A History of Money and Banking in the United States: The Colonial Era to World War II (51 page)

of pound sterling standard, since London was the great financial center during this period. This disparagement of gold, however, is faulty and misleading. It is true that London was the major financial center in that period, but the world was scarcely on a pound standard. Active competition from other financial centers—Berlin, Paris, Amsterdam, Brussels, New York—ensured that gold was truly the only standard money throughout the world.3 Furthermore, to stress only the few decades before 1914 as the age of the gold standard ignores the fact that gold and silver have been the world’s two monetary metals from time immemorial. Countries shifted to and from freely fluctuating parallel gold and silver standards, in attempts, self-defeating in the long run, to fix the rate of exchange between the two metals (“bimetallism”). The fact that countries stampeded from silver and toward gold monometallism in the late nineteenth century should not obscure the fact that gold and silver, for centuries, were the world’s moneys, and that previous paper money experiments (the longest during the Napoleonic Wars) were considered to be both ephemeral and disastrously inflationary. Specie standards, whether gold or silver, have been virtually coextensive with the history of civilization.4 Apart from a few calamitous 3See Palyi,
Twilight of Gold
, pp. 1–21, 118–19. See also David P. Calleo,

“The Historiography of the Interwar Period: Reconsiderations,” in
Balance of Power or Hegemony: The Interwar Monetary System,
Benjamin M.

Rowland, ed. (New York: Lehrman Institute and New York University Press, 1976), pp. 227–60. Calleo shows that the pre-1914 gold standard was a genuine, multicentered gold standard, not a British sterling standard.

4Professor Timberlake misconstrues the historical research of Luigi Einaudi on “imaginary money” in the Middle Ages. Far from showing, as Timberlake believes, that moneys of account can be “imaginary” in relation to media of exchange, they simply reveal various countries’ experiences with various relationships between gold and silver, both commodity moneys. See Luigi Einaudi, “The Theory of Imaginary Money from Charlemagne to the French Revolution,” in
Enterprise and Secular Change
, F.C. Lane and J.C. Riemersma, eds. (Homewood, Ill.: Richard D. Irwin,
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A History of Money and Banking in the United States:
The Colonial Era to World War II

experiments, such as John Law’s Mississippi Bubble and the South Sea Bubble in the 1710s, and apart from the generation-long experience in Britain during the Napoleonic War, until the twentieth century specie rather than paper had always been the standard money.

In the classical gold standard, every nation’s currency was defined as a unit of weight of gold, and therefore the paper currency was redeemable by its issuer (the government or its central bank) in the defined weight of gold coin. While gold bullion, in the form of large bars, was used for international payment, gold coin was used in everyday transactions by the general public. For obvious reasons, it is the inherent tendency of every money-issuer to create as much money as it can get away with, but governments or central banks were, on the gold standard, restricted in their issue of paper or bank deposits by the iron necessity of immediate redemption in gold, and particularly in gold coin on demand. As in the familiar Hume-Cantillon international price-specie flow mechanism, an increase of bank notes or deposits in a country beyond its gold stock increases the supply of money, say francs in France. The increase of the supply of francs and incomes in francs leads to (a) an increase in both domestic and foreign spending, hence raising imports; and (b) a rise in domestic French prices, in turn making domestic goods less competitive abroad and lowering exports, and making foreign goods more attractive and raising imports. The result is an inexorable deficit in the balance of payments, putting pressure upon French banks to supply gold to English, American, or Dutch exporters. In short, since in fractional reserve banking, paper and bank notes pyramid as a multiple of gold reserves, this expansion of the already engorged top of the inverted 1953), pp. 229–61; Richard Timberlake,
Gold, Greenbacks, and the
Constitution
(Berryville, Va.: George Edward Durell Foundation, 1991); and Murray N. Rothbard, “Aurophobia, or Free Banking on What Standard?”
Review of Austrian Economics
6, no. 1 (1992): 97–108.

The Gold-Exchange Standard in the Interwar Years
355

pyramid, must inexorably be followed by a loss in the bottom supporting the swollen liabilities. In addition, clients who are holders of French bank notes or deposits, are apt to become increasingly concerned, lose confidence in the viability of the French banks, and hence call on those banks to redeem in gold—putting those banks at risk for a devastating bank run.

The result will be an often panicky and sudden contraction of bank notes, generating a recession to replace the previous inflationary boom, and leading to a contraction in notes and deposits, a drop in the French money supply, and a consequent fall in domestic French prices. The balance-of-payments deficit is reversed, and gold flows back into French coffers.

In short, the classical gold standard put a severe limit upon the inherent tendency of monopoly money-issuers to issue money without check. As Ludwig von Mises pointed out, this international specie-flow mechanism also described a correct, if primi-tive, model of the business cycle. While central banking and fractional reserve banking allowed play for a boom-bust cycle, the inflationary boom, and its compensating bust, was kept in strict bounds.5 While scarcely perfect or lacking problems, the classical gold standard worked well enough for the world after World War I to look back upon it with understandable nostalgia.6

5Prices during the boom did not necessarily increase in historical terms. If a secular price fall was occurring due to increased production, as happened in much of the nineteenth century, the inflationary boom took the form of prices being higher than they would have been in the absence of the expansion of money and credit.

6While the United States was the only major power before 1914 to lack a central bank, the quasi-centralized national banking system performed a similar function in the years between the Civil War and 1914. Instead of the government conferring a monopoly note-issuing privilege upon the central bank, the federal government conferred that privilege upon a handful of large, federally chartered “national banks,” located in New York and a few other Eastern financial centers.

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A History of Money and Banking in the United States:
The Colonial Era to World War II

BRITAIN FACES THE POSTWAR WORLD

At the end of World War I, only the United States dollar remained on the old gold-coin standard, at the one-twentieth-of-an-ounce par. The other powers suffered from national fiat currencies; suddenly, their currencies were no longer units of weight of gold but independent names, such as pound, franc, mark, etc., their rates depreciating in relation to gold and volatile with respect to one another. Except for mavericks such as Cambridge’s John Maynard Keynes, it was generally agreed that this system was intolerable, and that a way must be found to reconstruct a world monetary order, including restoration of a world money and medium of exchange. At the heart of the European monetary crisis was Great Britain, which would take the lead in trying to solve the problem. In the first place, London had been the major prewar financial center; and second, Britain dominated the postwar League of Nations, and in particular its powerful Economic and Financial Committee. Furthermore, though inflated and depreciated, the British pound was still in far better shape than the other major currencies of Europe. Thus, while the pound sterling in February 1920 was depreciated by 35 percent compared to its 1914 gold par, the French franc was depreciated by 64 percent, the Belgian franc by 62 percent, the Italian lira by 71 percent, and the German mark in terrible shape by 96

percent.7 It was clear that Britain was in a position to guide the world to a new postwar monetary order, and it eagerly took up what turned out to be the last remnants of its old imperial task.

The British understandably decided that the fluctuating fiat money system inherited from the war was intolerable, and that it was vital to return to a sound international money, the gold standard. However, at the same time, they also decided that they would have to return to gold at the old prewar par of 7Palyi,
Twilight of Gold
, pp. 38–39.

The Gold-Exchange Standard in the Interwar Years
357

$4.86. Apparently, few if any economists or statesmen at the time argued for cutting British losses, starting with the real world as it existed in the early 1920s, facing reality, and going back to gold at the realistic, depreciated $3.20 or $3.50 per pound sterling. In view of the enormous difficulties the decision to go back to gold at $4.86 entailed, it is difficult in hind-sight to understand why there was so little support for going back at a realistic par or why there was so much drive to go back at the old one.8 For going back to a pound 30 to 35 percent above the market rate, meant that English exports upon which the country depended to finance its exports, were now priced far above their competitive price in world markets. Coal, cotton textiles, iron and steel, and shipbuilding, in particular, the bulk of the export industries that had generated prewar prosperity, became permanently depressed in the 1920s, with accompanying heavy unemployment in those industries. In order to avoid export depression, Britain would have to have been willing to undergo a substantial monetary and price deflation, to make its goods once more competitive in foreign markets. But, in contrast to pre-World War I days, British wage rates had been made rigid downward by powerful trade-unionism, and particularly by a massive and extravagant system of national unemployment insurance. Rather than accept a rigorous deflationary policy, therefore, to accompany its return to gold, Britain insisted on just the opposite: a continuation of monetary inflation and a policy of low interest rates and cheap money. Thus, Great Britain, in the post-World War I world, committed itself to a monetary policy based on three rigidly firm but mutually self-contradictory axioms: (1) a return to gold; (2) returning at a sharply overvalued pound of $4.86; and (3) continuing a policy of inflation and cheap money. Given a program based on such grave inner self-contradiction, the 8For an early English critique of not going back at a realistic par, see Lionel Robbins,
The Great Depression
(New York: Macmillan, 1934), esp.

pp. 77–87.

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A History of Money and Banking in the United States:
The Colonial Era to World War II

British maneuvered on the world monetary scene with brilliant tactical shrewdness; but it was a policy that was doomed to end in disaster.

Why did the British insist on returning to gold at the old, overvalued par? Partly it was a vain desire to recapture old glories, to bring back the days when London was the world’s financial center. The British did not seem to realize fully that the United States had emerged from the war as the great creditor nation, and financially the strongest one, so that financial predominance was inexorably moving to New York or Washington. To recapture their financial predominance, the British believed that they would have to bring back the old, traditional, $4.86. Undoubtedly, the British also remembered that after two decades of war against the French Revolution and Napoleon, the pound had quickly recovered from its depreciated state, and the British had been able to restore the pound at its pre-fiat money par. This restoration was made possible by the fact that the post–Napoleonic War pound returned quickly to its prewar par, because of a sharp monetary and price deflation that occurred in the inevitable postwar recession.9 The British after World War I apparently did not realize that (a) the restoration of the pre–Napoleonic War par had required a substantial deflation, and (b) their newly rigidified war structure could not easily afford or adapt to a deflationary policy. Instead, the British would insist on having their cake and eating it too: on enjoying the benefits of gold at a highly overvalued pound while still continuing to inflate and luxuriate in cheap money.

9The pound sterling was depreciated by 45 percent before the end of the Napoleonic War. When the war ended, the pound returned nearly to its prewar gold par. This appreciation was caused by (a) a general expectation that Britain would resume the gold standard, and (b) a monetary contraction of 17 percent in one year, from 1815 to 1816, accompanied by a price deflation of 63 percent. See Frank W. Fetter,
Development of British
Monetary Orthodoxy, 1797–1875
(Cambridge, Mass.: Harvard University Press, 1965).

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Another reason for returning at $4.86 was a desire by the powerful city of London—the financiers who held much of the public debt swollen during the war—to be repaid in pounds that would be worth their old prewar value in terms of gold and purchasing power. Since the British were now attempting to support more than twice as much money on top of approximately the same gold base as before the war, and the other European countries were suffering from even more inflated currencies, the British and other Europeans complained all during the 1920s of a gold “shortage,” or shortage of “liquidity.” These complaints reflected a failure to realize that, on the market, a

“shortage” can only be the consequence of an artificially low price of a good. The “gold shortage” of the ‘20s reflected the artificially low “price” of gold, that is, the artificially overvalued rate at which pounds—and many other European currencies—returned to gold in the 1920s, and therefore the arbitrarily low rate at which gold was pegged in terms of those currencies.

More particularly, since the pound was pegged at an overvalued rate compared to gold, Britain would tend to suffer in the 1920s from gold flowing out of the country. Or, put another way, the swollen and inflated pounds would, in the classic price-specie-flow mechanism, tend to drive gold out of Britain to pay for a deficit in the balance of payments, an outflow that could put severe contractionary pressure upon the English banking system. But how could Britain, in the postwar world, cleave to these contradictory axioms and yet avoid a disastrous outflow of gold followed by a banking collapse and monetary contraction?