In September 1931 Great Britain ceased paying gold for UK currency and there ended the interwar international gold standard, as most of the world followed Britain off gold. The doctoral thesis I’m writing takes up the story from there. What kind of beast was the international monetary system for the remainder of the 1930s? The figure above illustrates one of the central points. It is a 3D representation of an equation which solves for the optimum choice of domestic assets of the central bank, based on an optimisation of a simple central bank “loss function” at work in the 1930s.
In English: the central bank tries to get the money supply as close to its target quantity of money as possible, but is constrained by the existence of something called a “cover limit”. These limits were ubiquitous in the 1930s, outliving even gold-to-currency convertibility, and dictated a minimum proportion of gold (or foreign assets) that the central bank must hold as a proportion of the money supply. The X axis is the range of such a proportion, from zero (which was the case in Germany) to 0.5. For higher cover limits, the central bank is not able to achieve its target money supply. The money supply target can be reached when the combination of foreign and domestic assets is 2 (because central bank assets back the money supply).
In the figure, when foreign assets are 2, there is no problem — the central bank does not need to acquire domestic assets, and they trace out the level of zero on the Z axis. Now, as we wind foreign reserves backward to smaller levels, higher levels of domestic assets are needed in order to achieve that magic 2 of the money supply target. Yet this is progressively less achievable at higher cover limits and lower reserves.
The loss function, optimisation and 3D graph illustrate the fetters on central banks even after the suspension of gold convertibility. In a sense, the “gold standard” existed in a limping form throughout the 1930s, which helps explain the high levels of observed central bank conservatism during that decade, whether it be the proclivity to peg the exchange rate or the willingness to leave foreign reserve losses unsterilized.