Why do economies take so long to recover from a financial crisis? What role do financial markets play in the macroeconomy and how should monetary policy responses account for them? Will private contracts that specify payment in alternative (crypto-)currencies survive without government regulation?
Many of these questions are as central to the macroeconomic debate as they are ageless. Time and again, policymakers, economists and ordinary citizens have struggled with these issues, occasionally forging new paths but more often just overlooking the lessons of bygone eras only to discover them anew. And few episodes in our history contain as many lessons for macroeconomists as the Great Depression.
The abrogation of gold clauses
On 18 February 1935, the United States Supreme Court issued one of its most controversial ever decision on economic matters. By a slim five to four majority, the court effectively invalidated the so-called gold clauses on debt contracts. The decision represented a watershed in the power of US congress to regulate money and monetary policy. Its background was fittingly dramatic; the stakes enormous.
In 1933, the new Roosevelt administration, seeking to stimulate an economy in the midst of its worst crisis in the 20th century, abandoned the Gold Standard, setting the stage for a massive devaluation of the dollar and a rapid increase in commodity prices over the next few years (Hausman et al. 2017). A forgotten, yet key component of this programme was the joint resolution of Congress on 5 June 1933, a dramatic legal development that invalidated the gold clauses in public as well as private debt contracts.
Prior to 1933, many bond issues had clauses that allowed for repayment in gold as well as paper. These contractual agreements, known as ‘gold clauses’, became popular in the aftermath of the Civil War, when a dual monetary system emerged and gold began to trade at a premium to paper money. Although this premium disappeared by 1879, and Congress removed the last ties to silver in 1900, the use of gold clauses in private debt contracts was still widespread in 1933.
Abrogation instantly created the prospect of a massive redistribution of wealth. A series of lawsuits ensued, with four eventually reaching the Supreme Court. Nevertheless, with the dollar down by nearly 70% by early 1935, enforcing existing gold clauses would have threatened many corporate bond issuers with bankruptcy.
In a complex – and very confused – ruling, the Supreme Court determined that Congress’s action, although deemed invalid, could nevertheless be maintained because of the “lack of actual damages” to the plaintiff (Hart, Jr 1935). For all practical purposes, gold clauses were henceforth nullified.1
The essence of the ruling hinged on the power of Congress to regulate the currency and the monetary system, with the court ultimately agreeing with the government’s argument that its power in these matters must be absolute. The ability of private citizens to settle contracts in gold was adjudged to pose an imminent threat to this authority. The echo of this decision to the current debate surrounding the widespread adoption of cryptocurrencies and ‘smart contracts’ is bound to be considerable.
The economic implications of the abrogation
Devaluation and the uncertainty surrounding the court’s decision on abrogation had profound economic implications. While aggregate GDP recovered and grew by 11% and 9% in 1933 and 1934, respectively, private investment nevertheless fell and now stood a staggering 72% below its pre-1929 trend levels (Cole and Ohanian 2004).
In a recent paper (Gomes et al. 2019), we show that the legal uncertainty surrounding the elimination of the gold clauses accounted for most of this disparity. Using hand-collected historical data from the balance sheets, income statements, and bond characteristics of all publicly traded industrial US firms between 1930 and 1936, we are able to perform a detailed comparison of the behaviour of corporate investment across firms with varying levels of exposure to gold clauses in their debt contracts.
We find that the existence of gold-denominated debt led to a significant reduction in investment over 1933 and 1934. This effect of gold clause exposure on investment is then dramatically reversed following the Supreme Court's decision to uphold abrogation. Any differences in corporate investment across firms have largely disappeared by the end of 1936.
We calculate that about one-third of the drop in the aggregate investment of public firms over 1933—1934 is explained by these events. By 1936 nearly all of the, now positive, net investment is accounted for by the elimination of these leverage risks to corporate balance sheets.
As anticipated by existing theories of debt overhang, firms exposed to leverage risk chose to instead increase their equity payout during 1933 and 1934, again reversing this behaviour following the Supreme Court's decision: as the likelihood of default increased, equity holders had an incentive to expropriate bondholders by increasing equity payout. We observe the same patterns for small and large firms, although the latter – with their ample cash holdings – were largely insulated from the distress of the financial intermediation sector (Bernanke 1983, Calomiris and Mason 2003).
Our findings strongly suggest that the massive contraction in corporate investment was not due to a lack of funding or limited access to capital markets. These factors played a role no doubt, but the dramatic increase in debt burdens and the downward rigidity of debt contracts seem to have created serious agency problems that significantly undermined the economic recovery. Economists often emphasise the role of nominal rigidities in prices and wages, but history suggests the long-lived nature of nominal debt contracts have the potential to create far more serious disruptions to the economy.2 Policymakers should take note.
Today, gold clauses are no longer common in bond contracts, but the risk we identify remains especially relevant for many emerging economies, where corporations issue bonds denominated in foreign currencies (often the US dollar). The possibility of a local currency depreciation exposes these emerging market issuers to leverage risk, much like gold clauses exposed US issuers to the dollar's devaluation in the 1930s.3 And the challenges faced then would no doubt befall Greece or any other country seeking to exit the euro area.
Bedoya, A, C González, S Pernice, J M Streb, A Czerwonko, and L Díaz Santillán (2007), “Database of corporate bonds from Argentina”, CEMA Working Papers: Serie Documentos de Trabajo.
Bernanke, B S (1983), “Nonmonetary Effects of the Financial Crisis in the Propagation of the Great Depression”, American Economic Review 73: 257–276.
Calomiris, C W and J R Mason (2003), “Consequences of bank distress during the Great Depression”, American Economic Review 93: 937–947.
Cole, H L and L E Ohanian (2004), “New Deal policies and the persistence of the Great Depression: A general equilibrium analysis”, Journal of Political Economy 112: 779–816.
Gomes, J F, M Kilic, and S Plante (2019), “Leverage Risk and Investment: The Case of Gold Clauses in the 1930s”, Working paper.
Gomes, J F, U Jermann, and L Schmid (2016), “Sticky leverage”, American Economic Review 106: 3800–3828.
Hart Jr, H M (1935), “The Gold Clause in United States Bonds”, Harvard Law Review 48: 1057.
Hausman, J K, P W Rhode, and J F Wieland (2019), “Recovery from the Great Depression: The Farm Channel in Spring 1933”, American Economic Review 109(2): 427-72.
 In 1977 Congress amended its resolution and made gold clauses legal again. Unsurprisingly, this failed to spark much interest among investors.
 A formal quantitative model of this mechanism is provided in Gomes et al. (2016).
 97% of Argentine corporate bonds were denominated in US dollars in 2002, and the devaluation of the peso triggered a wave of bankr