The History of the Gold Standard

Throughout history, communities have used precious metals as the currency of trade. These metals were used as the means for which trade could take place and were therefore the currency of the state. Later, with their own specific currency, they would base said currency typically on silver. Britain was the exception to this, as starting as early as 1717, they backed the British currency in gold. After the Napoleonic Wars (which induced financial unease), the British parliament passed a law in 1819, forcing the Bank of England to make all its currency notes changeable to gold. In 1844, through the Bank Charter Act, the Bank developed a branch called the “Issue Department” which was solely responsible for making sure each British note was backed up with gold. In the United States, the Coinage Act in 1702, specified that the US Mint ratio between silver and gold was 15/1 (respectively). In 1934, a new Coinage Act was passed, demanding that the ratio would be 16/1. Due to inflation, few countries were drawn to the system. During the “mid-century, the dominant direction of movement was away from the gold standard, not to it” (6). Inflation threatened to uproot the system, and some large states (namely Belgium, Switzerland, and the Netherlands) were too afraid to try and follow the gold standard for fear that it may completely dismantle the international system. In 1877, there was a conference in Paris which was interested in developing some sort of global standard. It did not, however, succeed in doing so.

Unilateral actions of individual governments eventually made up for the lack of success at the Paris conference of 1877. In 1871 Germany initiated the process by purchasing about half of the gold needed for circulation with compensation received for the Franco-Prussian War. The Germans then sold their silver on the world to bimetallic France, that inturn limited silver coinage in an effort to limit aid to its German rival. Latin Monetary Union members (Belgium, Switzerland, Italy, Greece and France) as well as silver standard countries (Netherlands, Denmark, Norway and Sweden) followed suit by limiting or suspending silver coinage and shifting to gold. The shift to the gold standard was a domino effect as the appeal of adopting the standard became more attractive with each country that joined. With the gold the standard throughout Europe, the U.S. converted in 1979 followed by Japan and then most of Asia. Although China and portions of Latin America remained on silver, gold had become the international monetary standard (6-7).

Although gold was the international standard, it operated differently depending on the country. While only gold coin circulated in France, Germany, the U.S., Australia, South Africa and Egypt, other countries issued token coin and paper currency convertible into gold. Some countries adopted full gold standards where convertibility was automatic (Britain and the U.S.) while others adopted "limping" gold standards where convertibility was at the option of the authorities who had the right to make use of silver as a result of their bimetallic status (France and Belgium). Additionally, some countries had a "fiduciary system" where authorities were allowed to issue a certain amount of unbacked currency while requiring the rest to be fully colaterized with gold (Britain, Finland, Norway, Japan, Russia). Other countries had a "proportional system" where all currency was treated alike but permitted the central bank to maintain a ratio of gold reserves to currency issue of less than 100 percent (Belgium, Holland and Switzerland). Other countries maintained a hybrid system combining features of both the proportional system and the fiduciary system (Germany, Austria-Hungary, Italy). Countries also differed on practices and states governing the composition of international reserves. The reserves of many countries were convertible into gold, while those of others took the form of claims on countries who's currencies were convertible into gold (India, Philippines, and Latin America). Many maintained a portion of their reserves in British treasury bills in London

Collapse of the Inter-war Gold Standard in Britain

Most countries that had adopted the gold standard during its “classical” years (1870-1914) had abandoned the peg by the end of World War I, and this caused volatility in the now free-floating exchange rates. The desire for stable exchange rates led to the reinstatement of the gold standard for six years, and this system eventually entered a stage of collapse with Britain suspension of convertibility on September 19, 1931.

The collapse of the inter-war gold standard in Britain precipitated the demise of the gold standard as a whole. Much of this was due to the fact that, “the success of the “British experiment” was necessary to prove to the world that one could leave the gold standard.”  Britain presented a successful model for switching from pegged to floating exchange rates, whereas previous attempts by European countries to adopt floating rates had failed disastrously, convincing most countries that high inflation would certainly result if the peg was abandoned.

Wandscheider’s analysis shows that in addition to previous experience with or fear of high inflation, high per capita income growth, large foreign currency and gold reserves, trade with other countries on gold, and international creditor status all tended to increase the probability that a country would remain on the gold standard. Wandscheider also found that democracy, a high percentage of left-wing representation in parliament, sterling bloc membership, and high inflation rates did the opposite. The latter were the conditions under which Britain operated around the time of the decision to abandon the gold standard. Domestic and international conditions both played a role in Britain’s dramatic policy realignment. On the international level, there was widespread deflation and drop in prices due to imbalances between surplus and deficit countries; deficit countries were forced to deflate in order to maintain fixed parities because they lacked sufficient reserves, whereas surplus countries neglected to adjust their money supply or price levels to account for their increased foreign investments. Domestically, Britain was in the midst of government political crisis. Whether this crisis was the root cause of leaders’ action or a reaction to the government’s attempts to maintain the gold peg, it was a factor in leaders’ decision.

Keynes himself also affected the decision to move to flexible exchange rates. Although Keynes may not have directly influenced fiscal policy through his writings, his lasting influence on policy was to convince policymakers that they should focus on the effects that they could have on macroeconomic conditions. His book's purpose was not to directly influence policy, but, “Its real import was to align the inherited theories of fiscal and monetary policy with their observed effects.”  He argued that this macroeconomic management could secure economic growth and stability better than could the gold standard. Britain found that with flexible exchange rates, they could, as Keynes had advised, engage in expansionary fiscal policy without the fear of the depreciation of their exchange rate that would typically follow a budget deficit.

References