The Indian “Gold-Exchange Standard” Received Great Praise from Keynes for Its Inflationary Potential

The gold-exchange standard was not created de novo by Great Britain in the interwar period. It is true that a number of European central banks before 1914 had held foreign exchange reserves in addition to gold, but these were strictly limited, and they were held as earning assets—these after all were privately owned central banks in need of earnings—not as instruments of monetary manipulation. But in a few cases, particularly where the pyramiding countries were from the Third World, they did function as a gold-exchange standard: that is, the Third World currency pyramided its currency on top of a key country’s reserves (pounds or dollars) instead of on gold. This system began in India, after the late 1870s, as a historical accident. The plan of the British imperial center was to shift India which, like many Third World countries, had been on a silver standard, onto a seemingly sounder gold, following the imperial nations. India’s reserves in pound sterling balances in London were supposed to be only a temporary transition to gold. But, as in so many cases of seeming transition, the Indian gold-exchange standard lingered on, and received great praise for its modern inflationary potential from John Maynard Keynes, then in his first economic post at the India Office. It was Keynes, after leaving the India Office and going to Cambridge, who trumpeted the new form of monetary system as a “limping” or imperfect gold standard but as a “more scientific and economic system,” which he dubbed the gold-exchange standard. As Keynes wrote in February 1910, “it is cheaper to maintain a credit at one of the great financial centres of the world, which can be converted with great readiness to gold when it is required.“ In a paper delivered the following year to the Royal Economic Society, Keynes proclaimed that out of this new system would evolve “the ideal currency of the future.”

Elaborating his views into his first book, Indian Currency and Finance (London, 1913), Keynes emphasized that the gold-exchange standard was a notable advance because it “economized” on gold internally and internationally, thus allowing greater “elasticity” of money (a longtime code word for ability to inflate credit) in response to business needs. Looking beyond India, Keynes prophetically foresaw the traditional gold standard as giving way to a more “scientific” system based on one or two key reserve centers. “A preference for a tangible reserve currency,” Keynes declared blithely, “is . . . a relic of a time when governments were less trustworthy in these matters than they are now.” He also believed that Britain was the natural center of the new reformed monetary order. While his book was still in proofs, Keynes was appointed a member of the Royal Commission on Indian Finance and Currency, to study and make recommendations for the basic institutions of the Indian monetary system. Keynes dominated the commission proceedings, and while he got his way on maintaining the gold-exchange standard, he was not able to convince the commission to adopt a central bank. However, he managed to bully it into including his annex favoring the state bank in its report, completed in early 1914. In addition, in his work on the commission, Keynes managed to enchant his doting mentor, Alfred Marshall, the unquestioned ruler of academic economists in Britain.

—Murray N. Rothbard, A History of Money and Banking in the United States: The Colonial Era to World War II, ed. Joseph T. Salerno (Auburn, AL: Ludwig von Mises Institute, 2002), 387-389.