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Gold has played a crucial role in the international monetary system since the ancient era. Since their introduction, gold coins have been used as money in many countries, circulating long before the introduction of paper currency.
Even after the introduction of paper currencies, monetary systems continued to maintain an explicit link to gold, with the paper used in exchange for the physical precious metal on demand.
And by the later part of the 19th Century, the world's major currencies were already fixed to the precious metal at a specified price per ounce, under what was known as the Gold Standard, which persisted in various forms for about a hundred years.
- 1 The Classical Gold Standard
- 2 The Gold Standard Period
- 3 Decline of the Standard
- 4 The Breakdown
- 5 The Bretton Woods System
- 6 Will It Become Money Again?
The Classical Gold Standard
Nearly all countries fixed their currency's values using a specified amount of gold – or at least linked it to that of a country that was doing so. No restrictions whatsoever were placed on the import and export of the precious metal as domestic currencies could freely be converted into gold at the set price.
Gold coins alongside coins of other specified other metals (like silver) and notes freely circulated, with varying composition depending on the country. Even exchange rates between participating currencies of the world were fixed.
Under this standard, central banks had two (2) main overriding monetary policy functions:
- Maintain fiat currency convertibility into gold at a specified price and defend the exchange rate
- Accelerate the adjustment process to an imbalance in the balance of payments, but this was mostly violated
This standard existed from the 1870s to the outbreak of World War I in 1914. In the early 19th century after the Napoleonic Wars, turbulence had subsided, either specie (silver, gold, or copper coins) or specie-backed bank issue notes was regarded as money.
But originally only the United Kingdom and some of its selected colonies used a Gold Standard. Portugal joined in 1854. Other countries were mostly on a silver or a bi-metallic standard.
How It Worked
The money supply of a country was linked to gold, but the necessity of its ability to convert fiat money into gold based on demand restricted the amount of fiat money in general circulation to a multiple of the reserves of the central bank.
International monetary system on this Standard was mostly self-correcting when it came to international settlement in gold with countries running a balance of payments deficit experiencing an outflow, declined price level, reduced money supply, increased competitiveness, and a correction generally in the balance of payments deficit.
On the other hand, the reverse was also true for a country with a balance of payments surplus. This was known as price-specie flow mechanism as set out by an 18th century economist and philosopher David Hume.
The Rules Of The Game
The phrase “rules of the game” is attributed to Keynes. While there were no rules explicitly set out in the classical Standard, central banks and governments were implicitly expected to conduct themselves in a certain manner. In a crisis such as a war, the Standard would temporarily be suspended and restored at the same parity afterwards.
While there were minor violations of the rules, the credibility of this system was not compromised provided such violations were limited, with minor deviations from the official parity, and any suspension was strictly temporary and for a clear purpose.
The degree of cooperation between various central banks also helped in maintaining the standard. For instance, the US Treasury (1893), the Bank of England (1890 and 1906-7 Baring crisis), and the German Reichsbank (1898) were all helped by other central banks.
The Gold Standard Period
This is from the mid-17th century, including the period the British Government made a decision to allow the exchange to occur freely, and the presentation of documents, basically from the UK, in relation to the establishment of gold coinage which was the core of the British financial system.
Heyday of the Standard (1820-1930)
The period from when the UK gold standard was established in the early 19th century to its re-establishment after World War I. It deals with three themes:
- the legal position of gold pertaining to the currency systems of the great western nations;
- international agreements pertaining to gold; and
- political debates on the role of gold.
It also covers European monetary arrangements.
After The Standard (1931 – 1999)
It covers from the post World War I Standard in the 1930s to the Central Banks' Gold Agreement/Washington Agreement on Gold in 1999. There are four themes addressed in the documents:
- the collapse of the set standard;
- the international gold market;
- legislation, mostly from the US, affecting gold; and
- international agreements pertaining to gold.
Decline of the Standard
Its Perceived Merits And Demerits
After the Napoleonic Wars in the 19th century, societies turned to precious metals (gold and silver) or bi-metallic standards, and later to the international Standard to curb the potential for runaway inflation in general.
Throughout history, especially in the 18th century, when money was loosely tied to precious metals, governments and central governments, in several cases, found themselves printing too much currency, often increasing money supply, thereby, devaluing the currency.
But tying paper currency enabled society to link its central bank's ability to print money to the actual amount of gold it had in its possession – creating confidence in the currency as citizens could trade their paper currency in exchange for gold. This created price stability – a prerequisite for greater economic activity.
- Confidence in stable exchange rates facilitated massive flows of direct investment, opening up the emerging markets of that era.
- World trade expanded and several countries profited from the rapid growth and low stability.
- The Standard did not permit policymakers to stimulate the economy via a monetary stimulus – the core of modern-day Keynesian economics.
- Tying the currency of a nation to gold meant tying money supply to the world stock of monetary gold, in which growth varies with the pace of another new mine supply. This meant that large discoveries could create a monetary stimulus, which could be unnecessary at the time.
- On the other hand, if the gold output was low during a certain period, the monetary base expansion was limited, restraining economic growth.
This took place at the beginning of World War II, as countries turned to inflationary policies in order to finance the war and reconstruction efforts.
Practically, only the U.S. maintained the standard as the war went on. The Standard's reputation created a widespread desire to get back to gold afterwards, but differing inflationary experiences – both during and after the war, such as the German hyperinflation (1922-4) – only meant that an immediate return to pre-war parities was not feasible.
Additionally, there was concern over whether sufficient gold would be available to underpin the standard, especially in the absence of some of the major new mining discoveries from the later part of the 1890's.
These concerns began in early 20th century. However, the solution was to permit a “Gold Exchange Standard” to emerge, for central banks to acquire a larger part of the stock, thereby reducing gold coins in domestic circulation, and begin holding cumulative amounts of their reserves in foreign currency assets, in dollars or sterling.
Based on this, most countries, except China and the Soviet Union, managed to return to the standard in the 1920's.
Many countries, however, did not return at the right price/exchange rate.
The United Kingdom, for instance, returned at its own pre-war rate, but any decline in UK competitiveness only meant that sterling became heavily overvalued. On the other hand, France, having experienced inflation rates higher than the UK, came back at a different post-war parity, scooping an undervalued exchange rate. The U.S., having experienced lower inflation rates than most other countries, retained its parity, which also led to an effective undervalued exchange rate.
In addition, this resulted in massive balance of payments imbalances, an unfortunate situation exacerbated by unwillingness by the central banks to cooperate and abide by the rules of the game.
The enormous outflows experienced by deficit countries, especially the UK, undermined confidence in convertibility – a necessity for the function of the Standard. The result was a run on sterling, ultimately removing the UK from the Standard in 1931.
The Great Depression caused widespread deflation and unemployment, and other countries, wishing to seek inflationary policies and consequently devalue their currency in an effort to promote competitiveness, gradually followed suit.
The Bretton Woods System
During World War II, it was quite clear that a new international system would then replace the Standard as soon as the war ended, and its design was outlined at the Bretton Woods Conference in the United States in 1944.
U.S. economic and political dominance necessitated the dollar to be at the center of the system. Following the chaos experienced during the inter-war period, there was a burning desire for stability, as exchanged rates were viewed as trade essentials. There was also a desire for more flexibility than the conventional Standard could provide.
The system resolved to fix the dollar at US$35 per ounce (the existing parity at the time), while other currencies had fixed adjustable exchange rates to the dollar. But unlike the traditional Standard, the system allowed capital controls to enable governments to stimulate their economies (when the need arose), without financial market penalties.
The world economy was growing rapidly in the Bretton Woods era. Keynesian economic policies allowed governments to lessen economic fluctuations. Additionally, recessions were minor, but strains began emerging in the 1960's. Persistent but low level global inflation led to very low gold price in real terms.
In addition, the persistent US trade deficit practically drained US reserves. However, some considerable resistance influenced the idea of devaluing the US dollar, as this would have required surplus countries to agree to increase their exchange rates against the dollar to bring about the necessary adjustment.
In the meantime, the pace of economic growth showed the inadequate level of international reserves and the invention of Special Drawing Rights (SDR) did not solve this problem. Even though capital controls remained, they grew considerably weaker by the late 1960's than in the beginning of 1950's, thus raising capital flight prospects from, or even speculation against, currencies perceived as weak.
The formation of the London Gold Pool took place in 1961, which saw 8 nations pooling their reserves to strongly defend the US$35 per ounce anchor, and hinder the price of gold from moving upwards – a concept that worked for a while before strains started showing up.
In March 1968, an inherently fragile two-tier market was quickly introduced with an ideal freely floating private market and even official transactions at the specified parity. Both the US deficit problem and speculations against the dollar intensified – causing other central banks to become increasingly reluctant to accept US dollars in settlement. This resulted in an untenable situation.
Ultimately, in August 1971, an announcement by President Nixon stated the US intention to end on-demand convertibility of the US dollar for other nations' central banks. The Bretton Woods system eventually collapsed as gold continued to trade freely in global markets.
Will It Become Money Again?
The return to the classical Gold Standard would encounter many hurdles, underpinned by serious concerns over expansive monetary policies of central banks, inflation, as well as the price at which countries would return to the system. This does not appear feasible. Furthermore, concerns over the value of fiat currencies would cause households to redeem fiat currencies, potentially depleting gold reserves of central banks.
On the other hand, if countries returned at a higher price, it would create wealth distribution hurdles for countries holding or producing gold, and even those that do not. In addition, it would require the world's major trading economies to sign agreements and participate actively, but attempts to arrive at international agreement on global economic changes have been futile in the past, except for Bretton Woods.
Gold, now as it always did, plays a new key role on the international monetary system. And the analysis of this role is now a subject of great debate globally.