The Gold Standard Versus Democracy

I had planned to write a simple article explaining how the gold standard works but I ran into a few problems.  One problem is that there is no single gold standard.  The prewar gold standard was the model for the interwar gold standard but the interwar standard never really worked, and the gold standard of the Bretton Woods System differed from both of the previous systems.  Another problem is that a gold standard arises from the history, economics and politics of a particular place and time, and serves the interests of diverse trading partners. For that reason you would need an entire book to explain it, if not several books.  This article has a narrower focus—the claim that voters would naturally reject the imposition of a new gold standard.  

This is an interesting claim, considering the many calls on the Internet for a return to the gold standard.  The writers seem to think that a gold standard would limit the Federal Reserve’s ability to print currency, which they see as the central problem of the economy.  But the reinstatement of a new gold standard at this time would help the capital markets rather than the middle and working classes. 

My sources are Barry Eichengreen (please see reference below) and Beth A. Simmons.  They both use David Hume’s rendition of the ‘price-specie-flow’ mechanism.  Simmons calls Hume’s approach ‘classical’ and Eichengreen says of it, “The strength of this formulation—one of the first general equilibrium models in economics—was its elegance and simplicity.  It was a parsimonious description of the balance-of-payments adjustment mechanism of the mid-eighteenth century.” 

Neither author recommends a return to the gold standard as a cure for today’s problems;  the prewar system seems to represent an ideal, and one of the things they try to do is explain why the interwar system didn’t work as smoothly as the prewar system.  Both authors end up blaming the rise of worker organizations and universal suffrage, but in the process they mention other possible culprits: Simmons cited the lack of trust between countries brought on by the Great War and its aftermath; and Eichengreen cited uncontrolled capital flows and the misbehavior of central banks. 

According to Simmons, Hume’s rendition of the ‘price-specie-flow’ mechanism was based on a stylized economy in which two categories of commodities—goods and gold—were traded.  When the price of goods rose domestic residents substituted less expensive imports.  Residents of the foreign country—if there were no production increases—would have to cut their consumption to accommodate increased foreign demand for their goods.  Gold would flow from the country with higher prices for goods to that with higher prices for gold, meaning that the resulting balance of trade settlements was made by gold shipments from the deficit to the surplus countries.  (Simmons, 31)

However Hume said nothing about the determinants of capital flows, such as the level of interest rates and the activities of commercial and central banks.  Hume’s model was extended to include these things but it wasn’t properly elaborated until after World War I in the report of the Cunliffe Committee (a British government committee established to consider postwar monetary problems).  (Eichengreen, 25) 

When arbitrage is included (capital market in addition to market for goods and gold) adjustment won’t work this way, but through interest rate differentials and capital flows.  Now when domestic prices for securities rose (interest rates fell) capital flowed from the country in which interest rates are low to the country in which they are high until security prices and interest rates were equalized internationally.  

Thus the Balance of Payments deficit (sum of trade balance deficit plus capital outflow) would not have to be covered fully by an international transfer of gold.  If capital flows covered the trade imbalance gold didn’t have to be transferred at all. (Simmons, Page 31)

You can see how this begins to take on the irrefutable logic of a balance sheet.  But there were stringent norms for countries on the gold standard.  According to Simmons, under a fixed-rate regime external balance was more important than the domestic economy if there was a conflict. The first goal of the gold standard was currency stability, and the basic premise was that countries pursue economic policies compatible with maintenance of fixed parities.    

Although there were no fixed rules for the provision of liquidity, potential creditors often attached conditions (implied or explicit).  In the real world it looked something like this: France was denied American credits after 1923 in part because of its government’s failure to ratify war debt agreements with the United States.  A loan to Britain was delayed in September 1931 because the Labour party refused to cut unemployment insurance from the budget.   

Because democratization undermined the focus of the nineteenth century on external balance, during the interwar years several states gave up democracy in favor of repression.  The power to repress demands for growth and pass austere budgets by decree signals a government’s ability to control inflationary pressures, while markets assume that regimes based on popular sovereignty have an incentive to avoid policies that bring severe economic contraction in the short run.  And market expectations make all the difference.  Democracy and equality signaled to markets that the gold standard was no longer inviable.  So although there may not be an actual move toward authoritarianism, in many countries cabinets were empowered to rule by decree until fiscal reforms were implemented. (Simmons, 43)

An independent monetary institution is one logical outcome of the market’s supremacy, because such an institution can make the necessary adjustments without fear of the political repercussions.  In the United States, the independent Federal Reserve was established in 1913.  Since that time American presidents, who were at the mercy of domestic politics, challenged its independence.  

After the second world war politicians had no desire to see monetary policy tighten again.  The result in America was a running battle between presidents and Fed chairmen.  Harry Truman pressed William McChesney Martin, who ran the Fed from 1951 to 1970, to keep rates low despite the inflationary consequences of the Korean War.  Martin refused.  After Truman left office in 1953, he passed Martin in the street and uttered just one word: “Traitor.”

Lyndon Johnson was more forceful.  He summoned Martin to his Texas ranch and bellowed: “Boys are dying in Vietnam and Bill Martin doesn’t care.”  Typically, Richard Nixon took the bullying furthest, leaking a false story that Arthur Burns, Martin’s successor, was demanding a 50% pay rise.  Attacked by the press, Burns retreated from his desire to raise interest rates.  The Battle of Three Centuries: The History of Central Banks

When the Bank of England was established in 1694, no one expected central banks to evolve into the all-powerful institutions of today.  However it immediately became obvious that paper money was a more useful medium of exchange than gold or silver, particularly for large amounts.  Paper money was good for the people as well.  It gave them more chances to trade as it improved government finances.  Unfortunately, the notes of private banks were less trustworthy than those printed by a national bank and backed by a government with tax-raising powers.   

Central banks have always favored creditors over debtors.  For example, prices remained stable during the nineteenth century but the Bank of England had to raise interest rates to attract foreign capital whenever its gold reserves started to fall.  This loaded the burden of economic adjustment onto workers, through lower wages or higher unemployment.  At that time the vote was limited to men of property, so the bank was insulated from political repercussions. 

The costs were also high for countries on the periphery of the system.  According to Eichengreen, banking systems at the periphery were fragile and vulnerable to disturbances that could bring a country’s foreign as well as domestic financial arrangements crashing down, all the more so in the absence of a lender of last resort.  In addition, primary-producing countries outside north-central Europe were subject to large goods-market shocks.  Those who specialized in the production and export of a narrow range of commodities were exposed to volatile fluctuations in the terms of trade.  They also experienced destabilizing shifts in international capital flows.  And a decline in the volume of capital flows toward primary-producing regions did not come with a stabilizing increase in demand for their commodity exports elsewhere in the world, as it did for Britain and other European creditors.  Furthermore, a decline in commodity export receipts would make a capital-importing country less attractive to investors.  Financial flows would dry up as doubts arose about the adequacy of export revenues for servicing foreign debts.  As a result, exports suffered from the scarcity of credit.  The democratic nature of these countries was an additional complication—it made them unwilling to impose central bank dictates. Eichengreen cites the experience of the United States.  

At the turn of the twentieth century America was one of the countries at the periphery, and there were doubts about the United States’ commitment to support the dollar price of gold.  The small farmer was critical of inflation, and the opinion of small farmers mattered because males in the United States had universal suffrage.  Worse from the point of view of the markets, even the thinly populated states of the agricultural and mining West had two senators. Silver mining was an important industry and political lobby as well, and silver-mining interests  were concentrated in the same regions of the US as indebted farmers, leading to the formation of coalitions.  And last but not least, American agriculture did not benefit from tariffs, meaning that tariffs could not buy farmers’ support for the gold standard as they could in Europe.  All of this changed at the end of the nineteenth century.

In the 1890s the leaders of the Populist movement thought deflation was due to the fact that output worldwide was growing faster than the global gold stock.  So they urged the government to issue more money, ideally in the form of silver coin, to stop the fall in the price level.  This led to the 1890 Sherman Silver Purchase Act.  Prices stopped falling as predicted and silver replaced gold in circulation.  But as spending rose, the US balance of payments moved into deficit, draining gold from the Treasury.  For a while it was feared that the Treasury would eventually lack the specie required to convert dollars into gold, but when a poor European harvest boosted US exports the fears subsided.  

They returned however, with the victory of Grover Cleveland in the 1892 presidential election.  Market participants (my emphasis) worried that he would compromise with the powerful soft-money wing of his party.  (The soft-money wing of the Democrats favored a combination of greenbacks and silver, but Cleveland was a Democrat who favored hard-money policies.)  By April,1893 the Treasury’s gold reserve fell below the minimum of $100 million and investors shifted capital into European currencies.  In the Autumn of that year Cleveland declared himself for hard money.  But although the Sherman Act was repealed on November 1, the underlying conflict reappeared in the next presidential campaign.  It was finally resolved in favor of the gold standard when Republican William McKinley was elected president over William Jennings Bryan, the candidate of the Democrats and Populists.  Bryan had campaigned for unlimited silver coinage and implored the electorate ‘not to crucify the American farmer and worker on a ‘cross of gold.’  His proposals had caused capital to take flight and interest rates to rise.  McKinley, who had recently been ‘converted to the cause of gold and monetary orthodoxy,’ became the next president. The markets got their wish and capital came flowing back into the United States, despite the needs of American agriculture. 

The gold standard was even worse for ‘Latin’ countries in southern Europe and South America, including Argentina, Brazil, Chile, Italy, and Portugal.  They were repeatedly forced to suspend gold convertibility and to allow their currencies to depreciate.  This was blamed on the political influence of groups that favored inflation.  But who were the groups promoting the market’s policies? “In Latin America, as in the United States, depreciation was welcomed by landowners with fixed mortgages and by exporters who wished to enhance their international competitiveness.  These two groups were often one and the same.”  (Eichengreen, 40)

Again, the problem for progressives who want to study this material is that the logic of the market seems irrefutable.  However the reality is that the banks, who are supposed to facilitate domestic business and international trade, have set themselves over the inhabitants of the land.  Intuitively we know there is something wrong with this picture but intuition is not enough.  What is needed is an understanding of the financial and monetary system.   

Now I’ll discuss the other culprits mentioned by Eichengreen.  There is a widely accepted argument that the gold standard broke down because of uncontrolled capital mobility.  It posits that the gold standard was successful after World War II because capital mobility was limited under the Bretton Woods System.  This loosened the controls on policy and allowed policy makers to pursue domestic goals without destabilizing the exchange rate.  Then the postwar recovery increased capital flows and the shift to floating rates was the inevitable result.  Eichengreen argues against this interpretation, and in the process he reveals the market’s Achilles heel.  

He argues that international capital mobility was high before World War I as well, but this did not prevent the operation of pegged exchange rates under the classical gold standard.  What really happened after World War II is that limits on capital mobility substituted for limits on democracy as a source of insulation from market pressures. Governments may no longer have been able to take whatever steps were needed to defend a currency peg, but capital controls (see definition below) limited the extremity of the steps that were required.  By limiting the resources that the markets could bring to bear against an exchange rate peg, controls limited the steps that governments had to take in its defense.  However this situation came to an end when capital controls became more difficult to enforce.  In response, some countries moved toward more freely floating exchange rates while others sought to stabilize their exchange rates by establishing a monetary union.

And this is where he argues that the shift from classical liberalism in the nineteenth century to embedded liberalism in the twentieth century (the rise of unions, etc.) brought down the gold standard. (Page 3)  It is this period that I want to emphasize because it reveals the tradeoff between the uncontrolled movement of capital and democracy.  

The other hopeful piece of information involves the part the central banks played in the gold standard’s demise:  In 1925, long after economists remembered what the prewar gold standard looked like, John Maynard Keynes coined the phrase “The rules of the game.”  It implied that central banks were guided by a rigid, if unspoken, code of conduct.  But it was discovered in 1944 that they are not guided by such a code of conduct.  

While trying to explain why the international monetary system had functioned so poorly in the 1920s and 1930s Ragnar Nurkse tabulated by country and year the number of times between 1922 and 1933 that the domestic and foreign assets of central banks moved together, as if the authorities had adhered to “the rules of the game,” and the number of times they did not.  Finding that domestic and foreign assets moved in opposite directions in the majority of years, Nurkse attributed the instability of the interwar gold standard to widespread violations of the rules and, by implication, the prewar stability of the classical gold standard to their preservation.  But when in 1959 Arthur Bloomfield replicated Nurkse’s exercise using prewar data, he found to his surprise that violations of the rules were equally prevalent before 1913.

For Eichengreen it is clear that factors other than the balance of payments influenced central banks’ decisions about where to set the discount rate.  He concludes that profitability was one of these factors, given that many central banks were privately owned.  This would have had a powerful effect.  

The system depended on the central bank to adjust the money supply when necessary, typically through the discount rate.  By manipulating its discount rate, the central bank could thereby affect the volume of domestic credit.  It could increase or reduce the availability of credit to restore balance-of-payments equilibrium without requiring gold flows to take place.  When a central bank anticipating gold losses raised its discount rate, reducing its holdings of domestic interest-bearing assets, cash was drained from the market.  The money supply declined and external balance was restored without requiring actual gold outflows.  This is what is referred to as the rules of the game.  

The point is that the private interests within the central banking system would know that if they set the discount rate above market interest rates, they might end up without business, and this knowledge might cause them to fudge the necessary adjustments.

Eichengreen mentions other pressures on the bankers that might limit their ability to carry out their function (but in my opinion they don’t represent dereliction of duty to the same degree as the profit motive).  The bank might be influenced by fears of depressing the economy or increasing the cost to the government of servicing its debt.  Eichengreen concludes that the notion that banks follow the rules of the game is misleading. (Page 27-28)

So is he saying it is irrelevant whether the banks follow the rules of the game?  Not exactly.  It seems to me the issue is the different levels of trust that existed before and after the Great War. According to Eichengreen, the stronger the belief in the system and its credibility, the more scope central banks have to deviate from the rules. So it seems likely that the main problem in the interwar period was a lack of belief in the system’s credibility.  And since belief is the one thing the system cannot do without the trauma of the first world war would have been a powerful contributor to the downfall of the gold standard.  

Market players would like us to believe that democracy is the problem and the repression of democratic institutions is the solution.  This is a bald-faced lie. 

Sources and definitions:

Barry Eichengreen, Globalizing Capital: A History of the International Monetary System, (Princeton University Press, 2008).

Definition of Capital Controls:  Capital controls are measures taken by either the government or the central bank of an economy to regulate the outflow and inflow of foreign capital in the country.  The measures taken may be in the form of taxes, tariffs, volume-restrictions, or outright legislation.  They may be applicable to the whole economy, sector-specific, or industry-specific.  The controls might also be duration-specific (short-term, medium-term, or long-term flows).  They affect the appreciation or depreciation of currency exchange rates, bubble bursts in a stock market, equity and bond markets. 


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