Centralized economic and monetary discussions were not common in the nineteenth century. Therefore, it is not easy to document the origins of the gold standard. During this period, there was a general acceptance that currencies should have a metallic content. However, the agreement did not entail a consensus on which metal should be used. A gold standard became the basis for an international monetary arrangement, initially through usage but later through the establishment of a convention. Under the gold standard, the theory of the process of economic adjustment emphasizes its automatic nature. Domestic currencies were equated with a given quantity of gold. The metal was freely coined and traded, and governments purchased and sold gold at a fixed price. This paper attempts to discuss: the nature of international gold rule, 1880-1914; and the effects of this standard in terms of stabilizing the financial systems and facilitating long-term adjustments to eliminate trade imbalances.
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The Nature of International Gold Standard Rule, 1880-1914
The gold standard rule was a commitment mechanism to set the price of a country’s currency in terms of gold to prevent governments from following: first, using debt finance to smooth revenues over time. For instance, when a government is faced with unusual expenditures, such as wartime expenditures, it may find it efficient to sell bonds that charge higher taxes, which can reduce work effort at the period of emergency (Eichengreen, 119). The government issues the debt on the assumption that taxes would be increased once the emergency is passed, to service and reduce the debt. In this case, government fiscal policy that is not time consistent, would be to charge a capital levy or to default on the debt, once the public has bought it. Adoption of such policy will enable government to acquire additional resources in the present, however, in the event of a future emergency would make it difficult for the government to dispose of its bonds at favorable prices. Thus, a credible commitment, such as gold standard rule, was necessary to force government to honor its outstanding debts; and second, the gold standard rule prevented governments from altering monetary growth from its pr-announced intentions, by barring the authorities from cheating, to preserve price stability in the long term (Gallaroti 8).
The gold standard rule involved defining a gold coin as a fixed measure of gold, such as, one dollar. The country’s monetary authority was then committed to maintaining the mint price of gold fixed through the acquisition and disposal of gold in unlimited potions. The bimetallic system based on gold and silver prevailed in most countries until the third quarter of the nineteenth century. The monetary authorities in these countries would define would measure the weight of both gold and silver coins, purchasing and selling them freely (Gallaroti 55).
The international gold standard rule emerged by 1880 following adoption from bimetallism, silver monometallic, and paper to gold as a basis of currencies by majority of countries. The key rule of the international standard was to maintain gold convertibility at the par established. It also ensured maintenance of fixed prices of Gold which in turn ensured fixed exchange rates. Throughout the period 1880-1914, the exchange rates were characterized by a high degree of fixity in the major countries. Therefore, the international gold standard was a successful form of exchange rate system. Primarily, the gold standard rule was a domestic rule with an important international dimension. This international dimension served to make domestic gold standard rule more credible. Adherence to the international gold standard rule was enforced by mechanisms that included improved access to international capital markets, the hegemonic supremacy of England, and the operations of the “rules game” (Gallaroti 8).
The majority of countries examined sustenance of gold convertibility as necessary in gaining access at terms that are favorable to the international capital markets of principle countries, especially England and France. Creditors at that time would examine gold convertibility as a sign of stable government finance and the future ability to service debt. This was important for developing countries, such as, Austria-Hungary, and Latin America that had wished to have access to long-term capital. It was also necessary for countries that wished to finance war expenditures. For instance, Japan financed their war of 1905-1906 with Russia with foreign loans after joining the gold standard. These countries feared the consequences of pulling out once joining the international gold standard. England was the most successful country in the nineteenth century. Therefore, as members of the international gold standard, England and other progressive nations, presented a strong argument for other countries to join the international gold standard (Gallaroti 10).
The operation of the “rules of the game” by government monetary authorities was a significant part of the commitment mechanism to the international gold standard rule. During the operation of the rules game, monetary authorities were required to alter the discount rate to accelerate the adjustment to a change in external balance (Bloomfield 47). For instance, when a nation was experiencing a deficit in its balance of payments and there was a gold outflow, the monetary authority, observing a decline in its gold reserves, was mandated to increase its discount rate for the purpose of reducing domestic credit. The price levels would be reduced by the resultant drop in the money supply. The higher short-term domestic interest rates attracting capital from abroad assisted the adjustment process (Dornbusch 313).
Effects of the International Gold Standard, 1880-1914
The period 1880 until 1914 is commonly viewed as a halcyon period especially in international monetary relations. During this period, financial crises happened, for instance, the barring crisis in 1890, and in 1893 and 1907. Throughout this period, the major central banks were able to maintain gold convertibility in their currencies. This system was only interrupted by the outbreak of World War 1 in 1914. Probably, the system might have functioned reasonably well for a longer duration had war not intervened in that year. There are several effects that can be attributed to international gold standard, 1880-1914. This paper discusses only two major effects, which include; stabilization of the financial markets, and facilitation of long-term adjustments such as elimination of trade imbalances.
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Stabilized the Financial Systems
The city of London was central to the international gold standard system. The Bank of England was at the center of the London financial community. London’s strategic position in the international financial community at that time clearly indicated the Bank of England was the Central Bank of the world. The international financial system during this period was characterized by stability (Dornbusch 313). For instance, there were unchanging exchange rates among countries with gold; that is, devaluations were rare. In addition, the problems of balance of payments were not disruptive as it came to be witnessed under the Breton woods system (Krugman 541).
The international gold standard, 1880-1914 stressed international stability. There were two main explanations for this international stability; first, the development of trade imbalances in the short run, led capital to flow in the opposite direction. The counter flow of capital would occur because of the effects of gold flows on money supplies and interest rates. Such effects on interest rates were generated by central authorities in the UK. Obviously, the changed flows of capital in reaction to changes in interest rates were primarily stock adjustment processes and therefore inherently temporary. Thus capital flows do not offer a satisfactory explanation of long-term flow adjustment. Once stock capital adjustment had taken place and capital has ceased moving, the outward gold flows caused by original trade imbalance would reappear (Gallaroti 6).
Applications of the Rules of International Gold Standard facilitated long term adjustments such as Elimination of Trade Imbalances
Hume-price-specie-flow mechanism explained long-term adjustment. According to the Hume-price-specie-flow explanation, international payment imbalances caused money supply changes in the countries involved. In turn, this resulted in change in prices, that is, increase in the country receiving gold, and a reduction in the country losing gold; and these price changes altered the international flow of goods in such a way as to eliminate the initial trade imbalance. In the adjustment process, prices reduce along with the money stock in the deficit country, while both rise in the surplus country (Gutian 1977).
Hume-price-specie-flow mechanism points out how domestic economic imbalances interact with international payment flows to restore balance in the financial system (Krugman 539). As surplus demand develops in one economy, there emerges incipient upward pressure on prices, rendering domestic goods expensive relative to those from abroad. This tends to increase the number of imports demanded resulting to trade deficits. Such deficits have to be financed by gold sales from the deficit country under gold standard regime. The resulting gold outflow reduces the country’s stock money, exerting downward pressure on prices, restoring competitiveness, and eventually wiping out the trade deficit, and with it the gold outflow (Bloomfield 47).
This similar process can be seen from a different viewpoint that emphasizes the role of the money market, rather than that of the goods market, in the adjustments. The monetary variant of the transmission mechanism notes that an excess demand for goods is an excess supply of money, and views the trade deficit as the channel through which cash balance holdings are taken back to their desired level. Hence, the gold outflow will continue until the outstanding stock of money equals the quantity of money demanded. Here, expenditure will once again be at par with income, and balance will have been restored to the trading account (Bloomfield 48).
Governments had to conform to the implicit “rules of the game” to enable the domestic economy to interact with the rest of the system. In other words, governments had to desist from interfering with the regime’s operations. They were required to refrain from trying to offset the effects of gold flows on the money market. This specifically implies that when gold coins are exported directly or domestic currency is converted in for gold to pay for imports, governments do not take deliberate actions to counteract the effects of these events on the stock of money and the economy at large. For instance, when gold flows out, the amount of money in the economy is allowed to decline, with implications across the economy. Decreases in money supply tend to be related to downward pressure on prices, and possibly on output and unemployment in the short run. On the other hand, increases in the supply have an opposite effect (Krugman 534).
In sum, it is clear that countries adhered to the rules of the gold standard with a measure of discretion. Nevertheless, some of the margins of discretion were embodied in the architecture of the gold standard system. Countries exercised individual judgments which played a bigger role than had been envisioned. This reflected the importance of economic objectives relative to the primary aim of gold standard, which was price stability through the maintenance of convertibility. Additionally, national concerns over the level of economic activities or the state of business confidence also contributed and encouraged the need for discretion in the implementation of the rules of the game (Eichengreen 35).
Despite this measure of discretion, the gold standard seems to be thought of as a regime that worked relatively well. The impression that discretion was not abused to the point of blurring the existence of the rules in its operation might be the possible reason. Though not followed always, gold standard rules were adhered to broadly so that policy inconsistencies across countries did not result in the abandonment of the standard. The international gold standard came to an abrupt end with the outbreak of World War I in 1914, when convertibility of currencies into gold was discontinued and governments directed their economic policies to the war efforts (Gutian 1977).
Bloomfield, Arthur, I. Monetary Policy under International Gold Standard, 1880-1914. New York: Federal Reserve Bank, 1959.
Dornbusch, R. Exchange Rates and Inflation. Cambridge: MIT Press, 1991.
Eichengreen, B. The Gold Standard in Theory and History. London: Routledge, 1997.
Gallaroti, G. The Anatomy of an International Monetary Regime. Oxford: Oxford University Press, 1995.
Gutian, M. Rules and Discretion in International Economic Policy. New York: International Monetary Fund, 1992.
Krugman, P. International Economics: Theory and Policy. New York: Dominic Salvatore.