Currency Wars_ The Making of the Next Global Crisis - James Rickards [25]
In international trade, these supply and demand factors equilibrated in the same way. A nation with improving terms of trade—an increasing ratio of export prices versus import prices—would begin to run a trade surplus. This surplus in one country would be mirrored by deficits in others whose terms of trade were not as favorable. The deficit nation would settle with the surplus nation in gold. This caused money supply in the deficit nation to shrink and money supply in the surplus nation to expand. The surplus nation with the expanding money supply experienced inflation while the deficit nation with the decreasing money supply experienced deflation. This inflation and deflation in the trading partners would soon reverse the initial terms of trade. Exports from the original surplus nation would begin to get more expensive, while exports from the original deficit nation would begin to get less expensive. Eventually the surplus nation would go to a trade deficit and the deficit nation would go to a surplus. Now gold would start to flow back to the nation that had originally lost it. Economists called this the price-specie-flow mechanism (also the price-gold-flow mechanism).
This rebalancing worked naturally without central bank intervention. It was facilitated by arbitrageurs who would buy “cheap” gold in one country and sell it as “expensive” gold in another country once exchange rates, the time value of money, transportation costs and bullion refining costs were taken into account. It was done in accordance with the rules of the game, which were well-understood customs and practices based on mutual advantage, common sense and the profits of arbitrage.
Not every claim had to be settled in gold immediately. Most international trade was financed by short-term trade bills and letters of credit that were self-liquidating when the imported goods were received by the buyer and resold for cash without any gold transfers. The gold stock was an anchor or foundation for the overall system rather than the sole medium of exchange. Yet it was an efficient anchor because it obviated currency hedging and gave merchants greater certainty as to the ultimate value of their transactions.
The classical gold standard epitomized a period of prosperity before the Great War of 1914 to 1918. The subsequent and much maligned gold exchange standard of the 1920s was, in the minds of many, an effort to return to a halcyon prewar age. However, efforts in the 1920s to use the prewar gold price were doomed by a mountain of debt and policy blunders that turned the gold exchange standard into a deflationary juggernaut. The world has not seen the operation of a pure gold standard in international finance since 1914.
The Creation of the Federal Reserve—1907 to 1913
The second of the currency war antecedents was the creation of the Federal Reserve System in 1913. That story has antecedents of its own, and for those one must look back even further, to the Panic of 1907. This panic began amid a failed attempt by several New York banks, including one of its largest, the Knickerbocker Trust, to corner the copper market. When Knickerbocker’s involvement in the scheme came to light, a classic run on the bank commenced. If the Knickerbocker revelations had occurred in calmer markets, they might not have triggered such a panicked response, but the market was already nervous and volatile after massive losses caused by the 1906 San Francisco earthquake.
The failure of the Knickerbocker Trust was just the beginning of a more general loss of confidence, which led to another stock market crash, even further bank runs, and finally a full-scale liquidity crisis and threat to the stability of the financial system as a whole.