Abstract:

The first period during which majority of world countries used gold as a currency is
known as the Classical gold standard. Gold acted as a sort of international currency
and epitomized the period of relatively free trade in goods and labor and capital.
This period of high economic growth is sometimes called the first age of
globalizationi. On the other hand, Gold Exchange standard, the system implemented
after the World War I, showed much less success. This period was characterized by
economic disintegration and ended with the Great Depression and series of
worldwide crises. Eventually, the countries who abandoned gold recovered first, and
recent research place much of the blame on the gold standard itself. What were the
reasons for this striking discrepancy? It might be that gold is the best possible basis
for international monetary system, and that GES performed worse because the
system was mismanaged. Or perhaps there were other factors at play? In this essay
I will try to explain that there were two different factors, independent of mechanics
of gold standard itself, that determined how successfully it performed.

Introduction
It is an interesting curiosity how 18th century Britainadopted de facto gold when
Isaac Newton accidentally underpriced silver relative to gold, thus causing only gold
to remain in circulation. A wider move to a strictly gold standard was made around
1870 when in a chain reaction number of European countries joined, probably to
exploit benefits of larger integration with the leader of industrial revolution. What
emerged spontaneously and worked successfully to preserve value of money in the
long run

The gold standard was portrayed as a synonymous with financial stability. During
and after the world war it was abandoned, and period of fiat money that followed
brought damaging inflation and hyperinflation. Consequently, the monetary
authorities wanted to restore the previous system as soon as possible. This attitude
towards the gold standard as something that guarantees stability and must be
pursued at any cost in order to avoid much worse alternatives is today called gold
standard mentality (Eichengreen and Temin, 2000). Emergence of the new system
was, once again, mostly uncoordinated. Some countries returned at the previous
exchange rate, while others devalued. Most of countries did not have enough actual
gold so they held foreign currency as part of their reserves. By 1929, the entire
industrialized world, with the except of Spain, had returned to gold ii.
Some economists, such as Kindleberger (The world in depression, 1973) attributed
the following Great depression to the abandonment of gold standard. So long as the
GS was maintained, it would had remained just another cyclical contraction.
According to his theory of hegemonic stability, the successful functioning of prewar
CGS was attributed to the dominant role of Bank of England which acted as
international lender of last resort, and subsequent failure of GES was described by
unwillingness of US to take over the role. Rare were economists, like Gustav Cassel,
who even in the 1920s recognized potentially harmful repercussion gold standard
may have.
Milton Friedman and Anna Schwartz (1963) famously turned attention to the
tendency of gold standard to overly limit money supply and create monetary shocks
that cause contractions in the real economy. Barry Eichengreen contributed
significantly to the topic by describing the difference in the working of GS in two
periods in the light of different wider social and political environment it operated in.
The XIX century enabled it to be an important factor of economic integration and
development, without activating peculiarities described by Friedman. Without the
key factors present, it was actually an obstacle to economic recovery and played a
central role in the occurrence and spread of worldwide depression.
The rest of the essay is organized as follows: First, to be able to understand
differences in performances of CGS and GES, we have to describe main theories
about how the gold standard as a monetary system is supposed to operate on an
international level. The next section will focus on that. In the second part, I will try
to use Eichengreens viewpoint to further explain these differences.
The mechanisms of gold standard

Gold standard works to regulate countrys money supply by constraining the

amount of money authorities can issue to the amount of gold they have. The
purpose of this commitment is to ensure that amount of currency in circulation, and
hence the price level, would not vary much. Indeed, CGS did manage to provide
price stability in the long run, as between 1880 and 1914 average annual inflation
rate averaged only 0.1 percent. The main obligation of central banks or their
equivalents1 is to ensure that they have enough gold reserves to make the
commitment to pay gold credible. As long as the system works across countries and
there is a free trade in gold, this creates a quasi-fixed exchange rate regime 2 where
relative prices of currencies were derived from the value for which gold is
redeemable in each country. Under the properly functioning gold standard then less
exchange risk and stable prices eliminate uncertainty and make long term planning
easier. This also works to stimulate international trade.
Managing capital flows in order to preserve convertibility of currency into gold was
crucial for the upkeep of the Gold Standard. Countries tried to avoid large gold
movements by maintaining stable balance of payments. To make this possible on
international level, they needed a mechanism that would influence gold flow and
prevent large and persisting imbalances from occurring. Such mechanism
involved, among other things, depreciating the real exchange rate to
make domestic economy more competitive, improve trade balance, and
stimulate gold inflows. As the exchange rates were fixed, adjustments to external
shocks were not done through depreciating nominal exchange rate when demand
for gold increased the price of gold in terms of domestic currency stayed the same.

1 The late XIX century notion of central bank is different than todays. More of them
were private, e.g Bank of England, and USA did not have a central bank

2 The exchange rate was able to deviate by an amount corresponding to cost of

shipping gold, so called golden points. If the exchange rate exceeded this price the
payments would be made by actually shipping gold
Instead, the price level of other goods fell; real depreciation was achieved by
adjusting the price levels, what is sometimes called an internal devaluation.

Another complication that arises on the gold standard is that trying to maintain the
same parity often conflicts domestic goals. Having to use monetary policy to
influence gold flows meant that central banks sometimes had to apply restrictive
policy during economic downturn or amplify the boom by expansion. This is nicely
captured by so-called policy trilemma, which suggests that a country can have only
two of the following: fixed exchange rate, independent monetary policy and
freedom of international capital movements. Although a simplification, it is a rather
good one, and often confirmed in practice. iii The classical gold standard was a
highly-globalized period of mostly fixed rates, free capital mobility, and, hence,
limited monetary independence.iv
How did CGS work to prevent drains of gold from central banks and stabilize BoP?
For example, a large swing in lending (capital account) would be rapidly, almost
simultaneously (Taussing, Eg 12) followed by corresponding swing in trade (current
account).3
Traditional descriptions of the functioning of Gold Standard v relied dominantly on
Price-specie-flow mechanism, automatic price adjustment mechanism described by
David Hume in the XVIII century, and stabilizing actions of central banks, so called
rules of the game.

Price specie flow mechanism, shows how price levels self-adjust to correct
imbalances that occur when gold changes hands: Country with a trade deficit
experiences a gold outflow and has less money in circulation; as a consequence,
prices drop. Similarly, they rise in the surplus country. As a consequence of lower
prices, deficit country export become more competitive and a reverse trend in
trade occurs, eliminating trade imbalance and stabilizing gold reserves. In its basis,
it is the monetarists quantity theory of money argument: changes in money supply
cause price changes.
Central banks could further reinforce this mechanism by playing by so called rules
of the gamevi of the gold standard: faced with an increased demand for gold, due
to greater internal demand or due to movement of capital abroad, they should lower
the pressure by contracting domestic credit, which was usually done by rising the
discount rate. As a result, market interest rise would rise, lowering domestic prices
and attracting short term capital from abroad. Increased gold inflows then offset
current account deficit. In the case of balance of payments surplus, central banks
were supposed to do the opposite: decrease the discount rate in order to reduce
capital inflows and speed up adjustment towards BoP equilibrium.

3 This essay deals mainly with how gold standard functioned at the center and
that is mainly European industrial states such as Britain, Germany and France.
There is separate issue of how the standard worked for economies at the
periphery (Latin America and Eastern Europe), where countries having problems
adhering to gold sometimes devalued. Lets just note that this also contributed to
the image of gold standard as hallmark of development
The fact that term rules of the game was coined in 1920s by Keynes does not
serve to prove that it guided the behavior of central banks in the 19 th century.
Nurkse (1944) and Bloomfield (1959) showed that rules were frequently violated in
both periods. In practice, there were little incentives for individual countries with
expanding reserves to strictly follow the rules and raise their interest rate, as they
would not benefit directly from reducing their gold inflows; this adjustment works
only to maintain stability of the system as a whole by stimulating flow of capital
back to deficit countries.
The world was more complicated than simple rules would suggest. Countries
sometimes sterilized gold inflows (did not monetize new gold) in order to avoid rise
in domestic prices and increase their coverage ratio, and thus prevented stabilizing
price level adjustments described by Hume to happen across countries. This meant
that deficit countries competing for limited supply of gold had to apply stricter
monetary policy and bore higher costs of holding to the gold standard.

All of these problems were present to some degree both before and after the war,
yet the prewar system was much more resilient. Economists of the interwar period
tried to develop more accurate descriptions of the working of classical gold
standard. Their numerous attempts were sometimes only a more detailed
description of PSF mechanism, adopted to take account of workings of more modern
capital markets. Or they replaced it with another similar automatic adjustment
mechanism of capital account, such as automatic policy or banking system
adjustment. Largely, they efforts were mistaken in trying to place the burden of
adjustment on individual component of BoP instead of looking at simultaneous
adaptations of current and capital account. Successful and rapid adjustments under
the GS remained hard to explain.

Importance of credibility and cooperation

if not trough automatic price stabilization and central banks following rules of the
game, how did than the CGS operate fairly smooth in the XIX century, at least in
core economies such as Britain, France, and Germany? Already mentioned Barry
Eichengreen argues that gold standard should be analyzed as a political as well as
an economic system. Two additional factors work to enable its functioning:
credibility of the central banks commitment to maintain gold convertibility and
international cooperation that solved problems when one of the banks was unable
to do so. The thesis is as follows: when those factors were present, as in the prewar
period, GS was able to work towards wider balance of payments equilibrium without
harming the economy. When those factors were absent, such as in the interwar
period, trying to maintain the gold standard created persisting imbalances that were
destabilizing.

Credibility during the CGS meant that governments and central banks
commitment to a policy was not questioned. Defending the gold reserves and
maintaining convertibility was of utmost importance and market participants didnt
doubt banks ability to do so. This meant that in the face of gold outflows which
could cause problems and weaken exchange rate4, private investors would buy the
currency expecting capital gains when government stabilized situation; thus, capital
flowed in considerable amount, revering the process of gold flows and minimizing
the need for interventionvii.
Social environment of the CGS ensured that focusing monetary policy on defending
the parity did not cause pressures that could threaten the credibility of the
commitment to gold. As described by macroeconomic trilemma, policies required to
influence gold flows can be inconsistent with domestic prosperity. Consequently,
domestic political pressures could influence governments choice of international
policies, their credibility and hence their economic effect. However, in the late XIX
century environment government enjoyed protection from having to make painful
trade-offs. There was no well-articulated theory of how monetary or fiscal policy
could be used to stabilize production or reduce unemployment, so potentially
negative effects of balancing gold flows to maintain fixed exchange rate under gold
standard could largely be ignored. Additionally, limited voting and political rights
meant that interest of workers who suffered the most from this could not be heard.
When internal devaluation (described in the previous part as an important element
in bringing BoP under fixed exchange rates towards equilibrium) had to occur, the
fact that wages were more flexible downwards meant that deflationary pressures
that did occur under CGS were absorbed without causing great increase in
unemployment.

In times of crisis, when previously described mechanisms did not suffice, credibility
was supported by high degree of international cooperation. Restrictive and
loosening policies could be done by simultaneous interventions of central banks,
often by following the Bank of England. This was of utmost importance as unilateral
action of a single bank is risky and can drain its reserves quickly. Convertibility
crises were contained trough abundant lending to weak-currency country. For
example, in 1890 Barings crisis, Bank of France and the Russian state bank
replenished the reserves of Bank of England, and in 1893 a consortium of European
banks contributed to US Treasurys defense of the gold standard. Crises were not
uncommon in CGS, but they were regularly solved on an international level because
banks recognized it is in their interest to do so. Eichengreen (1992) uses this as
evidence that prewar system was successful not because it was managed
successfully by BoE (as suggested by Kindleberger), but because it was
decentralized international system. He even goes so far to say that resources of
threatened country extended beyond its own reserves to those that could be
borrowed from other gold-standard countries.

Unique politic and social environment therefore made prewar Gold Standard seem
successful and prevented serious imbalances from occurring, and worked to
mitigate systems potential weaknesses: the problem that follows fixed exchange
rates, of having to choose between internal and external stability, did not frequently
occur and was solvable. The latter period of Golden Exchange standard certainly
then lacked many of key factors that facilitated credibility and cooperation in the

4D
prewar period, and therefore serves as counterexample to prove the importance of
these two.

To begin with, credibility suffered because a variety of political and economic

changes shattered the particular constellation of political relationships which served
as a basis for policymaking in prewar era. Spread of unionism and labor parties,
fight for democracy and voting rights extended the political scene and made the
issue of wage levels and employment increasingly important. This meant that,
unlike in the CGS, when the goals of internal and external stability conflicted each
other, it was no longer clear which would dominate. New economic ideas, such as
that of Keynes, advocated more active use of fiscal and monetary policy to
stimulate the economy. Increased wage rigidity made adjustment of price level
downwards more painful. Not only did the pressure to act in a way that could
jeopardize the gold standard increased, it became costlier not to do so. Of course,
commitment and ability to defend parity was no longer beyond question.
Consequently, speculative destabilizing capital flows which were almost nonexistent
in the prewar period became increasingly common, intensifying the pressure on
countries losing gold. The importance of direction of speculative capital flows can be
seen from the fact that they were one of the main force leading some European
countries off gold in 1931. (Bordo)

Credibility was further degraded by the fact that many countries held significant
portion of their reserves in foreign currency (US dollars and British pound), and
could easily come under a threat if those countries were unable to defend their
parity. In new, less stable system, international cooperation became even more
significant but increasingly hard to achieve. The new answer to monetary policy
trilemma included capital controls and trade barriers. The international disputes
over war debts and reparations obstructed cooperative action, and lack of
collaboration was probably the most influential single reason for the instability of
the GES.

After the war, many countries had their reserves go down, but due to war inflation
prices moved in the opposite direction. Countries that decided to return to previous
parity like Britain had to undergo deflation and also implement restrictive monetary
policy to attract gold. Countries that devalued their exchange rate, like France,
gained on competitiveness and experienced inflows. However, they often sterilized
inflows to avoid increasing domestic money supply and prevent inflation, thus
employing a kind of restrictive policy themselves. Countries losing reserves devoted
to defending parity had little choice but to contract their money supply and increase
interest rate; and this scenario persisted over continuous period of time. Keynes
(year?) noted that had the countries like Britain chose to devalue their currency at
the level that would correctly account for the price change during inflation, the
problem of persistent gold outflows and BoP deficits would have been reduced. But
it hadnt been so: by 1932, US and France held over 70% percent of the world's
monetary gold, making it harder for the rest of world to maintain convertibility
without causing serious unemployment, a compromise that was possible during
Classical gold standard. Policymakers inflicted with gold standard mentality kept
on pursuing policies whose main purpose was to preserve gold standard; policies
that worked well in prewar prosperity but had damaging results in different world of
1930s. A recent research on this topic agrees that this was one of the main factors
contributing to Great Depression, the collapse of output and prices; precisely what it
was intended to prevent.

Conclusion

To sum up, maintaining international gold standard requires that countries have
mechanism to avoid large gold losses and balance of payment problems. Under
fixed exchange rates, such mechanism sometimes required internal devaluation .
Rules of the game, PsF and similar automatic adjustment mechanism have limited
power to explain how these adjustments occurred and why gold standard had
worked much better before than after the WWI. Different economic and pollitical
circumstances rendered the first system more credible, meaning that speculative
capital flows were stabilizing and in general less adjustment was needed; in times of
crisis, there was ample willingness to cooperate on international level. Governments
were protected from pressure to trade exchange rate stability for other goals. The
world after world war did not provide such comfort. Without credibility and
cooperation to back it up, badly reconstructed GES created imbalances, which
perhaps could have been solved with international cooperation, change of policies
and revaluation of gold.
The GES was obviously mismanaged, but when evaluating it we should not forget
that system of exchange rates which gold standard creates puts managing reserves
as central banks top priority, reduces their ability to use monetary policy to
influence economy and can be incompatible with domestic stability. Therefore the
standard itself might contribute to unstable environment, as was the case during
Great Depression. The idea of using gold to support trust on which money is based
is certainly plausible, but the gold standards history teaches us that trust and
credibility can be influenced by variety of factors. Maybe a lesion to be learned here
is that international monetary system is far more than set of theories and textbook
equations. It is evolving, socially constructed institution, whose current set of
possibilities and limitation is a result of continuous working of many different forces.
Therefore its complete understanding requires appreciation of its history and
environment it operates in.

Literature:
Eichengreen, B. (1992), Golden Fetters, Oxford: Oxford University press, Chapter 1
(Introduction), 2 (The Classical Gold Standard in Interwar Perspective).

Eichengreen, B. (1996) Globalizing capital: A history of the international monetary

system. 1st ed. United States: Princeton University Press, pp. 3-61.
Kr 10 In terms of the macroeconomic policy trilemma discussed above, the gold standard
allowed high degrees of exchange rate stability and international financial capital mobility,
but did not allow monetary policy to pursue internal policy goals.

automatic? The pre-World War I period was characterized by economic growth and expanding world trade
i Ferguson

ii Bernakee 5

iii Obsfeld article

iv Bordo

v Bordo

vi Paper on RoG

vii GFT 5, Orourke 173