This book is about the changing character of monetary cooperation among nations since the end of the Second World War. This is a question of far more than a narrow technical interest. Money links countries. Its primary function is as an instrument of exchange. Money provides a way of translating ideas into practice and of allocating resources. The management of money is at a fundamental level concerned with the flow of information. By itself monetary exchange cannot produce new ideas and technologies—it is so to speak irrelevant to the heart of the mechanism that drives economic development—but it is a nerve center, distributing ideas about how those technologies may be used. When it fails to function properly, the course of development is impeded and the enrichment of mankind halted.
This book is about the changing character of monetary cooperation among nations since the end of the Second World War. This is a question of far more than a narrow technical interest. Money links countries. Its primary function is as an instrument of exchange. Money provides a way of translating ideas into practice and of allocating resources. The management of money is at a fundamental level concerned with the flow of information. By itself monetary exchange cannot produce new ideas and technologies—it is so to speak irrelevant to the heart of the mechanism that drives economic development—but it is a nerve center, distributing ideas about how those technologies may be used. When it fails to function properly, the course of development is impeded and the enrichment of mankind halted.
When in 1944, at the international conference at Bretton Woods, an international agency for monetary cooperation was created, its charge explicitly included “to facilitate the expansion and balanced growth of international trade” (Article 1 of the IMF Articles of Agreement). Monetary relations are a necessary means for facilitating trade and the gains that it provides, but they can also be a mechanism for transmitting shocks. The most persistent problem facing monetary policymakers has been the spillover of potentially damaging effects from the outside world through the international system. The most enduring debate has been over the extent to which human ingenuity can invent an abstract procedure or rule, or a way of looking at the world, that makes the instrument of exchange less controversial, avoids the need for consultation or negotiation, and eliminates the possibility of arguments, clashes, and mutually destructive behavior. This is a debate that has not definitively been resolved, and probably cannot be; but—this book will suggest—it has come closer to resolution.
The purpose in this work is not to treat the issue of monetary cooperation as simply an arcane issue appropriate politically for high-level discussions between technocrats or for seminars by academic economists. The obstacles in the way of increased cooperation have frequently been less technical than emotional or political. The establishment of international linkages requires not just a willingness and an understanding on a high bureaucratic level, but also a society that is prepared to tolerate or even welcome the cooperation and agreement that is needed for the working of the international order. This book also carries a broader hope that explaining the processes concerned with international money (and demystifying it) can make the process of cooperation more widely acceptable and ensure that generally beneficial policies are easier to implement.
In particular, much of the material of the book is concerned with the work and thought of the International Monetary Fund, the body created at the Bretton Woods conference, and its relationship to other institutional mechanisms for international cooperation as well as uninstitutionalized international monetary contacts (that is, the vast movements of the world’s financial markets). Initially, the purpose of the IMF was to enforce rules about adjustment in international monetary relations as well as to provide temporary resources to deal with balance of payments problems. It was intended in this way to help to ease the constraints that the open international economy had previously placed on national economic development: with what happens—simply stated—when the test of the world does not buy sufficient goods and services to pay for the items consumed as imports by a country. This had in the past been precisely the sore point, where the economic contacts involved in globalization became painful. A great deal of the subsequent part of the story, after 1944, is how the interplay of institutions and markets changed the character of balance of payments problems and how the result increased the IMF’s role of giving advice and information and reduced relatively its regulatory functions.
The introductory part of the book deals with the historical features of the world economy in the absence of an IMF or an analogous institution. The problem of adjustment to the external or international economy is a very old one—as old as the world economy itself and measurable in millennia rather than decades. Only by surveying that history is it clear why a more institutionalized approach was needed and what drove the idealism (and perhaps even utopianism) that lay behind the Bretton Woods conference. After this, the survey examines three issues, which will form a thread of continuity for the analysis of the past five decades: first, the relation of monetary development to the world economy; second, how economic development may be frustrated by national policy responses; and third, what functions international institutions, and in particular, the IMF, have had to perform in order to encourage nation-states, and markets, not to stand in the way of increased general prosperity.
Many of the modem problems can usefully be seen in a far larger historical perspective. It has become commonplace to think of the modern world as driven inexorably to become ever more interconnected. We reflect that we are caught up in a single global economy. We see popular consumer items moved across continents; workers losing their jobs because of technical or market changes on the other side of the globe; and, in the financial sector, movements that in their size outstrip any physical movement of goods. The process of financial integration has accelerated dramatically since the mid-1980s. The daily average net foreign exchange dealings in 1992 ($880 billion) were equivalent to a third of the whole year’s world trade (only five years earlier, in 1987, daily foreign exchange dealings in the major financial centers were worth only about a tenth of world trade).1 The economic integration of the world is a process that constantly creates more opportunities for many people, but also more dangers and more fears. The course of globalization has not been smooth. It may not be much comfort to those affected by these changes to realize that the developments that appear to sweep over them are by no means novel. For centuries, the broadening of markets has also brought both growth and disruption.
Responses to Internationalization
Within any society, the costs and benefits of economic globalization are always unevenly distributed. An apparent lack of fairness will increase the hurt involved in coming to terms with change. The actual distribution of loss and gain depends on a mixture of political and economic circumstances; and the perception of how appropriate it is will reflect prevailing moral attitudes. In the absence of an adequate domestic consensus about internal measures that might correct the arising shifts of resources, changes are perceived as unjust as well as painful. Globalization hurts most where there is little social cohesion and no agreement on a just distribution; and it brings most benefits where societies are both stable and just.
When the global economy is felt to be damaging, we are tempted to deal with the cause. A popular response attempts to stop the change that is apparently being imposed from the outside. National sovereignty is reasserted in the face of the frightening external challenge. Sometimes the response may be extremely aggressive. “Why should we create suffering for ourselves? We should create suffering for others,” one Russian opponent of economic reform and opening stated.2 Such reactions against globalism—even in less extreme manifestations—then threaten to undermine the benefits of the process. For the benefits have unquestionably been immense.
Over the last two centuries an increase in the pace of economic activity has produced for much of the world dramatic rises in wealth and living standards. This transformation was in the first instance the result of improved transport and communications, as well as of changes in the pattern of demand. It can be described by the term market integration, the linking of previously isolated local markets. As the cost of moving goods over long distances fell, self-sufficiency broke down and an interdependent economy was created.
One of the characteristics of periods of high growth in the world economy was that trade increased with production or even at a faster pace (see Figures 1-1 and 1-2). In the expanding environment of the late nineteenth century, industrial production and world trade grew at approximately the same annual rate (estimated at over 3 percent). For most of the period of very dynamic growth after the Second World War, trade grew even quicker than output: in the initial growth spurt between 1948 and 1958, the volume index of world exports grew at an annual rate of 6.2 percent, while that of manufacturing output grew by 5.1 percent annually; in the 1960s, the difference between the rates was even greater (between 1958 and 1970 the respective figures are 8.3 percent and 6,6 percent). These statistics reveal the extent to which trade liberalization stimulated the world economy and fueled a production boom.3
By contrast, the collapse of the interwar economy was marked by larger contractions in trade. Poor trade performance was associated with a generally weak economy. Even in the expansionary phase of the 1920s, at the height of the postwar recovery, trade recovered less quickly than production. In 1929 trade was 35 percent above its 1913 level, but industrial output was 47 percent higher.4 The poor commercial performance was a major cause of general economic vulnerability.
The association of trade problems and poor output performance is also evident in the period after the end of the sustained post-1945 boom. In the much more unstable 1970s, when growth rates fell and the consequences produced increased misery and rising political conflicts, the growth rate for trade barely exceeded that of output (3.9 percent and 3.6 percent, respectively, during 1970–82). After the sharp recession of the early 1980s, the recovery of trade provided a hope that growth might again be possible. Between 1986 and 1995, trade grew once again substantially faster than output (an average rate of 5.3 percent, compared with 2.9 percent).5
The observation of such long-run trends in trade and output can induce economic prophecies, which in turn may affect behavior (the predictions come to have a certain self-fulfilling character). In the virtuous cycle psychology of the expansion period, trade appears as a means for general enrichment. On the other hand, in the vicious cycle psychology of contraction, trade imposes costs in employment and wealth and states intervene to constrain it. In the era of a heady “ever onward and upward” expansion, trade conquers the world. In the gloom of depression, even the most distinguished economists calculate that there exists a long-run tendency for the share of trade to decline relative to output. The experience of the interwar period convinced, for instance, John Maynard Keynes of this thesis.
The evolution of trade reveals the uneven and irregular pace of internationalization. Intensive periods of increasing integration were succeeded by efforts to promote disengagement and disintegration, as if men and women were taken by surprise by the unexpected rush of events and wanted to go in a different, older, and more familiar direction.
New trade patterns can create dramatic and disruptive changes of employment. But perhaps the most obvious and immediately apparent symptom of dislocation is an alteration of a country’s international position as measured by the balance of payments. Until the twentieth century this could be observed as an inflow or outflow of precious metals—metallic money. In the mercantilist tradition, stocks of metal were identified with political strength. A country with a positive payments balance accumulated gold and silver, and also power. An alternative tradition in economic thought argued the position, which later became known as liberalism or Manchesterism, that greater international integration facilitated the domestic accumulation of riches. Two competing world views thus stood in rivalry with each other: economic Liberalism as the doctrine of those who were impressed by the gains from trade and mercantilism as the response of those facing the costs of transformation and adjustment. If an unfavorable balance of payments meant national weakness, every country would engage in a fight to secure as large a share as possible of a limited stock of gold and silver, using a wide range of measures: from the restriction of imports, to economizing on the domestic use of precious metals by currency debasement, to the direct use of physical force against other states. The results in each case would make almost every country poorer than it otherwise would have been.
A system of agreed rules on the international distribution of costs of adjustment could offer a means of avoiding outright conflicts that would harm the world as a whole.6 There are various options, of which the simplest to implement is a pure automatism, as under the late nineteenth century gold standard. (The actual practice, however, was not as simple as the gold standard ideology suggested: some central banks, particularly in France and Germany, in fact treated it as a managed system.) In the absence of high levels of tariff protection, the adoption of the gold standard by one major economy after another was accompanied by a period of great commercial expansion and prosperity. But an automatic mechanism need not be popular, and often the system itself was blamed for the difficulties of adjustment and for a diversity of national and personal economic misfortunes. Sometimes governments may have found it convenient to attribute the misfortunes of their populations to an external force. However, almost as frequently, an automatic process may exacerbate father than soothe conflicts if its outcome is very widely felt to be contrary to well-defined national interests. National self-defense then requires aggressive action against the whole world order and not merely a modest alteration or reformulation of policy. In some periods, such as that following the First World War, the existence of an automatic set of rules for this reason encouraged the formulation of beggar-thy-neighbor policy responses. States came to believe that they could only increase their own prosperity at the expense of the system.
A hard system of rules, which is required in any adherence to an automatic mechanism, runs the risk that if the rules are thought to be too inflexible and incapable of amendment, participants will break with the whole order. An automatic system cannot be modified, only accepted or rejected. On the other hand, a complete absence of conventions or rules produces anarchy. In the light of this dilemma, the question arose whether it was possible to formulate a set of principles for making rules and altering them in the light of changing circumstances.
In the second half of the twentieth century, an innovation took place, which is the real subject of this study: the creation of an institutionalized and quasi-judicial process for applying rules in the international system at the 1944 Bretton Woods conference. It differed fundamentally from the crudely automatic character of the gold standard or interwar international economic management. It required both the elaboration of a very complex body of rules and of an institutional mechanism for deciding on their application, the penalization of violations, and, when necessary, on the amendment of rules.
Such a system cannot of course produce instant harmony and immediate satisfaction. It would have been surprising if it had. Lawyers regularly report that all participants in a court case emerge dissatisfied with the final outcome (assuming that there is one), since law requires the arbitration of difference and the adjustment and confrontation of viewpoints. The same verdict might well be drawn with regard to the quasi-judicial settlement of differences over matters of international economic policy.
But there always remains the further and more radical possibility of complete rejection of the idea of an interacting, mutually beneficial community. In the liberal world economic system, the participants recognize that all are affected by the actions of others and that they need to modify their actions in the light of their interdependence. The alternative is mercantilism,7 in which the participants engage in a search for their own advantage and the disadvantage of their competitors. In the modern world, the restrictive approach has often been associated with populism.
Without an international system capable of flexibility and adaptation, societies will swing in a perpetual pendulum between these responses: between internationalism and national self-assertion, and between acceptance and rejection of the international order.
Disintegration and Integration
The earliest systematic presentation of these competing formulations of the effect of economic interactions was expressed as a response to the political turmoil and the monetary inflation of sixteenth century Europe. Large quantities of silver entered circulation, first from Central European mines, then (and in much more substantial quantities) from the territories seized by Spain in Mexico and Peru. Because soldiers insisted on being paid in metallic money, gold and silver bullion came to be the immediate and visible manifestation of military and political power, and the accumulation of bullion the major goal of state policy. Countries that could amass and hold the biggest hoards would command the greatest power in the international state system. Against this alluring political calculation, the notion that riches might be spread more evenly remained until the eighteenth century a minority view. One way of describing early modern Europe’s dramatic experience with globalization is as follows: the benefits of globalization accrued to the political system, to the absolute monarchs, and the costs were paid by urban commercial and manufacturing centers.
Only in the eighteenth century was the idea of mutual benefit through commerce systematically expounded: first by writers associated with the world’s great commercial cities in Amsterdam and London, and later, toward the end of the century, by the writers of the Scottish Enlightenment and above all, of course, by Adam Smith. Commerce brought riches, at first to the trading cities on coasts and rivers, and then, as transportation and communications improved, to a much wider inland economy. Better roads and canals in the seventeenth and eighteenth centuries, and railroads and bigger sailing ships and then steamships in the nineteenth century, created a manufacturing revolution (the “Industrial Revolution”). There remained objections from the point of view of military and strategic calculations to the spread of general enrichment, but the opportunities created by better communications always made the military-mercantilist option seem too costly an imposition.
The easier movement of goods produced a transformation of trading flows and consequently of production. In the 1870s, the development of grain cultivation on the American prairies, and at the same time the opening up of Russia’s grain-growing areas through the railroad, led to a sharp fall in western European cereal prices. Farmers reacted by demanding tariff protection in order to isolate their domestic markets from the impact of the international economy. The late 1870s ended the great movement of trade liberalization on the lines suggested by Manchesterite free-trading principles that had dominated the international history of the first part of the nineteenth century. Country after country imposed protective tariffs between 1879 and 1881: Germany, France, Austria-Hungary, Italy. The tariffs still were set at low levels by comparison with twentieth century responses to economic crisis, and in general were aimed at the protection of agricultural products. But they still contributed to a period of slower growth in international commerce, and only after the mid-1890s did the international economy return to its fast pace of development.
Growth phases in the world economy did not simply lead to an increase in the volume of goods moved physically from one country to another. The possibility of sending goods made attractive economic activity in new centers, and millions of men and women responded to this new call. Partly pushed by dismal conditions at home, partly lured by limitless opportunities held out by new continents, people moved. Population pressure in the sixteenth century had helped to create the momentum for the expansion of imperialism by the Portuguese, the Spanish, and, later, the Dutch, the French, and the British. In the nineteenth century, the streams of people became much more voluminous. Thirty-six million emigrated from Europe between 1871 and 1915, mostly to North and South America.8 Similarly large numbers of Indians and Chinese migrated (under contracts or as indentured labor) to tropical countries, either to plantations managed by Europeans or into the construction of railways and settlements or into mining.9
In the same way as the shocks produced by the movement of goods led to protectionist responses, at the end of the century the classical receiver countries of immigration tried to reduce the new flows of people attempting to cross frontiers. In 1882 the United States suspended Chinese immigration, and then in 1921 and 1924 in the Quota Acts applied quantitative restrictions to discriminate against emigrants from Eastern Europe and the Mediterranean region.
Developing and settling new areas of production required the transfer of resources: farming and building equipment, as well as supplies for the new settlers. The third element was the relatively uninhibited movement of capital, which, together with the transfers of goods and people, sustained the great enlarging and unification of the world economy over the course of the nineteenth century. As with labor movements, there was a mixture of push and pull. Great periods of outflow from urope coincided with the relative stagnation of the European economy and the limiting of investment opportunities, as well as the perception of greater possibilities of gain elsewhere. Transfers of capital fluctuated in response to new information about economic opportunities and the self-reinforcing waves of optimism and pessimism generated by that information. Often this development represented a relatively long-term commitment by the investors; and, in many cases, flows of information and technical skills accompanied the capital. Nevertheless, the flow of funds was uneven and jerky. Crises in the countries that received the capital outflow from Europe produced panics on European markets. When American banks and mines and railroads failed in 1857 or 1873 or 1884, or Argentine local authorities suspended debt service in 1890, European banks collapsed, European central banks lost gold, and European business activity faltered. In a less secure political framework than that of the United States, financial problems or defaults led the European powers to impose a political solution and to extend the grip of colonial rule. The reorganization of the debt of the Turkish Ottoman Empire after the default of 1875 became a model for the intervention of Western powers. Foreign creditors took over the management of the customs and monopolies of the Empire as the “dette ottomane.” A few years later, when the Egyptian government defaulted in 1882, Britain and France responded immediately by sending troops to enforce a new financial regime.
The transfer of goods, people, and capital required a relatively sophisticated financial apparatus. Goods traded across the oceans required relatively long-term credits. The three-month or 90-day bill of exchange came to be a standard, reflecting the time required to take goods to ports, load, ship, and then unload them once more.
Some measurements of the degree of financial integration in the world economy indicate that at the beginning of the twentieth century the world was more interconnected than at any subsequent time (including the 1990s, despite the trillions of dollars of daily currency movements). These measurements examine the behavior of saving and investment levels. Investment and savings were coordinated on a global level, with the result that a surplus of investment in one area or state (that is, a balance of payments current account deficit) could be smoothly financed by the export of surplus savings from another area. Even in the highly integrated 1980s and 1990s, such transfers were much more difficult and raised many more political eyebrows than in the golden era that preceded the First World War.10
But the fundamental mechanism that allowed the operation of this beautifully coordinated financial system was already securely in place before the great upsurge of economic activity in the nineteenth century. The idea of a world financial system is very old—at least as old as the fact of long-distance trade. Small high-value goods, but particularly precious metal and money, had always moved long distances. Coins from the early years of the Roman Empire have been found across the Indian Ocean, in India, Sri Lanka, and on the coast of Thailand and southern Vietnam.11 After 1000 A.D., large quantities of Sudanese gold were taken across the Sahara and from the fourteenth century entered into general circulation in the Mediterranean. The long-distance flow of coins and precious metals encouraged financial innovation. Again, a critical impetus was given by the inflow of New World silver in the sixteenth century to Spain, from where it flowed through commercial and political transactions (the maintenance of Spanish armies) to the Mediterranean, the rest of Europe, and then further eastward. The inflationary stimulus of Spanish silver internationalized the economy and created powerful incentives for investment and technical innovation. An almost contemporary and analogous stimulus was given in East Asia by the rapid development of Japanese silver production (which by the end of the sixteenth century accounted for an estimated one third of the world’s silver output).12
In the fourteenth century, merchants in the Mediterranean developed the negotiability of foreign bills of exchange. By the sixteenth century, bills drawn on Genoese or Seville or London houses could be traded, endorsed, and discounted hundreds of miles away. When a bill-trading institution was created in Amsterdam in the early seventeenth century, bills could even be used as an instrument of short-term lending in transactions in which there were no physical movements of goods.
The result of this period of innovation was the creation of what might be termed an integrated international capital market. By the early eighteenth century, Amsterdam newspapers regularly reported the prices of English stocks, and Amsterdam houses conducted sales and purchases. By the beginning of the twentieth century, the London Times carried the previous day’s prices for 50 American shares, and in Amsterdam, Berlin, Paris, and Vienna shorter lists were quoted. The integrated world financial system was at the outset extremely vulnerable to shocks: the temporary cessation of the flow of news, dramatic new information, or just the emergence of large interest rate differentials, all produced abrupt swings in value and massive movements of money across the exchanges.
The prevalence of periodic financial panic is both a sign of the extent of integration and a reason why many people saw international finance as profoundly destabilizing. A recent analysis of the linking of price movements of stocks in different markets during panics shows that the level of financial integration of European markets remained at a constant and high level throughout the eighteenth and nineteenth centuries. Only in the crisis of 1907, when in addition American market information was transmitted via submarine cables, had an enhanced degree of integration emerged.13
By the beginning of the twentieth century a world had been united by information to a quite astonishing extent. As better and speedier information arrived, the possibility of a breakdown grew less, and the belief developed that the system was becoming more stable. Particularly in retrospect, the early twentieth century glowed with a rosy optimism. Looking back in 1919 on the vanished security of the world before the Great War, John Maynard Keynes wrote:
The inhabitant of London could order by telephone, sipping his morning tea in bed, the various products of the whole earth, in such quantity as he might see fit, and reasonably expect their early delivery upon his doorstep; 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; or he could decide to couple the security of his fortunes with the good faith of the townspeople of any substantial municipality in any continent that fancy or information might recommend. He could secure forthwith, if he wished it, cheap and comfortable means of transit to any country or climate without passport or other formality, could despatch his servant to the neighboring office of a bank for such supply of the precious metals as might seem convenient, and could then proceed abroad to foreign quarters, without knowledge of their religion, language, or customs, bearing coined wealth upon his person, and would consider himself greatly aggrieved and much surprised at the least interference. But, most important of all, he regarded this state of affairs as normal, certain, and permanent, except in the direction of further improvement, and any deviation from it as aberrant, scandalous, and avoidable.14
One of the reasons for optimism about the possibility of combining growth with stability lay in the victory, not just of an idea of integration, but also a vision of a particular form of institutional arrangement to facilitate the flow of information and prompt a rational and speedy response to that information. The importance of trade in the late nineteenth century, and the awareness of governments that avoidance of the international commercial economy meant economic backwardness and the likelihood of military defeat and political humiliation, produced a willingness to accept a common financial system, in the form of the international gold standard. The gold standard was a kind of information standard. Its nearly universal adoption by the beginning of the twentieth century was a consequence of the spectacular success and the economic power of Great Britain, the country that had first committed itself to the gold standard, at the end of the Napoleonic wars.15 In stages between 1871 and 1875, the new German Empire accepted the principle of a gold currency, which it financed with the war indemnity imposed on France after the French defeat of 1870–71. France, forced to give up large quantities of silver, abandoned the bimetallic silver-gold standard in 1873. The United States returned to currency stability with a pure gold standard between 1873 and 1879, after a period of currency instability and inflation in the wake of the Civil War. Japan, similarly caught up in political transformation and modernization, joined the gold standard in 1875. When Austria-Hungary (1892), the Russian Empire (1895), India (1899), and Mexico (1904) followed, the system had become virtually universal.
Often the immediate consequences of joining the golden version of the international system were costly. Gold had by no means been the most obviously effective basis for an international monetary system. Most contemporary economists had believed in the theoretical superiority of the French-style bimetallic system.16 New members of the gold-based system faced extraordinarily heavy adjustment costs. Russia’s adoption of an international standard involved a sharp deflation, in which the government attempted the twin tasks of balancing the budget and forcing an export surplus by using high taxes to make Russia’s farmers market a higher proportion of their grains. In human terms, the costs of what would later be called an adjustment strategy” were quite terrifying. In the circumstances of the great Russian famine of 1891–92, in which millions died, this represented a call, not to export or die, but to export and die. The Finance Minister who began the process of adjustment, I.A. Vyshnegradskii, indeed claimed that “we must export though we die.”17 The government program was opposed by populists, Russian nationalists, conservatives, and socialists on the grounds that it involved needless sacrifice for the sake of subjecting Russia to foreign influence. Some critical economists claimed that the potential long-term economic benefits could not justify either the costs imposed on Russia’s population or the political dependency established by linking Russia to the world market. They thought that the additional foreign capital attracted as a result of stabilization would not compensate for the income lost through the imposition of the deflationary program. Though Vyshnegradskii was dismissed, the government fundamentally ignored the objections: in part because it needed foreign investment to develop key areas essential to Russia’s military and strategic position, in part because it wanted to cultivate foreign alliances through the encouragement of external investment, and in part because of the prestige of gold. The gold standard attracted populist protests in other gold standard countries in the 1890s. In the United States William Jennings Bryan campaigned for the presidency on the promise to stop the people being “crucified on a cross of gold.” In Germany farmers and conservative populists also supported the demand for bimetallism: a joint gold and silver standard that they believed would be more inflationary and would consequently wipe out their debts. Even in Britain, the country par excellence of the gold standard, silver found some adherents.18
The attraction of the British model, and its influence in spreading the gold standard as the appropriate form of mediation for international financial relations, should not obscure the fact that this system depended for its success not on coercion but on cooperation. The Bank of England was the central bank at the center of the system. Keynes, looking back after the First World War, compared it to the invisible conductor of an international orchestra.19 But, in a crisis, its very limited reserves meant that it needed the support of other central and private banks. In the most serious crisis of the late nineteenth century, when an Argentine default threatened to bring down a major London merchant bank (the Baring crisis of 1890), the Bank of England dealt with the run on the Baring bank and the drain on the pound sterling by borrowing from foreign central banks and also from Rothschilds in Paris.20 Throughout the quarter century of the nearly universal operation of the classical gold standard, the major central banks worked closely with each other. This financial harmony developed despite the growing political tensions between the Great Powers. It even encouraged some observers, such as Sir Norman Angell, to conclude that financial relations provided both an incentive and a model for international cooperation and the maintenance of peace.21
The Bank of England was able to play the role of international conductor in large part because of the willingness of other countries to hold a substantial part of their currency reserves in the form of deposits in London. Russia and Japan both held large sterling assets. In the decade before the First World War, Indian reserves played an increasingly important part in maintaining the stability of the gold standard. India had developed in the late nineteenth century into a powerful exporter and built up the surplus position on its balance of payments in the form of assets held in London. The Indian Gold Standard Reserve increased its portfolio of British government securities from £3.5 million in 1902 to £16 million in 1912.22
Such a precariously balanced system on occasion seemed close to breakdown. In March and then in October 1907, U.S. banks collapsed in the aftermath of banking runs, and Americans drew substantial amounts of gold from Europe. The Bank of England urgently needed to acquire gold to meet the losses. It cooperated with the Bank of France, and took gold from 24 countries. The lesson of 1907 appeared to be that the cooperative gold standard still worked, but only just, and that it was endangered by U.S. financial instability. “Experience seems to prove that the raising of the Bank Rate to a sufficient level never fails to attract Gold, provided the higher rate is kept effective.”23
In the end, the system broke down not because of internal structural inadequacies, but because of the outbreak of hostilities between the European powers in August 1914. In the first days of mobilization, financial panics—produced by the desire to make assets liquid—forced the major belligerents to suspend the legal basis for the operation of the gold standard, the requirement that currencies should be convertible into gold. It was assumed that such a suspension was just a consequence of the wartime emergency and that the new measures would last only “for the duration.” As the war continued for a much longer period than envisaged by any of the participants of the decisions of July and August 1914, it became clear that this belief was mistaken and the almost universal confidence in the automatic stability of the economic system in the face of political upheaval misplaced. After the trauma of the war, a long and painful search for a new international order began.
A New Disintegration of the International Economy
In the event, the First World War, in practice a European war, had destroyed the foundation on which the old gold standard had been built, primarily because it completely changed the relationship of Europe with the rest of the world. It altered the prewar pattern of industrialization, in which a number of advanced European economies traded with a commodity trading periphery. Industrial production in the United States increased dramatically. The newer chemical and electrical industries benefited from the confiscation of German patents. From being a net debtor, the United States became a large and powerful creditor country. Elsewhere, Japan and India emerged as major textile producers and exporters. As the world’s industrial shape changed, so did the pattern of trade. In addition, a large part of European shipping had been destroyed, so that after the war, European invisible earnings fell off dramatically. Altogether, the structural shift in the world economy was bound to be reflected in balance of payments problems for all European states in a postwar world.
Second, and especially in the belligerent countries, the war produced a colossal expansion of state activity and of expectations about what the state should do to direct the economy. The strength of the new hopes limited the willingness and the capacity of societies to make the adjustments to living standards required by the emergence of balance of payments problems. As a consequence, in the aftermath of the First World War, the balance of payments became the focus of intense and painful political debate.
In every country, the war had been paid for primarily through an increase in state indebtedness, in almost every case financed through the issue of paper currency, with convertibility into metallic money suspended during the war. Each side hoped that it would be able eventually to impose that cost as the victor on the vanquished. In 1918, with the Treaty of Brest Litovsk and a subsequent Auxiliary Treaty, Germany came close to realizing its war aim of hanging what Germany’s Secretary of Finance called “the lead weight of billions” around the necks of the Russian people. The Auxiliary Treaty included a gigantic indemnity. Less than a year later, the Western allies at Versailles more successfully presented German negotiators with a similar demand. In 1921, Germany’s reparation liability was fixed by the London Schedule at 132 billion gold marks: a sum corresponding to almost two times the prewar national income.
The financial aftermath of the war was inflation, and in Germany and Central Europe extreme currency instability and hyperinflation. Inflation was the result of large fiscal deficits, stemming from the cost of servicing war debts, increased subsidies to enterprises, and greater social transfer payments, but also because of the reluctance of states to control monetary policy for fear that a deflationary shock might produce social and political destabilization. There seemed in short to be “structural” pressures in postwar societies that encouraged the process of money creation.24 The common hope during the war, that there might be a simple and automatic “return to normalcy” at the cessation of hostilities, appeared quite illusory.
Instead, the recreation of an international economy took a great deal more negotiation, intervention, and management than had been necessary for the operation of the classic gold standard and involved a considerable bruising of national and social sensitivities. Because the level of wartime and postwar inflation varied so much from country to country (with Russia and Austria-Hungary at one extreme, and the United States at another), calculating an appropriate framework of new exchange rate parities proved immensely difficult. The story of the 1920s is a sad chronicle of attempts, often high-minded and frequently ingenious, but in the final analysis doomed to futility, to deal with the tangled international financial legacy of the Great War. Initially, governments followed a two-tier strategy: first, to create an environment for the restoration of a system of stable exchange rates, and, second, to deal with the problem cases of hyperinflation.
At the international economic conference of Genoa in 1922, most countries still urged a restoration of prewar exchange rates, except in the cases such as Austria or Germany where such a course would be self-evidently hopeless. But there was also a realization that a general return to the gold standard would be highly deflationary.25 In order to solve this problem, the experts agreed with a suggestion initiated by the British that greater use should be made of foreign exchange as reserves, a generalization of the prewar Japanese or Indian practice. The foreign exchange suggestion represented an attempt to steer a middle course between the deflation involved in return to gold and the inflationary pressures generated as a product of wartime emergency and then perpetuated as what one observer called a “post-war Finance Ministers’ drug habit.”
According to some commentators, the gold exchange standard as a result had a destabilizing and inflationary bias. A paper produced for the Bank for International Settlements (BIS) retrospectively described the system as possessing an “undeniable tendency to credit expansion.”26 But another analysis made an exactly opposite diagnosis. The possibility of withdrawals or funds in the gold exchange standard could produce a spiral of deflation, as currency issues were generally linked to reserves in a fractional system. In a country with a 40 percent reserve requirement, a withdrawal of funds near the reserve limit would require a contraction of currency issue of two and a half times (100/40) the amount of the withdrawal. In addition, if the major holders of gold and reserves sterilized inflows and refused to undertake monetary expansion, the pressure of adjustment would fall on the countries with inadequate reserves, which would be consequently obliged under the rules of the system to undertake severe contraction. By the end of the 1920s, France and the United States attracted severe criticisms from other countries for creating a world deflationary bias through the excessive accumulation of reserves. In practice, the experience of the gold exchange standard did indeed confirm the fears of those who thought that its operation would be deflationary.
The system envisaged in the Genoa discussions required a much more active role to be taken by the major central banks in managing the system and in establishing a cross-national coordination of policy.27 Coordination and cooperation, in the view of the Genoa experts, could only occur on the basis of a commitment to the maintenance of the system as a whole and not simply the pursuit of national goals. This would be provided by a sort of politically neutralized central bank management: the Genoa report referred to central banks “free from political pressure.” The agreed object of both national and international credit policy should be not simply the maintenance of the established parities, but also the avoidance of “undue fluctuations” in the purchasing power of gold.28 At the conference, it was recognized that U.S. action in this respect would be essential to the restoration of an international monetary system, since the United States had emerged from the war as the major international creditor.
At least in personal and institutional terms, the central Anglo-American axis of the financial cooperation required for the working of the gold exchange standard initially functioned well. Governor Montagu Norman of the Bank of England and Governor Benjamin Strong of the Federal Reserve Bank of New York maintained a close and even intimate relationship, facilitated by the new communications technology that allowed a much quicker response to common financial problems. They exchanged frequent letters and cables across the Atlantic, and they visited each other. Strong wrote to Norman with ease and familiarity: “You are a dear queer old duck and one of my duties seems to be to lecture you now and then.”29
What did lecturing mean? On occasion, as required by the logic of the system, the central bankers sacrificed the good of their own country for the sake of the working of the system as a whole. The two most spectacular examples of such altruism proved ultimately most destructive. In 1925, Norman pressed successfully for a return of sterling to gold at the prewar parity of $4.86, because he believed that this would facilitate the resumption of the City of London’s normal role in the world economy. It was a move that benefited British financial interests, but not the country as a whole; neither, in the end, did it help to stabilize the international financial order. The result of Norman’s action was an overvaluation that produced permanent British balance of payments problems in the second half of the 1920s. In 1927, following a meeting of the key central bankers in Long Island, Benjamin Strong gave way to European demands for an interest rate reduction that might help the European economies, although there were also domestic indications of recession that made U.S. monetary easing seem appropriate. The result helped to fuel the speculative U.S. stock boom of 1928–29, which actually diverted funds away from Europe and prepared the ground for the great Wall Street crash of 1929.
The new system also at first appeared to function well in that it attracted more and more countries into its orbit. Norman and Strong evolved a common approach to the problem of economic stabilization in the war-ravaged countries of Central Europe. The system required a great deal of discretionary management. Strong was highly critical of plans that attempted to treat the exchange problems of all countries in an equal way, and believed that such schemes would be “doomed to failure.”30 A subjective and ad hoc approach to the politics of stabilization, budget balancing, and central bank reform was required in order to fit the peculiar political circumstances of each country.
Originally, the central bankers relied on stabilization programs drawn up by the League of Nations: the first objects of this technique were Austria in 1922 and then Hungary in 1923. The League’s recommendations included dramatic and harsh budgetary stabilization measures, as well as banking controls to prevent a re-emergence of inflation based on private credit. The governments that applied the programs were usually weak and insecure. On their own, they would not have had enough political strength to implement measures that were bound to disappoint major domestic interest groups: businessmen and farmers expecting government subsidies, labor movements that wanted increased social security provision, or civil servants who expected to stay in the jobs that had been created for them during and after the war. The packages could only be applied because they came from the outside and carried the authority of an international institution. Thus, they appeared to be external to the domestic political debate and the pressures of vested interests. The international institution could act in domestic politics as a kind of “bogeyman” onto whom could be unloaded all the blame for the harshness and pain of stabilization measures. In addition, because stabilization was linked to official loans and the likelihood of further private sector capital flows once the appropriate official “signal” was given, the reform programs held out some hope of eventual prosperity.
The most important case of a return to the international monetary system was the stabilization of the German mark in the aftermath of the hyperinflation of 1921–23. The Legal package was the work of an international committee of experts (the Dawes Commission, named after its chairman, the American banker Charles Dawes) and involved the creation of a new currency, the Reichsmark, the establishment of an independent central bank with foreign representation on its Advisory Council, and an international flotation of a $190 million loan for the German government to allow the resumption of its reparations payments to the Western powers. After Germany returned to the gold standard, Britain established gold convertibility in 1925, and inflation came to an end in France in 1926, the spread of the new international monetary system appeared unstoppable. Italy adopted a stabilization program, with the assistance of Strong and Norman, in 1927. By the end of 1928, except for China and a few small countries on the silver standard, only Spain, Portugal, Romania, and Japan had not been brought back into the gold standard system. Romania went back on gold in 1929, Portugal did so in practice in 1931, and Japan in January 1930. In December 1930, the BIS gave Spain a stabilization loan, but the convertibility operation was frustrated by a revolution in April 1931, carried out by republicans, who, as one of the most attractive features of their program, opposed the foreign stabilization credits. Spain thus avoided joining the otherwise nearly universal gold exchange standard club and thus escaped much of the internationally transmitted pain of the world depression.
By the time Portugal, Spain, and Japan were contemplating stabilization, the instabilities and vulnerabilities of the system had become clear. After 1929, the world experienced a dramatic monetary contraction. Contemporaries blamed either the limited potential for expansion of the world’s gold stock (Gustav Cassel), or the policies of the French and U.S. monetary authorities (Sir Henry Strakosch).31 These countries experienced gold inflows in the late 1920s and accumulated substantial reserves, but did not allow these international reserves to affect domestic monetary creation. By the summer of 1931, on the eve of the crisis that brought down the gold exchange standard, the United States had two fifths of the world’s gold reserves and France one fifth.32 Sterilization limited expansion in France and the United States, while the countries losing reserves were obliged by the mechanism of the gold exchange standard to apply restriction. International flows thus had a lopsided and deflationary effect: on the one hand, no expansion in the surplus countries; on the other hand, the necessity of contraction in countries with deficits.
The result was a system highly vulnerable to shocks. The first shock was the slide in commodity prices after 1925, and their precipitous decline after 1929. Capital flows had in any case been rather more short term after than they had before the First World War, and less associated with the technology transfers that often accompany long-term flows. With often speculative motives underlying investment abroad, a change in expectations had a quite dramatic effect. This price collapse altered expectations of capital markets. Countries with a heavy dependence on primary product exports became unattractive prospects, and capital flows slowed down. As service payments became more difficult, and larger quantities of exports needed to be thrown on the market, prices fell further and it became impossible to attract new capital inflows.33
Financial shocks followed the commodity price shock. The vulnerability was greatest where, in the Central European Tradition, banks had close ties with industry, engaged both in lending and in the purchase of securities for their own account, and had become by the end of the 1920s in effect gigantic industrial holding companies. In May 1931 the largest Austrian bank, the Vienna Creditanstalt, failed.34 Banking panics spread to Hungary and Germany; and in each case the financial crisis was accompanied by a movement of funds across the exchanges, as both residents and foreigners tried to withdraw deposits. The Central European response included not only bank restructuring but also voluntary freezing agreements for short-term foreign debt (Standstill Agreements) and the imposition of exchange controls. This way of tackling the problem helped to produce a domino effect across national frontiers. When it became clear that British banks had substantial assets locked into Central Europe by the financial collapses and the Standstill Agreements, they themselves became the targets of a scramble for liquidity. In September 1931 the same mixture of banking vulnerability and outflow of funds across the exchanges that had in the previous summer gripped Central Europe led to the British abandonment of the gold standard. Britain had been unable either to stabilize the global economy, as it had helped to do before 1914, or to restore its own position in the international order.35
September 21, 1931 marked the end of the attempt to create a new international monetary system after the First World War. It remained for all who had participated in it, or witnessed it, a scarring trauma: after 1945 economists as diverse in their attitudes and prescriptions as Robert Triffin, Friedrich Hayek, and Raúl Prebisch pitched their policy prescriptions in terms of the need to avoid another 1931. At the Bretton Woods conference of 1944 the specter of 1931 still haunted the participants.
The same mechanism as had brought down the British pound immediately also produced financial destabilization in the United States (from 1931 to 1933) and France (from 1932 to 1936). Banking runs and currency drains ended only when those countries too left the gold standard.36
In the face of the commodities shock and the financial shock, the international cooperation established between central bankers in the 1920s proved hopelessly inadequate. The tie between London and New York had been a personal one and had suffered after the death of Governor Benjamin Strong in 1928. Relations between the Bank of England and the Bank of France were strained in 1929 during the course of negotiations for the revision of the German reparations settlement. The new reparations plan, the Young Plan, which was accepted in 1930, included an attempt to institutionalize international economic cooperation through the establishment of a world bank. The Treaty of the Hague created the BIS, primarily as a depolitcized mechanism for the administration of reparations—the transfer of marks from Germany into foreign currencies to be paid to the reparations creditors. But Article 3 of the BIS’s Statutes required it to “promote the cooperation of central banks and to provide additional facilieappeared in Chain, ts for international financial operations.”37 In 1930 Governor Norman of the Bank of England suggested that the BIS should become a major provider of short-term funds for the stabilization of currency markets. In early 1931 he proposed that the BIS should launch a bond-based stabilization fund, which would assist in the “relief and rehabilitation” of the problem countries of the depression in Eastern Europe and Latin America. But neither scheme attracted much support, and both encountered great French hostility. Norman soon concluded that “the BIS is already slipping to the bottom of a ditch and in that position seems to do no more than perform a number of routine and Central Banking transactions.”38
The results of the failure of cooperation became fully apparent after the crisis of the summer of 1931. The initial victims of the collapse of confidence, Austria, Hungary, Germany, and Romania, in imposing trade and exchange controls ended the free convertibility of currencies that had been the central feature of the international system. Walking in St. James’s Park in London during a break in the German Standstill negotiations, the distinguished German banker Carl Melchior said: “What we have now experienced is a destruction of the rules of the game of the capitalist system, which depends on a strict compliance with rules. It is the first time that I have had to reject fulfilling an agreement that I have signed voluntarily, because of the wish of the state.”39
The only way to rescue currencies and prices after 1931 appeared to involve abandonment of gold. On April 20, 1933, the newly elected U.S. President Franklin D. Roosevelt cut the link between the dollar and gold. The Federal Reserve Bank of New York attempted to negotiate a new sterling-dollar parity. Then, in the middle of a World Economic Conference meeting in London, he announced (on July 3, 1933) that the United States had no intention of stabilizing the dollar. Domestic priorities (raising agricultural prices and stopping the banking runs that resulted from the U.S. deflation) had precedence before the requirements of an international system: “The sound internal economic system of a Nation is a greater factor in its well-being than the price of its currency in changing terms of the currencies of other nations.”40 With Roosevelt’s message, any hope of reaching an agreement on currency stabilization and tariff reduction at London disappeared.
Speculative flows, similar to those that had destabilized U.S. financial institutions between 1931 and 1933, afflicted countries that still formed part of “gold bloc”: Belgium, France, and Switzerland. Belgium was the first to leave, after banking runs in early 1935. France and Switzerland followed in October 1936.
After the French franc was forced off the gold standard, the major Western states launched a small-scale attempt to restore international financial cooperation. The British and U.S. governments issued a declaration promising not to respond to the French move by devaluing “to obtain an unreasonable competitive advantage.” In October 1936, France, Britain, and the United States committed themselves to consult about daily exchange rates and to settle daily balances between the national exchange equalization accounts. The package devised to cover the French devaluation has been termed the Tripartite Monetary Agreement, and some commentators see it as the prelude to much more systematic postwar cooperation.41 In fact, however, there was no agreement to a long-term stabilization of currencies, and no commitment to any specified exchange rate. The formal contents were thus very limited, and October 1936 did not in fact mean an end to speculative attacks on the French franc. In June 1937 the franc was devalued a second time, and floated for a time before a new attempt at stabilization was risked. The financial panics of the depression destroyed the possibility of large capital flows for investment purposes in the 1930s. There were substantial movements of capital, but they reflected speculation, nervousness, and capital flight. As a result of the growing political tensions in continental Europe, the United States, which had been a major capital exporter during the boom of the 1920s, became a large capital importer.
The motivation of the Western countries in promising better monetary coordination was as much political as narrowly or purely financial. Democracy in Europe was on the defensive, and the threat from Nazi Germany ever greater. The United States and Britain believed France to be economically and politically unstable, and accumulated evidence to show that Germany was encouraging runs on the franc in an attempt to weaken France yet further. U.S. Treasury Secretary Henry Morgenthau warned that capital flight from France was undermining the French government and contained “the danger of a movement toward autarchy and political dictatorship.”42 Foreign assistance, even in the form of a very weak commitment to renounce competitive devaluation, might encourage France to resist German expansion.
By 1936, it had become clear to many that there existed a close connection between the breakdown of economic cooperation and the rise of dictatorship, violent nationalism, and foreign policy aggression. The link between failed economic cooperation and rising international tension was most apparent in trade relations. The world depression had been accompanied by the imposition of protectionism in the form of quotas, tariff increases, and managed trade. The resulting contraction of world trade made the depression more severe. Individual measures of economic protection may have had a rationale, and states could and sometimes did argue that they were merely-acting in order to stop the worldwide deflation spilling over into their area.43 It was hard to prove that specific tariff or trade measures affected the world economy. Even the most notorious of interwar tariffs, the U.S. Hawley-Smoot Act of 1930, cannot be shown to have directly led to a sharp drop in international trade. But it encouraged other states to take similar steps;44 and the cumulation of effects was catastrophic.
Hawley-Smoot and the wave of imitations also prepared the way for a new type of power politics. The combination of exchange and trade controls gave states containing big markets a powerful bargaining instrument in their dealings with smaller and weaker states. In 1931, in the wake of the financial crisis, Germany concluded bilateral clearing agreements with Hungary and Romania. After the establishment in 1933 of Adolf Hitler’s National Socialist dictatorship, Germany used trade relationships explicitly as a way of drawing small states in southeastern Europe into its power orbit.45 In a series of bilateral agreements, Germany bought products at prices higher than those prevailing on world markets. An economic gain for the small countries—better prices and access to foreign markets—was achieved at the cost of the establishment of political dependence.
Japan in the depression faced the collapse of the long distance markets built up during the 1910s and 1920s. The U.S. Hawley-Smoot tariff (as well as the development of rayon) damaged Japanese silk producers. The major export of the 1920s, cotton textiles, had been sold largely in the British Empire, and these markets were closed off by the British adoption in 1932 of Imperial Preference. Japan responded in part by attempting to develop nearby export markets; and in part after December 1932 by a dramatic depreciation of the yen to stimulate exports. The combination of these policies produced the only major export-led recovery of the 1930s. But it also increased the attractions of territorial expansion in Asia in search of markets and raw materials.
The alternation of trade diplomacy with a violent grasping for empire was not the only mechanism by which the depression undermined international peace. The depression also acted internally to destroy the stability of democratic regimes. Throughout Europe and Latin America, parliamentary regimes disintegrated in the face of their inability to deal with the economic crisis. At the same time, the collapse of international collaboration reduced the incentives for states to behave responsibly. In the 1920s, hopes for external assistance in economic stabilization and for large future capital inflows acted as a deterrent to wild foreign policy initiatives. Italy, under the dictatorial rule of Mussolini since 1922, nevertheless behaved with restraint and moderation until the early 1930s; but when the gains held out by cooperation vanished, the dictator turned to international terror and external expansion.
When the Second World War broke out, many observers drew a straightforward lesson from the economic and political experience of the 1930s. Economic crisis produced political instability; and the failure of international cooperation made more likely a breakdown of peace, In this case, it fell to economists and statesmen not only to attempt to avoid depression in the future but also to search out ways of promoting, and institutionalizing, international economic cooperation. They needed to devise a way of preventing a brief euphoric faith in internationalism turning rapidly, as it had after the First World War, into defiant and destructive nationalism.
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