The gold standard broke down at the outset of World War I, as countries resorted to inflationary policies to finance the war and, later, the 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 were concerns, 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 already 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 stock⁶, 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.” ⁷

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 $20.64/oz parity it had held throughout World War I and the 1920s. The dollar price of gold was gradually raised until it was fixed at the new parity of $35/oz in early 1934. Most other countries though remained on floating or managed exchange rates until the outbreak of World War II.

⁶See Tim Green, 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. World War 1 increased the desire of governments to hold gold and central bank reserves rose rapidly in the interwar period.
⁷“Rebalancing the Global Recovery,” Bernanke, Ben, Federal Reserve Board, November 19, 2010. Available at http://www.federalreserve.gov/newsevents/speech/bernanke20101119a.htm