FX101 - The Rise and Fall of the Gold Standard

For thousands of years, gold has been regarded as a substance of value and used as a currency in human societies. With the advent of paper notes, the circulation of gold began to decrease. However, it remained the base upon which these paper notes were backed. Nowadays, gold plays little to no role in the value and circulation of currency. So what happened? Read on for a look at the rise and fall of the gold standard.

The Rise

Gold’s use as a currency began thousands of years ago in Asia Minor. As the most resistant to corrosion of all the major metals, it’s not difficult to understand why. Its durability and attractive glow and hue, as well as the subsequent ability to retain value fairly well over time, certainly gave it an edge over other commodities that have been used as currency.

Despite the popularity of the Byzantine gold bezant in Europe, silver coins were just as common and, after the fall of Byzantium, became the predominant form of currency. The discovery of silver by the Spanish in the New World reinforced this trend, and a burgeoning global silver trade saw silver’s continued dominance well into the 18th and 19th centuries. At which point, gold began to make its comeback.

The Establishment

From the mid-18th to late 19th century, an ongoing trade deficit with China (at that point a huge driver in the silver trade) and European wars had been draining silver from all of the Western European economies, as well as that of the United States.

The interaction between central banking and the currency basis was also causing economic instability. Governments demanding specie as payment were exhausting the economy of money and the proliferation of paper notes occurred as a result. The failing stability of silver, coupled with devalued notes and the need for a solid basis on which to back money resulted in the rapid acceptance of the gold standard.

While a 1704 proclamation made by Queen Anne established a de facto gold standard in the British West Indies, a formal standard would not come about in Britain until 1821. A serious silver shortage in Britain during the French Revolutionary and Napoleonic wars forced a major recoinage program by the Bank of England in the wake of the victory over Napoleon. The introduction of the gold sovereign in 1816 led directly to the establishment of this formal standard of gold specie.

It was not until 1844, however, with the Bank Charter Act that the full gold standard in the sense it is known today became established: Bank of England notes were to be fully backed by gold, becoming the legal standard. In the aftermath of the 1821 establishment of a gold specie standard, Britain made efforts to introduce this new coinage system to its colonies. Although in territories with an already entrenched monetary system, such as its North American colonies, India, and some of the West Indies, such efforts proved unsuccessful.

Still, when it came to the gold standard itself, Britain met with greater success. In the decades following 1844, the entire empire would join the gold standard or peg their currency to it.

It was not Britain and its empire alone entertaining or obliged to adopt a gold standard.

Germany, the United States, and the Scandinavian Monetary Union adopted a gold standard in 1873. The Latin Monetary Union (composed at this time of France, Belgium, Italy, Switzerland, Greece, Finland, Romania, Spain, Austria-Hungary, and Serbia, though later joined by Bulgaria, Russia, and Tunisia) adopted the gold standard in 1878, though it had been operating with a de facto gold standard since 1873.

The Collapse of the First Gold Standard

By the conclusion of 1913, the first, or classical, gold standard had reached its peak. Even prior to the outbreak of war, financial mismanagement by the Banque de France (one of the three pillars of the gold standard system, together with the Bank of England and Germany’s Reichsbank) had put pressure on it, but the gold standard was still going strong when the First World War forced many countries to abandon it.

Throughout the British Empire, treasury notes replaced the circulation of gold specie, and a similar process was undergone in France, Germany, and the rest of Europe. Indeed, of all the major world economies, only the United States and Japan remained on the gold standard throughout the war.

The Post-War Gold Standard & the Great Depression

Britain never actually repealed the gold specie standard during the war years (1914-1918). But while the standard remained technically de jure, the gold specie standard was in practice suspended. This would remain the case until the 1925 British Gold Standard Act, which both introduced the gold bullion standard (marking a return to a gold standard), and repealed the gold specie standard. Gold specie would no longer circulate, but the British government was now compelled to sell gold in the form of 400-ounce troy bars at a fixed price.

Many countries followed Britain in returning to the gold standard after the war. While this period was marked by relative stability, it also saw a process of deflation that ultimately led to the Great Depression. Indeed, the return to the gold standard is considered one of the primary causes of the global stock market crash; with primary blame assigned to the United States and France. By significantly increasing their own gold reserves, the US and France created an artificial shortage. This shortage put significant deflationary pressure on other countries.

The failure of the major economies’ governments to cooperate to solve this issue led to the ruin that would follow. By September 1931, the collapse of the central banks in both Austria and Germany, followed by a subsequent loss of confidence in sterling, forced Britain and most every other country to abandon the gold standard. The US effectively followed suit in 1933.

By staying on the gold standard, each government risked their respective populations cashing in deposits to purchase gold, which would deplete reserves. To deter this action, governments had to keep interest rates high, which made it too difficult for people and businesses to borrow. In abandoning the gold standard, governments could lower interest rates and pump more money into their economies.

Most economists agree that the gold standard was the most significant reason behind the Great Depression, and the abandonment of that standard was the greatest factor behind the recovery.

Bretton Woods

While most countries had largely abandoned the gold standard by the early 1930s, it survived; and in 1944 it was reborn with the Bretton Woods Agreement. The gold standard under Bretton Woods, however, would be significantly different from those versions that had come before. No longer would it allow for domestic convertibility, and indeed, the role of gold itself would be restrained considerably.

Bretton Woods tied the US dollar to gold while simultaneously pegging the currencies of the signatory nations to the dollar, though governments were permitted to take dollars but insisted on delivery in gold. Under Bretton Woods, exchange rates would be fixed and currency values tightly controlled. Meant to curtail bond markets and international currency manipulation, the system would see international flows of investment go into Foreign Direct Investment (FDI) instead (for example the construction of factories overseas). An International Monetary Fund was established as well to combat destabilizing flows of financial speculation.

Designed to open up world trade and limit disparities in trade, Bretton Woods was a product of the wisdom acquired from the disasters of two world wars and a worldwide economic depression. Economic warfare had led to “military warfare on an even vaster scale”, and in an effort to prevent any such wars in the future, Bretton Woods would highly regulate the production and values of currencies in order to better facilitate global trade.

The Fall

The Bretton Woods System led to the ascendancy of the US dollar in global finance. But while it would see the rise of a new global order and, with the related Marshall Plan, allow for the recovery and (re-)development of Europe, Asia, and the rest of the world, by the late 1960s it was in trouble.

The Vietnam War, Lyndon B. Johnson’s domestic spending on social programs, and rising oil prices were resulting in greater spending and borrowing by the US than the constraints Bretton Woods allowed for. With French concerns about their US dollar reserves and that the US couldn’t continue this trend of spending and borrowing and continue to guarantee deliveries of gold, they threatened to begin to insist on gold deliveries. This raised a big issue, as there was at the time more US currency in circulation than there was gold to back it up.

Other countries followed France, and by 1970 US gold coverage had decreased from 55% to 22%. Faith in the dollar was falling dramatically, and more and more dollars were being printed and shipped overseas to cover government social and military spending. Most significantly, President Nixon passed an order making the dollar inconvertible to gold directly. This was done without consulting other members of the IMF or even his own State Department. The writing was on the wall.

In 1971, the Smithsonian Agreement was signed: renegotiating and redesigning the exchange rate regime. The agreement failed to enforce fiscal discipline by the US government or the Federal Reserve, however; and the Fed actively undermined the agreement in order to improve the domestic employment rate. This lack of compliance saw the continued trend of monetization of the US dollar overseas.

With growing pressure on the official rate of the dollar to gold, Japan and the European Economic Community abandoned Bretton Woods in February 1973. In 1976, the Jamaica Accords formally ratified the end of Bretton Woods. The currencies of the major economies would float freely against others, and gold would again be traded freely. No longer would governments back their currencies with a commodity. The days of the gold standard were finally at an end.