Before World War I, gold standard worked efficiently and remained widely accepted. It succeeded in ensuring exchange stability among the countries.
But with the starting of the war in 1914, gold standard was abandoned everywhere mainly because of two reasons: (a) to avoid adverse balance of payments and (b) to prevent gold exports falling into the hands of the enemy.
After the war in 1918, efforts were made to revive gold standard and, by 1925, it was widely established again. But, the great depression of 1929-33 ultimately led to the breakdown of the gold standard which disappeared completely from the world by 1937.
The gold standard failed because the rules of the gold standard game were not observed. Following were the main reasons of the decline of the gold standard.
1. Violation of Rules of Gold Standard:
The successful working of the gold standard requires the observance of the basic rules of the gold standard:
(a) There should be free movement of gold between countries;
(b) There should be automatic expansion or contraction of currency and credit with the inflow and outflow of gold;
(c) The governments in different countries should help facilitate the gold movements by keeping their internal price system flexible in their respective economies.
After World War I, the governments of gold standard countries did not want their people to experience the inflationary and deflationary tendencies which would result by following the gold standard.
2. Restrictions on Free Trade:
The successful working of gold standard requires free and uninterrupted trade of goods between the countries. But during interwar period, most of the gold standard countries abandoned the free trade policy under the impact of narrow nationalism and adopted restrictive polices regarding imports.
This resulted in the reduction in international trade and thus the breakdown of the gold standard.
3. Inelastic Internal Price System:
The gold standard aimed at exchange stability at the expense of the internal price stability. But during the inter-war period, the monetary authorities sought to maintain both exchange stability as well as price stability.
This was impossible because exchange stability is generally accompanied by internal price fluctuations.
4. Unbalanced Distribution of Gold:
A necessary condition for the success of gold standard is the availability of adequate gold stocks and their proper distribution among the member countries.
But in the inter-war period, countries like the U.S.A. and France accumulated too much gold, while countries of Eastern Europe and Germany had very low stocks of gold. This shortage of gold reserves led to the abandonment of the gold standard.
5. External Indebtedness:
Smooth working of gold standard requires that gold should be used for trade purposes and not for the movement of capital. But during the inter-war period, excessive international indebtedness led to the decline of gold standard.
There were three main reasons for the excessive movement of capital between countries:
(a) After World War I, the victor nations forced Germany to pay war reparation in gold,
(b) There was movement of large amounts of short-term capital (often called as refugee capital) from one country to another in search of security,
(c) There was plenty of borrowing by the underdeveloped countries from the advanced countries for investment purpose.
6. Excessive Use of Gold Exchange Standard:
The excessive use of gold exchange standard was also responsible for the break-down of gold standard. Many small countries which were on gold exchange standard kept their reserves in London and New York.
But, rumors of war and abnormal conditions forced the depositing countries to withdraw their gold reserves. This led to the abandonment of the gold standard.
7. Absence of International Monetary Centre:
Movement of gold involves cost. Before 1914, such movement was not needed because London was working as the international monetary centre and the countries having deposit accounts in the London banks adjusted their adverse balance of payments through book entries.
But during inter-war period, London was fast losing its position as an international financial centre. In the absence of such a centre, every country had to keep large stocks of gold with them and large movements of gold had to take place.
This was not proper and easily manageable. Thus, gold standard failed due to the absence of inter-national financial centre after World War I.
8. Lack of Co-operation:
Economic co-operation among the participating countries is a necessary condition for the success of gold standard. But after World War I, there was complete absence of such co-operation among the gold standard countries, which led to the downfall of the gold standard.
9. Political Instability:
Political instability among the European countries also was responsible for the failure of gold standard. There were rumours of war, revolutions, political agitations, fear of transfer of funds to other countries. All these factors threatened the safe working of the gold standard and ultimately led to its abandonment.
10. Great Depression:
The world-wide depression of 1929-33 probably gave the final blow to the gold standard. Falling prices and wide-spread unemployment were the fundamental features of depression which forced the countries to impose high tariffs to restrict imports and thus international trade. The great depression was also responsible for the flight of capital.
11. Rise of Economic Nationalism:
After the World War I, a wave of economic nationalism swept the European countries. With an objective to secure self-sufficiency, each country followed protectionism and thus imposed restrictions on international trade. This was a direct interference in the working of the gold standard.