policies was bringing Britain to the ‘verge of revolution’.19
Notwithstanding Maynard Keynes’ impassioned assault on gold, the Conservative Party's victory in the 1924 general election heightened expectations of a return to the gold standard. Winston Churchill, who had roamed the political wilderness since spearheading the Gallipoli debacle in 1915, was surprised to find himself appointed Chancellor of the Exchequer in Stanley Baldwin's government. This meant that the decision about sterling's link to gold fell to him. While no intellectual laggard, Churchill never mastered the details of monetary policy and relied on advice from experts in the field. Although Keynes was among those whom he consulted, the establishment orthodoxy prevailed. In his budget of April 1925, Churchill announced Britain's return to the gold standard at the pre-war rate. This soon proved to be a mistake that he came to regret.
At the level at which it was fixed to gold, sterling was significantly overvalued, making Britain's exports uncompetitive. France, on the other hand, returned to the gold standard in 1928 at one-fifth of the 1914 parity, significantly undervaluing the franc and thereby making French exports far more attractive.20 As a consequence, capital flooded into France with its undervalued currency and into the US, which was experiencing a stock market boom, while uncompetitive British industry was starved of investment.
In a series of articles, pamphlets and books written and published between 1923 and 1936, Keynes launched an intellectual attack on the classical economic orthodoxy and its reliance on gold, which he called a ‘barbarous relic’. These works addressed not just monetary policy, but its relationship with employment, prices and trade. His theories were to form an intellectual basis for economic policies that predominated in the West in the post-war years up until the 1970s.
He argued that gold as a foundation for the monetary system had only worked during the 19th century because new mining discoveries had fortuitously kept pace with economic growth. The operation of monetary policy to avoid the loss of gold reserves, as was the prevailing practice, entailed raising interest rates at times of economic weakness, which served to raise savings and exacerbate falling consumer demand, further compounding falling profits. Given the fluctuating pace of economic growth and variances between different trading partners, he believed that central banks were much better positioned to manage a country's monetary affairs without gold as a reference. This is, in fact, the system commonly followed today with floating fiat currencies, but was a revolutionary concept at the time.
Keynes also explained that inflation and deflation, more than just a rise and fall in prices, were a means of wealth transfer between different groups and social classes within society. Classical economic theory held that, in a free market, wages would naturally adjust to a level at which there would be full employment. Keynes debunked this theory and showed that there was no natural tendency for full employment. For structural and even psychological reasons, wages do not necessarily adjust in line with falls in prices and profits. Further, since falling wages themselves removed economic demand, deflation could actually worsen unemployment. This meant that high unemployment could persist indefinitely unless governments intervened to boost consumption demand. Crucially, he argued that such government spending would have a ‘multiplier’ effect, since it would stimulate other economic activity. This therefore justified governments’ use of deficit spending at times of rising unemployment as a means of ‘pump priming’ the economy to induce a return to growth.
Citing his famous remark that ‘In the long run, we are all dead’,21 critics of Keynesian economic theory have often accused him of advocating policy short-termism and irresponsible government spending that would lead to ever rising deficits. This is inaccurate, as Keynes actually believed strongly in balanced budgets over an economic cycle. However, governments have tended to lack the political will or discipline to rein in their budgets in the good times.
There is no doubt that Keynes’ theories were founded on Britain's particular economic circumstances at the time. Nevertheless, it became clear that the rigidity of the gold standard was a major underlying contributor to the worldwide breakdown in trade and economic hardship of the 1930s. The need to maintain fixed exchange rates forced central banks to raise interest rates to prevent outflows of gold just as economic demand was already shrinking. Due to the nature of fractional reserve banking systems,22 the impact of withdrawals of gold was magnified through the reduction in banks’ capacity to lend. In turn, this caused asset prices to tumble, which led to loan defaults that further compounded economic weakness. As panic set in, scenes of depositors queued up outside banks to withdraw their savings became commonplace. Some 9,000 banks in the US failed during the 1930s.23
Via the transmission mechanisms of international trade and investment, economic problems in one country spread to others and prosperity declined globally. Even countries that had run large trade surpluses suffered. France had maintained strong exports by keeping the franc undervalued, but the Banque de France incurred huge losses on its sterling balances when Britain was forced to devalue the pound in 1931.
Keynes was convinced that the global monetary order needed to be radically reformed. Instead of society adjusting to the requirements of the gold standard, he believed that it was monetary policy that needed to adapt to the natural tendencies of society. In his vision, there needed to be a more flexible mechanism of international exchange rates to allow for periodic adjustments in response to imbalances in trade or capital flows, and the role of the barbarous relic in monetary policy needed to be gradually phased out. And this is precisely the plan that he drew up.
Two Competing Plans
Hitler's invasion of Poland in September 1939 precipitated the commencement of WW2 in Europe. Even before America was drawn into the war by the Japanese attack on Pearl Harbour in December 1941, it was already entangled via the Lend-Lease programme, through which it was providing material and financial support to a cash-strapped Britain. Churchill described America's Lend-Lease programme as a ‘most unsordid act’,24 but it was also one of calculated self-interest since, if Britain were to be defeated by Germany, the US would be left standing alone against a fascist-controlled Europe. For Britain, however, it meant it would face a costly debt to the US after the war.
Keynes returned to the Treasury as an unpaid advisor to the Chancellor of the Exchequer after WW2 started. By this time, he was becoming a part of the establishment that he had previously derided. He was elected to the Court of the Bank of England in 1941 and then ennobled as Baron Keynes of Tilton the following year. Understanding the implications of his country's financial position and the need to plan ahead for its changed circumstances after the war, he began work in August 1941 on a plan for a new post-war global monetary order.
Anxious to avoid a repeat of the policy mistakes of the 1920s and 1930s, his plan sought to replicate the stability of the gold standard within a more flexible framework. There were two key elements to his proposal.
First, there was to be a new global reserve currency created, which he called Bancor (French for ‘bank gold’). Bancor was to have a fixed exchange rate against all members’ currencies and gold, but it was provided that countries with persistent balance of payments deficits would be subject to automatic devaluations, while countries running persistent surpluses would be subject to upwards adjustments of their exchange rates. This created a ‘pegged but adjustable’ currency system that enabled changes in countries’ relative balance of payments to be reflected in their exchange rates over time.25
Second,
