How did the world benefit from the gold standard?
The world experienced a dramatic expansion in the volume of trade and economic integration during the first wave of globalization, which took place between 1870 and the start of the First World War in 1914. During this period, the exports as a share of world GDP doubled to 8%, and sustained increases in international flows of goods, capital and labor were observed (Maddison, 2001; O’Rourke and Williamson, 1999) .
In addition, increased economic ties between countries have also resulted in closer integration of markets.
This is reflected in the narrowing of commodity price differentials around the world. For example, the wheat price gap between the United States and Britain has shrunk by 73%, and similar trends are seen for a wide range of commodities, including cotton, iron, copper and coal (O’Rourke and Williamson, 1999).
The wide adoption of the gold standard coincided with the first wave of globalization. Great Britain, the main trading nation at the time, first adopted the gold standard in 1821. Continental European countries, such as France, Belgium, Switzerland and Italy, had all a large part of their circulation in gold (Flandereau, 1996). At the International Monetary Conference held in 1867 in Paris, gold was chosen as the natural basis for global monetary unification (Flandereau, 1996). Many countries quickly followed suit.
In 1913, 48% of the countries of the world officially adopted the gold standard. And these countries accounted for 67% of global GDP and 70% of global trade at the time (Tetenyi, 2019).
Naturally, this leads to an examination of the impact of the adoption of the gold standard on international trade. Assessing the current literature, I come to the following conclusion. While the emergence of the gold standard has certainly promoted international trade by reducing trade costs and increasing capital market integration, the ultimate effect must be nuanced as it is statistically difficult to disentangle endogeneity which is inevitably present in the study of the interaction between international trade and the gold standard.
To begin the discussion, it must be recognized that the emergence of the gold standard led to the trade boom seen in the first wave of globalization by lowering the cost of transaction.
Jacks, Meissner and Novy found that 44% of the increase in trade was attributable to a reduction in transaction costs (2010). Moreover, most of the fall in trade costs, especially for France and Britain, was concentrated between 1870 and 1880. This was a period when the international community increasingly adhered to the standard -gold (Jacks et al., 2010). Based on the Jacks et al. model, the emergence and adoption of the gold standard represented a 3.6% decline in trade costs (2010).
The reduction in the cost of trade can be explained by the reduction in exchange rate volatility. If both trading partners are on the gold standard, the exchange rate between their currencies becomes virtually fixed. This eliminates the exchange rate risk that international traders face. This constitutes a significant part of the transaction cost given the efforts required to manage this risk. As Jacks et al. demonstrated, there is a statistically significant and positive correlation between the cost of trade and exchange rate volatility (2010).
While a simple single-digit percentage reduction in the cost of trade may seem negligible, it can have a significant positive impact on trade volume given a high elasticity of substitution.
In fact, a country pair on the gold standard traded 30% more than country pairs on other currency regimes (Lopez & Meissner, 2003). To further illustrate the significant impact of the gold standard on international trade. Lopez and Meissner constructed a model that shows that the volume of world trade would be 20% lower between 1880 and 1910 if no country adopted the gold standard (2003). While the robustness of these results will be examined in the next part of this essay. It can be concluded that there is a general consensus in the literature that the gold standard had a non-negligible positive impact on international trade during the first wave of globalization.
In addition to increasing the volume of trade, the adoption of the gold standard hastened the integration of the capital market.
By adhering to the gold standard, countries signaled monetary prudence and credibility to investors. This allowed them to lend at a more favorable rate (Bordo & Rockoff, 1996). Obstfeld and Taylor found that countries that adhered to the gold standard could lend at a discount of 30 basis points on average compared to countries under other monetary regimes (2003). The “good stewardship seal of approval” has also enabled peripheral countries to access loan capital from international investors. Especially those from Western Europe (Bordo & Rockoff, 1996). This development, the facilitation of international capital flows, was eventually made possible by the adoption of the gold standard.
Although the literature seems to offer a compelling narrative regarding the impact of the gold standard on international trade. It is not as effective in removing endogeneity in statistical analysis. For example, in the Lopez & Meissner study, the authors acknowledged that there are limitations to their results (2003).
The correlation between the adoption of the gold standard and the increase in the volume of trade probably contains endogeneity and therefore does not constitute a causal relationship.
A potential explanation could be that countries have strong economic preconditions. And increasingly strong trade ties with other gold-standard countries are more likely to adopt the gold standard. And therefore, the increase in trade volume after adoption is not solely the result of the gold standard. But simply a continuation of existing trends. They also acknowledged that the sample size of the data used to derive their result was limited.
Although they attempted to establish the causal relationship by applying instrumental variable estimation. The choice of the instrumental variable is controversial. In order to support the claim that 20% of the increase in world trade between 1880 and 1910 was the result of the emergence of the classical gold standard, Lopez & Meissner chose the ratio between the gold reserve and money in circulation to instrument for a country’s adoption of the gold standard (2003). One can wonder whether this instrument only affects the level of economic integration through the adoption of the gold standard.
A large gold reserve could be a direct result of strong economic integration and liberal trade policies, which facilitate a larger inflow of gold.
Alternatively, a large gold reserve could signal robust monetary conditions. And therefore attracts deposits and investments from international investors with a low appetite for risk. Moreover, Lopez & Meissner also recognized that they were not able to reject the null hypothesis of endogeneity by applying the test of Hausmann (2003).
In conclusion, the emergence of the gold standard has undoubtedly favored international trade. Due to lower trade costs and improved capital market integration. However, it is difficult to eliminate endogeneity when examining the complex interplay between the emergence of the gold standard and international trade. And results that attempt to quantify the impact will be assessed with a grain of salt.
How did the world benefit from the gold standard?
Written by Tiger Guo
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How did the world benefit from the gold standard? The references
Bordo and Rockoff (1996). “The Gold Standard as a ‘Good Stewardship Seal of Approval’ The Journal of Economic Historyy, 56 (2): 389-428.
David Jacks, Christopher M. Meissner and Dennis Novy, “Trade Costs in the First Wave of Globalization” (2010) Explorations in economic history flight. 47 (2) p. 127-141
Flandreau (1996). “The French crime of 1873: an essay on the emergence of the international gold standard, 1870-1880” The Journal of Economic History56 (4): 862-897.
Lopez and Meissner (2003). “Exchange Rate Regimes and International Trade: Evidence from the Classical Gold Standard Era” American Economic Review93 (1): 344-353.
O’Rourke, K., & Williamson, J. (1999). International capital flows: causes and consequences.
Obstfeld and Taylor (2003). “Sovereign Risk, Credibility and the Gold Standard: 1870-1913 versus 1925-1931” Economic review113 (487): 241-275. Tetenyi, Laszlo, 2019. “Trade, Misallocation, and Capital Market Integration,” IWH-CompNet Working Papers 8/2019, Halle Institute for Economic Research (IWH).