Młynarski’s attitude to the Gold Exchange Standard

 Triffin’s view on the weaknesses of GES was determined primarily by his knowledge of the specificity of this system in the period of 1922-1931[1], while Młynarski’s attitude (1884-1972) to its defects resulted from his perception of the Polish economist, who considered it as an imperfect substitute for the classical gold standard (GS), which had operated until 1914[2]. It  facilitated international trade, payments, capital movements and the maintenance of balance of payments, characterised by a high degree of automatism (Mundell 1999, p. 226).

Młynarski as an economist was undoubtedly shaped by I. Fisher. Młynarski got acquainted with his quantitative theory during his stay in the United States in 1915, where he acquired Fisher’s complete works, which made him abandon sociology and philosophy (Głowiński 2012, p. 287). The fascination with economic theory was reinforced by changes in the international monetary system after WWI. During the war, countries suspended the convertibility of currencies into gold, and war expenses were financed by excessive money issuance, which caused inflation after the war (Głowiński 2012, p. 287). Already at the beginning of the 1920s, Młynarski began to publish texts on monetary issues, but they were limited to the situation in the post-war Poland. Undoubtedly, he had an impact on the shape of the currency reform in 1924 (Leszczyńska 2013, p. 104).  However, it was not until the publication of the book “Gold and Central Banks” in 1929 that he gained international recognition (Głowiński 2012, pp. 289, 415).

Młynarski was convinced that without the adoption of  GES after WWI, it would not have been possible to restore settlements in international trade (Młynarski 1929, p. 71). He also saw the danger associated with the popularisation of the system and its lengthy duration. It should be added that  GES recommended in Genoa in 1922 was to be only a temporary solution, not an improvement of the classical gold standard (Rueff 2012, p.70). However, the defectiveness of GES described as Młynarski’s dilemma had the character of a paradox, in contrast to Triffin’s dilemma[3]. Młynarski showed the paradox of GES, because on the one hand this system was to provide liquidity to Europe, so the United States granted it dollar loans (this threatened the  lack of convertibility of  key currencies, primarily the dollar, into gold due to depositing foreign currency reserves of central banks operating within the GES area in the accounts of foreign commercial banks, which brought the interest included in reserves, i.e. it increased the number of rights to gold in the future) (Młynarski 1929, pp. 11 and 112). On the other hand,  due to protectionist practices, mainly by  the United States, there was a risk of liquidity limitation for GES countries, which could not repay loans with exports (Młynarski 1929, p. 97).  A system that could ostensibly cause global inflation by using foreign currencies instead of gold to cover the domestic issuance of GES currencies brought deflation.

Młynarski posed the question of whether the movements of gold before WWI had the same effects as movements of reserve currencies in the GES system (Młynarski 1929, p. 74). If, before WWI, gold flowed into the country as a result of the export of goods, the central bank increased the amount of money in circulation, also increasing the availability of credit. At the same time, monetary circulation abroad declined as gold, which was the basis for banknote issuance, was used to finance imports (credit also decreased).

In the GES system, the situation was different. When the central bank of a country received reserve currencies instead of gold in the settlement of exports, it increased the amount of money in circulation, but did not contribute to reducing the money supply abroad (Młynarski 1929, p. 75). The purchase of reserve currencies therefore had unilateral effects, unlike the purchase of gold. This highlights the fact that reserve currencies are rights to gold, not gold, i.e. the purchase of currencies by the central bank is part of a transaction that must ultimately end with their exchange for bullion (Młynarski 1929, p. 77). However, the essence of GES lies in the fact that the central bank holds currencies among other assets and does not exchange them for gold in gold centres (Młynarski 1929, p. 78). Therefore, the GES central bank opens an account with a commercial bank of a country with the gold-linked currency and receives interest in exchange for resignation from exchanging foreign exchange reserves for gold[4]. The same bullion can therefore be the basis for further credit expansion. Therefore, the longer the GES has been in operation and the more widely it is used, the stronger the tendency is to increase the level of foreign exchange reserves as the economy grows (Młynarski 1929, p. 79). According to forecasts of insufficient growth in gold production, this situation must have led to the loss of ability to exchange reserve currencies for bullion in the long run[5]. In the light of Młynarski’s observations, huge masses of capital of central banks operating within  GES appeared on international markets, which was unprecedented before WWI (Młynarski 1929, p. 80).

Accordingly, in the GES system, bullion did not outflow from a given country as a result of a negative balance of payments, and the transaction between importers and exporters itself had different effects in financial settlements from the effects of the flow of goods in the gold standard system. In this system, the dollars received by the exporter functioned simultaneously on two markets: in the exporting country and in the importing country, so import did not reduce the amount of money in circulation of the other country, as in the case of the gold standard. This mechanism is illustrated in Figure 1.

Figure 1. Operation of the foreign exchange and gold system in the years 1922-1931:

The presented example of the flow of goods (Q) and money (M) shows that an exporter from country A operating in the gold exchange standard (GES) after delivering goods (Q) to an importer in country B using the gold standard system (GS) receives a check for $ 1000 (M$), which he then sells to the central bank (CB). In return, it buys the corresponding amount of the national currency (Mn) issued by the central bank. In this way, the money supply in the exporting country increases, although it does not decrease in the importing country, because the CB deposits dollars from the export of goods in the commercial bank (CB) in the country – the gold centre (B). Such a deposit brings profits to CB in the form of interest (I), but also constitutes the basis for creating credit on the market in country B, making commercial banks independent of the policy of the central bank of country B (Młynarski 1931, p. 19). As Młynarski pointed out, such a loan was not generated by savings, but by the working capital of an exporter from country A. The more cheques of this type CB bought, increasing the number of deposits abroad, the greater was the level of short-term loans (they were short-term only by name, because they could be transferred between commercial banks for years), which did not come from savings, but from working capital (Młynarski 1929, p. 82):  

All are in accord that a credit which is not derived from savings and which assumes considerable dimensions may have inflationary effects.

Młynarski believed that the gold exchange standard complicated the process of adjusting prices and, instead of facilitating it, hindered the equalisation of world prices (Młynarski 1929, p. 83). Moreover, under the gold standard, central banks did not issue notes to purchase foreign currencies and did not accumulate such reserves, and an increase in the interest rate attracted only private capital generated by savings or working capital deposited in commercial banks (Młynarski 1929, p. 83). In the GES system, the increase in interest rates also attracted private capital, but in addition to it, capital began to flow in the form of deposits of central banks, which did not exist in the classical GS system, contributing to credit expansion many times exceeding the inflow of foreign deposits (Młynarski 1929, p. 83). This phenomenon began to hinder the control of the central banks of the GS countries over the money market, because commercial banks became independent of their supervision as a result of the massive inflow of foreign capital, not reacting to changes in the interest rate, so open market operations became necessary (Młynarski 1929, p. 84). In particular, changes in the interest rate almost ceased to affect the price level, although they had an almost immediate effect on the level of the exchange rate (Młynarski 1929, p. 85).

Młynarski, like Triffin later in the 1960s, proposed a reform of the GES system to eliminate its aforementioned disadvantages. In this context, he stressed the key role of close cooperation between the central banks of the GS and GES countries, with the coordinating role of the Bank for International Settlements, established in 1930.

The reform of the system should consist in prohibiting the GES central banks from selling foreign currencies as a component of reserves and depositing them in foreign commercial banks, while simultaneously approving the sales of gold (Młynarski 1931, p. 90). Certainly, if necessary, GES central banks would be able to sell currencies in exchange for gold in order to maintain the minimum level of reserves required by the statutes, but these transactions were to be in the form of special transactions between central banks, which would take place through the Bank for International Settlements (Młynarski 1931, pp. 90-92). A special transaction would mean that if a central bank opened an account with another central bank in which it would deposit its foreign exchange reserves, it could convert some of them into gold (Młynarski 1931, p. 93). In this way, gold reserves would be created and deposited with a foreign central bank for future settlements. Certificates issued on the basis of such gold deposits[6] could be the subject of purchase and sales, causing that there would be no gold movements in settlements, but only changes in accounting entries (Młynarski 1931, p. 93).

Młynarski saw, however, that his reform proposal would not solve the current problems of countries that did not have sufficient gold stocks; in such a case there was a need to prepare ground for proper reforms. He believed that it was necessary to create a new form of credit by the central banks of countries with insufficient gold reserves through cooperation in order to obtain liquidity without the help of creditor countries (Młynarski 1938, p. 138). His concept was uncomplicated, which he illustrated with a simple example. If country A imports goods worth 100 million francs from country B, and country B imports goods worth 60 million francs from country A, it is impossible to settle the whole thing, because country A will owe 40 million francs (Młynarski 1938, p. 141). However, if the central banks concluded an agreement under which they would grant each other a working capital loan of 30 million francs and agreed “that up to the amount of this loan they would sell to importers, on the presentation of invoice, crossed cheques in  francs and drawn by one central bank on another”, there could not be a permanent surplus of liabilities of one of the banks (Młynarski 1938, p. 141). This solution would not have to be limited to bilateral agreements. Młynarski was convinced that its advantage would become visible only in the case of extending it to many countries (Młynarski 1938, p. 142):

Let us imagine, though, that the system of mutual working capital loans will cover not two, but ten banks. Then, it would be easier to liquidate temporary surpluses of liabilities, because the bank being a debtor to one of the members of the system at a certain time may also be a creditor to another bank. Clearing of drawn checks could be done in triangular or polygonal combinations. The ideal solution would be to use the Bank for International Settlements as a common hub for all participants in the system…  [it] could, temporarily, help the debtor bank with its own credit.

These words bring to mind the principle of operation of special drawing rights, which arose on the initiative of Triffin. Their task also boils down to providing liquidity in the event of insufficient reserves of central banks (Pszczółka 2011, p. 318).

It is worth emphasising, however, that  contrary to Młynarski’s suggestion,  SDRs were created as a result  of Triffin’s warnings about the risk of global deflation, which, according to him, was caused by the reduction of the balance of payments deficit by the US. The solution eventually introduced in 1969 and the related events at the end of the Bretton Woods system period revealed the fallacy of Triffin’s predictions about illiquidity and deflation, and instead – the world faced excess liquidity and inflation (Bordo, McCauley 2017, p. 7).

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[1] The GES system was proposed during the Genoa Conference in 1922 for countries that lost significant gold reserves as a result of WWI (Leszczyńska 2013, p. 47). In turn, the United States, Great Britain and France remained on the gold standard, and their currencies formed the basis for the issuance of the currencies of the GES countries. In the literature, the GES is referred to as a system covering both countries with the gold exchange standard and gold standard. Triffin believed that GES collapsed in 1931 with the devaluation of the pound (Triffin 1960, p. 9).

[2]Before WWI, the outflow  of gold was treated as a natural and temporary phenomenon, therefore reserves in central banks were used to transfer them from  one country to another according to the movements of goods, but in the opposite direction (Młynarski 1938, p. 128). In the first place, however, gold coins that were used in circulation (only after WWI, they were removed)  flowed away. Therefore, it was believed that the gold standard could automatically restore external and internal balance, which translated into equalisation of the price level on a global scale (Leszczyńska C.  2013, p. 11).

[3] A paradox is something inconsistent with the belief, very useful in science, because with their solution the truths previously hidden are discovered (Kotarbiński 1986, p. 208).

[4] See: (Rueff 2012, pp. 29-30): For illustration: funds flowing from the United States to a country using the gold exchange standard system increase the money supply in the “receiving” country by an appropriate amount without reducing the money supply on the market of the country of origin. The issuing bank to which the funds go and which records them in its reserves leaves them in escrow in the New York market, where, as before, they may form the basis for granting credit.

[5] See: (Młynarski 1929, p. 79): The steadily increasing accumulation of foreign exchange reserves is the most essential feature of the gold exchange standard. The accumulation of foreign exchange reserves, however, is nothing but accumulation of short-term credits granted to foreign countries by the banks which apply this system. The balance of foreign payments thus is not adjusted by gold, but by short-term credits granted to foreign countries by a bank which purchases foreign exchange. Instead of gold fluctuation, we have an ebb and flow of short-term credit.

[6] Młynarski also referred to these certificates as cheques (Młynarski 1938, p. 136): Instead of selling foreign currency, cheques made out to foreign central banks, payable in gold, could be sold. This would be a form of selling gold from a foreign deposit, instead of from a vault on the spot. Cheques or certificates should be for grams of gold and valid for a certain period of time…

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Małgorzata Korczyk