A History of Money and Banking in the United States: The Colonial Era to World War II

by Murray N. Rothbard

  If our workmen were prepared to accept a reduction of 10 percent in their wages or increase their efficiency by 10 percent, a large proportion of our present unemployment could be overcome. But in fact organized labor is so attached to the maintenance of the present standard of wages and hours of labor that they would prefer that a million workers should remain in idleness and be maintained permanently out of the Employment Fund, than accept any sacrifice. The result is to throw on to the capital and managerial side of industry a far larger reorganization than would be necessary: and until labor is prepared to contribute in larger measure to the process of reconstruction, there will inevitably be unemployment.73

  Leith-Ross might have added that the “preference” for unemployment was made not by the unemployed themselves but by the union leadership on their alleged behalf, a leadership which itself did not have to face the unemployment dole. Moreover, the willingness of the workers to accept this deal might have been very different if there were no generous Employment Fund for them to tap.

  It was in fact the highly militant coal miners’ union, led by the prominent leftist Aneurin “Nye” Bevan, that was the first to stir up grave doubt about the glory of the British return to gold. Not only was coal a highly unionized export industry located in the north, but already overinflated coal-mining wages had been given an extra boost during the first Labor government of Ramsay MacDonald, in 1924. In addition to the high wage rates, the miners’ union insisted on numerous cost-raising restrictive, featherbedding practices, some of them resurrected from the defunct postmedieval guilds. These obstructionist tactics helped rigidify the British economy, preventing changes and adaptations of occupation and location, and hampering rationalizing and innovative managerial practices. As Professor Benham trenchantly pointed out:

  Employers who wished to make changes had to face the powerful opposition of organized labor. The introduction of new methods, such as the “more looms to a weaver” system, was resisted. Strict lines of demarcation between occupations were maintained in engineering and elsewhere. A plumber could repair a pipe conveying cold water; if it conveyed hot water, he had to call in a hot water engineer. Entry into certain occupations was rendered difficult. A man can become an efficient building operative in a few months; an apprenticeship of four years was required. British railways could not have their labour force as they chose. A host of restrictions, insisted upon by the Trade Unions, made this impossible.74

  By 1925, the year of the return to gold, British coal was already facing competition of rehabilitated, newly modernized, low-cost coal mines in France, Belgium, and Germany. British coal was no longer competitive, and its exports were slumping badly. The Baldwin government appointed a royal commission, headed by Sir Herbert Samuel, to study the vexed coal question. The Samuel Commission reported in March 1926, urging that miners accept a moderate cut in wages, and an increase in working hours at current pay, and suggesting that a substantial number of miners move to other areas, such as the south, where employment opportunities were greater. But this was not the sort of rational solution that would appeal to the spoiled, militant unions, who rejected those proposals and went on strike, thereby generating the traumatic and abortive general strike of 1926.

  The strike was broken, and coal-mining wages fell slightly, but the victory for rationality was all too pyrrhic. Keynes was able to convince the inflationist press magnate, Lord Beaverbrook, that the miners were victims of a Norman–Churchill–international banker conspiracy to profit at the expense of the British working class. But instead of identifying the problem as inflationism, cheap money, and the gold bullion–gold-exchange standard in the face of an overvalued pound, Beaverbrook and British public opinion pointed to “hard money” as the villain responsible for recession and unemployment. Instead of tightening the money supply and interest rates in order to preserve its own created gold standard, the British Establishment was moved to follow its own inclinations still further: to step up its disastrous commitment to inflation and cheap money.75

  During the general strike, Britain was forced to import coal from Europe instead of exporting it. In olden times, the large fall in export income would have brought about a severe liquidation of credit, contracting the money supply and lowering prices and wage rates. But the British banks, caught up as they were in the ideology of inflationism, instead expanded credit on a lavish scale, and sterling balances piled up on the continent of Europe. “Instead of a readjustment of prices and costs in England and a breaking up of the rigidities, England by credit expansion held the fort and continued the rigidities.”76

  The massive monetary inflation in Britain during 1926 caused gold to flow out of the country, especially to the United States, and sterling balances to accumulate in foreign countries, especially in France. In the true gold-standard days, Britain would have taken all this as a furious signal to contract and tighten up; instead it persisted in continuing inflationism and cheap money, lowering its crucial “bank rate” (Bank of England discount rate) from 5 percent to 4.5 percent in April 1927. This action further weakened the pound sterling, and Britain lost $11 million in gold during the next two months.

  France’s important role during the gold-exchange era has served as a convenient whipping boy for the British and for the Establishment ever since. The legend has it that France was the spoiler, by returning to gold at an undervalued franc (pegging the franc first in 1926, and then officially returning to gold two years later), consequently piling up sterling balances, and then breaking the gold-exchange system by insisting that Britain pay in gold. The reality was very different. France, during and after World War I, suffered severe hyperinflation, fueled by massive government deficits. As a result, the French franc, classically set at 19.3¢ under the old gold standard, had plunged down to 5¢ in May 1925, and accelerated its decline to 1.94¢ in late July 1926. By June 1926, Parisian mobs protesting the runaway inflation and depreciation surrounded the Chamber of Deputies, threatening violence if former Premier Raymond Poincaré, known as a staunch monetary and fiscal conservative, was not returned to his post. Poincaré was returned to office July 2, pledging to cut expenses, balance the budget, and save the franc.

  Armed with a popular mandate, Poincaré was prepared to drive through any necessary monetary and fiscal reforms. Poincaré’s every instinct urged him to return to gold at the prewar par, a course that would have been disastrous for France, being not only highly deflationary but also saddling French taxpayers with a massive public debt. Furthermore, returning to gold at the prewar par would have left the Bank of France with a very low (8.6-percent) gold reserve to bank notes in circulation. Returning at par, of course, would have gladdened the hearts of French bondholders as well as of Montagu Norman and the British Establishment. Poincaré was talked out of this path, however, by the knowledgeable and highly perceptive Emile Moreau, governor of the Bank of France, and by Moreau’s deputy governor, distinguished economist Charles Rist. Moreau and Rist were well aware of the chronic export depression and unemployment that the British were suffering because of their stubborn insistence on the prewar par. Finally, Poincaré reluctantly was persuaded by Moreau and Rist to go back to gold at a realistic par.

  When Poincaré presented his balanced budget and his monetary and financial reform package to Parliament on August 2, 1926, and drove them through quickly, confidence in the franc dramatically rallied, pessimistic expectations in the franc were changed to optimistic ones, and French capital, which had understandably fled massively into foreign currencies, returned to France, quickly doubling its value on the foreign exchange market to almost 4¢ by December. To avoid any further rise, the French government quickly stabilized the franc de facto at 3.92¢ on December 26, and then returned de jure to gold at the same rate on June 25, 1928.77

  At the end of 1926, while the franc was now pegged, France was not yet on a genuine gold standard. Officially, and de jure, the franc was still set at the prewar par, when one gold ounce had been set at approximately 10
0 francs. But now, at the new pegged value, the gold ounce, in foreign exchange, was worth 500 francs. Obviously, no one would now deposit gold at a French bank in return for 100 paper francs, thereby wiping out 80 percent of his assets. Also, the Bank of France (which was a privately owned firm) could not buy gold at the current expensive rate, for fear that the French government might decide, after all, to go back to gold de jure at a higher rate, thereby inflicting a severe loss on its gold holdings. The government, however, did agree to indemnify the bank for any losses it might incur in foreign exchange transactions; in that way, Bank of France stabilization operations could only take place in the foreign exchange market.

  The French government and the Bank of France were now committed to pegging the franc at 3.92¢. At that rate, francs were purchased in a mighty torrent on the foreign exchange market, forcing the Bank of France to keep the franc at 3.92¢ by selling massive quantities of newly issued francs for foreign exchange. In that way, foreign exchange holdings of the Bank of France skyrocketed rapidly, rising from a minuscule sum in the summer of 1926 to no less than $1 billion in October of the following year. Most of these balances were in the form of sterling (in bank deposits and short-term bills), which had piled up on the continent during the massive British monetary inflation of 1926 and now moved into French hands with the advent of upward speculation in the franc, and with continued inflation of the pound. Willy-nilly, and against their will, therefore, the French found themselves in the same boat as the rest of Europe: on the gold-exchange or gold-sterling standard.78

  If France had gone onto a genuine gold standard at the end of 1926, gold would have flowed out of England to France, forcing contraction in England and forcing the British to raise interest rates. The inflow of gold into France and the increased issue of francs for gold by the Bank of France would also have temporarily lowered interest rates there. As it was, French interest rates were sharply lowered in response to the massive issue of francs, but no contraction or tightening was experienced in England; quite the contrary.79

  Moreau, Rist, and the other Bank of France officials were alert to the dangers of their situation, and they tried to act in lieu of the gold standard by reducing their sterling balances, partly by demanding gold in London, and partly by exchanging sterling for dollars in New York.

  This situation put considerable pressure upon the pound, and caused a drain of gold out of England. In the classical gold-standard era, London would have responded by raising the bank rate and tightening credit, stemming or even reversing the gold outflow. But England was committed to an unsound, inflationist policy, in stark contrast to the old gold system. And so, Norman tried his best to use muscle to prevent France from exercising its own property rights and redeeming sterling in gold, and absurdly urged that sterling was beneficial for France, and that they could not have too much sterling. On the other hand, he threatened to go off gold altogether if France persisted—a threat he was to make good four years later. He also invoked the spectre of France’s World War I debts to Britain.80 He tried to get various European central banks to put pressure on the Bank of France not to take gold from London. The Bank of France found that it could sell up to £3 million a day without attracting the angry attention of the Bank of England; but any more sales than that would call forth immediate protest. As one official of the Bank of France said bitterly in 1927, “London is a free gold market, and that means that anybody is free to buy gold in London except the Bank of France.”81

  Why did France pile up foreign exchange balances? The anti-French myth of the Establishment charges that the franc was undervalued at the new rate of 3.92¢, and that therefore the ensuing export surplus brought foreign exchange balances into France. The facts of the case were precisely the reverse. Before World War I, France traditionally had a deficit in its balance of trade. During the post–World War I inflation, as usually occurs with fiat money, the foreign exchange rate rose more rapidly than domestic prices, since the highly liquid foreign exchange market is particularly quick to anticipate and discount the future. Therefore, during the French hyperinflation, exports were consistently greater than imports.82 Then, when France pegged the franc to gold at the end of 1926, the balance of trade reversed itself again to the original pattern. Thus, in 1928, French exports were only 96.1 percent of imports. On the simplistic-trade, or relative-purchasing-power criterion, then, we would have to say that the post-1926 franc was over- rather than undervalued. Why didn’t gold or foreign exchange flow out of France? For the same reason as before World War I; the chronic trade deficits were covered by perennial “invisible” net revenues into France, in particular the flourishing tourist trade.

  What then accounted for the amassing of sterling by France? The inflow of capital into France. During the French hyperinflation, capital had left France in droves to escape the depreciating franc, much of it finding a haven in London. When Poincaré put his monetary and budget reforms into effect in 1926, capital happily reversed its flow, and left London for France, anticipating a rising or at least a stable franc.

  In fact, rather than being obstreperous, the French, succumbing to the blandishments and threats of Montagu Norman, were overly cooperative, much against their better judgment. Thus, Norman warned Moreau in December 1927 that if he persisted in trying to redeem sterling in gold, Norman would devalue the pound. In fact, Poincaré prophetically warned Moreau in May 1927 that sterling’s position had weakened and that England might all too readily give up on its own gold standard. And when France stabilized the franc de jure at the end of June 1928, foreign exchange constituted 55 percent of the total reserves of the Bank of France (with gold at 45 percent), an extraordinarily high proportion of that in sterling. Furthermore, much of the funds deposited by the Bank of France in London and New York were used for stock market loans and fueled stock speculation; worse, much of the sterling balances were recycled to repurchase French francs, which continued the accumulation of sterling balances in France. It is no wonder that Dr. Palyi concludes that

  [i]t was at Norman’s urgent request that the French central bank carried a weak sterling on its back well beyond the limit of what a central bank could reasonably afford to do under the circumstances. No other major central bank took anything like a similar risk (percentage-wise).83, 84

  Monty Norman could neutralize the French, at least temporarily. But what of the United States? The British, we remember, were counting heavily on America’s continuing price inflation, to keep British gold out of American shores. But instead, American prices were falling slowly but steadily during 1925 and 1926, in response to the great outpouring of American products. The gold-exchange standard was being endangered by one of its crucial players before it had scarcely begun!

  So, Norman decided to fall back on his trump card, the old magic of the Norman-Strong connection. Benjamin Strong must, once more, rush to the rescue of Great Britain! After Norman turned for help to his old friend Strong, the latter invited the world’s four leading central bankers to a top-secret conference in New York in July 1927. In addition to Norman and Strong, the conference was attended by Deputy Governor Rist of the Bank of France and Dr. Hjalmar Schacht, governor of the German Reichsbank. Strong ran the American side with an iron hand, keeping the Federal Reserve Board in Washington in the dark, and even refusing to let Gates McGarrah, chairman of the board of the Federal Reserve Bank of New York, attend the meeting. Strong and Norman tried their best to have the four nations embark on a coordinated policy of monetary inflation and cheap money. Rist demurred, although he agreed to help England by buying gold from New York instead of London, (that is, drawing down dollar balances instead of sterling). Strong, in turn, agreed to supply France with gold at a subsidized rate: as cheap as the cost of buying it from England, despite the far higher transportation costs.85

  Schacht was even more adamant, expressing his alarm at the extent to which bank credit expansion had already gone in England and the United States. The previous year, Schacht had acted on his c
oncerns by reducing his sterling holdings to a minimum and increasing the holdings of gold in the Reichsbank. He told Strong and Norman: “Don’t give me a low [interest] rate. Give me a true rate. Give me a true rate, and then I shall know how to keep my house in order.”86 Thereupon, Schacht and Rist sailed for home, leaving Strong and Norman to plan the next round of coordinated inflation themselves. In particular, Strong agreed to embark on a mighty inflationary push in the United States, lowering interest rates and expanding credit—an agreement which Rist, in his memoirs, maintains had already been privately concluded before the four-power conference began. Indeed, Strong gaily told Rist during their meeting that he was going to give “a little coup de whiskey to the stock market.”87 Strong also agreed to buy $60 million more of sterling from England to prop up the pound.

  Pursuant to the agreement with Norman, the Federal Reserve promptly launched its greatest burst of inflation and cheap credit in the second half of 1927. This period saw the largest rate of increase of bank reserves during the 1920s, mainly due to massive Fed purchases of U.S. government securities and of bankers’ acceptances, totaling $445 million in the latter half of 1927. Rediscount rates were also lowered, inducing an increase in bills discounted by the Fed. Benjamin Strong decided to sucker the suspicious regional Federal Reserve banks by using Kansas City Fed Governor W.J. Bailey as the stalking horse for the rate-cut policy. Instead of the New York Fed initiating the rediscount rate cut from 4 percent to 3.5 percent, Strong talked the trusting Bailey into taking the lead on July 29, with New York and the other regional Feds following a week or two later. Strong told Bailey that the purpose of the rate cuts was to help the farmers, a theme likely to appeal to Bailey’s agricultural region. He made sure not to tell Bailey that the major purpose was to help England pursue its inflationary gold-exchange policy.