For instance, in countries where this system was adopted, each time a commodity was exported, the exporter of that good would receive payment in gold and the importer purchasing certain merchandise abroad, would make payment by exporting gold. For a country with a trade deficit, the number of imports would exceed the number of exports. The deficit country would then experience a significant gold outflow. “With less money (gold coin) circulating internally, prices would fall in the deficit country. With more money circulating abroad, prices rose in the surplus country. The specie flow thereby produced a change in relative prices (hence the name “price-specie-flow model”). (Eichengreen, 2008, pg. 24)
In return, domestic residents would decrease their purchase of goods and services since imports would become more expensive whereas the foreign residents would increase their purchase of goods and services since imported goods would become less expensive for them. While the country running a balance of payments deficit would experience a rise in its exports and a decline in its imports until up to a point where the balance of trade is restored. This formulation of the balance of payments equilibrium created by Hume proves us the multiple benefits as well as the way in which the gold standard system has operated.
In addition to its ability to restore the balance of payments equilibrium in countries with a trade deficit, the high level of openness granted by the gold standard system had also served to expedite the process of economic integration which mostly benefited the world's leading exporters. Even though this system supremely favored Britain as the vanguard of this system. “Because, London was the center for the world’s principal gold, commodities, and capital markets, because of the extensive outstanding sterling-denominated assets, and because many countries used sterling as an international reserve currency (as a substitute for gold), it is argued that the Bank of England, by manipulating its bank rate, could attract whatever gold it needed and, furthermore, that other central banks would adjust their discount rates accordingly.” (Braga de Macedo & Eichengreen & Reis, 1996, pg. 17)
Therefore, it could just as easily be argued that the Bank of England had the financial prowess and the capacity to exert a powerful pressure on the price levels as much as on the money supplies of other countries that were adhering to the rules of the gold-standard.
Contrary to its financial comparative advantages, the gold standard system also had three distinct shortcomings. Costs of this system included the tricky position that governments had to deal with, which forced countries to obey a set of stringent rules and surrender the control of their money supply. For instance, under this system, (I) countries were expected to fix the mint price at a par value and legalize melting of gold coins which were basically unfavorable requests for countries that were short of gold reserves at the time. Another pitfall of this system was the fact that (II) one metal was given too much importance which essentially favored countries with gold mines than those without, which also turned it into a biased system.
Nevertheless, the greatest deficiency of this system was (III) whenever a member country would decide to break the rule, it was set to gain from it. For instance, if we were to suppose that the general price levels are greater in country A than in country B (if PA > PB) and if country A was to quietly break the gold standard rule and increase its money supply (even if it does not have enough gold), then it would still keep on importing goods and services from country B and continue to pay in gold while maintaining higher price levels. Thus, according to the rules, if a country was running a trade deficit, it had to allow a certain amount of gold outflow until its price level was restored to the par value exchange rate of other countries. Some countries in Europe, such as France and Belgium that were operating on the gold standard system, chose not to follow this rule.
An example of a case where this rule was strictly observed was the case of the Central Bank of England, also known as the Bank of England. During the gold standard era, the Bank of England engaged in a leadership position as the most influential mechanism that would enforce the gold-standard regime. It has done so by strategically utilizing its monetary policies to maintain a certain level of gold convertibility.
In response to the demands of the Bank of England, other central banks in Europe acceded to the new policies it imposed by and assumed a passive stance. This was largely because of the benefits that they were able to accrue by clinging onto the sterling as the reserve asset. “Britain financed exports and imports in sterling bills, other countries their third-country trade also in sterling bills. Other countries thus had to hold balances in sterling.” (Kindleberger, 1993, pg. 71)
In addition, the Bank of England’s persistent agenda to uphold its dominant status as the central monetary authority during the era of the classical gold standard was further advanced by its extensive monetary operations that encouraged global trends such as; increasing short-term capital mobility and motivating central banks to push domestic rates downwards with the inflow of gold into these banks. Despite the Bank of England’s relatively scarce gold reserve, central banks had to continue to yield to the pressures exerted by it as they had a limited ability to effectively change their own monetary conditions, much less the international order itself. “On this showing, the Bank of England set the level of world interest rates, which accounts for the fact that national interest rates moved up and down together, while other countries had power only over a narrow differential between the domestic level and the world rate.” (Kindleberger, 1993, pg. 73)
In response to the policies enforced by the Bank of England, insolvent central banks that suffered a significant loss in their gold reserves resorted to their domestic asset holdings so that they could push interest rates upwards, which would then attract short-term capital and limit the outflow of fresh capital. In turn, this reactionary policy would strengthen their domestic economies.
In addition, under the gold standard regime, sterling bills were the only worldwide-accepted currencies that also simultaneously retained the privilege of substituting for real money in other European countries.
While the Bank of England, as the central decision-making monetary authority of the classical gold standard era, had unlimited access to international markets. This allowed it to arbitrarily determine national interest rates of other countries as well. Therefore, it would not be a far-fetched argument to claim that the classical gold standard was after all a system based completely on the British sterling.
With the outbreak of WWI, governments and central banks around the world were forcefully confronted with a need to finance high levels of military expenditures with an extremely limited source of tax revenue. Driven by the need to out compete each other in the race for war, many belligerent countries have gradually started abandoning the gold standard to issue un-backed paper currencies (which then would cause massive hyperinflation levels in these countries) while the Bank of England had temporarily suspended gold convertibility which meant that it had abolished the gold standard until after the war.
The Inter-war Period (1918-1939)
At the onset of WWI, most industrialized nations of Europe have started issuing fiat currencies (un-backed paper) in an effort to fuel the war machine. This was a period in which precious metals such as “gold” and “silver” had become a critical resource for the procurement of war material. As a consequence of the rising value of gold and silver, governments have pursued protectionist policies to prohibit the export of such precious metals while continuing to issue fiat currencies without any value.