Economic instability, unemployment and decline in international trade were some common features of the interwar years. The stagnation of the European economies and the growth of the U.S. economy lowered the world’s trade- income ratio. The fall in international trade after 1914 and the rise in power of trade unions accompanied by expenditure on reparations gave rose to a depression in the early 1920’s which was particularly severe in the U.K. and the United States. A period of hyperinflation followed in countries such as Germany, Austria and Poland. This hyperinflation brought about drastic changes in the economies of these countries for e.g. After the war Germany used its industrial power to print a huge amount of currency which made reparation payments to other countries totally worthless, and it cleared out savings of millions of German citizens. In 1918 the exchange rate was eight marks (German currency) to one dollar. By January of 1923 this increased all the way up to 7,260 marks. Because of this hyperinflation, many citizens lost loyalty in the system of government and the economy was on a verge of a collapse. The poor economic conditions that existed in Europe after the Great War ultimately led to the stock market crash which further led to The Great Depression in1929, one of the worst economic depressions that the world has ever seen.
The economic policy followed after the end of the war was largely an attempt to return to pre war conditions. These included a return to the economic system of gold standard. The phrase “gold standard” is defined as the use of gold as the standard value for the money of a country. A nation with a precious metal monetary standard (such as the gold standard) undertook, at least in theory, to buy or sell gold at a particular and a predetermined rate against the national currency i.e. If a country will redeem any of its money in gold it is said to be using the gold standard. Under such a system, the a pair of countries that undertook it against the same precious metal, there existed a mint-par exchange rate depending upon the metal content in their coinage. Most of the major economies of the world adopted the gold standard before the First World War. As a result they established fixed exchange rates with each other. Appendix shows a list of countries that followed the gold standard in the pre war as well as the inter war period. The working of the classical gold standard can be best described by the price-specie mechanism. According to the "rules of the [gold-standard] game," central banks were supposed to reinforce, rather than "sterilize" (moderate or eliminate) or ignore, the effect of gold flows on the monetary supply. A trade deficit would cause gold to flow out of the country and hence decreases the money supply of an economy and vice versa. This would further lead to a fall in domestic prices as a result of which exports become cheaper and imports become expensive and hence the deficit would be corrected. But in the actual world gold flows were rare and the payment flow included investment and not just payment for trade i.e. the gold flows depended upon the total balance of payments and not just trade balance. Hence a country with a negative balance of payments would increase its interest rates so as to reduce imports and promote foreign direct investment.
The primary basis for the stability of the classical gold standard(pre 1914) is that there existed an absolute private-sector credibility in the commitment to the fixed domestic-currency price of gold on the part of the centre country (Britain), two (France and Germany) of the three remaining core countries. The word credibility in this context implies the belief of people in zero convertibility risk (the probability that the central-bank notes would not be redeemed in gold at the established mint price) and zero exchange risk (the probability that the mint uniformity between two currencies would be distorted). The credibility which was essential for the stability of the gold standard depended upon the policies of the central bank and the government. It also depended upon the reserves of gold that the central bank held. Some of the government and central bank policies (pre 1914) which helped in the stability of the gold standard include
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By early 20th century South Africa, the main world gold producer sold most of its gold in London actively to the Bank of England which meant that the bank had the means to replenish its reserves of gold.
- Headship of the Bank of England which meant other central banks would often device their monetary policy to that of the Bank which kept monetary policies synchronized.
- Forthcoming central bank assistance when needed, that is, during financial crises.
- Shocks to the domestic and world economies were uncommon and generally mild.
In short the classical gold standard existed in a time of world harmony and prosperity that coincided with a notable increase in the supply of gold.
The classical gold standard ended with the beginning of the World War I. The events of the War changed the political and financial basis of the world. The international gold standard was no longer viable. The immediate cause of the breakdown of the classical gold standard was political: the commencement of World War I in 1914. However, it was the Bank of England's insecure liquidity position and the gold-exchange standard that were the underlying cause.
Although the gold standard was suspended during the war, most of the world’s major economies showed strong desire to revert back to the gold standard. As a result readoption of the gold standard took place. However the resulting gold standard system was different from the classical gold standard in several respects. First, the new gold standard was led by the United States rather than Britain. This meant that the gold value of the American dollar would serve as the reference point around which other currencies would align their currencies. Second, the core would now have two centre countries, the United Kingdom and the United States. Third the contingency aspect of convertibility conversion, that required restoration of convertibility at the mint price that existed prior to World War I, was broken by various countries, even core countries. The fourth way in which the interwar gold standard was different from the classical experience was the mix of gold-standard types i.e. the gold coin standard that existed in the classical period, was far less common in the interwar period. Most countries were on a gold-exchange standard. The central banks of countries on the gold-exchange standard would convert their currencies not into gold but rather into "gold-exchange" currencies (currencies themselves convertible into gold), in practice often sterling.
The factors that led to the stability of the classical gold standard were no longer prevalent in the interwar gold standard which led to its instability. After the failure of the gold standard to hold through difficult times (World War 1), a lack of confidence in the system was created which further worsened the economic difficulties faced by the major economies of the world. It was clear that the world needed a better economic system so as to maintain international economic stability. The fall of the gold standard can be explained by the following reasons
- The rate of growth of the global economy was far greater than the supply of gold. As a result smaller economies began holding currencies such as the British Pound sterling and U.S. dollar which had by now become the global reserve currencies. The following graph shows the supply of gold in the pre war and inter war period.
- Many countries tried to protect their gold stock by raising the interest rates thereby enticing investors to retain their deposits rather than getting them converted to gold. These new and higher interest rates only made things worse for the global economy, and finally, in 1931, the gold standard in England was suspended, leaving only the U.S. and France with large reserves of gold.
- The correction of the balance of payments was hindered by powerful trade unions which helped to keep both unemployment and wages high in the British export industry.
- In the pre war period, London was the one dominant financial centre; in the interwar period it was joined by New York. Both private and official holdings of foreign currency could shift among the two centres, as interest-rate differentials and confidence levels altered.
- The credibility in authorities' commitment to the gold standard was not absolute. Convertibility risk and exchange risk could be well above zero, and currency speculation could be destabilizing rather than stabilizing.
- There was no crucial leadership role provided by the Bank of England, and central-bank cooperation was inadequate to establish credibility in the commitment to currency convertibility.
The "international gold standard," defined as the period of time during which all four core countries were on the gold standard, existed from 1879 to 1914 in the classical period and from 1926 or 1928 to 1931 in the interwar period. The interwar gold standard was a dismal failure in longevity, as well as in its association with the greatest depression the world has known.
Bibliography
- “A History of the World Economy” International Economic Relations since 1850 James Foreman-Peck
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“Slouching Towards Utopia?: The Economic History of the Twentieth Century-X. World War I-J” Bradford DeLong University of California at Berkeley and NBER February 1997
- “Golden Fetters” B. Eichengreen ,1992 Oxford University Press
- http://tx.essortment.com/goldstandards_rgvh.htm
Sovereign risk, credibility and the gold standard: 1870-1913 versus 1925-31 Maurice Obstfeld & Alan M. TaylorArticle provided by in its journal
- “The Gold Standard in Theory and History” B. Eichengreen
- http://www.eh.net/encyclopedia/article/officer.gold.standard
Appendix
a Including colonies (except British Honduras) and possessions without a national currency: New Zealand and certain other Oceanic colonies, South Africa, Guernsey, Jersey, Malta, Gibraltar, Cyprus, Bermuda, British West Indies, British Guiana, British Somaliland, Falkland Islands, other South and West African colonies.
b Or perhaps 1798.
c Including countries and territories with U.S. dollar as exclusive or predominant currency: British Honduras (from 1894), Cuba (from 1898), Dominican Republic (from 1901), Panama (from 1904), Puerto Rico (from 1900), Alaska, Aleutian Islands, Hawaii, Midway Islands (from 1898), Wake Island, Guam, and American Samoa.
d Except August – October 1914.
e Including Tunisia (from 1891) and all other colonies except Indochina.
f Including Newfoundland (from 1895).
g Including British East Africa, Uganda, Zanzibar, Mauritius, and Ceylon (to 1901).
h Including Montenegro (to 1911).
I Including Belgian Congo.
j Including Netherlands East Indies.
k Including colonies, except Portuguese India.
l Including Greenland and Iceland.
m Or perhaps 1883.
n Including Korea and Taiwan.
o Including Borneo.
p Approximate beginning date.