Practical analysis for investment professionals
16 April 2013

Did the Gold Standard Work? Economics Before and After Fiat Money

Suddenly gold is being proposed as a cure-all for the weakening dollar, allowing it to retain its place as the international reserve currency — a trophy taken, not without a fight, from the British pound at the Bretton Woods conference in 1944. Predictably, many commentators are reducing the most sophisticated, technical economic issues to a paella of nationalism, confusion about basic economic facts, and old-fashioned avarice.

To help throw up some light, let’s start with the simple questions: How is a classical gold standard supposed to work? How did it actually work out in the past? Why did previous versions of the international reserve currency lose their mantle? What is the record of the fiat currency version of the dollar as an international reserve currency? And why is it now rather than some other moment that gold is so much discussed?

The Classical Gold Standard

In the classical gold standard, the domestic money supply is directly tied to a country’s stock of gold. The theory was first enunciated by David Ricardo and can be traced to the founder of economics, Adam Smith, whose motivation was to avoid any impediment to the increased efficiency of production and the sacred tenet of the international division of labor.

Under an international gold standard mechanism, the gold-linked note issue of a country experiencing a loss of gold due to a trade deficit would be automatically contracted, depressing the price level. The deficit country’s exports would then become more attractive to foreign countries whilst imports would become more expensive thereby self-correcting the deficit. Global imbalances were automatically restrained by credit expansion in surplus countries and contractions in deficit countries.

Classical economists in the heyday of the gold standard were interested in increasing the international efficiency of production, which needed the elimination of at least one variable, the volatile prices of input and output of goods which the standard encouraged (the price of labor proved to be rather stickier). On one intuitive level, the standard was seen as preventing the moral injustice of inflation eating into the savings of the dominant class and encouraging the supply of goods and food for the fast-growing population, which the Reverend Thomas Malthus famously condemned as the result of a lack of “moral restraint.”

Under a classic gold standard, exchange rates are fixed, and so any deviation of domestic price levels from the world gold price triggers the alarm of exports and imports of physical gold before things move too far from equilibrium. If Canada enjoys a trade surplus, gold flows in automatically from its trading partners who run up deficits. Canada’s money supply is expanded by the inflowing gold, which will tend to cause inflation, self-correcting declines in exports due to higher prices for non-Canadians and to Canada’s citizens having more money to spend on imports, eventually correcting the surplus. Deficit countries are prevented from consuming the part of their production that they will need for exports in order to rebalance.

How Did the Classical Gold Standard Actually Work in Practice?

For the most part, the answer seems to be things turned out pretty badly. Its heyday as common currency for the British Empire in the later part of the 19th and early 20th century was interrupted by the First World War. Even before then the mechanism had been tested by support for bimetallist alternatives to crucifying “mankind upon a cross of gold,” as William Jennings Bryan put it, and the 1880s trade depression with its attendant evils of the exhaustion of gold stocks and an explosion of gold hoarding (more below on this below).

American cartoon by Grant Hamilton, 1896, on William Jennings Bryan's "Cross of Gold" speech at the Democratic National Convention in Chicago, which won Bryan the presidential nomination.

American cartoon by Grant Hamilton, 1896, on William Jennings Bryan’s “Cross of Gold” speech at the Democratic National Convention in Chicago, which won Bryan the presidential nomination.

In 1914 the mechanism for international payments dramatically collapsed. Half of world trade was financed by British credits — which, with stock markets mostly shut for the duration of the war, meant bills could not be rolled over or paid with the usual ease. Over the summer of 1914, defaults gradually gummed up the discount and acceptance markets, and a run on the Bank of England’s gold facility led to a suspension of specie payments.

Fast forward to the interwar period, and it seems there is an echo in the room. A gold exchange standard, not quite the same thing as a classical gold standard — “based on national hoarding and cross-border diplomatic haggling,” as Benn Steil described it — was patched together in the 1920s. But this failed to survive the monetary and trade chaos of the 1930s. Some argue this is because it wasn’t as strict as the classical gold standard resembling more a highly margined derivative instrument. Administrators also had the nasty habit of checking only outflows not inflows of gold.

Yet the attraction of gold endured. Perhaps it is the notion of a fixed monetary supply to curb the natural human instinct to spend. It emerged that the British and their pound, then the international reserve currency, had returned to the gold standard after the war at too high a rate, prompting a violent depression. Successive British and other governments on the standard effectively committed themselves to making it more expensive to foreigners to buy their goods, inflicting (perhaps on class grounds) the hair shirt of suffering on the teeming hordes of unemployed and struggling exporters.

There were some successes in several countries, France and the surplus countries for example, and the Federal Reserve’s “King Midas” policy of sterilizing gold inflows was initially quite successful. But soon, the keystone principle of international division of labor came to be regarded as an overrated encumbrance. In the face of the Great Depression, unsuccessful trade restrictions, stubborn unemployment, and political meltdowns, the gold standard collapsed again in 1933. The United States went off the gold standard at a time when the metal was being extensively hoarded by citizens spooked by the collapse of about half of the nation’s banks.

A telling footnote to the end of the US gold standard interwar experiment is Franklin D. Roosevelt’s unique and possibly unconstitutional method of economic management to bolster the gold price and help American producers of gold denominated goods:

From his bed each morning, Roosevelt would, after briefly conferring with his advisers, set a daily target for bumping up the gold price, not always through scientific methods. One day, November 3rd, the president suggested that gold should go up twenty-one cents. “It’s a lucky number” he explained, “three times seven.”

In choosing the path of national currency management, Roosevelt was rejecting the contradictions of a gold standard mechanism under the pressures of his times and also setting out his stall against economic internationalism in favor of several other “isms”: isolationism or at most bilateralism. He decided to ban gold hoarding and shifted control of reserves to Washington too.

The Battle of Bretton Woods: An International Reserve Currency Gets Ditched

As the Second World War reached its bloody conclusion, negotiators of the purse strings of the United States and its allies, notably Great Britain, met with ever-increasing urgency to try and agree on financial arrangements for a new world after the war. No one, aside from politically irrelevant (and not yet liberated) France, suggested a return to the gold standard.

Instead two competing global plans, were fought over between erstwhile allies Britain and America. The British, with their Imperial Preference system favoring trade within their Empire block were deeply distrusted by Roosevelt: “When you sit around with a Britisher he usually gets 80 per cent of the deal,” he growled.

Storied economist John Maynard Keynes led the British delegation and argued unsuccessfully for an International Clearing Union, which would allow members to have some control over their exchange rates. Keynes wanted everything based around one theoretical supracurrency with gold subscriptions limited to a small percentage of country quotas. The British also needed a giant bank overdraft to prop up their sagging empire and trade deficits, but struggled to convince the Americans they were worthier allies than Stalin’s Russia.

Harry Dexter White, representing America, argued for a stabilization fund of fixed sterling dollar exchange rates, limited liability for America, control over gold-backed dollars by Congress, and a fund structure rather than that of a bank. White, who was later found to be involved in spying for Russia, essentially schemed to limit the growth of British reserves and undermine the imperial trading block in order to help American traders.

The battle between Keynes, seeking “natural justice” for the disproportionate sacrifices Britain had endured to defeat Nazisim, and White, gunning for American-Soviet interests, is ably related in Benn Steil’s new book. Steil concludes that, “The British had been anxious to see themselves as partners with the Americans in creating the ground rules for the postwar order, yet at every step to Bretton Woods the Americans had reminded them, in as brutal a manner as necessary, that there was no room in the new order for the remnants of British imperial glory.”

Aside from setting up the IMF and sowing the seeds of the World Bank, the Bretton Woods Agreement made the US dollar, with its comforting gold reserves, the only gold convertible currency. Whilst every other currency could devalue against the dollar, the dollar could only devalue against gold.

Nevertheless, British insistence on preserving monetary sovereignty which permitted unilateral exchange rate changes even if unauthorized, made the IMF, which grew out of Bretton Woods, something of a “toothless tiger.” Opt-outs and transition periods of indeterminate length, amongst other things, prevented a full implementation of the Bretton Woods Agreement.

Yet Another Failed Gold Exchange Standard

By 1971, “the dollar was in essence the last ship moored to gold, with all the rest of the world’s currencies on board, and the United States was cutting the anchor and sailing off for good,” according to Steil. Nixon’s inflationary administration, overspending in Vietnam, asked the markets the question: Could an abundant dollar remain tied to gold even when stocks of gold had declined to lamentable levels? The answer was no. Attempts were made to revive it in 1973 through the G10, but nothing came of it. The fiat dollar was now king.

So Could an International Monetary System Be Made to Work without Gold?

The fiat money system based on paper notes, not gold backing, does have a number of advantages. Milton Friedman embraced the political reality that holding a gold standard together in endless international conferences was chimerical. The advantage of allowing the market to determine the level of the dollar against other currencies is that it frees policymakers to focus on national economic objectives rather than their balance of payments. The gold standard evil of unilateral exchange rate depreciation might not be such a big deal after all. On the other hand, Friedrich Hayek did not share Friedman’s view of floating exchange rates, believing the consequence would be volatile capital flows.

After Nixon closed the gold window, radical alternatives to the fiat money system based around international money, a revived gold standard, or private money competition were simply not congenial to governments, particularly the United States according to Steil’s telling of recent history. By the 1980s Friedman was in the ascendant with Paul Volcker acting to raise interest rates to almost any level and at any cost that would lower inflation.

The Great Moderation in the Greenspan era seemed to prove that gold was indeed a “barbarous relic,” just as Keynes had said. In the 1990s central banks even sold off large portions of their gold stocks driving the price down to $290 per ounce.

Why the Talk of a Return to the Gold Standard?

Working against a return to the gold standard today is a sickly combination of dollar deficiencies, a mountainous US trade deficit, the parallel mountain of Chinese surpluses, undervaluation of the Chinese currency, pressure from competitive devaluations in competing currencies, and the emergence of regionally significant political blocs.

What is different now from 1944, is that there isn’t any dominant leader-nation to coordinate such a shift, China is not ready for that role, and there has so far been no event big enough to prompt it. Which nation can tell China, Japan, Germany, and the emerging markets what to do with their surpluses and boss around the deficit countries too?

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Photo credit: Northwestern Litho. Co, Milwaukee

About the Author(s)
Mark Harrison, CFA

Mark Harrison, CFA, was director of journal publications at CFA Institute, where he supported a suite of member publications, including the Financial Analysts Journal, In Practice summaries, and CFA Digest. He has more than 12 years of investment experience as a portfolio manager and securities analyst. Harrison is a graduate of the University of Oxford.

17 thoughts on “Did the Gold Standard Work? Economics Before and After Fiat Money”

    1. Merle Clondike says:

      We are told Gold is different than fiat money, but this is a fallacy. Gold has to be pegged. It can be pegged too low or too high. Gold is fia money, too.

      1. MK says:

        That’s actually a misunderstanding. To use gold standard means pegging a currency to ounces of Gold not the other way around

  1. Brad says:

    You might find my take on fiat money interesting.

  2. J.P. says:

    “For the most part, the answer seems to be things turned out pretty badly. Its heyday as common currency for the British Empire in the later part of the 19th and early 20th century was interrupted by the First World War.”

    What I’ve always loved about you “experts” who deride the gold standard is how you cherry-pick everything. For example, “things turned out pretty badly” in the “lat[t]er part of the 19th” century. Really? England was the banker for the world in the 19th century and from 1815 to 1914 was a period of huge worldwide economic expansion AND was a period of unprecedented PEACE. I’m sure that it’s just an AMAZING COINCIDENCE that the world employed a gold standard at that time.

    The gold standard is NOT a monetary standard that can provide the kind of massive military expenditures on the scale of WWI. The war ruined the gold standard because of the deficit financing that both sides engaged in so as to prosecute the war. It’s RIDICULOUS to damn a system that neither side was abiding by. The gold standard isn’t perfect but the economic turmoil that resulted from the war was NOT a result of the gold standard; it was the result of deficit financing by a de facto fiat standard. Get it right, please.

    By the end of the war, the West had foolishly opted to adopt a fiat standard instead of trying to tweak the gold standard. Titanic wars, deficit spending, perpetual inflation, increasing government interference in your lives is NOT the fault of the gold standard.

    1. John Rock says:

      “England was the banker for the world in the 19th century and from 1815 to 1914 was a period of huge worldwide economic expansion AND was a period of unprecedented PEACE??????”

      Well, why wouldn’t England be the Banker for the world when huge wealth was flowing to Britian and America (in the form of heavy tariffs on British goods imported to America) from mighty Indian civilization which was colonized, looted, de-industrialized and Indian farm lands were used for growing opium by East India company (Rothchild family) that caused man made famines and forced starvation which led to the deaths of 85 million Indians for 200 yrs between (1747 to 1947) – The period of colonization of mighty Indian civilization by the British looters.

      India was the largest economy and richest civilization in the world between 1 AD to 1700 AD with a GDP average of 25 to 30% until the time of British invasion in 18th century according to OECD economist Angus Maddison who did a 20 yrs research on world economy for 2000 yrs. Angus Maddison’s book “World economy, a millennial perspective and historical statistics” says it all.

      Recently a sunken colonial British/Indian ship called SS Gairsoppa (named after a stunning waterfall in India, Bangalore) off the coast of Ireland by German U boat in 1942 was discovered. It was filled with 200 million dollars worth of silver bars looted from colonial India. It happened during the fag end of colonialism in 1942. Imagine how much wealth would have been looted by the British from India for 200 yrs before 1942 during peak colonialism.

      History cannot be built on lies and the truth would eventually come out in this period of Internet revolution. Thanks to internet.

    2. I agree that the supposed ‘experts’, who in most cases are little more than panderers to power, love to cherry pick data points to prove that which cannot be proven. The interesting part for me was how they gloss over the fact that World War I could not have taken place unless governments chose to abandon the gold standard. Since no population in Europe was willing to pay the full costs of the war governments chose to hide the real costs by abandoning convertibility. Before that war was totally over the world had more than 17 million dead, progressives and socialists came to power everywhere and Western society was in decline.

  3. Great post! Been reading a lot about currency and precious metals. Thanks for the info here!

  4. blah blah says:

    Here’s the summation of your article: anyone that has the motivation will find a way to abuse whatever system is in place if they so choose. We saw it with gold standard systems (as you pointed out). We see it with FIAT systems. Who is in charge of the system is an important part. The system having poor checks and balances (letting someone hoarde currency) also lets someone from the bottom-up manipulate the system. So, really, both systems come down to the corruption of man.

    However, a gold-standard system is more in tune with the people. They can have precious metals that are worth something. FIAT currency is more in tune with bankers. It provides a mechanic for them to manipulate markets (and people) with interest rates (and/or flooding the market with currency or drawing it out).

    Both systems can be flawed. I do feel precious metals should be used for more important things other than sitting in a vault or a person’s pocket book. We have all kinds of electronics and tech that precious metals are used in. They’re only useful if you use them, so locking them away as currency is like locking your virgins away for fear of them getting pregnant and propogating the human race. (IE: it just doesn’t make sense, and seems unnatural).

    But, both systems are abuseable.. because people can abuse them. And folks that abuse them will not put checks and balances into place to prevent abuse. Otherwise they lose their competitive advantage. In fact, the FED loves FIAT currency, because they can use it to manipulate our markets. They lower interest rates and hand out money, let things grow for a bit, then raise interest rates and call in loans… It’s like a harvest. They sow the seeds of growth, watch the growth, then reap it into their own pockets.

  5. Rolands says:

    I think this would be a question that can be debated for ages. Although with fiat money, credit creation is one of the important aspects that helps economies. But with gold, where it is only finite, it would have meant that the world would have had to live frugally and within its means.

    With gold standard we would have advanced at a very slower pace.

  6. Michael Carrigan says:

    A fiat currency enables socialists and other autocrats to redistribute wealth more easily. Just inflate the currency and pay off your supporters. Even if the Fed and other central bankers can be trusted for now, there is no assurance that their successors can be trusted in the future. The coming crisis is set to be worse than 2008. One only has to look at the on-balance sheet debt, off-balance debt of the United States and the general dependence upon debt to meet current obligations over time to see what is coming.

    Fixing a currency to an objective standard contributes to constraining a government to live within its means. A fiat currency is one more type of Ponzi scheme. Eventually, it crashes.

    While 100% gold reserves are not required, an additional constraint to fractional reserve banking would be the elimination of the FDIC. Banks can issue all the paper that they want. Their depositors don’t have to bank there if they feel uncomfortable. Now, bankers are rewarded with profits when times are good and bailed out when times are bad. They just work elsewhere except for the very few bank officers actually prosecuted by the FDIC. Why spread the contagion all over the world? Keep it contained.

    The United States has plenty of assets counted at zero on the books known as federal lands. The question is whether American want a country or not. Whether they want the country deeded over to the UN or some other one world successor all for the sake of security over freedom. We might as well have some control over the process instead of the U.S. dissolving as a result of a world court order brought by its creditors, whether foreign or not.

    Commodities have temporal value in the present world. Gold, land, cattle. The real currency. We have mere scrip now.

    When it comes, the end shall come quickly. With war.

    Those being carried by the creditors will feel compelled to submit.

    Genesis 47
    13 And there was no bread in all the land; for the famine was very sore, so that the land of Egypt and all the land of Canaan fainted by reason of the famine.

    14 And Joseph gathered up all the money that was found in the land of Egypt, and in the land of Canaan, for the corn which they bought: and Joseph brought the money into Pharaoh’s house.

    15 And when money failed in the land of Egypt, and in the land of Canaan, all the Egyptians came unto Joseph, and said, Give us bread: for why should we die in thy presence? for the money faileth.

    16 And Joseph said, Give your cattle; and I will give you for your cattle, if money fail.

    17 And they brought their cattle unto Joseph: and Joseph gave them bread in exchange for horses, and for the flocks, and for the cattle of the herds, and for the asses: and he fed them with bread for all their cattle for that year.

    18 When that year was ended, they came unto him the second year, and said unto him, We will not hide it from my lord, how that our money is spent; my lord also hath our herds of cattle; there is not ought left in the sight of my lord, but our bodies, and our lands:

    19 Wherefore shall we die before thine eyes, both we and our land? buy us and our land for bread, and we and our land will be servants unto Pharaoh: and give us seed, that we may live, and not die, that the land be not desolate.

    20 And Joseph bought all the land of Egypt for Pharaoh; for the Egyptians sold every man his field, because the famine prevailed over them: so the land became Pharaoh’s.

    21 And as for the people, he removed them to cities from one end of the borders of Egypt even to the other end thereof.

    22 Only the land of the priests bought he not; for the priests had a portion assigned them of Pharaoh, and did eat their portion which Pharaoh gave them: wherefore they sold not their lands.

    23 Then Joseph said unto the people, Behold, I have bought you this day and your land for Pharaoh: lo, here is seed for you, and ye shall sow the land.

    24 And it shall come to pass in the increase, that ye shall give the fifth part unto Pharaoh, and four parts shall be your own, for seed of the field, and for your food, and for them of your households, and for food for your little ones.

    25 And they said, Thou hast saved our lives: let us find grace in the sight of my lord, and we will be Pharaoh’s servants.

    26 And Joseph made it a law over the land of Egypt unto this day, that Pharaoh should have the fifth part, except the land of the priests only, which became not Pharaoh’s.

    Revelation 17
    5 And upon her forehead was a name written, Mystery, Babylon The Great, The Mother Of Harlots And Abominations Of The Earth.

    6 And I saw the woman drunken with the blood of the saints, and with the blood of the martyrs of Jesus: and when I saw her, I wondered with great admiration.

    7 And the angel said unto me, Wherefore didst thou marvel? I will tell thee the mystery of the woman, and of the beast that carrieth her, which hath the seven heads and ten horns.

    18 And the woman which thou sawest is that great city, which reigneth over the kings of the earth.

    Revelation 18
    8 Therefore shall her plagues come in one day, death, and mourning, and famine; and she shall be utterly burned with fire: for strong is the Lord God who judgeth her.

    9 And the kings of the earth, who have committed fornication and lived deliciously with her, shall bewail her, and lament for her, when they shall see the smoke of her burning,

    10 Standing afar off for the fear of her torment, saying, Alas, alas that great city Babylon, that mighty city! for in one hour is thy judgment come.

    11 And the merchants of the earth shall weep and mourn over her; for no man buyeth their merchandise any more:

    12 The merchandise of gold, and silver, and precious stones, and of pearls, and fine linen, and purple, and silk, and scarlet, and all thyine wood, and all manner vessels of ivory, and all manner vessels of most precious wood, and of brass, and iron, and marble,

    13 And cinnamon, and odours, and ointments, and frankincense, and wine, and oil, and fine flour, and wheat, and beasts, and sheep, and horses, and chariots, and slaves, and souls of men.

    14 And the fruits that thy soul lusted after are departed from thee, and all things which were dainty and goodly are departed from thee, and thou shalt find them no more at all.

    15 The merchants of these things, which were made rich by her, shall stand afar off for the fear of her torment, weeping and wailing,

    16 And saying, Alas, alas that great city, that was clothed in fine linen, and purple, and scarlet, and decked with gold, and precious stones, and pearls!

    17 For in one hour so great riches is come to nought. And every shipmaster, and all the company in ships, and sailors, and as many as trade by sea, stood afar off,

    18 And cried when they saw the smoke of her burning, saying, What city is like unto this great city!

  7. Mike Nelson says:

    “Under a classic gold standard, exchange rates are fixed…” Why that assumption? In a true free market rates aren’t fixed. You tweak the facts to fit your narrative.

  8. I think it’s important to point out that the US was never SUPPOSED to be on a “gold standard”. The Founding Fathers, specifically Judge Roger Sherman, had no intentions EVER of a gold standard. They set up a system of barter using GOLD AND SILVER COIN to do the bartering. Read Article 1 (sections 8 and 10) of the US Constitution.

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