The Fall of Sterling: Reserve Currency to Brexit

The UK pound sterling held the dominant reserve currency role starting in 1816, following the end of the Napoleonic Wars and the official adoption of the gold standard by the UK.

During the glory years of sterling as a global reserve currency, the exchange value of sterling was remarkably stable. In 2006, the UK House of Commons produced a 255-year price index for sterling that covered the period 1750–2005.

The index had a value of 5.1 in 1751. There were fluctuations due to the Napoleonic Wars and the First World War, but even as late as 1934, the index was at only 15.8, meaning that prices had only tripled in 185 years.

But once the sterling lost its lead reserve currency role to the US dollar, inflation exploded. The index hit 757.3 by 2005. In other words, during the 255 years of the index, prices increased by 200% in the first 185 years while the sterling was the lead reserve currency, but went up 5,000% in the 70 years that followed.

Many observers assume the 1944 Bretton Woods conference was the moment the US dollar replaced sterling as the world’s leading reserve currency. In fact, that replacement of sterling by the dollar as the world’s leading reserve currency was a process that took 30 years, from 1914 to 1944.

The world went off the classic gold standard when the First World War broke out in 1914, and Britain needed to print money to fight the war.

When the First World War was over and the world entered the early 1920s, countries like Britain wanted to go back to the gold standard but didn’t quite know how to do it. There was a conference in Genoa, Italy, in 1922 where the problem was discussed.

Before the First World War, a certain amount of gold backed up a certain amount of paper money. But during the war, the paper money supply was doubled. That left only two choices if countries wanted to go back to a gold standard.

They could’ve doubled the price of gold — basically cut the value of their currency in half — or cut the money supply in half. They could’ve done either, but they had to get to the parity either at the new level or the old level. The French decided to cut the value of the currency in half, opting for parity at the new level.

The UK had the same decision to make, but pursued a different course than France. Instead of doubling the price of gold, the British cut their money supply in half. They went back to the pre-First World War parity.

That was a decision made by Winston Churchill, who was Chancellor of Exchequer at that time. It was extremely deflationary. Churchill felt duty-bound to live up to the old value. The point is, when Britain doubled its money supply, Churchill might not have liked it. But it was a fact, and he should have accepted that the nation had devalued its currency.

He cut the money supply in half and that threw the UK into a depression three years ahead of the rest of the world. While the rest of the world ran into the depression in 1929, it started in the UK in 1926. Returning to gold at a much higher price measured in sterling would have been the right way to go. Choosing the wrong price was a contributor to the Great Depression that followed.

Getting the price of gold right

Economists today say, ‘We could never have a gold standard. Don’t you know that the gold standard caused the Great Depression?’

I do know that — it was a contributor to the Great Depression. But it was not because of gold. It was because the wrong gold price was chosen and that was highly deflationary.

The lesson of the 1920s is not that a country can’t have a gold standard, but that it needs to get the price right.

Britain continued down that path until, finally, it was unbearable for the UK, and it devalued in 1931. Soon after, the US devalued in 1933. Then France and the UK devalued again in 1936. There was a period of successive currency devaluations and so-called ‘beggar-thy-neighbour’ policies.

The result was, of course, one of the worst depressions in world history. There was skyrocketing unemployment and crushed industrial production that created a long period of very weak to negative growth. It was not resolved until the Second World War and then, finally, at the Bretton Woods conference.

Scholar Barry Eichengreen has documented how the US dollar and sterling seesawed over the 20 years following the First World War, with one taking the lead from the other as the leading reserve currency and in turn giving back the lead. In fact, the period from 1919–1939 was really one in which the world had two major reserve currencies — US dollars and sterling — operating side by side.

Finally, in 1939, England suspended gold shipments in order to fight the Second World War and the role of sterling as a reliable store of value was greatly diminished apart from the UK’s special trading zone of Australia, Canada and other Commonwealth nations. The 1944 Bretton Woods conference was merely recognition of a process of US dollar reserve dominance that had started in 1914.

There, 730 delegates from 44 nations met at the Mount Washington Hotel in the final days of the Second World War to devise a new international monetary system.

The delegates there were acutely aware that the failures of the international monetary system after the First World War had contributed to the outbreak of the Second World War. They were determined to create a more stable system that would avoid beggar-thy-neighbour currency wars, trade wars and other dysfunctions that could lead to shooting wars.

It was at Bretton Woods that sterling was finally dethroned and the US dollar was officially designated the world’s leading reserve currency — a position it still holds today.

Now the Brexit vote is over, the sterling will suffer yet another blow. With the Leave vote winning, we have seen a sudden loss of confidence in the British pound.

Belonging to the EU without joining the Eurozone never made sense in terms of economic efficiency. Instead, being part of the EU was always a halfway house to full monetary integration.

Had the Remain vote won, the effort to integrate into the Eurozone would not have been far behind. Instead, voters opted to Leave, and the plan to a full monetary integration has been left in the wind. For now.

Brexit or not, the power of the sterling ended a long time ago.

These are precisely the types of currency shifts that can make or break investors. And it’s why Shae and I spend so many hours researching the best ways to play the ongoing currency wars. In fact, just today we released Shae’s latest recommendation, one that my IMPACT system indicates could be set for double digit gains.

You can find out more about our work here.

All the best,

Jim Rickards,
Strategist, Strategic Intelligence

Two Other Stories in Money Morning This Week

News about the Brexit and its effects on markets has been unavoidable this week. On Tuesday Jason Stevenson discussed the contagion events that could rock Europe as a consequence — and how you could trade them.


James G. Rickards is the editor of Strategic Intelligence, the newest newsletter from Port Phillip Publishing. He is an American lawyer, economist, and investment banker with 35 years of experience working in capital markets on Wall Street. He is the author of The New York Times bestsellers Currency Wars and The Death of Money. Jim also serves as Chief Economist for West Shore Group.


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