Under what was called a gold specie standard (sometimes called a 100 per cent reserve gold standard) the central bank was required to hold gold in proportion to the currency it issued (the proportion being the gold currency exchange rate), which meant it could always ensure full convertibility at the agreed exchange rate of currency into gold.<\/p>\n
The monetary authority agreed to maintain the “mint price” of gold fixed by standing ready to buy or sell gold to meet any supply or demand imbalance. We should be clear that it was thought likely at the time that no major gold discoveries would be made in the future and so the price of gold was demand-determined (fixed supply).<\/p>\n
It meant that if the central bank wanted to issue more currency then it had to get more gold to back it. That became the role of trade. Gold was considered to be the principle method of making international payments. Accordingly, as imbalances in trade (imports and exports) arose this necessitated that gold be transferred between nations (in boats) to fund these imbalances. Trade deficit countries had to ship gold to trade surplus countries.<\/p>\n
For the surplus nations, the inflow of gold would allow their central banks to expand their money supplies (issue more notes) because they had more gold to back the currency. The rising money supply would push against the inflation barrier (given no increase in the real capacity of the economy) which would ultimately render exports less attractive to foreigners and the external surplus would decline.<\/p>\n
For the deficit nations, the loss of gold reserves to the surplus nations forced their governments to withdraw paper currency which was deflationary and had the consequence of increasing unemployment, and driving down output growth and the general level of prices. The latter improved the competitiveness of their economy which also helped resolve the trade imbalance. But it remains that the deficit nations were forced to bear rising unemployment and vice versa as the trade imbalances resolved.<\/p>\n
Under the gold standard, the government could not expand base money if the economy was in trade deficit. It was considered that the gold standard acted as a means to control the money supply and generate price levels in different trading countries which were consistent with trade balance. The domestic economy however was forced to make the adjustments to the trade imbalances.<\/p>\n
Monetary policy became captive to the amount of gold that a country possessed (principally derived from trade). Variations in the gold production levels also influenced the price levels of countries.<\/p>\n
In practical terms, the adjustments to trade that were necessary to resolve imbalances were slow. In the meantime, deficit nations had to endure domestic recessions and entrenched unemployment. So a gold standard introduces a recessionary bias to economies with the burden always falling on countries with weaker currencies (typically as a consequence of trade deficits). This inflexibility prevented governments from introducing policies that generated the best outcomes for their domestic economies (high employment).<\/p>\n
Ultimately the monetary authorities were not able to resist the demands of the population for higher employment. <\/p>\n
The onset of World War I interrupted the operation of the gold standard and currencies were valued by whatever the specific government wanted to set it at. The reason was that governments wanted the leeway to fund the war efforts and realised that they could not be hostage to the gold stocks their central banks held in reserve.<\/p>\n
The ensuing 25 odd years saw significant instability with attempts to go back to the standard in some countries proving extremely damaging in terms of gold losses and rising unemployment.<\/p>\n
The UK abandoned the gold standard in 1931 as it was facing massive losses of gold. It had tried to maintain the value of the Pound in terms the pre-WW1 parity with gold but the war severely weakened its economy and so the pound was massively over-valued in this period and trade competitiveness undermined as a consequence.<\/p>\n
After World War 2, the IMF was created to supersede the gold standard and the so-called gold exchange standard emerged. Convertibility to gold was abandoned and replaced by convertibility into the US dollar, reflecting the dominance of the US in world trade (and the fact that they won the war!).<\/p>\n
This new system was built on the agreement that the US government would convert a USD into gold at $USD35 per ounce of gold. This provided the nominal anchor for the exchange rate system.<\/p>\n
The Bretton Woods System was introduced in 1946 and created the fixed exchange rates system. Governments could now sell gold to the United States treasury at the price of $USD35 per ounce. So now a country would build up USD reserves and if they were running a trade deficit they could swap their own currency for USD (drawing from their reserves) and then for their own currency and stimulate the economy (to increase imports and reduce the trade deficit).<\/p>\n
The fixed exchange rate system however rendered fiscal policy relatively restricted because monetary policy had to target the exchange parity. If the exchange rate was under attack (perhaps because of a balance of payments deficit) which would manifest as an excess supply of the currency in the foreign exchange markets, then the central bank had to intervene and buy up the local currency with its reserves of foreign currency (principally $USDs).<\/p>\n
This meant that the domestic economy would contract (as the money supply fell) and unemployment would rise. Further, the stock of $USD reserves held by any particular bank was finite and so countries with weak trading positions were always subject to a recessionary bias in order to defend the agreed exchange parities. The system was politically difficult to maintain because of the social instability arising from unemployment.<\/p>\n
So if fiscal policy was used too aggressively to reduce unemployment, it would invoke a monetary contraction to defend the exchange rate as imports rose in response to the rising national income levels engendered by the fiscal expansion. Ultimately, the primacy of monetary policy ruled because countries were bound by the Bretton Woods agreement to maintain the exchange rate parities. They could revalue or devalue (once off realignments) but this was frowned upon and not common.<\/p>\n
Whichever system we want to talk off – pure gold standard or USD-convertible system backed by gold – the constraints on government were obvious.<\/p>\n
Those constraints would return immediately the world moved back onto a gold standard.<\/p>\n
Further, a gold standard dramatically restricts the capacity of the government to manage a crisis such as the world has been enduring for the last 5 odd years. The gold standard was one of the reasons the Great Depression was worse than the Global Financial Crisis. The central banks then were unable to ensure financial stability by expanding their monetary bases.<\/p>\n
The proponents argue that price stability would be the principle gain from a return to the gold standard. They argue that it stops central bank printing presses running because monetary growth would be tied to the growth in the gold stock.<\/p>\n
Of-course, this view assumes that when the central bank expands the monetary base there is automatically inflation. You guessed it – the Quantity Theory of Money interacting with the equally defunct concept of the money multiplier leads to that conclusion.<\/p>\n
It is a pity that it doesn’t remotely describe the reality. How is it that inflation has not been accelerating in the US over the last few years or in Japan for nearly two decades?<\/p>\n
How come Japan has been fighting deflation as its monetary base expands?<\/p>\n
How does a currency lose its domestic value if there are millions of people unemployed wanting to work and firms willing to employ them if some new orders appears in their books?<\/p>\n
How would we get an inflation if firms have capacity to expand should new spending growth emerge?<\/p>\n
Why hasn’t the substantial expansion in the US monetary base manifested as a proportional expansion in spending?<\/p>\n
Please read my blogs – Money multiplier and other myths<\/a> and Building bank reserves will not expand credit<\/a> and Building bank reserves is not inflationary<\/a> – for further discussion (even answers to those questions).<\/p>\n Even a cursory glance at the principle evidence shows the idea has no merit. The US maintained the gold standard from June 1919 to March 1933 (more or less) although it was on the standard in 1914-1917.<\/p>\n The history of the US participation in the gold standard is well described in this interesting US Federal Reserve Bulletin paper from June 1989 – The International Gold Standard and U.S. Monetary Policy from World War 1 to the New Deal<\/a><\/p>\n Here is a graph taken from US Bureau of Labor Statistics<\/a> data for the Consumer Price Index from 1913 to 2011. It shows the annual inflation rate from 1914 to 2011.<\/p>\n Under the gold standard, domestic prices were prone to sharp fluctuations as the stock of gold changed and\/or the nation’s external trade situation changed. An external deficit nation was subject to short and sudden plunges in prices. Deflation is generally considered to be highly undesirable.<\/p>\n The evidence is fairly clear (although complicated by other factors which I don’t mention here) – price stability has been higher in the period after gold standard arrangements were abandoned.<\/p>\n The average inflation rate in the period 1914 to 1971 was lower than in the period following 1971 but that is because of the violent swings into deflation. If we take the average of the positive inflation rates we get 4.6 per cent and 4.5 per cent, respectively for the pre-1971 and post-1971 periods. So inflation was not lower during the period when the gold standard or variations of the same operated.<\/p>\n Moreover, the variance in the inflation rate from 1914 to 1971 was 33.5 whereas from 1971 to 2011 is was 8.8. Price stability requires low inflation but also low variability. Variability introduces uncertainties which spill over into the real economy by distorting consumption and investment decisions.<\/p>\n
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