Gold in the Interwar Period

1
Gold in the Interwar Period
Hjalmar Schacht
Winston Churchill
JM Keynes

• Lecture 13 Thursday, 22 October 2009J A
  Morrison

2
Decline and Fall of the Gold Standard

• Gold and the Balance of Payments
• The Return to Gold (1919-1925)
• The New Gold Standard (1925-1931)
• Gold in the Great Depression and War

3
Decline and Fall of the Gold Standard

• Gold and the Balance of Payments
• The Return to Gold (1919-1925)
• The New Gold Standard (1925-1931)
• Gold in the Great Depression and War

4
The gold standard ideal was built on two vital
policy prescriptions(1) the exchange rate must
remain permanently fixed(2) states must
readily convert domestic currency into gold.
5
But remember the balance of payments
constraint.States only have four ways to
reconcile imbalances of payments.And following
the gold standard ideal precludes two
6
Remember this slide?
Lecture 6 Balance of Payments (Slide 41)
7
Reconciling the Balance of Payments Under the
Gold Standard
Sure everything is easier if you have tons of
gold in reserve. But how many states do?

• Adjustment of Reserves
• Adjustment of Internal Prices Incomes
• Exchange Rate (ER) Adjustment
• Exchange Controls
• Capital Controls Limit convertibility
• Commercial Policy

8
States without massive reservesor the ability to
acquire massive reservesreally have two options
to alleviate imbalances of payments under the
gold standard(1) use commercial policy
(tariffs, subsidies, c.)(2) allow
price-specie-flow to dictate changes in domestic
macroeconomic conditions
9
Many states have found that they dont like those
choices. Since even before the beginning of the
gold standard, they have devised various
waysgold devicesto be on the gold standard
without really having to follow all of the rules
of the gold standard game.
10
As an empirical matter, many states on the gold
standard did not maintain full convertibility of
their currencies or ensure stable market exchange
rates.
11
This practice continues today (albeit without
gold!).Few states simultaneously maintain full
convertibility and a truly stable ER.States
with currency boards (Hong Kong Falkland
Islands) are the exception to the rule.
12
Understanding how states responded to the
constraints imposed by the gold standard will
help you understand how states organize their
monetary systems today.
13
But were ahead of ourselves.Lets get back to
the 1920s
14
Decline and Fall of the Gold Standard

• Gold and the Balance of Payments
• The Return to Gold (1919-1925)
• The New Gold Standard (1925-1931)
• Gold in the Great Depression and War

15
II. The Return to Gold

• The Legacy of WWI
• The Paths Back to Gold

16
The gold standard was always more of an ideal
than reality...And the First World War took the
reality even further from the ideal.
17
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

18
After the War Overvaluation

• European currencies were overvalued
• Currency increases outstripped gold reserves
• Market value of currency lt 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

19
II. The Return to Gold

• The Legacy of WWI
• The Paths Back to Gold

20
States eventually returned to the international
monetary system in three different ways currency
reform, stabilization, and restoration.
21
In some countries, the issuance of fiat currency
had been abused. These statesAustria, Hungary,
Germany, and Polandsuffered
22
Hyperinflation.
Here, the exchange value plummeted below the
intrinsic value of the paper itself.
23
Most of these countries turned to currency reform.
24
(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

Hjalmar Schacht
25
In other countries, the inflation had been
moderate. There the currency was either
stabilized or restored.
26
(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

27
Who argued that latter point (about credibility)?
John Locke
Montague Norman
28
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.)
29
(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!

30
So, countries returned to gold in three different
ways. What was the experience of these
countries on the new gold standard?
31
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.
32
Attempts to Revive Gold

• The Adoption of Gold (continued)
• The Return to Gold (1919-1925)
• The New Gold Standard (1925-1931)
• Gold in the Great Depression and War

33
The Experience Back on Gold was Determined by

• Exchange Rate Values
• Several Exogenously Determined Shifts in
  International Economic Flows
• Nature of the Gold Standard Itself
• ? Well take each in turn.

34
III. The New Gold Standard

• Exchange Rate Values
• Exogenous Changes in Intl Econ Flows
• Workings of the Gold Standard Itself

35
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.
36
The cases of Britain and France will illuminate
this.
37
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

38
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

39
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

40
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
41
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

42
But shouldnt the price-specie-flow mechanism
have moderated this? Shouldnt the franc have
appreciated and the pound depreciated, mitigating
this trend?
43
In theory, yes. But, as a practical matter, the
price-specie-flow model broke downlargely as a
result of French intervention.
44
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

45
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.)
46
III. The New Gold Standard

• Studying the Balance of Payments
• Exogenous Changes in Intl Econ Flows
• Workings of the Gold Standard Itself

47
Throughout this period, there were structural
changes (exogenously determined) in the patterns
of trade and capital flows.
48
Change in Trade Patterns

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

49
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.
50
But that didnt happen.What happened instead?
51
The US loaned the money back to Europe,
specifically Germany.
52
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

53
The implication the US amassed gold reserves,
limited the production of dollars, and maintained
an undervalued currency.
54
? There is a contemporary parallel here with
China and the US today!
55
III. The New Gold Standard

• Studying the Balance of Payments
• The Balance of Payments
• Workings of the Gold Standard Itself

56
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.

57
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
58
This explains why some statesFrance the
UShoarded gold.
59
What was the cumulative result of these events?
60
Source Eichengreen, Globalizing Capital, 65.
61
Source Eichengreen, Globalizing Capital, 65.
(Note that the United States is omitted here.)
62
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?
63
Attempts to Revive Gold

• The Adoption of Gold (continued)
• The Return to Gold (1919-1925)
• The New Gold Standard (1925-1931)
• Gold in the Great Depression and War

64
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!

65
Most economists have agreed that the devaluations
of the 1930s were part of the solution.
66
But the question remains, how do we explain this
sudden abandonment of the GS ideal?
67
Fragility of New Gold Standard Regime

• All Gold Standard Regimes Depend on
• Leadership of Major Economies (Kindleberger)
• Supporting International Norms (Eichengreen)
• Committed, Compliant Populace (Polanyi)
• Luck Increase in Gold No Exogenous Shocks
  (Keynes)
• New Gold Standard was even further from GS
  Ideal than Prewar Gold Standard

68
(1) 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
• Kindleberger US had all of the gold the US
  needed to provide the world with liquidity but
  did the opposite!

69
(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

70
(3) Polanyi Empowered Populace

• Due to balance of payments constraint, GS ideal
  sacrifices MPA
• Practical Implications
• Deflationary bias
• Price decreases brought about by unemployment
• Why would a state give up MPA?
• ? Serves capital at the expense of labor!
• Polanyis Historical Shift democratization
• Prewar poor werent represented ? GS
• 1920s poor stop putting up with GS

71
(4) 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 didnt create
  catastrophe
• In 20th 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!

72
How should that institution be structured?
73
? Well consider that next time when we consider
Keynes attempts to shape the postwar monetary
system.
74
Key Points from Lecture

• States always possessed political incentives
  (read policy autonomy!) to compromise on GS
  Rules/Ideal (convertibility ER stability)
• Prewar GS was compromised but New GS was even
  more so (e.g. France US)
• Several exogenous changes made adhering to gold
  more difficult in 1930s than before (see Point
  IV)
• Interpretations of interwar period governed
  perspectives on international monetary system for
  decades