Gold Standard
By Michael D. Bordo
T he gold standard was a commitment by participating countries
to fix the prices of their domestic currencies in terms of a specified
amount of gold. National money and other forms of money (bank
deposits and notes) were freely converted into gold at the fixed
price. England adopted a de facto gold standard in 1717 after the
master of the mint, Sir Isaac Newton, overvalued the guinea in
terms of silver, and formally adopted the gold standard in 1819. The
United States, though formally on a bimetallic (gold and silver)
standard, switched to gold de facto in 1834 and de jure in 1900
when Congress passed the Gold Standard Act. In 1834, the United
States fixed the price of gold at $20.67 per ounce, where it
remained until 1933. Other major countries joined the gold standard
in the 1870s. The period from 1880 to 1914 is known as the
classical gold standard. During that time, the majority of countries
adhered (in varying degrees) to gold. It was also a period of
unprecedented ECONOMIC GROWTH with relatively FREE TRADE in
goods, labour, and capital.
The gold standard broke down during World War I, as
major belligerents resorted to inflationary finance, and was briefly
reinstated from 1925 to 1931 as the Gold Exchange Standard.
Under this standard, countries could hold gold or dollars or
pounds as reserves, except for the United States and the
United Kingdom, which held reserves only in gold. This version
broke down in 1931 following Britain’s departure from gold in the
face of massive gold and capital outflows. In 1933, President
Franklin D. Roosevelt nationalized gold owned by private
citizens and abrogated contracts in which payment was specified in
gold. Between 1946 and 1971, countries operated under the
Bretton Woods system. Under this further modification of the gold
standard, most countries settled their international balances in U.S.
dollars, but the U.S. government promised to redeem other central
banks’ holdings of dollars for gold at a fixed rate of thirty-five
dollars per ounce. Persistent U.S. balance-of-payments deficits
steadily reduced U.S. gold reserves, however, reducing confidence
in the ability of the United States to redeem its currency in gold.
Finally, on August 15, 1971, President Richard M. Nixon
announced that the United States would no longer redeem
currency for gold. This was the final step in abandoning the gold
standard.
Widespread dissatisfaction with high INFLATION in the late 1970s
and early 1980s brought renewed interest in the gold standard.
Although that interest is not strong today, it seems to strengthen
every time inflation moves much above 5 percent. This makes
sense: whatever other problems there were with the gold standard,
persistent inflation was not one of them. Between 1880 and 1914,
the period when the United States was on the “classical gold
standard,” inflation averaged only 0.1 percent per year.
How the Gold Standard Worked
The gold standard was a domestic standard regulating the
quantity and growth rate of a country’s MONEY SUPPLY. Because
new production of gold would add only a small fraction to the
accumulated stock, and because the authorities guaranteed free
convertibility of gold into non-gold money, the gold standard
ensured that the money supply, and hence the price level, would
not vary much. But periodic surges in the world’s gold stock, such
as the gold discoveries in Australia and California around 1850,
caused price levels to be very unstable in the short run.
The gold standard was also an international standard
determining the value of a country’s currency in terms of other
countries’ currencies. Because adherents to the standard
maintained a fixed price for gold, rates of exchange between
currencies tied to gold were necessarily fixed. For example, the
United States fixed the price of gold at $20.67 per ounce, and
Britain fixed the price at £3 17s. 10½ per ounce. Therefore, the
exchange rate between dollars and pounds—the “par exchange
rate”—necessarily equalled $4.867 per pound.
Because exchange rates were fixed, the gold standard caused
price levels around the world to move together. This movement
occurred mainly through an automatic balance-of-payments
adjustment process called the price-specie-flow mechanism.
Here is how the mechanism worked. Suppose that a
technological INNOVATION brought about faster real economic
growth in the United States. Because the supply of money (gold)
essentially was fixed in the short run, U.S. prices fell. Prices of U.S.
exports then fell relative to the prices of imports. This caused the
British to DEMAND more U.S. exports and Americans to demand
fewer imports. A U.S. balance-of-payments surplus was created,
causing gold (specie) to flow from the United Kingdom to the United
States. The gold inflow increased the U.S. money supply,
reversing the initial fall in prices. In the United Kingdom, the gold
outflow reduced the money supply and, hence, lowered the price
level. The net result was balanced prices among countries.
The fixed exchange rate also caused both monetary
and nonmonetary (real) shocks to be transmitted via flows of gold
and capital between countries. Therefore, a shock in one country
affected the domestic money supply, expenditure, price level, and
real income in another country.
The California gold discovery in 1848 is an example of a
monetary shock. The newly produced gold increased the U.S.
money supply, which then raised domestic expenditures, nominal
income, and, ultimately, the price level. The rise in the domestic
price level made U.S. exports more expensive, causing a deficit in
the U.S. BALANCE OF PAYMENTS. For America’s trading partners, the
same forces necessarily produced a balance-of-trade surplus. The
U.S. trade deficit was financed by a gold (specie) outflow to its
trading partners, reducing the monetary gold stock in the United
States. In the trading partners, the money supply increased, raising
domestic expenditures, nominal incomes, and, ultimately, the price
level. Depending on the relative share of the U.S. monetary gold
stock in the world total, world prices and income rose. Although the
initial effect of the gold discovery was to increase real output
(because wages and prices did not immediately increase),
eventually the full effect was on the price level alone.
For the gold standard to work fully, central banks, where they
existed, were supposed to play by the “rules of the game.” In
other words, they were supposed to raise their discount rates—the
interest rate at which the central bank lends money to member
banks—to speed a gold inflow, and to lower their discount rates to
facilitate a gold outflow. Thus, if a country was running a balance-
of-payments deficit, the rules of the game required it to allow a gold
outflow until the ratio of its price level to that of its principal trading
partners was restored to the par exchange rate.
The exemplar of central bank behaviour was the Bank of
England, which played by the rules over much of the period
between 1870 and 1914. Whenever Great Britain faced a balance-
of-payments deficit and the Bank of England saw its gold reserves
declining, it raised its “bank rate” (discount rate). By causing
other INTEREST RATES in the United Kingdom to rise as well, the rise
in the bank rate was supposed to cause the holdings of inventories
and other INVESTMENT expenditures to decrease. These reductions
would then cause a reduction in overall domestic spending and a
fall in the price level. At the same time, the rise in the bank rate
would stem any short-term capital outflow and attract short-term
funds from abroad.
Most other countries on the gold standard—notably France
and Belgium—did not follow the rules of the game. They never
allowed interest rates to rise enough to decrease the domestic price
level. Also, many countries frequently broke the rules by
“sterilization”—shielding the domestic money supply from external
disequilibrium by buying or selling domestic securities. If, for
example, France’s central bank wished to prevent an inflow of gold
from increasing the nation’s money supply, it would sell securities
for gold, thus reducing the amount of gold circulating.
Yet the central bankers’ breaches of the rules must be put into
perspective. Although exchange rates in principal countries
frequently deviated from par, governments rarely debased their
currencies or otherwise manipulated the gold standard to support
domestic economic activity. Suspension of convertibility in England
(1797-1821, 1914-1925) and the United States (1862-1879) did
occur in wartime emergencies. But, as promised, convertibility at
the original parity was resumed after the emergency passed. These
resumptions fortified the credibility of the gold standard rule.
Performance of the Gold Standard
As mentioned, the great virtue of the gold standard was
that it assured long-term price stability. Compare the
aforementioned average annual inflation rate of 0.1 percent
between 1880 and 1914 with the average of 4.1 percent between
1946 and 2003. (The reason for excluding the period from 1914 to
1946 is that it was neither a period of the classical gold standard
nor a period during which governments understood how to
manage MONETARY POLICY.)
But because economies under the gold standard were so
vulnerable to real and monetary shocks, prices were highly unstable
in the short run. A measure of short-term price instability is the
coefficient of variation—the ratio of the standard deviation of annual
percentage changes in the price level to the average annual
percentage change. The higher the coefficient of variation, the
greater the short-term instability. For the United States between
1879 and 1913, the coefficient was 17.0, which is quite high.
Between 1946 and 1990 it was only 0.88. In the most volatile
decade of the gold standard, 1894-1904, the mean inflation rate
was 0.36 and the standard deviation was 2.1, which gives a
coefficient of variation of 5.8; in the most volatile decade of the
more recent period, 1946-1956, the mean inflation rate was 4.0, the
standard deviation was 5.7, and the coefficient of variation was
1.42.
Moreover, because the gold standard gives government
very little discretion to use monetary policy, economies on the
gold standard are less able to avoid or offset either monetary
or real shocks. Real output, therefore, is more variable under the
gold standard. The coefficient of variation for real output was 3.5
between 1879 and 1913, and only 0.4 between 1946 and 2003. Not
coincidentally, since the government could not have discretion over
monetary policy, UNEMPLOYMENT was higher during the gold
standard years. It averaged 6.8 percent in the United States
between 1879 and 1913, and 5.9 percent between 1946 and 2003.
Finally, any consideration of the pros and cons of the gold standard
must include a large negative: the resource cost of producing
gold. MILTON FRIEDMAN estimated the cost of maintaining a full
gold coin standard for the United States in 1960 to be more
than 2.5 percent of GNP. In 2005, this cost would have been about
$300 billion.
Conclusion
Although the last vestiges of the gold standard disappeared in
1971, its appeal is still strong. Those who oppose giving
discretionary powers to the central bank are attracted by the
simplicity of its basic rule. Others view it as an effective anchor for
the world price level. Still others look back longingly to the fixity of
exchange rates. Despite its appeal, however, many of the
conditions that made the gold standard so successful vanished in
1914. In particular, the importance that governments attach to full
employment means that they are unlikely to make maintaining the
gold standard link and its corollary, long-run price stability, the
primary goal of economic policy.
About the Author: Michael D. Bordo is a professor of economics
at Rutgers University. From 1981 to 1982, he directed the research
staff of the executive director of the U.S. Congressional Gold
Commission.
Further Reading
Bordo, Michael D. “The Classical Gold Standard—Some Lessons for
Today.” Federal Reserve Bank of St. Louis Review 63, no. 5 (1981): 2-17.
Bordo, Michael D. “Financial Crises, Banking Crises, Stock Market
Crashes, and the Money Supply: Some International Evidence, 1870-
1933.” In Forrest Capie and Geoffrey E. Wood, eds., Financial Crises and
the World Banking System. London: Macmillan, 1986.
Bordo, Michael D., and A. J. Schwartz, eds. A Retrospective on the
Classical Gold Standard, 1821-1931. Chicago: University of Chicago Press,
1984. Especially “The Gold Standard and the Bank of England in the Crisis
of 1847,” by R. Dornbusch and J. Frenkel.
Bordo, Michael D., and A. J. Schwartz, eds. “Transmission of Real and
Monetary Disturbances under Fixed and Floating Rates.” Cato Journal 8,
no. 2 (1988): 451-472.
Ford, A. The Gold Standard, 1880-1914: Britain and Argentina. Oxford:
Clarendon Press, 1962.
Officer, L. “The Efficiency of the Dollar-Sterling Gold Standard, 1890-
1908.” Journal of Political Economy 94 (1986): 1038-1073.
