New research by University of California economists Maurice Obstfeld and
Alan Taylor reveals that capital markets viewed governments' policy
commitments with much more scepticism during the inter-war period of the
restored gold standard period – 1925-31 – than during the pre-1914 era.
Their findings, published in the latest issue of the Economic Journal, are
relevant for more recent attempts to peg exchange rates. The intrinsic political
difficulty of committing to harsh medicine when an exchange rate is in peril
makes fixed rates look unstable in the absence of elaborate institutional
engineering, suc h as that supporting Europe’s economic and monetary union.
As the recent experience of Argentina shows, apparently far-reaching
legislative or even constitutional measures will still collapse in the face of
contradictory political realities.
Obstfeld and Taylor’s results also serve to pinpoint the precise historical
epoch from which the general fragility of fixed exchange rates dates, and they
suggest that these weaknesses were present even before the onset of the
Great Depression.
This research is the first consistent comparison of government borrowing
spreads for the pre-1914 and inter-war gold standards. Before World War
One, a government's adoption of the gold standard was sufficient to earn it a
borrowing discount of up to 30 basis points on its gold- or sterlingdenominated
borrowing. Furthermore, neither the country's public debt level
nor its terms of international trade mattered for the spread, given the
announced monetary system.
In the inter-war period, however, markets were more sceptical and imposed
harsher borrowing terms both when public debt levels were high and the
terms of trade weak. Countries such as Australia and Argentina, which
tolerated deflation so as to return to gold at the pre-war rate of exchange,
were not rewarded with easier borrowing terms. Only countries like France,
which returned to gold at depreciated but more sustainable rates, reaped
benefits in terms of lower public borrowing costs.
Obstfeld and Taylor's statistical evidence is consistent with narrative historical
accounts that view the inter-war period as one of political transition toward
wider enfranchisement of the population, especially the working classes.
Before World War One, political rulers had greater power to impose deflation
and fiscal austerity in order to stay on gold. The extension of political power
and government-funded social benefits after World War One made it much
more difficult for governments to impose such sacrifices.
According to Obstfeld and Taylor, international capital markets recognised this
sea change, which made a government commitment to gold, in and of itself,
less convincing in the inter-war period. Instead, credibility hinged more on
objective measures of the authorities' ability to maintain the gold parity: debt
levels, the terms of trade and the economy's general competitiveness.
ENDS
Notes for Editors: ‘Sovereign Risk, Credibility and the Gold Standard: 1870-
1913 versus 1925-31’ by Maurice Obstfeld and Alan M. Taylor is published in
the April 2003 issue of the Economic Journal.
Obstfeld is at the University of California, Berkeley; Taylor is at the University
of California, Davis.
For Further Information: contact Maurice Obstfeld via email:
obstfeld@econ.berkeley.edu; Alan Taylor at: amtaylor@ucdavis.edu; or RES
Media Consultant Romesh Vaitilingam on 0117-983-9770 or 07768-661095
(email: romesh@compuserve.com).