The Gold Standard, like the Exchange Rate Mechanism, ensures stable exchanges and economic discipline. Why, then, was there so many criticism of the return to gold in 1925?
In March 1919, the large trade deficit and low level of gold reserves resulted in formal abandonment of the gold stand by the UK. On Apr. 28, 1925, Churchill announced in his Budget speech that there would be an immediate return to gold at pre-1913 parity.
Reddaway (Lloyds Bank Review, 1970) expresses in his article that returning to gold at $4.76 was a failure of the committee that they had not done enough research and had not have enough consideration and look at other countries apart from the US. The committee failed to take account of prices in any external country apart from USA and also used the wrong indices (wholesale price) for their calculation and hence derived the wrong result.
The policy announcement in 1919 of the intention of returning to pre-1913 gold standard was equivalent to the announcement of a contractionary monetary policy. Under flexible ER regime of 1919-1925 contractionary monetary policy is expected to result in an appreciating of nominal ER, deflate the price level (given high rate of inflation after the First World War) and improving competitiveness. However, because the ER is determined in an asset market that adjust relatively quickly, we would expect to observe an appreciation of the real ER in the short-run whereby the ER deviates from the PPP equilibrium.
According to Keynes’ The Economic Consequences of Mr Churchill, when UK returns to gold in 1925, sterling was 10% overvalued. To determine the magnitude of overvaluation Keynes used purchasing power parity theory (PPP) which state that flexible exchange rate reflects movements in relative prices between countries.
Matthews argue that exchange rate was not overvalued and exchange rate in 1925 reflected more forces of economics fundamental than government intervention. This is due to the use of supply-side theory of exchange rate. High replacement ratio as an indicator (resulting from generous benefit system) increases search unemployment, forcing employers to bid up real wages to attract workers away from leisure: the exchange rate simply reflected the adjustment to supply-side shocks in the UK labour market, hence no overvaluation. To improve UK competitiveness, there need to be more flexibility in the labour market. However, it is not clear that the replacement ratio had large impact on UK wage costs or unemployment. More research needs to be undertaken on these supply-side influences.
Redmond (1984) presents a number of comparisons which suggest that PPP calculations for the dollar and the pound in 1925 relative to 1913 range from an undervaluation of 4% to an overvaluation of 17%, depending on which type of price index is used for comparison. Keynes’ result of a 10% overvaluation is a special outcome of the specific retail price indices he used. Redmond suggest a more representative indicator of competitiveness is the real multilateral exchange rate, which measures both nominal exchange rate variations and relative price movements for a wide sample of UK trading partners. The table below shows the result that the UK exchange rate was overvalued in 1925 by between 5 and 20%: only the magnitude depends on the type of price index used.
Multilateral real effective ER for the pound, 1924-30 (1913=100)
Deflating by wholesale prices Deflating by retail prices
However, we have to have in mind that a number of UK trading partners were not on gold during this period. Moreover, real exchange rate within gold country might have varied as a result of differential price and productivity movements across countries. Furthermore, Solomou and Catao (1994), show that 1913 represents a low point on the level of the real effective exchange rate during the period 1870-1913.
Does overvaluation matter? Increase in sterling price of export means a reduction in our competitiveness. Eichengreen (1986 and 1992) studies a cross-section of twelve countries during 1921-1927 including UK and found that there is extensive evidence of overvaluation in the UK, Germany and Norway. This is shown by the level of competitiveness as measured by the real ER.
In the case of the UK, given the adverse effects of the First World War (in terms of a loss of markets) it would seem sensible to argue that for the UK to maintain international competitiveness in the 1920s, a depreciated ER would have been a necessary feature of a more successful UK cyclical recovery. Depression, however have hysteresis effect, returning to gold at pre-1913 parity make the country suffered a persistent adverse output effect in the attempt to re-establish the old parity.
According to Keynes, if the government admit that the problem of overvaluation is primarily a monetary one and say to labour that return to gold at $4.76 is not attack on real wages and can make money wage have to fall by 10% to compensate an increase if £ by 10%, or there is an increase in productivity, there would have been no problem. This also means that when the adjustment is complete, the cost of living would fall about 10%. He suggests two alternative ways of bringing about the reduction of money wages. First, by apply economic pressure and to intensify unemployment by credit restriction, until wages are forced down. This will be difficult since reduction in money wage means lower standard of life if other industries don’t reduce their money wage to decrease cost of living. Moreover, those that are subjective to reduction in money wage first are not guarantee to be compensated later by lower cost of living and hence they will resist as long as they can. Second, this will effect a uniform reduction of wages, by agreement. Our export industries are suffering because they are the first to be asked to accept the 10% reduction of their money wage.
The tight monetary conditions of 1925-31 were a consequence of pressure on the exchanges that showed itself by an exchange rate that was frequently below par. There was an adverse effect on current account, but this is not the main factor that creates pressure on exchange position. Financial institutions at home and abroad were what mattered, as current account was difficult to see clearly. In 1914, overseas-owned London deposits and bills were matched by the total of short term debts. The fact Britain was not in the position of borrowing short to lend long was due to the ability of the Bank of England to defend the position of London with relatively low gold reserve.
By the twenties, London was no longer the natural habitat of the balances associates with such a large proportion of trade. It’s balance sheet position had deteriorated so that the short-term debts of foreigners were only half of the short-term assets of overseas holders in London (M>X). The export of capital exceeds the positive surplus that on the balance of payments current account, and had to be financed by attraction of the short-term funds.
Wright says in his article that the change in parity led to an incipient export of capital even without speculative effects because of the increase in price. However, the disequilibrium should adjust, sterling price of British capital should fall leading to a fall in quantity later. Although there is no relevant data for this, he says, the effect via prices of the relative attractiveness of real assets in Britain and overseas cannot be ignored particularly in relation to U.S. shares.
Wright concluded that there were some adverse effects due to the overvaluation. The weakness of pound was a consequence of a change in the balance-sheet of London and of capital outflow. How far it was aggravated by the effects of appreciation on current account was less clear. Despite the apparently high level of unemployment there was a growth in the number of persons employed of 1.25m between 1925 and 1929. Growth of GNP in the same period, 12.5%, was not negligible by British standards. However, it was distinctly lower then in the USA and several other countries. The events of the twenties may not seem so obviously to be the result of one ingredient in the economic policy of that period. It was the structural problem that seem to coincide with the deterioration of the main industries
In conclusion, there was definitely an overvaluation when the British return to gold and there were persistent adverse effects due to this. The adverse effect, however, cannot be blamed on overvaluation alone, but also on structural problems of the main industries, shortermism of financial institutions, low productivity and wage rigidity. There does not exist a successful role model that UK should follow. Neither large depreciation (leading to high inflation) nor returning to the pre-1913 parities were appropriate responses.
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