CHAPTERS IN ECONOMIC POLICY
Part. I
Unit 2
Monetary policy before World War II: The
role of gold standard
The classical gold standard was characterized by the
following principles:
•
interconvertibility between domestic money and gold
at a fixed official price
•
freedom for private citizens to import and export gold
•
a set of rules relating the quantity of money in
circulation in a country to that country’s stock of gold
Provided that:
- each country adhering to the gold standard is willing to
convert its domestic currency into a fixed weight of
gold;
- the price of gold is set on the world markets subject only
to the margins covering shipping and insurance cost
(“law of one price”)
an international gold standard establishes fixed exchange
rates between national currencies
At least in principle:
-
balance of payments settlement are effected through
international tranfer of gold;
- balance of payments equilibrium is obtained through the
impact of gold flows on internal economic conditions
-
The gold standard has been frequently interpreted
and presented as a self-equilibrating system
- As a consequence of this alleged property, it was
advocated during the XX century by several liberal
economists, who advocated policies based on rules
rather than discretion (M. Friedman, L. von Mises, F.
Hayek)
- The first example of a formal model of the gold standard
as a self-equilibrating system was actually David
Hume’s price-specie flow mechanism (Political
Discourses, 1752)
- Hume’s implicit assumption: flexibility (in particular,
downward flexibility) of prices and nominal wages
- In Hume’s analysis there is no mention of the role of
banks, either private banks or the Central bank
•
i)
ii)
Hume’s analysis highlights the close connection
between:
gold movements and money supply
the supply of currency and the price level
The price-specie flow mechanism emphasizes the impact
of price movements on the balance of trade
In the XVIII century, in the international transactions trade in
goods was definitely more important than capital flows
- During the XIX century the textbook treatments of the
classical gold standard included the banking system, but
portrayed central banks as obeying “rules of the game”
• According to these “rules”, monetary authorities had to
intervene in order to reinforce the impact of gold flows on
domestic money and credit and to speed up the
equilibrating mechanism
-E.g.: if a Central bank was losing gold as a consequence
of a current account (net export) deficit, monetary
authorities had to raise the discount rate
- This measure caused:
i) an increase of the cost to the banking sector of
rediscounting at the Central bank. This determined a
reduction in aggregate demand and production (Y). As a
consequence, Import decreased;
ii) an inflow of capital from abroad (the current account
deficit is compensated in the short run by a capital
account surplus)
• The actual working of the gold standard was however
quite different from these stylized accounts:
1) far from being the normal state of affairs prior to the XX
century, the gold standard prevailed on a global scale for
scarcely a third of century (from 1880 to 1914). At the
beginning of the XIX century, domestic currencies were
based on silver rather than on gold
- Britain was an exception having been on a de facto gold
standard from 1717 and on a full legal gold standard from
1821 (as a result of the so called resumption act)
- Gold standard was adopted at an international level only
from the beginning of the 1870s: Germany adhered to
this system in 1871; United States in 1879
• 2) Convertibility of banknotes issued by central banks
was indeed a powerful check against hyperinflation in
that it ruled out debt monetization
• Debt monetization: is the process by which the
government issues bonds and forces the Central bank to
buy them; the central bank pays the government bonds
with the money it creates, and the government uses that
money to finance the deficit
• However:
a) convertibility was actually guaranteed only in a few
countries (the “core” of the system: Britain, US,
Germany). In other countries (France, Belgium, Italy)
convertibility was at the authority option;
b) since the relative price of gold in terms of goods and
services is far from fixed, in the medium and long run
domestic price stability was far from granted (e.g. during
the 1880s most European countries experienced
substantial deflation);
3) the gold standard was on the whole an asymmetric and
deflationary biased system:
countries running a current account deficit (NX0) were
forced to adopt restrictionary monetary policies and to
accept higher unemployment in the short run, in order to
reduce domestic prices and nominal wages and therefore
to improve their ability to compete internationally
on the contrary, countries running a current account surplus
could simply “sterilize” the inflow of gold and were by no
means forced to adopt expansionary monetary policies
4) far from working automatically, the classical gold
standard was to certain extent a managed system, in that
it was managed by the Bank of England.
- London was the most important financial centre of the time
and this pre-eminence provided the Bank of England with
significant leverage over international flows of capital and
gold
-
-Monetary policies were harmonized internationally through
a leader-follower interaction: when the bank rate was
raised in London, central banks in continental Europe
had no choice but to adopt restrictionary policies
(similarities with the European Monetary System in the
1980-90s)
- With the outbreak of World War I, convertibility was
suspended either de facto or de jure by all European
countries
- In the belligerent countries debt monetization became the
rule. This brought high and persistent inflation
- After the war, as a consequence of high inflation, the
return to pre-war parities became infeasible. Gold
standard was suspended and nominal exchange rates
were let to float (the only exception being the United
States)
-
Widespread agreement among economists after WWIthat
returning to gold was in itself a desirable goal
- In UK this topic was analysed by an influential board set
by the government (the Cunliffe Committee)
- In 1918 the Cunliffe Committee issued a Report (the First
Interim Report) according to which re-establishing the
prewar parity was not merely a desirable goal but an
essential measure to ensure financial stability
-
The Committee’s report provided also a classic, albeit
idealized, description of the working of the pre-WWI
working of the gold standard:
“When the exchanges were favourable, gold flowed freely
into this country and an increase of legal tender money
accompanied the development of trade. When the
balance of trade was unfavourable and the exchanges
were adverse, it became profitable to export gold. The
would-be exporter bought his gold from the Bank of
England and paid for it by a cheque on his account. The
Bank obtained the gold from the Issue Department in
exchange for notes taken out of its banking reserve, with
the result that its liabilities to depositors and its banking
reserve were reduced by an equal amount, and the ratio
of reserve to liabilities consequently fell. [CONT.]
“If the process was repeated sufficiently often to reduce the
ratio in a degree considered dangerous, the Bank raised
its rate of discount. The raising of the discount rate had
the immediate effect of retaining money here which
would otherwise have been remitted abroad and of
attracting remittances from abroad to take advantage of
the higher rate, thus checking the outflow of gold and
even reversing the stream”
- If the adverse condition of the exchanges was due not
merely to “seasonal fluctuations”, but to “structural”
circumstances the previous procedure was not sufficient
• However, following the raising of the Bank’s discount
rate,
• “new enterprises were postponed and the demand for
constructional materials and other capital goods was lessened
[…] The result was a decline in general prices in the home
market which, by checking imports and stimulating exports,
corrected the adverse trade balance which was the primary
cause of the difficulty”
• In conclusion:
“There was an automatic machinery by which the volume of
purchasing power in this country was continuously
adjusted to world prices of commodities in general.
Domestic prices were automatically regulated so as to
prevent excessive imports; and the creation of banking
credit was so controlled that banking could be safely
permitted a freedom from state interference which would
not have been possible under a less rigid currency
system”
- The Committee’s point of view was strongly criticized by
J.M. Keynes.
- In his Tract on Monetary Reform (1923) Keynes:
i) observed that the re-establishment of the prewar parity of
the pound implied a severe deflationary process in UK;
ii)
provided a detailed analysis of the negative
macroeconomic and redistributional effects of monetary
instability (and particularly of deflation)
“In the first pIace, deflation is not desirable, because […]
redistributes wealth in a manner injurious, at the same
time, to business and to social stability. Deflation […]
involves a transference of wealth from the rest of the
community to the rentier class and to all holders of titles
to money; just as inflation involves the opposite. In
particular it involves a transference from all borrowers,
that is to say from traders, manufacturers, and farmers,
to lenders, from the active to the inactive” (Keynes, 1923,
p. 118)
• Furthermore:
“The policy of gradually raising the value of a country's
money […] above its present value in terms of goods […]
amounts to giving notice to every merchant and every
manufacturer that for some time to come his stock and
his raw materials will steadily depreciate on his hands”
(Keynes, 1923, p. 119)
As a consequence:
“It will be to the interest of everyone in business to go out of
business for the time being; and of everyone who is
contemplating expenditure to postpone his orders so
long as he can. The wise man will be he who turns his
assets into cash, withdraws from the risks and the
exertions of activity, and awaits in country retirement
the steady appreciation promised him in the value of
his cash. A probable expectation of deflation is bad
enough; a certain expectation is disastrous” (Keynes,
1923, p. 119)
iii) In his Tract Keynes analysed also the trade off between
internal balance (domestic price level stability) and
external balance (exchange rates stability) and argued
that, particularly after WWI, domestic price stability had
to be considered by far the most important goal
In Keynes words:
“In pre-war days, when almost the whole world was on a
gold standard, we had all plumped for stability of
exchange as against stability of prices, and we were
ready to submit to the social consequences of a
change of price level for causes quite outside our
control, connected, for example, with the discovery of
new gold mines in foreign countries or a change of
banking policy abroad. But we submitted, partly
because we did not dare trust ourselves to a less
automatic (though more reasoned) policy, and partly
because the price fluctuations experienced were in fact
moderate” (Keynes, 1923, p. 126)
- Keynes admits that “prudent people should desiderate a
standard of value which is independent of finance
ministers and state banks” and that “the chief object of
stabilising the exchanges is to strap down ministers of
finance”
- However, he observed, gold itself had become a
'managed' currency
“The United States has not been able to let gold fall to its
'natural' value, because it could not face the resulting
depreciation of its standard. It has been driven,
therefore, to the costly policy of burying in the vaults of
Washington [Federal Reserve] what the miners of the
Rand have laboriously brought to the surface.
Consequently gold now stands at an 'artificial' value,
the future course of which almost entirely depends on
the policy of the Federal Reserve Board of the United
States” (Keynes, 1923, p. 134)
•
In conclusion:
“The gold standard is already a barbarous relic. AlI of us,
from the Governor of the Bank of England downwards,
are now primarily interested in preserving the stability
of business, prices, and employment, and are not
likely, when the choice is forced on us, deliberately to
sacrifice these to the outworn dogma, which had its
value once, of £ 3, 17s, 101/2 d per ounce” (Keynes,
1923, p. 138)
In 1925, however, Winston Churchill, then Britain’s
Chancellor of the Exchequer, decided to return to the
gold standard at the prewar parity
To a large extent, the interests of the British industry were
sacrificed to the interests of finance, though
“there were those who hoped that US prices would rise
sufficiently to relieve Britain of the burden of deflation”
(Eichengreen, 1992)
-However in US the Fed pursued a policy of de facto price
stabilization and sterilized the inflows of gold
-As predicted by Keynes, at least in the short run the
outcome for UK was a severe recession, higher
unemployment and social unrest