Tuesday, 18 September 2012

The Rise and Fall of The Gold Standard, II.

If you've read our first post on Gold standard (the monetary policy where the nation's currency is pegged to a fixed amount of gold), you know that in the 1870's it came and took the world like a storm. The reliability of prices lead to utopistic efforts of international financial co-operation. Where did the dream disappear then? Read below to discover the story of the slow demise of the gold standard, finally disappearing exactly one century after it's popularity peak.
McKinley, President of USA advocating the gold standard on a poster.
Source: Center for History and Media

 Veni, vedi, vici?


Throughout the Middle Ages, currencies around the world were effectively on silver or gold standard, being made of one of the two metals. Hence, the silver and bi-metal standards – the latter using a fixed exchange rate between gold and silver – were predominant before the gold standard. However, many countries already switched to the gold standard by the 19th century – but the decisive blow came only then.
The 1870 discovery of California silver mines suddenly made the price of silver fell, and hence the precious metal much less precious than before. This caused all bi-metal regimes to switch to the much more precious gold – if they could. There was simply not enough gold for everyone – so countries like Austria-Hungary and France stuck with some silver as a necessity.

War never changes


The scarcity of gold already signalled the major deficiency of the gold standard – during a time of recession and increased need of money supply, the central banks couldn't change interest rates (or print money) due to their peg to gold.
This exact thing happened during the First World War in 1914. Not only did efforts like the Latin Monetary Union died in vain, but there also came the worst conflict experienced by mankind so far – at least 15 million people died. The four years of futile trench war devastated European economies, and all came off the gold standard during the war years in order to finance their efforts – and when Germany lost in 1918, it was forced to pay so much tribute to the Allies, that the central bank's gold reserves essentially vanished. This made the country unable to return to a gold standard, and caused a hyperinflation.

The Roaring Twenties


The World War, while being devastating for participants, ironically laid the seeds for a decade of subsequent economic growth. The 1920's – or the Roaring Twenties they came to be called – caused a huge increase in output of all European and the economies and the USA, and the Allies were able to return to a gold standard. All is good when the end is good, right?
Apparently, no. Think what happens when the growth of the money supply can't keep up with the growth of the economy because of a peg – the monetary policy becomes contractionary. This gradually slowed the boom, soon turning it to be the biggest bust of all time – the Great Depression.

Dark decades


The Great Depression would have been devastating enough on it's own – but the forced gold standard accompanied with a worldwide atmosphere of panic caused a huge deflation in western economies. This meant that prices became lower over time – discouraging everyone from ever investing again. The worst years of the slump lasted from 1929 to 1933 – and while economies then started to recover, another setback followed in 1937 – and with the Second World War starting in 1939, there was no possibility for the world economy to recover anytime soon. Countries once again left the gold standard – with a new economic world order only being established again near the end of the conflict, in 1944.

Bretton Woods


In 1944 in New Hampshire, 730 delegates of 44 Allied nations gathered in the resort town of Bretton Woods to discuss an alternative to the gold standard. The result was a strange mix – the participants would peg their currencies to the US dollar, and the US dollar would in turn be convertible to gold.

The 'dollar standard'


You might wonder how was this any different from the gold standard if gold is still there? The answer is, quite – prices still remained pegged, but given the simple fact that there were more dollars than gold, it made it's actual implementation way more flexible. The Federal Reserve could print dollars if they so wished (and they regularly did). Don't forget that the USA dollar wasn't pegged – they only had an obligation to change dollars to gold upon request, which didn't happen very often due to the trust in the superpower's currency. The IMF and the World Bank were also established, and countries could borrow foreign currencies from the former if they found themselves incapable of maintaining the peg.

Final demise and the era of free-float


The new system had it's faults as well – it wasn't universal, only affecting the Western side of the Iron Curtain, and the declining economic influence of the USA in relation to other (re-)emerging powers like Japan and the European Community caused disputes about the leading role of the dollar. It wasn't these factors which brought down the system, however – rather the domestic inflation in the USA during the 1970's. The USA couldn't uphold it's obligation to exchange gold anymore – hence in 1971, President Richard Nixon – without previous consultation – announced the 'closure of the gold window', hence abruptly ending the gold standard. This was the Nixon Shock – and we've been living in a free-floating economy ever since, with all the features described in our monetary policy post.

Congratulations! Now you know the full history of the gold standard – feel free to ask your questions in comments, or to suggest new topics for coverage.

Other posts of the series:

Rise an Fall of The Gold Standard, I. - The Rise of Gold
Rise and Fall of The Gold Standard, 1.5 - Intriguing Facts about Gold You Didn't Know Before 

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