Esprit de Currency

• Author: Douglas A. Irwin
• Position: the Robert E. Maxwell ’23 Professor of Arts and Sciences at Dartmouth College and a research associate of the National Bureau of Economic Research.

THE INTERNATIONAL monetary system and the international trading system are usually considered distinct entities that serve different functions. But exchange rate policy and trade policy are highly interrelated. Tensions between the two have been evident throughout history—such as during the Great Depression and the Bretton Woods era—and may become increasingly apparent in the years to come. The membership of the International Monetary Fund (IMF) and the World Trade Organization (WTO) will have to work together to defuse disputes over exchange rate policy—most notably between the United States and China—that could spill over and adversely affect trade relations.

Depression-era protectionism

The Great Depression of the 1930s is a prime example—albeit rarely so recognized—of how exchange rate policies can create difficulties for trade policy. That decade saw a virulent outbreak of protectionist trade policies that contributed to a collapse of world trade. In fact, higher trade barriers accounted for about half of the 25 percent decline in the volume of global trade between 1929 and 1932 and stunted the growth of trade for the remainder of the decade.

Yet countries varied significantly in the extent to which they increased tariffs and imposed import quotas. A key factor in determining a country’s trade policy response was not—perhaps surprisingly—the degree to which it suffered from falling output and rising unemployment, but rather its exchange rate policy under the gold standard (Eichengreen and Irwin, 2010; Irwin, 2012). Under the gold standard, a country’s monetary policy was largely determined by the amount of gold reserves held by its central bank. With each country defining the value of its domestic currency in terms of gold, countries that operated on the gold standard also had fixed exchange rates with one another.

In the late 1920s, the United States and France began attracting gold from the rest of the world, but their central banks did not expand their money supplies as they accumulated reserves. This constituted a deflationary shock to the world economy that contributed to the Great Depression. Other countries faced the choice of reducing their gold outflows and addressing their balance of payments difficulties either by changing their exchange rate or by imposing import controls. Depending on their commitment to the gold standard, countries chose either to keep the exchange rate fixed and restrict trade or to let the exchange rate go and keep trade open.

For example, countries such as France that opted to stay on the gold standard adopted many more trade restrictions than did other countries. Furthermore, because central banks in countries with a fixed exchange rate had to focus on maintaining exchange rate parity, they were unable to use monetary policy to reverse deflation and relieve the financial distress of the period—thereby prolonging the Great Depression.

By contrast, countries that abandoned the gold standard and allowed their currencies to depreciate—for example, Sweden—not only were able to avoid much of the damaging protectionism of the period, but also were free to use expansionary monetary policies to help end the Depression.

Wrong lessons

Unfortunately, the architects of the post–World War II international economic order did not always draw the right lessons from this period. Instead of recognizing that flexible exchange rates allowed for an independent monetary response to national economic conditions, most economists and policymakers recoiled at what they perceived to be the currency turmoil of the 1930s. Because countries left the gold standard at different times, the exchange rate changes were large and abrupt, jolting world trade and financial markets. Because fixed exchange rates were considered the norm, these changes came to be labeled “competitive devaluations,” implying that they were a beggar-my-neighbor policy used by countries to improve their competitive position at the expense of others’.

But to call these...