The Case for A Gold Currency: Part 1

By Jai Khemani

Jai recently got 2 A*s and an A in his A levels and is now looking forward to university. Jai is particularly passionate about political economy and a believer in laissez-faire capitalism. The less government the better! His main interests in Economics are Healthcare, monetary, public finances and business cycle theory. He adheres to the Austrian School of Economics, with Ludwig Von Mises and Murray Rothbard as personal favourites.  Jai is currently interning at The Cobden Centre and is working on some interesting economics projects.

The gold standard is a system where the nation’s money supply is determined by the supply of gold that is mined. Over time we have had different types of gold standard economies and countries have even suspended the gold standard during wars (e.g.: WWI). Until WWI the world had the international gold standard. Under a gold standard, paper money like $ and £ are not money- they are simply substitutes for a specific weight of gold.

History of Gold:

Mankind has used gold for thousands of years as money. However, the modern gold standard system is the most important.

International Gold Standard system (1870-1914) (Classical Gold Standard)

This was when money was redeemable for gold and there were few interruptions. This was the most stable monetary order in the history of gold. Every major currency such as the £, US$ and Franc were all redeemable for gold. Gold was the real money. £ is simply a name to define a weight of gold. Under this system, exchange rates were fixed based on how much weight of gold equalled 1 unit of currency. £1 was 1/4th of an ounce and $1 was 1/20.67th of an ounce, resulting in an exchange rate of $4.86/£.

In the long run, the money supply growth was extremely limited. Money supply could only grow if the amount of gold mined was increased. As a result, this made the value of money very stable. For example, after the 1848 California gold rush, inflation averaged 1.5% per year (according to Larry White), but as the amount of gold mined slowed, then there was gentle deflation. The net result is that between 1800 and 1900, the price level fell slightly. The reason is because as saving and investment increase and technology improved, the output of goods and services grew faster than the money supply, resulting in deflation. However, since 1971, when Nixon ended Bretton Woods, the dollar has lost 82% of its value.

Unfortunately, the order was destroyed when WW1 broke out. Unfortunately, between 1914 and 1933, the world never transitioned back fully, resulting in a disorganized monetary order. By 1933, the Europeans abandoned gold and the U.S changed the value of gold from $20/ounce to $35 and banned all private ownership of gold. All gold had to be turned over to the Treasury.

Price Specie Flow Mechanism:

This mechanism existed during the classical gold standard. Under the classical gold standard, the money supply was rigid and was only subject to change if more gold was mined. However, there were many cases where countries printed more banknotes and more money in circulation than the gold supply. This would not last and hence the system would correct via the price specie flow mechanism. The mechanism would correct balance of payments deficits and also resolve situations where a county’s exchange rate is overvalued or undervalued.  In today’s economy, many people think China is deliberately under-valuing the Yuan. Under the PSFM, the Chinese would experience either an inflow or outflow of gold, until the Yuan accurately reflected its true value. Consequently, ‘currency manipulation’ would be impossible.

Imagine there is x amount of gold in the UK and x amount of £. The Bank of England one day decides to print more £ to finance war or deficits or create a boom so that the government can get re-elected. The increase in supply of £ relative to the amount of gold will cause UK prices to be higher than the world prices. This makes UK exports more expensive, reducing the UKs exports and making balance of payments negative. As a result, the deficit leads to an outflow of gold, UK banks will be forced to reduce the money supply as they have a contractual obligation to redeem £ for gold. This will once again reduce prices, thereby reversing the artificial boom. As a result, printing your way to prosperity would not last long. This brings us to the next part: business cycles.

Bretton Woods System (1946-1971)

After WW2, the U.S established itself the dominant economic power. Thus, the Bretton Woods agreement was born. The US$ would be convertible for gold. 1 ounce was $35. Citizens and banks could not own gold. Gold could only be convertible at an international level, between central banks and foreign governments. Exchange rates were fixed but this time, the £ was convertible for US$ not gold. As a result, the whole system was pyramided on top of $, not gold like in the 1880s.

The Bretton Woods system eventually collapsed, mainly because the U.S abused its position. The first problem with the BW system was that the price specie flow mechanism was unable to operate. If the U.S ran large balance of payments deficits then inflation would be exported to other countries. Take a French exporter. If the U.S imported from the French, dollars would outflow into France as opposed to gold. As a result, the French were flushed with US$. Given that French people used Francs, it meant that the French central bank had to print Francs to then convert the huge amount of $. As a result, supply of Francs in France went up, pushing prices up, while Americans got cheap goods. This worked as long as foreign governments were happy to hold and accept $, which they did for a while.

However, the Europeans began to lose patience with America in the late 1960s. In the late 1960s, the U.S printed $ rapidly to pay for Vietnam and the Great Society, leading to a huge inflow of $ into Europe, pushing European prices upwards. As a result, foreigners were subsidizing the U.S. Eventually, as the US’s foreign liabilities far exceeded the gold stock, the Europeans demanded their gold back. Instead of stop printing gold, Nixon ended convertibility in 1971.

Gold Standard Would Encourage Savings and Prevent Inflationary Booms

Interest rates are determined by people’s desire to save or consume. The market interest rate would be based on people’s time preferences. A lower time preference would indicate that people have more desire to save as opposed to consuming now. This increases the supply of loanable funds and hence lower market interest rate. This, in turn, allows other people to borrow more money for capital investment. This results in more investment on long-term projects and hence allows the supply of more goods in the future. As there is more saving, it means there will be more consumption in the future and hence the capital investment is justified.


  1. However, when the central bank increases the supply of money and increases the amount of available in the loan market, it reduces interest rates. This would make it seem that there is an increase in ‘delayed consumption’ and hence more funds for investment.
  2. Businessmen are misled into thinking that there is a large amount of savings that will be spent in the future.
  3. Therefore, capital investment and investments into ‘’longer processes of production’’ (higher order goods) all increase. Hence the capital structure is lengthened.
  4. Businesses take the newly acquired funds and bid up the prices of capital and hence shift large amounts of investment from consumer goods to capital goods.
  5. This marks the boom period of the business cycle. The large investments made in capital goods stimulate more employment in these industries. This is known as ‘Malinvestment’.
  6. These long-term projects are erroneous as the demand was never there and hence the investments are abandoned. Asset prices begin to fall and labour that was employed in these capital goods industries are now unemployed. The bust period now begins.
  7. It is capital goods industries that suffer the most in the economy.
  8. Asset prices fall, consumer confidence falls, more labour becomes unemployed and economic growth slows and more business and households enter bankruptcy.
  9. The bust also includes the liquidation of the malinvestments and hence a reallocation of capital in the correct proportions (according to consumer preferences). This is the readjustment process. The greater the misallocation, the more violent the readjustment process. This marks a recession.

The key takeaway was that central banks expanded the money supply. Under a 100% gold standard without any increase in the supply of gold, the money supply cannot change. Hence to expand credit and capital investment, saving in the economy must increase. As a result, a 100% gold standard economy would force economic growth to be achieved through saving and capital investment as opposed to consumption, which may only stimulate the economy in the short run. This increase in productive capacity means that growth can occur without hurting future growth and hence makes credit bubbles much less severe, as the ability to expand the money supply and trigger an inflationary boom is limited.


Business cycles Pre-1914 vs Post 1914:

Before WW1, the international gold standard system was in place, where every major power made their currencies redeemable for gold and stuck to it. Post 1913, the gold standard was suspended regularly.

The most severe recessions during the gold standard was between 1913 and 1919, culminating in the 1920 depression as well as the 1920s boom, which culminated in the 1930 recession. The boom and bust pre 1913 were small in comparison.

The Roaring 1920s:

During the 1920s the world was still on the gold standard, unfortunately, the total money supply grew faster than the supply of gold. This is shown by the fact that the total money supply increased from $44.7bn to $71.8bn between 1921 and 1929 (Rothbard, America’s Great Depression) despite an only 15% increase in the total gold reserves. One reason is that the absence of a full, 100% reserve gold standard allowed a more than proportional increase in the total money supply. The main cause of the U.S inflating its money supply was the UK. Before WW1, the £ was valued at $4.86, however after WW1 its market value was only around $4. However, Churchill in 1925 returned to the pre-war parity, making the sterling overvalued. Though the UK suffered from high unemployment throughout the 1920s, the Federal Reserve partly remedied the situation by inflating the U.S money supply, thereby stopping the price-specie flow mechanism. As a result, the US inflated its money supply, generating a stock market and housing bubble. Between 1921 and 1929, the Dow Jones Index grew by 436%.

1920-1921 Depression:

In 1913, the Federal Reserve was created and in 1917, the export of gold was banned, gold reserves were held by the Fed (central bank) and private banks issuing money was heavily taxed. In effect, after 1913, the Fed suspended the gold standard and monopolized money. The Fed reduced reserve ratio from 21% to 9.8%.  As a result, between 1913 and 1919, the money supply doubled, triggering a large asset bubble. For example, between 1915 and 1919, the Dow Jones Industrial average rose by 92.8%. The boom eventually ended, culminating in the 1920 depression, which swiftly ended when Harding/Coolidge were elected. The reason why the doubling of the money stock did not generate such a large increase in the stock market is because the money was instead used to fund capital machinery used for building war supplies.