2. Phase II: World War I and After

If the classical gold standard worked so well, why did it break down? It broke down because governments were entrusted with the task of keeping their monetary promises, of seeing to it that pounds, dollars, francs, etc., were always redeemable in gold as they and their controlled banking system had pledged. It was not gold that failed; it was the folly of trusting government to keep its promises. To wage the catastrophic war of World War I, each government had to inflate its own supply of paper and bank currency. So severe was this inflation that it was impossible for the warring governments to keep their pledges, and so they went “off the gold standard,” i.e., declared their own bankruptcy, shortly after entering the war. All except the United States, which entered the war late, and did not inflate the supply of dollars enough to endanger redeemability. But, apart from the U.S., the world suffered what some economists now hail as the Nirvana of freely-fluctuating exchange rates (now called “dirty floats”) competitive devaluations, warring currency blocks, exchange controls, tariffs and quotas, and the breakdown of international trade and investment. The inflated pounds, francs, marks, etc., depreciated in relation to gold and the dollar; monetary chaos abounded throughout the world.

In those days there were, happily, very few economists to hail this situation as the monetary ideal. It was generally recognized that Phase II was the threshold to international disaster, and politicians and economists looked around for ways to restore the stability and freedom of the classical gold standard.