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Gold has been a medium of exchange for a very long time. Although until the late nineteenth century gold had to compete with silver as the preferred standard unit of account in international financial transactions, gold has been used to measure wealth since antiquity. In the sixteenth and seventeenth centuries, following the discovery of rich gold mines in the Americas, the prevailing economic theory, mercantilism, recommended the pursuit of restrictive trade policies designed to discourage the importation of foreign goods and to encourage the exportation of domestic goods so as to increase the stock of precious metals, and of gold in particular, in the treasuries of the most important European kingdoms. But the gold standard refers to a more recent and specific phase in monetary history—a phase that is now past, and probably irrevocably so. Most contemporary economics textbooks pay only scant attention to it (Kimball 2005). A few economists, however, still advocate a return to the practices that defined the gold standard for reasons that are discussed further below.
Under the gold standard, as it began to take shape in the 1870s, currencies were backed by gold exclusively. Within a country, paper money could be redeemed for a guaranteed amount of gold and, internationally, fixed exchange rates determined the quantities of gold that central banks could use to clear international balance of payment accounts. In practice, however, this strict principle allowed for a limited degree of flexibility allowing the central banks of the countries that adhered to the gold standard regime to engage in a variety of manipulations (e.g., convertibility was severely limited in many of the less powerful countries). Great Britain was almost continually on a gold standard from the 1750s until 1913, with the exception of about two decades (1798 to 1821) when the Napoleonic wars and their aftermath forced the Bank of England to issue nonconvertible paper currency. Most of the other powers, however, including the United States, based their currencies on both gold and silver until the 1870s. (In fact, the word for silver in French also means money.) But by the 1870s because the price of silver had become too unstable, most European powers and the United States chose to hold only gold in their bank reserves, and to officially establish the convertibility of their currencies in gold only. By the 1890s a process of gold standardization had occurred: Most countries were by then part of an international financial regime based on a fixed exchange rate for gold.
The transition to the gold standard was not entirely smooth. There were political interests that opposed it. In the United States, for example, farmers in the Midwest continued to support a return to bimetallism for about two decades after the United States (unofficially) adopted the gold standard in 1879, in part because they felt that the rules of the gold standard made it more difficult for them to obtain credit and made them more dependent on what they perceived as the whims of the “eastern banks,” impersonated as the wicked Witch of the East in L. Frank Baum’s fairy tale The Wizard of Oz. In fact, the United States did not legally switch to the gold standard until 1900 (Littlefield 1964).
Before World War I
The pre–World War I gold standard worked very efficiently as a means to maintain price stability. Gold, and to a lesser extent British pounds, flowed between countries to compensate for trade surpluses and deficits. In theory, the system functioned automatically: If the real exchange rate for a given currency was above the nominal exchange rate in gold, exports suffered and imports increased, creating a balance of payments deficit; external creditors asked to be paid in gold and the resulting outflow of gold had the effect of lowering domestic prices, thereby stimulating exports and discouraging imports and eventually bringing down the real exchange rate nearer to, or even below, the nominal rate, and the pendulum swung in the other direction. The monetary authorities were expected to take appropriate measures to facilitate this process: raising the bank rate, which, in turn, led to rising interest rates, in order to decrease investments and reinforce the deflationary effect of an outflow of gold, while at the same time ensuring that the outflow of gold would not continue indefinitely, or lowering it to reinforce the inflationary effects of an inflow of gold, but also thereby preparing the ground for a reduction in that inflow. That these measures often had a deflationary effect was of little concern at a time when governments were not held responsible for unemployment. The effectiveness of the system was reinforced by the fact that investors, often anticipating the measures that monetary authorities were about to adopt, moved their funds from country to country, thereby bringing about the equilibrium that these measures would have reestablished and diminishing at the same time the need for such measures.
Already in the years immediately preceding World War I there were signs of tension in the system. The outbreak of the war led to its collapse. The interwar years were much more troubled as far as the international monetary system is concerned. Although most nations that had suspended convertibility into gold reinstituted it in the 1920s, it never functioned as well as it had before the war and by 1937 it had been abandoned by all countries. (Germany had done so in 1931, Britain in 1933, and the
United States in 1933; France and Japan held on until 1936.) There is no complete agreement on the question of whether the demise of the gold standard was brought about by the Great Depression or whether the gold standard was itself a major cause of the severity of the depression. The latter thesis points to the fact that the United States and France, two countries with trade surpluses, together held more than half of the gold while also pursuing deflationary policies, which led to a contraction of the money supplies in much of the rest of the world that made it impossible to initiate expansionary programs in timely fashion to deal with the onset of the depression (Bordo 1993; Eichengreen 1992). But what is certain is that at the end of World War II, the gold standard was widely regarded as having been a failure.
The Bretton Woods Agreement
The participants in the 1944 conference held in Bretton Woods, New Hampshire, were seeking to establish an international system that would retain the stability and predictability of the pre–World War I gold standard but would not cause the rigidities that many then suspected had significantly contributed to the worsening of the worldwide 1930s depression. The agreement they adopted resulted in a system that was still, at least indirectly, based on gold, although by this time only the U.S. dollar was directly convertible into gold, and only among central banks. However, all signatories to the Bretton Woods Agreement were committed to maintain something approximating fixed rates of exchange in relation to the dollar, but with enough flexibility to allow them to manage their economies so as to produce full employment. Hence dollars rather than gold became the main components of the reserves of most central banks. The heyday of that system from the mid-1950s to the mid-1960s coincided with—and to an extent that is difficult to measure, helped to bring about—a period of exceptional economic growth (especially in western Europe and Japan) and expanding international trade. But it also placed severe constraints on the United States. By 1971 the United States had definitely ceased to guarantee the convertibility of the dollar. Since that date gold has been demonetized, even though the central banks of many countries continue to hold more or less significant stocks of gold. Floating rates are now the rule, with the exception of some countries that have more or less permanently pegged their currencies to a stronger one or others, such as the euro zone, that have established a monetary union.
A return to something like the gold standard has been advocated by some economists, notably those associated with the school of thought known as Austrian economics, so named because it can trace its roots to the writings of prominent Austrian economists such as Carl Menger. Adherents of Austrian economics have very little confidence in the ability of governments and central banks to effectively guide the course of economic events. It is, therefore, the self-regulating nature of the old gold standard that leads them to advocate revisiting this concept. They usually recommend the creation of a system in which the central banks would be forced to “play by the rules,” if necessary by privatizing these banks. Although this would certainly offer strong guarantees against inflation, the need for such a system appears less compelling in the early twenty-first century than it did in the 1970s and 1980s, when inflation was much more of threat than it has been since then. There is very little political support in the world for such a reform.
- Bordo, Michael D. 1993. The Bretton Woods International Monetary System: A Historical Overview. In A Retrospective on the Bretton Woods System, ed. Michael D. Bordo and Barry Eichengreen. Chicago: University of Chicago Press.
- Eichengreen, Barry. 1992. Golden Fetters: The Gold Standard and the Great Depression, 1919–1939. New York: Oxford University Press.
- Kimball, James. 2005. The Gold Standard in Contemporary Economic Principle Textbooks: A Survey. Quarterly Journal of Austrian Economics 8 (3): 59–80.
- Littlefield, Henry M. 1964. The Wizard of Oz: Parable of Populism. American Quarterly 16 (1): 47–58.
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