Introduction
Over the years, businessmen and nations have used gold as an investment and a medium of exchange due to its relative advantages. Gold is less likely to suffer from inflation, thus its price is relatively stable due to its immune to government manipulation and tinkering especially in its pure form in most economies. Gold standard prompted many debates over its existence and this began as early as 1913 (Kearns n.d). According to Garrison (1985), the gold standard refers to the outcome of market processes. Bordo (2008) states that the gold standard was established as an attempt by the participating countries to standardize the prices of their local currencies using a specified quantity of gold as the unit of measure.
Countries began applying the gold standard in their economies at different times with the period between 1880 and 1914 being the time in which most countries adopted the gold standard. Initially, the debates were on how the gold standard could be uniformly implemented so that every country would equally benefit. Implementing rules that would not interfere with the national policies of the member countries of the gold standard proved an uphill task since each country had its fears on the impacts of the gold standard on its economy. Over time, many countries were able to adopt the gold standard although the factors that influenced the price varied in each country. Adoption of the gold standard came with many advantages and disadvantages in the monetary systems and economies of the world (Bordo 2008).
Background to the study
Over the years, gold has found increased use as the yardstick with which to assess the monetary systems of the different countries. According to Bordo (2008), the gold standard entailed a commitment by member countries to base their currency on a standard amount of gold. So that the gold standard may remain effective during the application, there were four main rules which must be adhered to. To start with, it was a requirement for the gold value to be fixed with regard to the currency of every member country. In addition, there was also the need to ensure that gold movements went on uninterrupted among the member countries that utilized gold as a form of their monetary system. Finally, all the member countries were required to have high wage flexibility. Finally, the country’s domestic money supply was required to be linked to the inflow and outflow of gold (Kearns, n.d).
Between 1880 and 1914, a majority of the countries were seen to increasingly adopt the gold standard. According to Bordo (2008), this period was referred to as the classical gold standard. The United Kingdom is one of the countries which had adopted the gold standard in its currency system in 1717. The United States also adopted the gold standard in 1834. This was achieved by fixing the price of one ounce of gold at $ 20.67 which persisted until 1933. During the gold standard period, a number of countries experienced unprecedented economic growth. Once World War I had broken out in 1914, this has a drastic impact on the gold standard system and eventually, it broke down (Bordo 2008).
As a result of World War I, there was inflation. This resulted in a number of the countries reinstating the gold standard once more, with a view to coping with the impending recession. During the 1920s, the United Kingdom was among the countries that sought to readopt the gold standard in their currency system.
Most countries adopted the gold standard in an effort to promote their financial stability. This was attained by limiting the excessive expansion of credit in addition to ensuring the stability of the country’s exchange rate. According to Peden (2000, p. 190), the gold standard did not prevent countries from experiencing a reduction in prices. Due to its rigidity, the adoption of the gold standard is considered to be one of the major causes of depression that occurred in the 1930s (Garrison 1985).
After World War II, most European countries incorporated the concept of economic integration. One of the core objectives of economic integration was to establish a single currency.
Major Changes that have taken place in the Gold Standard
The gold standard has undergone several changes in the financial system of the world since 1900 up to date. The United States Congress passed the Gold Standard Act in 1900 while the UK enacted theirs in 1925 to make it de jure standard in their financial system (Bordo 2008). However, the gold standard was affected by World War I when major rival states resorted to inflationary finance as they struggled to meet the costs of the war. This situation was resolved temporarily between 1925 and 1931. During this time, the two major economies, the UK and the US held their reserves in gold only. However, the UK’s withdrawal from the gold standard in 1931led to substantial gold as well as capital flows. The UK’s departure was mainly due to its inability to maintain the convertibility of currencies into gold. This was prompted by the huge gold outflows that passed across the Atlantic Ocean. This had earlier forced other countries like New Zealand and Australia to withdraw. The UK became even more reluctant to return to the gold standard as it sold its gold stock to finance its activities during the Napoleon War. As a result, the US nationalized the gold that was owned by private individuals and also terminated contracts that required that payments be made in gold (Bernstein 2000, 74).
World War II also affected the gold standard as it caused inflation in most economies. In the period that followed from1946 to1971, countries adopted the US dollar as their international monetary system for exchanges. However, the US failed in its quest to trade its currency in gold and canceled the idea in 1971. An increase in inflation rates in the 1970s and 1980s almost renewed the quest for the gold standard although that did not happen. The need for the gold standard only seems to reappear whenever the global inflation level moves to over 5% (Bordo 2008). Today, the global monetary system adopts the US dollar as the reserve currency in major transactions as attempts to adopt other alternatives have not been successful.
Changes in the world financial system as a result of the gold standard
Increase in debt
The gold standard led to monetary inflation and an increment in government debt. This resulted from the fact that the government increased its borrowing in an effort to support the public considering the decline in their purchasing power. Upon the global economy recovering in 1921, countries that had adopted the gold standard experienced an increment in the level of economic stability (Bernstein 2000).
This led to a decline in the country’s rate of interest while the price of equity and bonds increased. Due to the rise in the country’s level of debt, various economies experienced deflation with regard to consumer demand. The ultimate result was that these countries underwent a depression. In an effort to eliminate the depression, most countries adopted a currency devaluation policy. The decision to adopt the currency devaluation policy resulted from the fact that the debt was denominated in paper money. According to Bordo (2008), this was attained by increasing the price of paper money in relation to that of gold. The resultant effect was an increment in the world monetary base to a level above the debt.
Another change that occurred in the financial system during the gold standard includes fixing the exchange rate against gold. In addition, the $ was made be convertible to gold at a predetermined price which was agreed by a number of Central Banks. The price was set at $ 35 per ounce.
Monetary fluctuation
The gold standard also led to a significant monetary fluctuation in the world’s financial system. This arises from its effect on the country’s monetary supply. According to Endres (2005, p.4), when a country experienced a surplus in its balance of payments, there was an increase in the amount of gold inflow culminating in an increment in the money supply. An increase in the amount of money supply led to inflation culminating in a decline in the number of exports and imports.
Countries that were experiencing a deficit in their balance of payment were forced to adopt currency deflation policy in an effort to preserve the amount of gold reserve in their central banks. On the other hand, countries that were experiencing surplus with regard to their gold reserves adopted a sterilization policy in an effort to prevent an increment in gold inflow. The United Kingdom and France were some of the countries which experienced a surplus in their gold reserve.
On the other hand, countries that had a minimal amount of gold reserve became vulnerable to intense gold outflow. The United Kingdom is one of the countries which were forced to adopt deflationary policies in an effort to adhere to the gold standard.
Currency unification
Over the past decade, some European countries considered entering into economic integration. This was attained through the formation of the European Union. In 1999, eleven of the European Union member countries came to a consensus to adopt the currency unification policy. These countries include France, Germany, Austria, Belgium, Ireland, Finland, Spain, Netherlands, Italy, Luxembourg, and Portugal (Pinder & Usherwood, 2007, p. 34). However, some of the European Union countries such as the United Kingdom did not adopt the single currency. This resulted in member countries adopting a single currency referred to as the Euro (Butorina, 2006, p.54). In its formative years, the Euro was only used to undertake cashless transactions such as a stock market transaction. It was not until 1st January 2002 that real money in form of coins and bills went into circulation. There are benefits and costs associated with currency unification.
The United Kingdom’s stance on the Euro
The UK had refused to join the adoption of the Euro money as it did not favor the fiscal union of member states. UK had feared that the policies of EMU could override its national policy. The UK was more focused on protecting the pound.
Benefits attained for not adopting a single currency
Ability to stimulate the economy
Adopting a single currency limit a country’s ability to control its monetary policy. This means that it is not possible for the government to stimulate the economy, especially during localized recessions. United Kingdom’s decision not to adopt a single currency has given the firm an upper hand with regard to its ability to stimulate economic growth. One of the ways through which this can be attained is by controlling the rate of unemployment.
Exchange rate stability
For a number of years, the United Kingdom did not accept joining the Exchange Rate Mechanism (ERM). According to Mundell and Zak (2002, p.12), adopting a single currency would result in difficulties in the process of the country attaining stability in its exchange rate. Instability in a country’s exchange rate is a threat to its economic prosperity. This arises from the fact that exchange rate instability is associated with other effects such as tax burdens, instability in the financial market, increase in the interest rate and debts, and a decline in wage rate (Mundell & Zak, 2002, p.12). Upon experiencing currency instability, it takes a long period for a country to stabilize its currency. Exchange rate instability can lead to a reduction in the level of confidence. By not adopting the single currency, the United Kingdom has been able to attain stability in its exchange rate since it has the capacity to incorporate currency devaluation in an effort to respond to economic changes. According to Buxbaum (1996, p.104), it is difficult for a country to undertake currency devaluation if it has adopted a single currency. This is mainly so if the country is the only one that is experiencing economic shocks. However, if the economic shocks are uniform in all the countries, it is relatively easy for exchange stability to be achieved if economic shocks are uniform in all the member countries.
Elimination of asymmetry of economic shocks
The United Kingdom is safe from economic shocks that may occur in the macroeconomic environments of member states that have adopted the Euro.
Imbalances in the economic systems of a member state may cause symmetric shocks to the union members. Its decision not to adopt the Euro has enabled stability of prices in the country as well as sound public finances.
By adopting a single currency, a country can be affected by economic shocks which arise from member countries. This arises from the existence of openness between the member countries. According to Gulde and Prokopenko (2004, p. 20), asymmetry of shocks arises from differences in the country’s production structure. United Kingdom’s independence eliminates the asymmetry of shock.
Improved sovereignty
The United Kingdom has managed to attain sovereignty in its monetary policy. This arises from the fact that its central bank is independent to formulate and implement its monetary policy. The United Kingdom government also enjoys the rare privilege of controlling the financial actions of the country’s central bank. However, by adopting the EMU, a country’s central bank is controlled by an external body that is not elected by the people. Therefore adopting a single currency would result in a country losing its sovereignty.
Cost of not adopting currency unification
High cost of the transaction
By not adopting the currency unification policy, firms in the United Kingdom experience a high cost of the transaction. According to Buckley (2004, p.34), adopting a single currency leads to the elimination of transaction costs. It is estimated that firms in the United Kingdom spend approximately 1.5 billion pounds annually in the process of transacting with other firms in the European Union. This is due to the fact that firms are required to transact using the Euro hence the need to convert. An increase in transaction cost limits the firm’s profitability. The ultimate result is that the firm’s contribution to the country’s Gross Domestic Product (GDP) is reduced.
Exchange rate fluctuations
Adopting a single currency leads to the elimination of uncertainty associated with exchange rate fluctuations. In the process of investing in foreign countries, firms consider the existing rate of exchange. This arises fact that the exchange rate is characterized by intense fluctuation which may result in the firm experiencing a decline in the level of profitability. As a result of currency fluctuation, the United Kingdom may experience a decline in the number of foreign investors thus limiting the country’s rate of economic growth. Proponents of currency unification are of the opinion that it results in an increment in the rate of economic trade. This is due to the fact that fluctuations in the currency rate are eliminated.
The adoption of a single currency can enable a country to compete effectively with other member countries. According to Buxbaum (1996, p.103), the European Monetary Union can result in a rise in the rate of market integration. This means that trade between members of the European Union can be improved. By not adopting the single currency limits trade between the United Kingdom and other countries such as the Far East countries.
Adopting a single currency can result in a firm attaining price stability. However, this depends on whether the country can be allowed to implement excessive expansionary monetary policy. In addition, adopting the EMU can enable the United Kingdom Central Bank to achieve political independence. This can result enable the country to achieve price stability. Its decision to exclude itself from the EMU limits the country’s ability to achieve price stability.
Conclusion
The gold standard was faced by many challenges leading to countries withdrawing their membership at some points during a different time. The withdrawal of the UK from the gold standard and the declaration of the US that it could no longer redeem currencies in gold negatively impacted the gold standard.
The gold standard had a number of effects on the international financial system. One of the effects includes monetary inflation and an increment in the level of government debt. In an effort to eliminate the depression, most countries adopted a currency devaluation policy.
Countries that had adopted the gold standard also experienced an increment in the level of economic stability. In addition, there was a decline in the rate of interest. Most economies fixed their exchange rate against the gold which was convertible at a predetermined rate. In addition, most economies experienced fluctuation in their financial systems.
After the effects of the world war, most European countries adopted the concept of economic integration. The adoption of a single currency was one of the goals of the integration. However, the United Kingdom did not. By not adopting a single currency, the United Kingdom has been able to stimulate its economy. In addition, the country has been able to achieve exchange rate stability. Elimination of asymmetry of economic shocks has also been attained. The country has also been able to attain sovereignty with regard to the formulation and implementation of monetary and fiscal policy.
However, there are some costs which the country has incurred by not adopting the single currency. One of these costs relates to the increased transaction cost. It also experiences a high level of exchange rate fluctuation in addition to reduced price stability. Increased transaction costs can lead to a reduction in firms’ profitability and hence their contribution to the GDP. On the other hand, exchange rate fluctuation can limit foreign investment.
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