The Gold Standard

As part of my research on gold for last week’s blog post, I saw an item on the Internet about how gold had only stopped being used as a Gold Standard in recent years, so I decided to do just a bit of research. This was because what the writer of the article had said simply didn’t seem right to me. I learned that at the time of London’s first Olympics in 1908, the amount of money in circulation in the UK was tied to the amount of gold in the economy. The gold standard had prevailed for most of the previous two centuries and was to continue until World War I began in 1914. But the UK was not the only country whose monetary system was based on gold. From 1880 to 1914, almost all of the world’s leading economies had followed suit, with each country fixing the price of gold in their local currency. In the UK, the price of one troy ounce of gold was £4 5s 0d (£4.25). In the US it was fixed at $20.67. This implied a fixed exchange rate between pound sterling and the dollar ($4.87 per £1) with all the other countries on the gold standard. To enhance the credibility of the arrangements, authorities guaranteed that paper money was fully convertible into gold and anyone could request to convert their pounds into the equivalent value of gold. This was because it limited the ability of governments to print money and the gold standard stopped countries from deliberately devaluing their own currency in order to improve the competitiveness of their exports or pay off their debts. As a result, membership of the gold standard was seen as a commitment to sound government finance. By constraining the growth in money supply, the gold standard was also believed to contribute to stable prices. Over long periods this was generally the case, as price levels in the UK were much the same in 1914 as they were in 1880. However, the gold standard’s inflexibility had major disadvantages. Changes in the world’s money supply were dependent not on economic conditions, but on the amount of new gold that was mined. This meant that on the one hand, monetary policy could not be used to respond to recessions and booms but on the other, significant rises in gold production would lead to faster money supply growth and ultimately inflation, regardless of a country’s underlying economic conditions. World War I saw the end of the gold standard as governments suspended the convertibility of their currencies into gold in order to freely finance rapidly escalating military expenditure. It was briefly reintroduced in some countries after the War, including the UK from 1925 to 1931, but fell apart again during the Great Depression. After World War II, a form of gold standard under the Bretton Woods system which involved the dollar being fixed to gold and then other currencies being fixed to the dollar was in operation until 1971. So technically, a ‘gold standard’ is a monetary system in which the standard economic unit of account is based on a fixed quantity of gold. This was the basis for the international monetary system from the 1870s to the early 1920s, and from the late 1920s to 1932, as well as from 1944 until 1971 when the United States unilaterally terminated converting the US dollar to gold foreign central banks, effectively ending the Bretton Woods system, though many states still hold substantial gold reserves. In fact it seems that historically, the silver standard and bimetallism have been more common than the gold standard and the shift to an international monetary system based on a gold standard reflected accident, network externalities and ‘path dependence’ (a concept in economics and the social sciences, referring to processes where past events or decisions constrain later events or decisions) occurred. Great Britain accidentally adopted a ‘de facto’ gold standard in 1717 when Sir Isaac Newton, who was then master of the Royal Mint, set the exchange rate of silver to gold far too low, thus causing silver coins to go out of circulation. As Great Britain became the world’s leading financial and commercial power in the 19th century, other states increasingly adopted Britain’s monetary system. The gold standard was largely abandoned during the Great Depression before being reinstated in a limited form as part of the post-World War II Bretton Woods system. The gold standard was abandoned due to its propensity for volatility, as well as the constraints it imposed on governments, as by retaining a fixed exchange rate, governments were hamstrung in engaging in expansionary policies to, for example, reduce unemployment during economic recessions. There is a consensus among economists that a return to the gold standard would not be beneficial and most economic historians reject the idea that the gold standard ‘was effective in stabilising prices and moderating business-cycle fluctuations during the nineteenth century.’ So it was that we slipped into a ‘gold specie standard’ in 1717 by over-valuing gold at 15.2 times its weight in silver, ‘specie’ meaning money in the form of coins rather than notes. It was unique among nations to use gold in conjunction with clipped, underweight silver shillings, addressed only before the end of the 18th century by the acceptance of gold proxies like token silver coins and banknotes. From the more widespread acceptance of paper money in the 19th century emerged the gold bullion standard, a system where gold coins do not circulate, but authorities like central banks agree to exchange circulating currency for gold bullion at a fixed price. First emerging in the late 18th century to regulate exchange between London and Edinburgh, it was noted how such a standard became the predominant means of implementing the gold standard internationally in the 1870s. Restricting the free circulation of gold under the Classical Gold Standard period from the 1870s to 1914 was also needed in countries which decided implement the gold standard while guaranteeing the exchangeability of huge amounts of legacy silver coins into gold at the fixed rate (rather than valuing publicly-held silver at its depreciated value).

Here in the United Kingdom the English pound sterling, introduced around the year 800 CE, was initially a silver standard unit worth 20 shillings or 240 silver pennies. The latter initially contained 1.35 g fine silver, reducing by 1601 to 0.464 g, hence giving way to the shilling (12 pennies) of 5.57 g fine silver. The problem of clipped, underweight silver pennies and shillings was a persistent, unresolved issue from the late 17th century to the early 19th century. In 1717 the value of the gold guinea (of 7.6885 g fine gold) was fixed at 21 shillings, resulting in a gold-silver ratio of 15.2 higher than prevailing ratios in Continental Europe. Great Britain was therefore ‘de jure’ under a bimetallic standard with gold serving as the cheaper and more reliable currency compared to clipped silver and full-weight silver coins did not circulate but went to Europe where 21 shillings fetched over a guinea in gold. Several factors helped extend the British gold standard into the 19th century, namely the Brazilian Gold Rush of the 18th century supplying significant quantities of gold to Portugal and Britain, with Portuguese gold coins also legal tender in Britain. Also ongoing trade deficits with China (which sold to Europe but had little use for European goods) drained silver from the economies of most of Europe. Combined with greater confidence in banknotes issued by the Bank of England, it opened the way for gold as well as banknotes becoming acceptable currency in lieu of silver. In addition was the acceptability of token or subsidiary silver coins as substitutes for gold before the end of the 18th century. Initially issued by the Bank of England and other private companies, permanent issuance of subsidiary coinage from the Royal Mint commenced after the Great Recoinage of 1816.

The British gold sovereign or £1 coin was the pre-eminent circulating gold coin during the classical gold standard period.

Following the Napoleonic Wars, Britain legally moved from the bimetallic to the gold standard in the 19th century in several steps, when the 21-shilling guinea was discontinued in favour of the 20-shilling gold sovereign or £1 coin. From the second half of the 19th century Britain then introduced its gold standard to Australia, New Zealand, and the British West Indies in the form of circulating gold sovereigns as well as banknotes that were convertible at par into sovereigns or Bank of England banknotes. The classical gold standard of the late 19th century was not merely a superficial switch from circulating silver to circulating gold. The bulk of silver currency was actually replaced by banknotes and token currency whose gold value was guaranteed by gold bullion and other reserve assets held inside central banks. In turn, the gold exchange standard was just one step away from modern flat currency, with banknotes issued by central banks and whose value is secured by the bank’s reserve assets, but whose exchange value is determined by the monetary policy of the central bank and its objectives on purchasing power in lieu of a fixed equivalence to gold. The final chapter of the classical gold standard ending in 1914 saw the gold exchange standard extended to many Asian countries by fixing the value of local currencies to gold or to the gold standard currency of a Western colonial power. The Netherlands East Indies guilder was the first Asian currency pegged to gold in 1875 via a gold exchange standard which maintained its parity with the gold Dutch guilder. International monetary conferences were called up before 1890, with various countries actually pledging to maintain the ‘limping’ standard of freely circulating legacy silver coins in order to prevent the further deterioration of the gold–silver ratio which reached 20 in the 1880s. However, after 1890 the decline in the price of silver could not be prevented further and the gold–silver ratio rose sharply above 30. In 1893 the Indian rupee of 10.69 g fine silver was fixed at 16 British pence (or £1 = 15 rupees; gold-silver ratio 21.9), with legacy silver rupees remaining legal tender. Nearly similar gold standards were implemented in Japan in 1897, in the Philippines in 1903 and in Mexico in 1905 when the previous yen or peso of 24.26 g silver was redefined to approximately 0.75 g gold or half a United States dollar (ratio 32.3). Japan gained the needed gold reserves after the Sino-Japanese War of 1894–1895. For Japan, moving to gold was considered vital for gaining access to Western capital markets. Governments with insufficient tax revenue suspended convertibility repeatedly in the 19th century., however the real test came with the onset of World War I. The gold specie standard came to an end in the United Kingdom and the rest of the British Empire with the outbreak of that war. A run on sterling caused Britain to impose exchange controls that fatally weakened the standard, convertibility was not legally suspended but gold prices no longer played the role that they did before. In financing the war as well as abandoning gold, many of the contributors suffered drastic inflations. Price levels doubled in the United States and Britain, tripled in France and quadrupled in Italy. Exchange rates changed less, even though European inflation rates were more severe than America and this meant that the cost of American goods decreased relative to those in Europe. Between August 1914 and spring of 1915, the dollar value of U.S. exports tripled and its trade surplus exceeded $1 billion for the first time. Ultimately, the system could not deal quickly enough with the large deficits and surpluses. This was previously attributed to downward wage rigidity brought about by the advent of unionised labour, but is now considered as an inherent fault of the system that arose under the pressures of war and rapid technological change. In any event, prices had not reached equilibrium by the time of the Great Depression which served to kill off the system completely.

The gold specie standard ended in the United Kingdom and the rest of the British Empire at the outbreak of World War I, when Treasury notes replaced the circulation of gold sovereigns and gold half sovereigns. Except legally, the gold specie standard was not abolished. The end of the gold standard was successfully effected by the Bank of England through appeals to patriotism urging citizens not to redeem paper money for gold specie. It was only in 1925, when Britain returned to the gold standard in conjunction with Australia and South Africa, that the gold specie standard was officially ended. The British Gold Standard Act 1925 both introduced the gold bullion standard and simultaneously repealed the gold specie standard and the new standard ended the circulation of gold specie coins. Instead, the law compelled the authorities to sell gold bullion on demand at a fixed price, but ‘only in the form of bars containing approximately four hundred troy ounces (12kg) of fine gold’. The pound left the gold standard in 1931 and a number of currencies of countries that historically had performed a large amount of their trade in sterling were pegged to sterling instead of to gold. The Bank of England took the decision to leave the gold standard abruptly and unilaterally. Many other countries followed Britain in returning to the gold standard, leading to a period of relative stability but also deflation. This state of affairs lasted until the Great Depression from 1929 to 1939 and forced countries off the gold standard. In the summer of 1931, a Central European banking crisis led Germany and Austria to suspend gold convertibility and impose exchange controls as a run on Austria’s largest commercial bank had caused it to fail. The run spread to Germany, where the central bank also collapsed. International financial assistance was too late and in July 1931 Germany adopted exchange controls, followed by Austria in October. The Austrian and German experiences, as well as British budgetary and political difficulties, were among the factors that destroyed confidence in sterling, which occurred in mid-July 1931. Runs ensued and the Bank of England lost much of its reserves. On September 19, 1931, speculative attacks on the pound led the Bank of England to abandon the gold standard, ‘ostensibly temporarily’. However, the ostensibly temporary departure from the gold standard had unexpectedly positive effects on the economy, leading to greater acceptance of departing from the gold standard. Loans from American and French central banks of £50 million were insufficient and exhausted in a matter of weeks, due to large gold outflows across the Atlantic. The British benefited from this departure. They could now use monetary policy to stimulate the economy. Australia and New Zealand had already left the standard and Canada quickly followed suit. The interwar partially-backed gold standard was inherently unstable because of the conflict between the expansion of liabilities to foreign central banks and the resulting deterioration in the Bank of England’s reserve ratio. France was then attempting to make Paris a world class financial centre, and it received large gold flows as well. Upon taking office in March 1933, U.S. President Franklin D. Roosevelt departed from the gold standard and by the end of 1932, it had been abandoned as a global monetary system. Finally Czechoslovakia, Belgium, France, the Netherlands and Switzerland abandoned the gold standard in the mid-1930s. So it was ended many years ago. Much has been written subsequently about the gold standard, but one economist seems to have summed it up by saying “We don’t have the gold standard. It’s not because we don’t know about the gold standard, it’s because we do.”

This week…

Let there be spaces in your togetherness, and
Let the winds of the heavens dance between you.
Love one another but make not a bond of love;
Let it rather be a moving sea between the shores of your souls.
Fill each other’s cup but drink not from one cup.
Give one another of your bread but eat not from the same loaf.
Sing and dance together and be joyous,
But let each one of you be alone, even as the strings of a lute are alone
Though they quiver with the same music.
Give your hearts, but not into each other’s keeping.
For only the hand of Life can contain your hearts.
And stand together, yet not too near together.
For the pillars of the temple stand apart,
And the oak tree and the cypress grow not in each other’s shadow.

~ Khalil Gibran (06 January 1883 – 10 April 1931)

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