The Political Economy of Commitment to the Gold Standard

August 2002

J. Lawrence Broz Department of Political Science

University of California, San Diego (858) 822-5750

jlbroz@ucsd.edu

Prepared for delivery at the 2002 Annual Meeting of the American Political Science Association, August 29 - September 1, 2002. Copyright by the American Political Science Association. For comments on an earlier draft, I thank Benjamin J. Cohen, Jeffry Frieden, Kate McNamara, and participants in the “Understanding the Gold Standard: New Lessons from an Old Rule” conference, University of Notre Dame, May 3-5, 2002. I also thank Michael Bordo for extensive comments and for graciously sharing his data. I’m indebted to Stephanie Rickard for research assistance.

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Title: The Political Economy of Commitment to the Gold Standard

Abstract: Recent literature supports the view that the classical gold standard was a commitment

mechanism, designed to resolve time inconsistency problems in macroeconomic policy. Yet

some nations were more successful in making and maintaining the commitment than others. I

consider the political and economic factors that were required to adopt the gold standard. I argue

that (1) political system instability and (2) non-democratic political institutions reduced the

ability of nations to credibly commit to gold. I also contend that (3) interest group pressure from

the export sector during the deflationary era (1880-1897) made adherence to gold less likely. I

test these claims on a panel of 23 developed and developing countries and find robust support for

hypotheses (1) and (3) and modest support for (2).

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1. Introduction

From 1880 to 1914, an integrated world economy was forged for the first time, extending

from the core of Western European industrializers to areas of recent settlement in the periphery.

At the center of this integrated economy was the gold standard, a rule-based monetary regime

that stabilized exchange rates and lent credibility and predictability to governments’

macroeconomic policies. The gold standard, however, operated very differently for developed

and developing nations. While most industrialized “core” countries (e.g. England, France,

Germany) were able to adopt and maintain the gold standard throughout the period, some

“peripheral” developing countries never joined the regime. Others joined it when conditions

were favorable (i.e., in non-dilemma situations when internal and external policy did not

conflict), but abandoned it when economic conditions deteriorated. For countries on the

periphery, such as Greece, Argentina, and Brazil, the gold standard was more the exception than

the rule.

These varied experiences represent something of a puzzle. Developing countries had

stronger economic incentives to join the gold standard yet they found it more difficult than

developed countries to adopt and maintain the regime. Among the benefits of a solid

commitment to gold was access to international capital, vital for development, on favorable

terms (Bordo and Rockoff 1996). The paradox is that while capital-poor developing countries

were the most in need of using the gold standard as a “good housekeeping seal of approval,” they

found making and keeping the commitment problematic. Even the most successful gold standard

countries in the periphery never attained the levels of commitment found in the North Atlantic

core.

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To address this puzzle, I build upon the insight that the classical gold standard was a

commitment mechanism, designed to resolve the time inconsistency problem in fiscal and

monetary policy. My claim is that commitment to gold required certain favorable political

conditions in addition to the economic circumstances emphasized in the existing literature. I

focus first on the relationship between political instability and adherence to gold. Other things

equal, greater political instability reduces the capacity of governments to make credible

commitments because political volatility shortens the time horizons of political leaders and

thereby induces uncertainty about the future course of policy (Leblang 2002). I also consider the

effects of political institutions, namely the extent of democracy, on gold standard performance. I

argue that nations with democratic institutions were more likely than non-democratic nations to

commit to the gold standard. This claim recognizes that “democracy” prior to 1914 was

bourgeois democracy. In most objectively democratic nations of the day, participation was

limited to propertied capital owners and net asset holders – groups that benefited from stable

prices and exchange rates. Democratic institutions meant that decisions over money were taken

out of the hands of the sovereign, who had incentives to pursue time inconsistent policies, and

placed in the hands of the enfranchised constituencies that gained from monetary stability (North

and Weingast 1989). The conservative policies that preserved the gold standard can thus be

understood as the by-product of the conservatism of the enfranchised bourgeois (Gallarotti

1995). Finally, I consider pressures from special interests, as suggested by Frieden (1997, 1991)

and Eichengreen (1995). From the 1870s to 1897, price levels fell globally as the demand for

gold outstripped supply. It was not until gold discoveries in South Africa and the Klondike that

the price trend shifted upward. During the deflationary period prior to 1897, adopting gold also

meant a real appreciation of the currency, which harmed producers of traded goods (e.g.,

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agricultural exporters) and benefited nontradables producers. I thus expect nations with

powerful traded goods producers to have had a more difficult experience committing to the gold

standard.

I test these arguments on a panel of 23 developed and developing countries over the full

1880-1913 period, and in sub-periods that reflect trends in world prices (deflation: 1880-1897;

inflation: 1897-1913). Briefly, I find that political system instability decreased the likelihood

that a country would be on the gold standard. The effect is especially strong during the 1880-

1897 period, when the world price level trended downward and appreciation made it more

difficult for nations to commit to gold. I also find moderate support for the argument that

democratic institutions and gold standard adherence are positively related. The relationship is

positive in all specifications and significant in several. Lastly, I find evidence supporting the

interest group hypothesis. During the period when world prices were falling (1880-1897),

nations with larger traded goods sectors (as proxied by exports per capita) were significantly less

likely to commit to gold.

The outline of our paper is as follows. The next section describes the variation to be

explained – successful adoption/adherence to the gold standard – and surveys existing

explanations for these outcomes. Section 3 develops my political economy arguments. Section

4 presents quantitative evidence on the decision to go on or off gold, and conclusions follow in

Section 5.

2. The Rise of the Gold Standard

To be on the gold standard meant to (1) fix an official price or “mint parity” for gold and then to

convert domestic currency freely into gold at that price, and (2) to impose no restrictions on the

export or import of gold by private citizens. Before 1870, few countries had adopted this

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monetary regime. Great Britain, a notable exception, had been on gold for more than a century,

albeit with an interregnum during the Napoleonic wars. In the 1850s, Australia and Canada

joined the standard. The only other European country to adopt gold convertibility before 1870

was Portugal, which joined in 1854 but fell off gold in 1891 and moved to a paper (fiat) standard

for the remainder of the period.

In the 1870s, a rush of nations switched from bimetallism to gold. Germany used an

indemnity from the Franco-Prussian War to finance the creation of its gold standard in 1871.

Other prominent European nations followed. Sweden, Denmark and Norway went jointly on

gold as part of the Scandinavian monetary union established in 1873. In 1878, France, Belgium,

and Switzerland also abandoned bimetallism for gold. The United States, after adjusting to the

inflationary hangover of the greenback period, rejoined gold on a de facto basis in 1879; de jure

recognition arrived in 1900 with the Gold Standard Act. By the 1880s, most developed Atlantic

economies were on gold (Eichengreen and Flandreau 1998; Gallarotti 1995; Meissner 2001; Reti

1998).

By contrast, nations in the less-developed periphery of Europe, Latin America, and Asia

did not adopt the gold standard until later (Greece 1910, Mexico 1905, Russia 1897, Japan

1897), or adhered to gold irregularly (Argentina, Brazil), or did not adopt gold at all (Spain,

Paraguay, Indonesia). Perhaps as a consequence, price and exchange rate stability, the most

praiseworthy features of a gold standard, were largely limited to the North Atlantic core.

Table 1 illustrates these points. The first column gives the date at which a country first

joined the gold standard; the second shows the total number of years a country was on gold

during the classical gold standard period (1880-1913). The third column contains a measure of

economic development, per capita GDP, and the fourth indicates inflation performance,

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expressed in period (1880-1913) averages. The final column gives the standard deviation of the

nominal exchange rate over the period 1880-1913, an indicator of exchange rate variability.

Despite many holes in the data, Table 1 paints a relatively clear picture. In comparison to the

rich, developed nations of the North Atlantic core, peripheral countries on the southern edge of

Europe, in Latin America, and in Asia adopted the gold standard later, or not at all, and suffered

relatively high inflation and exchange rate variability. Note, however, that Italy, Spain, and

Portugal “shadowed” the core, having low inflation rates and fairly stable exchange rates, despite

being off gold for substantial periods (Bordo and Schwartz 1994). Greece, however, countered

this regional pattern, as it experienced high inflation and exchange rate variability.

2c. The Gold Standard as a Commitment Mechanism

Recent analyses treat the gold standard as a mechanism for enhancing the credibility of

government promises to pursue far-sighted fiscal and monetary policies and to run large, fiscal

deficits only in the event of a well-defined emergency, such as war (Bordo and Kydland 1995;

Bordo and Rockoff 1996, Flandreau et al 1998; Bordo and Flandreau 2001). With roots in the

rational expectations literature, this argument builds on the time inconsistency problem described

by Kydland and Prescott (1977) and Barro and Gordon (1983). Government policy is time

inconsistent when a policy plan, calculated as optimal based on the government's objectives and

expected to hold indefinitely into the future, is subsequently revised. The government has an

incentive to adopt policies that are different from the optimal plan, once market agents rationally

incorporate presumptive government actions into their decisions. The usual example of time

inconsistency in monetary policy is surprise inflation produced by the monetary authority’s effort

to reduce unemployment. A time inconsistent fiscal policy, which is more relevant to the pre-

1914 era, would be to use inflation to default on government debt once the public has purchased

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it, or to finance a fiscal deficit (Bordo and Flandreau 2001; Flandreau et al 1998). Accordingly,

the government would benefit from having access to a commitment mechanism to keep it from

changing planned future policy.

The gold standard was such a mechanism since it provided an automatic rule for the

conduct of policy. Like other fixed-exchange rate regimes, monetary policy under the gold

standard had to be subordinated to the requirements of maintaining the peg to gold, effectively

“tying the hands” (eliminating the discretion) of the authorities (Canavan and Tommasi 1997).

Adherence to a fixed parity of gold required a country to follow domestic monetary and fiscal

policies consistent with long-run maintenance of the peg. Thus, by limiting the discretionary

power of monetary authorities to finance fiscal deficits or to inflate the price level, the problem

of time inconsistency was neatly resolved (Bordo and Kydland 1995).

While the gold standard can be seen as a institutional mechanism to improve

macroeconomic performance, there is substantial evidence that the gold standard did not buy

automatic credibility for all countries that adopted it: nations in the North Atlantic core were

blessed with an extraordinary degree of credibility while peripheral nations suffered from what

might be termed a “credibility deficit.” One measure of this deficit is the fact that core countries

were able to issue debt abroad denominated in their own currencies while peripheral sovereign

borrowers, even when on gold, had their international loans denominated in a foreign currency

(e.g., sterling) and/or had gold clauses requiring repayment in gold inserted in contracts (Bordo

and Flandreau 2001). Only the UK, the US, France, Germany, The Netherlands, Belgium,

Denmark, and Switzerland could issue bonds in their own currencies during the period. For the

rest of the gold standard club, loans were contracted in the lender’s currency or had gold clauses,

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indicating that exchange-rate risk remained high despite the maintenance of gold and de facto

exchange rate stability.

Another indicator of the periphery’s credibility deficit was the differential response to

violations of the gold convertibility rule in the core and in the periphery. For core countries,

such as England, France, and the U.S., the gold standard worked effectively as a contingent rule:

a rule with escape clauses (Bordo and Schwartz 1996). These countries maintained their long-

term credibility even when they temporarily suspended convertibility during a well-known crisis,

such as a major war. The credibility of the commitment was so secure in the core that market

players were fully confident that gold convertibility would be restored at the original parity after

the crisis had passed, even if it meant deflating the national economy.1 Unlike the core

countries, peripheral members of the club were not blessed with this extraordinary credibility.

For example, when Latin American countries suspended gold payments in wartime or in the face

of financial crises and terms of trade shocks, financial markets responded in destabilizing

fashion: temporary suspensions triggered expectations of permanent depreciations rather than of

eventual stabilization, resulting in large, speculative capital outflows (Bordo and Schwartz

1996).

A final measure of the credibility deficit was the response that followed any deviation

from the so-called “rules of the game.” In England, France, and Germany, the high degree of

credibility meant that modest manipulations of the gold points, such as raising the buying price

of gold – a small depreciation – could easily attract gold as investors anticipated the increase to

be temporary (Bordo and MacDonald 1997; Dutton 1984; Bloomfield 1959). In addition, the

1 McKinnon (1993) refers to this as the “restoration rule.”

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absence of exchange rate risk meant that small increases in domestic interest rates could easily

attract large capital inflows. In the periphery, by contrast, any sign of faltering, such as a modest

stabilizing depreciation, typically resulted in capital flight, due to the lack of credibility (Ford

1963). Interest rate increases were similarly ineffective in stemming the outflow of capital, again

due to the lack of credibility. The exodus of capital in turn precipitated currency crises,

depreciation, and debt crises (since loans were payable in foreign currency). All this sounds

remarkable familiar to students of recent international financial crises.2

The paradox is that while capital-poor peripheral countries were most in need of

credibility, they found it very difficult to attain. Having a credible commitment to gold would

bring access to foreign capital vital to development. Peripheral countries were in fact eager to

fasten their currencies to gold because gold convertibility could serve as a signal to foreign

creditors of sound government finance and future ability to service debt. Indeed, in a study of

nine peripheral countries, Bordo and Rockoff (1996) tested the role of gold adherence as a “good

housekeeping seal of approval” and found that the risk premium charged on foreign loans was

lowest for the group of gold standard countries that never left gold, slightly higher for those

countries that temporarily devalued, and still higher for those countries that temporarily left gold

and permanently devalued or that never adhered.3 Similarly, Sussman and Yafeh (2000) show a

huge drop in spreads after Japan joined the gold standard. By contrast, Martin-Acena (1993)

found that Spain suffered a significant loss in potential output because its failure to join the gold

standard precluded the nation from access to foreign capital on favorable terms.

2 Bordo and Flandreau (2001) develop the parallels between today’s developing country peggers and peripheral countries during the gold era. 3 Obstfeld and Taylor (2002) find strong evidence in support of Bordo and Rockoff (1996).

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According to Eichengreen (1992: 60), “the role of the gold standard as a credibility-

creating device was most prominent on the fringes of the gold standard.” For peripheral

countries, however, it was far harder to generate credibility via the commitment. Even the most

successful gold standard countries in the periphery never attained the levels of credibility found

in the North Atlantic core. Sovereign borrowers on the periphery had to pay a premium on

international loans – an historical analog to today’s “peso” problem – even when they were on

gold and maintaining stable exchange rates. Spreads over rates in London averaged between 2 to

5 percent for Greece, Portugal, Russia and Italy between 1880-1913 and remained even when

these developing-country borrowers were on gold (Bordo and Flandreau 2001).

Why the gold standard was more credible in the core than in the periphery is a question

that relates to exchange rate regime choice, for if the gold standard did not buy automatic

credibility, the benefits of joining the regime would certainly be reduced. Bordo and Flandreau

(2001) bring modern financial insights (e.g. the “hollowing out” thesis and “fear of floating”) to

bear on the question and argue that a key difference between the core and the periphery was

“financial maturity.” Financial maturity is an expansive concept that encompasses the

development of wide and deep financial markets and sound fiscal and monetary arrangements.

Yet the basic idea is easily distilled: countries with less developed financial systems were unable

to issue debt in their own currencies, which left them especially vulnerable to currency mismatch

problems, currency crises, and debt defaults. When such a country raised public spending (e.g.,

Argentina in the 1890s), and increased its public debt, the share of debt denominated in a foreign

currency (sterling) increased, creating an explosive situation. Capital flow reversals in this

context would provoke first a currency crisis, then a debt crisis, as devaluation (or depreciation)

raised the costs of repaying the debt to unsustainable levels. A debt crisis, in turn could easily

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undermine weak banking systems, causing a major decline of output. The problems that the

periphery had with adopting and sustaining the gold standard seem consistent with this view.

Moreover, the problems have not changed very much for today’s “periphery” (Calvo and

Reinhart 2000a; Calvo and Reinhart 2000b).

3. Credibility and Political System Attributes

In this section, I introduce political factors that might help explain the varied experiences

with the gold standard that differentiate the periphery and core. The basic insight is that market

agents have rational expectations regarding economic policy and incorporate political

information into their expectations that a commitment can or will be honored in the future. I

argue that two forms of political information matter with respect to expectations of gold standard

commitment: information on the level of political instability and information on the degree of

democratic accountability. Political instability, by increasing the likelihood of future changes in

economic policy, reduced the credibility of a commitment to gold. Democracy, in its limited late

nineteenth century form, enfranchised supporters of gold and thereby increased the likelihood

that a government would commit credibly to gold.

These arguments rest on the idea that adopting gold was insufficient, on its own, to

generate credibility. Indeed, with the exception of Switzerland, which elevated the gold standard

to constitutional status, all governments simply pledged adherence to the basic rules of

membership and took steps to acquire gold reserves adequate to back the currency at the official

parity. There was nothing inherent in these pledges to make the commitment irrevocable: it was

a policy choice that could be reversed as easily as it was made.4 The possibility of policy change

suggests that the ultimate credibility of the gold standard rested upon expectations that (1) future

4 Note, however, that Russia and Greece accumulated gold reserves above 100 percent – a de facto currency board arrangement (Bordo and Flandreau 2001: 40).

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governments would remain committed to the promise, and (2) that a government would pay high

political costs if it broke the commitment to gold.

I argue that the degree of political instability negatively affected credibility by increasing

expectations of policy change by future governments (Leblang 2002; Bernhard and Leblang

2002). In the absence of complete information on the policy preferences of varied individual

politicians, political parties, and coalitions, investors during the gold standard era had to infer the

future course of fiscal and monetary policy largely from observable political events. Among the

most easily observed bases for such inferences was political change, ranging from a change of

cabinet ministers to outright revolution. Such changes in government would imply a higher

likelihood of monetary and fiscal policy change, especially if new leaders were drawn from a

pool that contained opponents to gold standard orthodoxy as well as supporters. This is not to

say that future governments would necessarily have to be opposed to gold standard discipline for

political instability to reduce credibility. Rather, in contexts where political leaders, elected or

otherwise, were more likely to be replaced – where political turnover was high – the probability

of a policy reversal increased. Again, it is expectations that matter. A change in political

leadership simply increases the likelihood that there will be an alteration in economic policy.

If commitment is more difficult in the face of frequent political change, then countries

with unstable political systems would have difficulty committing to and maintaining the gold

standard. Even if they made a formal pledge to gold, political disturbances would induce

uncertainty over future economic policies, undermining the credibility of the promise. This lack

of credibility, in turn, would reduce incentives to join or stay in the gold club since membership

could not eliminate inflationary expectations nor allow access to foreign capital on favorable

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terms. While the costs of going on gold stay the same, the expected benefits fall with political

instability. Thus, my first hypothesis:

H1: The higher the level of political instability, the lower the probability that a country would adopt and/or maintain the gold standard.

My second argument is that political institutions affected the costs to policymakers of

adhering to the gold standard, with political regime type (democratic/non-democractic) being the

relevant institution. In recent work, regime type has been found to be highly correlated with

exchange rate choice during the post-Bretton Woods period: non-democratic systems are

significantly more likely to adopt a fixed exchange rate for credibility purposes than democratic

countries (Broz 2002, Leblang 1999). Why authoritarian governments today prefer pegs as a

means to lower inflation is a matter of debate. One argument is that autocratic governments peg

because they are more insulated from the domestic audiences that suffer from adjusting the

economy to the peg and thus bear lower political costs when they do so (Leblang 1999). That is,

lower political costs ex post increase the likelihood that autocracies will choose a peg ex ante. A

competing argument is that the transparency of a pegged regime makes it a preferred

commitment technology in authoritarian systems because it substitutes for political system

transparency (Broz 2002). When political decision-making is not transparent, as in autocracies,

governments must look to a commitment technology that is more transparent and constrained

(pegged exchange rates) than the government itself.

I argue that the relationship between democracy and exchange rate regime was just the

opposite during the gold standard era: democracies were more likely to adopt a fixed parity to

gold than autocracies. This sign reversal recognizes that before 1914 “democracy” meant the

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enfranchisement of a very narrow set of constituencies: middle and upper income propertied

males engaged in commercial and financial activities. As rentiers, these actors would favor gold,

ceteris paribus, because being on gold protected their wealth from the inflation tax and ensured

that their income from financial assets maintained its purchasing power. After 1914, with the

enfranchisement of a broader, more diverse cross-section of society, including the working class

and others rendered unemployed when a government focused policies on maintaining a currency

peg, it became politically more difficult for democracies to fix exchange rates (Eichengreen

1992; Simmons 1994). With the decline of bourgeois democracy in the 20th century, more

flexible forms of commitment based upon domestic nominal anchors (monetary and inflation

targets, central bank independence) were developed to substitute for the gold standard.

Then, as now, the effect of democratic institutions on credibility depended upon the

groups to whom policymakers were accountable. Before 1914, gold credibility was associated

with the constitutional rule of the commercial and financial class, suggesting a positive

relationship between democracy and commitment to gold. This claim builds on North and

Weingast (1989), who develop the relationship between the onset of limited government in

England and government credibility. They argue that limited government was a self-reinforcing

institution: the government received economic resources from asset owners, who were vested

with political rights by the creation of a powerful parliament. The empowerment of parliament

in fiscal matters tied the hands of the sovereign. Parliament provided the coordination

mechanism by which asset holders could easily (and legitimately) create a coalition to punish the

sovereign if it acted in a time inconsistent manner.

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As applied to the gold standard, a similar logic can be developed. By enfranchising

rentiers while denying political voice to popular interests, bourgeois democracy should have

made the commitment to gold more credible.

H2: The greater the extent of (bourgeois) democracy, the higher the probability that a country would adopt and/or maintain the gold standard.

Frieden (1997) analyzes votes in the U.S Congress on the gold standard in the 1890s through an

interest group lens.5 Noting that adopting the gold standard meant currency stability and real

appreciation, due to the excess global demand for gold before 1897, he finds that the larger the share of

agricultural exporters in a district the more likely a congressmen would vote against gold. Similar

pressures from powerful agricultural interests seeking depreciation were also present in the Latin

American periphery. Ford (1962) attributed Argentina’s poor gold standard record to the exporting

interests who formed the dominant political group: “For in Argentina, the economic and political

structure was such that a depreciating paper currency (in terms of gold) moved the distribution of a

given real income in favor of these interests and against wage-earners, both rural and urban” (1962: 90-

1). Likewise, in Brazil, “the Executive was always prepared to lend support to coffee valorization

schemes, and the secular depreciation of the milreis resulted from politically motivated decisions aimed

at benefiting the leading sector of the export-producing bourgeois” (Fritsch 1989).

These arguments, which derive from an open economy perspective (Broz and Frieden 2001),

suggest that additional political economy factors were at play in shaping the decision to commit

credibility to gold. While the gold standard brought benefits to the rentier class, it also produced

5 See also Hefeker 1995.

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concentrated costs for producers of tradable goods prior to 1897, via real appreciation. If such groups

were sufficiently powerful in the extant political system, democratic or otherwise, they could make the

commitment to gold a tenuous proposition. After 1897, however, when new gold discoveries allowed

the supply of gold to outpace demand, the opposition of tradables producers should have necessarily

diminished.

H3: Prior to 1897, the larger and more powerful the traded goods sector, the lower the probability a nation would commit to gold.

Empirical Model and Results

In this section, I test empirically the propositions relating political instability, bourgeois democracy, and

interest group pressures to the choice of exchange rate regime during the gold standard era. The sample

consists of 23 developed and developing countries over the period 1880-1913.6 The countries were

determined by data availability but represent a variety of experiences with the gold standard.7 The

dependent variable is dichotomous: one if the country is on the gold standard in a given year, zero

otherwise. To estimate correct errors for a panel dataset that is groupwise heteroscedastic, I ran a probit

model with Huber/White robust estimates of variance using the “cluster” command in Stata 7. The

command specifies that observations are independent across countries (clusters) but not necessarily

within countries. These variance estimates are robust in the sense of providing correct coverage rates to

6 Countries in the sample are: Argentina, Australia, Austria-Hungary, Belgium, Brazil, Canada, Chile, Denmark, Finland, France, Germany, Greece, Italy, Japan, Netherlands, Norway, Portugal, Russia, Spain, Sweden, Switzerland, United Kingdom, and United States. 7 Mike Bordo graciously provided most of the economic data for the analysis.

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much more than panel-level heteroscedasticity. In particular, they are robust to any type of correlation

within the observations of each group.8

My general claim is that political factors help explain why some nations were more

successful in adopting and maintaining the commitment to gold than others. One argument is that

democratic institutions, by empowering the bourgeois, made the commitment credible. To

measure political democracy, I use the variable POLITY, which is an aggregate index of the

extent of democratic accountability manifest in a nations political institutions (Marshall and

Jaggers 2000; Gurr, Jaggers, and Moore 1990). The POLITY score is computed by subtracting

the “autocracy” score from the “democracy” score in Polity IV, resulting in a unified polity scale

that ranges from +10 (strongly democratic) to -10 (strongly autocratic).9 I expect POLITY to be

positively associated with gold standard adherence.

Another argument is that political instability reduced the likelihood that a country would

commit to gold. My proxy is INSTABILITY, which I constructed mainly from the Polity data

and supplemented with political histories of Latin America.10 The variable is coded one if a

country experienced a change it its POLITY score, a revolution, a coup, or a civil war; zero

8 I also analyzed the data using duration models, flowing the approach developed for binary panel data by Beck, Katz and Tucker (1997). The results, available upon request, are very similar to those reported here. 9 Although the Democracy and Autocracy scores are highly correlated ( r = - .93), the categories and weights that make up the additive indices are somewhat different. The authors of the series note that the scales were not intended to be used separately. 10 I considered using Polity IV codings of (1) interruptions of authority patterns by an intervening foreign power, or a short-lived federation of states, (2) the complete collapse of political authority, and (3) periods of transition to a new form of political system. In my sample, however, there are no coded instances of interruptions or collapses and only three countries register experiences of transition to new forms of governance: Denmark (1901-1913), Portugal (1910), and Sweden (1907-1913). Furthermore, none of the many coups and revolutions in Latin America show up in any of these series!

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otherwise. I reviewed political histories of Latin America and Europe and included events that

did not show up in the Polity data; i.e., revolutions in Argentina in 1880 and 1890, and a

provincial revolt in the same country in 1893. Other events I found had made their way into the

Polity data: a coup in Brazil in 1889 and a civil war in Chile in 1891

I also consider the impact of interest group pressures. Several authors suggest that

producers of tradable goods (e.g., agricultural exporters) resisted adoption of gold, due to the

decline in their real income that was implied by currency appreciation during the era of falling

prices (1880-1897). The converse is that producers of nontradable goods would gain from the

gold standard in this period, as real appreciation shifted the distribution of real income in their

favor (Frieden 1991). My proxy for the political importance of the traded goods sector is

EXPORTS, which is exports per capita in constant U.S. dollars. Exports per capita is an

admittedly crude proxy for the lobbying behavior and political power of tradables producers, but

better proxies are difficult to identify, let alone obtain data on. Nevertheless the variable is

probably a reasonable approximation of the importance of avoiding the gold standard to the

exporting sector. I expect EXPORTS to be negatively associated with the propensity to peg to

gold during the 1880-1897 period, and unrelated in other periods.

To control for financial maturity as a covariate of gold standard adherence, I include

several alternative proxy variables. Bordo and Flandreau (2001) suggest that the ability to issue

international securities denominated in the domestic currency was the crucial characteristic of

financial maturity. However, the countries that could issue sovereign bonds in their own

currencies between 1880-1913 were on gold for the entire period, meaning that there is

insufficient variation in this dummy variable for regression analysis. As a substitute, I use the

interest rate premium on long-term government bonds. Inasmuch as financial maturity is related

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to the form that sovereign borrowing takes, it should also be reflected in the terms of borrowing.

If countries with undeveloped financial systems were prone to currency and debt crises, they

should have paid a higher premium than countries with mature systems, due to the higher

probability of exchange rate and default risk. To capture this aspect of financial maturity, I

created the variable SPREAD, which is Rit – RUkt, where Rit is the interest rate on long-term

government bonds in country i at year t minus the interest rate of the United Kingdom in year t.

SPREAD should be negatively related to being on the gold standard.

Another aspect of financial maturity is financial depth: the extent of monetization.

Money economizes on resources by serving as a medium of exchange, a store of value, and a

standard of deferred payments. Once a monetary base is specified, banks of deposit and central

banks amplify it into a money stock that consists largely of bank money convertible into the

monetary base. Liquid liabilities to GDP is a typical measure of financial depth and thus of the

overall size of the financial sector. Liquid liabilities equal currency plus demand and interest-

bearing liabilities of banks and other financial intermediaries. Yet it is imprecise because non-

bank intermediaries, such as insurance and securities companies, issue liabilities that do not wind

up in the broad money aggregate. According to Rousseau and Sylla (2001), these omissions are

likely to be far less important in the gold standard period than they are today. Thus, following

Bordo and Flandreau (2001) and Rousseau and Sylla (2001), I use the ratio of broad money (M2)

to gross domestic product, or M2/GDP, to measure financial depth. The larger the ratio of M2 to

GDP, the more financially mature a nation; therefore, the more likely it would be to adopt the

gold standard. Alternatively, countries with high per capita income may have had more mature

financial systems. To the extent that money balances are a luxury good, and the income

elasticity of money demand is greater than one, as evidenced in Bordo and Jonung (1987) for a

21

number of countries prior to 1914, then real income per capita would roughly capture financial

depth (Bordo and Flandreau 2001). Thus, I include use real gross national product per capita,

RGDPPC, as a third measure of financial maturity.

Table 2 provides results of probit estimations that include alternative measure of financial

depth. Model 1 contains M2/GDP. The estimate on M2/GDP is positive and highly significant,

suggesting that countries with greater financial depth were more likely to adopt gold.

Model 2 adds a second indicator of financial depth, RGDPPC, to the baseline regression.

Both variables measuring financial depth are properly signed but only RGDPPC is significant,

suggesting that a nation’s real wealth captures additional aspects of financial development (the

correlation between M2/GDP and RGDPPC is r = .26). Alternatively, real per capita income

may be picking up unspecified aspects of economic development that are associated with

exchange rate regime choice. Lacking a detailed specification of the relationship, I simply treat

real income as a control for purposes of testing my political arguments.

The final model in Table 2 (Model 3) includes SPREAD, the difference in interest rates

over the UK rate. While the coefficient on SPREAD is negative and significant, the variable is

highly collinear with RGDPPC and M2/GDP (r = -.49 and r = -.35 respectively). The variables

are cointegrated, and all three capture common elements of financial development. However,

likelihood ratio tests of Model 3 versus Model 2 yield an χ2 statistic of 28.41 with one degree of

freedom; the test of Model 3 versus Model 1 yields a statistic of 58.89. The probability of

obtaining either result by chance is, to computer precision, zero.

Table 3 introduces the political variables into the analysis. Model 4 includes an indicator

of political volatility (INSTABILITY), an index of democratic institutions (POLITY), and a

control for financial system attributes (SPREAD). All three estimates are correctly signed and

22

statistically different from zero. Political instability would appear to make it less likely that a

nation would be on the gold standard, while higher levels of democracy increased the likelihood

of being on gold. In Model 5, I add EXPORTS to assess whether a larger export sector made it

less likely for a nation to adopt gold. The coefficient estimate is negative but insignificant,

which is what I expect for the entire sample period. The special-interest argument should matter

only during the era of global deflation, when adopting gold meant real appreciation (see below

for further analysis).

Model 6 is a robustness check on the relationship between political instability, democracy

and adherence to the gold standard. I include both SPREAD and M2/GDP as economic controls.

The coefficient and standard error on INSTABILITY hardly change but the POLITY estimate

falls in magnitude and significance.

In Table 4, I divide the sample into sub-periods in order to see if price level trends shaped

the political feasibility of adopting gold. Models 7 and 8 contain observations in the deflationary

era (1880-1897) while Models 9 and 10 are for the period when the price level was rising (1897-

1913). My priors are that the EXPORTS, the proxy for the anti-gold influence of traded goods

producers, will be negative and significant prior to 1897 but not afterwards. The estimates do

seem to confirm a structural break in the data. However, the results in Table 4 also suggest that

the two periods were distinct in more fundamental ways. While all three of my political

economy variables find support in the 1880-1897 period, none reach significance in the post-

1897 sample. I discuss this interesting finding in the conclusion.

4a. Substantive Interpretation

Table 5 provides a more intuitive interpretation of the results. I simulated the predicted

probability of a country being on the gold standard and then examined how the predicted

23

probabilities of being on gold change as the values of my political economy variables move from

their 25th to 75th percentile values (or from zero to one for categorical variables).11 The values in

Table 5 are thus first differences. For each simulation, I set control variables at their means and

categorical variables to zero. Since Clarify generates confidence intervals around the predicted

probabilities, I also report significance levels of the first differences.

The first section of the table contains the change in the predicted probability of adopting

gold as INSTABILITY moves from zero to one for each of the models. For Models 4-8, the

change is substantively very large and statistically significant. The effect is strongest in Model

7, which is for the 1880-1897 sub-period: as INSTABILITY moves from zero to one, the

probability of being on the gold standard decreases by 38 percent. In other words, an occurrence

of political instability (i.e., a change in country’s Polity score, a revolution, or a coup) decreases

the probability by 38 percent. However, after 1897 (Models 9 and 10), the relationship weakens

dramatically and may exist solely by chance.

The second part of the table reveals that bourgeois democracy, as proxied by POLITY,

has a large positive impact on the probability of being on gold, especially in Model 7. There

are, however, considerable differences in significance levels across the models. In Models 4, 5,

and 7, the effect is strong and significant. The impact of moving from the 25th percentile of

POLITY (-3) to the 75th percentile (8) is to increase the probability of being on gold by 26

percent, on average (.20 in Model 4, .18 in Model 5, .41 in Model 7). If Brazil, with a POLITY

score of –3, were to become as democratic as the England or France (POLITY = 8), it would be

26 percent more likely to be on gold, all else equal. However, the absence of conventional

significance levels in four of the seven models leaves this inference open to challenge.

11 I used the “Clarify” software developed by Tomz et al (1998; King et al 2000) for these simulations.

24

The final section of Table 5 reports first differences for EXPORTS, my proxy for the

interest group pressures. The most powerful results occur in the two models that restrict

observations to the 1880-1897 period (Models 7 and 8). As EXPORTS move from its 25th

percentile (8.81) to its 75th percentile (33.14), the probability of being on gold declines by 17.5

percent, on average (.17 in Model 7 and .18 in Model 8). For example, if Finland were to have

Chile’s larger export sector, its probability of adopting gold would fall by about this amount.

5. Conclusion

Countries had varied experiences with the gold standard between 1880 and 1913. The

nations of the North Atlantic core (e.g. the US, UK, Germany and France) typically went on gold

early and stayed faithfully on the regime for the entire period. This long-term commitment

resolved the time inconsistency problem, brought superior inflation performance, exchange rate

stability, and even a modicum of flexibility within the gold points. By contrast, peripheral

nations in Europe, Latin America, and Asia tended to adopt the gold standard later, more

irregularly, or not at all. They suffered credibility deficits, higher inflation rates and more

variable exchange rates. Part of the explanation for these mixed experiences relates to financial

system characteristics. Nations with underdeveloped financial systems were subject to special

problems that reduced the benefits of membership: speculative attacks, debt crises, and defaults

on sovereign loans. But political factors also shaped decisions to go on and off gold. In this

paper, I have developed the political side of membership in the gold regime.

I begin with the idea that the classical gold standard was a commitment mechanism

designed to resolve the time inconsistency problem in monetary policy. I then construct and

evaluate several political economy arguments that help explain why countries were more or less

successful in adopting and maintaining the commitment. The results are easily summarized.

25

Serious political instability reduced the chances of adopting the gold standard while democratic

institutions increased the likelihood of being on gold. In addition, a larger export sector reduced

the chances of adopting gold, but only until deflation ended in 1897.

I draw several inferences from the results. First, political instability, in the form of

changes in political institutions, revolutions, and coups, reduced the time horizons of elites and

thereby reduced the credibility of their promises to behave consistently over time in setting

monetary and fiscal policies. Adopting gold was less likely under these circumstances because

political shocks created a credibility deficit, which reduces the benefits of membership. Second,

democracy in this era enfranchised the social classes that gained most from the gold standard and

vested these creditor and mercantile wealthholders with authority over macroeconomic policy

via a legislature filled with their agents. Democratic participation in this restricted form

constrained opportunism and made it easier for democratic polities to commit credibly to gold.

Third, societal constituencies influenced the choice of exchange rate regime independently of

political volatility and political institutions, as results pertaining to the interest group approach

suggest. As long as adopting gold meant a real appreciation of the domestic currency (e.g.

between 1880 and 1897), leaders presiding over large export sectors had to be conscious of the

political costs of harming this sector. Thus, democracy supported the commitment to gold and

policymakers were responsive to the sectoral distributional effects of the standard.

The final inference relates to the fundamentally different results that obtain for the 1897-

1913 sample. Adoption of gold is not related to any of my political variables in these

regressions. While I do not expect opposition from exporters to matter during this era, since

such opposition dried up with the rise in the world price level, I did expect political instability

and democracy to continue to play a role. The absence of such effects suggest that there was

26

something qualitatively different about this period. Part of the difference may be due to the

network externalities emphasized by Frieden (1993) and Meissner (2002). As more countries

joined the gold standard, the benefits of adopting the standard increased. This is because trade

and investment between countries on a common monetary standard can be conducted with lower

transaction costs (foreign exchange risk and hedging costs). The increase in such benefits may

have dominated the effects of political system characteristics by the later stages of the gold

standard era.

27

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Table 1: Gold Standard Club Country Date adopted Years on gold GDP per capita Inflation Exchange rate variability

United Kingdom 1816 34 3,080 -0.06 0.00 Australia 1852 34 3,128 0.60 0.00 Canada 1853 34 2,359 0.72 0.00

Germany 1872 34 2,193 0.86 0.01 Denmark 1873 34 2,730 0.22 0.01 Norway 1873 34 2,891 0.75 0.01 Sweden 1873 34 2,131 0.41 0.00

Netherlands 1875 34 2,874 0.02 . Finland 1877 34 1,267 0.58 . Belgium 1878 34 4,286 0.15 0.16 France 1878 34 1,761 -0.05 0.00

Switzerland 1878 34 . -0.10 . United States 1879 34 3,524 0.09 0.00

Romania 1890 24 . . . India 1899 21 . . . Japan 1897 17 417 2.44 0.39 Russia 1897 17 . 1.26 .

Argentina 1863, 1883, 1899 17 833 4.82 0.14 Costa Rica 1900 14 . . .

Ecuador 1900 14 . . . Austria-Hungary 1902 12 . 0.39 .

Portugal 1854 11 589 0.66 0.14 Philippines 1903 11 . . .

Italy 1884 10 1,183 0.05 0.16 Brazil 1888, 1896, 1906 10 216 4.75 1.39

Mexico 1905 9 . . . Bolivia 1908 6 . . . Chile 1895 4 . 4.40 .

Greece 1910 4 . 1.52 1.37 Nicaragua 1912 2 . . . Bulgaria -- 0 . . .

China -- 0 . . . Guatemala -- 0 . . .

Haiti -- 0 . . . Honduras -- 0 . . . Indonesia -- 0 . . . Paraguay -- 0 . . .

Persia -- 0 . . . Peru -- 0 . . . Spain -- 0 2,058 0.41 0.74

Columbia 1871 0 . . . Notes: Adoption dates are from Meissner (2001) and Bordo and Schwartz (1996). “--“ indicates the country did not adopt gold. “Years on Gold” is the total number of years that a country was on the gold standard, 1880 to 1913. “GDP per capita” is a period average (1880-1913) in constant 1989 dollars. Inflation is the percent change in CPI (GDP deflator for Arg., Bra., and Por.) averaged over 1880-1913. Exchange rate variability is the standard deviation in the nominal exchange rate of the $US, averaged over the 1880-1913 period.

32

Table 2: Gold Standard Membership: Financial Maturity DV = 1 if on gold (1) (2) (3)

Constant -0.219 -1.237 1.494 (0.427) (0.456)*** (0.866)* M2/GDP 0.024 0.018 0.001 (0.011)** (0.014) (0.012) RGDPPC 0.008 0.003 (0.002)*** -0.003 SPREAD -0.942 (0.248)*** Log Likelihood -390.869 -298.941 -223.922 Observations 734 700 686 Probit with robust standard errors, adjusted for clustering, in parentheses. * significant at 10%; ** significant at 5%; *** significant at 1%

33

Table 3: Gold Standard Membership: Political Economy DV = 1 if on gold (4) (5) (6) Constant 2.181 2.373 2.344 (0.442)*** (0.592)*** (0.603)*** SPREAD -1.121 -1.183 -1.141 (0.255)*** (0.296)*** (0.255)*** M2/GDP 0.002 (0.012) INSTABILITY -0.588 -0.61 -0.595 (0.291)** (0.288)** (0.277)** POLITY 0.058 0.053 0.036 (0.026)** (0.025)** (0.031) EXPORTS -0.003 -0.004 (0.003) (0.004) Log Likelihood -226.110 -220.751 -210.588 Observations 690 680 651 Probit with robust standard errors, adjusted for clustering, in parentheses. * significant at 10%; ** significant at 5%; *** significant at 1%

34

Table 4: Gold Standard Membership: Split sample DV = 1 if on gold (7) (8) (9) (10) 1880-1897 1880-1897 1897-1913 1897-1913 Constant 4.605 3.678 1.52 1.691 (0.841)*** (0.979)*** (0.776)* (0.727)** SPREAD -2.287 -2.197 -0.663 -0.693 (0.370)*** (0.397)*** (0.319)** (0.259)*** M2/GDP 0.026 -0.004 (0.014)* (0.013) INSTABILITY -1.21 -0.91 -0.549 -0.567 (0.276)*** (0.295)*** (0.414) (0.417) POLITY 0.118 0.086 0.048 0.051 (0.067)* (0.063) (0.045) (0.05) EXPORTS -0.018 -0.02 0.003 0.004 (0.006)*** (0.006)*** (0.005) (0.006) Log Likelihood -60.971 -50.485 -128.678 -128.412 Observations 352 323 349 349 Probit with robust standard errors, adjusted for clustering, in parentheses. * significant at 10%; ** significant at 5%; *** significant at 1%

35

Table 5: First Differences: Political Economy Variables POLITICAL INSTABILITY

First Difference

Model 4 -.21** Model 5 -.22** Model 6 -.21** Model 7 -.38*** Model 8 -.32* Model 9 -.18 Model 10 -.18 POLITY First Difference Model 4 .20** Model 5 .18** Model 6 .12 Model 7 .41* Model 8 .30 Model 9 .14 Model 10 .15 EXPORTS First Difference Model 5 -.02 Model 6 -.02 Model 7 -.17*** Model 8 -.18*** Model 9 .03 Model 10 .03 Note: First differences are the change in the predicted probability of being on the gold standard (DV=1) as variables of interest move from their 25 percentile to their 75 percentile values, holding other continuous variables to their means and categorical variables to zero. (For POLITICAL INSTABILITY, the change in probability reflects a move from zero to one). * significant at 10%; ** significant at 5%; *** significant at 1%

36

Table 6: Summary Statistics

Full Sample (Models 2-6) Variable Obs Mean Std. Dev. Min Max DEP. VAR. 768 .708 .455 0 1 M2/GDP 748 38.734 18.931 10.426 113.496 RGDPPC 730 194.213 83.992 53.328 422.760 SPREAD 759 1.452 1.518 -.02 15.41 INSTABILITY 727 .0413 .199 0 1 POLITY 727 2.421 5.939 -10 10 EXPORTS 772 30.932 38.847 .705 217.916

1880-1897 (Models 7-8)

Variable Obs Mean Std. Dev. Min Max DEP. VAR. 414 .638 .481 0 1 M2/GDP 380 35.194 15.839 10.426 113.496 RGDPPC 378 176.177 74.018 57.267 385.188 SPREAD 398 1.747 1.8655 0 15.41 INSTABILITY 378 .0344 .182 0 1 POLITY 378 1.219 5.822 -10 10 EXPORTS 404 25.394 31.888 .705 163.617

1897-1913 (Models 9-10) Variable Obs Mean Std. Dev. Min Max DEP. VAR. 377 .785 .411 0 1 M2/GDP 391 42.346 21.179 12.009 113.496 RGDPPC 374 211.875 89.1223 53.328 422.759 SPREAD 384 1.194 1.192 -.02 15.41 INSTABILITY 370 .046 .21 0 1 POLITY 370 3.6 5.813 -10 10 EXPORTS 391 36.449 44.030 1.945 217.916