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The Interwar Instability

If the gold standard era before 1914 has been viewed as the classic example of international monetary soundness, the interwar period has played the part of a nightmare, which postwar officials have been determined to avoid repeating. Payments, balances, and exchanges, gyrated chaotically in response to World War I, and The Great Depression.

After World War I, the European countries had to struggle with a legacy of inflation and political instability. Their currencies had become inconvertible during the war, since their rates of inflation were much higher than that experienced in the United States, the new financial leader.

In this setting Britain made the fateful decision to return to its prewar gold parity, achieving this rate by April 1925. Though the decision had been defended as a moral obligation, and as a sound attempt to restore international confidence in Britain's role at the center of a reviving world economy, the hindsight consensus is that bringing the pound back up to $4.86656 was a serious mistake.

It appears to have caused considerable unemployment and stagnation in the traded goods industries, as theories predicted.

France, Italy, and some other European countries, chose a more inflationary route, for complicated political reasons. A succession of French revolving-door governments was unable to cut government spending or raise taxes to shut off large budgetary deficits that had to be financed largely by printing new money. Something similar happened in Italy, both before, and immediately after, the 1922 revolution that brought Mussolini to power.

The ultimate in inflation, however, was experienced by Germany, where the money supply, prices, and the cost of foreign exchange all raised more than a trillion fold in 1922-23.

Money became totally worthless; by late 1923 not even a wheel barrowful of paper money could buy a week's groceries. The mark had to be reissued in a new series equal to the prewar dollar value, with old marks forever unredeemable.

The failure of the reputable Creditanstalt in Austria caused a run on German banks and the mark, since Germany had lent heavily to Austria. The panic soon led an attack to the pound sterling, which had been perennially weak and was now compromised by the fact that Britain had made heavy loans to the collapsing Germans.

On September 19, 1931, Britain abandoned the gold standard it had championed, letting the pound sink to its equilibrium market value. Between early 1933 and early 1934, the United States followed suit and let the dollar drop all gold value, as FDR and his advisers manipulated the price of gold in an attempt to create jobs, somehow.

What lessons do the interwar experience hold for postwar policymakers? During World War II expert opinion seemed to be that the interwar experience called for a compromise between fixed and flexible exchange rates, with emphasis on fixity.

The Bretton Woods agreement of 1944 tried, set up the International Monetary Fund, and laid down a set of rules calling for countries to change their exchange rates when a fundamental disequilibrium made this unavoidable.

This decision was paralleled by Ragnar Nurkse's book written for the League of Nations in 1944. Nurske argued, with some qualifying disclaimers, that the interwar experience showed the instability of flexible exchange rates.