The Gold Standard is primarily a system of fixing exchange rates via the price of Gold. There have been three such international monetary regimes in history: the Classical Gold Standard, which began with Britain in 1822 and collapsed with the start of the First World War, the Interwar Gold Exchange Standard seen as beginning with Britain returning to Gold at its pre-war parity in 1924 and ending with America's abandonment of gold in 1933, and the Bretton Woods system, from the end of the Second World War to its collapse under Nixon in 1971.
A country was “on” the Gold Standard if it exhibited certain features. Firstly, it had to fix its currency to gold, by buying and selling gold for set prices, so the price of gold could float within a narrow range. Secondly, it had to allow free trade in gold, so gold could enter and leave the country without restrictions, ensuring that he domestic price of gold is the same as that in every other country on the Gold Standard. Fixing currencies to that of another country on the Gold Standard would have the same effect as joining the Gold Standard directly.
Although countries were meant to link their money supplies to reserves of gold, this was rarely done strictly. Central Banks often held reserves in excess of their requirements, and could often adjust their gold/currency ratio at will. The only enforcement mechanism they faced was the confidence of investors, who might flee the country if they thought the bank did not have enough reserves to secure its position. However, these reserves did not have to be held in Gold, but could be in any other currency in which investors had confidence. The greater the confidence of investors, the lower the ratio of Gold to Currency the Central Bank could hold – so that prior to the First World War, the most secure economy at the centre of the system, Great Britain, held the least gold as a proportion of its GDP.
The purpose of the Gold Standard was both to enhance price stability and to facilitate multilateral trade and investment. Investing abroad was very risky when exchange rates were floating, before the advent of hedging allowed cheap and effective risk management. In order to stay on the gold standard a country had to prevent its prices rising faster than that of other currencies fixed to gold. Therefore, governments and Central Banks had to control the money supply and use fiscal and monetary policy to prevent inflation, which usually meant low growth and high unemployment were the results of trade deficits.
This was the result of the “Trilemma” problem. Under the Gold Standard, an economy did not have an independent monetary policy. It had to use its interest rates to keep its exchange rate constant. This was often seen as an advantage by governments of countries on the Gold Standard, as it allowed them to avoid criticism for poor economic performance, high unemployment, etc., as they could claim these were necessary costs of maintaining the system.
The Gold Standard was supposedly governed by a set of practices lovingly referred to as “The Rules of the Game”. These were meant to assure stability in each participating economy's balance of payments, to make sure no country ran continuous deficits or surpluses. They were as follows:
- Under a balance of payments deficit
- Bank loses Gold
- Money Supply falls
- Prices fall
- Imports fall
- Exports Rise
- Equilibrium is Restored
Under the Rules of the Game, the Central Bank should short cut this process to prevent loss of Gold, so on seeing its reserves fall, it should:
- Raise interest rates;
- Investment falls,
- Demand falls,
This speeds up the process by which prices adjust, and so Balance of Payments equilibrium is reached sooner.
- Under a balance of payments Surplus
- The Bank gains Gold
- Money Supply rises
- Prices rise
- Imports rise
- Exports fall
- Equilibrium is Restored
Under the Rules of the Game, the central bank ought to short-cut this process. On seeing its reserves rise it is meant to:
- Lower interest rates; so
- Investment rises,
- Demand rises,
By which prices rise sooner, preventing the economy hoarding stocks of gold.
However this is a principle weakness of the Gold Standard. If an economy is running a balance of payments deficit, it has a strong incentive to abide by the rules of the game. This is because it has only limited stocks of gold, and cannot afford to continue losing gold for long. Therefore, Governments and Central Banks would always raise interest rates, to stem their loss of Gold, and bring in foreign investment (hot money), to fill their coffers.
On the other hand, a country running a Balance of Payments surplus is seeing gold flow into its borders, and no mechanism was in place to force it to abide by the Rules of the Game, and take action to return to balance of payments equilibrium.
This was a major downfall of the Gold Exchange Standard of the 1920s. It was the question of how to deal with a hegemonic economy that runs a persistent trade surplus. During the 19th Century Britain ran such a surplus, but it chose to abide by the "Rules of the Game", keeping its interest rates low, leading to a continous flow of lending to the rest often world, so the Gold Standard continued to function. However, after the First World War, when the USA took over this role, the Federal Reserve chose not to do the same. It kept its interest rates high, selling bonds to sterilise the inflow of gold and prevent its money supply expanding, preventing inflation and so hoarding the worlds supply of gold at Fort Knox, where it has stayed. This limited the outflow of investment to the rest of the world, and created deflationary international environment, setting the scene for the Great Depression and collapse of the Gold Exchange Standard.