ONE weekend in September 1941, John Maynard Keynes sat down in his farmhouse in Tilton to consider how the world's currencies might be managed once the war was over. Within a few days the prolific economist produced two papers. These set out his thoughts on what lay behind the breakdown in the early 1930s of the gold standard, in which currencies were linked at fixed rates to the gold price and so to each other.

For Keynes, the gold standard was not the self-regulating system that its advocates claimed it was. If trade became heavily unbalanced, as it did in the late 1920s, deficit countries were forced to adjust, by raising interest rates to curb demand for imports and cutting wages to restore export competitiveness. This was unduly painful. Wages did not fall naturally when gold (and thus money) was in short supply: they fell in response to higher unemployment. The pain might be eased if countries with trade surpluses spent more on imports, but they were not obliged to do so.

Keynes set out a scheme for a “clearing union” that he believed had the benefits to trade of a fixed exchange-rate system but without the gold standard's shortcomings. At its heart was an international clearing bank (ICB) that would settle the balance of transactions that gave rise to trade surpluses or deficits. Residual balances would be settled by member central banks, but each would have an overdraft facility at the ICB equal to the recent average of its country's exports and imports (its “quota”). The overdraft would afford deficit countries a credit buffer against the abrupt adjustments required under the gold standard.

The scheme would still discipline members with trade deficits. A country that used up more than a quarter of its limit would be allowed to depreciate its currency by 5% against the others. Higher overdrafts would incur an interest charge on a rising scale. A country that breached half its overdraft would be required to devalue, to sell some of its gold to the ICB and to prohibit capital exports. A hopelessly lax country would be expelled from the club.

Keynes's scheme would also require creditors not to hoard their trade surpluses. Countries in persistent credit with the ICB would be allowed (and then required) to revalue their currencies. Credits equal to a quarter of the ICB quota would be liable to a tax of 5%, rising to 10% for credits above half the quota.

This scheme formed the basis of Britain's position in the negotiations in 1944 at Bretton Woods, which created the post-war system of exchange rates. However, Keynes could not secure American support for “creditor adjustment”. This was in part because America had both the world's most powerful economy and (like Germany today) a big trade surplus. Britain was an indebted supplicant.

As Robert Skidelsky argues in his biography of Keynes*, this also reflected the contrasting views in America and Britain of the collapse of the gold standard. America associated its earlier prosperity with the standard's stability and the Depression with the system's breakdown. Britain linked the misery of the 1920s to the gold straitjacket and its subsequent recovery to being freed from it. The belief that more discipline for debtors is the cure for imbalances persists, though in Germany rather than America. Now a deficit country, America thinks surplus countries should adjust too.





* “John Maynard Keynes: Fighting for Britain 1937-1946” (Macmillan, 2000)