7. Britain and the Gold Exchange Standard

Britain, the major gold standard country before World War I, ended the war facing a set of grave, interlocking financial and economic problems, most of its own making. Along with the other warring nations, Britain had inflated sharply to finance the war effort. Each country except the United States (which had de facto suspended gold exports) had therefore been obliged to go off the gold standard. At the end of World War I, Britain determined that its own and the world’s economic health required a return to the gold standard. And, in a fateful decision, it also determined—with surprisingly little discussion—that the pound sterling would have to be reestablished at the traditional prewar par of approximately $4.86.[50] Because of the greater inflation in Britain than in the United States, the free-market exchange rate of the two currencies was far lower than $4.86. The British government, with the help of J.P. Morgan & Co., succeeded in artificially pegging the pound at $4.75 from early 1916 until March 1919. Finally, the British let the pound float, and it quickly plummeted, reaching a low of $3.21 in February 1920.[51]

Britain’s curious insistence on returning to the gold standard at a par overvalued by some 34% meant that the British had to face a massive price deflation. It was particularly important for Britain—dependent as it always has been on exports to purchase large quantities of imports—to keep its export prices competitive, and for that, deflation would be necessary. Although difficult at all times, deflation did not present major problems before World War I, since price and wage rates were flexible downward. But during the war, a massive system of high-benefit unemployment insurance and a strong network of trade unions had developed in Britain, making deflation impossible without the repeal of welfare state measures and the rolling back of trade union power. Britain was not willing to take such heroic measures; in fact it wished to continue permanently the pleasant system of cheap credit and inflation that it had pursued during the war. Yet it continued to insist on an unrealistic $4.86 par in order to regain London’s prewar prestige as the world’s financial center.

Britain, in short, insisted on resting its postwar foreign monetary policy on a pair of inconsistent but fiercely held axioms: (1) a return to gold at the overvalued prewar par and (2) a refusal to permit the deflation needed to make axiom 1 at all viable. In fact, it insisted on continuing an inflationary policy. Britain’s entire international financial policy during the 1920s was an attempt to square the circle, to maintain these two inconsistent axioms.

How could it do so? First, Britain would have to force or cajole other countries either to inflate themselves, so that Britain would not lose gold to them, or to return to a peculiar new form of gold standard, which would retain the prestige of gold without the content. Thus, Britain, operating particularly through the Financial Committee of the League of Nations (an organization that it controlled), induced or forced the vanquished or small victor states of postwar Europe (1) to return to gold at overvalued pars, thereby crippling their exports and subsidizing British imports, (2) to acquire their own central banks, so that they too could inflate in collaboration with the Bank of England, to discourage exports or gold from flowing from Britain, and (3), and perhaps most important, to return not to a classical gold standard but to a new form of “gold exchange standard.” In a genuine gold standard, each currency is backed by gold, and gold flows in or out of the country. In the new form, each European country was expected to keep its reserves not in gold, but in pounds sterling, which would be backed by gold. Then, when Britain inflated, instead of losing gold to other countries, the sterling balances would pile up in London and themselves be used as a base on which to pyramid European currencies.

Britain was further protected from its inflationary policies in the 1920s by pledging to redeem pounds not in gold coin, as before the war, but only in large-denomination gold bullion. This ensured that gold could not circulate within the country and that gold would only be redeemed by large-scale international holders.

Having manipulated most of the European countries into ceasing to become a threat to its inflationary policies, Britain was still faced with the problem of the United States. The danger was that a non-inflating, hard-money, genuinely gold standard country such as the United States would soon drain inflating Britain of its gold and thereby wreck the new jerry-built international monetary system. Britain, therefore, had to persuade the United States to inflate pari passu with Great Britain; in particular, U.S. price levels could be no lower than Britain’s and its interest rates no higher, so that gold funds would not be attracted out of London and into the United States. To persuade the United States to inflate—ostensibly in order to help Britain return to the gold standard—then became the premier task of Montagu Norman.[52]

Later in the 1920s, Emile Moreau, governor of the Bank of France and a caustic hard-money critic of Britain’s international financial policy, recorded in his diary that England had established

a basis for putting Europe under a virtual financial domination. The Financial Committee [of the League of Nations] at Geneva has been the instrument of 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 at the Bank of England, which serves both to support the pound and to fortify British influence. To guarantee against possible failure they are careful to secure the cooperation of the Federal Reserve Bank of New York. Moreover, they pass on to America the task of making some of the foreign loans if they seem too heavy, always retaining the political advantages of these operations.[53]

Moreau also recorded a fascinating report sent by his close aide in 1926 on the intentions of Montagu Norman. The aide reported that the chief objective of Norman and his group was

the setting up of links between the various Banks of Issue. ... The economic and financial organization of the world appears to the Governor of the Bank of England to be the major task of the Twentieth Century. ... Hence his campaign in favour of completely autonomous central banks, dominating their own financial markets and deriving their power from common agreement among themselves.[54]

Norman succeeded in getting the nations of Europe to agree to adopt the postwar gold exchange standard at the Genoa Conference, called by the Supreme Council of the Allies in April 1922. All of the details of the financial world of the 1920s were agreed on then by the Financial Commission of the Conference. Britain actually adopted this standard in 1925, and the other European nations followed at about the same time. The United States had decided at the last minute not to participate at Genoa because of Soviet participation, but the administration, especially the powerful Secretary of Commerce Herbert Hoover, was enthusiastic about the idea of inter-central bank collaboration of currency stabilization.[55]