Carroll Quigley - Tragedy and Hope - A History of the World in Our Time

In other countries the stabilization period was not so happy. In Britain, stabilization was reached by orthodox paths—that is, taxation as a cure for public debts and deflation as a cure for inflation. These cures were believed necessary in order to go back on the old gold parity. Since Britain did not have an adequate supply of gold, the policy of deflation had to be pushed ruthlessly in order to reduce the volume of money in circulation to a quantity small enough to be superimposed on the small base of available gold at the old ratios. At the same time, the policy was intended to drive British prices down to the level of world prices. The currency notes which had been used to supplement bank notes were retired, and credit was curtailed by raising the discount rate to panic level. The results were horrible. Business activity fell drastically, and unemployment rose to well over a million and a half. The drastic fall in prices (from 307 in 1920 to 197 in 1921) made production unprofitable unless costs were driven down even faster. This could not be achieved because labor unions were determined that the burden of the deflationary policy should not be pushed onto them by forcing down wages. The outcome was a great wave of strikes and industrial unrest.

The British government could measure the success of their deflation only by comparing their price level with world price levels. This was done by means of the exchange ratio between the pound and the dollar. At that time the dollar was the only important currency on gold. It was expected that the forcing down of prices in Britain would be reflected in an increase in the value of the pound in terms of dollars on the foreign exchange market. Thus as the pound rose gradually upward toward the pre-war rate of $4.86, this rise would measure the fall in British prices downward to the American (or the world) price level. In general terms, this was true, but it failed to take into consideration the speculators who, knowing that the value of the pound was rising, sold dollars to buy pounds, thus pushing the dollar down and the pound upward faster than was justified in terms of the changes in price levels in the two countries. Thus the pound rose to $4.86, while the British price level had not yet fallen to the American price level, but the Chancellor of the Exchequer, Winston Churchill, judging the price level by the exchange rate, believed that it had and went back on the gold standard at that point. As a result, sterling was overvalued and Britain found itself economically isolated on a price plateau above the world market on which she was economically dependent. These higher British prices served to increase imports, decrease exports, and encourage an outflow of gold which made gold reserves dangerously low. To maintain the gold reserve at all, it was necessary to keep the discount rate at a level so high (4% percent or more) that business activity was discouraged. The only solution which the British government could see to this situation was continued deflation. This effort to drive down prices failed because the unions were able to prevent the drastic cutting of costs (chiefly wages) necessary to permit profitable production on such a deflationary market. Nor could the alternative method of deflation—by heavy taxation—be imposed to the necessary degree on the upper classes who were in control of the’ government. The showdown on the deflationary policy came in the General Strike of 1926. The unions lost the strike—that is, they could not prevent the policy of deflation—but they made it impossible for the government to continue the reduction of costs to the extent necessary to restore business profits and the export trade.

As a result of this financial policy, Britain found herself faced with deflation and depression for the whole period 1920-1933. These effects were drastic in 1920-1922, moderate in 1922-1929, and drastic again in 1929-1933. The wholesale price index (1913 = 100) fell from 307 in 1920 to 197 in 1921, then declined slowly to 137 in 1928. Then it fell rapidly to 120 in 1929 and 90 in 1933. The number of unemployed averaged about 1% millions for each of the thirteen years of 1921-1932 and reached 3 million in 1931. At the same time, the inadequacy of the British gold reserve during most of the period placed Britain in financial subjection to France (which had a plentiful supply of gold because of her different financial policy). This subjection served to balance the political subjection of France to Britain arising from French insecurity, and ended only with Britain’s abandonment of the gold standard in 1931.

Britain was the only important European country which reached stabilization through deflation. East of her, a second group of countries, including Belgium, France, and Italy, reached stabilization through devaluation. This was a far better method. It was adopted, however, not because of superior intelligence but because of financial weakness. In these countries, the burden of war-damage reconstruction made it impossible to balance a budget, and this made deflation difficult. These countries accepted orthodox financial ideas and tried to deflate in 1920-1921, but, after the depression which resulted, they gave up the task. Belgium stabilized once at 107 francs to the pound sterling, but could not hold this level and had to devaluate further to 175 to the pound (October 1926). France stabilized at 124.21 francs to the pound at the end of 1926, although the stabilization was made de jure only in June 1928. Italy stabilized at 92.46 lire to the pound sterling in December 1927.

The group of countries which reached stabilization through devaluation prospered in contrast with those who reached stabilization through deflation. The prosperity was roughly equal to the degree of devaluation. Of the three Latin countries—Belgium, France, and Italy—Belgium devalued the most and was most prosperous. Her stabilization was at a price level below the world level so that the belga was undervalued by about one-fifth. This served to encourage exports. For an industrial country such as Belgium, this made it possible for her to profit by the misfortunes of Britain. France was in a somewhat similar position. Italy, on the contrary, stabilized at a figure which made the lira considerably overvalued. This was done for purposes of prestige—Mussolini being determined to stabilize the lira at a value higher than that of the French franc. The effects of this overvaluation of the lira on the Italian economy were extremely adverse. Italy was never as prosperous after stabilization as she had been immediately before it.

Not only did the countries which undervalued their money prosper; they decreased the disequilibrium between wealth and money; they were able to use the inflation to increase production; they escaped high taxes; they moderated or escaped the stabilization crisis and the deflationary depression; they improved their positions in the world market in respect to high-cost countries like Britain; and they replenished their gold stocks.

A third group of countries reached stabilization through reconstruction. These were the countries in which the old monetary unit had been wiped out and had to be replaced by a new monetary unit. Among these were Austria, Hungary, Germany, and Russia. The first two of these were stabilized by a program of international assistance worked out through the League of Nations. The last was forced to work out a financial system by herself. Germany had her system reorganized as a consequence of the Dawes Plan. The Dawes Plan, as we have seen in our discussion of reparations, provided the gold reserves necessary for a new currency and provided a control of foreign exchange which served to protect Germany from the accepted principles of orthodox finance. These controls were continued until 1930, and permitted Germany to borrow from foreign sources, especially the United States, the funds necessary to keep her economic system functioning with an unbalanced budget and an unfavorable balance of trade. In the period 1924-1929, by means of these funds, the industrial structure of Germany was largely rebuilt so that, when the depression arrived, Germany had the most efficient industrial machine in Europe and probably the second most efficient in the world (after the United States). The German financial system had inadequate controls over inflation and almost none over deflation because of the Dawes Plan restrictions on the open-market operations of the Reichsbank and the generally slow response of the German economy to changes in the discount rate. Fortunately, such controls were hardly necessary. The price level was at 137 in 1924 and at the same figure in 1929 (1913=100). In that six-year period it had reached as high as 142 (in 1925) and fallen as low as 134 (in 1926). This stability in prices was accompanied by stability in economic conditions. While these conditions were by no means booming, there was only one bad year before 1930. This was 1926, the year in which prices fell to 134 from the 1925 level of 142. In this year unemployment averaged 2 million. The best year was 1925, in which unemployment averaged 636,000. This drop in prosperity from 1925 to 1926 was caused by a lack of credit as a result of the inadequate supplies of domestic credit and a temporary decline in the supplies of foreign credit. It was this short slump in business which led Germany to follow the road to technological reorganization. This permitted Germany to increase output with decreasing employment. The average annual increase in labor productivity in the period 1924-1932 in Germany was about 5 percent. Output per labor hour in industry rose from 87.8 in 1925 to 115.6 in 1930 and 125 in 1932 (1928=100). This increase in output served to intensify the impact of the depression in Germany, so that unemployment, which averaged about three million in the year 1930, reached over six million late in 1932. The implications of this will be examined in detail in our study of the rise to power of Hitler. The stabilization period did not end until about 1931, although only minor Powers were still stabilizing in the last year or so. The last Great Power to stabilize de jure was France in June, 1928, and she had been stabilized de facto much earlier. In the whole period, about fifty countries stabilized their currencies on the gold standard. But because of the quantity of gold necessary to maintain the customary reserve ratios (that is, the pre-1914 ratios) at the higher prices generally prevailing during the period of stabilization, no important country was able to go back on the gold standard as the term was understood in 1914. The chief change was the use of the “gold exchange standard” or the “gold bullion standard” in place of the old gold standard. Under the gold exchange standard, foreign exchange of gold standard countries could be used as reserves against notes or deposits in place of reserves in gold. In this way, the world’s limited supplies of gold could be used to support a much greater volume of fictitious wealth in the world as a whole since the same quantity of gold could act as bullion reserve for one country and as gold exchange reserve for another. Even those countries which stabilized on a direct gold standard did so in a quite different way from the situation in 1914. In few countries was there free and gratuitous convertibility between notes, coin, and bullion. In Great Britain, for example, by the Gold Standard Act of May 1925, notes could be exchanged for gold only in the form of bullion and only in amounts of at least 400 fine ounces (that is, not less than $8,268 worth at a time). Bullion could be presented to the mint for coinage only by the Bank of England, although the bank was bound to buy all gold offered at 77 s . 10 1/2 d. per standard ounce. Notes could be converted into coin only at the option of the bank. Thus the gold standard of 1925 was quite different from that of 1914.