Lever of Empire: The International Gold Standard and the Crisis of Liberalism in Prewar Japan

Published by EH.NET (January 2007)

Mark Metzler, Lever of Empire: The International Gold Standard and the Crisis of Liberalism in Prewar Japan. Berkeley: University of California Press, 2006. xxii + 370 pp. $50 (cloth), ISBN: 0-520-24420-6.

Reviewed for EH.NET by Eugene N. White, Department of Economics, Rutgers University.

Drawing extensively on archival sources, University of Texas professor Mark Metzler provides a detailed history of Japan’s experience with the gold standard. Japan’s interwar quest to return to gold is instructive not only as a policy problem but also because it was a key issue in Japan’s struggle over whether to join a liberal global economy or build a state-controlled empire.

Following Germany’s example after the Franco-Prussian War of extracting reparations to facilitate a move to the gold standard, Japan gained the needed reserves after the Sino-Japanese War of 1894-1895 yielded an indemnity from China. Whether the gold standard offered a nation a seal of good housekeeping when it sought to borrow abroad is currently hotly debated. For Japan, Metzler shows that moving to gold was considered as vital to gaining access to Western capital markets. But empire and gold went hand in hand. To prevent Russian dominance of Korea, Britain signed an alliance with Japan in 1902 that recognized Japanese interest in Korea, after which the British Foreign Office supported the sale of Japanese bonds in London. Japan had equal success on Wall Street, where a critical role was played by Jacob Schiff of Kuhn, Loeb who was eager to see anti-Semitic Russia (and the Morgan bank) defeated. As a result 40 percent of the 1904-1905 Russo-Japanese war was funded with overseas borrowing.

While conquest and the gold standard marched together up to this point, they now pulled Japan in opposite directions. Military-industrial interests wanted to increase government spending, while those committed to the gold standard pressed for balancing the budget and husbanding resources to pay the foreign debt. Metzler translates the two competing policies (sekkyoku seisaku and sh?kyoku seisaku) as “positive” and “negative” policies, suggesting that they represented Keynesian and monetarist approaches. Better translations would be “active” and “passive” policy, which reflected the expansionary imperialist program and the “rules of the game” followed by a liberal state. Two dramatis personae occupied center stage in this battle: Inoue Junnosuke (finance minister and governor of the Bank of Japan) and Takahashi Korekiyo (vice governor of the Bank of Japan, finance minister and prime minister) who respectively campaigned for classic liberal and expansionary economic polices.

By declaring war against Germany in 1914, Japan easily seized German concessions in China. Emboldened, Japan attempted to gain hegemony, issuing the infamous but unsuccessful “Twenty-One Demands” to the Chinese government. The war cost relatively little and created extraordinary export opportunities. The trade surplus led to an inrush of gold, producing a monetary expansion and inflation, and Japan only exited the gold standard after the U.S. embargoed gold exports in 1917.

The worldwide postwar boom was amplified by “positive” policies pursued by finance minister Takahashi who saw an opportunity for Japan to catch up. The government floated new bonds to finance military spending, notably the anti-Bolshevik Siberian expedition. Warning about the dangers of a speculation boom, governor of the Bank of Japan Inoue, lobbied the cabinet to lift the gold embargo. When the Bank of Japan was permitted to raise interest rates in 1919, the boom came to a resounding end with a stock market crash and bank runs.

The battered economy never truly recovered in the 1920s. A gold standard at the prewar parity was a distant goal because postwar deflation was insufficient. Although volatile, the yen was often 20% below its prewar value. A key problem that worsened with time was the Japanese military’s political independence, which made budget cuts difficult. Fiscal policy was loose, but the Bank of Japan kept its key rate over 8% from 1919 to 1925. Chances of an early return to gold ended with the great 1923 Kant? earthquake that devastated Tokyo and Yokohama. The Bank of Japan provided massive credits to banks. Rolled over year after year, they added to the bad loans from the collapse of the postwar boom, undermining the solvency of the banking system.

After Britain’s return to gold in 1925, the government hoped to follow and began a retrenchment in 1926. The costs of an appreciating yen proved to be very high, wounding export industries. When the finance minister moved to clean up the banking system, a storm erupted in Parliament over the disclosure of weak banks. Rumors swirled, setting off a severe panic in 1927, in which 36 banks with 9% of deposits closed. The government fell, and Takahasi returned to the finance ministry, where he halted retrenchment and allowed the yen to depreciate.

Yet by 1929, a new government concluded that a restoration of the gold standard was necessary as Japan’s foreign loans were coming due and needed to be refinanced. Assistance came from the House of Morgan led by Thomas Lamont. An enthusiastic supporter of (some would say, apologist for) Japan, Lamont demanded a “thorough-going” deflation and an end to the government’s “extravagance.” He supported Inoue for whom a return to gold was a matter of honor. The government began an extraordinary campaign, exhorting people to give up unneeded luxuries; and a propaganda pamphlet was distributed to almost every household. Movies and popular songs promoted the government’s plan. The “Retrenchment Ditty,” a movie theme song, entreated the public: Let’s retrench, let’s retrench?..

You give up salt, I’ll give up tea isn’t it so? Lifting the gold embargo (that’s right absolutely) until the joyful lifting of the embargo.

In spite of the 1929 stock market crash a Morgan-led group of banks provided a $25 million loan (to which London added ?5 million) for a cushion of reserves that enabled Japan to lift the gold embargo on January 11, 1930. An overvalued yen caused gold to flow out, yielding a 25% decline in prices. The effects were wrenching. Wage cuts spread across industry, followed by strikes and rising unemployment. Indebted farmers began to fail when world rice and silk prices collapsed. Panics hit the Tokyo stock exchange in April and September 1930.

Whatever control the government had over the military was lost in 1931 when faked Chinese sabotage on the South Manchurian Railway allowed the army to attack China. After Britain abandoned gold in September 1931, a run on the yen began. Inoue tried to stop it by raising interest rates. For his efforts to restrain military spending, he was assassinated in 1932 by a member of the right-wing Blood Pledge Corps. Back at the finance ministry, Takahashi took the yen off gold in December 1931. Budget deficits were financed with money creation; but when inflation picked up, he tried to cut the military budget in 1936. Wrathful ultranationalist officers shot and hacked the 82-year-old finance minister to death in his bed. Gearing up for war, the army’s general staff drafted a five-year plan in 1937 that buried what remained of the liberal economy.

Metzler’s book provides a solid, nuanced and depressing account of the failure of the interwar gold standard in Japan. One can only speculate that had Japan returned to gold at less than its prewar value, the country could have avoided the wrenching deflation that radicalized the public and produced allies for the fanatics promoting imperial expansion.

Eugene N. White is professor of economics at Rutgers University and a NBER research associate. His most recent publication is “Bubbles and Busts: The 1990s in the Mirror of the 1920s,” in G. Toniolo and P. Rhode, editors, The Global Economy in the 1990s: A Long-run Perspective (Cambridge University Press, 2006). He is currently writing on war finance and the microstructure of the NYSE and the Paris Bourse.