The period 1870–1914 is considered the heyday of the international gold standard. The reason for the successful maintenance of fixed exchange rates for about four decades is that internal balance generally was sacrificed to maintain external balance, or the fixed exchange rate, during this period. The success of the pre–World War I gold standard is important when you consider the fact that no multilateral agreement enforced the system.

It is equally important to realize that the commitment to the gold standard came with the cost of lower growth rates.

In the late 19th century, the main benefit of joining the gold standard was to gain access to capital markets such as London, Paris, or Berlin. The tradeoff was the requirement to acquire gold reserves. However, many countries were ready to pay the price of access to capital markets. Coordination was achieved by maintaining convertibility, which fixed exchange rates between national monetary units within narrow limits.

A small number of countries also developed monetary agreements. In fact, one of the remarkable developments of this period was the emergence of regional monetary unions. Although no multilateral agreements were struck, countries’ actions implied loyalty to the metallic standard. Consider two examples:

  • Belgium, Italy, Switzerland, and France developed the Latin Monetary Union, starting in 1866. It lasted until the start of WWI in 1914.

  • Denmark, Norway, and Sweden established the Scandinavian Monetary Union between 1873 and 1914.

These monetary unions allowed their members to treat each other’s currency as legal tender. Central banks in these monetary unions accepted each other’s money and established a clearinghouse to settle balances.

However, problems were also brewing in the background. Whereas Britain was having large and persistent current account surpluses, other countries were running deficits. Remember that the price–specie–flow mechanism should have taken care of these imbalances. This mechanism implies that when surplus countries lend and deficit countries borrow, this reduces the pressure of imbalances on the fixed exchange rate.

However, surplus countries that were accumulating gold reserves were not lending to deficit countries. Central banks of countries with current account deficits were losing their gold reserves fast.

Especially toward 1914, the price-specie-flow mechanism ceased to function properly: The responsibility fell almost solely on deficit countries, while surplus countries continued accumulating their current account surpluses (and, therefore, gold reserves).

As a result, deficit countries felt the need to implement increasingly contractionary monetary policies that raised interest rates in these countries. Deficit countries did so to attract foreign capital flows into these countries. However, contractionary policies and higher interest rates led to decreasing growth and increasing unemployment.

As World War I started in 1914, countries abolished the gold standard. The world went back to the fiat currency system until 1918.