John Felan is an economist at the American Experiment Center.
A century ago, many of the world’s greatest statesmen gathered in the Italian city of Genoa to build a financial system for the post-war world.
Prior to 1914, the world’s leading economies were classical gold standard. It was based on the variability between paper money and gold at a certain parity price and free export and import of gold.
If a central bank sets a parity price of £ 5 per ounce of gold, for example, the expansion of money supply relative to the gold reserve will push the market price, say, £ 6 per ounce. In that case, it would mean taking £ 5 notes to the bank, buying 1 ounce of gold, and selling it on the market for 6. During the financial crisis, the process worked in reverse. If the market price goes down, say, £ 4 per ounce, then buying one ounce of gold in the market at £ 4 and selling it to the bank at £ 5 would make sense. In each case, the variable modifies the financial expansion or contraction. In an expansion, if they want to maintain their reserve ratio, gold will flow from banks, forcing the currency to shrink. Similarly, a contraction will see gold flow in banks which will expand their currency issue.
World War I broke this system. Countries financed their war efforts by printing money and suspending convertibility and exports. Between 1914 and 1918, total metal reserves as banknotes and deposits fell to 63 to 1 percent in Austria-Hungary, 57 to 10 percent in Germany, 60 to 9 percent in Italy, 64 to 17 percent in France, and 40 percent. 33 percent in Britain. This leads to massive inflation, which leads to a bust erosion. In 1920, the League of Nations reported:
“Everywhere currency and exchange disorders are hampering trade and restructuring. In some countries, this is one of the main reasons for the breakdown of economic and social systems. “
After the war most countries wanted to return the value of gold but faced a problem: they now had much more currency than their gold reserves. The parity price of gold was much lower than the market price, which would lead to a massive outflow of gold if convertibility was restored.
To solve this problem, among others, statesmen met in April and May 1922. Their solution was the exchange rate of gold.
Increasing gold exchange value reserves will eliminate the imbalance between currency and gold reserves. But gold stocks could not be expanded beyond new discoveries, so the exchange rate of gold allowed central banks to add to their gold reserves the wealth of countries whose currencies were convertible into gold. In reality these were sterling and dollars. By 1927, foreign exchange accounted for 42% of the total reserves (gold and foreign exchange) of the twenty-four European central banks, up from 27% in 1924 and 12% in 1913.
But Sterling’s wealth is no longer considered ‘as good as gold’. In 1925, Winston Churchill, Britain’s Chancellor of the Exchequer, re-established Sterling variability in pre-war parity – against his good judgment. This was too much and helped cripple British exports. Attempts to reduce wages by internal devaluation provoked a general strike in 1926. Countries like France and Germany began to change their sterling for gold. From 1924 to 1928, foreign exchange fell from 59% of Germany’s total reserves to only 8%. Sterling could not adapt; Liabilities were 2.5 billion, almost four times the Bank of England’s gold reserves.
In 1927, Montagu Norman, the governor of the Bank of England, persuaded his friend Benjamin Strong, the governor of the Federal Reserve Bank of New York, to reduce the Fed rate in the hope of easing the pressure on Sterling. Whatever action Sterling bought, some economists saw it as the cause of the bubble of the stock market that erupted so spectacularly in 1929.
The Wall Street crash and its aftermath destroyed the gold exchange standard. As the budget deficit widened, in 1931 Sterling came under renewed pressure. Unable to formulate a ‘stinginess’ system, the labor government collapsed and was replaced by a national government that immediately devalued (an external devaluation): “No one told us we could do it. ”, Observes a Labor politician. Others soon followed, as one country lost its connection with gold. By the end of 1932, 32 countries had stopped gold. The ‘beggar-your-neighbor’ devaluation will continue until the 1930s.
The value of gold is sometimes blamed for the Great Depression, but the value of classical gold has a long history: economist Richard Timberlake notes that “the operational gold standard was lost forever when the United States was at war in World War I”. The flaws of its successor, however, bear much more blame on the gold exchange value, designed a century ago.