Chapter 10 Outline

The Gold Standard

The gold standard had its origin in the use of gold coins as a medium of exchange, unit of account, and store of value--a practice that dates to ancient times. When international trade was limited in volume, payment for goods purchased from another country was typically made in gold or silver. However, as the volume of international trade expanded in the wake of the Industrial Revolution, a more convenient means of financing international trade was needed. Shipping large quantities of gold and silver around the world to finance international trade seemed impractical. The solution adopted was to arrange for payment in paper currency and for governments to agree to convert the paper currency into gold on demand at a fixed rate.

Nature of the Gold Standard

Pegging currencies to gold and guaranteeing convertibility is known as the gold standard. By 1880, most of the world's major trading nations, including Great Britain, Germany, Japan, and the United States, had adopted the gold standard. Given a common gold standard, the value of any currency in units of any other currency (the exchange rate) was easy to determine.

For example, under the gold standard, one US dollar was defined as equivalent to 23.22 grains of "fine" (pure) gold. Thus, one could, in theory, demand that the US government convert that one dollar into 23.22 grains of gold. Since there are 480 grains in an ounce, one ounce of gold cost $20.67 (480/23.22). The amount of a currency needed to purchase one ounce of gold was referred to as the gold par value. The British pound was defined as containing 113 grains of fine gold. In other words, one ounce of gold cost £4.25 (480/113). From the gold par values of pounds and dollars, we can calculate what the exchange rate was for converting pounds into dollars; it was £1 = $4.87 (i.e., $20.67/£4.25).

The Strength of the Gold Standard

The great strength claimed for the gold standard was that it contained a powerful mechanism for achieving balance-of-trade equilibrium by all countries.² A country is said to be in balance-of-trade equilibrium when the income its residents earn from exports is equal to the money its residents pay to people in other countries for imports (i.e., the current account of its balance of payments is in balance).

Suppose there are only two countries in the world, Japan and the United States. Imagine Japan's trade balance is in surplus because it exports more to the United States than it imports from the United States. Japanese exporters are paid in US dollars, which they exchange for Japanese yen at a Japanese bank. The Japanese bank submits the dollars to the US government and demands payment of gold in return. (This is a simplification of what would occur, but it will make our point.)

Under the gold standard, when Japan has a trade surplus, there will be a net flow of gold from the United States to Japan. These gold flows automatically reduce the US money supply and swell Japan's money supply. As we saw in Chapter 9, there is a close connection between money supply growth and price inflation. An increase in money supply will raise prices in Japan, while a decrease in the US money supply will push US prices downward. The rise in the price of Japanese goods will decrease demand for these goods, while the fall in the price of US goods will increase demand for these goods. Thus, Japan will start to buy more from the United States, and the United States will buy less from Japan, until a balance-of-trade equilibrium is achieved.

This adjustment mechanism seems so simple and attractive that even today, more than half a century after the final collapse of the gold standard, there are people who believe the world should return to a gold standard.

The Period between the Wars, 1918-1939

The gold standard worked reasonably well from the 1870s until the start of World War I in 1914, when it was abandoned. During the war, several governments financed part of their massive military expenditures by printing money. This resulted in inflation, and by the war's end in 1918, price levels were higher everywhere. The United States returned to the gold standard in 1919, Great Britain in 1925, and France in 1928.

Great Britain returned to the gold standard by pegging the pound to gold at the pre-war gold parity level of £4.25 per ounce, despite substantial inflation between 1914 and 1925. This priced British goods out of foreign markets, which pushed the country into a deep depression. When foreign holders of pounds lost confidence in Great Britain's commitment to maintaining its currency's value, they began converting their holdings of pounds into gold. The British government saw that it could not satisfy the demand for gold without seriously depleting its gold reserves, so it suspended convertibility in 1931.

The United States followed suit and left the gold standard in 1933 but returned to it in 1934, raising the dollar price of gold from $20.67 per ounce to $35 per ounce. Since more dollars were needed to buy an ounce of gold than before, the implication was that the dollar was worth less. This effectively amounted to a devaluation of the dollar relative to other currencies. Thus, before the devaluation the pound/dollar exchange rate was £1 = $4.87, but after the devaluation it was £1 = $8.24. By reducing the price of US exports and increasing the price of imports, the government was trying to create employment in the United States by boosting output. However, a number of other countries adopted a similar tactic, and in the cycle of competitive devaluations that soon emerged, no country could win.

The net result was the shattering of any remaining confidence in the system. With countries devaluing their currencies at will, one could no longer be certain how much gold a currency could buy. Instead of holding onto another country's currency, people often tried to change it into gold immediately, lest the country devalue its currency in the intervening period. This put pressure on the gold reserves of various countries, forcing them to suspend gold convertibility. By the start of World War II in 1939, the gold standard was dead.