Gold, Silver, and Monetary Stability

(February 23,2023- Johannes Wiegand)

An almost-forgotten 19th century episode shows that international cooperation can be essential for a stable global monetary system

The year 1873 marks a turning point in monetary history. In July, the Reichstag of the newly established German Empire replaced an array of silver-based currencies with the gold mark. In September, the Paris mint limited silver coinage, ending the double gold-silver monetary standard France had maintained for decades. And earlier that year, the US Congress legislated the phasing out of the temporary paper currency of the Civil War years, to replace it with a gold dollar once the government resumed specie (coin) payments (which happened in 1879).

With the United Kingdom already on gold, by the end of the 1870s all the world’s leading industrial nations used gold currencies. Silver—which, until 1873, had been on an equal footing with gold—became a secondary currency metal used mostly by periphery countries.

The monetary impact was stark. Between 1873 and the end of the decade, silver depreciated by some 20 percent relative to gold, after having traded at stable exchange values for 70 years. Gold countries experienced severe deflation that lasted until the early 1890s. The real repercussions are more difficult to assess because comprehensive national accounts for the 1870s are lacking, but indicators such as industrial production point to a severe and long recession in several countries—in Germany, for example, the post-1873 years are known as the Gründerkrise (a period of crisis).

Global bimetallism

Nineteenth century currency systems operated very differently from today’s monetary system. Money was tied to precious metals (bullion). Coins (specie) were minted from bullion, and paper money could be exchanged for bullion at guaranteed exchange values.

In the early 19th century, most countries tied their currencies to silver—except the UK and, beginning in the mid-1830s, the US, which were on gold. France tied its currency to both gold and silver: per an 1803 Napoleonic law, the French mint paid 200 francs for a kilo of silver and 3,100 francs for a kilo of gold. France’s double price guarantee established global bimetallism: it ensured not only a stable exchange value of 15½ between silver and gold but also quasi-fixed exchange rates between all countries on gold and silver currencies.

Global bimetallism worked as long as both gold and silver coins circulated in France. France would then operate as a global monetary stabilizer: through a mechanism called Gresham’s law, changes in the global quantities of gold and silver translated primarily into changes in France’s currency composition, while exchange rates between gold and silver currencies remained stable. Moreover, bimetallism was better at stabilizing prices than a regime based on only one currency metal, as supply shocks to gold and silver partially offset one another.

Gresham’s law

“Gresham’s law” states that, in fixed exchange rate systems, “bad money drives out good.” In the case of bimetallism, it worked as follows: the mint fixed the relative price of two currency metals. If the supply of one metal increased—for example, because of new discoveries or currency reforms that demonetized that metal—its market price would tend to fall, generating an incentive to bring bullion (raw metal) to the mint and convert it into specie (coins) to take advantage of the price guarantee. Conversely, the other, now scarcer (and therefore relatively more valuable), metal would be withdrawn from circulation. Changes in bullion supply therefore shifted the composition of specie in favor of the cheaper, “inflationary” currency metal, as long as the mint’s price guarantee was effective. This monetary principle is named for Sir Thomas Gresham, financial agent of Queen Elizabeth I.

Global bimetallism operated seamlessly until about 1850. Then, large gold discoveries in California and Australia increased global gold production by a factor of 5. Per Gresham’s law, the share of gold in French specie surged—from less than 30 percent around 1850 to more than 85 (!) percent in the mid-1860s.