The Resumption
Britain officially adopted the gold standard in 1821. The ‘English Specie Resumption’, as it was called, put an end to two decades of currency debasement that had financed Britain’s war with Napoleonic France. The Pound’s pre-war gold value was reinstated by a sharp contraction in money supply implemented by the Bank of England.
The monetary contraction resulted in a steep drop in prices and soaring unemployment. Britain’s choice of self-inflicted deflation rather than a currency devaluation to simply write off its financial excesses earned worldwide respect for the Pound as a premier store of value and a reserve currency of choice. Over the next century the Pound became the fulcrum of the international gold standard due to Britain’s centrality in trade and finance. Every major currency in the world came to emulate the Pound and was pegged to gold.
The Debasement
Things dramatically changed in 1914 when the assassination of Archduke Franz Ferdinand pushed Europe towards World War I. Within days, people started queuing outside the BoE to convert their Pounds into gold eliciting amusement from financial experts for the layman’s distrust of paper money.
Eventually, the experts who had dismissed currency debasement as a thing of the past were proved wrong when all major countries debased their currency during the four years of war.
Post War Realities
After WWI, political and financial figures remained fixated with returning the pound to gold at the pre-war exchange rate of $4.86, a la the Resumption. The BoE’s contraction of credit over 1920-22 brought down prices and worsened unemployment just like in the years leading up to The Resumption. The Pound responded by appreciating to $4.61 by the end of 1922.
The fixation with the value of the Pound completely overlooked the new economic realities of the post war world. There had been a great loss in Britain’s export competitiveness due to newer competition and higher domestic costs. These higher costs had elevated steady state British prices which in turn had permanently eroded the fair value of the pound. By fall 1924, British prices continued to be higher relative to the US and the Pound remained stuck around $4.35.
Secondly, global gold reserves had become disproportionately concentrated in the US. The high inflow of gold into the US during the war years had motivated Benjamin Strong, the Governor of the New York Federal Reserve Bank, to implement open market operations to sterilize the liquidity arising from gold inflows. This was a violation of the strictures of the Gold Standard.
Shaky Foundation
Britain’s international position was now financed by short term foreign inflows rather than export surpluses as was previously. The BoE’s ability to defend the pound’s value depended on its gold reserves which refused to grow (It hovered around $800mn for most of the 1920s). In fact the BoE had to keep monetary policy tight to prevent the loss of gold reserves. This meant that British monetary policy would be effective in retaining these short term foreign flows only if it matched the tightness in US monetary policy.
The loose monetary conditions in the US during 1925 gave BoE the chance to get back onto gold in April at $4.86 without losing its reserves. But this achievement had shaky foundations as it required the support of a $500mn collective loan from the Federal Reserve and JP Morgan.
Meanwhile, the shortage of gold was further exacerbated from December 1926 onwards when France pegged the Franc to gold at an undervalued rate and started accumulating gold reserves. The credibility of the BoE’s gold peg came into question as the overvalued Pound experienced outflows in favor of the undervalued Franc. The Pound’s days as the world’s preferred reserve currency were numbered.
Macrologue 