The Classical Gold Standard: How It Worked and Why It Ended

For several decades before the First World War, most of the world’s major economies tied their currencies to gold. Money could be exchanged for a fixed weight of gold, and gold moved between countries to settle international payments. This era, known as the classical gold standard, is often remembered as a time of stable money. The reality was more complicated, and understanding it helps make sense of later debates about gold and central banking.

Britain leads the way

Britain was the first major economy to operate on gold. In 1717, Isaac Newton, then Master of the Royal Mint, set a value for the gold guinea in silver shillings that overvalued gold relative to the market. Silver coins tended to leave circulation, and Britain drifted onto a de facto gold standard during the eighteenth century.

The arrangement was formalised after the Napoleonic Wars. The Coinage Act of 1816 made gold the sole standard of value, and the new gold sovereign was introduced in 1817. Convertibility of Bank of England notes into gold, suspended during the wars, resumed in 1821. Britain’s position as the world’s leading trading and financial power made sterling, backed by gold, the centre of the international system.

The wave of the 1870s

For much of the nineteenth century, many countries were on silver or on bimetallic systems that used both metals. The turning point came in the early 1870s:

• Germany, newly unified, adopted gold in 1871-1873, using the indemnity paid by France after the Franco-Prussian war.
• The Scandinavian countries formed a monetary union on gold.
• The Latin Monetary Union led by France suspended the free coinage of silver in the 1870s.
• The United States moved toward gold through the Coinage Act of 1873, which ended the free coinage of silver dollars, and formally adopted gold with the Gold Standard Act of 1900.
• Japan joined in 1897 and Russia in the same period.

By the end of the century, gold had become the dominant monetary standard of the industrial world. The political fight that this shift caused in America is told in our article on free silver and the Cross of Gold.

How it worked

Under a gold standard, each currency was defined as a fixed weight of gold, which automatically fixed exchange rates between currencies. Central banks and treasuries stood ready to convert notes into gold at that rate.

In theory, the system corrected itself. A country running a trade deficit would lose gold as foreigners demanded payment. The loss would shrink its money supply, pushing down prices and making its exports more competitive, until the deficit closed. This price-specie flow mechanism had been described by David Hume in the eighteenth century.

In practice, central banks, especially the Bank of England, managed the system actively by adjusting interest rates. Raising the bank rate attracted gold from abroad; lowering it let gold flow out. These conventions are often called the “rules of the game”, though historians have shown that they were not always followed.

Strengths and weaknesses

Long periods of falling prices, such as the deflation of the 1870s to the 1890s in several countries, weighed on farmers and debtors. New gold discoveries in South Africa and the Klondike in the 1890s eased the pressure.

1914 and the interwar attempt

The First World War ended the classical era. Warring governments suspended convertibility, restricted gold exports and financed the war partly by printing money. After the war, many countries tried to rebuild the system in a weaker form, the gold exchange standard, in which reserves could be held in currencies convertible into gold, such as sterling and the dollar, as well as in gold itself.

Britain returned to gold in 1925 at the pre-war parity, a decision that is widely seen as overvaluing sterling. The system was fragile and collapsed under the pressure of the Great Depression. Britain left gold in September 1931, and the United States changed its own gold rules in 1933 and 1934, a story told in The 1933 Gold Recall and the Gold Reserve Act.

Legacy

The gold standard never returned in its classical form. A modified link between the dollar and gold survived under the Bretton Woods system until 1971, described in Bretton Woods and the 1971 Gold Window. Gold remains, however, a major reserve asset, as explained in Central Banks and Gold.

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