The Gold Standard
In the absence of the gold standard, there is no way to protect savings from confiscation through inflation. There is no safe store of value. ~ Alan Greenspan in 1966
Some economists attribute the economic integration achieved in the 19th century to having an international gold standard. The standard appeared to work quite well from 1870 to the 1st World War, when international trade and capital flows increased with relative economic stability. Others cited the central role of Britain, particularly London, which was on the gold standard. The gold standard was instrumental to the perceptions of moneymen, upon whose confidence the values of currencies relied.
For most of history, money had to be backed by some tangible asset base to hold value, as its worth was otherwise inevitably spoiled by its issuer’s cavalier greed. Owing to the innate risk adversity of humans, the chosen backing asset has typically been the one that loses the least value over time.
Various commodities have served as monetary standards through history, including land, cattle, and wheat; but gold and silver have been most often employed. Gold as money began in Asia Minor thousands of years ago.
In medieval England, the “pound sterling” was legally defined as pound weight of sterling silver, but its coins were relative slivers of silver to their stated value. This was stretched into fantasy in the 1790s, when Britain suffered a silver shortage. The government made do with tokens that it had its citizens consider as silver.
During the Napoleonic Wars (1803–1815), England refused to exchange banknotes for whatever metals were in its vaults. By denying convertibility, the country had fiat money, backed only by the authority of its say-so.
After Napoléon suffered his final defeat, England re-coined its empire, with convertibility between the old and new currencies.
After allowing regional banks leeway in issuing small notes in the 1820s, the Bank of England got a monopoly on money in 1833.
The 1844 Bank Charter Act established that Bank of England notes were fully backed by gold, though the pound was still called “sterling.” The amount of gold that the Bank of England held ostensibly determined the country’s money supply.
Gold flowed in and out of the country as a function of the balance of payments. This caused fluctuations in the total money supply, which in turn moved price levels.
When international gold flows were slight, or inflows and outflows balanced, prices tended to be stable. Conversely, large inflows – as happened with the gold strikes in California and Australia in 1849–1851 – caused inflation, inciting sudden withdrawal from banks, which brought on financial panic.
Fluctuating precious-metal supply was a recurrent problem with metallic monetary standards through history; though, as the pace of trade picked up in modern times, contagions came more quickly and were more profoundly felt.
Numerous countries had tinkered with bimetallic standards. The US tried a gold/silver standard in the early 19th century. A fixed exchange rate proved impractical as metal supply gyration jerked the currency around. American banks suspending payment in silver propelled the country’s 1857 bank panic.
Price stability was hard to come by when the supply of standard metals was volatile. The untoward flutter from the gold strikes inspired France in the 1860s and 1870s to try to create, with other countries’ participation, an alternative money standard. After some success, the relative prices of gold and silver reversed from the discovery of new silver deposits. Rather than suffer the inevitable inflation, France and the others in its currency club fled back to a pure gold standard.
Like Britain during the Napoleonic Wars, governments running deficits repeatedly suspended convertibility in the 19th century.
Toward the end of the 19th century, to attain price stability, several silver-standard countries began to peg their currencies to the gold standards of the United Kingdom or United States. The gold standard reached its zenith in 1913 before crumbling with World War 1.
A run on sterling in England early in the war caused the country to impose exchange controls. This fatally weakened the gold standard. While convertibility was still the legal regime, it was honored in the breach.
Financing the war meant printing money. Drastic inflation followed. Price levels doubled in Britain and the US, tripled in France, and quadrupled in Italy.
At the close of the War the practical monetary solidarity of the world had disappeared, and the overprinting of paper money continued. ~ English historian H.G. Wells
The US was an exception in not suspending the gold standard during the Great War. The newly minted Federal Reserve, which was created in reaction to the Panic of 1907, manipulated the currency market to minimize the impact of gold inflows on the money supply, thereby curtailing inflation.
The ostensibly neutral United States fared better than European countries, which were destroying their capital stock via combat. Hence, when the gold standard was restored after WW1, the US turned from being a net debtor country before the war to a net creditor afterwards.
Post-war, Germany was having an antithetical experience to America. Its inflation fared no worse than France during the war, even though Germany had suspended the gold standard and was simply printing money to fund its war effort. This actually had less economic effect than it might have had otherwise, as Germany had much of its industrial power intact after the war.
But Germany, which lost the war, was forced in the Treaty of Versailles to pay crushing reparations that ensured a crippled economy. That guaranteed hyperinflation, which duly happened. By 1923, the German mark was worthless. The distress of the Germans was worse than it had been during the war.
Further insult to national pride included French and Belgian troops occupying Germany’s industrial heartland to extract payment in goods, such as coal. This set the stage for the rise of Hitler, who promised to restore the nation. However disastrous the outcome, in the early 1930s, after suffering over a decade of ineffective political timidity, the German people understandably looked to a strong leader to bring the country off its knees from the depredations of reparations.
By 1927, most countries had returned to the gold standard. But the nascent pre-war stability had been undermined.
Britain had returned to the gold standard in 1925 under Winston Churchill, then chancellor of the exchequer, by redistributing income at the expense of workers’ well-being. General strikes followed. These were strongly opposed by the government.
Rather than risk civil war, the unions backed down. But the episode sowed a bitter legacy of class division which has persisted to the present day.
In spite of Britain’s travails, much of Europe had recovered by the mid-1920s. 1924 to 1929 seemed a time of normality. Yet the foundation of that prosperity was fragile: heavily dependent, especially in Germany, on continuing US investment, which began to flag in the summer of 1928.
This was the beginning of the end of a speculative boom funded by America. US economic growth slowed after the 1st quarter of 1929. By the end of that summer, Europe was economically strained from cessation of American investments abroad.
Slowdown in the US was apparent in the autumn of 1929; though, with stock prices hitting an all-time high, American investors and politicians paid it little heed. Meantime, Britain, Germany, and Italy were already in the throes of a depression.
Any monetary system in a country with fairly unfettered trade offers the prospect of price instability, as its currency is subject to speculation by well-heeled financial pirates. Metal-standard monies are perhaps more prone, as a government has fewer options in response to an attack, other than to suspend convertibility, and so deny the very foundation upon which the currency is supposedly based.
Speculative attacks in Austria, Germany, and Britain in 1931 succeeded. Germany and Austria adopted exchange controls.
Britain was forced off the gold standard, even with determined assistance from America and France. Returning to fiat money allowed the country to use monetary policy to stimulate the economy. Britain’s currency became a bluster of self-confidence.
Australia and New Zealand had already left the gold standard. Canada soon followed.
Just as the gold standard has been credited in some corners as causative to prosperity at the end of the 19th century, it has conversely been damned as ushering in the Great Depression.
Unlike the gold standard before the 1st World War, the return to the standard after the war proved to have destabilizing consequences. This was largely because countries pursued a gold-exchange standard rather than work together toward price stability. The practice of currency exchange (repatriation) had much to do with how well the gold standard worked.
Contrary to other countries, in the wake of the prolonged economic downturn that came to be called the Great Depression, the US upped its adherence to the gold standard during the 1930s.
Following in the footsteps of President Franklin Delano Roosevelt’s (FDR) early 1933 executive order, the US Gold Reserve Act of 1934 nationalized the entire country’s gold supply. Banks had to turn in all their gold. In return, they got government certificates. American citizens continued to be legally barred from owning gold bars, coins, and certificates until 1975.
The Act also authorized devaluation: raising the price of gold. On 31 January 1934, FDR devalued the dollar 40%. This was an attempt to kick start the economy via currency manipulation, and it was not the last such attempt.
To try to stabilize the dollar, the Federal Reserve, with FDR’s approval, sterilized gold inflows worth $1.3 billion between December 1936 and July 1937. This was done to stem a feared potential for financial speculation, where gold inflows might be suddenly reversed. Price controls were also installed.
The resulting decline in the growth of the monetary base sent bond yields up, raised interest rates, and shut down a nascent recovery. The US economy fell into back into recession in 1937–1938.
The 2nd World War was a reprise of the monetary imbalances that had plagued the 1st World War. After the war, the 44 Allied countries set the world monetary order; its leaders convening under the auspices of the United Nations at Bretton Woods, New Hampshire.
So emerged the Bretton Woods system. Each country adopted a monetary policy that tied its currency to the US dollar. The IMF was charged with tiding countries over by bridging temporary imbalances of payments.
The gold standard was nominally kept, though with no domestic convertibility. In essence, the US dollar replaced the British pound as the key currency.
By the late 1960s, the rise of the Japanese, German, and other European economies left America with a continuing balance-of-payments deficit. The government sought a way to stem the loss of gold from its vault. US gold reserves had fallen to $10 billion in 1971, half of what they were in 1960.
The situation was compounded by policies intended to solve the payments problem, but which made little sense when viewed from the perspectives of American foreign policy or macroeconomic efficacy.
In May 1971, Germany left Bretton Woods, as it had tired of propping up the dollar. This move quickly strengthened its economy. The dollar dropped 7.5% against the Deutsche Mark.
Other countries began to demand redemption of their dollars for gold. On 9 August 1971, Switzerland deserted Bretton Woods. An international monetary crisis lay at America’s doorstep.
On 15 August 1971, on his own accord, President Richard Nixon abandoned the Bretton Woods system by terminating dollar convertibility and depreciating the dollar on foreign exchanges. These steps were quickly followed by higher trade tariffs, and wage and price controls to stem inflation.
The price of gold quickly shot up from $35 an ounce to $800. Nixon’s actions resulted in a decade of the worst inflation that the country had ever suffered, along with economic stagnation. The economic malaise was ably assisted by oil price shocks in 1973 and 1978, courtesy of Saudi Arabia.
Since the early 1970s, the international monetary system has been spun purely from fiat money. Currencies are completely a confidence game, turning international comparisons into national interest rates via government bond markets.
The repeated financial crises since fiat money became the world standard, and government moves to ameliorate or preclude such crises, provide ample illustration that fiat money is the antithesis of stability.
The emergence of fiat money typifies its evolution as an abstraction: becoming more a representation of value than an object of value itself. Owing to sovereign debt and the fickleness of financial speculators, who look solely opportunistically to extract profit, currencies have become an exercise in barely controlled chaos – a product of politically spun perception as much as anything. The volatility of cryptocurrencies, such as bitcoin, illustrates how a fiat currency’s value is nothing more than a social consensus which may be rigged. The price of bitcoin was, in fact, manipulated.
The trouble with paper money is that it rewards the minority that can manipulate money and makes fools of the generation that has worked and saved. ~ Adam Smith
Though freed as a monetary base, gold has not lost its allure as a safe haven when currencies look uncertain. The 2008 recession sent gold soaring in price.
Gold reached a record high of $1,895 an ounce on 5 September 2011, at a time of fear that the US government would default on its debt because of a political impasse. After the political shenanigans resolved, gold declined surprisingly swiftly.
Having no yield or earnings, gold is hard to value. Like paper money backed only by a government’s resolve, gold is precious only so long as enough people agree that it is. Money abides as a consensual symbolism.
Though the gold standard has been abandoned, governments still hoard the hoary precious metal. Britain’s governmental gold deposits are on the order of £156 billion ($221.7 billion), while the US retains a measly $11 billion (£7.7 billion).
We invented money and we use it, yet we cannot understand its laws or control its actions. It has a life of its own. ~ American author Lionel Trilling