History of the Gold Standard
Why the Dollar Was Backed by Gold
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.
Gold was part of a naturally occurring compound known as electrum, which the Lydians used to make coins. By 560 B.C., the Lydians had figured out how to separate the gold from the silver, and so created the first truly gold coin. The first king to use gold for coins was named Croesus, and his name lives on in the phrase "rich as Croesus."
In those days, the value of the coin was based solely on the value of the metal within, and the country with the most gold had the most wealth. As a result, Spain, Portugal, and England sent Columbus and other explorers to the New World. They needed more gold so they could be wealthier than each other.
Introduction of the Gold Standard
When gold was found at Sutter's Mill in 1848, it inspired the California Gold Rush the following year, which helped unify western America. At the time, it resulted in inflation because the United States was already on a de facto gold standard since 1834, so the flood of new gold led to rising prices.
In 1861, Treasury Secretary Salmon Chase printed the first U.S. paper currency. The Gold Standard Act of 1900 established gold as the only metal for redeeming paper currency. It set the value of gold at $20.67 an ounce.
European countries wanted to standardize transactions in the booming world trade market, so they adopted the gold standard by the 1870s. It guaranteed that the government would redeem any amount of paper money for its value in gold, and meant transactions no longer had to be done with heavy gold bullion or coins, since paper currency now had guaranteed valued tied to something real.
This huge change also increased the trust needed for successful global trade, and it came with its own risks: gold prices and currency values dropped every time miners found large new gold deposits.
In 1913, Congress created the Federal Reserve to stabilize gold and currency values in the United States. When World War I broke out, the United States and European countries suspended the gold standard so they could print enough money to pay for their military involvement.
The Great War proved to be the first nail in the coffin for the international gold standard.
After the war, countries realized they didn't need to tie their currency to gold, and that it may in fact be harming the world economy to do so. Countries quickly returned to a modified gold standard after the war, including the United States in 1919. But the gold exchange standard was causing deflation and unemployment to run rampant in the world economy, and so countries began leaving the gold standard en masse by the 1930s as the Great Depression reached its peak. The United States finally abandoned the gold standard entirely in 1933.
The Gold Standard and the Great Depression
Once the Great Depression hit with full force, countries had to abandon the gold standard. When the stock market crashed in 1929, 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.
The Federal Reserve kept raising interest rates in an attempt to make dollars more valuable and dissuade people from further depleting the U.S. gold reserves, but it made the cost of doing business more expensive. Many companies went bankrupt, creating record levels of unemployment.
On March 6, 1933, the newly-elected President Franklin D. Roosevelt closed the banks in response to a run on the gold reserves at the Federal Reserve Bank of New York. 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 created the gold reserves at Fort Knox. The United States soon held the world's largest supply of gold.
On 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, and authorized FDR to increase the price of gold from $20.67 per ounce to $35 per ounce (which consequently devalued the dollar).
1944 Bretton Woods Agreement
The 1944 Bretton Woods Agreement set the exchange value for all currencies in terms of gold. It obligated member countries to convert foreign official holdings of their currencies into gold at these par values.
The United States held the majority of the world's gold. As a result, most countries simply pegged the value of their currency to the dollar instead of gold. Central banks maintained fixed exchange rates between their currencies and the dollar by buying their own country's currency in foreign exchange markets if their currency became too low relative to the dollar. If it became too high, they'd print more of their currency and sell it. It became more convenient for countries to trade when they peg to the dollar. As a result, most countries no longer needed to exchange their currency for gold, as the dollar had replaced it.
The value of the dollar subsequently increased, even though its worth in gold remained the same. This made the U.S. dollar the de facto world currency.
End of the Gold Standard
In 1960, the United States 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 United States would no longer back up the dollar in gold.
Also, 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 due to fears that the United States would seize its bank accounts as a tactic in the Cold War. 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 continued to decline as President Nixon's economic policies created stagflation. Double-digit inflation reduced the eurodollar's value, and more and more banks started redeeming their holdings for gold. The United States could no longer meet this growing obligation.
That's when Nixon changed the dollar/gold relationship to $38 per ounce. He no longer allowed the Fed to redeem dollars with gold, which made the gold standard meaningless. The U.S. government repriced gold to $42.22 per ounce in 1973 and then decoupled the value of the dollar from gold altogether in 1976. The price of gold quickly shot up to $124.84.
The Legacy of Gold
Once the gold standard was dropped, countries began printing more of their own currency, 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.
Gold continues to have appeal as an asset of real value. Whenever a recession or inflation looms, investors return to gold as a safe haven. It reached its record high of $1,895 an ounce on September 5, 2011.
Advantages and Disadvantages of Gold
Fixed assets back the money's value
Provides a self-regulating and stabilizing effect on the economy
Discourages government budget deficits 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 caused significant fluctuations in the economy
The benefit of a gold standard is that a fixed asset backs the money's value. Proponents of a gold standard say it provides a self-regulating and stabilizing effect on the economy. Under the gold standard, the government can only print as much money as its country has in gold. That discourages inflation, which happens when too much money chases too few goods. It also discourages government budget deficits and debt, which can't exceed the supply of gold.
A gold standard rewards the more productive nations. For example, they receive gold when they export. With more gold in their reserves, they can print more money, in turn boosting investment in their profitable export businesses. The gold standard spurred exploration also prompted the Gold Rush in California and Alaska during the 1800s.
One problem with a gold standard is that the size and health of a country's economy are 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 United States never had that problem. It was the world's second-largest gold mining country after Australia. Most gold mining in the United States occurs on federally owned lands in 12 western states. According to the National Mining Association, Nevada is the primary source. Many developing countries are also major gold producers.
The gold standard makes countries obsessed with keeping their gold. They 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.
Government actions to protect their gold reserves caused significant fluctuations in the economy. In fact, between 1890 and 1905, the U.S. economy suffered five major recessions for this reason. Edward M. Gramlich mentioned these facts in his remarks at the 24th Annual Conference of the Eastern Economic Association on February 27, 1998. Gramlich was a member of the Board of Governors of the Federal Reserve.
Can America Return to a Gold Standard?
How would a return to the gold standard affect the U.S. economy? First, it would constrict the government's ability to manage the economy. The Fed would no longer be able to reduce the money supply by raising interest rates in times of inflation. Nor could it increase the money supply by lowering rates in times of recession. In fact, this is why many advocate a return to the gold standard. It would enforce fiscal discipline, balance the budget, and limit government intervention. The Cato Institute’s policy analysis, ”The Gold Standard: An Analysis of Some Recent Proposals,” presents an evaluation of methods for returning to the gold standard.
A fixed money supply, dependent on gold reserves, would limit economic growth. Many businesses would not get funded because of a lack of capital. Furthermore, the United States could not unilaterally convert to a gold standard if the rest of the world didn't. If it did, everyone in the world could demand that the United States redeem their dollars with gold. American reserves would be quickly depleted. Defense of the United States’ supply of gold helped cause the Great Depression. The Great Depression ended when Franklin D. Roosevelt launched the New Deal.
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 2011, there wasn't enough gold for the United States to pay off its debt. At that time, China, Japan, and other countries owned $4.7 trillion in U.S. Treasury debt.
Today, the U.S. economy is an important partner in an integrated global economy. Central banks work together throughout the world to manage monetary policy. It's too late for the United States to adopt an isolationist economic stance.