Forex: The Golden Age
The classical gold standard was a comparatively brief episode in world history, ending with the outbreak of World War I in 1914.
However, the features were defined in two ways.
A country was considered to be 'on' the gold standard if (1) its central bank pledged to buy and sell gold (and only gold) freely at a fixed price in terms of the home currency, and (2) its private residents could export or import gold freely.
Together, these two features defined a pure fixed-exchange rate mechanism of balance of payments adjustment.
Fixed exchange rates were established by the ratios of the prices at which central banks pledged to buy and sell gold for local currency.
Free export and import of gold in turn established the means for reconciling any differences between the demand and supply of a currency at its fixed exchange rate.
Deficits, requiring net payments to foreigners, were expected to result in outflows of gold, as residents converted local currency at the central bank in order to meet transactions obligations abroad.
Conversely, surpluses, were expected to result in gold inflows.
Adjustment was supposed to work through the impact of such gold flows on domestic economic conditions in each country.
The mechanism of liquidity creation under the classical gold standard was very nearly a pure commodity standard--- and that commodity, of course, was gold.
Silver lost its role as an important reserve asset during the decade of demonetization in the 1870s.
And national currencies did not even began to enter into monetary reserves in significant quantities until after World War I was the pound; its principal rivals were the French franc and the German mark.
But even as late as 1914, the ratio of world foreign exchange reserves to world gold reserves remained very low. The money standard even then was still essentially a pure commodity standard.
After World War I, observers tended to look back on the classical gold standard with a sense of nostalgia and regret--- a sort of Proustian Recherche du temps perdu.
As compared with the course of events after 1918, the pre-1914 monetary order appeared, in retrospect, to have been enormously successful in reconciling the tension between economic and political values.
During its four decades of existence, world trade and payments grew at record rates, promoting technical efficiency and economic welfare.
The image of the 'Golden Age', however, was a myth based on at least two serious misconceptions of how the gold standard had actually operated in practice.
One misconception concerned the process of balance of payments adjustment, the other involved the role of national monetary policies.
The process of balance of payments adjustment was said to have depended primarily on changes of domestic price levels.
The model was that of a so-called 'price-specie-flow' mechanism--- outflows of gold (specie) shrinking the money supply and inflating domestic prices.
National monetary policies, although reinforcing the adjustment process, were said to have been actually concerned exclusively with defense of the convertibility of local currencies into gold.
Central banks were said to have responded to gold flows more or less mechanically and passively, with a minimum of discretionary action or judgment.
They simply played the 'rules of the game', allowing gold flows to have their full impact on domestic supplies and price levels.
Combined, these misconceptions produced a myth of an impersonal, fully automatic, and politically symmetrical international monetary order dependent simply on a combination of domestic price flexibility and natural constraints on the production of gold to ensure optimality of both the and adjustment process and reserve supply.