The Gold Standard

In 1717 the master of the Royal Mint, the physicist Sir Issac Newton denominated the value of a gold guinea as 21 shillings. In 1817 a new coin, the sovereign was issued with a face value of £1, making gold worth £3.17 10.5d per ounce. To maintain the value of its paper currency the Bank of England would buy notes back promising to pay the ‘bearer on demand’ in gold coin. This ‘gold standard’ for the pound had the merit of preventing inflation as it fixed the amount of money the government issued to the amount of gold it held in the Bank of England’s vaults. This isn’t so different from the stone money of Yap where the money stays in the same place, but little notes of paper circulate which denote that the money is kept safe elsewhere saving the effort of moving the real money about.

Not only did the Gold standard ensure the stability of the value of money in the domestic economy it had the effect of fixing exchange rates with any other country that also backed their currency with gold. In 1867 the United States formally fixed the price of gold at $20.67 per ounce, therefore making the exchange rate between dollars and pounds $4.867. Anybody in England wishing to import something from the United States would need to buy dollars and if their own bank offered a rate of less than $4.867 they would refuse because all they had to do was take their pounds to the Bank of England, exchange the pounds for gold, transport the gold to the USA and sell it to the Federal Reserve for dollars. Thus the exchange rate between the dollar and the pound would vary only by as much as the cost of transportation, which in practice was very little as a proportion of the gold’s worth. The system relied on the free movement of specie and the willingness of banks to exchange currencies for gold coin. By 1880 most of the world had joined the Gold Standard, and its success was predicated on the strength of the UK economy. With Britain able and willing to exchange gold for pounds to anyone regardless of nationality, the pound became an effective provider of world liquidity because pound notes could be held as reserves without the inconvenience of storing a precious metal. However this meant that after 1880 the gold standard relied not just on gold, but also the ability of Britain to maintain enough gold reserves and other countries’ confidence in her political and economic power.

The Gold Standard is widely regarded as producing some key benefits: it provided an effective method of foreign exchange that encouraged world trade, it forced monetary authorities to adopt time consistent policies and, it provided macroeconomic stability in terms of growth with low inflation. Countries on the Gold Standard were expected to ‘play the game’, maintaining convertibility with gold (except in times of war) and speeding up balance of payments corrections by changing interest rates. Countries that played by the rules were seen as if they had a ‘Good Housekeeping’ award, which provided them with preferable access to London’s capital markets, and lower rates of interest, than transgressors. Furthermore, countries that were trusted, because of their good behavior, and who were believed would return to the gold standard after a war, found it easier to sell debt during that war. The result of the stability of exchange rates supposedly led to an unprecedented growth in world trade so much that1870 -1914 has been described by some as the first age of globalization.

The balance of payments mechanism under the Gold Standard
A country with a balance of payments deficit on its current account would experience outflows of gold. As gold reserves were depleted at the central bank, the money supply would contract. This forced up interest rates and had two effects, first aggregate demand was reduced and prices fell making exports cheaper for foreigners to buy and imports relatively dearer and thus helping to restore balance again. Second, foreign capital was attracted which helped to finance the deficit in the short run. The result was short-term price fluctuations but long-term low inflation.

The gold standard suspended 1914 -1925
Of course macroeconomic stability takes a back seat when wars break out and is subordinate to the need of governments to finance the conflict. Periods of great strife necessitated central banks suspending their promises to convert currency into gold. Wars result in government debt, and once the gold and reserve currencies are used up, bond sales are needed pushing up interest rates. Britain suspended convertibility to gold in 1914 but there was always faith that once the trouble passed the Bank of England would once again honour its commitment, which meant UK bonds were always saleable. But the First World War was of a greater magnitude than expected. With suspension of gold convertibility came inflation and after 1918, Britain’s reserves were depleted and huge debts owed to the Americans were outstanding, Britain’s own creditors were left by the war unable to pay. However in 1925 the then Chancellor of the Exchequer, Winston Churchill, despite Keynes’ strong objections, returned the UK to the Gold Standard at the old rate of $4.87.
The effect was immediate deflation as wartime price rises had left Britain’s exports uncompetitive. Worst hit by the deflation were the miners.

1926 and the General Strike
Heavy domestic use of coal during the war left the UK’s richest seams worked out. Meanwhile, The USA and Poland had been able to fill the gap in the world market. Under the Dawes Plan Germany was allowed to pay some of its war reparations by exporting coal free to France and Italy, depressing coal prices further. Re-entry to the Gold Standard made the problem worse, reducing domestic demand because of deflationary interest rates, and making British coal overpriced in world markets. To preserve profits, mine owners announced their intention to cut wages. The Miners Federation, the forerunner to the National Union of Miners, not unnaturally objected uniting under the slogan, ‘Not a penny off the pay, not a minute on the day.’

The Trades Union Congress, then as now, is the union of unions to which the majority of trades unions are affiliated. They responded by promising to support the miners. Meanwhile, the Conservative government intervened by providing a subsidy maintaining miners wages until a Royal Commission looked into the problem. The resulting report recommended a 13.5% wage cut. Negotiations with mine owners then broke down when a million miners were locked out of the pits and they became afraid many of them would not be allowed to return. On 4 May 1926 over 1.5 million, railwaymen, transport workers, printers, dockers, ironworkers and steelworkers went on strike in defence of the miners. However, the nine months time that the subsidy had bought allowed the government to organise a militia of special constables who kept most of the vital services running. After twelve days of strike the TUC admitted defeat. Although many miners held on for longer, eventually they too returned to work in November on lower wages, but many simply lost their jobs and remained out of work for years.

1931 heralded the end of the Gold Standard, which was precipitated by international speculation. Before the war Britain had been a powerful guarantor of the whole system. Now countries and institutions’ faith had been eroded and speculators moved their capital, sensing a devaluation of the pound. Gold moved abroad as international investors cashed in their pounds at the Bank of England, much of it ending up in France where their government was trying to establish Paris as a global financial centre. Out of gold and foreign currency, the government capitulated and stopped the convertibility of the pound. Britain immediately benefited as imports became more expensive and exports cheaper, but many countries now found there reserves, much of which were in pounds, instantly reduced in value. Without Britain playing its former pivotal role, and faced with their own balance of payments problems now that exporting to Britain was harder, one by one countries departed the scheme.

'When Britannia ruled the waves and the Pound was regarded with respect and awe in all the world's money markets. They assumed that the restoration of the Pound's parity with the American Dollar would re-establish Britain's pre-war prosperity. None seemed to realize that England had squandered its wealth between Sarajevo and Versailles, or that the country's shrunken export trade could no longer provide the surplus needed to re-establish London's fiscal ascendancy over the rest of the world.'

William Manchester The Last Lion: Winston Spencer Churchill Visions of Glory 1874-1932 (Sphere Books, 1983)

1944 The Bretton Woods system of exchange rates
As it became clear that Germany would lose the Second World War the USA and Britain began to plan for economic reconstruction. John Maynard Keynes, who spent the war working at the Treasury, and a team of officials came up with a plan that would, they hoped, provide international liquidity and encourage world trade. There was to be an international clearing union that would issue a new international currency, the bancor, to which countries would fix the value of their currencies. Countries with a balance of payments surplus would end up with credit in their accounts and earn interest, whilst those with deficits would be able to borrow. The bigger the deficit the more punitive the rates would be. Debtor countries would also be expected to remove the tariff and quota barriers that had been erected since the Great Depression of the 1930s. The American plan was more concerned with exchange rate stability. Each member country would subscribe $5bn, and a country in deficit could then sell its own currency from the central fund to buy another currency instead of having an overdraft as in the British plan. If there was a more fundamental balance of payments deficit, the country could devalue from its par value provided three quarters of the other members agreed. These plans formed the basis of discussions at a conference of world powers at Bretton Woods, New Hampshire in 1944. Although the meetings were successful and amicable, part of the success being attributed to the huge respect there was for Keynes, the USA by then was the most powerful country on earth able to dictate the terms. Britain was now left once more heavily indebted, its power further diminished, and Keynes’s plan for the bancor went unrealized. One result of the Bretton Woods conference was a scheme operated by a newly formed institution, the International Monetary Fund (IMF). Based in Washington DC the scheme was to: promote international monetary cooperation, facilitate the maintenance of full employment and rapid growth, make exchange rates stable, and avoid competitive devaluations and, provide a system to allow international payments and removal of currency movement restrictions.

Countries fixed their currencies to the dollar and in turn the Americans promised convertibility of the dollar to gold. Members could devalue their currencies by 10% of the original value but needed permission from other members whose deposits totaled more than 10% of the funds reserves if they wanted to devalue by more. Countries made their currencies fully convertible with other currencies, although this convertibility was limited to transactions in the current account only. Capital controls were imposed in order to deter speculation. In Britain this also included stopping people taking more than £50 with them abroad. Members provided contributions to the fund, 25% in gold and 75% in their own currencies, resulting in a total of $8.8 billion to lend countries in balance of payments trouble.

From 1946 until 1971 three problems dogged the fund: adjustment, liquidity and confidence. In 1949 Britain broke the rules, devaluing by more than 10% without permission and France in 1948 when it introduced a dual exchange rate – one for imports and another one for tourists and finance deals. IMF sanctions had little effect. Britain continued to have chronic balance of payments crises on its current account, which led to further devaluations in 1967 by the then Labour government of Harold Wilson. Wilson told the electorate that,‘it does not mean that the pound in your pocket or purse or in your bank has been devalued’. The claim was met with widespread derision and the following election was lost.

When full-convertibility was achieved in 1958, the system, which was planned to be one of adjustable pegs and minor devaluations and revaluations, was essentially a new gold standard because countries would not revalue their currencies upward when they had surpluses and were reluctant to devalue because of the perceived, and actual electoral humiliation that went with it.
Keynes’s plan had envisaged over $20 billion worth in the fund to provide sufficient international liquidity but the actuality was $8.8bn and this was not enough. At the end of the war most of the world’s gold had taken flight and ended up in the USA. The Americans had large balance of payments surplus having exported arms for much of the conflict and the other belligerents had bankrupted each other leaving themselves with huge debts and current account deficits.

A further problem of old also reappeared, the original Gold Standard had suffered because of a lack of supply, world trade increased faster than the gold supply leading to deflationary pressures and a lack of gold was still a problem, only partially solved by the introduction of an international currency called Special Drawing Rights (SDRs or ‘paper gold’), as an international unit of account in 1968.

A lack of confidence in fiat currencies has, as we saw with the first Chinese bank notes, always been a problem. At various times, for example in 1960 when the Democrats were expected to win the election, a lack of confidence in the dollar led to a rise in the price of gold that was only temporarily solved by the creation of a gold pool that bought and sold gold to maintain the dollar’s value. But as the 1960s wore on confidence in the dollar waned just as it had for the pound in the 1920s.

The end of the Bretton Woods system
Whereas at the start of the Bretton Woods System the USA ran a current account surplus, and a lack of liquidity was the problem, by the 1960s the size of their current account surplus was much reduced and too much liquidity in the form of dollars was the issue. The concern with maintaining full employment in America led to increased borrowing and hence increases in the money supply without backing from sufficient gold. Prices inevitably began to rise. Added to this was the Vietnam War, which ratcheted up government spending further, increasing the US current account deficit and the supply of dollars on world currency markets. Because of the declining confidence in the dollar, and the failure of adjustable pegging, countries and speculators began to exchange dollars for gold at the Federal Reserve. In 1971 President Richard Nixon, faced with a balance of payments deficit for the first time and rising domestic inflation, announced that the dollar would no longer be convertible into gold. Although aspects of the system limped on for 19 months the system eventually collapsed completely.

The success and failure of the Gold Standard(s)
From 1880 to 1914 when the Gold Standard was in its first phase of operation, world trade grew and long-term prices remained stable. However not everyone attributes the first period of globalization to the Gold Standard. Keynes thought its operation was merely coincidental with a period of relative peacefulness, improvements in technology and fortuitous discoveries of gold, without which there would have been a serious problem of deflation.

In its second phase from 1925 to 1931 the Gold Standard failed because, Britain was a shadow of its prewar self, blighted by an inability to compete in export markets at the old rate of exchange and unable to provide the international liquidity required and unable to force other countries to play by the rules. Britain’s exit from the scheme in 1931 forced other countries off the standard. The Gold Standard had offered a brief period of exchange rate stability but not before it had transmitted its deflation, unemployment and depression around the world. Its failure ushered in an age of protectionism and capital controls that didn’t fully disappear until the 1980s.
The Bretton Woods system was designed to avoid the problems of the old gold standard by pegging rather than fixing exchange rates. The IMF however lacked the funds and the power necessary to get countries to revalue or devalue appropriately and capital controls took time to dismantle. When capital controls were finally removed in 1958 they only applied to current account transactions and not the financial account. By 1958 the pegged exchange rate system was looking more like the old Gold Standard. When devaluations came they were by significant amounts rather than minor adjustments.

However, 1944 to 1971 has been called the Golden Age of Keynes. Countries did manage to devalue and keep their economies out of recession and at full employment for nearly 30 years. Finally it was America’s need to keep people in work and the effects of the Vietnam War that forced them to abandon convertibility with gold. Before 1914 monetary policy was essentially directed at keeping a fixed exchange rate and low inflation, this prevented it being used for other macroeconomic purposes, chiefly maintaining full employment. Before 1914 limitations on democracy tended to weaken the voices of the working classes, women for example didn’t get the vote until 1917 in the UK and in America 1920. With the advent of more democracy came an importance of achieving full employment. Ultimately the failure of fixed exchange rates has been because of the political necessity to keep people in jobs. Where, I wonder, have you read of that problem recently?

So what are the lessons of the Gold Standard(s)? With a system of fixed exchange rates it seems it is possible to have two but not all three of the following options:

• ability to set interest rates independently – for example to create full employment,
• a fixed exchange rate to promote trade,
• free movement of capital.