What is the gold standard? How did it come to exist? Is it still used today? Does it have any impact on the US Dollar? Welcome to yet another interesting post in which we shall take a look at this system that has been responsible for shaping the global monetary system. If this sounds interesting to you, then read on to find out what we have in store for you.
The gold standard is a system in which a predetermined amount of gold determines a country’s currency value. When paper money is generated and distributed to the public, the denominations are based on a gold weight appropriate for the bill. One ounce of gold might be equivalent to the lowest value note, such as a $1 bill, whereas 5 ounces could be equivalent to a $5 bill.
The government issuing the currency must keep an amount of gold in its possession that is equal to the value of the money in circulation. This is the only way to assure that a country’s currency retains its value under this standard; it is also what caused the gold standard’s demise. Learn why gold is no longer used to support currencies in the United States and around the world.
The Gold Standard’s Inception
Because gold is rare, difficult to obtain, malleable, and does not corrode, it has been the currency of choice throughout history. Around 600 B.C.E., it was first used as minted money in Lydia, which is today part of Turkey.
While gold was produced into coins and used for trading, it was not until the 19th century that the precious metal became a standard. Although Britain utilized gold as a standard as early as 1816, gold did not become a worldwide standard for evaluating currencies until the 1870s. After multiple attempts to employ alternative exchange mechanisms failed, the United States established the gold standard in 1879.
The Gold Standard Act of 1900 made gold the only metal that could be used to redeem paper currency in the United States. Because the act guaranteed that the government would redeem any amount of paper money for its face value in gold, transactions no longer required the use of heavy gold bullion or coins, as paper currency had a guaranteed value related to something actual.
The End of the Gold Standard
Political alliances shifted after World War I, international debts rose, and government finances suffered. The gold standard was not stopped throughout the war, but it was in limbo, displaying its inability to withstand both good and terrible times. This led to a loss of faith in the gold standard, exacerbating the economy’s problems. It became increasingly clear that the world’s global economy required a more flexible foundation.
At the same time, there was a strong desire among nations to return to the halcyon days of the gold standard. The British pound sterling and the US dollar became the worldwide reserve currencies as the gold supply continued to slip behind the growth of the global economy. Smaller countries began to hold these currencies in preference to gold. As a result, gold became increasingly concentrated in the hands of a few large nations.
The 1929 stock market crisis was just one of the world’s postwar problems. The pound and the French franc were out of sync with other currencies; Germany was still suffocated by war debts and repatriations; commodities prices were plummeting, and banks were overextended. Many countries attempted to maintain their gold reserves by boosting interest rates to attract investors to hold their deposits instead of converting them to gold. The global economy has only become worse as a result of these rising interest rates. The gold standard in England was suspended in 1931, leaving only the United States and France with significant gold holdings.
The US government then revalued gold from $20.67 per ounce to $35 per ounce in 1934, raising the amount of paper money required to purchase one ounce to help the country’s economy. As other countries were able to convert their existing gold stockpiles into additional US dollars, the dollar’s value plummeted. Because of the greater gold price, more gold was converted into US dollars, essentially giving the US a monopoly on the gold market. Gold output surged to the point where, by 1939, there was enough in the world to replace all of the world’s currencies.
**Also read: Gold in War | What is it good for?
The US Dollar vs. Gold
The top Western governments met as World War II came to an end to construct the Bretton Woods Agreement, which would serve as the underpinning for global currency markets until 1971. All national currencies were evaluated in reference to the US dollar, which became the dominant reserve currency, under the Bretton Woods regime. The dollar was then exchanged for gold at a set rate of $35 per ounce. The gold standard continued to operate in the global financial system, albeit in a more indirect fashion.
As a result of the agreement, gold and the US dollar have developed an unusual connection over time. In the long run, a falling dollar usually indicates higher gold prices. This is not always true in the near term, and the relationship might be shaky at best, as the one-year daily chart below shows. Notice how the correlation indicator changes from a significant negative correlation to a positive correlation and back again in the graph below. However, because the connection is still skewed toward the inverse (negative in the correlation research), gold tends to fall when the dollar rises.
The United States owned 75% of the world’s monetary gold at the conclusion of WWII, and the dollar was the only currency still backed directly by gold. As the world rebuilt itself after WWII, however, the United States’ gold reserves steadily declined as money poured into war-torn countries and the country’s own strong need for imports. The gold standard was suffocated by the high inflationary environment of the late 1960s, which sucked the final breath out of it.
The Current Situation
The gold standard entered its current chapter as a result of presidential initiatives. Following FDR’s decision to abandon gold, a stockpile grew at Fort Knox. After decades of international trading, this stockpile had shrunk to nearly nothing in 1971. President Richard Nixon removed the dollar’s gold peg in August 1971, essentially ending the Bretton Woods Agreement and introducing a totally fiat monetary system, with paper currency backed solely by the government’s word.
In 1985, the United States Treasury began selling gold coins to the general public for the first time in more than 50 years. The United States Mint is responsible for a considerable portion of the gold available to collectors and investors. Gold trade between the United States and other countries grew, bringing the gold standard – or lack thereof – into the twenty-first century.
In the United States today, there are two main groups: those who rely on and wish to keep the present, fiat monetary system, and those who fight for a return to the gold standard, citing fears that the dollar’s strength is eroding. It remains to be seen whether the gold standard is reinstated for the country or the world at large.
Frequently Asked Questions on “The Gold Standard”
1. What Benefits Does the Gold Standard Provide?
Because governments and banks cannot alter the money supply, the gold standard prevents inflation (e.g., overissuing money). The gold standard also helps to keep prices and exchange rates stable.
2. What Are the Gold Standard’s Disadvantages?
The supply of gold under the gold standard cannot keep up with demand, and it is not flexible in difficult economic times. Gold mining is also expensive and has serious environmental consequences.
3. What is the backing for the US dollar?
The US dollar is backed by the US government’s full faith and credit.
4. Will the United States return to the gold standard?
The United States is unlikely to return to the gold standard.
5. Why Did the United States Leave the Gold Standard?
To combat inflation and prevent foreign countries from overburdening the system by redeeming their dollars for gold, the United States abandoned the gold standard in 1971.
6. What Countries Are Currently Using the Gold Standard?
Today, no government follows the gold standard, despite the fact that several countries still hold vast gold holdings.
That’s all for this post on what the gold standard is about. I hope you learned something about what this system entails, and you can now share a thing or two with your peers. Be sure to check out the recommended resources as well, to gain more knowledge on various types of investments. If you have any questions or comments, then you can share them in the comments section and I will get back to you ASAP!
I wish you well,
Eric, Investor and Team Member at Gold Retired!