Chapter 1

The Asymmetric Discipline of the Gold Standard

In this chapter we shall discuss how and why despite having

direct link between exchange rate and monetary gold reserves Britain

did not have sufficient reserves. The indicator we have used is the

ratio of money supply to the magnitude of reserves. Despite having

low reserves Britain could get away with it because of the

international use of her currency as reserve currency. This was

because she had the hegemony over world politics, world trade and

finance. This use as reserve currency had created the expectation

that this currency will be stable which in effect had helped Britain to

have more money pulling power than the rest of the world through a

change in the rate of interest. This itself had helped her to maintain

the exchange rate stable and hence, to consolidate the position of the

pound-sterling as the reserve currency.

The basic theoretical features of the Gold standard system were:

( 1) Interconvertibility between domestic money and gold at a fixed

official price.

(2) Freedom for private citizens to import and export gold and

(3) A set of rules relating the quantity of money in circulation in a

country to that country's gold stock.

13

The exchange rates among national currencies were decided

through the relative amount of gold promise against the currency

notes by the respective central banks. So, the exchange rate of a

country was dependent upon its central bank's promise of the amount

of gold to pay in exchange of one unit of currency and this was fixed.

Hence, to keep the promise, central banks needed to keep sufficient

monetary gold reserve against their money in circulation. The

exchange rate of a country would be destabilized if the claim of the

foreigners on the gold due to holding of that country's money were

more than the monetary gold reserve of the central bank. So, for

instability of exchange rate balance of payment deficit would be a

necessary condition. If that country had large monetary gold reserve

that could cover the balance of payment deficit then the exchange

rate of that country would be stable. So, for keeping exchange rate

stable, a country in practice had three options, though in theory it

had only one; namely, keeping sufficient monetary gold reserve. The

other two options were firstly, through adjustment in current account

and secondly, through adjustment in capital account.

Most of the theoretical analyses of this system say that if there

is any disequilibrium in the balance of payments, the automatic

adjustment in price will bring the required change in the balance of

payments through current account adjustment. So, according to this

theory, disequilibrium in the balance of payments will have an impact

14

on money supply and hence on price. This change in price will bring a

change in the trade account. This adjustment process is based on

some critical assumptions, such as

(1) The whole effect of gold inflow and outflow will be on price and

not on output.

(2) The price change will be sufficient to adjust the trade balance

such that exchange rate remains at its original level.

As W.W. Scammel (1985) has pointed out, all these were

questionable assumptions in practice, not all of which were satisfied

even in the classic period of the Gold Standard, and even less in the

subsequent period leading to its breakdown in 1914. The main reason

was the possibility of taking other routes than price adjustment to

improve the current account, e.g., through changes in aggregate

demand. A reduction in aggregate demand might lower incomes and

price and improve trade balance. The main argument against

emphasizing this adjustment mechanism, however, is simply that it

operated only with lags too great and too uncertain to account for the

remarkably smooth and rapid pace at which exchange rates,

international gold flows and gold reserves of central banks seem to

have been altered generally during this period.1

Between the other two options other countries, apart from

Britain, mostly had to keep sufficient monetary gold reserve for the

stability of their exchange rate.

15

Table 1.1

The Composition of Reported Official Reserve in 35 Countries at the end of 1913

{Converted into millions of dollars at 1913 ~ Counb"ies Gold Silver Foreign Total

Exchang Reserve e

Three Main Creditors 1122.5 189.4 52.8 1364.7

United Kingdom 164.9 - - 164.9

France 678.9 123.9 3.2 805.6

Germany 278.7 65.9 49.6 394.2

Other Europe consist 1757 309.4 610.6 2677 of 17 counb"ies Western Hemisphere 1764.9 525.2 64.8 2354.9 consist of 7 counb"ies Africa, Asia, Australia 201.8 108.5. 403.9 714.2

Note: (1) 17 European countnes were Austria, Hungary, Belg1um, Bulgaria, Denmark, Finland, Greece, Iceland, Italy Netherlands Norway, Portugal, Rumania, Russia, Serbia, Spain, Sweden and Switzerland (2) 7 Western Hemisphere countries were Argentina, Bclivia, Brazil, Canada, Chile,

Uruguay and U.S.A. (3) The countries in Asia, and Africa were Algeria, Ceylon, Egypt, India, Japan,

Neth. Indes and Philippines. Source: Lindert, P.H. (1969), p -10

It is striking from the table that the Gold reserve to money

ratio was 5 to 10 times lower for the U.K. compared to other capitalist

countries (Table 1.2). This was because Britain could keep her

exchange rate stable by controlling the capital flow mainly through

changing the bank rate. It was evident from the comment of W.A.

Lewis: 2

'The Bank of England kept very little gold (in relation to money

supply) -some say because gold yielded no interest while others are more

1 Lindert, P.H.(1969) 2 Lewis, W. (1978)

16

charitable, whatever the reason, the consequence was that the Bank was

forced to react to slight losses of gold, changing the bank rate an incredible

number of times per year'.

Table 1.2

Monetary Gold-Money Ratio for some selected Countries Monetary Authority

Year France United United Kingdom States

1889 .256 .026 .117

1899 .267 .032 .112

1910 .304 .029 .105

Source: For exchange rate- Bloomfield, A.I. (1963) p-95 For money stock of France - The French International Accounts,

p333 For money stock of U.K. and U.S.A.- Friedman et al. 1982 For Gold stock- De Cecco,(1984)

In a parallel view, Marcello De Cecco (1984) also pointed out

that the Bank of England, 'in order to protect its reserves, made use

of controlling devices such as Bank rate, the gold devices and open

market operations'. According to W.W. Scammel, (1985), Bank rate

policy became effective as open market operations were having an

influence on money supply. Around the turn of the 20th century the

bank rate policy was a more popular tool and the frequency of its use

increased over time. In fact Keynes (1913) said,

"the essential characteristics of the British monetary system are,

therefore, the use of cheques as the principal medium of exchange and the

17

use of the bank rate for regulating the balance of immediate foreign

indebtedness. "

The question as to why, unlike other countries, only Britain

was able to keep her exchange rate stable without keeping

sufficiently large monetary gold reserve, can be answered with

reference to the international financial structure of that time. It gave

Britain far greater control over capital flows. Though France and

Germany had some influence over capital inflow, other countries did

not have this advantage. There are several reasons for that.

Table 1.3

Foreign Invesbnent of Major Lending Countries, 1870-1913

(in millions of dollars) Country 1870 1885 1900 1913

Great Britain 4900 7800 12100 19500

France 2500 3300 5200 8600

Gennany n.a. 1900 4800 6700

Netherlands 500 1000 1100 1250

U.S.A. negligible ne.;Jiigible 500 2500

Source: Woodruff, The Impact of Western Max (1966), p -150 Reprinted in Kindleberger, C.P., A Rnancial History of Western Europe, p -225,

First, Britain was the largest lender country in the world (Table 1.3).

Second, Britain's share was the largest in the world trade (Table 1.4).

Third, Britain had an unmatched supremacy in financing the

world trade. In 1914 Keynes calculated that international trade bills

18

financed by London stood at 350 million pounds.3

Table 1.4

Shares of World Trade for the Five Major capitalist Countries 1860-1913

(Per cent of World Trade) Years U.S.A. U.K. Germany France

Average 8.3 25.1 9.2 10.7 of 1860 and 1880 1881-85 10.0 19.1 10.4 10.7

1891-95 10.5 18.0 11.0 9.2

1901-D5 10.5 16.4 11.6 7.6

1911-13 10:1 14.1 12.2 7.5

Italy

3.3

3.3

2.6

2.8

3.0

' Sources: S1mon Kuznets, "Modern Econom1c Growth' (New Haven, conn. Yale University Press, 1966), p 306 -09. Reprinted in Gisselquist, D. 'The Political Economics of International Bank Lending", p -9

Fourth, it also had a large market for gold. Fifth, it had a large

Empire, which could be forced to make payments such as the Home

Charges in British sterling.

Finally, Britain had a large current account surplus throughout

this period. Even though i.t had a trade deficit, it had current account

surplus, due to huge net factor income, mainly from interest earning.

3 Aliber, R.Z,(2000). He has said " Traders in forei gn exchange need an inventory of foreign currencies; they want to minimize the cost of holding this inventory. The costs of holding this inventory could be minimized if the currencies are denominated in the currency of the country identified with low inter est rates. Before World War I, a large part of international trade was denominated in the British pound; since then much of the international trade has been denominated in the US dollar. Importers in many countries (except primarily US) need to pay US doll ars; exporters in these countries receive US dollars. So these traders began to acquire the US dollar deposits as part of their inventory. And the development of the reserve currency roles of the British pound and then of the US dollar followed the pattern s of trade finance".

19

Table 1.5

The Structure of United Kingdom's Current Account Balance

(in millions of pounds) Years 1881 1886 1891- 1896- 1901- 1906- 1911-

-85 -90 95 00 OS 10 15 Imports, 351.6 342.8 371.9 422.1 482.2 566.9 655.2

Exports 295.2 298.5 287.5 303.7 367.2 487.8 593.9

Balance -56.4 -44.3 -84.4 -118.4 -115.0 -79.1 -61.3

Invisible 8.1 8.0 7.6 8.5 12.9 12.1 14.2 Trade Payment Invisible 28.0 27.6 26.9 27.6 25.1 49.0 58.7 Trade Receipt Balance 19.9 19.6 19.3 19.1 12.2 36.9 45.5

Shipping 6.3 6.1 6.2 7.2 10.9 13.1 14.8 Payment Shipping 45.7 43.1 42.8 45.6 54.9 69.0 77.5 Receipt Balance 39.4 37.0 36.6 38.4 44.0 55.9 62.7

Emigrants -11.2 -11.1 -10.0 -10.7 -13.0 -17.6 -22.1 &Tourism Balance Total 48.1 45.5 45.9 46.8 43.2 75.2 85.1 Invisible Items Balance Trade and -8.3 1.2 -38.5 -71.6 -71.8 -3.9 23.8 Services Balance Interest& 64.8 84.2 94.0 100.2 113.0 151.4 188.0 Divident Balance Total 56.5 85.4 55.5 28.6 41.2 147.5 211.8 CurTent Account Balance Source: De Cecco, M. (1984)

(Table 1.5) This high interest earning might have been also a major

incentive for high foreign lending by Britain. The operation of these

factors together resulted in two dominant features characterizing the

international money market of that time. First, British sterling became

the most accepted medium of exchange worldwide. Second, it

20

--I :t /-

created international confidence in the stability of exchange rate of

sterling vis. a vis. Gold. As a result, on an international scale, British

sterling could function in practice as a reserve currency along with

gold. With the British sterling starting to function as reserve currency,

central banks of other countries had the option of choosing the

composition of the reserve fund, whether it should contain more gold

or sterling holding. The reason behind holding the sterling (excluding

U.S.) was that gold did not earn any interest while sterling deposits

did earn interest. In 1913, the formal and informal British Empire,

extending over parts of Africa, Asia and

Australia further contributed to this process. Together these

countries held about 150 million dollars worth of sterling deposits in

London.

Table 1.6

Reported Foreign Holdings of Major Currencies by the Monetary Authorities of Different Countries,

End of1913

(in millions of dollars) Countries England France Germany

Europe consists of 52.7 40.3 62.5 lOCounbies Africa-Asia- 344.8 13.0 2.0 Australia consists of 6 countries Source: Lmdert, P.(1969) p-19

Apart from these colonies and dominions, the independent

countries also held sterling deposits in London. The Japanese

government and Bank of Japan had together held deposits in London

21

__.,--··

THESIS 332.042 G9398 So

lllllllllllllllllllllllllllllll TH10640

worth of 101.1 million dollars in 1913. The National Bank of Greece

held deposits of around 10 million dollars in 1913. Other European

monetary authorities together also had deposited around 100 million

dollars in 1913. Some historians4 argue that the Gold Standard

system was actually a sterling standard system. But many others

oppose this view that the gold standard was a sterling standard

system. They argue that though the British sterling had the highest

proportion in stock of foreign currency denominated assets that were

held by central tanks as reserve, the proportion of this holding is

much smaller than the total monetary gold reserve. 5 Even this

evidence however cannot detract from the fact the British-sterling

had played a role of the most widely used reserve currency, apart

from gold. It showed that apart from gold it was the British-sterling

about which the international money market had the confidence that

its value would be stable and would be the most easy to convert into

gold. In short, it had greater liquidity. It helped Britain to have

greater money pulling power.

4 Cohen, Benjamin J. (1977). In this book he has written, "The classical gold standard was a sterling standard - a hegemonic regime- in the sense that Britain not only dominated the international monetary order, establishing and maintaining the prevailing rules of the game, but also gave monetary relations whatever degree of inherent stability they possessed ... .. It did not regard itself as responsible for global monetary stabilization or as money manager of the world. Yet this is preci sely the responsibility that was thrust upon it in practice ..... The widespread international use of sterling and the close links between the larger financial markets in London and smaller national financial markets elsewhere inevitably endowed Britain with the power to guide the World's monetary policy. Changes of policy by the Bank of England inevitably imposed a certain discipline and coordination on monetary conditions in other countries." 5Lindert, P.H.(1969)

22

The mechanism, through which London pulled money

internationally, was the interest rate. Higher interest rates in London

would attract short-term capital from abroad or prevent capital from

going abroad, since the probability of exchange gains was high.6 In

fact Keynes had suggested that this was the reason for the success of

bank rate change policy of Britain to influence capital. He comments/

"The drain (gold drain) could only be stopped if we can rapidly bring

to bear our counterbalancing claims. When we come to consider how

this can best be done, it is to be noticed that the position of a country

which is preponderantly a creditor in the international short-loan

market is quite different from that of a country which is

preponderantly a debtor. In the former case, which is that of Great

Britain, it is a question of reducing the amount lent; in the latter case

it is a question of increasing the amount borrowed. Machinery that is

adapted for action of the first kind may be ill suited for action of the

second. Partly as a consequence of this, partly as a consequence of

the peculiar organization of the London money market, the bank rate

policy for regulating the outflow of gold has been admirably

6 lewis, W.A. (1978) He said, "Whenever Britain began to recover from cyclical recession there would come a point where the Bank began to lose gold .... A financial crisis could occur ... The bank rate would go up sharply, and open market operations or equivalent would be launched. At this point oversees lending would be suspended because the stock exchange would react to the financial crisis, because the houses promoting such loans would think the moment inauspicious, and because those who held funds for foreign countries would keep them in london to ear n higher interest rate. 7 Keynes (1913)

23

successful in this country, and yet cannot stand elsewhere unaided by

other devices."

Bloomfield(1963) has pointed out that there had long been

recognition of the fact that before 1914 increases in the Bank of

England discount rate, were 'effective' in the market, and not offset

by corresponding increases in other lending centers. This had an

important short run effect in stemming drains on the gold reserves of

the Bank of England (whether external or internal in origin), and even

in reversing the flow of gold, by inducing equilibrating inflows of

capital through unilateral adjustment in the bank rate by the Bank of

England. When the Bank of England raised domestic interest rate,

other major countries did not necessarily follow it. In particular,

France followed Britain to a esser extent on rate of interest change.

As a matter of fact, during the period 1890-1900, France had

changed its bank rate only 9 times. For Germany it was 39 times,

where as for Britain the figure was 688•

But Peter Lindert(1969) has opposed Keynes view. The

essential assumption for the Keynes argument is that Britain was a

very big short-term creditor. This is a doubtful claim. As Lindert has

pointed out, seldom has it been argued that Britain was a net short­

term creditor. From the sources cited by Karl Strasser it can be

claimed that the London's holding of bills on foreign places were

estimated to have fallen far short of the level of foreign-held claims

24

on London. Marcello De Cecco9 also contradicted Keynes. He argued

that Britain used to borrow short run through obtaining the reserves

of the peripheral countries as deposits. And she then lent them as

long-term credit. In fact he argued further that this system could

have been stable when short-term creditors had absolute confidence

in the major country where they kept their reserves. And such a

degree of confidence could be reached when lesser countries were

politically or economically subservient. The findings of Peter Lindert

also confirm that the Bank of England clearly enjoyed a short-run

command over most of the sterling exchanges even without changes

in interest rate differential. This was especially true of the exchange

rates relating London to centers with very shallow money markets.

London also enjoyed hegemony among the three main centers,

although it was less pronounced. She had a clear edge over Berlin

and a more ambiguous advantage over Paris. The explanation he has

provided is that even in the absence of changes in international

interest rate differentials, London had superior money pulling power

not only over the less developed financial centers in Europe, but also

over the other major centers like Paris and Berlin. When discount

8 calculated by the author 9 According to him Britain was the World's banker. The smaller countries had to have deposit mainly in the Great Britain and lesser extent in France and Germany. This was seen as advantage for the Britain and lesser extent for France and Germany. They could afford to spend more abroad, both on current and on capital account. This meant that the greater countries could keep investing in the lesser. The Balance between short-term indebtedness and long run credit was often maintained bilaterally. A major country could invest in a peripheral country to more

25

rates rose together, the tendency of the banking system to increase

the liquidity of their portfolios would almost inevitably lead to a

movement of short-term funds towards the largest financial centers.

The tendency of banks to become more liquid in periods of increasing

tightness suggests that even if each major center had been neither a

net short-term debtor nor a net short-term creditor, flows of capital

towards larger and more prestigious centers should have been

expected when discount rates rose together. The operation of this

international adjustment mechanism depended upon a hierarchy of

financial centers. Since, London was in the first tier, Berlin and Paris

the second while Amsterdam, Vienna, Zurich, Milan and others were

in third, naturally London benefited most from such operations. On

the other hand he himself has pointed out that the available

exchange rate figures, at any rate, imply that tighter discount policy

in London, even when initiated elsewhere, set off waves of short-run

flows of capital toward the center of international finance from

periphery.

So both Keynes and Lindert had agreed on one fact namely

that the interest rate elasticity of capital flow was higher for the

countries in the center. Within the center, Britain had the highest

followed by France and then Germany. But there was disagreement

about the reason behind it. According to Keynes, it was because of

or less the amount of short-term deposits it received from that country. That was often the case with British investment abroad.

26

their short-term creditor position. But there were contradictory

evidence available on the claim of Britain's position as a short-term

net creditor. So it may be because of greater liquidity of the British

sterling denominated assets, which were followed in this respect by

assets denominated in the franc and mark, as Lindert has claimed. It

also implies that British-sterling had a greater use as an international

reserve, which implies greater confidence in the stability of the

exchange rate, and greater money pulling power. According to

Marcello De Cecco, such a degree of confidence can be reached

when lesser countries were politically or economically subservient.

These countries were denied the right to choose between gold and

sterling; they had to deposit any surplus, in sterling, in London. At

the same time London held deposits of the independent countries,

which could exercise the right to choose between gold and sterling

whenever they wanted. This can be explained by the fact that as this

dominance had made British sterling the reserve currency there was

a confidence in the stability in the value and liquidity of the sterling

denominated assets so that more reserve flowed into London. In

effect it helped Britain to have an effective rate of interest policy to

attract money towards it from the continent, which was the source

of funds for the short-run adjustment in British reserves as Lindert

mentioned.

27

In conclusion, the hegemony over world trade and finance and

control over economic and politically subservient countries had led to

an international arrangement in which the British sterling found wide

spread acceptance as reserve currency. All of these factors helped

Britain to have extraordinary money pulling power on an international

scale at the height of the Gold Standard. It can be shown with a

simple mathematical formulation also.

Suppose, we are in a two assets world, money and bond. The

wealth holders can hold currencies and bonds. The expected return

from keeping wealth in say country i will be

[(£)'' + q - m + (}!_),.- m ]. b b b c· <" I

p p

where, p refers to price, subscript b to the bond, subscript c to

the currency in question, superscript e to the expected value and m

to the risk premium and q to the rate of return of the bond.

If the net rate of return on the bond is denoted by r, what by

following Kaldor can be called the 'own rate of money interest', then

in short period equilibrium for currency i and j,

h ( p)" were, rb =- b+qb-mb p

28

If we define the long-run equilibrium as a state characterized by

c.£.r = 0 for both i and j, p

Following Keynesian tradition the objective of economic policy

in each country must be assumed to preclude having a persistently

higher interest rate than in the other, for that would entail lower

growth; it follows that policy must be such that

Now, if risk premium of the currency is taken as a function of

the level of reserve to money supply (R) and of the elasticity of

capital flows with respect to interest rate (E), then, assuming identical

functions for all currencies

where, k denotes any currency.

As the equality of fiSk premium of all countries is required for

the equilibrium, this means that R* = h(E*) for all k and h' -< 0

i.e. countries with high interest elasticity of capital flows will

have low ratios of reserves to money supply in equilibrium.

As a result, Britain could sustain the stability of its exchange

rate without having large reserves and this stability in exchange rate

29

itself had helped it to maintain the confidence in sterling, which

helped its use as reserve currency. The Gold Standard appeared a

stable and smoothly adjusting system, nevertheless, the practice was

different from the theory.

Apart from Britain, France and Germany were also lender

countries. Yet none of them managed to rival London in the business

of accepting and discounting foreign trade bills or in the volume of

total foreign lending. France's share in total world trade was also

small compared to Britain. The money deposited in these countries by

other countries was quite small compared to Britain. In 1912 only

1235 million francs were deposited in Paris, in Berlin it amounted to

only 152.3 million dollars in December 1913. The liquidity of franc

denominated and mark denominated assets was less than of those

denominated in the sterling. The central banks of these countries

sometimes had partially stopped the convertibility into gold. All these

led to a lesser use of these currencies as reserve currency. All these

were reasons contributing to the lesser international demand for

these two currencies as medium. of exchange. This, in turn,

contributed to the failure in generating such a confidence in these

currencies that they could be used widely as reserve currencies.

Consequently, neither Paris nor Berlin succeeded in matching the

international money pulling power of London. In contrast, the extent

of the use of a currency as an international medium of exchange and

30

its use as a store of wealth: both these factors worked together, hand

in hand, for Britain. Though, from time to time, Germany had tried to

use the bank rate device, its extent was limited. And the capital

inflows were not sufficiently large to solve the balance of payment

deficit problem. 10 Thus, even France and Germany had to keep large

monetary gold reserves, compared to Britain, to defend their

currency. This was even truer for the countries, which were in the

third tier of financial centers.

Keynes11 had described the situation very well. According to

his narration the majority of the European countries, for example,

France, Austria-Hungary, Russia, Italy, Sweden, or Holland had a gold

currency and an official bank rate. In none of them gold was the

principal medium of exchange and in none of them bank rate was not

the 'habitual support' to prevent outflow of gold. All these countries

had three options to maintain the exchange rate parity. First, a very

large gold reserve may be maintained. Second, free payments in gold

may be partially suspended and third, foreign credits and bills may be

kept which can be drawn upon when necessary. The Bank of France

uses the first two. Her bank rate was not fixed primarily with a view

of foreign conditions and a change in it is usually intended to affect

the domestic economy. Germany tried to bank upon the bank rate to

attract capital flow to ease off the pressure from the exchange rate

10 Bloomfield,(1963) p.70. 11 Keynes,(1913)

31

parity but it was not very successful. Her gold reserve was not large

enough. Free payment in gold was some times suspended, like in

november1912. To an increasing extent Reichsbank depends on

variation in her holding of foreign bills and credits for Austro-

Hungarian Bank foreign bills and credits had formed an important

part of the reserve and it was utilized at the time of stringency. In the

third quarter of 1911 the Bank had placed a ninimum amount of

4,000,000 pounds gold bills at the disposal of the Austro-Hungarian

market in order to support the exchange. In November 1912, Russia

had as foreign bills balances an amount of 26,630,000 pounds. In

the same time three Scandinavian countries, Sweden, Norway and

Denmark held the highest proportion in the form of balances abroad.

Table1.7

Reichsbank's Holding of Foreign Bills

(Exdudinq Credits), in pounds Years Average for Year Maximum Minimum

1895 120,000 152,000 100,000

1900 1270,000 3540,000 160,000

1905 1580,000 2490,000 970,000

1906 2060,000 2990,000 830,000

1907 2223,000 3000,000 1130,000

1908 3544,000 6366,000 977,800

1909 5362,000 7978,000 2824,800

1910 7032,000 8855,000 4893,300

Source: Keynes, Indian Currency and Finance, p -16

32

The reason for keeping a high portion of reserves as foreign

currency denominated assets by these countries was that the money

market was not so developed that it could work as a lender or be at

least self-supporting. The central banks to make them secure, had to

enter the international money market as short-term creditor, that

they could take out money at short notice. The only alternative would

have been the holding of a much larger reserve of gold, the expense

of which would have been nearly intolerable.

The question of being able to use of the currencies of the

Countries more peripheral to the system as international reserve

currency almost did not arise. In fact they had to keep large part of

their reserve not into gold but as sterling deposits in London or to

invest into the security market of developed countries, mainly in

London. Their role in international finance was to get themselves

exploited and by this serve the interest of the financial centers.

Typically they Yoere forced to provide money to the financial centers.

Thus India provided money to the London, financial center. India had

been one of the worst exhibitions of imperial exploitation. The

reserves, on which the Indian Monetary system was based, could be

used to supplement Britain's reserve and to keep it as the center of

the international monetary system. (See Table 1.8 relating to India as

a British colony). Apart from this, Britain used to have two other

channels, through which she could improved her balance of payments

33

by using India's colonial status. The first was the Home Charges and

second was through balance of trade. The Home Charges consisted

mainly of interest on debts to England incurred by the British Raj,

pensions of former Indian civil servants living in England, payments to

the war office for the upkeep of the Indian Army and of the whole

imperial Army and purchase of materials in England on the Raj's

account. India's foreign trade was structured in such a way that India

had a huge trade deficit with Britain and had huge trade surplus with

the rest of the world. Britain, instead of allowing India to have a Gold

Standard system, allowed her to have only a Gold Exchange Standard

system 12• In 1901, India's Gold Standard Reserve was 3447317

pounds, a which 2439093 pounds in gold were held in India and

1008424 pounds in British government stock were held in England. At

the end of the first quarter of 1902 the whole reserve was transferred

to London and invested in British government securities. This trend

continued until 1914. British government securities in the Gold

Standard Reserve's portfolio grew from 3.5 million pounds in the first

quarter of 1902 to 16 million pounds in the first quarter of the 1912.

In addition India office began to keep money from the Gold Standard

Reserve, at call and at short notice, with finance houses of the

London. This began in 1908, when 1131223 pound sterling was

deposited. It grew up to 3 million pounds by the first quarter of 1910.

12 Gold was not in circulation within the economy. It was paper money that was in circulation and it was backed by the gold reserve which was deposited in London.

34

Table 1.8

Gold Standard Reserve of India on 31st March 1913 (in pound)

Gold Silver in Securities at Money lent Total Deposited at Indian market at short Bank of Branch prices notices England 1620000 4000000 15945669 1005664 22571333

as a % of as a % of as a % of as a % of total is total is total is total is 7.17% 17.72% 70.64% 4.45% Source: Dadachanji, B. E. H1story of Indian Currency and Exchange (1927),

At the same time, the economically weaker countries (Lewis

termed them as Less Developed Countries who are borrowers and

among these we are talking about those who were politically

independent but economically weaker, like Argentina) could not keep

large reserve. This was because keeping large reserves for them was

very costly, somewhat similar to 'a man borrowing at 6% to keep

money in the bank at 3%'. Most of these countries had very

underdeveloped banking systems. They could not effectively influence

their financial markets. Even if their central banks tried to use the

bank rate to cover the deficit on the balance of payment with a view

to stabilizing the exchange rate, they were doomed to failure So, the

safe policy option for these countries for currency stability were

Firstly, keeping a balance of payment surplus as seen in Table

1.9 for Argentina. The second route to currency stability for

economically weaker countries was to keep a critical level of reserve

such that the intervention in the exchange market could be effective.

For details see Keynes, (1913)

35

Table 1.9

Trade Balances, capital Flows and overall Balances of Argentina

Annual Averages for Various Periods 1880-1913 Country Period Trade capital Flows Overall

Balance (outflow = - ) Balance Argentina 1911-1913 +37.3 +320.0 +10.0

1895-1900 +27.2 +30.8 +1.3

Source: Lindert, P. P-69

From the preceding discussion we can draw the following

conclusions.

First, there was a direct link between the exchange rate and

monetary gold reserve, but only in theory, for all countries.

Second, the stability of the exchange rate was scarcely

dependent on foreign exchange reserves in the case of Britain as the

dominant economic power of the time. The stability of the exchange

rate of other countries depended upon the stock of reserve they had.

Third, this difference in the link between gold reserve and

national currency was dependent crucially upon the ability of a

country to control capital flows.

Finally, a country, which had more influence on world trade

and finance, was also correspondingly more able to control

international capital flows. This gave rise to an apparently paradoxical

pattern: the more economically powerful a country, the less it needed

to maintain gold reserves to back its currency, the extreme case

being that of Britain. In short, the discipline imposed by the Gold

Standard was asymmetrical-it imposed discipline on the economically

weak, but showed leniency towards the economically strong

countries. As we shall argue in subsequent chapters, this asymmetry

extends beyond the period of the Gold Standard. The Gold Standard

has disappeared, but the asymmetric rules of the game it had set

survive.

37