Gold as money
Gold has always played an important role in the international monetary system. Gold coins were first struck on the order of King Croesus of Lydia (an area that is now part of Turkey), around 550 BC. They circulated as currency in many countries before the introduction of paper money. Once paper money was introduced, currencies still maintained an explicit link to gold (the paper being exchangeable for gold on demand).
By the late 19th Century, many of the world’s major currencies were fixed to gold at a set price per ounce, under the ‘Gold Standard’.
The Gold Standard persisted in different forms for about one hundred years. Read more about how it worked in practice, its advantages and disadvantages, and whether today’s major trading economies might ever return to a Gold Standard.
The classical Gold Standard
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
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.
The Bretton Woods system
It was clear during the Second World War that a new international system would be needed to replace the Gold Standard after the war ended. The design for it was drawn up at the Bretton Woods Conference in the US in 1944. US political and economic dominance necessitated the dollar being at the centre of the system. After the chaos of the inter-war period there was a desire for stability, with fixed exchange rates seen as essential for trade, but also for more flexibility than the traditional Gold Standard had provided. The system drawn up fixed the dollar to gold at the existing parity of US$35 per ounce, while all other currencies had fixed, but adjustable, exchange rates to the dollar. Unlike the classical Gold Standard, capital controls were permitted to enable governments to stimulate their economies without suffering from financial market penalties.
During the Bretton Woods era the world economy grew rapidly. Keynesian economic policies enabled governments to dampen economic fluctuations, and recessions were generally minor. However strains started to show in the 1960s. Persistent, albeit low-level, global inflation made the price of gold too low in real terms. A chronic US trade deficit drained US gold reserves, but there was considerable resistance to the idea of devaluing the dollar against gold; in any event this would have required agreement among surplus countries to raise their exchange rates against the dollar to bring about the needed adjustment. Meanwhile, the pace of economic growth meant that the level of international reserves generally became inadequate; the invention of the ‘Special Drawing Right’ (SDR) 1 failed to solve this problem. While capital controls still remained, they were considerably weaker by the end of the 1960s than in the early 1950s, raising prospects of capital flight from, or speculation against, currencies that were perceived as weak.
In 1961 the London Gold Pool was formed. Eight nations pooled their gold reserves to defend the US$35 per ounce peg and prevent the price of gold moving upwards. This worked for a while, but strains started to emerge. In March 1968, a two-tier gold market was introduced with a freely floating private market, and official transactions at the fixed parity. The two-tier system was inherently fragile. The problem of the US deficit remained and intensified. With speculation against the dollar intensifying, other central banks became increasingly reluctant to accept dollars in settlement; the situation became untenable. Finally in August 1971, President Nixon announced that the US would end on-demand convertibility of the dollar into gold for the central banks of other nations. The Bretton Woods system collapsed and gold traded freely on the world’s markets.
1 A new reserve asset, the SDR was created and given the value of 0.888571 gram of fine gold, the same value as the dollar in July 1944.
Might the world’s major trading economies ever return to a Gold Standard?
Notwithstanding the philosophical arguments in favour of a return to the classical Gold Standard, there would be many hurdles, underpinned by concerns over inflation and central banks’ expansive monetary policies.
At what gold price would countries return to the Gold Standard, for example? Returning at today’s gold price does not seem feasible. Concern over the value of fiat currencies would no doubt result in households redeeming fiat currencies en masse for gold, which would quickly deplete central banks’ gold reserves. They would soon be off the Gold Standard. But returning at a higher price would have important wealth distribution consequences for countries that hold or produce gold and those that don’t.
A return to the Gold Standard would also necessitate agreement and participation among the world’s major trading economies. Attempts to reach international agreement on changes to the global economic and financial architecture usually have ended in failure, Bretton Woods being the major exception8. This lack of international cooperation was the root cause of the failure of the classical Gold Standard, and is probably the most significant impediment to a new one ever being created.
Even if the problems of establishing a Gold Standard were overcome, policy makers would still need to address the fundamental problem that the annual growth in the gold stock – currently around one per cent per year - would not necessarily match growth in the monetary base.
Gold does have a critical new role to play in the international monetary system. The analysis of this new role is currently the subject of much debate internationally, a debate in which the World Gold Council is actively involved.
8Boughton, J., A New Bretton Woods?, (2009), in IMF Finance and Development, http://www.imf.org/external/pubs/ft/fandd/2009/03/boughton.htm