The gold standard is a monetary system where a country's currency or paper money has a value directly linked to gold. With the gold standard, countries agreed to convert paper money into a fixed amount of gold. A country that uses the gold standard sets a fixed price for gold and buys and sells gold at that price. That fixed price is used to determine the value of the currency. For example, if the U.S. sets the price of gold at $500 an ounce, the value of the dollar would be 1/500th of an ounce of gold.

The gold standard is not currently used by any government. Britain stopped using the gold standard in 1931 and the U.S. followed suit in 1933 and abandoned the remnants of the system in 1973.﻿﻿ The gold standard was completely replaced by fiat money, a term to describe currency that is used because of a government's order, or fiat, that the currency must be accepted as a means of payment. In the U.S., for instance, the dollar is fiat money, and for Nigeria, it is the naira.

The appeal of a gold standard is that it arrests control of the issuance of money out of the hands of imperfect human beings. With the physical quantity of gold acting as a limit to that issuance, a society can follow a simple rule to avoid the evils of inflation. The goal of monetary policy is not just to prevent inflation, but also deflation, and to help promote a stable monetary environment in which full employment can be achieved. A brief history of the U.S. gold standard is enough to show that when such a simple rule is adopted, inflation can be avoided, but strict adherence to that rule can create economic instability, if not political unrest.

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Gold Standard System Versus Fiat System

As its name suggests, the term gold standard refers to a monetary system in which the value of currency is based on gold. A fiat system, by contrast, is a monetary system in which the value of currency is not based on any physical commodity but is instead allowed to fluctuate dynamically against other currencies on the foreign-exchange markets. The term "fiat" is derived from the Latin "fieri," meaning an arbitrary act or decree. In keeping with this etymology, the value of fiat currencies is ultimately based on the fact that they are defined as legal tender by way of government decree.

In the decades prior to the First World War, international trade was conducted on the basis of what has come to be known as the classical gold standard. In this system, trade between nations was settled using physical gold. Nations with trade surpluses accumulated gold as payment for their exports. Conversely, nations with trade deficits saw their gold reserves decline, as gold flowed out of those nations as payment for their imports.

The Gold Standard: A History

"We have gold because we cannot trust governments," President Herbert Hoover famously said in 1933 in his statement to Franklin D. Roosevelt. This statement foresaw one of the most draconian events in U.S. financial history: the Emergency Banking Act, which forced all Americans to convert their gold coins, bullion, and certificates into U.S. dollars.﻿﻿ While the legislation successfully stopped the outflow of gold during the Great Depression, it did not change the conviction of gold bugs, people who are forever confident in gold's stability as a source of wealth.

Gold has a history like that of no other asset class in that it has a unique influence on its own supply and demand. Gold bugs still cling to a past when gold was king, but gold's past also includes a fall that must be understood to properly assess its future.

A Gold Standard Love Affair Lasting 5,000 Years

For 5,000 years, gold's combination of luster, malleability, density and scarcity has captivated humankind like no other metal. According to Peter Bernstein's book The Power of Gold: The History of Obsession, gold is so dense that one ton of it can be packed into a cubic foot.﻿﻿

At the start of this obsession, gold was solely used for worship, demonstrated by a trip to any of the world's ancient sacred sites. Today, gold's most popular use is in the manufacturing of jewelry.

Around 700 B.C., gold was made into coins for the first time, enhancing its usability as a monetary unit. Before this, gold had to be weighed and checked for purity when settling trades.

Gold coins were not a perfect solution, since a common practice for centuries to come was to clip these slightly irregular coins to accumulate enough gold that could be melted down into bullion. In 1696, the Great Recoinage in England introduced a technology that automated the production of coins and put an end to clipping.

Since it could not always rely on additional supplies from the earth, the supply of gold expanded only through deflation, trade, pillage or debasement.

The discovery of America in the 15th century brought the first great gold rush. Spain's plunder of treasures from the New World raised Europe's supply of gold by fives times in the 16th century. Subsequent gold rushes in the Americas, Australia, and South Africa took place in the 19th century.

Europe's introduction of paper money occurred in the 16th century, with the use of debt instruments issued by private parties. While gold coins and bullion continued to dominate the monetary system of Europe, it was not until the 18th century that paper money began to dominate. The struggle between paper money and gold would eventually result in the introduction of a gold standard.

The Rise of the Gold Standard

The gold standard is a monetary system in which paper money is freely convertible into a fixed amount of gold. In other words, in such a monetary system, gold backs the value of money. Between 1696 and 1812, the development and formalization of the gold standard began as the introduction of paper money posed some problems.

The U.S. Constitution in 1789 gave Congress the sole right to coin money and the power to regulate its value.﻿﻿ Creating a united national currency enabled the standardization of a monetary system that had up until then consisted of circulating foreign coin, mostly silver.

With silver in greater abundance relative to gold, a bimetallic standard was adopted in 1792. While the officially adopted silver-to-gold parity ratio of 15:1 accurately reflected the market ratio at the time,﻿﻿ after 1793 the value of silver steadily declined, pushing gold out of circulation, according to Gresham's law.﻿﻿

The issue would not be remedied until the Coinage Act of 1834, and not without strong political animosity. Hard money enthusiasts advocated for a ratio that would return gold coins to circulation, not necessarily to push out silver, but to push out small-denomination paper notes issued by the then-hated Bank of the United States. A ratio of 16:1 that blatantly overvalued gold was established and reversed the situation, putting the U.S. on a de facto gold standard.﻿﻿

By 1821, England became the first country to officially adopt a gold standard. The century's dramatic increase in global trade and production brought large discoveries of gold, which helped the gold standard remain intact well into the next century. As all trade imbalances between nations were settled with gold, governments had strong incentive to stockpile gold for more difficult times. Those stockpiles still exist today.

The international gold standard emerged in 1871 following its adoption by Germany. By 1900, the majority of the developed nations were linked to the gold standard. Ironically, the U.S. was one of the last countries to join. In fact, a strong silver lobby prevented gold from being the sole monetary standard within the U.S. throughout the 19th century.

From 1871 to 1914, the gold standard was at its pinnacle. During this period, near-ideal political conditions existed in the world. Governments worked very well together to make the system work, but this all changed forever with the outbreak of the Great War in 1914.

The Fall of the Gold Standard

With World War I, political alliances changed, international indebtedness increased and government finances deteriorated. While the gold standard was not suspended, it was in limbo during the war, demonstrating its inability to hold through both good and bad times. This created a lack of confidence in the gold standard that only exacerbated economic difficulties. It became increasingly apparent that the world needed something more flexible on which to base its global economy.

At the same time, a desire to return to the idyllic years of the gold standard remained strong among nations. As the gold supply continued to fall behind the growth of the global economy, the British pound sterling and U.S. dollar became the global reserve currencies. Smaller countries began holding more of these currencies instead of gold. The result was an accentuated consolidation of gold into the hands of a few large nations.

The stock market crash of 1929 was only one of the world's post-war difficulties. The pound and the French franc were horribly misaligned with other currencies; war debts and repatriations were still stifling Germany; commodity prices were collapsing; and banks were overextended. Many countries tried to protect their gold stock by raising interest rates to entice investors to keep their deposits intact rather than convert them into gold. These higher interest rates only made things worse for the global economy. In 1931, the gold standard in England was suspended, leaving only the U.S. and France with large gold reserves.﻿﻿

Then, in 1934, the U.S. government revalued gold from $20.67/oz to $35/oz, raising the amount of paper money it took to buy one ounce to help improve its economy.﻿﻿ As other nations could convert their existing gold holdings into more U.S dollars, a dramatic devaluation of the dollar instantly took place. This higher price for gold increased the conversion of gold into U.S. dollars, effectively allowing the U.S. to corner the gold market. Gold production soared so that by 1939 there was enough in the world to replace all global currency in circulation.

As World War II was coming to an end, the leading Western powers met to develop the Bretton Woods Agreement, which would be the framework for the global currency markets until 1971. Within the Bretton Woods system, all national currencies were valued in relation to the U.S. dollar, which became the dominant reserve currency. The dollar, in turn, was convertible to gold at the fixed rate of $35 per ounce. The global financial system continued to operate upon a gold standard, albeit in a more indirect manner.

The agreement has resulted in an interesting relationship between gold and the U.S. dollar over time. Over the long term, a declining dollar generally means rising gold prices. In the short term, this is not always true, and the relationship can be tenuous at best, as the following one-year daily chart demonstrates. In the figure below, notice the correlation indicator which moves from a strong negative correlation to a positive correlation and back again. The correlation is still biased toward the inverse (negative on the correlation study) though, so as the dollar rises, gold typically declines.

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