3 - From Gold to Fiat Money

Summary

The centralization of authority in national governments marked the twentieth century. In the realm of money, a fiat monetary standard run by national central banks replaced a commodity standard run largely impersonally. Only after repeated episodes of inflation and deflation did central banks realize their responsibility for the behavior of prices. The greatest episode of monetary instability was the Great Depression. As predicted by Adam Smith in the Wealth of Nations in the eighteenth century, the specialization of production allowed the creation of wealth in the nineteenth century. Economic specialization rests on two pillars: free trade and stable money. Stability of the purchasing power of money makes possible roundabout exchange instead of barter. In the Depression, governments and central banks brought down both these pillars.

The Gold Standard

In the heyday of the gold standard, the world had a dominant money market – London – and a preeminent central bank – the Bank of England. Britain viewed the gold standard as an extension of its imperial grandeur. A sine qua non for the international gold standard was the freedom to ship gold made possible by the absence of capital controls. That freedom of movement of capital made London the center of the world financial market, just as London was the center of the empire. No one could doubt the commitment of the Bank of England to maintaining the gold price of the pound.