From the Gold Standard to Bretton Woods

Cornel Ban

The gilded age upstairs

The gilded age downstairs

Pre WW I according to

Got a problem with war?

ww1

• Gold was used to fund the war• Its export was prohibited• As governments issued fiat money (unbacked

by gold) to finance deficits, exchange rates began to float and capital controls were introduced, leading to currency depreciations

• Only the dollar was backed by gold

Versailles, Versailles

Ouch!

Post-WW1

• Britain loses prominence• A key creditor, Germany becomes a debtor• Democracy, unions and left parties made the

fiscal and monetary bases of the Gold Standard unsustainable and demanded flexible exchange rates to accommodate shocks

Gold Standard versus democracy

Reintroducing gold convertibility

• Hyperinflation countries (Austria, Germany, Hungary) move first

• Austerity and loans from the League of Nations boost gold reserves to back the GS

• Central bank independence is strengthened

Why did GS 2.0 last only 5 years?

• The Great Depression triggered a deflationary spiral leading commodity exporters to cut reserve levels and then the money supply

• This led to demand to relax GS rules (inflationary gold bans that ruined the par values of currencies to gold)

Why did GS 2.0 last only 5 years?

• Banking crises in Austria and Germany depreciate gold and forex reserves

• Convertibility is suspended and exchange controls are introduced

• Where countries stay on gold, central banks sold off reserves and increased interest rates aggravating unemployment and adding to pressures for devaluation>currency war ensues in mid 30s

• Speculation on currencies remained

Germany’s Gold

• Run high inflation to cut war debt to the French->hyperinflation->new currency tied to real estate assets->another currency ends the crisis, supported by US capital inflows

• 1929: US inflows end->higher interest rates are useless following Fed’s higher interest rates->collapse of foreign reserves->austerity

The Great Depression

Lets get this straight

• Recession: When your neighbor loses his or her job

• Depression: When you lose your job.

Now seriously…

• Gross Domestic Product (GDP): Comprehensive measure of the nation’s output of final goods and services.

• Real GDP: GDP measured at a fixed price level (i.e., inflation adjusted).

• Recession: Sustained decline in real GDP (approximately two quarters).

• Depression: Very severe recession

How Great was the Great Depression?

• Real output (GDP) fell 29% from 1929 to 1933.• Unemployment increased to 25% of labor

force.• Consumer prices fell 25%; wholesale prices

32%.

Stock Market Boom and BustS&P Composite Index

Commercial Bank Failures, 1920-2004

Nominal and Real Interest Rates, 1922-33

Percent

Nominal

Real

Great Depression

• Bank runs plus contractionary monetary policy to defend the ratio between gold reserves and the money supplycurrency runsdepleted reservesexchange rate controlsoff gold

Neoclassicals

• If people save, the higher level of savings leads to lower interest rates

• Lower interest rates should lead to increased investment spending and demand stabilization

• Say’s law: a rational business will never hoard money but spend it

• Booms and busts are inevitable

Keynesians

• Demand-driven• Financial bust followed by underconsumption and

underinvestment• As prices dropped, a liquidity trap followed: even if the

interest rate falls, investment dos not increase because investors’ expectations of profit are lowered by expectations that the fall in consumption is long term

• Secular stagnation theory• Only government spending can improve expectations

Monetarists

• Money driven• An ordinary recession is met with the

shrinking of the money supply, causing people to hoard money and consume less, leading to a large fall in output and emplyment

• the recession to morph into a depression

Austrians

• Easy money during the 1920s led to malinvestment

Marxists

• Inherent instability• Classism

The Collapse of World Trade$ value imports of 75 countries

Why Did It Happen? Some Suggested Causes

• The stock market crash – end of the party• Collapse of world trade – globalization in reverse• Monetary collapse

Bank Failures

• 7000 banks failed -- many during “panics”

• Number of banks fell from 25,000 in 1929 to 15,000 by 1934

Possible Channels:• Loss of deposits decline in

expenditures• Customer relationships broken

harder to borrow• Money supply contraction

31

The chart shows that 99% of the population received a 9% increase in their income, while the top 1% saw

their income rise by 75%.

1,230,000 Americans

121,770,000 Americans

US credits and the Great Depression

• US becomes main creditor to European sovereigns and corporates

• To cool the speculative boom the Fed increases interest rates in 1928; money flows back in the US and interest rates go up in Europe

• The sudden stop in capital inflows compresses demand in Europe, forcing deflation there

The periphery seizes up

• Austria bails out the biggest bank while trying to stay on gold-depleted gold reservesmarkets fear devaluationcapital flightexchange controls end the GS

• Hungary• Germany: defended the GS reserves by

limiting credit until it triggered a banking crisis

Managed floating 30s

• Currencies values varies but governments can intervene on forex

• Monetary reflation: Central banks cut the discount rate recovery led by interest rate sensitive sectors

• Devaluations were done in an orderly fashion• Coordinated reflation impossible because of

different interpretation of monetary reflation• Propelled protectionist measures

Bretton Woods

• Exchange rate stability• Trade boom

Bretton Woods’ monetary system

• Pegged but adjustable exchange rates• Capital controls• IMF

• …but not Keynes’ Clearing Union

BW’s extra levees

• Interest rate caps• Development banks• Assets in which banks could invest were restricted• Financial markets were made to invest in

domestic strategic sectors• Licensing for importers to control trade

imbalances• Governments with full employment mandates

BW’s first cracks

• 1959: convertibility of currencies weakens exchange controls

• Needed by US interest to guarantee its exporters a level playing field

• Key for a multilateral trade regime• But high interest rates needed to maintain

credibility were limited by the postwar compromise: full employment and welfare state. The solution: exchange controls and devaluations

BW in the convertible 60s

• How to finance trade imbalances?• Weak currency countries: more generous IMF

assistance to increase their reserves to counter the speculative flows brought by the relaxation of controls

• Strong currency guys: you live beyond your means!

Triffin’s bank run

• The system had a tendency to meet excess demands for reserves through the growth of the demand for dollars

• once foreign dollar reserves looked large relative to US gold reserves made the system unstable,

• especially as the US foreign monetary liabilities exceeded its gold reserves

• If foreigners saw this and tried to cash in their US liabilities for dollars before the US was forced to devalue, the gold: dollar parity would be questioned