The gold standard is a currency measurement system that uses gold as a way to set the value of money. It ensures that currency under a gold-standard system can be exchanged for gold. The gold standard signifies an agreement between society and its monetary institutions that the currency they spend and earn is a stand-in for gold.
To fully understand the gold standard, it's important to understand how gold has been used for centuries to set the standard for currency value, why it's fallen out of favor, and its pros and cons.
Definitions and Examples
When you put $20 down on a blackjack table in Las Vegas or use your loose change to feed the parking meter downtown, you're using a currency that we all agree is valuable. When the gold standard is in play, the U.S. government agrees that if you want to trade in that $20 bill or those four quarters for gold, you can.
Gold has been used as the currency of choice throughout history. The earliest known use was in 600 B.C. in Lydia, which is in present-day Turkey. Some societies have used gold coins to trade for goods and services. Most of the time, paper and coin currency that are easy to move around have been the agreed-upon equivalent of gold in monetary systems where the gold standard is used.
In 1861, the first U.S. paper currency was printed. The Gold Standard Act of 1900 established gold as the only metal for redeeming paper currency. It guaranteed that the government would redeem any amount of paper money for its value in gold, and it meant that transactions no longer had to be done with heavy gold bullion or coins, because paper currency had a guaranteed valued tied to something real.
The first World War proved to be the first nail in the coffin for the international gold standard.
In 1913, Congress created the Federal Reserve to stabilize gold and currency values in the U.S. When World War I broke out, the U.S. and European countries suspended the gold standard so they could print enough money to pay for their military involvement.
After the war, countries realized that they didn't need to tie their currencies to gold, and that it may in fact harm the world economy to do so. Countries began leaving the gold standard en masse by the 1930s.
Once the stock market crashed in 1929, and the Great Depression hit, investors began trading in currencies and commodities. As the price of gold rose, people exchanged their dollars for gold. It worsened when banks began failing, as people began hoarding gold because they didn't trust any financial institution.
On March 6, 1933, President Franklin D. Roosevelt closed the banks in response to a run on the gold reserves at the Federal Reserve. By the time banks re-opened on March 13, they had turned in all their gold to the Federal Reserve. They could no longer redeem dollars for gold, and no one could export gold.
On April 20, FDR ordered Americans to turn in their gold in exchange for dollars, to prohibit the hoarding of gold and the redemption of gold by other countries. This action created the gold reserves at Fort Knox. The U.S. soon held the world's largest supply of gold.
As of January 30, 1934, the Gold Reserve Act prohibited the private ownership of gold except under license. It allowed the government to pay its debts in dollars, not gold.
Because the U.S. held a majority of the world's gold, most countries pegged the value of their currencies to the dollar instead of gold. As a result, most countries no longer needed to exchange their currencies for gold, as the dollar had replaced it.
The U.S. no longer has enough gold at current rates to pay off its debt owed to foreign investors. Even when gold hit its peak price of $1,896 an ounce in September of 2011, there wasn't enough gold for the U.S. to pay off its debt.
Alternative to the Gold Standard
In 1960, the U.S. held $19.4 billion in gold reserves, including $1.6 billion in the International Monetary Fund. That was enough to cover the $18.7 billion in foreign dollars outstanding.
As the U.S. economy prospered, Americans bought more imported goods and paid in dollars. This large balance of payments deficit worried foreign governments that the U.S. would no longer back up the dollar in gold.
The Soviet Union had become a large oil producer. It was accumulating U.S. dollars in its foreign reserves, since oil is priced in dollars. The Soviet Union deposited its dollar reserves in European banks, and these became known as "eurodollars."
By the 1970s, the United States stockpile of gold had declined. Double-digit inflation reduced the eurodollar's value, and more and more banks started redeeming their holdings for gold. The U.S. could no longer meet this growing obligation.
The dollar/gold relationship was changed to $38 per ounce during the Nixon administration. The Fed could no longer redeem dollars with gold, which made the gold standard meaningless.
Once the gold standard was dropped, countries began printing more of their own currencies, which resulted in inflation but also more economic growth. Although there are advocates for a return to the gold standard, it appears unlikely that those days will return. Economists regard the gold standard as necessary during its time, but no longer applicable in the modern world economy.
Advantages and Disadvantages of Gold
Provides a self-regulating and stabilizing effect on the economy
Discourages inflation and debt
Rewards productive nations
A country's economy is dependent upon its supply of gold
Countries fixate on keeping their gold
Actions to protect gold reserves cause significant fluctuations in the economy
Fixed assets: The benefit of a gold standard is that a fixed asset backs the money's value.
Provides a self-regulating and stabilizing effect on the economy: Under the gold standard, a government can only print as much money as its country has in gold.
Discourages inflation and debt: Inflation happens when too much money chases too few goods. The gold standard also discourages government budget deficits and debt, which can't exceed the supply of gold.
Rewards productive nations: If a country receives gold when it exports, it has more gold in its reserves. That means it can print more money, in turn boosting investment in its profitable export businesses. The gold standard also prompted the Gold Rush in California and Alaska during the 1800s.
A country's economy is dependent upon its supply of gold: The economy is not reliant on the resourcefulness of its people and businesses. Countries without any gold are at a competitive disadvantage. The U.S. never had that problem. It was the world's second-largest gold-mining country after Australia. Most gold mining in the U.S. occurs on federally owned lands in 12 western states.
Countries fixate on keeping their gold: Countries that are worried about gold tend to ignore the more important task of improving the business climate. During the Great Depression, the Federal Reserve raised interest rates. It wanted to make dollars more valuable and prevent people from demanding gold, but it should have been lowering rates to stimulate the economy.
Actions to protect gold reserves cause significant fluctuations in the economy: Between 1890 and 1905, the U.S. economy suffered five major recessions for that reason.
- The U.S. had officially been on the gold standard since 1900, when gold was established by law as the only metal for redeeming paper currency.
- However, the gold standard had been unofficially in effect since 1834.
- After years of inflation, stagflation, and eroding U.S. gold stockpiles, the value of the dollar was officially decoupled from gold in 1976, ending the gold standard.
- It's unlikely the U.S. would return to the gold standard, given how much the world economy has changed since then.