A brief history of the gold standard

What was the gold standard?
The gold standard was a monetary system that pegged currencies to the value of gold.

Why was the gold standard adopted?
Short answer: the gold standard was adopted in Great Britain in 1817 (other countries followed later), as a response to a quickly growing economy with the need for stable currency.

Long answer: leading up to the early 19th century, Great Britain had been on a bimetallic monetary system. Gold and silver coins circulated in the economy with an official exchange rate between the two. For example, in Great Britain one guinea (a gold coin) was valued at 21 shillings (a silver coin). However, at times foreign market exchange rates between gold and silver made it profitable to export one or the other, causing shortages in the circulating coinage.

Napoleon had been successful with the introduction of the gold franc and the promise to pay France’s soldiers, contractors and debtors in the new currency. Although victorious in the Napoleonic Wars, the UK’s economy was in shambles and the war years had brought massive inflation. A committee was appointed to advise on the nations monetary system. After several years, a Royal Proclamation was issued on 1 July 1817 that officially re-introduced the gold sovereign as ‘the lawful Gold Coin of the Realm’ and the standard unit of currency with an official valuation of one standard ounce of gold (11/12 fine) at £.3.17.10½. All notes and silver coins were exchangeable to gold at all times and this was made clear by the text, ‘We promise to pay the bearer on demand the sum of…’, that can still be read on British banknotes. 

Was the gold standard good or bad?
The gold standard filled an important purpose during a time of great economic expansion in Great Britain and other industrialising nations in the West. The standardisation of payments across borders and unquestionable trust in currencies backed by gold encouraged economic activity and growth.

If the gold standard acted as a catalyst for growth during industrialisation, it hindered countries from recovery during the Great Depression of the 1930s. There are countless arguments for and against the gold standard, its uses and effects on the world — some see it as a limiting monetary system and others interpret its transparent system of value as responsible. Ultimately there may be no perfect monetary system, especially not in a rapidly developing world. The gold standard filled its purpose up to the First World War, then the world changed enough to make it ineffective.

The gold exchange standard (1925-31)
What was the gold exchange standard, adopted in Great Britain in 1925? Why was it adopted and what led to it being abandoned?

After the First World War, countries aimed to reintroduce the gold standard. However, the two requirements of the gold standard, trust and international cooperation, had been abandoned in the four years of wartime upheaval. Price inflation and the hoarding of gold made it impossible for all countries to back their currency with gold, so the gold exchange standard allowed countries other than the US and UK to hold dollars and pounds as reserves, while the dollars and pounds in their turn was backed by gold.

By refusing to adapt to the post-war reality and embarking on deflationary measures to bring economies back to the gold standard system at pre-war exchange rate levels (such as increasing interest rates while reducing prices and wages), policy makers of the 1920s exacerbated the already challenging economic effects of the First World War, which would eventually lead to the Great Depression of the 1930s. As Barry Greenstein says in his research paper, ‘The Gold Standard and the Great Depression’ (NBER Working Paper #6060, 1997), the gold standard, ‘developed to cope with a world that no longer existed and sustained by social and political pressures that discouraged its abandonment, this intellectual construct spawned policy responses which were directly responsible for economic catastrophe.’

Chancellor of the Exchequer Winston Churchill, who later became a critic of the Gold Standard, recalled his decision to fix gold at the pre-war exchange rate the biggest mistake of his career. With the Sterling overvalued, it made the country’s exports suffer and unemployment rise. It also made the Sterling an easy target for speculators. In 1931, at the Great Depression’s nadir, wealthy private investors and central banks around the world converted their pounds into gold and the Bank of England gold reserve quickly depleted, forcing Great Britain to abandon the gold exchange standard, shortly followed by the US. Economic turmoil was sowing new political crises, and again, the world was heading towards war.

Near the end of the Second World War, the Allied leaders met at Bretton Woods to lay out plans for a new economic system known as the Bretton Woods International Monetary System, confirming the USD — backed by gold — as the reserve currency of the world. The Bretton Woods system would last until August 1971, when President Nixon found the USD in a similar overvalued situation and facing a request by the Bank of England to convert $3bn to gold. Since then, no currencies are backed by anything other than the ‘good faith and credit’ of their governments.