Gold standard

The gold standard has long been abandoned, but for a century and a half from 1821 to 1971, the gold standard (with the gold exchange standard) was a significant influence on the economic policies of the industrialised countries, and it was an important factor in the international development of the great depression.

The operation of the gold standard

A country was said to be on the gold standard when its central bank was required to give gold in exchange for any of the country's currency presented to it. The rates at which national currencies were freely convertible into gold determined their exchange rates, and all international debts were settled by the shipment of gold.

In classical economic theory, the maintenance of balance of payments equilibrium under the gold standard was deemed to operate through its influence upon the money supply. A balance of payments surplus would result in an inflow of gold into the reserves of the country's central bank, which would enable it to expand the money supply without risk of not having enough gold to meet possible demands. The increase in the money supply was expected to raise domestic prices, which would tend to reduce the surplus by raising imports and reducing exports. In principle, tbe reverse of those consequences would follow a balance of payment deficit. A balance of payments deficit, on the other hand, would necessitate an increase in interest rates in order to stem the resulting outflow of gold, and that would contract the money supply, producing a downward pressure on domestic prices which would tend to reduce the deficit by encouraging exports and encouraging domestic purchases at the expense of imports. However, the stabilising effect upon the balance of payments is accompanied by a destabilising effect upon domestic activity as a result of the expansion and contraction of the domestic money supply since the action needed to reduce imports involves a reduction in economic activity and vice versa.

The history of the gold standard

Paper currency was in general use before the 17th century, especially for large transactions. When the Bank of England was established in 1694, it made its first loan to the government of the day partly in the form of banknotes which then circulated as means of payment and were held as reserves by other banks. They were generally acceptable on the understanding that they could always be converted into gold or silver at a stipulated rate. In 1717, on the recommendation of Isaac Newton (then Warden of the Mint), the price of an ounce of gold was set at £3 17s 10 1/2d . That mistaken estimate of the relative values of gold and silver resulted in the displacement of silver by gold as the basis for currency valuation, setting an example that was followed by the rest of the world in the course of the following 200 years.

In 1797, however, a panic prompted withdrawals that threatened to exhaust the Bank of England's reserves of gold, and convertibility was suspended . Although intended to be temporary, that suspension lasted for 24 years. The result was an increase in the market price of gold to £4 10s an ounce by 1809 and a depletion of the Bank of England's gold reserves. A letter to a newspaper by the economist David Ricardo expressing concern at "the high price of bullion" led to the setting up of the Bullion Committee whose report recommending the resumption of convertibility at £3 17s 10 1/2d an ounce was put into effect in 1821.

The United States authorities had put the dollar on a silver standard since 1785, but, as a result of the setting of an official rate of exchange with silver, they unofficially adopted what amounted to a gold standard in 1834 and, after a fierce and protracted controversy , they formally adopted a gold standard of $20.67 an ounce in 1900. (effectively setting the S/£ exchange rate at $4.86 to the £). Germany and France adopted the gold standard in the 1870s, followed by the rest of the industrialised countries by the end of the century. Except for a temporary suspension on 1983, the dollar continued to be convertible to gold (but at a revised rate of $35 an ounce after January 1934) until the United States abandonment of the gold standard in 1971. . Britain left the gold standard in 1914, returned to it in 1925, and finally left it in 1931.

The gold exchange standard

Under the Bretton Woods agreement of 1944, the United States undertook to maintain the price of gold at $35 an ounce, but to allow the exchange of dollars only to governments and central banks, and other governments agreed each to maintain a fixed rate of exchange between its currency and the dollar. The new arrangement was in effect a gold standard except, that the agreement allowed for limited departures for the agreed parites by stipulating exchange rate bands, and provided for agreed exchange-rate devaluations under the supervision of the International Monetary Fund. That system was abandoned in 1971 when the dollar ceased to be convertible into gold.