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 coming to an end, the major Western nations met to develop the Bretton Woods Agreement. The agreement 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 completely replaced it. Fiat money is a term to refer to the currency that has no intrinsic value but is a means of payment. The paper for making 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 and cons of the gold standard
Gold has become an important part of the exchange rate system. It became currency and has become one of the assets to store 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 are some of them:
- Allows for long-term price stability. Under this standard, the money supply will be more controlled. High inflation is rare, and hyperinflation is basically impossible. The reason is that the money supply can only grow at a rate proportional to the increase in gold supply. Thus, the standard reduces the possibility of an excessive increase in the money supply.
- Reducing the uncertainty of international trade. Under the gold standard, international exchange rates are fixed between participating countries. When importing, a country indirectly pays for it in gold, it reduces the money supply. On the other hand, when exporting, they get gold as payment. Thus, on a net basis, the money supply is more controllable.
However, the gold standard also has several drawbacks.
- Benefiting countries that produce gold. Gold is rare. Not all countries have gold mines. As a result, the gold standard will be more favorable for countries with large gold reserves, such as China, Australia, the US, South Africa, and Russia. For countries that do not have gold mines, they can only obtain it through a trade surplus.
- Limits the economy’s ability to grow. When the productive capacity of an economy grows, the money supply must increase. Because it pegged it to gold, it means that the supply of gold in the economy must also grow at an equal rate. And, it was, of course, problematic because gold resources were scarce. The only option is economic growth at a lower rate.
- Monetary policy is useless for stabilizing the economy. Under the standard, the gold supply determines the money supply. So, it adds up when countries post a trade surplus or when they mine more gold.
Why was the gold standard abandoned?
As the Great Depression hit, people lost confidence in paper money. People prefer safe-haven assets to protect wealth. They then converted the money into gold. That boosted demand for gold so that the central bank ran out of gold. That caused the gold standard to collapse.
Great Britain became the first country to break the gold standard. They did it in 1931. The Great Depression caused the country’s gold reserves to shrink sharply along with a surge in the conversion of money to gold. European countries then followed suit.
However, the United States still held on to the gold standard for another two years, sending its economy even further into a trance under the Great Depression. In 1933, the United States effectively abandoned the gold standard during the administration of President Franklin D. Roosevelt. Then, the country officially abandoned the gold standard in 1971 when President Richard Nixon ended the Bretton Woods agreement.