In the 19th century after the Napoleonic Wars, societies
turned initially to gold, silver or bimetallic standards, and subsequently to
the international Gold Standard, in order to reduce the potential for run-away
inflation. Throughout history, and with some notable episodes in the 18th
century and around 1800 during periods when money was not tied tightly to gold
or silver, governments or central banks often printed too much currency,
increasing the money supply too fast—reducing the effective value of the
currency. By tying paper currency to gold, society linked the ability of a
central bank to print money to the amount of gold that it had in its possession
or to a multiple thereof. This provided tremendous confidence in the currency;
citizens knew that at any point they could redeem their paper currency for
gold. Thus, the primary advantage that has been attributed to the Gold Standard
is price stability - which provides the conditions for greater economic
activity and broader financial stability. During the Gold Standard, prices both
rose and fell, but over the long-term they were broadly stable1.
There is also plenty of evidence that cross-border
investment flows during the Gold Standard period were substantial2. Confidence
that exchange rates would hold facilitated the substantial flows of direct
investment that opened up the ‘emerging markets’ of the era, such as the
Americas (including the US West), Australia, New Zealand, and South Africa.
Global outflows of capital from the core European countries to countries of new
settlement were massive during this era and far higher than during most of the
20th century. Only towards the end of the 20th century did international
capital flows recover to comparable levels. Arguably, today they are often less
stable than during the Gold Standard period (witness the ‘Asian crisis’ of
1997-98) and can be in the ‘wrong’
direction from emerging markets to developed ones.
Indeed the period of the Gold Standard was a highly
successful one for the world economy. World trade expanded and most countries
benefited from relatively rapid growth and low instability. Experts debate to
what extent the Gold Standard enabled this and to what extent it flourished,
because of these favourable conditions. Most probably causality flowed in both
directions, but it would be hard to deny that the Gold Standard at least helped
to facilitate matters.
On the other hand, a major disadvantage of the Gold Standard
was that it did not allow policy makers to stimulate the economy through a
monetary stimulus —which is the foundation of modern-day Keynesian economics.
Furthermore, by tying a nation’s currency to gold, the money supply is instead
tied to the global stock of monetary gold, growth in which varies, in
particular, with the pace of new mine supply. Thus large discoveries of gold
can have the effect of creating a monetary stimulus—which might not be
appropriate at that particular time. Conversely, lower growth in gold output
during a particular period can limit the expansion of the monetary base,
restraining economic growth. Following the Californian and Australian gold
discoveries of the late 1840s and the 1850s, there was rapid growth in mine production.
This first levelled off and then fell back in the 1870s and 1880s, before
surging again with the South African and Klondike discoveries of the 1890s, and
improved production techniques.
Further, while the overall picture is one of rising prosperity,
there were times of hardship in all countries. The Gold Standard was famously
blamed for economic problems in the US. Discontent culminated in William
Jennings Bryan’s famous ‘cross of gold’ speech in the 1896 presidential
election campaign3. Nevertheless it is not just under a Gold Standard that
tensions arise between the desire or need to maintain a fixed exchange rate and
the desire to mitigate its adverse impacts on the domestic economy. The history
of currency boards and, indeed, the Eurozone crisis of 2010-11 are other
examples.
Why did the Gold Standard break down?
The Gold Standard broke down at the outset of the First
World War, as countries resorted to inflationary policies to finance the war
and, later, reconstruction efforts. In practice, only the US remained on the
standard during the war. The reputation of the Gold Standard meant that there
was a widespread desire to return to gold afterwards. However, differing
inflationary experiences during and after the war – including the German hyperinflation
of 1922-24 – meant that a return to pre-war parities was not automatically
feasible. A further problem was concern, in the absence of major new gold
discoveries after the 1890s, over whether there would be sufficient gold to
underpin the standard. These concerns had started to surface in the first
decade of the 20th century. The solution was to allow the emergence of a ‘gold
exchange standard’ whereby central banks both acquired a higher proportion of
the gold stock4, reducing the amount of gold coins in domestic circulation, and
also started to hold increasing amounts of their reserves in the form of
foreign currency assets, primarily sterling or dollars. On this basis, most
countries, with China and the Soviet Union being notable exceptions, returned
to a Gold Standard during the 1920s.
But many countries returned at the ‘wrong’ gold
price/exchange rate. The UK, for example, returned at its pre- war rate. But a
decline in UK competitiveness meant that sterling was now heavily overvalued.
France, by contrast, having experienced higher inflation than the UK, returned
at a different parity giving itself an undervalued exchange rate. The US did
not change its parity but having experienced lower inflation than most
countries this also resulted in an effective undervalued exchange rate. This
led to large balance of payments imbalances, a situation which was exacerbated
by central banks’ unwillingness to co-operate and follow the ‘rules of the
game’.
This is something that Federal Reserve Chairman Ben Bernanke
commented on in a speech in November 2010. He said: “the United States and
France ran large current account surpluses, accompanied by large inflows of
gold. However, in defiance of the so-called rules of the game of the
international Gold Standard, neither country allowed the higher gold reserves
to feed through to their domestic money supplies and price levels, with the
result that the real exchange rate in each country remained persistently
undervalued. These policies created deflationary pressures in deficit countries
that were losing gold, which helped bring on the Great Depression. The Gold
Standard was meant to ensure economic and financial stability, but failures of
international coordination undermined these very goals.” 5
The huge gold outflows that deficit countries were
experiencing, most notably the UK, also undermined confidence in convertibility
– an absolute necessity for the Gold Standard to function. This led to a run on
sterling, eventually forcing the UK off the Gold Standard in 1931. With the
widespread deflation and massive unemployment that came with the Great
Depression, other countries, wishing to pursue inflationary policies and
devalue their currency in a bid to boost competitiveness, gradually followed.
In the US, one of President Franklin D. Roosevelt’s first
acts on taking power in 1933 was to take the US off the US$20.64 per ounce
parity it had held throughout the First World War and the 1920s. The dollar
price of gold was gradually raised until it was fixed at the new parity of
US$35 per ounce in early 1934. Most other countries, though, remained on
floating or managed exchange rates until the outbreak of the Second World War.
1 Rolnick, A. and
Weber, W., Money, Inflation and Output under Fiat and Commodity Standards, Federal
Reserve Bank of Minneapolis Quarterly Review, Vol 22, No 2, Spring 1998; or
Bordo, M., Gold as a Commitment Mechanism: Past, Present and Future, World Gold
Council Research Study no. 11, December 1995
2Bordo M., The
Globalization of International Financial Markets: What Can History Teach Us,
(2000), provides a summary and discussion of evidence
3The speech, which
advocated a return to bimetallism and famously ended with the words, “you shall
not crucify mankind upon a cross of gold” was given at the Democratic
Convention. Bryan secured the Democratic nomination for the presidency but lost
to William McKinley.
4 Green, T., Central
Bank Gold Reserves: An historical perspective since 1845, World Gold Council
Research Study no. 23, November 1999, shows that global central bank gold
reserves only outstripped monetary gold in private hands from the beginning of
the 20th century. The First World War increased the desire of governments to
hold gold and central bank reserves rose rapidly in the inter-war period.
5 Bernanke, B.,
Rebalancing the Global Recovery, Federal Reserve Board, 19th November 2010.
Speech available here.
https://www.gold.org/history-and-facts/gold-money
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