At exactly the same time the Weimar hyperinflation was spiraling out of control, major industrial nations sent representatives to the Genoa Conference in Italy in the spring of 1922 to consider a return to the gold standard for the first time since before World War I. Prior to 1914, most major economies had a true gold standard in which paper notes existed in a fixed relationship to gold, so both paper and gold coins circulated side by side with one freely convertible into the other. However, these gold standards were mostly swept aside with the coming of World War I as the need to print currency to finance war expenditures became paramount. Now, in 1922, with the Versailles Treaty completed and war reparations established, although on an unsound footing, the world looked again to the anchor of a gold standard.
Yet important changes had taken place since the heyday of the classical gold standard. The United States had created a new central bank in 1913, the Federal Reserve System, with unprecedented powers to regulate interest rates and the supply of money. The interaction of gold stocks and Fed money was still an object of experimentation in the 1920s. Countries had also grown used to the convenience of issuing paper money as needed during the war years of 1914–1918, while citizens had likewise become accustomed to accepting paper money after gold coins had been withdrawn from circulation. The major powers came to the Genoa Conference with a view to reintroducing gold on a more flexible basis, more tightly controlled by the central banks themselves.
From the Genoa Conference there emerged the new gold exchange standard, which differed from the former classical gold standard in significant ways. Participating countries agreed that central bank reserves could be held not only in gold but in the currencies of other nations; the word “exchange” in “gold exchange standard” simply meant that certain foreign exchange balances would be treated like gold for reserve purposes. This outsourced the burden of the gold standard to those countries with large gold holdings such as the United States. The United States would be responsible for upholding the gold value of the dollar at the $20.67 per ounce ratio while other nations could hold dollars as a gold proxy. Under this new standard, international accounts would still be settled in gold, but a country might accumulate large balances of foreign exchange before redeeming those balances for bullion.
In addition, gold coins and bullion no longer circulated as freely as before the war. Countries still offered to exchange paper notes for gold, but typically only in large minimum quantities, such as four-hundred-ounce bars, valued at the time at $8,268 each, equivalent today to over $110,000. This meant that gold bullion would be used only by central banks, commercial banks and the wealthy, while others would use paper notes backed by the promises of governments to maintain their gold equivalent value. Paper money would still be “as good as gold,” but the gold itself would disappear into central bank vaults. England codified these arrangements in the Gold Standard Act of 1925, intended to facilitate the new gold exchange standard.
Notwithstanding the return to a modified gold standard, the currency wars continued and gained momentum. In 1923, the French franc collapsed, although not nearly as badly as the mark had a few years earlier. This collapse memorably paved the way for a golden age of U.S. expatriates living in Paris in the mid-1920s, including Scott and Zelda Fitzgerald and Ernest Hemingway, who reported on the day-to-day effects of the collapse of the French franc for the Toronto Star. Americans could afford a comfortable lifestyle in Paris by converting dollars from home into newly devalued francs.
Serious flaws in the gold exchange standard began to emerge almost as soon as it was adopted. The most obvious was the instability that resulted from large accumulations of foreign exchange by surplus countries, followed by unexpected demands for gold from the deficit countries. In addition, Germany, potentially the largest economy in Europe, lacked sufficient gold to support a money supply large enough to facilitate the international trade that it needed to return its economy to growth. There was an effort to remedy this deficiency in 1924 in the form of the Dawes Plan, named after the American banker and later U.S. vice president Charles Dawes, who was the plan’s principal architect. The Dawes Plan was advocated by an international monetary committee convened to deal with the lingering problems of reparations under the Versailles Treaty. The Dawes Plan partially reduced the German reparations payments and provided new loans to Germany so that it could obtain the gold and hard currency reserves needed to support its economy. The combination of the Genoa Conference of 1922, the new and stable rentenmark of 1923 and the Dawes Plan of 1924 finally stabilized German finance and allowed its industrial and agricultural bases to expand in a noninflationary way.
The system of fixed exchange rates in place from 1925 to 1931 meant that, for the time being, currency wars would play out using the gold account and interest rates rather than exchange rates. The smooth functioning of the gold exchange standard in this period depended on the so-called “rules of the game.” These expected nations experiencing large gold inflows to ease monetary conditions, accomplished in part by lowering interest rates, to allow their economies to expand, while those experiencing gold outflows would tighten monetary conditions and raise interest rates, resulting in an economic contraction. Eventually the contracting economy would find that prices and wages were low enough to cause its goods to be cheaper and more competitive internationally, while the expanding economy would experience the opposite. At this point the flows would reverse, with the former gold outflow country attracting inflows as it ran a trade surplus based on cheaper goods, while the expanding economy would begin to run a trade deficit and experience gold outflows.
The gold exchange standard was a self-equilibrating system with one critical weakness. In a pure gold standard, the gold supply was the monetary base and did the work of causing economic expansion and contraction, whereas, under the gold exchange standard, currency reserves also played a role. This meant that central banks were able to make interest rate and other monetary policy decisions involving currency reserves as part of the adjustment process. It was in these policy-driven adjustments, rather than the operation of gold itself, that the system eventually began to break down.
One of the peculiarities of paper money is that it is simultaneously an asset of the party holding it and a liability of the bank issuing it. Gold, on the other hand, is typically only an asset, except in cases—uncommon in the 1920s—where it is loaned from one bank to another. Adjustment transactions in gold are therefore usually a zero-sum game. If gold moves from England to France, the money supply of England decreases and the money supply of France increases by the amount of the gold.
The system could function reasonably well as long as France was willing to accept sterling in trade and redeposit the sterling in English banks to help maintain the sterling money supply. However, if the Banque de France suddenly withdrew these deposits and demanded gold from the Bank of England, the English money supply would contract sharply. Instead of smooth, gradual adjustments as typically occurred under the classical gold standard, the new system was vulnerable to sharp, destabilizing swings that could quickly turn to panic.
A country running deficits under the gold exchange standard could find itself like a tenant whose landlord does not collect rent payments for a year and then suddenly demands immediate payment of twelve months’ back rent. Some tenants would have saved for the inevitable rainy day, but many others would not be able to resist the easy credit and would find themselves short of funds and facing eviction. Countries could be similarly embarrassed if they were short of gold when a trading partner came to redeem its foreign exchange. The gold exchange standard was intended to combine the best features of the gold and paper systems, but actually combined some of the worst, especially the built-in instability resulting from unexpected redemptions for gold.
By 1927, with gold and foreign exchange accumulating steadily in France and flowing heavily from England, it was England’s role under the rules of the game to raise interest rates and force a contraction, which,
over time, would make its economy more competitive. But Montagu Norman, governor of the Bank of England, refused to raise rates, partly because he anticipated a political backlash and also because he felt the French inflow was due to an unfairly undervalued franc. The French, for their part, refused to revalue, but suggested they might do so in the future, creating further uncertainty and encouraging speculation in both sterling and francs.
Separately, the United States, after cutting interest rates in 1927, began a series of rate increases in 1928 that proved highly contrac-tionary. These rate increases were the opposite of what the United States should have done under the rules of the game, given its dominant position in gold and continuing gold inflows. Yet just as domestic political considerations caused England to refuse to raise rates in 1927, the Fed’s decision to raise rates the following year when it should have lowered them was also driven by domestic concerns, specifically the fear of an asset bubble in U.S. stock prices. In short, participants in the gold exchange standard were putting domestic considerations ahead of the rules of the game and thereby disrupting the smooth functioning of the gold exchange standard itself.
There was another flaw in the gold exchange standard that ran deeper than the lack of coordination by the central banks of England, the United States, France and Germany. This flaw involved the price at which gold had been fixed to the dollar in order to anchor the new standard. Throughout World War I, countries had printed enormous amounts of paper currency to finance war debts while the supply of gold expanded very little. Moreover, the gold that did exist did not remain static but flowed increasingly toward the United States, while relatively little remained in Europe. Reconciling the postwar paper-gold ratio with the prewar gold price posed a major dilemma after 1919. One choice was to contract the paper money supply to target the prewar gold price. This would be highly deflationary and would cause a steep decline in overall price levels in order to get back to the prewar price of gold. The other choice was to revalue gold upward so as to support the new price level given the expansion in the paper money supply. Raising the price of gold meant permanently devaluing the currency. The choice was between deflation and devaluation.
It is one thing when prices drift downward over time due to innovation, scalability or other efficiencies. This might be considered “good” deflation and is familiar to any contemporary consumer who has seen prices of computers or wide-screen TVs fall year after year. It is another matter when prices are forced down by unnecessary monetary contraction, credit constraints, deleveraging, business failures, bankruptcies and mass unemployment. This may be considered “bad” deflation. This bad deflation was exactly what was required in order to return the most important currencies to their prewar parity with gold.
The choice was not as stark in the United States because, although the U.S. had expanded its money supply during World War I, it had also run trade surpluses and had greatly increased its gold reserves as a result. The ratio of paper currency to gold was not as badly out of line relative to the prewar parity as it was in England and France.
By 1923, France and Germany had both confronted the wartime inflation issue and devalued their currencies. Of the three major European powers, only England took the necessary steps to contract the paper money supply to restore the gold standard at the prewar level. This was done at the insistence of Winston Churchill, who was chancellor of the exchequer at the time. Churchill considered a return to the prewar gold parity to be both a point of honor and a healthy check on the condition of English finances. But the effect on England’s domestic economy was devastating, with a massive decline of over 50 percent in the price level, a high rate of business failures and millions of unemployed. Churchill later wrote that his policy of returning to a prewar gold parity was one of the greatest mistakes of his life. By the time massive deflation and unemployment hit the United States in 1930, England had already been living through those conditions for most of the prior decade.
The 1920s were a time of prosperity in the United States, and both the French and German economies grew strongly through the middle part of the decade. Only England lagged. If England had turned the corner on unemployment and deflation by 1928, the world as a whole might have achieved sustained global economic growth of a kind not seen since before World War I. Instead, global finance soon turned dramatically for the worse.
The start of the Great Depression is conventionally dated by economists from October 28, 1929, Black Monday, when the Dow Jones Industrial Average fell 12.8 percent in a single day. However, Germany had fallen into recession the year before and England had never fully recovered from the depression of 1920–1921. Black Monday represented the popping of a particularly prominent U.S. asset bubble in a world already struggling with the effects of deflation.
The years immediately following the 1929 U.S. stock market crash were disastrous in terms of unemployment, declining production, business failures and human suffering. From the perspective of the global financial system, however, the most dangerous phase occurred during the spring and summer of 1931. The financial panic that year, tantamount to a global run on the bank, began in May with the announcement of losses by the Credit-Anstalt bank of Vienna that effectively wiped out the bank’s capital. In the weeks that followed, a banking panic gripped Europe, and bank holidays were declared in Austria, Germany, Poland, Czechoslovakia and Yugoslavia. Germany suspended payments on its foreign debt and imposed capital controls. This was the functional equivalent of going off the new gold exchange standard, since foreign creditors could no longer convert their claims on German banks into gold, yet officially Germany still claimed to maintain the value of the reichsmark in a fixed relationship to gold.
The panic soon spread to England, and by July 1931 massive gold outflows had begun. Leading English banks had made leveraged investments in illiquid assets funded with short-term liabilities, exactly the type of investing that destroyed Lehman Brothers in 2008. As those liabilities came due, foreign creditors converted their sterling claims into gold that soon left England headed for the United States or France or some other gold power not yet feeling the full impact of the crisis. With the outflow of gold becoming acute and the pressures of the bank run threatening to destroy major banks in the City of London, England went off the gold standard on September 21, 1931. Almost immediately sterling fell sharply against the dollar and continued dropping, falling 30 percent in a matter of months. Many other countries, including Japan, the Scandinavian nations and members of the British Commonwealth, also left the gold standard and received the short-run benefits of devaluation. These benefits worked to the disadvantage of the French franc and the currencies of the other gold bloc nations, including Belgium, Luxembourg, the Netherlands and Italy, which remained on the gold exchange standard.
The European bank panic abated after England went off the gold standard; however, the focus turned next to the United States. While the U.S. economy had been contracting since 1929, the devaluation of sterling and other currencies against the U.S. dollar in 1931 put the burden of global deflation and depression more squarely on the United States. Indeed, 1932 was the worst year of the Great Depression in the United States. Unemployment reached 20 percent and investment, production and price levels had all plunged by double-digit amounts measured from the start of the contraction.
In November 1932, Franklin D. Roosevelt was elected president to replace Herbert Hoover, whose entire term had been consumed by a stock bubble, a crash and then the Great Depression itself. However, Roosevelt would not be sworn in as president until March 1933, and in the four months between election and inauguration the situation deteriorated precipitously, with widespread U.S. bank failures and bank runs. Millions of Americans withdrew cash from the banks and stuffed it in drawers or mattresses, while others lost their entire life savings because they did not act in time. By Roosevelt’s inauguration, Americans had lost faith in so many institutions that what little hope remained seemed embodied in Roosevelt himself.
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sp; On March 6, 1933, two days after his inauguration, Roosevelt used emergency powers to announce a bank holiday that would close all banks in the United States. The initial order ran until March 9 but was later extended for an indefinite period. FDR let it be known that the banks would be examined during the holiday and only sound banks would be allowed to resume business. The holiday ended on March 13, at which time some banks reopened while others remained shut. The entire episode was more about confidence building than sound banking practice, since the government had not in fact examined the books of every bank in the country during the eight days they were closed.
The passage of the Emergency Banking Act on March 9, 1933, was of far greater significance than the bank inspections in terms of rebuilding confidence in the banks. The act allowed the Fed to make loans to banks equal to 100 percent of the par value of any government securities and 90 percent of the face value of any checks or other liquid short-term paper they held. The Fed could also make unsecured loans to any bank that was a member of the Federal Reserve System. In practice, this meant that banks could obtain all the cash they needed to deal with bank runs. It was not quite deposit insurance, which would come later that year, but it was the functional equivalent because now depositors did not have to worry that banks would literally run out of cash.
Interestingly, Roosevelt’s initial statutory authority for the bank closure in March was the 1917 Trading with the Enemy Act, which had become law during World War I and granted any president plenary emergency economic powers to protect national security. In case the courts might later express any doubt about the president’s authority to declare the bank holiday under this 1917 wartime statute, the Emergency Banking Act of 1933 ratified the original bank holiday after the fact and gave the president explicit rather than merely implicit authority to close the banks.
Currency Wars: The Making of the Next Global Crisis Page 8