Manipulation of Money & Credit & Gold (of course) -Part VIII
Banking & Credit – The Period of Deflation
(1927-1936)
Please recall, this is Carol Quigley’s breakdown of monetary periods in the period 1897-1947 (in his classic work Tragedy and Hope).
1. Reflation, 1897-1914
2. Inflation, 1914-1925
3. Stabilization, 1922-1930
4. Deflation, 1927-1936
5. Reflation, 1933-1939
6. Inflation, 1939-1947
We will be resuming Quigley’s discussion beginning with period 4 listed above.
The Period of Deflation, 1927-1936
The period of stabilization cannot be clearly distinguished form the period of deflation. In most countries, the period of deflation began in 1921 and, after about four or five years, became more rapid in its development, reaching after 1929 a degree which could be called acute. In the first part of this period (1921-1925), the dangerous economic implications of deflation were concealed by a structure of self-deception which pretended that a great period of economic progress would be inaugurated as soon as the task of stablization had been accomplished. The psychological optimism was completely unwarranted by the economic facts, even in the United States where these economic facts were (for the short term, at least) more promising than anywhere else. After 1925, when the deflation became more deep-rooted and economic conditions worsened, the danger from these conditions was concealed by a continuation of unwarranted optimism. The chief symptom of the unsoundness of the underlying economic reality – the steady fall in prices – was concealed in the later period (1925-1929) by a steady rise in security prices (which was erroneously regarded as a good sign) and by the excessive lending abroad of the United States (which amounted to almost ten billion dollars in the period 1920-1931, bringing out total foreign investment to almost 27 billion dollars by the end of 1930). The foreign lending of the United States was the chief reason why the maladjusted economic conditions could be kept concealed for so many years. Before the World War, the United States had been a debtor nation and, to pay these debts, had developed an exporting economy. The combination of debtor and exporter was a feasible one. The war made the United States a creditor nation and also made her a greater exporter than every by building up her acreage of cotton and wheat and her capacity to produce ships, steel, textiles, and so on. The resulting combination of creditor and exporter was not feasible. The United States refused to accept either necessary alternative – to reduce debts owed to her or to increase her imports. Instead, she raised tariffs against imports and temporarily filled the gap with huge foreign loans. But this was hopeless as a permanent situation. As a temporary solution, it permitted the United States to be both creditor and exporter; it permitted Germany to pay reparations with neither a budgetary surplus nor a favorable balance of trade; it permitted dozens of minor countries to adopt a gold standard they could not hold; it permitted France, Britain, and Italy, and other to pay war debts to the United States without sending goods. In a word, it permitted the world to live in a fairyland of self-delusions remote from economic realities.
These realities were characterized by (a) fundamental maladjustments, both economic and financial, which made it impossible for the financial system to function as it had in 1914, and (b) steady deflation.
… The financial maladjustments served to create an insufficiency of gold and a maldistribution of gold.
… The efforts to get around this by using a gold exchange standard rather than a gold standard were helpful in dealing with the problem of inadequate supplies of gold but increased the difficulty of the problem of maldistribution of gold, since the gold exchange standard did not respond to the flow of gold as readily and thus did not serve so well to stem such flows of gold. The need for gold was made greater by the existence of large floating balances of political or panic funds which might well move from one market to another independent of economic conditions [does this not sound like today’s U.S. Exchange Stabilization Mechanism and various IMF efforts?]. The need was increased by the fact that in 1920 there were three major financial centers which had to make payments by shipments of gold in contrast to the single financial center of 1914 where payments could be made by bookkeeping transactions. To rectify the problem to some degree, the Bank for International Settlements was created in 1929 but never functioned as its founders had hoped. Finally, the need for gold was increased by the enormous growth in foreign indebtedness, much of its of a political nature such as the war debts and reparations.
On top of this insufficiency of gold was superimposed a drastic maldistribution of gold. … This maldistribution resulted from the fact that when gold flowed into certain countries the automatic results of such a flow (such as rising prices or falling interest rates) which would have restored equilibrium in 1914 were prevented from acting in 1928. In this period, about four-fifths of the world’s gold supply was in five countries, and over half was in two, the United States and France. The gold had been brought to these two countries for quite different reasons – to the United States because it was the world’s largest creditor and to France because of its devaluation of the franc. Britain, on the other hand, had floating balances of about 800 million pounds, and handled each year 20 million pounds in transactions with a gold reserve of only 150 million pounds. Such a situation made it possible for France to use gold as a political weapon against Britain.
As a result of these conditions and the deflationary economic conditions described in Chapter 11, prices began to fall, at first slowly and then with increasing rapidity. The turning point in most countries was in 1925-1926, with Great Britain one of the earliest (January 1925). In the first half of 1929, this slow drift downward began to change to a rapid drop.
The economic effects of these soft prices after 1925 were adverse, but these effects were concealed for a considerable period because of various influences, especially the liberal credit policies of the United States (both foreign and domestic) and the optimism engendered by the stock-market boom. The façade of prosperity over unsound economic conditions was practically worldwide. … In Germany and in much of Latin America, the boom was based upon foreign borrowing (chiefly from the United States) …
The Crash of 1929
The history of the slump begins about 1927 when France stabilized the franc de facto at a level at which it was devalued and undervalued. This led to a great demand for francs. The Bank of France sold francs in return for foreign exchange. … The foreign exchange which France received for its francs was largely left in that form, without being converted into gold. By 1928 the Bank of France found that it held foreign exchange to the value of 32 billion francs (about $1.2 billion). At this point the Bank of France began to transfer its exchange holdings into gold buying the metal chiefly in London and New York. Because of the inadequate gold reserves in London, a meeting of central bankers in New York decided that the gold purchases of France and Germany should be diverted from London to New York in the future (July 1927). … When French gold purchases became noticeable in 1928, the Federal Reserve Bank adopted open market operations to counterbalance them, buying securities to a value equal to the French purchases of gold.
As a result there was no reduction in money in the United States. This money, however, was going increasingly into stock-market speculation rather than into production of real wealth.
…
Early in 1929, the board of governors of the Federal Reserve System became alarmed at the stock-market speculation, especially at its draining credit from industrial production. To curtail this, in April 1929, the Federal Reserve authorities called upon the member banks to reduce their loans on stock-exchange collateral. At the same time, it engaged in open-market operations which reduced its holding of banker’s acceptances from about $300 million to about $150 million. The sterilization of gold was made more drastic. It was hoped in this way to reduce the amount of credit available for speculation. Instead, the available credit went more and more to speculation and decreasingly to productive business. Call money rates in New York which had reached 7 percent at the end of 1928 were at 13 percent by June 1929. … By this time it was becoming evident that the prices of stocks were far above any value based on earning power and that this earning power was beginning to decline because of the weakening industrial activity. At this critical moment, on September 26, 1929, a minor financial panic in London (the Hatry Case) caused the Bank of England to raise its bank rate from 4.5 percent to 6.5 percent. This was enough. British funds began to leave Wall Street, and the overinflated stock market commenced to sag. By the middle of October, the fall had become a panic. … It was a financial disaster of unparalleled magnitude.
The stock-market crash reduced the volume of foreign lending from the United States to Europe, and these two events together tore away the façade which until then had concealed the fundamental maladjustment between production and consumption, between debts and ability to pay, between creditors and willingness to receive goods, between the theories of 1914 and the practices of 1928. Not only where these maladjustements revealed but they began to be readjusted with a severity of degree and speed made all the worse by the fact that the adjustments had been so long delayed. Production began to fall to the level of consumption, creating idle men, idle factories, idle money, and idle resources. Debtors were called to account and found deficient. Creditors who had refused repayment now sought it, but in vain. All values of real wealth shrunk drastically.
The Crisis of 1931
It was this shrinkage of values which carried the economic crisis into the stage of financial and banking crisis and beyond these to the stage of political crisis. As values declined, production fell rapidly; banks found it increasingly difficult to meet their demands upon their reserves; these demands increased with the decline in confidence; governments found that their tax receipts fell so rapidly that budgets became unbalanced in spite of every effort to prevent it.
The financial and banking crisis began in central Europe early in 1931, reached London by the end of that year, spread to the United States and France in 1932, bringing the United States to the acute stage in 1933, and France in 1934.
The acute stage began early in 1931 in central Europe where the deflationary crisis was producing drastic results. Unable to balance its budget or obtain adequate foreign loans, Germany was unable to meet her reparation obligations. At this critical moment, as we have seen, the largest bank in Austria collapsed because of its inability to liquidate claims being presented to it. The Austrian debacle soon spread the banking panic to Germany. The Hoover Moratorium on reparations relieved the pressure on Germany in the middle of 1931, but not enough to permit any real financial recovery. Millions of short-term credits lent from London were tied up in frozen accounts in Germany. As a result, in the summer of 1931, the uneasiness spread to London.
The pound sterling was vulnerable. There were five principle reasons: (1) the pound was overvalued; (2) costs of production in Britain were much more rigid than prices; (3) gold reserves were precariously small; (4) the burden of public debt was too great in a deflationary atmosphere; (5) there were greater liabilities than assets in short-term international holdings in London (about 407 million pounds to 153 million pounds). … To restore confidence among the wealthy (who were causing the panic) an effort was made to balance the budget by cutting public expenditures drastically. This, by reducing purchasing power, had injurious effects on business activity and increased unrest among the masses of the people. … Various physical and extralegal restrictions were placed on export of gold (such as issuing gold bars of a low purity unacceptable to the Bank of France). The outflow of gold could not be stopped. … It was realized that the movement of gold was subject to factors which the authorities could not control more than it was under the influence of factors they could control. It also shows – a hopeful sign – that the authorities after twelve years were beginning to realize that conditions had changed. For the first time, people began to realize that the two problems – domestic prosperity and stable exchanges – were quite separate problems and that the old orthodox practice of sacrificing the former to the latter must end. From this point on, one country after another began to seek domestic prosperity by managed prices and stable exchanges by exchange control. That is, the link between the two (the gold standard) was broken, and one problem was made into two.
The British suspension of gold was by necessity, not by choice. It was regarded as an evil, but it was really a blessing. As a result of this mistake, many of the benefits which could have been derived from it were lost by trying to counterbalance the inflationary results of the suspension by other deflationary actions. …
As a result of the British abandonment of the gold standard the central core of the world’s financial system was disrupted. This core, which in 1914 was exclusively in London, in 1931 was divided among London, New York, and Paris. London’s share depended on financial skill and old habits; New York’s share depended on her position as the world’s greatest creditor; Paris’s share depended on a combination of a creditor position with an undervalued currency which attracted gold. From 1927 to 1931, these three had controlled the world’s financial system with payment flowing in to the three, credits flowing out, and stable exchanges between them. The events of September 1931 broke up this triangle. Stable exchanges continued for the dollar-franc, leaving dollar-pound to fluctuate. This did not permit an adjustment of the maladjusted exchange rates of 1928-1931. Concretely, the undervaluation of the franc in 1928 and the overvaluation of the pound in 1925 could not be remedied by the events of 1931. A sterling-franc which would have eliminated the undervaluation of the franc would have resulted in a sterling-dollar rate which would have over-corrected the overvaluation of sterling. On the other hand, the depreciation of the pound put great pressure on both the dollar and the franc. At the same time, Britain sought to exploit as much as possible her economic relations with her home market, the empire, and that group of other countries known as the “sterling bloc”. …
Thus the world tended to divide into two financial groups – the sterling bloc organized about Britain and the gold bloc organized about the United States, France, Belgium, the Netherlands, and Switzerland.
The depreciation of sterling in relation to gold made the currencies of the gold bloc overvalued, and relieve Britain of that burdensome status for the first time since 1925. As a result, Britain found it easier to export and more difficult to import, and obtained a favorable balance of trade for the first time in almost seven years. On the other hand, the gold countries found their depression intensified.
As a third result of the British abandonment of the gold standard Britain freed herself from her financial subjection to France. This subjection had resulted from the vulnerable position of the British gold reserves in contrast to the bulging appearance of the French reserves. After 1931 the financial positions of the two countries were reversed.
As a fourth result, the countries still on gold began to adopt new trade barriers, such as tariffs and quotas, to prevent Britain from using the advantage of depreciated currency to increase her exports to them. The countries already off gold began to see the value in currency depreciation, and the possibility of races in depreciation began to form in the minds of some.
…
Because of the deflationary policy which accompanied the abandonment of gold in Great Britain, recovery from depression did not result except to a very slight degree. Neither prices nor employment rose until 1933, and, from that year on, the improvement was slow. The depreciation of sterling did result in an improvement in the foreign trade balance, exports rising very slightly and imports falling 12 percent in 1932 in comparison with 1931. This led to a revival of confidence in sterling and a simultaneous decline in confidence in the gold-standard currencies. Foreign funds began to flow to London.
The flow of capital into Britain early in 1932 resulted in an appreciation of sterling in respect to the gold currencies. This was unwelcome to the British government since it would destroy her newly acquired trade advantage. The pound sterling was appreciated in respect to the dollar … To control this, the government in May 1932, set up the Exchange Equalization Account with capital of 175 million pounds. This fund was to be used to stabilize the exchange rates by buying and selling foreign exchange against the trend of the market. In this way, the old automatic regulation by the market of the internal credit structure through the international flow of funds was broken. Control of the credit structure was left to the Bank of England, while control of the exchanges went to the Exchange Equalization Fund. This made it possible for Britain to adopt a policy of easy and plentiful credit within the country without being deterred by a flight of capital from the country.
… On this basis [in Great Britain] a mild economic recovery was built up.
… The improvement in Britain was not shared by the countries still on gold. As a result of the competition of depreciated sterling, they found their balances of trade pushed toward the unfavorable side and their deflation in prices increased. Tariffs had to be raised, quotas and exchange controls set up.
The Crisis in the United States, 1933
As a result of the British crisis, the gold countries of Europe sought to modify their financial basis from the gold exchange standard to the gold bullion standard. When Britain abandoned gold in September 1931, France was caught with over 600 million pounds in sterling exchange. This was equal to about 30 percent of her foreign-exchange holdings … The loss exceeded the total capital and surplus of the Bank of France. To avoid any similar experience in the future, France began to transfer her holdings of exchange into gold, much of it called from the United States. As confidence in the pound rose, that in the dollar fell. It became necessary to raise the New York discount rate … and to engage in extensive open-market buying of securities to counteract the deflationary effects of this. However, the gold exports and gold hoarding continued, made worse by the fact that the United States was the only gold standard country with gold coins still circulating.
As a result of the decline of confidence and the demand for liquidity, the American banking system began to collapse. … From February 1st to March 4th the Federal Reserve Bank in New York lost $756 million in gold; it called in $709 million from the other Federal Reserve Banks, which were also subject to runs.
The banks of the whole United States were closed by executive order on March 4 to be reopened after March 12th if their condition was satisfactory. Export of gold was subjected to license, convertibility of notes into gold was ended, and private holding of gold was made illegal. These orders, completed on April 20, 1933, took the United States off the gold standard. This was done in order that the government could pursue a policy of price inflation in its domestic program. It was not made necessary by the American international financial position, as this continued very favorable.
As a result of the abandonment of the gold standard by the United States, the central-exchange triangle between London, Paris, and New York was further disrupted. All three exchange rates were able to fluctuate, although the Exchange Equalization Account kept two of them relatively steady. To the worldwide problem of economic distress was now added the problem of exchange stabilization. A dispute ensued among Britain, France, and the United States over which of these two problems should be given priority. … This depreciation of both the dollar and the pound put great strain on the franc.
The World Economic Conference, 1933
The dispute over the priority of stablization or recovery reached its peak in the World Monetary and Economic Conference held in London from June 12 to July 27, 1933. [However, negotiations at this conference broke down …]
As a result of the failure of the Economic Conference, the countries of the world tended to divide into three groups: a sterling bloc, a gold bloc, and a dollar bloc. The gold and sterling blocs were formally organized, the former on July 3rd and the later on July 8th. A struggle ensued among these three in an effort to shift the economic burdens of past mistakes from one to another.
[Quigley goes onto to explain the reasons why The World Economic Conference broke down due to differences in “interests” amongst principally Great Britain, France, and the United States]
…
As a result of the crisis, regardless of the nature of its primary impact, all countries began to purse policies of economic nationalism. This took the form of tariff increases, licensing of imports, import quotas, sumptuary laws restricting imports, laws placing national origin, trade-mark, health, or quarantine restrictions on imports, foreign-exchange controls, competitive depreciation of currencies, export subsidies, dumping of exports, and so on. These were first established on an extensive scale in 1931, and spread rapidly as a result of imitation and retaliation.
The Crisis in the Gold Bloc, 1934-1936
After the breakup of the World Economic Conference, the United States continued its policy of domestic inflation. As the dollar depreciated, the pressure on the franc increased, while the pound, through the use of the Exchange Equalization Account, tried to follow a middle ground in a depreciated, but stable, relationship to the franc.
… Thus the world depression and the financial crisis which France had escaped for over three years were extended to her. … The American actions of 1934, which gave the world a 59-cent dollar and $35 gold, made the position of the gold bloc untenable. They had to suffer a severe deflation, or abandon gold, or devaluate. Most of them (because they feared inflation or because they had foreign debts which would increase in weight if their currency was to depreciate) permitted deflation with all its suffering. … Eventually, all members of the gold bloc had to abandon gold to some extent because of the pressure from the dollar.
…
We have said that the gold bloc was destroyed by the French devaluation of September 1936. This was accomplished almost immediately. Switzerland, the Netherlands, and Czechoslovakia devalued their currencies by about 30 percent and Italy by about 40 percent before the end of October.
The historical importance of the banker-engendered deflationary crisis of 1927-1940 can hardly be overestimated. It gave a blow to democracy an to the parliamentary system which the later triumphs of these in World War II and the postwar world were unable to fully repair. It gave an impetus to aggression by those nations where parliamentary government collapsed, and thus became the chief cause of World War II. It so hampered the Powers which remained democratic by its orthodox economic theories that these were unable to rearm for defense, with the consequence that World War II was unduly prolonged by the early defeats of the democratic states. It gave rise to a conflict between the theorists of orthodox and unorthodox financial methods which led to a sharp reduction in the power of the bankers. And, finally, it impelled the whole economic development of the West along the road from financial capitalism to monopoly capitalism and, shortly thereafter, toward the pluralist economy.
The controversy between the bankers and the theorists of unorthodox finance arose over the proper way to deal with an economic depression. We shall analyze this problem later, but here we should say that the bankers’ formula for treating a depression was by clinging to the gold standards, by raising interest rates and seeking deflation, and by insisting on a reduction of public spending, a fiscal surplus, or at least a balanced budget. These ideas were rejected totally, on a point-by-point basis, by the unorthodox economists (somewhat mistakenly called “Keynesian”). The bankers’ formula sought to encourage economic recovery by “restoring confidence in the value of money,” that is, their own confidence in what was the primary concern of bankers. … The unorthodox theorists sought to achieve this latter more quickly and more directly by restoring purchasing power, and thus prices, by increasing, instead of reducing, the money supply and by placing it in the hands of potential consumers rather in the banks or in the hands of investors.
This change in the accepted theories after 1934 was a slow growth, and formed part of the eclipse of financial capitalism; in the long run it meant that banks would be reduced from the masters of the economy to become its servant in a situation where the major economic decisions would not be based on the supply of money but on the supply and organization of real resources.
The end of financial capitalism may well be dated at the collapse of the gold standard in Britain in September 1931 …
(Cont'd in Part IX) |
