# Globalizing Capital ## Gold standard ### Was deflationary > We should ask whether nineteenth-century governments can be expected to have understood that the gold standard was a force for deflation. Is this a problem? Eichengreen seems to imply that it is [[Milton Friedman|Friedman]] said that bimetallism is better (presumably because of the larger money supply) How's the economy grows, naturally the money supply should as well, otherwise prices will continuously deflate. Deflation caused agricultural unrest in the United States The problem with the [[Petrodollar]] is that there are not enough dollars to price global trade in dollars, leading to a modern day mercantilism, which leads to increasing deficits in the current account > The United States, where silver-mining interests were strong and farmers opposing deflation were influential, convened an international monetary conference in 1878 in the hope of coordinating a shift to bimetallism. ### Money was privately issued but led to conflicts of interest In other countries, money in circulation took the form mainly of paper, silver, and token coin. Those countries were on the gold standard in that their governments stood ready to convert their monies into gold at a fixed price on demand. The central or national bank kept a reserve of gold to be paid out in the event that its liabilities were presented for conversion. Such central banks were usually privately owned institutions (the Swedish Riksbank, the Bank of Finland, and the Russian State Bank being exceptions) that, in return for a monopoly of the right to issue bank notes, provided services to the government (holding a portion of the public debt, advancing cash to the national treasury, watching over the operation of the financial system).34 They engaged in business with the public, which created scope for conflict between their public responsibilities and private interests. The Bank Charter Act (Peel’s Act), under which the Bank of England operated from 1844, acknowledged the coexistence of banking and monetary functions by creating separate Issue and Banking Departments.35 Other countries, in this and in other respects, followed the British example. But, as we shall see, attempts to segment these responsibilities were not completely successful. - Increasing money supply meant increasing liabilities for the central bank, which of course had to be defended or even backed 1:1 with gold reserves. A country could not increase their money supply indefinitely without also increasing their gold reserves ### How the Gold Standard worked The most influential formalization of the gold-standard mechanism is the price-specie flow model of David Hume.39 Perhaps the most remarkable feature of this model is its durability: developed in the eighteenth century, it remains the dominant approach to thinking about the gold standard today. As with any powerful model, simplifying assumptions are key. Hume considered a world in which only gold coin circulated and the role of banks was negligible. Each time merchandise was exported, the exporter received payment in gold, which he took to the mint to have coined. Each time an importer purchased merchandise abroad, he made payment by exporting gold. For a country with a trade deficit, the second set of transactions exceeded the first. It experienced a gold outflow, which set in motion a self-correcting chain of events. With less money (gold coin) circulating internally, prices fell in the deficit country. With more money (gold coin) circulating abroad, prices rose in the surplus country. The specie flow thereby produced a change in relative prices (hence the name “price-specie flow model”). Imported goods having become more expensive, domestic residents would reduce their purchases of them. Foreigners, for whom imported goods had become less expensive, would be inclined to purchase more. The deficit country’s exports would rise, and its imports fall, until the trade imbalance was eliminated. The strength of this formulation—one of the first general equilibrium models in economics—was its elegance and simplicity. It was a parsimonious description of the balance-of-payments adjustment mechanism of the mid-eighteenth century. But as time passed and financial markets and institutions continued to develop, Hume’s model came to be an increasingly partial characterization of how the gold standard worked. ### Drawbacks to Hume's model Accuracy required extending Hume’s model to incorporate two features of the late-nineteenth century world. One was international capital flows. Net capital movements due to foreign lending were larger, often substantially, than the balance of commodity trade. Hume had said nothing about the determinants of these flows—of factors such as the level of interest rates and the activities of commercial and central banks. The other feature was the absence of international gold shipments on the scale predicted by the model. Leaving aside flows of newly mined gold from South Africa and elsewhere to the London gold market, these were but a fraction of countries’ trade deficits and surpluses. Extending Hume’s model to admit a role for capital flows, interest rates, and central banks was feasible. But not until the end of World War I in the report of the Cunliffe Committee (a British government committee established to consider postwar monetary problems) was this version of the model properly elaborated.40 ### Cunliffe version of the price-specie mechanism The Cunliffe version worked as follows. Consider a world in which paper rather than gold coin circulated or, as in Britain, paper circulated alongside gold. The central bank stood ready to convert currency into gold. When one country, say Britain, ran a trade deficit against another, say France, importing more merchandise than it exported, it paid for the excess with sterling notes, which ended up in the hands of French merchants. Having no use for British currency, these merchants (or their bankers in London) presented it to the Bank of England for conversion into gold. They then presented that gold to the Bank of France for conversion into francs. The money supply fell in the deficit country, Britain, and rose in the surplus country, France. In other words, nothing essential differed from the version of the price-specie flow model elaborated by Hume. Money supplies having moved in opposite directions in the two countries, relative prices would adjust as before, eliminating the trade imbalance. The only difference was that the money supply that initiated the process took the form of paper currency. Gold, rather than moving from circulation in the deficit country to circulation in the surplus country, moved from one central bank to the other. ### Holes in the Cunliffe model But the Cunliffe version continued to predict, at odds with reality, substantial transactions in gold. To eliminate this discrepancy it was necessary to introduce other actions by central banks. When a country ran a payments deficit and began losing gold, its central bank could intervene to speed up the adjustment of the money supply. By reducing the money supply, central bank intervention put downward pressure on prices and enhanced the competitiveness of domestic goods, eliminating the external deficit as effectively as a gold outflow. Extending the model to include a central bank that intervened to reinforce the impact of incipient gold flows on the domestic money supply thus could explain how external adjustment took place in the absence of substantial gold movements. ### Discount rate - like supply chain (reverse) factoring See also: [[Gold Standard#Clarification on the role of the discount rate from the World Gold Council]] ==Typically, the instrument used was the discount rate.41 Banks and other financial intermediaries (known as discount houses) lent money to merchants for sixty or ninety days. The central bank could advance the bank that money immediately, in return for possession of the bill signed by the merchant and the payment of interest. Advancing the money was known as discounting the bill; the interest charged was the discount rate. Often, central banks offered to discount however many eligible bills were presented at the prevailing rate (where eligibility depended on the number and quality of the signatures the bill carried, the conditions under which it had been drawn, and its term to maturity). If the bank raised the rate and made discounting more expensive, fewer financial intermediaries would be inclined to present bills for discount and to obtain cash from the central bank. By manipulating its discount rate, the central bank could thereby affect the volume of domestic credit.42 It could increase or reduce the availability of credit to restore balance-of-payments equilibrium without requiring gold flows to take place.43 When a central bank anticipating gold losses raised its discount rate, reducing its holdings of domestic interest-bearing assets, cash was drained from the market. The money supply declined and external balance was restored without requiring actual gold outflows.== #### The above mechanic was the implicit "rules of the game", but which were not followed due to various reasons: - profitability, as central banks were private entities - decline in market share meant changes in the discount rate were ineffective (eventually fixed by issuing bills) - pressure from the government not to: - depress the economy by raising interest rates - make it difficult for the government to service debts This behavior on the part of central banks came to be known as playing by the rules of the game. There existed no rule book prescribing such behavior, of course. “The rules of the game” was a phrase coined in 1925 by the English economist John Maynard Keynes, when the prewar gold standard was but a memory.45 That the term was introduced at that late date should make us suspicious that central banks were guided, even implicitly, by a rigid code of conduct. In fact, they were not so guided, although this discovery was made only indirectly. In an influential treatise published in 1944 whose purpose was to explain why the international monetary system had functioned so poorly in the 1920s and 1930s, Ragnar Nurkse tabulated by country and year the number of times between 1922 and 1938 that the domestic and foreign assets of central banks moved together, as if the authorities had adhered to “the rules of the game,” and the number of times they did not.46 Finding that domestic and foreign assets moved in opposite directions in the majority of years, Nurkse attributed the instability of the interwar gold standard to widespread violations of the rules and, by implication, the stability of the classical gold standard to their preservation. But when in 1959 Arthur Bloomfield replicated Nurkse’s exercise using prewar data, he found to his surprise that violations of the rules were equally prevalent before 1913. Clearly, then, factors other than the balance of payments influenced central banks’ decisions about where to set the discount rate. Profitability was one of these, given that many central banks were privately owned. If the central bank set the discount rate above market interest rates, it might find itself without business. This was a problem for the Bank of England beginning in the 1870s. The growth of private banking after mid-century had reduced the Bank’s market share. Previously, it had been “so strong that it could have absorbed all the other London banks, their capitals and their reserves, and yet its own capital would not have been exhausted.”47 When the Bank’s discounts were reduced to only a fraction of those of its competitors, a rise in its discount rate (Bank rate) had less impact on market rates. Raising Bank rate widened the gap between it and market rates, depriving the Bank of England of business. If the gap grew too large, Bank rate might cease to be “effective”—it might lose its influence over market rates. Only with time did the Bank of England learn how to restore Bank rate’s effectiveness by selling bills (in conjunction with repurchase agreements) in order to drive down their price, pushing market rates up toward Bank rate.48 Another consideration was that raising interest rates to stem gold outflows might depress the economy. Interest-rate hikes increased the cost of financing investment and discouraged the accumulation of inventories, although central banks were largely insulated from the political fallout. Finally, central banks hesitated to raise interest rates because doing so increased the cost to the government of servicing its debt. Even central banks that were private institutions were not immune from pressure to protect the government from this burden. The Bank of France, though privately owned, was headed by a civil servant appointed by the minister of finance. Three of the twelve members of the Bank’s Council of Regents were appointed by the government. Most employees of the German Reichsbank were civil servants. Although the Reichsbank directorate decided most policy questions by majority vote, in the case of conflict with the government it was required to follow the German chancellor’s instructions. #### Defending gold convertibility required insulation from political pressures. Credible commitments to maintaining gold convertibility gave central banks more leeway to deviate from the rules. Any simple notion of “rules of the game” would therefore be misleading—increasingly so over time. Central banks had some discretion over the policies they set. They were well shielded from political pressures, but insulation was never complete. Still, their capacity to defend gold convertibility in the face of domestic and foreign disturbances rested on limits on the political pressure that could be brought to bear on the central bank to pursue other objectives incompatible with the defense of gold convertibility. Among those in a position to influence policy, there was a broad-based consensus that the maintenance of convertibility should be a priority. As we shall now see, the stronger that consensus and the policy credibility it provided, the more scope central banks possessed to deviate from the “rules” without threatening the stability of the gold standard. ### The gold standard as a historically-specific institution #### How did trade imbalances resolve if the "rules" were not followed? ##### (1) many factors helped insulate central banks from political pressures ##### (2) Prices and wages were flexible If not through strict fidelity to the rules of the game, how then was balance-of-payments adjustment achieved in the absence of significant gold flows? This question is the key to understanding how the gold standard worked. Answering it requires understanding that this international monetary system was more than the set of equations set out in textbooks in the section headed “gold standard.” It was a socially constructed institution whose viability hinged on the context in which it operated. The cornerstone of the prewar gold standard was the priority attached by governments to maintaining convertibility. In the countries at the center of the system—Britain, France, and Germany—there was no doubt that officials would ultimately do what was necessary to defend the central bank’s gold reserve and maintain the convertibility of the currency. “In the case of each central bank,” concluded the English economist P. B. Whale from his study of the nineteenth-century monetary system, “the primary task was to maintain its gold reserve at a figure which safeguarded the attachment of its currency to the gold standard.”50 Other considerations might influence at most the timing of the actions taken by the authorities. As long as there was no articulated theory of the relationship between central bank policy and the economy, observers could disagree over whether the level of interest rates was aggravating unemployment.51 The pressure twentieth-century governments experienced to subordinate currency stability to other objectives was not a feature of the nineteenth-century world. The credibility of the government’s commitment to convertibility was enhanced by the fact that the workers who suffered most from hard times were ill positioned to make their objections felt. In most countries, the right to vote was still limited to men of property (women being denied the vote virtually everywhere). Labor parties representing working men remained in their formative years. The worker susceptible to unemployment when the central bank raised the discount rate had little opportunity to voice his objections, much less to expel from office the government and central bankers responsible for the policy. The fact that wages and prices were relatively flexible meant that a shock to the balance of payments that required a reduction in domestic spending could be accommodated by a fall in prices and costs rather than a rise in unemployment, further diminishing the pressure on the authorities to respond to employment conditions. For all these reasons the priority that central banks attached to maintaining currency convertibility was rarely challenged. #### Central Bank credibility led to stabilizing capital inflows from investors anticipating inhervention; thus, central banks had leeway to deviate from the rules in the short term Hence, central banks could delay intervening as ordained by the rules of the game without suffering alarming reserve losses. They could even intervene in the opposite direction for a time, offsetting rather than reinforcing the impact of reserve losses on the money supply. Doing so neutralized the impact of reserve flows on domestic markets and minimized their impact on output and employment.56 Central banks could deviate from the rules of the game because their commitment to the maintenance of gold convertibility was credible. Although it was possible to find repeated violations of the rules over periods as short as a year, over longer intervals central banks’ domestic and foreign assets moved together. Central banks possessed the capacity to violate the rules of the game in the short run because there was no question about obeying them in the long run.57 Knowing that the authorities would ultimately take whatever steps were needed to defend convertibility, investors shifted capital toward weak-currency countries, financing their deficits even when their central banks temporarily violated the rules of the game.58