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
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