Gold Standard

By Minh Nguyen, Daniel Lee and Nick Iorio

Overview

The Gold Standard is a monetary system in which the standard economic unit of account is a fixed weight of gold and all currency issuance is regulated by the gold supply. Currencies that are backed by fixed amounts of gold have a constant exchange rate between each other.

Purposes of a gold standard

• To prevent inflationary expansion of the money supply
  
• To maintain a fixed value against which other prices can be measured
  
• To allow wider circulation with greater trust in the stability of money.

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Why Pick Gold As The Standard?

• First known metal. Valuable throughout the ages because of scarcity. High value for its beauty and resistance to corrosion and rust.
  
• As a result, gold had long been used as a form of money and store of wealth by merchants and traders.
  
• Gold would supplant silver as the basic unit of international trade at various times (Islamic Golden Age, peak of Italian trading during the Renaissance, during the 19th century).
  

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Brief History of Gold Standard

• To understand the adoption of the international gold standard in the late 19th century, it is important to follow the events of the late 18th century and early 19th. In the late 18th century, wars and trade with China, which sold many trade goods to Europe but had little use for European goods, drained silver from the economies of Western Europe and the United States. Coins were struck in smaller and smaller amounts, and there was a proliferation of bank and stock notes used as money. In the 1790s England suffered a massive shortage of silver coinage and ceased to mint larger silver coins.
• In 1844 the Bank Charter Act established that Bank of England notes, fully backed by gold, were the legal standard. This 1844 act marked the establishment of a full gold standard for British money.
  
• Other major countries joined the gold standard in the 1870s. The period from 1880 to 1913 is known as the "classical gold standard". During that time the majority of countries adhered to gold. It was also a period of unprecedented economic growth with relatively free trade in goods, labor and capital.
• Dates of adoption of Gold Standard:
  • 1871: Germany
  • 1873: Latin Monetary Union (Belgium, Italy, Switzerland, France)
  • 1873: United States de facto (in practice but not by law)
  • 1875: Scandinavia by monetary Union: Denmark, Norway and Sweden
  • 1875: Netherlands
  • France internally
  • 1876: Spain
  • 1879: Austria
  • 1897: Russia
  • 1897: Japan
  • 1898: India
  • 1900: United States de jure (legally)

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Theory of Gold Standard

• Rest on the idea advocated by economist David Hume, that inflation is caused by an increase in the quantity of money and that uncertainty over the future purchasing power of money lowers business confidence and leads to reduced trade and capital investment. The gold standard would remove this uncertainty (friction between kinds of currency) which would dramatically benefit the economy.
• Advocates of the gold standard often believe that the governments are destructive of economic activity, and that a gold standard, by reducing their ability to intervene in markets, will increase personal liberty and economic vitality.

How the Gold Standard Works

• In simple words, the Gold Standard was a monetary system in which the gold supply was tied to a country's currency. Currency holders were given the ability to freely convert their gold into fiat money, which would assure that the price level, and money supply would not vary much since the supply of gold was generally fixed. They believed that it would not vary much since they thought that the addition of new gold into the economy would only account for a small fraction of the gold supply. Unfortunately they did not account for big monetary shocks such as the California Gold Rush.

• As an international standard, the value of a country's currency was determined in terms of other country's currencies since the price level per unit of account was fixed. This also allowed for exchange rates between currencies and gold to remain fixed. As a result, this would cause price levels around the world to move together. However, this also made countries more vulnerable to (non)monetary shocks, as a shock in one country would affect the domestic money supply, expenditure and real income in another country due to fixed prices.

• Price levels moving together occurs through an automatic balance-of-payments adjustment process called the "price-specie(gold)-flow" mechanism. The way this mechanism worked is that when something, such as a technological innovation, brought about faster real economic growth in the United States, U.S. prices would fall, provided the supply of money (gold) was essentially fixed in the short run. (Supply side shifts right) Prices of U.S. exports then fall relative to the prices of imports. This causes foreign countries to demand more U.S. exports and Americans to demand fewer imports. A U.S. balance-of-payments surplus is created, causing gold to flow from another country into the United States. This gold inflow increases the U.S. money supply (gold), reversing the initial fall in prices. In the other countries, the gold outflow reduces the money supply (gold) and, hence, lowers the price level. The net result is a balance in prices among countries; essentially a global equilibrium.

• For the gold standard to be effective, central banks, were supposed to follow a certain set of rules. When the supply of gold was low, due to a slow inflow from foreign countries, these central banks were suppose to raise their discount rates in order to cause a decrease in investment expenditures which would then cause a reduction in overall domestic spending and finally, a fall in the price level. As a result, gold inflow increased from foreign buyers. When the supply of gold was high, banks were required to lower their discount rates to facilitate a higher gold outflow as more investment would occur resulting in a higher price level and an overall lower net export.

Performance of Gold Standard

• What a central bank was suppose to do during the Gold Standard, was properly executed by the Bank of England. This bank "played" by the rules over much of the period between 1870 and 1914. Whenever Britain faced a balance-of-payments deficit and the Bank of England saw its gold reserves declining, it raised its 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 investment expenditures to decrease. This would then cause a reduction in overall domestic consumption and eventually a fall in the price level. In practice, this would slow down the outflow of gold, and increase the inflow instead.

• Most other countries on the gold standard on the other hand, 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 its money supply, it would sell securities for gold, thus reducing the amount of gold circulating.

• Gold standard during a monetary shock caused price levels to be very unstable the during short run: The California gold discovery in 1848. The discovery of a large amount of gold leads to an increase in the U.S. money supply. This had an effect which raised domestic expenditures, nominal income, and in the end, a higher price level. This change in the price level caused U.S. exports to look expensive to foreign markets and eventually caused a deficit in the balance of payments, as more gold outflowed than inflowed.

• Global markets respond to this change by increasing their money supply, increasing their domestic expenditures, nominal incomes, and eventually their own price levels too. Value of money is slow to adapt to changing economic times. Wages, often locked through contracts, or the distaste to change them by employers. Either or, it takes too long for them to change in relation to the market, which causes unemployment.

• Countries that held to gold standard through 1933 (like the US) or 1936 (like France) suffered the worst from the Great Depression. Commitment to the gold standard prevented Federal Reserve from expanding the money supply to stimulate domestic spending as panic from a recessionary economy forces people to withdraw gold from the money supply in an effort to save. Instead of recovering from a recession, the gold standard became a factor in helping to cause a depression.

• As can be seen from the history of the gold standard, it did not fair well in general as many banks failed to follow the rules necessary for the gold standard to be effective. That, coupled with the effect of monetary shocks, and the handicap that the gold standard placed on government monetary policies, further worsened economic recessions. It should also be important to note that before World War II, eight recessions have worsened into depressions under the gold standard, however post-World War II, the U.S. economy has undergone 9 recessionary periods in which economic recovery has always been successful due to keynesian policy. Quite commonly the most notorious effect of the gold standard was that of the Great Depression which will be discussed in detail in the following section.

The Gold Standard and the Great Depression

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• Uncertainty in the market beginning in the late 1920's caused demand for gold to increase.
• Increased demand forced prices for gold to go up, but the dollar was unable to adjust to the increased price for gold. The dollar had to remain at a set price.
• The U.S. experienced a strong run on the dollar between September and October of 1931 when the British Pound failed. The failure of the pound caused alarm and brought people to banks seeking to ensure their assets in gold.
• In response to the increased demand on gold the U.S. raised interest rates to try and increase the value of the dollar. This pushed the market into a deflationary gap. Further attempts to solve the monetary crisis had a conctractionary effect on the economy.
• When raising the interest rates on money the Federal Reserve did not account for the fact that by increasing interest rates they were actually forcing the market further into a deflationary gap and forcing prices down. The exact opposite of what they wanted to do.
• By raising interest rates, the Federal Reserve was acting as if the U.S. economy was in an inflationary gap when in fact it had been in a deflationary gap due to reduced prices and a decreased agregate demand.
• The pattern of conctractionary fiscal policy in order to prevent runs on national currency was followed by several nations during the late 1920's and early 1930's. These policies caused a world wide decline of 15% in output during this period for countries who remained on the gold standard.
• One reason that the Great Depression affected the whole world was due to the fact that smaller economies on the Gold Standard had to follow what larger economies were doing. If the U.S. raised interest rates, but investors wanted gold to back up their dollars they could convert their currency for foreign currency and demand payment in gold. This potential force economies to all follow contractionary policies; even if the policy was not good for the national economy. The general pattern that occurred during the depression was an increase in interest rates decreased output and prices.
• Countries that removed themselves off of the gold standard generally noticed an increase in output and a stabilization of national currency.
• Stabilization occurred because countries currencies could float on the market. This made adjustment to economic conditions much easier and allowed for expansionary as well as contractionary fiscal policy.

Bretton Woods Conference

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• Held by the allies to determine the economic structure of the world after World War II
• Economic policies developed as a result of the conference led to an era known as the "30 Glorious Years"
• Put U.S. back on Gold Standard after it had come off of it in 1933.
• Three general principles learned from the Great Depression affected the conference attendees:

 *Need an iron clad backer to support Gold Standard
 *Need a system that allows for periodic exchange rate adjustments
 *Need more than a central bank.  International institutions necessary to support world economy

• These lessons led to the creation of the International Monetary Fund and World Bank and placing the U.S. as the leader of the new economic order.
• High in inflation during the 1960's was accepted by the U.S. in order to keep the alive the flexibility in the international monetary system.
• Richard Nixon finally took the U.S. off the Gold Standard because of the inability of the U.S. to further accept policies that were in fact hurting U.S. economic growth. The U.S. dollar was allowed to float.
• It was finally realized when the U.S. went off the Gold Standard that countries generally do better if they can manage their own fiscal policy instead of having to react to other countries' policies in order to protect their economies.

Pros and Cons of Gold Standard

Pro's

• Major benefit of the gold standard was that it assured long-term price stability and consequently, a low level of inflation.
• The gold standard prevents a country from printing too much money which is a source of inflation.
• If all countries are on a gold standard, there is then only one real currency, gold, from which all others derive their value; giving some sort of stability in the foreign exchange market, provided monetary/nonmonetary shocks are absent.

Con's

• Based on historical events, it can be seen that the gold standard restricts countries from having their exchange rates respond to changing circumstances in countries.
• Severely limits the stabilization (monetary) policies that the Fed can use. Thus countries with gold standard tend to have severe economic shocks as they are less able to avoid or offset either monetary or real shocks.
• Economies under the gold standard were highly vulnerable to real and monetary shocks,so prices were highly unstable in the short run.
• The resource cost of producing gold is high. 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 1990 this cost would have been measured at $137 billion.
• Causes unemployment due to price stickiness (on the downward direction/higher outflow) if there is a surge in the outflow of gold because employers face higher costs in relation to slow changing wages.

Works Cited

• "Gold_Standard" Wikipedia: The Free Encyclopedia. November 7 2006

<http://en.wikipedia.org/wiki/Gold_standard >

• Bordo, Michael D. "Gold Standard". The Library of Economics and Liberty. November 7 2006

<http://www.econlib.org/library/Enc/GoldStandard.html >

• DeLong, Brad. "Why Not The Gold Standard". November 7 2006
  <http://econ161.berkeley.edu/Politics/whynotthegoldstandard.html >
• DeLong, Brad. "Jim Hamilton on the Gold Standard and the Great Depression". December 13 2005. Delong's Semi-Daily Journal. November 23 2006

<http://delong.typepad.com/sdj/2005/12/jim_hamilton_on.html >

• Hamilton, James. "Gold Standard and the Great Depression". December 12 2005. Econbrowser. November 23 2006 <http://www.econbrowser.com/archives/2005/12/the_gold_standa.html >
• "Speech by Governor Ben S. Bernanke: Money, Gold and the Great Depression". FRB. November 26 2006

<http://www.federalreserve.gov/boarddocs/speeches/2004/200403022/default.htm >

• "Nixon Tries Price Controls". PBS online. November 26 2006

<http://www.pbs.org/wgbh/commandingheights/shared/minitextlo/ess_nixongold.html >

• Kangas, Steve. "Myth: The gold standard is a better monetary system". THE LONG FAQ ON LIBERALISM. November 27 2006

<http://www.huppi.com/kangaroo/L-gold.htm >

• Moffat, Mike. "What was the Gold Standard". About: Economics. November 27 2006

<http://economics.about.com/cs/money/a/gold_standard_2.htm >