Protectionist policies caused problems because
(1) They ignored the principle of comparative advantage and therefore reduced world income.
(2) US protectionism caused special problems since the United States was now the world’s
leading creditor nation. When it made it difficult for its debtors to sell products they found it hard
to obtain US dollars to service their debts. This problem relates to the international financial
system and is covered below under that heading.
International Financial System
It was taken for granted after the First World War that the only feasible system of
multilateral payments was the gold standard (in spite of the fact that this system had only really
operated for two decades before 1913). For most countries it was assumed that the pre-war
exchange rates should be adopted. They failed to take account of changes which had taken place
(1) Inflation rates had differed between countries. For example inflation after 1918 was
considerably higher in the United Kingdom than in the United States but Britain went on to gold
at the pre-war exchange rate (£1 = $4.20), which meant that British goods were relatively more
expensive than before in terms of US dollars. Unless prices came down in Britain or rose in the
United States the United Kingdom would have difficulty exporting its goods (and so it proved).
(2) There were new problems associated with high levels of foreign debt arising out of
borrowing from the United States by its allies and the reparations bill imposed on Germany after
(3) There had been a change in the pattern of international investment.
(4) There was no longer a single dominant world financial centre.
(5) Many countries were short of gold reserves.
Each of these factors is discussed below.
1. Inflation : Inflation occurred in every major industrial country in the years following the war
but the rate varied from country to country. Some countries experienced hyperinflation (e.g.
Russia, Hungary). The most famous example and the most important from the point of view of
the international economy was the German hyperinflation of 1922/23. At one point prices were
increasing in Germany at a rate of 300 % per day.
The major cause of the hyperinflation was government budget deficits financed by money
creation but reparations payments have also been blamed. The argument was that because of
reparations payments the value of the mark fell, which meant that the price of imported good (in
terms of marks) rose and this triggered the inflation. Another view is that the German
government deliberately caused hyperinflation to strengthen its argument that Germany could
not afford to pay reparations.
In 1924 the hyperinflation was ended when a new mark was introduced (1 new mark = 1
trillion old marks) and strict controls were placed on the right of the Reichsbank (Germany’s
central bank at that time) to create new money. At the same time the Dawes Plan rescheduled
Germany’s reparation payments (i.e. gave Germany more time to pay them).