The Stability of the Interwar Gold Exchange Standard: Did Politics Matter?

TLDR: This article proposed a discrete time duration model (using a panel data set of 24 countries for 1928-1936) to analyze how economic and political indicators affected a country's term on the gold standard.

Abstract: Economic historians have devoted enormous attention to the collapse of the interwar gold standard. This article proposes a discrete time duration model (using a panel data set of 24 countries for 1928–1936) to analyze how economic and political indicators affected a country's term on the gold standard. High per capita income, international creditor status, and prior hyperinflation increased the probability of continuation. In contrast, democratic regimes left early. Unemployment, sterling group membership, higher inflation, and the experience of banking crises reduced the time a country remained on the gold standard. This study also predicts sample countries' survival probabilities.

Figures

Figure 2: Survival Rates for the U.K. and U.S.

Table 2: Summary of Hypothesized Effects

Table 1: Countries on the Gold Exchange Standard, 1919-1938

Table 5: Regression Results for Democracies, dependent variable leaving the gold standard

Figure 3: Survival Rates for Germany and France

Figure 1: Number of Sample Countries on the Gold Exchange Standard

Full text

The Stability of the Inter-war Gold Exchange Standard
Did Politics Matter?
by
Kirsten Wandschneider
September 2005
MIDDLEBURY COLLEGE ECONOMICS DISCUSSION PAPER NO. 05-18
DEPARTMENT OF ECONOMICS
MIDDLEBURY COLLEGE
MIDDLEBURY, VERMONT 05753
http://www.middlebury.edu/~econ

The Stability of the Inter-war Gold Exchange
Standard
Did Politics Matter?
Kirsten Wandschneider
1
Economics Department
Middlebury College
Middlebury, VT, 05753
e-mail: kwandsch@middlebury.edu
This Version: August 2005
1
I thank Ann Carlos, Kim Clausing, Chris Meissner, Larry Neal, Helen Popper, seminar participants
at the Middlebury economics department seminar, the Green Mountain Economic History Workshop,
the 2004 SSHA meetings, and the UBC Economic History seminar for comments and discussions.
Thanks also go to J
¨
urgen von Hagen, Mark Hallerberg, and members of the ZEI in Bonn, Germany,
where part of this paper was completed.

Abstract
The collapse of the inter-war gold standard has frequently been studied in economic his-
tory. This paper proposes a discrete time duration model to analyze how economic and polit-
ical indicators affected the length of time a country remained on the gold standard. We rely
on a panel data set of 24 countries over the years 1922-1938, and incorporate new measures of
political and institutional variables. The results of this study identify high per capita income
growth, large foreign currency and gold reserves, trade with other countries on gold, interna-
tional creditor status, and the prior experience of hyperinflation as factors that increased the
probability that a country would remain on gold. In contrast, democratic regimes that were
exposed to a relatively high percentage of left-wing representation in parliament left the gold
standard early. We also offer predicted survival probabilities for selected key countries on the
gold standard. These survival rates show that Britain abandoned the gold exchange standard
at a much higher survival probability, compared with other countries in the system.

1 Introduction
In contrast to the classical gold standard (1870-1914), the inter-war gold standard lasted a
mere six years, before it collapsed in the early 1930s. A multitude of theories and hypotheses
address the question of why the inter-war gold exchange standard was so fragile. Economists
have traditionally cited structural problems within the system (Feinstein, Temin and Toniolo
1997), gold imbalances (Triffin 1947), the lack of an international hegemon (Kindleberger
1976), or persistent deflation (Bernanke and James 1991, Eichengreen 1992) as possible causes.
More recently, researchers have suggested that the changing social and political structures in
the inter-war years contributed to the economic difficulties (Eichengreen (1992), Simmons
(1994), Tortella (2003)), arguing that the reconstruction of the gold standard as gold exchange
standard in the years following WW I was incompatible with the rise of democracy.
The question of when and why countries choose to abandon fixed exchange rate regimes is
particularly interesting with respect to the relationship between exchange rate regime choice
and the propagation of financial crises. The inter-war gold exchange standard has been char-
acterized by Keynes as the ‘Golden Fetters’ that had to be shed by Britain to avoid a prolonged
crisis (Keynes 1932) and thus provides an excellent example to deepen our understanding of
the factors that contribute to instabilities in fixed exchange rate regimes.
This paper offers a rigorous approach to simultaneously test the influence of economic and
political factors on the disintegration of the inter-war gold standard in a dynamic framework.
The dynamic approach allows one to model the timing of when countries chose to leave the
regime. It is implemented by applying a duration model of 24 countries. Political factors are
integrated through a partisan veto player approach following Tsebelis (1995). Moreover, we
explicitly model the survival probabilities of different countries on the gold standard over
time, emphasizing that the choice to leave the regime was taken at very different survival
rates by various countries.
We find that high per capita growth, large foreign currency and gold reserves, trade with
other countries on gold, international creditor status, and the prior experience of hyperinfla-
tion extended the time a country would remain on gold. In contrast, democracy, a relatively
high percentage of left-wing representation in parliament, sterling bloc membership, and
high inflation rates shortened the time a country would stay on the gold standard. Also,
1

from our analysis Britain could be characterized as a fair weather friend that left the gold
standard when it had a 60% survival probability, while other key countries in the system
remained on gold until survival probabilities had fallen below 20%.
2 The Inter-war Gold Exchange Standard - A Brief History
By the end of WW I most countries that had previously adhered to the gold standard had
abandoned their peg to gold. Exchange rates were freely floating and extremely volatile. In
search for a new monetary order, governments and central bankers demanded an interna-
tional currency system with stable exchange rates. There was a longing for the pre-war order
of the classical gold standard that had promoted trade, financial integration, and prosper-
ity.
1
But officials hesitated to re-instate the pre-war system, out of fear that the gold standard
restoration would induce a global shortage of gold. Wartime inflation had shifted price lev-
els, so that for many countries a return to gold at the pre-war parity would have implied
an overvaluation of their currencies. Thus, the pressure to return to pre-war parities would
induce deflation and delay reconstruction and the resumption of economic growth. A return
at new exchange rates, in contrast, might have worsened a worldwide gold scramble and
would have raised questions about the credibility of the new regime.
2
The establishment of an inter-war monetary system was further complicated by a num-
ber of historical events, the most important of which was the problem of post-war reparation
payments (Kindleberger 1993). Although the peace treaties held Germany and its allies re-
sponsible for the war and burdened them with reparation payments, the actual amount of
the payments was negotiated country by country throughout the early 1920s. The reparation
demands of the war ’winners’ and the official judgement of what the ’losers’ would be able
to pay differed widely. For Germany the large reparation demands, as well as the French
commitment to extract them by force, led to a devastating budget situation and accelerated
the hyperinflation (Holtfrerich 1986).
1
An explicit discussion of how the classical gold standard promoted trade and financial integration can be
found, for example, in O’Rourke and Williamson (1999).
2
For an explicit discussion of the credibility of the inter-war gold exchange standard, refer to Bordo, Edelstein
and Rockoff (1999).
2

Frequently asked questions

Q1. What are the contributions mentioned in the paper "The stability of the inter-war gold exchange standard did politics matter?" ?

The collapse of the inter-war gold standard has frequently been studied in economic history. This paper proposes a discrete time duration model to analyze how economic and political indicators affected the length of time a country remained on the gold standard. The results of this study identify high per capita income growth, large foreign currency and gold reserves, trade with other countries on gold, international creditor status, and the prior experience of hyperinflation as factors that increased the probability that a country would remain on gold. 

Q2. What might be the reason why countries would adhere to the gold standard?

The incidence of hyperinflation prior to the gold standard might induce countries to adhere to the regime in order to sustain credibility. 

Q3. What was the key signal of stability and credibility for the new system?

To halt the gold outflow, Britain returned to gold at the pre-war parity, a choice that was regarded as a key signal of stability and credibility for the new system. 

Q4. What factors are important for the willingness to defend or devalue a currency?

Factors that matter for the willingness to defend or devalue a currency are electoral timing, constituent interests, and government partisanship. 

Q5. What was the effect of the return to gold at the pre-war parity?

Wartime inflation had shifted price levels, so that for many countries a return to gold at the pre-war parity would have implied an overvaluation of their currencies. 

Q6. What would have been the consequences of Britain’s adoption of gold?

Without Britain on gold, the adoption of gold as monetary anchor by other countries would have implied a further shift of gold reserves and deposits away from London and to New York. 

Q7. What is the effect of multiple veto players on the duration of the gold standard?

Multiple veto players also capture the fragmentation of many of the young democracies, especially in east and central Europe during the inter-war years. 

Q8. What is the effect of multiple veto players on the probability of a regime change?

Countries with coalition governments of multiple veto players should display increased political stability, reducing the probability of a regime change. 

Q9. How long would the U.S. remain on gold?

For the purpose ofthis analysis the U.S. is counted as being on gold for a total of 12 years, from 1922 to 1933.10a country would remain on gold. 

Q10. Why did officials hesitate to re-instate the pre-war system?

But officials hesitated to re-instate the pre-war system, out of fear that the gold standard restoration would induce a global shortage of gold. 

Q11. What is the famous example of a country leaving the gold standard?

The most famous example for this type of behavior is Great Britain, which left the gold standard in September of 1931 with a bank rate of 4.5%.9 

Q12. What was the effect of the return to pre-war parities on the economy?

the pressure to return to pre-war parities would induce deflation and delay reconstruction and the resumption of economic growth. 

Q13. What is the hazard function for a continuous time duration model?

Let the discrete hazard ht be the probability that a transition occurs in the interval [t, t + 1), conditional on no transition until time t. 

Q14. What variables did not affect a country’s decision to stay on gold?

Variables that did not affect a country’s decision whether to remain on gold or abandon the regime include discount rate adjustments, the experience of banking crises and unemployment. 

Q15. What is the hazard function for a continuous time model?

The above hazard function takes a complementary log log form and can be interpreted as the discrete time model to the underlying continuous time proportional hazards model. 

Q16. What is the way to determine when a country should abandon the gold standard?

While it is difficult to derive an exact benchmark of when countries should leave the regime, the authors can assume that once survival rates fall below 50%, it is probably more advantageous for a country to abandon the gold standard. 

Q17. What is the important fact about the decline of the inter-war gold standard?

In the historical narrative the relatively fast recovery of Britain after the crisis is often associated with the country cutting its ties to the gold standard early (Eichengreen 1992).