During the war, national monetary and financial systems were managed according to the dictates of the economic and political situation and the surging demands of the war effort. The expression of this disintegration was that prices rose extremely unevenly across countries, producing huge shifts in the terms of trade, competitiveness and purchasing power.
This robbed the monetary and financial order of legitimation as a “natural” order and made it an object of political contention. Even at the new center of global power, in the United States, as I outline in hegemony note #4, the stresses of wartime mobilization tore at the social and political order. The Wilsonian project of the “new freedom” collapsed between 1918 and 1920, triggering a savage deflation. The “normalization” of fiscal and monetary policy amounted to a reactionary backlash against social and political change.
The impact of the American deflation on the rest of the world was spectacular and drove home the fundamental shift that had been brought about by the war.
From 1914 onwards the might of the British Empire and its allies had been at the mercy of US loan policy. Now they found that their efforts to manage the aftermath of the Great War were dictated by the US too. Budget balance depended on the terms of war debt deals that might be agreed with American negotiators under the watchful eyes of the Congressional War Debt Commission. But even more urgent was the impact of US macroeconomic policy.
The global impact of America’s deflationary policy in 1920-1921 was novel and dramatic. America’s fiscal policy and tariffs sucked demand out of the global economy at the same time as the first rate hikes ever delivered by the Federal Reserve sucked gold and with it monetary liquidity out of the world economy. And rather than responding to the huge gold inflow by loosening policy, as the rules of the gold standard should have dictated, the Federal Reserve, instead, continued to hold a tight policy. This compounded the deflationary effects on the world economy.
Hypothetically, the rest of the world could have bucked the Fed’s deflationary policy. But it would have done so at the risk of currency devaluation and spiraling inflation. This would have hurt the standard of living and raised the domestic cost of US dollar debts. If you wanted to gain a favorable debt deal, or receive new lending from Wall Street, you needed to stick close to US policy. The effect was to transmit deflation to the rest of the world.