Forex: The Gold-exchange Standard's Convertibility
With regard to the strain of the gold exchange standard during and after the World War I, governments were in the process of abandoning their inherited attitudes of laissez-faire in general economic policy.
Apparently conditions had changed, politically and socially. A Bolshevik revolution had succeeded in Russia; elsewhere, socialism was almost universally on the rise.
First, governments could no longer afford to tolerate a certain amount of price or income deflation or inflation simply for the sake of maintaining convertibility of their currencies at a fixed price.
Domestic stability now had to take precedence if politicians were to hold onto their jobs.
If before World War I central banks rarely adhered to the gold-standard rules of the game in the positive sense, after the war they rarely adhered to them even in the negative sense.
Instead, a variety of new instruments were devised to counteract and neutralize the domestic monetary influence of external payments disequilibria, just the opposite of what was needed to make a restored gold standard work.
Second, prices and wages were becoming increasingly rigid, at least in a downward direction, under the impact of rising trade unionism and expanding social welfare legislation.
Indeed, domestic price flexibility was a top requirement for a mending gold standard.
Without it (and with exchange rates fixed), a disproportionate share of the adjustment process had to consist of changes of domestic incomes, output, and employment.
It was precisely in order to avoid such impacts, of course, that governments were becoming increasingly interventionist in economic affairs.
But the consequences of such interventionism inevitably included a complete short-circuiting of the external adjustment mechanism that the same governments were laboring so hard to rebuild.
A third problem was the distortion structure of exchange rates established under the new gold exchange standard,
In insisting upon a return to convertibility at their prewar parities, governments were taking insufficient note of the fact that price relationships between national economies had been dramatically altered since 1914.
Inconvertibility and floating exchange rates had broken the links between national price movements, and domestic inflation rates had varied enormously.
The pound, for example, restored to convertibility at its old prewar parity of $4.86, was overvalued by at least ten percent,; but since subsequent changes of the parity were ruled out by the gold standard rules of the game.
It was not surprising that the British balance of payments stayed under almost continuous strain until 1931, and British unemployment rates remained uncomfortably high.
The French, on the other hand, who were an exception to the general rule in returning to gold (de facto in 1926, de jure in 1928) at just one-fifth of their prewar parity, undervalued the franc by perhaps as much as 25 percent.
The result in this case was an almost immediate drainage of funds from London to Paris, adding to Britain's woes and, in the end, contributing importantly to the final collapse of the ill-fated experiment in 1931.