The Interwar Gold Standard: Policy Choices and Consequences

Reconstructing the Gold Standard

After World War I, there was a widespread willingness to return to stable currencies through a gold standard or an equivalent system. This led to the Gold-Exchange Standard, where currencies were backed not only by gold but also by "hard currencies" (like the British Pound Sterling and the US Dollar) that were convertible into gold. A central question was at which parity to return. Significant differences in wartime inflation had left various currencies at different distances from their pre-war parity with gold.

The Challenge of Setting Parity

If a country wanted to return to its pre-war parity but its currency was inflated, it had to revalue its currency upwards. This required deflating the economy to attract capital and achieve a trade surplus. The necessary policies included:

• Contractionary Monetary Policies: Lowering prices, reducing wages, and raising interest rates.
• Contractionary Fiscal Policies: Maintaining balanced budgets.

A Lack of International Coordination

Each country chose to enter the new system when it was convenient for them and selected its own parity. This lack of coordination resulted in some currencies being overvalued (not fully compensating for inflation relative to the US dollar/gold) and others being undervalued. The interwar gold standard operated from July 1926, when the French Franc entered, until September 1931, when the British Pound abandoned it.

Divergent National Strategies: France vs. The UK

France: Devaluation and Growth

France refused to self-inflict a recession. It returned to the gold standard in July 1926 at a devalued parity, which allowed it to enjoy economic growth during the 1920s.

The UK: Austerity and Stagnation

In contrast, the United Kingdom imposed austerity measures to deflate its economy. It returned to the gold standard in 1925 at the pre-war parity, a decision made partly to preserve the real value of the City of London's foreign investments. This led to a stagnant economy for much of the 1920s.

Systemic Problems of the Interwar Gold Standard

Asymmetric Adjustments and Deflationary Bias

The lack of coordination led to systematic misalignments: some currencies, like the French Franc and the US Dollar, were undervalued, while others, like the British Pound and the German Mark, were overvalued. Consequently, some countries ran persistent balance-of-payments deficits while others had surpluses. The system's adjustment mechanism was asymmetric:

• Deficit countries were forced to deflate their economies.
• Surplus countries could avoid inflation by "sterilizing" gold inflows—keeping the gold without expanding their domestic credit and money supply accordingly.

This created a global deflationary bias.

The Shift from Stabilizing to Destabilizing Capital Flows

The Pre-War Stabilizing Effect

Before the war, adjustments were less controversial. Investors expected central banks in deficit countries to "play by the rules of the game" by raising interest rates. This would accelerate deflation and attract capital. Confident in this commitment, capital would flow into these countries in anticipation of gains from higher interest rates, thus accelerating the adjustment mechanism and having a stabilizing effect.

The Post-War Destabilizing Effect

The post-war political landscape had changed dramatically with the rise of democracy, the extension of the franchise, and the growing influence of working-class parties. Inflicting a recession to maintain a fixed exchange rate now faced significant domestic political opposition. Investors realized that governments might choose to devalue their currency rather than impose painful austerity. As a result, capital began to move away from deficit countries in anticipation of losses from devaluation, creating destabilizing effects that undermined the entire system.