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The gold exchange standard was a self-equilibrating system with one critical weakness. In a pure gold standard, the gold supply was the monetary base and did the work of causing economic expansion and contraction, whereas, under the gold exchange standard, currency reserves also played a role. This meant that central banks were able to make interest rate and other monetary policy decisions involving currency reserves as part of the adjustment process. It was in these policy-driven adjustments, rather than the operation of gold itself, that the system eventually began to break down.

One of the peculiarities of paper money is that it is simultaneously an asset of the party holding it and a liability of the bank issuing it. Gold, on the other hand, is typically only an asset, except in cases—uncommon in the 1920s—where it is loaned from one bank to another. Adjustment transactions in gold are therefore usually a zero-sum game. If gold moves from England to France, the money supply of England decreases and the money supply of France increases by the amount of the gold.

The system could function reasonably well as long as France was willing to accept sterling in trade and redeposit the sterling in English banks to help maintain the sterling money supply. However, if the Banque de France suddenly withdrew these deposits and demanded gold from the Bank of England, the English money supply would contract sharply. Instead of smooth, gradual adjustments as typically occurred under the classical gold standard, the new system was vulnerable to sharp, destabilizing swings that could quickly turn to panic.

A country running deficits under the gold exchange standard could find itself like a tenant whose landlord does not collect rent payments for a year and then suddenly demands immediate payment of twelve months’ back rent. Some tenants would have saved for the inevitable rainy day, but many others would not be able to resist the easy credit and would find themselves short of funds and facing eviction. Countries could be similarly embarrassed if they were short of gold when a trading partner came to redeem its foreign exchange. The gold exchange standard was intended to combine the best features of the gold and paper systems, but actually combined some of the worst, especially the built-in instability resulting from unexpected redemptions for gold.

By 1927, with gold and foreign exchange accumulating steadily in France and flowing heavily from England, it was England’s role under the rules of the game to raise interest rates and force a contraction, which, over time, would make its economy more competitive. But Montagu Norman, governor of the Bank of England, refused to raise rates, partly because he anticipated a political backlash and also because he felt the French inflow was due to an unfairly undervalued franc. The French, for their part, refused to revalue, but suggested they might do so in the future, creating further uncertainty and encouraging speculation in both sterling and francs.

Separately, the United States, after cutting interest rates in 1927, began a series of rate increases in 1928 that proved highly contrac-tionary. These rate increases were the opposite of what the United States should have done under the rules of the game, given its dominant position in gold and continuing gold inflows. Yet just as domestic political considerations caused England to refuse to raise rates in 1927, the Fed’s decision to raise rates the following year when it should have lowered them was also driven by domestic concerns, specifically the fear of an asset bubble in U.S. stock prices. In short, participants in the gold exchange standard were putting domestic considerations ahead of the rules of the game and thereby disrupting the smooth functioning of the gold exchange standard itself.

There was another flaw in the gold exchange standard that ran deeper than the lack of coordination by the central banks of England, the United States, France and Germany. This flaw involved