Many people are familiar with the gold standard, but few understand it. The gold standard was the system whereby gold and claims to gold were used as money.
For nations operating under the gold standard, their currency could be exchanged for a specified amount of gold based on the international value of their currency. The gold standard, or any international monetary standard, lowered the transaction costs of trade between nations.
In the late 19th and early 20th centuries, many developed countries thrived under the gold standard. During this period, the international gold standard was operated by state-backed central banks. However, mismanagement of the gold standard by central banks caused the system to collapse. The prevalence of the gold standard came to an end after financial crises in the early 20th century.
In the late decades of the international gold standard, mismanagement led to volatile prices. Much of this instability occurred during World War I and the Great Depression. With the start of World War I, the international gold standard ceased to function as it had since its establishment in the 1870s. Nations such as France, the United Kingdom, and Germany suspended the gold standard, choosing to spend gold and print money to fund the war. Even the United States, which remained on the gold standard, disallowed gold exports during the war.
This created several problems.
First, by printing new money not backed by gold, nations devalued the market exchange rates of their currencies. Attempts to re-establish the old exchange rates after the war ultimately proved unsuccessful.
Second, abandoning the gold standard weakened the international price of gold, causing price levels to soar. As nations sought to re-establish the gold standard after the war, markets experienced the opposite problem. Prices collapsed, and a sharp, if brief, depression ensued.
Economist Scott Sumner points out in his book The Midas Paradox that the gold standard had a greater impact on the decisions of policymakers than the size of the economy. Disturbances in the gold market, such as private hoarding and the discovery of gold in countries outside the gold standard community, could impact a state’s economic conditions. It would be impossible, according to Sumner, to fully understand the events of the Great Depression without partially focusing on this dysfunction in the international gold market.
After the stock market crashed in 1929, the decline in prices led to a dramatic increase in central banks’ demand for gold. In aggregate, central banks began increasing the size of their gold reserves. As gold’s value increased, prices in terms of gold began to fall. This placed major stress on the banking system. Numerous bank runs reinforced a growing crisis, further increasing demand for gold instead of bank notes.
Monetary intervention in the United States and other countries led to the gold standard’s downfall. Erratic policy by the central bank created tremendous price fluctuations throughout the late-1910s and much of the 1930s. Eventually, developed nations abandoned the gold standard. It is of note, however, that the gold standard’s poor management by central banks – and not the use of gold or commodity money more generally – was the problem.
Meet the Author
Mark Simonson is a graduate student in the NDSU Department of Agribusiness and Applied Economics.