The International Gold Standard and U.S. monetary policy from World War I to the New Deal

Federal Reserve Bulletin, June, 1989 by Leland Crabbe

The International Gold Standard and U.S. Monetary Policy from World War I to the New Deal

Before the First World War, most of the world, including the United States, Great Britain, and every country in Europe, maintained gold standard. In the United States, the Resumption Act had restored the gold standard in 1879, and the Gold Standard Act of 1900 had established gold as the ultimate standard of value. Internationally, the gold standard committed the United States to maintain a fixed exchange rate in relation to other countries on the gold standard, a commitment that facilitated the flow of goods and capital among countries. Domestically, the gold standard committed the United States to limit the expansion of money and credit, and thus it restrained inflationary pressures.

The international gold standard did not function ideally, however. Although the gold standard provided a basis for nominal stability over the long run, the U.S. and world economy suffered in the short run through periods of depression and inflation due to changes in the world's supply of and demand for gold. Moreover, the U.S. commitment to the international gold standard had a cost: It confined, though it did not preclude, discretionary management of the domestic economy.

From the First World War to the New Deal, amid upheaval in international and domestic financial markets, the United States honored its commitment to redeem dollars for gold at $20.67 per ounce. Maintenance of the gold standard, however, recurrently interfered with the Federal Reserve's broader objective of stabilizing the domestic economy. During the First World War, the United States and other belligerents fully or partly suspended the gold standard, de jure or de facto, to prevent it from hampering the war effort. In 1920, when the United States alone operated the gold standard without restrictions, the Federal Reserve imposed a severe monetary contraction, which defended the gold standard but contributed greatly to a depression. Hoping to stabilize the world economy in the 1920s, the industrial nations, notably Britain and France, restored the international gold standard. The restoration--which must be judged a failure--compelled the Federal Reserve to make choices between its international and its domestic objectives. Indeed, throughout the 1920s and early 1930s, Federal Reserve policy alternated between management of the international gold standard and management of the domestic economy. With the devaluation of the dollar in 1933, the United States established the principle that domestic policy objectives had primacy over the dictates of the gold standard. (See table 1 for the major events covered in this paper and the insert on page 425 for definitions of terms regarding the gold standard.)

THE FIRST WORLD WAR

The First World War nearly demolished the international gold standard. While none of the countries at war demonetized gold or refused to buy gold at a fixed price, none adhered strictly to the tenets of the gold standard. When the war began, belligerent governments instituted several legal and practical changes in the gold standard, which they viewed as a temporary suspension of the rules rather than as a permanent abandonment of the international monetary system. Previous wars had often forced suspension; peace had always brought restoration.

U.S. Response to the 1914 Crisis

Although the United States did not enter the war until 1917, the outbreak of war in Europe in 1914 immediately disrupted U.S. financial and commodity markets, the latter being heavily dependent on London for the financing of exports. In July 1914, U.S. firms had a large amount of short-term debts payable in Europe, primarily in London; but this position was normal in the summer, as borrowers expected to use the proceeds from exports of cotton and grain to pay off their liabilities in the fall. As Europe moved toward war, the world's financial markets became highly disorganized, especially after acceptance and discount houses in London shut down their operations. Late in July, as foreigners began liquidating their holdings of U.S securities and as U.S. debtors scrambled to meet their obligations to pay in sterling, the dollar-pound exchange rate soared as high as $6.75, far above the parity of $4.8665. Large quantities of gold began to flow out of the United States as the premium on sterling made exports of gold highly profitable. Under the pressure of heavy foreign selling, stock prices fell sharply in New York. The banking and financial systems in the United States seemed on the verge of collapse.

Relief came without the suspension of the gold standard in the United States. On July 31, the New York Stock Exchange joined the world's other major exchanges in closing its doors, thus easing pressure on the gold standard by preventing the export of gold arising from foreign sales of U.S. corporate securities. In August, unsafe shipping conditions and the unavailability of insurance further slowed gold exports. Still, with the export sector in disarray and with $500 million in short-term debts coming due in Europe, the United States needed to implement additional actions to defend the exchange value of the dollar. The most important relief measure came on August 3, when Secretary of the Treasury William McAdoo authorized national and state banks to issue emergency currency by invoking the Aldrich-Vreeland Act. Because it allowed banks to use such notes to meet currency withdrawals and to safeguard reserves, this emergency measure kept panic from sweeping over the banking system. In early September, less than a month after its first members took the oath of office, the Federal Reserve Board, in conjunction with the Secretary of the Treasury, organized a syndicate of banks that subscribed $108 million in gold to pay U.S. indebtedness in Europe. Less than $10 million was actually exported from this gold fund, however, because the organization of the fund itself provided foreign creditors with the assurance they required.