A Monetary System Backed by Gold: The Rise and Fall of the Classical Gold Standard

 Ludwig Van Beethoven: Symphony No. 7

A Monetary System Backed by Gold

Most of you reading this are probably aware that the current global monetary system employs currencies that are not backed by anything tangible. You cannot redeem Dollars, Euros, Pesos, etc. for an equivalent amount of gold or other precious metals. But this has not always been the case and in fact, just over 100 years ago most of the wealthiest nations and states in the world were part of an economic or monetary system that backed its currency with gold. This system has become known by economists and historians as the “classical gold standard”. The classical gold standard existed from the late nineteenth until the early twentieth century. Scholars often cite World War I as its terminal point and for the most part, it worked fairly well for the member nations until war and speculation forced nations, one by one, to abandon the system. In fact, a survey of the classical gold standard reveals that its global implementation ebbed and flowed with war and peace cycles respectively and although it was revived to a certain extent toward the middle of the twentieth century, it was not the old classical gold standard. The following report examines the history of the classical gold standard and its eventual demise with attention paid to both its inherent benefits and problems for the member nations.

The Conceptual Framework

In order to understand the history of the classical gold standard, a brief analysis of its theoretical ideas and practical implications is warranted. The classical gold standard was not the first monetary system to employ gold as a standard of value. Numerous ancient and medieval societies such as the Persians, Greeks, and Romans all used gold coins as currency but it was the first monetary system to use fully convertible bank notes as its currency. In theory, one could exchange his or her paper money at a bank for gold as long as the bank was on the classical gold standard. For the most part, both the philosophy behind the classical gold standard and its practical applications were straightforward and simple.

For the classical gold standard to work properly, all participants agreed to fixed-rates as opposed to variable rates on the currency. The major agents behind the system were not national governments usually but central banks such as the Bank of England, because it was the banks that handled most of the gold that backed the currency. This is not to say that governments had little to do with the system; governments were the entities that passed laws and ultimately decided if they would be on the gold standard, but in the end it was the banks that controlled the gold. For a country to be a part of the classical gold standard system, it only had to “say” it was on gold, fix a legal value on its national currency, and then the national mint or central bank would buy or sell gold. The economic mechanics behind the system were also fairly simple. If a country had an economic deficit then gold would leave and the money supply would diminish, which would lead to prices falling on domestic goods. Because of this, the number of exports would then increase and imported goods would decrease. The opposite of this would take place when a country had a surplus. The simplicity of the classical gold standard system made it very attractive for many nations to join, but the road to global implementation was a fairly lengthy process that had more than a few twists and turns.

The Origins of the Classical Gold Standard System

The process whereby most of the wealthiest nations of the world came to be on the classical gold standard was uneven and unofficial for the most part. Most nations came to the standard at different times and many never passed an official law or proclamation stating that they were in fact on it. Because of this, there is no exact date when the classical gold standard began, but by the 1820s many countries, including the United States, were on a specie standard of one type or another. Many countries preferred gold as the specie to back their currency, while others used silver or a combination of the two. By 1880, every major nation had its currency legally backed by gold at a fixed-rate, which is the point where one can definitively say the world was on the classical gold standard. The process to arrive at the classical gold standard did not happen overnight and examining its inception is integral for understanding its global importance

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Although the classical gold standard may have been official by 1880, its inception began about 100 years earlier in England. In the eighteenth century, the British Empire was the greatest the world had ever seen as it lived up to its moniker, “the empire that the sun never sets on.” Truly, the British Empire was vast as it ruled colonies on every continent through its superior navy and maybe more importantly, its economic prowess. The English became scions of economics as philosophers such as Adam Smith led the way in the theoretical field, while bankers and merchants in London made England the nerve centre of the world’s economy. Britain’s first major move towards the classical gold standard came as they were fighting the rebellious Americans during the Revolutionary War when Parliament demonetized silver in 1774. Parliament made the step in order to gain more control of an increasingly volatile banking industry, but unknown to them at the time, their move would have repercussions that would reverberate throughout the world for over a century.

Parliament’s actions paved the way for the Bank of England to replace the Royal Mint as the main regulatory institution of monetary matters in Great Britain, which eventually placed it on a level of power close to that of Parliament itself. With silver demonetized, Britain then chose to have gold back its currency, but despite the effort, its actions actually paved the way for paper money’s extensive use in modern society. For instance, by the early nineteenth century banknotes comprised over 60% of the monetary circulation in Britain while the rest of Europe was still primarily paperless during the same period. Britain’s march towards the classical gold standard was temporarily halted during the Napoleonic Wars (1797-1821), but was set back on the path in earnest when Parliament adopted measures in 1816 that officially adopted the gold standard. One could say that the British invented the classical gold standard, but it would never have been the influential system that it was if other European nations had not also moved to gold.

The Rest of Europe and the Classical Gold Standard

Because of Britain’s colonial power and its standing as the preeminent economic powerhouse in the nineteenth century, the other nations of Western Europe began to adopt the classical gold standard slowly but surely. In the beginning of the nineteenth century, the German speaking world was a collection of independent and often bickering kingdoms, but by the middle of the century most of those kingdoms coalesced under the leadership of Otto von Bismarck to become united Germany. Before unification, most German speaking kingdoms were on a bi-metallic, silver and gold combination, monetary system but not long after the inception of the modern German state the country moved to the classical gold standard. Not long after Germany was officially unified, it also won the Franco-Prussian War over France in 1871, which not only resulted in more land for the new state, but also a surplus in gold as a war time reparation payment by France. The surplus in gold allowed Germany to go on the classical gold standard and a short time later its major trading partners in Scandinavia also went on gold and the Netherlands followed in 1875.

The Austro-Hungarian Empire was continental Europe’s largest country at the time and although it was slow to adopt the classical gold standard, it saw the economic writing on the wall and did so in 1892. The tsars of Russia, ever wanting to be counted among their European peers, went on the classical gold standard in 1895, which was also the same year that the growing powerhouse of Japan joined its ranks. Europe’s process to go on the classical gold standard was initiated by Britain and although it took a few decades to complete, by 1900 all European currencies were backed by gold. The United States also went to the classical gold standard during the nineteenth century, but the process it took was a bit different from Europe’s.

The U.S. and the Classical Gold Standard

The process to go on gold in the United States was a bit more acrimonious as it involved sectional rivalries and the influential silver interests. Early in American history, silver was always an important commodity and it partially backed the Dollar until the 1830s when the country chose gold over silver. The United States temporarily went off the gold standard during the American Civil War (1861-65), but went back on it officially, like many of the European nations discussed above, in 1875. The process to officially go on the classical gold standard was complicated and for a time, it looked as though silver may have won as the commodity that backed the U.S. currency.

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After the dust of the Civil War had cleared, Americans found themselves embroiled in a new national conflict that pitted “hard money” against “soft money” interests. The hard money faction was comprised primarily of northeast businessmen who were involved in import-export companies. These people preferred gold as it was the world standard and used to back the money of the British with whom they had extensive business connections. The soft money faction was supported by farmers and domestic industrialists who saw gold as the reason for the low prices on their exported goods and the high prices on imported machinery they purchased. The conflict came to a head in 1873, which happened to be the same year as an economic recession.

Discoveries of rich silver veins in the western U.S. states in the middle of the nineteenth century proved to be a boon to many towns and individuals throughout the west, but also ironically served to end silver’s importance in relation to American currency. The surplus of silver caused by the extensive number of western silver mines led to its devaluation and eventually Congress order the U.S. Mint to stop producing silver dollars on February 12, 1873. The move by Congress unofficially put the United States back on the gold standard and angered silver and soft money interests so much that they began to refer to it as the “Crime of ’73.” But the silver and soft-money interests did not give up easily as 1873 proved to be a battleground year between the factions when the country entered into a recession known as the “Panic of ’73.”

As with any recession or depression, many were looking for scapegoats and the soft-money and silver factions found it in the gold standard. Farmers and domestic steel manufacturers had a difficult time paying for imported equipment during the Panic and so they aligned with the silver interests to form the Greenback Party in 1875. Although the Greenback Party attracted sizable support in rural sections of America, it never became much more than an “anti-gold” party and support for it evaporated by the turn of the century. The fate of gold and silver was sealed in the United States during the 1896 presidential election when William McKinley, who was a pro-gold Republican, narrowly defeated pro-silver Democrat William Jennings Bryant. McKinley’s victory ended the gold versus silver debate in the United States, but less than two decades later, the classical gold standard collapsed.

The Demise of the Classical Gold Standard

Just like with any political, cultural, or economic system the collapse of the classical gold standard cannot be attributed to one cause, but instead to a number of factors converged to bring the system down. Perhaps the greatest factor, or factors, that led to the end of the classical gold standard were inherent problems with its structure; some of the same reasons that made it lucrative for nations to join the classical gold standard were also factors in their desire to quit it.

Among the reasons for a country to defect was the desire to devalue its currency. On face value this may not sound like a sound economic policy, but by doing so a country can make its exports more competitive on the international market. If only one or two countries do this then it is not a threat to the system, but when multiple countries decide to follow this policy simultaneously, which is what happened with the classical gold standard, then the system finds itself in peril. The fixed-rates, which were a quintessential aspect of the classical gold standard, also contributed to its decline. Fixed-rates eliminate the possibility for independent monetary policy and, as discussed above in the United States, are largely opposed by domestic industries. The concept of convertible bank notes also caused inherent problems to the system as central banks were vulnerable to transnational capital flows and speculation, which meant that proper species resources were at times tenuous in some banks. The inherent problems with the system of the gold standard were probably the largest factors in its collapse, but outside pressures also played a role in its demise.

As noted above, nations tend to go off the gold standard during prolonged or intense wars, which coincidentally were the external circumstances that ended the classical gold standard, specifically World War I. After the war many of the nations that were on the classical gold standard attempted to revive the system but a lack of will and initiative seemed to doom any reasonable efforts. Germany was under the yoke of onerous reparations, Russia was transitioning to communism, and Britain’s international influence and prestige had waned considerably. Perhaps the United States could have been the agent to step in and revive the classical gold standard but the political will was lacking; after World War I Americans wished to return to their isolationist cocoon and move on with their lives apart from Europe. The classical gold standard had an impressive run, but as with most systems it had a finite life span.

Bibliography

Frieden, Jeffry A. “The Dynamics of International Monetary Systems: International and Domestic Factors in the Rise, Reign, and Demise of the Classical Gold Standard.” In Coping with Complexity in the International System, edited by Jack Snyder and Robert Jervis, 137-162. Boulder, Colorado: Westview Press, 1993.

Knafo, Samuel. “The Gold Standard and the Origins of the Modern International Monetary System.” Review of International Political Economy 13 (2006): 78-102.

Purvis, Thomas L. A Dictionary of American History. London: Blackwell, 2002.

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