Economics and The Public Welfare

Chapter 23

The De Facto Stabilization of the Franc, and the Gold Exchange Standard

We interrupted the story of French finance at the end of 1926 to give an account of significant developments in Great Britain in 1925 and 1926. We now return to the de facto stabilization of the French franc in December of 1926, when the French Government and the Bank of France concluded that the franc had risen as far as they dared allow it to rise, and intervened to prevent a further rise. The franc by this time had risen from a low of 2¢ in late July of 1926 to something over 4¢, and the stabilization was effected in the neighborhood of 4¢—approximately 20% of the prewar gold parity of 19.3¢.

But the stabilization was not effected by a definite resumption of the gold standard at a fixed par. Under the strict gold standard a paper currency is held in approximately fixed relation to gold by an automatic and very simple system: the monetary authority, in the case of francs the Bank of France, will pay out gold of fixed weight and fineness on demand as bank notes are presented for redemption, or as depositors request gold in exchange for their deposit balances. On the other hand, the bank will issue new bank notes freely or give new deposit credits in exchange for gold of the same fixed weight and fineness. A paper currency will never rise much above this parity, because if it rises enough to cover the moderate cost of shipping gold, gold will come in from abroad for presentation to the bank, and the supply of paper money will be increased. Nor will the paper money fall much below this parity, because if such a tendency starts, the holders of the paper will take it to the bank and get gold for it.

Lack of New Legal Par Prevents Bank of France from Receiving Gold in Paris. But in 1926 the Bank of France was not free under the laws which existed in France to make use of this simple procedure. The old prewar law still stood, under which gold presented to the Bank of France in Paris could be accepted only at the old parity, which was several hundred per cent above the actual market value of the paper franc. No one would take gold to the Bank on those terms, since he would thereby lose most of its value. The Bank did not dare purchase gold freely in France at the actual market rate, because if the government should subsequently stabilize the franc at a higher parity, the Bank would have a loss on all gold so purchased.

Could Buy and Sell Foreign Exchange and Gold Abroad, Guaranteed Against Loss. The government had, however, made provisions to indemnify the Bank of France for any losses which might occur on foreign exchange transactions in effecting stabilization, and the Bank, when it intervened in the foreign exchange markets to hold down the franc, did so primarily by buying and selling foreign exchange. It could also deal in gold abroad, since this was regarded as a foreign exchange transaction, and to some extent the Bank of France purchased gold to be held in foreign countries for its account, increasing the supply of francs in the process and holding down the price of francs. But the overwhelming bulk of the operations in this stabilization process was in the purchase of foreign exchange. Occasionally, if the franc for a short time showed weakness, the Bank of France would reverse its operations, selling foreign exchange, but on balance the overwhelming bulk of its stabilization operations was purchases.

In Stabilizing Franc, Bought $1,000,000,000 of Foreign Exchange in a Year. The foreign exchange holdings of the Bank of France moved upward with startling rapidity from a small sum in the summer of 1926 to a figure estimated at around a billion dollars in October of 1927. Not all of this was shown in the balance sheet of the Bank of France. Part of it was supposed to be in the hands of governmental agents.

Chiefly Sterling. The Bank of France was thus creating new francs, not against gold in its own vault, but against deposits and short term paper in foreign countries which were on the gold standard, and which could and would presumably pay gold. To an appalling extent, moreover, these foreign balances of the Bank of France were in the form of sterling. England had, as we have seen, engaged in a great expansion of bank credit in 1926, particularly during the prolonged strike, and a great deal of this sterling had gone to the Continent. When the tide turned in France and heavy speculation in the franc began, these Continental holdings of sterling were employed in the purchase of francs, and the Bank of France, to hold the franc down, had to buy sterling.

Startling Substitution of Gold Exchange for Gold Standard. This represented the substitution of the gold exchange standard for the gold standard on an unprecedented scale. France, it may be added, was not alone in this. A great many of the smaller central banks of Europe were doing the same thing. At the end of March, 1927, the Federal Reserve Bulletin estimated that the liquid foreign assets of thirty central banks amounted to $1,600,000,000, and by July of 1927 the figure had risen to $1,900,000,000.1

Reichsbank Increases Gold and Reduces Foreign Balances. Most, but not all, of the Continental European central banks increased their holdings during the year July, 1926, to July, 1927. Notable exceptions were the Reichsbank, which increased its gold at home and reduced it foreign balances sharply during the year, the Netherlands Bank, and the National Bank of Norway. The Bank of Italy tripled its foreign holdings from July, 1926, to July, 1927. The National Bank of Belgium figure rose from 30,000,000 francs in July, 1926, to 2,220,000,000 francs in July, 1927. Similar causes were at work for these banks. The great expansion of bank credit in the United States, with an immense volume of foreign loans, was putting dollars into the hands of Italians and Belgians and others who wished to covert them into their local currencies, and the central banks were buying them. They were also buying the overabundant sterling.

Dangers of Gold Exchange Standard—Extraordinary Ease of Bank Expansion. In the prewar days the gold exchange standard was recognized as a makeshift device, usually designed as a transitional step toward the full gold standard. It was a convenient device for small countries or poor countries. A poor country might well consider the interest it earned on foreign exchange holdings, and prefer not to hold all its reserves in non-interest bearing gold. India had it. The Straits Settlement had it. The Philippines used it. The Austro-Hungarian Bank, prior to 1914, carried a substantial part of its reserve in the form of foreign bills and foreign balances, as did the National Bank of Belgium. But in general the great money markets carried their own gold. Redemption of paper money was generally made in gold throughout the gold standard world. The gold exchange standard was regarded as feasible only because it was unusual, and only because there was a great gold standard world on which to depend. Confined to minor countries it constituted a safe enough device, but if the effort were made to universalize the gold exchange standard it is obvious that insolvable problems arise.

First, obviously, if no country is willing to hold gold and if every country upon receiving gold promptly redeposits it in some other country, the gold would find no home. There would, moreover, be a constant expansion of deposit balances as the gold moved from country to country. Second, if no country paid out gold in redeeming its paper money, but merely paid in checks on some other country, the holder of paper money could never get gold. The gold standard would everywhere cease to exist. And the gold exchange standard would itself break down, since it is predicated on the existence of gold standard countries and ultimate redemption in gold. Third, the process would lead to a violent break in money rates as surplus reserves piled up in every money market, making possible an unlimited expansion of bank credit as the banks all over the world tried to make use of their surplus reserves.

Bank of France Alert to Dangers. It was a dangerous situation, an alarming situation, and the Bank of France was in no way ignorant of the problems which its sudden immense increase in foreign exchange holdings involved. The policy in the Bank of France at the time was made by three extremely able men: Professor Charles Rist, of the University of Paris, who functioned for a time as Deputy Governor of the Bank of France and who was more or less continuously in its councils; Quesnay, later an official of the Bank for International Settlements, whose premature death saddened the international financial community; and Cariguel, a skillful trader in foreign exchange and a man with very much more than a foreign exchange trader’s grasp of central banking problems. The Bank of France knew the danger.

Unable to use the procedure of the automatic gold standard, it nonetheless tried to check the flow of funds to Paris by acting on its own account in the way in which commercial forces would have acted had the de jure gold standard been established. Seeing that the use of the same gold as reserve in two money markets at the same time was generating an unsound expansion, the Bank of France sought to correct it by converting part of its foreign exchange holdings into gold—particularly by buying gold in London—and also began to transfer part of its holdings of foreign exchange from Europe to New York by selling sterling for dollars.

Had the Bank of France been free to buy gold in Paris in 1926, France would never have gained a billion dollars in foreign exchange. She would have gained instead perhaps 300 million dollars of gold. The gold, coming to France from London, New York, and other gold centers, would have checked credit expansion at those centers, would have cut under the reserves of the Bank of England and the Federal Reserve System, would have forced a tightening of the money rates in New York and London and other financial centers, at the same time that it led to a decline in money rates in Paris. It may be observed that money rates did decline in Paris very sharply as the volume of francs increased through the foreign exchange purchases of the Bank of France, as shown by the following table:

Open Market Discount Rate—Paris *
August, 1926	7.00
December, 1926	5.77
January, 1927	4.99
February, 1927	4.45
March, 1927	3.89
April, 1927	3.17
May, 1927	2.46
June, 1927	2.25
July, 1927	2.13
August, 1927	2.04

* Federal Reserve Bulletin, Oct., 1927.

Bank of France Tries to Convert Sterling into Gold in London, and into Dollars. The Bank of France undertook to act as the foreign exchange dealers would have acted had the gold standard been in existence, in part by buying gold in London. They also began to transfer part of their exchange holdings from sterling to dollars.

Putting Burden on Sterling, and Draining Gold of Bank of England. These transactions put a heavy burden on sterling exchange, and made drains on the gold reserve of the Bank of England. The position of London became difficult. There was no question of London’s ability to protect itself, but London was reluctant to employ the prewar expedient of raising Bank Rate and tightening the money market. London was under the spell of cheap money doctrine. France did take enough gold out of London in the early part of 1927, however, so that the London bill rate, which had stood at 3 11/16% on May 13, 1927, rose to 4 3/8% (just under Bank Rate of 4 1/2%) on June 3, 1927.

British, Reluctant to Raise Interest Rates, Protest. The British protested. There was a great deal of discussion of the matter in the London press during the first half of 1927. Montagu Norman, Governor of the Bank of England, personally urged the Bank of France to do nothing of the sort, telling them that sterling was good for them, and that they could not have too much sterling. He tried to induce various Continental central banks to put pressure on the Bank of France to induce it not to take gold from London. One official of the Bank of France said privately during this period, “London is a free gold market, and that means that anybody is free to buy gold in London except the Bank of France.” Another official said privately that it was possible for the Bank of France to sell some £3,000,000 in a day in quiet ways, and through indirect channels, without attracting the attention of the Bank of England; but if more than that were sold, an immediate protest would come. It is very hard indeed for “money management” to do the thing that the full gold standard automatically does.

We have, then, the setting for the Conference of Governors held in New York in the summer of 1927, the Conference participated in by four men: the Governor of the Bank of England, Montagu Norman; the Governor of the Federal Reserve Bank of New York, Benjamin Strong; the Governor of the Reichsbank, Hjalmar Schacht; and Professor Charles Rist, Deputy Governor of the Bank of France. Before giving an account of this conference and its momentous consequences, however, it is best to give a resume of financial developments in the United States from the spring of 1924 to the summer of 1927.

• 1This point will be discussed at length in Chap. 34.