The History of FX: Part 1
What was the “Gold Standard”?
The Gold Standard was a system under which most countries fixed the value of their currencies to a specified amount of gold or linked their currency to that of a country which did so. Domestic currencies were freely convertible into gold at the fixed price and there was no restriction on the import or export of gold. As each currency was fixed in terms of gold, exchange rates between participating currencies were also fixed.
The History of the Gold Standard
In the early 1800’s money (currencies) consisted of gold, silver or copper coins or bank issue notes. Originally only the UK and some of its colonies were on a Gold Standard, joined by Portugal in 1854.
In 1871, the newly unified Germany took steps which essentially put it on a Gold Standard. The impact of Germany’s decision, coupled with the UK’s economic and political dominance at that time and the attraction of accessing London’s financial markets, was sufficient to encourage other countries to turn to gold.
By 1900 all countries, apart from China and some Central American countries, were on a Gold Standard. This lasted until it was disrupted by the First World War. Periodic attempts to return to a pure classical Gold Standard were made during the inter-war period, but none survived past the 1930’s Great Depression.
How the Gold Standard worked
Simply put it required fixing the value of a country’s currency in terms of a specific weight of gold.
For example, the United States defined one USD to equal 23.22 fine grains of gold or setting a price of USD $20.67 for one troy ounce of gold.
To “economize” on gold reserves after the war, many countries, including Britain but not the United States, stopped circulating gold coins. Instead, these countries instituted a gold bullion standard, under which notes could be exchanged for gold bars. Under the international gold standard, currencies that were fixed in terms of gold were tied together by a system of fixed exchange rates. The fixed relative quantity of gold between two currencies in the system was known as the parity.
The pre-war parity between the dollar and the pound sterling was $4.8665 to 1 pound, but the dollar-pound exchange rate could move in either direction away from the parity benchmark by a small amount to the gold export point, where it became profitable to ship gold to the country with the stronger currency.
In short all currencies were “fixed” to the value of gold. That meant, for example: if you were in the UK and wanted to buy USD you would have to sell your GBP and receive its value in gold at a fixed rate. You would then have to sell your gold to buy USD at its fixed rate to gold.