Currency Wars: The Making of the Next Global Crisis (11 page)

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Authors: James Rickards

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BOOK: Currency Wars: The Making of the Next Global Crisis
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By 1927, with gold and foreign exchange accumulating steadily in France and flowing heavily from England, it was England’s role under the rules of the game to raise interest rates and force a contraction, which, over time, would make its economy more competitive. But Montagu Norman, governor of the Bank of England, refused to raise rates, partly because he anticipated a political backlash and also because he felt the French inflow was due to an unfairly undervalued franc. The French, for their part, refused to revalue, but suggested they might do so in the future, creating further uncertainty and encouraging speculation in both sterling and francs.
Separately, the United States, after cutting interest rates in 1927, began a series of rate increases in 1928 that proved highly contrac-tionary. These rate increases were the opposite of what the United States should have done under the rules of the game, given its dominant position in gold and continuing gold inflows. Yet just as domestic political considerations caused England to refuse to raise rates in 1927, the Fed’s decision to raise rates the following year when it should have lowered them was also driven by domestic concerns, specifically the fear of an asset bubble in U.S. stock prices. In short, participants in the gold exchange standard were putting domestic considerations ahead of the rules of the game and thereby disrupting the smooth functioning of the gold exchange standard itself.
There was another flaw in the gold exchange standard that ran deeper than the lack of coordination by the central banks of England, the United States, France and Germany. This flaw involved the price at which gold had been fixed to the dollar in order to anchor the new standard. Throughout World War I, countries had printed enormous amounts of paper currency to finance war debts while the supply of gold expanded very little. Moreover, the gold that did exist did not remain static but flowed increasingly toward the United States, while relatively little remained in Europe. Reconciling the postwar paper-gold ratio with the prewar gold price posed a major dilemma after 1919. One choice was to contract the paper money supply to target the prewar gold price. This would be highly deflationary and would cause a steep decline in overall price levels in order to get back to the prewar price of gold. The other choice was to revalue gold upward so as to support the new price level given the expansion in the paper money supply. Raising the price of gold meant permanently devaluing the currency. The choice was between deflation and devaluation.
It is one thing when prices drift downward over time due to innovation, scalability or other efficiencies. This might be considered “good” deflation and is familiar to any contemporary consumer who has seen prices of computers or wide-screen TVs fall year after year. It is another matter when prices are forced down by unnecessary monetary contraction, credit constraints, deleveraging, business failures, bankruptcies and mass unemployment. This may be considered “bad” deflation. This bad deflation was exactly what was required in order to return the most important currencies to their prewar parity with gold.
The choice was not as stark in the United States because, although the U.S. had expanded its money supply during World War I, it had also run trade surpluses and had greatly increased its gold reserves as a result. The ratio of paper currency to gold was not as badly out of line relative to the prewar parity as it was in England and France.
By 1923, France and Germany had both confronted the wartime inflation issue and devalued their currencies. Of the three major European powers, only England took the necessary steps to contract the paper money supply to restore the gold standard at the prewar level. This was done at the insistence of Winston Churchill, who was chancellor of the exchequer at the time. Churchill considered a return to the prewar gold parity to be both a point of honor and a healthy check on the condition of English finances. But the effect on England’s domestic economy was devastating, with a massive decline of over 50 percent in the price level, a high rate of business failures and millions of unemployed. Churchill later wrote that his policy of returning to a prewar gold parity was one of the greatest mistakes of his life. By the time massive deflation and unemployment hit the United States in 1930, England had already been living through those conditions for most of the prior decade.
The 1920s were a time of prosperity in the United States, and both the French and German economies grew strongly through the middle part of the decade. Only England lagged. If England had turned the corner on unemployment and deflation by 1928, the world as a whole might have achieved sustained global economic growth of a kind not seen since before World War I. Instead, global finance soon turned dramatically for the worse.
The start of the Great Depression is conventionally dated by economists from October 28, 1929, Black Monday, when the Dow Jones Industrial Average fell 12.8 percent in a single day. However, Germany had fallen into recession the year before and England had never fully recovered from the depression of 1920–1921. Black Monday represented the popping of a particularly prominent U.S. asset bubble in a world already struggling with the effects of deflation.
The years immediately following the 1929 U.S. stock market crash were disastrous in terms of unemployment, declining production, business failures and human suffering. From the perspective of the global financial system, however, the most dangerous phase occurred during the spring and summer of 1931. The financial panic that year, tantamount to a global run on the bank, began in May with the announcement of losses by the Credit-Anstalt bank of Vienna that effectively wiped out the bank’s capital. In the weeks that followed, a banking panic gripped Europe, and bank holidays were declared in Austria, Germany, Poland, Czechoslovakia and Yugoslavia. Germany suspended payments on its foreign debt and imposed capital controls. This was the functional equivalent of going off the new gold exchange standard, since foreign creditors could no longer convert their claims on German banks into gold, yet officially Germany still claimed to maintain the value of the reichsmark in a fixed relationship to gold.
The panic soon spread to England, and by July 1931 massive gold outflows had begun. Leading English banks had made leveraged investments in illiquid assets funded with short-term liabilities, exactly the type of investing that destroyed Lehman Brothers in 2008. As those liabilities came due, foreign creditors converted their sterling claims into gold that soon left England headed for the United States or France or some other gold power not yet feeling the full impact of the crisis. With the outflow of gold becoming acute and the pressures of the bank run threatening to destroy major banks in the City of London, England went off the gold standard on September 21, 1931. Almost immediately sterling fell sharply against the dollar and continued dropping, falling 30 percent in a matter of months. Many other countries, including Japan, the Scandinavian nations and members of the British Commonwealth, also left the gold standard and received the short-run benefits of devaluation. These benefits worked to the disadvantage of the French franc and the currencies of the other gold bloc nations, including Belgium, Luxembourg, the Netherlands and Italy, which remained on the gold exchange standard.
The European bank panic abated after England went off the gold standard; however, the focus turned next to the United States. While the U.S. economy had been contracting since 1929, the devaluation of sterling and other currencies against the U.S. dollar in 1931 put the burden of global deflation and depression more squarely on the United States. Indeed, 1932 was the worst year of the Great Depression in the United States. Unemployment reached 20 percent and investment, production and price levels had all plunged by double-digit amounts measured from the start of the contraction.
In November 1932, Franklin D. Roosevelt was elected president to replace Herbert Hoover, whose entire term had been consumed by a stock bubble, a crash and then the Great Depression itself. However, Roosevelt would not be sworn in as president until March 1933, and in the four months between election and inauguration the situation deteriorated precipitously, with widespread U.S. bank failures and bank runs. Millions of Americans withdrew cash from the banks and stuffed it in drawers or mattresses, while others lost their entire life savings because they did not act in time. By Roosevelt’s inauguration, Americans had lost faith in so many institutions that what little hope remained seemed embodied in Roosevelt himself.
On March 6, 1933, two days after his inauguration, Roosevelt used emergency powers to announce a bank holiday that would close all banks in the United States. The initial order ran until March 9 but was later extended for an indefinite period. FDR let it be known that the banks would be examined during the holiday and only sound banks would be allowed to resume business. The holiday ended on March 13, at which time some banks reopened while others remained shut. The entire episode was more about confidence building than sound banking practice, since the government had not in fact examined the books of every bank in the country during the eight days they were closed.
The passage of the Emergency Banking Act on March 9, 1933, was of far greater significance than the bank inspections in terms of rebuilding confidence in the banks. The act allowed the Fed to make loans to banks equal to 100 percent of the par value of any government securities and 90 percent of the face value of any checks or other liquid short-term paper they held. The Fed could also make unsecured loans to any bank that was a member of the Federal Reserve System. In practice, this meant that banks could obtain all the cash they needed to deal with bank runs. It was not quite deposit insurance, which would come later that year, but it was the functional equivalent because now depositors did not have to worry that banks would literally run out of cash.
Interestingly, Roosevelt’s initial statutory authority for the bank closure in March was the 1917 Trading with the Enemy Act, which had become law during World War I and granted any president plenary emergency economic powers to protect national security. In case the courts might later express any doubt about the president’s authority to declare the bank holiday under this 1917 wartime statute, the Emergency Banking Act of 1933 ratified the original bank holiday after the fact and gave the president explicit rather than merely implicit authority to close the banks.
When the banks did reopen on March 13, 1933, depositors lined up in many instances not to withdraw money but to redeposit it from their coffee cans and mattresses, where it had been hoarded during the panic of the preceding months. Although very little had changed on bank balance sheets, the mere appearance of a housecleaning during the holiday combined with the Fed’s new emergency lending powers had restored confidence in the banks. With that behind him, FDR now confronted an even more pernicious problem than a bank run. This was the problem of deflation now being imported into the United States from around the world through exchange rate channels. CWI had now arrived at the White House doorstep.
When England and others went off the gold standard in 1931, the costs of their exports went down compared to costs in other competing nations. This meant that competing nations had to find ways to lower their costs to also remain competitive in world markets. Sometimes this cost cutting took the form of wage reductions or layoffs, which made the unemployment problem worse. In effect, the nations that had devalued by abandoning gold were now exporting deflation around the world, exacerbating global deflationary trends.
Inflation was the obvious antidote to deflation, but the question was how to achieve inflation when a vicious cycle of declining spending, higher debt burdens, higher unemployment, money hoarding and further spending declines had taken hold. Inflation and currency devaluation are substantially the same thing in terms of their economic effects: both decrease the domestic cost structure and make imports more expensive and exports less expensive to other countries, thus helping to create domestic jobs. England, the Commonwealth and Japan had gone this route in 1931 with some success. The United States could, if it so chose, simply devalue against sterling and other currencies, but this might have prompted further devaluations against the dollar with no net gain. Continuation of paper currency wars on a tit-for-tat basis did not seem to offer a permanent solution. Rather than devalue against other paper currencies, FDR chose to devalue against the ultimate currency—gold.
But gold posed a unique problem in the United States. In addition to official holdings in the Federal Reserve Banks, gold was in private circulation in the form of gold coins used as legal tender and coins or bars held in safe-deposit boxes and other secure locations. This gold could properly be viewed as money, but it was money being hoarded and not spent or put into circulation. The easiest way to devalue the dollar against gold was to increase the dollar price of gold, which Roosevelt could do with his emergency economic powers. FDR could declare that gold would now be convertible at $25 per ounce or $30 per ounce instead of the gold standard price of $20.67 per ounce. The problem was that the benefit of this increase in the gold price would go in large measure to the private gold hoarders and would do nothing to free up the hoards or put them back in circulation. In fact, more people might convert paper dollars to gold bullion in anticipation of further gold price increases, and those hoarding gold might sit tight for the same reason, with their original convictions having already been confirmed. Roosevelt needed to ensure that any gains from the revaluation of gold would go to the government and not the hoarders, while citizens would be left with no forms of money except paper. If gold could be removed from private hands and if citizens could be made to expect further devaluations in their paper money, they might be inclined to start spending it rather than hold on to a depreciating asset.

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