Foreign Exchange Markets Summary Essay

An edifying instance of a system of fixed exchange rates, and certainly debatably of a monetary union, is the classical gold standard. This had its zenith after the partial collapse of attempts to extend the Latin Monetary Union, and had an astonishingly short life. The collapse of the gold standard is an imperative instance of a ‘disunion’.

As explained in Chown 1994, the UK had legitimately been on a silver standard since Newton’s recoinage of 1696, however with the growth of trade, gold became the more significant circulating medium. A Committee on Coin, one of many during the century, was set up in 1787, although before it reached any conclusion, the Napoleonic Wars intervened, and the British adopted an inconvertible paper currency: reform of the coinage had to wait.

Action was taken in advance of the 1821 Resumption of Payments, and the UK initiated a formal gold standard in 1816. The sovereign was described as 123.27447 grains of standard 22 carat gold that is 113.0016 grains of fine gold: silver was given a submissive status. Silver coins, legal tender for no more than £2, were intentionally struck underweight. At market prices a pound of silver was worth 61 shillings however was struck into coins worth 66 shillings, a purposeful action to avert silver coinage leaving the country. This gave some margin against a fall in the ratio which was, in the event, adequate, however merely just, to survive a period of rising silver prices which lasted until about 1870.  (Dilip K. Das, 1993).

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Portugal adopted a gold standard in 1854 and Canada in 1867, although the international gold standard merely really came into being when Germany adopted gold in 1873, incidentally sealing the fate of bimetallism, and bringing in other countries for example the USA (1879), Austria-Hungary (1892), Russia and Japan (1897). Several large countries were never members. The system broke down in 1914, with a short-lived revitalization between the wars.  (Dilip K. Das, 1993).

Gold and silver currencies had of course a much longer history, although the history incorporated numerous debasements, and it was merely with the quite general introduction of free minting in the19th century that travelers and traders could securely assume fixed parities. Under the classic gold standard, every participating country’s coinage was described as a specific weight of gold, banknotes were convertible into gold, and also there were no restrictions on converting bullion into coins and vice-versa. A sovereign, or a US gold eagle, was just a denomination of gold as, in 1999, the deutschmark and the French franc were technically denominations of the euro.

The ‘automatic’ mechanism was easy in concept, and had indeed been described by David Hume in 1752. Assume a participating country suffers an ‘asymmetric shock’ and for that, or any other reason, internal prices rise. Given that the exchange rate is fixed, the change in relative prices means that its exports fall, and its imports rise, causing a balance of trade deficit which outcome in an export of gold, which means that there is a decline in the quantity of money in circulation. Domestic demand falls, forcing down prices and wages, until a new equilibrium is reached, although at a lower level to take account of the real economic loss from the shock. (Dilip K. Das, 1993).

            This might appear brutal however balance of trade deficits could as well be financed, again automatically, by capital movements. In the above circumstances tight money would, as part of the process of reducing demand, force up interest rates, as well as these higher rates would attract capital from other, unaffected, countries – provided that market participants assumed that exchange rates would stay stable, and that the deficit country would not default. Short-term fluctuations could be financed in this way, although countries with deficits ensuing from unsound or extravagant internal policies would be left to meet the problem by a sharp and salutary internal deflation.

There are abundance of examples to illustrate that it did not always work like that however in principle the consequence of the gold standard was to uphold equilibrium, and purchasing power parity, by forcing internal prices down or up in response to changing circumstances.

In the more modern world fixed exchange rates, with inconvertible fiat money, can merely be maintained if governments take purposeful action to rouse or restrain internal demand in response to balance of payments surpluses or deficits. As this history shows, sometimes they did, and sometimes they didn’t, however the key difference between the 19th and 20th centuries is that, for whatever reason, it turned out to be very difficult in fact to lessen money wages. An event which would in earlier times have caused a mild recession plus a reduction in wage levels would, in the changed circumstances, cause huge unemployment and a depression on the 1930s scale. The old adjustment process had ceased to work efficiently, and a more flexible exchange rate regime started to look attractive.

A gold standard, or certainly any further commodity standard, does not, as its more enthusiastic advocates sometimes claim, guarantee stable prices. For prices to be stable, the effective money supply needs to grow in line with the size of the economy, neither more nor less. The stock of gold grows yearly as new gold is mined; however the rate of growth depends on gold discoveries. The gold brought home from South America by the conquistadores sparked off inflation in Spain, with grave long-term damage to that country’s economy. Throughout the last couple of centuries, the world’s economy has been increasing, and if gold had remained the merely accessible money, there would have been a strict and unbearable limit to economic expansion: a deflationary bias. During the 19th century there were significant gold discoveries, although more notably the growing use of banknotes and bank deposits meant that money, generally defined, became a high and rising multiple of the gold stock.

The gold standard thus did not offer the perfect solution, either to the problem of stable prices or that of how trading nations regulate their economies to changing conditions, but had, in the eyes of many, one great advantage. It kept one set of economic decisions out of the hands of politicians.

Without a doubt, one of the great debates on money over the years has been ‘rules versus discretion’: a government which has the power to influence monetary conditions and to keep money supply adjusted to the varying needs of trade and commerce can attain much, if it uses that power intelligently. It can as well cause great damage if it does not recognize that power, or uses it only to attain short-term political advantage or to patch up an urgent problem, and history, together with very recent history, has too many instances of both to give us much comfort. Even a benevolent and wise government may well discover that the issues are too subtle, and the data required too unreliable, for them to be sure of doing more good than harm.

The proper price for gold is one that permits reinstatement of the gold standard without creating inflation or deflation. No one actually knows the correct price, which can be found merely in market equilibrium.

Gold has certain individuality that makes it extremely desirable as a substitute for certain currencies, however without the problems peculiar to a particular nation. The ensuing demand shifts could make the price of gold rather unstable, since the quantity is comparatively fixed. Under a fixed exchange rate system, this would be less of a problem. However in today’s world of flexible exchange rates, with the price of gold free to fluctuate, finding the proper gold price is certainly difficult. Throughout a period of high inflationary bias and doubt regarding future inflation, the price of gold exemplifies a risk premium. Therefore, the market price of gold in such a period would be higher than it ought to be were a gold standard to be restored at that time, and going on the gold standard at such a price could involve large inflation risks. In the same way, too low a price would carry considerable deflation risk.

History offers numerous instances of the effects of mispricing gold. For instance, when Britain returned to the gold standard in 1925, it chose a price of gold consistent with the general price level of 1914. This directed to deflation and unemployment, a circumstances no longer satisfactory to modern policy-makers. Likewise for the United States, during the War Between the States, the huge issuance of paper money after the gold standard was abandoned caused the doubling of prices. Afterward, awaiting the succeeding restoration of the gold standard at the prewar price, the country was put through a huge deflation to “bring policy under control” as a precondition to returning to gold. (Marc Flandreau, Owen Leeming, 2004).

The actual stock of gold held by the Bank of England was comparatively low during the period when Great Britain maintained the world gold standard. Present-day stocks are owned mostly by individuals, with the rest held primarily by central banks in Western countries. Table below presents the estimated gold holdings in the world. Central banks outside the United States have around twenty-four percent of the world’s gold. Private holdings constitute almost fifty percent of the world’s gold stock, either in bullion form or in the form of jewelry. The U.S. government holds nearly ten percent of the world’s gold stock, definitely an amount adequate to carry out the functions necessary to maintain a gold standard.

TABLE: Estimated Gold Holdings

Central banks other than U.S.
23.9%
Private bullion holdings
23.6%
Jewelry, decorations
22.7%
U.S. government
9.4%
IMF and other international institutions
7.0%
Soviet Union
2.1%
China
0.5%
Undetermined or lost
10.8%
(Marc Flandreau, Owen Leeming, 2004).

The amount of gold in existence is significant merely relative to the price that is set for the gold. What in fact matters is the stock of gold relative to new supply, given the chosen price. In actual fact, the present stock of gold is enormous relative to new supplies that could come on stream. The foremost producers of gold in the world are the Soviet Union and South Africa. However if the Soviet Union produced gold at full potential for the next hundred years, the productivity would equal the current holdings of the U.S. Treasury. The supply of new gold will come out gradually, as the price of gold changes relative to prices of other commodities and to the relative cost of gold production. Certainly, the prospect that considerable deposits of new gold will be discovered is a risk associated with going on a gold standard. (Marc Flandreau, Owen Leeming, 2004).

References:

Chown, John (1996). A History of Money, Routledge: London, 1994, paperback edn

Dilip K. Das (1993). International Finance: Contemporary Issues; Routledge

Marc Flandreau, Owen Leeming (2004). The Glitter of Gold: France, Bimetallism, and the Emergence of the International Gold Standard, 1848-1873; Oxford University Press