I was reading a post on a forum about an explanation of how the gold standard exacerbated The Great Depression. In short, the poster made a point about the implications that a fixed exchange rate has on interest rates between two countries and how this affects capital flow and, consequently, investment.
Commodity backed currencies (at least w.r.t gold) have been less stable historically than a floating currency. Why? Because in an open economy, the growth and declines of a nations business cycle, famines, wars directly translate to fluctuations in domestic prices. What I don’t think you realize is that when you say “Gold Backed” you really mean “Gold Pegged”, as never in the history of this nation, nor in post industrialized england has there ever been enough gold to actually exchange dollars for gold. So, it has always been a fractional reserve commodity backed system. Instead, what you have can be more accurately described simply as a gold peg, that is the nominal value of the dollars has a fixed exchange rate for a quantity of gold. If any two nations both have a gold backed currency, then those two currencies are essentially pegged to eachother.
This creates problems when one country experiences more rapid economic growth than its currency counterpart. Because of a relationship called the interest parity condition, which states that two countries with pegged currencies must have the same interest rate (leaving out risk), as an economy starts to expand more rapidly it demands more currency (and thus gold), thus its interest rates increase. If the foreign country’s interest rates rise while domestic interest rates remain constant, then capital will flow towards foreign bonds where they will receive a higher interest rate (a higher return), and thus interest rates will increase domestically to prevent this from occurring… But if interest rates increase domestically while our nation is either presently in a slump or incapable of handling the shock of increased interest rates, the increase in interest rates will reduce investment, lowering output and sending us into a recession. This is called deflationary pressure. This pressure has caused many a run on central banks, and this causes many central banks to consider devaluation, which undermines the credibility of the system in the first place, thus leading to the run.
I haven’t given it much thought, but I immediatley see the fact that since business cycles are caused by manipulation of credit in the first place, then a true commodity backed currency would prevent such phenomena from coming into fruition in the first place. But it is still true that the demand for currency would not be homogenous from country to country.
He cites this paper as a source: http://www.dartmouth.edu/~dirwin/Did%20France%20Cause%20the%20Great%20Depression.pdf