Friday, February 20, 2009

Gold Standard Explained

  • In the early days of money, gold coins were used to pay for goods. The money had intrinsic value. Cut a gold coin in half and you had two pieces half its value.
  • With a rise in the volume of goods and services produced there was a need for notes and coins.
  • The gold standard was a way to fix the value of money by allowing them to be converted into a certain amount of gold. This gave people faith in the new 'paper money'.
  • For example, in 1717, United Kingdom fixed £1 to 113 grains (7.32 g) of fine gold.
  • Throughout the nineteenth and early twentieth century, other countries also adopted the gold standard. They set their currency at a certain level against gold. Exchange rates were very stable and only moved after an agreed adjustment.
  • American Express could print travellers' cheques and say exactly how much foreign currency it would buy.

Advantage of Gold Standard

  • The advantage of the gold standard is that the amount of gold was relatively stable. It means that governments couldn't print money and create inflation. It also created confidence in the financial system.
  • The gold standard also creates stability in exchange rates. This creates greater certainty for international trade. Also, exporters know they can't rely on devaluation to improve competitiveness, encouraging firms to cut costs and increase efficiency.

Breakdown of Gold Standard

  • However, in the First world war, the costs of the war were so great countries abandoned the gold standard so they could print more money and pay for the war. This led to inflation which persisted after the war.
  • After the first world war, countries returned to the gold standard.
  • In the early 1920s. Defeated axis powers like Germany, Hungary and Austria couldn't pay their reparations (denominated in gold). Germany printed money causing the famous hyperinflation.
  • However, the UK (under Winston Churchill as Chancellor of Exchequer in 1925) rejoined the gold standard at a rate that was too high £1 = $4.85. The UK economy had suffered during the first world war and the attempt to maintain the £ at the prewar rate caused many problems. Keynes was very critical of the decision:
“In truth, the gold standard is already a barbarous relic.”
-Monetary Reform (1924), p. 172
  • A return to the gold standard meant UK exports were too expensive causing falling demand for UK manufacturers. In the 1920s, because of the gold standard, the UK experienced deflation and a prolonged period of high unemployment (even before the Great Depression)
  • On the other hand, the US dollar was undervalued, this contributed to a boom in US economy which led to the credit bubble and stock market crash of 1929.
  • In the 1930s, the Great Depression caused many to leave the gold standards and allow their exchange rate to devalue. The UK left in 1931.
  • After the second world war, Britain had depleted its gold reserves in paying for the war, a return to the gold standard was not practical.

UK in Gold Standard

Note: 1925, rejoined gold standard at pre-war parity. Left gold standard in 1931 and suffered sharp devaluation.

real interest rates
This shows the real interest rates necessary to keep the UK in the gold standard. It was only after 1931 that real interest rates fell.

The Gold Standard led to problems for the UK manufacturing sector:

  • Firstly, exports were uncompetitive leading to lower aggregate demand
  • Secondly, high real interest rates led to further deflationary pressure and lower economic growth

real gdp 1920s

Bretton Woods
  • However, to guard against the inflationary potential of floating exchange rates and Central Banks with the power to print money, the Bretton Woods system was set up.
  • This was a fixed exchange rate system where countries pegged their currency to the dollar and the US fixed the price of gold at $35.
  • Bretton woods broke down in the 1970s.
Some (Austrian economists) argue we should rejoin the gold standard to protect against inflation and the power of Central banks to inflate away debt which benefits governments and those with debts but destroys the income of savers.

Disadvantages of Gold Standard

  • However, the gold standard has many drawbacks because of its ability to create deflationary pressures e.g. which harmed the UK economy in the 1920s
  • Inflation or deflation could be created by variations in production of gold.
  • In recessions, monetary policy becomes ineffective because governments cannot increase the money supply.
  • Fixed exchange rates can encourage speculative attacks on the currency. (e.g. it was argued the US was forced to raise interest rates in Great depression to protect value of currency)


Anonymous said...

(1) Is there any way of setting up a Gold Standard which would avoid the past disadvantages you outline?

(2) Given that logical deduction (as per the Austrian economists) must use some, albeit basic, empirical data - after all, "for every debit there is a credit" - can there ever be a rapprochment between this camp and the econometricians?

Anonymous said...

Under the gold standard, as described, a country is only as financially stable as it has a sufficient
reserve of gold to back its currency. This means, those countries that are developing have little, if
any opportunity to grow if they do not have a gold reserve backing their currency. Moreover,
there is the reluctance, if not the impossibility of borrowing because by definition, the borrower is
acquiring a portion of wealth that is not backed by anything other than his credit and that is not
gold. Indeed, the ability to lend under the gold standard carries with it the same objections as
printing money because the lender is in effect extending value that is not backed up by gold
causing the same inflationary conditions as if money had been printed.

So why is it that under certain conditions, non gold standard economies are able to maintain a
stable, non-inflationary status? The reason lies in the maintaining the standard of value for the
currency by allowing the free market as part of the equation to regulate the currency’s supply and
demand. On the other hand, where government engages in passing programs that cannot be paid
for by current revenues, which represent the level of national productivity, the supply of money
increases without being backed by productivity, the equivalent of gold, and the trend is
inflationary. As the increase in productivity of labor justifies increased wages without increasing
the costs of the product, so the increase in productivity results in increased revenues that allow for
financing government programs. Moreover, where the gold standard inhibits lending because of
the relative scarcity of the metal to finance programs, the system of a central monetary banking
system that monitors and regulates bank reserves and economic conditions can provide for
substantial lending programs, which increase the money supply but where the potential productive
return on the investment increasing the supply of goods and/or serves as an offset to the economic
affect caused by the increase in the money supply. Both systems are susceptible to abuse. The
gold standard by government manipulation of the value of gold relative to its currency and the
monetary fiat system that allows government to print money to finance programs otherwise
unsupported by existing revenues.

Anonymous said...

Nice essay. Something missing though…like a very MAJOR thing missing. Currency notes arose as receipts for gold, which is why they were based on gold in the first place. You hand in your gold, you get a receipt, which you can then use to trade instead of carrying your gold around. At any time, you can redeem your receipt for the gold, because it is a receipt, it is NOT MONEY. Whoever decided to allow these receipts to be unexchangeable for the gold they represent to the full amount is a thief. When currency became zero backed by gold the robbery became complete. A piece of paper in exchange for gold WAS NOT THE AGREEMENT. The agreement was to take a piece of paper as a RECEIPT for the gold STILL OWNED by the bearer of the gold. Not allowing the bearer to redeem his gold, means the bearer has been robbed, and given paper while the bank keeps the gold. It would be interesting to know the original legislation that allowed this to happen. In the UK that piece of legislation may be legal but it is unlawful, because it legalises stealing. HM government does not have the power to break Common Law as each Bill must be presented for ratification to the Monarch, who has sworn an oath to uphold the law of the land, which is COMMON LAW. (commit no harm or loss to others, and no fraud in business dealings.).