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-VIII. The Pre-World War I Gold Standard-
J. Bradford DeLong
University of California at Berkeley and NBER
January 1997; DRAFT 1.00
- International Finance
- The Pre-WWI Business Cycle
What made the upward leap in international trade, the creation of an integrated world economy--a world economy where for the first time trade was not confined to luxuries and intoxicants but extended to staples and necessities--possible in the years before World War I? Falling costs of ocean transportation was one major factor. The development and extension of the international political and economic order called the gold standard was another.
The gold standard was in its origins a very simple thing: governments and central banks all over the world declared that their currencies were as good as gold-show up with £100 note, or a $100 bill, at the British Bank of England or the U.S. Treasury and the man behind the counter would give you a specified, fixed, unchanging quantity of gold: about 4.5 (troy) ounces in the case of the $100 bill, and about 22 (troy) ounces in the case of the £100 pound note.
Why did this matter? It mattered because as long as the gold standard stood entrepreneurs could make their plans for and build their factories engaged in international trade without having to worry about what we today call foreign exchange risk. Consider the plight of an American manufacturer deciding in 1980-when one British pound sterling sells for $2.32-to compete with British producers by exporting to London; spending the early 1980s building factories to expand capacity, and then finding in 1985 that one pound sterling sells not for $2.32 but for $1.30 on the foreign exchange market. The simple movement in exchange rates since 1980 has raised the manufacturer's costs relative to those of British competitors by 80 percent. You can bet that a very large number of productive operations and markets that looked profitable to American businesses in 1980 no longer looked profitable in 1985.
This is foreign exchange risk: the risk that governments following sensible or nonsensical policies or international currency speculators responding to their own "animal spirits" will cause exchange rates to shift in a way that destroys a particular line of trade or bankrupts importers and exporters. This foreign exchange risk is in large part avoided under a gold standard. And this near-absence of foreign exchange risk was one powerful factor driving the expansion of international trade and finance in the years before World War I.
How did the gold standard reduce foreign exchange risk-and close to eliminate the risk that a country would embark on a policy of inflation that would endanger established wealth? In its idealized form, the gold standard carried out these tasks by virtue of its working as an automatic equilibrating mechanism.
If ever a central bank or a Treasury printed "too many" banknotes under a gold standard, the first thing that would happen would be that those excess bank notes would be returned to the Treasury by individuals demanding gold in exchange. Thus each country's domestic supply of money was linked directly to its domestic reserves of gold.
Suppose a country under the gold standard ran a trade deficit in excess of foreigners' desired investments. It, too, would find those who had sold goods to its citizens lining up outside the Treasury looking to exchange banknotes for gold. And these foreign suppliers of imports would then ship the gold back to their countries. The money stock at home would fall as gold reserves fell. And with a falling money stock would come falling prices, falling production, and falling demand for imports.
So balance of payments equilibrium would be restored, and countries' price levels kept in roughly appropriate competitive alignment, by the gold standard as sources of disequilibrium were removed by shipments of gold, or threatened shipments of gold, that raised and lowered nations' reserves. Monetary authorities would find themselves restrained from pursuing over-inflationary policies by fears of the gold drains that would result. And since central bankers in every country were all working under the same gold standard system, they would all find their policies in rough harmony without explicit meetings of G-7 finance ministers or explicit international policy coordination.
The pre-World War I gold standard was not invented. It just grew, starting in the 1870s when Germany joined Britain, which had defined its currency primarily in terms of gold since 1717, when Sir Isaac Newton was Master of the Mint. Increased German demand for gold pushed up its price; increased American mining of silver pushed down its price. Countries that had long tried to keep both gold and silver coins legal tender found their gold reserves falling, as people would buy cheap silver on the world market, exchange it for currency, and then bring the currency into the Treasury for gold. By the end of the 1870s nearly the whole world was on the gold standard.
That exchange rates were stable under the pre-World War I gold standard is indisputible. Devaluations were few among the industril powers, and rare. Exchange rate risk was rarely a factor in economic decisions.
It is important to recognize that the gold standard was a historically-specific institution. The cornerstone of the gold standard was the commitment by all industrial-economy governments and central banks to maintaining convertibility of their currency. The pressure that twentieth-century--democratic--governments would feel to abandon currency convertibility and the stable exchange rate peg in order to boot employment or attain other economic objectives was simply absent. The credibility of the government's commitment to the gold standard rested on the denial of the franchise to the working class. As long as the right to vote was still limited to middle and upper-class males, those rendered unemployed when the central bank raised is discount rate and tightened monetary policy had little voice in politics. As long as union movements remained relatively weak, the flexibility of wages and prices that would allow the gold-standard system to quickly readjust to equilibrium was present.
Later on these two preconditions for the functioning of the gold standard would erode, and the gold standard would cease to be a politically and economically-feasible institution.
At the periphery of the world economy, the gold standard functioned with less success. Primary product-producing econmies were subject to large economic shocks as the prices of their exports rose and fell. Countries at the periphery were also subject to large shocks as British investors' willingness to loan capital abroad went through its own less-than-rationally-based cycles. Latin countries were repeated forced off of the gold standard and into devaluation by financial crises.
Not only did trade expand under the gold standard, but international capital markets expanded in the years before World War I as well. It became a commonplace for rich people in Europe or North America to have their money invested in far-flung enterprises on other continents. This outflow of capital from the industrial core to the industrializing, mineral-rich periphery was greatly assisted by the gold standard.
Later, the British economist John Maynard Keynes was to look back on this era of free trade and free capital flows as a golden age:
...for [the middle and upper classes] life offered, at a low cost and with the least trouble, conveniences, comforts, and amenities beyond the compass of the richest and most powerful monarchs of other ages. The inhabitant of London could order by telephone, sipping his morning tea in be, the various products of the whole earth... he could at the same moment and by the same means adventure his wealth in the natural resources and new enterprises of any quarter of the world, and share, without exertion or even trouble, in their prospective fruits and advantages.... He could secure... cheap and comfortable means of transit to any country or climate without passport or other formality.... But, most important of all, he regarded this state of affairs as normal, certain, and permanent, except in the dierction of further improvement, and any deviation from it as aberrant, scandalous, and avoidable.
Certainly free trade, free capital flows, and free migration helped greatly enrich the world in the generations before World War I. And certainly those economies that received inflows of capital before World War I benefitted enormously. It is not so clear that the free flow of capital was beneficial to those in the capital-exporting countries. France subsidized the pre-World War I industrialization of Czarist Russia (and the pre-World War I luxury of the court and expansion of the military) by making investments in Russian government and railroad bonds a test of one's French patriotism. A constant of French pre-World War I politics was that someday there would be another war with Germany, during which France would conquer and re-annex the provinces of Alsace and Lorraine that Germany had annexed as part of the settlement of the Franco-Prussian War of 1870-71. (And that France had taken from the feeble and oddly-named Holy Roman Empire of the German Nation as part of the settlements of the Thirty Years' War of 1618-48 and the Wars of Louis XIV of 1667-1715.) French military strategy depended on a large, active, allied Russian army in Poland threatening Berlin and forcing Germany to divide its armies while the French marched to the Rhine. Hence boosting the power of the Czar by buying Russian bonds became a test of French patriotism.
But after World War I there was no Czar ruling from Moscow. There was Lenin ruling from Petrograd-subsequently renamed Leningrad-subsequently returned to its original name of St. Petersburg. And Lenin had no interest at all in repaying creditors from whom money had been borrowed by the Czar.
British investors did better from their overseas investments, but they still did not do very well The year 1914 saw close to 40 percent of Britain's national capital invested overseas. No other country has ever matched Britain's high proportion of savings channeled to other countries. Britain's overseas investments were concentrated in government debt, in infrastructure projects like railroads, streetcars, and utilities, and in securities guaranteed by the local governments.
However, in the forty years before World War I, British investors in overseas assets earned low returns, ranging as low to perhaps 2% per year in inflation-adjusted pounds on loans to dominion governments. Such returns were far below what presumably could have earned by devoting the same resources to the expansion of domestic industry. British industry in 1914, and British infrastructure, were not as capital intensive as American industry and infrastructure were to become by 1929. It is difficult to argue that Britain's savings could not have found productive uses at home, if only British firms could have been challenged appropriately and managed productively. And the difference in rates of return cannot be attributed to risk: overseas investments were in the last analysis more exposed to risk than were domestic investments.
But for capital importing countries, like the U.S., Canada, Australia, and others like India and Argentina, the availability of large amounts of British-financed capital to speed development of industry and infrastructure was a godsend. It allowed for earlier construction of railroads and other infrastructure. It allowed for the more rapid development of industry.
Of course, the actual, real-world gold standard did not work as smoothly as the idealizations of economic theorists. But it did provide a stable underpinning to the growth of the world economy in the years before World War I.
The Pre-World War I Business Cycle
However, there is a negative side to the gold standard. The gold standard was good not only at encouraging international trade expansion and boosting international capital flows, but also at quickly transmitting business cycles and financial panics around the world as fast as the telegraph wire could carry them. So borrowing foreign capital from Britain had costs as well: it tied the borrower's economy to the financial and employment cycles of Great Britain. "When London sneezes," the saying went, "Argentina [or Canada, or the U.S.] catches pneumonia."
How did this work? Look in some detail at the industrialization of the United States to see how the typical pre-1929 depression had its origin in the gold-standard links with the London-centered world economy.
The years between the Civil War and the 1890s saw the great railway booms. In 1870 and 1871 U.S. railroad construction reached its first post-Civil War peak. The number of miles of operated railroad in the U.S., then around 50,000, grew at about twelve percent per year. The construction of 6,000 miles of railroad track each year employed perhaps one-tenth of America's non-farm paid labor force and half of the production of America's metal industries.
Four years later, railroad construction had collapsed. In 1875, railroad mileage grew at only three percent. Railroad construction employed less than three percent of America's non-farm paid labor force, and required perhaps fifteen percent of the production of America's metal industries.
The depression of 1873 had its origins in British investors loss of confidence that American railroads and infrastructure-that day's equivalent of investments in the Pacific Rim. The largest investment house in the United States-that of Jay Cooke, politically well-connected industrial visionary who financed Abraham Lincoln's armies, and whose picture hangs in the Treasury Department's antique collection in the General Counsel's office-went bankrupt.
As a result of the collapse of Jay Cooke and Company the City of London sneezed. The U.S. economy caught pneumonia. The share of America's non-agricultural labor force building railroads fell from perhaps one in ten in 1872 to perhaps one in forty by 1877-a seven percentage point boost to non-agricultural sector unemployment from this source alone.
Such a wave-first of expanded railroad construction as capital flowed in, and then of contraction as capital flowed out-must have been difficult to absorb just as the Mexican recession of 1995 proved very painful. Each wave of railroad building required an expansion of capacity in iron and steel for rails, timber for ties, equipment for locomotives and cars, furniture to equip the cars to carry passengers on the new lines, and most important the redirection of one million workers to railroad construction. As the wave passed, suppliers and workers would have to find new markets and new jobs. The dislocation generated may well have been extreme and severe. But we know little about how it was accomplished, or about what workers who built railroads in 1871 were doing in 1875.
It is hard to attribute such spasms of construction to independent disturbances in finance: railroad finance was then more-or-less the sole business of Wall Street. By default such depressions appear to have been driven by waves of optimism about future growth, followed by recognition of overbuilding and contraction until the economy had grown enough that it seemed that shipping by rail was a railroad's and not a farmer's market.
The gold standard appears also in the depression of the 1890's. The possibility that "free silver" might sweep American politics made investors and financiers uneasy. Relative to what they would earn if they kept their cash, investments, and capital in London, a free-silver victory and subsequent devaluation might well have cost them a third of their wealth as measured by the international yardstick of the gold standard. Perhaps the free-silver movement was powerful enough to cause capital flight, investment shortfall, and depression, but not strong enough to secure devaluation and monetary expansion to reduce the debt burdens of farmers and create a booming labor market for urban workers. The U.S. thus got the worst of both worlds: it suffered the disadvantages of being on the gold standard without reaping the gold standard advantage of keeping financiers confident and investing. Moreover, the panic of 1907 followed a recession in Great Britain. As a result of the recession, the Bank of England raised interest rates to pull gold to London to boost its reserves. This left the United States short of currency to be paid out to farmers and middlemen during the fall shipment of the harvest to the East. Financial panic followed, and recession followed the financial panic.
It is very clear that depressions before 1929 were more painful than depressions today. Those who lost their jobs had no welfare state to cushion them. Individual states had sketches of a future welfare system, but such embryonic systems did not have the resources to cope with episodes of widespread unemployment. Extended families, friends, and local benevolent associations must have provided support for those who lost their jobs to remain, for the most part, fed and housed. American cities during depressions at the turn of the century were centers of poverty and want, but apparently not of mass near-starvation.
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