Friday, January 24, 2014

On the Overwrought Distinction Between the Classical and Interwar Gold Standards (A Preview of My Current Project)

In his critique of the standard interpretation of the interwar gold standard, Richard Timberlake claims that “the Fed and other central banks’ deliberate management of the gold-exchange standard prevented monetary adjustment in the period 1929-33 from resembling the pattern of equilibrium of the classical gold standard (2007, 326).” He goes on to equate a “true” gold standard with the classical gold standard. In similar fashion, Milton Friedman argues that the gold-exchange standard was a “pseudo gold standard” because France and the United States engaged in sterilized gold inflows (1961). Though they were avoided, the same policies were possible under the classical gold standard, making the distinction dubious. The difference between the classical gold standard and the interwar gold standard was a difference in degree, not kind.

The gold standard grew continually more cumbersome after it was officially adopted during the 1870s. That gold, and gold alone, was employed under all legal tender regimes in the West altered the standard’s operation. If a major central bank changed its gold reserve ratio or interest rate, this would certainly impact the price of gold elsewhere. This was true during the classical standard just as it was during the interwar gold standard. Before World War I, this was obscured by informal coordination of central bank policies, led by the Bank of England. As phrased by Barry Eichengreen, “when the Bank of England raised her rate, the Bank of France and the Reichsbank were quick to follow (1989, 13).” The stability offered by such an arrangement masked its underlying weakness.

When national governments suspended the gold standard, both in law and in practice, and England gave up her leadership, the managed gold standard lost its coordinating mechanism. The problem was augmented by another feature of the gold standard: the tendency toward centralization of gold reserves in the previous half century. In 1914, most of the world’s monetary gold was stored at a small number of central banks. By 1922, “the world market in gold was practically coterminous with the monetary demand of one great country” as nearly half of the world’s monetary gold resided at the Federal Reserve (Hawtrey 1947, 97). Consolidation made prices even more sensitive to changes in the demand and supply of gold. When coordination of independent central banks from the Bank of England ceased, the price of gold became unhinged, swinging wildly between 1914 and 1920 and again between 1929 and 1932.

This problem was inherent in the system. It was not a defect of the gold standard per se. It was a defect of management under a system of fixed exchange rates where deflation must almost inevitably follow an unbacked expansion of the money stock by the central bank. Under a system of floating exchange rates, on the other hand, the economy probably would have adjusted to a higher price level and “the subsequent collapse would almost surely not have occurred (Friedman 1961, 68).” Of course this also could have been avoided by a return to the gold standard at adjusted parities, but such an option was politically unpalatable.[1] In light of political constraints, the economic instability associated with the latter decades of the gold standard was not a glitch, but rather the logical end of a monometallic legal tender regime.

[1] “The implications drawn by Cassel from this situation were that countries should not go back to prewar parities, or if the objective was price stability, to the prewar system at all. A much talked of advantage of the prewar system was its ‘high degree of stability’, and which ‘we should now endeavor to restore’. Adopting mispriced currencies and squabbling over inadequate gold reserves were not the ways to do it. He was ignored by policymakers and rejected by most economists.” (Mazumder and Wood, 2013, 162)

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