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Why Didn't They Just Give Up on Gold?
If one takes a casual look at the gold standard era, there are some perplexing observations. For example, when countries would go to war, they would suspend convertibility of paper money into gold. Then, after the war was over, these countries would return to gold at the previous parity. The result would often be a period of significant deflation and recession.
It is not hard to see how a casual observer might find this completely insane. Why have a gold standard at all if you are just going to abandon it whenever you like? Why commit to something in the future that will result in substantial economic costs?
Naturally, there are lazy arguments to explain this behavior. Why suspend convertibility during the war? Because governments aren’t really committed to the gold standard, of course. Why restore convertibility at the previous parity when it imposes such significant economic costs? Because governments didn’t employ enough economists to tell them how harmful this would all be.
In fact, if you travel in the right circles, you might hear someone tell you that whatever his other faults, Napoleon got this right. He was a hard money man. No less a figure in economics than Milton Friedman was puzzled by the fact that the British resorted to inflationary finance during the Napoleonic Wars whereas the French did not, despite the British being more credit-worthy than the French.
How can we understand this behavior?
First, let’s think about how the gold standard works. Under the gold standard, the unit account which we will call the “dollar” is defined as a particular quantity of gold. For example, one might define 1 dollar as equal to 1/35 oz. of gold. This implies that the nominal price of gold is fixed at $35 per ounce. Of course, the market for gold has to clear. If the nominal price is fixed, the supply and demand for gold must determine the real price of gold. That means that fluctuations in the supply and demand for gold result in corresponding changes in the price level.
Second, let’s think about war. During times of war, states need to raise a lot of money very quickly to buy/build equipment and weapons, and pay (and train) soldiers. In addition, they need to have the financial infrastructure in place such that they have an open-ended commitment to finance the war.
Now, given this understanding, one can potentially explain the observed behavior of countries on the gold standard and the seemingly paradoxical observations about Britain and France during the Napoleonic Wars.
Governments prefer to smooth taxation over time. Why? Well, people don’t seem to like wild fluctuations in their tax rates. Given this assumption that governments prefer to adjust tax rates slowly over time, this means that war is likely to result in a significant amount of short-term borrowing. But where does the state get the money?
Consider the British. While we might think of the Bank of England today as some technocratic institution that determines monetary in an attempt to target a particular rate of inflation, it was once a significant source of war finance. The British government could go to the Bank of England and ask for a loan. The loan would expand the Bank’s balance sheet. On the asset side, the Bank gained a loan from the government (often with the explicit claim to a certain type of future tax revenue). On the liability side, this expanded the bank notes issued by the Bank.
However, a long, open-ended conflict financed by the Bank of England creates a potential problem. For a given quantity of gold reserves, as the bank’s liabilities expand, it becomes more difficult for the Bank to credibly commit to redeeming its liabilities for gold.
With this as a background, it is easy to understand why the British government would suspend the convertibility of bank notes into gold. By doing so, this would allow the Bank of England to expand its liabilities without having to maintain its commitment to redemption.
But why promise to restore the gold standard at the previous parity?
With convertibility suspended, fluctuations in the supply and demand for gold no longer determine the price level. Instead, changes in the supply and demand for paper money would determine the price level. Without a commitment to restore the gold standard at the previous parity, not only would the money supply increase, but money demand would decline. Why? People know that the supply of paper money is expanding. This causes them to expect higher rates of inflation, which increases the opportunity cost of holding money and reduces money demand.
Think about the government’s objective. In order to use the Bank of England as a source of emergency financing, the government needs the expansion in the Bank’s balance sheet to be an expansion in real terms. If the price level starts rising faster than the money supply, then the real value of the bank liabilities is declining. This occurs if the increase in the money supply coincides with a corresponding decline in money demand.
Thus, the government needs to keep money demand anchored, but how? Well, by promising to return to the previous parity, the government is expressing a commitment to keep the long-run price level relatively constant regardless of what happens to the price level during the war. In other words, if the war results in inflation, the end of the war will result in a corresponding deflation. As long as people believe that the government is committed to restoring the previous parity, this will anchor money demand and allow this monetary-fiscal policy coordination to achieve its stated end of open-ended war finance.
My own work, comparing the experience of England and Sweden, demonstrates the importance of this commitment. England always explicitly promised to restore the convertibility at the previous parity. In contrast, during its Age of Freedom in the early 18th century, Sweden’s suspension of the convertibility was open-ended. There was no explicit commitment to restore convertibility. Without this commitment, and in contrast to the British experience, the Swedes quickly found that the Riksbank could not serve the role of open-ended war finance.
Evidently, states (or, more specifically, the stakeholders within the state) viewed the subsequent costly deflation as the necessary evil to maintain open-ended war finance. Thus, while it might seem odd to the casual observer that governments would resort to this type of behavior, there is a clear reason why governments continued to resort to suspension and restoration of convertibility and the maintenance of the parity between the unit of account and the underlying commodity.
But this brings us back to the French. Why didn’t the French resort to inflationary finance? After all, the Ancien Regime and the French Revolution had demonstrated very little fiscal responsibility. Isn’t this exactly who would be expected to resort to inflationary finance? The answer, as Bordo and White explain, is that they were unable to resort to this sort of inflationary finance precisely because the government had become so untrustworthy. Who would believe in a French commitment to debt repayment and a restoration of the commodity standard at the previous parity? Without the belief in the government’s commitment to restore convertibility, there was nothing to keep money demand anchored. Napoleon wasn’t a hard money man, he was politically and financially constrained.
In short, what all of this reveals is that the seemingly paradoxical observations about commodity money and war finance that started this post are actually not paradoxical at all when you are armed with a little economic reasoning.