Gold Standard

  1. Evolution of International Monetary Systems
  Before the Gold Standard (550 BC - 1870 AD)
  (a) Gold Standard (1870 - 1945)
(b) Bretton Woods System (1945- 1971)
(c) Contemporary Monetary System (1973 - )
  2. Before the Gold Standard

Gold and silver are easy to process
(melting point: G =1064o C, silver = 962o C, platinum = 1768o C).
Gold has one electron on the 6th circuit.
Silver has one electron on the 5th circuit of electrons.
Platinum has one electron on the 6th circuit
(but the 4th circuit is more dense)

(original artwork by Greg Robson).

The single electron on the outermost orbit may ensure stability (nonoxidization).

The world in the Sixth Century BC

Travels of Confucius (551 - 479 BC)

According to Graham Levy, the earliest known coins were changing hands in the 6th century BC in Anatolia, in the kingdom of Lydia. Around 550 BC, King Croesus minted gold coins, made from electrum, a natural alloy of gold and silver found in the River Pactolus that flowed past Sardis, Lydia's capital. This was 98% gold. A punch and anvil die was used to stamp the coins with what is assumed to be the Lydian emblem of a lion, or a lion's paws, cutting the metal to reveal its consistency.

Gautama Siddharta(b. in 563 BC)

Siddharta, Confucius, Lao Zi, and King Croesus were contemporaries.
Confucius' travel (12 years, 501 - 489 BC).

  Gold was a primary means of exchange in the Roman Empire, gold mining was an important motive for Roman invasion of Britain, which was also rich in resources such as copper, iron, silver and lead.


British Museum

Historic Gold Coins
The original gold coins of Croesus and other historic gold coins. This is the medallion of Constantine, who founded the Byzantine Empire (May 11, 330 AD).
  British pound: pound refers to the amount of silver coined into money.

lira : pound in Italian
peso: weight in Spanish
mark: 1/2 pound
Why weigh coins? Gresham's law: Bad money drives out good money (Sir Thomas Gresham, 1519-1579).

Economic reason for the Dark Age (5th - 13th century)

Massolino and Masaccio (Early Renaissance)

Gradually, Romans were neglecting to support the Roman troops. From the 3rd century AD, Roman soldiers were replaced by hired foreign mercenaries, and financial support was insufficient.

Production of gold was suspended throughout Europe after the fall of the Roman Empire. This suspension of gold production was a primary cause of the stagnation of the Western Europe for about a thousand years. After the fall of Constantinople in 1204 AD, the Byzantine empire was broken. It was reestablished in 1261, and lasted for two more centuries until 1453 AD.

Frescoes of Capella Brancacci, Florence show the Renaissance architecture and the bankers wearing silk clothes and turbans, indicating trade with the Middle East.

Due to massive expansion of trade, Venice suddenly became a major power, competing with Genoa, especially after Arsenale Nuovo (shipyard) was built in 1320. Arsenale served not only as a shipyard, but also was responsible for maintenance of 3000 galleys. Florence gradually emerged as the banking center. Florin was minted in 1252 in Florence, and Venetian Ducat (coins issued by a Doge/Duke) in 1284, but gold was not produced again in significant quantities until the 20th century.

2% before 1492, and 8% (1492-1800) of the total amount of gold minted (4.5 billion oz).

From the end of the 15th century, navigation skills were gradually developed, and the Portuguese and Spaniards began to explore other continents.

Gold market in Venice


Venice accumulated a large trade surplus, which was held in gold.

Rialto Bridge today (May 2003). The price of gold was fixed on this bridge during the Renaissance period.


  3. Gold Standard
The world in the 1870s

In the 1820s, the industrial revolution was taking place in England.

In the United States, the Civil War (1861-1865) ended.

In Japan, the military rule of Tokugawa shogunate (1603-1867) was just over, some ports were opened to trade with European countries, and Emperor Meiji was instituting a major change in Japan (Meiji Restoration).

Admiral Perry of the United States came to Uraga, Japan and forced Japan to open up to trade, causing the fall of shogunate and triggering the Meiji Restoration (1868-1912) (15th shogun, Yoshinobu returned the power to the Emperor).

Europe's trade deficit with China ⇒ Opium Wars. The second Opium War (1856-1860) was just over and imports of opium was legalized in China.

A typical painting in the 15th century

Increases in the supply of gold ⇒ The Renaissance

Constantinople, Venice's arch rival, was conquered in 1204 after the 4th crusade war. After the fall of Constantinople in 1453 AD, the majority of intellectuals moved to the city states of Venice, Milan and Florence. By the early 1500s, Venice built a large shipyard, constructing many ships and thereby accumulating a huge trade surplus (in gold).

Also, Genoa became its rival, amassing enough wealth to compete with Venice (Christoforo Colombo (Columbus) was a Genoese). Florence became the banking center. In the process the Catholic church amassed enormous wealth from their offering. For example, bishops and cardinals during this Renaissance period commissioned many paintings to show their power.

As illustrated in this painting, many donors and influential people are represented in the corners.

1870 - 1914

The gold standard has no precise date of origin. It gradually emerged around 1870-1880 when most of the industrial nations of Europe adopted the gold standard. (Great Britain adopted the gold standard in 1821, Australia in 1852, Canada in 1853, France in 1878, Germany in 1871, the US in 1879)

The gold standard lasted until 1914, before the outbreak of World War I. During this period, most of the industrial nations linked their currencies to gold and inflation rates were about 0.1 percent.

No treaty or agreement When these nations were on the gold standard, there were no formal agreements with other nations. No treaty was signed. Each nation defended its currency in terms of gold. Its treasury or central bank was required by law to buy and sell gold without limit at the stated price. The public had complete confidence in the convertibility of its currency into gold.


  4. Process of Adjustment


By the Gold Standard Act, 1900(copy) The Coinage Act of 1872 demonetized silver.

One dollar was defined to be equal to the value of 23.22 grains of pure gold (1 troy ounce = 480 grains of gold).


The gold content of pound sterling was fixed by Coinage Act of 1816 (copy) at 113 grains of pure gold.

Britain adopted the gold standard in 1821. By 1833, Bank of England was obligated to redeem its notes in gold and silver coins. (Bank of England Act, 1833 (copy)


Thus, the par exchange rate between the dollar and the pound was

p£ = 113/23.22 = $4.866


The cost of shipping gold from London to New York was $0.026 per pound. So the exchange rate was allowed to fluctuate within the limits of $4.866 ± 0.026. Thus,

$4.892 = gold import point for UK

$4.840 = gold export point for UK

If the spot price of pound fell below the gold export point, it is cheaper for Britons to convert £ into gold, export gold, convert gold into $ and make $ payments.

Gold export point
Why actual gold movement was negligible

During the period of gold standard, (i) prices were stable, and (ii) so little gold actually moved between countries. This was because central banks were not passive, but they adjusted the interest rates to prevent the gold outflow.

For example, when the exchange rate approached the gold export point, the Bank of England raised the bank rate (the interest rate the central banks charge commercial banks, equivalent to the discount rate in the US). This caused investors in New York to shift funds to London, because they could earn higher interest.

  Long term capital movement also lessened the need for current account adjustments. Current account adjustment requires drastic price changes under fixed exchange rate system. Without long term capital movement, price adjustments could have been deflationary.


  4. Problems with the Gold Standard
Three Problems

(1) The gold standard is deflationary. In a closed economy under the gold standard, a country's money supply is determined by its stock of gold. To increase its money supply, the government must mine more gold. ⇒Economic growth is constrained by the gold supply. Limited supply of gold stifles economic growth and causes deflation. True, inflation is bad, but deflation is even worse. Firms had to lay off workers as price declined.

According to the World Gold Council, annual production of gold is about 2,500 metric tons or 80 million troy ounces . This implies that gross world product (GWP) cannot grow more than about $80 billion (at $1000/oz), had the world been on the gold standard today. (If velocity of money were 10, this amount changes to $800 billion.) Thus, the gold standard would cause a severe deflation in the world economy.

Unless more gold is mined, the economy cannot grow. When the gold stock is fixed, an increase in real output only causes deflation. (^M = 0 = ^P + ^Y). The velocity of money does not change. If the gold supply is fixed, then money supply and PY are fixed as well. Thus, in a growing economy, the gold standard is deflationary and retards economic growth. The Fed was required to hold 40% of money in gold. Almost 2/3 of gold was stored in the vaults of central banks.

(2) Difficult to control money supply. Gold production is limited. Also, in an open economy, a balance of payments deficit causes gold outflows ). Thus, a single country's ability to expand money supply is limited by its balance of payments position. An expansion of money supply causes a trade deficit. A gold outflow would set off a deflation.

(3) Difficult to insulate the domestic economy. A country cannot insulate its economy from external shocks. The discovery of a new gold mine increases the local supply of gold, but does not affect real outputs in the short run. Thus, an increase in gold supply raises prices. Due to fixed links between currencies, inflation or depression in one country is easily transmitted to other countries. (The Great Depression started by the Wall Street crash of 1929 was quickly transmitted to Europe and Asia.) While inflation rates were low during the period of the gold standard, prices could have been unstable.

Quantity Theory of Money


For the world as a whole, the growth of money supply is constrained by the flow of newly produced gold. Thus, the economic growth rate of a country or the world is limited by the growth of new gold production.

No new gold production ⇒ no growth.


After the collapse of the Roman Empire in 476 AD, there was no gold to pay soldiers (root = solidus) or to mine gold and mint gold coins. (Gold mines in Spain and Dacia were almost exhausted.) This decline of gold production and continued gold outflow to China caused a decline in Western Europe.

No significant amount of gold was produced until the age of Renaissance. ⇒1000 year-long recession in Western Europe. The economic cause for the advent of Dark Ages.

According to Rafal Swiecki, the total amount of gold mined from the earth to the end of 2014 is about 4.5 billion (4.5 x 109) troy oz. (about 32,000 tons) Of this amount,

2% was produced prior to 1492,
8% during the period 1492-1800, (due to navigation skills and trade, this period begins with the fall of Byzantine empire and the Renaissance.)
20% during the interval 1801-1900, and
70% from 1901-1985

(US: 8000 tons, IMF = 2,800 tons)

Annual gold production is about 80 million ounces (2500 tons) or $80 billion (at $1000/oz). GWP grows about $3 trillion each year today.

US owns 8000 tons or 0.25 billion oz (worth $250 billion at $1000/oz). Total stock of gold is about 140,000 tons, only a quarter is held by governments. (Bullionmark).


  5. Fluctuating Exchange Rates, 1919-1925

During World War I the international gold standard ceased to function. Its operation was suspended with the outbreak of war in August 1914 when Archduke Franz Ferdinand, the heir to the Austro-Hungarian Empire (June 1914) was assassinated in Sarajebo. Consequences: Russia (1917), Germany (1918), UK (1918) and China (1911) became republics/democracies, and Austro-Hungarian empires were split into many small republics.

European economies had been interlocked closely, but they were suddenly cut loose from the connective mechanism by war.

Countries diverged and developed in different directions during the war. By the end of war in June 1918, inflation rates varied greatly, because nations printed more money to finance war. Russian revolution occurred in 1917. The structure of world economy was profoundly altered by 1918.

Adjust gold parity?

It was clear that prewar exchange rates could not be restored. Thus, many countries delayed and were hesitant to fix official par values of their currencies. They allowed their currencies to float more or less freely in the foreign exchange market.

These countries did not realize that floating rates were the only viable solution. Instead, there was a universal expectation that floating exchange rates regime was temporary, and that countries would soon return to the gold standard. The main question was not whether to restore the gold standard, but at what parities to restore the gold standard.

at what parity?

Some urged that prewar parities should be restored.

others argued that economic conditions had changed equilibrium exchange rates between national currencies, and hence gold parities should be adjusted.


If 1914 is taken as the base (= 100), wholesale prices in December 1918 were as follows:

US 202
France 355
UK 246

Germany was off the gold standard at the outset of WWI. Germany agreed to pay £6.6 billion. By the end of 1919, $1 = 9 marks. By November 1923, $1 = 4.2 trillion marks.

US After the war in 1918, US immediately announced that it would maintain the dollar price of gold at its prewar level. That is, it is willing to export gold at $20.67 per ounce.
Great Britain

It was thought that Britain's national honor was at stake. Failure to restore the prewar parity of pound would undermine confidence in pound. Accordingly, Britain resorted to a deflationary policy (1920-1925). During the Asian Financial Crisis of 1997, South Korea followed the same deflationary policy, causing a spectacular increase in the unemployment rate.

Gold Standard Act, 1925 (copy)

During the war, UK's money supply more than doubled. By April 1925, Winston Churchill announced that the Bank of England would again redeem its notes into gold. Britain was back on the gold standard in 1925 at its prewar parity.

Instead of doubling the price of gold, Winston Churchill, Chancellor of Excheqer, cut the money supply in half, which caused a depression in 1926 , three years ahead of the Great Depression in the US in 1929.

John Maynard Keynes wrote The Economic Consequences of Mr. Churchill, arguing that this policy would lead to a world depression. Churchill later acknowledged that this was the greatest mistake of his life.


Contraction of money supply and unemployment.

France French Franc dropped from $0.18 in 1918 to $0.0392 in 1926, which stopped gold outflow from France. After the depreciation, France returned to the gold standard in 1928.
  6. Gold Standard Restored (1925-1931)
Gold Exchange Standard

Under this system, each country holds gold or dollar or pound as reserve asset.
(This system was invented due to the limited supply of gold. The scheme was designed to reduce the amount of gold needed for the reserve country.)

(i) The United States and Great Britain were to hold only gold as reserve asset.

(ii) key reserve currencies: dollar and pound . Nonreserve countries were asked to hold dollar or pound (rather than gold) as reserve asset (Hence, gold exchange standard. dollars and pounds were gold substitutes.) Other currencies are convertible into reserve currencies at fixed parities.

(iii) The Dollar and pound were freely convertible into gold between central banks, but not for the general public.

(iv) Most countries that had been on the silver standard also pegged silver to the dollar by 1890s, except China and Hong Kong.

At restored parities, the British pound was somewhat overvalued at $4.866 = 1, whereas FF was undervalued at $0.0392 = Fr 1.

  Britain had a BP deficit, France had a BP surplus (and gold inflow followed).

Under the gold exchange standard, a country has to resort to the classical medicine of deflating the domestic economy when faced with chronic BP deficits.

Deflationary policies (monetary or fiscal) stifle growth.

Before World War II, European nations often resorted to this policy, in particular the Great Britain. Even though few currencies were convertible into gold, policy makers thought that currencies should be backed by gold and willingly adopted deflationary policy after WWI.

Policy options

In the decade that followed (1930s), these countries had 3 options to prevent gold outflow:

(a) countries tried to manage or stabilize the flexible exchange rates - by raising interest rate, but it did not prevent capital outflow.

(b) Some countries devalued their currencies, but many countries already did this without success. Nevertheless, this would be the best option.

(c) others imposed exchange control when faced with capital flight.

End UK Gold Standard (Amendment) Act, 1931 copy
On September 21, 1931, Britain suspended gold payments. This put an end to the vain attempt to restore the gold standard. Many countries followed Britain's lead and abandoned the link to gold. For example, Japan also abandoned gold convertibility in December 1931, after its invasion of Manchuria.

Devaluation of dollar

In April 1933, President Franklin Roosevelt suspended the gold standard.

Gold Reserve Act of 1934 (copy)
(i) GRA prohibited gold coinage. In 1933, gold trade of US citizens were outlawed. Now, private possession of gold and gold export are outlawed.

(ii) It allowed the President to change the gold content of dollar. In January 1934, President Franklin Roosevelt raised the price of gold from $20.67 to $35.00 per ounce. ⇒ This resulted in gold inflow into the US.

(40% devaluation of dollar, or 69% increase in the price of gold)

France devalued Franc in 1936. Europe was in a turmoil by the outbreak of WWII in 1939.