Gold Standard Explained
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In the early days of money, gold coins were used to pay for goods. The money
had intrinsic value. Cut a gold coin in half and you had two pieces half its value.
With a rise in the volume of goods and services produced there was a need for
notes and coins.
The gold standard was a way to fix the value of money by allowing them to be
converted into a certain amount of gold. This gave people faith in the new 'paper
money'.
For example, in 1717, United Kingdom fixed £1 to 113 grains (7.32 g) of fine
gold.
Throughout the nineteenth and early twentieth century, other countries also
adopted the gold standard. They set their currency at a certain level against gold.
Exchange rates were very stable and only moved after an agreed adjustment.
American Express could print traveler’s checks and say exactly how much foreign
currency it would buy.
Advantage of Gold Standard
The advantage of the gold standard is that the amount of gold was relatively stable. It
means that governments couldn't print money and create inflation. It also created
confidence in the financial system.
Breakdown of Gold Standard
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However, in the First World War, the costs of the war were so great countries
abandoned the gold standard so they could print more money and pay for war.
This led to inflation which persisted after the war.
After the First World War, countries returned to the gold standard.
In the early 1920s. Defeated axis powers like Germany, Hungary and Austria
couldn't pay their reparations (denominated in gold). Germany printed money
causing the famous hyperinflation.
However, the UK (under Winston Churchill as Chancellor of Exchequer in 1925)
rejoined the gold standard at a rate that was too high. The UK economy had
suffered during the First World War and the attempt to maintain the £ at the
prewar rate caused many problems. Keynes was very critical of the decision:
“In truth, the gold standard is already a barbarous relic.”
-Monetary Reform (1924), p. 172
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A return to the gold standard meant UK exports were too expensive causing
falling demand for UK manufacturers. In the 1920s, because of the gold standard
the UK experienced deflation and a prolonged period of high unemployment
(even before the Great Depression)
On the other hand the US dollar was undervalued, this contributed to a boom in
US economy which led to the credit bubble and stock market crash of 1929.
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In the 1930s, the Great depression caused many to leave the gold standards and
allow their exchange rate to devalue. The UK left in 1931
After the second world war, Britain had depleted its gold reserves in paying for
the war, a return to the gold standard was not practical.
Bretton Woods
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However, to guard against the inflationary potential of floating exchange rates and
Central Banks with power to print money, the Bretton woods system was set up.
This was a fixed exchange rate system where countries pegged their currency to
the dollar and the US fixed the price of gold at $35.
Bretton woods broke down in the 1970s.
Some (Austrian economists) argue we should rejoin the gold standard to protect against
inflation and the power of Central banks to inflate away debt which benefits governments
and those with debts but destroys the income of savers.
Disadvantages of Gold Standard
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However, the gold standard has many drawbacks because of its ability to create
deflationary pressures e.g. which harmed the UK economy in the 1920s
Inflation or deflation could be created by variations in production of gold.
In recessions, monetary policy becomes ineffective because governments cannot
increase money supply.
Fixed exchange rates can encourage speculative attacks on the currency. (e.g. it
was argued US was forced to raise interest rates in Great depression to protect
value of currency)