The Interwar Years, 1918–1939
Governments effectively suspended the gold standard during World War I and financed part of
their massive military expenditures by printing money. Further, labor forces and productive
capacity had been reduced sharply through war losses. As a result, price levels were higher
everywhere at the war’s conclusion in 1918.
Several countries experienced runaway inflation as their governments attempted to aid the
reconstruction process through public expenditures. These governments financed their purchases
simply by printing the money they needed, as they sometimes had during the war. The result was
a sharp rise in money supplies and price levels.
The Fleeting Return to Gold
The United States returned to gold in 1919. In 1922, at a conference in Genoa, Italy, a group of
countries including Britain, France, Italy, and Japan agreed on a program calling for a general
return to the gold standard and cooperation among central banks in attaining external and internal
objectives. Realizing that gold supplies might be inadequate to meet central banks’ demands for
international reserves (a problem of the gold standard noted in Chapter 18), the Genoa
Conference sanctioned a partial gold exchange standard in which smaller countries could hold as
reserves the currencies of several large countries whose own international reserves would consist
entirely of gold.
In 1925, Britain returned to the gold standard by pegging the pound to gold at the prewar price.
Chancellor of the Exchequer Winston Churchill, who favored the return to the old parity, argued
that any deviation from the prewar price would undermine world confidence in the stability of
Britain’s financial institutions, which had played the leading role in international finance during
the gold standard era. Though Britain’s price level had been falling since the war, in 1925 it was
still higher than in the days of the prewar gold standard. To return the pound price of gold to its
prewar level, the Bank of England was therefore forced to follow contractionary monetary
policies that contributed to severe unemployment.
British stagnation in the 1920s accelerated London’s decline as the world’s leading financial
center. Britain’s economic weakening proved problematic for the stability of the restored gold
standard. In line with the recommendations of the Genoa Conference, many countries held
international reserves in the form of deposits in London. Britain’s gold reserves were limited,
however, and the country’s persistent stagnation did little to inspire confidence in its ability to
meet its foreign obligations. The onset of the Great Depression in 1929 was shortly followed by
bank failures throughout the world. Britain left gold in 1931 when foreign holders of sterling
(including several central banks) lost confidence in Britain’s promise to maintain its currency’s
value and began converting their sterling to gold.
International Economic Disintegration
As the depression continued, many countries renounced the gold standard and allowed their
currencies to float in the foreign exchange market. In the face of growing unemployment, a
resolution of the trilemma in favor of fixed exchange rates became difficult to maintain. The
United States left gold in 1933 but returned in 1934, having raised the dollar price of gold from
$20.67 to $35 per ounce. Countries that clung to the gold standard without devaluing their
currencies suffered most during the Great Depression. Indeed, recent research places much of the
blame for the depression’s worldwide propagation on the gold standard itself (see the Case Study
on the next page).
Major economic harm was done by restrictions on international trade and payments, which
proliferated as countries attempted to discourage imports and keep aggregate demand bottled up
at home. The Smoot-Hawley tariff imposed by the United States in 1930 had a damaging effect
on employment abroad. The foreign response involved retaliatory trade restrictions and
preferential trading agreements among groups of countries. A measure that raises domestic
welfare is called a beggar-thy-neighbor policy when it benefits the home country only because it
worsens economic conditions abroad.
Uncertainty about government policies led to sharp reserve movements for countries with pegged
exchange rates and sharp exchange rate movements for those with floating rates. Many countries
imposed prohibitions on private financial account transactions to limit these effects of foreign
exchange market developments. This was another way of addressing the trilemma. Trade barriers
and deflation in the industrial economies of America and Europe led to widespread repudiations
of international debts, particularly by Latin American countries, whose export markets were
disappearing. In short, the world economy disintegrated into increasingly autarkic (that is, self-
sufficient) national units in the early 1930s.
In the face of the Great Depression, most countries resolved the choice between external and
internal balance by curtailing their trading links with the rest of the world and eliminating, by
government decree, the possibility of any significant external imbalance. By reducing the gains
from trade, that approach imposed high costs on the world economy and contributed to the slow
recovery from depression, which in many countries was still incomplete in 1939. All countries
would have been better off in a world with freer international trade, provided international
cooperation had helped each country preserve its external balance and financial stability without
sacrificing internal policy goals. It was this realization that inspired the blueprint for the postwar
international monetary system, the Bretton Woods agreement.
The International Gold Standard and the Great Depression
One of the most striking features of the decade-long Great Depression that started in 1929 was its
global nature. Rather than being confined to the United States and its main trading partners, the
downturn spread rapidly and forcefully to Europe, Latin America, and elsewhere. What explains
the Great Depression’s nearly universal scope? Recent scholarship shows that the international
gold standard played a central role in starting, deepening, and spreading the 20th century’s
greatest economic crisis.
In 1929, most market economies were once again on the gold standard. At the time, however, the
United States, attempting to slow its overheated economy through monetary contraction, and
France, having just ended an inflationary period and returned to gold, faced large financial
inflows. Through the resulting balance of payments surpluses, both countries were absorbing the
world’s monetary gold at a startling rate. By 1932 the two countries alone held more than 70
percent of it. Other countries on the gold standard had no choice but to engage in domestic asset
sales and raise interest rates if they wished to conserve their dwindling gold stocks. The resulting
worldwide monetary contraction, combined with the shock waves from the October 1929 New
York stock market crash, sent the world into deep recession.
Waves of bank failures around the world only accelerated the world’s downward economic
spiral. The gold standard again was a key culprit. Many countries desired to safeguard their gold
reserves in order to be able to remain on the gold standard. This desire often discouraged them
from providing troubled banks with the liquidity that might have allowed the banks to stay in
business. After all, any cash provided to banks by their home governments would have increased
potential private claims to the government’s precious gold holdings.
Perhaps the clearest evidence of the gold standard’s role is the contrasting behavior of output and
the price level in countries that left the gold standard relatively early, such as Britain, and those
that chose a different response to the trilemma and instead stubbornly hung on. Countries that
abandoned the gold standard freed themselves to adopt more expansionary monetary policies that
limited (or prevented) both domestic deflation and output contraction. The countries with the
biggest deflations and output contractions over the years 1929–1935 include France,
Switzerland, Belgium, the Netherlands, and Poland, all of which stayed on the gold standard
until 1936.
