The Gold Standard and Its Fall

The world of gold

A traveller who had crossed the world in the early years of the twentieth century, before the great catastrophe of 1914, would have experienced something that to us, accustomed to changing currency at every frontier, would seem almost miraculous. From London to Paris, from Berlin to New York, from St Petersburg to Buenos Aires, the principal currencies of the world were tied to gold by a fixed ratio, and for this reason tied to one another by stable exchange rates that hardly ever varied. The pound was worth so many dollars, the dollar so many francs, the franc so many marks, and these ratios were as fixed as the constellations, guaranteed by the promise of each central bank to convert its own money into a determined quantity of gold. One could plan international trade, sign a long-term contract, invest in a distant country without the fear that the value of money would change under one’s feet: value was anchored to gold, and gold was everywhere the same. It was the golden age of the classical gold standard, an international monetary system of a stability the world had never known before and would never know again.

It is worth asking why, among all metals and all things, it was gold that became the foundation of this order. Gold had accompanied the history of money since the first Lydian coins, but it had never been, until the nineteenth century, the sole foundation of the monetary system: for most of history silver had reigned, or both metals together in the bimetallism we have met. It was only in the course of the nineteenth century that gold became the monetary metal par excellence, supplanting silver, in a process tied to the rise of Great Britain, which had anchored the pound to gold and which, being the greatest commercial and financial power in the world, dragged the other countries onto the same road. The qualities that had made gold a money since antiquity — its scarcity, its inalterability, its beauty, the difficulty of extracting it that limited its quantity — made it the ideal anchor for a system that sought stability: precisely because gold cannot be created at will, to anchor money to gold meant to remove its quantity from the discretion of governments. And at the centre of the system stood London, the financial heart of the world, and the pound, which being the money of the dominant power served in effect as an international currency alongside gold: much of world commerce was settled in pounds, and the solidity of the pound, anchored to gold and guaranteed by the Bank of England, was the pivot around which the whole monetary order revolved [Davies 2002].

To that world one has often looked, afterwards, with nostalgia, as to an age of lost order and stability, and around the classical gold standard a kind of golden legend has formed: the idea of an almost perfect system, automatic, apolitical, that guaranteed the stability of prices and exchange rates without need of the discretionary intervention of governments, leaving it to the iron laws of gold to regulate everything. This image, like all legends, contains a kernel of truth — the gold standard truly worked, and gave the world decades of monetary stability — but it also conceals much, and precisely what it conceals is essential to understand why that system, apparently so solid, then collapsed so ruinously. This chapter tells the apogee and the ruin of the gold standard: its real functioning, behind the appearance of automatism; its hidden cost, behind the stability; the contradictions that brought it to collapse between the two world wars; and the attempts, failed and then partly successful, to reconstruct it, down to the compromise of Bretton Woods that was its last, ambiguous reincarnation. It is the story of how humanity tried to anchor money to a solid and immutable thing — precious metal — and of how it discovered, at a high price, that that anchoring had an unsustainable cost.

How it really worked

To understand the gold standard one must go beyond the image of automatism and look at the real mechanism, because it is there that its cost is hidden. The principle was simple: each country fixed the value of its money in a determined quantity of gold, and undertook to convert money into gold and gold into money at that fixed rate. From this it followed that the currencies of the different countries were tied to one another by fixed exchange rates, because all were anchored to the same metal. And from it also followed a mechanism of automatic adjustment of trade imbalances, which was considered the supreme merit of the system, but which was also, on closer inspection, its cruellest side.

Let us imagine a country that imports more than it exports, that buys from abroad more than it sells. To pay for those imports, it must let gold flow out, because gold is the ultimate international money with which accounts between nations are settled. The gold that leaves the country reduces its quantity of money in circulation, because money is anchored to gold: less gold in the vaults means less money in the economy. And here intervenes the quantity theory we have met: less money means lower prices. The country’s prices, falling, make its goods more competitive on foreign markets; exports increase, imports decrease, and gold begins to flow back, restoring equilibrium. The system, in theory, regulates itself: trade imbalances correct themselves through the flows of gold and the consequent movements of prices, without need of any intervention. This is the famous automatism of the gold standard, the clock that regulates itself.

But let us observe closely what that adjustment means, in concrete terms, for the country that loses gold. It means a reduction of the quantity of money, and therefore a fall in prices: deflation. And deflation, far from being a painless process of pure readjustment of prices, has very heavy social consequences. When prices fall, the revenues of enterprises fall too, which to survive must cut costs, and the principal cost is that of labour: they cut wages, they lay off. Deflation, in practice, means reduced wages, unemployment, bankruptcies, recession. The rebalancing of accounts with abroad that the gold standard guaranteed was paid for, by the country in deficit, with a dose of real economic suffering, inflicted on workers and enterprises in the form of unemployment and crisis.

There is, in deflation, a particularly insidious effect worth bringing to light, because it explains much of its capacity to destroy and will return in the chapter on debt crises. Debts are fixed in nominal terms: whoever must return a thousand, must return a thousand, whatever happens to prices. But when prices and incomes fall through deflation, those thousand to be returned become, in real terms, an ever more crushing burden: the debtor earns less, his revenues fall, but the debt remains nailed to the previous figure, and becomes therefore proportionally heavier. Deflation transfers wealth from debtors to creditors — the exact opposite of inflation, which we have seen do the contrary — and crushes those in debt under a load that grows in real terms precisely as their capacity to pay diminishes. In an economy laden with debt, deflation thus sets off a ruinous spiral: the debtors, crushed, fail or cut every expense to pay; the failures and the cuts further depress prices and incomes; the fall of prices further aggravates the real burden of the residual debts, and so on, in a downward spin that can drag the whole economy down. This mechanism, by which deflation and debt feed each other in a destructive spiral, is one of the most fearsome in economic history, and was one of the engines of the Great Depression of which we shall speak shortly.

The apparently apolitical automatism of the system concealed, then, a precise political and distributive choice: who had to pay the price of the adjustment? The answer, under the gold standard, was almost always the same: the workers paid it, through unemployment and the compression of wages. The stability of exchange rates, enjoyed by commerce and capital, was bought at the price of the instability of employment and incomes, offloaded onto the weakest [Eichengreen 2008].

The constraint that ties the hands

It is well to pause to state clearly the deep principle that the gold standard reveals, because it is one of the conceptual keys to understanding every monetary system, past and present. One can formulate it as a dilemma, indeed as a “trilemma”, an impossibility of having three things together. A country would like, ideally, to enjoy simultaneously three goods: fixed and stable exchange rates with the other currencies, which facilitate international commerce and investment; freedom of movement of capital, that is the possibility for money to enter and leave the country freely; and an autonomous monetary policy, that is the capacity to govern its own quantity of money and its own interest rates according to internal needs, for example to combat unemployment. The trilemma states that these three goods are not compatible all together: one can have at most two, never all three. One must always give up something.

It is well to make the trilemma concrete by observing the three possible solutions, because each corresponds to a monetary system that has really existed in history. The first solution is to give up autonomous monetary policy, keeping fixed exchange rates and free capital: it is the choice of the classical gold standard, where priority goes to the stability of exchange rates and one accepts to undergo the internal consequences of the flows of capital and gold. The second solution is to give up the fixity of exchange rates, keeping free capital and autonomous monetary policy: it is the choice of the world in which we live since the end of Bretton Woods, where currencies float freely against one another, their value varies continuously on the markets, but in exchange each central bank is free to govern its own money according to the internal economy. The third solution is to give up the freedom of movement of capital, keeping fixed exchange rates and autonomous monetary policy: it is the choice of those who impose capital controls, limiting the entry and exit of money so as to reconcile stable exchange rates and internal autonomy, and it was largely the logic of Bretton Woods. Every monetary system in history can be read as one of these three choices, a different renunciation in the face of the impossibility of having everything together. And every choice has its costs: whoever gives up autonomy undergoes crises without being able to cure them; whoever gives up fixity accepts the uncertainty of exchange rates; whoever gives up the freedom of capital sacrifices financial openness. The trilemma is one of those iron truths of economics that no cunning can circumvent: one can only choose which of the three goods to give up.

Under the gold standard, the choice was clear and conscious: one gave up autonomous monetary policy. Having fixed exchange rates (the anchoring to gold) and freedom of movement of capital, the country lost the capacity to govern its own money according to internal needs: it was forced to undergo deflation when it lost gold, even if this meant unemployment, because the absolute priority was to maintain the fixed exchange rate and convertibility. The quantity of money was not decided by the government on the basis of the necessities of the economy, but imposed by the flows of gold: the central bank had to raise rates and contract credit when gold left, even in full recession, to defend the gold reserve and the exchange rate. In other words, the gold standard tied the hands of the monetary authorities, preventing them from using money to mitigate internal crises. This was considered, by its supporters, the supreme merit of the system: precisely because it tied the hands, the gold standard guaranteed discipline, prevented abuses, ensured the stability of the value of money, removing it from the temptations of governments that we have seen in the previous chapter. But that same constraint, which in normal times guaranteed discipline, in times of crisis revealed itself a pitiless straitjacket, which obliged countries to inflict suffering on their citizens in the name of the defence of the exchange rate. The same rigidity that was the strength of the system would become, in the moment of the supreme test, its condemnation.

The spell broken

The great catastrophe that broke the spell of the gold standard was the First World War. When, in 1914, the great powers threw themselves into the conflict, governments found themselves facing colossal military expenses, immensely greater than anything they could finance with taxes or ordinary loans. And the gold standard, with its constraint tying money to gold, was incompatible with those expenses: to finance the war one had to print money in enormous quantities, well beyond what the gold reserve allowed. So, one after another, the belligerent countries suspended convertibility into gold, dissolved the golden constraint, and printed the money necessary to fight. The classical gold standard, the system that had upheld the world for decades, was abandoned within a few weeks in the face of the necessity of war. And with it ended the age of stability: the war was financed with inflation, prices rose, currencies depreciated, and the golden world of the pre-war dissolved forever.

When the war was over, the problem arose of what to do. And here emerges one of the most instructive knots of the whole affair, which requires to be understood without the presumption of hindsight. For the men of that time, the gold standard was not one system among many, but the system, the natural and civil order of money, identified with the stability, the prosperity and the good government of the pre-war. To return to gold appeared not a debatable choice, but an almost moral duty, the return to normality after the anomaly of the war, the re-establishment of the lost order. For this, in the twenties, countries strove to reconstruct the gold standard, to bring their currencies back to gold, often at the old pre-war rate. It was an understandable aspiration, and it would be unjust to judge it an obvious error: those who pursued it sincerely believed they were working at the restoration of a beneficial order, and could not know, as we know, where that road would lead.

And yet that return to gold concealed a mortal snare, and there were those who saw it with extraordinary lucidity. The most famous case is the British one. In 1925 Great Britain, under the guidance of the Chancellor of the Exchequer Winston Churchill, decided to bring the pound back to gold at the old pre-war rate, the same as before 1914. But in the meantime British prices had risen, during and after the war, more than that old rate allowed: to bring the pound back to the pre-war value meant, in effect, to overvalue the currency, to make it dearer than the real economy justified. And an overvalued currency makes a country’s goods too expensive abroad, depresses exports, forces a painful deflation to realign prices. It was exactly what happened: the return to gold at the old rate condemned the British economy of the twenties to a chronic deflation, to high unemployment, to bitter social conflicts, while the country tried to compress wages and prices to defend an exchange rate too high [Ferguson 2008].

The voice that predicted the disaster

To denounce the error with the greatest force and lucidity was the economist John Maynard Keynes, and it is worth reconstructing his argument, because he was by no means, as he is sometimes painted, a capricious enemy of gold or an advocate of easy inflation. Keynes saw something that escaped the custodians of the golden orthodoxy: that the constraint of gold, in the post-war world, had become incompatible with another fundamental requirement, that of social stability and employment. His critique of the British return to gold was harsh and prophetic: he showed that to defend the overvalued exchange rate would impose on the country years of deflation, of cut wages, of unemployment, and that this price was too high, precisely because it fell on the workers. In a world in which wages no longer let themselves be easily compressed — because the workers were organised, because the right to vote had been extended, because society no longer passively accepted unemployment as a fatality — the deflationary mechanism of the gold standard no longer worked without provoking lacerating conflicts and unacceptable suffering.

The heart of Keynes’s argument, which went well beyond the British case and which would revolutionise economic thought, was this: money must not be the servant of an abstract metallic constraint, but an instrument in the service of the real welfare of society, and first of all of employment. If to defend the golden exchange rate requires throwing millions of people into unemployment, then it is the golden exchange rate that must yield, not the people. Priority must be given to the real economy, to full employment, to social stability, and monetary policy must be free to pursue them, even at the cost of abandoning gold. It was a radical reversal of orthodoxy: for the custodians of the gold standard, the stability of the exchange rate was the supreme end to which everything else had to bend; for Keynes, it was the real economy that was the end, and money — gold included — only a means, to be managed according to that end. In this inversion of priorities — from money as master to money as instrument — lies one of the great turning points of twentieth-century economic thought, and the foundation of the monetary world in which we live, where no money is any longer anchored to gold and central banks manage the quantity of money according to the economy. Keynes saw all this decades in advance, and history would prove him right in the most dramatic way.

The chain of departures

The supreme test, the one that definitively destroyed the gold standard, was the Great Depression. When, beginning in 1929, the world economy plunged into the gravest crisis in the history of capitalism, the countries tied to gold found themselves prisoners of the golden constraint precisely at the moment when they would have had a desperate need to free themselves of it. The logic of the gold standard imposed, in the face of crisis and the flight of capital, raising interest rates and contracting credit to defend the gold reserve and the exchange rate: but to raise rates and contract credit in full depression meant to aggravate the crisis, to suffocate further an economy already on its knees, to increase unemployment and bankruptcies. The gold standard, which in normal times guaranteed discipline, in the Great Depression revealed itself a machine for amplifying and spreading the catastrophe: it forced every country to a deflationary policy at the moment when it needed the exact opposite, and transmitted the crisis from one country to another through the system of fixed exchange rates, preventing anyone from healing so long as it remained tied to gold.

It was then that one of the most revealing phenomena of all monetary history occurred, and one of the clearest proofs in favour of Keynes’s thesis. Countries began, one after another, to abandon the gold standard, to unhook their own money from gold, freeing themselves of the constraint that suffocated them. Great Britain, which had made of the return to gold a matter of honour, was forced to abandon it in 1931, in the face of the impossibility of defending the exchange rate any longer. Other countries followed, at different times. And one observed a clear and striking fact: the countries that abandoned gold earlier began to recover earlier. Freed from the deflationary constraint, they could finally loosen monetary policy, lower rates, restart credit and prices, and their economy began to rise again; while the countries that obstinately remained anchored to gold longer remained longer trapped in the depression. The correlation was so clear as to constitute almost a historical experiment: the abandonment of gold was the condition of recovery, and whoever left it earlier healed earlier. It was the demonstration, written in the suffering of millions of people, that the golden constraint had become no longer a safeguard of stability but an obstacle to healing, a straitjacket from which one had to free oneself in order to be able to cure the economy [Eichengreen 2008].

So, in the fire of the Great Depression, the classical gold standard died definitively. It was not a theoretical choice, but a surrender to necessity: countries abandoned gold because they could no longer afford to remain tied to it, because the social and political price of the constraint had become unsustainable. The golden legend of the pre-war shattered against the reality of the catastrophe, and with it the idea that money should be the servant of a metal. The world had learned, in the hardest way, the lesson of Keynes: that when the defence of gold conflicts with the welfare of society, it is gold that must yield.

The last reincarnation

And yet gold did not wholly disappear, and its history had a last, ambiguous reincarnation, which deserves to be told because it casts a bridge toward the contemporary monetary world. Toward the end of the Second World War, in 1944, while the conflict was drawing to a close, the representatives of the allied nations gathered in the American locality of Bretton Woods to design the monetary order of the post-war. They had before their eyes the twofold failure of the recent past: on one side the monetary chaos, the competitive devaluations and the instability of the thirties, following the collapse of the gold standard; on the other the deadly rigidity of the gold standard itself, which had amplified the depression. It is worth dwelling on the first of these evils, because it was one of the nightmares that most obsessed the designers of the new order. After the gold standard had crumbled, in the thirties countries began to devalue their currencies in competition, each trying to make its own goods cheaper abroad by lowering the value of the currency, to steal exports and employment from its neighbours. But when everyone devalues against everyone, no one draws a lasting advantage from it, and the result is only instability, mutual mistrust, contraction of world commerce: a monetary war of all against all, in which each tries to offload his own crisis onto the others, which in English was effectively called by an expression meaning “beggar thy neighbour”. That period fitted into a long history of recurrent monetary and financial crises, which the systematic study of past centuries shows recurring with disconcerting regularity whenever monetary discipline dissolves and trust shatters [Reinhart & Rogoff 2009]. It was precisely this chaos that the negotiators of Bretton Woods wished to avert: to reconstruct an order of stable exchange rates that would prevent the return to competitive devaluations, but without reproducing the deadly rigidity of the old gold standard.

The system that came out was an ingenious compromise, and it carried in its name the shadow of gold. The currencies of the world were no longer anchored directly to gold, but to the American dollar, at fixed exchange rates; and the dollar alone remained convertible into gold, at an established rate, but only for the central banks of the other countries, not for private persons. In substance, the dollar became the reference money of the world, guaranteed by the gold kept in the United States, and all the other currencies anchored themselves to the dollar. It was an indirect gold standard, mediated by the dollar: gold remained the ultimate foundation, but at one step’s distance, and the system left individual countries a margin of autonomy in internal monetary policy that the old gold standard did not grant. That margin was made possible also by controls on capital movements, the price paid to reconcile stable exchange rates with national economic policies. It was, in a certain sense, the attempt to have the stability of gold without its rigidity, to hold together two things that the trilemma declared compatible only by giving up full freedom of capital. Keynes himself was among the protagonists of that conference, a testimony to how central his ideas had by then become.

But for this very reason Bretton Woods carried within itself, from birth, a contradiction destined to explode. The system rested on the promise that the dollar was convertible into gold, and therefore on the trust that the United States would always have gold enough to honour that promise. But the world needed ever more dollars for its commerce and its reserves, and therefore the United States had to issue them in growing quantity, well beyond — in time — the quantity of gold it kept. There re-emerged, on a global scale and with the dollar in place of the old convertible banknotes, the same contradiction of the fractional reserve: the mass of dollars in circulation grew until it far exceeded the gold that should have guaranteed them, and sooner or later the promise of convertibility would become impossible to maintain. It was a time bomb set from the beginning in the heart of the system, and it would explode, as we shall see, in 1971, when an American president would sever the last link between the dollar and gold, putting an end not only to Bretton Woods, but to millennia of history in which money had been, in one way or another, anchored to precious metal.

What gold teaches

Let us draw together this long affair, because its lessons are fundamental to understanding the monetary world in which we live. The gold standard was humanity’s great attempt to give money a solid and immutable anchor, removing it from the arbitrariness of governments by tying it to a thing no one could create at will: gold. And that attempt had, for a time, a notable success: it guaranteed decades of stability of prices and exchange rates, facilitated international commerce and investment, prevented inflationary abuses. The discipline of gold was real, and real were its benefits. Whoever today regrets the gold standard, or yearns for a return to gold, grasps an authentic requirement: the desire for a stable money, removed from political manipulation, endowed with a certain value not erodible by inflation.

But the history of the gold standard shows also, with equal clarity, why that anchor proved unsustainable, and why the world ended by abandoning it. The golden constraint gave the stability of exchange rates at the price of the stability of employment: it tied the hands of the authorities, preventing them from curing internal crises, and in moments of depression it turned from safeguard into straitjacket, forcing countries to inflict on their citizens deflation, unemployment and suffering in the name of the defence of the metal. In a world in which society was no longer willing to accept that price — a world of organised workers, of democracies with extended suffrage, of states that took on the responsibility for the welfare of citizens — the rigidity of gold became politically and socially intolerable.

This conflict, it is worth saying, is by no means resolved, and it still divides today economists and observers into two camps that have faced each other for generations. On one side there are those who regret the discipline of gold, and distrust the discretionary power of central banks to create money: these see in the abandonment of gold the removal of the last brake on inflation and abuse, and consider that a money unhooked from every external constraint is destined, sooner or later, to be debased by governments without discipline. It is the sensibility that, in different forms, animates the nostalgics of gold, certain thinkers of the Austrian school, and today also a part of those who look with favour on digital currencies of limited quantity, of which we shall speak in the last chapter. On the other side there are those who, in the wake of Keynes, hold that to tie money to a metal is a harmful anachronism, which sacrifices real welfare — employment, growth, social stability — on the altar of an abstract rigidity: for these the flexibility won by abandoning gold is a conquest of civilisation, which allows crises to be cured instead of undergone, and the risks of inflation it entails are the price, acceptable and manageable, of this freedom. This dispute between discipline and flexibility, between constraint and autonomy, is one of the great open questions of monetary thought, and we do not claim here to close it: we limit ourselves to showing its historical roots, which sink precisely into the experience of the gold standard and its collapse, and to making it understood that both positions are born of authentic requirements — the need for stability on one side, the need for flexibility on the other — that the government of money must somehow reconcile, without ever being able to satisfy both fully.

The great lesson of the gold standard is therefore the discovery of a deep conflict, which runs through all modern monetary history: the conflict between discipline and flexibility, between the stability of the value of money and the capacity to use it for the welfare of society. Gold offered the first by giving up the second; the world, in the end, chose the second by giving up the first, and set out toward fiat money, unbound from every metal, managed by central banks according to the economy. It was a liberation, but also a gamble: because, the anchor of gold abandoned, the stability of money would no longer depend on an external and impersonal constraint, but only on the wisdom and the discipline of whoever governs money. Whether that wisdom was equal to the task, or whether humanity, freed from the straitjacket of gold, would abuse its new freedom by unleashing inflation, is the question to which the next chapters respond — the story of the fiat era, of inflation and of the struggle to tame it, which begins exactly where gold ends.