gold standard

As opposed to fiat money, a gold standard is where every currency note is backed by a certain amount of gold, hence the name.

The US was on a gold standard for its currency up until (US President) Nixon closed the gold exchange window in 1971, thereby freeing the price of gold with respect to the US dollar and allowing gold to rise in price. The price of gold went from US$35/ounce to US$800/ounce by 1980.

The gold standard was a system whereby national currencies were based upon the price of gold. Various problems arose from this and it was abandoned by most governments by World War II. The final blow came when the United States abandoned it and most of the Bretton Woods Agreements in 1973.

The gold standard did work to keep prices largely stable over long periods of time. In this respect it helped prevent inflation, but there were also problems with it.

Money is a commodity like any other. The supply can fall short of what is needed. This is especially true of using gold as money. When trade between different nations or regions takes place it is often uneven. This means that gold will flow from places importing more than they export. This leads to a lack of currency and an economic slow down. In theory this should self correct the problem of gold outflows by making goods from elsewhere more expensive relative to locally produced ones. The main problem with this is that economies are high viscosity systems. Changes now take quite a while before they change economic activity. So the gold outflows continue long after a point that would be healthy and result in bank collapses and financial panic.

The second problem is related to the first. National governments recognized that insufficient currency for economic activity was a bad thing. Therefore they sought to keep the national currency strong to bolster confidence (preventing outflows) and as a matter of national pride. This usually only makes the problem worse. A great example of this policy at work was the Great Depression in the United States. To stop gold outflows and support the gold standard, interest rates were raised by the Federal Reserve. This helped slow the flight of gold, but resulted in even less money being loaned by banks and an exacerbation of the recession into a general depression that spread worldwide.

An additional problem is that the money supply contracts and expands somewhat randomly when gold is used as currency. The production of gold is in private hands and dependant upon discovery of new sources. Using the gold standard today would make South Africa the producer of 39.1% of the world’s currency and give that nation a control over the world economy unmatched even by OPEC. (Note the next largest producer, the US only had 9.3% of the world's gold ore reserves.)

Lastly there has never been enough gold to go around. People do not value gold highly enough (the price is often below $300 per troy ounce today) for the current world supply of gold to be used as currency. In the past this has meant large amounts of the world were on the barter system before paper money started to be used to represent some amount of precious metal.

Generally economists agree that a gold standard is inferior to fiat currency backed by a central banking system.

Metaphorically, a "gold standard" is a highly-valued and well-accepted instance of a class against which other such instances can be compared.

The gold standard for websites looking to encourage vast and free-wheeling, if sometimes uncontrolled discussion about current events, is Slashdot.

In psychology and medicine, a treatment that is designated the "gold standard" is not necessarily the best treatment, but it is one that has been around a long time, intensively studied, and is relatively well-understood. Experimental treatments can then be compared to it, as well as to placebo, in order to determine their effectiveness and usefulness in comparison to existing therapies and to each other.

For example, many studies of antidepressant medication or psychotherapy still use imipramine, an old tricyclic antidepressant as their gold standard. While the SSRIs are generally thought to be better, imipramine has been used much more extensively and offers a common basis of comparison among studies.

Before the invention of money (long long ago, in a galaxy not so far away), people used barter in order to get the things they didn't have enough of. This became quite cumbersome, so they agreed on a representative unit of wealth. Rather than having to carry around anvils, or fish, or wool whenever you had to buy something, they instead carried around this unit of currency - in many cases, it was gold (today, it might be dollars).

At some point in the history of banking, this unit of currency was no longer used, but was instead replaced by the writing of paper checks from one bank account to another. However the gold remained in the bank, even though it was no longer used - this was an attempt to give some legitimacy to the new paper notes being used - the gold standard.

The problem with this idea is that it is similar to the creation of a "dollar standard" - creating a new currency to use, while holding a reserve of dollars in the bank to give the new currency some legitimacy. The problem is that the commodity held in reserve was merely a unit of exchange and derives its value mainly from its previous use as currency. The original backing of the currency is lost.

The Sumerians, as part of their development of a standard of weights and measures, placed the royal stamp on each piece of gold to guarantee that it was the same amount as every other similarly stamped gold piece. They simply agreed that this was worth a bushel of wheat - the value was never in the gold. For each amount of gold issued by the king, a certain amount of wheat is kept in reserve in order to ensure that gold has some value. This ensures that the value of the gold with respect to wheat did not change - no inflation. When the gold is returned to the king, it is redeemed with the wheat that it represented. This, in effect, is a "wheat standard".

(Thanks to Gritchka for help.)

The Gold Standard is primarily a system of fixing exchange rates via the price of Gold. There have been three such international monetary regimes in history: the Classical Gold Standard, which began with Britain in 1822 and collapsed with the start of the First World War, the Interwar Gold Exchange Standard seen as beginning with Britain returning to Gold at its pre-war parity in 1924 and ending with America's abandonment of gold in 1933, and the Bretton Woods system, from the end of the Second World War to its collapse under Nixon in 1971.

A country was “on” the Gold Standard if it exhibited certain features. Firstly, it had to fix its currency to gold, by buying and selling gold for set prices, so the price of gold could float within a narrow range. Secondly, it had to allow free trade in gold, so gold could enter and leave the country without restrictions, ensuring that he domestic price of gold is the same as that in every other country on the Gold Standard. Fixing currencies to that of another country on the Gold Standard would have the same effect as joining the Gold Standard directly.

Although countries were meant to link their money supplies to reserves of gold, this was rarely done strictly. Central Banks often held reserves in excess of their requirements, and could often adjust their gold/currency ratio at will. The only enforcement mechanism they faced was the confidence of investors, who might flee the country if they thought the bank did not have enough reserves to secure its position. However, these reserves did not have to be held in Gold, but could be in any other currency in which investors had confidence. The greater the confidence of investors, the lower the ratio of Gold to Currency the Central Bank could hold – so that prior to the First World War, the most secure economy at the centre of the system, Great Britain, held the least gold as a proportion of its GDP.

The purpose of the Gold Standard was both to enhance price stability and to facilitate multilateral trade and investment. Investing abroad was very risky when exchange rates were floating, before the advent of hedging allowed cheap and effective risk management. In order to stay on the gold standard a country had to prevent its prices rising faster than that of other currencies fixed to gold. Therefore, governments and Central Banks had to control the money supply and use fiscal and monetary policy to prevent inflation, which usually meant low growth and high unemployment were the results of trade deficits.

This was the result of the “Trilemma” problem. Under the Gold Standard, an economy did not have an independent monetary policy. It had to use its interest rates to keep its exchange rate constant. This was often seen as an advantage by governments of countries on the Gold Standard, as it allowed them to avoid criticism for poor economic performance, high unemployment, etc., as they could claim these were necessary costs of maintaining the system.

The Gold Standard was supposedly governed by a set of practices lovingly referred to as “The Rules of the Game”. These were meant to assure stability in each participating economy's balance of payments, to make sure no country ran continuous deficits or surpluses. They were as follows:

1. Under a balance of payments deficit
2. Bank loses Gold
3. Money Supply falls
4. Prices fall
5. Imports fall
6. Exports Rise
7. Equilibrium is Restored

Under the Rules of the Game, the Central Bank should short cut this process to prevent loss of Gold, so on seeing its reserves fall, it should:

1. Raise interest rates;
2. Investment falls,
3. Demand falls,

This speeds up the process by which prices adjust, and so Balance of Payments equilibrium is reached sooner.

Likewise:

1. Under a balance of payments Surplus
2. The Bank gains Gold
3. Money Supply rises
4. Prices rise
5. Imports rise
6. Exports fall
7. Equilibrium is Restored

Under the Rules of the Game, the central bank ought to short-cut this process. On seeing its reserves rise it is meant to:

1. Lower interest rates; so
2. Investment rises,
3. Demand rises,

By which prices rise sooner, preventing the economy hoarding stocks of gold.

However this is a principle weakness of the Gold Standard. If an economy is running a balance of payments deficit, it has a strong incentive to abide by the rules of the game. This is because it has only limited stocks of gold, and cannot afford to continue losing gold for long. Therefore, Governments and Central Banks would always raise interest rates, to stem their loss of Gold, and bring in foreign investment (hot money), to fill their coffers.

On the other hand, a country running a Balance of Payments surplus is seeing gold flow into its borders, and no mechanism was in place to force it to abide by the Rules of the Game, and take action to return to balance of payments equilibrium.

This was a major downfall of the Gold Exchange Standard of the 1920s. It was the question of how to deal with a hegemonic economy that runs a persistent trade surplus. During the 19th Century Britain ran such a surplus, but it chose to abide by the "Rules of the Game", keeping its interest rates low, leading to a continous flow of lending to the rest often world, so the Gold Standard continued to function. However, after the First World War, when the USA took over this role, the Federal Reserve chose not to do the same. It kept its interest rates high, selling bonds to sterilise the inflow of gold and prevent its money supply expanding, preventing inflation and so hoarding the worlds supply of gold at Fort Knox, where it has stayed. This limited the outflow of investment to the rest of the world, and created deflationary international environment, setting the scene for the Great Depression and collapse of the Gold Exchange Standard.

A friend of mine and I had a discussion about the gold standard and the use of currency during a car trip. It came about from us discussing Alan Greenspan, interest rates and how our government manages to keep the dollar at a reasonably constant value over time.

My question to him was, why did people start using gold for trading all these years ago? He immediately said that it was to supplant the barter system (as seeya discusses above) and to make the transfer of goods and services more efficient.

But why gold, I asked him. Does gold, in itself, have some intrinsic quality that makes it valuable to people? The only reasons we can come up with, at least in a pre-industrial age context, is that gold really has no useful qualities besides that it's shiny, pretty, and neat to look at. There is no other reason for people to have wanted to hoard any amounts of gold besides being able to say "I have the biggest pile of pretty, shiny stuff in the village."

But why select gold as the tool to use in barter, I asked? Why did the ancients not select another metal, such as the far more common copper, or silver, or perhaps even the more rare platinum? My friend suggested that perhaps it was because it *is* shiny to look at, and is universally accepted as something exotic and hard to come by. I think there are more simple reasons for this: gold, having its natural rarity, makes it impossible for counterfeiters to come up with a store of faked gold to use as currency (Perhaps this is one reason there were so many alchemists in the ancient world). This prevents the problem of "printing lots of bills" so to speak, and resulting in rampant inflation.

Obviously there are economic concepts in place today that results in us having stable currencies not backed by gold, but that's why there are people like Alan Greenspan at the helm.

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Lucy-S adds that gold is also valuable because it doesn't tarnish or rust (read: corrode), and maintains its luster a long time.

The reason gold was chosen as the de facto currency for most of human history is based on two factors. First, it was scarce and hard to mine. Second, its low melting point, chemical stability and high mass make its authenticity easy to verify. As long as human economies were based on agriculture, gold worked very well as a currency. Because it was hard to fake, and hard to obtain, the money supply was essentially fixed. Agricultural economies are also fixed, with the quanity and quality of land essentially a fixed variable. So much land produced so much economic activity. Any commodity that was stable in supply would work. Gold fit that description to a tee.

Gold became inadequate when economies moved from agriculture to industry. Suddenly economic activity was capable of rapid, exponential change as innovation and other technological factors began to drive production. At that point a growing economy needed a more fluid currency, whose supply could be varied as needed. The stability in supply that worked so well in an agricultural economy was completely inadequate for more modern economic models. Hence the abandonment of the gold standard. It worked for centuries, but progress has made the gold standard obsolete.