A Visual of Shale Oil's Impact on American Imports

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CO recently ran a Bloomberg story on Texas shale's impact on both OPEC's energy exports to the United States and OPEC's share of the world crude oil and natural gas market.

The Cautious Optimism Correspondent for Economic Affairs would like to highlight in particular a chart that was buried in the lower pages of that story that underscores the impact of shale oil and natural gas on America's traditional role as massive energy importer. This visual communicates in the most explicit terms how quickly America's prior dependence on OPEC, Canadian, and Mexican energy imports has fallen due to shale hydraulic fracturing.

Lessons from the Great Depression: What Really Started the Great Depression? (Part 3 of 3)

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10 MIN READ - The Cautious Optimism Correspondent for Economic Affairs and Other Egghead Stuff concludes his series on what really started the Great Depression. Monetary policy wonks, goldbugs and economic history buffs will be gripped by the collapse of the 1925-31 European gold-exchange standard and the subsequent deflation’s role in enabling the rise of fascism.

In Part 2 we described the new gold-exchange standard that Britain invented to replace the traditional classical gold standard that had governed global trade for nearly half a century. We conclude with Britain’s monetary subjugation of Europe, the collapse of the new gold-exchange standard after only six years, and the subsequent lessons that were willfully unlearned by the postwar economics profession.

V. FORCING GOLD-EXCHANGE UPON EUROPE

As Britain engineered its novel gold-exchange standard to foist paper pounds sterling on Europe as a substitute for traditional gold reserves, the plan’s architects brushed aside economists who appropriately called the plan a paper-hybrid standard.

But while dismissing academics and dissenting policy critics was one thing, convincing European governments to go along with the gold-exchange standard was another matter (see Part 2 to learn about the gold-exchange standard). Much of Europe would demand a return to the more honest classical gold standard and prefer to redeem in tangible reserves instead of hoarding British paper obligations which could be produced without limit.

The British Treasury’s Ralph Hawtrey and Bank of England Governor Montagu Norman were called upon to overcome the international political obstacles.

Due to its status as a wartime creditor to many near-bankrupt European nations and its influential position heading the League of Nations Financial Committee, Great Britain relentlessly strongarmed over thirty countries into accepting gold-exchange including Germany, Austria, Hungary, Belgium, France, the Netherlands, Greece, Italy, Norway, Poland, and Portugal to name a few. Hawtrey worked out the technical details during the 1922 Genoa financial conference while Norman pressured finance ministers and his counterparts at other central banks. Paris reluctantly went along, with Bank of France Governor Emile Moreau complaining in his diary that:

“England having been the first European country to reestablish a stable and secure money has used that advantage to establish a basis for putting Europe under a veritable financial domination. The Financial Committee at Geneva has been that policy. The method consists of forcing every country in monetary difficulty to subject itself to the Committee at Geneva, which the British control. The remedies prescribed always involve the installation in the central bank of a foreign supervisor who is British or designated by the Bank of England, which serves both to support the pound and to fortify British influence… … The currencies [of Europe] will be divided into two classes. Those of the first class, the dollar and pound sterling, based on gold, and those of the second class, based on the pound or the dollar.”

The final formality was to gain approval from Parliament and His Majesty’s Government.

In one of his famous policy dinners Chancellor of the Exchequer Winston Churchill was persuaded by Hawtrey, Keynes, and banking and commercial interests of the benefits of the new gold-bullion-exchange standard. Churchill, never sophisticated in financial and economic matters, deferred to the experts; pleased to hear only that the British pound would soon be returned to international pre-eminence.

The pound officially went back on gold at the old prewar par of $4.86 under the British 1925 Gold Standard Act although the new gold-bullion-exchange standard was a gold standard in name only, bearing almost no resemblance to the classical gold coin standard that had preceded it and devoid of the traditional rules that had previously imposed anti-inflationary checks on governments and central banks for centuries. As Austrian economist Murray Rothbard eloquently summarized Britain’s new policy:

“They were attempting to clothe themselves in the prestige of gold while trying to avoid its anti-inflationary discipline. They went back, not to the classical gold standard, but to a bowdlerized and essentially sham version of that venerable standard.”

Thus British policymakers believed they had shirked all the deflationary consequences of returning to gold at the old par of $4.86 while successfully pursuing a contradictory policy of persistent inflation. European trading partners were effectively bullied into accumulating pound sterling liabilities and treating them as equal to gold.

Over the next several years the Bank of England would pursue a consistently inflationary monetary policy, its paper liabilities piling up ever higher in the central banks of Europe—liabilities that it was hopelessly ill-equipped to redeem should financial distress strike one day. And those liabilities, serving as a reserve “equal to gold” on the continent, induced another layer of inflation in Europe itself. Other governments found themselves flush with new paper reserves to pyramid their own domestic banknote and demand deposits upon.

Little did Britain know how soon the day of reckoning—when they would be asked to make good on their unworkable promises—would come and that its own inflationary policies would help bring it about, but for now Threadneedle Street was content to keep the printing presses rolling.

However there remained one major trading partner that refused to treat sterling as a reserve and stubbornly insisted on gold redemption. As Britain continued to inflate and its exports became more expensive on the world market, sterling liabilities promptly returned from that country’s uncooperative central bank demanding prompt conversion and sustaining Britain’s chronic gold drains.

That troublesome country was the United States, and in British eyes something had to be done to solve the so-called American problem. Thus Montagu Norman would appeal to his old friend New York Federal Reserve Governor Benjamin Strong for a favor: to engineer a major Fed intervention to assist Great Britain.

VI. EUROPEAN RECESSION AND THE COLLAPSE OF THE GOLD-EXCHANGE STANDARD

Thus Montagu Norman traveled to New York and convinced his friend and colleague Benjamin Strong to launch the aggressive Fed QE campaign of 1927-1928 to raise American prices aside Britain’s in an attempt to curb its trade deficits (see Part 1 of this series for more on the New York Fed’s inflation).

The ruse worked. It balanced trade flows between the two nations, but as Alan Greenspan wrote in 1966:

“It [the Fed’s QE] stopped the gold loss, but it nearly destroyed the economies of the world in the process. The excess credit which the Fed pumped into the economy spilled over into the stock market, triggering a fantastic speculative boom.”

We all know the boom led to the famous crash in October of 1929 which coincided with America entering recession that same summer.

Europe, also dealing with the consequences of gold-exchange inflation, fell into recession shortly thereafter and central banks which had accumulated enormous sterling liabilities began to approach the Bank of England to cash in some of their credits. But London had inflated far beyond any credible capacity to redeem its sterling liabilities (that was the whole point of the gold-exchange standard it had foisted upon Europe), and even modest claims on gold would quickly drain its woefully inadequate reserves.

In August of 1931 Bank of France Governor Emile Moreau sought to redeem some of his country’s vast sterling balances which by then constituted one-fifth of France’s monetary reserves and a full two-thirds of Britain’s entire gold holdings. Montagu Norman, knowing full well that his central bank would be bankrupted if only two or three major central banks converted their sterling balances, resisted Moreau and threatened to devalue the pound if France went through with its demands. Norman even lectured Moreau that more sterling was actually good (!) for France. Moreau backed down and trimmed his remittance calls.

On September 18, 1931 Bank of Netherlands Governor Gerard Vissering also expressed concerns about rising sterling balances. Montagu Norman cajoled his old friend into abstaining and assured him the Bank of England would remain on the gold standard “at all costs.”

But even the slowed pace of redemption was enough to alarm Bank of England directors and British policymakers. The quantity of liabilities they had printed simply overwhelmed their tangible gold reserves which were quickly evaporating. Britain was reaping the consequences of the European inflation that she herself had promoted.

On September 20th, two days after Norman assured the Netherlands that he would uphold the gold standard forever, the Bank of England suspended gold convertibility and promptly devalued. For the first time in its 237 year history, Great Britain failed to make good on a peacetime pledge to fully redeem its notes and deposits in gold to resolve balance of payments (its own citizens lost that right for good in 1925).

Britain could have avoided all the tragedy if, at the end of the Great War, she had simply accepted the historic policy options of devaluation or deflation instead of adopting the gold-exchange standard to pursue the contradictory policy goals of prewar gold convertibility and constant inflation. And even as late as 1931 as its gold reserves were falling, the Bank of England could still have salvaged the gold standard by raising interest rates to stop the inflation and attract more deposits. But proto-Keynesian cheap money theories had by then conquered domestic politics and Britain was wedded to an inflation-at-all-costs policy. Hence she took the easy-out of virtual bankruptcy and Europe was plunged into monetary chaos.

VII. GLOBAL CONSEQUENCES AND CONTEMPORARY MISINTERPRETATIONS

As the economy slowed in Europe and bank failures multiplied—including the spectacular collapse of Austria’s Kreditanstalt—European citizens began to withdraw cash and gold from the system. Given the scale of the preceding inflation, and the short supply of gold due in part to Britain’s refusal to meet its redemption commitments, a continuous drain of reserves from the financial system precipitated painful deflations across the continent. In one of the more consequential cases the German Brüning deflation of the early 1930’s produced high unemployment and fertile economic ground for the rise of Nazism. While historians famously blame the Versailles Treaty for Hitler’s ascendancy, the truth is Britain’s own interwar monetary policy was equally or even more culpable.

Facing harsh deflations which, given Britain’s gold default, governments were unable to stem or reverse, European central banks went off gold one by one and launched a series of competitive devaluations, the last being France in 1936.

The United States, which held the world’s largest gold reserves and had not participated in the ruinous gold-exchange scheme, could have remained on gold and avoided Great Depression with proficient monetary policy from its entrusted Federal Reserve governors. However, nearly criminally negligent incompetence at the Fed led to a series of spectacular banking panics in 1930, 1931, and 1933 (nearly 10,000 American banks failed in total) and the U.S. went off gold in April of 1933. That is another story for a future column on American monetary policy during the Great Depression.

And so the gold standard as the world had known it died in the early 1930’s.

Sadly, even the lessons of the sorry affair were soon to be lost or deliberately covered up. In the 1947 edition his book “The Gold Standard in Theory in Practice” Ralph Hawtrey, co-architect of gold-exchange himself, explained that…

“The cause of the failure of the gold standard was simple. It was the appreciation of the value of gold in terms of wealth [ie. deflation]. Gold had not supplied a stable unit for the measurement of values.”

…without making any reference to the fatal flaw within the gold-exchange ploy itself: that it spurred British inflation that necessarily would reverse itself into painful deflation the moment a few central banks lost confidence in Britain’s ability to make good on its pledges.

Contemporary mainstream economists, mostly apologists for fiat money and staunch gold opponents, bemoan that the gold standard “failed” in the 1930’s or that “the gold standard caused the Great Depression.” Ben Bernanke writes on his Brookings Institute blog that:

“The gold standard of the 1920’s was brought down by the failure of surplus countries to participate equally in the adjustment process.” [ie. inadequate central bank cooperation]

Aside from the fact that central bank cooperation was not required under the traditional classical gold standard, anyone familiar with the pre-1931 European gold-exchange standard and the 1927 New York agreement can see the core problem was not failure by European central banks to abstain from cashing in their legal claims on gold. Rather the 1920’s gold standard was brought down by its own perverse design: a “managed” sham of a gold-exchange standard that replaced gold with unlimited quantities of paper and freed Britain to issue far more banknote and deposit liabilities than she could ever possibly repay.

Thus to blame “the gold standard” is to embrace a fallacious misnomer, just as it would be a grave error to argue “commercial aviation failed” after central banks removed engines, wings, and landing gear from jetliners while they were in midair flight.

George Mason University’s pro-gold economist Lawrence H. White has more astutely noted that...

“The interwar period shows us a case where central banks—not the gold standard—ran the show.”

...and…

“Several authors identify genuine historical problems that they blame on the gold standard, when they should instead blame central banks for having contravened the gold standard.”

And more forthright is prominent Austrian economist Ludwig von Mises who wrote in 1965:

“The gold standard did not fail. Governments deliberately sabotaged it, and still go on sabotaging it.”

Note:  The Cautious Optimism Economics Correspondent credits the late Professor Murray Rothbard for much of the content in this article. 

Those who wish to learn more about the ill-fated gold-exchange standard can read Rothbard's 1963 book "A History of Money and Banking in the United States" in Chapter 4: "The Gold-Exchange Standard in the Interwar Years," available free online at the Ludwig von Mises Institute's website.

https://mises.org/library/history-money-and-banking-united-states-colonial-era-world-war-ii

Golden Comments: Paul Krugman Teaches Economics and Society at Masterclass

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While the Cautious Optimism Economics Correspondent could devote a fulltime job to covering the cornucopia of Paul Krugman's gaffes, errors, and fallacies, he will confine himself to just two observations:

1) Reading the comments under the Paul Krugman MasterClass post is some of this year’s best free entertainment (simply click on the video link below and see comments underneath).

https://www.facebook.com/masterclassofficial/videos/197126141224469/

2) The “fee” for gaining Krugman’s razor-sharp insights is a steep $180 per year or $90 per lesson. Which confirms he needs some major cash to cover the large stock market short position he took on election night 2016.

Lessons from the Great Depression: What Really Started the Great Depression? (Part 2 of 3)

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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 the 1920’s.

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 gold standard.

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 hyperinflation.

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 RULES

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” standard.

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 gold reserves.

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 currencies.

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 Finance

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.

Lessons from the Great Depression: What Really Started the Great Depression? (Part 1 of 3)

No, it wasn't income inequality which was just a symptom of the real cause: bad monetary policy—this time with urging from Great Britain.

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10 MIN READ - The Cautious Optimism Correspondent for Economic Affairs and other Egghead Stuff continues his series on the Great Depression addressing the pesky and poorly understood question of what started the whole sorry affair.

I.  NEW YORK CITY: JULY 1, 1927

Meeting in the New York Federal Reserve Building, the heads of the world’s four largest central banks convened to discuss a major policy change in the new era of international monetary cooperation. Attending were:

Benjamin Strong—Governor of the New York Federal Reserve

Montagu Norman—Governor of the Bank of England

Hjalmar Schacht—Governor of the German Reichsbank

Charles Rist—Deputy Governor of the Bank of France

The American governor Strong and his British counterpart Norman surprised their French and German opposite numbers with a startling announcement: the Federal Reserve would launch an aggressive asset purchase and quantitative easing campaign, effectively bolstering U.S. inflation in an effort to curtail Great Britain’s chronic trade deficits with the United States.

The meeting itself was a fait accompli, a mere formality since the decision had long since been agreed upon between Strong and Norman—close working associates and personal friends. Germany’s Schacht and France’s Rist, hard-money advocates who preferred adherence to the traditional workings of the pre-WWI classical gold standard with minimal state interference, were shaken by the development which they viewed as potentially destabilizing to the international monetary system. But powerless to do anything about it they reluctantly agreed—at which point Strong turned to Rist and excitedly proclaimed:

 “I’m going to give a little coup de whiskey to the [U.S.] stock market!”

Strong kept his word. In the eighteen months that ensued the Federal Reserve expanded its balance sheet from $1.175 billion to $1.824 billion—an increase of 55%—and the U.S. money supply ballooned at its fastest rate of the entire 1920’s decade.

Newly created money and bank credit quickly spilled over into asset markets and fueled speculation as the Dow Jones Industrial Average advanced from an alltime high of 175.35 in early July 1927 to 386.10 in September 1929, a stunning advance of over 120% in just 26 months. Real estate speculation pushed commercial and particularly residential property prices into record territory. Cheap credit spawned irrational business investment projects such as factory overexpansion and competitive groundbreakings for “world’s tallest building” in New York City.

And the rich (who by definition own assets) got a lot richer while the poor (who by definition don’t own assets) saw only meager gains. Thus wealth inequality—which today’s progressives are so obsessed with and claim in and of itself causes recessions—widened due to the central bank induced inflow of money. The climax of the Roaring Twenties was underway.

Oddly enough, since most of the new money flooded into asset speculation the wholesale and consumer price indexes signaled subdued inflation. Fooled by what appeared to be only moderate price pressures, America’s greatest contemporary economist Irving Fisher concluded that the U.S. economy had entered a new era of prosperity, famously declaring in the New York Times that “Stock prices have reached what looks like a permanently high plateau” on October 21, 1929—six days before the Black Tuesday crash.

Misled by holes in his own Quantity Theory of Money, it was a mistake that Irving’s Monetarist successors would go on to make decades later, including the great Milton Friedman himself who saw no  inflation problems in 2005 and declared "The stability of our economy is greater than it has ever been in our history. We really are in remarkable shape.”

But back to the 1920’s. Benjamin Strong, who had always suffered from poor health, died from tuberculosis in October of 1928 leaving it to his successor George L. Harrison to wind up the Fed’s easing campaign at the end of the year, tightening credit and raising interest rates in 1929. Starved of plentiful new money to fuel the credit boom the economy began to sink into recession by the summer of 1929, and dangerously overvalued asset market bubbles began to burst, culminating with the famous stock market crash in October.

The 1927 secret meeting is only known to us because Charles Rist wrote of it in his personal diaries. And the Fed as policy culprit rings with depressing familiarity of other such episodes in economic history. But the story behind the 1927 Fed QE decision is truly unique among history’s credit-induced tragedies. Its origins ultimately laid the groundwork that dragged two continents into a cataclysmic monetary collapse that transformed what should have been just another credit-fueled recession (in the tradition of 1819, 1825, 1837, 1857, 1873, 1893, 1907, and 1921) into the Great Depression.

And the ill-fated joint decision by the Federal Reserve and Bank of England would prove so fatal that it would force the world off the centuries-long venerable gold standard only a few short years later—ironically because Strong and Norman attempted to “cheat” with policies that the traditional gold standard would never have allowed.

This column tells that story, because it’s impossible to truly understand what started the Great Depression and particularly why its severity and duration were so unprecedented without grasping its unique monetary policy origins.

II.  BEFORE THE ROARING TWENTIES: THE INTERNATIONAL CLASSICAL GOLD STANDARD

To understand why Great Britain asked for inflationary assistance from the Federal Reserve in 1927 it’s essential to revisit the global economy before 1914 when the industrialized world operated under the 19th century classical gold standard (roughly 1870-1914 with Britain first to adopt it de jure in 1816 and the United States last in 1879).

Under the classical gold standard, every country’s currency was defined as a unit weight of gold. For example, the U.S. dollar was not a piece of paper but rather the dollar was literally about 1/20th an ounce of gold—or 23.22 grains of gold to be exact. The British pound sterling was defined as approximately 1/4th an ounce of gold or 113.00 grains. Francs, marks, lira, etc… were also literally unit weights of gold. Paper banknotes and demand deposit balances were simply claims on dollars, pounds, francs, etc… hence why old banknotes of the 19th century bore the promise “Will pay the bearer on demand five dollars.”

Because both the dollar and the pound were defined as unit weights of gold, the “exchange rate” between the two was fixed. And since one pound sterling contained 4.86 times more gold than one dollar, the pound sterling equaled $4.86—an exchange rate that had been unchanged since the U.S. Coinage Act of 1834.

Another important attribute of the classical gold standard was that any institution that issued paper banknotes or demand deposit balances (usually created when that institution loaned money) was obligated to convert those notes or deposits on demand in gold coin. In the U.S. that commonly meant gold eagle coins equal to $20 in gold, or in Britain the gold sovereign containing one pound sterling equivalent in gold. Other countries’ currencies followed the same rules.

The constant threat of on-demand redemption by all holders of paper liabilities was critical as it kept issuing institutions “honest.” That is, whether they were commercial banks—as was the case in the USA and Canada—or central banks such as the Bank of England, the threat of redemption served as a natural check against overissuance or overexpansion of credit.

The handful of pre-WWI examples of irresponsible overexpansion by banks were virtually always the consequence of government intervention overturning private redemption contracts such as legally suspending gold convertibility (Great Britain during the Napoleonic Wars 1797-1825, USA during the War of 1812 from 1812-1815) or attempts to substitute government paper for gold (USA: “Greenback” paper money during the Civil War). But in the relatively free and undisturbed periods of money and banking, institutions were kept in check by market forces that prevented inflationary overexpansion.

The same rules applied to entire nations. If one country’s commercial banks or central bank printed too many banknotes or created too much demand deposit checkbook money (ie. inflation), prices would rise in that country and, given fixed exchange rates, competing imported products became cheaper. Consumers in the inflating country would buy more imports, sending their currency (say in this case, British pounds) overseas. The receiving country (say, France) had little use for pounds and would submit them for redemption to the Bank of England and gold would flow across the Channel.

With its gold reserves diminishing, the British banking system would be forced to end its overexpansion or even contract, and prices would fall back into line. Conversely, with French gold reserves rising the resulting increase the money supply would make French products more expensive leading to higher British imports and an equilibrium would ensue.

Scottish philosopher David Hume observed this phenomenon and wrote about it in the 1750’s. The tendency for freely moving international commerce to put a check on overexpansion of money and credit vis-à-vis a country’s gold reserves has been known since as the Hume price-specie-flow mechanism. And under this self-regulating international monetary system—even with occasional destabilizing interventions by governments—the world saw an explosion in wealth creation and international trade. For example worldwide foreign investment rose from 7% of GDP in 1870 to 18% of GDP in 1914 (NBER: Estevadeordal, Frantz, Taylor). That’s a near tripling not of foreign investment, but of its share of world GDP. Since world GDP rose by approximately 147% during the same period (A. Madison), total foreign investment rose by 530% in just 44 years.

The same is true of total world trade. From 1870 to 1914 global trade rose from 10% of GDP to 21%, or in absolute terms an increase of 419%. And these gains were accompanied by a dramatic decline in major European wars during the latter half of the 19th century and early 20th century.

So understanding what made the classical gold standard work so well in the late 19th century is also essential to identifying what went wrong in the 1920’s, a tragic story that we will visit in Part 2 of this series…