Reserve management: From gold standard to gold exchange standard

The 1920s and 1930s were pivotal decades for foreign exchange portfolio management by central banks. The period saw the rise and fall of the so-called gold-exchange standard. The idea of replacing the gold standard with a gold exchange standard, building on pre-war experience with key currencies, was fully articulated at the Genoa Conference in 1922. The Financial Commission of the conference was presided over by British Chancellor of the Exchequer Sir Robert Horne. It considered remedies for the perceived dangers of global deflation. The war and its aftermath had seen considerable monetary creation: return to the pre-war order implied "tapering" and, by implication, deflation and associated pressures, including unemployment. This was not an appetising prospect for Western powers now haunted by the spectre of the Bolshevik Revolution.
Along with this general concern with the future of Western capitalism were also specifically British concerns that returning to a gold standard along prewar lines would make it difficult for Britain to regain its position as a monetary centre. Forced to adopt austerity measures, Britain would have to discourage capital exports and the provision of trade finance to foreign customers, creating a marketing opportunity for U.S. financial institutions.
This is how the Genoa Conference was led to re-imagine the pre-war gold standard as having sowed the seeds of a superior gold exchange standard now to be implemented (Nurkse 1944, p. 29). The key innovation lay in the attempt to systematise the way foreign exchange reserves were handled and in codifying previously ad hoc practices. Resolution 9 of the report of the Financial Commission to the Genoa Conference declared that the aim of the convention would be to "centralise and coordinate the demand for gold, and so avoid those wide fluctuations in the purchasing power of gold which might otherwise result from the simultaneous and competitive efforts of a number of countries to secure metallic reserves." Resolution 11 stated that the "maintenance of the currency at its constant gold value must be assured by the provision of an adequate gold reserve of approved assets, not necessarily gold."
It may be an exaggeration to speak of a "Genoa Order" because, like so many other expert recommendations of the time, the agreements on the report of the Financial Commission fell to pieces subsequently. That said, many of the ideas had an enduring impact (Clavin 2013). The effect of Genoa was visible in the many financial stabilisation programmes adopted under the auspices of the League of Nations in the 1920s. In Austria, Danzig, Hungary, Bulgaria, Estonia and Greece, League of Nations "packages" included newly created or reorganised central banks with statutes that authorised them to hold foreign exchange as a component of their reserves (League of Nations 1932).
a) The Mlynarski Dilemma: The gold exchange standard envisaged at Genoa had inherent contradictions, including one that came to be known later as the so-called "Triffin paradox," after the Belgian economist Robert Triffin (1947), who leveled the same critique against the dollar-based Bretton Woods System. In the 1920s and 1930s the argument was identified with Feliks Mlynarski, the Polish-born economist and subsequently affiliate of the Financial Committee of the League of Nations, who pointed to it in Mlynarski (1929). Under the gold exchange standard, the gold supply problem was simply replaced by the confidence problem of key currencies. This confidence problem would inevitably arise when foreign exchange reserves grew large relative to the gold stocks of the key-currency central banks, exposing the latter to the equivalent of a bank run problem. But it could arise even earlier as a result of instability on the London and New York markets and associated policy uncertainty, as events would soon reveal.
Austrian stipulations regarding which currencies the central bank could hold provide a case in point. Austrian statute stated that foreign currencies held as reserves would have to be not just convertible but also stable and liquid. The statutes adopted in the 1920s permitted investment in inconvertible currencies but allowed only "foreign currencies which have not undergone any violent fluctuation of exchange" to be counted as part of the "cash" Reserve (Kisch and Elkin 1928, p. 163-4). This was both a weakening and a continuation of the logic pioneered by Belgium some 70 years earlier when inconvertible currencies were shunned as legitimate components of the reserve but admitted as collateral.
The emphasis of Austrian lawmakers on "currencies which have not undergone any violent fluctuation of exchange" suggested foreign exchange accumulation was not conceived as a form of asset diversification but as an indirect way of holding gold. The problem was that by the 1920s the architects of central bank statutes could look to many examples of how convertibility promises could be and had been broken. Hence only countries with the strongest commitment to the maintenance of convertibility had the capacity to emerge as reserve centers. The result was a hierarchical international monetary order. The situation, as envisaged in the Genoa Report, would be one in which certain of the participating countries" would come to "establish a free market in gold and thus become gold centres." These special participating countries would peg their currencies to gold, whereas the rest of the world in turn would peg to those currencies. The Bretton Woods System after World War II, in which the dollar was pegged to gold while other currencies were pegged to the dollar, was a lineal descendent of the Genoa order.
The contrasting composition of central banks reserves in reserve and non-reserve currency countries illustrates the implications of this arrangement. In late 1929, at the height of the gold exchange standard, the average proportion of foreign exchange in the reserves of 24 countries that did not produce a key currency stood at 37 per cent. In contrast, the Bank of England held foreign exchange equal to only 11 per cent of its combined gold and foreign exchange holdings (and foreign exchange holdings were not allowed to be included in the statutory reserve). The typed forms on which the Bank of England recorded its foreign exchange holdings listed only two foreign exchange entries (the fact that they were typed suggests that the recorders did not expect this to change this frequently): "French franc securities" and "Dollar investments." Dollar investments, moreover, made up fully 99 per cent of Bank of England's foreign exchange as of late 1929. The Federal Reserve, for its part, held no more than negligible quantities of foreign exchange. This, then, was a profoundly asymmetric system, again anticipating Bretton Woods. In the republic of currencies, some currencies were more equal than others.
(b) The Leverage Cycle
A powerful procyclical element was built into this system: During expansions, non-key currencies central banks were happily accumulating sterling and dollars, allowing them in turn to expand their own money supplies, while the key currency countries themselves did nothing to contract theirs. During contractions, when doubts might arise about the stability of key currencies, there was a tendency to flee to gold. Non-key-currency countries would dump their foreign exchange holdings and demand gold from reserve-currency central banks in return, putting pressure on the reserves of the latter, in turn forcing them to raise interest rates in an effort to rebuild their reserves (or at least to prevent them from declining further). The central banks of the key-currency countries were thus in no position to play a countercyclical role, like that of the Fed starting in 2008. The result was not unlike the leverage cycle emphasised by Geanakoplos (2009), where improvements in the quality of collateral leads to increases in leverage and credit, although central banks rather than commercial banks were at the center of the story.
The dilemmas of the gold exchange standard were evident in the behaviour of the largest of all non-key currency central banks, the Bank of France. The French central bank had not entirely given up hope of regaining its pre-World War I status. The presence of its currency in the ledgers of the Bank of England and the books of Paul Einzig suggests that some took this possibility seriously. Such ambitions required following the example of the U.S. and Britain. The stabilisation law of 1928 therefore defined reserves as comprising solely gold, although the Bank of France also held very large amounts of foreign exchange beyond the statutory gold reserve (Bouvier 1989, Mouré 2002).
Holding reserves exclusively in gold was the hallmark of a key-currency country. At the same time, accumulating sterling and dollars was tempting, for it promised financial returns. Torn between these conflicting objectives, the Bank of France alternated between accumulating foreign exchange and seeking to liquidate its previously-acquired holdings. Eventually, after having at one point held nearly half of world's foreign exchange reserves, the Bank of France ended up incurring large losses when Britain abandoned the gold standard in 1931 before French central bank could dispose of its sterling holdings (Accominotti 2009).
Jamaluddin Ahmed, PhD FCA is the General Secretary of Bangladesh Economic Association and a
member of Board of Directors of Bangladesh Bank.
[email protected]