2 History of the modern gold standard

The adoption of gold standards proceeded gradually, which leads to conflicts between different economic historians as to when the "real" gold standard began. Sir Isaac Newton included a ratio of gold to silver in his assay of coinage in 1717 which created a relationship between gold coins and the silver penny which was to be the standard unit of account in the Law of Queen Anne, for some historians this marks the beginning of the "gold standard" in England. However, more generally accepted is that a full gold standard requires that there be one source of notes and legal tender, and that this source is backed by convertibility to gold. Since this was not the case throughout the 18th century, the generally accepted view is that England was not on a gold standard at this time.

2.1 The crisis of silver currency and bank notes ( 1750- 1870)

To understand the adoption of the international gold standard in the late 19th century, it is important to follow the events of the late 1700s and early 1800s. In the late 18th century, wars and trade with China, which sold to Europe, but had little use for European goods, drained silver from the economies of Western Europe and the US. Coins were struck in smaller and smaller amounts, and there was a proliferation of bank and stock notes used as money.

In the 1790s England suffered a massive shortage of silver coinage, and ceased to mint larger silver coins, issued "token" silver coins and overstruck foreign coins. With the end of the Napoleonic Wars, England began a massive recoinage program, that created standard gold sovereigns and circulating crowns and half-crowns, and eventually copper farthings in 1821. The recoinage of silver in England after a long drought produced a burst of coins: England struck nearly 40 million shillings between 1816 and 1820, 17 million half crowns and 1.3 million silver crowns. The 1819 Act for the Resumption of Cash Payments set 1823 as the date for resumption of convertibility, reached instead by 1821. Throughout the 1820s small notes were issued by regional banks, which were finally restricted in 1826, while the Bank of England was allowed to set up regional branches. In 1833, however, the Bank of England notes were made legal tender, and redemption by other banks was discouraged. In 1844 the Bank Charter Act established that Bank of England Notes, fully backed by gold, were the legal standard. According to the strict interpretation of the gold standard, this 1844 act marks the establishment of a full gold standard for British money.

The USA adopted a silver standard based on the "Spanish milled dollar" in 1785. This was codified in the 1792 Mint and Coinage Act, and by the use by the Federal Government of the "Bank of the United States" to hold its reserves, as well as establishing a fixed ratio of gold to the US dollar. This was, in effect, a derivative silver standard, since the bank was not required to keep silver to back all of its currency. This began a long series of attempts for America to create a bimetallic standard for the US Dollar, which would continue until the 1920s. Gold and silver coins were legal tender, including the Spanish real, a silver coin struck in the Western Hemisphere. Because of the huge debt taken on by the United States Federal government to pay for the Revolutionary War, silver coins struck by the government left circulation, and in 1806 President Jefferson suspended the minting of silver coins.

The US Treasury was put on a strict hard money standard, doing business only in gold or silver coin as part of the Independent Treasury Act of 1848, which legally separated the accounts of the Federal government from the banking system. However the fixed rate of gold to silver overvalued silver in relation to the demand for gold to trade or borrow from England. The drain of gold in favor of silver led to the search for gold, including the " Gold Rush" of 1849 in California. Following Gresham's law, silver poured into the US, which traded with other silver nations, and gold moved out. In 1853 the US reduced the silver weight of coins, to keep them in circulation, and in 1857 removed legal tender status from foreign coinage.

In 1857 the final crisis of the free banking era of international finance began, as American banks suspended payment in silver, rippling through the very young international financial system of central banks. In the United States this collapse was a contributory factor in the American Civil War, and in 1861 the US government suspended payment in gold and silver, effectively ending the attempts to form a silver standard basis for the dollar. Through the 1860- 1871 period various attempts to resurrect bi-metallic standards were made, including one based on the gold and silver franc, however, with the rapid influx of silver from new deposits, the expectation of scarcity of silver ended.

The interaction between central banking and currency basis formed the primary source of monetary instability during this period. The combination that produced economic stability was restriction of supply of new notes, a government monopoly on the issuance of notes directly and indirectly, a central bank and a single unit of value. Attempts to evade these conditions produced periodic monetary crisis - as notes devalued, or silver ceased to circulate as a store of value, or there was a depression as governments, demanding specie as payment, drained the circulating medium out of the economy. At the same time there was a dramatically expanded need for credit, and large banks were being chartered in various states, including, by 1872, Japan. The need for a solid basis in monetary affairs would produce a rapid acceptance of the gold standard in the period that followed.

2.2 Establishment of the International Gold Standard ( 1871- 1900)

Germany was created as a unified country following the Franco-Prussian War; it established the Reichmark , went on to a strict gold standard, and used gold mined in South Africa to expand the money supply. Rapidly most other nations followed suit, since gold became a transportable, universal and stable unit of valuation. See Globalization.

Dates of Adoption of a Gold Standard:

• Germany 1871
• Latin Monetary Union 1873 ( Belgium, Italy, Switzerland, France)
• United States 1873 de facto
• Scandinavia 1875 by monetary Union: Denmark, Holland, Norway and Sweden,
• France internally 1876,
• Spain 1876
• Austria 1879
• Russia 1893
• Japan 1897
• India 1898
• United States 1900 de jure.

Throughout the decade of the 1870s deflationary and depressionary economics created periodic demands for silver currency. However, such attempts generally failed, and continued the general pressure towards a gold standard. By 1879, only gold coins were accepted through the Latin Monetary Union, composed of France, Italy, Belgium, Switzerland and later Greece, even though silver was, in theory, a circulating medium.

By creating a standard unit of account which was easily redeemable, relatively stable in quantity, and verifiable in its purity, the gold standard ushered in a period of dramatically expanded trade between industrializing nations, and "periphery" nations which produced agricultural goods - the so called "bread baskets". This "First Era of Globalization" was not, however, without its costs. One of the most dramatic was the Irish Potato Famine, where even as people began to starve it was more profitable to export food to Britain. The result turned a blight into a humanitarian disaster. Amartya Sen in his work on famines theorized that famines are caused by an increase in the price of food, not by food shortage itself, and hence the root cause of trade based famines is an imbalance in wealth between the food exporter and the food importer.

At the same time it caused a dramatic fall in aggregate demand, and a series of long Depressions in the United States and the United Kingdom. This should not be confused with the failure to industrialize or a slowing of total output of goods. Thus the attempts to produce alternate currencies include the introduction of Postal Money Orders in Britain in 1881, later made legal tender during World War I, and the " Greenback" party in the US, which advocated the slowing of the retirement of paper currency not backed by gold.

By encouraging industrial specialization, industrializing countries grew rapidly in population, and therefore needed sources of agricultural goods. The need for cheap agricultural imports, in turn, further pressured states to reduce tariff barriers, so as to be able to exchange with the industrial nations for capital goods, such as factory machinery, which were needed to industrialize in turn. Eventually this pressured taxation systems, and pushed nations towards income and sales taxes, and away from tariffs. It also produced a constant downward pressure on wages, which contributed to the "agony of industrialization". The role of the gold standard in this process remains hotly debated, with new articles being published attempting to trace the interconnections between monetary basis, wages and living standards.

By the 1890s in the United States, a reaction against the gold standard had emerged centered in the Southwest and Great Plains. Many farmers began to view the scarcity of gold, especially outside the banking centers of the East, as an instrument to allow Eastern bankers to instigate credit squeezes that would force western farmers into widespread, leading to a consolidation of western property into the hands of the centralized banks. The formation of the Populist Party in Lampasas, Texas specifically centered around the use of "easy money" that was not backed by gold and which could flow more easily through regional and rural banks, providing farmers access to needed credit. Opposition to the gold standard during this era reached its climax with the presidential campaign of Democrat William Jennings Bryan of Nebraska. Bryan argued against the gold standard in his Cross of gold speech in 1896, comparing the gold standard (and specifically its effects on western farmers) to the crown of thorns worn by Jesus Christ at his crucifixion. Bryan ran and lost three times, each time carring mostly Southern and Great Plains states.

2.3 Gold Standard from peak to crisis ( 1901- 1932)

By 1900 the need for a lender of last resort had become clear to most major industrialized nation s. The sagacity of the system was proven largely by examples such as the 1890 bail out of Barings Bank by the Bank of England. Barings had been threatened by imminent bankruptcy. Only the United States still lacked a central banking system.

There had been occasional panics since the end of the depressions of the 1880s and 1890s which some attributed to the centralization of production and banking. The increased rate of industrialization, however, had also served to push living standards higher. Peace and prosperity reigned through most of Europe, albeit with growing agitation in favor of socialism and communism.

This came to an abrupt halt with the outbreak of World War I. Britain was almost immediately forced to gradually end its gold standard, ending convertibility to Bank of England notes starting in 1914. By the end of the war England was on a series of fiat currency regulations, which monetized Postal Money Orders and Treasury Notes. The need for larger and larger engines of war, including battleships and munitions, created inflation. Nations responded by printing more money than could be redeemed in gold, effectively betting on winning the war and redeeming out of reparations, as Germany had in the Franco-Prussian War. The United States and the United Kingdom both instituted a variety of measures to control the movement of gold, and to reform the banking system, but both were forced to suspend use of the gold standard by the costs of the war. The Treaty of Versailles instituted punitive reparations on Germany and the defeated Central Powers, and France hoped to use these to rebuild her shattered economy. Much of the war had been fought on French soil. Germany, facing the prospect of yielding much of her gold in reparations, could no longer coin gold "Reichmarks". Germany moved to paper currency. The series of arrangements to prop up the gold standard in the 1920s would constitute a book length study unto themselves, with the Dawes Plan superseded by the Morgenthau Plan. In effect the US, as the most persistent positive balance of trade nation, loaned the money to Germany to pay off France, so that France could pay off the United States. After the war, the Weimar Republic suffered from hyperinflation and introduces " Rentenmarks ", an asset currency to halt it. These were withdrawn from circulation in favor of a restored gold Riechmark in 1942.

In the United Kingdom the pound was returned to the gold standard in 1925, by the somewhat reluctant Chancellor of the Exchequer Winston Churchill, on the advice of conservative economists at the time. Although a higher gold price and significant inflation had followed the WWI ending of the gold standard, Churchill returned to the standard at the pre-war gold price. For five years prior to 1925 the gold price was managed downward to the pre-war level, meaning a significant deflation was forced onto the economy.

John Maynard Keynes was one economist who argued against the adoption of the pre-war gold price believing that the rate of conversion was far too high and that the monetary basis would collapse. He called the gold standard "that barbarous relic". This deflation reached across the remnants of the British empire everywhere the Pound Sterling was still used as the primary unit of account. In the United Kingdom the standard was again abandoned in 1931. Sweden abandoned the gold standard in 1929, the US in 1933, and other nations were, to one degree or another, forced off the gold standard.

As part of this process, many nations, including the US, banned private ownership of large gold stocks. Instead, citizens were required to hold only legal tender in the form of central bank notes. While this move was argued for under national emergency, it was controversial at the time, and there are still those who regard it as an illegal and unconstitutional usurpation of private property. While this is not a mainstream view, many of the people who hold it are influential out of proportion to their numbers.

2.4 The Depression and Second World War ( 1933- 1945)

In 1933 the London Conference marked the death of the international gold standard as it had developed to that point in time. While the United Kingdom and the United States desired an eventual return to the Gold Standard, with President Franklin Delano Roosevelt saying that a return to international stability "must be based on gold" - neither was willing to do so immediately. France and Italy both sent delegations insisting on an immediate return to a fully convertible international gold standard. A proposal was floated to stabilize exchange rates between France, Britain and the United States based on a system of drawing rights, but this too collapsed.

The central point at issue was what value the gold standard should take. Cordell Hull, the Secretary of State for the US, was instructed to require that reflation of prices occur before returning to the Gold Standard. There was also deep suspicion that Britain would use favorable trading arrangements in the Commonwealth to avoid fiscal discipline. Since the collapse of the Gold Standard was attributed, at the time, to the US and the UK trying to maintain an artificially low peg to gold, agreement became impossible. Another fundamental disagreement was the role of tariffs in the collapse of the gold standard: with the liberal government of the United States taking the position that the actions of the previous American Administration had exacerbated the crisis by raising tariff barriers.

In the years that followed nations pursued bilateral trading agreements, and by 1935, the economic policies of most Western nations were increasingly dominated by the growing realization that a global conflict was highly likely, or even inevitable. During the 1920s the austerity measures taken to restabilize the world financial system had cut military expenditures drastically, but with the arming of the Axis powers, war in Asia, and fears of the USSR exporting revolution, the priority shifted toward armament, and away from re-establishing a gold standard. The last gasp of the 19th century gold standard came when the attempt to balance the United States Budget in 1937 lead to the "Roosevelt Recession". Even such gold advocates as Roosevelt's budget director conceded that until it was possible to balance the budget, a gold standard would be impossible.

Nazi Germany, as part of its pogrom against various minorities including homosexuals, the physically or mentally handicapped, Slavic citizens, Gypsies, and Jews, used the gold looted from them to finance its war effort. Some Swiss banks were some of the international banks who ended up handling gold deposits from this source. The gold was then deposited with the Reichbank and used as the basis for notes to be issued which were to be accepted as currency. The Reich then instituted wage and price controls, backed by internment in prison camps, to prevent this "Mefo financing" from producing hyper-inflation.

During the 1939- 1942 period, Britain depleted much of its gold stock in purchases of munitions and weaponry on a "cash and carry" basis from the US and other nations. This depletion of Britain's reserve signalled to Winston Churchill that returning to a pre-war style gold standard was impractical, instead, John Maynard Keynes, who had argued against such a gold standard, became increasingly influential: his proposals, a more wide ranging version of the "stability pact" style gold standard, would find expression the Bretton Woods Agreement.

2.5 Post-war International Gold Standard ( 1946- 1971)

(See Bretton Woods system)

3 Theory

3.1 Differing definitions of "gold standard"

If the monetary authority holds sufficient gold to convert all circulating money, then this is known as a 100% reserve gold standard, or a full gold standard. Some believe there is no other form of gold standard, since on any "partial" gold standard the value of circulating representative paper in a free economy will always reflect the faith that the market has in that note being redeemable for gold. Others, such as some modern advocates of supply-side economics contest that so long as gold is the accepted unit of account then it is a true gold standard.

In an internal gold-standard system, gold coins circulate as legal tender or paper money is freely convertible into gold at a fixed price.

In an international gold-standard system, which may exist in the absence of any internal gold standard, gold or a currency that is convertible into gold at a fixed price is used as a means of making international payments. Under such a system, when exchange rates rise above or fall below the fixed mint rate by more than the cost of shipping gold from one country to another, large inflows or outflows occur until the rates return to the official level. International gold standards often limit which entities have the right to redeem currency for gold. Under the Bretton Woods system, these were called "SDRs" for Special Drawing Rights.

3.2 Effects of gold backed currency

The commitment to maintain gold convertibility tightly restrains credit creation. Credit creation by banking entities under a gold standard threatens the convertibility of the notes they have issued, and consequently leads to undesirable gold outflows from that bank. The result of a failure of confidence produces a run on the specie basis, which is generally responded to by the bankers suspending specie payments. Hence, notes circulating in any "partial" gold standard will either be redeemed for their face value of gold (which would be higher than its actual value ) - this constitutes a bank "run"; or the market value of such notes will be viewed as less than a gold coin representing the same amount.

In the international gold standard imbalances in international trade were rectified by requiring nations to pay accounts in gold. A country in deficit would have to pay its debts in gold thus depleting gold reserves and would therefore have to reduce its money supply. This would cause prices to deflate, reducing economic activity and, consequently, demand would fall. The resulting fall in demand would reduce imports; thus theoretically the deficit would be rectified when the nation was again importing less than it exported. This lead to a constant pressure to close economies in the face of currency drains in what critics called "beggar thy neighbor" policies. Such zero-sum gold standard systems showed periodic imbalances which had to be corrected by rapid falls in output.

In practice however this could seriously destabilize the economy of countries which ran a trade deficit, because people tended to make a run on the bank to retrieve their money before gold reserves were exported, thus causing banks to collapse and wiping out savings. Bank runs and failures were a common feature of life during the period when the gold standard was the established economic system. It also created a counter-cyclical effect, as governments taxed trade, they accumulated gold and silver coin, which reduced the monetary base for the private economy. This paradox lead to "money droughts" and inflation, as governments taxed, often to pay for wars, and paid in coin, while the velocity of money decreased in the private economy as individuals hedged against the uncertain political situation by hoarding gold. Each attempt to introduce paper money was met, sooner or later, with either over-printing of money and the resulting collapse of the "fiat" money, including paper francs, continentals printed by the pre-Constitutional US Congress and various "bubbles". Or it would create the demand by the government to be paid only in specie, which devalued the existing paper money.

The gold standard, in theory, limits the power of governments to cause price inflation by excessive issue of paper currency, although there is evidence that before World War I monetary authorities did not expand or contract the supply of money when the country incurred a gold outflow. It is also supposed to create certainty in international trade by providing a fixed pattern of exchange rates. The gold standard in fact is deflationary, as the rate of growth of economies generally outpaces the growth in gold reserves. This, after the inflationary silver standards of the 1700s was regarded as a welcome relief, and an inducement to trade. However by the late 19th century, agitation against the gold standard drove political movements in most industrialized nations for some form of silver, or even paper based, currency.

3.3 Advocates of a renewed gold standard

Thus, the internal gold standard is supported by anti-government economists, including extreme monetarists, Objectivists, followers of the Austrian School of Economics and even many proponents of libertarianism. Much of the support for a gold standard is related to a distrust of central banks and governments, as a gold standard removes the ability of a government to manage the value of money, even though, historically, the establishment of a gold standard was part of establishing a national banking system, and generally a central bank.

The international gold standard still has advocates who wish to return to a Bretton Woods-style system, in order to reduce the volatility of currencies, but the unworkability of Bretton Woods, due to its government-ordained exchange ratio, has allowed the followers of Austrian economists Ludwig von Mises, Friedrich Hayek and Murray Rothbard to foster the radical idea of a total emancipation of the gold price from a State-decreed rate of exchange and an end to government monopoly on the issuance of gold currency.

Many nations back their currencies in part with gold reserves, using these not to redeem notes, but as a store of value to sell in case their currency is attacked or rapidly devalues. Gold advocates claim that this extra step would no longer be necessary since the currency itself would have its own intrinsic store of value. A Gold Standard then is generally promoted by those who regard a stable store of value as the most important element to business confidence.

It is generally opposed by the vast majority of governments and economists, because the gold standard has frequently been shown to provide insufficient flexibility in the supply of money and in fiscal policy, because the supply of newly mined gold is finite and must be carefully husbanded and accounted for.

A single country may also not be able to isolate its economy from depression or inflation in the rest of the world. In addition, the process of adjustment for a country with a payments deficit can be long and painful whenever an increase in unemployment or decline in the rate of economic expansion occurs.

One of the foremost opponents of the gold standard was John Maynard Keynes who scorned basing the money supply on "dead metal". Keynesianists argue that the gold standard creates deflation which intensifies recessions as people are unwilling to spend money as prices fall, thus creating a downward spiral of economic activity. They also argue that the gold standard also removes the ability of governments to fight recessions by increasing the money supply to boost economic growth. Much of this thought has been reversed when stagflation hit the United States in the early '70s in contradiction to Keynes' General Theory of Employment Interest and Money.

Gold standard proponents point to the era of industrialization and globalization of the 19th century as the proof of the viability and supremacy of the gold standard, and point to Britain's rise to being an imperial power, conquering nearly one quarter of the world's population and forming a trading empire which would eventually become the Commonwealth of Nations as imperial provinces gained independence.

Gold standard advocates have a strong following among commodity traders and hedge funds with a bearish orientation. The expectation of a global fiscal meltdown, and the return to a hard gold standard has been central to many hedge financial theories. More moderate gold bugs point to gold as a hedge against commodity inflation, and a representation of resource extraction, in their view gold is a play against monetary policy follies of central banks, and a means of hedging against currency fluctuations, since gold can be sold in any currency, on a highly liquid world market, in nearly any country in the world. For this reason they believe that eventually there will be a return to a gold standard, since this is the only "stable" unit of value. That monetary gold would soar to $5,000 dollars an ounce, over 10 times its current value, may well have something to do with some of the advocacy of a renewed gold standard, holders of gold would stand to make an enormous profit.

Few economists today advocate a return to the gold standard. Notable exceptions are some proponents of Supply-side economics and some proponents of Austrian Economics. However, many prominent economists, while they do not advocate a return to gold, are sympathetic with hard currency basis, and argue against fiat money. This school of thought includes US central banker Alan Greenspan and macro-economist Robert Barro . The current monetary system relies on the US Dollar as an "anchor currency" which major transactions, such as the price of gold itself, are measured in. Currency instabilities, inconvertibility and credit access restriction are a few reasons why the current system has been criticized, with a host of alternatives suggested, including energy based currencies, market baskets of currencies or commodities. Gold is merely one of these alternatives.

The reason these visions are not practically pursued is based on the same reasons that the gold standard fell apart in the first place: a fixed rate of exchange decreed by governments have no organic relationship between the supply and demand of gold and the supply and demand of goods.

Thus gold standards have a tendency to fall apart as soon as it becomes advantageous for governments to overlook them. By itself, the gold standard does not prevent nations from switching to a fiat currency when there is a war or other exigency, even though by paradox, gold gains in value through such circumstances.

The practical matter that gold is not currently distributed according to economic strength is also a factor: Japan, while one of the world's largest economies, depending on which measure, it has gold reserves far less than could support that economy. Finally the quantity of gold available for reserves, even if all of it were confiscated and used as the unit of account, would put the value of gold upwards of 5000 dollars an ounce on a purchasing parity basis. If the current holders of gold imagine that this is the price that they will be paid for giving up their gold, they are quite likely to be disappointed. For these practical reasons - inefficiency, misallocation, instability, and insufficiency of supply - the gold standard is likely to be more honoured in literature than practiced in fact.

4 Gold as a reserve today

During the 1990s Russia liquidated much of the former USSR's gold reserves, while several other nations accumulated gold in preparation for the Economic and Monetary Union. The Swiss Franc left a full gold convertible backing. However, gold reserves are held in significant quantity by many nations as a means of defending their currency, and hedging against the US Dollar, which forms the bulk of liquid currency reserves. Weakness in the dollar tends to be offset by strengthen of gold prices. Gold remains a principal financial asset of almost all central banks along side foreign currencies and government bonds. It is also held by central banks as a way of hedging against loans to their own governments as an "internal reserve".

In addition to other precious metals, it has several competitors as store of value: the US dollar itself and real estate. As with all stores of value, the basic confidence in property rights determines the selection of which one is chosen, as all of these have been confiscated or heavily taxed by governments. In the view of gold investors, none of these has the stability that gold had, thus there are occasionally calls to restore the gold standard. Occasionally politicians emerge who call for a restoration of the gold standard, particularly from the libertarian right and the anti-government left. Mainstream conservative economists such as Barro and Greenspan have admitted a preference for some tangibly backed monetary standard, and have stated that a gold standard is among the possible range of choices.

Some privately issued modern notes (such as e-gold) are backed by gold bullion, and gold. Both coins and bullion are widely traded in deeply liquid markets, and therefore still serve as a private store of wealth. In effect, the holder of such currencies is long gold, short their own currency and writing checks on their account.

In 1999, to protect the value of gold as a reserve, European Central Bankers signed the "Washington Agreement", which stated they would not allow gold leasing for speculative purposes, nor would they "enter the market as sellers" except for sales that had already been agreed upon. A selling band was set. This was intended to prevent further deterioration in the price of gold. (See Washington Consensus)

In 2001 Malaysian Prime Minister Mahathir bin Mohamad proposed a new currency that would be used initially for international trade between Muslim nations. The currency he proposed was called the gold dinar and it was defined as 4.25 grams of 24- carat gold. Mahathir Modamad promoted the concept on the basis of its economic merits as a stable unit of account and also as a political symbol to create greater unity between Islamic nations.

5 Related articles

• International Monetary Fund
• goldbug
• Digital gold currencies

6 External links

• Gold Anti-Trust Action Committee website
• A Gold Polaris by Jude Wanniski (Advocates for a return to a gold standard)
• [1] - text of Executive Order 6102
• [2] - FDIC statement of policy regarding Public Law 93-373
• "Gold and Economic Freedom" by Alan Greenspan
• Gold information for researchers
• Fact: The gold standard causes deflation and depressions - A Keynesian view of the gold standard.
• [3] NBER on the contribution of the Gold Standard to the Great Depression

economics

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