The Classical Gold Standard—1870 to 1914
Gold has served as an international currency since at least the sixth century BC reign of King Croesus of Lydia, in what is modern-day Turkey. More recently, England established a gold-backed paper currency at a fixed exchange rate in 1717, which continued in various forms with periodic wartime suspensions until 1931. These and other monetary regimes may all go by the name “gold standard”; however, that term does not have a single defined meaning. A gold standard may include everything from the use of actual gold coins to the use of paper money backed by gold in various amounts. Historically the amount of gold backing for paper money has ranged from 20 percent up to 100 percent, and sometimes higher in rare cases where the value of official gold is greater than the money supply.
The classical gold standard of 1870 to 1914 has a unique place in the history of gold as money. It was a period of almost no inflation—in fact, a benign deflation prevailed in the more advanced economies as the result of technological innovation that increased productivity and raised living standards without increasing unemployment. This period is best understood as the first age of globalization, and it shares many characteristics with the more recent, second age of globalization that started in 1989 with the end of the Cold War.
The first age of globalization was characterized by technological improvements in communication and transportation, so that bankers in New York could speak on the phone to their partners in London and travel time between the two financial hubs could be as short as seven days. These improvements may not have been widespread, but they did facilitate global commerce and banking. Bonds issued in Argentina, underwritten in London and purchased in New York created a dense web of interconnected assets and debts of a kind quite familiar to bankers today. Behind this international growth and commerce was gold.
The classical gold standard was not devised at an international conference like its twentieth-century successors, nor was it imposed top-down by a multilateral organization. It was more like a club that member nations joined voluntarily. Once in the club, those members behaved according to well- understood rules of the game, although there was no written rulebook. Not every major nation joined, but many did, and among those who joined, capital accounts were open, free market forces prevailed, government interventions were minimal and currency exchange rates were stable against one another.
Some nations had been on a gold standard since well before 1870, including England in 1717 and the Netherlands in 1818, but it was in the period after 1870 that a flood of nations rushed to join them and the gold club took on its distinctive character. These new members included Germany and Japan in 1871, France and Spain in 1876, Austria in 1879, Argentina in 1881, Russia in 1893 and India in 1898. While the United States had been on a de facto gold standard since 1832, when it began minting one-troy-ounce gold coins worth about twenty dollars at the time, it did not legally adopt a gold standard for the conversion of paper money until the Gold Standard Act of 1900, making the United States one of the last major nations to join the classical gold system.
Economists are nearly unanimous in pointing out the beneficial economic results of this period. Giulio M. Gallarotti, the leading theorist and economic historian of the classical gold standard period, summarizes this neatly in The Anatomy of an International Monetary Regime:
Among that group of nations that eventually gravitated to gold standards in the latter third of the 19th century (i.e., the gold club), abnormal capital movements (i.e., hot money flows) were uncommon, competitive manipulation of exchange rates was rare, international trade showed record growth rates, balance-of-payments problems were few, capital mobility was high (as was mobility of factors and people), few nations that ever adopted gold standards ever suspended convertibility (and of those that did, the most important returned), exchange rates stayed within their respective gold points (i.e., were extremely stable), there were few policy conflicts among nations, speculation was stabilizing (i.e., investment behavior tended to bring currencies back to equilibrium after being displaced), adjustment was quick, liquidity was abundant, public and private confidence in the international monetary system remained high, nations experienced long-term price stability (predictability) at low levels of inflation, long-term trends in industrial production and income growth were favorable and unemployment remained fairly low.
This highly positive assessment by Gallarotti is echoed by a study published by the Federal Reserve Bank of St. Louis, which concludes, “Economic performance in the United States and the United Kingdom was superior under the classical gold standard to that of the subsequent period of managed fiduciary money.” The period from 1870 to 1914 was a golden age in terms of noninflationary growth coupled with increasing wealth and productivity in the industrialized and commodity-producing world.
A great part of the attraction of the classical gold standard was its simplicity. While a central bank might perform certain functions, no central bank was required; indeed the United States did not have a central bank during the entire period of the classical gold standard. A country joining the club merely declared its paper currency to be worth a certain amount in gold and then stood ready to buy or sell gold at that price in exchange for currency in any quantity from another member. The process of buying and selling gold near a target price in order to maintain that price is known today as an open market operation. It can be performed by a central bank, but that is not strictly necessary; it can just as well be performed by a government operating directly or indirectly through fiscal agents such as banks or dealers. Each authorized dealer requires access to a reasonable supply of gold with the understanding that in a panic more gold could readily be obtained. Although government intervention is involved, it is conducted transparently and can be seen as stabilizing rather than manipulating.
The benefit of this system in international finance is that when two currencies become anchored to a standard weight of gold, they also became anchored to each other. This type of anchoring does not require facilitation by institutions such as the IMF or the G20. In the classical gold standard period, the world had all the benefits of currency stability and price stability without the costs of multilateral overseers and central bank planning.
Another benefit of the classical gold standard was its self-equilibrating nature not only in terms of day-to-day open market operations but also in relation to larger events such as gold mining production swings. If gold supply increased more quickly than productivity, which happened on occasions such as the spectacular discoveries in South Africa, Australia and the Yukon between 1886 and 1896, then the price level for goods would go up temporarily. However, this would lead to increased costs for gold producers that would eventually lower production and reestablish the long- term trend of price stability. Conversely, if economic productivity increased due to technology, the price level would fall temporarily, which meant the purchasing power of money would go up. This would cause holders of gold jewelry to sell and would increase gold mining efforts, leading eventually to increased gold supply and a restoration of price stability. In both cases, the temporary supply and demand shocks in gold led to changes in behavior that restored long-term price stability.
In international trade, these supply and demand factors equilibrated in the same way. A nation with improving terms of trade—an increasing ratio of export prices versus import prices—would begin to run a trade surplus. This surplus in one country would be mirrored by deficits in others whose terms of trade were not as favorable. The deficit nation would settle with the surplus nation in gold. This caused money supply in the deficit nation to shrink and money supply in the surplus nation to expand. The surplus nation with the expanding money supply experienced inflation while the deficit nation with the decreasing money supply experienced deflation. This inflation and deflation in the trading partners would soon reverse the initial terms of trade. Exports from the original surplus nation would begin to get more expensive, while exports from the original deficit nation would begin to get less expensive. Eventually the surplus nation would go to a trade deficit and the deficit nation would go to a surplus. Now gold would start to flow back to the nation that had originally lost it. Economists called this the price-specie-flow mechanism (also the price-gold-flow mechanism).
This rebalancing worked naturally without central bank intervention. It was facilitated by arbitrageurs who would buy “cheap” gold in one country and sell it as “expensive” gold in another country once exchange rates, the time value of money, transportation costs and bullion refining costs were taken into account. It was done in accordance with the rules of the game, which were well-understood customs and practices based on mutual advantage, common sense and the profits of arbitrage.
Not every claim had to be settled in gold immediately. Most international trade was financed by short-term trade bills and letters of credit that were self-liquidating when the imported goods were received by the buyer and resold for cash without any gold transfers. The gold stock was an anchor or foundation for the overall system rather than the sole medium of exchange. Yet it was an efficient anchor because it obviated currency hedging and gave merchants greater certainty as to the ultimate value of their transactions.
The classical gold standard epitomized a period of prosperity before the Great War of 1914 to 1918. The subsequent and much maligned gold exchange standard of the 1920s was, in the minds of many, an effort to return to a halcyon prewar age. However, efforts in the 1920s to use the prewar gold price were doomed by a mountain of debt and policy blunders that turned the gold exchange standard into a deflationary juggernaut. The world has not seen the operation of a pure gold standard in international finance since 1914.
