Treasury Today Country Profiles in association with Citi

The gold standard

Close up of gold

What do Alan Greenspan, Ron Paul and Robert Zoellick have in common? All three are calling for a return to the gold standard, in one form or another. And although the system fell out of favour over 60 years ago, volatility in foreign exchange means alternatives to the current system could gain popularity. This article looks at what the gold standard is and what its implications for treasury could be.

Various exchange rate mechanisms have been tried over the years, leading to the – largely – floating currency system favoured by most developed economies today.

The basic principle behind a gold standard system is that each participating country fixes the price of its domestic currency in line with a set quantity of gold. That means money, whether physical or electronic, can be converted into gold at that set price. As several countries participate in the system, each tying the price of their currencies to gold, those currencies are in turn exchangeable at fixed rates.

The gold standard links money supply to the quantity of gold available. As two countries trade, any balance of trade imbalance can be settled by the transfer of gold, affecting the supply of money in each country, changing their prices and reducing that imbalance. Similarly, central banks set interest rates in reaction to trade imbalances to stabilise the money supply – raising interest rates in time of balance of payments deficits, attracting gold and stemming the overall outflow, for example. The aim is to keep price levels stable, ensuring the effective exchange rate remained as stable as the fixed official rate.

History

England was effectively operating on a gold standard from 1717 and, following an interlude around the Napoleonic Wars, formally moved to the system in 1819. The USA, meanwhile, fixed the price of gold at $20.67 per ounce in 1834, again formalising the system at a later date, in 1900. Other countries followed – by 1870 Portugal, Turkey, Brazil and Australia had also joined the gold standard; many more moved to the gold standard by 1880, including France, Germany, the Netherlands and Switzerland; and by 1900 most major economies across Europe, South America and parts of Asia and Africa had joined the mechanism. Each nation which adopted a fixed exchange rate thus fixed the rate of its currency against every other participant.

The period from 1880 to 1914 is often described as the ‘classical gold standard’. The First World War put an end to that, however, as governments involved in the conflict resorted to printing money to finance their vastly increased expenditure. The price of gold floated in many countries – in the UK, for example, the price of an ounce increased from £4.24 to £5.65 between 1918 and 1920. The sterling price fluctuated until the gold standard was re-adopted in 1925, close to its previous rate at £4.27 per ounce.

This return to gold was not to last. Countries which had devalued currencies relative to the pre-war exchange rate tended to prosper more than those, like the UK, which kept the old rate at the expense of reduced competitiveness of their industries. Re-adoption of the gold standard in the 1920s was widespread. However, due to factors including the Great Depression and an overvalued sterling, Britain left the gold standard once more in 1931. Most participants followed suit and dropped the practice in the first half of the 1930s, the move away from gold allowing depreciation and so an export boost to their struggling economies.

Towards the end of the Second World War the Bretton Woods system was established under which participating nations were pegged to the US dollar. The dollar was then itself fixed against gold. This lasted from 1944 until the US abandoned its gold peg in 1971. The dollar became seen as a reserve currency in itself, with many countries using it as a peg against which to fix their own domestic currencies, again with varying levels of success.

The benefits

The first and clearest advantage to corporates of a gold standard system is the elimination of a large portion of FX risk when trading with participating nations. Though prices may change internally, prices in contracts signed in a foreign currency will not change in value against the domestic currency before the money is delivered.

Treasury Today’s European Corporate Treasury Benchmarking Study 2010, in association with J.P. Morgan, found FX risk was the most important area of risk management for 39.1% of treasurers, a far larger proportion than for any other risk. Removing a large element of that risk clearly reduces the burden on the treasurer and allows a greater focus on the many other tasks the department carries out.

Chart 1: Upon which area of risk management has your treasury department MOST focused on over the past 6-12 months?
Chart 1: Upon which area of risk management has your treasury department MOST focused on over the past 6-12 months?

Source: Treasury Today’s European Corporate Treasury Benchmarking Study 2010, in association with J.P. Morgan

Chart 2: One ‘gold’ mark = ‘Reichs’ mark 1918-1924
Chart 2: One ‘gold’ mark = ‘Reichs’ mark 1918-1924

Note: One ‘gold’ mark value in grammes of fine gold (1913) = 0.35842g; ‘Reichs’ mark = currency not tied to the gold standard in 1918 to 1924.

Source: Law about the Revaluation of Mortgages and other Claims (Revaluation Act 1925), issued 16th July 1925 (Aufwertungsgeseiz, Reichsgesetzblatt, Teil 1, 1925, p.133-135) and author’s calculations.

Wider macroeconomic effects also pass down to the treasurer. When the gold standard was at its most effective, before 1914, inflation was low (around 0.1%) and stable. This reduces other risks for treasury – particularly those which are cash rich and need to protect holdings’ value. The contrast with current inflation in countries like the UK, or the stagflation of the 1970s, is particularly stark. Even when a country is the only one backing its currency with gold, it stops the government adjusting the money supply by printing money or devaluing the currency in other ways, thus creating stability.

That certainty and consistency passed onto the bond market. Adoption of the gold standard gave credibility to countries approaching the global capital market, and made the terms of any issuance more favourable. Indeed, researchers at the University of California believe up to 30 basis points were shaved off a country’s borrowing spreads thanks to adherence to the gold standard (spreads at the time were measured against British consol rates). This benefit was particularly strong in more peripheral economies, though it is uncertain as to whether or not this apparent increase in stability led to a reduction in capital market funding costs for corporates.

Disadvantages

In purely practical terms, reverting to the gold standard would be enormously problematic – insufficient gold is actually in existence to match the amount of US dollars in circulation, let alone any other currencies on top of that.

Proponents of a return to the gold standard frequently point out that it is only confidence in a currency which lets it hold its value, and claim that a solid commodity, like gold, backing the currency makes it stronger and less likely to lose value. However, confidence is also required in a gold-backed system. Certainty of commitment, through the gold standard, might have helped governments raise money cheaply before 1914, but that did not hold true in the 1920s. The aforementioned Californian researchers found other factors became more important in determining debt interest levels – most notably the level of national debt and being a part of the British Empire. That is, gold had lost its power to convince investors of the guaranteed value of the currency. Once that is lost – and it may be a hard task to gain that trust initially anyway – the maintenance of a currency at a fixed price against gold becomes more difficult.

Another issue on the confidence side is that of other monetary policies – current orthodoxy suggests increasing the money supply during an economic downturn is beneficial, and the constraints imposed by a gold standard would hamper any such efforts.

Similarly, the apparent inflation-controlling powers of the gold standard are not all they first seem. Inflation may have averaged less than 0.1% in the years before 1914 but – in the UK, at least – actually fluctuated significantly around that mark. Further, prices were not stabilised from 1925 to 1931 but in fact fell at an unsteady rate, suggesting the gold standard does not automatically maintain price levels. However, it must be remembered that this period was initially one of slow growth in many non-US countries, and the Great Depression followed, so it is far from a ‘typical’ period in terms of stability from which to draw conclusions on the gold standard’s effectiveness.

The fixing of exchange rates in any way has its downsides, predominantly in the lack of flexibility. When an economy with a floating exchange rate performs poorly a depreciating currency cushions the blow by making its goods cheaper relative to those of other countries. That provides an export boost. When currencies are fixed – either with the gold standard, Bretton Woods or the Euro – this is not possible. Under the Bretton Woods system countries including Britain devalued their currencies when pressures became too great. That results in sudden shock moves, however, rather than the more gradual and fluctuating shifts reflecting demand and supply for the currency that we see under the current floating regime. Problems are building in the Eurozone with countries like Greece and Portugal struggling, when they would simply devalue as one part of recovery if they were not in the fixed structure of the euro. If a gold standard was to be adopted now as widely as it was in its prime, countries like Brazil and China could find their exchange rates locked in at very low rates, stopping the rise of the currencies and providing a competitive advantage. However, that could result in either regular re-valuations – eliminating the certainty which is one of the major advantages of the system – or the gold standard collapsing as countries leave once more.

A possible future

Of course, some in favour of a gold standard might only care if their own currency – say, the US dollar – was to be backed by gold. Ron Paul, for example, believes the dollar’s position as reserve currency of choice would be preserved through the backing of gold. This might give more stability in terms of the money supply. However, that would not bring the traditional benefits of certainty of exchange rates. Also, if it did slow the devaluation of the dollar it could stop the US becoming more competitive internationally.

Nonetheless, the return of inflation in some parts of the world alongside uncertainty over quantitative easing has seen a resurgence of interest in theories around ‘hard’ currencies which is unlikely to disappear in the short term.

Discussion of – and, in some circles, enthusiasm for – a return to the gold standard and fixed exchange rates should not lead treasurers to believe it is likely to happen and so abandon FX hedging strategies – though they should be aware of the nature of those discussions.

Chart 3: 1900 – 2011 exchange rates
Chart 3: 1900 – 2011 exchange rates