'The most remarkable aspect of the classical gold standard, therefore, is not the willingness of countries at different levels of industrialisation to observe the very strict rules but, rather, the developments which made it possible for these economies to adhere to the rules over such a long period.' (Dr Milivoje Panic 1992:117)
The classical gold standard which operated for the three decades prior to 1913 and the interwar gold standard have given rise to numerous debates, chiefly the question of the existence of a gold standard. This has arisen primarily over the disagreement expressed over how the gold standard actually worked, whether countries adhered to the rules of the standard and to why the interwar gold standard actually failed? This paper proposes to argue that the gold standard existed, and to fulfil this by noting that; 1) agreement over how the mechanism worked is not fundamentally necessary; 2) that countries, by and large, adhered to the rules and; 3) that the influence of the interwar gold standard became too much for the member countries. This approach necessarily shelves two other appropriate essay titles that can be applied to a discussion of the gold standard; the specific role of gold and the manner in which the standard operated. One will conclude, by agreeing with Panic, noting that the gold standard existed to the point where it did not conflict with national policies for the members of the club and that when such a situation arose, the system collapsed. Its demise thus proving its powerful existence.
The Origins of the Gold Standard
An international conference was held in Paris in 1867 at which most of the participants voted in favour of a gold standard. The United Kingdom stood alone in its adherence to the standard at that time, but the following twenty years were to witness a considerable number of new members. German membership in 1871 heralded the erection of the international gold standard, reinforced by United States accession in 1879. By this time many of the other European, Scandinavian and Eastern European countries were also members of the 'club'. The standard essentially grew out of the problems of bimetallism, the need for a developed financial system to support increasing industrial development. Friedman notes that 'though Britain's choice of gold instead of silver for this purpose was something of an accident, it was a major reason why the United States made the same choice roughly sixty years later.'
What was the Classical Gold Standard?
Eichengreen states that taking an idealised view, 'the gold standard was a remarkably durable and efficient mechanism for insuring price and income stability, relieving balance of payments pressure and reconciling the actions of national monetary authorities.' Scammell notes that there were four main rules of the game for all member countries:
a) A gold value must be fixed for the currency of every country within the system.
b) There must be free movement of gold between countries within the system.
c) The monetary system of all member countries must be such that the domestic money supply is linked more or less automatically to movements of gold in and out of the country.
By following the above three rules, the adjustment function of the standard will be satisfied. However, if this is to be accompanied by domestic balance, a fourth rule is necessary:
d) That within each country there must be a high degree of wage flexibility.
One should note that there were important differences in the manner in which member countries adhered to the central features of the gold standard regime. It is possible to differentiate countries given the extent to which (1) gold coin circulated internally, (2) whether convertibility was automatic or at the authorities discretion and (3) ultimately, the cover system which linked the quantity of currency and coin in circulation to the country's reserve.
How did the Standard Operate? - the Classical / Traditional Explanation
Richard Cantillon's price-specie flow mechanism, as later developed by J. S. Mill, is recognised as the standard explanation underpinning the balance of payments adjustment mechanism present in the gold standard. Firstly, one notes that it operates in a world where only goods and financial assets are traded internationally, and factors of production are immobile between countries. This means that trade deficits must be eliminated promptly since no country is capable of financing them for long out of its own reserves. Secondly the process by which deficits are removed is entirely automatic. It requires therefore no interference from governments or central banks. Finally, the automatic nature of the processes set in motion by trade imbalances and the movement of gold ensures that the operation of the price-specie flow mechanism is perfectly symmetrical. What is happening in a country experiencing current account deficits and losing gold, is exactly the reverse of developments in a country enjoying current account surpluses and accumulating gold.
More concisely these features translate into a system whereby a country's price level rises, in itself giving rise to a balance of payments deficit financed by exporting gold. This loss of gold causes the quantity of money in circulation to contract. As money is held for transaction purposes only, the fall in its quantity leads automatically to a contraction in aggregate demand and output. Excess capacity and unemployment brings money wages and prices down, increasing external demand for a country's exports. This increase combined with a fall in demand for imports eliminates the current account deficit. Panic summarises this process noting that 'whatever the disturbance, it is assumed to give immediate rise to changes in relative prices followed by gold movements that will quickly restore the whole system to equilibrium.'
It is also possible to incorporate into the price-specie flow model an interest-rate mechanism. In a deficit country, as the quantity of money in circulation falls, a rise in interest rates relative to those other countries follows, which stimulates an inflow of short term funds due to the higher capital returns available. This, as a result prevents the quantity of money from declining as rapidly as it would have done in the absence of a rise in interest rates. Whatever assumption is made about the interest rate elasticity of demand for goods, the process will continue and remove the balance of payments deficit.
As noted above the price-specie model makes very definite predictions about a number of key variables:
a) Initially one would expect any current account surplus or deficit to be reversed.
b) The model predicts that output should either fall or grow more slowly in deficit countries than in surplus ones.
c) Wage levels should increase in surplus countries (following the expansion in their money supply and output) and decrease in deficit countries.
d) The model simultaneously eliminates balance of payments surpluses and deficits through changes in relative prices, with the price levels rising in surplus countries and declining in deficit ones.
Now that the origins, the rules and the manner in which the standard was supposed to operate have been defined, one is now free to deal with the criticisms levelled at the above and in answering these, prove the existence or influence of the gold standard. Four major areas of disagreement have emerged, that of the price-specie flow explanation, adherece to the 'rules' of the gold standard, the gold/money stock ratio, and the national sovereignty of member countries. We shall consider these in turn.
The Classical Loophole - Does it Matter?
It has been noted previously that the price-specie flow mechanism and the definite predictions that it makes about the gold standards have an influence on a number of variables. Panicconcludes that 'had the classical gold standard really depended for its existence entirely on the price-specie flow and interest rate mechanisms as the traditional accounts of its operation lead one to believe, it would never have got off the ground; or alternativel , if it had been adopted and lasted, it would have been a period of perpetual stagnation in most members of the 'club'.' He continues noting that 'instead the system survived for over three decades, a period during which all these countries achieved a radical transformation of their economies.'
Panic finds in his investigation of all of the variables influenced by the price-specie mechanism that few of these variables corresponded to predictions made by this model. It is noted how the UK managed to run current account surpluses every year 1880-1914, of the order of an average of 4.5% of GDP at current prices. Germany in a similar fashion ran consecutive current account surpluses of the order of 1.8% a year. He concludes that 'the adjustment process could not have worked in the way traditionally described by classical, neoclassical and Keynesian economists.' Panic's quantitative estimates preclude the use of gold reserves and capital inflows as being of a large enough magnitude to finance current account deficits, of the kind that were experienced in some member countries. Thus the search for the proper adjustment mechanism has ensued. Given this, one is left with the question of whether the gold standard existed, or more explicitly did it contribute in a positive way to any important variable and is this overshadowed by the disagreement over its operation?
An initial response to this is to cite Eichengreen when he notes that 'the extent of exchange rate stability under the classical gold standard is impressive in comparison with the most recent decade.' His conclusion is that in the absence of any obvious superiority in terms of price or income stability, the outstanding feature of the classical gold standard 'appears to have been its association with exchange rate stability.' As evidence he points to the absence of a significant number of balance of payments crises, even in the face of the inherent financial instability of the period 1880 to 1914. Triffin would argue that this stability was at the expense of the peripheral countries. However we now have a situation where there is a smooth balance of payments mechanism to be explained as opposed to a mechanism that has to be proven to exist.
In attempting to explain the operation of the gold standard there have been many approaches. Whale proposed the spending approach. Whale (1937) and Scammell (1965) put forward the capital flows approach where the trade balance no longer equals the gold outflow from a country, but where the balance of payments deficit is the sum of the trade balance deficit and the capital outflow. McCloskey and Zecher (1976) advocated the monetary approach to the balance of payments, citing the effects of the law of one price on Hume's approach. Superficially, this would appear to cast serious doubt over the gold standards existence, if it can not be dissected and all of its influences methodically noted. However one agrees with Eichengreen as he concludes that 'these authors should not be seen as presenting alternative models but simply as attaching different values to certain critical parameters.'
The 'Rules' of the Game
A second argument that has been proposed, is that in effect there was no gold standard because countries and more specifically their central banks, did not adhere fully to the 'rules' of the game. The violations were mostly to have been committed against the second rule of the gold standard that was noted earlier, namely that there should be free movement of gold between member countries. However, one wholeheartedly agrees with Panic in expressing the view that 'the fact that the authorities accepted these rules and allowed freedom of international gold movements did not mean that they were indifferent to changes in their monetary reserves, especially in times of crisis. On the contrary, instead of blindly following 'market forces', they frequently took steps within the limits permitted by 'the rules' to influence the behaviour of the private sector.' Of course, some central banks went further than the bank of England, which as Scammell notes relied on discount rate changes and the use of various gold devices to alter the flows of gold. Continental banks relied more on legal impediments to the exportation of gold, France being a prime example. There are two points though that may be put forward to bolster the author's opinion that the 'rules' of the game were respected.
Firstly, Eichengreen's suggestion that 'perhaps the most popular explanation for the gold standard's smooth operation is that it was a managed system and that it was managed by the bank of England' cannot be ignored. Secondly, Scammell states that 'the effectiveness of the Bank of England's operations during the period may be questioned. The best that can be said is that there was a steady improvement from about 1900 as the bank gained power and recognition as a central bank...Sayers draws attention to the bank's failure to deal with seasonal drains of gold each Autumn as a serious 'blot on its record'.' Thus we conclude that any notion that the gold standard may not have existed because its rules were not in reality adhered to, can be dismissed.
The Gold / Money Stock Ratio
'According to the League of Nations estimates, paper currency and bank deposits accounted in 1913 for nearly 9/10th's of overall monetary circulation in the world and gold for little more than 1/10th.' Triffin continues stating that 'the term 'gold standard' could hardly be applied to the period as a whole, in view of the overwhelming dominance of silver during its first decades, and of bank money during the later ones.' Bordo states that 'working with a small gold reserve, the bank of England nevertheless avoided catastrophe in the wake of Britain's huge capital exports and general international interests. How did it achieve that result?'
In answer to this question it is cited that 'a strategic element was involved - all the players were aware of the consequence of collectively seeking to convert sterling into gold.' Despite the fact that there was not enough gold to convert all of the money stock under the gold standard, this in itself is not proof that the gold standard did not exist. The maldistribution of gold and the inadequacy of world gold output were reasons cited for the collapse of the interwar gold standard. This is completely different to stating that only 10% of a country's money stock was backed by gold, as with today's liquidity reserves, the fact that 10% of the money stock was convertible supplied the necessary amount of confidence in the financial system.
National Sovereignty
'You shall not press down upon the brow of labour this crown of thorns. You shall not crucify mankind upon a cross of gold.' In the introduction it was stated that it is this paper's argument that the gold standard existed until such time as it conflicted with individual members' national policies. The interwar period provides an excellent example of the existence and powerfulness of the international gold standard, when it directed countries to follow deflationary policies or to abandon the system. The members chose to leave the club and any of the advantages that resulted from membership. Earlier it was noted that exchange rate stability was as such an advantage. In this instance the 'rules' of the game could not be superseded. The gold standard had always exerted this deflationary influence but prior to the first war as Scammell notes, the economies proved themselves able to absorb the required changes. '[In] an era of swift industrial expansion, an adjustment of the gold standard type could be achieved without deflationary effects - with little surplus capacity in the industrial countries and investment opportunities abundant, the switches of demand involved could be accomplished easily and smoothly.' However, with reference to the interwar gold standard Eichengreen concludes that 'investors were fully cognisant of governments' growing hesitancy to sacrifice other objectives on the altar of exchange rate stability.' Previous to this, membership 'did not interfere with the major economic changes to which they were strongly committed.' This point is supported by Bordo when he quotes Lindert's study which noted 'that Sweden remained on the gold standard because the country grew rapidly, not vice versa.'
It is hard to reconcile the view that the gold standard did not exist or exerted no influence when even Keynes concluded, through his 'Tract on Monetary Reform' (1923) and the Macmillan Committee (1931), that the question of whether 'adherence to an international standard may involve the payment of too heavy a price in the shape of domestic instability?', should be answered in the affirmative.
Conclusion
This paper has progressed through a description of the classical gold standard, its rules and its 'traditional' mode of operation. The author has always been mindful of the arguments put forward to discredit the existence of any gold standard. One has alluded to four prominent areas of disagreement: the price-specie flow explanation, adherence to the rules of the gold standard, the gold/money stock ratio and the national sovereignty of member countries. As stated in the introduction, one's conclusion is that the gold standard did exist up to the point that member countries could no longer avoid its difficult policy prescriptions, the collapse of the system in essence proving its existence. Thus Scammell's conclusion that 'there can be no doubt that the international gold standard as it evolved in the 19th century provided the growing industrial world with the most efficient system of adjustment for balances of payments which it was ever to have, either by accident or conscious planning,' seems to encapsulate this paper.
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