The Gold Standard was a system under which nearly all countries fixed the value of their currencies in terms of a specified amount of gold, or linked their currency to that of a country which did so. Domestic currencies were freely convertible into gold at the fixed price and there was no restriction on the import or export of gold. Gold coins circulated as domestic currency alongside coins of other metals and notes, with the composition varying by country. As each currency was fixed in terms of gold, exchange rates between participating currencies were also fixed.
Central banks had two overriding monetary policy functions under the classical Gold Standard:
- Maintaining convertibility of fiat currency into gold at the fixed price and defending the exchange rate.
- Speeding up the adjustment process to a balance of payments imbalance, although this was often violated.
The classical Gold Standard existed from the 1870s to the outbreak of the First World War in 1914. In the first part of the 19th century, once the turbulence caused by the Napoleonic Wars had subsided, money consisted of either specie (gold, silver or copper coins) or of specie-backed bank issue notes. However, originally only the UK and some of its colonies were on a Gold Standard, joined by Portugal in 1854. Other countries were usually on a silver or, in some cases, a bimetallic standard.
In 1871, the newly unified Germany, benefiting from reparations paid by France following the Franco-Prussian war of 1870, took steps which essentially put it on a Gold Standard. The impact of Germany’s decision, coupled with the then economic and political dominance of the UK and the attraction of accessing London’s financial markets, was sufficient to encourage other countries to turn to gold. However, this transition to a pure Gold Standard, in some opinions, was more based on changes in the relative supply of silver and gold. Regardless, by 1900 all countries apart from China, and some Central American countries, were on a Gold Standard. This lasted until it was disrupted by the First World War. Periodic attempts to return to a pure classical Gold Standard were made during the inter-war period, but none survived past the 1930s Great Depression.
How the Gold Standard worked
Under the Gold Standard, a country’s money supply was linked to gold. The necessity of being able to convert fiat money into gold on demand strictly limited the amount of fiat money in circulation to a multiple of the central banks’ gold reserves. Most countries had legal minimum ratios of gold to notes/currency issued or other similar limits. International balance of payments differences were settled in gold. Countries with a balance of payments surplus would receive gold inflows, while countries in deficit would experience an outflow of gold.
In theory, international settlement in gold meant that the international monetary system based on the Gold Standard was self-correcting. Namely, a country running a balance of payments deficit would experience an outflow of gold, a reduction in money supply, a decline in the domestic price level, a rise in competitiveness and, therefore, a correction in the balance of payments deficit. The reverse would be true for countries with a balance of payments surplus. This was the so called ‘price-specie flow mechanism’ set out by 18th century philosopher and economist David Hume.
This was the underlying principle of how the Gold Standard operated, although in practice it was more complex. The adjustment process could be accelerated by central bank operations. The main tool was the discount rate (the rate at which the central bank would lend money to commercial banks or financial institutions) which would in turn influence market interest rates. A rise in interest rates would speed up the adjustment process through two channels. First, it would make borrowing more expensive, reducing investment spending and domestic demand, which in turn would put downward pressure on domestic prices, enhancing competitiveness and stimulating exports. Second, higher interest rates would attract money from abroad, improving the capital account of the balance of payments. A fall in interest rates would have the opposite effect. The central bank could also directly affect the amount of money in circulation by buying or selling domestic assets though this required deep financial markets and so was only done to a significant extent in the UK and, latterly, in Germany.
The use of such methods meant that any correction of an economic imbalance would be accelerated and normally it would not be necessary to wait for the point at which substantial quantities of gold needed to be transported from one country to another.
The ‘rules of the game’
The ‘rules of the game’ is a phrase attributed to Keynes (who in fact first used it in the 1920s). While the ‘rules’ were not explicitly set out, governments and central banks were implicitly expected to behave in a certain manner during the period of the classical Gold Standard. In addition to setting and maintaining a fixed gold price, freely exchanging gold with other domestic money and permitting free gold imports and exports, central banks were also expected to take steps to facilitate and accelerate the operation of the standard, as described above. It was accepted that the Gold Standard could be temporarily suspended in times of crisis, such as war, but it also was expected that it would be restored again at the same parity as soon as possible afterwards.
In practice, a number of researchers have subsequently shown1 that central banks did not always follow the ‘rules of the game’ and that gold flows were sometimes ‘sterilised’ by offsetting their impact on domestic money supply by buying or selling domestic assets. Central banks could also affect gold flows by influencing the ‘gold points’. The gold points were the difference between the price at which gold could be purchased from a local mint or central bank and the cost of exporting it. They largely reflected the costs of financing, insuring and transporting the gold overseas. If the cost of exporting gold was lower than the exchange rate (i.e. the price that gold could be sold abroad) then it was profitable to export gold and vice versa.
A central bank could manipulate the gold points, using so-called ‘gold devices’ in order to increase or decrease the profitability of exporting gold and therefore the flow of gold. For example, a bank wishing to slow an outflow of gold could raise the cost of financing for gold exporters, increase the price at which it sold gold, refuse to sell gold completely or change the location where the gold could be picked up in order to increase transportation costs.
Nevertheless, provided such violations of the ‘rules’ were limited, provided deviations from the official parity were minor and, above all, provided any suspension was for a clear purpose and strictly temporary, the credibility of the system was not put in doubt. Bordo2 argues that the Gold Standard was above all a ‘commitment’ system which effectively ensured that policy makers were kept honest and maintained a commitment to price stability.
One further factor which helped the maintenance of the standard was a degree of cooperation between central banks. For example, the Bank of England (during the Barings crisis of 1890 and again in 1906-7), the US Treasury (1893), and the German Reichsbank (1898) all received assistance from other central banks.
1Bloomfield, A., Monetary Policy Under the Gold Standard, 1880 to 1914, Federal Reserve Bank of New York, (1959); Dutton J., The Bank of England and the Rules of the Game under the International Gold Standard: New Evidence, in Bordo M. and Schwartz A., Eds, A Retrospective on the Classical Gold Standard, NBER, (1984)
2Bordo, M., Gold as a Commitment Mechanism: Past. Present and Future, World Gold Council Research Study no. 11, December 1995