Hard Lessons from China's Silver Standard

飞雪寒冰

Chinese macroeconomic historian Ray Huang used to say the Qing Dynasty never understood monetary and fiscal policy, and therefore was unable to compete against the West. In those days, monetary policy in China was essentially tied to silver, the national money standard since the Ming Dynasty.  

Modern economists tend to forget that the First Great Global Imbalance occurred during the Ming Dynasty, when China ran a huge current account surplus with the West. Exported Chinese porcelain, silk and spices were bought with silver. During the Wan Li period, the Ming Dynasty encouraged exports to raise money for fighting the invading Manchus. A huge drain of silver to China from the West caused deflation, which led to exports of opium to China in an effort to restore the balance of trade.

The combination of opium, unemployment tied to falling exports, corruption, natural disasters, and a huge outflow of silver from 1809-'42 gradually brought down the Qing Dynasty.

In Boston last month, I bought a new book by Tomoko Shiroyama called China During the Great Depression. It's about how mistakes during currency reform from 1929-'37 changed China's fate.

飞雪寒冰

In 1867, an international monetary conference in Paris included a push for a shift from bimetallism (gold-silver) toward gold as the international standard. This policy was promoted by Britain and France. And by 1910, every major country was on gold -- except China. As countries went to a gold standard, silver prices began to depreciate. This devaluation actually gave China an export advantage. But by borrowing in sterling silver or gold, China suffered because silver's value continued to fall against gold. Under these circumstances, the country had to export more to pay debt.

Between 1890 and 1930, China had a current account surplus in terms of an inflow of silver, as silver devalued against gold. This led to the industrialization of the Yangtze River Delta. During this period, domestic and international banks began to flourish by financing trade as well as trading in silver. When there was an export surplus and silver inflow, banks could lend to finance trade as well as real estate, thus expanding the money supply.

However, in times of silver outflow, banks had to contract credit, putting real estate prices under pressure. Bank credit multipliers depended on the state of global silver prices. In other words, Chinese monetary policy was at the mercy of international forces, beyond the control of the government, whose leaders did not understand modern monetary policy.

飞雪寒冰

From 1929-'31, while the rest of the world was suffering from the Great Depression, China initially escaped deflation by using the silver standard. Other countries went (wrongly) back to the gold standard. After September 1931, when everyone abandoned the gold standard and devalued their currencies, China suffered for remaining on the silver standard, which rose sharply against other currencies. The result was a sharp net outflow of silver, a trade deficit and domestic deflation.

The American Silver Purchase Act was implemented in 1934 to protect domestic U.S. silver prices. This worsened conditions for China. The silver outflow meant banks had to liquidate their loans to finance the outflow. This “deleveraging” of paper credit due to an outflow exacerbated the crisis, in exactly the way the world suffers today from the current crisis. Shanghai suffered a real estate crisis and, consequently, a banking crisis.

In other words, by sticking to silver, China suffered more than necessary from the Great Depression. This was because the international supply and demand of silver was beyond the control of the Chinese government, and its domestic economic growth and investment were completely at the mercy of international silver prices

飞雪寒冰

After the banking crisis of 1934, China's Nationalist government had no alternative but to reform the currency. On November 4, 1935, China abandoned the silver standard and created a central bank. But it did not link the yuan to the British pound, U.S. dollar or yen (the currencies of the most important powers in Asia at that time). More importantly, China did not introduce exchange controls. This was probably a mistake, because once war with Japan broke out and fiscal expenditures got out of control, currency stability could not be maintained, and inflation soared, ultimately destroying the government's credibility.

There are important political economy lessons from the past currency regimes. You can only maintain monetary and foreign exchange stability when you have political stability, as well as the independent tools to maintain the fiscal and monetary discipline (including bank credit discipline) necessary to protect that monetary stability.

Minor economies that do not have their own credit system can borrow it by linking to the currencies of major trading partners. However, major players cannot do this without political ramifications. The lesson from the silver standard is that you cannot rely on a standard that is beyond your control. Do you think a global currency standard by a global central bank would be better at maintaining your currency stability? Think again