Interwar Period (1914-1939).

The gold standard broke down during World War I (1914- 1918) and a severe
contraction in 1907, as well as a number of smaller-scale recessions. This was
largely due to the fact that policy makers and central banks gave priority to the
achievement of external balance, often at the expense of internal balance and goals
such as full employment.
After World War I, in twenties, the exchange rates were allowed to fluctuate. This
was the result of large fluctuations in currency values. Consequently, the trade
could not develop. Once a currency became weak, it was further weakened because
of speculative expectations. The reverse happened with strong currencies, because
of these unwarranted fluctuations in exchange rates, the trade volumes did not
grow in proportion to the growth in GNP. Many attempts were made to return to gold
standard. U.S. could adopt it in 1919, U.K. in 1925 and France in 1925. U.K. fixed
pre-war parity. In 1934, U.S. modified the gold standard by revising the price of gold
(from $20.67/ounce to $35/ounce) at which the conversions could be effected.
Till World War II practically the above practice remained in force. The gold standard
to which countries returned in mid twenties was different than which existed prior to
1914. The major difference was that instead of two international reserve assets,
there were several currencies, which were convertible to gold and could be termed
as reserves. Apart from pound, French Francs, U.S. dollar had also gained
importance. Whenever French accumulated International Business Finance pound
sterling, they used to convert these into gold. The second difference was that
Britain had returned to gold standard with a decline in relative costs and prices.
In 1931 the crisis began with the failure of a branch banking institution in Austria
called Ke Kredit Anstalt. Had British, U.S. and French banks did not cooperated, this
could have a small impact on world exchange rate environment, but French banks
did not cooperate. Germans withdrew their money from Austria leading to
deepening of crisis led to dismemberment of Gold Standard.
In reviewing the experience in the United States, one stylized fact is fairly
uncontroversial: there was a dramatic reduction in the money supply of about 33
percent between 1929 and 1933, and was briefly reinstated from 1925 to 1931 as
the Gold Exchange Standard. Under this system, the US and the UK could hold gold
reserves, but other nations could hold both gold and dollars or pounds sterling as
reserves with the aim of avoiding the problem of gold shortage that had plagued the
system before. The onset of the Great Depression in 1929 was quickly followed by
massive bank failures throughout the world. Britain was forced off the gold standard
in 1931 when foreign holders of pounds sterling began converting their holdings
into gold. As the Depression continued, countries sequentially decided to go off the
gold standard and allowed their currencies to float in the foreign exchange market
and this had a major impact in the transmission of a financial shock into a full blown
economic depression. There are two general views on what actually happened: (1)
the monetary contraction was the result of the international monetary systems
adherence to the gold standard; and (2) the United States could have enacted
expansionary monetary policy despite the gold standard, so the contraction was a
monumental policy blunder.
Under the gold standard, expansionary monetary policy via low interest rates had
the potential to spur a speculative attack on a currency and to force an adjustment
in gold parityor even a full blown abandonment of gold convertibility. The
monetary policy could have been more expansionary early on in the downturn.
The role of the gold standard may have been more important in terms of the
transmission of the crisis internationally. During the 1930s, most countries
attempted to maintain the gold standard. Based on the adjustment mechanism
defined by a strict gold standard, countries initially tried to deflate via
contractionary monetary and fiscal policies in order to support the gold standard in
the face of a decline in global trade flows. The classical adjustment mechanism via
deflation did not work as quickly and painlessly as theorized.