Photo Credit (CC 2.0 license): Smabs Sputzer

World War II is one of most interesting periods in financial history, particularly because the sweeping conflict caused the bankruptcy of the British Empire to unfold with stunning speed.  It took barely more than 10 years for the British pound sterling to go from a respected global reserve currency to a second-class credit.

Between the World Wars, from 1919 to 1938, the British Empire ostensibly reached the zenith of its power.  It achieved its greatest geographical extent in the early 1920s, when it controlled almost 1/4 of the world’s surface area and nearly the same proportion of the earth’s population.  Unfortunately for the British, this façade of colonial dominance was largely an illusion.

But it was a very powerful illusion all the same.  Throughout the 1930s, Great Britain was viewed as one of an elite group of superpower nations that included France and the United States, as well as upstarts Germany and Japan.

And Britain’s currency, the pound sterling, supported this mainstream narrative.  Until 1931, the pound had been the world’s reserve currency, with each pound equal to a British gold sovereign containing 0.2354 troy ounces (7.32 grams) of pure gold.  Even after the Great Depression forced Great Britain off the gold standard, the pound still traded for around $5 on the FX markets during the mid to late 1930s.  This was actually a slightly stronger rate than when both the U.S. and the U.K. had been on the classical gold standard before the early 1930s.

But the outbreak of World War II shattered this fantasy and quickly ushered in the bankruptcy of the British Empire.  The first inkling of the disaster to come occurred when the pound plummeted from $4.61 to $3.99 in the harrowing month of September 1939, after it became apparent that Nazi Germany wasn’t backing down in its quest for European hegemony.

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Because the United Kingdom was ill-prepared for the outbreak of hostilities, it naturally sought to procure additional supplies and materials from abroad – most notably from the United States.  But the U.S. was keen to preserve its neutrality in the European conflict.

As a result, the U.S. government adopted a “cash and carry” approach to selling goods in November of 1939.  This allowed any combatant nation to purchase materials from the United States, provided they pay in hard money (gold, U.S. dollars or U.S. securities) and find a way to transport the material themselves.

Great Britain found itself in an excellent position to take advantage of the United State’s cash and carry policy.  The British Empire was primarily a maritime power and still maintained a tenuous control over the all-important North Atlantic shipping lanes, despite attempts by Nazi U-boats to disrupt those routes.  So the U.K. transported massive amounts of gold bullion, U.S. dollars and U.S. securities to the United States in exchange for desperately needed supplies.

But as Hitler’s Wehrmacht steamrolled through Continental Europe, Britain’s prospects dimmed considerably.  The surrender of France in June 1940 was a particularly devastating blow to the U.K.’s war effort.  In the summer of 1940, as the Battle of Britain raged over English air space, Winston Churchill and his cabinet began to come to the realization that the bankruptcy of the British Empire was quickly approaching if drastic action wasn’t taken.

First Britain resorted to some creative financing.  The U.S. had previously expressed interest in leasing airfields in certain British possessions for military purposes.  Although Churchill had initially rebuffed the proposal, the exigencies of total war soon forced him to reconsider.

On September 2, 1940, the U.S. and Great Britain formalized their Destroyers for Bases Agreement.  In exchange for 50 obsolete U.S. Navy destroyers, Britain agreed to give the U.S. 99-year, rent-free leases on naval and air bases in various locations in Newfoundland and some Caribbean islands.

Around the same time, Churchill approved a vitally important secret mission that is commonly known as the Tizard Mission today.  Named after its leader, British scientist Henry Tizard, it was the wholesale transfer of cutting-edge British technologies to the United States in September 1940.  This was done in the hope that the U.S. could perfect and mass produce these inventions in time to have a significant impact on the outcome of the war.

These top-secret technologies included microwave radar via the cavity magnetron, the proximity fuse, schematics for a prototype jet engine and the Frisch-Peierls memorandum on the viability of a nuclear bomb, among others.

The technology passed to the Americans during the Tizard Mission was theoretically a gift, with no explicit, reciprocal payment demanded.  However, it is reasonable to assume that Churchill secretly hoped such a generous gesture would obligate the Americans to continue supplying the British war effort, even if the teetering Empire was not able to meet the strict guidelines of the United State’s cash and carry philosophy.

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By late 1940, the British Empire’s bankruptcy was imminent.  On December 8, 1940, Prime Minister Churchill wrote a letter to this effect to President Roosevelt.  In it Churchill stated:

The more rapid and abundant the flow of munitions and ships which you are able to send us, the sooner will our dollar credits be exhausted.  They are already, as you know, very heavily drawn upon by the payments we have made to date.  Indeed, as you know the orders already placed or under negotiation…many times exceed the total exchange resources remaining at the disposal of Great Britain.  The moment approaches when we shall no longer be able to pay cash for shipping and other supplies.

Consequently, President Roosevelt pushed the U.S. Congress for the passage of the Lend-Lease Act.  This legislation would drop the pretense of American neutrality by authorizing the shipment of weapons, ammunition and other war materials to the Allied countries (primarily Britain, Free France and China) in exchange for the leasing of military bases in Allied territory during the war.  No money would change hands; instead this would effectively be a U.S. donation to the Allied cause.

But as a prerequisite for the passage of the Lend-Lease Act, the United States demanded that Great Britain open its books, thus revealing the intimate details of its financial insolvency to the U.S. Secretary of the Treasury, Henry Morgenthau.

In addition, the Roosevelt administration insisted that an important British-owned, U.S.-domiciled company be sold in order to confirm that they had definitively run out of liquid U.S. dollar assets.  The British duly complied, announcing the March 1941 fire-sale of the American Viscose Corporation – a manufacturer of synthetic textiles and the largest U.K. holding left in the U.S.  The company only realized a fraction of its appraised value.

The Lend Lease Act was finally passed on March 11, 1941.  U.S. weapons and supplies soon flowed into the bereft British Empire in massive quantities.

To compound difficulties for the British, it soon became apparent that the crown jewel of their empire, India, would not remain under British rule for long once the war was over.  This political development made it impossible for the British to attempt to partially recover the cost of the war from India.  And to make the British Empire’s grave financial situation even worse, it was clear that many of its other colonies would also demand their independence once the war concluded.

When World War II finally ended, the pound-dollar exchange rate was $4.03, the level it had been pegged at by the Bank of England at the beginning of the conflict in 1939.  But the British Empire’s fiscal situation had deteriorated massively during the intervening years, leaving its currency extremely overvalued.

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As part of its war-time negotiations with the United States, Great Britain had agreed to open up its consumer markets to U.S.-made goods after the war.  This severely undercut post-war profits for British businesses.  In addition, by 1945 the British economy had completely converted to a war-footing and was slow to retool to meet domestic consumer demand.

Like all warring nations, Great Britain had borrowed heavily to help fund its war effort.  In 1945, Britain’s aggregate debt (much of it held by foreign interests) was a staggering £21 billion, which was equivalent to over 75,000 metric tons of gold at then current exchange rates.  This was more than 2.5 times the combined national gold reserves of every country on earth at the time!

In other words, it was a sum that could never be paid back without resorting to currency devaluation.

Britain’s initial emergency move was to remove all silver from her circulating coinage.  From 1920 until 1946, every British denomination from the tiny 3-pence to the massive crown (5-shilling coin) had been struck from 50% fine silver.   Starting in 1947, the British Royal Mint changed over to a base-metal, cupro-nickel alloy, allowing the government to save money on coinage costs.  In addition, the British Royal Mint could “mine” the existing circulating coinage for its silver content, gradually replacing it with less expensive base-metal coins.

But the coup de grace came on September 19, 1949 when the British Chancellor of the Exchequer, Stafford Cripps, was finally forced to devalue the once prestigious pound sterling from $4.03 to $2.80 – an overnight 30% loss of purchasing power.  With this stunning act, the British pound definitively lost its global reserve currency status.  The bankruptcy of the British Empire was complete.

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