When Winston Churchill was appointed Prime Minister in November 1924, he is said to have thought it was an almost ceremonial post as Prime Minister of the Duchy of Lancaster, and, given his lack of interest in economics, was as surprised as anyone to find out that it was actually the second most powerful office in the British government, constitutionally as Chancellor of the Exchequer. “I was surprised,” he wrote, “and the Conservative Party was stunned.”
The controversies that would arise after Churchill’s tenure have an impact on today’s policy debates. It’s all about macroeconomics and exchange rates: how exchange rates affect trade and development, whether exchange rates should be fixed or floating, and the problems these issues pose for policymakers. In the short term, Churchill’s decisions led to the general strike of 1926, and these arguments continue to resonate in the long term.
Churchill inherited the difficult task of returning Britain to the pre-World War I parity gold standard. In 1914, sterling was convertible to gold at a rate of £4.25 per ounce. This means an exchange rate of 1 pound to $4.87. When war broke out, convertibility was suspended to prevent the loss of gold, and Britain, like other combatants – to a much lesser extent, in fact – issued currency to finance the war. Between 1914 and 1918, the share of total metal reserves in paper money and deposits (currency) decreased from 40% to 33%.
In 1918, the Cunliffe Committee recommended a return to convertibility, but the mismatch between currency and reserves caused a financial crisis, as holders of pounds exchanged them for gold and reserves were depleted. Britain’s postwar government tried to increase its foreign exchange reserves by creating an international balance of payments surplus and tightening monetary policy with high interest rates, but this also led to a decrease in the amount of currency in circulation. This caused the pound to rise from a low of $3.38 per pound in February 1920 to $4.78 per pound in March 1925.
Churchill had doubts about returning to pre-war gold parity, but he also doubted his ability to match economic wisdom with Montagu Norman, the Governor of the Bank of England, who was a strong advocate of policies that would protect London’s place as the center of the financial world. “if [economists] “They were soldiers or generals, so I could understand what they were saying,” Churchill grumbled. “Actually, they all speak Persian.”
He had hoped that John Maynard Keynes, a public intellectual since he published The Economic Consequences of Peace in 1919, would do it. In 1925, Keynes published a pamphlet entitled The Economic Consequences of Mr. Churchill, in which he argued that Britain’s relatively high unemployment rate was “a matter of relative prices at home and abroad. The prices of our exports on the international market are too high.” The problem, Keynes wrote, was that “the value of the pound abroad has increased by 10 percent, even though its purchasing power over British labor has remained unchanged.” If Americans wanted to buy a product priced at £1, they used to have to hand over $4.33, now they have to hand over $4.78. Rather, he argued, it was “a 10 per cent reduction in the funds we have to accept ($4.33 or 90p)”, which is pushing profits into losses and contributing to the economic recession.
“On this there is no difference of opinion,” Keynes wrote, and he was right. All believed that excessive wages in export industries such as coal were the problem. The difference was that Norman and his colleagues proposed lowering nominal wages and lowering the domestic price level, or in other words, devaluing internal valuations, in order to restore profitability.
Keynes believed that a domestic currency devaluation was impossible. That would require “fighting each group in turn,” he wrote. “Those who are attacked first will face a decline in their standard of living, because the cost of living will not fall until everyone else is also successfully attacked. They are therefore justified in defending themselves… until the economically weakest are driven to the ground, it must be a war,” he continued. Keynes’s remedy was external devaluation, which would reduce the value of the pound, or exchange rate, back to $4.33 to the pound “in order to raise its price abroad.”
Norman, who described Keynes as “always absolutely fascinating, but always absolutely wrong,” got his way. In April 1925, Churchill announced in his advocacy speech that Britain would return to the gold standard at pre-war parity.
But in this case Keynes was right. As prices rose in foreign currency terms, British coal exports plummeted, profits slipped into losses, mine owners demanded wage cuts and trade unions resisted. Keynes wrote that the miners “have to make this sacrifice in order to cope with circumstances for which they are in no way responsible and over which they have no control.” The government set up a committee and enacted a one-off grant to postpone the issue until the following year, but when the government-appointed Coal Disputes Tribunal reported in July 1925, one of its members, Sir Josiah Stamp, explicitly blamed a “return to money” for the unrest. The committee submitted its report in March 1926, recommending wage cuts, which led to a general strike in May, the largest industrial unrest in British history.
The debate over a return to the gold standard under Churchill will likely resurface. Milton Friedman advocated floating exchange rates for similar reasons as Keynes, which were also at the heart of Margaret Thatcher’s opposition to Britain’s membership in Europe’s single currency. As countries around the eurozone struggle with the debt crisis of 2010-2013, the unlikely pairing of Keynes and Friedman has once again resonated. When faced with an imbalance, it was considered better to adjust external prices (exchange rates), if possible, than to adjust all internal prices (price levels).
An exchange rate is simply the price of one currency in exchange for another, and fixing this price is no different from fixing any other currency.
Churchill’s private secretary, Sir James Grigg, wrote in his memoirs: “Winston almost came to believe that his decision to return to gold had been the biggest mistake of his life.” As great as he was, there was fierce competition for that title, but he may have been right all the same.
