Historically, the gold standard has been an economic system in which a standard economic unit of account is based on a fixed quantity of gold. The gold standard is most often considered to have originated in the Middle Ages. However, it has been used in a variety of different times throughout history.
History
During the 19th century, the United States was under the gold standard. It was the first country to adopt the gold standard, in 1821. By the end of World War I, most countries had abandoned it. However, the desire to return to the gold standard remained strong amongst nations.
The Gold Standard was based on the idea that all trade imbalances between nations should be settled in gold. Consequently, international currency values would stay stable. This system would also prevent currency fiddling by central banks.
The Gold Standard had its high points from 1871 until 1914. It operated on a more complex principle than a pure gold standard. In a nutshell, more specie (gold) was exported to countries that sold more goods to foreign markets, and more specie was imported by countries that imported more goods. This would lead to higher prices for the exporting countries, and lower prices for the importing countries.
The Gold Standard’s low points came from its shortcomings in the late 1800s. During the mid-century period, gold supply weakened behind the growth of the global economy. Consequently, smaller countries began to hold other currencies instead of gold. Moreover, inflation threatened to undermine the gold standard.
The gold standard was also hampered by its inability to hold through both good and bad times. During the Great Depression, gold was worth less officially than its relative buying power. This posed a dilemma for the U.S. government. It could only issue so many dollars.
As a result, the United States was getting closer to the legal limit on its currency’s gold stock. During World War I, the government could not expect other countries to redeem large amounts of dollars for gold. This was a factor in the decision to maintain the gold peg.
The gold standard’s low points also came from its inability to hold through both good and bad times. By the mid-1920s, hyperinflation had decimated the German middle class. During the Ruhr occupation, the German central bank issued non-convertible marks to buy foreign currency to make reparations. In the early 1920s, this policy lead to hyperinflation, which decimated the middle class.
Classical gold standard
During the Classical Gold Standard, a nation’s money supply was linked to its gold reserves. If the country’s trade deficit grew, the gold reserves would decrease. If the trade surplus grew, the country would receive gold inflows. This price-specie flow mechanism, which was invented by Richard Cantillon, was later developed by J. S. Mill.
The classical gold standard was used to settle trade before the First World War. It also helped conserve stability in late nineteenth-century Europe. However, it posed challenges for governments.
Countries with a trade deficit would have a deflationary risk. This risk would increase if there was a recession. The risk of deflation was reduced if interest rates were raised. This would attract money from abroad, which would lower the price of borrowing. In addition, higher interest rates would improve the capital account.
The classical gold standard was used by most European countries from 1870 until 1914. However, the gold standard broke down during World War I. Most European countries decided to revert to a new gold standard in 1922.
Some countries, such as Great Britain, used a gold-coin standard while other countries used a silver standard. In some countries, such as Spain, the daily medium of exchange was a silver dollar.
Under the classical gold standard, most countries had a legal minimum ratio of gold to notes or currencies. However, the use of the silver dollar did not increase. In the early 19th century, specie was used as money. Countries that were exporting goods would have higher prices and receive more specie inflows. On the other hand, countries that were importing goods would have lower prices and less specie inflows.
The domestic aspects of the gold standard did not guarantee exchange rate stability. Moreover, it violated balance of payments imbalances. For instance, Great Britain had a trade deficit with the United States. As a result, it ran out of its gold reserves in 1931. This was followed by the Great Depression. In the 1920s, many countries began to spread Keynesian theories. This made raising interest rates challenging.
The classical gold standard also damaged GDP growth. The instability of balances contributed to the Great Depression. It was also a contributing factor in the collapse of the gold exchange standard.
Interwar gold standard
During the interwar period, the United States held a significant portion of the world’s gold reserves, as did Germany and France. These large holdings made the gold standard unstable.
The United States was the largest core country. Its commitment to the gold standard was hampered by recurrent financial panics and political pressures to maintain gold exports. The United States also had no central bank. In 1917, it adopted extralegal restrictions on convertibility. The Treasury refused to sell bars and allowed banks to form syndicates to pressure gold arbitrageurs.
Several European countries suspended coinage of silver during the interwar period, although Germany and France embraced the gold standard. This led to a situation where the value of the dollar was the reference point for other currencies. The dollar’s price level was higher than those of other countries. Speculators believed that the currency would weaken in the opposite direction and that they could profit by purchasing the domestic currency with foreign currency.
In the mid-1890s, the U.S. Treasury lost credibility as a commitment to the gold standard because of runs on its gold reserve. This led to a near collapse of the gold standard.
Other core countries also had strong balance-of-payments shocks. In the absence of deflation, they could not compensate for reductions in exports. Thus, the gold standard was unstable because of its conflict with the world’s liquidity expansion. The result was a depressed export sector and chronic balance-of-payments difficulties.
The Bank of England provided economic support to other central banks. It also served as a residual purchaser of gold. However, the Bank of England’s liquidity position was precarious.
In addition, it was difficult to agree on a strategy for restraining a run on sterling. There was also a lack of credibility in the U.S. Treasury’s commitment to the gold standard.
The gold-exchange standard was also unstable because of its conflict with the world’s liquidity expansion. Consequently, the exchange rate stabilized only when it was reestablished as a fixed exchange rate. The process of establishing a fixed exchange rate was piecemeal and irregular.
End of the gold standard
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The gold standard limited the amount of money that could be printed. It also gave the government and banking system the discipline to keep inflation under control. However, it did not prevent other currencies from devaluing.
Countries that devalued their currencies also experienced a decrease in the value of their gold reserves. As the dollar became the dominant currency for international trade, the amount of gold held by the United States declined.
By 1931, many countries in the British Empire and Scandinavia had abandoned the gold standard. In the United States, the Bretton Woods agreement fixed the dollar’s exchange rate to the U.S. dollar from 1945 to 1971. During this time, major trading partners also imposed exchange restrictions to maintain official levels.
In the United States, however, the government and the banking system found loopholes that allowed prices to diverge from official settlements. Private gold markets also existed. As a result, the government could not determine its own exchange rate.
A few years after the end of the gold standard, the Federal Reserve System was formed. This system was created in response to a wave of bank runs in 1930-1933. Although the system was intended to provide sufficient liquidity to banks, it also failed to do so. Rather than allowing the banks to create money, the system provided reserves.
As a result, the dollar became overvalued internationally. This meant that the government had to issue more money to maintain the gold price at its official level. In order to do so, the government would have to lower interest rates. This would have sped up gold exports, but it would also have caused a decrease in the quantity of gold held in the United States.