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The Sterling Trap
One of the often cited causes for the Great Depression was the French monetary policy of converting their foreign exchange holdings into gold, thereby causing a credit squeeze in New York and a deflationary pressure on the sterling in London.
"... the damage done by French policies lay to a much greater degree in the government's choice of monetary regime - its commitment to the gold standard, with minimal use of foreign exchange reserves..."1
However, a review of history shows that the French monetary authorities' decision to liquidate their foreign exchange holdings appears to stem less from malicious intent and more from a will to limit foreign exchange losses. Furthermore, it was not the "commitment to the gold standard" which caused the economic panic, but rather the policy of accumulating foreign exchange reserves.
As part of the Genoa Conference in 1922, it was proposed that central banks would also hold gold convertible currencies as foreign exchange reserves due to the scarcity of gold. It was promoted then, as it still is today, that the quantity of available gold is insufficient to properly function as money in the global economy.
The pound sterling returned to its pre-WW1 parity to gold in 1925 and was regarded as overvalued relative to major currencies of continental Europe such as the French franc and the German reichsmark (Keynes, 1925).
Following the events of WW1, France experienced ten years of currency instability. In the second half of 1926, the French government mandated the Banque de France (BdF) to buy foreign exchange on the market to avoid excessive currency appreciation (Blancheton, 2001). This effectively pegged the French franc to the British pound sterling and U.S. dollar.
Through a process of maintaining an undervalued currency, France recorded trade balance surpluses. When the franc was made convertible to gold on June 25th 1926, the BdF held more than half of the world's volume of foreign reserves (Nurske, 1944). The construction of huge underground vaults located 25 metres below the BdF's central building in Paris was completed in 1927 for the storage of gold and currency notes (Netter, 1994).
The new franc Poincaré was defined as 0.0655 grams of gold at 900 fineness (amounting to 0.05895 grams of pure gold). This represented an 80 percent devaluation relative to gold compared to before WW1.2 The new currency was hoped to provide the same level of stability that the franc de germinal had provided during the classical Gold Coin Standard of the 19th century.3
In 1929, when it was feared that the Bank of England (BoE) might devalue the pound sterling due to insufficient gold reserves, the BdF began rebalancing its holdings away from the pound sterling towards gold and the U.S. dollar.4
British monetary authorities were acutely aware of the gold purchases by the BdF as most of it was drawn from London. At the time, the BoE was pursuing a policy of maintaining low interest rates to reduce unemployment. In 1930, from May to December, the French gold reserves increased by 648 metric tonnes (valued at eleven billion francs).
In response to growing criticism in newspapers from New York, Berlin and London, Robert Lacour-Gayet, the director of economic studies at the BdF, wrote a response stating that the levels of foreign exchange remained the same and that the rising gold was a result of economic laws and the normal functioning of the gold standard.
"If gold flows to France, it is because the franc has greater purchasing power than the pound or the dollar. The gold standard is fulfilling its function as leveller of prices. Gold becomes scarce in the country where it is valued least, and goes to the country where its value is greatest. If the central banks of the affected countries adopt an appropriate discount policy, equilibrium will be quickly restored." (La Stabilisation du pouvoir d'achat de l'or, 1930)
French monetary authorities held that the BoE needed to work within the normal functioning of a gold standard. The gold losses it experienced were indicating that corrective action was needed. Examples of these underlying issues were excessive levels of debt, poorly controlled credit expansion, artificially low interest rates, open market operations, an insufficient gold reserve and excessive foreign lending.
From October 1930 to July 1931, the BdF switched towards supporting the pound sterling, including a £25 million loan to the BoE made in July 1931 (Mouré, 1991). While official communications between Clément Moret, the governor of the BdF, and Robert Kindersley, the director of the BoE spoke of "the noble principle of market solidarity", the real reasons were more pragmatic.5 The BdF realized it was in a trap, unable to unwind its large holding of pound sterling on the exchange market without precipitating a currency crisis and incurring a massive exchange loss.
This policy of supporting the pound sterling came to an abrupt end on Sunday, September 20th 1931 when the British government issued a statement announcing its decision to "suspend for the time being" the clause of the Gold Standard Act of 1925 requiring the Bank of England to sell gold at the fixed price.
This measure was enacted to stop the large withdrawals of BoE gold following the deteriorating economic situation following the collapse of Austria's Kreditanstalt. Following the suspension of pound sterling convertibility into gold, the British currency immediately experienced a decline of 40% to $3.45 before recovering to $3.92 in October.
To describe this action by stating that the pound sterling simply "depreciated", while technically correct, fails to instil the gravity of the event. The repercussions to those countries holding pound sterling lost heavily.
The most recent loan of £25 million granted two months earlier, previously valued at 3.1 billion francs dropped to a value of only 2.5 billion francs. In a BoE report published January 21st 1932 titled "The suspension of the Gold Standard in Great Britain and its effect on the countries of Europe" the amount of pound sterling held by the BdF was estimated at £62 million (7.7 billion francs).
The BdF was not alone in liquidating all foreign holdings in favour of gold. In Belgium, the Banque Nationale de Belgique sold all visible foreign exchange for the precious metal. In Switzerland, the Banque Nationale Suisse liquidated all sterling accounts held at the BoE and increased its gold reserves.
The continental central banks which adhered to the gold standard (the "gold bloc") all saw heavy losses on their sterling balances. The Banca d'Italia in particular, as the Italian lira was stabilized in December 1927 on a gold exchange standard and the largest proportion of its reserves were still in pound sterling.
The central banks of Norway and Sweden, followed shortly after by Finland, imitated the BoE moves and ended convertibility of their currencies, causing them to devalue in sympathy with the pound sterling.
Are Foreign Exchange Reserves Beneficial?
Foreign exchange reserves were initially proposed as a means of addressing the perception of the quantity of gold being insufficient for supporting global trade. The pound sterling was often the preferred currency of continental Europe due to both the proximity of Britain (lower shipping costs associated with transporting bullion) and its pre-WW1 exchange rate parity.
Britain exported pound sterling for goods and incurred a negative balance of payments year after year. Under the classical gold coin standard (pre-1914), this would have ultimately necessitated a rise in the gold price expressed in pound sterling as gold became less scarce (and therefore more valuable) in Britain. Within a short period of time, the citizens of the Britain would be increasing the quantity of goods for export, as the gold received in payment would have increasing purchasing power. Through this process, trade import/export imbalances are both temporary and self-correcting via the free market. However, under the new gold exchange standard, the BoE was simply able to print more currency and the imbalances (trade deficits) were allowed to continue.
When the BoE repudiated its obligation to redeem pound sterling in gold, the value of the British currency fell violently and those who held unto sterling-denominated holdings suffered greatly.
The cost of this default was also carried by citizens of countries where the central bank quickly copied the BoE's decision. While this may have prevented an exchange loss, the devaluation of their currency in sympathy with sterling, ultimately resulted in higher prices for goods and services.
Foreign exchange reserves, often promoted as a stabilizing factor, can be clearly seen to become a destabilizing force as seen from the example above. Large accumulations of any currency becomes a burden for the holder as they cannot be quickly unwound without driving the underlying currency down and precipitating the very capital loss that the holder is attempting to avoid.
Such was the position that the monetary officials of the BdF found themselves in during the 1930's.
1 Taken from page 150 of Bernanke & Mihov (2000) "Deflation and Monetary Contraction in the Great Depression: An Analysis by Simple Ratios", in Essays in the Great Depression. Other authors such as Paul Einzig and Clark Johnson hold that French monetary policy was deliberately aggressive.
2 Nations had gone off the gold standard in order to print additional money to fund the military efforts of WW1. In France, the number of notes in circulation had increased from 14 million in 1913 to 383 million by 1928. (Mouré, 2002)
3 The franc de germinal is named after the month Germinal in the French Republic Calendar.
4 In the financial weekly L'Economiste Français, there were frequent references to the credibility of the pound sterling - "the ongoing weakness of the British pound" (6 July 1929), "fears ... on the solidity of British currency" (21 September 1929), "a certain mistrust" of sterling (5 October 1929) and "a question of confidence" (10 January 1930).
5 When the French Senate's Finance Commission, which was investigating on the loss endured after the sterling crisis, asked the Bank officials whether they had been prudent enough, they replied: "We seized every chance we could to liquidate our sterling pound holdings" but "circumstances were far from favouring full implementation of this policy". The Bank said it did not want to "provoke the depreciation of a currency in which it had considerable holdings", reminding that it "would have been the first to suffer" from a sterling collapse. (Archives BdF, 1397199403/163, "Réponses aux questions posées par la Commission des Finances du Sénat".)
6 When calculated in terms of gold, this amounts to a loss of 35.5 metric tonnes. At November 21th 2009 market price of US$1172 per troy ounce this amounts to US$1.3 billion.
Accominotti, Olivier (2008) The Sterling Trap - Foreign Reserve Management at the Bank of France, 1928-1936.
Bank of England (Report dated 21 January 1932) "The suspension of the Gold Standard in Great Britain and its effect on the countries of Europe" Bank of England Archives, OV48/9, 1538/4, no. 86.
Bernanke, Ben S. & Mihov, Ilian (2000) "Deflation and Monetary Contraction in the Great Depression: An Analysis by Simple Ratios", in Essays in the Great Depression, 135-50, quote from page 150.
Blancheton, B. (2001) Le Pape et l'Empereur: la Banque de France, la Direction du Trésor et la politique monétaire de la France (1914-1928).
Brown Jr., William Adams (1940) The International Gold Standard Reinterpreted, 1914-1934.
Einzig, Paul (1931) Behind the Scenes of International Finance.
Johnson, H. Clark (1998) Gold, France and the Great Depression, 1919-1932
Keynes, John Maynard (1925) The Economic Consequences of Mr. Churchill.
Mouré, Kenneth J. (1991). Managing the Franc Poincaré: economic understanding and political constraint in French monetary policy, 1928-1936.
Mouré, Kenneth J. (2002) The Gold Standard Illusion - France, The Bank of France, and the International Gold Standard 1914-1939.
Netter, Maurice (1994) Histoire de la Banque de France.
Nurkse, R. (1944) International Currency Experiences: Lessons from the inter-war period.