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November/December 1981

Perspectives O n: Gold
I n f l a t i o n h a s b e e n a c h r o n i c a f f l i c t i o n o f m o s t e c o n o m i e s o f t h e w o r l d s i n c e W o r l d W a r II
a n d h a s b e c o m e a c u t e s i n c e t h e m i d 1960s. R e p e a t e d d e c l a r a t i o n s b y g o v e r n m e n t s o f t h e i r
d e t e r m i n a t i o n to d e a l w ith t h e p r o b l e m b y a d o p t i n g c o n s e r v a t i v e m o n e t a r y a n d fiscal p o l i c i e s
h a v e b e e n b e l i e d b y c o n t i n u e d large b u d g e t d eficits a n d e x c e s s iv e ly r a p id a n d e rra tic m o n e y
g r o w t h . In t h e U n i t e d States, d i s i l lu s io n m e n t w ith d i s c r e t i o n a r y e c o n o m i c p o l i c i e s has l e d to a
v a riety o f s u g g e s t i o n s fo r p l a c in g c o n s tra in ts o n s u c h p o lic ie s . O n e o f t h e m o s t f r e q u e n t l y
h e a r d s u g g e s t i o n s is t o l im it m o n e y c r e a t i o n b y r e q u i r i n g th a t m o n e y b e c o n v e r t i b l e i n t o , o r
o t h e r w i s e l i n k e d t o , g o l d . T h e t w o a r t i c l e s in th is i s s u e o f

Economic Perspectives

discuss tw o

i s s u e s o f g r e a t i m p o r t a n c e in j u d g i n g r e c e n t p r o p o s a l s t o a d o p t a g o l d s t a n d a r d : t h e a l l e g e d
a u to m a ticity o f in te rn a tio n a l a d ju s tm e n t u n d e r a g o ld s ta n d a rd a n d th e d ifficu lty — a n d q u e s ­
tio n a b le w i s d o m — o f g e t t i n g 'g o v e r n m e n t s to s u b o r d in a t e d o m e s t i c e c o n o m i c o b je c t i v e s to
th e s u c c e s s fu l o p e ra tio n o f su c h a standard.

Gold in the international arena:
how automatic is international


T h e r e a re s e v e r a l v a rieties o f g o l d
sta n d a rd , e a c h w ith w id e ly d iffe rin g
im p lica tio n s fo r th e d e g r e e o f a u t o ­
m a ticity o f in te rn a tio n a l a d ju s tm e n t .

The demise of the gold standard
H i s t o r i c a l e x p e r i e n c e o f f e r s litt le
r e a s o n to b e l i e v e that g o v e r n m e n t s
w o u l d b e w illin g to m a k e t h e s a c rific e s
n e c e s s a r y to a b id e b y th e " r u le s o f
the g o ld sta n d a rd g a m e ."

November/December 1981, Volum e V, Issue 6
Economic Perspectives is published bimonthly by the Research Department of the Federal
Reserve Bank of Chicago. The publication is produced under the direction of Harvey
Rosenblum, Vice President, and is edited by Larry R. Mote, Vice President, with the assistance of
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Gold in the international arena: how
automatic is international adjustment?
W i l l i a m L. W i l b y

W h ile to the layman the idea of a modern
day “ gold standard" conjures up images of
gold coins and bullion hidden in the crypts of
Fort Knox “ b ackin g " the value of the A m e ri­
can cu rre n cy, to students of international
eco nom ics, the connotation of a gold stan­
dard is quite d ifferen t. To the latter, the gold
standard is m erely one of several alternative
systems of international m onetary adjust­
m ent— a system for settling, and ultim ately
co rrectin g , paym ents im balances in a co u n ­
try's international accounts. H ow ever, given
the key role of the dollar in international
trade (dollars are used in over 70 percent of all
in te rn a tio n a l tran sa ctio n s), it should be
obvious to anyone, w h eth er layman or inter­
national fin a n cie r, that any unilateral move
by the U nited States towards a gold standard
w ould have dram atic im plications for the
international m onetary system. This suggests
that any jud g m ent on the merits of such a
move must take into consideration its inter­
national im pact.
This article focuses on one small aspect of
the gold standard: the supposed autom aticity
of the international gold standard in restoring
eq u ilib riu m in a co u n try’s balance of pay­
ments. Although there are num erous other
issues p ertinent to the evaluation of the gold
standard as a system of international adjust­
m ent, many of these issues revolve around
the responses of national econom ies to dis­
tu rb a n ce s o rig in a tin g a b ro ad . These re ­
sponses depend upon the speeds of adjust­
ment of a plethora of eco nom ic variables—
questions that w ere considered beyond the
scope of this article. Rather, we w ill focus
here on the narrow q uestion: To what extent
does the international gold standard rem ove
the d iscretio nary ability of governm ents to

Federal Reserve Bank o f Chicago

control their national monetary supplies, there­
by forcing the adjustm ents necessary to re­
store eq u ilib riu m in the balance of payments?
To answ er this question, we w ill first
exam ine the intellectual roots of the ideal­
ized gold standard, the so-called price-specie
flow m echanism , with a view towards u nder­
standing both the origins of the concept of
international adjustm ent and the merits of
the gold standard w hen it is left to operate
freely. Second, we w ill exam ine the theoreti­
cal operation of the gold standard when we
move from the realm of com m odity money to
the existence of fractio n ally backed or credit
m oney. Fin ally, w e w ill look briefly at the
actual functioning of the gold standard d u r­
ing the period considered to be most repre­
s e n ta tiv e o f its o p e r a tio n in a p u re fo r m — th e

period 1879-1913.
It w ill be argued below that w hile the
pure international gold standard should, in
p rin cip le, function well as a system of interna­
tional adjustm ent, its operation in practice
leaves considerable room for governm ent
m anipulation. M oreover, the historical record
indicates that it was the threat of reserve flows
(which could exist under any system of fixed
exchange rates) and a specific governm ent
focus on the balance of payments that ensured
a general w o rld w id e coordination of m one­
tary policy rather than gold flows p e r se.
The price-specie flow mechanism
The earliest analyses of the role of gold
(and other precious metals as w ell) in the
system of international trade and payments
gave rise to the d octrine of m ercantilism , and
the system of protective trade regulations
that was inspired by it. Simply stated, the d oc­


trine of m ercantilism em phasized the im por­
tance of having an excess of exports over
imports in order to accum ulate “ treasure”
through a favorable balance of trade. N um er­
ous protectionist m easures (the British Corn
Laws w ere one such exam ple) were designed
to achieve this end by prom oting exports and
taxing imports at prohibitive levels.
This d octrine cam e to be criticized on
several g rou n d s (m u ch of Adam Sm ith's
W ealth o f Nations is an attack on m ercan til­
ism), but some of the strongest criticism s of
m ercantilism came from British w riters in the
late 17th and early 18th centuries who argued
that a policy of accum ulating treasure, or
“ sp ecie,” 1 was self-defeating because of the
econom ic repercussions triggered by the build­
up of specie itself. The clearest articulation of
these ideas is found in the w ritings of David
H um e, an 18th century Scottish philosopher.
Hume argued that the national stock of money
(or sp ecie, since the two w ere synonym ous in
Hume's time) would take care of itself, regard­
less of the degree of m ercantilistic interven­
tion designed to produce a favorable balance
of trade.
Hum e made his case by postulating that
four-fifths of all the m oney in Great Britain
had been destroyed overnig ht, and then p ro­
ceeding to show the consequences. Prices of
British com m odities and wages would fall
p ro p ortio nally to the d eclin e in m oney. Brit­
ish exports w ould thus becom e less expensive
relative to foreign goods, and the resultant
excess of exports over im ports would cause
Britain to exp erien ce an inflo w of specie (a
balance-of-paym ents surplus) until the in ­
com ing m oney paym ents restored the British
money supply to its “ natural le ve l.” 2

C o n versely, if the British m oney supply
w ere increased fivefo ld , prices and wages in
England w ould rise so high that no country
could purchase British com m odities, w hile
British subjects w ould desire to purchase only
the cheaper foreign goods. The outflow of
m oney to purchase foreign goods (a balanceof-paym ents deficit) w ould shrink the British
m oney supply until the “ level of m oney” in
Great Britain w ere equal to that in neighbor­
ing countries.
The forces that caused m oney to seek its
“ natural le ve l” w e re , according to H um e,
self-equilibrating and sym m etrical between
co untries, and w ould thus operate to m ain­
tain a fairly even balance of trade between
nations. This m echanism of adjustm ent is
know n as the price-specie flow mechanism
and is the classical prototype of what modern
econom ists mean when they speak of an
“ international adjustment m echanism .” M ore­
over, the m echanism also defines in a very
prim itive way the idealized operation of the
international gold standard.
As one can see from the preceding
exam ples, the effective functioning of the
price-specie flow m echanism requires ad­
herence to certain “ rules of the game” — rules
that also govern the operation of the ideal­
ized international gold standard. First, each
m onetary authority must take steps to fix the
value of its cu rren cy in terms of gold. Second,
there must be no restrictions on the flow of
gold between co untries. T h ird , each m one­
tary authority must ensure that the issuance
of notes or the creation of checking deposits
is in some fixed relationship to its gold
If gold is the only acceptable money

v ‘Specie” generally refers to money in coin. In
Hume's time specie consisted of other precious metals
besides gold. However, because of its physical attributes,
gold eventually evolved as the preferred store of value.

relationship, presumably flows of money and goods
would result until these natural levels were reestab­
lished. This proposition first appeared in print with the
works of Isaac Gervaise over 250 years ago. See Gervaise,
"The System or Theory of the Trade of the World, 1720,”
in Economic Tracts (Baltimore: The Johns Hopkins Press,
1956). The theory has much in common with the modern
monetary approach to the balance of payments. See
Jacob A. Frenkel and Harry G. Johnson, eds., The Mone­
tary Approach to the Balance of Payments (London:
Allen & Unwin, 1975).

The concept of the "natural level” of money is a
primitive concept of monetary equilibrium. Given the
worldwide quantity of specie and the worldwide quan­
tity of goods, there was presumably a "natural” price
level based on the relative amounts of both. If the rela­
tionship between the quantity of goods and the quantity
of money for one country were to deviate from the world


Econom ic Perspectives

w o rld -w id e, these rules are autom atically
en fo rced . To g ether, they ensure that deficits
and surpluses in a country's international
transactions translate into gold flow s, w hich
in turn are translated into m ovem ents in a
country's dom estic money supply. H ow ever,
the degree to w hich this mechanism is in fact
self-equilibrating and self-correcting, as Hume
argued, depends on the predictability and
precision of the relationship between the
“ level of m oney'' and p rices— an issue hotly
debated by econom ists. M o rever, as should
becom e clear in the follow ing section, when
notes or paper cu rren cy are allowed to exist
in addition to, and as a substitute for gold, the
operation of the price-specie flow m echa­
n is m b e c o m e s o p e n to g o v e r n m e n t
“ tin k e rin g ."
The theoretical operation of a gold
There is no such thing, even in theory, as
“ th e " gold standard. O ne may define three
d ifferen t levels of operation of a gold stan­
dard d epending on the degree to w hich the
creation of credit m oney is wedded to its gold
base: (1) a gold-specie standard, (2) a goldb ullion standard, and (3) a gold-exchange
standard. Each of these three types of stan­
dards has d iffering im plications for the opera­
tion of the international adjustm ent m echa­
nism ,and will be discussed in turn. To illustrate
the operation of each of these standards, it is
assumed that there are only two (fictitious)
co u n tries, Am erica and Europa, each with a
single bank w hich is also the m onetary au­
th o rity. All coin and cu rren cy are minted or
exchanged by, and all deposits are held w ith,
their respective central banks.
U nder a g o ld -sp ecie standard, gold is the
only form of m oney, and the nation's c u r­
rency is sim ply a unit of account for a sp eci­
fied w eight of gold. For exam ple, the country
of A m erica might define its cu rren cy, the d o l­
lar, as being o ne-half ounce of gold of a speci­
fied degree of purity. The Am erican mint is
always w illin g to coin one-half ounce of gold
of the specified purity into a one dollar coin.

Federal Reserve Bank o f Chicago

Thus, the price of one-half ounce of gold can
never fall below one dollar or rise above one
d o llar, since the two are synonym ous. M ore­
o ver, if a Europan mark is defined as onequarter o unce of gold of sim ilar purity, the
exchange rate betw een the mark and the dol­
lar is fixed at two m arks/dollar.
U nder this system, if Am erica sold Europa
100 bushels of wheat and received 200 gold
marks in paym ent, the Am erican exporters
could take the 200 marks (50 ounces of gold)
to the Am erican mint and receive 100 gold
dollars in return. The Am erican money supply
increases by 100 dollars, and H um e’s pricespecie flow m echanism begins to generate
forces raising Am erican prices and making
Am erican wheat m ore expensive to the Euro­
pans. Sim ultaneously, Europan exports be­
com e cheaper to citizens of Am erica, since
the Europan m oney supply declines by the
am ount of the gold outflow .
The im portant consideration under a
gold-specie standard is that gold and money
are synonym ous. To the extent that several
countries are on a gold-specie standard, the
exchange rates betw een their dom estic cu r­
rencies are autom atically fixed , and a selfequilibrating international monetary system
comes as part of the package— but only if one
accepts the existence of a fairly rigid link
between the quantity of money and prices.
U nder a g old -b u llion standard, a national
cu rren cy exists side by side with gold (which
may or may not be co in ed ), and the value of
the cu rren cy is specified in terms of a fixed
am ount of gold. An individual may always sell
gold at a price at least as high as that offered
by the m onetary autho rity, and a buyer may
always purchase gold at least as cheaply as the
governm ent’s p rice—w hich effectively fixes
the price of gold and the value of national
cu rren cy in terms of gold. If two countries are
on a gold-bullion standard, the exchange rate
between their currencies is fixed within the
bounds set by the costs associated with gold
shipm ent (see box).
The effects of gold flows and purchases
and sales of gold by the m onetary authority
w ill have vastly differen t effects on the supply


of money depending on the extent to w hich
the m onetary authority is required to m ain­
tain gold “ backing ” for the national currency.

If 100 percent gold “ backing” is req u ired —
that is, the m onetary authority must hold one
d o llar’s worth of gold in its coffers for each

Gold export and import points
A lthough the exchange rate betw een two
curren cies can be fixed by setting a fixed price
for each of them in term s of gold, it is in fact the
process of gold arbitrage* that actually m ain­
tains the exchange rate w ith in relatively fixed
lim its. Since gold arbitrage has certain costs
associated w ith it, inclu din g the cost of ship ­
ping, in su ra n ce , and interest foregone during
the period of transit, the cu rren cy exchange
rate can actually fluctuate betw een boundaries
established by these costs. These boundaries
are called the g o ld -e x p o rt p o in t and the goldim port point.
Let us d e rive the gold exp o rt and im port
points for the exam ple in the text. If the A m e ri­
can do llar equals o ne-h alf oun ce of gold (or
e q u iv ale n tly , if the p rice of gold is $2 per
o u n ce), and if the Europan m ark equals onequarter oun ce of gold, then the m int exch an g e
rate equals two m arks per do llar. If w e further
assum e that it costs .04 dollars (= .08 m arks) to
ship one ounce of gold from A m erica to Europa,
the gold exp o rt point from A m erica equals
$.51/m ark and the gold im port point equals
$.49/m ark. (R em em b er that one m ark equals
only o ne-quarter oun ce of gold so that the
transport cost for one m ark equals $.01 or .02
m arks.) The gold-export point from Europa
equals 2.04 m arks/do llar and the gold-im port
point equals 1.96 m arks/d o llar. Sim ply stated, at
the gold export point, the local cu rren cy is so
expensive in term s of foreign cu rren cy that it
pays traders to obtain foreign cu rren cy by
exchanging local cu rren cy for gold at the local
mint price and then gold for foreign cu rren cy at
the foreign m int p rice, rather than exchanging
local curren cy for foreign cu rren cy directly.
In terms of e co n o m ic analysis the foreign
exchange dem and and supply functions becom e
“ infinitely elastic” at the gold export and im port
points. That is, outside the boundaries of the
gold points, m arket adjustm ents consist totally

of quantity changes (i.e ., gold flow s) rather than
of both price and quantity changes. To u n d e r­
stand this po int, co nsid er the diagram below
w hich depicts the m arket for Europan marks.
Price of m arks, R

The quantity of m arks is on the horizo ntal axis,
and the price of m arks (in term s of d o llars) is on
the vertical axis. The m int exchange rate, Rm , is
the price of m arks established by the ratio of
mint gold prices (= $.50/m ark). If transport costs
w ere as given p revio usly and if the price of
m a rk s w e r e fo r so m e re a s o n to e q u a l
$.515/m ark, it w ould pay som eone w ho wanted
to exchange dollars for marks to purchase gold
at $2 per o u n ce, ship it to Europa at $.04 per
o u n ce , and then sell the gold to the Europan
m int for fo ur m arks. He thereb y w ould have
obtained an exchange rate of $2.04/4.00 = $.51,
the same as the gold-export point. The savings
of $.005/m ark w ould equal $1,000 on a $100,000
transaction. Thus, the m arket for direct exchange
of dollars for m arks w ould “ dry u p ” outside the
gold points. W ithin the gold points, how ever,
the exchange rate adjusts in such a w ay as to
establish e q u ilib riu m betw een the supply and
dem and for the cu rre n cie s (as at Re on the
diagram ). In fact, the m int rate (Rm ) essentially
becom es m eaningless, and the exchange rate
fluctuates freely betw een the gold points.

•Arbitrage is the process of simultaneously buying and selling in different markets to take
advantage of price differentials.


Econom ic Perspectives

paper dollar it issues— then it can issue new
paper dollars only by acquiring additional
gold, usually exchanging them one for one
with the p ub lic. In this type of system, paper
m oney takes the form simply of receipts for
the gold deposited by the public with the
central bank. H ow ever, outside the realm of
100 percent gold backing for a cu rren cy lies
the fourth dim ension of "c re d it" money.
Again using Am erica and Europa for illus­
tr a tiv e p u rp o s e s , a ssu m e in it ia lly th at
A m erica has gold dollars and paper dollars
existing side by side with 100 percent gold
backing of the paper currency. If an A m eri­
can citizen loses co nfid ence in the paper d ol­
lar, he can always exchange it for a gold dollar
and the actions of the m onetary authority in
doing so have no effect on the Am erican
m oney sup p ly; only the relative com position
of that m oney supply between gold and
paper dollars changes.
O n the other hand, if Am erican law
requires only that the m onetary authority
retain 50 percent gold backing behind each
paper d o llar, th en — assuming that paper d ol­
lars had been expanded to the legal lim it— an
exchange of paper for gold dollars with the
m onetary authority forces it to contract the
m oney supply. Suppose, for exam ple, that an
A m erican citizen takes 50 paper dollars to the
m onetary authority to exchange for 50 gold
dollars. Because gold holdings of the m one­
tary autho rity are reduced by 50, the out­
standing level of paper dollars must fall by an
additional 50 (for a total of 100, including the
50 paper dollars exchanged for gold) if the
m onetary autho rity is to m aintain the proper
ratio to its gold "b a se ." Sim ilarly, if the A m er­
ican citizen in the exam ple is an im porter who
exchanges the paper dollars for gold in order
to pay a Europan exp o rter, there is a net co n ­
traction of 100 in the A m erican m oney supply
and, if Europa also m aintains 50 percent gold
backing of the paper m ark, an increase of 100
dollars (= 200 m arks) in the Europan money
supply. This o ccurs even though the balanceof-paym ents transaction was only 50 dollars
(= 100 m arks). Stated d ifferen tly, the legal
gold backing ratio requires the Am erican

Federal Reserve Bank o f Chicago

m onetary authority to re in fo rce the m one­
tary contraction w rought by the gold outflow
and the Europan m onetary authority to re in ­
fo rce the m onetary expansion wrought by
the gold inflo w by retracting or issuing paper
m oney.3
Fractional backing to a nation's currency
in the form of gold or any other com m odity
puts an effective ceiling on the amount of
new m oney that can be created by the mere
issuance of lO U s. Thus, by "callin g in " loans
to the governm ent or selling governm ent
securities to the p u b lic, Am erica's monetary
authority can reduce its m oney supply by the
additional 50 dollars needed to maintain its
gold ratio. Sim ilarly, by purchasing securities
from the governm ent or the p u b lic, the cen ­
tral bank of Europa can expand its money
supply to m aintain a 50 percent level of gold
backing. These types of transactions are called
open market operations.
To sum m arize, under a gold-bullion stan­
dard, the price of gold, the gold value of the
cu rre n cy, and the exchange rate (if the other
country is on either a gold-specie or goldbullion standard) are fixed. H ow ever, the
operation of the H um ean price-specie flow
m echanism may be slightly different if only
fractional gold backing of the national cu r­
rency is req u ired . Specifically, a fractional
gold-bullion standard w ill result in a m ulti­
plied response of the national money supply to
trade surpluses or deficits or to conversions of
the dom estic fiat cu rren cy into gold if the
national m onetary authority attempts to main­
tain a fixed fractional ratio of gold to its other
m onetary liabilities. The successful operation
of the p rice-specie flow m echanism under a
fractional gold-bullion standard thus requires
that governm ent decisions determ ine two
specific rules and, in tu rn , that governm ents
adhere to the rules they have established.
These rules co ver: the m inim um level of frac­
The normal procedure is for the government to
auction securities to the public (borrow money) to make
up any gap between its expenditures and receipts. When
the monetary authority increases the money supply it
does so by purchasing these securities from their holders
(many of whom are banks) through government security
dealers and paying for them by a check written on itself.


tional gold backing of the cu rren cy and
w hether or not the central bank should allow
gold flows to have a m u ltip lie d effect on
national m oney supplies by engaging in rein ­
forcing open m arket operations to keep the
ratio fixed . (As a polar case of the latter, the
governm ent m ight pursue a policy of “ ste rili­
zatio n ," offsetting the gold flows com pletely.)
Although sim ilar in concept to both the
gold-specie and gold-bullion standards, the
g old -excha n g e standard allows even more
scope for discretionary governm ent decisions
to interfere with the “ autom atic" nature of
the price-specie flow m echanism . U nder this
system, gold coins are not put into circu la ­
tion, nor does the m onetary authority buy or
sell its cu rren cy in exchange for gold. Rather,
it buys and sells its own cu rren cy in exchange
for the cu rren cy of another country that is
itself on a gold-specie or gold-bullion stan­
dard. Continuing with our exam ple, if the d o l­
lar is fixed in p rice in term s of gold such that
Am erica is on a gold-bullion standard, and if
the m onetary authority of Europa always
stands ready to exchange one dollar for two
marks or one m ark for one-half d o llar, then
the mark is effectively valued in terms of gold
even though it cannot be exchanged directly
for gold. In this case, if the dollar is worth
one-half ounce of gold, the mark is necessar­
ily worth one-quarter ounce of gold.
This is sim ilar to the system w hich was in
effect from 1944 to 1971 under the terms of
the Bretton W oods agreem ent. The U.S. d o l­
lar was fixed in term s of gold and was the only
cu rren cy directly exchangeable for gold. The
exchange rates of most other currencies were
fixed in term s of dollars by the w illingness of
their national m onetary authorities to buy or
sell dollars at the fixed exchange rate.
H ow ever, the gold exchange standard
has even m ore “ slippages" than the bullion
standard to prevent its operation as e n vi­
sioned by H um e. C o n sid er what happens if
Am erica is on a fractional gold-bullion stan d ard ,Eu ro p a ison a gold-exchange standard,
and Am erica exp erien ces a 50 dollar deficit
(as in the previous exam ple). Because its cu r­
rency is an international reserve, Am erica


uses dollars to pay for its excess im ports. The
Europan exporters who receive paym ent are
likely to exchange the 50 dollars with Europa's
m o netary a u th o rity fo r 100 m arks (again
assuming an exchange rate fixed at two marks
per dollar), increasing Europa’s m oney supply
by that am ount. U nder these circum stances,
the degree of m onetary adjustm ent in both
countries again depends entirely on the poli­
cies and actions of their central banks.
If Europa considers the dollar an official
reserve that is as “ good as g o ld " and if it also
maintains a ratio of 50 percent between o ffi­
cial reserves and its national m oney supply, it
must rein force the m oney supply expansion
by an additional 100 marks (for a total of 200,
as in the previous case) to maintain that fixed
ratio. O f co urse, if the Europan m onetary
authority so chooses, it can accum ulate the
dollar reserves w ithout any further actions,
thereby lim iting the increase in its dom estic
m oney supply to the 100 marks it previously
exchanged for dollars. Still another option
open to the Europan m onetary authority is to
“ ste rilize " the 100 m ark increase by selling
100 marks worth of governm ent securities,
thus negating the entire m onetary effect of its
earlier foreign exchange transaction.
The portfolio decisions of the Europan
monetary authority also determ ine the effect
of these international transactions on A m e ri­
ca's m oney supply. If the Europan m onetary
authority decides to hold the dollar balances
it receives from the exporter in the form of
demand deposits with the Am erican central
bank, the Am erican m oney supply remains
the same or falls by 50 dollars depending on
w hether it is defined to include other central
bank balances. O n the other hand, if Europa
uses the 50 dollars to purchase governm ent
securities from the Am erican central bank,
the A m erican m oney supply falls by that
am ount.4 If Europa exchanges the dollars for
4On the other hand, if Europa purchased the securi­
ties from the American public, the money supply would
remain unchanged. In the U.S. today the Federal Reserve
purchases securities from the public for its central bank
customers so that there is no net effect on the U.S. money

Econom ic Perspectives

gold instead of secu rities, the gold drain
causes a m ultiplied contraction in the A m eri­
can m oney su p p ly— but only if Am erica is
w illin g to rein fo rce the gold drain by co n ­
tracting its m oney supply sufficiently to m ain­
tain a fixed gold ratio. O th erw ise, Am erica
can renounce (or relax) the gold standard and
o ffset the gold d rain by open m arket
To su m m arize, even under an interna­
tional banking system consisting only of ce n ­
tral banks and no com m ercial banking sys­
tem , with all deposit m oney held in the form
of deposits or other liabilities of these central
banks, a gold exchange standard allows co n ­
siderable discretion to governm ents and ce n ­
tral banks. Not only is there leeway in govern­
mental decision-making for the "cen ter” coun­
try w hose cu rre n cy is used as an international
reserve (the same leeway as under the goldbullion standard), but there are additional
choices open to every "sa te llite ” country.
These choices are: first, w hether or not to
treat holdings of the center co un try’s cu r­
rency as reserves on an equal footing with
gold; second, how to divide the com position
of its portfolio between gold and the cu r­
rency of the center co u n try; and th ird ,
w h eth er to hold the cu rren cy of the center
country in interest-bearing or noninterest­
bearing fo rm , or both, and in what p ro­
Although it should be easy enough to
legislate rules with respect to these matters
that w ould enable a fractio n ally based gold
standard to operate in a m anner sim ilar to
H u m e’s price-specie flow m echanism , the
actions req uired of the m onetary authority in
adhering to these rules often impose a heavy
price in term s of adjustm ent on the real
eco nom ies invo lved . If changes in the money
supply affected only prices, the problem
w ould not be so com plicated. But, in the
short run , changes in the money supply affect
a w hole host of variables such as em ploym ent
and interest rates in addition to just the price
level. It is changes in these real variables that
governm ents generally resist most fo rcefu lly,
p articularly if the prevailing world trend in

Federal Reserve Bank o f Chicago

these variables runs counter to the policy
goals of the governm ent. W hen the monetary
system is com plicated to include a com m er­
cial banking system, the pressures on a govern­
ment to offset the effects of changes in gold
on the reserves of the banking system become
particularly acute.
Theory versus practice
In actual p ractice, the operation of the
international adjustm ent mechanism under a
gold standard is even less straightforward
than th ep recedin gsim p lified examples would
suggest. The structures of most financial sys­
tems leave considerably more room for slip­
page in the linkages of a gold-centered pay­
ments system.
First, contrary to the assumptions of the
exam ples, most deposits of the non-bank
public are not held with central banks, but
instead are held with private banks, which in
turn hold their deposits with th ecen tral bank.
Thus, the gold base becom es two steps re­
moved from deposit-m oney liabilities, and
the m ultiplied effect on national money sup­
plies of a change in gold depends on the size
and fixity of the ratios maintained between
gold and central bank liabilities and between
the latter and m oney. For exam p le, if the U.S.
governm ent required the Federal Reserve to
hold gold equal to 10 percent of its reservedeposit liabilities and, in turn , required com ­
m ercial banks to maintain reserves at the Fed
equal to 10 percent of their own deposit liabil­
ities, a 10 m illion dollar gold outflow would
force the Fed to engage in reinforcing open
market sales culm inating in a 100 m illion dol­
lar change in Federal Reserve deposits. This
would force the banking system to contract
deposits by 1 b illion dollars—a m ultiplier of
one hundred!
The pressures on the Fed to resist such
drastic changes in the nation’s money supply
in response to international disequilibria
would be great indeed. To the extent that
banks hold reserves in excess of those required
by the Fed, the m ultiplier is somewhat smaller,
but an additional elem ent of discretion on


the part of the com m ercial banking system is
added to the supposed “ autom aticity” of the
price-specie flow m echanism .5
Sim ilarly, the existence of near-m oney
deposits in m oney market funds and in U.S.
nonbank financial interm ediaries makes the
relationship betw een changes in the U.S.
monetary base and the various monetary
aggregates even m ore un p red ictab le. D e­
posit interest rate ceilings in com bination
with volatile m arket interest rates induce
shifts from one type of deposit m oney to
another, such that the precise effect on any
single measure of m oney is often d ifficult to
Finally, the possibility of short-term capi­
tal movem ents in response to expectations
and interest rate differentials can seriously
com plicate the idealized working of the pricespecie flow m echanism .7
But what about the em pirical evidence?
Did the gold standard during its historical
heyday actually operate as envisioned by
Hume? O r did governm ents intervene and
“ tin k e r" with its actual operation? To answer
these questions, let us briefly exam ine the
5ln actual fact most banking systems have some form
of “ lagged” reserve accounting which reduces the useful­
ness of the concept of a multiplier. What we would likely
see, in the absence of a change in this type of reserve
accounting, would be drastic movements of the federal
funds rate in response to gold flows. Alternatively, were
the Federal Reserve to use interest rates as an operating
target of monetary policy (as it did prior to October,
1979), the rules of the gold standard would force the Fed
to "sterilize” , or offset, the reserve effects of gold flows
by increasing or decreasing reserves to maintain the
target interest rate. Thus, the question of a return to a
gold standard cannot be considered without also consid­
ering the whole range of technical instruments of mone­
tary control.
‘ Different types of deposit liabilities have different
levels of reserve requirements and different interest rate
ceilings. As interest rates change these various ceilings
may become binding constraints on the returns to hold­
ing particular types of deposits. As people shift funds
from one type of deposit to another to avoid the effect of
these ceilings, the average ratio of reserves to deposits
also changes, and with it the effects of a given change in
reserves on the various monetary aggregates.
7Even under the gold bullion standard (see box),
there is room for exchange rate movements between the
gold points and short-term capital flows to take advan­
tage of interest differentials between countries.


operation of the price-specie flow m echa­
nism under the international gold-bullion
standard just before and after the turn of the
The historical record
The halcyon days of the gold standard
w ere between 1879 and 1914. This period was
unusual in that it was characterized by rapid
real econom ic growth, a relative absence of
restrictions on trade and movem ents of capi­
tal and labor, and, in general, an absence of
wars or revolutions. In terms of the conduct
of m onetary policy, how ever, there are other
characteristics of this period that stand ou t.8
First and most im portantly, the central
banks of most trading nations did not gener­
ally engineer m ultiplied expansions or co n ­
tractions of their m oney supplies in response
to balance-of-paym ents flows. Instead, they
allowed considerable flexib ility in the gold
“ co ve r" ratios behind the issuance of their
national currencies. A study by A rthur I.
Bloom field in 1959 com pared year-to-year
changes in central bank holdings of securities
with changes in central bank holdings of gold
over the 1880-1913 period. He found that
movements in these two classes of assets were
in the opposite direction 60 percent of the
tim e, rather than in the same direction as
would be predicted if m onetary authorities
w ere indeed engaging in reinforcing open
m arket operations to maintain their money
supplies in some fixed relationship to gold.9
Bloom field's study also found that some ce n ­
tral banks deliberately introduced flexib ility
in the gold ratio by varying reserve re q u ire ­
ments during the period, either by changing
the reserve ratios or by changing the d e fin i­
tions of what constituted reserves.1
A second observation on the conduct of
See Robert M. Stern, The Balance of Payments (New
York: Aldine, 1973), p. 112.
9Arthur I. Bloomfield, Monetary Policy Under the
International Cold Standard, Federal Reserve Bank of
New York, 1959, pp. 47-51.
10lbid. p. 18.

Econom ic Perspectives

m onetary policies during this period co n ­
cerns the key role of the discount rate as an
instrum ent of m onetary policy. Discount rate
m ovem ents to induce or reverse short-term
capital flow s w ere the prim ary tool used by
central banks to m aintain stability in their
exchange rates and equilibrium in their pay­
ments balances; open market operations were
rarely e m p lo yed .1 In many cases discount
rate changes w ere used to counteract the
threat of gold losses or short-term capital
flig ht, and in alm ost all cases they w orked in a
direction opposite that of central bank gold
reserve changes, as would be expected.
Finally, Bloom field's study notes that price
and discount rate m ovem ents in the co u n ­
tries he studied w ere generally p arallel, ind i­
cating fairly synchronous movements in ind i­
vidual business cycles, and in the application
of m onetary p olicy. The study further ind i­
cates that the sim ilarity of m ovem ents in
national discount rates reflected not only the
broadly synchronous pattern of cyclical busi­
ness activity but, in the case of many of the
central banks, com petitive or defensive dis­
co unt rate changes. In other w ords, when
one bank increased its discount rate, there
was a ten d en cy for others to follow suit to
guard against the possibility of outflows of
short-term capital or gold. Thus, there was
evid en ce of co ord inatio n in the im plem enta­
tion of m onetary p o licy, albeit not always as
the result of voluntary cooperation.
W hat co nclusio ns can be drawn from the
findings of Bloom field's study? Bloom field
him self co nclud es that the operation of the
p re -1 9 1 4 g o ld s ta n d a rd w as less th an
autom atic:
Far from responding invariably in a m echan­
ical w ay, and in accord with some sim ple or
unique ru le, to m ovem ents of gold and
other external reserves, central banks were
constantly called upon to exercise, and did
exercise, discretion and judgem ent in a

"Bloomfield cities only two documented instances
of open market operations during the entire period. Ibid,
pp. 45-46.

Federal Reserve Bank o f Chicago

w ide variety of ways. C lea rly, the pre-1914
gold standard was a managed and not a
quasi-autom atic one from the view point of
the leading individual countries. Nor did
that system always w o rk as "sm o o th ly" as is
believed. Critical situations arose from time
to tim e in various countries necessitating
"e m e rg e n cy" measures by central banks
and governm ents to safeguard the co ntin­
uing co nvertib ility of the currency. In all
respects, th en , the differences between
central bank policies under the pre-1914
gold standard and after W orld W ar I were
essentially differences of degree rather
than of kin d .1
Bloom field fu rth er concludes that the osten­
sible "h a rm o n y " of m onetary policy during
the pre-1914 perio d, as manifested by the
synchronous discount rate movem ents, was
brought about not so m uch by the operation
of the gold standard as by a lack of conflict
between dom estic policy goals and balanceof-payments eq u ilib riu m .
W ith a bit m ore hindsight, these co n clu ­
sions may be extended considerably. A l­
though price stability, generally thought of in
terms of "d efen d ing the cu rre n cy ", was cer­
tainly a co ncern of central b an kersd u rin g th e
pre-1914 perio d, the ability of m onetary pol­
icy to influ en ce real variables such as the rate
of output or em ploym ent was not generally
appreciated. M o reo ver, the com bined use of
m onetary and fiscal policy to pursue such
dom estic objectives as full em ploym ent and
price stability was also largely u n kno w n. John
M aynard Keynes' w ell-know n treatise, T h e
G e n e r a l T h e o r y o f E m p lo y m e n t, Interest, a n d
M o n e y , w hich won w ide acceptance for such
policies, was not published until 1936. Also,
reliable inform ation on price-level m ove­
ments was not im m ediately available for use
as a m onetary indicator. O n the other hand,
data on reserve flow s w e r e an im m ediate,
tangible indicator of the state of econom ic
activity and, as a co nseq u en ce, helped to
reinforce the single-m inded focus on the bal­

12lbid. p. 60.


ance of paym ents as the target of m onetary
This preoccupation with external balance
exacted a high price in term s of the perfor­
mance of the dom estic econom ies. National
prices and output fluctuated considerably
more during the gold standard period than
they have in recent years, although the gold
standard period was free of the pronounced
inflationary bias that has characterized many
non-gold standard periods. In the United
States, for exam p le, the co efficient of varia­
tion (that is, the ratio of the standard devia­
tion to the mean) of annual percentage
changes in the price level was 17.0 for the
gold standard period and 1.3 for the period
1946-1979. Likew ise, the co efficient of varia­
tion of changes in real per capita incom e was
3.5 under the gold standard and 1.6 in the
post-war p erio d .1 Sim ilar results hold for the
United Kingdom . Although this variation re­
flected dow nw ard as w ell as upward price
m ovem ents, so that prices w ere stable over
the long run , it rem ains highly doubtful
w hether countries today would be w illing to
allow such drastic fluctuations in econom ic
As for the w idespread reliance on the
discount rate as the prim ary tool of monetary
policy during the era of the gold standard, it
must be rem em bered that the use of open
market operations as a day-to-day instrum ent
of m onetary control was u n kn o w n. M o re­
over, governm ent security markets in most
countries were not sufficiently well-developed
and integrated to enable open m arket op era­
tions to have the speedy, p recise, and w id e ­
spread im pact that they have in the United
States today.
It thus seems reasonable to conclude that
the harm ony in the im plem entation of m one­
tary policy during the years of the gold stan­
dard was d ue, at least in part, to the prim itive

13Michael David Bordo, "The Classical Gold Stan­
dard: Some Lessons for Today,” Review, Federal Reserve
Bank of St. Louis, vol. 63 (May 1981), p. 14.


state of the art. The absence of any effective
alternative to the discount m echanism as the
prim ary instrum ent of m onetary policy and
the single-m inded focus on b alance-ofpayments eq u ilib riu m as the target of that
policy go a long way towards explaining the
em pirical evidence on the behavior of central
banks under the pre-1914 gold standard.
The so -called au to m atic adju stm ent
m echanism often attributed to the intern a­
tional gold standard leaves considerable room
for slippage and, under a fractio nally backed
gold-bullion standard, even re q u ire s the
assistance of governm ental policy to re in ­
force its effects. In practice, the successful
operation of the international gold standard
was due not so much to the autom atic eq u ili­
brating effects of gold flows as to a (histori­
cally unique) general harm ony in the practice
of m onetary policy and the policy priority
given to balance-of-payments considerations.
Although the priority given to balance-ofpayments considerations was certainly a result
of the threat of gold reserve losses, it was also
due in no small part to the fact that dom estic
stabilization policies w ere largely unknow n.
From the perspective of the current inter­
national m onetary system, the one lesson to
be drawn from exp erien ce under the classical
gold standard seems to be that the threat of
reserve losses can provide pressure to har­
m onize m onetary policies if governm ents are
w illin g to abide by the rules necessary to the
operation of such a standard. Recent e x­
perience also seems to indicate that the threat
of exchange rate depreciation can provide
similar pressure. But the w illingness of nations
to abide by the international gold standard
presupposes a w illingness to place balanceof-payments and foreign exchange consider­
ations above dom estic policy goals. W hether
it is realistic to expect such a drastic reo rd er­
ing of priorities on the part of the w o rld ’s
sovereign governm ents is doubtful at best.

Econom ic Perspectives

The demise of the gold standard
John H. W o od
It is iro n ic that most of the recent agita­
tion for a return to some form of gold stan­
dard has com e from the United States, whose
o fficial p olicies played a leading role in the
destruction of that standard. After describing
the co nd u ct of governm ents necessary for
the successful operation of a gold standard,
this article tells the story of the failure of the
post-W orld W ar I attempt by the British to
restore the pre-1914 m onetary system— an
attem pt doom ed to failure by the refusal of
the U nited States and France to play by the
rules of the gold standard game.
Governments and the gold standard
W e begin with a system in w hich the
m edium of exchang e— i.e ., m oney— consists
only of som e useful com m odity and paper
claim s on specified am ounts of that com m od­
ity. M any com m odities have served the dual
function of m oney and the m onetary base
and the theory portions of our story are app li­
cable to any of them . H o w ever, gold w ill be
the only com m odity considered because of
its almost universal acceptance as m oney, to
the exclusion of other com m odities, by west­
ern societies in the 19th and 20th centuries.
G o vernm ents are not necessary to the
gold standard. If there are free markets in
gold and w heat, their relative prices— i.e ., the
rate of exchange of gold for w heat—w ill
depend upon private supplies and dem ands
for the two com m odities. Suppose one ounce
of gold (of a particular degree of fineness) is
w orth seven bushels of w heat in the m arket
place. Also suppose that business is trans­
acted partly w ith gold coins that weigh 1/35 of
an o unce and are called “ dollars.” The dollar
is the unit of account and other coins and
goods are valued in terms of the dollar. For
exam p le, one bushel of w heat, w hich is worth
1/7 of an ounce of gold, is quoted at a price of
$5. Gold coins w eighing 10/35 of an ounce

Federal Reserve Bank o f Chicago

carry the stamp “ Ten D o llars” on one side
and the likeness of A lexander Hamilton on
the other side.
H o w ever, people find it convenient to
transact most of their business not with gold
coins but with pieces of paper— bank notes
and ch ecks—that are convertible into gold.
W hen you deposit 100 ounces of gold in a
bank, the bank either credits your checking
account w ith $3500 or presents you with bank
notes of various denom inations totaling $3500.
Banks hold reserves of gold in order to carry
out their p rom ise, under threat of bank­
ruptcy, to convert their paper liabilities into
gold upon d em an d . G iven the public's
m oney-holding p references for gold relative
to bank liabilities and the proportions of gold
held by banks as reserves against those liab ili­
ties, the quantity of m oney (i.e ., bank liabili­
ties plus gold coins held by the nonbank pub­
lic) in an econom y is determ ined by the
m onetary gold stock. The m onetary gold
stock is in turn determ ined by the domestic
production of gold, the acquisition or loss of
gold through international transactions, and
fluctuations in the dem and for gold for non­
monetary uses.
All of these factors w ere from time to
time sources of fluctuation in the money
supply under the gold standard. But an upper
lim it was placed on the rate of increase of the
m oney supply by the rate at w hich an econo­
my's m onetary gold stock could be aug­
mented and by the m inim um reserve ratio
w hich banks could hold without provoking
fears for their failu re on the part of creditors.
Th ere is no such upper lim it under our pres­
ent “ paper standard” in w hich the greater
part of the m onetary base is not the monetary
gold stock but central bank liabilities that are
limited by neither legal nor prudential consid­
G o vern m en t may play a part in the o p er­
ation of the “ p u re ” gold standard described


above, for exam ple, by verifying the weights
of coins and by im posing reserve req u ire­
ments on banks. These activities may (or may
not) contribute to the smooth operation of
the system, but they play no essential part.
The only essential pattern of behavior that the
system requires of governm ent is that it allow
itself to be lim ited by the same constraints to
w hich private actors are subject. Specifically,
when the governm ent issues paper currency
of its o w n, that cu rre n cy, like bank liabilities,
must be co nvertib le into gold. This limits its
paper issues in the same way that prudential
reserve considerations lim it the deposits of
Although governm ents n e e d not play an
active part in the operation of the gold stand­
ard, they have in fact done so. The rem ainder
of this paper is largely a story of the support­
ive and destructive interventions of govern­
ments in the fu n ctio n in g of the gold standard
preceding and im m ediately follow ing W orld
War I.
Automatic adjustment under the gold
The theory (and, to a large extent, the
practice) of the gold standard provided for an
autom atic m echanism that corrected balance-of-paym ents disequilibria and prevent­
ed unlim ited inflations or deflations. First,
consider a dom estic m onetary disturbance in
the form of an expansion of bank credit and
the m oney supply. Suppose banks respond to
increases in credit dem ands and interest rates
by reducing their reserve ratios. The conse­
quences are inflation and a balance-of-payments deficit as dom estic goods rise in price
relative to foreign goods. Am ericans are buy­
ing m ore from foreigners than they areselling
to foreigners. If the international means of
payment is gold, as it was in the 19th century,
instead of dollars, as has been the case since
about 1940, the dollar claim s accum ulated by
foreigners w ill be converted into gold. The
loss of reserves by Am erican banks, even
given their new and low er desired reserve
ratios, forces a contraction of m oney and


credit. A m erican prices stop rising and p er­
haps even d e clin e , and the balance-of-payments deficit is corrected as the Am erican
inflation is exp orted—for foreign banks e x­
pand their lending as they acquire gold from
the United States.
In addition to the external drain of gold
discussed above, there w ill also probably be
an internal drain as m ore m oney of all kinds,
including gold co in , is needed to carry out
tra n sa ctio n s at th e h ig h e r p ric e s . R. G .
Hawtrey argued that the internal drain was
norm ally a larger and sw ifter force than the
external drain in 19th-century gold standard
adjustm ent.1
Now consider a second, non-m onetary
disturbance: a balance-of-paym ents deficit
due to a bad harvest. The m echanism of
adjustm ent is identical to that in the first case:
a loss of bank reserves, m onetary contraction,
deflation, and restoration of the balance of
payments. Harvest fluctuations w ere proba­
bly the most im portant source of monetary
and price instability in the United States
between its return to the gold standard in
1879 and the form ation of the Federal Reserve
System in 1913.1
As a third and final exam ple, consider the
effects of a “ Keyn esian ” depression in W est­
ern Europe, characterized by a drastic fall in
incom e but w ithout a significant fall in prices,
on m oney and prices in the United States.
U nem ployed Europeans reduce their pur­
chases of Am erican goods, causing an out­
flow of gold from the United States and resul­
tant declines in m oney and credit.
In sum m ary, autom atic adjustment under
the gold standard is neither more nor less
than the international transm ission of eco­
nom ic disturbances. U nder the gold stan­
dard, inflations, deflations, high incom es, and
unem ploym ent are exported to and imported
from other co untries. O u r own inflations and

1R. G. Hawtrey, A Century of Bank Rate (London:
Longman, Green, and Co., 1938), ch.3.
2Milton Friedman and Anna J. Schwartz, A Monetary
History of the United States, 1867-1960 (Princeton:
Princeton University Press, 1963), ch. 3.

Econom ic Perspectives

deflations are lim ited in extent by the gold
standard— at the price of accepting the infla­
tions and deflations of others. Discretionary
m onetary policy is severely lim ited. Am erican
m oney and prices are controlled to an im por­
tant extent by fo reigners; and foreign money
and prices are subject to fluctuations in the
United States.
The operation of this autom atic adjust­
ment m echanism requires at least passive
acceptance by governm ents, including non­
in te rfe re n ce with the free flow of gold and
other goods. Dom estic inflations may be pro­
longed by restrictions on the export of gold,
subsidies for exports, and tariffs and quotas
on im ports. Free trade is necessary to the full
realization of the co rrective effects of the
gold standard m entioned at the beginning of
this section.

But governm ents can do more than re­
frain from in te rferen ce with the gold stan­
dard. The adjustm ents described above are
probably indeed "au to m atic'’ in the sense of
being inevitab le, under the conditions as­
sum ed, given enough tim e to w o rk. H ow ­
eve r, those adjustm ents may be too slow for
those co ncern ed with the solvency of banks
and the preservation of a country's gold
reserves. W hen this is the case, governm ents
can play an active role in speeding up the
adjustm ent process, som etim es called the
"ru le s of the gold standard g a m e."3The play­
ers designated by governm ents to play this
game are central banks. In order to under­
stand how the game should be played, it is
necessary to exam ine the conduct of the Bank
of England, w hich was the only major central
bank w illing to play by the rules.
The Bank of England (Bank) was until
1945 a private firm . But from its inception in
1694 the Bank had im portant, w ell-defined
p ub lic responsibilities. No harm is done by

th in kin g of the Bank as an o fficia l, or at least a
q u asi-o fficial, agency. It enjoyed special
m onopoly privileges regarding note issue in
London, operated under a series of short­
term charters renew able by parliam ent, and
served as the Treasury's main depository and
an im portant source of credit to the govern­
ment. H ow ever, the Bank was not at first a
"cen tral b an k" in the sense in w hich that term
cam e to be used in the 19th and 20th cen tu r­
ies; i.e ., it was not conceived as a regulator of
the m onetary base or a lender of last resort to
the financial system. N evertheless, by a com ­
bination of its m onopoly privileges, its special
roles as governm ent depository and creditor,
and, most im portant, its conservative lending
b eh avio r, the Bank had by the end of the 18th
century acquired the substance of the central
banking powers and responsibilities later con­
ferred by law on the Bank, the Federal Reserve
System, and other official central banks.
Because of the Bank's well-deserved rep­
utation for soundness, its note and deposit
liabilities w ere considered "as good as gold."
As a co nsequ en ce, the reserves of other
banks w ere held predom inantly in the form
of the note and deposit liabilities of the Bank
of England. Claim s on banks by the nonbank
public and by other banks were routinely
settled by the exchange of claim s on the Bank
of England because people w ere satisfied that
the latter w ere alw ays, with certainty, co n ­
vertible into gold. The Bank had become the
holder of "th e ultim ate cash reserve of the
co u n try ."4
The effect of this arrangem ent was that
the Bank's liab ilities, with the gold held out­
side the Bank as cu rren cy or as reserves in
banks, constituted the monetary base. W hen
gold came into the Bank, due either to a
favorable balance of payments or to a reduc­
tion in the dom estic dem and for cu rren cy,
the Bank was in a position to expand its lend­
ing. This meant an increase in the reserves of
other banks and therefore a m ultiple expan­
sion of total bank credit and the money

John Maynard Keynes, A Treatise on Money, vol. II
(London: Macmillan, 1930), p. 306.

4Walter Bagehot, Lombard Street (New York:
Scribner, Armstrong, and Co., 1873), p. 315.

Central banks and the rules of the gold
standard game

Federal Reserve Bank o f Chicago


supply— precisely in the m anner of a Federal
Reserve open market purchase in the 1980s.
By behaving in this m anner, by doing
what comes naturally to any profit-seeking
bank, the Bank of England— long before the
d e velo p m e n t of the term or even the
theory— was by the end of the 18th century
playing according to the rules of the gold
standard game. C o n sid er, for exam ple, a flow
of gold to Britain resulting from inflation on
the C o ntinent. M uch of this gold found its
way to the Bank of England. U nder these
conditions, the Bank often expanded its lend­
ing by a m ultiple of the increase in its gold
reserve. O th er banks, w hich tended to hold
the additional note and deposit liabilities of
the Bank as their own reserves, also expanded
their own credit. British financial institutions
had developed in such a way that the central
bank, the Bank of England, accentuated the
effects of gold flows. A gain or loss of gold had
a twice m ultiple effect on m oney and prices—
first on the m onetary base through central
bank lending, and then on the lending of
other banks due to changes in the m onetary
The operation of the pre-1914 gold
In order to understand the Bank's behav­
ior between 1844 and 1914, we must begin
with the Restriction Period of 1797-1821, when
Britain was not on the gold standard. O fficial
policy between that tim e and 1931 was d om i­
nated by a reaction to what was generally
thought to be the Bank's m isconduct w hile
free of gold standard constraints.5
M aintenance of co nvertib ility between
the nation's m oney and gold at a fixed rate of
exchange was only the Bank of England's
second most im portant objective. First was
support of the state. During the 1790s, the
Bank purchased substantial quantities of
5For an extensive discussion of the events and the
controversies arising from those events between 1797
and 1865, see Jacob Viner, Studies in the Theory o f Inter­
national Trade (London: George Allen and Unwin, 1937),
ch. 3-5.


governm ent securities issued to finance the
war with Napoleon. The consequences were
expansions of the m onetary base and the
m oney supply, inflatio n , and a loss of gold.
The Bank was very close to being unable to
make good on its prom ise to convert its liab il­
ities into gold at the historic rate of exchange.
The choices faced by the Bank and the
governm ent were either a restriction of credit,
thereby forcing the governm ent to finance
the war w ithout resorting to the Bank (i.e ., to
rely upon taxes and private len din g), or a
legal suspension of the Bank's obligation to
redeem its liabilities in gold. The latter course
was chosen in 1797 and again during W orld
War I, as was the case for A m erican banks
during and for several years after the Civil
Present-day A m ericans w ill not be sur­
prised to learn that the Bank of England's
behavior under these co nd itio n s— i.e ., its
response to (1) a release from the necessity of
keeping a prudent gold reserve and (2) pres­
sure from a g o vern m en t ru n n in g large
d eficits—was expansionary. The Bank only
did what has com e to be expected of central
banks during w artim e. But it was severely crit­
icized and held responsible by politicians and
econom ists for the rapid increase in prices,
averaging nearly 4 percent per year, between
1797 and 1813.
Th en , when it was assigned the task of
reversing the w artim e inflation so that the
cu rren cy might increase in value sufficiently
to restore the gold standard at the prewar
rate, the Bank came under even m ore w id e­
spread attack—this time joined by unem ­
ployed w o rkers, failed bankers, and bankrupt
businessm en—for causing a 50 percent fall in
prices (nearly 7.5 percent per year) between
1813 and 1822. Even after the resum ption of
co nvertib ility in 1821, the Bank's behavior was
highly erratic and continuously a source of
controversy in and out of parliam ent. U n re­
strained central banks have considerable dis­
cretion even under the gold standard, at least
in the short run , until their policies force the
suspension of the system. This had occurred
in 1797 and fears of a repetition of that exp e­

Econom ic Perspectives

rien ce w ere w idespread.
The co untry had had enough of discre­
tionary m onetary policy and attempted to
rectify matters in the Bank Charter Act of 1844
by tying the Bank to a rule. The Bank was
divided into two departm ents. Gold was held
in the Issue D epartm ent, w hich had no fu n c­
tion except to exchange bank notes for gold.
This was the m onetary ru le : changes in the
B an k’s note liabilities w ere tied , pound for
p o u n d , to its gains and losses of gold. The
Banking D epartm ent, on the other hand, was
designed to be free to behave " lik e any other
b an k .” 6 The Banking Departm ent was expect­
ed to pursue profits, with no thought of any
larger p u b lic re sp o n sib ility, by extending
credit on the basis of its reserve, w hich took
the form of its holdings of the Issue Depart­
m ent's notes.7
But the Act of 1844 was badly designed. It
took no account of the Ban k’s deposit liab ili­
ties. Th en , as now , most business purchases
w ere paid for by ch eck , and the money
supply consisted p rincipally of demand d e­
posits. C o n seq u en tly, a rule for the Bank's
notes left the main portion of the monetary
base untouched . For the Bank's deposit liab il­
ities w ere now the special preserve of the
Banking D epartm ent, w hich had in effect
been told to pretend that its lending policies
did not dom inate the reserves of other banks
or the co u n try’s m oney supply.8
A co nseq u en ce of the Act of 1844 was
th atth e Bank began to play by the ru le so f the
game w ith , if possible, even m ore zeal than
b efo re. It im m ediately em barked on an e x­
pansion that, in com bination with other c ir­
cum stances, including a poor harvest in 1846,
6Bagehot, p. 41.
7See John H. Wood, “ Two Notes on the Uniqueness
of Commercial B a n k s Journal o f Finance, vol. 25 (March
1970), pp. 99-108 for a formal description of the Bank’s
structure and its role in the monetary system under the
Act of 1844.
8AII of this was recognized at the time by Tooke and
other critics of the Act of 1844. See Thomas Tooke, An
Inquiry Into The C urrency Principle; the C onnection of
the C urrency with Prices and the Expediency o f a Separa­
tion o f Issue from Banking (London: Longman, Brown,

led to an adverse balance of payments and a
loss of gold. The Bank accordingly sharply
reversed its liberal p olicy, causing the panic
of 1847. U n dau n ted, the Bank persisted in its
destabilizing policies, precipitating further
financial crises in 1857 and 1866.
The Bank changed its behavior after 1866
as it apparently becam e m ore conscious of its
role as the co u n try’s central bank— i.e ., as the
regulator of the m onetary base and the lender
of last resort. Some people attributed this
change to W alter Bagehot's articles in The
Econom ist and his book Lom bard Street
(1873), w hich rem ains unsurpassed as a de­
scription of the responsibilities of a central
bank under the gold standard. W hatever the
reason, the Bank now began to play the gold
standard game with a little less enthusiasm. It
adopted a m iddle way between the rules of
the game and co ncern for dom estic stability.
The years betw een 1880 and 1914 have
been called the heyday of the gold standard.
The gold standard had been adopted by most
m ajor western countries by 1880 but never
fully recovered from the changes arising out
of W orld W ar I. O n e of the most interesting
and inform ative studies of the conduct of the
Bank of England, as w ell as other central
banks, during this period was published by
A rthur Bloom field in 1959.9 Bloom field p re ­
sented two sets of data bearing on the degrees
to w hich 11 central banks played by the rules
of the gold standard game. First, Bloom field
found that for most co un tries, including the
United Kingdom , central bank discount rates
and reserve ratios tended to be inversely
co rrelated . For exam p le, central banks usu­
ally low ered their lending rates when they
acquired gold and usually raised their rates
when they lost g o ld .1 This is consistent with
the rules of the gam e, although the co rrela­
tions w ere not sufficiently high to persuade
9Arthur I. Bloomfield, M onetary Policy Under The
International C old Standard: 1880-1914 (New York: Fed­
eral Reserve Bank of New York, 1959).

Green, and Longmans, 1844), pp. 101-24.

1 See ibid. pp. 30-35. The countries were the United
Kingdom, Germany, France, Belgium, the Netherlands,
Denmark, Finland, Norway, Switzerland, Russia, and

Federal Reserve Bank o f Chicago


Bloom field that the game had been played
with as much enthusiasm as he had expected
to find.
But changes in discount rates are im por­
tant only to the extent that they induce
changes in central bank cred it. The evidence
presented by Bloom field on the response of
central bank credit to changes in gold hold­
ings strongly suggests that the rules of the
game w ere violated m ore often than obeyed.
In nine of the eleven co untries, annual
changes in central bank credit tended to
offset the effects of gold on the m onetary
base far more than half the tim e. O n ly the
Bank of England and the Bank of Finland
accentuated the effects of gold inflows almost
as often as they neutralized those flow s.1
The choice
By adopting the gold standard and playing by
the rules, Britain purchased long-run price
stability at the cost of short-run instability.*2
O ther countries joined the gam e, but only
half-heartedly, and Britain's own enthusiasm
waned with tim e. The choice that had been
made and the p rice that had been paid w ere
well understood by econom ists, the general,
p ub lic, and central bank o fficials. The Bank of
England, the Act of 1844, and the gold stan­
dard w ere subjected to almost continuous
attack from most sectors of society, especially
businessmen. Cham bers of Com m erce passed
resolutions condem ning the gold standard
"Ibid., pp. 47-51.
"See Benjamin Klein, "The Impact of Inflation on
the Term Structure of Corporate Financial Instruments:
1900-1972,’’ in William L. Silber, ed., Financial Innovation
(Lexington, Mass.: D.C. Heath, 1975), pp. 125-49 and
Michael D. Bordo, "The Classical Gold Standard: Some
Lessons for Today,” Review , Federal Reserve Bank of St.
Louis, vol. 63 (May 1981), pp. 2-17 for evidence that yearto-year fluctuations in prices and output were greater
under the gold standard than since 1945 but that longerrun changes in prices have been greater in the latter
"See "The Petition of the Merchants, Bankers, and
Traders of London Against the Bank Charter Act; July
1847” in T. E. Gregory, ed., Select Statutes, Docum ents
and Reports Relating to British Banking, 1832-1928, vol. II
(London: Oxford University Press, 1929), pp. 3-7.


and petitioned parliam ent to com pel the Bank
to alter its b eh avio r.1 Following the crises of
1847 and 1857, parliam ent form ed com m ittees
to inqu ire into the w orkings of the financial
Horsley Palm er, a directo r and form er
G o vernor of the Bank, testified in 1848thatan
increase in Bank Rate "presses upon all
branches of com m erce in a way that is most
prejudicial to th em ; the raising of the rate of
interest, I am given to understand, stopped
very largely the m ercantiletransactions of the
co un try—exports as well as im p o rts."1 The
fall in prices resulting from a restriction of the
Ban k’s credit "destroys the labor of the co u n ­
try; at the present m om ent in the neighbor­
hood of London and in the m anufacturing
districts you can hardly move in any direction
w ithout hearing universal com plaints of the
want of em ploym ent of the labourers of the
co un try." James Spooner, Birm ingham banker
and m em ber of parliam ent, continued the
q u estioning: “ That you ascribe to the m ea­
sures w hich it was necessary to adopt in order
to preserve the co nvertib ility of the note?”
Palmer re p lied : " I think that the present
depressed state of labour is en tirely ow ing to
that circu m stan ce." The then G o vern or and
Deputy G o vern or of the Bank agreed with
Palm er. A colleague of Spooner's, Edward
C ayley, suggested to the G o vernor in a hostile
leading question that " the price of the co n ­
vertibility of the note under that state of
things is the disem ploym ent of labour and the
ruin of the m erchants of the co u n try ." After
squirm ing a bit, the G o vern o r adm itted that
an increase in Bank Rate w ould "Prob ab ly for
a tim e . . . lead toa disem ploym ent of lab o u r.”
A half century later leading econom ists
were still deploring the "evils of our present
monetary system ."1 Knut W icksell predicted
that “ the danger of basing the w h o le of our
eco nom ic system on som ething so capricious
"The quotations in this paragraph are from Hawtrey,
pp. 27-29.
"Alfred Marshall, "Remedies for Fluctuations of
General Prices,” Contem porary Review (March 1887),
reprinted in A. Pigou, ed., M em orial o f A lfred Marshall
(London: MacMillan, 1925), p. 188.

Econom ic Perspectives

as the o ccu rren ce of a certain precious metal
must sooner or later com e to lig h t.” 1 *W ick6
sell,^ A lfred M arsh all,1 and John Stuart M ill1
in England and Irving Fisher2 in the United
States gave lengthy accounts of gold's sins
and how they w ere aggravated by central
banks. But econom ists w ere confronted by a
dilem m a that still has not been solved. The
ch o ice of m onetary systems lay between “ the
cross of gold” 2 and a discretionary monetary
authority under the thum b of a profligate
governm ent. Except for the overseas section
of the C ity of London, w hich believed that
London's financial suprem acy depended on
the m aintenance of a fixed rate of exchange
betw een the pound and gold, no one seemed
fond of the prevailing system. H ow ever, based
on th eir bitter exp erien ce of unrestrained
paper standards, especially the 1791-1821 Re­
striction Period in Britain and the colonial
paper issues and C ivil W ar greenbacks in
A m erica, they liked the alternative even less.
A third possibility— a discretionary system
managed in an intelligent, non-political, noninflationary w ay— appeared so outlandish that
it was rejected out of hand.2
The necessities of war finance forced the
16Knut Wicksell, Lectures on Political Economy, vol.
II, translated by E. Classen (London: Routledge and
Kegan Paul, 1935), pp. 125-26.
“ Wicksell, Interest and Prices, translated by R. F.
Kahn (London: Macmillan, 1936) pp. 165-96.
18Marshall, pp. 188-211.
1 John Stuart Mill, Principles o f Political Economy
(London: Longmans, Green and Co., 1848), pp. 651-77.
20lrving Fisher, The Purchasing Power o f M oney
(New York: Macmillan, 1911), pp. 234-348.
21William Jennings Bryan, Speech closing the plat­
form debate at the Democratic Convention, July 8,1896.
Published in Bryan’s Speeches, vol. I (New York: Funk
and Wagnalls, 1913), pp. 238-49.
“ Published proposals for solving this dilemma would
fill a good-sized library. Several of the better known
schemes may be found in M ill, Bk. Ill; Marshall, pp.
192-211; Knut Wicksell, Interest and Prices, ch. 12, and
Fisher, ch. 13. Most were designed to alleviate the rigidity
of the gold standard without accepting the flexibility of a
discretionary monetary authority. For a discussion of our
continued failure to find a satisfactory solution, see John
R. Hicks, “ Monetary Theory and History—An Attempt at
Perspective,” in Critical Essays in M onetary Theory (Ox­
ford: Clarendon Press, 1967).

Federal Reserve Bank o f Chicago

effective suspension of convertibility during
W orld W ar I, as the governm ent again bor­
rowed heavily from the Bank. Inflation during
and im m ediately after the war was much
m ore severe in the U nited Kingdom than in
the United States. W holesale prices increased
approxim ately 175 percent between mid1914 and the end of 1920 in Britain, compared
with 100 percent in the United States. The
adverse in flu en ce of these price changes on
the dollar value of the pound was exacer­
bated by Britain's loss of im portant export
markets during the w ar. The value of the
pound was m aintained by exchange controls
and other expedients w h ile the war lasted.
But the lifting of controls allow ed the pound
to fall from its prew ar value of $4.86 to a low of
$3.44 in N ovem ber 1920.2
The return to gold
These events did not alter the govern­
ment's determ ination, expressed in 1918, “ that
after the war the conditions necessary to the
m aintenance of an effective gold standard
should be restored w ithout d elay.” 2 This
meant a restoration of the prew ar parity with
gold, and therefo re with the dollar. The Bank
of England sought to achieve this objective by
means of a severely contractionary monetary
policy. Its credit was reduced 20 percent dur­
ing the next two years and w holesale prices
fell 34 percent. The United States was sub2 Converting shillings and pence to decimals, the
pound had been defined early in the 18th century such
that one fine ounce of gold was worth approximately
£4.2479 (although the rate of £3.89375 per standard ounce
was quoted more frequently.) The dollar had been
defined by law in 1792 such that one ounce of fine gold
was worth $20.67. The dollar/pound exchange rate was

Our use of $4.86 is slightly inaccurate but follows custom.
24First Interim Report of the Committee on Currency
and Foreign Exchanges After the War, 1918, Summary
and Conclusions,” reported in Gregory, vol. II, p. 361.
This Committee was called the Cunliffe Commission
after its Chairman, Lord Cunliffe, who was Governor of
the Bank of England from 1913 to 1918.


jected to sim ilar, but less extrem e shocks and
Am erican w holesale prices fell 16 percent. By
the end of 1922, the pound had risen to $4.61
and “ the Authorities w ere in a position to
begin serious consideration of the tactics for a
return to p a r."2
W hat tactics? C entral bankers knew
neither m ore nor less in the 1920s than in the
1980s about how to reduce inflation o r, in the
case at hand, how to cause d eflation. What
other course is there but a restriction of
cre d it? F u rth e rm o re , th ey had learn ed
nothing since 1848, as w e have learned
nothing since 1922, about how to do this
w ithout severe eco nom ic disruption. U nem ­
ploym ent was 14 percent of the labor force
when the Bank perceived itself to be closing
in on the goal of $4.86. Economists and busi­
nessmen, w h ile not quite rejecting the gold
standard co m p le te ly , reco iled from the
governm ent’s program .2 But the perm anent
staffs of the Bank and the Treasury were
determ ined to return to gold as soon as pos­
sible regardless of the “ d isco m fo rts"2 in ­
vo lve d and p ersu ad ed p o litic ia n s to go
along.2 W ith some exceptions due to dom es­
tic pressures, restrictive m onetary and fiscal
policies w ere co ntinued u ntil, after a fall to

25D. E. Moggridge, The Return to C o ld 1925: The
Formulation of Econom ic Policy and its Critics, (Cam­
bridge: Cambridge University Press, 1969), p. 16.

26Nearly all economists who wrote or testified on the
subject opposed a return to gold at the prewar parity at
the real costs that they argued were implied by the
government’s policies. For examples, see John Maynard
Keynes, A Tract on M onetary Reform (London: Macmil­
lan, 1923) and A. C. Pigou, “ Memorandum on Credit,
Currency, and Exchange Fluctuations,” submitted to the
Brussels Conference, 1920. Partially reproduced in W. A.
Brown, The International G old Standard Reinterpreted,
7974 -34 , vol. I (New York: National Bureau of Economic
Research, 1940), pp. 222-23. For a discussion of the oppo­
sition of other groups, see W. A. Brown, England and the
New C old Standard, 1919-1926 (New FHaven: Yale Univer­
sity Press, 1929), ch. 10.

$4.26 in January 1924, the pound was gotten
up to $4.86 in June 1925 and the Gold Stand­
ard Act officially restored the country to the
sum m er of 1914.2
The United States, France, and the collapse
of the gold standard
The question of w hether the pound was
overvalued at $4.86 during and after 1925 is
still controversial. In any case, external co n ­
siderations continued to dom inate British
monetary and fiscal policy. Deflation and
unem ploym ent continued through 1929, and
after that matters got w orse. Although the
authorities w ere prepared to bear the costs
(and in the event did bear the costs) of defla­
tion sufficient to return to and then to m ain­
tain the gold standard at the prewar parity,
they had hoped that deflation w ould not be
necessary. To a large exten t, British policies
w ere based on the expectation that the large
accum ulations of gold in the United States
during and after the war would eventually be
allowed to affect Am erican m oney and prices.
The British waited in vain for the United
States to begin to play the gold standard game
as the Bank of England had played it before
1914. But they cannot com plain that they
w ere deceived. Benjam in Strong, President of
the Federal Reserve Bank of New York and
the most influential official in the Federal
Reserve System until his death in 1928, made
clear that his goal was price stability and that
the rules of the game w ere som ething d e­
voutly to be avoided rather than fo llow ed. In
1923, Strong w rote to M ontagu Norm an,
G o vern or of the Bank of England, that with
A m erica’s “ excessive gold stock we must
entirely ignore any statutory or traditional
percentage of reserve and give greater weight
to what is taking place in prices, business
activity, em ploym ent, and credit volum e and

2 This was the euphemism applied by Montagu
Norman, Governor of the Bank of England from 1920 to
1944, to the costs of the gold standard.
2 For a detailed account of official thinking during
this period see D. E. Moggridge, British M onetary Policy,
1924-1931: The Norman Conquest of $4.86 (Cambridge:
Cambridge University Press, 1972).


29Except that domestic gold circulation was abol­
ished and the complete, pure gold standard was suc­
ceeded by an international gold standard in which gold
would be paid only to foreigners.

Econom ic Perspectives

tu rn o ve r.30 Th en , perhaps thinking that his
message was a bit harsh in view of what the
British w ere trying to accom plish, Strong
added : " O f course we must not close our
eyes to the bearing this may have upon
Eu ro p e ____” As w e shall see below , Am erican
officials in fact took little account of the
effects of their policies on others.
Strong opposed legislation that would
have required the Federal Reserve to stabilize
the price level because, among other reasons,
he felt that factors outside the System's co n ­
trol also affect prices. N evertheless, he ac­
cepted price stability as the Fed's prim ary
goal, w hich he proposed to achieve by a
m onetary base ru le : “ If I w ere C zar of the
Federal Reserve System I'd see that the total
of our earning assets did not go much above
or b elow th eir last year's average, after
deducting an am ount equalling from time to
tim e our total new gold im ports.'' Such a gold
n eutralization policy is, of course, the exact
antithesis of the gold standard game.
In 1944 Ragnar Nurkse presented evi­
dence on the w illingness of central banks to
play by the rules of the game during the
interw ar p erio d .3 W ith one small and one
large excep tio n , his results w ere sim ilar to
B lo o m field ’s for the prewar period. The cen ­
tral banks w hose behavior was reported by
both Bloom field and Nurkse at least partially
neutralized gold flows 64 percent of the time
between 1880 and 1914, com pared with 67
percent of the tim e between 1922 and 1931.3
The small exception w asthat the Bank of Eng­
land co nform ed to the rules 60 percent of the
tim e during the 1922-31 period com pared
w ith 48 p ercent of the tim e between 1880 and
1914— a d ifferen ce that may not be statisti­

cally significant in view of the small number
of observations in the later period.
Th e m ajo r d iffe re n c e b etw een the
m onetary systems observed by Bloom field
and Nurkse was the em ergence of a new and
dom inant actor in the form of an Am erican
central bank that had discretionary powers
and was determ ined to prevent the gold
standard from u nderm ining dom estic stabil­
ity. Nurkse reported that the Federal Reserve
at least partially neutralized gold flows during
nine of the ten years 1922-31. His results
are shown in the ch art, w hich covers a som e­
what longer perio d, 1921-33. During 12 of
these 13 years, changes in Federal Reserve
credit (A F ) w ere the opposite of changes in
the governm ent's gold holdings (A G ), which
until W orld II made up the largest part of the
m onetary base.3 The A m erican governm ent’s
stock of gold grew from $1,290 m illion in
D ecem ber 1913 to $2,451 m illion in 1920,
$3,985 m illion in 1925, and $4,225 m illion in
3 The exception to this neutralization policy in
Nurkse’s data, which were March-to-March changes,
was 1931. The exception in the end-of-year changes
shown in the chart is 1924.

Changes in Federal Reserve credit
(A F) and U.S. official gold
holdings* (A G )
billion dollars

3 This and other statements by Strong are quoted
from Lester V. Chandler, Benjamin Strong, Central
Banker (Washington, D.C.: The Brookings Institution,
1958), ch. 6, which is appropriately titled “ New Goals,
New Methods.”
3 Ragnar Nurkse, International Currency Experience:
Lessons o f the Inter-W ar Period (Princeton, N.J., Prince­
ton University Press, 1944), pp. 237-39.

*G is the monetary gold stock less gold coin in circulation.

32Nurkse presented no data for Belgium or the Soviet
Union and reported both Austria and Hungary.

SO U RCE: B a n k in g a n d M o n e t a r y S ta tistic s, 1914-1941 (Washington,
D .C .: Board of Governors of the Federal Reserve System, 1943), pp.

Federal Reserve Bank of Chicago


1930— from 27 percent of the w orld's gold
reserves in 1913 to 38 percent in 1930. This
accum ulation of gold was due not only to the
Federal Reserve's conservative m onetary pol­
icy (Am erican m oney and prices in 1929 were
virtually unchanged from their 1925 levels)
but to successively higher protective tariffs
culm inating in the Sm oot-Hawley Act of 1930.
Am erican policies w ere reinforced be­
ginning in D ecem ber 1926 by France, w hich
returned to the gold standard at a rate of
exchange considerably below that prevailing
during most of the preceding several years
and w hich is w id ely thought to have u nd er­
valued the fran c. It now becam e a race
between the U nited States and France to see
who could accum ulate the most gold. French
gold reserves rose from $711 m illion in
Decem ber 1926 to $2,699 m illion in 1931. At
the end of 1931, the United States and France
owned 60 percent of the w orld's gold reserves,
com pared with 39 percent in 1913 and 43 p er­
cent in 1920.
M oney, p rices, and incom e fell rapidly in
Britain between the fall of 1929 and the fall of
1931, but not as rapidly as in the U nited States
and France. The British balance of payments
w orsened, gold drains becam e more severe,
and, fin ally, in Septem ber 1931, the Bank of
England was no longer able to maintain the
co nvertib ility of the cu rren cy. The pound was
allow ed to float and by the end of the year
had fallen to $3.37.
The British must accept a large part of the
blame for the tim ing of the collapse of the
gold standard. In retrospect, it appears that
they returned to gold too soon or at the
wrong rate or both— although their argu­
ment that a return to gold at a d ifferent rate
would have been inconsistent with the essen­
tial idea of a gold standard is unansw erable. A
34For evidence that official French policy was to
return to gold at a rate that would give its export indus­
tries an advantage in world markets, see R. S. Sayers, “ The
Return to Gold, 1925,” in L. S. Pressnell, ed., Studies in the
Industrial Revolution (London: Athlane, 1960).
35Moggridge, British M onetary Policy, p. 7.


gold standard under w hich rates are adjusted
w henever cu rren cies com e under pressure is
not worth its nam e. C e rtain ly, it performs
none of its intended fu n ctio n s— in particular,
the elim ination of m onetary discretion. H ow ­
ever, the stated objectives and behavior of
France3 and especially the United States sug­
gest that the gold standard w ould not have
had much of a fu tu re regardless of the c o n d i­
tions under w hich it was restarted. It is in co n ­
ceivable that a gold standard can w ork when
the dom inant trading country treats dom estic
objectives as param ount.
Britain has been called variously the
um pire and the conductor of the pre-1914
gold standard. But these terms understate Brit­
ain's im portance, for she was also the major
player. She played as w ell as called the tune.
An understanding of the role of London in
the operation of the system requires a grasp
of “ the im m ensely strong underlying position
of Britain in the international econom y. In the
cen tu ry before 1913, in every year but tw o,
Britain had been in surplus on cu rren t
a cco u n t.''3 London was also, as the world's
b anker, the depository for large amounts of
foreign funds. These factors meant that Lon­
don exerted a large and continuing pull on
the w orld's gold—w hich was allowed to flow
out again because Britain was also the w orld's
largest overseas investor. She lost this posi­
tion after the war to a co untry that showed a
strong inclination to accum ulate gold.
The Bank of England treated gold as an
instrum ent, som ething to be used to expand
credit when it flowed in and som ething to be
paid out, w ithout regret, upon dem and. In
com m on with others, the British loved easy
m oney and good tim es, w hich the Bank sup­
plied w henever it was able. The Bank's appar­
ent eagerness to see how close it could trim its
reserves w ithout quite falling off the gold
standard was a source of am azem ent and
co n ce rn .3 This pattern of behavior, probably
3 The admonition to keep a larger reserve was prob­
ably the most urgent advice of both Tooke, An Inquiry
Into the C urrency Principle, and Bagehot, Lombard

Econom ic Perspectives

essential to a successful gold standard, was
diam etrically opposed to that of France and
the U nited States not only during the 1920s
but also in the 1960s, w hen the form er co u n ­
try again evinced a strong desire to accum u­
late gold and the latter w orried that gold was
actually being called upon to perform its
function as a reserve. The decision of the
U nited States in August 1971 to renege on its
prom ise to foreign central banks to redeem
dollars in gold— i.e ., to apply its gold reserve
to the use for w hich it was presum ably in ­

tended37— raises serious doubts about this
country's ability to succeed Britain as man­
ager of an internatio nal gold standard. Per­
haps more im portantly, the high domestic
costs of adhering to the rules of the gold
standard game raise serious doubts aboutany
co untry's ability and w illingness to take on
such a responsibility.

3 What possible function can America’s gold reserve
now perform except as a continuing reminder to for­
eigners of our unreliability as an international banker?

Agriculture and farm finance
1980 developments in rural credit markets.................................
A new role for federal crop insu ran ce.........................................





Banking, credit, and finance
The significance and measurement of concentration ..........
District trends in banking concentration ....................................
Structural change in Wisconsin in the 1970s...............................
Interest rates and inflation..................................................................
Improving housing finance in an inflationary environment:
alternative residential mortgage instruments..........................





Economic conditions
The Midwest and the recession........................................................
Economic events in 1980—a chronology......................................



Government finance
Federal tax and spending reform ...................................................











International trade and finance
Interest rates and exchange rates under the Fed’s
new operating procedure: the uneasy m arriag e..................
The internationalization of U.S. agriculture...............................
Gold in the international arena: how automatic
is international adjustment?.............................................................
The demise of the gold standard.....................................................
Money and monetary policy
Interest rate volatility in 1980.............................................................
The discount rate—will it float?........................................................
Benjamin Franklin and monetary policy in
colonial Pennsylvania..........................................................................

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