Gold in the Interwar Period Lecture 13 – Thursday, 21 October 2010 J A Morrison 1 Hjalmar SchachtWinston Churchill JM Keynes

Decline and Fall of the Gold Standard I.The Return to Gold ( ) II.The New Gold Standard ( ) III.Gold in the Great Depression and War IV.A Case: the Puzzle of Great Britain 2

I. The Return to Gold 1.The Legacy of WWI 2.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 convertibility 6

I. The Return to Gold 1.The Legacy of WWI 2.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 statesAustria, 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 Hjalmar 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 LockeMontague Norman 15

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 ( ) II.The New Gold Standard ( ) III.Gold in the Great Depression and War IV.A Case: the Puzzle of Great Britain 20

The Experience Back on Gold was Determined by: 1. Exchange Rate Values 2. Exogenously Determined Shifts in International Economic Flows 3. Nature of the Gold Standard Itself Well take each in turn. 21

II. The New Gold Standard 1.Exchange Rate Values 2.Exogenous Changes in Intl Econ Flows 3.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 dont fall immediately Foreign purchases cost less (by moving through gold) than do domestic Result: exports decline; imports rise 25

The Economic Crisis of 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 dont 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, : Deficit –1928: Small surplus France – : Surplus United States –Surplus most years in 1920s 29

But shouldnt the price-specie- flow mechanism have moderated this? Shouldnt 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 downlargely 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 – : French repeatedly intervene to stop appreciation of the franc Gold travels from Britain to France – : 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 Payments 2.Exogenous Changes in Intl Econ Flows 3.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 didnt 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 – : Allies receive $2bn from Germany – : 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 (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 Payments 2.The Balance of Payments 3.Workings of the Gold Standard Itself 44

Gold Shortage : 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,

This explains why some statesFrance & the US hoarded gold. 47

What was the cumulative result of these events? 48

49 Source: 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 ( ) II.The New Gold Standard ( ) 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: 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 19 th C, world was lucky: –there was enough gold to go around –following GS orthodoxy didnt create catastrophe In 20 th C, the world would not remain lucky –Global economy requires liquidity –Dont 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, well just consider one: Great Britain (GB). 61

Attempts to Revive Gold I.The Return to Gold ( ) II.The New Gold Standard ( ) III.Gold in the Great Depression and War IV.A Case: the Puzzle of Great Britain 62

As you know, Britains 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 werent 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 natl economic pie –Political wrangling determines how pie is cut 3 Is: 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 GBs 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 73

Key Points from Lecture 1. 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 74