From the Gold Standard to Bretton Woods

The classical gold standard, which prevailed among the major economies from roughly the 1870s until the outbreak of the First World War in 1914, rested on a simple principle: each participating country defined its currency in terms of a fixed weight of gold and stood ready to convert paper money into gold on demand. Because every currency was pegged to gold, exchange rates between countries were effectively fixed, moving only within narrow bands set by the cost of shipping and insuring bullion, the so-called gold points. The system was supposed to be self-correcting through what economist David Hume had described in the eighteenth century as the price-specie-flow mechanism: a country running a trade deficit would lose gold, its money supply would contract, prices would fall, exports would become more competitive, and the deficit would close on its own. In practice, as economic historian Barry Eichengreen has documented, central banks frequently violated these so-called "rules of the game" by sterilizing gold flows rather than allowing them to work automatically, and the system depended heavily on cooperation among a small number of central banks, above all the Bank of England, and on the credibility of governments’ commitment to convertibility rather than on any mechanical law.