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)
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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.
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