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The classical gold standard (which ended in 1914) and the interwar gold standard are examined within the same framework, but their experiences are vastly different.

Types of Gold Standard

All gold standards involve (a) a fixed gold content of the domestic monetary unit, and (b) the monetary authority both buying and selling gold at the mint price (the inverse of the gold content of the monetary unit), whereupon the mint price governs in the marketplace. A ‘coin’ standard has gold coin circulating as money. Privately owned bullion (gold in form other than domestic coin) is convertible into gold coin, at (approximately) the mint price, at the government mint or central bank. Private parties may melt domestic coin into bullion – the effect is as if coin were sold to the monetary authority for bullion. The authority could sell gold bars directly for coin, saving the cost of coining.

Under a pure coin standard, gold is the only money. Under a mixed standard, there are also notes issued by the government, central bank, or commercial banks, and possibly demand deposits. Government or central-bank notes (and central-bank deposit liabilities) are directly convertible into gold coin at the fixed price on demand. Commercial-bank notes and demand deposits are convertible into gold or into gold-convertible government or central-bank currency. Gold coin is always exchangeable for paper currency or deposits at the mint price. Two-way transactions again fix the currency price of gold at the mint price.

The coin standard, naturally ‘domestic’, becomes ‘international’ with freedom of international gold flows and of foreign-exchange transactions. Then the fixed mint prices of countries on the gold standard imply a fixed exchange rate (mint parity) between their currencies.

A ‘bullion’ standard is purely international. Gold coin is not money; the monetary authority buys or sells gold bars for its notes. Similarly, a ‘gold-exchange’ standard involves the monetary authority buying and selling not gold but rather gold-convertible foreign exchange (the currency of a country on a gold coin or bullion standard).

For countries on an international gold standard, costs of importing and exporting gold give rise to ‘gold points’, and therefore a ‘gold-point spread’, around the mint parity. If the exchange rate, number of units of domestic per unit of foreign currency, is greater (less) than the gold export (import) point, arbitrageurs sell (purchase) foreign currency at the exchange rate and also obtain (relinquish) foreign currency by exporting (importing) gold. The domestic-currency cost of the transaction per unit of foreign currency is the gold export (import) point; so the ‘gold-point arbitrageurs’ receive a profit proportional to the exchange-rate/gold-point divergence. However, the arbitrageurs’ supply of (demand for) foreign currency returns the exchange rate to below (above) the gold export (import) point. Therefore perfect arbitrage would keep the exchange rate within the gold-point spread. What induces gold-point arbitrage is the profit motive and the credibility of the monetary-authorities’ commitment to (a) the fixed gold price and (b) freedom of gold and foreign-exchange transactions.

A country can be effectively on a gold standard even though its legal standard is bimetallism. This happens if the gold – silver mint-price ratio is greater than the world price ratio. In contrast, even though a country is legally on a gold standard, its government and banks could ‘suspend specie payments’, that is, refuse to convert their notes into gold; so that the country is in fact on a ‘paper standard’.

Countries on the Classical Gold Standard

Britain, France, Germany and the United States were the ‘core countries’ of the gold standard. Britain was the ‘centre country’, indispensable to the spread and functioning of the standard. Legally bimetallic from the mid-13th century, Britain switched to an effective gold standard early in the 18th century. The gold standard was formally adopted in 1816, ironically during a paper-standard regime (Bank Restriction Period). The United States was legally bimetallic from 1786 and on an effective gold standard from 1834, with a legal gold standard established in 1873–4 – also during a paper standard (the greenback period). In 1879 the United States went back to gold, and by that year not only the core countries but also some British dominions and non-core western European countries were on the gold standard. As time went on, a large number of other countries throughout the globe adopted gold; but they (along with the dominions) were in ‘the periphery’ – acted on rather than actors – and generally (except for the dominions) not as committed to the gold standard.

Almost all countries were on a mixed coin standard. Some periphery countries were on a gold-exchange standard, usually because they were colonies or territories of a country on a coin standard.

In 1913, the only countries not on gold were traditional silver – standard countries (Abyssinia, China, French Indochina, Hong Kong, Honduras, Morocco, Persia, Salvador), some Latin American paper-standard countries (Chile, Colombia, Guatemala, Haiti, Paraguay), and Portugal and Italy (which had left gold but ‘shadowed’ the gold standard, pursuing policies as if they were gold-standard countries, keeping the exchange rate relatively stable).

Elements of Instability in Classical Gold Standard

Three factors made for instability of the classical gold standard. First, the use of foreign exchange as official reserves increased as the gold standard progressed. While by 1913 only Germany among the core countries held any measurable amount of foreign exchange, the percentage for the rest of the world was double that for Germany. If there were a rush to cash in foreign exchange for gold, reduction of the gold of reserve-currency countries would place the gold standard in jeopardy.

Second, Britain was in a particularly sensitive situation. In 1913, almost half of world foreign-exchange reserves was in sterling, but the Bank of England had only three per cent of gold reserves. The Bank of England’s ‘reserve ratio’ (ratio of ‘official reserves’ to ‘liabilities to foreign monetary authorities held in London financial institutions’) was only 31 per cent, far lower than those of the monetary authorities of the other core countries. An official run on sterling could force Britain off the gold standard. Private foreigners also held considerable liquid assets in London, and could themselves initiate a run on sterling.

Third, the United States was a source of instability to the gold standard. Its Treasury held a high percentage of world gold reserves (in 1913, more than that of the three other core countries combined). With no central bank and a decentralized banking system, financial crises were more frequent and more severe than in the other core countries. Far from the United States assisting Britain, gold often flowed from the Bank of England to the United States, to satisfy increases in US demand for money. In many years the United States was a net importer rather than exporter of capital to the rest of the world – the opposite of the other core countries. The political power of silver interests and recurrent financial panics led to imperfect credibility in the US commitment to the gold standard. Indeed, runs on banks and on the Treasury gold reserve placed the US gold standard near collapse in the 1890s. The credibility of the Treasury’s commitment to the gold standard was shaken; twice the US gold standard was saved only by cooperative action of the Treasury and a bankers’ syndicate, which stemmed gold exports.

Automatic Force for Stability: Price Specie-Flow Mechanism

The money supply is the product of the money multiplier and the monetary base. The monetary authority alters the monetary base by changing its gold holdings and domestic assets (loans, discounts, and securities). However, the level of its domestic assets is dependent on its gold reserves, because the authority generates demand liabilities (notes and deposits) by increasing its assets, and convertibility of these liabilities must be supported by a gold reserve. Therefore the gold standard provides a constraint on the level (or growth) of the money supply.

Further, balance-of-payments surpluses (deficits) are settled by gold imports (exports) at the gold import (export) point. The change in the money supply is the product of the money multiplier and the gold flow, providing the monetary authority does not change its domestic assets. For a country on a gold-exchange standard, holdings of foreign exchange (a reserve currency) take the place of gold.

A country experiencing a balance-of-payments deficit loses gold and its money supply decreases automatically. Money income contracts and the price level falls, thereby increasing exports and decreasing imports. Similarly, a surplus country gains gold, exports decrease, and imports increase. In each case, balance-of-payments equilibrium is restored via the current account, the ‘price specie-flow mechanism’. To the extent that wages and prices are inflexible, movements of real income in the same direction as money income occur; the deficit country suffers unemployment, while the payments imbalance is corrected.

The capital account also acts to restore balance, via interest-rate increases in the deficit country inducing a net inflow of capital. The interest-rate increases also reduce real investment and thence real income and imports. The opposite occurs in the surplus country.

Rules of the Game

Central banks were supposed to reinforce (rather than ‘sterilize’) the effect of gold flows on the monetary base, thereby enhancing the price specie-flow mechanism. A gold outflow decreases the international assets of the central bank and the money supply. The central-bank’s ‘proper’ response is: (1) decrease lending and sell securities, thereby decreasing domestic assets and the monetary base; (2) raise its ‘discount rate’, which induces commercial banks to adopt a higher reserves–deposit ratio, thereby reducing the money multiplier. On both counts, the money supply is further decreased. Should the central bank increase its domestic assets when it loses gold, it engages in sterilization of the gold flow, violating the ‘rules of the game’. The argument also holds for gold inflow, with sterilization involving the central bank decreasing its domestic assets when it gains gold.

Monetarist theory suggests the ‘rules’ were inconsequential. Under fixed exchange rates, gold flows adjust money supply to money demand; the money supply is not determined by policy. Also, prices, interest rates, and incomes are determined worldwide. Even core countries can influence these variables domestically only to the extent that they help determine them in the global marketplace. Therefore the price-specie flow and like mechanisms cannot occur. Historical data support this conclusion: gold flows were too small to be suggestive of these processes; and, at least among the core countries, prices, incomes, and interest rates moved closely in correspondence, contradicting the specie-flow mechanism and rules of the game.

Rather than rule (1), central-bank domestic and international assets moving in the same direction, the opposite behaviour – sterilization – was dominant, both in core and non-core European countries. The Bank of England followed the rule more than any other central bank, but even so violated it more often than not!

The Bank of England did, in effect, manage its discount rate (‘Bank Rate’) in accordance with rule (2). The Bank’s primary objective was to maintain convertibility of its notes into gold, and its principal tool was Bank Rate. When the Bank’s ‘liquidity ratio’ (ratio of gold reserves to outstanding note liabilities) decreased, it usually increased Bank Rate. The increase in Bank Rate carried with it market short-term interest rates, inducing a short-term capital inflow and thereby moving the exchange rate away from the gold-export point. The converse also held, with a rise in the liquidity ratio generating a Bank Rate decrease. The Bank was constantly monitoring its liquidity ratio, and in response altered Bank Rate almost 200 times over 1880–1913.

While the Reichsbank also generally moved its discount rate inversely to its liquidity ratio, other central banks often violated rule (2). Discount-rate changes were of inappropriate direction, or of insufficient magnitude or frequency. The Bank of France kept its discount rate stable, choosing to have large gold reserves, with payments imbalances accommodated by fluctuations in its gold rather than financed by short-term capital flows. The United States, lacking a central bank, had no discount rate to use as a policy instrument.

Reason for Stability: Credible Commitment to Convertibility

From the late 1870s onward, there was absolute private-sector credibility in the commitment to the fixed domestic-currency price of gold on the part of Britain, France, Germany, and other important European countries. For the United States, this absolute credibility applied from about 1900. That commitment had a contingency aspect: convertibility could be suspended in the event of dire emergency; but, after normal conditions were restored, convertibility and honouring of gold contracts would be re-established at the pre-existing mint price – even if substantial deflation was required to do so. The Bank Restriction and greenback periods were applications of the contingency. From 1879, the ‘contingency clause’ was exercised by none of these countries.

The absolute credibility in countries’ commitment to convertibility at the existing mint price implied that there was zero ‘convertibility risk’ (Treasury or central-bank notes non-redeemable in gold at the established mint price) and zero ‘exchange risk’ (alteration of mint parity, institution of exchange control, or prohibition of gold export).

Why was the commitment to credibility so credible?

  1. 1.

    Contracts were expressed in gold; abandonment of convertibility meant violation of contracts – anathema to monetary authorities.

  2. 2.

    Shocks to economies were infrequent and generally mild.

  3. 3.

    The London capital market was the largest, most open, most diversified in the world, and its gold market was also dominant. A high proportion of world trade was financed in sterling, London was the most important reserve-currency centre, and payments imbalances were often settled by transferring sterling assets rather than gold. Sterling was an international currency – a boon to other countries, because sterling involved positive interest return, and its transfer costs were much less than those of gold. Advantages to Britain were the charges for services as an international banker, differential interest return on its financial intermediation, and the practice of countries on a sterling (gold-exchange) standard of financing payments surpluses with Britain by piling up short-term sterling assets rather than demanding Bank gold.

  4. 4.

    ‘Orthodox metallism’ – authorities’ commitment to an anti-inflation, balanced-budget, stable-money policy – reigned. This ideology implied low government spending, low taxes, and limited monetization of government debt. Therefore, it was not expected that a country’s price level would get out of line with that of other countries.

  5. 5.

    Politically, gold had won over paper and silver, and stable-money interests (bankers, manufacturers, merchants, professionals, creditors, urban groups) over inflationary interests (farmers, landowners, miners, debtors, rural groups).

  6. 6.

    There was a competitive environment and freedom from government regulation. Prices and wages were flexible. The core countries had virtually no capital controls, Britain had adopted free trade, and the other core countries had only moderate tariffs. Balance-of-payments financing and adjustment were without serious impediments.

  7. 7.

    With internal balance an unimportant goal of policy, preservation of convertibility of paper currency into gold was the primary policy objective. Sterilization of gold flows, though frequent, was more ‘meeting the needs of trade’ (passive monetary policy) than fighting unemployment (active monetary policy).

  8. 8.

    The gradual establishment of mint prices over time ensured that mint parities were in line with relative price levels; so countries joined the gold standard with exchange rates in equilibrium.

  9. 9.

    Current-account and capital-account imbalances tended to be offsetting for the core countries. A trade deficit induced a gold loss and a higher interest rate, attracting a capital inflow and reducing capital outflow. The capital-exporting core countries could stop a gold loss simply by reducing lending abroad.

Implications of Credible Commitment

Private parties reduced the need for balance-of-payments adjustment, via both gold-point arbitrage and stabilizing speculation. When the exchange rate was outside the spread, gold-point arbitrage quickly returned it to the spread. Within the spread, as the exchange value of a currency weakened, the exchange rate approaching the gold-export point, speculators had an ever greater incentive to purchase domestic with foreign currency (a capital inflow). They believed that the exchange rate would move in the opposite direction, enabling reversal of their transaction at a profit. Similarly, a strengthened currency involved a capital outflow. The further the exchange rate moved toward a gold point, the greater the potential profit opportunity in betting on a reversal of direction; for there was a decreased distance to that gold point and an increased distance from the other point. This ‘stabilizing speculation’ increased the exchange value of depreciating currencies, and thus gold loss could be prevented. Absence of controls meant such private capital flows were highly responsive to exchange-rate changes.

Government Policies That Enhanced Stability

Specific government policies enhanced gold-standard stability. First, by the turn of the 20th century, South Africa – the main world gold producer – was selling all its gold output in London, either to private parties or to the Bank of England. Thus the Bank had the means to replenish its gold reserves. Second, the orthodox-metallism ideology and the leadership of the Bank of England kept countries’ monetary policies disciplined and in harmony. Third, the US Treasury and the central banks of the other core countries manipulated gold points, to stem gold outflow. The cost of exporting gold was artificially increased (for example, by increasing selling prices for bars and foreign coin) and/or the cost of importing gold artificially decreased (for example, by providing interest-free loans to gold importers).

Fourth, central-bank cooperation was forthcoming during financial crises. The precarious liquidity position of the Bank of England meant that it was more often the recipient than the provider of financial assistance. In crises, the Bank would obtain loans from other central banks, and the Bank of France would sometimes purchase sterling to support that currency. When needed, assistance went from the Bank of England to other central banks. Also, private bankers unhesitatingly made loans to central banks in difficulty.

Thus, ‘virtuous’ interactions were responsible for the stability of the gold standard. The credible commitment to convertibility of paper money at the established mint price, and therefore to fixed mint parities, were both a cause and an effect of the stable environment in which the gold standard operated, the stabilizing behaviour of arbitrageurs and speculators, and the responsible policies of the authorities – and these three elements interacted positively among themselves.

Experience of Periphery

An important reason for periphery countries to join and maintain the gold standard was the fostering of access to core-countries’ capital markets. Adherence to the gold standard connoted that the peripheral country would follow responsible macroeconomic policies and repay debt. This ‘seal of approval’, by reducing the risk premium, involved a lower interest rate on the country’s bonds sold abroad, and very likely a higher volume of borrowing, thereby enhancing economic development.

However, periphery countries bore the brunt of the burden of adjustment of payments imbalances with the core (and other western European) countries. First, when the gold-exchange-standard periphery countries ran a surplus (deficit), they increased (decreased) their liquid balances in the United Kingdom (or other reserve-currency country) rather than withdraw gold from (lose gold to) the reserve-currency country. The monetary base of the periphery country increased (decreased), but that of the reserve-currency country remained unchanged. Therefore, changes in domestic variables – prices, incomes, interest rates, portfolios – that occurred to correct the imbalance were primarily in the periphery.

Second, when Bank Rate increased, London drew funds from France and Germany, which attracted funds from other European countries, which drew capital from the periphery. Also, it was easy for a core country to correct a deficit by reducing lending to, or bringing capital home from, the periphery. While the periphery was better off with access to capital, its welfare gain was reduced by the instability of capital import. Third, periphery-countries’ exports were largely primary products, sensitive to world market conditions. This feature made adjustment in the periphery take the form more of real than financial correction.

The experience of adherence to the gold standard differed among periphery groups. The important British dominions and colonies successfully maintained the gold standard. They paid the price of serving as an economic cushion to the Bank of England’s financial situation; but, compared with the rest of the periphery, gained a stable long-term capital inflow. In southern Europe and Latin America, adherence to the gold standard was fragile. The commitment to convertibility lacked credibility, and resort to a paper standard occurred. Many of the reasons for credible commitment that applied to the core countries were absent. There were powerful inflationary interests, strong balance-of-payments shocks, and rudimentary banking sectors. The cost of adhering to the gold standard was apparent: loss of the ability to depreciate the currency to counter reductions in exports. Yet the gain, in terms of a steady capital inflow from the core countries, was not as stable or reliable as for the British dominions and colonies.

Breakdown of Classical Gold Standard

The classical gold standard was at its height at the end of 1913, ironically just before it came to an end. The proximate cause of the breakdown of the classical gold standard was the First World War. However, it was the gold-exchange standard and the Bank of England’s precarious liquidity position that were the underlying cause. With the outbreak of war, a run on sterling led Britain to impose extreme exchange control – a postponement of both domestic and international payments – making the international gold standard inoperative. Convertibility was not suspended legally; but moral suasion, legalistic action, and regulation had the same effect. The Bank of England commandeered gold imports and applied moral suasion to bankers and bullion brokers to restrict gold exports.

The other gold-standard countries undertook similar policies – the United States not until 1917, when it adopted extra-legal restrictions on convertibility and restricted gold exports. Commercial banks converted their notes and deposits only into currency. Currency convertibility made mint parities ineffective; floating exchange rates resulted.

Return to the Gold Standard

After the First World War, a general return to gold occurred; but the interwar gold standard differed institutionally from the classical gold standard. First, the new gold standard was led by the United States, not Britain. The US embargo on gold exports was removed in 1919, and currency convertibility at the pre-war mint price was restored in 1922. The gold value of the dollar rather than pound sterling was the typical reference point around which other currencies were aligned and stabilized. The core now had two central countries, the United Kingdom (which restored gold in 1925) and the United States.

Second, for many countries there was a time lag between stabilizing the currency in the foreign-exchange market (fixing the exchange rate or mint parity) and resuming currency convertibility. The interwar gold standard was at its height at the end of 1928, after all core countries were fully on the standard and before the Great Depression began. The only countries that never joined the interwar gold standard were the USSR, silver-standard countries (China, Hong Kong, Indochina, Persia, Eritrea), and some minor Asian and African countries.

Third, the ‘contingency clause’ of convertibility conversion, that required restoration of convertibility at the mint price that existed prior to the emergency (the First World War), was broken by various countries, and even core countries. While some countries (including the United States and United Kingdom) stabilized their currencies at the pre-war mint price, others (including France) established a gold content of their currency that was a fraction of the pre-war level: the currency was devalued in terms of gold, the mint price was higher than pre-war. Still others (including Germany) stabilized new currencies adopted after hyperinflation.

Fourth, the gold coin standard, dominant in the classical period, was far less prevalent in the interwar period. All four core countries had been on coin in the classical gold standard; but only the United States was on coin interwar. The goldbullion standard, non-existent pre-war, was adopted by the United Kingdom and France. Germany and most non-core countries were on a gold-exchange standard.

Instability of Interwar Gold Standard

The interwar gold standard was replete with forces making for instability.

  1. 1.

    The process of establishing fixed exchange rates was piecemeal and haphazard, resulting in disequilibrium exchange rates. Among core countries, the United Kingdom restored convertibility at the pre-war mint price without sufficient deflation, and had an overvalued currency of about ten per cent. France and Germany had undervalued currencies.

  2. 2.

    Wages and prices were less flexible than in the pre-war period.

  3. 3.

    Higher trade barriers than pre-war also restrained adjustment.

  4. 4.

    The gold-exchange standard economized on total world gold via the gold of the United Kingdom and United States in their reserves role for countries on the gold-exchange standard and also for countries on a coin or bullion standard that elected to hold part of their reserves in London or New York. However, the gold-exchange standard was unstable, with a conflict between (a) the expansion of sterling and dollar liabilities to foreign central banks, to expand world liquidity, and (b) the resulting deterioration in the reserve ratio of US and UK authorities.

    This instability was particularly severe, for several reasons. First, France was now a large official holder of sterling, and France was resentful of the United Kingdom. Second, many more countries were on the gold-exchange standard than pre-war. Third, the gold-exchange standard, associated with colonies in the classical period, was considered a system inferior to a coin standard.

  5. 5.

    In the classical period, London was the one dominant financial centre; in the interwar period it was joined by New York and, in the late 1920s, Paris. Private and official holdings of foreign currency could shift among the two or three centres, as interest-rate differentials and confidence levels changed.

  6. 6.

    There was maldistribution of gold. In 1928, official reserve-currency liabilities were much more concentrated than in 1913, British pounds accounting for 77 per cent of world foreign-exchange reserves and French francs less than two per cent (versus 47 and 30 per cent in 1913). Yet the United Kingdom held only seven per cent of world official gold and France 13 per cent. France also possessed 39 per cent of world official foreign exchange. The United States held 37 per cent of world official gold.

  7. 7.

    Britain’s financial position was even more precarious than in the classical period. In 1928, the gold and dollar reserves of the Bank of England covered only one-third of London’s liquid liabilities to official foreigners, a ratio hardly greater than in 1913. UK liquid liabilities were concentrated on stronger countries (France, United States), whereas UK liquid assets were predominantly in weaker countries (Germany). There was ongoing tension with France, which resented the sterling-dominated gold-exchange standard and desired to cash in its sterling holding for gold, to aid its objective of achieving first-class financial status for Paris.

  8. 8.

    Internal balance was an important goal of policy, which hindered balance-of-payments adjustment, and monetary policy was influenced by domestic politics rather than geared to preservation of currency convertibility.

  9. 9.

    Credibility in authorities’ commitment to the gold standard was not absolute. Convertibility risk and exchange risk could be high, and currency speculation could be destabilizing rather than stabilizing. When a country’s currency approached or reached its gold-export point, speculators might anticipate that currency convertibility would not be maintained and that the currency would be devalued.

  10. 10.

    The ‘rules of the game’ were violated even more often than in the classical gold standard. Sterilization of gold inflows by the Bank of England can be viewed as an attempt to correct the overvalued pound by means of deflation. However, the US and French sterilization of their persistent gold inflows reflected exclusive concern for the domestic economy and placed the burden of adjustment (deflation) on other countries.

  11. 11.

    The Bank of England did not provide a leadership role in any important way, and central-bank cooperation was insufficient to establish credibility in the commitment to currency convertibility. The Federal Reserve had three targets for its discount-rate policy: strengthen the pound, combat speculation in the New York stock market, and achieve internal balance – and the first target was of lowest priority. Although, for the sake of external balance, the Bank of England kept Bank Rate higher than internal considerations would dictate, it was understandably reluctant to abdicate Bank Rate policy entirely to the balance of payments, with little help from the Federal Reserve. To keep the pound strong, substantial international cooperation was required, but was not forthcoming.

Breakdown of Interwar Gold Standard

The Great Depression triggered the unravelling of the gold standard. The depression began in the periphery. Low export prices and debt-service requirements created insurmountable balance-of-payments difficulties for gold-standard commodity producers. However, US monetary policy was an important catalyst. In 1927 the Federal Reserve favoured easy money, which supported foreign currencies but also fed the New York stock-market boom. Reversing policy to tame the boom, higher interest rates attracted monies to New York, weakening sterling in particular. The crash of October 1929, while helping sterling, was followed by the US depression.

This spread worldwide, with declines in US trade and lending. In 1929 and 1930 a number of periphery countries –both dominions and Latin American countries – either formally suspended currency convertibility or restricted it so that currencies violated the gold-export point.

It was destabilizing speculation, emanating from lack of confidence in authorities’ commitment to currency convertibility, which ended the interwar gold standard. In May 1931 there was a run on Austria’s largest commercial bank, and the bank failed. The run spread to other eastern European countries and to Germany, where an important bank also collapsed. The countries’ central banks lost substantial reserves; international financial assistance was too late; and in July 1931 Germany adopted exchange control, followed by Austria in October. These countries were definitively off the gold standard.

The Austrian and German experiences, as well as British budgetary and political difficulties, were among the factors that destroyed confidence in sterling, which occurred in mid-July 1931. Runs on sterling ensued, and the Bank of England lost much of its reserves. Loans from abroad were insufficient, and in any event taken as a sign of weakness. The gold standard was abandoned in September, and the pound quickly and sharply depreciated on the foreign-exchange market, as overvaluation of the pound would imply.

Following the UK abandonment of the gold standard, many countries followed, some to maintain their competitiveness via currency devaluation, others in response to destabilizing capital flows. The United States held on until 1933, when both domestic and foreign demands for gold, manifested in runs on US commercial banks, became intolerable. ‘Gold bloc’ countries (France, Belgium, Netherlands, Switzerland, Italy, Poland), with their currencies now overvalued and susceptible to destabilizing speculation, succumbed to the inevitable by the end of 1936.

The Great Depression was worsened by the gold standard: gold-standard countries hesitated to inflate their economies, for fear of suffering loss of gold and foreign-exchange reserves, and being forced to abandon convertibility or the gold parity. The gold standard involved ‘golden fetters’, which inhibited monetary and fiscal policy to fight the Depression. As countries left the gold standard, removal of monetary and fiscal policy from their ‘gold fetters’ enabled their use in expanding real output, providing the political will existed.

In contrast to the interwar gold standard, the classical gold standard functioned well because of a confluence of ‘virtuous’ interactions, involving government policies, credible commitment to the standard, private arbitrage and speculation, and fostering economic and political environment. We will not see its like again.

See Also