Under the gold standard, the value of a nation’s money is closely correlated with the price of gold.

Countries participating in the gold standard agree to exchange paper money for a set quantity of gold. A nation adhering to the gold standard establishes a gold price, which it purchases and sells at that rate. The value of its currency is then established using that fixed price. For instance, the dollar would be worth 1/500th of an ounce of gold if the United States were to set the price at $500 per ounce.

No government currently uses the gold standard. Britain abandoned it in 1931, and the United States did the same in 1933. The remaining parts of the system were finally abandoned in 1973.12 Fiat money, a word used to describe currency that is utilized because of a government decree, or fiat, that the currency must be accepted as a means of payment, totally superseded the gold standard. For example, the dollar is fiat money in the United States, whereas the naira is in Nigeria.

The attraction of a gold standard is that it removes imperfect people’s authority over money issuance. By limiting the amount of gold that can be physically issued, a society may be able to prevent the dangers of inflation.

A cursory look at the history of the U.S. gold standard demonstrates that inflation can be prevented when such a basic rule is implemented, but that stringent adherence to it may lead to political turmoil as well as economic instability.

Fiat System vs. Gold Standard System

In contrast, a fiat system of money allows a currency’s value to dynamically fluctuate against other currencies on foreign exchange markets rather than being based on any tangible asset.

The Latin word fieri, which means an arbitrary act or decree, is where the word “fiat” originated. According to this derivation, fiat currencies’ value ultimately stems from the fact that a government decision defines them as legal tender.

The classical gold standard, as it has come to be known, was the basis for international trade in the decades preceding World War I. Under this method, actual gold was used to resolve trade disputes between countries. Gold was amassed by countries with trade surpluses as payment for their exports. On the other hand, as gold moved out of those countries to pay for their imports, those with trade deficits experienced a decrease in their gold holdings.

A History of the Gold Standard

“We have gold because we cannot trust governments,” the renowned President Herbert Hoover said to President Franklin D. Roosevelt in 1933. One of the most drastic developments in American financial history was predicted by this statement: the Emergency Banking Act, which compelled all citizens to exchange their gold certificates, coins, and bullion for US dollars.3. The U.S. Treasury acquired title to gold from private holders in 1934 when President Roosevelt signed the Gold Reserve Act of 1934.

Although the laws prevented the flow of gold during the Great Depression, they did not alter the belief of gold bugs, who would always maintain that gold is a reliable source of wealth.

Throughout history, the supply and demand of gold have been uniquely influenced by it, setting it apart from other asset classes. Gold bugs continue to cling to a time when gold was king, but understanding gold’s past means understanding its fall from grace to properly evaluate its future.

The Gold Standard’s Ascent

A monetary system known as the gold standard allows paper money to be freely exchanged for gold. Stated otherwise, under such a monetary system, the value of money is backed by gold. The advent of paper money caused several issues, which led to the establishment and formalization of the gold standard between 1696 and 1812.

The only authority to create money and set its value was granted to Congress by the U.S. Constitution in 1789.4 The monetary system that had previously been based on foreign coin, primarily silver, in circulation could now be standardized thanks to the creation of a single national currency.

Gold and Silver: A New Standard

Since silver was more plentiful than gold in 1792, a bimetallic standard was established. Although the officially recognized 15:1 silver-to-gold parity ratio represented the market ratio at the time, Gresham’s rule states that after 1793, the value of silver rapidly decreased, forcing gold out of circulation.

It would take the Coinage Act of 1834 to resolve the problem, and not without significant political backlash. Hard-money supporters argued for a ratio that would drive out small-denomination paper notes issued by the then-detested Bank of the United States and put gold coins back into circulation, albeit perhaps not necessarily to displace silver. The U.S. was placed on a de facto gold standard when a ratio of 16:1, which grossly overpriced gold, was established.

Adoption of the Gold Standard

England was the first nation to formally adopt the gold standard in 1821. Large-scale gold discoveries were brought about by the century’s sharp rise in international trade and production, which contributed to the gold standard’s durability well into the following century. Since gold was used to settle all trade disputes between countries, governments had a strong motive to hoard gold for use in tougher times. These reserves are still in place today.

Germany’s adoption of the gold standard led to the creation of the international gold standard in 1871. Most developed countries were connected to the gold standard by 1900. Strangely, the United States was among the last nations to accede. In reality, during the 19th century, the United States was spared from having gold as its exclusive monetary standard because of a robust silver lobby.

The gold standard was at its height from 1871 to 1914. Most of the nations that adopted the gold standard during this time, including Australia, Canada, New Zealand, and India, had almost perfect political circumstances. But all of this was altered in 1914 when the Great War broke out.

The Gold Standard’s Decline

Following World War I, there was a shift in political allegiances, a rise in global debt, and a decline in public finances. The gold standard showed its inability to hold through both good and terrible times during the war, even though it was not stopped. This led to a decline in trust in the gold standard, which made the economic problems worse. It was becoming more and more clear that the world’s global economy needed a more flexible foundation.

Meanwhile, there was still a strong national yearning to go back to the good old days of the gold standard. The British pound sterling and the US dollar were designated as the world’s reserve currencies as the availability of gold continued to lag behind the expansion of the global economy. Diminished Rather than gold, countries started to hoard more of these currencies. The end effect was a marked concentration of gold in the hands of a small number of powerful countries.

The 1929 stock market crash was just one of several post-war challenges facing the world. The French franc and the pound were out of step with other currencies; Germany was still being choked by war debts and reparations; commodity prices were plummeting; and banks were overleveraged. Raising interest rates to encourage investors to hold onto their deposits rather than turning them into gold was one way that several nations attempted to safeguard their gold reserves.

The situation for the world economy grew worse as a result of these increasing interest rates. After England abandoned the gold standard in 1931, the only countries with significant gold holdings were the United States and France.

Then, to boost its economy, the American government revalued gold in 1934, increasing the amount of paper money needed to purchase one ounce from $20.67 to $35.8 The moment foreign countries realized they could exchange their current gold reserves for additional US dollars, the dollar saw a sharp depreciation. Due to the rising gold price, more gold was converted into US dollars, giving the US a monopoly on the gold market. The world’s gold supply increased dramatically, and by 1939, it had replaced all of the world’s gold reserves.

The US dollar versus gold

The major Western nations convened as World War II was drawing to a close to draft the Bretton Woods Agreement, which would serve as the foundation for the world’s currency markets until 1971. All national currencies were evaluated in the Bretton Woods system relative to the US dollar, which emerged as the main reserve currency. In turn, the dollar may be exchanged for gold at a set rate of $35 an ounce. Even though it did so more covertly, the gold standard remained the foundation of the global financial system.

Over time, the agreement has led to an unusual relationship developing between gold and the US currency. In general, rising gold prices follow a sinking dollar over time. As the accompanying one-year daily chart shows, this is not always the case in the short term, and the relationship can be shaky at best. Take note of the correlation indicator in the image below, which alternates between a high negative correlation and a positive correlation. However, because of the correlation study’s bias toward the inverse (negative), gold usually decreases when the value of the dollar increases.

The dollar was the only currency still directly backed by gold at the end of World War II, and the United States possessed 75% of the world’s monetary gold. But as the world recovered from World War II, money from both its strong import demand and the inflow of funds to war-torn countries caused the United States’ gold holdings to steadily decline. The gold standard was nearly destroyed by the high levels of inflation of the late 1960s.

The Pool of Gold

When a Gold Pool comprising the United States and many European countries ceased selling gold on the London market in 1968, the price of gold was left up to the market. Only central banks were allowed to trade at $35 per ounce with the United States between 1968 and 1971. The market price of gold might be maintained by the official parity rate by creating a pool of gold reserves available. As a result, member countries were under less pressure to sustain their export-led growth objectives by appreciating their currencies.

But America’s balance of payments quickly started to suffer from the Vietnam War, rising international competition, and the monetization of debt to fund social programs. In the final weeks of his presidential campaign, Senator John F. Kennedy said he would not try to weaken the dollar if elected. This was in response to the surplus turning into a deficit in 1959 and mounting concerns that other countries might begin to exchange their dollar-denominated assets for gold.

Due to member countries’ reluctance to fully cooperate in keeping the market price of gold at the US price, the Gold Pool dissolved in 1968. In the years that followed, Germany and France declared plans to exchange gold for dollars, and Belgium and the Netherlands did the same.

Nixon was forced to close the gold window when Britain demanded payment in gold in August of 1971. The dollar will no longer be based on gold by 1976, which officially signaled the end of the gold standard.

Nixon ended the direct convertibility of US currencies into gold in August 1971. This move severed the official link between gold and the international currency market, which had grown more dependent on the dollar since the Bretton Woods Agreement was implemented. The U.S. dollar, and by extension, the global financial system it effectively sustained, entered the era of fiat money.

Is the Gold Standard Still in Use?

At the moment, no nation adheres to a gold standard. As was previously indicated, in 1931 Britain abandoned the gold standard, and in 1933 the United States followed suit. The United States eliminated currencies’ direct convertibility into gold in 1971. Put otherwise, no nation issues a currency that is backed by gold. In the United States, the government’s ability to continuously produce revenue backs the value of the currency.

What Are the Advantages and Disadvantages of the Gold Standard?

Because governments and banks are unable to influence the money supply, such as by issuing more money than needed, proponents of the gold standard contend that it prevents inflation. Foreign exchange rates and prices are also stabilized by the gold standard.

However, under the gold standard, the supply of gold is fixed and cannot adjust to the demands of the market during difficult economic times. Gold mining is also expensive and has a detrimental externality on the environment.

Why Was the Gold Standard Abandoned by the US?

To control inflation and stop foreign countries from overloading the system by exchanging their dollars for gold, the United States abandoned the gold standard in 1971.

What Would Take Place if the Gold Standard Was Reinstituted?

Even if a return to the gold standard by the US is extremely unlikely, the concept has gained some traction recently. Most notably, Judy Shelton, a former President Donald Trump’s economic counselor, is well-known for advocating a return to the gold standard. (Trump proposed Shelton to the Fed in 2019, but she finally lost enough support.

A move back to the gold standard would restrict the Federal Reserve’s capacity to create money and implement monetary policy during pivotal points in the economy, such as recessions. Additionally, economists have suggested that a return to the gold standard would make the economy more unstable because of its susceptibility to fluctuations in the price and availability of gold. Most economists and central bankers are opposed to the idea of going back to the gold standard.

Was the Great Depression Caused by the Gold Standard?

The gold standard was only one of many contributing causes that led to the Great Depression, the longest and most severe economic downturn in modern history. Though they cannot agree on a single explanation, economists have identified protectionist trade policy and the 1929 stock market crash as two of the catastrophe’s primary causes. The Great Depression was also influenced by the gold standard, which made it more difficult for monetary policy to stabilize the economy.

Although it has captivated people for 5,000 years, gold hasn’t always served as the foundation for the monetary system. Less than 50 years, from 1871 to 1914, saw the existence of a truly international gold standard.

The arrival of paper money, a more adaptable medium of exchange for our intricate financial system, decades earlier marked the beginning of the end of the gold standard, even though a weakened version persisted until 1971. Although gold is no longer used as a standard, its value is still determined by the demand for the metal, which determines its price today. For nations and central banks, gold is a significant financial asset. In addition, the banks utilize it as a gauge of the state of the economy and as a hedge against government loans. Some people think that investing in gold could help diversify their holdings.

The U.S. dollar and gold have a long-standing association; generally, the relationship will be inverse over time. While the idea of establishing a new gold standard is frequently discussed in light of market volatility, the current system is far from ideal.