A History of Money and Banking in the United States: The Colonial Era to World War II

by Murray N. Rothbard

  In the first place, under the old gold standard, the nominal currency, whether issued by government or bank, was redeemable in gold coin at the defined weight. The fact that people were able to redeem in and use gold for their daily transactions kept a strict check on the overissue of paper. But in the new gold standard, British pounds would not be redeemable in gold coin at all: only in “bullion” in the form of bars worth many thousands of pounds. Such a gold standard meant that gold could not be redeemed domestically at all; bars could hardly circulate for daily transactions, so that they could only be used by wealthy international traders.

  The decision of the British Cabinet on March 20, 1925, to go back to gold was explicitly predicated on three conditions. First was the attainment of a $300 million credit line from the United States. Second was that the bank rate would not increase upon announcement of the decision, so that there would be no contractionary or anti-inflationary pressure exercised by the Bank of England. And third and perhaps most important was that the new standard would be gold bullion and not gold coin. The chancellor of the Exchequer would persuade the large “clearing banks” to “use every effort... to discourage the use of gold for internal circulation in this country.” The bankers were warned that if they could not provide satisfactory assurances that they would not redeem in gold coin, “it would be necessary to introduce legislation on this point.” The Treasury, in short, wanted to avoid “psychologically unfortunate and controversial legislation” barring gold redemption within the country, but at the same time wanted to guard against the risk of “internal drain” (that is, redemption in the property to which they were entitled) from foreign agents, the irresponsible public, or “sound currency fanatics.”43 The bankers, headed by Reginald McKenna, were of course delighted not to have to redeem in gold, but wanted legislation to formalize this desired condition.

  Finally, the government and the bankers agreed happily on the following: the bankers would not hold gold, or acquire gold coins or bullion for themselves, or for any customers residing in the United Kingdom. The Treasury, for its part, redrafted its banking report to allow for legislation to prevent any internal redemption if necessary, and “enforce” such a ban on the all-too-willing bankers.

  Under the Gold Standard Act of 1925, then, pounds were convertible into gold, not in coin, but in bars of no less than 400 gold ounces, that is $1,947. The new gold standard was not even a full gold bullion standard, since there was to be no redemption at all in gold to British residents; gold bullion was only due to pound-holders outside Great Britain. Britain was now only on an “international gold bullion standard.”44

  The purpose of redemption in gold bullion only, and only to foreigners, was to take control of the money supply away from the public, and place it in the hands of the governments and central bankers, permitting them to pyramid monetary inflation upon gold centralized into their hands. Thus, Norman, when asked by the governor of the Bank of Norway for his advice about returning to gold, urged Norway to return only in gold bars, and only for international payments. Norman’s reasoning is revealing:

  [I]n Norway the convenience of paper currency is appreciated, and confidence in the value of money does not depend upon the existence of gold coin.... Demand is rendered more inelastic wherever the principle of gold circulation, for currency or for hoarding, is accepted, and any inelasticity may be dangerous.... I do not believe that gold in circulation can safely be regarded as a reserve that can be made available in case of need, and I think that even in times of abundance hoarding is bad, because it weakens the command of the Central Bank over the monetary circulation and hence over the purchasing power of the monetary unit.

  For these reasons, I suggest that your best course would be to establish convertibility of notes into gold bars only and in amounts which will ensure that the use of monetary gold can be limited, in case of need, to the settlement of international balances.45, 46

  Norway, and indeed all the countries returning to gold, heeded Norman’s advice. The way was paved for this development by the fact that, during World War I, the European countries had systematically taken gold coins out of circulation and replaced them with paper notes and deposits. During the 1920s, virtually the only country still on the classical gold-coin standard was the United States.

  Despite this tradition, it was still necessary for Monty Norman and the Bank of England to exert considerable pressure to force many European nations to return to gold bullion rather than gold coin. Thus, Dr. William Adams Brown, Jr., writes:

  In some countries the reluctance to adopt the gold bullion standard was so great that some outside pressure was needed to overcome it... [that is] strong representations on the part of the Bank of England that such action would be a contribution to the general success of the stabilization effort as a whole. Without the informal pressure... several efforts to return in one step to the full gold standard would undoubtedly have been made.47

  THE GOLD-EXCHANGE STANDARD, NOT GOLD

  The major twist, the major deformation of a genuine gold standard perpetrated by the British in the 1920s, was not the gold bullion standard, unfortunate though that was. The major inflationary camouflage was to return, not to a gold standard at all, but to a “gold-exchange” standard. In a gold-exchange standard, only one country, in this case Great Britain, is on a gold standard in the sense that its currency is actually redeemable in gold, albeit only gold bullion for foreigners. All other European countries, even though nominally on a gold standard, were actually on a pound-sterling standard. In short, a typical European country, say, “Ruritania,” would hold as reserves for its currency, not gold but British pounds sterling, in practice, bills or deposits payable in sterling at London. Anyone who demanded redemption for Ruritanian “rurs,” then, would receive British pounds rather than gold.

  The gold-exchange standard, then, cunningly broke the classical gold standard’s stringent limits on monetary and credit expansion, not only for the other European countries, but also for the base or key currency country, Great Britain itself. Under the genuine gold standard, inflating the number of pounds in circulation would cause pounds to flow into the hands of other countries, which would demand gold in redemption. Thereby gold would move out of British bank and currency reserves, and pressure would be put on Britain to end its inflation and to contract credit. But, under the gold-exchange standard, the process was very different. If Britain inflated the number of pounds in circulation, the result, again, was a deficit in the balance of trade and sterling balances piling up in the accounts of other nations. But now that these nations have been induced to use pounds as their reserves rather than gold, these nations, instead of redeeming the pounds in gold, would inflate, and pyramid a multiple of their currency on top of their increased stock of pounds. Thus, instead of checking inflation, a gold-exchange standard encourages all countries to inflate on top of their increased supply of pounds. Britain, too, is now able to “export” her inflation to other nations without paying a price. Thus, in the name of sound money and a check against inflation, a pseudo gold standard was instituted, designed to induce a double-inverted pyramid of inflation, all on top of British pounds, the whole process supported by a gold stock that does not dwindle.

  Since all other countries were sucked into the inflationary gold-exchange trap, it seemed that the only nation Britain had to worry about was the United States, the only country to continue on a genuine gold standard. That was the reason it became so vitally important for Britain to get the United States, through the Morgan connection, to go along with this system and to inflate, so that Britain would not lose gold to the United States.

  For the other nations of Europe, it became an object of British pressure and maneuvering to induce these countries themselves to return to a gold standard, with several vital provisions: (a) that their currencies too be overvalued, so that British exports would not suffer, and British imports would not be overstimulated—in other words, so that they join Britain in overvaluing thei
r currencies; (b) that each of these countries adopt their own central bank, with the help of Britain, which would inflate their currencies in collaboration with the Bank of England; and (c) that they return, not to a genuine gold standard, but to a gold-exchange standard, keeping their balances in London and refraining from exercising their legal right to redeem those sterling balances in gold.

  In this way, for a few years Britain could have its cake and eat it too. It could enjoy the prestige of going back to gold, going back at a highly overvalued pound, and yet continue to pursue an inflationary, cheap-money policy instead of the opposite. It could inflate pounds and see other countries keep their sterling balances and inflate on top of them; it could induce other countries to go back to gold at overvalued currencies and to inflate their money supplies;48 and it could also try to prop up its flagging exports by using cheap credit to lend money to European nations so that they could purchase British goods.

  Not that every country was supposed to return to gold at the overvalued, prewar par. The rule of thumb imposed in the 1920s was that (a) currencies, such as that of Britain herself, that had depreciated up to 60 percent from prewar (for example, the Netherlands and the Scandinavian countries) would return at the prewar par; (b) currencies that had depreciated from 60 to 90 percent were to return to gold within that zone, but at a rate substantially above their lowest rate (for example, Belgium, Italy, Czechoslovakia, and France). The French franc, which had depreciated to 240 to the pound due to massive inflation, returned to gold at the doubled rate of 124 to the pound. And (c) only those currencies that had been wiped out by devastating hyperinflation, like Austria, Bulgaria, and especially Germany, were allowed to return to gold at a realistic rate, and even they were stabilized at a little bit above their lowest point. As a result, virtually every European currency suffered from the requirement to raise the value of its currency artificially above its depreciated level.49

  The gold-exchange standard was not created de novo by Great Britain in the interwar period. It is true that a number of European central banks before 1914 had held foreign exchange reserves in addition to gold, but these were strictly limited, and they were held as earning assets—these after all were privately owned central banks in need of earnings—not as instruments of monetary manipulation. But in a few cases, particularly where the pyramiding countries were from the Third World, they did function as a gold-exchange standard: that is, the Third World currency pyramided its currency on top of a key country’s reserves (pounds or dollars) instead of on gold. This system began in India, after the late 1870s, as a historical accident. The plan of the British imperial center was to shift India which, like many Third World countries, had been on a silver standard, onto a seemingly sounder gold, following the imperial nations. India’s reserves in pound sterling balances in London were supposed to be only a temporary transition to gold. But, as in so many cases of seeming transition, the Indian gold-exchange standard lingered on, and received great praise for its modern inflationary potential from John Maynard Keynes, then in his first economic post at the India Office. It was Keynes, after leaving the India Office and going to Cambridge, who trumpeted the new form of monetary system as a “limping” or imperfect gold standard but as a “more scientific and economic system,” which he dubbed the gold-exchange standard. As Keynes wrote in February 1910, “it is cheaper to maintain a credit at one of the great financial centres of the world, which can be converted with great readiness to gold when it is required.” In a paper delivered the following year to the Royal Economic Society, Keynes proclaimed that out of this new system would evolve “the ideal currency of the future.”

  Elaborating his views into his first book, Indian Currency and Finance (London, 1913), Keynes emphasized that the gold-exchange standard was a notable advance because it “economized” on gold internally and internationally, thus allowing greater “elasticity” of money (a longtime code word for ability to inflate credit) in response to business needs. Looking beyond India, Keynes prophetically foresaw the traditional gold standard as giving way to a more “scientific” system based on one or two key reserve centers. “A preference for a tangible reserve currency,” Keynes declared blithely, “is... a relic of a time when governments were less trustworthy in these matters than they are now.”50 He also believed that Britain was the natural center of the new reformed monetary order. While his book was still in proofs, Keynes was appointed a member of the Royal Commission on Indian Finance and Currency, to study and make recommendations for the basic institutions of the Indian monetary system. Keynes dominated the commission proceedings, and while he got his way on maintaining the gold-exchange standard, he was not able to convince the commission to adopt a central bank. However, he managed to bully it into including his annex favoring the state bank in its report, completed in early 1914. In addition, in his work on the commission, Keynes managed to enchant his doting mentor, Alfred Marshall, the unquestioned ruler of academic economists in Britain.51

  While Montagu Norman was the field marshal of the gold-exchange standard of the 1920s, its major theoretician was longtime Treasury official Ralph Hawtrey. When Hawtrey rose to the position of director of Financial Enquiries at the Treasury in 1919, he delivered a speech before the British Association on “The Gold Standard.” The speech presaged the gold-exchange standard of the 1920s. Hawtrey sought not only a system of stable exchange rates as before the war, but also a monetary system that would stabilize the world purchasing power of gold, or world price levels. Hawtrey recommended international cooperation to stabilize price levels, and urged the use of an index number of world prices, a proposal reminiscent of Yale Professor Irving Fisher’s suggestion for a “tabular” gold-exchange standard made in 1911. In practice, such calls for price-level stabilization, which were pursued by Benjamin Strong in the 1920s, were really calls for price inflation, to combat the dominant secular trend in a progressing free-market economy of falling prices.

  In the post–World War I world, this attempt at dual stabilization meant that the governments would have to salvage the high postwar price levels from the threat of deflation, and in particular to alleviate the “shortage” of gold compared to the swollen totals of paper currencies existing in Europe. As Professor Eric Davis writes:

  There had been concern in official circles that a return to the Gold Standard would be inhibited by a shortage of gold. Prices were much higher than before the war, and thus if there was a general return to the old parities there might be insufficient gold.... Hawtrey picked up on the idea that the Gold Exchange Standard could be widely introduced to economise on the use of gold for monetary purposes. Since countries would hold foreign exchange, much presumably in sterling balances as a substitute for gold, there was a special advantage for Britain: the demand for the pound would be increased at the same time the demand for gold lessened.52

  The central instrument for imposing the new gold-exchange standard on Europe was the international financial conference called by the League of Nations at Genoa in the spring of 1922. At a previous international financial conference at Brussels in September 1920, the league had established a powerful financial and economic committee, which from the very beginning was dominated by Montagu Norman through his allies on the committee. Head of the committee was British Treasury official Sir Basil Blackett, and also dominant on the committee were two of Norman’s closest associates, Sir Otto Niemeyer and Sir Henry Strakosch. All of these men were ardent price-level stabilizationists. Moreover, Norman’s chief adviser in international monetary affairs, Sir Charles S. Addis, was also a dedicated stabilizationist.53

  Prodded by Norman, British Prime Minister Lloyd George successfully urged the British Cabinet, in mid-December 1921, to call for a broad economic conference on the postwar reconstruction of Europe, to include discussions of German reparations, Soviet Russian reconstruction, the public debt, and the monetary system. At a meeting of the Allied Supreme Council at Cannes in early January 1922, Lloyd George got the delegates to p
ropose an all-European economic and financial conference for the reconstruction of Central and Eastern Europe. Promptly the British set up an interdepartmental committee on economics and finance to prepare for the conference. Head of the committee was the permanent secretary of the Board of Trade, Sir Sidney Chapman. The aim of the Chapman Committee was to return to a gold standard, restore international credit, and establish cooperation between the various central banks. On March 7, 1922, the Chapman Committee issued its report for a draft agreement, which included currency stabilization, central bank cooperation, and adoption of a gold-exchange rather than a straight gold standard, with each country deciding on the rate at which it would return to gold.

  The European economic conference occurred at Genoa from April 10 to May 19, 1922. The conference divided itself into several commissions, including economic and transportation commissions. The relevant commission for our concerns was the Financial Commission, headed by British Chancellor of the Exchequer Sir Robert Horne. The Financial Commission divided itself into three subcommissions, on credits, exchanges, and currency. Credit resolutions dealt with intergovernmental loans, and exchanges was an attempt to eliminate exchange controls. Currency was the subcommission dealing with the international monetary system. The crucial committee, however, was a large Committee of Experts covering all three subcommissions, and which actually drew up the resolutions finally passed by the conference. The Committee of Experts was appointed solely by Sir Robert Horne, and it met in London during the early stages of the Genoa Conference. This large committee, consisting of government officials and financial authorities, was headed by the ubiquitous Sir Basil Blackett.