This post is a continuation of The Gold Standard Between the Wars (Part I). In that post, the international gold standard was rebuilt as countries fixed their exchange rates, whether at pre-war rates or newer sharply reduced valuations. As was recounted, the speed with which countries restored their currencies’ link to gold masked the difficulty with which this was done. Returning to gold, especially for Britain, meant deflation and economic pain. All this was suffered to build something far removed from the pure gold standards that characterized the late 19th century. Instead, the system built in the 1920s was far more fragile for various fundamental and largely unavoidable reasons.

Problems

           Countries returned to gold at exchange rates that often seemed improperly low or high. There were concerns throughout the interwar years about the sustainability of the exchange rates of the major economies. Of course, fixed exchange rates were nothing new; they were an inseparable feature of the pre-First World War gold standard as well, so the concern may seem peculiar. Why were the levels of these rates wrongly set and unsustainable in 1929 but not in 1909 or earlier?

£1,000 Bank of England note, 1925 (Source: Numizon.com)

           Under a conventional understanding of the gold standard, it was thought that the valuation of a currency could not be ‘mis-valued’ for long. This was because, under the so-called ‘price-specie-flow’ mechanism, a country with an overvalued currency would experience trade deficits since it would be disadvantageous for foreigners to buy goods denominated in an overvalued currency. The deficits would then deplete the country’s gold reserves, lower the money supply, and reduce prices until the currency was no longer overvalued, or that is to say, until the currency no longer bought too few goods.

           Conversely, a country with an undervalued currency, one in which the currency bought too many goods, would see trade surpluses as foreigners imported products that looked cheap in terms of their own currencies. This would lead to gold inflows as foreigners paid for their imports, a rising money supply in the surplus-producing country, and rising prices until the currency no longer looked undervalued, or put differently, until the currency no longer bought as many goods.

           This was an understanding of how the gold standard worked that dated back 150 years at least. However, the self-regulating magic of the price-specie-flow mechanism required sharp cycles of inflation and deflation which governments and central banks were no longer willing to accept. Prices had to be volatile for the system to work and, true to form, the gold standard era of the 19th century was one that saw high price level volatility, especially when it came to deflationary episodes.

           Since these cycles were politically and economically undesirable, central banks developed means of altering the effects of the price-specie-flow mechanism. For example, during the 1920s, the Federal Reserve in the United States contracted and then restrained bank credit to offset the growth in American gold holdings, preventing the inflation that would have eventually haltered foreigners’ purchase of dollars with gold from abroad. Moves like this broke the old mechanism.

           As a result, Britain’s peg to gold continued to be seen as overvalued compared to that of France and the United States, causing the former to suffer large gold outflows to the latter. Because France and the United States implemented policies that ‘sterilized’ the effect of gold inflows, preventing local inflation, sterling would seem perpetually overvalued, with no correction occurring. This caused persistent deflation in Britain.

           This deflation could have led to a right-sizing of the exchange rate eventually, if with more-than-necessary pain along the way, if it weren’t for the unhelpful actions of other countries. Instead, even the surplus-producing countries, most notably France and America, had central banks perhaps excessively hyper-focused on inflation and too willing to put up with deflation. Suppressed price-levels in these countries prevented the pound from ever returning to a sensible relative level, even with substantial deflation.

           At the problem’s core was the fact that independent countries wanted to maintain an independent monetary policy, putting strain on the system of fixed exchange rates in a world where gold could be transferred freely. Occasionally, central banks would cooperate, keeping the gold standard alive by putting the preservation of the system above other economic interests but these were the exceptional moments. Growing imbalances and scarce mutual desire to address them imperiled the system.

           In the 19th century, the world looked to London and the Bank of England to maintain the system. Now, the growing importance of New York and Washington relative to London meant the system was leaderless as no single authority was able to marshal the restored system.

End of the Gold Standard

           The gold standard faced existential challenges in the late 1920s and 1930s. In 1929 and 1930, some of the first victims appeared. Falling commodity prices and reduced foreign lending by American investors caused commodity-exporting and indebted countries, like Argentina, Brazil, and Australia, to either abandon gold or depreciate their currencies by 1930.

           Then, in 1931, the failure of Austria’s largest bank, Kreditanstalt, an event that marked the start of the Great Depression in Europe, caused Germany and Austria to use their foreign currency assets to support their currencies in the wake of capital flight. Almost simultaneously, a banking crisis engulfed the United States. The emerging Great Depression cast doubts about the U.S. dollar and the British pound’s link to gold. Since 97% of foreign exchange reserves at the time were denominated in one of these two currencies, this undermined the system.

           The first to fold was Britain. The moment came after a political impasse about how to deal with competing fiscal budget and economic priorities led to a change in government. Around the same time, interest rates were increased despite a weakening economy in order to defend the gold reserves by enticing capital to the country. Britain abandoned the gold standard on September 21, 1931. In just the two months preceding the system’s demise, Britain had lost £200 million in gold and foreign exchange reserves; £43 million was lost in just the last four business days before the decision.

           The dominoes began to fall quickly. Two countries, Portugal and Yugoslavia had the distinction of both adopting and then abandoning gold in that very year. Indeed, when Britain abandoned gold in September 1931, their decision was copied within a month by each of the Scandinavian countries, most of the sterling-linked dominions of the British Empire, and many others. Countries facing higher unemployment or banking crises, like Germany and Austria, were also quick to abolish their currencies’ link to gold in the early 1930s.

           As for the United States, it initially remained committed to the now not-so-international gold standard. So, the Federal Reserve responded to Britain’s exit by raising its own interest rates from 1.5% to 3.5% in just the span of a couple weeks in October 1931. This was done in order to restore confidence in the country’s gold standard by encouraging inflows and discouraging outflows of money.

           If there were justified fears that the U.S. might withdrawal from the system, especially if there was reason to believe this might be followed by a devaluation as Britain’s withdrawal had, then foreigners, especially the French, would withdrawal their U.S. dollar reserves. The French were at this time, by a considerable margin, the most reserve-rich country in Europe.

           In any case, whatever the move did for confidence in the short run, the increase in American interest rates did not help financial conditions. Bank failures and the increasingly bleak outlook for the gold standard eventually meant that even the U.S. would be encouraged to put an end to the system. The break with gold by the United States came in 1933 and this event prompted another wave of exits, including that of South Africa and many other countries in the Americas.

Summary of data from Kirsten Wandschneider’s “The Stability of the Interwar Gold Exchange Standard: Did Politics Matter?”

           In Britain, the interwar return to the gold standard lasted just about six years. This brief tie to gold lasted about as long as in Germany. The system was maintained a few years longer in France and Italy, two of just a very short list of countries to stick with the system after the United States left it in 1933. However, it lasted far less long in many other countries, just a few months in some.

           Besides breaking with gold, many countries also imposed foreign exchange controls and even devalued their currencies substantially at some point in the 1930s. Its currency long judged overvalued, Britain had devalued simultaneously with its abandonment of gold. The pound promptly fell from $4.86 to $3.89, and by year-end 1931 it was at $3.37. Other countries depreciated by choice rather than necessity in order to avoid exports becoming less marketable abroad; however, this zero-sum strategy could not work to everyone’s advantage.

           The remaining gold-standard holdouts, most notably France, folded by 1936, plagued by these competitive currency devaluations in other currencies, pressing budget considerations on the eve of war, and economies in need of expansionary monetary policy. Generally, the speed with which countries abandoned the gold standard correlated positively with the timing of the recovery. In fact, Spain, which never returned to gold in the 1920s, actually avoided the deflation and depression of the era. The Great Depression inaugurated the second era of floating exchange rates in the 20th century.

Lesson

           The failure of the gold standard is not, in hindsight, surprising. There are numerous explanations offered by experts to explain the failure. What is surprising is how fundamental and irreversible these underlying challenges were. Therefore, it’s difficult to imagine any slightly different arrangement working any better.

           From growing democracy to the emergence of a new multipolar financial world, from a lack of international cooperation to monetary systems pushed to the limits, the challenges revealed how much the world had changed with the First World War. Returning to a 19th century monetary system was as impossible an aim to achieve as turning back time and literally returning to the 19th century in its entirety. The political and economic circumstances had changed too much and in too many respects to make this possible and, since theory does not reflect change so quickly as experience, failure was necessary to make the lesson clear.

More from the Tontine Coffee-House

           Read the first part of this two-part post. Consider subscribing to this blog’s newsletter or checking out book recommendations, which include many of the sources often referenced in my posts. 

Further Reading

1.     Accominotti, Olivier, and Youssef Cassis. “Chapter 25 – International Monetary Regimes: The Interwar Gold Exchange Standard.” Handbook of the History of Money and Currency, edited by Stefano Battilossi and Kazuhiko Yago, Springer, Singapore, 2020, pp. 633–664.

2.     Bernanke, Ben, and Harold James. “The Gold Standard, Deflation, and Financial Crisis in the Great Depression: An International Comparison.” Essays on the Great Depression, 2000.

3.     Crabbe, Leland. “The International Gold Standard and U.S. Monetary Policy from World War I to the New Deal.” Federal Reserve Bulletin, June 1989, pp. 423–440.

4.     Eichengreen, Barry, and Jeffrey Sachs. “Exchange Rates and Economic Recovery in the 1930s.” The Journal of Economic History, vol. 45, no. 4, Dec. 1985, pp. 925–946.

5.     Wandschneider, Kirsten. “The Stability of the Interwar Gold Exchange Standard: Did Politics Matter?” The Journal of Economic History, vol. 68, no. 1, Mar. 2008, pp. 151–181. 

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