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In this article we will discuss about:- 1. Meaning of the Gold Standard 2. Types of the Gold Standard 3. Rules 4. Working 5. Decline 6. Merits 7. Demerits 8. Non-Restoration.
Meaning of the Gold Standard:
The gold standard is a monometallic standard in which the value of the monetary unit is fixed in terms of a specified weight and purity. As pointed out by Robertson, “Gold standard is a state of affairs in which a country keeps the value of its monetary and the value of a defined weight of gold at an equality with one another.”
Coulborn’s definition is simple. He writes, “The gold standard is an arrangement whereby the chief piece of money of a country is exchangeable with a fixed quantity of gold of a specified quality.”
Types of the Gold Standard:
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The meaning of the gold standard, as given above, relates to its general form. But different countries at different times adopted different types of gold standard which are explained as under.
1. Gold Currency Standard:
This standard prevailed prior to 1914 in the UK, USA and certain other countries. It was also known as the gold coin standard, gold circulation standard or full or pure gold standard. It had six main features:
(i) Gold coins of a definite weight and fineness circulated within the country. For instance, in England the sovereign was the gold coin which contained 123.2744 grammes of gold of 11/12th purity,
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(ii) The gold coin (i.e. sovereign in Britain) was full and unlimited legal tender,
(iii) Non-gold metallic coins and paper currency notes also circulated side by side but they were convertible on demand into gold coins at fixed rates,
(iv) There was free coinage in gold. Any body could take gold or jewellery to the mint for coinage,
(v) Gold coins could be freely minted for other purposes, and
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(vi) Export and import of gold was free and unrestricted.
Since this standard was costly to operate, it was given up after the first world war in favour of the gold bullion standard.
2. Gold Bullion Standard:
This standard was in operation in the UK between 1925-31 and in India between 1927-31.
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This monetary system had five distinguishing features:
(1) Gold coins did not circulate within the country. The legal tender currency in circulation consisted of paper currency notes and token coins of silver and other metals,
(ii) These were convertible at fixed rates into gold bars or bullion. For instance, in England currency notes were convertible into gold bars containing 400 oz. of gold at the fixed price of £3-17s-10d per oz. of 11/ 12th fineness. When India adopted this system in 1927, rupee was convertible into gold bars containing 40 tolas at the price of Rs. 27, 7 annas 10 pies per tola.
(iii) For converting currency into gold, the monetary authority was required to keep gold bars in reserve,
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(iv) The monetary authority also bought gold from the public at a fixed price,
(v) Gold was freely exported and imported.
3. Gold Exchange Standard:
This system was in operation in India between 1898 to 1913 and in a number of eastern countries which were poor and did not possess sufficient gold. But mostly such countries were under the colonial rule and their currencies were linked with the currency of the ruling country.
The principal features of this monetary system were:
(i) Gold coins did not circulate within the country,
(ii) The currency consisted of paper notes and token coins of silver and other metals,
(iii) These were not convertible into gold coins or bullion,
(iv) But the local currency was linked with some foreign currency which was on gold currency standard,
(v) It was convertible into such foreign currency at a fixed rate. For instance, the Indian rupee coins were convertible into British sterling at the ratio of 1s-4d per rupee,
(vi) Since the currency was indirectly linked with gold, prices of goods and services were consequently determined by the price of gold,
(vii) Gold could not be exported and imported freely. Only the monetary authority was authorised to export or import gold. But actually payments were made in the securities of the two countries. For instance, rupee and sterling securities were bought and sold by England and India respectively at the fixed exchange rate of 1s-4d per rupee.
4. Gold Reserve Standard:
England was the first country to abandon the gold standard in 1931, followed by the USA in 1933 and France in 1936. This led to instability in their exchange rates. To maintain exchange stability, they entered into Tripartite Monetary Agreement in September 1936 and they were joined by the Netherlands, Belgium and Switzerland in the same year.
This Agreement came to be known as the Gold Reserve Standard and worked successfully till the outbreak of the Second World War in September 1939.
The main features of this system were:
(a) There were no gold coins within the country,
(b) The currency consisted of paper notes and token coins of cheap metals,
(c) This currency was inconvertible into bullion,
(d) Under the Agreement, each country maintained an Exchange Equalisation Fund which kept gold, local currency and foreign exchange. The exchange rate was stabilized by purchase and sale of foreign exchange or gold from the fund,
(e) There was no free export or import of gold except by the Fund authority for maintaining stability in the exchange rate. Such gold was meant to be kept in the Fund,
(f) There was strict secrecy about the reserves of gold and foreign exchange kept in the Fund.
5. Gold Parity Standard:
This system has emerged with the establishment of the International Monetary Fund in 1944. It does not possess any feature of the various gold standards explained above. Under this system, every country has to declare the par value of its monetary unit in terms of a fixed quantity of gold.
So this is not gold standard in the real sense of the term, except that it aims at keeping the exchange rate of the currency stable in terms of gold. “But whatever form the gold standard may take, its essential characteristic is that the currency is, either directly or at one move, either in volume or in value, linked to gold.”
Crowther has distinguished between domestic and international gold standard. According to him. “The domestic gold standard is mainly concerned, with the volume of money and with its influence on the domestic price level.
The international gold standard is concerned with the external value of the currency and with problem of maintaining the stability of foreign exchange.” All the variants of the gold standard discussed above differ with regard to” the operation of the domestic gold standard in one respect or the other.
But they have one feature in common relating to the maintenance of exchange stability under international gold standard. We shall, therefore, be concerned with the discussion of the working of the international gold standard which was abandoned by the countries of the world in 1930s.
Rules of the Gold Standard:
The gold standard functioned smoothly before the First World War. In order to study its working, it is essential to analyse the conditions for its success. These conditions have come to be known as the “rules of the game”.
The Macmillan Committee pointed out in this connection, “It is difficult to define in precise terms what is implied by the rules of the game.” The management of an international standard is an art and not a science, and no one would suggest that it is possible to draw up a formal code of action. Much must be left to time and circumstances.” But it recommended the following general principles for the successful working of the international gold standard.
1. It should involve a common agreement among nations as to the objectives for which it existed.
2. It should bring stability of prices and guarantee stability of exchange.
3. Individual central banks should avoid such actions which might endanger stability of prices through their effects on the policy of other central banks.
Given these three principles the countries on the gold standard were expected to observe the following rules or conditions for its smooth working.
1. There should be free and unrestricted export and import of gold between countries.
2. The country receiving (importing) gold should expand credit within the country and the gold-exporting country should contract credit.
3. There should be a high degree of price, wages, income and cash flexibility in countries on the gold standard so that these change with gold movements. For instance, when gold flows into the country, money supply should increase which should lead to rise in prices, wages and income, and costs would be adjusted accordingly. The opposite would be the case in the event of the outflow of gold to other countries. It would lead to decrease in money supply, fall in prices, wages, income and costs. Thus the success of the gold standard depends upon flexibility in the economic set-up of the economy.
4. The successful working of the gold standard presupposed the existence of free trade among nations. The gold standard was essentially a laissez-faire standard.
5. The country on the gold standard should strictly adhere to the policy of maintaining exchange stability and other objectives should be subservient to it.
6. There should be no disturbing large capital movements based on speculative activities. In fact, the smooth working of the gold standard depended to a large extent upon the degree to which the movement of short-term funds could be influenced by changes in the bank rate.
7. Another condition was that the gold value of the domestic currency was to be kept stable. It should not be overvalued or undervalued.
8. Last but not the least, the success of the gold standard required normal times. That is why, it broke down during the First World War and the disturbed conditions following the War.
9. The gold standard worked smoothly so long as the countries followed these rules to the letter. As pointed out by Crowther, “The gold standard is a jealous god. It will work provided it is given exclusive devotion.” This continued up to 1914 and after that when they started breaking these rules gradually, the gold standard broke down.
Working of the Gold Standard:
The question arises: how did the gold standard work or what was the mechanism of the gold standard? The answer to this question is related to the functioning of the gold standard before 1914. All countries which were on the gold standard in the late 19th and early 20th century were inter-related and inter-dependent.
A country having a favourable balance of trade received gold from other country, because it had excess of exports over imports. On the contrary, a country having an unfavourable trade suffered from the loss of gold on account of the excess of imports over exports. This movement of gold affected both the countries, the country with the inflow of gold and that having an outflow of gold.
The monetary reserves of the country with the gold inflow would increase. It would lead to an increase in the internal money supply of the country. The increased money supply was reflected in increased expenditures on goods and services. This led to rise in prices, wages, income, and costs.
Consequently, the increase in the cost-price structure of the economy’s domestically produced goods became relatively dearer in comparison with foreign goods. This tended to reduce exports and increase imports. Thus a surplus in the balance of payment of a country caused by a favourable balance of trade would be automatically corrected in the country with the gold inflow.
On the other hand, the reverse process would be repeated in the country with the gold outflow. The outflow of gold would lead to decline in its monetary reserves. This would decrease the internal money supply of the country.
As a result, prices declined along with wages, income, and costs. This made the domestically produced goods relatively cheaper than foreign goods. So exports increased and imports declined. Thus a deficit in the balance of payments of a country caused by an unfavourable balance of trade was automatically corrected in the country with gold outflow.
Was it Automatic? From the above analysis of the working of the gold standard, it seems that there was some visible hand which helped the attainment of “automatic equilibrium” in the balance of payments of both gold inflow and gold outflow countries. But this is not a correct view about the actual working of the gold standard.
In reality, there was a large degree of management in its working even during its hey days before the First World War. Powerful central banks, like the Bank of England managed the internal policies of the government in each country for the gold standard to function the way the economists thought it should function.
One of the principal objectives of the central bank policy was to maintain stable exchange rates for a country on the gold standard. The adjustment in the domestic price level as a result of gold movements was not automatic. Rather, it was modified by the bank rate policy of the central bank.
Moreover, the total currency in a country was connected to gold reserves which increased or decreased with the rise or fall in the latter. It was the total volume of currency which affected the price level in turn. So the central bank operated the bank rate policy to undertake corrective measures within the economy for keeping exchange rates stable with gold outflows or inflows.
When there was an outflow of gold, the gold reserves of the country declined. Consequently, the total volume of currency also declined and prices fell. But in order to protect the monetary reserves of the country, the central bank raised the bank rate. Higher interest rates induced the indigenous capitalists to invest funds internally and also attracted foreign investment to the country.
These tendencies led to the reduction of gold outflow and also to an inflow of gold. In either case, the monetary reserves of the country were protected. Similarly, the bank rate was lowered and prices increased when there was an inflow of gold.
As a matter of practice, the central bank seldom adopted corrective measures in the event of gold inflow. The increase in the monetary reserves of the country was welcomed. So it was left to the gold losing country to undertake corrective measures.
The Deflationary Bias:
Whenever a country lost gold, it experienced falling prices, In fact, it W3S in the interest of the gold losing country to deflate prices. But it became difficult to bring revival once deflation started. If the country lost much gold during a short period of time, the deflating pressures along with the rise in the bank rate would bring a financial crisis.
Since wages are rigid in the downward direction, it would lead to large scale unemployment. Once the economy was in deep depression, it was difficult to bring a revival with the efforts of the central bank. Considering all this, Mrs. Joan Robinson pointed out that the gold standard had an “inherent bias towards deflation”.
There were two more reasons for the deflationary bias of the gold standard mechanism.
First, trade took place between countries of unequal size. But gold standard presupposed trade relations between homogeneous countries of approximately equal size.”
Second, for some countries balance of payments were more important relative to their internal economy, while for others balance of payments had less importance. Naturally, countries which depended more on imports having large gold outflows tended to have deflationary bias.
Despite this deflationary bias, the gold standard functioned smoothly prior to 1914. This is because “the gold standard mechanism was … never put to a really severe test. Major international interruptions were absent, the price-cost structures of the different countries were in conformity with the exchange rates and internati6nal capital movements served mainly to put sufficient reserves at the disposal of those countries which were, at the moment in need of it.”
The Decline and Fall of the Gold Standard:
The gold standard could work only if the “rules of the game” were observed which could be observed under normal conditions. But when the First World War broke out in 1914, the belligerent countries went off the gold standard because they had to suspend convertibility of currency into gold. They withdrew gold coins from circulation and replaced them by-paper currency.
England prohibited the melting of gold coins and the export of gold though it did not stop conversion of notes into gold coins. Some of the countries did make payments to the neutral countries in gold. During the War the belligerent countries suffered from inflation of varying degrees.
But they could not be controlled because the countries could not observe the rules of the game. So the gold standard virtually broke down during the War period.
After the War, most countries suffered from inflation of varying degrees which made it difficult to fix gold value of domestic currency at pre-War rates. Prestige led Great Britain to return to the gold standard at the pre-War parity and it was commonly estimated that the pound was overvalued by 10 per cent.
This was because the price level in Britain was higher than in America by this percentage. The actual exchange rate was fixed at $4.866=£1 but the equilibrium rate was $4.38=£1. So England’s goods were overpriced and of America’s under-priced. This adversely affected British exports and favoured imports from America. But Italy overvalued its Lira and France undervalued its Franc. By 1928 the restoration of the gold standard was complete.
But it was not the same gold standard which existed before the 1914 war. Rather, it was a truncated gold standard with failure of the governments to follow the golden rules of the gold standard game. Consequently, with the beginning of the Great Depression in 1929, the final collapse of the gold standard began. Four South American countries were the first to go off the gold standard by the end of 1930. England, along with twenty-two other countries, abandoned the gold standard in 1931. By the end of 1936, practically all countries had left the gold standard.
Causes of the Breakdown of the Gold Standard:
Economists have pointed to a number of causes which led to the breakdown of the gold standard. First, the monetary authorities in the different countries were no longer exclusively devoted to the aims of the gold standard as they had been before the War. As put by Crowther, “Gold standard is a jealous god.
It will work provided it is given exclusive devotion.” They were not prepared to follow the rules of the gold standard. After the restoration of the gold standard in 1920s, every country wanted to have price stability. But the primary objective of the gold standard was to have exchange stability. So price stability was not compatible with the maintenance of the gold standard. Hence it broke down for failure to observe this golden rule of the game.
Second, the technical task of maintaining exchange stability was more difficult than before the First World War. Exchange stability could be maintained by making adjustment in the internal price level of countries. But it was difficult to make constant readjustment in prices due to three reasons:
(i) The domestic currencies were either overvalued or undervalued;
(ii) There was downward rigidity in the wage-cost structure in case of downward readjustment of prices; and
(iii) Readjustments were also difficult because the short-term funds of banks could not be influenced by changes in the rate of interest. The short-term funds were affected more by speculation or fear than by the interest rate.
Third, the imposition of Reparations and the insistence on the repayment of War debts from Germany made it difficult for the foreign market to be controlled by the weapons of the gold standard. To pay Reparations and War Debts, Germany had to buy dollars irrespective of its gold reserve position and the bank rate, and the countries which received such payments could not make adjustments accordingly.
Fourth, almost every country imposed high tariffs. Imposition of high tariffs especially by the creditor countries restricted imports from debtor countries. This was a clear violation of the rule of the gold standard. When a debtor country was losing gold, it was essential for it to lower internal prices in order to expand exports.
But high tariffs by the creditor countries prevented the expansion of exports and thus made adjustments in foreign exchange difficult. This led many countries to abandon the gold standard.
Fifth, the central banks failed to observe the golden rule: “expand credit when gold is coming in; contract credit when gold is going out.” The United States and France, which were receiving gold did not expand credit sufficiently. On the other hand, Germany and Great Britain which were losing gold tried to make adjustments by borrowing from the gold-receiving countries. This meant the non-observance of the rule of the gold standard. There were, however, some immediate causes which led to the breakdown of the gold standard beginning from 1930.
(i) The first cause was the steep fall in the price levels of a number of countries. This brought a fall in the demand for exports and reduced the foreign exchange earnings of exporting countries. These were the countries which depended on exports of raw materials whose prices fell sharply. Their export earnings declined considerably but they could not protect their gold reserves from falling as they continued to make gold payments for their international obligations.
(ii) The second immediate cause of the abandonment of the gold standard was the virtual cessation of international lending from 1929. We saw above that many debtor countries had been borrowing from the United States to meet their international payment and protect their gold reserves during 1920-27. But with the coming in of the Great Depression, such countries stopped borrowings and found it difficult to make repayments of interest and principal because their export earnings were declining.
(iii) The last immediate cause was the presence of large short-term international debts against London and New York financial markets. These were payable on demand at short notice. A wave of fear caused the lenders of these short-term funds or “Hot Money” to ask for their repayments. It all started with the failure of the largest bank in Austria, the Credit Anstalt in May 1931. This led to international banking panic in Germany, France, United States and Great Britain, where there were run on banks by creditors with the result that they stopped payments and froze credits in terms of gold. And the gold standard had finally ended.
Hawtrey observes, “The immediate cause of the crisis, it is true, was the withdrawal of foreign money, first from Austria and Germany and then from England, But this was the result of distrust, and the distrust was directly due to the appreciation of gold.”
Merits of the Gold Standard:
The international gold standard which operated for more than three decades in different forms had certain merits.
1. Inspired Public Confidence:
The gold standard inspired public confidence because the domestic currency was linked with gold. People knew that gold was an internationally accepted medium of payment, and a standard and a store of value. Therefore, they had full confidence in the paper currency which was convertible into gold bullion or coins or securities.
2. No outside Interference:
The international gold standard had the merit of working without any outside interference by any other country or international authority.
3. Automatic Operation:
The gold standard functioned smoothly provided ‘the rules of the game” were observed. These rules were not complex but easy to understand and follow for the countries. Thus the gold standard provided a simple and automatic monetary system to the countries of the world.
4. Stable Exchange Rates:
Another merit of the gold standard was that it maintained stable exchange rates between countries. The exchange rate of every country was fixed in terms of its mint par or the gold value of its currency. The actual exchange rate between gold export and gold import points which took account of the cost of transporting gold from one country to the other. Thus the exchange rate was stable and fluctuations occurred only between the two gold points.
5. Stable Internal Prices:
The gold standard secured relative stability of internal prices. When there was an inflow of gold, prices rose. And they fell with gold outflow. But when prices rose, exports diminished and imports increased. On the other hand, fall in prices led to expansion of exports and decline in imports.
These opposite tendencies started gold outflow in the former case and gold inflow in the latter case. Ultimately, price stability was maintained in the trading countries.
6. Check on Inflation:
Under the gold standard the currency of a country was linked with gold and was convertible into it. As the issuing of currency was backed by specified quantity of gold, there was a limit up to which the authorities could issue currency. For every increase in the amount of currency, gold reserves were also required to be increased to a given extent.
There was thus an automatic check on the issuing of paper currency by a country. There was also no fear of inflation, because the country could not increase the quantity of money in unlimited quantity. As against this, the present system of managed paper standard, having a fixed gold backing, leads the authorities to issue paper money in unlimited quantities thereby leading to inflation.
7. Expansion of International Trade:
The gold standard helped in the expansion of international trade. This was made possible by stable exchange rate and stable value of gold in countries. These led to the expansion of international trade and capital movements.
Demerits of the Gold Standard:
Despite these merits, the actual working of the gold standard revealed a number of disadvantages which the countries of the world had to experience.
Some of them were as under:
1. Fair Weather Standard:
Critics pointed out that the gold standard acted like a fair weather friend. It worked smoothly in normal or peace times but failed during war or economic crises. Its actual working shows that it had to be suspended during the First World War and finally abandoned during the Great Depression. So it was a fair weather standard.
2. Not Automatic:
It is a misnomer to say that the gold standard worked automatically. In fact, all varieties of it had to be managed by the monetary authority or the central bank. The gold standard did not work automatically. The central bank had to change the bank rate in accordance with gold movements in order to affect the price level.
3. Exchange Stability at the Cost of Economic Stability:
One of the principal objectives of the gold standard was to maintain exchange stability. But this was always attained at the cost of economic stability. When every time there were gold movement, the internal price level had to be adjusted accordingly in order to maintain exchange stability.
These price fluctuations led to internal economic instability which ultimately harmed the country. It is for this reason that now-a-days all countries prefer internal price stability to exchange stability.
4. Anarchy in World Credit Control:
Hawtrey characterised the gold standard as state of anarchy in world credit control. Since the gold standard was a laissez-faire standard and operated only under normal times, it failed miserably in conditions of severe inflation or deflation. During the First World War, inflation spread to all countries of the world.
On the other hand, when depression started in 1929 it became a worldwide phenomenon. Thus the gold standard by itself was unable to control either inflation or deflation. Rather, it had to sacrifice itself at the altars of inflation and deflation.
5. Deflationary Bias:
According to Mrs. Joan Robinson, the gold standard had an inherent bias towards deflation. It was in the interest of the gold losing country to deflate prices, But once deflation started it became very difficult to bring revival even with the best efforts of the central bank. The long drawn depression of 1930s proved this fact without any shadow of doubt.
6. No Independent Policy:
A country on the gold standard could not follow an independent policy of its own. It had to follow that policy which was adopted by all other countries. Failure to follow a common policy along-with other countries mean; abandoning the gold standard. This implied breaking of all trade relations with countries on the gold standard which could be harmful for the country.
7. Costly Standard:
The gold standard was a costly standard because it was based on gold. Every country had to circulate gold coins or keep gold reserves. As against this the paper standard is much cheaper and also economises the use of gold.
8. Rigid Standard:
The gold standard was a rigid standard because for its success the rules of the game had to be observed in letter and spirit. A country could not increase the money supply to finance a war or development activities or any financial emergency without increasing the gold reserves with its central bank.
If it had to export gold to import the necessary equipment, raw materials and other goods it needed for war or development purposes. It was expected to reduce the internal price level by force in keeping with the rules of the gold standard game. Thus it was a highly rigid standard.
9. Adverse Effects of Interest Rate Changes:
Under one of the rules of the gold standard, the central bank of the country was required to affect changes in the bank rate in keeping with gold movements. When there was an infl6w of gold, the bank rate was lowered, while it was raised with the outflow of gold. Such changes in interest rates were forced upon trade and industry simply to expand or reduce money income within the country. They, therefore, adversely affected trade and industry.
Taking into account the various disadvantages of the gold standard enumerated above, it can be concluded that the gold standard was an unnecessary standard. The managed paper standard can secure on all the advantages enjoyed by the gold standard minus its disadvantages. That is why the gold standard is now a thing of the past and is only of academic interest, never to be restored again.
Non-Restoration of the Gold Standard:
After the collapse of the gold standard, no country was willing to restore the gold standard for the following reasons:
First, the supply of gold could not be increased to meet its increasing demand. So no country was willing to export it to observe the rules of the game.
Secondly, more so because the majority of gold reserves flowed into the United States.
Thirdly, no country was willing to bring instability to its economy for the sake of maintaining exchange stability.
Fourthly, development of nationalism motivated every country to formulate economic policies in keeping with its self-interest.
Lastly, every country felt that it could manage its monetary affairs in a far better way by adopting a managed paper standard than the gold standard.
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