payment positions among the ‘gold establishments.’ There are a number of
reasons why so few balance of payment difficulties arose during the classic gold
standard. Each will be in turn be given greater detail and analysed comprehensively
before coming to a conclusion on the most significant factor contributing to stable
exchange rates. The balance of payment adjustment is a process supposed to show
trade imbalances cannot last indefinitely and will eventually return to equilibrium.
The price-specie-flow model, David Hume (1752), provides a simplified explanation
of how the adjustment process might have worked during the classic gold standard.
The other view is that the classic gold standard was a managed system. ‘How well
the system was managed’ is a critical question. I shall assess this by looking at how
well European banks abided by the so called ‘Rules of the game.’ What can not be
doubted is that the Bank of England was instrumental in decision making and policy
selection throughout the period of the standard. An alternate hypothesis is that capital
loans levered the standard towards exchange rate stability. By providing countries
with the necessary finances they craved, inter-trade was able to expand rapidly
Balance adjustment is an automatic mechanism that sequentially turns a payment
imbalance (a trade surplus or deficit) into a balance of payment equilibrium.
Numerous models have been used to try and best explain how the adjustment
procedure working during the Gold standard. The most famous is of the 18th century
philosopher David Hume. His price-specie-flow model gives the example of a country
with a trade surplus (exports > imports). Any gold earned through export earnings
will be used by domestic consumers to purchase goods and services. Rising
demand among citizens will lead to a higher average price level in the economy. The
upward movement in national prices now leads to exports falling and imports rising.
Slowly the international competitiveness of the country should diminish and the loss
of specie (gold) results in a return to a balance of payment equilibrium. The opposite
chain of events should occur in the case of a country with a balance deficit.
There is no apparent disparity in the balance adjustment for gold and silver standard
countries. In spite of this, Exchange rate data clearly contrasts the fortunes of the two
monetary systems. From the 1900-1914, the nominal effective exchange rate (NEER)
of the countries on the silver standard ranged from 70 to 115 compared with 96 to
105 for those on the gold standard. A relevant article found that ‘among Latin
American currency regimes and the silver standard bloc, NEER variations often
reached 50% of the respective mean.’ Economists now perceive the
whole process of adjustment not to be as coordinated and seamless under the gold
regime. Besides, differences in the price of exports and imports should have been less
of an issue during the gold standard. The integration of gold prices along with
constant exchange rates enacted an almost global currency. As Eichengreen puts it;
‘once arbitrage creates a tendency for prices to be equated across markets, the
balance-of-payments adjustment process can no longer operate through Humeian
relative price effects.’ With evidence lacking it can be suggested that while a useful
model in theory, the price-specie-flow model failed to work in reality and had little or
nothing to do with exchange rate or for that matter balance of payment stability.
The alternative argument is that the authority the Bank of England held over
financial transactions had a stabilising influence over the global economy.
Eichengreen confirms the widely held view that the Bank of England had ‘the
capacity to exercise leadership in the management of the international monetary
system.’ Using the various policy measures at its disposal, the Bank was able to
reinforce the adjustment process. Interest rates or Bank rates (‘the rate of interest at
which it was willing to discount money market paper’) were increase/decreased in
times of balance of payment deficit/surplus to maintain equilibrium. Interest rates
were raised in times of a deficit in order to curb local aggregate demand and domestic
export expenditure while the simultaneous rise in bank rates increased the inflow of
short-term capital. Yet the thesis that policies introduced by the central bank of
London were mirrored by fellow economies is disputed. Harmonization of policies
would never have had a beneficial effect with countries experiencing diverse
economic conditions. Furthermore, the stability of the world economy was never the
priority for the Bank of England with hardly any meetings occurring between the
main European central banks prior to 1914. The absence of harmonisation and co-
operation over policies might have weakened London’s position as the sole
‘command centre’ of the Gold standard. However, by concentrating on its own
exchange rates, it is possible that the Bank of England indirectly stabilised
international exchange rates.
It was taken for granted that all countries followed sound economic practise when
faced with slowdowns in economic performance (for example, adjust interest rates
appropriately to temper the trade balance). The extraordinary successes of exchange
rates during the gold period toughened this stance. In 1959, an essay by the
renowned economist Arthur Bloomfield, found the ‘Rules of the game’ were not
observed in 60% of cases. The ‘Rules of the game’ was a term coined up by
Keynes. You were not a dissident of the game if monetary polices were regularly
used to reinforce the adjustment process; ‘expanding the domestic monetary base
when gold flowed in and contracting it when gold flowed out.’ Britain itself ‘played
by the rules’ and was the paradigm of sound economic behaviour for much of the
classic gold standard. European central banks were far more lethargic in their
behaviour. ‘For most other countries on the gold standard, there is evidence that
interest rates were never allowed to rise enough to contract the domestic price level.’
However, such is the financial authority borne by the Bank of England that the
fixation of exchange rates was relatively straightforward due to its disciplinary
approach to rules.
An arrangement of short-term capital loans assisted exchange rate stability during
the gold standard. Eichengreen suggests that ‘the gold standard operated smoothly
over a relatively long period of time because capital movements automatically
generated stabilizing demands for good.’ Countries that ran a budget deficit (Russia,
Latin America and the British Empire) made durable claims on the trade-surplus
countries (France, Germany, Holland, Belgium, the US and Britain). Trade-deficit
countries then used capital in their possession to purchase exports from surplus
countries that had financed the transfer of capital in the first place. ‘Hence a capital
outflow, instead of weakening the balance of payments, would be neutralized by a rise
in commodity exports to the capital-importing countries.’ British terms of trade
improved, with Britain exporting large amounts of primary commodities to its
colonies. The rising trade levels accommodated real economic growth throughout the
gold standard region. Hence, both the creditors and debtors gained from the loan
deals conducted under a mainly free-trade gold standard. London again played a vital
role, filling gaps in the system and ‘functioning to some limited extent as a lender of
last resort for the world monetary system,’ when other institutions failed to sign of
loans. In addition, Capital flows through the late 19th and early 20th century
‘significantly reduced the burden of gold flows in the adjustment mechanism.’
Capital was more than an adequate replacement for gold and was utilised as a reserve
asset. Proficient economic performance of the central countries on the gold
standard would have been insufficient for the overall smooth running of the monetary
system. It was sustainable, long-term capital loans to the less outstanding countries
that reduced imbalance adjustment pressures and provided an environment in which
trade could blossom.
I assessed three factors that could have contributed to the stable exchange rates seen
under the Classic gold standard: (1) price-specie-flow mechanism, (2) A monetary
system managed mainly by the Bank of England, (3) Capital loans expanded trade
patterns and prevented any main countries from experiencing an economic crisis. In
an overview of my findings.(1):Too simple a model to apply to real-world examples
Silver standard countries experience of unstable exchange rates not working in its
favour. (2):More likely – Britain was the perfect model of behaviour and this had
a multiplier effect throughout the monetary system. (3): Any slowdowns in the
main countries could have destabilised the whole gold standard and hence
exchange rates – by in effect protecting themselves with the export of capital the
main countries helped promote trade within the standard. In truth, the stability
of exchange rates was probably down to a mixture of (2) and (3) with (1) acting
as a useful if limited economic theory. The superb financial organisation of the
Bank of England and its dominance over the monetary standard served to
enhance the stability of the gold standard. Other countries could rest in the
knowledge that the Bank of England was not likely to go bust any time soon.
Such assurances by the leading creditor of its time along with its capacity to readily
offer bearable loans kept countries faith in the gold standard, which ultimately led to
stable exchange rates
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