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History of the Gold Standard


Korean Minjok Leadership Academy
International Program
Ko, Young Kun
Term Paper, AP European History Class, November 2007



Table of Contents


I. Introduction
II. The Exchange Economy (Before the Gold Standard)
III. Establishment of the Gold Standard
III.1 Definition
III.2 England / The United Kingdom
IV. After the Gold Standard
V. Conclusion
VI. Notes
VII. Bibliography



I. Introduction
            "In the beginning, God created the market". But first, what is the market ? In the dictionary, the market is usually defined as "a meeting together of people for the purpose of trade by private purchase and sale". This definition provides a slight clue to the starting point of the history of the market. This paper however is not focused on the market itself. It will be focused on the medium of the market, which is called money.
            The history of money can be mainly divided into five stages. Starting off with simple commodity exchange, it evolved into first commodity money. Commodity money then became standardized, and then money evolved into paper money linked to commodity, finally into modern fiat money. The Gold Standard, which is going to be the main focus of the paper, is associated to the third and fourth stage; standardized commodity money and paper money linked to commodity.
            The next part will briefly summarize the simple exchange economy and commodity money. In the third part, there will be a main body of this paper, discussing the gold standard in the United Kingdom. Why the United Kingdom? First, it was the first state to establish the Gold Standard, thus other states can be seen as following the U.K. Second, it has been the center of the European economy from the 18th century until World War II. The fourth part will explain the Bretton Woods System and what followed beyond the Bretton Woods System. Lastly, there will be the conclusion of this paper.
            The main question to be answered is the impact of the Gold Standard on modern society. Although President Nixon of the U.S. abandoned the Gold Standard, the Gold Standard leaves an important mark on modern currencies. By observing the history of money under the Gold Standard System, the main question would be answered step by step.


II. The Exchange Economy
            During the prehistoric era, mankind made several accomplishments that would forever change the course of history. One of such is agricultural revolution, where mankind first started to settle down in one area, and actually grow their own food. This was significant in mainly two ways; first, it enabled mankind to build villages, accelerating the division of labor. Second, such division of labor led to the revitalization of the market. Before, such revolution, mankind is believed to have directly traded using commodity.
            After such revitalization, the problem of direct exchange emerged. Direct exchange was proved to be an inefficient way of trade. For example, a hunter sells a piece of leather, and a farmer sells wheat. In order for exchange to happen, hunter must demand wheat, and farmer must demand leather, which would have a low probability. Thus trade required high transaction cost. Such high cost of trade lead to the introduction of commodity money.
            Commodity money varied when it was first introduced, depending on the distinctive features of each society. Examples of such distinctive feature would mainly be the geographical location of villages. Villages located near seashore used shells as their commodity money, and agricultural society mainly used grains as commodity money. There are also some erratic examples such as island of Yap, where they use rock as a medium of exchange. The value of rock is measured by its size. With the introduction of commodity money, the exchange of commodity became much easier and convenient.
            However, commodity money still had some problems. First, currency was not unified. Even within one village, the quality of currency varied. Some used high-quality grains for currency, which would be a rare occasion. Majority used low-quality commodities, since it has equal amount of purchasing power compared to the same amount of high-quality commodities. This phenomenon is what we call Gresham's law; "Bad money drives out good" During Sir Gresham's time (1519-1579), England suffered severe debase of the Pound, due to frequent scrapping of gold coins, making such a coin into a low quality coin. Considering that Sir Thomas Gresham was the financier for Edward VI and Elizabeth I of England, we may argue that England during the Tudor Dynasty demanded gold standard.
            Second, some commodities were less mobile. It is widely known that Spartans actually used heavy iron to prevent frequent exchange. This shows that less mobile commodity money increases the cost of exchange, thus prevent active market. Without such an active market, the division of labor would be impossible, causing less total factor productivity. This is one of the main reasons why gold was chosen as main commodity money. Also to solve this problem, before establishing the Gold Standard, legal notes such as bank notes were already in use before the 1700s.
            Third, a monetary policy cannot be implemented, since government loses its control over monetary supply. This makes the economy susceptible to sudden variations in economy, such as inflation and deflation, because such commodity could be made not only by the government, but by the public too. A large influx of commodity money would cause inflation. Spain, for example, suffered from severe inflation after the discovery of America. The influx of gold from the Inca and Maya civilizations eventually increased the supply of gold in Spain, thus decreasing the value of gold in Spain. Obviously, the original gold holder's wealth decrease and the price level in Spain increase, causing harms that inflation is known to cause. If the government can successfully manage the monetary supply within its own economy, inflation and deflation can be actively managed, which is impossible under the commodity money system.
            Such problems were the mechanisms toward the standardized currency, such as gold coins under the Gold Standard System. Still there is one critical question to be answered before moving on to the actual implementation of gold standard ; 'Why was gold chosen instead of other commodities such as silver, brass, copper or stone ?' Gold was chosen because of four reasons ; its rarity, divisibility, durability and general ease of identification (1). Silver, which has been a potential rival to gold, is lacking of rarity and general ease of identification. It is more abundant than gold, and it is hard to distinguish from other metals, such as iron, due to its similar color.

III. Establishing the Gold Standard
            The stage coach is a public coach regularly traveling a fixed route between two or more stations (stages). It was first introduced in London in 1640s and in Paris 20 years later. Stage coaches became a common means of public transportation in the 1690s. Early stage coaches were poorly designed, but soon effective design emerged. There were several elements that reinforced the utility of stage coaches.

III.1 Definition
            By definition, the Gold Standard is a monetary system in which the standard unit of account is a fixed weight of gold. Each measure of currency, such as pound, can be exchanged as legal amount of gold. Before 18th and 19th century, the silver standard was common within European nations, due to the overvaluation of silver. With overvalued silver, it would be rather wise to use silver instead of gold, since gold as commodity is valued higher than the gold as money. If gold coinage is in circulation, it was likely to be melted and used as a jewel instead. In the 18th and 19th century, such a Gold Standard was established with paper money in circulation. With paper money, the holder could demand the national bank to exchange the money with a certain amount of gold.

III.2 England / The United Kingdom
            Unlike other European nations, England established the Gold Standard in the 18th century. England had a great background for achieving the Gold Standard. Before the establishment of the Gold Standard, the Silver Standard was used throughout England, like other European nations. The British penny contained precise amount of pure silver. Under Henry VIII, a penny had 1.555 g of pure silver.
            In 1688, a group of political figures, known as "immortal seven", invited William III of Orange, and his wife Mary to become the co-monarchs of England. This lead to the so-called Glorious Revolution, deposing King James II. James II, as a Roman Catholic, was hated by the political figures and bishops in England, since England had already established the Anglican Church. William III, a new king of England, in 1694 established the Bank of England by granting a royal charter to a private institution.
            In 1699, Sir Isaac Newton became master of Mint. Sir Isaac Newton managed to change from silver based coinage to gold coins, shifting from the silver standard to the gold standard, by devaluating silver coinage. By devaluating silver coinage, gold as money exceeded the value of gold as commodity.
            However, by the time of Sir Isaac Newton, bank notes were more frequently used than coins. Coins formed less than half the English money supply. This meant the shift of power of monetary regulation from the king to the money market. As mentioned before, the Bank of England was established as a private institution. The chart shows the number of banks in England and Wales from 1784 to 1830. The increasing number of banks implies first active money market in London, second, less power of the government on the money market. However, the government still had the choice to abandon the Gold Standard System, which it frequently uses during the war era.

Figure 1 : The Number of Banks in England and Wales, 1784-1830 (2)


            In 1789, a revolution erupted in France. The United Kingdom declared war on Republic of France. From 1792 to 1815, with very brief interruptions, the United Kingdom was at war with France, the latter for much of the time controlling the European continent. The British government had to abandon the Gold Standard, since the war required investment at a scale no longer covered by gold supplies. From 1793 to 1801, Britain spent over 15 million Pound Sterling to help its allies, such as Russia, Austria, etc. Unable to withstand such a budget deficit, in 1797, the government finally proposed the Bank Restriction Act, preventing notes from being exchanged to gold.
            Like Britain, many other nations temporarily abandoned the Gold Standard during war time to increase war effort, such as the United States during the U.S. Civil War. However, all countries tried to restore their Gold Standard System once such crises were over. Britain, after the Napoleonic war, successfully readopted the Gold Standard in 1821.
            The United Kingdom, with its Bank of England and the Gold Standard, replaced the Netherlands as the financial center of Europe. The successful Gold Standard and banking system also helped Britain to become the industrial center of Europe, since banks could provide large funds which is needed for building factories. The British East India Company also established banks in Colonies, such as India, Singapore and others. During the 19th century, the international gold standard was beginning to be adopted, since most other nations began to adopt the International Gold Standard. For example, after the United States adopted the Gold Standard in 1900, the exchange ratio between the British Pound and American Dollar was fixed, if the ratio of gold per Dollar or Pound did not change. 1 Dollar was exchanged to 23.22 grains of gold, and 1 Pound Sterling was exchanged to 113 grains of gold. Thus 1 Pound would be 113/23.22 = 4.87 Dollar under the International Gold Standard. By the early 20th century, most nations had adopted the International Gold Standard.
            From the late 18th to the early 20th century the British Empire expanded to become the World's largest Empire - "The sun never sets in the British Empire". The Empire included India, Australia, Canada, New Zealand, and many entities of less size and importance, such as Hong Kong and St. Helena. In the late 19th century gold was found in unprecedented quantity in the Transvaal, acquired by Britain in the Second Boer War in 1902. Figure 3 shows the size of gold production. In response to the huge influx of gold, the Royal Mint decreased the issuance of silver coins, thus shifting from a Bimetallic Standard heavily leaning on the usage of silver coins to a Bimetallic Standard less heavily leaning on the usage of silver coins.

Figure 3 : The Amount of Gold Coins Issued (4)


            It was not the only the South African mines that gave impact to England. The trade with China also had impact on the Bimetallic Standard. Chinese, using silver as their currency, accepted silver for tea, and silk. European, suffering large loss from the trade with China, had to suffer large silver outflow, from 18th to 19th century. Therefore, in order to establish stable money supply, the British government had to use gold instead of silver. Britain sought to reduce the massive outflow of silver into China which it regarded due to Chinese trade restrictions, and following the Opium War (1839-1842) it imposed trade regulations on China which reduced the outflow of silver, and then even resulted in a flow of bullion in the opposite direction.

Figure 4 : The Number of Banknotes issued in the U.K., 1800-1944 (5)


            The Gold Standard does not necessarily mean using gold coins to trade. Banknotes were used mainly, that could be converted to certain amount of gold in the bank. The graph shows the amount of banknotes issued from 1800 to 1944. In this graph, there are three eras when the amount of banknotes increased dramatically. First is the Napoleonic war era, which cannot be seen easily through the graph. The amount of central bank banknote issued doubled during this era. After the war, money supply became stabilized until the World War one, which finally made United Kingdom abandon the Gold Standard.
            Britain tried to return to Gold standard in 1925 but failed, abandoning the Gold Standard in 1931. This attempt is shown on the graph as the decrease of banknotes after the war. However, the British government thought it is impossible to return to the Gold Standard. Moreover, with great depression starting from 1929, Keynesian economists were put in charge of economic policy. Following passages from "The General Theory" asserts that Keynes was against the Gold Standard.

      Never in history was there a method devised of such efficacy for setting each country's advantage at variance with its neighbors' as the international gold (or, formerly, silver) standard. For it made domestic prosperity directly dependent on a competitive pursuit of markets and a competitive appetite for the precious metals. When by happy accident the new supplies of gold and silver were comparatively abundant, the struggle might be somewhat abated. But with the growth of wealth and the diminishing marginal propensity to consume, it has tended to become increasingly internecine. (6)

            As we can infer from this paragraph, Keynes thought international gold standard is rather a form of economic suicide. His other paragraph criticizes it from another perspective.

      [...] under the system of domestic laissez-faire and an international gold standard such as was orthodox in the latter half of the nineteenth century, there was no means open to a government whereby to mitigate economic distress at home except through the competitive struggle for markets. For all measures helpful to a state of chronic or intermittent under-employment were ruled out, except measures to improve the balance of trade on income account. (7)

            This shows that the fiscal policy or any means of government intervention would be stopped by the International Gold Standard. Since the government intervention is critical is adjusting the economy, according to J.M Keynes, the Gold Standard should be abolished.
            Just as Keynes wished, the Gold Standard was abandoned, causing increase of banknotes just before the World War II. World War II, just like World War I, caused enormous increase again, tripling the amount of banknotes issued.
            However, in 1944, in Bretton Woods, New Hampshire, representatives of the Allied Nations met to discuss the post-war economy, which would again introduce a Gold Standard.

IV. After the Gold Standard
            In 1944, the delegates from 44 Allied Nations gathered in New Hampshire, Bretton Woods, for the United Nations Monetary and Financial Conference, to discuss post-war economy, signing Bretton Woods Agreement.
            The Bretton Woods Agreement's main goal was to establish fixed exchange rate, thus giving stable monetary background to the international economy. In the 1930s, during the Great Depression, money also contributed to the instability of the economy. Not only that due to the rising power of the United States, Bretten Woods also meant the reorganization of the economy based on the U.S. Dollar. Since the United States had 80% of total global gold reserves at the time, the Dollar was considered to be stable, thus the Dollar was adopted as the standard currency.
            35 U.S. Dollars could be converted to one ounce of gold, and every foreign currency had fixed value measured in Dollar. For example, in 1945, one Pound was 4.30 Dollar. In order to change the fixed exchange rate, each nation had to make proposal. Britain, in 1949, devalued the Pound to 2.80 U.S. Dollar. Other countries also did devalue or overvalue their currencies until in 1971, with the U.S. going of the Gold Standard, Bretton Woods system was terminated.
            The 1950s marked the start of the so-called Pax Americana or Pax Dollarium. New York became the financial center of the globe. However, fixed exchange rates had the problem of producing disequilibrium in Balance of Payment. That is why the International Monetary Fund was founded. Keynes, the first economist to propose such idea, however had a different perspective from the U.S., since he was representing the British. The U.S. wanted to have bigger power of creditor; however Keynes did not take the power seriously. The IMF followed much of United States' idea. For example, during the financial crisis in Korea in 1997, the IMF, which is mainly controlled by the U.S, had a critical role over the Korean economy.
            In 1971, President Nixon announced that the U.S will quit the Bretton Woods system. He also announced that the U.S. will not converse money to gold, meaning Federal Reserve note is not granted with right for gold conversion. Due to the ongoing Vietnam War, the U.S. was suffering from serious inflation. Inflation, causing trade deficit, was threatening the Bretton Woods, with the value of Dollar decreasing. World became floating exchange rate system. From then on, world is under floating exchange system, with complete fiat money.


V. Conclusion
            Throughout this paper, we observed the history of the Gold Standard, starting from the 18th century to modern society. From the 18th century Silver Standard, 19th century Gold Standard, to 20th century Bretton Woods and floating exchange system, the system kept changing. In the introduction, I mentioned the main question to be answered in this paper, what were the consequences of such Gold Standard ? Observing such flow, we can conclude that the Gold Standard is inconsistent with today's economy, since modern economy is using complete fiat money, without any linkage to gold or silver..
            The Gold Standard is always an option for the world economy. It showed its feasibility for the last centuries. However, many economists view the possibility of a "Return of Gold Standard," low. The information era has started, thus the market became closer to perfect information. The problem of gold standard is that it can easily cause disequilibrium, since economy cease to stay in one position, against the stability of gold standard. That is why U.S suffered from severe disequilibrium in Balance of Payments, causing Nixon to abandon Bretton Woods. Floating exchange system, with complete fiat money, on the other hand can solve these problems, preventing such in the first hand. Gold standard, thus, maybe concluded as an outdated system, a past we must outstrip.


Notes

(1)      Article : Gold Standard, from Wikipedia
(2)      English Historical Documents, 1783-1832 vol XI (London, 1959), p.596.
(4)     
(5)     
(6)      J.M Keynes. Ch24 III
(7)      J.M Keynes. Ch25 IV


Bibliography

Note : websites quoted below were visited in October 2007.
1.      Cook, Chris. Britain in the Nineteenth Century 1815 ? 1914. New York : Pearson Education Inc. 1999
2.      Davies, Glyn. A History of Money from Ancient Times to Present Day. Cardiff : University of Wales press, 2002
3.      Keynes, John Maynard. General Theory of Employment, Interest and Money. Cambridge : Cambridge UP, 1935.
4.      Article Money. Encyclopaedia Britannica. Micropaedia, 15th ed. 1998
5.      Article : Gold Standard, from Wikipedia, http://en.wikipedia.org/wiki/Gold_standard
6.      Article : U.S. States Note, from Wikipedia, http://en.wikipedia.org/wiki/United_States_Note
7.      Article : Bretton Woods System, from Wikipedia, http://en.wikipedia.org/wiki/Bretton_Woods_system
8.      Article : Gresham's Law, from Wikipedia, http://en.wikipedia.org/wiki/Gresham's_Law


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