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10 MIN READ - The Cautious Optimism Correspondent for Economic Affairs and
Other Egghead Stuff continues with his analysis of what really started the
Great Depression. Or what he modestly refers to as "the most important
chapter in the world history of money."
In Part 1 we outlined the rules governing the international
classical gold standard up to 1914 and foreshadowed the means by which bad
monetary policy led to its demise while setting the stage for the beginning of
the Great Depression. We continue now with the end of the classical gold
standard and the sham paperized “gold-exchange” standard that replaced it in
III. WORLD WAR I: THE WORLD GOES OFF GOLD
The outbreak of World War I ended the idyllic global
classical gold standard arrangement. As with all large-scale wars, the
belligerent governments went off the gold standard and freed their central
banks to inflate aggressively as a means to finance war expenditures without
the level of taxation that would otherwise be required. The only participant
country that remained on gold was the United States, in part because it entered
the war later. But even the U.S. government imposed a ban on international gold
exports, so for all practical purposes the U.S. was on an exclusively domestic
As the war dragged on, European governments inflated
profusely and the value of their currencies plummeted. By the time of the
Treaty of Versailles so much unbacked paper money had been manufactured that
the British pound had lost 35% of its prewar value. But that loss was nothing
compared to the French franc (-64%), Belgian franc (-62%), Italian lira (-71%),
and German mark which had depreciated by 96% even before the Weimar
Given the enormous increase in paper money and demand
deposit balances in Europe, it was practically impossible for most nations to
return to the gold standard at their prewar pars for that would require a sharp
deflationary contraction of prices. Also many had gone heavily into debt to the
United States (Great Britain being a major debtor) and to Great Britain (most
European allies) meaning that there would be large gold drains to come.
Soon-to-be depleted gold reserves could simply not support the inflated money
supply if each unit of money was to serve as a claim on the prewar gold weight.
So European countries took the only option available to
them: they returned their currencies to gold but at a sharply lower unit weight
definition (ie. devaluation). Permanent devaluation was the formal nail in the
coffin that consummated the inflationary tax imposed on European citizens to
pay for the Great War, but there was really no other option other than going
off gold completely.
The two exceptions were Great Britain and of course the
United States (we’ll overlook Canada from the discussion as it was a unique
case). The United States, despite inflating heavily itself to finance wartime
expenditures, still had sufficient gold reserves to redeem at 1/20th of an
ounce to the dollar throughout. Great Britain was a more complex problem and
chose an ill-advised workaround solution that would sow the seeds for what
would become the Great Depression.
IV. BRITAIN RETURNS TO THE GOLD STANDARD… AND BREAKS ALL ITS
Great Britain was determined to return the pound sterling to
gold at the prewar par in an attempt to recapture her status as the world’s
financial center from New York. But given such an inflated money supply she
faced a difficult choice. Her two options were:
-Maintain the current money supply by returning to gold at a
devalued par, but blemish the pound’s international reputation.
-Return to gold at the more prestigious prewar par and
accept painful deflation back to the prewar money supply.
Devaluation would certainly compromise Britain’s attempts to
leapfrog New York as the world’s financial capital and was quickly ruled out.
But could she return to gold at the prewar par and endure the accompanying
deflation and likely recession?
Yes. After the Napoleonic Wars Great Britain returned to
gold at the 1797 par and the result was a contraction of the money supply as
commercial banks and the Bank of England were forced to contract credit to
realign paper claims with actual gold reserves. The contraction produced a
painful recession followed by a long period of stable expansion. The United
States had taken the same medicine after the War of 1812, the Civil War, and
even the deflationary Depression of 1920-21.
But the British political landscape was notably changed by
the 1920’s. Trade unions, emboldened by Labour policies, resisted falling wages
even if the overall price level fell accordingly and resulted in no real
change. National unemployment insurance now empowered workers to ride out
prolonged joblessness and thus refuse to accept jobs with lower nominal but
unchanged real wages.
And a new generation of economists berated the evils of
deflation and espoused the virtues of inflation—among them Ralph Hawtrey and
John Maynard Keynes—both products of Cambridge (ironically neither Hawtrey nor
Keynes ever earned an economics degree). In the eyes of British policymakers a
solution had to be found that allowed Britain to return to gold at the old
$4.86 par, but without accepting the politically problematic deflation.
It was Hawtrey and Keynes who would devise, foster, and
successfully effectuate the solution.
First, Britain would return not to the traditional gold-coin
standard, whereby holders of banknotes and demand deposits could redeem their
pounds in small denomination coins. Rather, the British government would
mandate that all gold be centralized at the Bank of England, melted down into
large gold bars of at least 400 ounces weight, and that gold redemptions must
convert to a minimum amount of one bar of gold bullion. Hence, the gold-coin
standard, the product of the previously more laissez-faire system, was replaced
with a gold-bullion standard.
The desired effect of the gold-bullion standard was clear:
The overwhelming bulk of British citizens were simply not wealthy enough to
afford gold redemptions of that size. 400 ounces was the equivalent of 1,549
pounds in the 1920’s, an astronomical sum at the time. To put it into perspective,
today a 400 ounce bar of gold bullion is worth approximately $500,000 in U.S.
currency. Thus the number of American citizens who have the spare cash lying
around to convert a minimum of $500,000 to gold is completely negligible from a
policy standpoint—which was the whole objective of adopting bullion over coin:
to disqualify the bulk of the populous from ever redeeming.
Therefore under gold bullion, the Bank of England would not
have to devalue and in fact could continue with a policy of inflating even
more pound banknotes and credit atop the same insufficient reserves of gold.
For, as the thinking went, gold reserves would no longer be insufficient given
that nearly all British citizens would be unable to exercise their legal rights
and the central bank’s gold would go mostly unclaimed.
By 1925 the façade was ended completely and British citizens
were legally prohibited from redeeming their money into gold at all, freeing
the Bank of England completely from a huge disciplinary obstacle that had kept
it in check during the classical gold standard era.
Now Britain’s only
remaining concern was overseas holders of pound sterling liabilities—the
greatest of whom were central banks.
For that problem, Hawtrey and Keynes recommended another
rule-skirting solution: Britain would replace the old classical gold
standard—where overseas holders of paper pound sterling notes or demand deposit
balances could convert those liabilities into gold—with a new “gold-exchange”
The gold-exchange standard was a cunning ruse designed to
circumvent the discipline of the classical gold standard by replacing gold
reserves with paper pound sterling reserves. Under this new system the Bank of
England would inflate pound banknote and demand deposit balances atop its centralized
Unsurprisingly the resulting price inflation would continue
to induce more imports than exports and British pounds would still flow
overseas. But instead of its trading partners redeeming their accumulated
sterling balances to the Bank of England for gold, the countries of continental
Europe would be pressured to accept pounds sterling as “equal to gold” and use
the paper liabilities as a pseudo-gold base to inflate their own paper
Although European central banks could technically redeem
their sterling balances for gold, the gold-exchange standard allowed their
governments to augment their own depleted gold reserves with a paper substitute
and pursue their own inflation. This way Britain could have its inflationary cake
and eat it too, printing more pounds without losing gold overseas—effectively
“exporting” its inflation and short-circuiting the Hume price-specie-flow
market mechanism (see part 1 to review David Hume’s price-specie-flow system).
Hard money opponents of the scheme quipped that a
gold-bullion-exchange system that substituted paper reserves for gold ones was
really no gold standard at all. But they were swiftly brushed aside by the
plan’s architects including Keynes who had long argued that...
“A preference for a
tangible reserve currency is… …a relic of a time when governments were less
trustworthy in these matters than they are now.”
-Keynes, Indian Currency and
In the third and final chapter of this article we will
review the consequences of the British
pound-sterling-bullion-international-gold-exchange standard when European
central banks all ran for the exits in 1931.