A New World Order: Explaining the Emergence of the Classical Gold Standard

Christopher M. Meissner
University of Cambridge - Faculty of Economics and Politics; National Bureau of Economic Research
(NBER)

September 2002

NBER Working Paper No. w9233

Abstract:     
The classical gold standard only gradually became an international monetary regime after 1870. This
paper provides a cross-country analysis of why countries adopted when they did. I use duration
analysis to show that network externalities operating through trade channels help explain the pattern
of diffusion of the gold standard. Countries adopted the gold standard sooner when they had a large
share of trade with other gold countries relative to GDP. The quality of the financial system also
played a role. Support is found for the idea that a weak gold backing for paper currency emissions,
possibly because of an unsustainable fiscal position or an un-sound banking system, delayed
adoption. A large public debt burden also led to a later transition. Data are also consistent with the
idea that nations adopted the gold standard earlier to lower the costs of borrowing on international
capital markets. I find no evidence that the level of exchange rate volatility or agricultural interests
mattered for the timing of adoption

What Was The Gold Standard?

The Gold Standard vs. Fiat Money
From Mike Moffatt, former About.com Guide

See More About:

 gold standard
 bretton woods
 fiat money
 money supply

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[Q:] I saw the term "Gold Standard" mentioned in one of my textbooks. What was the gold
standard and how does it differ from today's system of money.

[A:] Excellent question! First we'll have a quick history lesson, then we'll see how it works
and how it differs from fiat money.

Definition of the Gold Standard

My normally extensive Economics Glossary does not have an entry on the gold standard, so
we'll have to look elsewhere for a definition. An extensive essay on the gold standard on The
Encyclopedia of Economics and Liberty defines the gold standard as "a commitment by
participating countries to fix the prices of their domestic currencies in terms of a specified
amount of gold. National money and other forms of money (bank deposits and notes) were
freely converted into gold at the fixed price." A county under the gold standard would set a
price for gold, say $100 an ounce and would buy and sell gold at that price. This effectively
sets a value for the currency; in our fictional example $1 would be worth 1/100th of an ounce
of gold. Other precious metals could be used to set a monetary standard; silver standards were
common in the 1800s. A combination of the gold and silver standard is known as
bimetallism.

A Very Brief History of the Gold Standard

If you would like to learn about the history of money in detail, there is an excellent site called
A Comparative Chronology of Money which details the important places and dates in
monetary history. During most of the 1800s the United States was had a bimetallic system of
money, however it was essentially on a gold standard as very little silver was traded. A true
gold standard came to fruition in 1900 with the passage of the Gold Standard Act. The gold
standard effectively came to an end in 1933 when President Franklin D. Roosevelt outlawed
private gold ownership (except for the purposes of jewelery). The Bretton Woods System,
enacted in 1946 created a system of fixed exchange rates that allowed governments to sell
their gold to the United States treasury at the price of $35/ounce. "The Bretton Woods system
ended on August 15, 1971, when President Richard Nixon ended trading of gold at the fixed
price of $35/ounce. At that point for the first time in history, formal links between the major
world currencies and real commodities were severed". The gold standard has not been used in
any major economy since that time.

What Do We Use Today?

Almost every country, including the United States, is on a system of fiat money, which the
glossary defines as "money that is intrinsically useless; is used only as a medium of
exchange". We saw in the article "Why Does Money Have Value" that the value of money is
set by the supply and demand for money and the supply and demand for other goods and
services in the economy. The prices for those goods and services, including gold and silver,
are allowed to fluctuate based on market forces. Next we'll look at how the monetary system
used can change other variables in the economy.

(Continued from Page 1)

The Benefits and Costs of a Gold Standard

The main benefit of a gold standard is that it insures a relatively low level of inflation. In
articles such as "What is the Demand for Money?" we've seen that inflation is caused by a
combination of four factors:

1. The supply of money goes up.

2. The supply of goods goes down.
3. Demand for money goes down.
4. Demand for goods goes up.

So long as the supply of gold does not change too quickly, then the supply of money will stay
relatively stable. The gold standard prevents a country from printing too much money. If the
supply of money rises too fast, then people will exchange money (which has become less
scarce) for gold (which has not). If this goes on too long, then the treasury will eventually run
out of gold. A gold standard restricts the Federal Reserve from enacting policies which
significantly alter the growth of the money supply which in turn limits the inflation rate of a
country. The gold standard also changes the face of the foreign exchange market. If Canada is
on the gold standard and has set the price of gold at $100 an ounce, and Mexico is also on the
gold standard and set the price of gold at 5000 pesos an ounce, then 1 Canadian Dollar must
be worth 50 pesos. The extensive use of gold standards implies a system of fixed exchange
rates. If all countries are on a gold standard, there is then only one real currency, gold, from
which all others derive their value. The stability the gold standard cause in the foreign
exchange market is often cited as one of the benefits of the system.

The stability caused by the gold standard is also the biggest drawback in having one.
Exchange rates are not allowed to respond to changing circumstances in countries. A gold
standard severely limits the stabilization policies the Federal Reserve can use. Because of
these factors, countries with gold standards tend to have severe economic shocks. Economist
Michael D. Bordo explains:

"Because economies under the gold standard were so vulnerable to real and monetary shocks,
prices were highly unstable in the short run. A measure of short-term price instability is the
coefficient of variation, which is the ratio of the standard deviation of annual percentage
changes in the price level to the average annual percentage change. The higher the coefficient
of variation, the greater the short-term instability. For the United States between 1879 and
1913, the coefficient was 17.0, which is quite high. Between 1946 and 1990 it was only 0.8.

Moreover, because the gold standard gives government very little discretion to use monetary
policy, economies on the gold standard are less able to avoid or offset either monetary or real
shocks. Real output, therefore, is more variable under the gold standard. The coefficient of
variation for real output was 3.5 between 1879 and 1913, and only 1.5 between 1946 and
1990. Not coincidentally, since the government could not have discretion over monetary
policy, unemployment was higher during the gold standard. It averaged 6.8 percent in the
United States between 1879 and 1913 versus 5.6 percent between 1946 and 1990."

So it would appear that the major benefit to the gold standard is that it can prevent long-term
inflation in a country. However, as Brad DeLong points out, "if you do not trust a central
bank to keep inflation low, why should you trust it to remain on the gold standard for
generations?" It does not look like the gold standard will make a return to the United States
anytime in the foreseeable future