In classical economics imbalances in international trade were rectified automatically by the gold standard. A country in deficit would have to pay its debts in gold thus depleting gold reserves and would therefore have to reduce its money supply. The resulting fall in demand would reduce imports and the lowering of prices would boost exports; thus theoretically the deficit would be rectified (Rockwell, 10). In practice however this could seriously destabilize the economy of countries which ran a trade deficit, because people tended to make a run on the bank to retrieve their money before gold reserves were exported, thus causing banks to collapse and wiping out savings. Bank runs and failures were a common feature of life during the period when the gold standard was the established economic system (Thompson, 96). The gold standard limits the power of governments to cause price inflation by excessive issue of paper currency, although there is evidence that before World War I monetary authorities did not expand or contract the supply of money when the country incurred a gold outflow.
Theoretically it also creates certainty in international trade by providing a fixed pattern of exchange rates (Snyder, 139). Thus, the gold standard is supported by many advocates of classical economics, monetarism, Objectivism, and even proponents of libertarianism (Moure, 88). However, the disadvantages are that it may not provide sufficient flexibility in the supply of money, because the supply of newly mined gold is not closely related to the growing needs of the world economy for a commensurate supply of money. A single country may also not be able to isolate its economy from depression or inflation in the rest of the world. In addition, the process of adjustment for a country with a payments deficit can be long and painful whenever an increase in unemployment or decline in the rate of economic expansion occurs. Opponents of the gold standard such as Keynesianisms argue that the gold standard creates deflation which intensifies recessions as people are unwilling to spend money as prices fall, thus creating a downward spiral of economic activity.
The gold standard also removes the ability of governments to fight recessions by increasing the money supply to boost economic growth (Michaels, 61). Opponents of the gold standard thus argue that an expanding economy with a supply of gold that increases more slowly than the economy expands would cause a tiny, but steady, deflation. It is believed by gold standard opponents that this gradual deflation would throw the economy into recession (Snyder, 139). No mainstream economist today advocates a return to the gold standard. However, a near century-long period of deflation has already occurred in Britain while on the Gold Standard during the 1800's. During that century the price, in gold, of goods and services in Britain was halved.
The gradual century of deflation did not cause a century of recession. Quite the contrary, the British empire during that period was the undisputed economic power of the world (Thompson, 98). However critics of the gold standard say that this may well have been due to the fact that Britain was able to import cheap raw materials from the Empire and manufacture goods more cheaply than its competitors, allowing it to run trade surplus ses (Moure, 93). The Sumerians, as part of their development of a standard of weights and measures, placed the royal stamp on each piece of gold to guarantee that it was the same amount as every other similarly stamped gold piece.
They simply agreed that this was worth a bushel of wheat - the value was never in the gold. For each amount of gold issued by the king, a certain amount of wheat is kept in reserve in order to ensure that gold has some value. This ensures that the value of the gold with respect to wheat did not change - no inflation with respect to wheat. When the gold is returned to the king, it is redeemed with the wheat that it represented.
This, in effect, is a "wheat standard" (Snyder, 141). The problem with the idea of a gold standard is that it is similar to the creation of a "dollar standard" - creating a new currency to use, while holding a reserve of dollars in the bank to give the new currency some legitimacy. The problem is that the commodity held in reserve was merely a unit of exchange and derives its value mainly from its previous use as currency. The original backing of the currency is lost (Timmerman's, 56). The gold standard was first put into operation in Great Britain in 1821. In the full internal and international gold standard of the pre-1914 world, gold could be exchanged for equal weights of gold coinage, coins could be melted down for their gold content, and gold coin or bullion could be exported freely (Michaels, 63).