What is the Gold Standard? | Overview & Definition
The gold standard is defined as a monetary system that links its country's currency to the price of a set amount of gold. Widely used around the world during the 19th and early 20th centuries, the gold standard was a common monetary system until 1971, when the U.S. severed the dollar's convertibility to gold and adopted a fiat system.
How the Gold Standard Worked
Under the gold standard, the value of a country's currency was directly linked to the amount of gold held in reserve by its central bank. The central bank would issue currency notes redeemable for a fixed amount of gold. This meant that if you had a $5 bill in your pocket, the country had $5 worth of gold in reserve. In theory, you could exchange that $5 bill for $5 worth of gold. A benefit on the international scale meant that the countries participating in the gold standard created a fixed exchange rate between each other, making international trade and investment more predictable.
Creating a fixed exchange rate between countries would theoretically promote economic stability. By constraining the amount of currency in circulation to the amount of gold held in reserve, the gold standard influences the government's monetary policy. In theory, this prevented inflation, as a government couldn't simply print more money to get itself out of economic trouble unless it had the gold to back it up.
Origins of the Gold Standard
No matter how far back in time you go, you will find examples of humans using gold as a basis for currency. Gold's rarity and durability made it a highly prized commodity, and it was often used as a medium of exchange in early civilizations. During the Middle Ages, gold coins were widely used throughout Europe as a means of payment.
The gold standard we know didn't come about until the 19th century. Britain was the first country to adopt the gold standard in 1821, followed by many other countries, including France, Germany, and the United States. By the late 1800s, the gold standard had become the dominant monetary system in the world. These countries pegged their currencies to a fixed weight of gold, allowing them to price international transactions. Eventually, many more nations followed suit to join the West in trade.
Benefits and Drawbacks of the Gold Standard
Proponents of the gold standard argue that it provided stability and predictability to the international monetary system and helped to promote economic growth and international trade. Under the gold standard, inflation should be rare since the money supply can only grow as big as the supply of gold the country has in reserve. Because currencies were pegged to gold, there was little room for currency fluctuations, which made it easier for businesses to plan and invest in foreign countries.
However, there were also significant drawbacks to the gold standard. Because the money supply was linked to the amount of gold in reserve, it was difficult for governments to respond to economic crises by expanding the money supply. This meant that the gold standard could exacerbate economic downturns and limit governments' ability to take action to mitigate their effects. Also, countries that produce less gold than others may be left at a disadvantage than countries that have an abundant supply of precious metals.
We saw both sides of the argument raise points during a critical point in the United States economic history, the Great Depression. Those against the gold standard argued that the gold standard prevented the federal government from being able to respond quickly and appropriately. Across the aisle, proponents of the gold standard argued the Federal Reserve bent the rules to expand the money supply, which in their eyes, led to the crisis.
The End of the Gold Standard
The gold standard began to unravel during the First World War when countries abandoned it in order to finance their war efforts. After the war, many countries returned to the gold standard, but it was a weakened system. The Great Depression of the 1930s dealt a fatal blow to the gold standard, as countries were forced to abandon it in order to stimulate their economies and respond to the crisis. In 1933, President Roosevelt signed an executive order making it illegal to own gold privately. Americans were forced to sell their gold coins and gold bullion to the government for a fixed price of $20.67 per ounce. Anyone caught with gold could face fines and up to 10 years in prison. So, while the U.S. dollar was still backed by gold, American citizens were cut off from the supply.
By the end of the Second World War, the gold standard had been replaced by the Bretton Woods system, which pegged the value of the U.S. dollar to gold, and other currencies to the U.S. dollar. By the end of WWII, the U.S. had ¾ of the world's gold. This, tied with the fact that the U.S. dollar was the only currency still backed by gold, led to the final whimpers of the gold standard.
When Did the U.S. Get off the Gold Standard?
By 1971, the U.S. dollar could no longer be converted into gold, leading to the fiat currency system we have today. The change from the gold standard to a new system was for two reasons; inflation and stopping a default on its debts. Inflation was strangling the U.S. economy in the 1970s.
Similar to the bank runs we see today, a gold run would have been disastrous. If foreign countries had attempted to redeem the dollars lent to them during the world wars, the U.S. would have been overburdened trying to compensate dollars for gold. In August of 1971, after Great Britain attempted to be paid in gold, President Richard Nixon ended the dollar's ability to convert into gold directly.
Enter the Fiat System
Under the gold standard, nations would accept gold as payment for trade and exports. Nations with a trade deficit would see their gold reserves decline as they sent it out to pay for imports. In contrast, a fiat stem allows currencies in the foreign exchange market to fluctuate dynamically. The fiat system is not tied to any physical commodity and is based solely on government authority. This means that the value of a country's currency is determined by supply and demand and the strength of the government's monetary policy.
Proponents of the fiat system argue that it provides more flexibility and allows governments to respond more effectively to economic crises. However, critics of the fiat system assert that it can be susceptible to inflation and lead to currency devaluation.
Gold has maintained its purchasing power for as long as people can remember and won't be stopping anytime soon. Remember the $20 Americans received per ounce when returning their gold to the U.S.? Today, that same gold ounce would get you close to $2000. Many central banks around the world still hold gold as a large percentage of their assets. Although the gold standard has died out, economists agree that it is wise to diversify your portfolio with some amount of gold or other precious metals.
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