The Gold Standard — Gold That Bound the World

In the previous episode we watched modern banking sprout in Renaissance Italy. The money-changer’s table, the bill of exchange, double-entry bookkeeping, and the Medici — the craft of handling money grew into a force that supported commerce and art.

Yet however much bills and ledgers developed, there was one thing people could not help but ask in the end. This paper certificate, this coin — by what exactly is its value guaranteed? The further commerce spread across borders, the more a common ‘standard of value’ that everyone would recognize was sought. In time the world came to seek its answer in a single metal: gold. This episode follows the story of how, through a long contest between gold and silver, the world came to be bound together by one metal.

Gold and Silver, the Contest of Two Metals

For a long age, humanity’s money was supported by two metals, gold and silver. Gold is scarce and keeps its luster, suited to high-value transactions and the storing of wealth. Silver is more familiar and easy to use for everyday payments. Many nations adopted a ‘bimetallic standard,’ taking both as the basis of money.

But using two metals at the same time carried a troublesome problem. The market value of gold and silver constantly shifts with changes in output and other factors. Even when a state decreed by law that ‘gold and silver shall be exchanged at this ratio,’ a distortion arose whenever the market reality diverged from it.

Here appears the famous ‘Gresham’s law’ — the saying that bad money drives out good. The metal treated as undervalued at the legal ratio would vanish from circulation as people hoarded it or melted it down into bullion. Only the metal treated as overvalued remained in the market. The bimetallic standard carried this instability structurally.

Britain’s Path That Opened the Way to Gold

The pioneer that led the world toward the gold standard was Britain. One of its triggers, it is said, lay with an unexpected figure: Isaac Newton, known for universal gravitation.

While serving as Master of the Royal Mint in 1717, Newton set the exchange ratio between gold coins and silver coins. But under that setting, silver came out slightly undervalued, and just as Gresham’s law would have it, silver coins withdrew from circulation while gold coins remained at the center. Thus Britain, less by clear intention than in the course of events, tilted toward a de facto gold-centered system.

That this became clear in law came in the nineteenth century. By the Coinage Act of 1816, Britain legally established a gold standard with gold as the sole basis. The sovereign gold coin was taken as the standard, and the value of one pound was tied to a fixed quantity of gold. Further, in 1844, the Bank Charter Act (Peel’s Bank Act), enacted under Prime Minister Robert Peel, set in place a system by which the Bank of England issued convertible notes exchangeable for gold. Notes could be turned into gold at any time — this very promise was the heart of the gold standard.

Central Banks and Convertible Notes

Another pillar that supported the gold standard was the central bank.

To guarantee that notes could be exchanged for gold at any time, someone had to serve as the guardian of that promise: to hold, as a reserve, gold matching the notes issued, and to answer with gold whenever people brought notes in. The ones who took on that role were the central banks of each country, beginning with the Bank of England. The central bank held the sole power to issue currency and, keeping a close watch on the quantity of gold reserves, maintained the credit of the currency.

Under this mechanism, the quantity of money was naturally bound to the quantity of gold. A government could not print notes as it pleased. As long as gold served as an anchor, the value of the currency would not fall unrestrained — that was the reassurance the gold standard gave. Prices were stable over the long run, and people, it is said, found it easier to foresee future value.

What the central bank fulfilled was not only the role of guardian of the reserve. When gold threatened to flow abroad, it raised interest rates to hold it back; when the inflow was excessive, it lowered them. This practice of adjusting the quantity of currency according to the comings and goings of gold became the prototype of later monetary policy. Yet the central bank of that time did not, as today, take employment or the business cycle as a direct target. Above all, defending convertibility into gold came first, and consideration for people’s lives was placed within that constraint — a point that should be noted.

The Pound System That Bound the World, and Its Rigidity

In the latter half of the nineteenth century, the major nations adopted the gold standard one after another. As each country’s currency was tied to a fixed quantity of gold, the exchange ratios among currencies also stabilized automatically. From London to New York, Paris, and Berlin — money crossed borders at fixed ratios, and trade and investment grew greatly.

Standing at its center was Britain, which held the hegemony of the world at the time, and its currency, the pound. The City of London became the heart of international finance, and the pound functioned as a de facto international currency. The international gold standard of this age is often called the ‘pound system.’ A common measure called gold bound the world economy together within a single web.

But stability was at the same time rigidity. That the quantity of money was bound to the quantity of gold meant that even when an economy grew and more currency was needed, the currency could not be increased if the gold reserves were insufficient. A flexible response — easing finance in a recession to support the economy — was hard to take. The discipline of the gold standard, it is pointed out, sometimes bound nations tightly and forced pain upon them. Stability and rigidity were the front and back of the same mechanism.

Thus the world of the nineteenth century was bound by a single thread called gold. Notes, bills, and the currencies of every nation all arrived, in the end, at gold. Gold guaranteed the value of money — a point of arrival that humanity reached after a long course of trial and error.

But this intricate mechanism did not promise eternal stability. Entering the twentieth century, two world wars — unprecedented events — drove the finances of every nation to their limit. To cover the enormous costs of war, the chain of gold was stretched, and in time severed. In the next episode, money parted from the backing of gold steps out into a new age.