What Is the Gold Standard? (Pros, Cons, and More)

Last updated on October 4, 2023

So what is the gold standard in simple terms? The gold standard used to be a way countries tied their paper money to gold. Imagine if a country said, “One piece of paper money equals a small piece of gold.”

This meant they had to keep a fixed amount of gold in their vaults.

For instance, if the U.S. decided that one piece of paper money was worth 1/500th of a small piece of gold (let’s say the gold is worth $500), then that’s how they determined the value of the dollar.

But here’s the thing: no country does this anymore. Britain was the first to stop in 1931, and the U.S. followed suit in 1933, getting rid of the rest of the system in 1973.

Now, we use something called “fiat money.” That’s a fancy term for money that a government says everyone has to accept. In the U.S., it’s the dollar, and in Nigeria, it’s the naira.

People liked the gold standard because it kept the government from making too much money. See, with gold, there’s only so much of it in the world, so it’s hard for governments to print tons of money and mess things up.

The goal of money rules isn’t just to avoid making money worth less (that’s inflation), but also to avoid making it worth more (that’s deflation). You want it to stay just right, like Goldilocks’ porridge.

But here’s the twist: history shows that sticking too tightly to these rules can cause problems, even making people angry.

The Gold Standard: Highlights
The gold standard ties a country’s money to gold.
England was the first to use it, thanks to finding lots of gold.
The Bretton Woods agreement said the U.S. dollar was the most important, and it was like having $35 worth of gold.
But in 1971, President Nixon said no more turning dollars into gold.

What you'll learn:

➤Differences of Gold Standard vs Fiat System

What is the Gold Standard System?

The gold standard system is a monetary system where the value of a currency is tied to gold. In this system, a country’s currency has a fixed value based on a specific amount of gold.

What is a Fiat System?

In contrast, a fiat system is a monetary system where a currency’s value is not linked to any physical commodity like gold. Instead, the value of the currency is allowed to fluctuate against other currencies on the foreign exchange markets.

How is the Value of Fiat Currency Determined?

The term “fiat” originates from the Latin word “fieri,” which means an arbitrary act or decree. In the case of fiat currencies, their value is ultimately based on the fact that they are declared as legal tender by government decree.

What Was the Classical Gold Standard?

Before World War I, international trade operated under the classical gold standard. This system involved settling trade balances between nations using physical gold. Countries with trade surpluses received gold as payment for their exports, while nations with trade deficits saw their gold reserves decrease as they paid for their imports with gold.

☞ Read More: What Is Inflation? (And How to Control It)

➤ The Gold Standard’s History

Why Did President Herbert Hoover Mention Gold in 1933?

In 1933, President Herbert Hoover made a famous statement about gold, expressing a lack of trust in governments. This statement foreshadowed a significant event in U.S. financial history known as the Emergency Banking Act. This act required all Americans to exchange their gold coins, bullion, and certificates for U.S. dollars.

What Was the Purpose of the Emergency Banking Act?

The Emergency Banking Act aimed to halt the outflow of gold during the Great Depression. By compelling people to convert their gold assets into U.S. dollars, the government sought to stabilize the financial situation at the time.

☞ Read More: When to Retire (And Why Age Matters)

Did the Emergency Banking Act Change Public Perception of Gold?

Despite the Emergency Banking Act’s success in addressing immediate financial concerns, it did not alter the beliefs of gold bugs. Gold bugs are individuals who firmly believe in the enduring stability of gold as a wealth-preserving asset.

Why is Gold’s History Unique?

Gold stands out from other asset classes due to its distinctive impact on its supply and demand. While gold bugs hold onto a past when gold held significant influence, it’s crucial to acknowledge that gold’s history also includes periods of decline. Understanding this history is vital for accurately assessing its future role and value.

What Makes Gold So Captivating for 5,000 Years?

Gold has held a unique allure for humanity over a span of 5,000 years, thanks to its exceptional qualities, including luster, malleability, density, and scarcity. To put its density into perspective, one cubic foot can contain a ton of gold.

From Worship to Adornment

Gold’s initial use was primarily for religious worship, as evident in ancient sacred sites around the world. In modern times, the most widespread use of gold is in crafting exquisite jewelry.

The Birth of Gold Coins

Around 700 B.C., gold marked a significant milestone when it was fashioned into coins for the first time. This transformation enhanced its practicality as a form of currency. Prior to this, gold transactions required meticulous weighing and purity checks.

Overcoming Imperfections

Gold coins faced imperfections, as they were often slightly irregular. To accumulate sufficient gold for melting into bullion, individuals would clip these coins. The year 1696 marked a turning point with the Great Recoinage in England, introducing automated coin production and eliminating the practice of coin clipping.

The Complex Growth of Gold’s Supply

Gold’s supply didn’t expand through a straightforward process. Instead, it grew through deflation, trade, plunder, or debasement, as Earth’s resources weren’t a reliable source of additional gold.

The Great Gold Rush

In the 15th century, the first significant gold rush reached America. Spain’s extraction of riches from the New World quintupled Europe’s gold supply in the 16th century. Subsequent gold rushes occurred in the Americas, Australia, and South Africa during the 19th century.

Paper Money Emerges

Europe introduced paper money in the 16th century, primarily in the form of debt instruments issued by private entities. Although gold coins and bullion continued to play a significant role in Europe’s monetary system, paper money began to take prominence in the 18th century.

The ongoing debate between paper money and gold ultimately led to the establishment of the gold standard.

➤ How Did the Gold Standard Rise?

Defining the Gold Standard

The gold standard is a monetary system where paper money can be readily exchanged for a fixed amount of gold, effectively anchoring the value of money to gold. The origins of this monetary system trace back to the late 17th century as a response to the challenges posed by the introduction of paper money.

The U.S. Constitution Shapes Currency

In 1789, the U.S. Constitution granted Congress the exclusive authority to coin money and regulate its worth. This paved the way for a unified national currency, standardizing a previously diverse monetary system that relied heavily on foreign coins, particularly silver.

Silver and Gold

In 1792, a bimetallic standard emerged, with silver and gold coexisting. Although the official silver-to-gold ratio of 15:1 initially mirrored market conditions, the value of silver dwindled after 1793, causing gold to become more prominent, driven by Gresham’s law.

The Coinage Act of 1834

In 1834, the Coinage Act aimed to restore gold coins to circulation. Advocates sought a ratio of 16:1, not to displace silver but to reduce the prevalence of small-denomination paper notes issued by the disliked Bank of the United States. This ratio, which favored gold, effectively placed the U.S. on a de facto gold standard.

The Global Adoption of the Gold Standard

England took the lead in 1821 by officially adopting the gold standard, capitalizing on the century’s gold discoveries and global trade expansion. As nations settled trade imbalances with gold, governments began accumulating gold reserves, a practice that endures today.

The International Gold Standard

The international gold standard gained traction in 1871 following Germany’s adoption. By 1900, most developed nations were on board. Remarkably, the U.S. was a latecomer, as strong advocacy for silver prevented gold from becoming the exclusive monetary standard during the 19th century.

The Golden Era

From 1871 to 1914, the gold standard thrived, enjoying favorable political conditions in numerous countries, including Australia, Canada, New Zealand, and India. These nations embraced the gold standard. However, the outbreak of World War I in 1914 would alter the landscape dramatically.

➤ How Did the Gold Standard Fall?

World War I Challenges

As World War I unfolded, global dynamics shifted. Political alliances changed, international debts mounted, and government finances deteriorated. The gold standard, while not suspended during the war, struggled to withstand the turmoil.

This highlighted its limitations during both prosperous and challenging periods, eroding confidence in the system.

Desire to Preserve the Gold Standard

Despite the challenges, many nations remained enamored with the idea of returning to the gold standard’s stability. However, as the global economy outpaced the growth of available gold, the British pound sterling and the U.S. dollar emerged as dominant reserve currencies.

Smaller nations began holding these currencies instead of gold, concentrating gold reserves among a few major nations.

The Great Depression and Monetary Policies

The aftermath of the 1929 stock market crash compounded global difficulties. Currencies like the pound and the French franc faced misalignment with others. Germany grappled with war debts, while commodity prices plummeted and banks extended themselves.

To safeguard their gold reserves, many countries raised interest rates to discourage converting deposits into gold, inadvertently worsening the global economic situation.

Suspension of the Gold Standard

In 1931, England suspended the gold standard, leaving only the U.S. and France with substantial gold reserves. In 1934, the U.S. government revalued gold from $20.67 to $35 per ounce to stimulate its economy.

This led to a significant devaluation of the U.S. dollar as other nations exchanged gold for more dollars, allowing the U.S. to accumulate vast gold reserves.

The Bretton Woods Agreement

As World War II neared its conclusion, leading Western powers crafted the Bretton Woods Agreement, shaping global currency markets until 1971.

Under this system, all currencies were tied to the U.S. dollar, which was convertible to gold at a fixed rate of $35 per ounce. The gold standard endured indirectly through this arrangement.

Gold and the U.S. Dollar

The relationship between gold and the U.S. dollar was complex. Over time, a weakening dollar typically led to rising gold prices, although short-term fluctuations occurred.

However, following World War II, the U.S. saw its gold reserves dwindle as funds flowed to war-ravaged nations and imports surged. By the late 1960s, high inflation further strained the gold standard.

The Gold Pool and America’s Dilemma

In 1968, the Gold Pool, including the U.S. and European nations, halted gold sales on the London market, allowing market forces to determine gold prices.

This eased pressure on member nations to appreciate their currencies. Yet, growing competition from foreign countries, debt monetization, and the Vietnam War strained America’s balance of payments.

End of the Gold Standard

As nations feared dollar-redemption for gold, President John F. Kennedy vowed not to devalue the dollar. The Gold Pool collapsed in 1968, and countries like Belgium and the Netherlands exchanged dollars for gold, with Germany and France considering similar actions.

In August 1971, Britain requested gold payments, prompting President Nixon to sever the dollar’s direct convertibility into gold. This marked the official closure of the gold window in 1976, ending the gold standard era. Approximately half of the world’s gold had been mined after 1971.

With Nixon’s decision, the international currency market, which had relied on the dollar since Bretton Woods, lost its gold link. The U.S. dollar and the global financial system entered the fiat money era, severed from the gold standard.

➤ What Is The Gold Standard FAQ

What are the pros of the gold standard?

The gold standard safeguards against inflation by preventing governments and banks from manipulating the money supply, such as overissuing money.

It also brings stability to prices and foreign exchange rates.

What are the cons of the gold standard?

The gold supply struggles to keep up with demand, making it inflexible during economic challenges.

Gold mining is costly and results in negative environmental impacts.

Why did the US leave the gold standard?

In 1971, the U.S. left the gold standard to combat inflation and prevent foreign nations from burdening the system by exchanging their dollars for gold.

Which countries currently use the gold standard?

No country presently adheres to the gold standard, though some retain significant gold reserves.

What replaced the gold standard?

Following the gold standard’s collapse, fiat currency emerged as the preferred alternative, succeeding gold and silver as the primary medium for economic transactions.

➤ Final Thoughts

For millennia, gold has held a captivating allure, but it didn’t always underpin our monetary systems. A genuine international gold standard saw only a brief existence, spanning less than five decades, from 1871 to 1914.

The slow demise of this standard had its roots in the introduction of paper money—an adaptable instrument suited to the complexities of our financial world. Today, gold’s value is determined by demand, and although it no longer serves as a standard, its significance remains profound.

Nations and central banks hold gold as a critical financial asset, employing it to hedge against government loans and as an economic health indicator.

In a free-market context, gold should be regarded as a currency akin to the euro, yen, or U.S. dollar. It shares a long-standing, often inverse relationship with the U.S. dollar. While discussions about reinstating a gold standard arise during market turbulence, it’s essential to recognize that such a system is not without flaws.

Treating gold as a currency and trading it as such can help mitigate risks compared to paper currency and the broader economy. However, it’s crucial to remember that gold is forward-looking. Waiting until disaster strikes may not offer an advantage if its price already reflects an ailing economy.

References

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