How Did Gold Become Real Money? Part III

A continuation of the article series started on HVG BrandChannel. Excerpts from Gergely Juhasz's forthcoming book. The published content offers thought-provoking lessons that are relevant to today's challenges as well.

I. The Origins of Modern Finance: Gold and the Birth of the Modern Financial System

The Development of the British Government Bond Market and the Unofficial British Gold Standard

Following the turbulent period after the English Revolution, William of Orange's landing in England in 1688 enabled the relationship between the sovereign and Parliament to be stabilised, establishing the framework of constitutional monarchy on the principle of "the monarch reigns but does not govern." However, public trust in the state was still so low that the costs of ongoing wars could only be financed at very high interest rates and only through short-term loans. The state needed cheap, long-term credit.

The issuance of new long-term bonds was greatly facilitated by a financial innovation. The state granted certain monopolies to privately owned listed companies (1694 Bank of England: banking monopoly; 1698 New East India Company: trading monopoly; and later the South Sea Company, which became notorious as the world's greatest stock market bubble, receiving a South American slave trade monopoly in 1711).

Jonathan's Coffee House, where the predecessor of the London Stock Exchange operated and where not only shares and bonds but also commodities were traded.

Source: wikimedia

The model worked as follows: private capital flowed into the monopoly-holding companies in the form of capital increases; the companies that received this capital then subscribed, in exchange for the monopoly, to newly issued long-term government bonds at low interest rates, typically in the form of perpetual annuity bonds paying a fixed annual coupon, on which the state held an immediate buy-back option.

Investors also benefited, as the share prices of these companies on the secondary market initially climbed ever higher. Since the capital owners typically paid for capital increases with short-term, high-interest government debt instruments, the young capitalist British Treasury was able to swap its expensive short-term debt for cheaper long-term debt, bringing interest rates down from 8-14% to around 6%. However, this was still critical, as the War of Spanish Succession (in which the British participated from 1707 to 1714) required considerable expenditure, and debt servicing reached a revenue-to-interest ratio of 60%, a level close to sovereign default.

British debt service as a percentage of government revenue, 1692-1812.

Source: piketty.pse.ens.fr

Sovereign default was averted through further financial innovation. Since there were still many high-coupon fixed-term bonds in circulation on which the state held no buy-back option, the idea was as follows: the shares of the South Sea Company, founded in 1711, were offered in exchange for the non-redeemable bonds held by investors, in such a form that for every pound of new capital the company could book two pounds of capital increase in its accounts and negotiate the conversion ratio with subscribers. The success was enormous. Almost everyone exchanged their high-yield fixed bonds for the rapidly accelerating South Sea shares. The South Sea Company then subscribed to the state's perpetual, low-interest annuity instruments, which the state could unilaterally repurchase. The deal was personally patronised by King George I and the cream of England's aristocratic, political, and financial elite. But in 1720 the bubble burst and investors who had bought into South Sea stock at high prices suffered enormous losses, many losing their entire fortunes, and the state's reputation was damaged for decades. Nevertheless, the manoeuvre was judged a success from the Treasury's perspective.

Two things gave the system stability: firstly, investors accepted the lower interest rates because they understood that the state had become a far better debtor than before; and secondly, the bonds were convertible at the Bank of England's counters into officially circulating guinea gold coins. Although the bonds were not fully gold-backed, investors felt secure in the knowledge that they could convert them into gold coins at any time.

The story is worth dwelling on at such length because it demonstrates how creative a state can be in managing its debt when that debt reaches a fatally critical level (historically, a debt burden of 200-240% of GDP, or a debt service ratio of 60% relative to state revenues, has proved fatally critical).

The First Fiat Money System Without Gold Backing in Great Britain

The British bond market functioned reasonably well throughout the 18th century, financing increasingly costly wars even as the GDP-relative national debt climbed ever higher (one of the largest outlays was the American War of Independence, 1775-1783, which the British ultimately lost).

However, crisis struck during the war against revolutionary France: the GDP-relative national debt approached 200%, confidence wavered, and when Napoleon's armies captured Mantua in northern Italy and a few hundred French soldiers landed in Wales, panic broke out. The Bank of England was besieged by holders seeking to convert their bonds into gold coin, and conversions were "temporarily" suspended on 28 February 1797, a suspension that lasted nearly 23 years, during which bond prices on the secondary market fell sharply. The era of the unofficial British gold standard thus came to an end and the first well-documented period of "fiat money" - credit money similar to that used today - began (all modern currencies are fiat currencies, i.e. currencies established by government decree).

British national debt as a percentage of GDP, 1690-2016.

Source: Pamfili M. Antipa: Britain's First Experience with Paper Money

Financing the debt became extremely costly, but the temporary abandonment of the gold standard nonetheless gave the British state a military advantage, because it had more money available for waging war than its rivals. Confidence was maintained by continually holding out the prospect of a return to the gold standard; it was even enshrined in law that the gold basis must be restored within six months of the conclusion of peace. The official exchange rate of the gold guinea was 21 shillings, but against the pound banknotes issued by country banks and the Bank of England (whose official value was 1 pound, i.e. 20 shillings), gold traded at a premium. Around 1813 the gold guinea coin was approximately 45% above the theoretical gold content of the paper pound, which led people to hoard gold coins, giving rise to a gold shortage.

A 1810 inquiry committee report concluded that too much paper money was in circulation, which in their view was causing inflation, and recommended a return to the gold standard. The report's other findings are also noteworthy, as they resonate with contemporary problems (savers suffered significant losses in real terms; workers also lost out because wages adjusted to inflation only with a lag; the state, by contrast, gained substantially from the depreciation; and the central bank, i.e. the Bank of England, was providing direct budgetary financing, and so on).

After the Napoleonic Wars ended, consolidation began and there was growing interest in restoring the convertibility of British bonds into gold. The return to the gold standard was not entirely smooth, as prices began to fall and a deflationary period followed, causing severe difficulties. A new currency was needed to replace the guinea that could be exchanged one-for-one against the paper pound (the nominal value of the pound was 20 shillings, while the gold guinea had been 21 shillings since 1717). The gold content of the new currency therefore had to be reduced by approximately 5%. Nevertheless, the currency reform was successful; the gold sovereign, thanks to the British Empire and the volume of gold flowing through London, had a distinguished career and was one of the world's most widely circulated gold coins until 1914, while the British Royal Mint continues to strike it as investment gold to this day.

Queen Victoria's sovereign of 1901.

(22-carat gold coin, gross weight: 7.98 grams, net gold content: 7.32 grams)

Source: Royalmint.com

Following the currency reform begun in 1816, Great Britain officially adopted the gold standard in 1819, which functioned successfully until 1914 and the outbreak of the First World War.

The British succeeded in "growing out" of their national debt, partly thanks to the restored gold backing, partly thanks to innovations in energy and technology, and partly thanks to the immeasurable wealth flowing in from India. Although the nominal debt barely declined, GDP growth was so vigorous that by 1900 the GDP-relative national debt had fallen to below 30%, down from a record of approximately 260% around 1810.

II. The United States and Precious Metal Currencies

Banks and Precious Metal Currencies at the Founding of the USA

Meanwhile, the USA had operated a bimetallic monetary system since 1792, based on the silver dollar and the gold dollar. The value of the dollar was defined in terms of fine silver weight, with 24.056 grams of fine silver equalling one dollar. Fifteen units of silver were equivalent to one unit of gold; the most important gold coin was the 10-dollar Eagle, which contained 16.037 grams of fine gold.

The first official dollar was the "Flowing Hair" silver dollar in the USA.

Source: wikipedia

Banks were regulated at the state level (state banks) and were authorised to issue banknotes and accept deposits. In principle, their banknotes were redeemable against dollar precious metal coins minted by the federal mints.

The First Central Banking Experiments in the USA

In the early years of the USA, central authority was considerably weaker than that of the individual states. However, under the treasury secretaryship of Federalist Alexander Hamilton, who campaigned to strengthen central power, a federal-licensed central bank with branch offices in the main commercial centres was successfully launched in 1791, covering the entire USA. It received a 20-year operating licence, which expired in 1811 and was not renewed after considerable political debate.

War broke out with the British in 1812, so in 1814 the convertibility of banknotes into precious metals was suspended, a situation that persisted until 1817. This wartime period, as in Europe, caused inflation in the USA; banking precious metal reserves were depleted, the banknotes of most banks traded at a significant discount, and a chaotic financial situation emerged.

The First Major Financial Crisis in the USA

The time came to establish the second central bank. The licence for the Second Bank of the United States (SBUS) was signed by President Madison in 1816 after considerable political wrangling. The expectation of the new bank was that it would stabilise the disorganised money markets, but instead the SBUS engaged in very substantial lending, particularly through its western and southern branches. In the increasingly loose monetary environment, land and stock speculation accelerated, and even the "price" of slaves, i.e. physical labour, rose sharply. The bubble grew ever larger and the money supply expanded enormously relative to the banks' precious metal reserves. The bank's president, ex-soldier William Jones, and his successor, lawyer-politician Langdon Cheves, seeing the runaway inflation and sensing that the SBUS itself might go bankrupt, applied the brakes and reined in the SBUS's reckless lending, and began redeeming the banknotes of private banks held among the SBUS's assets for gold and silver coin. The withdrawal of liquidity was catastrophic, and in January 1819, when cotton prices fell 25% in a single day, panic broke out. The sudden tightening led to bank failures and the bankruptcy of farmers, as land values depreciated sharply, banks called in loans to recover their money, and import prices also fell sharply, as prices were also declining in Great Britain at the time, partly due to the return to the gold standard there. Deflation and crisis swept through the entire economy, and the USA experienced the first major depression in its history. As the contemporary William Gouge observed: "The bank was saved, and the people were ruined."

Inflation in the USA and Great Britain, 1816-1914, based on wholesale prices.

(1910-14 prices = 100)

Source: Cooper, Dornbusch, Hall 1982

Return to Decentralisation and Precious Metals

Disillusionment brought new winds to politics. The hard-money "Jacksonians" gained strength, but initially President Andrew Jackson's anti-inflationary policy appeared not to succeed, for largely external reasons. China's appetite for silver was satisfied by the opium export trade, and indeed the flow of silver reversed, with silver remaining in America. Moreover, Mexico began minting overvalued copper coins, so the quantity of silver coins in the USA increased substantially, and people, with partially restored confidence, deposited it in the banks. Thanks to the fractional reserve banking system, bank lending grew even without a reduction in the reserve ratio. Credit was again largely directed towards land speculation, and in 1835-36 the sale of federal lands grew to approximately five times its previous level.

In the summer of 1836, President Jackson issued the Specie Circular, requiring payment for federal lands to be made in gold and silver only, which was the first significant step towards placing government finances on a precious metal basis.

The end of the expansionary credit cycle was most clearly signalled by the Bank of England's interest rate increase in the second half of 1836, and a further deflationary period began until 1844, accompanied by a contraction in the money supply.

Jackson's greatest achievement, by his own account, was breaking the financial hegemony of the Second Bank of the United States (SBUS). Despite the enormous financial power behind the SBUS, he succeeded in ensuring that the SBUS's licence, which expired in 1836, was not renewed. Jackson and his successor Martin Van Buren established the independent treasury system, which existed until the American Civil War. The Treasury operated without a central bank, independent of the banking system. The basis of the budget was the stock of precious metals held in treasury vaults. During Jackson's presidency, by 1837, the entire federal debt was repaid; perhaps this is why, in the second half of the deflationary period from 1836 to 1844, consumption and national output were able to grow.

III. The Great Gold Discoveries and London's Central Role in the 1800s

The Rapid Growth of Gold Mining in the 1800s

In the early 1800s, world gold production was approximately 0.5-1 million ounces per year. Thanks to the great gold discoveries and technological advances, this grew in several waves to approximately 20 million ounces (approximately 620 tonnes) per year by the start of the First World War.

World gold production between 1805 and 1980.

(logarithmic scale, million ounces/year)

Source: Cooper, Dornbusch, Hall 1982

The California Gold Rush

The discovery of gold in California in January 1848 coincided with the USA's territorial expansion at the expense of Mexico, so it is no surprise that within barely a year at least 300,000 people flooded into California from the eastern United States and from every corner of the world.

Hungarians also participated in the California Gold Rush. In the early days, anyone could mint gold dollars in California, and the Hungarian politicians and officers of the War of Independence who emigrated to America after the defeat together with Hungarian companions, Samu Wass and Ágoston Molitor, founded the Wass and Molitor refinery and mint in 1851, which operated with remarkable success despite the difficult conditions.

A "Hungarian" $50 coin from the Wild West, a product of the Wass and Molitor refinery and mint, San Francisco, 1855.

Source: Hungarian National Museum

During this period London's character as a financial centre was further strengthened, greatly aided by the storage of gold, which formed the foundation of finance. The largest gold storage vault was operated even then by the Bank of England.

London's storage capacity, and the London precious metals clearing house that settled precious metal transactions, represented an even larger business than gold refining itself. In 1888, for example, weekly turnover in the London Precious Metals Clearing House was already £100 million, and even this did not require moving physical gold and silver stocks; financial settlement was also carried out without the use of banknotes, through book entries between the parties. By this point the infrastructure had developed that has since given London its distinctive role in precious metals trading, storage, clearing, and precious metal-backed lending.

South African Gold and the Boer Wars

The increasingly vigorous world economy required ever-greater quantities of gold from 1870 onwards, in the era of the classical gold standard, to ensure an adequate money supply. After 1886 news emerged that vast quantities of gold had been found in the Transvaal, then in Boer possession in South Africa.

Gold production in the Witwatersrand basin from 1880 to 2020, in kilograms of fine gold per year.

Source: South African Journal of Science

The British Empire could obviously not be left out of mining money of such value, and so the possession of the Witwatersrand goldfields became one of the triggering causes of the Second Anglo-Boer War (1899-1902), which ended in the defeat of the Boers.

The Alaskan Gold Rush (from 1896), made famous by Jack London, also caused a significant increase in gold supply on the market.

IV. The American Civil War and the Gold Standard Era in the USA

Gold, Greenbacks, and the Launch of the American Bond Market

In 1861 the American Civil War broke out. During the brutal conflict, which claimed close to one million lives, the infrastructure of the southern states was largely destroyed, and when the war ended in 1865 a reconstruction period of nearly a decade began.

The Civil War provided the opportunity for the centralising political will envisaged by Alexander Hamilton nearly 70 years earlier to prevail over the decentralised model of strong individual states. The US financial system was reshaped accordingly. The new order laid the groundwork for the USA's rise to superpower status in the 20th century.

As a consequence of the war, the federal budget went completely "off the rails": the $66 million budget of 1861 had grown to $1.3 billion just four years later.

The Union financed its war costs by beginning to issue the "greenback" dollar banknote in 1862.

As hopes of a quick victory faded, the convertibility of greenbacks into gold had to be suspended in July 1863, and they began to depreciate against gold. Inflation took off, with wholesale prices nearly doubling over the course of the war. Treasury Secretary Salmon P. Chase, aiming to halt the depreciation, sought the solution in restricting gold coin circulation and then sold large quantities of gold to reduce the gold premium against the paper dollar. Despite this, in April 1864 the greenback depreciated further, worth only 56 cents in gold dollar terms. The intervention had to be abandoned to preserve enough gold in the Treasury to cover imports and pay interest on government bonds.

Chase then resorted to a more drastic measure and introduced a bill banning gold from monetary circulation. After its approval, chaos broke out on the market and the greenback exchange rate fell to 40 cents against gold. The law had to be swiftly repealed, and Chase left office to become Chief Justice of the United States shortly afterwards.

Jay Cooke and the War Bonds

By autumn 1862 it was clear that the budget could not be financed by tax increases and greenback issuance alone, and further avenues had to be explored.

Fortunately, there appeared on the scene an extraordinarily ambitious investment banker named Jay Cooke, who founded his investment bank together with his brother, journalist Henry Cooke. The Cooke brothers succeeded in establishing good connections with several influential political figures of the time, including Treasury Secretary Chase, influential Republican congressman John Sherman, and even General Grant. The Cooke brothers' firm ultimately became the exclusive primary dealer for American federal bonds. Since the federal bonds were not convertible into gold, only the yields derived from them were, genuine talent was needed to sell them. Jay Cooke was born for exactly this, having organised a sales network of 2,500 members, including numerous banks that were simultaneously his clients. In the streets and in the press they launched massive advertising campaigns, and they were the first to introduce government bond sales via telegraph. The combination of connections and hard work bore fruit: $500 million of the "5-20" bonds were sold, and in total nearly $2 billion of federal treasury bills and bonds were sold during the war years. Jay Cooke, through his half-percent bond subscription commission, became one of America's wealthiest and most influential individuals.

Centralisation of the Banking System: The National Bank Act

The Cooke brothers and their political network also stood primarily behind the new banking law (National Bank Act), adopted in several stages between 1863 and 1865, which has had lasting consequences, as the processes originating from this law also provided the background for the founding of the Federal Reserve in 1913.

Against the intellectual legacy of Founding Father President Jefferson and President Andrew Jackson, both believers in precious metal backing and a decentralised banking system, the Hamiltonian centralising principle of strong central government finances and the usefulness of a printing press that operates "at the push of a button" prevailed.

The reform of the reserve system was far-reaching. Previously every bank had held its own reserves, with a significant share represented by precious metal reserves. Thereafter the reserves of banks were channelled into a New York-centred reserve system in accordance with three categories of federal licence. The innermost tier of "central reserve city" licensed banks, typically headquartered in New York (with a small share in Chicago and St. Louis), could hold reserves for the second-tier "reserve city" licensed banks, and the reserves of "country bank" licensed rural banks flowed to the second-tier and, indirectly, to the first-tier "central reserve city" banks.

The precious metal (specie) reserves of New York "central reserve city" banks in millions of dollars, 1874-1888, from the 1888 annual report of the US bank regulator (OCC).

(specie: the total of gold and silver coins, treasury precious metal certificates, and stock exchange clearing house gold certificates)

Source: fraser.stlouisfed.org

A portion of the deposits placed with central reserve city banks could be used by other banks as their own reserve holdings, increasing leverage and making the system entirely dependent on the "health" of the centrally positioned banks. The proportional share of precious metals in reserves fell, while the share of US federal bonds grew substantially. As a result, a "built-in" primary market for federal bond issuance was created, and the restructuring of reserve requirements enabled the increased money supply demands of the post-Civil War American economy to be met without a proportional increase in precious metal volumes. This system could easily become inflationary if the centre started the printing presses or increased lending by lowering benchmark interest rates.

The Demand for a Return to Precious Metal Backing in the USA

At the end of the Civil War the greenback was still trading at a discount, worth only 69 cents against the gold dollar. Thus, as reconstruction got underway, the question of converting the greenback banknote and federal bonds back into gold resurfaced (interest on the bonds had been paid in gold even during the war, funded by customs revenues collected in gold). Financial circles that had bought treasury instruments cheaply had an interest in restoring convertibility. However, most of the technological giants of the age (primarily railway and steel entrepreneurs) had no interest in tighter monetary policy, as ample money supply helped keep interest rates lower, enabling them to issue bonds more cheaply. Inflation eroded the real value of their debts, and abundant money supply raised the prices of their shares.

The Coinage Act of 1873

Although the USA was officially on a bimetallic monetary system (both precious metal currencies were legal tender at a fixed and guaranteed 1:16 gold-to-silver exchange ratio), in practice almost only gold coins circulated in payment, because the California Gold Rush of the 1850s had resulted in proportionally far more gold being mined than silver, which had driven silver out of domestic monetary circulation, effectively placing the country on the gold standard. Then came the Civil War and with it financial chaos.

In the early 1870s, however, the tables appeared to be turning. The German Empire began minting gold marks in 1871 from the war reparations paid by France, and it became clear that it would abandon the silver standard.

One of the first imperial gold 20-mark coins, bearing the portrait of Emperor Wilhelm I. The gold coin was struck in Berlin in 1871.

Gross weight: 7.965 grams, fineness: .900, net gold content: 7.168 grams.

Source: ma-shops

It was also foreseeable that newly discovered silver deposits would cause a significant silver oversupply. Worldwide, silver began to be "destocked" and increasing pressure was placed on countries with silver standards or bimetallic monetary systems.

In the USA, before cheap silver could flood the country, the Coinage Act was amended in February 1873 in a rather clever manner by removing the silver dollar from the list of coins that could be freely minted from silver bullion. Thereafter, silver bullion owners and mines could only receive the market price for their silver rather than the guaranteed 1:16 ratio.

The Panic of 1873 and the Depression

Many attributed the Panic of 1873 to the demonetisation of silver, since the transition from silver to gold was deflationary in nature and the contraction of the money supply may have been the pin that pricked the stock market balloon.

In reality, however, the post-Civil War "railway mania" had by this point reached a mature phase on the stock exchanges, and a correction was anticipated in the stock and bond markets that had turned into a bubble. This burst on 10 September 1873, when Jay Cooke's bank collapsed on the New York Stock Exchange. Cooke, despite being one of the world's wealthiest men, had overextended himself. He had wanted to connect his favourite city, Duluth on Lake Superior, by rail to the Pacific Ocean, to make it the primary hub of the Great Lakes region and a rival to Chicago. The construction of the 2,700-kilometre railway line consumed all his capital and, in the tightened liquidity market, no one would subscribe to his railway bonds.

Numerous star securities became worthless and the depression of 1873-77 broke out worldwide (the protracted form of recession accompanied by deflation).

The Gilded Age

After lengthy debate and a four-year grace period, in 1879 paper money and bonds were once again convertible into gold. The USA returned to the gold standard.

Wholesale prices declined on a sustained trend for nearly 20 years, and bond prices on the secondary market rose substantially. The fall in yields came with rising bond prices, and investors who had invested in treasury bonds at the right time amassed fabulous fortunes.

Total precious metal (specie) reserves of all American banks in millions of dollars in 1888, from the 1888 annual report of the US bank regulator (OCC). The precious metal ratio was 6.3%.

(specie: the total of gold and silver coins, treasury precious metal certificates, and stock exchange clearing house gold certificates)

Source: fraser.stlouisfed.org page 257.

The era named the "Gilded Age" after Mark Twain's novel coincided with the British Victorian era, the French Belle Epoque, and the Austro-Hungarian Monarchy's post-Compromise "Happy Peacetime." Productivity grew, wages rose, technological innovations became part of everyday life, and the most beautiful buildings that define urban landscapes were constructed during this period. The world's most significant economies were all on the gold standard, world trade and capital flows became open, and the exchange rates of currencies against each other were fixed in gold.

For these reasons, this era has been surrounded by nostalgia ever since the First World War and right up to the present day.

Treasury gold certificate payable in gold coin from 1882, bearing the portrait of assassinated President James A. Garfield.

Source: wikipedia

Silver Loses Its Monetary Role (Demonetisation)

Silver's exchange rate losses further increased due to the German Empire's switch to the gold basis, causing great pain to those who remained in the game until last. The USA moved in early 1873 (Coinage Act 1873), the Netherlands in 1875, Romania in 1890, and the Austro-Hungarian Monarchy only in 1892 switched to the gold basis, although the desire had already arisen during the negotiations on the 1867 Compromise.

The gold/silver cross rate at the end of the 19th century.

Source: longtermtrends

Note: The conversion of the Austro-Hungarian Monarchy's silver reserves only took place in 1893 through the Rothschild bank. Hungarians had long been pressing for the transition, and the opportunity for more effective advocacy opened up with the appointment of Gyula Kautz as Governor. However, due to the Austro-Hungarian Bank's cumbersome decision-making structure, significant losses had already accumulated by then.

The only brief respite in silver's precipitous decline came from the Sherman Silver Purchase Act passed in the USA in 1890, which the pro-silver lobby (primarily farmers and miners) secured in the legislature with the help of Senator Sherman, creating additional annual demand of 4.5 million ounces of silver through treasury purchases.

Due to demonetisation, silver completely broke away from the natural earth-crust-based (and Sumerian-era) 1:13 to 1:16 exchange ratio and depreciated to a 1:35 gold/silver cross rate by 1899.

V. The Operation of the Classical Gold Standard (1870-1914)

The definition of the gold standard, as formulated by one of the era's most influential researchers, Arthur Bloomfield: The national monetary unit was defined in terms of a certain quantity of gold. The central bank or treasury stood ready to buy or sell gold at the fixed exchange rate of the national currency. Gold could be freely minted (from bullion at the holder's request), and gold coins constituted a significant proportion of circulating currency. Furthermore, gold could be freely exported from and imported into the country.

The Theoretical Foundations of the Gold Standard

The early functioning of the gold standard was illuminated by David Hume's 1752 essay "Of the Balance of Trade", which describes how the free movement of precious metal currencies equalises trade imbalances between countries. The free movement of gold and silver introduces a kind of self-regulating system into trade between nations, as money flows to where more goods can be obtained for the same amount. According to Hume, there is no point in obstructing free trade and no need to fear the outflow of precious metal currency from the home country, as an equilibrium will eventually establish itself.

Another important theoretical insight, the international finance trilemma, holds that a country with an open economy must choose which two of the three concepts at the corners of the triangle to prioritise, as all three cannot be controlled simultaneously.

The international finance trilemma (Mundell-Fleming trilemma).

Source: dtk.tankönyvtár.hu

Gold Points and the Keynesian "Rules of the Game"

During the gold standard era, similar to the modern eurozone, exchange rate stability and free capital movement were applied as conditions of the trilemma, so monetary policy autonomy largely had to be surrendered. The so-called "gold points" - export and import gold points - had to be maintained by the central bank through raising or lowering the discount rate.

In principle, therefore, monetary policy was completely reduced to raising or lowering the interest rate, intended to prevent the unintended outflow or inflow of precious metal reserves by keeping currency cross rates within a tolerance band. Following Keynes (albeit some 30-40 years later), this mechanism and the compelled interest rate response to it were termed the "rules of the game."

The Gold Standard in Practice Among Core and Peripheral Countries

Looking more closely at practice, however, the situation was somewhat different: the gold-based system was not implemented in its entirety, and the "rules of the game" were not applied exactly as theory dictated, because gold standard countries sought to retain as much of their monetary autonomy as possible.

As seen in earlier chapters, the start of the classical gold standard era was not uniform: the British had switched to the gold basis considerably earlier, the USA in 1879, the German Empire and the Netherlands after the Franco-Prussian Wars switched from silver to gold, while the Austro-Hungarian Monarchy, Italy, and Romania joined the gold standard institution considerably later. In Europe, Great Britain, Germany, France, Belgium, and the Netherlands stood at the centre of the countries that adopted the gold basis, while Sweden, Norway, Italy, and the Austro-Hungarian Monarchy were closer to the centre but still considered peripheral countries; further afield were the Balkan countries, Romania, Bulgaria, and Serbia. Not all countries ensured full gold convertibility; for example, the Austro-Hungarian Monarchy did not, which was advantageous during larger market shocks in the gold standard era, such as the 1899-1902 Boer Wars, the 1907 banking crisis, and the 1912/13 Balkan Wars.

M. Morys's 2010 study demonstrated that core countries adjusted their discount rates more frequently and required significantly lower gold coverage than peripheral countries. Gold point violations also occurred less frequently in core countries. Gold standard countries followed different priorities depending on their position. Core countries concentrated on keeping exchange rate bands with each other narrow, while peripheral countries focused on maintaining high precious metal coverage ratios, following somewhat different "rules of the game."

Coverage of banknotes issued by European gold standard countries with gold (average, minimum, and maximum values).

Source: M. Morys, 2010: Monetary Policy under the Gold Standard (English)

Note: coverage was only required for banknotes in circulation, not for deposits held at the central bank. Had the latter also required coverage, the coverage ratios would have been lower than the figures in the table.

The Gold Standard and Inflation

One of the most fascinating questions for posterity regarding the gold standard era is how effective the gold standard was as a tool for protecting against inflation.

When discussing the gold standard institution's effects on price stability, the deflationary impact of the gold basis is most frequently emphasised. The argument of Warren and Pearson regarding the gold standard era holds that prices must rise when the rate of growth in the quantity of monetary gold exceeds the proportional expansion of economic output, and must fall when production grows faster than the quantity of monetary gold.

The widespread adoption of the gold standard coincided with the onset of a very significant deflationary period. In the USA, wholesale prices nearly halved between 1872 and 1896. Although the removal of silver from bimetallic systems and its replacement with the independent gold basis was undoubtedly deflationary, this alone does not explain the deflation that bankrupted so many debtors during this period and served as fertile ground for resentment towards bondholders and financiers. It is likely that a considerably larger role was played by the fact that precisely in 1873 a long-inflating stock market bubble burst, subsequently causing recession and then decades of depression accompanied by deflation.

Interest rates and inflation in the USA during the gold standard era, 1870-1914.

(dotted line: long-term nominal interest rates (forward-looking) based on railway bond yields; solid line: annual change in price level based on the wholesale price index, shown on the right axis; dashed line: backward-looking, annualised real yield on a 20-year investment)

Source: Richard N. Cooper: The Gold Standard: Historical Facts and Perspectives (English)

Note: if someone was bold enough to buy a long-term bond in 1872 at a 7.5% nominal coupon, they could have earned an ex-post real yield of 10.4% on an investment held until 1892, since the price index fell from 130 to 80 in this deflationary period. By contrast, if someone bought a long-term bond at the end of the bond bull market in 1896 and held it until 1916, they would have achieved an ex-post real yield of only 1.2% on a bond with a nominal yield of 4.3%, as the price index had in the meantime risen from 70% to above 100%.

When reviewing money supply factors affecting inflation, it should be noted that the discovery of new gold deposits and the advent of cyanide processing technology after 1890 significantly increased the quantity of gold that could be extracted.

When examining changes in the money supply, it is striking how much faster banknotes in circulation and demand deposits (which were not included in money supply statistics at the time) grew compared to circulating gold; the former approximately two-and-a-half times, the latter approximately five times over the period examined.

Changes in money supply and "central bank" reserves in gold standard countries.

USA, UK, and France ("three countries") and the USA, UK, France, Germany, Italy, the Netherlands, Belgium, Sweden, Switzerland, and Japan ("eleven countries") combined (1885-1928). Values are in billions of dollars.

Source: Richard N. Cooper: The Gold Standard: Historical Facts and Perspectives (English)

In the USA between 1879 and 1913, against a 3.5-fold increase in the quantity of monetary gold, money supply growth (including demand deposits) was 8.4-fold.

It is worth revisiting the more detailed chart of the growth in gold mining output to determine whether the reversal of deflation in 1896 following the 1873 crisis coincided with a surge in gold extraction.

It is true that gold mining output was in dynamic expansion during this period, but it still lagged conspicuously behind the pace of growth of other (credit) monetary forms.

In any case, neither the quantitative growth of gold nor of silver was precisely predictable in advance, making it inherently unsuitable for an automated, algorithm-like equalising mechanism. Nor could this have been realistic at the time, as we have seen that several central banks occasionally prioritised their domestic economic interests over exchange rate stability. Richard N. Cooper made a similar argument in the 1982 Gold Commission debate convened by the US Congress, which debated the controllability of the painful inflation of that era, when he maintained that the gold standard was neither complete nor free from autonomous central bank intervention, as strict adherence to rigid rules would have been politically untenable.