Britain Return to Gold in 1925

Economic History

The Gold Standard, like the Exchange Rate Mechanism, ensures stable exchanges and economic discipline. Why, then, was there so many criticism of the return to gold in 1925?

In March 1919, the large trade deficit and low level of gold reserves resulted in formal abandonment of the gold stand by the UK. On Apr. 28, 1925, Churchill announced in his Budget speech that there would be an immediate return to gold at pre-1913 parity.

Reddaway (Lloyds Bank Review, 1970) expresses in his article that returning to gold at $4.76 was a failure of the committee that they had not done enough research and had not have enough consideration and look at other countries apart from the US. The committee failed to take account of prices in any external country apart from USA and also used the wrong indices (wholesale price) for their calculation and hence derived the wrong result.

The policy announcement in 1919 of the intention of returning to pre-1913 gold standard was equivalent to the announcement of a contractionary monetary policy. Under flexible ER regime of 1919-1925 contractionary monetary policy is expected to result in an appreciating of nominal ER, deflate the price level (given high rate of inflation after the First World War) and improving competitiveness. However, because the ER is determined in an asset market that adjust relatively quickly, we would expect to observe an appreciation of the real ER in the short-run whereby the ER deviates from the PPP equilibrium.

According to Keynes’ The Economic Consequences of Mr Churchill, when UK returns to gold in 1925, sterling was 10% overvalued. To determine the magnitude of overvaluation Keynes used purchasing power parity theory (PPP) which state that flexible exchange rate reflects movements in relative prices between countries.

Matthews argue that exchange rate was not overvalued and exchange rate in 1925 reflected more forces of economics fundamental than government intervention. This is due to the use of supply-side theory of exchange rate. High replacement ratio as an indicator (resulting from generous benefit system) increases search unemployment, forcing employers to bid up real wages to attract workers away from leisure: the exchange rate simply reflected the adjustment to supply-side shocks in the UK labour market, hence no overvaluation. To improve UK competitiveness, there need to be more flexibility in the labour market. However, it is not clear that the replacement ratio had large impact on UK wage costs or unemployment. More research needs to be undertaken on these supply-side influences.

Redmond (1984) presents a number of comparisons which suggest that PPP calculations for the dollar and the pound in 1925 relative to 1913 range from an undervaluation of 4% to an overvaluation of 17%, depending on which type of price index is used for comparison. Keynes’ result of a 10% overvaluation is a special outcome of the specific retail price indices he used. Redmond suggest a more representative indicator of competitiveness is the real multilateral exchange rate, which measures both nominal exchange rate variations and relative price movements for a wide sample of UK trading partners. The table below shows the result that the UK exchange rate was overvalued in 1925 by between 5 and 20%: only the magnitude depends on the type of price index used.

Multilateral real effective ER for the pound, 1924-30 (1913=100)

Deflating by wholesale prices Deflating by retail prices

1924 95.2 83.4

1925 94.8 79.6

1926 92.0 73.8

1927 97.3 81.5

1928 98.5 81.9

1929 101.3 84.9

1930 103.5 87.2

Source: Redmond (1984)

However, we have to have in mind that a number of UK trading partners were not on gold during this period. Moreover, real exchange rate within gold country might have varied as a result of differential price and productivity movements across countries. Furthermore, Solomou and Catao (1994), show that 1913 represents a low point on the level of the real effective exchange rate during the period 1870-1913.

Does overvaluation matter? Increase in sterling price of export means a reduction in our competitiveness. Eichengreen (1986 and 1992) studies a cross-section of twelve countries during 1921-1927 including UK and found that there is extensive evidence of overvaluation in the UK, Germany and Norway. This is shown by the level of competitiveness as measured by the real ER.

In the case of the UK, given the adverse effects of the First World War (in terms of a loss of