There are plenty of conspiracy theories in the world of finance, but I happen to find this particular theory quite convincing. Two reasons:
- It actually offers an answer to the question: “Why do we still use the US dollar as our primary trading currency?”
- And secondly, I feel like it explains why we keep accusing America of going to war over oil. The trouble is: each time someone says that to me, I raise an eyebrow. What exactly do we mean by this “go to war over oil” business? Do they mean that America seizes the oil reserves for some American corporation? I’m afraid that’s a fairly glib approximation for something that doesn’t seem to be happening…
But I’m cruising ahead here. Let me set some background (the point of this first post).
The World of Money Until the 1900s
As I’ve mentioned in plenty of previous posts, humans have used gold as money (in one form or another) for centuries. And by “world” I mean Europe and Asia. The other continents were only colonial outposts until fairly recently in the grand scheme of time.
Yes, America. You too.
But this was not the Gold Standard (I’ll get to that in a moment).
It’s also worth pointing out that the use of silver was actually more widespread before the gold from the New World started arriving on European shores. In fact, silver was the first metal used as currency. And in Ancient Greece, the silver Athenian tetradrachm was the first “internationally” accepted currency standard (irony or grim warning?).
The Conversion from Silver to Gold
In the late 1700s, Britain experienced a massive shortage of silver – which meant a massive shortage in silver coinage. After two decades of this coinage drought, the UK embarked on a massive recoinage program (in 1821), introducing gold sovereigns and copper farthings. Finally, in 1844, the Bank Charter Act officially established the Bank of England as the Bank of England, confirmed that Bank of England notes were fully backed by gold, and granted them sole legal tender status. At this point, Britain officially went onto the Gold Standard.
Why am I focusing on Britain? Because British Empire was the world power at that point in time. And the major trading partner to almost all countries. Soon after Britain’s adoption of the Gold Standard, the other nations followed suit.
What exactly is the Gold Standard?
We all talk about the Gold Standard as though it’s obvious what it is – people just used gold to pay for stuff, or something. And as though the Pound Sterling, the US dollar and the Deutschemark were all inventions that only happened after the, um, Gold Standard disappeared (?!). Which is not true at all.
The Gold Standard was (and is) a legal commitment imposed on a country’s Central Bank to convert a single unit of the currency they issued for a certain amount of gold.
So, for example, in the UK the Pound Sterling was fixed at 113 grains of pure gold by Coinage Act of 1816. Another example: in the United States, the US dollar was defined as 23.22 grains of pure gold by the Gold Standard Act of 1900. And because most major trading countries/empires agreed that gold had a universal value, it gave us an implied exchange rate for trade (based on how much each currency was worth in gold grains).
This is great in a perfect world where all things remain the same. But the world is not perfect, so the fixed gold exchange caused problems. In particular, the gold standard meant that a country’s money supply was fixed in relation to the country’s gold reserves (after all, these central banks were all committed to exchanging every single issued pound and/or dollar notes for gold at a predetermined rate).
So if there was a sudden need for more money to pay for stuff, like armaments in a time of war, there was no quick way of borrowing money…
World War I
As World War I began, the gold standard was practically abandoned. Countries printed money in order to finance the war efforts, causing inflation and dramatic shifts in competitiveness.
As World War I ended, most countries then tried to return to the Gold Standard. And for Britain in particular, this failed miserably. Let me try to explain why.
The Crisis of Competitiveness
Generally speaking, economic growth is determined by a country’s capital (resources and financing), its labour force, and its labour force’s productivity. It’s a bit like a factory: in general, hiring more staff will increase production. As will buying new machines that operate more efficiently. And incentivising staff to work faster.
Let’s say that the factory then has a major fire, where machines are burnt, people die, and the labour force that’s left is demoralised. What that sounds like, apart from “disaster”, is that production is about to get really slow.
And what would happen to the factory’s share price? It would plummet to the point where investors consider the share fairly valued in relation to the new (and lower) production potential.
So if we apply that principle to Britain:
- Britain’s resources had been heavily expended on the war effort.
- Britain had lost 2.19% of her population during World War I, with a further 3% wounded in action.
- Most of these losses were young men, meaning that a significant portion of the labour force had been wiped out. And not only this: these would have been the young men producing the next generation of young men.
- And in addition, the labour force that remained still needed to be retrained in industry that was not wartime-related.
- So each of the three factors (capital, labour force and labour productivity) had been significantly affected by the war.
- Meaning that she was not going to be as competitive as she was before it.
Today, if the same thing happened, the world market would echo with the thunder of a thousand million investor feet fleeing from the Pound Sterling in every direction. And as the currency depreciated, Britain’s exports would have become cheaper for everyone else. The currency would have eventually balanced out when the lower productivity was matched by relative “cheapness”.
In other words, if Britain wanted to return to the Gold Standard, then she should have done so at a dramatically weaker exchange rate (like a pound for 50 grains of gold rather than 113 grains) to compensate for her loss of competitiveness.
Only, they decided to do it at 113 grains.
Why, you might well ask? National honour, baby. The US – who’d suffered less relative to the chaos of Europe (only 0.13% of the US population died in the Great War) – had promptly announced a return to their pre-War parity to gold in 1918. And the UK attempted to follow suit – in order to patriotically defend the Pound.
I’d like to go back to the factory and its share price. To recap the metaphor: the factory had a fire, so the share price should be plummeting.
But let’s say that instead, the company turns to you and says:
“No no, there’s nothing to worry about. Before the fire, each of our shares could buy you 100 grains of gold. We believe that it’s our duty to you, our shareholders, to ensure that you still get 100 grains of gold for every share that you hold – regardless of what happens to the factory. Therefore, we are going to keep the share price constant by committing to exchange any shares that you wish for 100 grains of gold each, no questions asked…
“But before you all rush to change your shares for gold, we’d like to ask for your loyalty in return by imploring you not to exchange them, and remembering that if we’re committed to the exchange, and you can exchange the shares at any time you like, then holding the share is exactly the same as holding the gold!”
What would you have done? Personally, I’d have been rushing to the front of the line to get my gold. With encouraging elbows.
So Britain started to experience speculative runs on the Pound (where pound holders would change them for gold). And in 1931, she left the Gold Standard. The USA would follow in her footsteps two years later. And any serious efforts to return to it again were put on hold by the arrival of World War II.
And it’s at the end of World War II where it really gets interesting.
Rolling Alpha posts about finance, economics, and sometimes stuff that is only quite loosely related. Follow me on Twitter @RollingAlpha, or like my page on Facebook at www.facebook.com/rollingalpha. Or both.