History Points To a Brutal Rebalance, 1920s Style

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My colleague Joe Calhoun introduced the idea many months ago that everything has happened before, and if you are careful and studious with historical precedence you can find anecdotes for nearly every situation no matter how modern or crazy (or crazy modern). The historical record is littered with both examples of surreal conditions producing even more seemingly unbelievable occurrences and relevant lessons to take from such periods of straying out of the margin of safety. This is particularly true in economics, perhaps even more so in monetary economics.

Given the deposit/bank run scenarios running through popular imagination due to the mess in Cyprus, the mind easily wanders to the early 1930's and the charred aftermath of bank runs and panics. But in the current context of a European Central Bank and political authority deeply committed to monetary union no matter the end economic result, I think the decade before the 1930's provides the most useful historical comparisons.

Inevitably when speaking of the 1920's and monetary dysfunction, the pre-eminent case study is that of the German Republic in the years after World War I. I suppose hyperinflationary collapse will leave that kind of legacy; it certainly has in Germany itself. What is less well-known, and I think very applicable to trying to understand the dangers of monetary interventions in 2013, is the French franc crisis of 1926.

While Germany descended into the depths of hyperinflation by 1923, the French Republic nearly followed in the years immediately after. Apart from being on the victorious side in the "Great War", there were a lot of similarities between France and Germany in the early years of the 1920's. Both countries had been physically scarred by war, and both were under massive fiscal constraints. As is the case in nearly every instance of hyperinflation, fiscal imbalances are the proximate cause.

Historical figures seem to disagree as to the scale, but the French government was running huge budget deficits even after the end of WWI (estimated 27 billion to 43 billion francs in 1919, and between 10 billion and 12 billion as late as 1923). The continuation of a large fiscal deficit placed the French currency in the same class as the German mark. If the German government would resort to paper marks under the burdens of the deficits at the time, it would seem logical that the French might eventually appeal to the same methods.

So as the German mark descended into utter worthlessness, the French franc began to feel the strains of speculation. From December 1923 through March 1924, the franc depreciated from about 80 francs per British pound to nearly 115. That was an astounding move, particularly for a world not at all used to floating rates of exchange. In early March 1924, the Bank of France intervened in the exchange markets, pledging its gold reserves as collateral for foreign currency loans: a £4 million loan with four British banks and $100 million with a JP Morgan subsidiary.

While the intervention was successful in recouping some of the speculative losses (the franc rose back to 78 francs to the pound by later the same month), it would only provide some temporary cover for the government to try to address the deficit situation. There was political turmoil in May 1924 as the Bloc National was defeated by a consortium of leftist parties (dubbed the "Cartel des Gauches" by opponents) which brought with them familiar leftist solutions. However, it was not really a durable political "cartel" as much as varied expressions of voter dissatisfaction.

The French Treasury was well aware of not just voter resentment but also investor perceptions of dysfunction. For reasons that were not always valid, the Treasury operated under constant fear of rollover risk since a good portion of French debt was volatile, short-term Bons de la Défense Nationale. Worried that currency fears might drive investors out of these securities (what we might call today a "busted auction"), the French Treasury began "cooperating" with the Bank of France to increase note circulation (currency) and advances to the government. Importantly, however, these means of monetarism were intentionally hidden through various accounting conventions.

By October 1924, note circulation in France had exceeded the legal limit. The hidden money printing (given the name faux bilans), plus knowledge of indirect advances into the Treasury, became public information in February 1925. The Bank was made to promise to bring note circulation below the legal limit, but could not arrive at a reasonable course to do so. The currency reacted sharply and thus began a durable rift between the Bank and the Treasury.

On April 11, 1925, the Bank finally published an accurate accounting of note circulation that was a huge 2 billion francs over the legal ceiling (governments and central banks not following their own rules, who would have thought?). Not sure how to address the growing problem, French Premier Eduoard Herriot's government introduced a bill that would levy a tax on capital throughout the Republic. He was defeated in the Senate and another political crisis shortly followed, but the idea of the levy remained as long as the "cartel" remained.

Appealing to expediency, the government voted to increase the note ceiling by 4 billion francs in April 1925, then by 6 billion in June, followed by 7.5 billion that November. The threat of capital levy plus the increase in legal note circulation drove the franc back down to 115 francs per British pound by the end of 1925 as investors fled.

Operating within the construct created by the Genoa Conference in 1922, the US dollar was put atop the international exchange pyramid as the only currency truly convertible into gold. The British pound would still be convertible, but only in large quantities of bullion that were usable only in international exchange. Other national currencies would absorb dollars and pounds as part of their national "reserves", and thus would have only indirect claims on real money (gold).

So as a result of the French economic situation of the early 1920's, the Bank of France's reserves increasingly held dollars and pounds rather than gold. These reserves were somewhat useful (and only up to a point) in trying to stabilize the franc in 1925, but limited the ability of the French central bank to support the franc fully (the bank itself was conflicted on the legal authority to intervene as well). Instead, the Bank was often reliant on loans from foreign banks, such as that from JP Morgan, since the demands of foreign trade for France absorbed a good deal of potential foreign currency reserves (and since gold remained in New York and London).

By the beginning of 1926, inflation had risen dramatically within France (and I'm sure newspapers of the day were full of news about "unexpected" dysfunction, though I'm not sure what is the French translation for headwinds) and the German parallel was beginning to heavily influence investor expectations. The franc's devaluation was a vice on the French government, increasing expenditures while tax revenues fell with the currency. That meant that the threat of the capital levy became ubiquitous as it was such an "easy" solution, augmented by expected tax increases across the board.

Throughout the period the central bank and the Treasury were often at odds over how to deal with the franc's depreciation. The Treasury wanted more currency intervention, going so far as to ask for a $100 million loan directly from the Federal Reserve Bank of New York (the precursor of dollar swaps we see today) with French gold (in possession of the Bank of France) as collateral. The Bank refused to back the plan on the grounds it would severely damage French creditworthiness. In this surreality of late 1925/early 1926, the Treasury was desperate for monetary means to end the growing crisis while the central bank continuously argued for fiscal measures - it was always somebody else's problem.

By May 1926, the franc had fallen sharply, below 175 francs per pound. The Treasury got the Bank to use $56 million in Morgan funds, analogous to its actions of 1924, but it made little difference outside of a minor correction in course. By July, the franc had fallen all the way to 235 francs to the pound, an astounding collapse in value that had the country on the verge of hyperinflation.

Then it suddenly reversed. Change finally came to the Bank and to many government positions. On May 26, 1926, the government appointed a committee of experts whose task it was to move away from fiscal and monetary experimentation with an overarching goal to achieve fiscal and currency stability. The appointments to the committee were viewed to be in opposition to the "cartel", and thus took the issue of capital levy off the table. In response, JP Morgan offered to loan additional dollars with French Treasury bills as collateral rather than demanding gold.

Most of all, however, the committee called for stabilizing the franc through gold. The fiscal deficit, which incidentally had improved, was to be closed through a sharp increase in indirect taxes while direct taxation was actually reduced (and the capital levy buried permanently). The government would also institute a sinking fund to retire its short-term bons as much as possible to remove the temptation toward monetization and the threat of rollover risk.

While France's flirtation with hyperinflation ended in 1926, by 1927 the country was back within the throes of currency problems, but in the other direction. On August 7, 1926, the Bank of France was finally given legal authority to purchase reserves and gold. Given that statutory authority and the monetary policy of restoring the gold standard to the franc (revalorization), France began to be seen as a place to make "easy" money.

The country had relatively high interest rates and severely depressed valuations, plus the element of future gold stability erased a lot of uncertainty that plagued the nation since the end of WWI. As early as autumn 1926, only a few months away from the prospect of hyperinflation, the French government was urging the Bank to intervene in the franc to "moderate" its rise from the ashes. The monetary pendulum had swung extremely fast in a short period.

By early 1927, France was accumulating a large balance of foreign reserves as "capital" returned. Economists at the Bank of France worried, through their own calculations and estimates, that the franc would rise well above the pre-crisis level of 80 francs per pound. This was thought in Paris to be driven by relative monetary changes, particularly a reduced rediscounting rate in London. Given the franc's near-death experience just the year before, the French government, now with support of the Bank, opted for a gold-based solution: they would convert foreign exchange for gold on the foreign markets.

This would accomplish all of their goals simultaneously, from stabilizing the franc to revalorization. The problem was London and the gold exchange standard itself. On May 16, 1927, the Bank of France requested a large purchase of gold in both London and New York. The Federal Reserve Bank of New York easily converted $100 million to gold and sent it off for Paris. To ensure "internal stability", the move was "sterilized" as FRBNY purchased an equivalent amount of treasury bills to offset the drain of specie (gold money). Thus in New York, the banking system lost real money but gained an equivalent amount of fungible currency through the Fed.

In London, the Bank of France opted to purchase £20 million of gold from the Bank of England. Lord Montagu Norman, Governor of the Bank of England at the time, felt that the French should be responsible for their own currency matters and reserves. He advocated that interest rates in Paris should come down and that the French might consider allowing prices to rise.

Eventually, a compromise was reached where the Bank of France would get its gold needs filled solely in New York through FRBNY, and that London would increase market rates somewhat. So the path of heightened speculation would proceed through New York, rather than Paris.

Some of what resulted in the years after 1927 certainly owed to the imbalance of gold in the United States after World War I. Indeed, part of the Bank of France' acceptance of the compromise to gain gold exclusively from New York was its view that the United States had not done enough to allow for a natural rebalance of gold holdings back into Europe. High interest rates on the continent were a product of that attempt, but in the foreign exchange setup of the Genoa Conference, Europe was only to attract foreign currency as reserves and not real money.

The net effect of this system of dual-reserve currencies was an era of inflating currency (as the franc crisis ably demonstrates). Had the French been on the classical gold standard from the outset, the monetary tomfoolery would have been nonexistent. Such a loss of confidence in the franc would have been closely followed with a loss of gold rather than sterling or dollars, and thus a dramatic decline in the fortunes of the French economy in relatively short order. The deficit imbalance would have never reached such disproportionate heights because there would not have been enough real money to simply monetize or inflate it away. Thus, capital levies would never have been proposed in any serious fashion - they would have been totally unnecessary since gold is essentially a self-correcting mechanism.

Of course, these problems were not unique to France. The gold exchange standard allowed every central bank to skirt the traditional "rules of the game", whereby international imbalances were traditionally and exclusively settled in gold. That meant external imbalances were increasingly the responsibility of individual central banks and national governments, introducing political elements into erstwhile non-political monetary issues.

The dual-reserve currency allowed for an international scheme whereby individual nations could follow nationalistic monetary policies without fear of being forced out of them by sound money. In the French crisis, they were able to use Sterling as a reserve and basis to inflate the franc in order to avoid hard choices about what seemed to be structural deficits and political inabilities to implement those hard choices. When time came to "cash in" on pound reserves, the exchange standard pushed that off on the Federal Reserve System's imbalance of gold.

But the Fed, in extremely close cooperation with the Bank of England, "sterilized" any gold conversions internally. That meant escalating and inflating currency reserves would pile up everywhere and no imbalance would truly get resolved by any real money movements anywhere. Until 1929.

There are so many parallels here to 2013 that it is hard to know exactly where to begin. The capital levy in France is very much analogous to the deposit confiscation in Cyprus, as is the tendency of the removal of a true gold standard to allow central banks and governments to go beyond their own laws and statutes. Without a true money option, governments "own" the monopoly power over "money" (currency in this case), and can be counted on to do whatever it takes to maintain that status quo, even at the expense of the national currency or economy (this seems like the default option).

More than those more obvious parallels, I think the entire episode of the franc crisis in 1926, including the pre-cursors and after-effects, demonstrate conclusively that monetary engineering is itself a fool's errand. There was no ability in real-time or otherwise to discern a proper course of action once the monetary means were under political authority. Politics will always take precedence. Even from a purely monetary stance, a "correct" solution was not always obvious because there was no way to divine exactly what was driving the human emotions of fear or even greed (francs were near collapse in July 1926, then rising precipitously and "dangerously" only a few months later).

From a pure market stance, the only way to resolve these types of monetary crises is to avoid them altogether; or at least as much as possible. That means the public should be given sole authority to regulate monetary means, eliminating most of the political intrusion into what should be solely economic concerns. But the reality is that imbalances are an inherent part of the economic mechanism. There will always be imbalances due to billions of tiny differences that add up in one way or another, whether opinions or abilities, such diffused mechanisms that can never truly be anticipated. The solution in the 1920's, particularly as identified in the Genoa framework, was to allow central banks the "flexibility" to craft national solutions outside the rigid gold standard and the public right of withdrawal.

Long before World War I, the "cross of gold" was well understood in popular terms to mean adjustments in the monetary imbalances were to be borne by national economies - loss of gold meant rising unemployment. For populists of the day, gold was equivalent to economic distress. It was simply lost that gold meant dispersed power; the people sold their right to monetary control for the empty promise of economic security. The Progressives sought to exploit that promise as a means to break the direct link of monetary imbalance into economic imbalance through the experiment of monetary engineering (the long held dream of true currency elasticity). Central banks, in cooperation with commercial banks, would be staffed with experts that could operate and manage economic and even fiscal affairs through monetary flexibility, something that would never have been achieved under the constraint of gold. It was a new age of central planning.

Some things never change. Whether it was/is simply too much politics or an inability to accurately measure those billions of daily, real world imbalances, monetary engineering through a centralized structure inevitably leads to instability. Instability itself can take any number of forms, from consumer inflation to "structural" current account imbalances to, my "favorite", asset inflation. In the end, even hyperinflation is a real possibility as fiscal needs outweigh, in the minds of the experts, the public's own interpretations of appropriateness, particularly since these central means are imposed ostensibly for our own good. The experts always seem to fail to understand the real balance - hyperinflation, or even its threat, is not up to the experts. However, capital levies or deposit confiscations are, I hear, for the greater good.

The appearance of any of these forms of instability is the fingerprint of improperly calibrated monetary means. Markets aren't perfect, but imbalances get resolved, often brutally, long before they reach dangerous proportions. The persistence of imbalances into existential disasters is the hallmark of central bank "flexibility" and the hubris of such an attempt. There is no shortage of historical record on this account.

Jeffrey Snider is the Chief Investment Strategist of Alhambra Investment Partners, a registered investment advisor. 

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