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

These realities were characterized by (a) fundamental maladjustments, both economic and financial, which made it impossible for the financial system to function as it had in 1914, and (b) the steady deflation.

The fundamental maladjustments were both economic and financial. The economic maladjustments were those which we have already indicated: the industrialization of colonial areas; the overproduction of raw materials and food as a result of wartime high prices, the overexpansion of heavy industry as a result of wartime needs, the obsolescence of much of heavy industry in Europe and in Britain which made it impossible to compete with newer equipment or to cope with the shifts in consumer demand, and the steadily increasing disadvantage of producers of raw materials and food in contrast with producers of industrial goods. To these old factors were added new ones such as the great increase in productive efficiency in Germany and the United States, the return of Russia and Germany to the European economy about 1924, and the return of Europe to the world economy in the period 1925-1927. Many countries sought to resist these factors, both old and new, by adopting political interference with economic life in the form of tariffs, import quotas, export subsidies, and so on.

The financial maladjustments served to create an insufficiency of gold and a maldistribution of gold. The inadequacy of the supply of gold arose from several causes. It has been estimated that the world’s stock of gold money needed to increase by 3.1 percent per year in the 1920’s to support the world’s economic development with stable prices on the gold standard. The production of new gold after 1920 was below this rate.

Moreover, as a result of the activities of the League of Nations and financial advisers like Professor E. W. Kemmerer of Princeton University, every country was encouraged to get on the gold standard. This led to a “gold rush” as each country tried to obtain a supply of gold large enough to provide adequate reserves. Because there were more countries on gold in 1928 than in 1914 and because prices in general were higher, more gold was needed in reserves.

The efforts to get around this by using a gold exchange standard rather than a gold standard were helpful in dealing with the problem of inadequate supplies of gold but increased the difficulty of the problem of maldistribution of gold, since the gold exchange standard did not respond to the flow of gold as readily and thus did not serve so well to stem such flows of gold. The need for gold was made greater by the existence of large floating balances of political or panic funds which might well move from one market to another independent of economic conditions. The need was increased by the fact that in 1920 there were three major financial centers which had to make payments by shipments of gold in contrast to the single financial center of 1914 where payments could be made by bookkeeping transactions. To rectify this problem to some degree, the Bank for International Settlements was created in 1929 but never functioned as its founders had hoped. Finally, the need for gold was increased by the enormous growth in foreign indebtedness, much of it of a political nature such as the war debts and reparations.

On top of this insufficiency of gold was superimposed a drastic maldistribution of gold. This was conclusive proof that the financial system of 1914 had broken down, for the old system would have operated automatically to distribute gold evenly. This maldistribution resulted from the fact that when gold flowed into certain countries the automatic results of such a flow (such as rising prices or falling interest rates) which would have restored equilibrium in 1914 were prevented from acting in 1928. In this period, about four-fifths of the world’s gold supply was in five countries, and over half was in two, the United States and France. The gold had been brought to these two for quite different reasons—to the United States because it was the world’s greatest creditor and to France because of its devaluation of the franc. Britain, on the other hand, had floating balances of about , £ 800 million, and handled each year £ 20,000 million in transactions with a gold reserve of only £ 150 million. Such a situation made it possible for France to use gold as a political weapon against Britain.

As a result of these conditions and the deflationary economic conditions described in Chapter 11, prices began to fall, at first slowly and then with increasing rapidity. The turning point in most countries was in 1925-1926, with Great Britain one of the earliest (January 1925). In the first half of 1929, this slow drift downward began to change to a rapid drop. The following table will show the changes in wholesale prices for five principal countries:

Wholesale Price Indices

(1913

= 100)

UNITED STATES

BRITAIN

FRANCE

ITALY

GERMANY

1924

141

166

489

554

137

1925

148

159

550

646

142

1926

143

148

695

654

134

1927

137

142

642

527

138

1928

139

137

645

491

140

1929

137

120

627

481

137

1930

124

104

554

430

125

1931

I05

102

520

376

111

1932

93

90

427

351

97

1933

95

90

398

320

93

1934

108

92

376

313

98

1935

115

93

339

344

102

1936

116

99

411

385

104

*937

124

114

581

449

106

The economic effects of these soft prices after 1925 were adverse, but these effects were concealed for a considerable period because of various influences, especially the liberal credit policies of the United States (both foreign and domestic) and the optimism engendered by the stock-market boom. The facade of prosperity over unsound economic conditions was practically worldwide. Only in France and the United States was it a boom in real wealth, but in the latter it was by no means as great as one might think from a glance at stock prices. In Britain, the boom appeared in the form of the flotation of new stocks of unsound and fraudulent companies and a minor stock-market boom (about one-third as fast a rise in security prices as in the United States). In Germany and in much of Latin America, the boom was based upon foreign borrowing (chiefly from the United States) the proceeds of which were largely put into nonproductive construction. In Italy, held down by the over-evaluation of the lira in 1927, the boom was of short duration.

THE CRASH OF 1929

The history of the slump begins about 1927 when France stabilized the franc de facto at a level at which it was devalued and undervalued. This led to a great demand for francs. The Bank of France sold francs in return for foreign exchange. The francs were created as credit in France, thus giving an inflationary effect which can be seen in the behavior of French prices in 1926-1928. The foreign exchange which France received for its francs was largely left in that form without being converted into gold. By 1928 the Bank of France found that it held foreign exchange to the value of 32 billion francs (about $1.2 billion). At this point the Bank of France began to transfer its exchange holdings into gold, buying the metal chiefly in London and New York. Because of the inadequate gold reserves in London, a meeting of central bankers in New York decided that the gold purchases of France and Germany should be diverted from London to New York in the future (July 1927). To prevent the resulting outflow of gold from having a deflationary effect which might injure business, the New York Federal Reserve Bank dropped its discount rate from 4 percent to 3% percent. When the French gold purchases became noticeable in 1928, the Federal Reserve Bank adopted open market operations to counterbalance them, buying securities to a value equal to the French purchases of gold.