A hundred years ago all the main countries of the world adhered to a fixed-exchange rate system known as the gold standard.
Their domestic currencies were freely convertible into specified amounts of gold; they maintained fixed proportions between the quantity of money in circulation and the gold reserves of their central banks. An ounce of gold was worth 3.83 pounds sterling and dollars 18.60, giving a sterling-dollar exchange rate of 4.86.
The appeal of the gold standard was that it provided not just exchange rate stability, which encouraged international trade, but promised long-run stability in prices, since the obligation to maintain convertibility acted as a check on the ‘over-issue’ of notes by governments.
The gold standard was suspended de facto during the first world war and de jure immediately after it. It was restored between 1925 and 1931. Between 1945 and 1971 a diluted form of gold exchange standard (the Bretton Woods System) was in place. For the past 17 years currencies have floated.
Maintaining a fixed exchange rate system was evidently much easier in the 19th century than it has been in the 20th. The debate surrounding Britain’s return to gold in 1925 helps explain why.
In retrospect, the First World War proved fatal to the old gold standard. True enough, criticism of it had started before the war. The main point made by monetary reformers like Irving Fisher and Knut Wicksell was that the quantity of gold, and therefore money, fluctuated with the cycles of gold mining rather than with business needs, so that the gold standard system failed to maintain price stability.
The transformation from an automatic to a managed system was already under way before the war. The war itself, though, was a watershed. It was fought by all belligerents on a wildly inflationary basis. By 1919 the currencies of victors and losers alike were well below their par gold values.
Moreover, since the inflation rate had varied from country to country, the relative values of their currencies were no longer the same. Currencies were left free to float in 1929. Nevertheless, the official view everywhere favoured resumption of specie payments as soon as possible at the pre-war par values. In Britain this doctrine was enshrined by the Cunliffe Report of 1918, and formed the basis of policy.
However, the mechanics and costs of returning to gold were not well understood. The crux of the matter, as far as Britain was concerned, was that its policy was tied to that of the United States. US wholesale prices had doubled between 1914 and 1920 whereas British wholesale prices had trebled. Enough new gold had been mined to support a higher price level without reducing the gold value of the two currencies, but most of this was in the US.
In principle, convertibility at pre-war values could have been restored without undue deflation had the monetary policies of the US and Britain been sensibly coordinated but no machinery for cooperation existed.
Landing of inflation was a necessary condition but the required British deflation would have been much less had America attempted, for example, to stabilise its domestic prices at their 1920 level. Instead, the Federal Reserve Board did nothing to offset, and by its interest rate policy actively promoted, the heavy fall in prices which accompanied the collapse of the brief postwar boom in early 1920.
Given the British commitment to the pre-war sterling-dollar exchange rate, Britain had to follow the deflationary course set in America; and more savagely, since British prices had risen higher.
Policymakers were not apparently conscious of having any choice in the matter. Underlying the deflationary stance in both countries was the conviction that justice to the bondholder required that war loans be paid back in currency which as nearly as possible equalled their pre-war purchasing power.
Thus, the process of back to gold involved, for Britain, two years of unprecedentedly high real interest rates, the effect of which was to cripple British industry and leave as its legacy an unemployment rate of 10 per cent which lasted until 1940.
By the time the Great deflation had ended in 1923 British wholesale prices had fallen from their 1920 peak of 324 (1913=100) to 160 and weekly wage rates from 252 to 180 in the same period. Unemployment had gone up from 3 per cent in 1920 to 22 per cent in the second quarter of 1921 before falling back to 11 per cent. The sterling-dollar rate, having sunk to 3.5 at the height of the boom, had improved to 4.50 by early 1923, but the wholesale British/price index was still higher than America’s.
It was in the light of these events that Keynes turned decisively against the policy of going back to gold. By the end of 1922 he was arguing that relief of unemployment required a rise in the British price level of some 15 to 20 per cent, and ‘that the improvement of sterling towards par is hampering that.’
In July 1923 he called the rise in Bank Rate from 3 per cent to 4 per cent (in reponse to a sudden fall in sterling) ‘one of the most misguided mvoements of that indicator which has ever occurred.’
In his Tract for Monetary Reform, published in December 1923, he argued that, faced with the choice, price stability must take priority over exchange stability. Given America’s preponderant pull over gold, to fix the sterling-dollar exchange would be ‘to surrender the regulation of our price level and the handling of the credit cycle to the hands of the Federal Reserve Board of the United States.’
Having witnessed the social and economic costs of forcing down wages and prices, Keynes was now saying that a country’s exchange rate should adjust to its wages system, rather than the other way round. This argument was eventually to prove lethal to the gold standard.
Winston Churchill became Baldwin’s Chancellor of the Exchequer on November 6 1924. The Gold and Silver Act of 1920, preventing the export of gold, was due to expire at the end of 1925 and a decision had to be made whether or not to renew it. If the decision went against renewal the best time would be in the spring of 1925 when demands on the exchange were lightest.
Most informed opinion now favoured an immediate return to gold. Keynes and Reginald McKenna, chairman of the Midland Bank, were against. A few bankers, plus the Federation of British Industry, favoured postponement.
No one seems to have considered the possibility of devaluation: fixing the exchange at the rate which had prevailed de facto for most of the 1923-4 between 4.40 and 4.50.
The Chamberlain-Bradbury Committee, set up in 1924 to consider the question of the return to gold, reported in February 1925 that the moment was opportune. A capital-induced rise in the exchange had carried the pound to 4.68, just short of parity.
Very few men were involved in the actual decision making process – Churchill himself, Sir Otto Niemeyer, Controller of Finance at the Treasury, Lord Bradbury, an ex-Permanent Secretary, Montagu Norman, Governor of the Bank of England, and a handful of bankers. Industrialists were not consulted, Norman believing that ‘the merchant, manufacturer, workman, etc, should be considered, but not consulted any more than about the design of a battleship.’
The main issue concerned the extent of the divergence between British and US prices. Niemeyer’s main arguement was that British and American prices were ‘within 4 1/2 per cent of each other, if not nearer’, so that the ‘extra sacrifice’ needed to achieve par would be negligible.
Prof Donald Moggridge has drawn attention to the completely innumerate nature of the calculations. According to R S Sayers, Norman’s method of working out purchasing power parities was ‘to add together figures suggested by, say, six authorities and divide them by six and take the resulting average as the best working assumption.’
Churchill understood little about the intricacies of finance. Nevertheless, he had been well briefed in the Keynes-McKenna line. Some of the objections he raised to the policy of returning to gold were no doubt designed to elicit cogent argumetns for his own public use when announcing the return.
But it is hard not to believe that his memorandum to Niemeyer of February 22 1925 reflected his own genuine feelings: ‘The Treasury have never, it seems to me, faced the profound significance of what Mr Keynes calls the ‘paradox of unemployment amidst dearth’. The Governor shows himself perfectly happy at the spectacle of Britain possessing the finest credit in the world simultaneously with a million and a quarter unemployed.’ It is impossible not to regard . the object of full employement as at least equal, and probably superior, to the other valuables objectives you mention .. The community lacks goods, and a million and a quarter people lack work.
‘It is certainly one of the highest functions of national finance to bridge the gulf between the two. This is the only country in the world where such conditions exist. The Treasury and Bank of England policy has been the only policy consistently pursued. It is a terrible responsibility for those who have shaped it, unless they can be sure that there is no connection between the unique British phenomenon of chronic unemployment and the long, resolute consistency of a particular financial policy. I would rather see Finance less proud and Industry more content.’
The Treasury’s consistent response to this line of argument was to stress that the return to gold was an employment policy. British unemployment could only be mopped up by a worldwide trade recovery. For this, stabilisation of the exchanges was a necessary precondition. Repayment of foreign creditors in full value pounds was also deemed necessary if London’s position as the world’s premier capital and money market was to be restored.
The British experience under the gold standard in the intervening years killed it completely as a model for emulation. In the 1930s it became accepted that each country must manage its exchange rate in the interests of domestic employment.
The Bretton Woods System was a heroic effort to combine the advantages of fixed exchange rates with national autonomy in the conduct of economic policy.
Once again the British experience was negative, commitment to a fixed value of sterling being associated with the stop-go policies which, allegedly, hampered Britain’s economic growth.
Yet British reactions should not be taken as definitive, or paradigmatic. In 1925 the pound was over-valued in relation to the dollar, and the German, French and Belgian currencies. It proved impossible to correct this over-valuation, not only because international cooperation was lacking, but more importantly because the British wage-price structure had become peculiarly rigid. The same rigidity coloured Britain’s experience of the dollar standard between 1945 and 1971.
So many extraordinary, ‘impossible’, things have been happening in economics in the last ten years that a return to some form of gold standard, while unlikely, is no longer beyond the bounds of possibility.
Robert Skidelsky 