Essay: The currency of gold

Prior to the 1870s, European countries faced challenges trying to maintain smooth financial operations under various gold, silver, and bimetallic standards. Discoveries of silver, technological advancements, and France’s loss to Germany in the Franco-Prussian war were among the factors that eventually gave way to the emergence of the Classical Gold Standard in the 1870s. After experiencing a series of numerous rapidly evolving monetary systems, countries such as Germany, the Netherlands, France, Belgium, and Switzerland became the first to commit to a monetary system regarded as the classical gold standard. The monetary authorities of these countries practiced the classical gold standard with an obligation to guarantee the value of its specified legal tender through convertibility to gold (Redish 1990). As more countries joined the gold standard, a homogenous international monetary system was born. The most notable characteristics of the classical gold standard system include the use of a standardized commodity for monetary functions, the achievement of long term price stability, trade with fixed exchange rates, and the role of central banks. Each of these elements of the classical gold standard presented countries with benefits and costs to their overarching goals of economic prosperity.
Gold emerged as an appropriate metal for a commodity standard because it possessed durability, recognizability, divisibility, and portability. Early economic writers had stressed the importance of such properties in order for money to be a suitable medium of exchange, and gold satisfied these requirements (Bordo 1981). Standardized commodity money proved beneficial for closed economies on the gold standard, especially when one considers that gold as a commodity itself could self-regulate its value, achieving its own market equilibrium price and quantity as a response to competitive market forces.

The ability of gold to respond automatically to market forces in a closed economy was beneficial for price stability, but it also brought complications. High resource costs of producing gold presented challenges to countries hoping to maintain a full commodity money standard. Often, gold production became too costly for strict adherence to the gold standard, and fiat money had to be introduced as a substitute for gold (Bordo 1981). Additionally, worries surrounding the amount of gold in circulation occasionally emerged. An instance of such concern took place in the United States in the 1890s, when the public “feared that there might come a time when the Treasury would lack the specie required to convert dollars into gold” (Eichengreen 1996). The use of a fixed, tangible commodity for currency or backing of currency was beneficial for standardizing monetary systems, though its high costs did create some of these technical concerns.

Perhaps the most widely regarded benefit of the classical gold standard was its long term price stability. The aforementioned ability of gold to self-adjust its value helped to regulate market price levels for the goods it would be used to purchase. Under the gold standard, decreases in overall price levels coincided with an increase in the purchasing power of a fixed amount of gold. Thus, the production of gold became more profitable, increasing the amount of gold in circulation to raise price levels enough to fully compensate for the initial decrease.

When people commend the gold standard’s price stabilizing abilities, however, they fail to acknowledge the severe lag in the process of price stabilization within an economy. In actual practice, it would take many years for such price adjustments to reach full effect, as each link of the chain was a response to a preceding link that had to be in practice in order for any responses to be triggered. Though they took time to become activated, these automatic price stabilizers minimized inflation. So, price stability was more achievable in the long run than it was during short term financial fluctuations.

Today, it is debated whether or not the absence of noticeable inflation during the classical gold standard was indeed optimal. Without slight inflation, consumers had little incentive to spend their money sooner, lessening the potential multiplier effects associated with consumption spending. This consequently may have hindered the ability of economies backed by the classical standard to grow to their full potential domestically. Additionally, when faced with zero inflation, some companies may have been hesitant to increase their wages (Milligan 2015). Again, this did little to stimulate GDP. These costs of the classical gold standard’s stable price levels targeted potential economic growth and should not be ignored.

However, the classical gold standard created significant benefits for trade operations between countries with open economies. The period of 1870-1913 is even considered by some economists to be a “‘golden age’ [for its] massive interregional flows of capital, labor, and goods,” (Bordo and Rockoff 1996). Financially globalized countries that adhered to the gold standard were able to access more potential trade opportunities as they exhibited evidence of financial rectitude in a way resembling a “Good Housekeeping Seal of Approval” (Bordo and Rockoff 1996). With this increase in credibility, countries showed that they could be dependable trade partners, suggesting that they would only run a trade deficit under extreme circumstances. Additionally, the classical gold standard created smooth conversions between currencies, leading to the establishment of fixed exchange rates.

Such fixed exchange rates created interconnectedness between classical gold standard economies, for better or for worse. Both monetary and real shocks were transmitted through capital flows, so “a shock in one country affected the domestic money supply, expenditure, price level, and real income in another country” (Bordo 2008). This interconnectedness allowed countries to reap the benefits of another economy’s success, but it also meant that countries were especially impacted when a financial crisis occurred overseas. The increased capital flows that took place in open economies were backed by Hume’s price-specie flow mechanism, which settled deficits automatically. The price-specie flow mechanism led to an adjustment of balance of payments between two countries in ways that were only possible through gold flows. When fixed exchange rates deviated from parity, investor incentives to arbitrage emerged. However, the cost of arbitrage often exceeded the expected profit, so investor arbitrage was uncommon and was not a particularly prevalent cost to economies.

The classical gold standard did indeed impose limitations for the monetary policy of central banks. Implicit, passive rules that were categorized under broader rules of the game “precluded each government from exercising any enduring influence over its own national price level” and insisted that price levels be determined solely by the supply and demand of gold (McKinnon 1993). Under the rules of the game, if central banks sought fixed exchange rates and free monetary flows, they had little freedom to conduct their own monetary policy. Some use this reasoning in the argument that there was no need for a central bank under the classical gold standard, as the monetary system could sustain itself (Bordo 1981).

However, not all banks followed the rules of the game. Banks could deviate from the rules and raise their discount rates in order to maintain convertibility of currency. They did so with little regard for the domestic costs of unemployment that resulted (Eichengreen 1996). Victims of interest rate hikes to preserve banks’ main priorities of convertibility were powerless and especially affected by their central bank’s choices to maintain a strong external image over their wellbeing. Further, when banks strictly followed the rules of the game, they were unable to act as lenders of last resort. Often times, “the trade-off between the gold standard and domestic financial stability was blunted,” as banks prioritized ease of convertibility (Eichengreen 1996). The classical gold standard repeatedly presented central banks with choices on whether or not to follow the rules of the game. What was beneficial to the bank’s adherence to the gold standard was occasionally costly to the people, and vice versa.

Though the classical gold standard appeared to be highly beneficial to world economies, the most knowledgeable economists today are also mindful of its costs. Last year’s presidential election in the United States raised some conversation about the possibility of returning to a gold standard, a path supported by individuals such as Ted Cruz and Donald Trump. Nearly all economists agree that this system would not be a viable option for countries today, and that the gold standard is mostly admired by Republican economists because it “…suits a political moment” and is “essentially the monetary equivalent of a government shutdown” (Rauchway 2015). This brings to attention the influence of perspective when distinguishing the benefits and costs of the classical gold standard. It is important to look back upon the results of the classical gold standard as a whole and how they contributed to well being of the overall economy, while remaining unbiased and mindful of the impacts on both individual and widescale levels.

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