened. I mean the chapter where you go over the courts final decision, the announcement it was like a big event. It was like a carnival people were waiting because this was a huge, huge deal for the country. People were closely following. So it is a bit surprising now we've forgotten about it. This collective amnesia that you mentioned. In fact the only mentioned I recall seeing about this event was a work by Randy Krasner and that is it. But otherwise this book is the first treatment I've seen.

Edwards: Yeah. Randy wrote a very nice piece which he also related to Argentina. And what he did is he looked at what happened to the stock market the day after the ruling of the Supreme Court which was February at 18th of 1935. And so he found out that the stock markets went up the day after. And then he was careful in his conclusion to say the fact that that happened in the US and '35 doesn't mean that retro actively and unilaterally changing contracts, dead contracts is beneficial for every country. And then he sort of hedges his position regarding Argentina.

Beckworth: Okay. Interesting. Yep. A great paper and this book really broadened my understanding. So I highly encourage our listeners to go out and get their copy. So let's jump into it in more detail and work our way through the history and you do a great job outlining the history, the personalities really these people really make the story. And you start near the beginning of the election around the election and inauguration time and you first bring up this Brain Trust. So tell us about the Brain Trust that helped FDR guide his policy and shape his thinking.

Edwards: Right. So FDR was governor of New York. And many people including some of the most influential journalists of the time people like Walter Lippmann thought that he was a lightweight. He came from a very prominent family. His cousin Ted had been President and FDR wanted to be President but people had their doubts both within the Democratic Party and whether he was going to be able to beat President Hoover in spite of the depression. So what FDR does in early '32 is he assembles a group of academic advisors and this is the first time a candidate gets academic advisors to work with him through the election. And this group is known the name is given to them by a reporter from the New York Times as the Brains Trust. Brains with an S at the end. Not Brain but Brains. There is a big discussion on this issue whether it's Brain or Brains.

Beckworth: Interesting.

Edwards: So there are three senior members all of them professors at Columbia. Raymond Moley is the chief advisor. He's a political scientist that teaches Criminal Law at Columbia Law. There's Adolf Berle sort of a law genius. He was a young lawyer and had to work with by then Justice Louis Brandeis and had been a Republican up early. And the third member is the only economist Professor at Columbia called Rexford Tugwell. He's a professor at Columbia. He's in charge of the first year freshman course in Economics. It's a year long course but he's not allowed to teach graduate students. So he's a full professor but sort of not at the top echelon of the Economics Department at Columbia.

Edwards: And they start advising FDR and putting together a program and one of the points that I make in the book is that none of them knows anything about gold or money or a monetary policy or currencies. And I document that by letters, memoranda, memoirs and so on and so forth. So the first point to make is that of course as we know one of the early decisions that FDR makes is to get... Take the US off the gold standard but this was not a pre conceived planned move. It's sort of evolved and they found themselves in a position where they had to do it. And the brain... Neither the Brains Trust nor FDR himself were committed before the election to taking the US off the standard. In fact they were accused by Hoover planning to do that and Roosevelt sort of promised not to do it but then he did.

Beckworth: Yes, very interesting Columbia's influence on FDR. I didn't appreciate it. But the Columbia University at large influence. And then as you mentioned and as these individuals themselves acknowledged they weren't monetary economists but yet they kind of went along. As you mentioned FDR is a great experimenter and they were too. They had open minds was trying something new. And it was also fascinating to read that as you just mentioned the gold standard itself was not an issue up until late 1932. Right? So he's going to become President early 1933 FDR and no one's talking about undoing the gold standard, reflecting the economy through it. And it's Hoover... If I understand your interpretation correctly. It's Hoover who actually puts this conversation on the table. Hoover begins to accuse FDR of doing it. And through that conversation it actually kind of makes this a topic.

Edwards: Yes and no. Mostly yes to what you are saying. So this is what happens there is a group throughout of academics mostly led by Irving Fisher the famous Yale professor. Who... And this group believes that we should get out of the gold standard. Every country should get out of the gold standard. Fisher writes about an alternative monetary regime which he calls the Compensated Dollar where instead of the dollar being pegged to gold it's pegged to a basket of commodities. He made that proposal for the first time in 1911 and then sort of in a very Irving Fisher obsessive way keeps writing about this a famous article or famous of that time in the QJ in the Quarterly Journal of Economics called the Compensated Dollar. So there is this group of academics that thinks that they should... The US should get out. And there is a group of industrialists that think that the US should get out of the gold standard and they form a lobbying group called the Committee on the Nation.

Edwards: Now there is also a group of people mostly from the rural states that want us to go back to bimetallism and re-monetized silver in order to make credit more of amply available. So there are groups that want us to get off but the mainstream view including people like Jacob Bina at the time at Chicago and Sean Petter and so on. They all believe that he yes the gold standard has problems but it's the best that we have and we should not get out of it. And indeed it is Hoover when he decides to step up the campaign who accuses FDR of wanting to get off the gold standard. And there is a fascinating entry in Adolf Berle one of the Brains Trust the senior members in his diary is trying to say, "Well how do we respond to Hoover? How do we convince the people that this is not what we're going to do?" And I quote from that entry in my book.

Beckworth: Yes, it was interesting to see FDR say we're not going to do this but then a few months later that's the direction he goes in moving toward getting off the gold standard. And another interesting observation you bring in your book is an assassination attempt on FDR in early 1933 which I wasn't aware of either. An unemployed worker...

Edwards: A bricklayer.

Beckworth: Bricklayer, yes.

Edwards: Italian immigrant. Right. Yeah. So it's interesting to... So 1933 is the last time the President is inaugurated in March rather than in after that year as we know it's January 20. So there's a long period between the election which is in November and inauguration and it's known at the time as the Interregnum. And so FDR goes on vacation sailing with one of his friends and he comes back in Miami. And so you read the newspaper stories at the time and they say he's going to sort of slowly there's going to be a slow motorcade from the pier to the train station and he's going to say hi to and salute all the people that are in Miami.

Edwards: But the main concern there is that it is now February 14th and there's still no cabinet announced. And more than that there's no sense of what he's ready to do economically while the country's about to collapse. And then this guy this Italian bricklayer, unemployed bricklayer shoots at him. A woman who is standing by him at the last minute sort of pushes his arm and the bullets then hit Mayor Cermak from Chicago who dies a few days later. So...

Beckworth: That's an amazing story.

Edwards: It's amazing sort of because it also distracts FDR according to multiple at the time and he then delays taking and appointing a Secretary of the Treasury. And that makes the banking crisis even worse.

Beckworth: Yeah, were not for that one lady could be a very different history in the US in 1930. So that is an amazing story that that woman just happened to be there and happened to cause the assassination to fail. As you mentioned we go all the way up to inauguration and Hoover as you tell in the book tries to get the President Elect FDR to do something about banking but it's not until he actually comes into office. And the first order of business for him is to fix the bank. So talk about FDR's attempts to fix the banks.

Edwards: Right. So banks are failing... But we had 30,000 banks or more or less at the time. Many of them are very small banks that are serving only a particular town. The way I visualize that is old western movies where every town had a bank. That bank was have one branch operation very small. And they were failing right and left. And many, many states about 30 or so had decreed by early... Late February, early March banking holidays. And on February 15 the day after the assassination attempt a bank in Detroit owned by Henry Ford goes down. And this creates a generalized panic. And Herbert Hoover then wants to decree or declare a national banking holiday in order to put things in order. And he asks FDR to... Who is an incoming president to agree on doing this and FDR says, "No."

Edwards: So he's inaugurated and the banking crisis is getting worse. And that night... So he's inaugurated on Saturday on Sunday they discuss what's going on. And on the Sunday night or early morning like after midnight on Monday, March 6 they decide to declare a National Banking Holiday. And what is interesting is that because the debate was what kind of legal authority did the Federal Government have to declare a National Holiday? And they use the authority given to the Federal Government by a 1917 act called the Trading With The Enemy Act. But we're not at war we don't have enemies declared enemies. And yet we use the authority given to the government by that act to close all the banks which are closed for one week. All of that week and then the Emergency Banking Act these passed on Thursday. In the house there was only one copy of the Act and only the speaker has it but he hasn't read it either. And it's passed by a very, very wide majority without anyone having read the act.

Beckworth: Okay. Very interesting. Now I want to quickly go back to Hoover. You mentioned how Hoover was rebuffed by the President. The President wouldn't respond to his requests to help with banks until the President actually took office. And I want to ask you there's a cynical take you could look at that with or there's a more benign view. The cynical take is FDR wanted to wait till he got an office increase the blame on Hoover let him be president or things got worse. The more benign view which we outline in your book is FDR was still shaping his cabinet. He himself wasn't sure what to do. So where do you stand on that? What was the motivation for waiting until he actually got into office?

Edwards: Yeah. Well I think that as with most things including SAT questions it's all of the above. It's both. So FDR and in particular FDR's wife really disliked Hoover. And Hoover had humiliated Roosevelt. They didn't like each other and they said nasty things about each other in public and the press picked that up. So the story goes that in the Governor's Bowl in '32 Hoover deliberately entered the White House dining room where the governors were waiting about 40 minutes late in order to have FDR stand for 40 minutes. And it was really painful because of his handicap.

Edwards: So Eleanor Roosevelt really hated Hoover. And this is what you get from reading the memoirs and the archives all the time. So yeah. So FDR wanted indeed to put as much blame as possible on Hoover. At the same time he didn't really know what to do. And as we were saying earlier he closes all the banks for one week. Then they put together the Emergency Banking Act which allows the government to... He closed forever some banks and then recapitalize other banks. But that act is basically identical to the draft that had been prepared by the Hoover people. Okay? And yet FDR takes all the credit. I mean it is true that his first fire chat talk on Sunday the 13th, March 13 he really contributed to changing expectations and then people came back and re-deposited their money in the banks but they really disliked each other. And Hoover I think that he was a much better President than it's known or than most people think about. I mean he... I don't know. We're talking about it like Hoover.

Beckworth: Right. Yeah. And unfortunately he has this legacy now. He will always be known as a President who didn't do enough.

Edwards: Right. I think that the do nothing President-

Beckworth: Do nothing President.

Edwards: Is really, very unfair to him.

Beckworth: Right. Right. Well let's move on to the next phase which is really the key part of your book. And this is all the attempts that the President applied to the gold standard different... A number of steps were taken. On April 5th an executive order was issued that everyone must sell their gold holdings to the Fed at $20 and 67 cents an ounce which was the official price at the time. And there are some other things after that... Let's talk about that that first executive order there. What was the motivation for that?

Edwards: Yeah, so the banks are closed as we said on March 6 National Holiday. And the reason why they're closed is that there's a bank panic and people are taking out cash and gold and stashing both under their mattresses. So the banks are closed. They have this plan where they sort of label every bank either as A, B or C. A are sound and can open right away. B banks are sound but illiquid or need some infusion of equity but they can be salvaged at the end and C banks are going to be closed forever. And they do that the President gives his first fireside chat and those people, "Listen now we've solved the problem bring your money back." And people do that. But they don't bring back enough gold. And everyone is very worried about the cover ratio and the free gold issue. So the Fed should have extra gold in order to back the money supply.

Edwards: So then his advisors tell him, "Well one way to do this is to use the authority that you got in the Emergency Act." Which is that you can embargo and force people to sell the goal to you and that's what happens to you not to the Federal Reserve. And that's what happens on April 5th when the executive order was passed in order and forced people to sell all their gold at the official prize $20 and 67 cents an ounce which had been in effect since 1834.

Beckworth: Okay. Now at this point then does the gold standard end for the average person?

Edwards: Well it's ambiguous. We in the internet international markets almost nothing happens to the price of the dollar. The Franchers are squarely on the gold standard. The Brits are off but so we can look at the currency rate and see what's going on. And the Secretary of the Treasury says, "The gold standard still on except that you guys cannot hold any gold but it's on." Okay. Which is a strange situation. And the President officially announces that we're off gold on April 19. So that is two weeks after the executive order that mandated people to sell the gold to the Federal Reserve. And the announcement that we're getting off gold has to do with a political pressure that comes from the rural members of Congress. Well in particular two senators and the most prominent one is Senator Elmer Thomas who really pressures the President to do something about commodity prices and that's when on April 19 then FDR says, "We're off the gold standard." But still we haven't devalued the dollar. The dollar continues to have the official price of $20 and 67 cents all the way to late January of '34.

Beckworth: Yep, it's interesting the initial push against gold was for the banks the May... I'm sorry, the April 5th executive orders you mentioned. And then the secondary push is from these senators from rural areas you mentioned Senator Elmer Thomas. Talk about...

Edwards: There are two main senators. And an interesting side here is that the other senator is Burton Wheeler whom as I say in the book 40, 50, 70 years later, 80 years later he's really known for being a fictional character in Philip Roth's novel The Plot Against America. And in that novel Charles Lindbergh is elected President instead of FDR in the second re-election and Burton Wheeler is the Vice president, fictional Vice president. He was an isolationist and is firm believer of the rural sector and he said the spirit of America really comes from the prairies and from the countryside and he wanted to re-monetize silver in order to increase credit to farmers.

Beckworth: Yeah. So where would you trace FDR's his desire to reflate the economy? Was it more to fix the banks? Or was it this political pressure from Congress? Or was it his own evolving understanding of how the economy worked?

Edwards: Well I think that there are three issues. He did understand that the deflation had greatly inflated the real value of debt. And that was a point that Irving Fisher made and FDR understood that and if you read his speeches, his... The memoranda that were exchanged. And his papers you realize that he did that. He was also elected thanks to the rural vote. That was very important. And I think thirdly there is a personal psychological issue. He thought of himself as a gentleman farmer. And he had of course the Russo family farm in upstate New York. It lost money all the time but they produced eggs and Christmas trees and had an apple or apples they had orchards. And also he had his property in Georgia in Warm Springs where he became a close friend of many of the Georgia farmers and thus he was very interested in getting the price of cotton up.

Edwards: So a combination of these factors and so if you read what he's saying in the press conferences and different sort of media's his main concern is about commodity prices. And he says that when he announces that we're off the gold standard he says that many, many times our purpose is to bring commodity prices up to a level where our farmers can have a decent standard of living.

Beckworth: Yeah, that's very interesting. There's been some discussion about him wanting to return the price level. Preparing for the show I went back and read some of the talks, some of the fireside chats. And in one place he uses the term the price level maybe he meant commodity prices but he talks about returning to where it was before the crisis starts. And there's been a lot of work by people like Guddi Ergot son he had this famous AER article with great expectations the end of the depression where you get this impression that maybe FDR was the original price level targeter. Right? A lot of discussion about price level targeting. Do you think he had in his mind kind of a rough understanding or thinking that was consistent with the price level target?

Edwards: I don't think so. At the time Sweden had a price level targeting program as a way of getting out of the depression. And there was a congressman from Maryland in 1932. I... His name is escaping me at this point. But he is a supporter of Irving Fisher's view on the dollar. And he wants to get some kind of price level targeting. But I don't think that FDR was on board at that level of sophistication.

Beckworth: Well he did talk about the returning prices to where they were before though. Didn't he mention that?

Edwards: Yes. He did. He did. And there was a big discussion in newspapers about what did he mean by that before? What did before mean? Commodity prices peak at the end of World War One in 1919. But sort of people conclude that what he really has in mind is 1926. And so people start as the days progress during '33 people say, "Well, this is where he wants to go." And then they start speculating what would be the required new level of the price of gold that would satisfy or would be consistent with getting the prices back to 1926.

Beckworth: Yeah. So he may not have been an explicit price level targeter. But it sounds like he's groping in the dark in a room called price level targeting. He had some glimpses at some insights that would be consistent with it. The term you use in your book is controlled inflation or the term that they use. They wanted to have controlled inflation as opposed to run away or something worse. So it has I guess it sounds...

Edwards: No. There is certainly a component to that. And there's also a discussion that it's never put clearly in the terms economists would but it's about relative prices. And FDR in several occasions says, "It is true that the inputs that farmers use have decline in prices but the prices of the products, of the commodity of hogs and eggs and wheat and corn and barley have declined by more than price of tractors and fertilizer." So there's a discussion about relative prices. There's a discussion about the price level and there is a discussion about inflation. No one really wants inflation in the sense of going being like Argentina like 25% a year. No one wants that.

Beckworth: Right. And they just want to return to where it was before the controlled inflation. And that gets us back to our conversation about all these steps that were made. So there was first the executive order again in April 5 that everyone had to give up their gold to the Fed sell to the Fed. There was the other executive order on April 20 that you mentioned that the US no longer export gold effectively took the US off the gold standard. And in between that there was this Thomas amendment. You mentioned already Senator Elmer Thomas from Oklahoma. Tell us about that amendment. What did it empower President FDR to do?

Edwards: Yeah. So Thomas was from Oklahoma and he was one of the leaders of the... What was known at the time as Inflation is Bloc. And as I said Burton Wheeler was another member. And they wanted to... So they were discussing the Agriculture Adjustment Act, the AAA. And they would not... These are all from the Democratic Party and they would not... These senators. They would not pass that act unless there was a devaluation. And they wanted to have an amendment that would force the President either to devalue the dollar or to monetize silver but force the President. And FDR of course is like that. And so there's a negotiation and they come to the conclusion that the Act will give the President options. And it would mandate the President to try to get the price level up. And then it gives it option.

Edwards: One option is to issue Treasury greenbacks as during their civil war. Another one is to monetize silver. And a third one is to devalue of the dollar relative to gold for up to 50%. And when the amendment is passed then Walter Lippmann for instance writes a column in the Herald-Tribune and says, "Inflation has been legislated." And but nothing happens, right? So now FDR who like to experiment has these three options in front of him but nothing happens for a while. And then so now we are in May. And so we're off the gold standard and now he has the authority to do these things. Remember that the constitution and we'll get to that says that Congress has the power to mint currency and determine the value they're all. So Congress in this act sort of delegates this power to the presser in the Thomas amend.

Beckworth: Okay. Now the Thomas amendment was that used to justify the eventual devaluation of the dollar in January 1934?

Edwards: No, they passed an additional. They passed the Gold Act of '34 which is passed on January 30th. And then the dollar is devalued from 20.67 to 35 which is the value of the dollar that as a college student I grew up with and sort of grew up with. So that was the value until the end of Bretton Woods $35 per ounce. So that was set on January 31st 1934.

Beckworth: All right. So that was authorized by this Gold Act of 1933 or 1934.

Edwards: '34.

Beckworth: '34. Yes. So the Thomas amendment was much more just a way too plicate to hear out the congressional pressure for controlled inflation like here's a film a bone make them happy even though FDR really didn't use it very much.

Edwards: Yeah, it confirmed now beyond an executive order that we are all the gold standard. Okay? But they still don't do anything and here is where the Gold Clauses come into play where sort of FDR is really happy now he can do whatever he wants. And he can sort of follow the bricks and devalue the dollar with respect to gold. And then someone told me, "Wait a minute, Mr. President if you do that every Railway Company, every utility, most mortgage debtors in this country will go bankrupt because all contracts are written in terms of gold and if you increase the value of gold or devalue the dollar relative to gold by 50% their debts are going to go up equity proportionally because that's what the loss and also every single government security is in expressed gold terms." And then he says, "Wow. Well let's use our congressional majority and let's get rid of these clauses." And that's what they do on June 5th.

Beckworth: Okay. And that was very fascinating story there too. So you have all these developments and I'm wondering based on your reading of the literature, the history, the archives which development was most shocking to the public? So you have the April 5 move where you give up gold if you're the public to the Fed. April 20 no more gold exports takes the US slightly off the standard. Or June 5th when Congress passes the resolution that all Gold Clauses past and future are going to be nullified. Was there one more than the other that was traumatic to the public? Or?

Edwards: Well there is. So let me give you a two part answer. There is sort of there are conflicting views that even one specific person had. The Depression was really bad. It was barely turning around or not turning around at all. And they liked the fact that FDR was doing things. And he was the pretty good communicator. He was able to convince them that the Brits were turning the corner. They were beginning to recover and that getting off the gold standard was a good thing to do. So people were appalled by the fact that they had to sell their gold coins that they had received as christening gift or mitzvah gift and they were, "This is very un-American. I mean how come we cannot hold gold coins among our savings?" And they were appalled by that and... But at the same time they had hope.

Edwards: Now let me give you the second part of the answer which takes us back to 1932. So here we have in the midst of the depression and finally FDR wins the domination. He beats Al Smith the former governor of New York and his really political mentor. And so FDR is the first President that gives a speech at the Convention after being nominated. In that time the candidates stayed away in their home state. And so he flies to Chicago to give a speech. And the delegates as he is standing there ready to give his speech are chanting and what they chant is, "We want beer. We want a beer." So the main issue here in the middle of this debacle and this tragedy gold and so on is that people really wanted prohibition to come to an end. To a real end. And so the mood of the nation is we want prohibition to come to an end. And at the same time all these things are happening. Right. So which I think it's a nice sort of anecdote.

Beckworth: Okay. Well let's jump into the Supreme Court because clearly there's going to be resistance from creditors to losing the Gold Clauses and their contracts with their debtors. So tell us about the Supreme Court. What does it do? How does it do it?

Edwards: Okay. So the court at the time was divided very much like now. The Chief Justice was a very prominent highly respected Republican, progressive Republican Charles Evans Hughes. He had been Governor of New York, Secretary of State and Republican candidate to the presidency and he almost beat Woodrow Wilson in 1916. It's one of the closest in terms of electoral vote closest presidential elections ever. And there are four... So he's the Chief Justice, progressive Republican so sort of a centrist. Four progressive Democrats including some giants of the law Louis Brandeis and Benjamin Cardozo and they are four conservatives. So the court is divide.

Edwards: And what happens is that during '34 after the official devaluation of the dollar and number lawsuits are brought in. Some have to do with private debt and these are people that own private bonds that were written in terms of gold and they want to be paid at the new price of gold. And some of them have to do with government debt. And it's a lot of confusion. So the government asked the Supreme Court to consolidate a number of cases and to rule as soon as possible in order to sort of lift the uncertainty that has sort of descended over the financial markets. And there are three cases but let's focus on two. One is about private debt. And one is about a Liberty bond, a Government bond.

Edwards: The private debt is railway. There are two but the government makes... Has standing and is part of the private debt cases as well because the government is the RFC the Record Fraction Finance Corporation is a junior creditor. And the government says if we pay the claimant according to the new price of gold less funds will be available for us Junior claimants and we are the government and the government will lose money. So the Supreme Court then has to rule on private debt and public debt. And there are two rulings that are issued on February 18. The hearings go really poorly for the government. And it's fascinating to read the reports and the journalist articles at the time.

Edwards: The Attorney General argues for the government during the first day which is unusual. It has happened a number of times but not very, very, very often. It's not the Attorney General who argues the cases for the government. And and everyone says... I mean based on the questions that the judges asked that the government has done very poorly. And then there is a several weeks about five weeks. At the time the court ruled very soon after the cases were heard where there's a lot of uncertainty and the financial markets are reacting assuming that the abrogation of the Gold Clause will be declared unconstitutional. And the government is also getting ready for that possibility. And FDR even draft a speech where he's going to say, "I will not abide by the rule." And that's fascinating to me.

Beckworth: Wow. So Supreme Court rules in favor of the government and it rules five to four in favor of nullifying the Gold Clause in the Private contracts and interestingly it rules actually against the public or the government contracts eight to one. But then it says there's no damages. So effectively it lets the law stand that nullifies all the Gold Clauses.

Edwards: Right. That is what makes it particularly controversial and at first even if there are things that the government has lost the one of the cases. So on the private cases the court five to four but the majority is very... Says, "This is very simple." The Constitution gives Congress the power to run monetary policy, to mint coins and determine their value thereof. And if in order to exercise that power they have to change contracts retroactively. They can do that if they want and that's it.

Edwards: On the public case they say, "You cannot use that power." Because there is another power that the Constitution gives to Congress and that is to issue debt on the credit of the United States. And implicit in that is that you paid back. And you cannot use one power to offset another power. So I to and as you say it's unconstitutional. But then it says and this users again going back to your earlier point. The price level argument and says because there's been deflation there are no damages. People who bought these bonds today even if they get in depreciated the paper dollars their money back they can buy more goods than originally. So no damages. And then the government gets free.

Beckworth: Yeah. I encourage the listeners to read the book. Very fascinating. The details surrounding this case is a big spectacle. There's a celebration at the White House. The Chief Justice... I'm sorry. The Justice James Clark McReynolds has a great speech or rant he gives afterwards. It's a big drama that unfolds. For the second time we've got to move on. And you talk about the consequences of this ruling that the economy seem to do just fine despite the warnings, the fears that this was breaking the Rule of Law, creating uncertainty, contracts no longer respected. The economy continued to recover despite this. Correct?

Edwards: Well the... Yeah. The economy continues to recover until 1937. There's a big sigh of relief among most people by this time because '34 is a year of recovery. And the reason why I say your recovery is because after the devaluation which is significant from 20 and 67 per ounce to 35. There is a very significant inflow of gold and the Fed decides not to sterilize. So and we learned this from Milton Friedman and a short book. So high powered money goes up the multipliers stops falling and liquidity increases. And 34 is recovery year and during 35 and 36 that continues until 37 when we had the 37 recession because the Fed changed its policy and so did the Federal government with respect to fiscal policy. So yeah, could recovery continue? And the government has no trouble whatsoever rolling over its debt. It doesn't have to pay more for the newer debt that it issues. It's very different from modern debt restructurings where there are very serious negative costs or consequences that governments have to pay. None of that was seen in '35 in the US.

Beckworth: Yeah, and when we think about the consequences and what's going on in the economy in the background there's a lot of moving parts here. And this story is really about... The way I look at it this story is really about FDR and the Treasury taking the reins of monetary policy from a Fed that really was enacted didn't do much '29 to '33 during the Great contractions. You mentioned they tighten again in '36 '37 but the devaluation, the reflation that FDR does independent of what the Fed is doing is really a testament to him kind of taking the reins and moving things forward on his own.

Beckworth: Now you go on and talk about the longer run implications. So the short run implications are the recovery that the ruling did not stall it. The Fed is what's called it later on. But there's also this conversation about the long run implications and you come up with this term or there's a term that you use called excusable defaults and you argue that's different than what we saw in Argentina and in other emerging markets today. So can you explain that to us?

Edwards: Yeah. I mean I did not invent the term. It's been around. And Herschel Grossman, the late Herschel Grossman and his colleague Banike from... So Herschel was at Brown. And Banike is at Texas. They have a very nice paper and the notion is that there are two types of default and lawyers have this notion as well. And there is excusable default that is related to either Act of God Force Majeure or a necessity and the markets understand that. And then there is another kind of default which comes from being highly responsible not taking into account budget constraints, not being frugal. And that's the kind of default that we associate these days with countries like Argentina and Greece. And so the point I make is that there are some defaults where the public understands and thus understand that they don't set a precedent.

Edwards: It doesn't mean that if you work with the sovereign to solve it that it will create a moral hazard situation where there's going to be a repetition of that situation. And I argue that this is the case in the US and also everything was done in a very legal fashion. The Rule of Law was sort of followed at every turn and the Court of Claims was in and then the Supreme Court and there was due process and claimants have plenty of time to present their case. And so that makes a big difference with the RB prairie way in which the Argentina's of the world... I have nothing against Argentina. I love the country. But there is a repeat history there of sort of irresponsibility.

Beckworth: Okay. So going back to a comment you made earlier one could look at the US and say, "Hey, you were a Banana Republic too." But what you've just said suggests otherwise they followed a series of steps. Congress voted a new law. It was reviewed by the Supreme Court and found legal as opposed to a powerful leader a dictator suddenly changing what was in the contracts.

Edwards: Yeah, there... I mean there is the sense that and also people work on bids by the nature of that there were no clear alternatives at that time. Now I would argue today that maybe it was I mean there were a couple of plans that were put forward that would have reduced the cover ratio and I talk a little bit in the book about it. But people were convinced that there was a necessity to do this and that there were no alternatives. And that this did not set precedent and that the US was not going to go on devaluing the dollar year after year. And that proved to be true until we came into the exorbitant privilege issue of the 1970s and then the collapse of the Bretton Woods system.

Beckworth: Okay. So let's talk about your last chapter titled Could It Happen Again? So what are the implications for today?

Edwards: Well I think that there are two implications. One which we already saw and that is that good lawyers around the world know about this case and now that the book is out more lawyers know about it. And in international tribunals including in arbitration tribunals the point that Argentina made in 2003, 2004 that there was this precedent is going to be made again and again and again. And it could happen again, it will happen again. And countries will continue to default. You read the paper today we have Turkey, we have Pakistan, remember of Argentina, again facing difficulties.

Edwards: So it will happen internationally and the argument of necessity and the precedent of the Supreme Court rulings will be used again. But the most important and interesting question is in I think in the advanced countries and there was a discussion earlier on of whether... I mean a couple of years ago whether Greece should leave the eurozone. And now there're sort of discussions about Italy. And if they do that exactly the same problem will come up because every contract in Italy and every contract in Greece is in euros. So if you reintroduce the Italian lira at the value rate would you do with a contract? Right?

Beckworth: Right.

Edwards: We're going to have and then again these cases will be used by lawyers as legal precedent. And then the question is whether it will happen in the US? And the answer is that it will not... It cannot happen in a repeated way because now every contract is in paper dollars. It's only one currency except I guess tips, Treasury tips. But there are no massive contracts in a different currency. But then we come to contingent liabilities and social security debt and so on and so forth. And those will now kind of be paid as a promised. And then there will be a necessity which is the argument that set tips by the Supreme Court. Was a secondary argument of the government in '35. And that will be used again. So I'm not a lawyer. I learned a lot about constitutional law by writing the book and I talked to a number of colleagues here at UCLA and other constitutional lawyers.

Edwards: So I think that the notion that the whole general argument about necessity in order for the nation to survive and to continue to do business and to make progress will come up at some point related to social security and medicare. And when the contracts are rewritten and people go to court these cases will again come into the floor and lawyers, constitutional lawyers will have to go back and read. Again the majority ruling. There is a conquering ruling by Justice Harlan Stone which is very interesting. He vowed to the majority but writes a concurring opinion and then of course a minority opinion that you mentioned by which was presented by Justice Clark McReynolds.

Beckworth: Yes. And despite his fears the Rule of Law still prevails in the United States. But your book is a great cure for the collective amnesia as you call it. So when these events do come up people will read your book or they will turn to your book and draw from that. Well with that our time is up. Our guest today has been Sebastian Edwards. Sebastian thank you for coming on the show.

Edwards: David thanks so much for having me. It's been a lot of fun talking to you.

About Macro Musings

Hosted by Senior Research Fellow David Beckworth, the Macro Musings podcast pulls back the curtain on the important macroeconomic issues of the past, present, and future.