One century ago, many great statesmen of the world gathered in the Italian city of Genoa build a monetary order for the post-war world.
Prior to 1914, the world’s major economies were based on the classic gold standard. This was based on convertibility between paper money and gold at a fixed parity price and on the free export and import of gold.
If a central bank sets a parity price of £5 an ounce of gold, for example, an expansion of the money supply relative to gold reserves would drive the market price up to, say, £6 per ounce. In this case it would make sense to take a £5 note to the bank, buy 1 ounce of gold and resell it in the market for £6. During monetary contractions, the process worked in reverse. If the market price fell to, say, £4 an ounce, it would make sense to buy an ounce of gold in the market for £4 and sell it to the bank for £5. In each case, convertibility corrected for monetary expansion or contraction. During an expansion, gold would flow out of the banks, forcing a contraction in the currency if they wished to maintain their reserve ratios. Similarly, a contraction would see gold flow to banks which would increase their currency issuance.
The First World War broke this system. Countries financed their war efforts by printing money and convertibility and exportability were suspended. Between 1914 and 1918, total metal reserves as a percentage of banknotes plus deposits fell from 63 to 1% in Austria-Hungary, from 57 to 10% in Germany, from 60 to 9% in Italy, from 64 to 17% in France and from 40 to 33% in Great Britain. This caused runaway inflation, followed by a collapse. In 1920, the League of Nations reported:
“Everywhere, the disorder of currency and exchange hinders trade and delays reconstruction. In some countries, it is a primary factor among those that cause a collapse of the economic and social system.
After the war, most countries wanted to return to the gold standard, but faced a problem: there was now a lot more currency in relation to their gold reserves. Gold parity prices were well below market prices, which would lead to massive outflows of gold once convertibility was restored.
To solve this problem, among others, the statesmen met in April and May 1922. Their solution was the gold exchange standard.
The gold exchange standard would resolve the imbalance between money and gold reserves by increasing reserves. But the stock of gold could not be increased beyond new discoveries, so the gold-exchange standard allowed central banks to add to their gold reserves the assets of countries whose currencies were convertible. Golden. In practice, these were pounds sterling and dollars. In 1927, currencies accounted for 42% of the total reserves (gold and currencies) of twenty-four European central banks, compared to 27% in 1924 and 12% in 1913.
But sterling assets were no longer considered ‘as good as gold’. In 1925, Britain’s Chancellor of the Exchequer, Winston Churchill – against his better judgment – restored the convertibility of sterling to pre-war parity. It was too high and helped cripple British exports. Attempts to lower wages through internal devaluation have caused the general strike of 1926. Countries like France and Germany started exchanging their pound for gold. From 1924 to 1928, foreign exchange fell from 59% of Germany’s total reserves to just 8%. Sterling couldn’t cope; liabilities stood at $2.5 billion, nearly four times the Bank of England’s gold reserves.
In 1927, Montagu Norman, Governor of the Bank of England, convinced his friend Benjamin Strong, Governor of the Federal Reserve Bank of New York, to lower the Fed funds rate in the hope of easing pressure on the pound sterling. . Whatever relief this action bought in sterling, some economists saw it as a cause of the stock market bubble that burst so spectacularly in 1929.
The Wall Street crash and its aftermath destroyed the gold exchange standard. As budget deficits mounted, the pound came under renewed pressure in 1931. Unable to pass “austerity” measures, the Labor government collapsed and was replaced by a national government which rapidly devalued (a external devaluation): “Nobody told us that we could do that. observed a Labor politician. With one central country severing its link to gold, others soon followed. By the end of 1932, 32 countries had lost gold. Beggar-thy-neighbor devaluations would continue throughout the 1930s.
The gold standard is sometimes blamed for the Great Depression, but the classic gold standard was history then: as an economist Richard Timberlake note: “The operational gold standard ended forever when the United States became a belligerent in World War I”. The flaws of its successor, the gold-exchange standard, devised a century ago, however, carry much more guilt.
John Phelan is an economist at American Experience Center.