A word of caution to today's monetary policymakers: even seemingly modest modifications can have profound, unforeseen consequences
China’s devaluation of the yuan last week surprised many market observers. The yuan, which is pegged to the dollar, had been rising in tandem with the US currency—in part because of expectations the Federal Reserve will increase interest rates soon. With China’s economy slowing, currency markets were pressing for the yuan to depreciate, and the Chinese government, seeking to boost competitiveness in export markets, gave in to the pressure and moved the peg.
This isn’t the first time the two countries’ monetary policies have been closely intertwined. In the Great Depression, China found itself vulnerable to the price of silver, thanks to the misguided moves of US policymakers.
The Great Depression was a global crisis—almost. Every significant economy was devastated, with one notable exception: China. The reason was simple. In 1929, the US and every other major nation pegged their currencies to gold. As the economic historian Barry Eichengreen has described, adherence to this standard punished countries by imposing “golden fetters" that led to crippling deflation. The fixed exchange rates of the gold standard helped transmit the monetary shocks around the world.
China, alone among the world’s major economies, operated under a silver standard in which the currency was pegged to a specific weight of that metal. This had the effect of allowing its currency to depreciate, and largely shielded it from the worst effects of the Great Depression. The economic historian Ramon Myers concluded that “China simply did not experience any national economic depression as the world depression deepened."
As the Depression worsened in the early 1930s, the world’s biggest economies came off the gold standard, allowing them to expand their money supplies and stimulate demand. As plenty of scholars have observed, countries that did so recovered more quickly. The US took the plunge in 1933, during the first year of Franklin Roosevelt’s presidency.
That was the first blow to the Chinese economy, ruining the competitive advantage it possessed when all other countries remained on the gold standard. As its currency began to appreciate, making its goods more expensive in world markets, its balance of payments turned negative, and imports exceeded exports. The worst was yet to come.
In the US, Senator Key Pittman of Nevada was hatching a plan that would prove the undoing of China. Pittman, the chairman of the Foreign Relations Committee, professed to be concerned that China was stuck with a silver currency that had limited purchasing power in global markets. If Pittman could drive up the price of silver, he proclaimed, China would see its purchasing power increase, enabling it to purchase more goods from the US. Both countries would benefit.
It wasn’t a coincidence that Nevada’s economy was highly dependent on silver mining. Nor was the fact that Pittman had significant investments in the dormant mines around his state’s famous Comstock Lode.
But however dubious Pittman’s motives may have been, he possessed (forgive the expression) sterling political skills, and he soon marshaled these on behalf of his beloved silver interests, joining forces with legislators from other mining states to push through a comprehensive program to drive up the price of silver.
Pittman convinced Congress to pass a bill that obligated the Treasury Department to purchase domestic or foreign silver until the metal constituted a full quarter of the US monetary supply or when the price hit $1.29. The Treasury Department raised legitimate concerns that the “artificially swollen price" of silver would drain the reserves of countries such as China. Pittman brushed these worries aside.
Once the law was enacted, Treasury began purchasing silver at the price of $1.29, netting silver producers a tidy 64.5 cents profit after mint charges. This amounted to a sizable subsidy to silver mining interests: The global price for silver was then a mere 35 cents an ounce.
The price soon rose, almost doubling within the year. The citizens of Nevada were pleased.
In China, however, the dramatic spike in silver prices turned the monetary system upside down. Although economists disagree about the magnitude of the blow to China, most subscribe to Milton Friedman’s account, which shows that the economy effectively imploded in 1934. The spike in silver prices triggered major deflation. Exports plunged still further, and Arthur Young, who served as a financial adviser to China from 1927 to 1941, later noted that it passed from “moderate prosperity to deep depression."
Meanwhile, the Chinese government’s efforts to stem the flow of silver overseas failed: In 1935, 173 million ounces left the country. In November that year, the Chinese government threw in the towel, nationalized what silver was left, and put the country on a paper currency standard. Two years later, the Japanese invaded, forcing Chiang Kai-shek’s Nationalist government to undertake a huge armament campaign paid for with paper money. Without silver reserves, inflation soon spiraled out of control. Between 1937 and 1945, prices rose more than 150% a year.
This was a disaster for Chiang Kai-shek and a boon for Mao Tse-Tung’s Communists. As the credibility of the nationalist government collapsed along with its currency, Mao swept to power. This was definitely not the outcome that Senator Pittman imagined when he first proposed to pump up the price of silver.
So a word of caution to today’s monetary policymakers: even seemingly modest modifications can have profound, unforeseen consequences. Bloomberg