2. YESTERDAY’S CRISIS: THE GREAT DEPRESSION
To answer the first question, we should have in mind the institutional framework of the two crises. Until the mid 1930s, the central banking “mantra” was the gold standard. Its basic, unwritten rule was that money supply should be contained, to avoid inflation[5].  What does “contain” mean? Containment meant, in the gold standard, to maintain the convertibility of national currency into gold at a fixed rate: the amount of currency (simplifying, of banknote circulation) could not exceed a multiple of gold in the central bank reserve. This ratio was determined – in general, by legislation – as a minimum percentage of the gold cover of circulation: often, but not necessarily, 40%.
A variation was the gold exchange standard, where gold could be supplemented by “hard” currencies in the central bank’s reserve: this of course permitted a corresponding expansion of money supply.
To comply with this rule, the “art” of the central banker consisted in keeping that ratio above that percentage – or, as Bagehot wrote, above the “apprehension” minimum.[6] Approaching this apprehension threshold, the central bank had either to deflate, i.e. reduce circulation and money supply, or to increase the amount of gold in reserve. Deflation was achieved by tightening credit conditions (and fiscal policy), at the cost of resource unemployment and output contraction. Gold accumulation might be even harder to achieve: by a surplus in the balance of payments, with a consequent inflow of gold, but this often meant to squeeze domestic demand. In extreme difficulty, rather than increasing the physical stock of gold, a country would increase the price of gold in terms of national currency (i.e., decrease the gold content of the national currency: substantially, a currency devaluation).
To make this point more clear by an example, let’s take the case of Italy after the First World War. The huge war expenditure had debased the Italian currency – that is, had increased money supply well beyond what the gold and foreign exchange reserve of the Bank of Italy  would allow. Consequently, Italy had to abandon the gold standard and lira became inconvertible into gold. However, at the end of 1927 Italy, largely for reasons of prestige and anyway following the “mainstream”, returned to gold convertibility, by: 1) deflating the money supply, i.e. reducing currency in circulation; 2) lowering the lira gold content (it was: 1 lira = 290.3 milligram of fine gold; it became: 1 lira = 79.2 milligram of fine gold).
Here we compare figures for gold and foreign exchange in reserve (Italy was on a gold exchange standard basis), and banknote circulation, before and after the “return to gold”, that is: in 1926 and 1928. In between the two years, circulation was deflated (see B), while the lira gold content was reduced (the lira was devalued in terms of gold) and foreign currency in reserve was raised through international loans (see A). The gold/circulation ratio (A/B) increased as a consequence from 13% to 74%.

Table 4. Bank of Italy: reserve and circulation (1926-1928, bln lire)

Source: Banca d’Italia (1993)

We can notice that, even though Ralph Hawtrey titled his book “The Art of Central Banking” (1932), the options available to central banks in a gold standard regime were pretty limited. In the debate “rules versus discretion”, the “science” called economics had defined the rules of the game, and these rules were strict enough to leave to the central bank just a narrow path, a restrictive bias.
Hawtrey, to be sure, spoke of “art” for the simple reason that he compared central banking in his times (the 1920-30s) with a previous 19^th century monetary standard, as conceptualized by David Ricardo, whereby the national currency was “based exclusively on a specie standard (the use of coins as hand to hand currency) [and] the central bank would be absolutely dependent upon its reserves of coin to meet any increased demand for currency” (p 117): the most pure, rigid form of gold standard (gold specie standard). By Hawtrey’s times, this wasn’t any more the case, so the central bank, with the right to issue banknotes and act as lender-of-last-resort, had to be mindful not to create “too much” supply of money.
If we look at the Bank of Italy’s balance sheet in 1928, after Italy’s restoration of gold standard, there are other interesting features:

Table 5. Balance sheet (asset side) of the Bank of Italy 1928 (bln lire)

Source: Banca d’Italia (1993)

^Note

5.  This rule was translated in different ways into central banks’ statutes. ↑

6.  In Lombard Street, p. 307. ↑

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