The Economics of Gold: The Gold Standard
Many economists and nearly all politicians recoil at the mere mention of a return to the gold standard. This is often due to either a misunderstanding of a gold standard or a general dislike of sound money.
Throughout history, gold and silver have been used as either money itself, or as the yardstick for a national currency. The characteristics of gold (durability, scarcity, distinctiveness etc.) mean it is not easy to counterfeit. But that’s not to say people haven't tried.
The Byzantine empire flourished for centuries until the dilution of the coinage, by reducing the gold content, brought international financial chaos and an end to the “one reliable medium of exchange” the world had.
The Basics of a Gold Standard
To many people the idea of carrying gold coins in their pockets or a wallet or purse etc., would be ridiculous. A simpler solution would be to have a certificate or receipt that could be transferred or exchanged on demand for a specified amount of gold. This is, how many banks, and “gold warehouses” would operate.
Despite being a well-known critic of the gold standard, Milton Friedman actually gave one of the most concise descriptions of a gold standard. Friedman said
"A real, honest-to-God gold standard has many advantages. If such a standard could exist, it would be one in which gold was literally money, and money literally gold, under which transactions would literally be made in terms either of the yellow metal itself, or of pieces of paper that were 100 per cent warehouse certificates for gold."
Under this kind of system, Friedman explained, irresponsible monetary policy would be curtailed by the discipline of the gold standard. The kind of gold standard that countries have operated under have been much different.
A concept often used in economic circles is Gresham’s Law, named after English financier Sir Thomas Gresham (1519-1579). The law, implies simply that “good money drives out bad money”, is perhaps more accurately described “artificially overvalued money tends to drive an artificially undervalued money out of circulation”. This can be explained when looking at the differences between the nominal or face value of a gold coin when compared with its intrinsic metal value. For example, a gold sovereign is considered to have a nominal value of £1 sterling. It’s intrinsic value, or the value of its metal content is around £340. It would be inconceivable that someone would pay £5 for a pint of beer with 5 gold sovereigns. That would be around £1,700!! Instead, they will most likely hold on to them, removing them from circulation; and instead use a piece of paper that says “I promise to pay the bearer on demand the sum of five pounds”. The sovereign, is therefore undervalued by its £1 denomination, whereas the £5 banknote is now overvalued.
The 100% Gold Standard
The gold standard which Friedman spoke of earlier would be the 100% gold standard, where money is gold and gold is money. The free-flowing movement of gold coins or 100% gold-backed banknotes would be the purest form of a gold standard and is argued for by many free market advocates.
The Classical Gold Standard
The system which most people would be familiar with would be the standard used in the period from 1821-1914, which is often referred to as the “classical” gold standard. The main characteristics were:
- The monetary unit being defined as a weight of gold.
- Bank notes were redeemable in gold on demand
- Gold coins and bank notes are both in circulation
Between 1834-1933, the US dollar was legally defined as 1/20th of an ounce of gold or $20 per ounce. Likewise, ¼ ounce of gold was known as £1.
There is an important distinction to make. This is not to say that 1/20th of an ounce of gold was worth one dollar or ¼ ounce was worth £1. The dollar and pound were used to define a specific weight of gold, just like one yard is defined as 0.9144 metres or 1 fluid ounce is equal to 29.57 millilitres.
Understanding this distinction between the different currencies’ relationships with gold means that they are not as different as we would sometimes believe. All were defined as a specified gold weight, so currencies too could be exchanged with the understanding that any of them would be redeemable at face value.
The money supply, whether gold or claims to gold, is therefore more-or-less constant depending on inflows of new gold. As this supply is “fixed”, prices tend to lower over the long term as technological advances improve the production process and lower costs.
The Destruction of The Gold Standard
Throughout the period from the adoption of the gold standard, its stability was on occasion undermined due to banking crises which were often caused by increasing paper claims (bank notes) to gold over the amount of physical gold. This led to a number of boom-and-bust cycles which would reappear frequently up until the present day.
The outbreak of World War I led to a financial quandary for many European governments. Financing a war is often expensive. It is even more cumbersome when issued bank notes are redeemable in gold. So, governments had to inflate their paper currencies but renege on pledges to gold by coming off the gold standard. Britain also persuaded its citizenry to purchase war bonds with their gold sovereigns. This “patriotic” act, led to the end of widespread circulation of sovereigns in the economy.
The continual printing of paper banknotes led to inflationary chaos within a number of countries, with the most notorious example being the hyperinflation in the Weimar Republic which peaked in 1923. Countries began to re-institute the gold standard in an attempt to stabilise their currency and restore public confidence. The new gold standard, however would be different to the one that was abandoned at the start of WWI.
The New Gold Standard & The Great Depression
In the UK, pounds were now only redeemable in large gold bars rather than in the coins that were in everyday use leading up to the war. These were only used for large, often international, financial transactions and were often way out of reach for the average person.
The US dollar, however was still redeemable in gold, so many European countries, rather than holding gold, held dollars or other gold-convertible currencies which were at least in some respects, “as good as gold”. This was known as a gold exchange standard.
The decision to return the UK to a gold standard, by then Chancellor of the Exchequer Winston Churchill, was not a bad idea, but its implementation involved the foolish attempt to return to its pre-war parity. This parity, did not take into account the 10-20 percent inflation during the post-war period, meaning the pound was now essentially overvalued.The end result of this was gold began to flow out of the country. Instead of returning to a more sensible parity, or contracting credit, the British government not only inflated further to offset the gold loss, but also asked the US to do the same; the reason being that Britain would no longer lose gold if the US also inflated their currency.
The effects of Churchill's return to the pre-war parity gold standard came as no surprise. John Maynard Keynes whose opinons on the gold standard had changed over time, wrote in 1925:
"If Mr. Churchill had restored gold by fixing the parity lower than the pre-war figure, or if he had waited until our money values were adjusted to the pre-war parity, then these particular arguments would have no force. But in doing what he did in the actual circumstances of last spring, he was just asking for trouble. For he was committing himself to force down money wages and all money values, without any idea how it was to be done. Why did he do such a silly thing?"
The credit-driven surge in stock prices was well underway. In the last 6 months of 1927, stocks rose by 20%, which the Fed tried to curb by reversing its inflationary policies. The reduction in deposits (current accounts) and shifts to time deposits (longer-term deposits), only delayed the inevitable, and the stock market crashed on the 24th October 1929.
The Great Depression
Inflationist policies only increased during the financial collapse as governments attempted to dig themselves out of a hole, by digging further. Bank runs developed in the US and Europe as depositors and creditors began to withdraw their balances. On July 14th 1931 all banks in Berlin were closed by a government decree and the knock-on effect soon hit London.
Throughout this period and long after, gold and the gold standard became the supposed cause of the financial crisis. As Lionel Robbins explained the common sentiment:
"...the experience of these years shows the Gold Standard as such to be a generator of instability. It was on the Gold Standard that the American boom was generated, it is urged. It was adherence to the Gold Standard which was responsible for the economic difficulties of Great Britain. It was the Gold Standard which engendered this great mass of floating balances which eventually brought the whole structure to disaster. Experience is conclusive against the Gold Standard".
The Bretton Woods Agreement
Following the disastrous policies of the 1930s and a second World War, much of the world’s economy struggled. Surprisingly, the laisse-faire approach adopted by new Chancellor Konrad Adenaur and Economics Minister Ludwig Erhard helped to rejuvenate the German economy which became known as the Wirtschaftswunder or the “economic miracle”. Meanwhile, the US would adopt the post-war aim of restoring a stable international monetary system. The new standard would be similar in many respects to the gold exchange standard used previously except the dollar would now be the only key currency, valued at 1/35th of an ounce. Also, dollars would now only be redeemable in gold to foreign governments and central banks. (This follows US Executive Order 6102 enacted by FDR to restrict private US gold holdings).
The Bretton Woods Agreement, named after the area in New Hampshire where it was established, involved foreign nations “pegging” their currencies to the dollar, which would still be pegged to gold. Foreign countries would then hold dollar reserves, while the US would hold gold reserves, partly due to America’s post-war gold stock of around $25 billion. Many of these currencies, however, were greatly overvalued after 1945, so the undervalued dollar became more scare which led to a world dollar shortage, which would ultimately lead to even more inflation.
Throughout the 50s and 60s, Western European countries and Japan grew tired of the pile-up of dollars which were now becoming more and more overvalued. The only realistic option was to redeem their gold at $35 per ounce, which over a course of 20 years, reduced the US gold stock to less than half of its original holding and by 1968, the system began to quickly unravel.
The gold price which the US committed to keep at $35 was much higher in the free gold market. Despite new attempts to ignore the market, and the mainstream belief that the gold price would reduce to as low as $10 an ounce, it grew, and by 1973 was around $125 per ounce.
Bretton Woods was brought to an end when Richard Nixon reneged on the promise to redeem gold for US dollars, ending the agreement and removing any link whatsoever with gold.
After Bretton Woods
Once Bretton Woods finally collapsed, ther were further attempts to establish an international monetary system, but this time, with no gold connection whatsoever.
The Smithsonian Agreement was a pledge to maintain fixed exchange rates among the world’s currencies. With many currencies already undervalued against the dollar, the excess of Europe’s dollar reserves along with the dollar devaluation, the free-market gold price was driven to $215 and ounce. The Smithsonian Agreement collapsed in February 1973, a little over a year after it was implemented.
Since then, a system of fluctuating exchange rates has flipped the idea of currencies on its head. Where the dollar, pound and franc, were defined weights of gold; the current use of separating terms, has seemingly emerged from the adoption of a paper or fiat currency.
We will have more articles on The Economics of Gold coming soon.