Gold standard

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This article is on the monetary principle. For gold standard in diagnostic testing see gold standard

The gold standard is a monetary system in which the standard economic unit of account is a fixed weight of gold. When several nations are on a fixed unit of account gold standard then the rates of exchange between national currencies effectively becomes fixed.

The gold standard may also be viewed as a monetary system in which changes in the gold price are accepted as the sole measure of inflation/deflation and where monetary policy operates to vigourously oppose either.

Typically under a gold standard paper money circulates as certificates: convertible into gold on demand. It may be said that the exchange rate between paper money and gold is fixed.



Introduction

Due to its rarity and durability gold has long been used as a means of payment. The exact nature of the evolution of money varies significantly across localities and era. Gold's high value for its weight made it useful as both a store of value, and a unit of account for stored value of other kinds. Early monetary systems based on grain would use gold to represent the stored value. Banking began when gold stored on account could be transfered by a giro system, or lent at interest.

History of the Modern Gold Standard

The adoption of gold standards proceded gradually, which leads to conflicts between different economic historians as to when the "real" gold standard began. Sir Isaac Newton included a ratio of gold to silver in his assay of coinage in 1717 which created a relationship between gold coins and the silver penny which was to be the standard unit of account in the Law of Queen Anne, for some historians this marks the beginning of the "gold standard" in England. However, more generally accepted is that a full gold standard requires that there be one source of notes and legal tender, and that this source is backed by convertibility to gold. Since this was not the case through out the 18th century, the generally accepted view is that England is not on a gold standard at this time.

The Crisis of Silver Currency and Bank Notes (1750-1870)

To understand the adoption of the international gold standard in the late 19th century, it is important to follow the events of the late 1700's and early 1800's. In the late 18th century, wars and trade with China, which sold to Europe, but had little use for European goods, drained silver from the economies of Western Europe and the US. Coins were struck in smaller and smaller amounts, and there was a proliferation of bank and stock notes used as money.

In the 1790's England suffered a massive shortage of silver coinage, and ceased to mint larger silver coins, issued "token" silver coins and overstruck foreign coins. With the end of the Napoleanic Wars, England began a massive recoinage program, that created standard gold sovereigns and circulating crowns and half-crowns, and eventually copper farthings in 1821. The recoinage of silver in England after a long drought produced a burst of coins: England struck nearly 40 million shillings between 1816 and 1820, 17 million half crowns and 1.3 million silver crowns. The 1819 Act for the Resumption of Cash Payments set 1823 as the date for resumption of convertibility, reached instead by 1821. Throughout the 1820's small notes were issued by regional banks, which were finally restricted in 1826, while the Bank of England were allowed to set up regional branches. In 1833, however, the Bank of England notes were made legal tender, and redemption by other banks was discouraged. The continuation of bank notes in circulation led to inflationary money problems, and in 1844 the Bank Charter Act established that Bank of England Notes, fully backed by gold, were the legal standard. According to the strict interpretation of the gold standard, this 1844 act marks the establishment of a full gold standard for British money.

The USA adopted silver standard based on the "spanish milled dollar" in 1785. This was codified in the 1792 Mint and Coinage Act, and by the use by the Federal Government of the "Bank of the United States" to hold its reserves, as well as establishing a fixed a ratio of gold to the US dollar . In effect, a derivative silver standard, since the bank was not required to keep silver to back all of its currency. This began a long experiment with attempts for America to create a bimetallic standard for the US Dollar, which would continue until the 1920's. Gold and silver coins were legal tender, including the Spanish real, a silver coin struck in the Western Hemisphere. Because of the huge debt taken on by the United States Federal government to pay for the Revolutionary War, silver coins struck by the government left circulation, in 1806 Jefferson suspended minting silver coins.

The US Treasury was put on a strict hard money standard, doing business only in gold or silver coin as part of the Independent Treasury Act of 1848, which legally separated the accounts of the Federal government from the banking system. However the fixed rate of gold to silver set overvalued silver in relationship to the demand for gold to trade or borrow from England. The drain of gold in favor of silver led to the search for gold, including the "Gold Rush" of 1849 in California. Following Gresham's law, silver poured into the US, which traded with other silver nations, and gold moved out. In 1853 the US reduced the silver weight of coins, to keep them in circulation and in 1857 removed legal tender status from foreign coinage.

In 1857 the final crisis of the free banking era of international finance began, as American banks suspended payment in silver, rippling through the very young international financial system of central banks. In the United States this collapse was a contributory factor in the American Civil War, and in 1861 the US government suspended payment in gold and silver, effectively ending the attempts to form a silver standard basis for the dollar. Through the 1860-1871 period various attempts to resurrect bi-metallic standards are made, including one based on the gold and silver franc, however, with the rapid influx of silver from new deposits, the expectation of scarcity of silver ends.

The interaction between central banking, and currency basis, forms the primary source of monetary instability during this period. The combination of economic stability was restriction of supply of new notes, a government monopoly on the issuance of notes directly and indirectly, and a single unit of value. Attempts to evade these conditions produces periodic monetary crisis, as either notes devalued, or silver ceased to circulate as a store of value, or there was a depression as governments, demanding specie as payment, drained the circulating medium out of the economy. At the same time there is a dramatically expanded need for credit, and large banks are being chartered in various states, including, by 1872, Japan. The need for a solid basis in monetary affairs would produce a rapid acceptance of the gold standard in the period that followed.

Establishment of the International Gold Standard (1871-1900)

Germany was created as a unified country following the Franco-Prussian War, it established the Reichmark went on to a strict gold standard, and used gold mined in South Africa to expand the money supply. Rapidly most other nations followed suit, since gold became a transportable, universal and stable unit of valuation. See Globalization.

Dates of Adoption of a Gold Standard: Germany 1871, Latin Monetary Union 1873 (Belgium, Italy, Switzerland, France), United States 1873 de facto, Scandinavia 1875 by monetary Union: Denmark, Holland, Norway and Sweden, France internally 1876, Spain 1876, Austria 1879, Russia 1893, Japan 1897, India 1898, United States 1900 de jure.

Throughout the decade of the 1870's deflationary and depressionary economics create periodic demands for silver currency. However, such attempts generally failed, and continue the general pressure towards a gold standard. By 1879, only gold coins are accepted through the Latin Monetary Union, composed of France, Italy, Belgium, Switzerland and later Greece, even though silver is, in theory, a circulating medium.

By creating a standard unit of account which was easily redeemable, relatively stable in quantity, and verifiable in its purity, the gold standard ushered in a period of dramatically expanded trade between industrializing nations, and "periphery" nations which produced agricultural goods - the so called "bread baskets". This "First Era of Globalization" was not, however, without its costs. One of the most dramatic was occurred with the Irish Potato Famine, where even as people began to starve, it was more profitable to export food to Britain, the result turned a blight into a humanitarian disaster. Amartya Sen in his work on famines theorized that famines are caused by an increase in the price of food, not by food shortage itself, and hence the root cause of trade based famines is an imbalance in wealth between the food exporter and the food importer.

At the same time it caused a dramatic fall in aggregate demand, and a series of long Depressions in the United States and the United Kingdom. This should not be confused with the failure to industrialize or a slowing of total output of goods. Thus the attempts to produce alternate currencies include the introduction of Postal Money Orders in Britain in 1881, later made legal tender during World War I, and the "Greenback" party in the US, which advocated the slowing of the retirement of paper currency not backed by gold.

By encouraging industrial specialization, industrializing countries grew rapidly in population, and therefore needed sources of agricultural goods. The need for cheap agricultral imports, in turn, further pressured states to reduce tariff barriers, so as to be able to exchange with the industrial nations for capital goods, such as factory machinery, which were needed to industrialize in turn. Eventually this pressured taxation systems, and pushed nations towards income and sales taxes, and away from tariffs. It also produced a constant downward pressure on wages, which contributed to the "agony of industrialization". The role of the gold standard in this process remains hotly debated, with new articles being published attempting to trace the interconnections between monetary basis, wages and living standards.

Gold Standard from Peak to Crisis (1901-1932)

By 1900, the need for a lender of last resort had become accepted through out the major industrialized countries, only the United States lacked a central banking system. For example, in 1890, the Bank of England organizes a bail out of Barings, which was within 24 hours of bankruptcy. While there had been periodic panics since the end of the depressions of the 1880's and 1890's, the rate of industrialization had served to push living standards higher. Peace and prosperity reigned through most of Europe, though there was increasing agitation in favor of socialism and communism.

This came to an abrupt halt with the out break of World War I. Almost immediately Britain is forced to gradually end its gold standard, ending convertibility to Bank of England notes starting in 1914, by wars end, England is on a series of fiat currency regulations, which monetize Postal Money Orders and Treasury Notes. The need for larger and larger engines of war, including battleships and munitions, created inflation. Nations responded by printing more money than could be redeemed in gold, effectively betting on winning the war, and redeeming out of reparations, as Germany had in the Frano-Prussian War. The United States and the United Kingdom both instituted a variety of measures to control the movement of gold, and to reform the banking system, but both were forced off of the gold standard by the costs of the war. The Treaty of Versailles instituted punative reparations on Germany and the defeated Central Powers, and France hoped to use these to rebuild her shattered economy, since much of the war had been on French soil. Germany, of course, having to pay gold in reparations could no longer coin gold "Reichmarks" and moved to paper currency. The series of arrangements to prop up the gold standard in the 1920's would constitute a book length study unto themselves, with the Dawes plan superceded by the Morgenthau plan. In effect the US, as the most persistent positive balance of trade nation, loaned the money to Germany to pay off France, so that France could, in turn, pay off the United States. After the war, the Weimar Republic suffered from hyperinflation, introduces an asset currency, the Rentenmark, which is withdrawn from ciruclation in favor of a restored gold Riechmark in 1924.

In the United Kingdom the pound was returned to the gold standard in 1925, by the somewhat reluctant Chancellor of the Exchequer Winston Churchill, on the advice of conservative economists at the time. Although a higher gold price and significant inflation had followed the WWI ending of the gold standard, Churchill returned to the standard at the pre-war gold price. For five years prior to 1925 the gold price was managed downward to the the pre-war level, meaning a significant deflation was forced onto the economy.

John Maynard Keynes was one economist who argued against the adoption of the pre-war gold price believing that the rate of conversion was far too high, and that the monetary basis would collapse. This deflation reached across the remnants of the British empire everywhere the Pound Sterling was still used as the primary unit of account. In the United Kingdom the standard was again abandoned in 1931. Sweden abandoned the gold standard in 1929, the US in 1933, and other nations were, to one degree or another, forced off of the gold standard.

As part of this process, many nations, including the US, banned private ownership of large gold stocks, and instead required citizens to hold only legal tender in the form of central bank notes. While this move was argued for under national emergency, it was controversial at the time, and there are still those who regard it as an illegal and unconstitutional usurpation of private property. While this is not a mainstream view, many of the people who hold it are influential out of proportion to their numbers.

The Depression and Second World War (1933-1945)

In 1933 the London Conference marked the death of the international gold standard as it had developed to that point in time. While the United Kingdom and the United States desired an eventual return to the Gold Standard, with President Franklin Delano Roosevelt saying that a return to international stability "must be based on gold" - neither was willing to do so immediately. France and Italy both sent delegations insisting on an immediate return to a fully convertable international gold standard. A proposal was floated to stabilize exchange rates between France, Britain and the United States based on a system of drawing rights, but this too collapsed.

The central point at issue was what value the gold standard should take. Cordell Hull, the Secretary of State for the US, was instructed to require that reflation of prices occur before returning to the Gold Standard. There was also deep suspicion that Britain would use favorable trading arrangements in the Commonwealth to avoid fiscal discipline. Since the collapse of the Gold Standard was attributed, at the time, to the US and the UK trying to maintain an artificially low peg to gold, agreement became impossible. Another fundamental disagreement was the role of tariffs in the collapse of the gold standard: with the liberal government of the United States taking the position that the actions of the previous American Administration had exacerbated the crisis by raising tariff barriers.

In the years that followed nations pursued bilateral trading agreements, and by 1935, the economic policies of most Western nations were increasingly dominated by the growing realization that a global conflict was highly likely, or even inevitable. During the 1920's the austerity measures taken to restabilize the world financial system had cut military expenditures drastically, with the arming of the Axis powers, war in Asia, and fears of the USSR exporting revolution, the priority shifted toward armament, and away from re-establishing a gold standard. The last gasp of the 19th century gold standard came when the attempt to balance the United States Budget in 1937 lead to the "Roosevelt Recession". Even such gold advocates as Roosevelt's budget director conceded that until it was possible to balance the budget, a gold standard would be impossible.

Nazi Germany, as part of its pogrom against the Jews, used the gold looted from them to finance its war effort, using Switzerland's banking system as a way to launder the gold. The gold was then deposited with the Reichbank, and used as the basis for notes to be issued which were to be accepted as currency. The Reich then instituted wage and price controls, backed by internment in prison camps, to prevent this "Mefo financing" from producing hyper-inflation.

During the 1939-1942 period, Britain depleted much of its gold stock in purchases of munitions and weaponry on a "cash and carry" basis from the US and other nations. This depletion of Britain's reserve signalled to Winston Churchill that returning to a pre-war style gold standard was impractical, instead, John Maynard Keynes, who had argued against such a gold standard, became increasingly influential: his proposals, a more wide ranging version of the "stability pact" style gold standard, would find expression the Bretton Woods Agreement.

Post-War International Gold Standard (1946-1971)

(See Bretton Woods system)

Theory

Differing Definitions of "Gold Standard"

If the monetary authority holds sufficient gold to convert all circulating money, then this is known as a 100% reserve gold standard, or a full gold standard. Some believe there is no other form of gold standard, since on any "partial" gold standard the value of circulating representative paper in a free economy will always reflect the faith that the market has in that note being redeemable for gold. Others, such as some modern advocates of supply-side economics contest that so long as gold is the accepted unit of account then it is a true gold standard.

In an internal gold-standard system, gold coins circulate as legal tender or paper money is freely convertible into gold at a fixed price.

In an international gold-standard system, which may exist in the absence of any internal gold standard, gold or a currency that is convertible into gold at a fixed price is used as a means of making international payments. Under such a system, when exchange rates rise above or fall below the fixed mint rate by more than the cost of shipping gold from one country to another, large inflows or outflows occur until the rates return to the official level. International gold standards often limit which entities have the right to redeem currency for gold. Under the Bretton Woods system, these were called "SDRs" for Special Drawing Rights.

The Classical Gold Standard

The commitment to maintain gold convertibility tightly restrains credit creation. Credit creation by banking entities under a gold standard threatens the convertibility of the notes they have issued, and consequently leads to undesirable gold outflows from that bank. The result of a failure of confidence produces a run on the specie basis, which is generally responded to by the bankers suspending specie payments. Hence, notes circulating in any "partial" gold standard will either be redeemed for their face value of gold (which would be higher than its actual value) - this constitutes a bank "run"; or the market value of such notes will be viewed as less than a gold coin representing the same amount.

In the international gold standard imbalances in international trade were rectified by requiring nations to pay accounts in gold. A country in deficit would have to pay its debts in gold thus depleting gold reserves and would therefore have to reduce its money supply. This would cause prices to deflate, reducing economic activity and, consequently, demand would fall. The resulting fall in demand would reduce imports; thus theoretically the deficit would be rectified when the nation was again importing less than it exported. This lead to a constant pressure to close economies in the face of currency drains in what critics called "beggar thy neighbor" policies. Such zero-sum gold standard systems showed periodic imbalances which had to be corrrected by rapid falls in output.

In practice however this could seriously destabilize the economy of countries which ran a trade deficit, because people tended to make a run on the bank to retrieve their money before gold reserves were exported, thus causing banks to collapse and wiping out savings. Bank runs and failures were a common feature of life during the period when the gold standard was the established economic system. It also created a counter-cyclical effect, as governments taxed trade, they accumulated gold and silver coin, which reduced the monetary base for the private economy. This paradox lead to "money droughts" and inflation, as governments taxed, often to pay for wars, and paid in coin, while the velocity of money decreased in the private economy as individuals hedged against the uncertain political situation by hoarding gold. Each attempt to introduce paper money was met, sooner or later, with either over-printing of money and the resulting collapse of the "fiat" money, including paper francs, continentals printed by the pre-Constitutional US Congress and various "bubbles". Or it would create the demand by the government to be paid only in specie, which devalued the existing paper money.

The gold standard, in theory, limits the power of governments to cause price inflation by excessive issue of paper currency, although there is evidence that before World War I monetary authorities did not expand or contract the supply of money when the country incurred a gold outflow. It is also supposed to create certainty in international trade by providing a fixed pattern of exchange rates. The gold standard in fact is deflationary, as the rate of growth of economies generally outpaces the growth in gold reserves. This, after the inflationary silver standards of the 1700's was regarded as a welcome relief, and an inducement to trade. However by the late 19th century, agitation against the gold standard drove political movements in most industrialized nations for some form of silver, or even paper based, currency.

Advocates of a Renewed Gold Standard

Thus, the internal gold standard is supported by many advocates of classical economics, monetarism, Objectivism, and even proponents of libertarianism. Much of the support for a gold standard is related to a distrust of central banks and governments, as a gold standard removes the ability of a government to manage the value of money, even though, historically, the establishment of a gold standard was part of establishing a national banking system, and generally a central bank. The international gold standard still has advocates who wish to return to a Bretton Woods style system, in order to reduce the volatility of currencies. Many nations back their currencies in part with gold reserves, using these not to redeem notes, but as a store of value to sell in case their currency is attacked or rapidly devalues.

The Gold Standard then is generally promoted by those who believe that a stable store of value is the most important element to business confidence. It is generally opposed by the vast majority of governments and economists, because it has frequently been shown to provide insufficient flexibility in the supply of money and in fiscal policy, because the supply of newly mined gold is not closely related to the growing needs of the world economy for a commensurate supply of money. A single country may also not be able to isolate its economy from depression or inflation in the rest of the world. In addition, the process of adjustment for a country with a payments deficit can be long and painful whenever an increase in unemployment or decline in the rate of economic expansion occurs.

One of the foremost opponents of the gold standard was John Maynard Keynes who scorned basing the money supply on "dead metal". Keynesianists argue that the gold standard creates deflation which intensifies recessions as people are unwilling to spend money as prices fall, thus creating a downward spiral of economic activity. They also argue that the gold standard also removes the abillity of governments to fight recessions by increasing the money supply to boost economic growth.

Gold standard proponents point to the era of industrialization and globalization of the 19th century as the proof of the viability and supremacy of the gold standard, and point to Britain's rise to being an imperial power, conquering nearly one quarter of the world's population and forming a trading empire which would eventually become the "Commonwealth of Nations" as imperial provinces gained independence. Gold standard advocates have a strong following among commodity traders and hedge funds with a bearish orientation. The expectation of a global fiscal meltdown, and the return to a hard gold standard has been central to many hedge financial theories. More moderate gold bugs point to gold as a hedge against commodity inflation, and a representation of resource extraction, in their view gold is a play against monetary policy follies of central banks, and a means of hedging against currency fluctuations, since gold can be sold in any currency, on a highly liquid world market, in nearly any country in the world. For this reason they believe that eventually there will be a return to a gold standard, since this is the only "stable" unit of value.

Few economists today advocate a return to the gold standard. Notable exceptions are some proponents of Supply-side economics and some proponents of Austrian Economics. However, many prominent economists, while they do not advocate a return to gold, are sympathetic with hard currency basis, and argue against fiat money. This school of thought includes US central banker Alan Greenspan.

The reason these visions are not practically pursued is based on the same reasons that the gold standard fell apart in the first place: there is no organic relationship between the rate which gold is dug out of the ground and the economic growth of nations and gold standards fall apart as soon as it becomes convenient for governments to overlook them. While, in theory, a gold standard should be hard money, in practice, it is based on monetary discipline, and thus does not prevent nations from switching to a fiat currency when there is a war or other exingency. The practical matter that gold is not currently distributed according to economic strength is also a factor: Japan, while one of the world's largest economies, depending on which measure, it has gold reserves far less than could support that economy. Finally the quantity of gold available for reserves, even if all of it were confiscated and used as the unit of account, would put the value of gold upwards of 4000 dollars an ounce on a purchasing parity basis. If the current holders of gold imagine that this is the price that they will be paid for giving up their gold, they are quite likely to be disappointed. For these practical reasons - inefficiency, misallocation, instability, and insufficiency of supply - the gold standard is likely to be more honoured in literature than practiced in fact.

Gold as a reserve today

During the 1990's Russia liquidated much of the former USSR's gold reserves, while several other nations accumulated gold in preparation for the Economic and Monetary Union. The Swiss Franc left a full gold convertible backing. However, gold reserves are held in significant quantity by many nations as a means of defending their currency, and hedging against the US Dollar, which forms the bulk of liquid currency reserves. Weakness in the dollar tends to be offset by strengthen of gold prices. Gold remains a principle financial asset of almost all central banks along side foreign currencies and government bonds. It is also held by central banks as a way of hedging against loans to their own governments as an "internal reserve".

In addition to other precious metals, it has several competitors as store of value: the US dollar itself and real estate. As with all stores of value, the basic confidence in property rights determines the selection of which one is chosen, as all of these have been confiscated or heavily taxed by governments. In the view of gold investors, none of these has the stability that gold had, thus there are occasionally calls to restore the gold standard. Occasionally politicians emerge who call for a restoration of the gold standard, particularly from the libertarian right and the anti-government left. Mainstream conservative economists such as Barro and Greenspan have admitted a preference for some tangibly backed monetary standard, and have stated that a gold standard is among the possible range of choices.

Some privately issued modern notes (such as e-gold) are backed by gold bullion, and gold, both coins and bullion are widely traded in deeply liquid markets.

In 1999, to protect the value of gold as a reserve, European Central Bankers signed the "Washington Agreement", which stated they would not allow gold leasing for speculative purposes, nor would they "enter the market as sellers" except for sales that had already been agreed upon. A selling band was set. This was intended to prevent further deterioration in the price of gold.

In 2001 Malaysian Prime Minister Mahathir bin Mohamad proposed a new currency that would be used initially for international trade between Muslim nations. The currency he proposed was called the gold dinar and it was defined as 4.25 grams of 24-carat gold. Mahathir Modamad promoted the concept on the basis of its economic merits as a stable unit of account and also as a political symbol to create greater unity between Islamic nations.

The "Washington Consensus"

While much of what is written about the gold standard comes from the point of view of what are often derrisively referred to as "gold bugs", the "neo-liberal" economic policies which are currently favored by Western economists owe a great deal to the classical period gold standard. Instead of gold, hard currency, particularly the dollar, is the standard unit of account, and nations often back their currencies with holdings of dollars and US securities. This means that, in effect, there is a standard, hard, unit of account, and it is based on factors extrinsic to most economies. As long as the United States maintains fiscal discipline, a questionable assumption in light of the borrowing binge of George W Bush Jr, the "dollar hegemony", functions to no small extent as a descendant of the "first age of globalization".

The Washington Consensus is widely criticized for many of the same reasons that the classical era gold standard was, that it favors rich over poor nations, that it hobbles the development of peripheral nations by discouraging manufacturing, that it places too much power in the hands of monetary authorities, and that it is prone to manipulation. However, it is also the basis for world monetary policy, even if there are a number of interest groups which would prefer some other standard.

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