What is the gold standard? Read on for an overview of what it is and when it began, as well as why and when it was removed.
Although no government currently uses the gold standard, it is important to examine its historical roots to get a better understanding of how the current economic landscape came to be.
From its introduction in the 1800s to its complete removal in 1971, the pros and cons of the gold standard have been widely debated, with whispers that President Donald Trump is interested in bringing it back to the United States.
Read on for an overview of the gold standard is and when it began, as well as why and when it was removed and what it was replaced with.
What is the gold standard?
The gold standard is a monetary system where the value of a country’s currency is directly linked to the yellow metal. When countries used the gold standard, a fixed price at which to buy and sell gold was set as a way to determine the value of their currency.
For example, if the US went back to the gold standard and set the price of gold at US$500 per ounce, the value of the dollar would be 1/500th of an ounce of gold. This offers reliable price stability.
The gold standard was appealing to many countries as they were searching for ways to standardize transactions in the bustling world trade market. With the gold standard in place, these countries were able to guarantee that the government would redeem any amount of paper money for its value in gold.
Additionally, by introducing the gold standard, transactions were no longer required to be done with heavy gold bullion or coins. It also increased the trust needed for successful global trade ― paper currency finally had value that was tied to something real.
Other advantages of the gold standard were that it limited the power of governments or banks to cause price inflation by excessive issue of paper currency, while also creating certainty in international trade by providing a fixed pattern of exchange rates.
The goal of this monetary policy was to prevent inflation, but also deflation, and to help promote a stable monetary environment.
Introduction of the gold standard
In 1821, the United Kingdom became the first country to adopt the gold standard. Prior to this time, silver had been the main world monetary metal, while the yellow metal was used intermittently for coinage in one or another country, but never as the standard, to which all other forms of currency were coordinated or adjusted.
By the 1870s, Germany took on a monometallic gold standard and as of 1900 the US and several other countries followed suit.
This shift in various other countries adopting the gold standard came when gold discoveries in western North America at the time had made gold more plentiful. In the full gold standard that thus prevailed until 1914, gold could be bought or sold in unlimited quantities at a fixed price in convertible paper money per unit weight of the metal.
In 1913, Congress created the Federal Reserve with the hopes of stabilizing both gold and currency values. Unfortunately, before it could fully get running, World War I broke out.
With the war in fully swing, European countries made the decision to suspend the gold standard in order to print enough money to pay for their military involvement. Unfortunately, printing money created hyperinflation.
After the war, countries realized the value of tying their currency to a guaranteed value in gold most countries returned to a modified gold standard.
By 1928, the gold standard was reestablished, with small changes to reflect the relative scarcity of gold.
During this time, most nations adopted a gold-exchange standard, in which they supplemented their central-bank gold reserves with currencies (US dollars and British pounds) that were convertible into gold at a stable rate of exchange.
The US took the new gold standard into its own hands and decided to set a new minimum dollar price for gold to be used for purchases and sales by foreign central banks.
This action by the US was known as “pegging” the price of gold, and acted as the basis for the restoration of an international gold standard after World War II; in this postwar system most exchange rates were pegged either to the US dollar or to the yellow metal.
The gold-exchange standard collapsed again during the Great Depression of the 1930s, and by 1937 not a single country remained on the full gold standard.
Removal of the gold standard
The gold standard was largely abandoned in an effort to combat the lingering effects of the Great Depression. The United States in particular decided to make the move away from gold because the country was facing both mounting unemployment and spiraling deflation.
In the early 1930s, the US government was unable to do much to stimulate the economy and believed that it needed to deter people from cashing in deposits and depleting the gold supply.
In response to a lackluster economy, the US Federal Reserve and several other governments kept raising interest rates in an attempt to make dollars more valuable and dissuade people from further depleting the US gold reserves. These higher rates worsened the Depression by making the cost of doing business more expensive. Many companies went bankrupt, creating record levels of unemployment.
In order to rectify the damage done by surging interest rates, in 1933, President Franklin D. Roosevelt cut the US dollar’s ties with gold, allowing the government to pump money into the economy while lowering interest rates.
“Most economists now agree 90 percent of the reason why the US got out of the Great Depression was the break with gold,” said Liaquat Ahamed, author of the book Lords of Finance.
Despite breaking free from the gold standard, the US continued to allow foreign governments to exchange dollars for the yellow metal until 1971. However, during that year fading gold reserves and a mounting deficit in its balance of payments eventually led the US suspending the free convertibility of dollars into gold at fixed rates of exchange for use in international payments.
That’s when President Richard Nixon realized he was putting a stop to dollar-flush foreigners from being able partake in these exchanges as he believed that they were depleting US gold reserves.
What replaced the gold standard?
The demise of the gold standard began as World War II was coming to an end. At this time, the leading Western powers met to develop the Bretton Woods agreement, which would be the framework for the global currency markets until 1971.
Benton Woods was developed at the United Nations Monetary and Financial Conference held in Bretton Woods, New Hampshire, from July 1 to July 22, 1944. Under the agreement, currencies were pegged to the price of gold, and the US dollar was seen as a reserve currency linked to the price of gold. This meant that all national currencies were valued in relation to the US dollar, since it had become a dominant reserve currency.
In turn, the greenback, was convertible to gold at the fixed rate of US$35 per ounce. The global financial system continued to operate upon a gold standard, in a far more indirect manner.
Despite the valiant attempts made by the governments involved during this time, the Bretton Woods agreement led to overvaluation of the US dollar, which led to concerns over the exchange rates and their tie to the price of gold.
By 1971, Nixon called for a temporary suspension of the dollar’s convertibility. Countries were then free to choose any exchange agreement, except the price of gold. In 1973, foreign governments let currencies float, which put an end to the Bretton Woods system and any trace of the gold standard was abolished.
From the 1970s to today, most countries run on a system of fiat money, which the glossary defines as “money that is intrinsically useless; is used only as a medium of exchange.” The value of money is set by the supply and demand for paper money and the supply and demand for other goods and services in the economy. The prices for those goods and services, including gold and silver, can fluctuate based on market conditions.
Trump and the future of the gold standard
While it is not widely addressed, Trump is a fan of the gold standard and often times has been caught praising it. In an often-quoted 2015 GQ interview, Trump says about the system: “[b]ringing back the gold standard would be very hard to do, but boy, would it be wonderful. We’d have a standard on which to base our money.” In a separate interview from the same year he also stated, “[w]e used to have a very, very solid country because it was based on a gold standard.”
However, despite the US President’s penchant for the yellow metal as a currency standard, the chance that the gold standard will re-emerge anytime soon are slim.
In fact, according to the Motley Fool’s Sean Williams, most economists agree that moving to a lower-key version of the gold standard in 1933 “was a big reason why the US emerged from the Great Depression,” and believe that a return “would be a mistake.”
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Securities Disclosure: I, Nicole Rashotte, hold no direct investment interest in any company mentioned in this article.