30 March 2008

The Gold Standard-1

There is actually a surprising amount of confusion about the gold standard, what it meant, where it was applied, and why it was eventually abandoned everywhere. In this post, I'd like to clear up what I regard as a few misconceptions about it. First, I want to point out that a brief introduction to the subject could easily fill a book of >400 pages. Therefore, I'll be linking to sources that substitute entirely for a detailed discussion. Chief among these is Lawrence H. Officer's 2008 essay, "Gold Standard."

The second point is that this post will be using some economic terms in unusual ways. These are:
  • Gold standard: currency regime characterized by commodity money; money is either physical gold (specie), or certificates matching some physical quantity of gold. In a gold specie standard, banks may issue credit but international balances of payments are restored by reductions in the deficit country's money supply, and concomitant reductions in the general price level (and hence a recession).
  • Gold exchange standard: currency regime in which paper money is in circulation, but the central bank maintains a fixed ratio of the national currency to gold. In some cases this may mean the monetary authorities maintain a "gold window" in which gold is bought and sold freely at a permanently fixed price.
  • Run on currency: a crisis caused by massive public sale of a particular currency. For example, in 1907 there was a panic during which investors demanded huge amounts of gold in exchange for dollars, bringing the US Treasury to the brink of illiquidity. In another case, viz., Argentina (2002), holders of australs demanded euros or US dollars, forcing the Argentinean currency board to abandon the peg of 1 austral = 1 US dollar. The risk of a run is especially severe when the authorities maintain an official peg.
  • Fiat money: a currency regime in which the value of the currency is fixed by the authorities by decree; there is a state monopoly on foreign exchange, and rates are likewise set by decree. In most countries where fiat money regimes are in force, commerce in gold is illegal or at least tightly regulated.

    In some cases, authors use the term "fiat money" to refer to any money whose value is not pegged to anything else, even when deep markets exist for alternative monies. Hence, the US dollar is called "fiat money" despite the fact that open markets exist for most other currencies and for precious metals. The US Federal Reserve is obligated to maintain whatever exchange rate it finds desirable through interest rates and reserves (Open Market Operations); it is "backed" by the productive potential of the United States, and not hoards of gold or silver. Nevertheless, most common usage insists that the US dollar is a fiat money, as if it were the Soviet ruble.
Prior to the Napoleonic Wars (1799-1815), paper money was rare and money mainly took the form of coins or or letters of credit. In marginal areas of European settlement, such as North America, paper money was used as script—as an IOU rather than legal tender.1 Subsequently, in the early 1700's, John Law was retained as a financial adviser to the French throne and introduced securities backed by shares in the Compagnie des Occidents, which were (in turn) given the status of legal tender for some transactions.2 In effect, Law's scheme leapfrogged the next 150 years of monetary evolution to create a currency based on a complex network of transactions. The scheme was a debacle.

A semi-modern scheme of paper money appeared in 1789 with true fiat money: the assignats, backed by land expropriated from the Church (also in France). This was badly managed and resulted in an episode of hyperinflation. It did lead to an interesting brush with totalitarianism when the state was obligated to use force to induce markets to accept the currency. The revolutionary government of the USA (the Continental Congress) issued negotiable bills of credit which bore 4% interest, called "Continental dollars." These also suffered from galloping inflation.3

The issue of coins in England was under the control of the Royal Mint, which had long fixed the pound to sterling silver (not gold).4 Owing to its peculiar economic relationship with the Continent, gold was overvalued in England and flowed to London. As a result, London was on a de facto gold standard by the 18th century, and an official gold standard by 1816. In 1821, Britain resumed convertibility of the pound (which had been suspended since 1797); it was now convertible to gold, not silver, and Britain remained on the gold standard to 1914. The USA adopted a bimetallic standard in 1792, which lasted until 1853/73.5 Spanish-speaking nations also mostly had bimetallic standards at some time during the 19th century. France had a bimetallic system from 1803 to 1865 (free coinage of silver ended in 1874).6


Between 1873 and 1898, most of the Western powers adopted a universal gold specie standard. Using the USA as an example: in 1879 the US adopted a gold exchange standard in which the dollar was fixed at $20.67/ounce of gold, and £4.24/ounce.
The “gold specie” standard called for fixed exchange rates, with parities set for participating currencies in terms of gold, and provided that any paper currency could on demand be exchanged for gold specie at the central bank of issue. The system was designed to bring automatic adjustment in case of external deficits or surpluses in transactions between countries, that is, balance of payments imbalances. The underlying concept was that any deficit country would have to surrender gold to cover its deficit, with the result that the volume of its money would be reduced, leading to lower prices, while the influx of that gold into the surplus country would expand the volume of that country’s money and lead to higher prices.
(Cross 1998)
The gold specie standard had permitted issuance of credit under rigorous accounting standards: banks were required to maintain large reserves, and the entire national banking system had supplies of reserves tightly restricted by each nation's system of accounts. Under the gold exchange standards set up between the Wars (1924-1931) and under Bretton Woods (1946-1971), national governments had a much less rigorous set of accounting constraints: they were obligated to maintain balances of payments such that they could defend pegs to gold (or, in the Bretton Woods framework, to the US dollar). The IMF existed to facilitate such defense provided national governments ran their fiscal affairs responsibly and avoided inflationary policies.

(Part 2)

Notes
  1. See Prof. Michael Sproul, "A Quick History of Paper Money and Banking" CSU Northridge (undated)

  2. John Law's scheme was actually very complicated:
    On 6 January [1718]... Law ...presented the overall plan to solve France's dual crises, the monetary crisis and the financial crisis... To solve the monetary crisis he... recommended that the General Bank be converted into a state bank and that all transactions above 500 livres would be obligatorily made in banknotes. To address the problem of the financial crisis he proposed developing the Company of the West in such a way that the public would convert its state debt into equity of the company: 'and to form a powerful trading company whose shares would interest the public the capital of which would be subscribed in paper owed by the King would thereby be discharged of it.'
    (Antoin E. Murphy, John Law: economic theorist and policy-maker, Oxford University Press (1997), pp.176-177). Law was apparently surprised by the bubble in shares of the Company, whose tangible assets consisted of the then-undeveloped coast of Louisiana (p.216). Law had not only pioneered the speculative share, he also introduced the call option, which made the collapse of the Mississippi Bubble a profoundly complicated affair.
  3. For assignats, see Florin Aftalion (Martin Thom, translator), The French Revolution : an economic interpretation, Cambridge University Press (1990), p.65-173. For continentals, see Jerry W. Markham, A financial history of the United States, M.E. Sharpe (2002), pp.60-68.

  4. The pound was pegged to a pound of sterling silver by Henry II in 1158, but underwent a massive debasements under Henry VIII ('43-51, in which the silver content of pounds was reduced by 73%). Elizabeth I and her adviser, Thomas Gresham restored the silver content at great cost to the public.

    See Fernand Braundel (1992), p357ff.
  5. James Laurence Laughlin, History of bimetallism in the United States (1895; complete text available online at link); the periods of metallic standards are clearly indicated in the table of contents. Bimetallism requires that governments define the exchange ratio between the two metals; for the USA, this was 1 oz. Au = 15 oz Ag until 1834, when the ratio was boosted to 16. The real ratio in 1834 was 15.6 or so; gold was hence overvalued, and silver disappeared from circulation. In 1853, Congress adopted a de facto gold standard, in that it reduced the amount of silver in small denomination coins so that the silver content conformed to the market ratio relative to gold. The result was that silver coins resumed circulation, but price ratios were now determined by that of gold exclusively.

  6. William A. Scott, Money And Banking, Henry Holt And Company (1903)

Sources & Additional Reading

Fernand Braundel (Siân Reynolds, translator), Civilization and Capitalism, 15th-18th Century: The perspective of the world, University of California Press (1992)

Sam Y. Cross, All About... The Foreign Exchange Market in the United States, Federal Reserve Bank of New York (1998), "Chapter 10: Evolution of the International Monetary System"

James Laurence Laughlin, The history of bimetallism in the United States, D. Appleton & Co. (1895)

Barbara Oberg. "New York State and the "Specie Crisis" of 1837" , Business and Economic History., 2nd Series, Vol. XIV (1985)

Lawrence H. Officer, "Gold Standard" EH.net (26 March 2008)

Bruce Smith, "The Relationship Between Money and Prices" Quarterly Review, Federal Reserve Bank of Minneapolis (Fall 2002)*

* In order to read, right click link and select "save link as," then open in PDF reader.

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