What were the perceived advantages and disadvantages of the Gold Standard?
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.