Gold as Monetary Arbiter – Modern Monetary History

By Michael Taylor, October 14, 2018

Basil Valentine, Practica cum duodecim clavibus in Musaeum
hermeticum reformatum et amplificatum (Frankfurt, 1678)

Michael Taylor looks at the evolving role of gold and how central banks have (mostly) learned that in the absence of the discipline of gold, their principal job is to protect the financial stability which alone confers value on scrip money.

Even very late into the Renaissance, alchemists laboured in their quest to transmute base materials into gold. That they laboured, and labour in vain, tells us something about the quality of gold which made it for so long an embodiment of value: while it could be exchanged for almost anything, there were no combinations of anything else that could be changed into gold. So it is, perhaps, no coincidence that one of the age’s pre-eminent scientists who also pursued lifelong alchemic projects, was also in charge of the UK’s mint, in charge of striking Britain’s gold coins.

That basic assumption of gold’s uniqueness and incorruptibility meant that for many countries, it emerged as the foundation upon which monetary and financial systems rested, until late into the 20th century.

But in Europe and the US it long shared this role with silver, with gold used for the most valuable currency, and silver for smaller value coins. Crucially, the exchange rate between gold and silver was assumed to be constant, and the monetary systems which evolved around it were instances of ‘bimetallism. For long periods in which the new supply of both was small and changed only irregularly, this was a good enough approximation. But the tensions inherent in bimetallism were never fully resolved, and in Europe, attempts to cope with them were formalized in 1865. with the birth of the Latin Monetary Union. Under this scheme, the founding members (France, Switzerland, Belgium, Italy) the exchange rate for silver and gold were fixed uniformly in each member country, with the coins issued able to be used in any member country. But it had flaws: in particular, it laid no boundaries for the number of small silver coins that could be struck, or the amount of government debt paper which could be issued, presumably convertible into gold.

Not surprisingly, countries facing fiscal difficulties – chief among them Italy – used these shortcomings to their own advantage, striking large numbers of silver coins, and issuing large amounts of supposedly convertible paper debt, and in doing to flooding the French market with silver, while bringing home gold. Wrangling between France, which kept demanding that Italy’s government made good the nominal promise that its public debt would ultimately be convertible into gold, and Italy, which in retaliation kept threatening to quit the Latin Monetary Union and thus confirm the devaluation of its government paper, was a familiar and recurrent feature of the latter part of the 19th century. As the French will, of course, not currently be thinking: ‘Plus ca change.’

Bimetallism was ultimately a victim of the Franco-Prussian war of 1870/71, as Germany demanded payment of reparations from France of 5 billion gold marks. Germany promptly used to demonetise silver in Germany, and while it adopted the gold standard, further vast supplies of silver flooded into the French market, in exchange for more gold. Within Germany, the cashflows fuelled a speculative bubble which helped feed the giant bust of 1873, which ushered in a global deflation which lasted until 1896.

The last quarter of the 19th century thus saw the slow and agonising disintegration of the Latin Monetary Union, and the rise of the gold standard.

In the US, bimetallism also effectively died with the 1873 Coinage Act, which, however, stopped short of formally outlawing silver’s role in legal currency. However, the de facto adoption of the gold standard intensified the deflationary forces let loose by the financial crash of 1873, and by 1896 (ironically, the year in which the late-19th century deflation abated) Democratic Party presidential candidate William Jennings Bryan was railing about farmers, debtors and Westerners being crucified on ‘a cross of gold’.

The slow death of bimetallism ushered in the age of the gold standard, which rapidly morphed into a de facto Sterling standard. The UK government had suspended metal convertibility for the duration of the Napoleonic Wars, finding itself more easily able to those wars via the guaranteed liquidity of active money markets than the more vulnerable supply of physical gold. Emerging victorious from the Napoleonic Wars enabled the UK to put Sterling back on the gold standard, but this time with the added benefit of fully-developed money market backing. Throughout the 19th century, this combination of purported convertibility and the world’s most liquid money markets helped London emerge as the world’s financial centre. For all practical purposes, the gold standard had turned into the Sterling standard.

The outbreak of World War One did for that, as the closing of the London money markets led to a demand for convertibility of Sterling assets into gold – a demand which it was quite impossible to meet. The de facto Sterling standard laboured on after the war, but with the UK’s wealth drained away in WW1, it was rightly seen as unsatisfactory. However, far more unsatisfactory were attempts by leading economies during the 1920s to re-adopt the gold standard at pre-war rates. The attempts were made because convertibility into gold was seen as a necessary condition to re-establish credibility in financial markets. As we know, the subsequent depressions did far more damage to financial confidence than could ever have been won by the appeal to gold.

In Japan, the attempt did worse than that. Japan’s attempt to re-capture international financial credibility after the post-World War 1 collapse in its terms of trade, and the financial scandals which were part of the backwash of the Tokyo Earthquake of 1923 eroded first trust in its financial institutions, then its major corporations (caught of gold-smuggling) and quickly its political class. Meanwhile, by the early 1930s, starvation was stalking the countryside of a nation that at the end of World War 1 had been Asia’s representative in the fully-developed world. From there the trajectory was of the military eclipsing the country’s political institutions, and initiating the attempted conquest of China, which in retrospect marked the real beginning of the World War 2.

In the dying days of WW2, it was understandable that no repeat of that experience could be tolerated, and a meeting in Bretton Woods attempted to construct a new structure for international finance, in which an international bank (the IMF) could issue notional currency (the Special Drawing Right), which would act as an economically more ‘rational’ source of monetary issuance than the vagaries of the global mining and prospecting industry. The architecture was impressive, and some of it survives today, but the dominance of the US in economic, financial, diplomatic, military, technological and political terms ensured that it was the dollar which inherited the role of the reserve currency.

As with the earlier Sterling standard, the dollar was notionally still convertible into gold, albeit that this was a necessary ‘consensual hallucination’. Eventually, however, under the strain of financing both the Cold War, and more specifically the Vietnam War, the uncomfortable grey light of dawn began to erode this consensual hallucination, and in 1971 President Nixon bowed to reality, removing the convertibility of the dollar. The gold standard was dead, an in its place the world began to run directly on the gold standard, underpinned by another hallucination – that of the reliable benevolent wisdom of the Federal Reserve’s Open Markets Committee (FOMC)

Like so much else in this story, the consequences were not understood at the time. At the FOMC meeting of December 1971, the committee was busy discussing what sort of guide might be possible to replace the failed certainties of the gold standard. The transcripts of that meeting are available. Let us read them: ‘Any settlement reached now might be considered to be an ‘interim’ arrangement in the sense that an element of guesswork was involved in deciding what pattern of rates would prove viable. More generally, it was reasonable to hope for agreements in the near future on the US gold price, on a new pattern of exchange rates, on wider bands, and on arrangement need to enable the IMF to function. How the question of convertibility would ultimately be resolved was in doubt at this point: all kinds of opinions were being advanced. Presumably, some provision for convertibility would be made when a longer-run reform of the international monetary system was agreed upon’.

However, while the FOMC was in full spate fretting about how to put monetary Humpty Dumpty back together again . . .  ‘Chairman Burns said he would interrupt the discussion to read a news report just received over the ticker. The report read as follows: ‘President Nixon and French President Pompidou have agreed on the need for a prompt realignment of exchanged rates through a devaluation of the dollar.’ ‘In cooperation with other nations, they agreed to work towards a prompt realignment of exchange rates through a devaluation of the dollar and revaluation of some other currencies’.

It took at least a decade for the lesson to be learned that no such arrangement would endure in the absence of a gold anchor. Since then, central banks have (mostly) learned that in the absence of the discipline of gold, their principal job is to protect the financial stability which alone confers value on scrip money. With the colossal monetary failure of the Great Financial Crisis and the subsequent stresses in the Eurozone, it seems likely even that lesson will face serious revision.


The Author: Michael Taylor is Founder and Director of ColdWater Economics Ltd, a UK-based consultancy offering macro analysis and advice for both institutional investors and hedge funds in the UK, US and Asia.

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