9. International Monetary System Until World War II International Finance © Mojmir Mrak

CONTENTS AND PURPOSE The Gold Standard (Period Before World War II) The Interwar Experience purpose: analysis of the forms of international monetary system in the period until World War II International Finance © Mojmir Mrak

The Gold Standard (Period Before World War II) first complete international monetary system based on the automatic balance-of-payments mechanism under fixed exchange rate: classical gold standard period: from about 1870 to 1914 (beginning of World War II) managed gold standard period: from 1926 to 1931 International Finance © Mojmir Mrak

Evolution of the Gold Standard replacement of bimetalism with gold standard in Great Britain (1816): Gresham’s Law, forfeiting different shares of silver in silver coins increasing financial dependency between countries because of trading (industrial revolution) unpromising political circumstances in Europe: numerous countries had to give up convertibility of their currencies Germany gave up bimetalism in 1871 and set up the gold standard International Finance © Mojmir Mrak

Evolution of the Gold Standard chain reaction in the area of establishing gold standard: strong interest of every country to implement the same international monetary system as their most important economic and financial partners have implemented International Finance © Mojmir Mrak

The Concept and Basic Logic of the Gold Standard rules of the game: country defines the gold content of its currency – the quantity of gold contained in one unit of domestic currency, and pledges that the central bank will buy or sell any amount of gold at that price free export and import of gold economic agents need to be confident that the country will follow both rules of the game International Finance © Mojmir Mrak

The Concept and Basic Logic of the Gold Standard fixed exchange rates between currencies included in the system: actual exchange rate could fluctuate above and below the mint parity by the transport costs actual exchange rate has to be within the gold points (gold export point and gold import point) arbitrage International Finance © Mojmir Mrak

Balance-of-Payments Adjustment Mechanism Under Gold Standard price-specie-flow mechanism: gold is the only form of international monetary reserves, hence a balance-of-payments deficit (surplus) causes gold outflow (inflow) country must guarantee complete back-up of domestic currency with gold there has to be price and wage flexibility International Finance © Mojmir Mrak

Balance-of-Payments Adjustment Mechanism Under Gold Standard International Finance © Mojmir Mrak

Functioning of the Gold Standard and Price-Specie Flow Mechanism in Reality following the rules of the game in practice: gold was not the only form of international monetary reserves: balance-of-payments disequilibria were eliminated with international capital flows foreign exchange reserves yield interest, transport costs are lower, no need to decrease the gold reserves at least partial sterilization of the effects of the balance-of-payments disequilibria: reducing the severity of the balance-of-payments adjustment process prices and wages were not completely flexible International Finance © Mojmir Mrak

Functioning of the Gold Standard and Price-Specie Flow Mechanism in Reality assessment of the functioning of the gold standard: relatively successful because of fairly favorable economic circumstances fairly successful from the point of view of the world economic center final assessment of the functioning of the gold standard: successful before the beginning of World War I International Finance © Mojmir Mrak

2. The Interwar Experience With the outbreak of World War I, the classical gold standard came to an end: exchange rate depended completely on the supply of and demand for foreign currency extremely negative effects of the lack of agreement on the functioning of the international monetary system three trials of establishment: Conference in Genova (1922) negotiations in 1933 three-party agreement between the USA, Great Britain and France (1936) International Finance © Mojmir Mrak

1919 – 1926: Experience With Flexible Exchange Rates entirely different economic and political circumstances at the end of World War I made quick return to stable economic circumstances realistically impossible flexible exchange rates were perceived as an exclusively temporary solution that needed to be replaced by a more permanent solution (going back to the pre-war classical gold standard) as soon as possible International Finance © Mojmir Mrak

1919 – 1926: Experience With Flexible Exchange Rates countries with hyperinflation and their return to the gold standard: high rate of inflation caused by printing of money, that was used for financing high budget deficits an ingredient of stabilization programs was establishment of the mint parity of national currencies, or return to gold standard return of other countries to the gold standard: which mint parity should be used? International Finance © Mojmir Mrak

1926 – 1931: Functioning of the Renewed Gold Standard Period differences in gold standard in the interwar period and before World War I: mint parity was established at the “wrong” level, resulting in continued problems in the balance-of-payments adjustments not a real gold standard, rather, a gold exchange standard: assumption of high confidence into countries with a reserve currency to guarantee unconditional conversion of their currencies into gold International Finance © Mojmir Mrak

1926 – 1931: Functioning of the Renewed Gold Standard Period not following the rules of the game or different priorities of national economic policies : countries started to systematically give priority to internal economic goals and relatively lower importance to balance-of-payments equilibrium sterilization economic nationalism period changed significance of the short-run capital flows: flows under the strong influence of lowered confidence into mint parities, which was reflected mostly in escape of capital from weak currencies International Finance © Mojmir Mrak

1926 – 1931: Functioning of the Renewed Gold Standard Period End of the gold standard: convergence of different causes that pressured the already weak international monetary system of renewed gold standard at the end of 1920s deflation and unemployment; New York Stock Exchange crisis (1929) decreased confidence International Finance © Mojmir Mrak

1931 – 1944: Period of Economic Nationalism cannot talk about the existence of an international monetary system economic nationalism: competitive devaluations protectionism "beggar thy neighbour" trade wars, international trade cut almost in half less international provision of credit and investment International Finance © Mojmir Mrak

1931 – 1944: Period of Economic Nationalism reasons for unsuccessful initiatives for the formation of a consistent international monetary system: countries were not prepared to make and implement international agreements that would limit their freedom in leading national economic policies unresolved debt problem of some European Countries from World War I after Roosevelt became the president of the USA, the American policy focused mainly onto economic reconstruction of the USA and lowered its interest in solving global problems of the international monetary system FRF coalition $ coalition £ coalition International Finance © Mojmir Mrak

Assessment of the Functioning of the International Monetary System During the Interwar Period period without a consistent international monetary system with extremely negative consequences on the size of the international trade and investment: lack of cooperation and agreement about the organization of the international monetary system has extremely negative consequences on the world economy as a whole, as well as individual countries as its components modified relationship between internal and external economic policy goals caused a significant change in international capital flows characteristics lack of willingness for cooperation in the interwar period was also a consequence of a change in the world financial center International Finance © Mojmir Mrak