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).
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