Did the Gold Standard Deserve its Three Deaths?

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Since 1971, when President Nixon announced that the United States would be terminating the convertibility of the US dollar into a fixed sum of gold, most currencies have become fiat, not being backed by any commodity. Today, currencies are supported solely by confidence. The US dollar appreciates when people think that the US economy is doing well, and vice versa. As a result, currencies have become more volatile, with extreme economic fluctuation occurring in places such as Southeast Asia in the late 1990s and Zimbabwe in the early 2000s. These events lead to complete financial failure and years of reversal in economic activity. Advocates of the gold standard point to these examples to support their arguments. Indeed, with such a catastrophic aftermath, the gold standard may seem rather compelling, raising the question of why America decided to end it. But Nixon was not the first person to decide that the gold standard was too cumbersome; other countries abandoned it following both the First World War and the Great Depression. Whether they were right to do so can only be answered by analysing the history of the standard.

The United Kingdom was the first country to introduce the gold standard, although not by choice. In 1717, Sir Isaac Newton, master of the Royal Mint, overvalued gold by 15.2 times its weight in silver. Silver, which had previously been the predominant medium of exchange, thus became far less desirable. Moreover, silver was in short supply in comparison to gold; in the 18th century, Brazil experienced a gold rush, supplying large amounts to Britain, while China imported large quantities of silver. Gold was preferred over silver for transactions.

However, throughout the 18th and 19th centuries, paper money became more widely accepted as a substitute, since physically carrying gold was inconvenient. In 1844, the Peeling Act institutionalised the gold standard, mandating the Bank of England to set prices for gold but also to maintain a certain ratio of gold reserves to banknotes issued. In 1849 and 1851, the Gold Rushes in Canada and Australia drastically increased its international supply. Now, countries which had previously not embraced the gold standard had enough of it to use as reserves for banking. At the same time, Britain was introducing the standard to many of its colonies, and being the largest economic power, this put pressure on other countries to introduce it. A combination of these factors led to the internationalisation of the gold standard, and by 1873, many major economies, including the German Empire and the United States, had adopted the system.

Despite various successes in expanding the supply of money and boosting international trade, the gold standard was largely suspended during the First World War. With governments needing to boost spending both militarily and domestically, more money was required and quickly. Many countries, with the exception of America, decided to suspend the gold standard to be able to print money without the backing of gold. However, this decision led to inflationary pressures in all the major participants of the war; prices in Britain doubled over the war, and tripled in France.

Germany suffered in the 1920s due to the lack of the gold standard. War reparations had cost it much of its reserves, and the German central bank attempted to issue unbacked marks to buy foreign currency for reparations. However, this backfired, leading to the mark dropping in value to one trillion marks per US Dollar. Meanwhile, the US relied on selling bonds to finance its war effort. This limited inflation to a certain extent, as it absorbed the excess of money within the domestic economy. As the war progressed, the US became increasingly attractive for foreign investment, which further helped them finance the war, and created a surplus of capital inflows. The US, over the war, transformed from a net debtor to a net creditor, since it began holding a lot more foreign debt. This creditor status helped cement the US position in the global economy.

In 1925, Churchill, as Chancellor of the Exchequer, returned Britain to the gold standard, setting exchange rates at pre-war parity, with the belief that it was important to maintain the British pound as a high value currency capable of being the global reserve  to restore confidence in the economy. However, this move proved a failure. First, the overvalued exchange rate made British exports less competitive on international markets, growing the trade deficit. Second, the gold standard prevented governments from pursuing large scale intervention; in order to maintain the fixed values, governments had to carefully regulate their spending. This became apparent directly after the war: the gold standard brought with it a period of deflation because it limited the money supply, leading to unemployment and declining wages, which governments were helpless to prevent. By itself, this already harmed the living standards of millions across the world.

However, the longest-lasting impact it had occurred during the Great Depression. Consumers cut expenditure by 10% in 1930, and ‘bank runs’ (mass withdrawals) were internationally rampant as people lost confidence in financial systems. People withdrew gold, contracting the supply of money, which worsened the depth of the depression. Moreover, since the gold standard linked economies internationally, economic shockwaves spread quickly worldwide. As central banks and governments were constrained by the standard, they couldn’t implement policies to soften the economic blows. Many countries therefore rapidly dropped their gold standards, but major countries such as Britain and the US were adamant to maintain tradition and were slow to transition. This was to their detriment; the British pound suffered multiple ‘speculative attacks’ as many people sold the pound simultaneously, depleting the reserve of gold. As a result, in 1931, the Bank of England announced a “temporary” moratorium on the gold standard. Positive economic effects immediately followed, which bolstered support for abolishing the gold standard. For five years after departing the gold standard, Britain’s per capita income was the highest in the world. The U.S. only abolished the gold standard in March 1933 after they had suffered prolonged economic downturn which required radical action to reverse.

Even though governments worldwide saw the flaws of the gold standard, it nevertheless returned in 1944, when preparations for a new international system were finalised at the UN Monetary and Financial Conference in Bretton Woods, New Hampshire. After 730 delegates from all 44 Allied nations deliberated for three weeks in the summer, the Bretton Woods agreement was born. Important institutions were set up that last to this day, including the International Monetary Fund (IMF) and the World Bank. The US, having recovered from the Great Depression, and untouched by the devastation ravaging Europe and Asia, was by this point the world’s dominant economic power. It was therefore able to set its own terms, dictating that international finance would run on gold and the US dollar. Learning from past mistakes, the American government gave the gold standard a new structure – the dollar would be convertible to gold at an official rate of $35 an ounce by central banks only, and other world currencies would have fixed exchange rates against the dollar, meaning they did not depend on gold reserves for their money supply.

 Nonetheless, post-war Europe still suffered a dollar shortage, meaning that even though they wanted to receive exports, they could not get them. The US was running a large surplus of trade, and its reserves continued growing, absorbing more dollars. The only way to help Europe out of its conundrum was to reverse this flow of money. But American politicians refused to import from other countries; the US was the most technologically advanced country after the war, and American consumers spurned low-quality European goods. America’s therefore decided to aid Europe financially and create multinational corporations. The most famous example of this was the Marshall Plan, which transferred $13.3 billion to Western European nations. In 1950, America began relying on deficit spending to finance its international economic programs. However, another problem was on the horizon – that of maintaining the fixed price of the dollar to gold. For example, there was the temptation for investors to buy gold at the Bretton Woods price and resell it at a higher price. Gold prices spiked to as high as $40 an ounce directly after the Cuban Missile Crisis, as people lost confidence in the dollar. The Kennedy administration, seeking to increase productivity and exports in order to maintain the dollar, passed the Tax Reduction Act of 1964 to stimulate investment. The program successfully grew the economy, and eased the burden of the standard for a little while.

Across the Atlantic, the gold standard caused more persistent problems. Throughout the 1960s, Britain had been facing economic decline with persistent trade deficits and did not have the fiscal policy to deal with its problems, leading to the pound being put under significant speculative pressure, with investors losing confidence rapidly in the pound’s ability to maintain its fixed value. To defend the currency, Harold Wilson’s government initially borrowed large sums of money, raised interest rates, and set import restrictions. These measures all artificially propped up the pound’s value, but were not sustainable in the long term, as they decreased economic growth and confidence in the pound even further. Facing a crisis, in 1967 Wilson devalued the pound by 14%. The crisis was not just a huge blow to Wilson’s government; it also demonstrated to the international community the difficulty of maintaining the Bretton Woods system. Although it boosted British exports by making them cheaper, it signalled the beginning of the end for the gold standard.

The Bretton Woods system ultimately collapsed in 1971 for many of the same reasons the pound was devalued. The growth of the European and Japanese economies led to a decline in in US economic power, making the international monetary system more vulnerable to friction between nations. This decline was also precipitated by major US disasters, such as the Vietnam War, which heavily indebted America, and decreased the confidence of investors in the dollar. This caused other nations to begin developing gold reserves. France, for example, was exchanging up to $200 million a year in the 1960s for gold in order to diversify its own reserves. By 1970 there was high pressure on America’s reserves, with the country owning only a fifth of the world’s gold. The price of the dollar was dropping, and unemployment and inflation were relatively high. To combat these issues, in August, Nixon stopped convertibility for gold. The immediate effects were positive, with the Dow Jones index rose by 33 points the next day.

Despite the two significant crises during Bretton Woods, the agreement also contributed to a period of sustained growth and low inflation in many countries. Although this can be partially attributed to post-war recovery being almost inevitable in Europe, the stability of exchange rates helped governments by allowing them to focus on domestic economic policy, such as encouraging investment and job creation. The fixed rates also facilitated trade through an institution known as the Global Agreement on Tariffs and Trade (GATT), a predecessor to the World Trade Organisation (WTO). Development was impressive during this period, with countries in East Asia benefitting from the ability to export with no restrictions. The system also encouraged countries to cooperate on monetary issues, which eased tensions in certain regions, and fostered long-term global economic cooperation. Perhaps we could conclude that the gold standard was useful for limiting inflation during times of prosperity, but when confidence decreased and countries began to face crises, it could not hold up.

Yet, the same could be said about today’s currencies. There are dozens of examples of economic collapse following the collapse of the gold standard which resulted from low confidence – Argentina, Indonesia, Russia, to name a few. In fact, uncertainty is higher today for developing countries, whose currencies usually have the lowest support from investors. Under the gold standard, the most economically powerful countries bore the brunt of speculation, and this transfer of risk has seen global inequality increase drastically. Nixon made the right decision on behalf of America to move away from the gold standard, but in doing so, he may have condemned many other poorer countries to financial disarray.

Rodrik, D., 2012, The Globalisation Paradox

Federal Reserve History, Creation of the Bretton Woods System

Eichengreen, B., 2019, Globalising Capital: A History of the International Monetary System – Third Edition