The Gold Standard

Overview

In 1924, John Maynard Keynes famously dismissed the gold standard as a ‘barbarous relic’. But the liberation of bank-created money from a precious metal anchor happened slowly.

What is it?

The gold standard is a monetary system where a country’s currency or paper money has a value directly linked to gold (pegged to gold). With the gold standard, countries agreed to convert paper money into a fixed amount of gold. A country that uses the gold standard sets a fixed price for gold and buys and sells gold at that price. That fixed price is used to determine the value of the currency. For example, if the U.S. sets the price of gold at $500 an ounce, the value of the dollar would be 1/500th of an ounce of gold.

The gold standard is a monetary system in which paper money is freely convertible into a fixed amount of gold. In other words, in such a monetary system, gold backs the value of money. Between 1696 and 1812, the development and formalization of the gold standard began as the introduction of paper money posed some problems.

The U.S. Constitution in 1789 gave Congress the sole right to coin money and the power to regulate its value. Creating a united national currency enabled the standardization of a monetary system that had up until then consisted of circulating foreign coin, mostly silver.

Advantages

The gold standard had it’s advantages, no doubt.

1. Exchange rate stability made for predictable pricing in trade and reduced transaction costs, while the long-run stability of prices acted as an anchor for inflation expectations. The gold standard stabilizes prices and foreign exchange rates.
2. Being on gold may also have reduced the costs of borrowing by committing governments to pursue prudent fiscal and monetary policies.
3. It arrests control of the issuance of money out of the hands of imperfect human beings. With the physical quantity of gold acting as a limit to that issuance, a society can follow a simple rule to avoid the evils of inflation. The goal of monetary policy is not just to prevent inflation, but also deflation, and to help promote a stable monetary environment in which full employment can be achieved. The gold standard prevents inflation as governments and banks are unable to manipulate the money supply (e.g., overissuing money).

Limitations or Disadvantages

A brief history of the U.S. gold standard is enough to show that when such a simple rule is adopted, inflation can be avoided, but strict adherence to that rule can create economic instability, if not political unrest.

The difficulty of pegging currencies to a single commodity based standard, or indeed to one another, is that policymakers are then forced to choose between free capital movements and an independent national monetary policy. They cannot have both. A currency peg can mean higher volatility in short-term interest rates, as the central bank seeks to keep the price of its money steady in terms of the peg. It can mean deflation, if the supply of the peg is constrained (as the supply of gold was relative to the demand for it in the 1870s and 1880s). And it can transmit financial crises (as happened throughout the restored gold standard after 1929). By contrast,a system of money based primarily on bank deposits and floating exchange rates is freed from these constraints.

Under the gold standard, the supply of gold cannot keep pace with its demand, and it is not flexible under trying economic times. Also, mining gold is costly and creates negative environmental externalities.

Is it used anymore?

The gold standard is not currently used by any government. Britain stopped using the gold standard in 1931, and the U.S. followed suit in 1933, finally abandoning the remnants of the system in 1973.

The gold standard was a long time dying, but there were few mourners when the last meaningful vestige of it was removed on 15 August 1971, the day that President Richard Nixon closed the so-called gold ‘window’ through which, under certain restricted circumstances, dollars could still be exchanged for gold. From that day onward, the centuries-old link between money and precious metal was broken.

Some history

1. With its large discoveries of gold, England became the first country to implement the gold standard.
2. Around 700 B.C., gold was made into coins for the first time, enhancing its usability as a monetary unit. Before this, gold had to be weighed and checked for purity when settling trades.
3. Gold coins were not a perfect solution since a common practice for centuries to come was to clip these slightly irregular coins to accumulate enough gold that could be melted down into bullion. In 1696, the Great Recoinage in England introduced a technology that automated the production of coins and put an end to clipping.
4. The Bretton Woods agreement established that the U.S. dollar was the dominant reserve currency and that the dollar was convertible to gold at the fixed rate of $35 per ounce.
5. In 1971, President Nixon stopped the convertibility of the U.S. dollar to gold.
6. In the decades before the First World War, international trade was conducted based on what has come to be known as the classical gold standard. In this system, trade between nations was settled using physical gold. Nations with trade surpluses accumulated gold as payment for their exports. Conversely, nations with trade deficits saw their gold reserves decline as gold flowed out of those nations as payment for their imports.
7. Gold bugs - people who are forever confident in gold’s stability as a source of wealth. They still cling to a past when gold ruled.
8. Since it could not always rely on additional supplies from the earth, the supply of gold expanded only through deflation, trade, pillage, or debasement.
9. Europe’s introduction of paper money occurred in the 16th century, with the use of debt instruments issued by private parties. While gold coins and bullion continued to dominate the monetary system of Europe, it was not until the 18th century that paper money began to dominate. The struggle between paper money and gold would eventually result in the introduction of a gold standard.
10. A true international gold standard existed for less than 50 years—from 1871 to 1914.

Adaption

By 1821, England became the first country to officially adopt a gold standard. The century’s dramatic increase in global trade and production brought large discoveries of gold, which helped the gold standard remain intact well into the next century. As all trade imbalances between nations were settled with gold, governments had a strong incentive to stockpile gold for more difficult times. Those stockpiles still exist today.

The international gold standard emerged in 1871, following its adoption by Germany. By 1900, the majority of the developed nations were linked to the gold standard. Ironically, the U.S. was one of the last countries to join. In fact, a strong silver lobby prevented gold from being the sole monetary standard within the U.S. throughout the 19th century.

From 1871 to 1914, the gold standard was at its pinnacle. During this period, near-ideal political conditions existed among most countries—including Australia, Canada, New Zealand, and India—that instituted the gold standard. However, this all changed with the outbreak of the Great War in 1914.

The fall of the Gold standard

With World War I, political alliances changed, international indebtedness increased, and government finances deteriorated. While the gold standard was not suspended, it was in limbo during the war, demonstrating its inability to hold through both good and bad times. This created a lack of confidence in the gold standard that only exacerbated economic difficulties. It became increasingly apparent that the world needed something more flexible on which to base its global economy.

At the same time, a desire to return to the idyllic years of the gold standard remained strong among nations. As the gold supply continued to fall behind the growth of the global economy, the British pound sterling and U.S. dollar became the global reserve currencies. Smaller countries began holding more of these currencies instead of gold. The result was an accentuated consolidation of gold into the hands of a few large nations.

The United States government holds more than 8,133 tons of gold—the largest stockpile in the world.

The stock market crash of 1929 was only one of the world’s post-war difficulties. The pound and the French franc were misaligned with other currencies; war debts and repatriations were still stifling Germany; commodity prices were collapsing, and banks were overextended. Many countries tried to protect their gold stock by raising interest rates to entice investors to keep their deposits intact rather than convert them into gold.

These higher interest rates only made things worse for the global economy. In 1931, the gold standard in England was suspended, leaving only the U.S. and France with large gold reserves.

Then, in 1934, the U.S. government revalued gold from $20.67 per ounce to $35 per ounce, raising the amount of paper money it took to buy one ounce to help improve its economy. As other nations could convert their existing gold holdings into more U.S dollars, a dramatic devaluation of the dollar instantly took place. This higher price for gold increased the conversion of gold into U.S. dollars, effectively allowing the U.S. to corner the gold market. Gold production soared so that by 1939 there was enough in the world to replace all global currency in circulation.

Gold vs. the U.S. Dollar

As World War II was coming to an end, the leading Western powers met to develop the Bretton Woods Agreement, which would be the framework for the global currency markets until 1971. Within the Bretton Woods system, all national currencies were valued in relation to the U.S. dollar, which became the dominant reserve currency. The dollar, in turn, was convertible to gold at the fixed rate of $35 per ounce. The global financial system continued to operate upon a gold standard, albeit in a more indirect manner.

At the end of WWII, the U.S. had 75% of the world’s monetary gold and the dollar was the only currency still backed directly by gold. However, as the world rebuilt itself after WWII, the U.S. saw its gold reserves steadily drop as money flowed to war-torn nations and its own high demand for imports. The high inflationary environment of the late 1960s sucked out the last bit of air from the gold standard.

The Gold Pool

In 1968, a Gold Pool, which included the U.S and several European nations, stopped selling gold on the London market, allowing the market to freely determine the price of gold. From 1968 to 1971, only central banks could trade with the U.S. at $35 per ounce. By making a pool of gold reserves available, the market price of gold could be kept in line with the official parity rate. This alleviated the pressure on member nations to appreciate their currencies to maintain their export-led growth strategies.

However, the increasing competitiveness of foreign nations combined with the monetization of debt to pay for social programs and the Vietnam War soon began to weigh on America’s balance of payments. With a surplus turning to a deficit in 1959 and growing fears that foreign nations would start redeeming their dollar-denominated assets for gold, Senator John F. Kennedy declared, in the late stages of his presidential campaign, that he would not attempt to devalue the dollar if elected.

The Gold Pool collapsed in 1968 as member nations were reluctant to cooperate fully in maintaining the market price at the U.S. price of gold. In the following years, both Belgium and the Netherlands cashed in dollars for gold, with Germany and France expressing similar intentions.

In August of 1971, Britain requested to be paid in gold, forcing Nixon’s hand and officially closing the gold window. By 1976, it was official; the dollar would no longer be defined by gold, thus marking the end of any semblance of a gold standard.

Approximately 50% of all the gold ever mined was mined after 1971.

In August 1971, Nixon severed the direct convertibility of U.S. dollars into gold. With this decision, the international currency market, which had become increasingly reliant on the dollar since the enactment of the Bretton Woods Agreement, lost its formal connection to gold. The U.S. dollar, and by extension, the global financial system it effectively sustained, entered the era of fiat money.

Why Did the U.S. Abandon the Gold Standard?

The U.S. abandoned the gold standard in 1971 to curb inflation and prevent foreign nations from overburdening the system by redeeming their dollars for gold.

The fiat system

The gold standard was completely replaced by fiat money, a term to describe currency that is used because of a government’s order, or fiat, that the currency must be accepted as a means of payment. In the U.S., for instance, the dollar is fiat money, and for Nigeria, it is the naira.

A fiat system is a monetary system in which the value of a currency is not based on any physical commodity but is instead allowed to fluctuate dynamically against other currencies on the foreign-exchange markets.

The term “fiat” is derived from the Latin fieri, meaning an arbitrary act or decree. In keeping with this etymology, the value of fiat currencies is ultimately based on the fact that they are defined as legal tender by way of government decree.

After effects of abandoning the gold standard

Money has ceased to hold its value in the way that it did in the era of the gold standard. The modern-day dollar bill acquired its current design in 1957. Since then, its purchasing power, relative to the consumer price index, has declined by a staggering 87%. Average annual inflation in that period has been over 4%, twice the rate Europe experienced during the so-called price revolution unleashed by the silver of Potosi. A man who had exchanged his $1,000 of saving for gold in 1970, while the gold window was still ajar, would have received just over 26.6 ounces of the precious metal. In 2008, with gold trading at close to $1,000 an ounce, he could have sold his gold for $26,596.

Reading material

1. Peter Bernstein’s book The Power of Gold: The History of Obsession
2. https://www.investopedia.com/ask/answers/09/gold-standard.asp