Definition of the Gold StandardMy normally extensive Economics Glossary does not have an entry on the gold standard, so we'll have to look elsewhere for a definition. An extensive essay on the gold standard on The Encyclopedia of Economics and Liberty defines the gold standard as "a commitment by participating countries to fix the prices of their domestic currencies in terms of a specified amount of gold. National money and other forms of money (bank deposits and notes) were freely converted into gold at the fixed price." A county under the gold standard would set a price for gold, say $100 an ounce and would buy and sell gold at that price. This effectively sets a value for the currency; in our fictional example $1 would be worth 1/100th of an ounce of gold. Other precious metals could be used to set a monetary standard; silver standards were common in the 1800s. A combination of the gold and silver standard is known as bimetallism.
A Very Brief History of the Gold Standard
If you would like to learn about the history of money in detail, there is an excellent site called A Comparative Chronology of Money which details the important places and dates in monetary history. During most of the 1800s the United States was had a bimetallic system of money, however it was essentially on a gold standard as very little silver was traded. A true gold standard came to fruition in 1900 with the passage of the Gold Standard Act. The gold standard effectively came to an end in 1933 when President Franklin D. Roosevelt outlawed private gold ownership (except for the purposes of jewelery). The Bretton Woods System , enacted in 1946 created a system of fixed exchange rates that allowed governments to sell their gold to the United States treasury at the price of $35/ounce. "The Bretton Woods system ended on August 15, 1971, when President Richard Nixon ended trading of gold at the fixed price of $35/ounce. At that point for the first time in history, formal links between the major world currencies and real commodities were severed". The gold standard has not been used in any major economy since that time.
The Benefits and Costs of a Gold Standard
The main benefit of a gold standard is that it insures a relatively low level of inflation. In articles such as " What is the Demand for Money? " we've seen that inflation is caused by a combination of four factors:
1. The supply of money goes up.
2. The supply of goods goes down.
3. Demand for money goes down.
4. Demand for goods goes up.
So long as the supply of gold does not change too quickly, then the supply of money will stay relatively stable. The gold standard prevents a country from printing too much money. If the supply of money rises too fast, then people will exchange money (which has become less scarce) for gold (which has not). If this goes on too long, then the treasury will eventually run out of gold. A gold standard restricts the Federal Reserve from enacting policies which significantly alter the growth of the money supply which in turn limits the inflation rate of a country. The gold standard also changes the face of the foreign exchange market . If Canada is on the gold standard and has set the price of gold at $100 an ounce, and Mexico is also on the gold standard and set the price of gold at 5000 pesos an ounce, then 1 Canadian Dollar must be worth 50 pesos. The extensive use of gold standards implies a system of fixed exchange rates. If all countries are on a gold standard, there is then only one real currency, gold, from which all others derive their value. The stability the gold standard cause in the foreign exchange market is often cited as one of the benefits of the system.
The stability caused by the gold standard is also the biggest drawback in having one. Exchange rates are not allowed to respond to changing circumstances in countries. A gold standard severely limits the stabilization policies the Federal Reserve can use. Because of these factors, countries with gold standards tend to have severe economic shocks. Economist Michael D. Bordo explains:
"Because economies under the gold standard were so vulnerable to real and monetary shocks, prices were highly unstable in the short run. A measure of short-term price instability is the coefficient of variation, which is the ratio of the standard deviation of annual percentage changes in the price level to the average annual percentage change.
The higher the coefficient of variation, the greater the short-term instability. For the United States between 1879 and 1913, the coefficient was 17.0, which is quite high. Between 1946 and 1990 it was only 0.8.
Moreover, because the gold standard gives government very little discretion to use monetary policy, economies on the gold standard are less able to avoid or offset either monetary or real shocks. Real output, therefore, is more variable under the gold standard. The coefficient of variation for real output was 3.5 between 1879 and 1913, and only 1.5 between 1946 and 1990. Not coincidentally, since the government could not have discretion over monetary policy, unemployment was higher during the gold standard. It averaged 6.8 percent in the United States between 1879 and 1913 versus 5.6 percent between 1946 and 1990."
So it would appear that the major benefit to the gold standard is that it can prevent long-term inflation in a country. However, as Brad DeLong points out, "if you do not trust a central bank to keep inflation low, why should you trust it to remain on the gold standard for generations?" It does not look like the gold standard will make a return to the United States anytime in the foreseeable future.
What Do We Use Today?
Almost every country, including the United States, is on a system of fiat money , which the glossary defines as "money that is intrinsically useless; is used only as a medium of exchange". We saw in the article " Why Does Money Have Value " that the value of money is set by the supply and demand for 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, are allowed to fluctuate based on market forces. Next we'll look at how the monetary system used can change other variables in the economy.
What is the gold standard?
It’s a monetary system that directly links a currency’s value to that of gold. A country on the gold standard cannot increase the amount of money in circulation without also increasing its gold reserves. Because the global gold supply grows only slowly, being on the gold standard would theoretically hold government overspending and inflation in check. No country currently backs its currency with gold, but many have in the past, including the U.S.; for half a century beginning in 1879, Americans could trade in $20.67 for an ounce of gold. The country effectively abandoned the gold standard in 1933, and completely severed the link between the dollar and gold in 1971. The U.S. now has a fiat money system, meaning the dollar’s value is not linked to any specific asset.
Why did the U.S. abandon the gold standard?
To help combat the Great Depression. Faced with mounting unemployment and spiraling deflation in the early 1930s, the U.S. government found it could do little to stimulate the economy. To deter people from cashing in deposits and depleting the gold supply, the U.S. and other governments had to keep interest rates high, but that made it too expensive for people and businesses to borrow. So in 1933, President Franklin D. Roosevelt cut the dollar’s ties with gold, allowing the government to pump money into the economy and lower interest rates. “Most economists now agree 90 percent of the reason why the U.S. got out of the Great Depression was the break with gold,” said Liaquat Ahamed, author of the book Lords of Finance. The U.S. continued to allow foreign governments to exchange dollars for gold until 1971, when President Richard Nixon abruptly ended the practice to stop dollar-flush foreigners from sapping U.S. gold reserves.
Why is gold in debate again?
Libertarian Rep. Ron Paul (R-Texas) made a return to “honest money” a key plank of his presidential run, and the idea took hold among Tea Party conservatives outraged over the Federal Reserve’s loose monetary policies since the financial crisis. They argue that the U.S. debt now exceeds $16 trillion because the government has become too cavalier about borrowing and printing money. When the Fed prints money, gold-standard advocates say, it cheapens the value of a dollar, promotes inflation, and effectively steals money from the citizenry. In a nod to those ideas, the Republican Party’s 2012 platform calls for the creation of a commission to investigate setting a fixed value for the dollar. The gold standard “forces the U.S. to live within its means,” said investment strategist Mark Luschini. “Think of it as a person with a debit card rather than a credit card. The debit card holder can only spend what he or she has in the bank.”
What are the downsides?
A fixed link between the dollar and gold would make the Fed powerless to fight recessions or put the brakes on an overheating economy. “If you like the euro and how it’s been working, you should love the gold standard,” said economist Barry Eichengreen. Beleaguered Greece, for instance, cannot print more money or lower its interest rates because it’s a member of a fixed-currency union, the euro zone. A gold standard would put the Fed in a similar predicament. Gold supplies are also unreliable: If miners went on strike or new gold discoveries suddenly stalled, economic growth could grind to a halt. If the output of goods and services grew faster than gold supplies, the Fed couldn’t put more money into circulation to keep up, driving down wages and stifling investment.
Could the gold standard come back?
It’s very unlikely. In a University of Chicago poll this year, not one of 40 top economists surveyed supported a return to gold. The last gold standard commission, established by President Ronald Reagan, voted by a wide margin against bringing it back. The size and complexity of the U.S. economy would also make the conversion extremely difficult. Just to back the dollars now in circulation and on deposit—about $2.7 trillion—with the approximately 261 million ounces of gold held by the U.S. government, gold prices would have to rise as high as $10,000 an ounce, up from about $1,780, causing huge inflation. “It could do massive damage to the economy,” said John Makin, an economist at the American Enterprise Institute. So why the clamor for its return? Nostalgia, said economist Charles Wyplosz. “People long for a simpler age,” when the U.S. “was the dominant economy and there were no financial markets to speak of.” It’s like “getting back together with that old girlfriend,” said MarketWatch’s David Weidner. The current system may not be perfect, he says, but what people forget is that “the gold standard never works.”
Gold is one of the most widely discussed metals due to its prominent role in both the investment and consumer world. Even though gold is no longer used as a primary form of currency in developed nations, it continues to have a strong impact on the value of those currencies. Moreover, there is a strong correlation between its value and the strength of currencies trading on foreign exchanges.
To help illustrate this relationship between gold and foreign exchange trading, consider these five important aspects:
1. Gold was once used to back up fiat currencies.
As early as the Byzantine Empire, gold was used to support fiat currencies, or the various currencies considered legal tender in their nation of origin. Gold was also used as the world reserve currency up through most of the 20th century; the United States used the gold standard until 1971 when President Nixon discontinued it.
One of the reasons for its use is that it limited the amount of money nations were allowed to print. This is because, then as now, countries had limited gold supplies on hand. Until the gold standard was abandoned, countries couldn't simply print their fiat currencies ad nauseum unless they possessed an equal amount of gold. Although the gold standard is no longer used in the developed world, some economists feel we should return to it due to the volatility of the U.S. dollar and other currencies.
2. Gold is used to hedge against inflation.
Investors typically buy large quantities of gold when their country is experiencing high levels of inflation. The demand for gold increases during inflationary times due to its inherent value and limited supply. As it cannot be diluted, gold is able to retain value much better than other forms of currency.
In April 2011, investors feared declining values of fiat currency and the price of gold was driven to a staggering $1,500 an ounce. This indicates there was little confidence in the currencies on the world market and that expectations of future economic stability were grim.
3. The price of gold affects countries that import and export it.
The value of a nation's currency is strongly tied to the value of its imports and exports. When a country imports more than it exports, the value of its currency will decline. On the other hand, the value of its currency will increase when a country is a net exporter. Thus, a country that exports gold or has access to gold reserves will see an increase in the strength of its currency when gold prices increase, since this increases the value of the country's total exports.
In other words, an increase in the price of gold can create a trade surplus or help offset a trade deficit. Conversely, countries that are large importers of gold will inevitably end up having a weaker currency when the price of gold rises. For example, countries that specialize in producing products made with gold, but lack their own gold reserves, will be large importers of gold. Thus, they will be particularly susceptible to increases in the price of gold.
4. Gold purchases tend to reduce the value of the currency used to purchase it.
When central banks purchase gold, it affects the supply and demand of the domestic currency and may result in inflation. This is largely due to the fact that banks rely on printing more money to buy gold, and thereby create an excess supply of the fiat currency.
5. Gold prices are often used to measure the value of a local currency, but there are exceptions.
Many people mistakenly use gold as a definitive proxy for valuing a country's currency. Although there is undoubtedly a relationship between gold prices and the value of a fiat currency, it is not always an inverse relationship as many people assume.
For example, if there is high demand from an industry that requires gold for production, this will cause gold prices to rise. But this will say nothing about the local currency, which may very well be highly valued at the same time. Thus, while the price of gold can often be used as a reflection of the value of the U.S. dollar, conditions need to be analyzed to determine if an inverse relationship is indeed appropriate.
The Bottom Line
Gold has a profound impact on the value of world currencies. Even though the gold standard has been abandoned, gold as a commodity can act as a substitute for fiat currencies and be used as an effective hedge against inflation. There is no doubt that gold will continue to play an integral role in the foreign exchange markets. Therefore, it is an important metal to follow and analyze for its unique ability to represent the health of both local and international economies.
