Why did countries abandon the Gold Standard?


A historical look at why Britain, at the time the center of the banking world, abandoned the Gold Standard. After WWI, it became harder for Britain to deflate its economy and incomes to compete in the world export markets and this nullified a key mechanism by which the Gold Standard operated. Eventually a run on the British pound caused the Bank of England to go off the Gold Standard.

Videos to watch before

What restrictions did the Gold Standard impose on member countries?
How did the Gold Standard benefit world trade?
How did the Gold Standard limit gov’t spending?
Why did the Gold Standard control inflation so well?
Why did the Gold Standard make it hard to create jobs?
Why did the Gold Standard cause economic shocks to transmit quickly?



“In this video we are going to talk about the experience that some countries had with the gold standard and why they eventually chose to leave. We are going to focus in this segment on Britain from 1900 to 1935. Each of these graphs you see to the left [Slide 1] shows some statistics about Britain over that time period. On the top left here we have the unemployment rate from 1900 to 1935, which ranges from a low of about 0% to a high of over 20%. On the top right we see the value of pounds in gold. If you had one British pound this tells you how much gold could you get in return for it and so as this graph goes down it means that you can get less gold in return for your pound, meaning the pound is becoming less valuable in terms of gold. On the bottom left over we see the interest rate that is set by the Bank of England and this ranges from a high of about 7% to a low of 2%. Finally on the bottom right we have the wholesale price level in Britain, which ranges from a low of about 10 to a high of about 25. This wholesale price is basically a measure of the price of numerous goods and services in the economy and will give us a sense for what the inflation rate was in Britain at a particular time.”

“I am going to put some markers to this graph to show you when World War I began and ended [Slide2]. The first line you see shows when WWI started in about 1914 and the second line shows when it ended in 1918. When we look at the period before the war, there are a couple of things we notice. The first is that the line showing the value of British pounds in gold is constant. The reason it is constant is because Britain is on the gold standard and that by definition implies that you can exchange British pounds for a fixed amount of gold. The other thing we notice is that the price level in Britain at that time before the war was very stable. As we’ve talked about in previous videos, this is something that the gold standard does very well: keep price levels stable. Finally, we also notice that the unemployment rate in Britain before the war was relatively tame with a high of about 6 or 7%.”

World War I

“In 1914 WWI began and to fund the war the British government borrowed a whole bunch of money and spent it on the war effort. All this spending effectively doubled the amount of money in circulation in the economy, which caused the price level to increase dramatically. On the chart on the left we can see the price level go from about 10 before the war to about 20 after the war. The other thing the British government did the moment they declared war on Germany was to suspend the gold standard. This made perfect sense: if the government is going to borrow a money and spend it thereby doubling the money supply, people will have a strong incentive to try to exchange their currency for gold. To prevent people from hoarding gold the government suspended the ability for people to convert their British pounds to gold. Even though the prices of pounds in gold on the chart is shown to be the same as it was before, in reality you couldn’t actually exchange British pounds for gold during this period. The other thing we notice by looking at the chart on the top left is that the unemployment rate in Britain during the war was extremely low [Slide 3]. This is because during the war a lot of the country’s labor was involved in the war effort and so it’s not surprising that the unemployment rate hit something very close to 0%. By 1918 the war was over and the price levels in Britain had more than doubled. At the same time Britain was off the gold standard and unemployment had been very low.

Experiences from the Napoleonic Wars

Now at this point the British central bank thought it was extremely important that Britain eventually return to the gold standard. The reason they thought it was important is because they were thinking of Britain’s experiences a hundred years prior to WWI. During the Napoleonic war Britain had done something very similar to what they had done during WWI. While they have been fighting the war with Napoleon they had doubled the money supply in the economy, thereby doubling prices. After the war was over they decided to return to the gold standard by increasing interest rates so as to contract the money supply back to the level it was at before the war. It was extremely painful to contract the money supply because it resulted in a million people being put out of work, but after Britain was back on the gold standard they were rewarded by about fifty or sixty years of prosperity. The British central bank tried to recreate this experience after WWI and that is why they felt that it was imperative that Britain return to the gold standard.

Now imagine that a country has doubled its money supply over four years such that the ratio of the amount of currency circling in the economy to the amount of gold just increased by a factor of two. Because the amount of money circulating has increased but the amount of gold has not changed, if you want to go back on the gold standard your main option is to contract your money supply. And how do you contract the money supply? The logical way to do it is to raise interest rates. So we can see that right after world war one the British central bank raised interest rates to 7% which caused the unemployment rate to shoot up to about 20% and which eventually started causing the price level to decline.

Sticky Prices

“But things didn’t really work out so well for Britain and you can see the reason on this yellow graph [of the price level]. As the central bank increases the interest rate, which causes the price level to start declining, the price level goes down but it doesn’t go down to the level that was before the war. This is a really big problem, because if you remember from our previous video, if a country is on the gold standard and has a relatively high unemployment rate, the only way that it can attract new gold and thereby expand its money supply and thereby cause the unemployment rate to go down is by creating a trade imbalance. The way you create a trade imbalance is by exporting more than you are importing. Because the price level in Britain wasn’t going down to the level that it was before the war, but more importantly that it wasn’t going down relative to other countries in the world at the time, British exports were still relatively expensive compared to exports from other parts of the world. That meant that Britain couldn’t compete with the goods and services that were being produced by other countries. Because people were not buying British goods, Britain was not able to create a trade imbalance which would cause gold to flow to them. So the fact that the price level wasn’t going down further was a huge problem. This is the reason that the unemployment rate in red is still elevated over this period that I’ve just circled [Slide 4]. Because prices in Britain didn’t go down enough, Britain was not competitive in the world market for goods and that caused the stubbornly high unemployment rates in the economy.”

“Now, what was it that caused this price level to not go down? If you look at this graph here [Slide 5] it shows the percentage of workers in Britain who were members of trade unions. You can see that the number of people who are part of the trade union increased tremendously from 1900 to about 1918. Because so many more people were members of trade unions it allowed workers to negotiate much better deals for themselves with their employers. This chart [Slide 6] shows the number of work days lost because of labor disputes in Britain and you can see that in the early 1900’s there were almost no workdays lost because of labor disputes, but by 1920’s it was relatively common for there to be labor disputes that would cause a loss in work days. Because of this, it made it hard for employers to cut down on wages for their workers, which made it hard for the British to produce goods more cheaply than other countries, which made it hard for them to export goods, which made it hard for them to attract gold, which made it hard for them to increase in money supply and lower unemployment.”

Going back on and then off the gold standard

“Despite all these problems the British thought is a good idea to go back on the gold standard. Not only did they go back on the gold standard but they went back on its at the same exchange rate to gold that they at before the war, despite the fact that they were significantly weaker economic power. To make matters worse, in 1929 the world entered a global recession and there was even less demand for British goods abroad and so it’s not surprising that the unemployment rate in Britain towards the and of the 1920’s skyrocketed to about 20%. To add to these problems in 1931 there were worries that a British bank was going to go insolvent. Because of this a lot of foreigners who had money sitting in British banks began to redeem their British pounds for gold and move the gold outside the country. This began depleting the central bank’s gold reserves and they were faced with the option of going off the gold standard or raising interest rates to try to stem the flow of gold to outside of Britain. Raising interest rates even more would have caused the unemployment rate that was already 20% to skyrocket even more and so it’s not surprising that by September 1931 Britain went off the gold standard.”

What this meant is that the British pound became less valuable compared to gold, which we can see in the green graph. We also see the deflation or the decreasing prices in Britain stop after they went off the gold standard [yellow graph]. Also, because the British pound was now worth less that meant that British exports we’re now cheaper to the rest of the world and so after Britain went off the gold standard unemployment started declining.


The big picture here is that even though the gold standard did a good job of containing inflation and keeping unemployment low in Britain pre-WWI, the system wasn’t flexible enough to allow Britain and other countries to deal with the realities of the post-WWI era. In the case of Britain these realities meant that workers had higher expectations for what their minimum wage would be and what the maximum hours they would work would be, which made it harder to deflate wages to make them more competitive relative to the rest of the world. These days most economists agree that it would be a bad idea for the world or the US to go back onto the gold standard. Hopefully after seeing these videos, you have a sense for why they think that is the case. These days gold does not function as the official currency in any country and so in the next few videos we’ll try to understand why gold is perceived to have value in this day and age.