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.”
“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.