The gold standard: an engine for more economic growth?

From Gerd Kommer  and  Felix Großmann  

In the five years since 2018, gold has delivered attractive returns. This fact and the widespread skepticism among many gold supporters towards conventional “FIAT money currencies” [1] leads to the not uncommonly heard claim that under the historic gold standard (which ended in the 1920s) the key economic variables would have looked better than under today's “paper money currencies”. The thesis that the gold standard is advantageous does not apply to perhaps the most important of all economic performance indicators, long-term economic growth. On the contrary: the gold standard seems to have slowed down economic growth at the time. To show this, let's take a short excursion into global currency history.

A Brief History of Monetary Systems

The Industrial Revolution began around 250 years ago around 1770. It began an incredible increase in global economic growth, household income and the life expectancy of the average citizen compared to the previous 2,000 years.

In 1717, around 50 years before the start of the Industrial Revolution, Great Britain (GB) became the first country to introduce a de facto national gold standard. In 1821 the introduction also took place de jure. [2] Nevertheless, the currency in the majority of western countries was silver-based until around 1872. The main reason for the dominance of silver as a precious metal backing for national currencies before the 1870s: then (as now) there was significantly more mined silver than gold on earth. The decision-makers therefore believed (and perhaps rightly so) that silver was more likely than gold to avoid an economically undesirable, deflationary shortage of coins in the country.

In 1872, the newly founded German Empire decided to switch from a silver-based to a gold-based currency. This change of a large, rapidly growing economic power that had recently won the Franco-German war, [3] In the years that followed, it motivated many other countries to switch from a silver-based to a gold-based currency standard. The reason was the “network effect” – it was easier to trade with other nations if you used the same currency standard as them, thereby eliminating exchange rate risk for everyone involved.

This is how what we now call the “classic gold standard” came into being. Its period of existence is generally given as 1873 to 1914. “Classic gold standard” means that the state set a fixed rate in a law between the national currency (the legal tender) and an ounce of gold and that the owner of a “money certificate” (e.g. a bank note) had the right to exchange it for physical gold at a bank at the legal rate, i.e. to buy gold. This physical gold belonged to the state in question itself or to its central bank, which itself was a de jure or de facto state appendage. [4] However, it would be a mistake to believe that all countries under the classic gold standard would have 100% of the paper money in circulation covered by gold reserves. The actual reserve ratio was often significantly lower and in some countries fell over time.

Even before the classic gold standard, currencies were backed by precious metals (predominantly silver), but the legal, political and infrastructural setup was less standardized and less uniform. True central banks in the current sense of the term did not yet exist in most countries, there was no legally fixed exchange rate for precious metals and, in addition to the central government, there were often other issuers of currencies backed by precious metals in a country or region.

Important in this context: From the beginning of the 19th century, currencies increasingly circulated no longer in the form of coins, but - as they were economically more efficient and more convenient - in the form of paper notes and in the form of Change [5] as well as bonds.

At the beginning of the First World War, the major economies withdrew from the classic gold standard that had previously dominated the world by repealing the right to exchange the national currency for gold at the legally fixed rate with the state. This was initially only intended as temporary suspension However, it later turned out to be final in almost all cases. The USA was the last major economy to end gold convertibility in 1933. The triggers for the end of the classic gold standard between 1914 and 1933 (depending on the country) were the budget deficits and debts from the First World War and - for the USA - the Great Depression from 1929 to 1937.

Why did the classic gold standard die between 1914 and 1933?

A precious metal-backed currency system (EM system) ultimately makes it impossible for a country to increase government spending quickly and significantly in a crisis situation, because the state cannot increase the money supply free of charge in an EM currency system for obvious reasons, as it would have to purchase new additional precious metal for each newly printed bank note. This expensive hurdle does not exist in a paper money or FIAT money system.

During the First World War, however, many countries wanted or had to quickly and noticeably expand their spending. For the USA, the First World War was not yet a major government spending problem, but the country (President Roosevelt) wanted to finance a gigantic government infrastructure program in 1933, the “New Deal”. Its aim was to combat unemployment, which had skyrocketed since 1929, and the resulting bitter poverty.

Again, it would be a mistake to assume that the removal of an EM standard from 1914 onwards (whether backed by silver, gold, gold-silver or another metal combination) was a new phenomenon. Throughout the history of EM-backed currencies since the introduction of paper banknotes, there have been repeated temporary suspensions of the official EM backing of a currency and it was always unclear at the beginning how long the respective suspension would last. The trigger was often a war or civil war, for example the abolition of the gold and silver convertibility of the US dollar from 1861 to 1879 on the occasion of the American Civil War (1861 to 1865). After the end of this suspension, the national currency (the banknotes) was generally worth less in gold because the money supply in circulation had meanwhile increased more than the national economic output and/or the government gold reserves that served to cover it - a form of inflation under the gold standard. Given the history of currencies in many countries, the recurring short-term cancellations or suspensions of EM standards must be viewed as a structural feature of EM-backed currency standards.

Another perhaps even older “plague” of EM-backed currencies over 2,000 years of monetary history was the manipulative reduction, the stretching of the precious metal content of coins. Debasement) by the sovereign institution that issued the currency or by private gangsters. Debasement naturally also leads to a loss of money value and inflation.

The reserve ratio (gold coverage ratio) was changed again and again in the classic gold standard and before that in the silver standard and the ratio was often not exactly known to the public because the state did not want it. An example of this was the undisclosed gold coverage ratio in the USA during the Bretton Woods system from 1944 to 1971 (more on this below).

Occasionally one encounters the claim in non-scientific publications on the gold standard that consumer goods inflation cannot exist under it. In Great Britain, inflation from 1732 to 1931 (200 years until the end of the EM standard in GB) was 0.41% p.a. Although inflation was low on average, it was clearly above zero. Cause: The above state and private manipulation as well as the banal fact that global gold production as well as a state's gold reserves did not grow sufficiently parallel to the amount of goods and services in circulation over time.

At the same time, EM-backed currencies repeatedly experienced deflation, which was harmful to economic growth and household incomes. The most famous case was the period from 1927 to 1933 of almost 40% cumulatively in the USA.

A strangely little-known evil of precious metals standards is that the year-to-year variation in the inflation rate is higher than under a FIAT money standard, with a simultaneously lower average inflation rate. Fluctuating, unsteady inflation undoubtedly also has negative effects on the economic activity of companies and households, i.e. the national economy. Low volatility in the inflation rate is likely to have a negative impact on the real trend growth of the economy.

All in all, currencies backed by precious metals suffered from “three notorious plagues”: (1) In times of emergency, the state could not expand the money supply in the short term. This made crises and their damaging impact on unemployment and household incomes deeper and longer than they needed to be. As governments realized this from World War I onwards, they suspended the EM standard in times of crisis. (2) EM-backed currencies lead to strong deflation at times, although on average they produce an inflation rate close to zero. Deflation clearly has a negative impact on economic growth and worsens the depth and duration of economic crises. (3) Annual inflation - although low on average - fluctuated more under the gold standard than under a FIAT money standard.

The curious intermediate phase of the Bretton Woods system

As the Second World War neared its end and the beginning of a “new world order” loomed, in 1944 44 Western countries made what we now know was a final attempt to save the classic gold standard. This international agreement was later called the “Bretton Woods System” after the American town where the political conference to sign the agreement took place. In this system there was only one country whose currency had a fixed gold ratio (and therefore only one country that had to hold corresponding gold reserves) - the USA. All other Bretton Woods member states simply had to keep the exchange rate of their currency to the US dollar within a relatively narrow corridor. There were no obligations for a specific gold reserve ratio on the part of the USA.

Whether the BW system could really be described as an “international gold standard” remains to be seen – perhaps more as a “watered down gold standard”. In any case, the system collapsed in 1971 after a relatively short 27 years when the United States, under President Nixon, suspended the gold peg of the US dollar unilaterally and without consultation with the other member states. Looking back, it can be said that the Bretton Woods system suffered from incurable birth defects, which are described in the Wikipedia article on it (here). Its failure should therefore come as no surprise. The specific trigger for its abolition was the strong expansion of American government spending and national debt in previous years, not least in connection with the Vietnam War, which intensified from around 1965. The USA did not counter-finance the increasing supply of dollar money with sufficient purchases of gold because that would have been too expensive.

The Unsuitability of the Gold Standard in the 21st Century

In general, it can be concluded from the monetary history of the past 200 years that the gold standard or another EM standard would be dysfunctional for a country - whether a democracy or a dictatorship - in the 21st century simply because it would make it impossible for that country to quickly expand the money supply to stabilize the economy in a serious crisis - for example if the country is attacked by a foreign aggressor and therefore has to sharply increase its military spending in a short period of time. The same applies, of course, to other types of exogenously caused crises, whether natural disasters, pandemics or severe economic recessions.

Some gold fans put forward the curious theory that there would be fewer wars under a gold standard. That seems far-fetched. That the gold standard would prevent an aggressor from initiating a war of aggression against a small, weak opponent is absurd for obvious reasons. In the case of a large adversary (and therefore potentially higher war-related financing requirements on the part of the aggressor), the gold standard would simply be suspended by the aggressor until further notice. History provides enough examples of this.

Economic growth under the gold standard and FIAT money standard

So we now know that in the centuries up to the 1920s, precious metal-backed monetary systems existed worldwide with only rare restrictions and/or short interruptions. This was followed everywhere by replacement by FIAT money systems. A relatively short but only partial exception was the Bretton Woods phase, in which only one country, the USA, had a gold-backed currency (albeit without a fixed coverage ratio) and a minority of the remaining 195 countries in the world tried to keep the exchange rate of their national currency relative to the dollar somewhat constant.

Another myth spread directly and indirectly, explicitly and implicitly by many gold fans on the Internet is that economic growth was higher under the gold standard than under the FIAT money standard. In the following table we illustrate that this is not true using the two countries Great Britain and the USA.

Table 1: Development of real economic growth per capita in Great Britain and the USA from 1845

► Inflation-adjusted increase in gross domestic product per capita. ► Data: www.ourworlddata.org

The table shows that the economic growth of these two countries was substantially higher in the FIAT money period (period 2) than in the precious metal period (period 1). The advantage of Period 2 is further strengthened if one excludes the 27-year Bretton Woods phase (a watered-down gold standard).

Why did we choose 1845 as the start of this growth comparison? Primarily because we wanted to evaluate two periods of equal length. If one had chosen the alternative periods 1821 to 1933 or 1879 to 1933 for period 1 (1821 was the starting date for the classic gold standard in the UK, 1879 in the USA), the basic numerical relationships in the table and the conclusion formulated above would not change.

What did this situation look like in other countries? To test the generalizability of our two-country observation in Table 1, we additionally performed an almost identical calculation for a larger group of 18 countries (excluding the US and UK) for which sufficient data was available, albeit data that is less granular and presumably of lower quality. [6] The main result of the calculation for the larger group was identical: per capita GDP growth in Period 2 noticeably exceeded that in Period 1.

One reason why history books and many practitioners' publications overstate economic growth in the 18th and 19th centuries relative to economic growth in the 20th and 21st centuries is the common mistake of looking at the growth of the entire economy instead of per capita growth. In the long term, no single factor influences the growth of an economy as much as population growth. Fortunately for our planet, population growth in Western countries slowed down sharply in the 20th and 21st centuries and has always varied greatly across different countries, [7] However, an objective, fair comparison of growth between two longer periods or between two countries is only possible on a per capita basis. In addition, per capita figures generally express better than overall economic figures how the well-being of the average citizen is changing.

You can see from the numbers in Table 1 mandatory deduce that the switch from the gold standard to the FIAT money standard between 1914 and 1933 was directly responsible for the subsequent increase in economic growth? Of course not. The global economy is too complex for that and, in addition to monetary policy, too many other factors impact economic growth at the same time. Nevertheless, in our view, the comparison in Table 1 is a strong indicator that the gold standard slows down economic growth and that a FIAT money standard does not necessarily have this disadvantage.

In this context, it must be mentioned that the greatest economic and political catastrophe of the past 200 years - the Second World War - occurred in Period 2 and that the speed of technical progress, at least as measured by groundbreaking inventions, tended to decrease after 1950 relative to the 100 years before. [8] So Period 2 had no obvious “unfair advantages” that promoted economic growth.

Conclusion

Precious metal-backed currencies were the global norm for a thousand or more years until the first quarter of the 20th century. There were only local or short-term exceptions to this norm. Around 1870, gold replaced the previously dominant silver as the most important precious metal for currency hedging purposes - the “classic gold standard” began. In the 19 years from 1914 to 1933, the gold standard was ended country by country in the wake of the First World War and the Great Depression that began in 1929. The gold standard experienced a temporary “mini-return” from 1944 to 1971 in the form of the Bretton Woods system.

If it could be proven that the gold standard or another precious metal standard had a beneficial effect on long-term economic growth, that would be a pro-gold standard argument worth considering. However, our consideration suggests that such proof fails even at the highest and simplest level of analysis shown here.

The likelihood that the gold standard will be reintroduced into a major economy in the foreseeable future is microscopic. It would not be helpful for the global economy, but would probably be harmful. This may be one of the reasons, although not the only reason, why there is no evidence of a majority in favor of reintroducing a gold standard anywhere - not among politicians, not among university economists, not among financial regulators and least of all among central bank decision-makers. Probably not in the populations of Western countries either.

Gold has not been a currency for over 90 years and probably never will be again. Today, gold is purely an investment, with the special feature that gold - unlike stocks, bonds and real estate - does not generate cash flows and therefore has no fundamental or intrinsic value/price that can be derived from its income. Unlike normal raw materials, gold also has no significant commercial use. [9] However, its 6,000-year history and tradition as an investment object and currency basis appear to be a sufficiently convincing reason not to generally ignore it as an investment.

Since the price of gold has been determined freely by supply and demand on the world market and gold has essentially been freely available to everyone - since 1975 - its real return has been significantly lower than that of stocks and at the same time higher volatility. [10] Nevertheless, due to its low correlation with stocks, bonds and real estate, the precious metal can play a role in a diversified portfolio as a moderate addition for convinced investors. We will go into gold as an investment in detail this blog article a.

Endnotes

[1] FIAT = Latin for “may it be”. With a normal FIAT currency (also called “paper money”), unlike the “classic gold standard” described here, there is no claim against the state to exchange a monetary unit (a “banknote”) for a specific amount of gold at any time.

[2] The distinction between de facto and de jure is important here. The de facto introduction of the gold standard in Great Britain in 1717 was based on a curious mistake by the great Isaac Newton, who incorrectly fixed the legal gold-silver rate in Great Britain while a de jure gold-silver standard still existed. At this point, Newton was “Master of the Mint,” an office that today could roughly be equated with a mixture of finance minister and central bank chief.

[3] France was the aggressor.

[4] Even though the owners of the central bank in some countries at that time were still private banks, the de facto ownership role lay with the state. This was ensured by laws, supervisory authorities and the right to appoint managers.

[5] Bills of exchange are non-exchange-traded, short-term promissory notes of a company that are structured so that they can be easily and quickly exchanged for cash at a bank. Until the 1970s, bills of exchange were a widespread form of short-term debt financing for companies worldwide.

[6] These 18 countries are: Australia, Austria, Belgium, Canada, Chile, Germany, Denmark, Spain, Finland, France, Italy, Japan, Netherlands, Norway, Peru, Sweden, Uruguay

[7] In many western countries the population is now shrinking. Demographers predict that the world population will also begin to decline before the end of the 21st century.

[8] See the article “Timeline of historic inventions” in the English Wikipedia.

[9] If you ignore jewelry as only a quasi-commercial use.

[10] In all major Western countries and in all socialist countries there were decades-long bans on private gold ownership in the 20th century: in Germany from 1923 to 1955, in the USA from 1933 to 1975, and in numerous countries even after 1975. Failure to comply usually resulted in draconian penalties.

literature

McWilliams, David (2024): “Money – A Story of Humanity”; Simon & Schuster; 2024; 400 pages

Meissner, Christopher (2002): “A New World Order: Explaining the Emergence of the Classical Gold Standard”; October 2002; in: The Journal of Economic History; 61; Issue 2; 2002

Eichengreen, Barry (2019): "Globalizing Capital. A History of the International Monetary System"; 3rd Edition, Princeton University Press, 2019, 298 pages