The "Gold Exchange Standard"
May 13, 2012
Sometimes you hear about the "gold exchange standard." This is
really just one of many varieties of gold standard systems. A gold
standard system, according to me, is a system with a certain policy
goal: to maintain the value of the currency at a fixed parity with
gold bullion. Then, you need to have some sort of operating
mechanism to achieve this goal. This operating mechanism has to work
-- that is, it has to actually achieve the goal -- in a reliable
fashion, for the indefinite future. Just crossing you fingers and
mumbling in public doesn't work. Just selling gold at a certain
price doesn't work. We looked at many such operating systems earlier
What Is the Best Type of Gold Standard System?
29, 2012: Gold Standard Technical Operating Discussions 3:
Automaticity Vs. Discretion
Gold Standard Technical Operating Discussions 2: More Variations
2012: Some Gold Standand Technical Operating Discussions
A "gold exchange standard" is one where the currency manager doesn't
have an independent peg to gold bullion. Rather, the currency is
pegged to another international, gold-linked currency, such as the
British pound or U.S. dollar. Obviously, if the British pound is
pegged to gold and your currency is pegged to the British pound,
then your currency is also pegged to gold. So, this is a variety of
a gold standard system. As for an operating mechanism, we have an
automatic currency board. Nothing wrong with that. Currency boards
work fine. Indeed, a direct bullion link is really no different than
a currency board, you just use gold instead of some other currency.
Because the currency is pegged to a target currency, like the
British pound, the primary reserve asset in this case is
high-quality British pound bonds. The central bank doesn't need to
hold any gold bullion. It might hold some anyway, as European
central banks did during the Bretton Woods period, even though they
were pegged to the dollar with a "gold exchange standard" type
arrangement, not to bullion directly.
There are some nice things about this arrangement. If, perhaps after
a war for example, you don't really have very much gold bullion, you
can establish something like this pretty quickly without having to
accumulate bullion. Also, virtually all gold standard systems do not
have a 100% bullion reserve. The primary reason is that it is
unprofitable. It costs a little money to run a currency system, and
without a profit, the currency system becomes a money-loser. The
only entity that can operate a money-losing system is the
government. However, for the last two hundred years, it has been
mostly private entities, first commercial banks and then central
banks, which have operated monetary systems. So, they want to make a
profit. To make a profit, you have to hold, as a reserve asset, some
interest-bearing bonds or loans. The more bonds you have, the higher
the profit. Thus, a system with no gold holdings, and 100% bond
holdings, is the most profitable. Also, you many want to make your
reserve asset independent of the local government, particularly if
the government has a recent history of pressuring the central bank
into financing government deficits. If 100% of your reserve assets
are foreign government bonds, then the central bank does not deal in
domestic bonds, and is relatively immune to "finance my deficit"
arguments. You don't have to deal with all the problems of storing
and shipping bullion, or meeting redemption requests.
One drawback of such a system is that you are reliant upon the
target currency remaining pegged to gold. This didn't work out so
well for those linked to the British pound, which was devalued in
1914, 1931, and numerous times thereafter. Or, for those linked to
the U.S. dollar, which was devalued in 1933 and then in 1971. Even
in this case, it is not strictly necessary that a central bank
follow the devaluation of the target currency. Indeed, in 1971, when
the U.S. dollar officially went off gold, most other major
governments also severed their dollar ties. They could have, from
that point forward, established an independent gold link. But, there
is some inertia in these things, and once pegged to a target
currency, the country is almost certain to follow that target
currency's devaluation, in one way or another.
The point of all this is, a "gold exchange standard" is a perfectly
usable gold standard system, with some advantages and disadvantages,
just like any other system you could devise. There is nothing
inherently wrong with it. Although the term "gold exchange standard"
is usually applied to the 1920s, in fact this system was in use
throughout the 19th century as well by some governments. It became
more common after 1920, as governments dealt with the process of
re-establishing their gold pegs after virtually everyone left gold
in World War I. There was never, in the pre-1914 era, in the 1920s,
or in the 1950s, a one-size-fits-all solution that everyone used.
Some governments used a "gold exchange standard" i.e. a currency
board with a major international gold-linked currency, and other
governments used a different system.
A few funny things have popped up over the years. First, some people
want to blame supposed problems with the "gold exchange standard"
for causing or exacerbating the Great Depression of the 1930s.
A gold standard system is a pretty simple thing. You could have some
potential problems. The value of gold itself could change. There
isn't much evidence that this has happened, which is why we continue
to use gold as a basis for monetary systems, but it is conceivable.
In that case, the value of currencies pegged to gold would also
change alongside, with potential consequences.
The second thing that can happen is that a country is not properly
observing the appropriate operating mechanisms -- in other words,
engaging in some sort of domestic "monetary policy" or maybe just
being incompetent -- and thus the currency's value diverges from its
gold peg, or, in this case, peg with the major international
Those are pretty much the only two things that can happen. Did
either of those happen in the 1920s?
The question of whether gold itself changed value, dramatically
enough to cause some meaningful effects, is a little too complex for
this time. I think this idea is much too popular, among those eager
to blame the Great Depression upon the gold standard itself, and not
backed up by much if any evidence at all. I looked at it in
considerable depth in the past, and found nothing of importance.
What did happen in the 1920s is that countries like Britain repegged
to gold at the prewar parity, which involved a substantial deflation
(rise in currency value) from the devalued state at which their
currencies ended the war. This had recessionary implications,
especially when exacerbated by other problems, as was the case in
Britain. Keynes complained about this. However, this was not a
problem of gold itself failing in its role as a standard of stable
monetary value, but rather the process of returning to the gold
standard policy. In other words, dealing with the consequences of
the wartime devaluation.
The other question is: did countries properly manage their
currencies, using the proper operating mechanisms, to maintain their
gold links? For the most part, it appears to me that they did. There
is no great record of currency difficulties during the 1920s. There
was a little fussing around the edges, but nothing of great import.
As the Great Depression began, the Keynesians of course wanted a
currency they could manipulate to help ameliorate the economic
difficulties. Thus, the gold standard was blamed for preventing this
manipulation. These are the "golden fetters" some people talk about,
a "fetter" being a device that prevents movement. This was no
failure of gold, to serve as a standard of stable monetary value,
but rather a change in policy goals.
With all that in mind, let's take a closer look at the 1920s, by way
of the book Golden Fetters: the
Gold Standard and the Great Depression 1919-1939, by Barry
Eichengreen. Eichengreen is a career Keynesian, so he has that
outlook. A lot of his analysis is rather laughable in my opinion.
Nevertheless, the book has quite a lot of good historical material,
and thus, like most books, serve as a good resource in that regard.
In Chapter 13, "Conclusion", Eichengreen sums up his arguments. He
starts by accusing the post-WWI gold standard system of being
subject to various "imbalances in international settlements." This
is always a focus of the Keynesian types, going back to the days of
David Hume, but it means nothing. "International settlements" are in
fact irrelevent for maintenance of a gold standard system, which
depends solely upon the proper management of base money supply,
which any central bank can do without assistance. The "balance of
payments" and "international settlements" are always a red herring,
a political football which can be wheeled out at any time to serve
practically any political purpose. It doesn't really mean anything
at all, but since people are confused by the issue, it is a handy
tool to blame anyone for anything, and sound convincing.
4, 2012: The Gold Standard and "Balanced Trade"
However, Eichengreen does bring up another important issue, having
more to do with politics than the gold standard system itself.
World War I transformed those
circumstances. The credibility of the commitment to gold was
undermined by the erosion of central bankers' insulation from
political pressures. In response to Europe's postwar experience
with inflation and stabilization, explicit analyses of the links
from restrictive monetary policy to unemployment were articulated
and widely circulated. Although the details of those analyses
differed across countries, they served to heighten awareness,
wherever they appeared, of the impact of monetary policy on
domestic economic conditions. ["Restrictive monetary policy"
refers to the process of raising currencies' value to their prewar
gold parities, as happened in Britain.] Individuals and groups
adversely affected by high interest rates and credit restriction
increasingly resisted their implementation. The growing political
influence of the working classes intensified pressure to adapt
monetary policy toward employment targets. Fiscal imbalances
[government budget deficits] and distributional conflicts
[expansion of welfare policies] magnified the strain felt by
A shadow was cast over the credibility of the commitment to gold.
... The markets, rather than minimizing the need for government
intervention, subjected the authorities' stated commitment [to
gold] to early and repeated tests.
Now this is a real issue. A gold standard system is going to come
under strain when the politicians start to talk about how much they
would rather have some other sort of system. You would sell the
bonds, sell the currency, and take your money elsewhere. Of course
you would. Just like people in Greece today, as they read, day after
day in the Financial Times,
the apparently unanimous agreement among the elites and
intellectuals that Greece should really have its own currency to be
devalued as soon as possible. This process is often interpreted as a
"balance of payments imbalance," which is why that always comes up
when the private markets start to react to the fact that
governments' stated desires are contrary to the proper maintenance
of a gold standard policy. The same happened in the 1960s. During
this capital flight, maintenance of the gold standard parity (via
reductions in base money supply) would likely lead to some increases
in interest rates on the short term, while the longer maturities
would also have rising rates due to the risk of devaluation. The
gold standard system would be blamed for this rise in rates. None of
this is particularly surprising, nor does it represent any inherent
flaw in the gold standard system of the time. It is exactly what you
would expect to happen, and exactly what is supposed to happen.
Maybe politicians should keep their mouth shut?
Then, Eichengreen brings up the standard Keynesian complaint, that
the gold standard system prevented the kind of money jiggering that
had become popular as a way to deal with economic difficulty.
And that's pretty much it from Eichengreen's conclusions. Nothing
particularly surprising there. If you account for some Keynesian
bias, goofy academic terminology, and some confusion regarding the
"balance of payments" and "international cooperation," it is all
pretty much as one would expect it to be.
Unfortunately, most gold standard advocates today haven't really
grasped what was going on in those days I think. They hear
criticisms like those of Eichengreen, and don't know how to
interpret them. Instead of dealing with the issues -- as Eichengreen
does -- they tend to try to escape it by saying that the "gold
exchange standard" wasn't really a gold standard system, or had some
sort of inherent flaw. The core of this notion seems to be that
countries that were pegged to a major international gold-linked
currency didn't hold much, if any, gold bullion. In the
superstitious and atavistic world of people who try to talk about
monetary policy without understanding it, less bullion means a
"weaker" gold standard system. This is one reason why, after 1971,
we have been subjected to various "100%" or "pure" gold standard
system proposals, which demand a 100% bullion reserve holding,
something which is historically almost unheard of. As I've noted in
the past, the Bank of England maintained the premier international
gold-linked currency of its day, the British pound, for sixty years
to 1914 while holding bullion reserves equivalent to an average of
about 1.5% of worldwide aboveground gold. That system didn't end
because of "not enough gold," but rather because of the turmoil of
World War I. The "strength" of a gold standard system comes from the
strength of policymakers' commitment to the principles of such as
system, plus the observance and understanding of the proper
operating mechanisms necessary to sustain the system.
To accusations that the gold standard systems of the 1920s caused or
exacerbated the Great Depression, the gold standard advocates often
hide behind "but it wasn't really a gold standard system" claims.
Well, actually, it was. People of the time thought so. It
successfully maintained the policy goal, which was to keep
currencies' values at a fixed parity with gold bullion. The main
problem, from the perspective of the Keynesians, is that this policy
goal was contrary to their own goals, to have a manipulable currency
to address economic problems.
26, 2009: Two Monetary Paradigms
These conflicts, of a gold standard policy combined with a desire
for "domestic" monetary manipulation, continued into the 1950s and
1960s. Thus, we had a good fifty years, 1920-1971, when the
experience of a gold standard system was not the smoothly
functioning example of the pre-1914 era, when capital moved freely
and easily around the world, but rather the era of incessant capital
flight and monetary difficulties ["balance of payments imbalances"]
as politicians from one country or another would say how much they
would like to do the things that a gold standard system expressly
forbids. Plus, the occasional actual devaluation.