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What is the Gold Standard and How Does it Work?

Over recent months there has been growing support in the EU to go back to a Gold Standard.  But what is the Gold Standard and how does it work?  Will it work in a modern society?

The Gold Standard was around for hundreds of years.  It was a commitment by participating countries to fix the prices of their domestic currencies to a specified amount of gold. National money and other forms of money were freely converted into gold at the fixed price.  The UK used a type of gold based standard as far back as1717 before formally adopting the Gold Standard in 1819.  In 1834, the United States fixed the price of gold at $20.67 per ounce, where it remained until 1933. Other major countries joined the gold standard in the 1870s. The period from 1880 to 1914 is known as the classical gold standard.

 

Why did the Gold Standard Break Down?

During WW1 countries needed to print money to pay for the cost of war.  It became impossible for the countries to hold enough gold in reserves to cover all the currency being printed.  It was briefly reinstated from 1925 to 1931 and called the Gold Exchange Standard. Under this standard, countries could hold gold or dollars or pounds as reserves, except for the United States and the United Kingdom, which held reserves only in gold. This Gold Exchange Standard broke down in 1931 following Britain’s departure from it due to it being unsustainable to keep gold reserves with the amount of debt and capital expenditure required for the British economy.

In 1933, during the Great Depression in the US, President Franklin D. Roosevelt nationalized gold owned by private citizens. The Gold Exchange Standard was abandoned as the US tried to create jobs to help bring the country out of depression.

 

Replacing the Gold Standard with a Dollar Based Standard

The Bretton Woods agreement was created in July 1944 when 730 representatives from 44 countries, mostly WWII Allies got together at Bretton Woods, New Hampshire, US.

Under the agreement, countries promised that their central banks would maintain fixed exchange rates between fiat currencies and US dollars. If a country's currency value became too weak relative to the dollar, the bank would buy up its currency in foreign exchange markets. This would lower the supply of the currency and raise the price.  If the value of the currency was too high then the central bank would print more money, thereby, reducing the currency’s price.  Under the agreement trade wars would not exist as each country agreed to regulate their currency so no country could benefit from manipulating the value of their currency.  The agreement meant that the Gold Standard ceased to exist and the world move onto the Dollar Standard.  The dollar was pegged to a set value of gold 1/35


The Collapse of the Bretton Woods System

In 1971, the United States was suffering from massive stagflation—a combination of inflation and recession, which, in turn has an effect on unemployment and economic growth prospects.

In response to an alarming drop in value of the US dollar, caused by too much currency in circulation, President Nixon started to devalue the dollar against gold. Nixon revalued the dollar to 1/38 of an ounce of gold, then 1/42 of an ounce. The devaluation plan backfired. It created a run on the U.S. gold reserves at Fort Knox as people redeemed their quickly devaluing dollars for gold.

In 1971, Nixon passed legislation removing the dollar from gold backing. Without price controls, gold quickly shot up to $120 per ounce ending the Bretton Woods system.

The creation of Bretton Woods resulted in countries pegging their currencies to the U.S. dollar. In turn, the dollar was pegged to the price of gold, and the U.S. became dominant in the world economy. The U.S. was the only nation that could print the globally accepted currency, and countries had more flexibility than they did with the old gold standard.

When the dollar ceased to be pegged to the price of gold, it became the monetary standard with other currencies pegging their currencies to it.

 

A Society Based on Debt

In a previous blog, I discussed how today’s economies are based on debt.  Every pound, dollar, euro or whatever the currency is for a specific country is loaned into existence.

Relevant governments agree to pay interest to holders of the debt (Bonds) until the debt is repaid.  Successive governments need to generate more debt each year to cover the costs of servicing the debt, running their infrastructure services such as hospital, schools and benefits.  There is insufficient tax take each year to balance the books and so more money has to be raised to meet the ever-increasing demand.  Governments are in a continuous spiral of creating more and more debt to provide for the services within their countries. 

The growth of debt is exponential, just look at how much was printed by each country for the first wave coronavirus.  America was in the Trillions of Dollars, Britain was £600+ billion and growing.

In the 2008-2014 Great Recession, governments adopted what was called “Austerity Measures” where they tried to cut back on debt spending and bring their countries debt under control.  The measures were in place for many years and was an experiment that was doomed to fail not only as countries could not balance their books (despite coming up with creative ways to seem as if they had) but it had far reaching consequences to economic growth with many countries barely coming out of recession.(again figures were manipulated for it to appear they had)  When the world economies are based on debt suddenly telling its citizens to reduce their own debt, start saving and stop shopping means the flow of income for growth stops.  It reduces the tax intake for countries forcing them to lend more money into existence.  It’s a vicious cycle.

 


A Gold Standard

This brings me back to the opening statement that EU are floating the idea of going onto a gold standard.  Will it work in modern society?

My belief is no.  Bullion has had a free run since 1971 and has become the safe haven for investors.  With the amounts physically held in storage by investors and the growing debt based economy it is doubtful that there is enough gold in circulation to meet demand.

The effect of coronavirus around the globe has seen many mines closed and the production of gold and silver has been greatly reduced.  Hence, when economies are struggling and people are looking for safe haven investments there is insufficient supply to meet demand resulting in the soaring prices we see today.  Most of the growth to date has been speculative with very little traditional investment.  It will be interesting to see where the price is likely to go once mainstream investors start moving into gold and silver.

China has on several occasions, raised the prospect of moving from dollar based markets to yuan based markets.  As a country which, denies it, but undoubtedly, manipulates the price of its currency the prospect of moving to a Yuan based global market is unlikely.  However, it is possible there could be some break away countries that support the Yuan and there could be 2 separate currency markets one pegged against the dollar and one pegged against the yuan.

Central Banks have started to purchase gold and hold reserves.  Since the introduction of the Basel3 agreement in April 2019, gold was deemed a zero risk asset many banks started to purchase gold to increase their reserves.

Gold would need to be nationalised for governments to move onto a gold standard again.  With the amount in circulation, with reserves held in banks, any form of nationalisation would collapse the world banking system.

I am sure, there are economists with more knowledge than I have about the money markets and the global economy who are behind the scenes trying to come up with a way of introducing a new type of gold standard, especially if, the EU are looking at it.  But, my belief is the economy is too fragile to be able to cope with the transition to a new gold standard.  Any transition, if implemented would most likely be once there has been a collapse of economies and currencies. Only time will tell.

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