Currency wars resemble most wars in the sense that they have identifiable antecedents. The three most powerful antecedents of CWI were the classical gold standard from 1870 to 1914, the creation of the Federal Reserve from 1907 to 1913, and World War I and the Treaty of Versailles from 1914 to 1919. A brief survey of these three periods helps one to understand the economic conflicts that followed.
The Classical Gold Standard—1870 to 1914
Gold has served as an international currency since at least the sixth century BC reign of King Croesus of Lydia, in what is modern-day Turkey. More recently, England established a gold-backed paper currency at a fixed exchange rate in 1717, which continued in various forms with periodic wartime suspensions until 1931. These and other monetary regimes may all go by the name “gold standard”; however, that term does not have a single defined meaning. A gold standard may include everything from the use of actual gold coins to the use of paper money backed by gold in various amounts. Historically the amount of gold backing for paper money has ranged from 20 percent up to 100 percent, and sometimes higher in rare cases where the value of official gold is greater than the money supply.
The classical gold standard of 1870 to 1914 has a unique place in the history of gold as money. It was a period of almost no inflation—in fact, a benign deflation prevailed in the more advanced economies as the result of technological innovation that increased productivity and raised living standards without increasing unemployment. This period is best understood as the first age of globalization, and it shares many characteristics with the more recent, second age of globalization that started in 1989 with the end of the Cold War.
The first age of globalization was characterized by technological improvements in communication and transportation, so that bankers in New York could speak on the phone to their partners in London and travel time between the two financial hubs could be as short as seven days. These improvements may not have been widespread, but they did facilitate global commerce and banking. Bonds issued in Argentina, underwritten in London and purchased in New York created a dense web of interconnected assets and debts of a kind quite familiar to bankers today. Behind this international growth and commerce was gold.
The classical gold standard was not devised at an international conference like its twentieth-century successors, nor was it imposed top-down by a multilateral organization. It was more like a club that member nations joined voluntarily. Once in the club, those members behaved according to well-understood rules of the game, although there was no written rulebook. Not every major nation joined, but many did, and among those who joined, capital accounts were open, free market forces prevailed, government interventions were minimal and currency exchange rates were stable against one another.
Some nations had been on a gold standard since well before 1870, including England in 1717 and the Netherlands in 1818, but it was in the period after 1870 that a flood of nations rushed to join them and the gold club took on its distinctive character. These new members included Germany and Japan in 1871, France and Spain in 1876, Austria in 1879, Argentina in 1881, Russia in 1893 and India in 1898. While the United States had been on a de facto gold standard since 1832, when it began minting one-troy-ounce gold coins worth about twenty dollars at the time, it did not legally adopt a gold standard for the conversion of paper money until the Gold Standard Act of 1900, making the United States one of the last major nations to join the classical gold system.
Economists are nearly unanimous in pointing out the beneficial economic results of this period. Giulio M. Gallarotti, the leading theorist and economic historian of the classical gold standard period, summarizes this neatly in The Anatomy of an International Monetary Regime: Among that group of nations that eventually gravitated to gold standards in the latter third of the 19th century (i.e., the gold club), abnormal capital movements (i.e., hot money flows) were uncommon, competitive manipulation of exchange rates was rare, international trade showed record growth rates, balance-of-payments problems were few, capital mobility was high (as was mobility of factors and people), few nations that ever adopted gold standards ever suspended convertibility (and of those that did, the most important returned), exchange rates stayed within their respective gold points (i.e., were extremely stable), there were few policy conflicts among nations, speculation was stabilizing (i.e., investment behavior tended to bring currencies back to equilibrium after being displaced), adjustment was quick, liquidity was abundant, public and private confidence in the international monetary system remained high, nations experienced long-term price stability (predictability) at low levels of inflation, long-term trends in industrial production and income growth were favorable and unemployment remained fairly low.
This highly positive assessment by Gallarotti is echoed by a study published by the Federal Reserve Bank of St. Louis, which concludes, “Economic performance in the United States and the United Kingdom was superior under the classical gold standard to that of the subsequent period of managed fiduciary money.” The period from 1870 to 1914 was a golden age in terms of noninflationary growth coupled with increasing wealth and productivity in the industrialized and commodity-producing world.
A great part of the attraction of the classical gold standard was its simplicity. While a central bank might perform certain functions, no central bank was required; indeed the United States did not have a central bank during the entire period of the classical gold standard. A country joining the club merely declared its paper currency to be worth a certain amount in gold and then stood ready to buy or sell gold at that price in exchange for currency in any quantity from another member. The process of buying and selling gold near a target price in order to maintain that price is known today as an open market operation. It can be performed by a central bank, but that is not strictly necessary; it can just as well be performed by a government operating directly or indirectly through fiscal agents such as banks or dealers. Each authorized dealer requires access to a reasonable supply of gold with the understanding that in a panic more gold could readily be obtained. Although government intervention is involved, it is conducted transparently and can be seen as stabilizing rather than manipulating.
The benefit of this system in international finance is that when two currencies become anchored to a standard weight of gold, they also became anchored to each other. This type of anchoring does not require facilitation by institutions such as the IMF or the G20. In the classical gold standard period, the world had all the benefits of currency stability and price stability without the costs of multilateral overseers and central bank planning.
Another benefit of the classical gold standard was its self-equilibrating nature not only in terms of day-to-day open market operations but also in relation to larger events such as gold mining production swings. If gold supply increased more quickly than productivity, which happened on occasions such as the spectacular discoveries in South Africa, Australia and the Yukon between 1886 and 1896, then the price level for goods would go up temporarily. However, this would lead to increased costs for gold producers that would eventually lower production and reestablish the long-term trend of price stability. Conversely, if economic productivity increased due to technology, the price level would fall temporarily, which meant the purchasing power of money would go up. This would cause holders of gold jewelry to sell and would increase gold mining efforts, leading eventually to increased gold supply and a restoration of price stability. In both cases, the temporary supply and demand shocks in gold led to changes in behavior that restored long-term price stability.
In international trade, these supply and demand factors equilibrated in the same way. A nation with improving terms of trade—an increasing ratio of export prices versus import prices—would begin to run a trade surplus. This surplus in one country would be mirrored by deficits in others whose terms of trade were not as favorable. The deficit nation would settle with the surplus nation in gold. This caused money supply in the deficit nation to shrink and money
supply in the surplus nation to expand. The surplus nation with the expanding money supply experienced inflation while the deficit nation with the decreasing money supply experienced deflation. This inflation and deflation in the trading partners would soon reverse the initial terms of trade. Exports from the original surplus nation would begin to get more expensive, while exports from the original deficit nation would begin to get less expensive. Eventually the surplus nation would go to a trade deficit and the deficit nation would go to a surplus. Now gold would start to flow back to the nation that had originally lost it. Economists called this the price-specie-flow mechanism (also the price-gold-flow mechanism).
This rebalancing worked naturally without central bank intervention. It was facilitated by arbitrageurs who would buy “cheap” gold in one country and sell it as “expensive” gold in another country once exchange rates, the time value of money, transportation costs and bullion refining costs were taken into account. It was done in accordance with the rules of the game, which were well-understood customs and practices based on mutual advantage, common sense and the profits of arbitrage.
Not every claim had to be settled in gold immediately. Most international trade was financed by short-term trade bills and letters of credit that were self-liquidating when the imported goods were received by the buyer and resold for cash without any gold transfers. The gold stock was an anchor or foundation for the overall system rather than the sole medium of exchange. Yet it was an efficient anchor because it obviated currency hedging and gave merchants greater certainty as to the ultimate value of their transactions.
The classical gold standard epitomized a period of prosperity before the Great War of 1914 to 1918. The subsequent and much maligned gold exchange standard of the 1920s was, in the minds of many, an effort to return to a halcyon prewar age. However, efforts in the 1920s to use the prewar gold price were doomed by a mountain of debt and policy blunders that turned the gold exchange standard into a deflationary juggernaut. The world has not seen the operation of a pure gold standard in international finance since 1914.
The Creation of the Federal Reserve—1907 to 1913
The second of the currency war antecedents was the creation of the Federal Reserve System in 1913. That story has antecedents of its own, and for those one must look back even further, to the Panic of 1907. This panic began amid a failed attempt by several New York banks, including one of its largest, the Knickerbocker Trust, to corner the copper market. When Knickerbocker’s involvement in the scheme came to light, a classic run on the bank commenced. If the Knickerbocker revelations had occurred in calmer markets, they might not have triggered such a panicked response, but the market was already nervous and volatile after massive losses caused by the 1906 San Francisco earthquake.
The failure of the Knickerbocker Trust was just the beginning of a more general loss of confidence, which led to another stock market crash, even further bank runs, and finally a full-scale liquidity crisis and threat to the stability of the financial system as a whole. This threat was stemmed only by collective action of the leading bankers of the day in the form of a private financial rescue organized by J. P. Morgan. In one of the most famous episodes in U.S. financial history, Morgan summoned the financiers to his town house in the Murray Hill neighborhood of Manhattan and would not allow them to leave until they had hammered out a rescue plan involving specific financial commitments by each one intended to calm the markets. The plan worked, but not before massive financial losses and dislocations had been sustained.
The immediate result of the Panic of 1907 was a determination by the bankers involved in the rescue that the United States needed a central bank—a government-established bank with the ability to issue newly created funds to bail out the private banking system when called upon. The bankers wanted a government-sponsored facility that could lend them unlimited amounts of cash against a broad range of collateral. The bankers realized that J. P. Morgan would not always be around to provide leadership, and some future panic could call for solutions that exceeded even the resources and talents of the great Morgan himself. A central bank to act as an unlimited lender of last resort to private banks was needed before the next panic arose.
America had a long history of antipathy to central banks. There had been two efforts at something like a central bank in U.S. history prior to 1913. The first of these, the Bank of the United States, was chartered by Congress at the urging of Alexander Hamilton in 1791, but its charter expired in 1811 during the presidency of James Madison and a bill to recharter the bank failed by a single vote. Five years later, Madison steered the chartering of a Second Bank of the United States through Congress. But this second charter had a limited life of twenty years and would be up for renewal in 1836.
When the time for renewal came, the Second Bank ran into opposition not only in Congress but from the White House. President Andrew Jackson had based part of his 1832 presidential campaign on a platform of abolishing the bank. After a contentious national debate, which included Jackson pulling all U.S. Treasury deposits out of the Second Bank of the United States and placing them in state-chartered banks, the rechartering did pass Congress. Jackson vetoed it, and the charter was not renewed.
The political opposition to both national banks was based on a general distrust of concentrated financial power and a belief that the issuance of national banknotes contributed to asset bubbles that were inflated away by easy bank credit. From 1836 to 1913, an almost eighty-year period of unprecedented prosperity, innovation and strong economic growth, the United States had no central bank.
Now, literally in the rubble of the 1906 San Francisco earthquake and the financial rubble of the Panic of 1907, a concerted effort began to create a new central bank. Given the popular distrust of the idea of central banking, the bank sponsors, led by representatives of J. P. Morgan, John D. Rockefeller, Jr., and Jacob H. Schiff of the Wall Street firm Kuhn, Loeb & Company, knew that an education campaign to build popular support would need to be conducted. Their political patron, Senator Nelson W. Aldrich, Republican of Rhode Island, who was head of the Senate Finance Committee, sponsored legislation in 1908 creating the National Monetary Commission. Over the next several years, the National Monetary Commission was the platform for numerous research studies, sponsored events, speeches and affiliations with prestigious professional associations of economists and political scientists, all with a view to promoting the idea of a powerful central bank.
In September 1909, President William H. Taft publicly urged the country to consider supporting a central bank. That same month, the Wall Street Journal launched a series of editorials favoring the central bank under the heading “A Central Bank of Issue.” By the summer of the following year, the popular and political foundations had been laid and it was now time to move toward a concrete plan for the new bank. What followed was one of the most bizarre episodes in the history of finance. Senator Aldrich was to be the primary sponsor of the legislation setting up the bank, but it would have to be drafted in accordance with a plan that satisfied the wishes of New York bankers still reeling from the Panic of 1907 and still searching for a lender of last resort to bail them out the next time a panic arose. A committee of bankers was needed to draft the plan for the central bank.
In November 1910, Aldrich convened a meeting to be attended by himself, several Wall Street bankers and Abram Piatt Andrew, the recently appointed assistant secretary of the Treasury. The bankers included Paul Warburg of Kuhn, Loeb; Frank A. Vanderlip of the Rockefeller-controlled National City Bank of New York; Charles D. Norton of the Morgan-controlled First National Bank of New York; and Henry P. Davison, the most senior and powerful partner at J. P. Morgan & Company after Morgan himself. Andrew was a Harvard economist who would act as technical adviser to this carefully balanced group of Morgan and Rockefeller interests.
Aldrich instructed his delegation to meet under cover of darkness at an isolated railway siding in Hoboken, New Jersey, where a private railroad car would be waiti
ng. The men were told to come singly and to avoid reporters at all costs. Once aboard the train, they used first names only so that porters could not identify them to friends or reporters once they left the train; some of the men adopted code names as an extra layer of security. After traveling for two days, they arrived in Brunswick, Georgia, along the Atlantic coast about halfway between Savannah and Jacksonville, Florida. From there they took a launch to Jekyll Island and checked into the exclusive Jekyll Island Club, partly owned by J. P. Morgan. The group worked for over a week to hammer out the Aldrich bill, which would become the blueprint for the Federal Reserve System.
It still took over three years to pass the Federal Reserve Act, the formal name given to the Aldrich bill based on the Jekyll Island plan. The Federal Reserve Act finally passed with large majorities on December 23, 1913, and went into effect in November 1914.
The Federal Reserve Act of 1913 contained many features promoted by Aldrich and Warburg designed to overcome traditional objections to a U.S. central bank. The new entity would not be called a central bank but rather the Federal Reserve System. It would not be a single entity but rather a collection of regional reserve banks guided by a Federal Reserve Board whose members would not be picked by bankers but rather by the president and subject to Senate confirmation.
On the whole, it looked decentralized and under the control of democratically elected officials. Inside the plan, however, was a de facto mechanism much more in line with the true intent of the Aldrich party on Jekyll Island. Actual monetary policy, conducted through open market operations, would be dominated by the Federal Reserve Bank of New York since New York was the location of the major banks and dealers with whom the Fed would do business. The Federal Reserve Bank of New York was run by a board of directors and governor, not selected by politicians but selected by its stockholders, who were dominated by the large New York banks. The result was a “Fed within the Fed,” run by the New York banks and amenable to their goals, including easy credit for bailouts as needed.
Currency Wars: The Making of the Next Global Crisis Page 6
