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The Political Economy of Commitment to the Gold Standard
First Draft: April 21, 2002
J. Lawrence Broz
Department of Political Science
University of California, San Diego
(858) 822-5750
[email protected]
Prepared for the conference “Understanding the Gold Standard: New Lessons from an Old
Rule.” University of Notre Dame, May 3-5, 2002. This is the first draft of a joint project with
Michael Bordo. Since I delayed so long in preparing this draft, Michael has not had a chance to
contribute to it, nor to correct my errors. I thank Michael for the body of work that inspired this
paper and for sharing the economic data that made it possible. I also thank Stephanie Rickard for
excellent research assistance and comments.
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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 the time inconsistency problem in monetary policy. Yet some
nations were more successful in making and maintaining the commitment than others. In this
paper, I consider the political as well as the economic factors that were required to adopt the gold
standard as a commitment mechanism. I argue that (1) political system instability reduced the
ability of nations to credible commit to gold, while (2) democratic political institutions increased
the likelihood of joining the gold club. I also contend that (3) interest group pressure from the
nontradable goods sector made adherence to gold more likely. I test these claims on a panel of
23 developed and developing countries covering the 1880-1913 period. I find robust support for
hypotheses (1) and (3) and modest support for (2). In addition, I obtain the unexpected result
that extreme forms of political instability (such as transitions to a new form of political system)
increase the probability of adopting gold.
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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 on the periphery
than it did at the core. While most industrialized “core” countries (e.g. England, France,
Germany) were able to adopt and maintain the gold standard throughout the period, some
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 such as Greece, Argentina,
and Brazil the gold standard was more the exception rather than the rule.
In this paper, I attempt to explain why developed and developing countries had such
varied experiences with the gold standard. The specific goal is to identify factors that made it
more difficult for nations in the periphery to adopt and maintain the gold standard, despite strong
economic incentives to do so. Among the benefits of a strong 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 peripheral countries were perhaps the most in need of using
the gold standard as a “good housekeeping seal of approval,” they found it very difficult to adopt
and maintain the commitment. Furthermore, even the most successful gold standard countries in
the periphery never attained the levels of credibility found in the North Atlantic core.
To address this variation, I draw upon the insight that the classical gold standard was a
commitment mechanism, designed to resolve the time inconsistency problem in monetary policy.
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I argue, however, that political factors help explain why some nations were more successful in
adopting and maintaining the commitment to gold than others. I focus first on the relationship
between political instability and adherence to the gold standard. All other things equal, greater
political instability should reduce the capacity of a government to commit to gold because
political instability shortens the time horizons of political leaders and thereby induces uncertainty
about the future course of macroeconomic policy. I also consider the effects of political system
characteristics (democratic constraints on executive authority) on gold standard performance. In
the context of the limited democracy of the era, I argue that countries with democratic
institutions were more likely to commit to the gold standard. As with the well-known British
case (North and Weingast 1989), countries that developed powerful parliaments that took
decisions over money out of the hands of the sovereign were more responsive to the enfranchised
constituencies that gained from monetary stability. Finally, I consider interest group factors as
suggested by Frieden (1997, 1991) and Eichengreen (1995). Since adopting gold also meant a
real appreciation of the currency, due to the fact that the world’s demand for gold outstripped
supply, groups harmed by appreciation (such as agricultural exporters) should have pressured
against the gold standard, while groups that gained (e.g., nontradables producers) should have
supported the commitment.
I test these arguments on a panel of 23 developed and developing countries over the
1880-1913 periods. Briefly, I find that political system instability decreased the likelihood that a
country would be on the gold standard. While the effect of political instability is evident across
all model specifications, it is not consistently negative. In fact, the results suggest that moderate
forms of political instability (such as high turnover in cabinet positions) reduced the chance of
being on gold, but more extreme forms of political instability (such as the complete collapse of
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political authority) increased the probability of being on gold. I discuss this paradoxical finding
in the conclusion. With regard to democracy, I find moderate support for the argument that
democratic institutions and gold standard adherence are positively related. I also find evidence
supporting the interest group hypothesis. In nations where the proportion of the population
living in large cities was higher (my admittedly problematic proxy for the relative strength of
nontradable versus tradable producers), the probability of being on gold increased.
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 the outcomes. Section 3 develops my political economy arguments. Section 4
presents quantitative evidence on the decision to go on or off gold. 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
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
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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 (e.g. Greece 1910, Mexico 1905, Russia 1897, Japan
1897), or adhered to gold irregularly (e.g. Argentina, Brazil), or did not adopt gold at all (e.g.
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,
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 seemed to have “shadowed” the core, having low inflation rates and fairly stable
exchange rates, despite being off gold for substantial periods (Bordo and Schwartz 1994).
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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 stabilize inflation (Bordo and Kydland 1995; Bordo and Rockoff 1996).
With roots in the rational expectations literature, this work builds on the time inconsistency
problem described by Kydland and Prescott (1977) and Barro and Gordon (1983). The problem
arises when monetary policy is set with discretion and wages and prices are not fully flexible.
Under these conditions, a policymaker may try to fool private agents by inflicting an inflationary
surprise, in the hope of engineering a temporary boost in output. However, forward-looking
private actors anticipate this incentive and take it into account when forming their ex ante
inflationary expectations. These expectations thus introduce an inflationary bias into wage
bargaining and price setting. Consequently, when the policymaker adopts surprise inflation, the
equilibrium outcome is higher inflation but not higher output. The key to solving this time
inconsistency problem is credibility. If the private sector believes that the preannounced policy
is credible, then expected inflation is kept in check at no cost to output.
Making a strong commitment to the gold standard provided an automatic rule for the
conduct of monetary policy that avoided the time inconsistency problem and enhanced the
credibility of the government’s commitment to low inflation. 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.
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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 inflation
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, 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 longterm 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
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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 and thereby triggered 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 (Bloomfield 1959; Dutton 1984). In addition, the 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
1
2
McKinnon (1993) refers to this as the “restoration rule.”
Bordo and Flandreau (2001) fully the develop the parallels between today’s developing country
peggers and peripheral countries during the gold era.
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The paradox is that while capital-poor peripheral countries were perhaps the 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. Similarly, in a case study of the Spanish
economy, 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.
According to Eichengreen (1992: 60), “the role of the gold standard as a credibilitycreating 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 (Bordo and Flandreau 2001). Spreads over rates in
London averaged between 2 to 5 percent for Greece, Portugal, Russia and Italy between 18801913 and remained even when these developing-country borrowers were on gold (Bordo and
Flandreau 2001).
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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, then and
now, is “financial maturity.” Financial maturity is a broad 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
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 core and periphery. The basic insight is that market
agents have rational expectations regarding economic policy and incorporate political
information into their expectations that an exchange rate commitment can or will be honored in
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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.3 The possibility of policy change
suggests that the ultimate credibility of the gold standard rested upon expectations that (1) future
governments would remain committed to the promise, and (2) that a government would pay high
political costs if it jettisoned the commitment to gold.
I argue that the degree of political instability negatively affected credibility by way of
increasing expectations of policy change by future governments. 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
3
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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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 (Leblang 2002).
If expectations of a policy commitment to gold were more difficult to obtain in the face
of frequent political change, then countries with unstable political systems would have difficulty
committing to and maintaining the gold standard. Even when 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, reduced incentives to join or stay in
the gold club since membership could not eliminate inflationary expectations nor allow access to
foreign capital on favorable 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 – authoritarian) 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
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countries (Leblang 1999, Broz 2002). 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
enfranchisement of a very narrow set of constituencies: typically, middle and upper income
males engaged in commercial and financial activities. These actors had a strong stake in
ensuring the commitment to stable macroeconomic policies and were thus solid gold standard
supporters (Eichengreen 1992; Simmons 1994). 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. New forms of commitment
based upon domestic nominal anchors (monetary and inflation targets, central bank
independence) were developed to substitute for the gold standard.
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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 middle 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.
As applied to the gold standard, a similar logic can be developed. By enfranchising
members of the middle and upper classes, while denying political voice to popular interests,
democracy should have made the commitment to gold more credible.
H2: The greater the level of political democracy, the higher the probability that a country would
adopt and/or maintain the gold standard.
Frieden (1997) evaluates a series of votes on the gold standard in the 1890 U.S Congress through
an interest group lens.4 Noting first that the gold standard meant currency stability and appreciation, 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
4
See also Hefeker 1995.
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present in the Latin American periphery. Ford (1962) attributed Argentina’s poor gold standard record
to the landowning and 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 bourgeoisie” (Fritsch
1989).
These arguments, which derive from an open economy perspective (see Broz and Frieden 2001),
suggest that additional political economy factors may have been at play in shaping the decision to
commit credibility to gold. While the gold standard brought broad benefits, such as lower inflation and
integration with the world economy, it also produced concentrated costs for producers of tradable goods,
via 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.
4. Empirical Model and Results
In this section, I test empirically the propositions relating political stability and democracy to the choice
of exchange rate regime during the gold standard era. The sample consists of 23 developed and
developing countries over the period 1880-1913.5 The countries were determined by data availability
but represent a variety of experiences with the gold standard.6 The dependent variable is dichotomous:
one if the country is on the gold standard in a given year, zero otherwise. To address problems of
5
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.
6
Mike Bordo graciously provided most of the economic data for the analysis.
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temporal dependence in binary panel data that violate the assumption that observations are independent
and can yield inflated z- values, I follow the approach developed by Beck, Katz and Tucker (1997).
These authors begin with the recognition that binary panel data are grouped duration data. From this
perspective, the problem of serially correlated errors can be easily resolved by including a set of dummy
variables in a probit/logit model that take into account the length of time since the country’s last
“failure.” In the present context, “time since prior failure” means the elapsed time since a country last
was on the gold standard. When there are a large number of time periods, Beck, Katz and Tucker (1997)
advocate replacing the dummy variables with a reduced set of natural cubic splines, which fit a smooth
function to the time dummies. I include three cubic splines to my data, using a utility program for
STATA written by Tucker (1999).7 The variable OFF GOLD SPELL counts the length in years of the
spell a country is not on the gold standard preceding the current observation, and ranges from zero to 30.
This variable and SPLINE1, SPLINE2, and SPLINE3 combine to capture the nature of duration
dependence in the data. They are equivalent to baseline “hazard rates”: the probability of failure (on
gold) when all independent variables are zero.
My key arguments are that political instability and non-democratic political institutions
reduce the likelihood that a country will adopt the gold standard. I employ two alternative proxy
variables for political instability. The first is CABINET CHANGES, defined as the numbers of
times in a year that a new premier is named and/or new ministers occupy 50 percent of the
cabinet posts (Banks 1994). I expect CABINET CHANGES to be negative, as high turnover in
the leading positions of government should make it difficult for a country to commit credibly to
7
Natural cubic splines fit cubic polynomials to a predetermined number of subintervals of a
variable, joining the polynomials at “knots” specified by the analyst. I experimented with a
number of knot placements and determined that knots placed at 1, 12, and 23 years of “off gold”
resulted in the best performance. Small changes in the number or placement of knots had little
effect on the results.
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gold. The second is INSTABILITY, which I constructed from the Polity IV data set (Marshall
and Jaggers 2000; Gurr, Jaggers, and Moore 1990). Polity IV provides annual indicators of
extreme political instability in the form 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. I created a
dummy variable equal to one if any of the three forms of serious political instability was present,
and 0 otherwise.
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, resulting in a unified polity scale
that ranges from +10 (strongly democratic) to -10 (strongly autocratic).8 I expect POLITY to be
positively associated with gold standard adherence.
I also consider the impact of interest group pressures. As indicated above, 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. The
converse is that producers of nontradable goods would gain from the gold standard, as
appreciation shifted the distribution of real income in their favor (Frieden 1991). Under the
assumption that nontradables activities (e.g., services) were more likely to take place in urban
areas in this era, I include the variable URBAN, which is the share of total population residing in
8
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.
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cities of more than 100,000 people. These data are from Banks (1994). I expect the estimate to
be positively related to the adoption of the gold standard.
To capture the role of 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 rough substitute, I use
the interest rate premium on long-term government bonds. Inasmuch as financial maturity is
related 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 interestbearing liabilities of banks and other financial intermediaries. Yet it is imprecise because non-
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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 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
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 baseline probit estimations that include alternative measure of
financial depth. Model 1 contains M2/GDP and the temporal variables described above. The
estimate on M2/GDP is positive and highly significant, suggesting that countries with greater
financial depth were more likely to adopt gold. Note also that the temporal variables give strong
indication of duration dependence. The four variables that comprise the cubic splines are highly
significant and negative, albeit with the exception of SPLINE2, which is positive. Duration
dependence is thus not linear: the probability of adopting the gold standard falls with the length
of the spell that a country is off gold, but rises in the intermediate period, then falls again in the
very long run.
Model 2 adds a second indicator of financial depth, RGDPPC, to the baseline regression.
Both variables measuring financial depth remain properly signed and significant, suggesting that
21
a nation’s real wealth captures additional aspects of financial development. Alternatively, real
wealth may be picking up unspecified aspects of economic development that are associated with
exchange rate regime choice. Lacking a detailed specification of the relationship, however, I
simply treat real wealth 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 = .60 and r = .40 respectively), producing
instability in the other estimates. This suggests that all three variables are capturing some
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 the
indicator of political turnover, CABINET CHANGES, POLITY to capture democratic
institutions, and SPREAD, a control for financial system attributes. The interest rate premium
and the proxies for political instability and democracy are correctly signed and statistically
different from zero at the 5 percent level. Turnover of political leadership makes it less likely
that a nation will be on the gold standard, while higher levels of democracy increase the
likelihood of being on gold. In Model 5, I add URBAN, as a means to assess whether a
preponderance of urban dwellers engaged in nontradable activities made it more likely for a
nation to adopt gold. The positive and significant coefficient estimates suggest this to be the
case, providing support for the open economy interest group perspective.
22
Model 6 is a robustness check on the relationship between political instability and gold
standard. Here I include INSTABILITY to capture extreme alterations in the political landscape
(such as the collapse of political authority), while leaving CABCNG in the model to capture
milder forms of political change. While all other coefficients remain stable, the positive and
significant result on INSTABILITY runs counter to my priors. It appears that serious
breakdowns in political institutions, such as the collapse of authority or the transition to a new
polity, make gold adoption more likely. On the other hand, the effect appears to be driven by a
small number of European countries that experienced transitions to new forms of governance in
the period (e.g., Sweden 1907-1913; Denmark 1901-1913). With the exception of Portugal in
1910 and Russia in 1906, no other peripheral countries were coded as having transitions or
collapses of authority in the Polity IV series. Nevertheless, this is a very interesting result and
one that remains significant despite different specifications of the model. For example,
INSTABILITY remains positive and significant even when CABCNG is excluded. Perhaps
leaders in a polity that is transitioning to a new political form latch onto gold as a means to
provide economic stability during the transition. Another possibility is that economic
mismanagement under the prior regime may prompt transitional leaders to adopt staunchly
orthodox and essentially automatic monetary arrangements as a means to signal the nation’s
commitment to macroeconomic discipline. I elaborate on these points in the conclusion.
Table 4 examines the robustness of the political economy results to alternative model
specifications. Model 7 adds RGDPPC to the model so as to control for other aspects of
economic development, financial or otherwise. The major impact is to cause the interest group
proxy, URBAN, to become insignificant. RGDPPC and URBAN are strongly collinear (r = .75),
so one should not read too much into these estimates. Mild political disturbances, as proxied by
23
CABCNG, remains significantly negatively, and the paradoxical effect of extreme political
instability, as captured by INSTABILITY, is significantly positive, as before. Finally,
democratic institutions increase the likelihood of being on gold, as indicated by the positive sign
on POLITY, although the estimate does not quite reach a conventional significant level (z =
.119).
Model 8 includes all three measures of financial development. Despite evidence of
multicollinearity in these terms (note the sign on M2/GDP is now negative), there is still support
for previous findings. Political turnover, as proxied by CABCNG, remains negatively related to
being on the gold standard, although the estimate is not quite significant (z = .117).
INSTABILITY remains (oddly) positive and significant while POLITY is positive and weakly (z
= .127) significant.
The final specification, Model 9, drops SPREAD (to reduce multicollinearity) and
thereby controls for real income and the ratio of money to GDP. None of the variables of
interest – CABCNG, INSTABILITY, POLITY, and URBAN – reach conventional levels of
significance in this model, although CABCNG and POLITY have the expected negative and
positive signs, respectively.
4a. Substantive Interpretation
Table 5 provides a more intuitive interpretation of the results. I used the “Clarify”
software developed by Tomz et al (1998; King et al 2000), to simulated the predicted probability
of a country being on the gold standard, and then examined how the predicted probabilities
change as the values of the political economy variables move from their minimum to maximum
values. I estimated each model in Tables 3 and 4, simulated a distribution of predicted values
while holding all other control variables as their mean (categorical variables were set to zero),
24
and observed how the predicted probability of being on gold changed as the variables of interest
moved from their minimum to their maximum value. Thus, the values presented in Table 5
represent the change in the predicted probability of being on gold. Since Clarify generates
confidence intervals around the predicted probabilities, I also report the statistical significance of
the first differences.
The first row of the table indicates that the impact of turnover in political leadership
(CABINET CHANGES) on the probability of being on gold is substantively very large and
statistically significant (with the exception of Model 8, which is plagued by multicollinearity). A
move from the minimum value of CABINET CHNAGES (zero) to the maximum value (3),
decreases the probability of being on the gold standard by 27 percent on average (-28 percent in
Model 4, -27 percent in Model 5, -26 percent in Model 6, -26 percent in Model 7, and –22
percent in Model 8, and –33 percent in Model 9). The change in predicted probabilities
associated with more severe forms of political instability (INSTABILITY) are relatively smaller,
but moderately important in absolute terms: on average, the probability of being on gold
increases by 5.75 percent as INSTABILITY moves from its minimum to its maximum values.9
Note that all first difference estimates are positive and significant, which suggests that the result
is quite robust. Recall, however, that the effect is driven primarily by two European gold
adherents, along with Russia and Portugal, as they transitioned to new polities.
The effect of democracy on exchange rate regime choice is most evident in Models 4-6,
which include SPREAD as a control for financial maturity. The impact of moving from the
lowest level of democracy found in the data (-10) to the highest level (10), is to increase the
9
Since this is a dummy variable, an occurrence of political “transition” increases the probability
by 5.75 percent.
25
probability of being on gold by 13.3 percent, on average (.17 in Model 4, .10 in Model 5, and .13
in Model 6). The sign reversals in Model 8 and 9 are due to collinearity, but the small and
insignificant first difference estimate from Model 9 suggests the finding is not robust to other
specifications.
The impact of having a large non-tradables sector, as proxied imperfectly by URBAN, is
important in terms of magnitude and significant in models that are free of collinearity problems
(Models 5, 6, and 9). The average effect of moving from the lowest level of URBAN (3.14 =
Russia) to the highest level (37.54 = Australia) is to raise the probability of adopting gold by 23
percent on average. This provides consistent support for the interest group argument.
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 varied 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. The
purpose of this paper is to develop the political side of membership in the gold regime.
26
To do so, 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. Having democratic political institutions and a large nontradables sector increased
the likelihood of being on the gold standard. Political instability, in the form of frequent
turnover in the political elite, reduced the chances of adopting gold while serious political
disturbances (transitions to a new polity) increased the likelihood of gold adherence.
Democracy in this era enfranchised constituencies that gained from the gold standard and
vested these asset holders with authority over macroeconomic policy via a legislature filled with
their agents. I contend that democratic participation in this restricted form constrained
opportunism and made it easier for democratic polities to commit credibly to gold. But societal
constituencies also influenced the choice of exchange rate regime irrespective of political system
characteristics, as results pertaining to the interest group approach suggest. Nations with large
nontradables sectors had an increased chance of being on gold. Thus, democracy supported the
commitment to gold and policymakers were responsive to the distributional effects of the gold
standard regardless of the form of political institutions.
The strongest and most interesting findings relate to political instability. Frequent
changes in cabinet posts and the premier reduce the probability of being on the gold standard.
This fits the logic of H1: high turnover of political leaders increases the likelihood of policy
change, thus making promises less credible in terms of market expectations. Adopting gold is
less likely ex ante because the alternation of leaders creates a credibility deficit, which reduces
27
the benefits of membership. However, more dramatic forms of political instability, such as
transitions to a new political system, seem to increase the chances of being on gold.
The reasons why serious political change is positively related to gold adherence are
unclear. It may be that major political system changes give policymakers incentives to try to
regain or maintain credibility by pegging the exchange rate. With market expectations running
in the opposite direction – toward devaluation or letting the exchange rate float – the credibility
gains might be substantial. Indeed, if markets expect policymakers to let the exchange rate float
during transitions, due to the difficulty in finding political support for the unpopular measures
required to defend the peg, then fixing the exchange rate (or keeping it fixed) sends a credible
signal of macroeconomic discipline because it comes when it is least expected. The commitment
to the peg becomes more credible as the government bears large political costs to defend it.
Alternatively, serious political instability might "re-shuffle" interest groups in a way that makes
commitment easier (Olson 1982). With the transition to a new political system, leaders may be
better able to commit because the old interest group structure is washed away. In this case,
transitions may loosen the hold that anti-gold standard groups have on public policy. These
seem like plausible ways to account for the result, but additional theoretical and empirical work
is certainly needed.
28
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31
Table 1: Gold Standard Club
a
Country
Date adopted
Years on gold GDP per capita Inflation Exchange rate variability
Australia
1852
34
3,128
0.60
0.00
Belgium
1878
34
4,286
0.15
0.16
Canada
1853
34
2,359
0.72
0.00
Denmark
1873
34
2,730
0.22
0.01
Finland
1877
34
1,267
0.58
.
France
1878
34
1,761
-0.05
0.00
Germany
1872
34
2,193
0.86
0.01
Netherlands
1875
34
2,874
0.02
.
Norway
1873
34
2,891
0.75
0.01
Sweden
1873
34
2,131
0.41
0.00
Switzerland
1878
34
.
-0.10
.
United Kingdom
1816
34
3,080
-0.06
0.00
United States
1879
34
3,524
0.09
0.00
Romania
1890
24
.
.
.
India
1899
21
.
.
.
Argentina
1863, 1883, 1899
17
833
4.82
0.14
Japan
1897
17
417
2.44
0.39
Russia
1897
17
.
1.26
.
Costa Rica
1900
14
.
.
.
Ecuador
1900
14
.
.
.
Austria-Hungary
1902
12
.
0.39
.
Philippines
1903
11
.
.
.
Portugal
1854
11
589
0.66
0.14
Brazil
1888, 1896, 1906
10
216
4.75
1.39
Italy
1884
10
1,183
0.05
0.16
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
.
.
.
Columbia
1871
0
.
.
.
Guatemala
-0
.
.
.
Haiti
-0
.
.
.
Honduras
-0
.
.
.
Indonesia
-0
.
.
.
Paraguay
-0
.
.
.
Persia
-0
.
.
.
Peru
-0
.
.
.
Spain
-0
2,058
0.41
0.74
Notes: Adoption dates are from Meissner (2001) and Bordo and Schwartz (1996). “--“ indicates the country did not
adopt gold. “Years on Gold” gives the total number of years that a country was on the gold standard between 1880
and 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: Probit Analysis of Gold Standard Membership: Financial Maturity
DV = one if on gold,
zero otherwise
M2/GDP
(1)
(2)
(3)
0.015
(0.005)***
0.011
(0.005)**
-0.002
(0.004)
0.004
(0.001)***
0.001
(0.002)
RGDPPC
SPREAD
-0.646
(0.223)*
OFF GOLD SPELL
-1.750
(0.280)***
-1.693
(0.272)***
-1.488
(0.256)***
SPLINE 1
-0.081
(0.015)***
-0.083
(0.016)***
-0.071
(0.016)***
SPLINE 2
0.012
(0.003)**
*
-0.005
(0.002)***
0.016
(0.005)***
0.014
(0.005)***
-0.014
(0.007)*
-0.012
(0.007)*
1.427
(0.222)***
0.934
(0.312)***
2.826
(0.669)***
-96.478
-83.694
-69.488
734
700
686
SPLINE 3
Constant
Log Likelihood
Observations
Notes: *p < .10, ** p < .05, *** p < .01
Robust (White's heteroskedastic-consistent) standard errors in parentheses.
33
Table 3: Probit Analysis of Gold Standard Membership: Political Economy
DV = one if on gold,
zero otherwise
(4)
(5)
(6)
SPREAD
-0.760
(0.158)***
-0.767
(0.160)***
-0.753
(0.159)***
CABINET
CHANGES
-0.315
(0.160)**
-0.328
(0.168)*
-0.327
(0.167)*
POLITY
0.047
(0.018)**
0.032
(0.017)*
0.038
(0.020)*
0.050
(0.020)**
0.047
(0.020)**
URBAN
INSTABILITY
1.182
(0.441)***
OFF GOLD SPELL
-1.202
(0.216)***
-1.160
(0.208)***
-1.154
(0.207)***
SPLINE 1
-0.061
(0.014)***
-0.058
(0.014)***
-0.058
(0.014)***
SPLINE 2
0.011
(0.003)***
0.011
(0.003)***
0.011
(0.003)***
SPLINE 3
-0.008
(0.003)**
-0.008
(0.004)**
-0.008
(0.004)**
Constant
3.066
(0.243)***
2.544
(0.354)***
2.539
(0.355)***
-69.154
-67.332
-67.059
608
608
608
Log Likelihood
Observations
Notes: *p < .10, ** p < .05, *** p < .01
Robust (White's heteroskedastic-consistent) standard errors in parentheses.
34
Table 4: Probit Analysis of Gold Standard Membership: Alternative Specifications
DV = one if on gold,
zero otherwise
(7)
(8)
SPREAD
-0.624
(0.174)***
-0.585
(0.209)***
RGDPPC
0.004
(0.003)
0.002
(0.004)
M2/GDP
(9)
-0.002
(0.005)
0.022
(0.008)***
CABINET
CHANGES
-0.374
(0.187)**
-0.322
(0.206)
-0.394
(0.169)**
INSTABILITY
1.024
(0.369)***
0.988
(0.372)***
1.052
(0.580)*
POLITY
0.042
(0.027)
0.040
(0.026)
0.002
(0.018)
URBAN
0.008
(0.023)
0.003
(0.026)
0.057
(0.014)***
OFF GOLD SPELL
-1.114
(0.210)***
-1.277
(0.254)***
-1.635
(0.269)***
SPLINE 1
-0.055
(0.016)***
-0.061
(0.018)***
-0.082
(0.016)***
SPLINE 2
0.011
(0.008)
0.010
(0.008)
0.014
(0.004)***
SPLINE 3
-0.010
(0.013)
-0.007
(0.013)
-0.009
(0.004)**
Constant
2.241
(0.640)***
2.607
(0.815)***
0.720
(0.361)*
-63.119
-50.052
-66.869
Log Likelihood
Observations
578
562
Notes: *p < .10, ** p < .05, *** p < .01
Robust (White's heteroskedastic-consistent) standard errors in parentheses.
610
35
Table 5: First Differences – Political Economy Variables
Change in probability of gold standard = 1 as each variable of interest moves from min to max.
First difference
CABINET CHANGES
Model 4 (SPREAD)
Model 5 (SPREAD)
Model 6 (SPREAD)
Model 7 (SPREAD, RGDPPC)
Model 8 (SPREAD, RGDPPC, M2/GDP)
Model 9 (M2/GDP)
-.28**
-.27*
-.26*
-.26*
-.22
-.33***
INSTABILITY
Model 6 (SPREAD)
Model 7 (SPREAD, RGDPPC)
Model 8 (SPREAD, RGDPPC, M2/GDP)
Model 9 (M2/GDP)
.08**
.05***
.04***
.06*
POLITY
Model 4 (SPREAD)
Model 5 (SPREAD)
Model 6 (SPREAD)
Model 7 (SPREAD, RGDPPC)
Model 8 (SPREAD, RGDPPC, M2/GDP)
Model 9 (M2/GDP)
.17**
.10*
.13**
-.10
-.09
.02
URBAN
Model 5 (SPREAD)
Model 6 (SPREAD)
Model 7 (SPREAD, RGDPPC)
Model 8 (SPREAD, RGDPPC, M2/GDP)
Model 9 (M2/GDP)
.23**
.22**
-.01
-.003
.24***
Notes: *p < .10, ** p < .05, *** p < .01.
Values represent the change in the predicted probability of being on the gold standard as political
variables move from their minimum to their maximum values, holding other continuous
variables to their mean and categorical variables to zero.
36
Table 6: Summary Statistics
Variable
Obs
Mean
Std. Dev.
Min
Max
ONGOLD
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
CABCNG
645
.547
.638
0
3
INSTBLTY
782
.0281
.1655
0
1
POLITY
727
1.871
6.135
-10
10
URBAN
727
12.337
7.218
3.147
37.542
OFF GOLD
SPELL
768
2.75
5.558
0
30
SPLINE 1
768
-85.390
226.509
-1711
0
SPLINE 2
768
-345.063
1135.69
-1037
0
SPLINE 3
768
-152.090
556.516
-5957
0