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The Gold Standard

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Introduction

In the pre-World War 1 era, the monetary policy of major economies was based on the amount of gold a sovereign country possessed. The concept was simple. Central banks in major economies pegged their currencies to the prevailing price of gold. For example if a $100 bill was exchanged at the American central bank, the bank will offer an equivalent sum in gold. Approximately, a $100 worth of gold weighed about 4.5 troy ounces. The same goes for the British pound. A £100 pound note would yield approximately 22 troy ounces of gold.

 There were several theories regarding the origins of the gold standard. The most common and acceptable to monetary theorists was the changes in supply with the two main metals that defined wealth – gold and silver. Flandreau traced the gold standard origins to the “gold standard in the defeat of France in the Franco-Prussian war and the German Empire’s use of the war indemnity to create a gold-based German national currency” (Milward 87-88).

The concept behind the gold standard had the philosophical underpinnings of David Hume’s specie flow. According to the theory, “specie flow responded to price differentials and price changes, and produced a self balancing order” (Flandreau and James 7). Gold was the logical choice during the early nineteenth century because England was dominating global trade and the gold discoveries in the 1840’s to 1850’s had built up the reserves of major economic powers (Flandreau and James 5). Politically, gold became a global currency when an ambiguous international agreement aiming for a universal international monetary system agreed to set the monetary standards based on the 25 French Franc gold coin. Liberalism had also taken its roots to initiate the steps for a more global economy (Flandreau and James 5). An obstacle to this move was how to shift silver based economies into the new gold standard. In addition, the collapse of the price of silver forced major economies to shift to gold. In essence, the concession of the four major economies namely Britain, Germany, United States and France was essential to make the transition complete.

In the ensuing sections of the paper, the discussion will focus on why the classical gold standard worked for pre-World War 1 economies and not for the Interwar periods. What were the factors that made the gold standard a success in the former and not in the latter?

The Past Revisited

There were six rules in the international standard. First, there must be a fixed price (parity) so that there would be ease in conversion to gold in the domestic market. Second, there should be no restriction on the export of gold. Third, banknotes and coinage were backed by gold reserves of the sovereign country. Fourth, in case of liquidity problem because egress of gold was faster than ingress, the central bank was allowed to hike interest rates. Fifth, should the first rule be suspended temporarily, the sovereign must restore the convertibility and should revert back to rates prior to the suspension. Finally, allow the price of gold to be determined by global supply and demand (Ickes 4).

Aside from the six rules, a generally accepted assumption that gold price was stable or promoted stability of monetary systems was also in place. There were benefits to pegging monetary standards on gold. First, it associated gold price level with that of the world’s gold supply. Second, inflation was prevented unless there were new gold discoveries. While gold did not prevent fluctuations in price levels, it produced long-term stability (Ickes 16).

The application of the gold standard prior to the interwar period was considered a success for several reasons. The global economy was booming and most of the world’s economies were experiencing growth. Due to rapid economic growth, there was also a reduction in transportation costs in major shipment hubs and an increased activity in international trade. There was also variability in income growth – it was valued higher under the gold standard. There was less monetary debate on the issue of monetary system. Since the labor sector did not understand the nuances of the gold standard, there was little resistance particularly in Britain. Britain was also the dominant economic power during that period and the Bank of England became the coordinator to create a harmonized global monetary policies. Britain had the cooperation of other countries in creating a universal monetary system (Illiev 4, Cooper, Dornbusch and Hall 5-6).

There were mitigating circumstances that the application of the gold standard as an international monetary system during the interwar period. After the war, several European countries returned to gold pegging its parity to pre-war levels. In 1925, Britain reverted back to the gold standard at prewar gold parity of 85 shillings per ounce. This inadvertently deflated the British currency. France followed suit in 1926 at a parity of one-fifth of the pre-war parity (Cooper, Dornbusch and Hall 19). The British economy remained depressed with an unemployment rate of 10% above. The effect of the reverting back to the gold standard was “incorrect” exchange rates had put much strain on the domestic economies (Cooper, Dornbusch and Hall 20).

When rule 3 was applied to the interwar condition, Keynes observed that new gold productions could only add 2% to the national reserves in contrast to the 3% requirement. To resolve the issue, minimum backing of gold on currency was reduced to two thirds to three-quarters. Keynes however observed that forcing the two-thirds to three-quarters scheme would eventually cause fragility in the system. The central banks, to respond to fluctuations would “restrict credit and raise interest rates.” This would in fact cause prices and wages to go lower (Cooper, Dornbusch and Hall 20-21). The gold reserves were also slowly depleted and the discovery of gold declined. It was difficult to maintain the requisites of the original gold standard rule. Table 1 shows an example of the year on year decline of consolidated gold and foreign exchange reserves of six creditor countries and eighteen debtor countries. The Central banks also began to liquidate their foreign exchange reserves thus driving the ratio of foreign exchange reserves to gold from 37% in 1930 to 11% by the end of 1932 (Ickes 33).

Table 1 – Central banks’ foreign exchange and gold reserves ($ million) (Nurkse 276)

End of: 1928 1929 1930 1931 1932
Total of 6 creditor countries          
Foreign exchange 1,878 1,604 1,679 1,024 348
Gold 1,987 2,430 2,943 4,214 4,872
Total 3,865 4,034 4,622 5,238 5,220
Foreign exchange as % of total 49 40 36 20 7
Total of 18 debtor countries          
Foreign exchange 642 688 621 192 157
Gold 1,503 1,411 1,373 1,059 1,007
Total 2,145 2,099 1,994 1,251 1,164
Foreign exchange as % of total 30 33 31 15 13

The second element that made the gold standard in interwar period unsuccessful was the worldwide economic uncertainty as a consequence of the previous war. The economies of major powers were depressed and huge amounts were used as war reparations or restoration work. In addition, if the previous gold standard had the support of major countries, many countries refused to revert back to the gold standard during the interwar period. France and the United States failed to return immediately to pre-1914 parity rates and most of the world’s currencies were floated. France and the United States pursued gold hoarding policies that “undermining the viability of the system, generating destabilizing capital flows and fostering lack of cooperation across countries” (Bayoumi and Bordo 143).

Another condition that made the gold standard fail during the interwar period was the concentration of the major bulk of the world’s gold reserve on three countries namely France, Germany and the United States. The combined shares of the three countries from 1927 to 1930 rose from 56% to 63%. This had a negative effect on the rest of the world as it caused deflation (Ickes 33). It had become unrealistic for other countries with declining national reserves to consider reverting back to the gold standards.

The gold standard was unable to stabilize the global exchange rate in the post-World War 1 period. Most countries had lost currency stability and their currencies had depreciated sharply against the US Dollar. The loss in exchange value was a consequence of the war and the war had also weakened the major economies of the world. The problem was exacerbated by “serious balance of payments problems, especially with dollar area countries; while large budgetary deficits to finance wartime commitments had stoked up inflationary pressures.” (Aldcroft 84).

In reality, the gold standard adopted in the interwar period was different from the classic gold standard. The Hume’s specie flow theory was abandoned amidst the chaotic situation of the war aftermath. Except for some countries like the United States, Sweden, the Netherlands and a few Latin American countries, the rest of the globe followed a watered-down version of the gold standard (Aldcroft 89). Adding more stress to the global monetary system was the need for each affected country to stabilize their currencies as well as balance their accounts. Unlike in the pre-War period where the economy was robust and generally the world was peaceful, it was difficult for the globe to recoup their losses. The gold standard became impractical for the situation.

The gold standard provided a stable financial basis for expanding economies. However, gold standard was weak when liquidity problems became evident. When global agricultural prices fell in 1924-1928, many creditors were unable to payback their debts. There was no lender of last resort to rescue ailing economies. Originally, in the gold standards provision, the Bank of England assumed that role. But the institution was also cash strapped and unable to respond accordingly (Neal and Weidenmeir 34).

Conclusion

            The classic gold standard was apparently applicable only to the periods prior to the war. The conditions in the interwar were quite different from that of the pre-war period. The proponents of the gold standard should have recognized at the onset that due to the consequences of war, it had rendered the gold standard inappropriate for the interwar years. The British had loss their overall leadership in global economics and politics. The emerging leader, the United States had a different strategy in dealing with international monetary issues. The world was in a state of disarray and for the gold standard to succeed, it must have the support of the majority.

Works Cited

Aldcroft, Derek, Currency Stabilisation in the 1920s: Success or Failure? Economic Issues, 7(Part 2) (2002):84-102.

Bayoumi, Tamim, and Michael D. Bordo. Getting Pegged: Comparing the 1879 and1925 Gold Resumptions, Oxford Economic Papers, 50 (1998):122-149.

Cooper, Richard N., Rudiger Dornbusch and Robert E. Hall. The Gold Standard: Historical Facts and Future Prospects, Brookings Papers on Economic Activity, 1982.1(1982):1-56.

Flandreau, Marc and Harold James. “Introduction” in International Financial History in the Twentieth Century: System and Anarchy, Ed. Marc Flandreau, Carl Ludwig Holtfrerich and Harold James. Cambridge University Press, UK.2003:1-16.

Ickes, Barry W. “Lecture Notes on the Gold Standard” econ.la.psu.edu 08 February 2007 <http://econ.la.psu.edu/~bickes/goldstd.pdf>

Illiev, Issidor. “The Evolution of the International Financial System: 1879-1971: Institutions, Incentives, Outcomes” issidor.com 08 February 2007 <http://www.issidor.com/pdfs/Intl_Fin_Sys_1879-1971.pdf>

Milward, Alan S., “The Origins of the Gold Standard” in Currency Convertibility: The Gold Standard and Beyond. Eds. Jorge Braga De Macedo, Barry Eichengreen and Jaime Reis Routledge. New York.1996: 87-101.

Neal, Larry and Marc Weidenmeir, “Crises in the Global Economy from Tulips to Today: Contagion and Consequences,” NBER Working paper, nber.org 08 February 2007 <http://www.nber.org/papers/w9174>

Nurkse, Ragnar, “The Gold Exchange Standard” in The Gold Standard in Theory and History. Eds. Barry Eichengreen and Marc Flandreau, Routledge, London,1997: 274-282.

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