Gold in a Deflationary Economy - Part- VI

The American Experience
Period 3: Inflation of 1897-1920

Duration: 23 years
Commodity Prices: +232%
Purchasing Power of Gold: -70%
Monetary System: Classic Gold Standard

This was the period of time to which economists referred as "the classic gold standard" period. Under this type of gold standard, issuers of money are required to hold sufficient gold reserves to handle the demands of individuals who wished to redeem their currencies into lawful money. National banknotes and bank reserves were redeemable in gold coins or bullion at any time. Each gold certificate issued by the U.S. Treasury contained the following declaration:

This certifies that there have been deposited in the Treasury of the United States of America twenty dollars in gold coin payable to the bearer on demand.

The fixed exchange rate of $20.67 per ounce of gold enabled gold coins and gold certificates to become popular mediums of exchange. The U.S. Treasury did not maintain 100% specie reserves for all its legal obligations during this period but it did hold more than 100% reserves to cover its gold certificates11. Bank runs and panics, therefore, were unnecessary since the holders of gold certificates could just show up and ask for gold coin instead.

However, the best laid plans of mice and men were destroyed by war. World War I prompted Europe to employ an inflationary policy, turning the overall period shown on the chart into an inflationary one in which gold, which had already been gradually losing purchasing power after the recovery from the severe deflation of the prior period, to plunge in purchasing power after the war began. The peak in inflation, and the Kondratieff Long Wave cycle, occurred in 1920. After that it was downhill until the Kondratieff and other cycles caused by overspending, then debt default, bottomed.

Aside from the war that ended this period of history, prosperity and relative economic stability were widespread after 1897. Prosperity returned to the United States in 1898 and was followed by a period of record-breaking production in 1900 and 1901. Although labor problems followed and there were other problems (the panic of 1907 touched off by the failure of the Knickerbocker Trust Company and leading to the suspension of payments from banks and a stock market collapse12), prosperity later returned and went uninterrupted until World War I when foreign trade with the United States collapsed and resulted in depression. 1914 was a year of depression, but fired-up factories to produce the war machine resulted in prosperity through the last half of 1920.

Again, inflation and war-the two culprits throughout history responsible for the sharpest losses in operational wealth-hurt holders of gold and proved once again that gold is actually a poor inflation hedge at times. The inflation that was doubtless exacerbated by, among other things, the inflationary policies of World War I resulted in a sharp loss in operational wealth of gold of 70%. Other factors that exacerbated the instability of prices after the war began involved a suspension not only of the stable economies under the classic gold standard and the free flowing international trade and the growing global economy, but also of a trend toward a return to bimetallism-the convertibility of currency into both gold and silver that had dominated global monetary systems before the Civil War in the United States.

Again, inflation and war hurt holders of gold and proved         
once again that gold is not always the best of inflation hedges.

Milton Friedman makes a case in Money Mischief that the U.S. and England were in the process of seeing the market price and the legal price gold/silver ratio return to the point at which the two governments could have returned to the bimetal system. Throughout recorded history, monetary systems have generally been based on a physical commodity, with silver usually playing a key role. The legal price ratio was determined by the weights assigned to the silver and gold coins. Government commitment, for example, was for the U.S. to exchange $20.67 for a fine ounce of gold, or $1.29 for a fine ounce of silver13.

However, after the Civil War, most advanced countries had shifted to a monometallic gold standard. The "Crime of 1873," as history labels it, changed monetary economics for years to come when the U.S., whose constitution gives Congress the power to "coin money, regulate the value thereof, and of foreign coin," "left out" of the Coinage Act of 1873 the legal mandate to also include silver in America's attempt to end the Civil War greenback episode and return to the bimetallic standard14. This changed the economics of the monetary system (in a bimetallic system, two metals allow the minting of coins with the cheaper of the metals to keep market forces in line). This later affected the ability of the U.S. and England to control the monetary problems caused by World War I, and in turn affected the economy in the post-inflationary environment of the 1920s and 1930s.