The Gold Standard
From around 1870 to the outbreak of the First World War in 1914, the prevailing system was the gold standard which was the epitome of the fixed exchange rate system.
All currencies were defined in terms of gold; indeed some were actually made of gold. Each participant country committed to guarantee the free convertibility of its currency into gold at a fixed price. This meant that residents had, at their disposal, a domestic currency which was freely convertible at a fixed price into another asset (gold) acceptable in international payments. This also made it possible for each currency to be convertible into all others at a fixed price. Exchange rates were determined by its worth in terms of gold (where the currency was made of gold, its actual gold content).
For example, if one unit of say currency A was worth one gram of gold, one unit of currency B was worth two grams of gold, currency B would be worth twice as much as currency A. Economic agents could directly convert one unit of currency B into two units of currency A, without having to first buy gold and then sell it. The rates would fluctuate between an upper and a lower limit, these limits being set by the costs of melting, shipping and re-coining between the two Currencies (If the difference in the rates were more than those transaction costs, profits could be made through arbitrage, the process of buying a currency cheap and selling it dear).
To maintain the official parity each country needed an adequate stock of gold reserves. All countries on the gold standard had stable exchange rates.
The question arose – would not a country lose all its stock of gold if it imported too much (and had a BoP deficit)?
- The mercantilist (Mercantilist thought was associated with the rise of the nation-state in Europe during the sixteenth and seventeenth centuries) explanation was that unless the state intervened, through tariffs or quotas or subsidies, on exports, a country would lose its gold and that was considered one of the worst tragedies.
- David Hume, a noted philosopher writing in 1752, refuted this view and pointed out that if the stock of gold went down, all prices and costs would fall commensurately and no one in the country would be worse off. Also, with cheaper goods at home, imports would fall and exports rise (it is the real exchange rate which will determine competitiveness). The country from which we were importing and making payments in gold would face an increase in prices and costs, so their now expensive exports would fall and their imports of the first country’s now cheap goods would go up. The result of this price-specie-flow (precious metals were referred to as ‘specie’ in the eighteenth century) mechanism is normally to improve the BoP of the country losing gold, and worsen that of the country with the favourable trade balance, until equilibrium in international trade is re-established at relative prices that keep imports and exports in balance with no further net gold flow. The equilibrium is stable and self-correcting, requiring no tariffs and state action. Thus, fixed exchange rates were maintained by an automatic equilibration mechanism.
Several crises caused the gold standard to break down periodically. Moreover, world price levels were at the mercy of gold discoveries.
- This can be explained by looking at the crude Quantity Theory of Money, M = kPY, according to which, if output (GNP) increased at the rate of 4 per cent per year, the gold supply would have to increase by 4 per cent per year to keep prices stable. With mines not producing this much gold, price levels were falling all over the world in the late nineteenth century, giving rise to social unrest.
- For a period, silver supplemented gold introducing ‘bimetallism’.
- Also, fractional reserve banking helped to economise on gold. Paper currency was not entirely backed by gold; typically countries held one-fourth gold against its paper currency.
- Another way of economising on gold was the gold exchange standard which was adopted by many countries which kept their money exchangeable at fixed prices with respect to gold but held little or no gold. Instead of gold, they held the currency of some large country (the United States or the United Kingdom) which was on the gold standard.
All these and the discovery of gold in Klondike and South Africa helped keep deflation at bay till 1929. Some economic historians attribute the Great Depression to this shortage of liquidity. During 1914-45, there was no maintained universal system but this period saw both a brief return to the gold standard and a period of flexible exchange rates.
The Bretton Woods System
The Bretton Woods Conference held in 1944 set up the International Monetary Fund (IMF) and the World Bank and re-established a system of fixed exchange rates. This was different from the international gold standard in the choice of the asset in which national currencies would be convertible. A two-tier system of convertibility was established at the centre of which was the dollar –
- The US monetary authorities guaranteed the convertibility of the dollar into gold at the fixed price of $35 per ounce of gold.
- The second-tier of the system was the commitment of monetary authority of each IMF member participating in the system to convert their currency into dollars at a fixed price.
The latter was called the official exchange rate.
For instance, if French francs could be exchanged for dollars at roughly 5 francs per dollar, the dollars could then be exchanged for gold at $35 per ounce, which fixed the value of the franc at 175 francs per ounce of gold (5 francs per dollar times 35 dollars per ounce).
A change in exchange rates was to be permitted only in case of a ‘fundamental disequilibrium’ in a nation’s BoP – which came to mean a chronic deficit in the BoP of sizeable proportions.
Such an elaborate system of convertibility was necessary because the distribution of gold reserves across countries was uneven with the US having almost 70 per cent of the official world gold reserves. Thus, a credible gold convertibility of the other currencies would have required a massive redistribution of the gold stock.
Further, it was believed that the existing gold stock would be insufficient to sustain the growing demand for international liquidity. One way to save on gold, then, was a two-tier convertible system, where the key currency would be convertible into gold and the other currencies into the key currency.
In the post-World War II scenario, countries devastated by the war needed enormous resources for reconstruction. Imports went up and their deficits were financed by drawing down their reserves. At that time, the US dollar was the main component in the currency reserves of the rest of the world, and those reserves had been expanding as a consequence of the US running a continued balance of payments deficit (other countries were willing to hold those dollars as a reserve asset because they were committed to maintain convertibility between their currency and the dollar).
The problem was that if the short-run dollar liabilities of the US continued to increase in relation to its holdings of gold, then the belief in the credibility of the US commitment to convert dollars into gold at the fixed price would be eroded. The central banks would thus have an overwhelming incentive to convert the existing dollar holdings into gold, and that would, in turn, force the US to give up its commitment. This was the Triffin Dilemma after Robert Triffin, the main critic of the Bretton Woods system.
Triffin suggested that the IMF should be turned into a ‘deposit bank’ for central banks and a new ‘reserve asset’ be created under the control of the IMF. In 1967, gold was displaced by creating the Special Drawing Rights (SDRs), also known as ‘paper gold’, in the IMF with the intention of increasing the stock of international reserves. Originally defined in terms of gold, with 35 SDRs being equal to one ounce of gold (the dollar-gold rate of the Bretton Woods system), it has been redefined several times since 1974. At present, it is calculated daily as the weighted sum of the values in dollars of four currencies (euro, dollar, Japanese yen, pound sterling) of the five countries (France, Germany, Japan, the UK and the US). It derives its strength from IMF members being willing to use it as a reserve currency and use it as a means of payment between central banks to exchange for national currencies. The original instalments of SDRs were distributed to member countries according to their quota in the Fund (the quota was broadly related to the country’s economic importance as indicated by the value of its international trade).
The breakdown of the Bretton Woods system was preceded by many events, such as the devaluation of the pound in 1967, flight from dollars to gold in 1968 leading to the creation of a two-tiered gold market (with the official rate at $35 per ounce and the private rate market determined), and finally in August 1971, the British demand that US guarantee the gold value of its dollar holdings. This led to the US decision to give up the link between the dollar and gold.
The ‘Smithsonian Agreement’ in 1971, which widened the permissible band of movements of the exchange rates to 2.5 per cent above or below the new ‘central rates’ with the hope of reducing pressure on deficit countries, lasted only 14 months. The developed market economies, led by the United Kingdom and soon followed by Switzerland and then Japan, began to adopt floating exchange rates in the early 1970s. In 1976, revision of IMF Articles allowed countries to choose whether to float their currencies or to peg them (to a single currency, a basket of currencies, or to the SDR). There are no rules governing pegged rates and no de facto supervision of floating exchange rates.
The Current Scenario
Many countries currently have fixed exchange rates. Some countries peg their currency to the dollar.
The creation of the European Monetary Union in January, 1999, involved permanently fixing the exchange rates between the currencies of the members of the Union and the introduction of a new common currency, the Euro, under the management of the European Central Bank.
From January, 2002, actual notes and coins were introduced. So far, 12 of the 25 members of the European Union have adopted the euro. Some countries pegged their currency to the French franc; most of these are former French colonies in Africa. Others peg to a basket of currencies, with the weights reflecting the composition of their trade. Often smaller countries also decide to fix their exchange rates relative to an important trading partner. Argentina, for example, adopted the currency board system in 1991. Under this, the exchange rate between the local currency (the peso) and the dollar was fixed by law. The central bank held enough foreign currency to back all the domestic currency and reserves it had issued. In such an arrangement, the country cannot expand the money supply at will. Also, if there is a domestic banking crisis (when banks need to borrow domestic currency) the central bank can no longer act as a lender of last resort. However, following a crisis, Argentina abandoned the currency board and let its currency float in January 2002.
Another arrangement adopted by Equador in 2000 was dollarisation when it abandoned the domestic currency and adopted the US dollar. All prices are quoted in dollar terms and the local currency is no longer used in transactions. Although uncertainty and risk can be avoided, Equador has given the control over its money supply to the Central Bank of the US – the Federal Reserve – which will now be based on economic conditions in the US.
On the whole, the international system is now characterised by a multiple of regimes. Most exchange rates change slightly on a day-to-day basis, and market forces generally determine the basic trends. Even those advocating greater fixity in exchange rates generally propose certain ranges within which governments should keep rates, rather than literally fix them. Also, there has been a virtual elimination of the role for gold. Instead, there is a free market in gold in which the price of gold is determined by its demand and supply coming mainly from jewellers, industrial users, dentists, speculators and ordinary citizens who view gold as a good store of value.
Bibliography : NCERT – Introductory Macroeconomics