Slouching Towards Utopia?: The Economic History of the Twentieth Century

-IX. How the Pre-World War I World Economy Worked: International Finance, the Gold Standard, and Politics-

J. Bradford DeLong

University of California at Berkeley and NBER

August 1996

The Gold Standard before World War I:

What made the upward leap in international trade, the creation of an integrated world economy-a world economy where for the first time trade was not confined to luxuries and intoxicants but extended to staples and necessities-possible in the years before World War I? Falling costs of ocean transportation was one major factor. The development and extension of the international political and economic order called the gold standard was another.

The gold standard was in its origins a very simple thing: governments and central banks all over the world declared that their currencies were as good as gold-show up with £100 note, or a $100 bill, at the British Bank of England or the U.S. Treasury and the man behind the counter would give you a specified, fixed, unchanging quantity of gold: about 4.5 (troy) ounces in the case of the $100 bill, and about 22 (troy) ounces in the case of the £100 pound note.

Why did this matter? It mattered because as long as the gold standard stood entrepreneurs could make their plans for and build their factories engaged in international trade without having to worry about what we today call foreign exchange risk. Consider the plight of an American manufacturer deciding in 1980-when one British pound sterling sells for $2.32-to compete with British producers by exporting to London; spending the early 1980s building factories to expand capacity, and then finding in 1985 that one pound sterling sells not for $2.32 but for $1.30 on the foreign exchange market. The simple movement in exchange rates since 1980 has raised the manufacturer's costs relative to those of British competitors by 80 percent. You can bet that a very large number of productive operations and markets that looked profitable to American businesses in 1980 no longer looked profitable in 1985.

This is foreign exchange risk: the risk that governments following sensible or nonsensical policies or international currency speculators responding to their own "animal spirits" will cause exchange rates to shift in a way that destroys a particular line of trade or bankrupts importers and exporters. This foreign exchange risk is in large part avoided under a gold standard. And this near-absence of foreign exchange risk was one powerful factor driving the expansion of international trade and finance in the years before World War I.

How did the gold standard reduce foreign exchange risk-and close to eliminate the risk that a country would embark on a policy of in_ation that would endanger established wealth? In its idealized form, the gold standard carried out these tasks by virtue of its working as an automatic equilibrating mechanism.

If ever a central bank or a Treasury printed "too many" banknotes under a gold standard, the first thing that would happen would be that those excess bank notes would be returned to the Treasury by individuals demanding gold in exchange. Thus each country's domestic supply of money was linked directly to its domestic reserves of gold.

Suppose a country under the gold standard ran a trade deficit in excess of foreigners' desired investments. It, too, would find those who had sold goods to its citizens lining up outside the Treasury looking to exchange banknotes for gold. And these foreign suppliers of imports would then ship the gold back to their countries. The money stock at home would fall as gold reserves fell. And with a falling money stock would come falling prices, falling production, and falling demand for imports.

So balance of payments equilibrium would be restored, and countries' price levels kept in roughly appropriate competitive alignment, by the gold standard as sources of disequilibrium were removed by shipments of gold, or threatened shipments of gold, that raised and lowered nations' reserves. Monetary authorities would find themselves restrained from pursuing over-in_ationary policies by fears of the gold drains that would result.

And since central bankers in every country were all working under the same gold standard system, they would all find their policies in rough harmony without explicit meetings of G-7 finance ministers or explicit international policy coordination.

The pre-World War I gold standard was not invented. It just grew, starting in the 1870s when Germany joined Britain, which had defined its currency primarily in terms of gold since 1717, when Sir Isaac Newton was Master of the Mint. Increased German demand for gold pushed up its price; increased American mining of silver pushed down its price. Countries that had long tried to keep both gold and silver coins legal tender found their gold reserves falling, as people would buy cheap silver on the world market, exchange it for currency, and then bring the currency into the Treasury for gold. By the end of the 1870s nearly the whole world was on the gold standard.

That exchange rates were stable under the pre-World War I gold standard is indisputible. Devaluations were few, and rare. Exchange rate risk was rarely a factor in economi decisions.

Thus not only did trade expand under the gold standard, but international capital markets expanded in the years before World War I as well. It became a commonplace for rich people in Europe or North America to have their money invested in far-_ung enterprises on other continents. This out_ow of capital from the industrial core to the industrializing, mineral-rich periphery was also greatly assisted by the gold standard.

Certainly those economies that received in_ows of capital before World War I benefitted enormously. It is not so clear that the free _ow of capital was beneficial to those in the capital -exporting countries. France subsidized the pre-World War I industrialization of Czarist Russia (and the pre-World War I luxury of the court and expansion of the military) by making investments in Russian government and railroad bonds a test of one's French patriotism. A constant of French pre-World War I politics was that someday there would be another war with Germany, during which France would conquer and re-annex the provinces of Alsace and Lorraine that Germany had annexed as part of the settlement of the Franco-Prussian War of 1870-71. (And that France had taken from the feeble and oddly-named Holy Roman Empire of the German Nation as part of the settlements of the Thirty Years' War of 1618-48 and the Wars of Louis XIV of 1667-1715.) French military strategy depended on a large, active, allied Russian army in Poland threatening Berlin and forcing Germany to divide its armies while the French marched to the Rhine. Hence boosting the power of the Czar by buying Russian bonds became a test of French patriotism.

But after World War I there was no Czar ruling from Moscow. There was Lenin ruling from Petrograd-subsequently renamed Leningrad-subsequently returned to its original name of St. Petersburg. And Lenin had no interest at all in repaying creditors from whom money had been borrowed by the Czar.

British investors did better from their overseas investments, but they still did not do very well The year 1914 saw close to 40 percent of Britain's national capital invested overseas. No other country has ever matched Britain's high proportion of savings channeled to other countries. Britain's overseas investments were concentrated in government debt, in infrastructure projects like railroads, streetcars, and utilities, and in securities guaranteed by the local governments.

However, in the forty years before World War I, British investors in overseas assets earned low returns, ranging as low to perhaps 2% per year in in_ation-adjusted pounds on loans to dominion governments. Such returns were far below what presumably could have earned by devoting the same resources to the expansion of domestic industry. British industry in 1914, and British infrastructure, were not as capital intensive as American industry and infrastructure were to become by 1929. It is difficult to argue that Britain's savings could not have found productive uses at home, if only British firms could have been challenged appropriately and managed productively. And the difference in rates of return cannot be attributed to risk: overseas investments were in the last analysis more exposed to risk than were domestic investments.

But for capital importing countries, like the U.S., Canada, Australia, and others like India and Argentina, the availability of large amounts of British-financed capital to speed development of industry and infrastructure was a godsend. It allowed for earlier construction of railroads and other infrastructure. It allowed for the more rapid development of industry.

Of course, the actual, real-world gold standard did not work as smoothly as the idealizations of economic theorists. Butit did provide a stable underpinning to the growth of the world economy in the years before World War I.

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The Business Cycle Under the Gold Standard:

However, there is a negative side to the gold standard. The gold standard was good not only at encouraging international trade expansion and boosting international capital _ows, but also at quickly transmitting business cycles and financial panics around the world as fast as the telegraph wire could carry them. So borrowing foreign capital from Britain had costs as well: it tied the borrower's economy to the financial and employment cycles of Great Britain. "When London sneezes," the saying went, "Argentina [or Canada, or the U.S.] catches pneumonia."

How did this work? Look in some detail at the industrialization of the United States to see how the typical pre-1929 depression had its origin in the United States' gold-standard links with the London-centered world economy.

The years between the Civil War and the 1890's saw the great railway booms. In 1870 and 1871 U.S. railroad construction reached its first post-Civil War peak. The number of miles of operated railroad in the U.S., then around 50,000, grew at about twelve percent per year. The construction of 6,000 miles of railroad track each year employed perhaps one-tenth of America's non-farm paid labor force and half of the production of America's metal industries.

Four years later, railroad construction had collapsed. In 1875, railroad mileage grew at only three percent. Railroad construction employed less than three percent of America's non-farm paid labor force, and required perhaps fifteen percent of the production of America's metal industries.

The depression of 1873 had its origins in British investors loss of confidence that American railroads and infrastructure-that day's equivalent of investments in the Pacific Rim. The largest investment house in the United States-that of Jay Cooke, politically well-connected industrial visionary who financed Abraham Lincoln's armies, and whose picture hangs in the Treasury Department's antique collection in the General Counsel's office-went bankrupt.

As a result of the collapse of Jay Cooke and Company the City of London sneezed. The U.S. economy caught pneumonia. The share of America's non-agricultural labor force building railroads fell from perhaps one in ten in 1872 to perhaps one in forty by 1877-a seven percentage point boost to non-agricultural sector unemployment from this source alone.

Such a wave-first of expanded railroad construction as capital _owed in, and then of contraction as capital _owed out-must have been difficult to absorb just as the Mexican recession of 1995 proved very painful. Each wave of railroad building required an expansion of capacity in iron and steel for rails, timber for ties, equipment for locomotives and cars, furniture to equip the cars to carry passengers on the new lines, and most important the redirection of one million workers to railroad construction. As the wave passed, suppliers and workers would have to find new markets and new jobs. The dislocation generated may well have been extreme and severe. But we know little about how it was accomplished, or about what workers who built railroads in 1871 were doing in 1875.

It is hard to attribute such spasms of construction to independent disturbances in finance: railroad finance was then more-or-less the sole business of Wall Street. By default such depressions appear to have been driven by waves of optimism about future growth, followed by recognition of overbuilding and contraction until the economy had grown enough that it seemed that shipping by rail was a railroad's and not a farmer's market.

The gold standard appears also in the depression of the 1890's. The possibility that "free silver" might sweep American politics made investors and financiers uneasy. Relative to what they would earn if they kept their cash, investments, and capital in London, a free-silver victory and subsequent devaluation might well have cost them a third of their wealth as measured by the international yardstick of the gold standard. Perhaps the free-silver movement was powerful enough to cause capital _ight, investment shortfall, and depression, but not strong enough to secure devaluation and monetary expansion to reduce the debt burdens of farmers and create a booming labor market for urban workers. The U.S. thus got the worst of both worlds: it suffered the disadvantages of being on the gold standard without reaping the gold standard advantage of keeping financiers confident and investing.

And the panic of 1907 and depression of 1908 followed a recession in Great Britain. As a result of the recession, the Bank of England raised interest rates to pull gold to London to boost its reserves. This left the United States short of currency to be paid out to farmers and middlemen during the fall shipment of the harvest to the East. Financial panic followed, and recession followed the financial panic

Whether the depressions that did occur were worse back before the Great Depression than they have been since World War II remains disputed; given our limited quantitative knowledge, it is likely to remain so.

That depressions before 1929 were more painful is, however, very clear. Those who lost their jobs had no welfare state to cushion them. Individual states had sketches of a future welfare system, but such embryonic systems did not have the resources to cope with episodes of widespread unemployment. Extended families, friends, and local benevolent associations must have provided support for those who lost their jobs to remain, for the most part, fed and housed. American cities during depressions at the turn of the century were centers of poverty and want, but apparently not of mass near-starvation.

All in all, the balance for the pre-World War I gold standard was probably positive: the boost it gave to world economic growth through making trade expansion easier and capital _ows larger probably outweighed any costs from tieing the whole world to Great Britain's business cycle. However, it is hard to argue that the post-World War I attempted restoration of the gold standard was beneficial, as we will see below.

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Empires:

Europe's sixteenth century overseas empires, in Latin America, in the Philippines, and in the spice islands of Indonesia, had firm economic rationales: in the wrods of the chronicler of the Spanish Conquistadores, Spain's warriors conquered the New World "to spread the word of God, and to get rich." Control over the high-value low-weight luxury goods of East Asia, or over the precious metals of Latin America, could make individuals' fortunes and provide a healthy boost to any early modern European royal treasury.

Europe's seventeenth and eighteenth century overseas empires also had an economic component: obtaining a near-monopoly of the tobacco or the slave trade, or conquering the sugar-growing islands of the Caribbean, could boost mercantile prosperity.

But by the nineteenth century little was needed in the way of luxuries that could not be made more cheaply in the industrial core of the world economy, and little was to be found in raw materials from further extensions of European empires. Yet the nineteenth century saw the European great powers complete their conquest of the world.

In the last years before World War I, only Ethiopia, Siam, Persia, Afghanistan, the Ottoman Empire (the core of which is now Turkey), China, and Japan could claim to be neither a colony nor an ex-colony of Europe's great powers. And the independence of all those save Ethiopia (which had slaughtered an invading Italian army) and Japan (with its junior empire of Taiwan, Korea, and scattered Pacific islands, along with large chunks of Manchuria) was heavily compromised.

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Democracy and Plutocracy:

"They control the people with the people's own money." So Louis Brandeis, strong Democratic political activist, wrote of the turn of the century financiers who he saw as controlling the American economy through their domination of the commanding heights of finance. The answer that Brandeis saw was simple: separate ownership from control, so that the bankers who collected the savings of the people through the acceptance of deposits would be unable to use those savings to increase their bargaining power vis-a-vis the managers of American enterprise.

It is doubtful that Louis Brandeis's proposed solution was any solution at all. Large-scale businesses borrow from banks, true. But remove some power to control and in_uence the managers of large-scale enterprises that borrow from the bankers, and where does it go? It _ows to the managers of the oligopolies and the monopolies that no longer have to look over their shoulders to make sure that Wall Street is satisfied; it does not _ow to the "people."

But if Brandeis's cure-to destroy the "money trust"-was false cure, it was a response to a real disease. For the United States as of the turn of the twentieth century was a much more economically and socially unequal place than it had been even thirty years before.

On the eve of the American Revolution, the United States-to-be had been a relatively egalitarian society. The richest one percent of households owned perhaps fifteen percent of the total wealth in the economy-a very low value for such an inequality statistic. Even by the immediae aftermath of the Civil War wealth was still not that concentrated: the top one percent of households appear to have had a little more than a quarter of the wealth of the country.

By 1900, however, the U.S. had become the Gilded Age country of industrial princes and immigrants living in tenements of our political memory. On the one hand, Andrew Carnegie building the largest mansion in Newport, Rhode Island with gold water faucets. On the other hand, 146 largely-immigrant workers dying in the 1911 Triangle Shirtwaist Factory fire in Manhattan because the exits had been locked to keep workers from taking fabric out of the building for their own clothes.

Surveys suggest that in 1929 the richest one percent of U.S. households held something like 45 percent of national wealth, and that the concentration of wealth had been sharply rising in the 1920s. We strongly suspect that World War I had seen substantial deconcentration, as in_ation eroded the value of bondholders' wealth and as high demand for labor boosted workers' earnings. It is my guess that the second was stronger than the first; that the concentration of wealth was eroded more during World War I than it was boosted in the 1920s, and that the concentration of wealth in the United States peaked sometime in the twenty years before World War I, with the richest one percent of households owning some 50% or so of total national wealth.

Attempts to count the wealth of the merchant princes themselves reinforce the suspicion that the pre-World War I U.S. was more unequal than at any time before or since.

A country of immigrants and plutocrats is very different from the country of yeoman farmers that the United States had been in its Founding Fathers' imagination, and in large part in reality, in the late eighteenth century.

Alexis de Tocqueville, a keen-eyed commentator on American society in the first half of the nineteenth century, had feared the growth of such a class of plutocrats, such an "aristocracy of manufacturers":

The territorial aristocracy of past ages was obliged by law, or thought itself obliged by cutom, to come to the help of its servants and relieve their distress. But the industrial aristocracy of our day, when it has impoverished and brutalized the men it uses, abandons them in time of crisis to public charity to feed them.... Between workman and master there are frequent relations but no true association.

I think that, generally speaking, the manufacturing aristocracy which we see rising before our eyes is one of the hardest that have appeared on the earth....

In the United States the rising concentration of wealth provoked a widespread feeling that something had gone wrong with the country's development. The rich (and many of the native-born not-so-rich) blamed foreigners: aliens born in China, Japan, Italy, Spain, Poland, and Russia who were incapable of speaking English, or understanding American values, or contributing to American society. Many of the middle class, especially the farmers, blamed the rich, the easterners, and the bankers.

Populism in America

Progressivism in America

European politics were very different. In Europe the trend was not toward greater inequality but toward greater equality, as rising wealth and incomes submerged the wealth of the descendants of old aristocracies in a deeper pool, and as a competing elite of manufacturers and bankers grew up alongside the older elite of landlords, ministers, royal favorites, and successful generals.

The fear of socialism

The spread of reform

from Bryan, Bryan, Bryan, Bryan

by Vachel Lindsay

I brag and chant of Bryan, Bryan, Bryan,

Candidate for president who sketched a silver Zion...

There were truths eternal in the gab and tittle-tattle,

There were real heads broken in the fustian and the rattle,

There were real lines drawn;

Not the silver and the gold,

But Nebraska's cry went eastward against the dour and the old,

The mean and the cold.

* * * * * *

He scourged the elephant plutocrats

With barbed wire from the River Platte.

The scales dropped from their mighty eyes.

They saw that summer's noon

A tribe of wonder coming

To a marching tune.

Oh, the longhorns of Texas,

The jay hawks from Kansas,

The plop-eyed bungaro and giant gassicus,

The varmint, chipmunk, bugabo,

The horned-toad, prarie-dog, and ballyhoo,

From all the newborn state arow,

Bidding the eagles of the west fly on...

Against the towns of Tubal Cain,

Ah,-sharp was their song.

Against the ways of Tubal Cain, too cunning for the young,

The longhorn calf, the buffalo, and wampus gave tongue

* * * * * *

And all these in their helpless days

By the dour East oppressed,

Mean paternalism

Making their mistakes for them,

Crucifying half the West,

Till the whole Atlantic coast

Seemed a giant spider' nest.

* * * * * *

July, August, suspense.

Wall Street lost to sense.

August, September, October,

More suspense,

And the whole East down like a wind-smashed fence.

Then Hanna to the rescue,

Hanna of Ohio,

Rallying the roller-tops,

Rallying the bucket-shops.

Threatening drouth and death,

Promising manna,

Rallying the trusts againt the bawling flannelmouth;

Invading misers' cellars,

Tin-cans, socks,

Melting down the rocks,

Pouring out the long green to a million workers,

Spondulix by the mountain-load, to stop each new tornado

And beat the cheapskate, blatherskite,
Populistic, anarchistic,

Deacon-desperado.

Election night at midnight:

Boy Bryan's defeat.

Defeat of western silver.

Defeat of the wheat.

Victory of letterfiles

And plutocrats in miles

With dollar signs upon their coats,

Diamond watchchains on their vests

And spats on their feet.

Victory of custodians,

Plymouth Rock,

And all that inbred landlord stock.

Victory of the neat.

Defeat of the aspen groves of Colorado valleys,

The blue bells of the Rockies,

The blue bonnets of old Texas,

By the Pittsburg alleys.

Defeat of alfalfa and the Mariposa lily.

Defeat of the Pacific and the long Mississippi.

Defeat of the young by the old and silly.

Defeat of tornadoes by the poison vats supreme.

Defeat of my boyhood, defeat of my dream.