Winston Churchill, in 1925 Chancellor of the Exchequer in the Conservative government headed by Stanley Baldwin, was pressed by the Governor of the Bank of England, Montagu Norman, to restore the British pound to its pre-war parity of $4.86, thereby re-establishing the gold standard in Britain, paving the way for a general restoration of the international gold standard, one of the first casualties of war in August 1914. Having accumulated an enormous stockpile of gold in exchange for supplies it provided to the belligerents, US restored convertibility into gold soon after the end of hostilities, but sterling had depreciated against the dollar by about 25 percent after the war, so Britain could not achieve its goal of restoring the convertibility into gold at the prewar parity without a tight monetary policy aimed at raising the external value of the pound from about $4 to $4.86.
In 1925, sterling had risen to within about 10% of the old parity, making restoration of the pre-war dollar parity seem attainable, thus increasing the pressure from the London and the international financial communities to take the final steps toward the magic $4.86 level. Churchill understood that such a momentous step was both politically and economically dangerous and sought advice from a wide range of opinion, pro and con, both inside and outside government. The most persuasive advice he received was undoubtedly from J. M. Keynes, who, having served as a Treasury economist during World War I and then serving on the British delegation to the Versailles Peace Conference, became world famous after resigning from the Treasury to write The Economic Consequences of the Peace, his devastating critique of the Treaty of Versailles, protesting the overly harsh and economically untenable reparations obligations imposed on Germany. Keynes advised Churchill that the supposedly minimal 10% appreciation of sterling against the dollar would impose an intolerable burden on British workers, who had suffered from exceptionally high unemployment since the 1920-21 postwar deflation.
Despite Keynes’s powerful arguments, Churchill in the end followed the advice of the Bank of England and other members of the British financial establishment. Perhaps one argument that helped persuade him to follow the orthodox advice was that of another Treasury economist, the great Ralph Hawtrey, who submitted a paper analyzing the effects of restoring the prewar dollar parity. Hawtrey argued that Britain and the world would benefit from the restoration of an international gold standard, provided that the restoration was managed in a way that avoided the deflationary tendencies associated a remonetization of gold. Hawtrey suggested that there was reason to think that the institution that mattered most, the U.S. Federal Reserve, with its huge stockpile of gold, would follow a mildly inflationary policy allowing Britain to maintain the prewar parity without additional deflationary pressure. However, Hawtrey warned that if the US did not follow an accommodative policy, it would be a mistake and futile for Britain to defend the parity by deflating.
Keynes, who never suffered from a lack of self-confidence, undoubtedly thought that he had gotten the better of his opponents in presenting the case against restoring the prewar dollar parity to Churchill. When the decision went against him, he vented his outrage at the decision, and perhaps his own personal frustration, by writing a short pamphlet, The Economic Consequences of Mr. Churchill, a withering rhetorical assault on Churchill and the decision to restore the pre-war dollar parity. However, the consequences of the decision to restore the prewar parity were, at least initially, less devastating than Keynes predicted. Contrary to Keynes’s prediction, unemployment in Britain actually declined slightly in 1926 and 1927, falling below 10% for the first time in the 1920s. Hawtrey’s conjecture that the Federal Reserve, then led by the head of the New York Federal Reserve Bank, Benjamin Strong, would follow a mildly accommodative policy, alleviating the deflationary pressure on Britain, turned out to be correct. However, ill health forced Strong to resign in 1928 only months before his untimely death. His accommodative policy was reversed just as the Bank of France started accumulating gold, unleashing deflationary forces that had been contained since the deflation of 1920-21.
Fast forward some four score years to today’s tragic re-enactment of the deflationary dynamics that nearly destroyed European civilization in the 1930s. But what a role reversal! In 1930 it was Germany that was desperately seeking to avoid defaulting on its obligations by engaging in round after round of futile austerity measures and deflationary wage cuts, causing the collapse of one major European financial institution after another in the annus horribilis of 1931, finally (at least a year after too late) forcing Britain off the gold standard in September 1931. Eighty years ago it was France, accumulating huge quantities of gold, in Midas-like self-satisfaction despite the economic wreckage it was inflicting on the rest of Europe and ultimately itself, whose monetary policy was decisive for the international value of gold and the downward course of the international economy. Now, it is Germany, the economic powerhouse of Europe dominating the European Central Bank, which effectively controls the value of the euro. And just as deflation under the gold standard made it impossible for Germany (and its state and local governments) not to default on its obligations in 1931, the policy of the European Central Bank, self-righteously dictated by Germany, has made default by Greece and now Italy and at least three other members of the Eurozone inevitable.
The only way to have saved the gold standard in 1930 would have been for France and the US to have radically changed their monetary policy to encourage an outflow of gold, driving down the international value of gold and reversing the deflation. Such a policy reversal, though advocated by Hawtrey and the great Swedish economist Gustav Cassel, was beyond the limited imagination of the world’s central bankers and monetary authorities at the time. But once started, the deflationary downward spiral did not stop until France, finally having had enough, abandoned gold in 1935. If the European central bank does not soon – and I mean really soon – grasp that there is no exit from the debt crisis without a reversal of monetary policy sufficient to enable nominal incomes in all the economies in the Eurozone to grow more rapidly than does their indebtedness, the downward spiral will overtake even the stronger European economies. (I pointed out three months ago that the European crisis is a NGDP crisis not a debt crisis.) As the weakest countries choose to ditch the euro and revert back to their own national currencies, the euro is likely to start to appreciate as it comes to resemble ever more closely the old deutschmark. At some point the deflationary pressures of a rising euro will cause even the Germans, like the French in 1935, to relent. But one shudders at the economic damage that will be inflicted until the Germans come to their senses. Only then will we be able to assess the full economic consequences of Mrs. Merkel.