3-28-14 100 years exactly, in fact. In 1914 gold was money. Money wasn’t debt or credit back then. It was simply gold, and banks created credit on top of their gold reserve base. They couldn’t go crazy in the credit creation process, because there was only so much gold in the world and its supply grew at around 2%.
Plus, gold (not debt) was a form of international payment, so once again debt growth didn’t get too excessive. If you ran a trade deficit, your creditors demanded payment in gold to settle the debt. If you ran out of gold, interest rates would rise (to discourage consumption and encourage saving) and the trade deficit would slowly swing back to surplus.
When a financial system goes from sound to unsound, it creates more claims on real assets than there are real assets in existence. So the system creates paper assets to absorb the constant supply of new money/credit/debt. Hence the explosion of the derivatives market in recent decades.
The carnage of the Great War led to great post-war efforts to put the “Humpty Dumpty” of the world financial order together again. Restoring the gold standard was, of course, a high priority. So badly had the war beggared the belligerents, however, that expedients were sought. The prime expedient, the “gold-exchange standard,” was a devilish seed that would blossom into the Great Depression.
As Lehrman Institute founder and Chairman Lewis E. Lehrman wrote in the Fall 2011 issue of The Intercollegiate Review:
… How did we get here? In 1922, at the little-known post–World War I Monetary Conference of Genoa, the gold-exchange standard was officially embraced by academic and political elites. It was there that the dollar and the pound were confirmed as official reserve currencies, so that these national currencies might substitute for what was said to be a “scarcity” of gold. But there was no true scarcity—only overvalued national currencies caused by the inflation of World War I. The overvaluation, relative to the gold monetary standard, was maintained after World War I despite a doubling and tripling of the general price level in national currencies during the war. The greatest economist of the twentieth century, Jacques Rueff, warned in the 1920s of the dangers of this flawed official reserve currency system, designed “in camera” by the experts. Rueff predicted a collapse of this newly rigged official reserve currency system. And it did collapse, in 1929–1931, with catastrophic effects.
The gold-exchange standard worked as follows: The United States remained on the classical gold standard, redeeming dollars in gold. Britain and the other countries of the West, however, returned to a pseudo-gold standard, Britain in 1926 and the other countries around the same time. British pounds and other currencies were not payable in gold coins, but only in large-sized bars, suitable only for international transactions. This prevented the ordinary citizens of Britain and other European countries from using gold in their daily life, and thus permitted a wider degree of paper and bank inflation. But furthermore, Britain redeemed pounds not merely in gold, but also in dollars; while the other countries redeemed their currencies not in gold, but in pounds. And most of these countries were induced by Britain to return to gold at overvalued parities. the result was a pyramiding of U.S. on gold, of British pounds on dollars, and of other European currencies on pounds–the “gold-exchange standard,” with the dollar and the pound as the two “key currencies.”
Now when Britain inflated, and experienced a deficit in its balance of payments, the gold standard mechanism did not work to quickly restrict British inflation. For instead of other countries redeeming their pounds for gold, they kept the pounds and inflated on top of them. Hence Britain and Europe were permitted to inflate unchecked, and British deficits could pile up unrestrained by the market discipline of the gold standard. As for the United States, Britain was able to induce the U.S. to inflate dollars so as not to lose many dollar reserves or gold to the United States.
The point of the gold-exchange standard is that it cannot last; the piper must eventually be paid, but only in a disastrous reaction to the lengthy inflationary boom. As sterling balances piled up in France, the U.S., and elsewhere, the slightest loss of confidence in the increasingly shaky and jerry-built inflationary structure was bound to lead to general collapse. This is precisely what happened in 1931; the failure of inflated banks throughout Europe, and the attempt of “hard money” France to cash in its sterling balances for gold, led Britain to go off the gold standard completely. https://mises.org/money/4s3.asp