Gold Standard

Evolution of International Monetary Systems

(a) Gold Standard (1870 - 1945)
(b) The Bretton Woods System (1945- 1971)
(c) Contemporary Monetary System (1973 - )

 

 

Before the Gold Standard

According to Graham Levy, the earliest known coins were changing hands in the 6th century BC in Anatolia, in the kingdom of Lydia. Around 550 BC, King Croesus minted metal coins, made from electrum, a natural alloy of gold and silver found in the River Pactolus that flowed past Sardis, Lydia's capital. This was 98% gold. A punch and anvil die was used to stamp the coins with what is assumed to be the Lydian emblem of a lion, or a lion's paws, cutting the metal to reveal its consistency. A major hoard of such coins was discovered in 1904–05 at the sanctuary of Artemis at Ephesus. In ancient and medieval times, national monies were exchanged by weight. Many of today's famous currencies date from the Middle ages when it was important to know the weight of metal contained in a coin. (The Hutchinson Family Encyclopedia)

Cyrus, the Persian King, was attacking the kingdom of Lydia. King Croesus sent a delegation with abundant gifts to the preistess of Delphi to receive an oacle. He received an oracle: If the king crosses a certain river (Halys, between Lydia and Medes/Persia), he will ruin a great kingdom. He expected to win, but was roundly defeated. He used the scorched earth strategy and laid waste the country side to impede the advance of the Persian army, but Cyrus followed him to Sardis and captured him (546 BC). After conquering Babylon (539 BC), Cyrus liberated Jews to return to their homeland (538 BC).

The polygonal wall of Delphi	Ruins of Delphi Unlike other kings who sent delegations, Alexander personally visited the temple and asked for an oracle (that he would conquer the ancient world), but was told to come back in the spring. Furious, Alexander dragged Pythia (priestess) by the hair out of the chamber until she screamed "Let go of me. You are invincible," upon hearing which, Alexander left because that is all Alexander wanted to hear.
The amphitheater in Delphi	Artemis of Ephesus, Athens Museum of Archeology. Because of the riot of silversmiths who were afraid of losing jobs, Apostle Paul found it prudent to leave Ephesus. (Acts 19:23-27)
Gerard van Honthorst, Croesus and Solon, Kunsthalle museum, Hamburg.	According to a legend King Croesus had many visitors. He asked Solon who was the happiest man he ever saw, and Solon named others. When Croesus showed displeasure, Solon said that no one knows what Gods have in store for him. After a few years, King Cyrus was trying to burn Croesus on stakes and he shouted Solon's name a few times. After learning Solon's story, King Cyrus released Croesus.

Ruins of Sardis (Harvard Art Museums)

Gold coins of Darius. [Courtesy of Coin Gallery]

Historic Gold Coins
The original gold coins of Croesus and other historic gold coins. Here is one with Constantine.

British pound: pound refers to the amount of silver coined into money.

lira : pound in Italian
peso: weight in Spanish
mark: 1/2 pound
Why weigh coins? Gresham's law: Bad money drives out good money (Sir Thomas Gresham, 1519-1579).

Rialto Bridge, Venice (May 2003). The price of gold was fixed on this bridge during the Renaissance period.

	Grand Canal with Realto Bridge, Venice (circa 1780) by Francesco Guardi (1712-1793), Venetian.
	Realto Bridge now.

Gold Standard

In the 1850s, the industrial revolution was taking place in England. In the United States, the Civl War (1861-1865) was just over. In Japan, the military rule of Tokugawa shogunate (1603-1867) was just over, some ports were opened to trade with European countries, and Emperor Meiji was instituting a major change in Japan. Admiral Perry of the United States came to Uraga, Japan and forced Japan to open up to trade, causing the fall of shogunate and triggering the Meiji Restoration. The second Opium War (1856-1860) was just over and imports of opium was legalized in China.

The gold standard has no precise date of origin. It gradually emerged around 1870-1880 when most of the industrial nations of Europe adopted gold standard. (Great Britain adopted gold standard in 1821, Australia in 1852, Canada in 1853, France in 1878, Germany in 1871, the US in 1879) It lasted until 1914, before the outbreak of World War I. During this period, most of the industrial nations linked their currencies to gold and inflation rates were about 0.1 percent.

When these nations were on the gold standard, there were no formal agreements with other nations. No treaty was signed. Each nation defended its currency in terms of gold. Its treasury or central bank was required by law to buy and sell gold without limit at the stated price. The public had complete confidence in the convertibility of its currency into gold.

Process of Adjustment

By the Gold Standard Act, 1900(copy)

One dollar was defined to be equal to the value of 23.22 grains of pure gold (1 troy ounce = 480 grains of gold). The gold content of pound sterling was fixed by Coinage Act of 1816 (copy) at 113 grains of pure gold. Britain adopted gold standard in 1821. By 1833, Bank of England was obligated to redeem its notes in gold and silver coins (Bank of England Act, 1833 (copy) Thus the par exchange rate between the dollar and the pound was

p_£ = 113/23.22 = $4.866

The cost of shipping gold from London to New York was $0.026 per pound. So the exchange rate was allowed to fluctuate within the limits of

$4.866 ± 0.026 = $4.892 = gold import point for UK

$4.84 = gold export point for UK

When the British pound falls below the gold export point, say to $4, then the Britons have to pay much more in £ than at the official rate. Thus, it is cheaper for Britons to convert £ into gold, export gold, convert gold into $ and make $ payments.

Figure 3. Gold export point

During the gold standard, (i) prices were stable, and (ii) so little gold actually moved from one country to another. This was because central banks were not passive, but they adjusted the interest rates to prevent gold flow.

For example, when the exchange rate approached the gold export point, the Bank of England raised the bank rate (the interest rate the central banks charge commercial banks). This caused investors in New York to shift funds to London, because they could earn higher interest rate.

Long term capital movement also lessened the need for current account adjustments. Current account adjustment requires drastic price changes under fixed exchange rate system. Without long term capital movement, price adjustments could have been deflationary.

Problems with the Gold Standard
1. Gold standard limits economic growth.	In a closed economy under the gold standard, a country's money supply is determined by its stock of gold. To increase its money supply, the government must mine more gold. ⇒Economic growth is constrained by the gold supply. Unless more gold is mined, the economy cannot grow. Increased real output only causes deflation. Thus, in a growing economy, the gold standard is deflationary and retards economic growth.
2. Monetary policy is ineffective.	In an open economy, a balance of payments deficit is followed by an gold outflow. Thus, a single country's ability to expand money supply is limited by its balance of payments position. An expansion of money supply would cause the country to lose gold, which would set off deflation.
3. Transmission of monetary shocks.	Discovery of a new gold mine increases the local supply of gold, but does not affect real outputs in the short run, thereby raising prices. Due to fixed links between currencies, inflation or depression in one country is easily transmitted to other countries. (The Great Depression started by the Wall Street crash of 1929 was quickly transmitted to Europe and Asia.) Thus, while inflation rates were low during the period of gold standard, prices could have been unstable.

The discipline of gold standard.

For the world as a whole, the growth of money supply is regulated by the flow of newly produced gold. Thus, the growth of a country or the world is limited by the growth of new gold production.

No new gold production => no growth.

After the collapse of the Roman Empire in 476 AD, there was no need to pay soldiers or to mine gold and mint gold coins. This halt of gold production caused a decline in the world economy for almost a thousand years, a major economic cause for the advent of Dark Ages. No significant amount of gold was produced until the age of Renaissance. According to Rafal Swiecki, the total amount of gold mined from the earth to the end of 1985 is about 3.85 billion (3.85 x 10⁹) troy oz. Of this amount, 2% was produced prior to 1492, 8% during the period 1492-1800, 20% during the interval 1801-1900, and 70% from 1901-1985

INTERWAR PERIOD, 1918-1940

During World War I the international gold standard ceased to function. Its operation was suspended with the outbreak of war in August 1914 when Archduke Franz Ferdinand, the heir to the Austro-Hungarian Empire (June 1914) was assassinated in Sarajebo (He survived the first but not the second attempt). European economies had been interlocked closely, but they were suddenly cut loose from the connective mechanism. Countries diverged and developed in different directions during the war. By the end of war in June 1918, inflation rates varied greatly, because nations printed more money to finance war. Russian revolution occurred in 1917. The structure of world economy was profoundly altered by 1918.

Fluctuating Exchange Rates, 1919-1926

1. It was clear that prewar exchange rates could not be restored. Thus, many countries delayed and were hesitant to fix official par values of their currencies. They allowed their currencies to float more or less freely in the foreign exchange market.
2. These countries did not realize that floating rates were the only viable solution. Instead, there was a universal expectation that floating exchange rates regime was temporary, and that countries would soon return to gold standard. The main question was not whether to restore gold standard, but at what parities to restore the gold standard.
   • some urged that prewar parities should be restored.
   • others argued that changed economic conditions had changed equilibrium exchange rates between national currencies, and hence gold parities should be adjusted.
3. If 1914 is take as the base (= 100), wholesale prices in December 1918 were as follows:

   US 202
   F 355
   UK 246

   US immediately announced that it would maintain the dollar price of gold at its prewar level. That is, it is willing to export gold at $20.67 per ounce.

4. Britain

   It was thought that Britain's national honor was at stake. Failure to restore the prewar parity of pound would undermine confidence in pound. Accordingly, Britain resorted to a deflationary policy (1920-1925). During the Asian Financial Crisis of 1997, South Korea followed the same deflationary policy, causing a spectacular increase in the unemployment rate.

   Gold Standard Act, 1925 (copy)
   As prices fell, unemployment remained high above 10%. By April 1925, Winston Churchill announced that the Bank of England would again redeem its notes into gold. Britain was back on the gold standard in 1925 at its prewar parity. However, the attempt to reduce prices and wages to support an overvalued pound provoked a general strike.

5. France,

   Franc dropped from $0.18 in 1918 to $0.0392 in 1926, which stopped gold outflow from France. France returned to the gold standdard in 1928.

Figure 4. Deflationary policy and unemployment.

Gold Standard restored (1925-1931)

Sometimes this system was called Gold Exchange Standard. Under this system, each country holds gold or dollar or pound as reserve asset. The United States and Great Britain were to hold only gold as reserve asset. Dollar and pound were freely convertible into gold. (That is, only between central banks, but not for the general public.) At restored parities, the British pound was somewhat overvalued at $4.866 = £1, whereas FF was undervalued at $0.0392 = Fr 1.

Britain had BP deficits, France had BP surplus (and gold inflow followed).

Gold Standard (Amendment) Act, 1931 copy
In 1931, Britain suspended gold payments. This put an end to the vain attempt to restore the gold standard. Many countries followed Britain's lead and abandoned the link to gold. For example, Japan also abandoned gold convertibility in December 1931, after its invasion of Manchuria.

In the decade that followed (1930s), these countries had 3 options:

1. countries tried to manage or stabilize the flexible exchange rates - by raising interest rate, but it did not prevent capital outflow.
2. Some countries devalued their currencies, but many countries already did this without success.
3. others imposed exchange control when faced with capital flight.

Devaluation of dollar

Gold Reserve Act of 1934 (copy)
In January 1934, President Franklin Roosevelt raised the price of gold from $20.67 to $35.00 per ounce. (40% devaluation of dollar, or 69% increase in the price of gold)