Gold in the Interwar Period
JM Keynes
Winston Churchill
Hjalmar Schacht
Lecture 13 – Thursday, 26 October 2011
J A Morrison
1
Decline and Fall of the Gold
Standard
I. The Return to Gold (1919-1925)
II. The “New Gold Standard” (19251931)
III. Gold in the Great Depression and
War
IV. A Case: the Puzzle of Great Britain
2
Decline and Fall of the Gold
Standard
I. The Return to Gold (1919-1925)
II. The “New Gold Standard” (19251931)
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: to
protect reserves, currencies were not
redeemable
• Practical effect: currencies continued to
float in the market
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 states—Austria,
Hungary, Germany, and
Poland—suffered…
9
Hyperinflation.
Here, the exchange value plummeted below the
intrinsic value of the paper itself.
10
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
Hjalmar Schacht
12
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 unemploymentproducing deflation
• Disadvantage: undermines credibility of
commitment to gold standard
14
Who argued that latter point
(about credibility)?
John Locke
Montague 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 (1919-1925)
II. The “New Gold Standard” (19251931)
• Gold in the Great Depression and
War
• 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
 We’ll take each in turn.
21
II. The “New Gold Standard”
1. Exchange Rate Values
2. Exogenous Changes in Int’l 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 don’t fall immediately
•  Foreign purchases cost less (by moving
through gold) than do domestic
25
The Economic Crisis of 19251926
• 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 don’t rise immediately
• Domestic purchases cost less than do
foreign (given the cost of converting into
gold)
• Result: imports decrease; exports
increase
27
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
28
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
29
But shouldn’t the price-specieflow mechanism have
moderated this?
Shouldn’t 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
down—largely 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
– 1926-1931: French repeatedly intervene to
stop appreciation of the franc
 Gold travels from Britain to France
– 1926-1931: 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
• Exogenous Changes in Int’l Econ
Flows
• 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 didn’t 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
– 1924-1929: Allies receive $2bn from Germany
40
– 1926-1931: US loans $1bn to Germany
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
• Workings of the Gold Standard Itself
44
Gold Shortage
• 1924-1929: considerable economic growth
but limited growth of gold supply
• Worldwide 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...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
46
This explains why some
states—France & the US—
hoarded gold.
47
What was the cumulative result
of these events?
48
Source: Eichengreen, Globalizing Capital, 65.
49
Source: Eichengreen, Globalizing Capital, 65.
(Note that the United States is omitted here.)
50
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
--> The US dramatically reduced
the amount of money it lent abroad!
(Kindleberger 70-74)
41
Attempts to Revive Gold
I. The Return to Gold (1919-1925)
II. The “New Gold Standard” (19251931)
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: 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!
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 19th C, world was lucky:
– there was enough gold to go around
– following GS “orthodoxy” didn’t create
catastrophe
• In 20th C, the world would not remain lucky
– Global economy requires liquidity
– Don’t 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, we’ll just consider one:
Great Britain (GB).
61
Attempts to Revive Gold
I. The Return to Gold (1919-1925)
II. The “New Gold Standard” (19251931)
III. Gold in the Great Depression and
War
IV. A Case: the Puzzle of Great Britain
62
As you know, Britain’s 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 weren’t empowered GS
– 1920s: poor stop putting up with GS
69
The “Polanyi thesis” maintains that
policymakers’ 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 policymaker 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 nat’l economic
“pie”
– Political wrangling determines how pie is cut
• 3 I’s: 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
• Virtually all British policymakers believed
defending GS was the best means to
preserve GB’s “pie”
• 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
• Their 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
74