Robert Mundell's Interpretation of the Interwar Period

By comparison with past centuries, the twentieth has produced extremes. Its earliest part was a benign continuation of the pax of the 19th century. But this calm before the storm was followed by World War I, communism, hyperinflation, fascism, depression, genocide, World War II, the atom bomb, and the Soviet occupation of Eastern Europe. There followed a period of comparative stability, punctuated by the balance of terror of the Cold War, the Nato Alliance, and decolonialism. Toward the end of the century the Cold War ended, the Soviet Empire was dismantled, democracy emerged in Eastern Europe, the Pax Americana flourished and the euro came into being. The clue to the 20th century lies in the links between its first and last decades, the “bookends” of the century.

In 1906, Whitelaw Reid, the US Ambassador to Britain, gave a lecture at Cambridge University with the title, The Greatest Fact in Modern History, in which the author, a diplomat, journalist and politician, was given as his subject, the rise and development of the United States!1 It cannot have been obvious then that the rise of the United States was the “greatest fact in modern history” but it was true that in a matter of only two centuries a small colony had become the biggest economy in the world. The first decade of the century hinted at what the last decade confirmed, viz., American preponderance. Forget the seventy-five years between 1914 and 1989!

An underlying theme of my lecture today is the role of the United States in what has been aptly called the “American century.” I want to bring out the role of the monetary factor as a determinant of political events. Specifically, I will argue that many of the political changes in the century have been caused by little-understood perturbations in the international monetary system, while these in turn have been a consequence of the rise of the United States and mistakes of its financial arm, the Federal Reserve System.

The twentieth century began with a highly efficient international monetary system that was destroyed in World War I, and its bungled recreation in the inter-war period brought on the great depression, Hitler and World War II. The new arrangements that succeeded it depended more on the dollar policies of the Federal Reserve System than on the discipline of gold itself. When the link to gold was finally severed, the Federal Reserve System was implicated in the greatest inflation the United States has yet known, at least since the days of the Revolutionary War. Even so, as the century ends, a relearning process has created an entirely new framework for capturing some of the advantages of the system with which the century began.

The century can be divided into three distinct, almost equal parts. The first part, 1900-33, is the story of the international gold standard, its breakdown during the war, mismanaged restoration in the 1920’s and its demise in the early 1930’s. The second part, 1934-71, starts with the devaluation of the dollar and the establishment of the $35 gold price and ends when the United States took the dollar off gold. The third part of the century, 1972-1999, starts with the collapse into flexible exchange rates and continues with the subsequent outbreak of massive inflation and stagnation in the 1970’s, the blossoming of supply-side economics in the 1980’s, and the return to monetary stability and the birth of the euro in the 1990’s. The century ends, however, with our monetary system in deficit compared to the first decade of the century and that suggests unfinished business for the decades ahead.

I. Mismanagement of the Gold Standard

The international gold standard at the beginning of the 20th century operated smoothly to facilitate trade, payments and capital movements. Balance of payments were kept in equilibrium at fixed exchange rates by an adjustment mechanism that had a high degree of automaticity. The world price level may have been subject to long-terms trends but annual inflation or deflation rates were low, tended to cancel out, and preserve the value of money in the long run. The system gave the world a high degree of monetary integration and stability.

International monetary systems, however, are not static. They have to be consistent and evolve with the power configuration of the world economy. Gold, silver and bimetallic monetary standards had prospered best in a decentralized world where adjustment policies were automatic. But in the decades leading up to World War I, the central banks of the great powers had emerged as oligopolists in the system. The efficiency and stability of the gold standard came to be increasingly dependent on the discretionary policies of a few significant central banks. This tendency was magnified by an order of magnitude with the creation of the Federal Reserve System in the United States in 1913. The Federal Reserve Board, which ran the system, centralized the money power of an economy that had become three times larger than either of its nearest rivals, Britain and Germany. The story of the gold standard therefore became increasingly the story of the Federal Reserve System.

World War I made gold unstable. The instability began when deficit spending pushed the European belligerents off the gold standard, and gold came to the United States, where the newly-created Federal Reserve System monetized it, doubling the dollar price level and halving the real value of gold. The instability continued when, after the war, the Federal Reserve engineered a dramatic deflation in the recession of 1920-21, bringing the dollar (and gold) price level 60 percent of the way back toward the prewar equilibrium, a level at which the Federal Reserve kept it until 1929.

It was in this milieu that the rest of the world, led by Germany, Britain and France, returned to the gold standard. The problem was that, with world (dollar) prices still 40 percent above their prewar equilibrium, the real value of gold reserves and supplies was proportionately smaller. At the same time monetary gold was badly distributed, with half of it in the United States. In addition, uncertainty over exchange rates and reparations (which were fixed in gold) increased the demand for reserves. In the face of this situation would not the increased demand for gold brought about by a return to the gold standard bring on a deflation? A few economists, like Charles Rist of France, Ludwig von Mises of Austria and Gustav Cassel of Sweden, thought it would.

Cassel(1925) had been very explicit even before Britain returned to gold:

“The gold standard, of course, cannot secure a greater stability in the general level of prices of a country than the value of gold itself possesses. Inasmuch as the stability of the general level of prices in desirable, our work for a restoration of the gold standard must be supplemented by endeavours to keep the value of gold as constant as possible…With the actual state of gold production it can be taken for certain that after a comparatively short time, perhaps within a decade, the present superabundance of gold will be followed, as a consequence of increasing demand, by a marked scarcity of this precious metal tending to cause a fall of prices…”

After gold had been restored, Cassel pursued his line of reasoning further, warning of the need to economize on the monetary use of gold in order to ward off a depression. In 1928 he wrote:

“The great problem before us is how to meet the growing scarcity of gold which threatens the world both from increased demand and from diminished supply. We must solve this problem by a systematic restriction of the monetary demand for gold. Only if we succeed in doing this can we hope to prevent a permanent fall of the general price level and a prolonged and world-wide depression which would inevitably be connected with such a fall in prices.”

Rist, Mises and Cassel proved to be right. Deflation was already in the air in the late 1920’s with the fall in prices of agricultural products and raw materials. The Wall Street crash in 1929 was another symptom, and generalized deflation began in 1930. That the deflation was generalized if uneven can be seen from the percentage loss of wholesale prices in various countries from the high in 1929 to September 1931 (the month that Britain left the gold standard): Japan, 40.5; Netherlands, 38.1; Belgium, 31.3; Italy 31.0; United States, 29.5; United Kingdom, 29.2; Canada, 28.9; France, 28.3; Germany, 22.0.

The dollar price level hit bottom in 1932 and 1933. The highlights of the price level from 1914 to 1934 are given in Table 1:

For decades economists have wrestled with the problem of what caused the deflation and depression of the 1930’s. The massive literature on the subject has brought on more heat than light. One source of controversy has been whether the depression was caused by a shift of aggregate demand or a fall in the money supply. Surely the answer is both! But none of the theories—monetarist or Keynesian—would have been able to predict the fall in the money supply or aggregate demand in advance. They were rooted in short-run closed-economy models which could not pick up the gold standard effects during and after World War I. By contrast, the theory that the deflation was caused by the return to the gold standard was not only predictable, but was actually, as we have noted above, predicted.

The gold exchange standard was already on the ropes with the onset of deflation. It moved into its crisis phase with the failure, in the spring of 1931, of the Viennese Creditanstalt, the biggest bank in Central Europe, bringing into play a chain reaction that spread to Germany, where it was met by deflationary monetary policies and a reimposition of controls, and to Britain, where, on September 21, 1931, the pound was taken off gold. Several countries, however, had preceded Britain in going off gold: Australia, Brazil, Chile, New Zealand, Paraguay, Peru, Uruguay and Venezuela, while Austria, Canada, Germany and Hungary had imposed controls. A large number of other countries followed Britain off gold.

Meanwhile, the United States hung onto to the gold standard for dear life. After making much of its sensible shift to a monetary policy that sets as its goal price stability rather than maintenance of the gold standard, it reverted back to the latter at the very time it mattered most, in the early 1930’s.

Instead of pumping liquidity into the system, it chose to defend the gold standard. Hard on the heels of the British departure from gold, in October 1931, the Federal Reserve raised the rediscount rate in two steps from 1_ to 3_ percent dragging the economy deeper into the mire of deflation and depression and aggravating the banking crisis. As we have seen, wholesale prices fell 35 percent between 1929 and 1933.

Monetary deflation was transformed into depression by fiscal shocks. The Smoot-Hawley tariff, which led to retaliation abroad, was the first: between 1929 and 1933 imports fell by 30 percent and, significantly, exports fell even more, by almost 40 percent. On June 6, 1932, the Democratic Congress passed, and President Herbert Hoover signed, in a fit of balanced-budget mania, one of its most ill-advised acts, the Revenue Act of 1932, a bill which provided the largest percentage tax increase ever enacted in American peacetime history. Unemployment rose to a high of 24.9 percent of the labor force in 1933, and GDP fell by 57 percent at current prices and 22 percent in real terms.

The banking crisis was now in full swing. Failures had soared from an average of about 500 per year in the 1920’s, to 1,350 in 1930, 2,293 in 1931, and 1,453 in 1932. Franklin D. Roosevelt, in one of his first actions on assuming the presidency in March 1933, put an embargo on gold exports. After April 20, the dollar was allowed to float downward.

The deflation of the 1930’s was the mirror image of the wartime rise in the price level that had not been reversed in the 1920-21 recession. When countries go off the gold standard, gold falls in real value and the price level in gold countries rise. When countries go onto the gold standard, gold rises in real value and the price level falls. The appreciation of gold in the 1930’s was the mirror image of the depreciation of gold in World War I. The dollar price level in 1934 was the same as the dollar price level in 1914. The deflation of the 1930’s has to be seen, not as a unique “crisis of capitalism,”as the Marxists were prone to say, but as a continuation of a pattern that had appeared with considerable predictability before—whenever countries shift onto or return to a monetary standard. The deflation in the 1930’s has its precedents in the 1780’s, the 1820’s and the 1870’s.

What verdict can be passed on this third of the century? One is that the Federal Reserve System was fatally guilt of inconsistency at critical times. It held onto the gold standard between 1914 and 1921 when gold had become unstable. It shifted over to a policy of price stability in the 1920’s that was successful. But it shifted back to the gold standard at the worst time imaginable, when gold had again become unstable. The unfortunate fact was that the least experienced of the important central banks—the new boy on the block—had the awesome power to make or break the system by itself.

The European economies were by no means blameless in this episode. They were the countries that changed the status quo and moved onto the gold standard without weighing the consequences. They failed to heed the lessons of history—that a concerted movement off, or onto, any metallic standard brings in its wake, respectively, inflation or deflation. After a great war, in which inflation has occurred in the monetary leader and gold has become correspondingly undervalued, a return to the gold standard is only consistent with price stability if the price of gold is increased. Failing that possibility, countries would have fared better had they heeded Keynes’ advice to sacrifice the benefits of fixed exchange rates under the gold standard and instead stabilize commodity prices rather than the price of gold.

Had the price of gold been raised in the late 1920’s, or, alternatively, had the major central banks pursued policies of price stability instead of adhering to the gold standard, there would have been no Great Depression, no Nazi revolution and no World War II.

II. Policy Mix Under the Dollar Standard

In April 1934, after a year of flexible exchange rates, the United States went back to gold after a devaluation of the dollar. This decreased the gold value of the dollar by 40.94 percent, raising the official price of gold 69.33 percent to $35 an ounce. How history would have been changed had President Herbert Hoover devalued the dollar, three years earlier!

France held onto its gold parity until 1936, when it devalued the franc. Two other far-reaching events occurred in that year. One was the publication of Keynes’ General Theory; the other signing of the Tripartite Accord among the United States, Britain and France. One ushered in a new theory of policy management for a closed economy; the other, a precursor of the Bretton Woods agreement, established some rules for exchange rate management in the new international monetary system.

The contradiction between the two could hardly be more ironic. At a time when Keynesian policies of national economic management were becoming increasingly accepted by economists, the world economy had adopted a new fixed exchange rate system that was incompatible with those policies.

In the new arrangements, which were ratified at Bretton Woods in 1944, countries were required to establish parities fixed in gold and maintain fixed exchange rates to one another.

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IV. Conclusions

It is time to wrap up the century in some conclusions. A first conclusion is that the international monetary system depends on the power configuration of the countries that make it up. Bismarck once said that the most important fact of the nineteenth century was that England and America spoke the same language. Along the same lines, the most important fact of the twentieth century has been the rise of the United States as a superpower. Despite the incredible rise in gold production, Gresham’s Law came into play and the dollar elbowed out gold as the principal international money.

The first third of twentieth century economics was dominated by the confrontation of the Federal Reserve System with the gold standard. The gold standard broke down in World War I and its restoration in the 1920’s created the deflation of the 1930’s. Economists blamed the gold standard instead of their mishandling of it and turned away from international automaticity to national management. The Great Depression itself let to totalitarianism and World War II.

The second third of the twentieth century was dominated by the contradiction between national macroeconomic management and the new international monetary system. In the new system, the United States fixed the price of gold and the other major countries fixed their currencies to the convertible dollar. But national macroeconomic management precluded the operation of the international adjustment mechanism and the system broke down in the early 1970’s when the United States stopped fixing the price of gold and the other countries stopped fixing the dollar.

The last third of the twentieth century started off with the destruction of the international monetary system and the vacuum sent officials and academics into a search for “structure.” In the 1970’s the clarion call was for a “new international monetary order” and in the 1990’s a “new international monetary architecture.” The old system was one way of handling the inflation problem multilaterally. Flexibility left each country on its own. Inflation was the initial result but a learning mechanism educated a generation of monetary officials on the advantages of stability and by the end of the century fiscal prudence and inflation control had again become the watchword in all the rich and many of the poor countries.

Today, the dollar, the euro and yen have established three islands of monetary stability,which is a great improvement over the 1970’s and 1980’s. There are, however, two pieces of unfinished business. The most important is the dysfunctional volatility of exchange rates that could sour international relations in time of crisis. The other is the absence of an international currency.

The century closes with an international monetary system inferior to that with which it began, but much improved from the situation that existed only two-and-a-half decades ago. It remains to be seen where leadership will come from and whether a restoration of the international monetary system will be compatible with the power configuration of the world economy. It would certainly make a contribution to world harmony.

The Federal Reserve, through its extensive network of consultants, visiting scholars, alumni and staff economists, so thoroughly dominates the field of economics that real criticism of the central bank has become a career liability for members of the profession, an investigation by the Huffington Post has found.

This dominance helps explain how, even after the Fed failed to foresee the greatest economic collapse since the Great Depression, the central bank has largely escaped criticism from academic economists. In the Fed’s thrall, the economists missed it, too.

“The Fed has a lock on the economics world,” says Joshua Rosner, a Wall Street analyst who correctly called the meltdown. “There is no room for other views, which I guess is why economists got it so wrong.”

Priceless: How the Federal Reserve Bought the Economics Profession