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What’s it: A gold standard is a monetary system in which the government pegs the domestic currency to gold. Under this system, the face value of your money is equivalent to the gold you will get when you exchange it. So, the government agreed to convert paper money into gold in a fixed amount. Therefore, the amount of money in circulation will change according to the supply of gold in a country.
The gold standard depends on the gold supply. Countries that are poor in gold minerals are not necessarily rich because they cannot mine gold. They only rely on supplies from exported goods. Therefore, in general, these standards are considered to limit the economy from growing.
However, this monetary system supports long-term price stability. The money supply is more measurable than when paper money was adopted.
A brief history of the gold standard
In a gold standard monetary system, you can convert freely into a fixed amount of gold. The gold standard was prevalent in several countries during the 19th to early 20th centuries.
In 1821, Britain was the first country to officially adopt the gold standard. Then, the international gold standard emerged in 1871 after Germany adopted it. In 1900, most developed countries adopted a similar policy.
The guarantee of banknotes with precious metals, such as gold, has had its ups and downs. This was in line with the political and economic conditions at that time. In fact, paper money in circulation was unguaranteed at all with gold deposits shortly after World War I.
Only as World War II was ending did the major Western nations meet to develop the Bretton Woods Agreement, which served as the framework for the global currency system until 1971.
Under the Bretton Woods system, all countries peg their money to the US dollar, the world’s reserve currency. Then, in turn, the US dollar was pegged to gold at the official exchange rate of around US$35 per ounce. This exchange option only applies to state banks and is unavailable to companies or individuals.
However, the agreement did not last long. The Bretton Woods system began to collapse in 1968. Many member states were reluctant to cooperate to maintain the agreement.
In the following years, Belgium and the Netherlands cashed in dollars for gold. Likewise, Germany and France took similar steps. In August 1971, Britain followed suit and asked for gold, forcing the intervention of the United States, Richard Nixon, to end the convertibility of the US dollar to gold on August 15, 1971. Since then, the world’s currency has not been pegged at all to gold.
Currently, the gold standard is out of date in most countries. Fiat money has completely replaced it. Fiat money refers to a currency that has no intrinsic value but is a means of payment. The paper used to make money is not worth the stated nominal value of the money, so we say that money has no intrinsic value.
Fiat money is acceptable to everyone because the government guarantees it. So, it is valuable and useful as a means of payment because the government says so.
Pros of the gold standard
Gold has become an important part of the exchange rate system. It has become currency and an asset that stores value.
Unlike paper money, gold has intrinsic value. Everyone admits it is valuable, even if there is no guarantee from the government. There are several advantages to the gold standard. Here’s a deeper dive into two key benefits:
Taming inflation: a more predictable price landscape
One of the gold standard’s biggest strengths is its potential to act as a natural governor of inflation. Since the money supply is directly tied to the amount of available gold, governments can’t simply print more money to stimulate the economy or cover spending deficits. This limitation helps prevent excessive money printing, a major driver of inflation.
With a stable money supply, the value of the currency fluctuates less dramatically. This predictability fosters trust among consumers and businesses. Consumers can be more confident that their money will retain its value over time, allowing them to plan for larger purchases without fearing runaway inflation. Businesses benefit from a more stable pricing environment, making it easier to budget for costs and set prices.
Fostering International trade: fixed exchange rates
The gold standard also simplifies and encourages international trade by establishing fixed exchange rates between countries on the system. This means currencies have a predetermined value in relation to gold, eliminating the fluctuations associated with floating exchange rates.
Imagine you’re a Brazilian company selling coffee to a Japanese importer. With fixed exchange rates, you know exactly how many Yen you’ll receive for your Brazilian Reais, reducing the currency risk involved in international transactions. This stability makes it easier for businesses to calculate costs and profits and set competitive prices in the global marketplace.
Additionally, fixed exchange rates can boost investor confidence in foreign markets. Since the value of their investments is less susceptible to sudden currency fluctuations, investors may be more willing to invest in companies and projects abroad. This increased investment flow can further stimulate international trade and economic growth.
Cons of the gold standard
While the gold standard offers some advantages, it also comes with limitations that can hinder economic growth and central bank control. Here are two main drawbacks to consider:
Unequal playing field: advantage for resource-rich nations
The gold standard can create an uneven playing field for countries. Nations with abundant gold reserves, like China, Australia, or the US, have a significant advantage. They can naturally grow their money supply alongside their economies simply by mining more gold.
However, countries without significant gold resources are left at a disadvantage. They can only increase their money supply by accumulating a trade surplus, essentially exporting more than they import. This can be a slow and challenging process, potentially limiting their economic growth.
Imagine a developing nation with strong potential for manufacturing and exports. Under the gold standard, they might struggle to access the necessary capital to invest in infrastructure and production if they can’t generate a consistent trade surplus to acquire gold.
Limited monetary policy tools: can governments react to crises?
The gold standard significantly restricts central banks’ ability to manage the economy through monetary policy. Since the money supply is tied to gold reserves, central banks have less flexibility to adjust interest rates or print money in response to economic fluctuations, which can be problematic during economic downturns.
For instance, during a recession, a central bank might want to lower interest rates to stimulate borrowing and investment. However, under the gold standard, they may be limited in their ability to do so if it conflicts with maintaining a gold-backed money supply. This inflexibility can make it harder for governments to address economic crises and promote long-term economic stability.
Why was the gold standard abandoned?
The gold standard’s reign ended dramatically during the Great Depression, a crippling economic downturn that began in 1929. Here’s how this historical event led to its demise:
As the Depression deepened, public trust in paper money plummeted. People feared its value would erode, prompting them to seek safe-haven assets like gold. This triggered a massive bank run, where citizens rushed to exchange their paper money for gold. This surge in demand quickly depleted central banks’ gold reserves.
Great Britain’s Fall (1931)
Faced with dwindling gold reserves due to the bank run, Great Britain became the first major nation to abandon the gold standard in 1931. This decision aimed to preserve their remaining gold and prevent a complete collapse of the financial system. Other European countries soon followed suit.
The US Clings On (Until 1971)
The United States initially maintained the gold standard for a few reasons. However, pressure mounted as the Depression continued. In 1933, under President Franklin D. Roosevelt, the US effectively severed the direct link between the dollar and gold, although full abandonment wouldn’t occur until later.
The Bretton Woods Farewell (1971)
The Bretton Woods Agreement, established after World War II, created a new international monetary system where currencies were pegged to the US dollar, which in turn was backed by gold. However, by the 1970s, this system became unsustainable due to factors like trade imbalances and the increasing global money supply. In 1971, President Richard Nixon officially ended the convertibility of the US dollar to gold, marking the true demise of the gold standard on a global scale.
Is the gold standard coming back? a debate for the modern era
The gold standard’s collapse in the 1970s ushered in the era of fiat currencies, where money derives its value from government backing rather than a physical commodity like gold. However, the debate on its potential return continues to this day.
Arguments for a return:
- Curbing inflation: Proponents argue that the gold standard’s limitation on money supply growth could help control inflation, especially in countries with a history of excessive money printing.
- Increased discipline: Some believe a return to the gold standard would force governments to be more fiscally responsible, as they wouldn’t be able to print money to cover spending deficits simply.
- Greater trust: A gold-backed currency could potentially instill greater confidence in the financial system, particularly during economic uncertainties.
Arguments against a return:
- Limited growth potential: Critics argue that a gold-backed system could hinder economic growth, especially in developing countries, as the money supply wouldn’t be able to expand as readily to meet growing economies.
- Less flexibility: Central banks would have limited tools to respond to economic crises, as they wouldn’t be able to adjust interest rates or print money as freely.
- Global coordination challenge: Reinstating the gold standard on a global scale would require significant international cooperation, which could be difficult to achieve in today’s complex economic landscape.
While there’s no imminent return to the gold standard on the horizon, central banks are closely monitoring the role of gold in the global financial system. Some countries continue to hold significant gold reserves, and the price of gold often fluctuates based on economic uncertainty.
The debate surrounding the gold standard’s potential return will likely continue. As economic conditions evolve and new challenges arise, the question of whether a gold-backed system could offer greater stability or hinder progress will remain a topic of discussion for economists, policymakers, and investors alike.
