golden fetters 2

Abstract and Keywords
The gold standard is conventionally portrayed as synonymous
with financial stability, and its downfall, starting in 1929, is
implicated in the global financial crisis and the worldwide
depression. A central message of this book is that precisely
the opposite was true: far from being synonymous with
stability, the gold standard itself was the principal threat to
financial stability and economic prosperity between the World
Wars I and II. To understand why, it is necessary first to
appreciate why the interwar gold standard worked so poorly
when its prewar predecessor had worked so well, next, to
identify the connections between the gold standard and the
Great Depression, and finally, to show that the removal of the
gold standard in the 1930s established the preconditions for
recovery from the Depression. These are the three tasks
undertaken in the book (which is arranged chronologically),
and they are summarized in the sections of this introductory
chapter.
University Press Scholarship Online
Oxford Scholarship Online
Introduction
Page 2 of 43
Keywords: economic instability, economic stability, financial instability,
financial stability, gold standard, Great Depression, interwar period, World War
I, World War II
“Finance is the nervous system of capitalism,” observed
Ramsay MacDonald, intermittently Britain's prime minister
between 1924 and 1935. If so, then the capitalist system in
MacDonald's years suffered from a chronic neurological
disorder. The 1929 Wall Street crash was followed by the
collapse of financial institutions and an implosion of activity on
financial markets. The subsequent downturn became the Great
Depression—the great economic catastrophe of modern times.
That catastrophe was a global phenomenon. Contrary to the
impression conveyed by much of the literature, which focuses
on the United States, the Great Depression was so severe
precisely because so many countries were affected
simultaneously. No national economy was immune. All
suffered financial difficulties and many experienced
debilitating financial crises. It is therefore logical to seek the
key that unlocks the puzzle of the Depression in the
institutions linking the financial markets of different countries.
Here the gold standard enters the story. For more than a
quarter of a century before World War I, the gold standard
provided the framework for domestic and international
monetary relations. Currencies were convertible into gold on
demand and linked internationally at fixed rates of exchange.
Gold shipments were the ultimate means of balance‐ofpayments
settlement. The gold standard had been a
remarkably efficient mechanism for organizing financial
affairs. No global crisis comparable to the one that began in
1929 had disrupted the operation of financial markets. No
economic slump comparable to that of the 1930s had so
depressed output and employment.1
The central elements of this system were shattered by the
outbreak of World War I. More than a decade was required to
complete their reconstruction. Quickly it became evident that
the reconstructed gold standard was less resilient than its
prewar predecessor. As early as 1929 the new international
monetary system began to crumble. Rapid deflation forced
countries producing primary commodities to suspend gold
Introduction
Page 3 of 43
convertibility and depreciate their currencies. Payments
problems spread next to the industrialized world. In the
summer of 1931 Austria and Germany suffered banking panics
and imposed exchange controls, suspending the convertibility
of their currencies into gold. Britain, along with the United
States and France, one of the countries at the center of the
international monetary system, was (p.4) next to experience a
crisis, abandoning the gold standard in the autumn of 1931.
Some two dozen countries followed suit. The United States
dropped the gold standard in 1933; France hung on until the
bitter end, which came in 1936.
The collapse of the international monetary system is
commonly indicted for triggering the financial crisis that
transformed a modest economic downturn into an
unprecedented slump. So long as the gold standard was
maintained, it is argued, the post‐1929 recession remained
just another cyclical contraction. But the collapse of the gold
standard destroyed confidence in financial stability, prompting
capital flight which undermined the solvency of financial
institutions. The financial crisis leapfrogged from country to
country, dragging down economic activity in its wake.
Removing the gold standard, the argument continues, further
intensified the crisis. Having suspended gold convertibility,
policymakers manipulated currencies, engaging in beggar‐thyneighbor
depreciations that purportedly did nothing to
stimulate economic recovery at home while only worsening the
Depression abroad. The world of finance was splintered into
competing currency areas, disrupting international trade,
discouraging foreign investment, and generally impeding
recovery.
The gold standard, then, is conventionally portrayed as
synonymous with financial stability. Its downfall starting in
1929 is implicated in the global financial crisis and the
worldwide depression. A central message of this book is that
precisely the opposite was true. Far from being synonymous
with stability, the gold standard itself was the principal threat
to financial stability and economic prosperity between the
wars.
Introduction
Page 4 of 43
To understand why, we must first appreciate why the interwar
gold standard worked so poorly when its prewar predecessor
had worked so well. Next, we must identify the connections
between the gold standard and the Great Depression. Finally,
to clinch the argument we must show that removal of the gold
standard in the 1930s established the preconditions for
recovery from the Depression. These are the three tasks
undertaken in this book. The remainder of this chapter
describes the connections between them and summarizes the
evidence presented.
How the Gold Standard Worked
Considerable agreement exists on the reasons for the contrast
between the stability of the classical gold standard and the
instability of its interwar counterpart. The dominant
explanation is expressed most clearly in the work of Charles
Kindleberger. Kindleberger argues that the stability of the
prewar gold standard resulted from effective management by
its leading member, Great Britain, and her agent, the Bank of
England. The British capital market is said to have increased
its foreign lending whenever economic activity turned down,
damping rather than aggravating the international business
cycle. The Bank of England is said to have stabilized the gold
standard system by acting as international lender of last
resort. Kindleberger contrasts the prewar situation with the
interwar period, when Britain was too weak to stabilize the
system and the United States was not prepared to do so. In an
application of what has come to be known as the theory of
hegemonic stability, Kindleberger concludes that the requisite
stabilizing influence was adequately supplied (p.5) only when
there existed a dominant economic power, or hegemon, ready
and able to provide it.2
Chapter 2 challenges this argument. It suggests that the
interwar period was hardly exceptional for the absence of a
hegemon. Nor was there a country that singlehandedly
managed international monetary affairs prior to World War I.
London may have been the leading international financial
center, but it had significant rivals, notably Paris and Berlin.
The prewar gold standard was a decentralized, multipolar
Introduction
Page 5 of 43
system. Its smooth operation was not attributable to
stabilizing intervention by one dominant power.3
The stability of the prewar gold standard was instead the
result of two very different factors: credibility and
cooperation.4 Credibility is the confidence invested by the
public in the government's commitment to a policy. The
credibility of the gold standard derived from the priority
attached by governments to the maintenance of balance‐ofpayments
equilibrium. In the core countries—Britain, France,
and Germany—there was little doubt that the authorities
ultimately would take whatever steps were required to defend
the central bank's gold reserves and maintain the
convertibility of the currency into gold. If one of these central
banks lost gold reserves and its exchange rate weakened,
funds would flow in from abroad in anticipation of the capital
gains investors in domestic assets would reap once the
authorities adopted measures to stem reserve losses and
strengthen the exchange rate. Because there was no question
about the commitment to the existing parity, capital flowed in
quickly and in considerable volume. The exchange rate
consequently strengthened on its own, and stabilizing capital
flows minimized the need for government intervention. The
very credibility of the official commitment to gold meant that
this commitment was rarely tested.5
(p.6) What rendered the commitment to gold credible? In
part, there was little perception that policies required for
external balance were inconsistent with domestic prosperity.
There was scant awareness that defense of the gold standard
and the reduction of unemployment might be at odds.
Unemployment emerged as a coherent social and economic
problem only around the turn of the century. In Victorian
Britain, social commentators referred not to unemployment
but to pauperism, vagrancy, and destitution. In the United
States such persons were referred to as out of work, idle, or
loafing but rarely as unemployed. In France and Sweden the
authorities referred not to unemployment but to vagrancy and
vagabondism. These terms betray a tendency to ascribe
unemployment to individual failings and a lack of
comprehension of how aggregate fluctuations, referred to by
Introduction
Page 6 of 43
contemporaries as the trade cycle, affected employment
prospects.6
Even observers who connected unemployment to the state of
trade rarely related aggregate fluctuations to interest rates or
monetary conditions. They had limited appreciation of how
central bank policy affected the economy. There was no wellarticulated
theory of how supplies of money and credit could
be manipulated to stabilize production or reduce joblessness,
like the theories developed by Keynes and others after World
War I. Those who focused on changes in money and credit,
such as Ralph Hawtrey, argued that these perversely amplified
the trade cycle.7 Rather than advocating active monetary
management to stabilize the economy, the majority of
observers advised a passive and therefore predictable
monetary stance.
The working classes, possessing limited political power, were
unable to challenge this state of affairs. In many countries, the
extent of the franchise was still limited. Labor parties, where
they existed, rarely exercised significant influence. Those who
might have objected that restrictive monetary policy created
unemployment were in no position to influence it. Domestic
political pressures did not undermine the credibility of the
commitment to gold.
The point should not be exaggerated. By the first decade of
the twentieth century, unemployment had become a
prominent social issue. The spread of unionism and extension
of the franchise had enhanced the political influence of those
most vulnerable to loss of work. There was a growing
consensus that high interest rates discouraged investment and
depressed trade. Central bankers were not insensitive to these
considerations. Still, when forced to choose between external
and internal targets, they did not hesitate.
Nor did policymakers believe that budget deficits or increased
public spending could be used to stabilize the economy. Since
governments followed a balanced‐budget (p.7) rule, changes
in revenues dictated changes in the level of public spending.
Countries rarely found themselves confronted with the need to
eliminate large budget deficits in order to stem gold outflows.
Introduction
Page 7 of 43
Firmly established norms existed concerning the distribution
of the fiscal burden. For revenues, central governments relied
primarily on import duties; taxes on income or domestic
activity were still costly to collect. The individuals required to
pay import duties, often purchasers of imported foodstuffs and
other consumer goods, tended to be wage earners with
relatively little political say. When revenue needs fluctuated,
import duties could be adjusted accordingly. The need to
eliminate a budget deficit did not automatically open up a
contentious debate over taxation. Governments could credibly
promise to direct fiscal as well as monetary instruments
toward balance‐of‐payments targets.
Thus, a particular constellation of political power, reinforced
by prevailing political institutions, and a particular view of the
operation of the economy provided the foundation for the
classical gold standard system. This combination of factors—
political institutions and influence on the one hand, the
prevailing conceptual framework on the other—was the basis
for the system's credibility.8
Ultimately, however, the credibility of the prewar gold
standard rested on international cooperation. When stabilizing
speculation and domestic intervention proved incapable of
accommodating a disturbance, the system was stabilized
through cooperation among governments and central banks.9
Minor problems could be solved by tacit cooperation,
generally achieved without open communication among the
parties involved. When global credit conditions were overly
(p.8) restrictive and a loosening was required, for example,
the requisite adjustment had to be undertaken simultaneously
by several central banks. Unilateral action was risky; if one
central bank reduced its discount rate but others failed to
follow, that bank would suffer reserve losses and might be
forced to reverse course to defend the convertibility of its
currency. Under such circumstances, the most prominent
central bank, the Bank of England, signaled the need for
coordinated action. When it lowered its discount rate, other
central banks usually responded in kind. In effect, the Bank of
England provided a focal point for the harmonization of
national monetary policies. By playing follow the leader, the
Introduction
Page 8 of 43
central banks of different countries coordinated the necessary
adjustments.10
Major crises, in contrast, typically required different
responses from different countries. The country losing gold
and threatened by a convertibility crisis had to raise interest
rates to attract funds from abroad; other countries had to
loosen domestic credit conditions to make funds available to
the central bank experiencing difficulties. The follow‐theleader
approach did not suffice, especially when it was the
leader, the Bank of England, whose reserves were under
attack. Such crises were instead contained through overt,
conscious cooperation among central banks and governments.
Central banks and governments discounted bills on behalf of
the weak‐currency country or lent gold to its central bank.
Consequently, the resources any one country could draw on
when its gold parity was under attack far exceeded its own
reserves; they included the resources of the other gold
standard countries. This provided countries with additional
ammunition for defending their gold parities.
What rendered the commitment to the gold standard credible,
then, was that the commitment was international, not merely
national. That commitment was activated through
international cooperation.
This theme of cooperative management is different from the
conventional focus in the gold standard literature, which
emphasizes the Bank of England's hegemonic role. The
incompatibility of the two views need not be overstated,
however. One way of reconciling them is to observe that their
relative importance varied with time and circumstances. In
relatively tranquil periods, the Bank of England's tacit
leadership provided the organizing framework for
international cooperation. In times of crisis, in contrast,
international cooperation was key. The Bank of England lost
her leadership status. During crises she became no more than
one of several central banks whose collective intervention was
needed to stabilize the gold standard system. At worst, she
lost even her capacity to contribute to international support
operations. During the most serious crises, notably in 1890
and 1907, the critical stabilizing role was exercised by other
Introduction
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central banks. The Bank of England herself became a hostage
to international cooperation. Far from international lender of
last resort, she was international borrower of last resort,
reduced to dependence on the assistance of the Bank of
France, the German Reichsbank, and other European central
banks.