Gold in the Interwar Period

Lecture 13 – Thursday, 21 October 2010

J A Morrison1

Hjalmar SchachtWinston ChurchillJM Keynes

Decline and Fall of the Gold Standard

I. The Return to Gold (1919-1925)II. The “New Gold Standard”

(1925-1931)III.Gold in the Great Depression

and WarIV.A Case: the Puzzle of Great

Britain

2

I. The Return to Gold

1. The Legacy of WWI2. The Paths Back to Gold

3

The gold standard was always more of an ideal

than the reality...

And the First World War took the reality even further from

the ideal.

4

WWI & Gold

• WWI prompted policymakers to abandon “rules of gold standard game”

• Convertibility: Suspended– Outright restrictions on gold export– “Backed” currencies no longer redeemable

in gold

• ER Stability: Abandoned– States issue fiat currency in excess of gold

reserves and stock of goods & services– Inflation of domestic prices (including gold)

follows 5

After the War: Overvaluation

• European currencies were overvalued– Currency increases outstripped gold reserves–Market value of currency < official value

• Immediate Response– Capital restrictions were removed, allowing

foreign exchange– BUT convertibility was still suspended:

currencies were not redeemable to protect reserves

• Practical effect: currencies continued to float in the market

• Only the US retained gold convertibility6

I. The Return to Gold

1. The Legacy of WWI2. The Paths Back to Gold

7

States eventually returned to the international

monetary system in three different ways: currency reform, stabilization, and

restoration.

8

In some countries, the issuance of fiat currency

had been abused.

These states—Austria, Hungary, Germany, and

Poland—suffered…

9

Hyperinflation.

10

Here, the exchange value plummeted below the intrinsic value of the paper itself.

Most of these countries turned to currency reform.

11

(1) Currency Reform

• Currencies replaced entirely

• Retenmark: backed by land & industrial securities

• Reichsmark (1924): backed by gold at prewar parity– $1 US: 4.2 RM

• Other countries with hyperinflation followed suit– Austria 1923; Poland 1924;

Hungary 1925

12Hjalmar Schacht

In other countries, the inflation had been

moderate.

There the currency was either stabilized or restored.

13

(2) Currency Stabilization

• Currency is stabilized at the new market value– Devalued from pre-war parity – Gold parity established at inflated rate

• Countries: Belgium 1925; France 1926; Italy 1927

• Advantage: saves from unemployment-producing deflation

• Disadvantage: undermines credibility of commitment to gold standard

14

Who argued that latter point (about credibility)?

John Locke Montague Norman15

One notable country decided to return to gold and demonstrate a most

serious commitment to the standard…

Britain elected to restore its currency to the prewar

standard.

(Sweden did as well, but it had much less trouble doing so.)16

(3) Restoration• Currency is returned to pre-war parity– Bank of England promises to exchange pounds at

old price (£1 = $4.86) – Currency supply must be contracted to preserve

reserves at old parity

• Classic debate– Keynes: stabilize at new price level– Treasury (including Norman): restore!!!

• Advantage: strong signal of commitment to gold

• Disadvantage: deflation unemployment!

17

So, countries returned to gold in three different ways.

What was the experience of these countries on “the new

gold standard”?

18

This question is crucial since understandings of the

experience on gold in the 1920s shaped the plans made after the Second

World War to rebuild the international monetary

system. 19

Attempts to Revive Gold

I. The Return to Gold (1919-1925)II. The “New Gold Standard”

(1925-1931)III.Gold in the Great Depression

and WarIV.A Case: the Puzzle of Great

Britain

20

The Experience Back on Gold was Determined by:

1. Exchange Rate Values2. Exogenously Determined Shifts in

International Economic Flows3. Nature of the Gold Standard Itself

We’ll take each in turn.

21

II. The “New Gold Standard”

1. Exchange Rate Values2. Exogenous Changes in Int’l Econ

Flows3. Workings of the Gold Standard

Itself

22

The first factor was the countries’ exchange rate

values.

Part of this followed from the paths they took back to gold. And part followed from their monetary policy after

the return.23

The cases of Britain and France will illuminate this.

24

The Pound in the Late 1920s• Path back to gold: restoration of prewar

parity – Revaluation: raise pound vis-à-vis gold– But there were too many pounds in

circulation!

• Monetary policy: reduce supply of pounds• April 1925 Return to Gold– Price of gold is artificially lowered– But other prices don’t fall immediately

• Foreign purchases cost less (by moving through gold) than do domestic

• Result: exports decline; imports rise 25

The Economic Crisis of 1925-1926

• Return prompts 10% deflation– Exacerbated challenges of post-war

adjustment

• National unemployment rate passes 20%–Much higher in certain industries

1926 General Strike: Coal miners bring Britain to brink of “revolution”

26

The Franc in the Late 1920s• Path back to gold: stabilize at new level– Devaluation: lower franc vis-à-vis gold

• Monetary Policy: maintain supply of francs– Price of gold is maintained/raised– But other prices don’t rise immediately

• Domestic purchases cost less than do foreign (given the cost of converting into gold)

• Result: imports decrease; exports increase 27

So, the British ER encouraged imports and

discouraged exports.

And the French ER encouraged exports and

discouraged imports.

You can imagine the implications of this for these

countries’ balances of payments…

28

Balances of Payments After the Return

• Britain– 1927, 1929-1931: Deficit – 1928: Small surplus

• France– 1927-1931: Surplus

• United States– Surplus most years in 1920s

29

But shouldn’t the price-specie-flow mechanism have moderated this?

Shouldn’t the franc have appreciated and the pound depreciated, mitigating this

trend?30

In theory, yes.

But, as a practical matter, the price-specie-flow model

broke down—largely as a result of French

intervention.

31

Price-Specie-Flow Fails• The Overvalued Pound– Domestic prices were downwardly sticky– Britons traded pounds for exchange reserves

• The Undervalued Franc– French enjoyed competitive advantage in

foreign markets– 1926-1931: French repeatedly intervene to

stop appreciation of the franc

Gold travels from Britain to France– 1926-1931: French reserves quadruple

32

So, the paths back to gold had some influence on

states’ experiences back on gold.

(And French attempts to maintain the undervalued

currency did not help.)33

II. The “New Gold Standard”

1. Studying the Balance of Payments2. Exogenous Changes in Int’l Econ

Flows3. Workings of the Gold Standard

Itself

34

Throughout this period, there were structural

changes (exogenously determined) in the patterns of trade and capital flows.

35

Change in Trade Patterns

• During WWI, the US took over export markets traditionally dominated by the Europeans

36

Foreign demand for US goods and services created

upward pressure on the dollar.

In theory, price-specie-flow should have appreciated the

dollar, eliminated the current account surplus,

and eventually redistributed gold back to Europe. 37

But that didn’t happen.

What happened instead?

38

The US loaned the money back to Europe, specifically

Germany.

39

Reparations and Loans

• The Allies repeatedly pressed Germany for reparations

• Plans– Dawes (1924): 1bn/year for 5 years; then

2.5bn annually– Young (1929): Germany pays $475m for 59

years

• Reality– 1924-1929: Allies receive $2bn from Germany– 1926-1931: US loans $1bn to Germany

40

Kindleberger has estimated that there was a swing of

something in the order of $2bn in U.S. lending between the

eighteen months from 1 January 1927 to 30 June 1928 and the fifteen months from 1

July 1928 to 30 September 1929.

(Kindleberger 70-74)41

The implication: the US amassed gold reserves, limited the production of

dollars, and maintained an undervalued currency.

42

There is a contemporary parallel here with China and

the US today!

43

II. The “New Gold Standard”

1. Studying the Balance of Payments2. The Balance of Payments3. Workings of the Gold Standard

Itself

44

Gold Shortage

• 1924-1929: considerable economic growth but limited growth of gold supply

• Ratio of Reserves to Notes Issued– 1913: 48%– 1927: 40%

• Implication: deflationary bias in the new gold standard; all countries struggled to secure gold.

45

“Never in history was there a method devised of such efficacy for setting each country's advantage at variance with its neighbours' as the

international gold (or, formerly, silver) standard. For it made domestic prosperity directly

dependent on a competitive pursuit of markets and a competitive

appetite for the precious metals.”-- JM Keynes, General Theory, 349

46

This explains why some states—France & the US—

hoarded gold.

47

What was the cumulative result of these events?

48

49Source: Eichengreen, Globalizing Capital, 65.

50(Note that the United States is omitted here.)

Source: Eichengreen, Globalizing Capital, 65.

So, the US and France were the big winners.

But clearly the stability of the system depended on

continued participation by the United States.

What happened when the United States looked inward

after the October 1929 stock market crash?

51

Attempts to Revive Gold

I. The Return to Gold (1919-1925)II. The “New Gold Standard”

(1925-1931)III.Gold in the Great Depression

and War

52

The Abandonment of Gold

• Abandonment– Britain: September 1931– 1932: 24 more countries suspend convertibility– US: 1933– France: 1936

• 1933 London Economic Conference: Attempt to Agree on Concerted Action (like the G20 today)– France: no devaluation here!– Britain and US: reflate, damn it!

53

Most economists have agreed that the

devaluations of the 1930s were part of the solution.

54

But the question remains, how do we explain this

sudden abandonment of the GS ideal?

55

Fragility of New Gold Standard Regime

• All Gold Standard Regimes Depend on:1. Leadership of Major Economies

(Kindleberger) 2. Supporting International Norms

(Eichengreen)3. Luck: Increase in Gold; No Exogenous

Shocks (Keynes)4. Domestic Support (Polanyi)

• “New” Gold Standard was even further from GS Ideal than Prewar Gold Standard

56

(1) Kindleberger: Failure of Leadership

• Late 1920s, US raised interest rates to cool overheating stock market– Attracted foreign capital– Decreased lending to Germany

• Stock market crash precipitated “orthodox” monetary policy: “Great Contraction” of US money supply

• US had all of the gold; the US needed to provide the world with liquidity but did the opposite!

57

(2) Eichengreen: Collapse of International Norms

• Prewar Gold– Countries cooperated (a la Broz on France &

England)– Markets bet with banks by moving ahead of

banks, markets helped to do the job of banks

• WWI shattered consensus: banks saw interests at odd; cooperation ceased

• New Gold Standard– Markets bet against banks markets

exacerbated disequilibria, making banks’ job harder

58

(3) Keynes: Luck ran Out• Keynes dreaded deflationary bias of gold

standard• In 19th C, world was lucky: – there was enough gold to go around– following GS “orthodoxy” didn’t create

catastrophe

• In 20th C, the world would not remain lucky– Global economy requires liquidity – Don’t depend on gold mines! Create an

international institution and a new global currency to do this!

59

Virtually everyone agrees that changing systemic

conditions (distribution of power, norms, supply of gold, &c.) increased the

difficulty of supporting the GS system.

But systemic explanations cannot explain the timing of

individual countries’ decisions.

60

To do that, we ought to consider each case

individually.

Here, we’ll just consider one: Great Britain (GB).

61

Attempts to Revive Gold

I. The Return to Gold (1919-1925)II. The “New Gold Standard”

(1925-1931)III.Gold in the Great Depression

and WarIV.A Case: the Puzzle of Great

Britain

62

As you know, Britain’s decision to suspend gold

convertibility in September 1931 is one of the cases

that I consider in my book manuscript.

63

Obviously, this shift is of intrinsic interest to me!

But I want to suggest that the extraordinary attention

this case garners is duly warranted.

It was both significant and surprising. 64

Significant• “Cheap money” (low interest rates)

earlier recovery in GB• Inspired regionalism, fracture of

global economic order• Demonstrated viability of flexible ERs

65

Surprising• History: GB was stalwart advocate of

GS• Interests: financiers & traders;

national prestige & gain• Institutions: Bank of Eng was “most

independent of central banks”

66

So, we have one hell of a puzzle!

67

Virtually all of the previous explanations follow in the tradition of Karl Polanyi…

68

Polanyi: Empowered Populace

• Due to balance of payments constraint, GS ideal sacrifices monetary policy autonomy MPA

• Different groups care more/less about MPA/ER stability–Wealthy prefer stable ER–Working class prefers MPA

• “Great Transformation” – Empowerment of working class– Prewar: poor weren’t empowered GS– 1920s: poor stop putting up with GS

69

The “Polanyi thesis” maintains that policy makers’ willingness

to impose the austerity necessary to defend the GS depends on the level of their accountability to the working

class.

This is operationalized by considering both the

constituency of the party in power and the independence

of the central bank.70

Prior to 1932, however, virtually every policy maker in Britain made saving the gold standard his/her top

priority.

And the Bank of England (BoE) was “the most

independent of central banks”! 71

My Model• ER Politics– ER policy chosen to maximize nat’l economic

“pie”– Political wrangling determines how pie is cut

• 3 I’s: ideas, interests, & institutions–Work along different dimensions– Combine to produce outcomes

• Ideas (strategies) – Chosen based on intellectual merits– Define range of perceived possibilities

72

My Argument• British policy makers believed defending GS was

the best means to preserve GB’s “pie”– Only Keynes and a few others challenged this

• Defense of gold ceased because of intellectual failure– BoE misinterpreted cause of crisis: budget rather

than overvaluation– Politicians balanced budget as instructed– BoE fails to raise interest rates

• Keynes let this happen• Failure successful experiment with floating

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Key Points from Lecture1. States always possessed political

incentives (read: policy autonomy!) to compromise on GS Rules/Ideal (convertibility & ER stability)

2. Prewar GS was compromised; but New GS was even more so (e.g. France & US)

3. Several exogenous changes made adhering to gold more difficult in 1930s than before (see Point III)

4. Interpretations of interwar period governed perspectives on international monetary system for decades

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