Reshaping Narrow Law and Art: The Gold Standard-3

(The Gold Standard 1 | 2 )

Some technical details

In Part 1, I proposed some definitions of gold exchange standard (GXS) versus gold standard. A more nuanced breakdown follows (Officer, 2008):

In principle, a country can choose among four kinds of international gold standards -- the pure coin and mixed standards, already mentioned, a gold-bullion standard, and a gold- exchange standard. Under a gold-bullion standard, gold coin neither circulates as money nor is it used as commercial-bank reserves, and the government does not coin gold. The monetary authority (Treasury or central bank) stands ready to transact with private parties, buying or selling gold bars (usable only for import or export, not as domestic currency) for its notes, and generally a minimum size of transaction is specified. For example, in 1925 1931 the Bank of England was on the bullion standard and would sell gold bars only in the minimum amount of 400 fine (pure) ounces, approximately £1699 or $8269. Finally, the monetary authority of a country on a gold-exchange standard buys and sells not gold in any form but rather gold- convertible foreign exchange, that is, the currency of a country that itself is on the gold coin or bullion standard.

During the two previous posts on the gold standard, I did not use this distinction, and feel some regret about it. Instead, I used "gold standard" to mean any financial system in which gold or gold substitutes are the sole form of legal tender; and I used GSX to mean any system in which gold is used as a benchmark of value (i.e., what Officer refers to as a "bullion standard" as well as a true "gold exchange standard").

As I mentioned regarding the Canadian bullion standard (1926-1931), regulations of bullion export were often invoked in times of crisis in order to prevent liquidity crises for vulnerable national treasuries. But even countries on the "gold coin" standard, such as the USA (1879-1917), France (1878-1914), and UK (1821-1914) had other ways of managing gold supplies.

There are costs of importing or exporting gold. These costs include freight, insurance, handling (packing and cartage), interest on money committed to the transaction, risk premium (compensation for risk), normal profit, any deviation of purchase or sale price from the mint price, possibly mint charges, and possibly abrasion (wearing out or removal of gold content of coin -- should the coin be sold abroad by weight or as bullion).

"Mint parity" is the ratio of one currency to another in terms of gold weight; so, for example, the UK pound sterling was worth $4.8665635, when expressed as comparative gold weight content. At the time, gold points were defined as the rates produced by buying gold in one country and selling it in another; more precisely, as the point...

... at which it would be as cheap for a person in one country who has to discharge an indebtedness to a creditor in another country, to do so by sending gold as by buying and remitting bills, As regards any particular country, there will be a point at which gold will be likely to leave it, and a point at which gold will be likely to come to it. Given the mint par between the currency units of two countries and the cost of sending gold, the gold points will be found by deducting the latter from the former for the outward gold point, and adding it thereto for the inward gold point.
The Banker's Magazine, vol.80, no.741 (Dec 1905), p.715

The above periodical helpfully takes the example of France and Britain: the pound sterling was then at a mint parity of 25.2213 francs; it cost about 7-10 centimes per sovereign (i.e., gold £1 coin), so the outward gold point is 25.15-25.12 and the inward gold point is 25.32. For purposes of international comparison, the cost of importing gold from the UK to France is .2776%. According to Officer's latter-day studies, this gold point was closer to 10.2 centimes, or .4063%.

Supposing it were zero? Or, say, something very close to zero? Well, if the US dollar were to sink to (say) 1 basis point below its mint parity with the sovereign, then one could make a fortune buying gold with dollars, exporting the gold to London and selling it to the Royal Mint, then taking the pounds and selling them for dollars. One would immediately buy gold and repeat the process. The amount of money made with each cycle would be tiny, but assuming it could be done in a day or so, one could actually contrive to leverage the operation to massively increase the profitability. Unsurprisingly, the gold point spread with the passage of time, so that such arbitrage became much more difficult. With a gold point of 45 basis points, and a spread of about twice that, there was some modest room for interest rate arbitrage among the major money markets (Vienna, Berlin, London, New York, and Paris).

I skimmed the abstracts of some other papers by Officer on gold point arbitrage. Most of these were unavailable for further study, but a general summary is available via the footnote.¹ Another feature of the global gold standard that Officer examined was the effect of interest rates; when interest rates were markedly different for similar classes of borrowers in different money markets, this also had a major impact on flows of money internationally. If interest rates in London were 3% and in New York were 3.75%, then this stimulated exports of gold to the USA (since holders of pounds would have them physically converted into US dollars, and the US dollar would rise in value). This would increase bank reserves of gold, naturally, allowing an expansion of the money supply (albeit at a higher interest rate than London's), and probable shift of the balance of trade in favor of the UK. The trade balance would reverse the flow, unless some spoke got in the wheel.

In practice, there was a bias toward inflation in boom years; different banking regimes in different countries led to different forms of price instability, so that gold and currency traders sought to arbitrage real interest rates rather than nominal ones. In this way, 19th century securities markets tended to be about as complicated as modern ones; it was just that, instead of the complex derivatives of today, traders had to factor in tangible barriers to the mathematically smooth adjustments of market equilibria.

Notes

These include "Gold-Point Arbitrage and Uncovered Interest Arbitrage under the 1925-1931 Dollar-Sterling Gold Standard," Explorations in Economic History, Volume 30, Issue 1 (January 1993) Pages 98-127; and Monetary standards and exchange rates, Routledge (1997), written with Maria Cristina Marcuzzo and Annalisa Rosselli. For a general summary of Officer's work, see Alan M. Taylor, "Review of Lawrence H. Officer, Between the Dollar-Sterling Gold Points: Exchange Rates, Parity, and Market Behavior." EH.Net Economic History Services (20 Mar 1998). The last article IS online and outlines the general thrust of Officer's research on the period of the global gold standard: that the cost of international gold shipments was relatively higher than formerly believed, and formed measurable boundaries of the rational exchange rates; that observed exchange rates moved within these boundaries, and were further restricted by covered interest rate arbitrage; and that weakly efficient markets prevailed under the global gold standard. Critics of the gold standard per se are not likely to be moved by such arguments because they relate to the technical administration of the standard, rather than the monetary policy it imposed.