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The Currency Standard of the Interwar Years (1918–1939)

As in the case of other wars, governments suspended the gold standard during World War I, to increase the money supply and pay for the war. Therefore, as in the case of all post-war eras, many countries faced much higher inflation rates at the end of World War I.

The U.S. returned to the gold standard in 1919, and other European countries and Japan reinstated the gold parity a couple years later. Considering the limited gold supply of the early 1920s, the European countries and Japan decided on a partial gold standard, where reserves consisted of partly gold and partly other countries’ currencies. This standard is known as the gold exchange standard.

These countries attempted to restore the gold standard in 1918 at the end of World War I, but for the most part, their attempts remained unsuccessful. One reason for the lack of success is that efforts were mostly unilateral. It means that countries decided about post-WWI parities without consulting each other.

This tendency to unilateralism had its own reasons. Post–World War I inflation rates varied among countries, depending on how much they inflated the economy during the war. But some countries chose their pre–World War I gold parity even though their post–World War I inflation rates were much higher than those of the prewar period.

Trying to move back to the gold standard

Britain was one country that went back to its pre–World War I parity, even though the post-war price level was higher than the prewar price level. The British government made this decision to maintain its credibility as the world’s superpower. However, maintaining the unrealistic prewar parity meant that the British pound was overvalued.

To avoid further problems with the gold parity, Britain implemented a monetary policy of higher interest rates (or lower quantity of money, essentially a contractionary monetary policy), which led to a weak output performance and unemployment in the years following the end of World War I.

Another important event after World War I later affected the decisions made during the Bretton Woods conference of 1944. As in the case of other countries, Germany suspended gold convertibility in 1914. However, unlike other countries, it couldn’t return to the gold standard after World War I.

Heavy reparations payments imposed on Germany forced the country to continue having a fiat currency and to print German marks, which created hyperinflation in Germany in the 1920s. Even though Germany recovered from hyperinflation during the National Socialist regime, that very regime led to World War II in 1939. The imposition of heavy reparations payments on Germany was noted as a mistake during the Bretton Woods conference in 1944.

Therefore, as far as the gold standard is concerned, the interwar period started on the wrong foot. Three fundamental problems characterized the interwar era from the beginning:

  • The post–World War I gold parities weren’t consistent with the post-war price levels.

  • Aware of the first problem, and in an attempt to maintain the external balance (to keep the fixed exchange rates and not lose gold reserves), central banks in many countries implemented contractionary monetary policies, which led to output decline and unemployment.

  • Despite the fact that a metallic standard requires a good amount of cooperation, the international monetary system of the interwar years cannot be described as such a system. The international disagreements ranged from disputes over Germany’s reparation payments during the early post–World War I years to trade restrictions during the Great Depression.

During the Depression era (1925–1931), a series of disastrous financial events affected almost all major countries. Examples of such events are the October 1929 New York stock market crash and bank failures around the world, especially in Austria and Germany in the early 1930s.

Additionally, Britain paid the price of an overvalued pound, and the currency was attacked in 1931. In other words, investors who were holding British pounds converted them into gold. The Bank of England lost a substantial amount of its gold reserves during this attack. This situation worsened bank failures around the world because banks in other countries were holding pound reserves, and suddenly the value of their foreign currency reserves substantially dropped.

Nevertheless, the 1931 attack on the British pound may have had an upside. Not only Britain, but also Australia, New Zealand, and Canada left the gold standard and both implemented expansionary monetary policies and lowered interest rates to promote growth and employment.

These countries experienced the Great Depression as a severe recession, but other countries — including the U.S., France, and Switzerland — remained committed to the gold standard and, therefore, experienced the Great Depression.

Holding the gold standard in the U.S.

Because a metallic standard requires maintaining the external balance, the U.S. was trying hard to prevent fluctuations in its gold reserves. In fact, the dangerous direction at that time was to lose a substantial amount of gold reserves. To avoid losing gold reserves and promote incoming capital flows, the U.S. tried to keep interest rates higher through contractionary monetary policies.

Declines in the money supply led to deflationary pressures, which created considerable problems for the banking system. Similar to the British pound, the dollar experienced a speculative attack in 1931. Foreign and domestic investors and U.S. banks were converting paper money into gold, depleting the Fed’s gold reserves.

Some economists blame the Fed’s insistence on the gold standard for the long duration and the severity of the Great Depression. Holding on to the gold standard prevented the Fed from implementing expansionary monetary policies to stimulate the economy and act as a lender of last resort during the time of bank runs.

By the way, the tendency toward contractionary monetary policy to maintain the external balance had been a problem of the metallic standard since the 19th century. Some economists call this race to higher interest rates under a metallic standard a deflationary vortex.

Even though the fixed exchange rate normally implies the effect of external imbalance on the exchange rate (which, in turn affects the demand for foreign goods), during the 1930s, policymakers reversed the direction of causality and used trade restrictions to improve their current account. Along with trade restrictions, strong capital controls led to a drastic decline in capital flows starting in the late 1920s.

In 1934, the gold parity implied an over 40 percent devaluation of the dollar, from $20.67 to $35 to the troy ounce (a measure that is used to weigh precious metals, 1 troy ounce = 31.1034768 grams). When the last countries with a gold standard left the gold parity in 1936, the metallic standard was gone and the world was preparing to go to war.

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