This article is on the monetary principle. For gold standard in diagnostic testing, see gold standard (test).

The gold standard is a monetary system in which the standard economic unit of account is a fixed weight of gold.

Under the gold standard, currency issuers guarantee to redeem notes in that amount of gold. Governments that employ such a fixed unit of account, and which will redeem their notes to other governments in gold, share a fixed currency relationship.

Supporters of the gold standard system claim it is more resistant to credit and debt expansion. Unlike a fiat currency, the money backed by gold cannot be created arbitrarily by government action. This restraint prevents the artificial inflation by the devaluation of currency. This is supposed to remove "currency uncertainty", keep the credit of the issuing monetary authority sound, and encourage lending. Nevertheless, countries under the gold standard underwent debt crises and depressions throughout the history of its use.

The gold standard is no longer used in any nation, having been replaced completely by fiat currency. It is still in private use by private institutions in the supply of digital gold currency, which use gold grams as money.

Why gold?

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Due to its rarity, durability, fungibility, and the general ease of identification through its unique color, weight, ductility and acoustic properties, gold is a commodity that merchants and traders came to select as a common unit of account - thus it has long been used as a form of money and store of wealth. The exact nature of the evolution of money varies significantly across time and place, though it is believed by historians that gold's high value for its beauty, density, resistance to corrosion, uniformity, and easy divisibility made it useful both as a store of value and as a unit of account for stored value of other kinds — in Babylon, a bushel of wheat was the unit of account, with a weight in gold used as the token to transport value. Early monetary systems based on grain used gold to represent the stored value. Banking began when gold deposited in a bank could be transferred from one bank account to another by a giro system, or lent at interest.

When used as part of a commodity money system, the function of paper currency is to reduce the danger of transporting gold, reduce the possibility of debasement of coins, and avoid the reduction in circulating medium to hoarding and losses. The early development of paper money was spurred originally by the unreliability of transportation and the dangers of long voyages, as well as by the desire of governments to control or regulate the flow of commerce within their dominion. Money backed by a specie is sometimes called representative money, and the notes issued are often called certificates, to differentiate them from other forms of paper money.

Through most of human history, however, silver was the primary circulating medium and major monetary metal. Gold was the metal that was used as an ultimate store of value, and as means of payment when portability was at a premium, particularly for payment of armies. Gold would supplant silver as the basic unit of international trade at various times, including the Islamic golden age, the peak of the Italian trading states during the Renaissance, and most prominently during the nineteenth century. Gold would remain the metal of monetary reserve accounting until the collapse of the Bretton Woods agreement in 1971, and remains an important hedge against the actions of central banks and governments, a means of maintaining general liquidity, and as a store of value.

Early coinage

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The first metal used as a currency was silver over 4000 years ago, when silver ingots were used in trade. Gold coins were first used from 600 BC. However long before this time gold, as per silver, was used as a store of wealth and the basis for trade contracts in Akkadia, and later in Egypt. Silver remained the most common monetary metal used in ordinary transactions until the twentieth century. It still circulates in certain bi-metallic coins, such as the Mexican 20 peso coin circa 2005.

The Persian Empire collected taxes in gold and, when conquered by Alexander the Great, this gold became the basis for the gold coinage of his empire. The paying of mercenaries and armies in gold solidified its importance: gold became synonymous with paying for military operations, as mentioned by Niccolò Machiavelli in The Prince two thousand years later. The Roman Empire minted two important gold coins: the aureus, which was approximately 7 grams of gold alloyed with silver, and the smaller solidus, which weighed 4.4 grams, of which 4.2 was gold. The Roman mints were fantastically active — the Romans minted and circulated millions of coins during the course of the Republic and the Empire.

After the collapse of the Western Roman Empire and the exhaustion of the gold mines in Europe, the Byzantine empire minted successor coins to the solidus called the nomisma or bezant. These were of the same weight and high purity as their Western Empire counterparts, and are still considered to be solidii. Unfortunately the Byzantine empire gradually degraded the purity of the coin from about the 1030s until, by the turn of the eleventh century, the coinage in circulation was only 15% gold by weight. This represented a tremendous drop in real value from the old 95-98% gold Roman coins.

From the late seventh century, trade was increasingly conducted in the dinar. The Dinar was a gold coin modelled on the original Roman solidus, having similar size and weight to the Byzantine solidus, but produced by the Arab Empire. The Byzantine solidus and the Arab Dinar circulated alongside one another for about 350 years before the solidus began its decline.

The dinar and dirham were gold and silver coins, respectively, originally minted by the Persians. The Caliphates in the Islamic world adopted these coins, but it is with Caliph Abd al-Malik (685–705) who reformed the currency that the history of the dinar is usually thought to begin. He removed depictions from coins, established standard references to Allah on the coins, and fixed ratios of silver to gold. The growth of Islamic power and trade made the dinar the dominant coin from the Western coast of Africa to northern India until the late 1200s, and it continued to be one of the predominant coins for hundreds of years afterwards. In this way the solidus size, purity and weight of coin - whether it was called the dinar, the bezant, or the solidus itself - was a desired unit of account for over 1300 years, and outlived three empires.

In 1284, the Republic of Venice coined their first solid gold coin, the ducat, which was to become the standard of European coinage for the next 600 years. Other coins, the florin, noble, grosh, złoty, and guinea, were also introduced at this time by other European states to facilitate growing trade. The ducat, because of Venice's pre-eminent role in trade with the Islamic world and its ability to secure fresh stocks of gold, would remain the standard against which other coins were measured.

Beginning with the conquest of the Aztec Empire and Inca Empire, Spain had access to stocks of new gold for coinage in addition to silver. The primary Spanish gold unit of account was the escudo, and the basic coin the 8 "escudos" piece, or "doblón", which was originally set at 27.4680 grams of 22 carat (92%) gold, using current measures, and was valued at 16 times the equivalent weight of silver. The wide availability of milled and cob gold coins made it possible for the West Indies to make gold the only legal tender in 1704. The circulation of Spanish coins would create the unit of account for the United States, the "dollar" based on the Spanish silver real, and Philadelphia's currency market would trade in Spanish colonial coins.

History of the modern gold standard

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The adoption of gold standards proceeded gradually. This has led to conflicts between different economic historians as to when the "real" gold standard began. Sir Isaac Newton included a ratio of gold to silver in his assay of coinage in 1717 which created a relationship between gold coins and the silver penny which was to be the standard unit of account in the Law of Queen Anne; for some historians this marks the beginning of the "gold standard" in England. However, more generally accepted is that a full gold standard requires that there be one source of notes and legal tender, and that this source be backed by convertibility to gold. Since this was not the case throughout the eighteenth century, the generally accepted view is that England was not on a gold standard at this time.

The crisis of silver currency and bank notes (1750–1870)

To understand the adoption of the international gold standard in the late nineteenth century, it is important to follow the events of the late eighteenth century and early nineteenth. In the late eighteenth century, wars and trade with China, which sold to Europe but had little use for European goods, drained silver from the economies of Western Europe and the United States. Coins were struck in smaller and smaller amounts, and there was a proliferation of bank and stock notes used as money.

In the 1790s England suffered a massive shortage of silver coinage, and ceased to mint larger silver coins, issued "token" silver coins and overstruck foreign coins. With the end of the Napoleonic Wars, England began a massive recoinage program, that created standard gold sovereigns and circulating crowns and half-crowns, and eventually copper farthings in 1821. The recoinage of silver in England after a long drought produced a burst of coins: England struck nearly 40 million shillings between 1816 and 1820, 17 million half crowns and 1.3 million silver crowns. The 1819 Act for the Resumption of Cash Payments set 1823 as the date for resumption of convertibility, reached instead by 1821. Throughout the 1820s small notes were issued by regional banks, which were finally restricted in 1826, while the Bank of England was allowed to set up regional branches. In 1833, however, the Bank of England notes were made legal tender, and redemption by other banks was discouraged. In 1844 the Bank Charter Act established that Bank of England Notes, fully backed by gold, were the legal standard. According to the strict interpretation of the gold standard, this 1844 act marks the establishment of a full gold standard for British money.

As a result many of Britain's colonies were forced to resort to using token coins in the 1800s. Large numbers of token coins were issued by businesses at this time. The most famous of which is the trade tokens of Strachan and Company, South Africa's first widely circulating indigenous currency - first issued in East Griqualand in 1874.

The US adopted a silver standard based on the "Spanish milled dollar" in 1785. This was codified in the 1792 Mint and Coinage Act, and by the Federal Government's use of the "Bank of the United States" to hold its reserves, as well as establishing a fixed ratio of gold to the US dollar. This was, in effect, a derivative silver standard, since the bank was not required to keep silver to back all of its currency. This began a long series of attempts for America to create a bimetallic standard for the US Dollar, which would continue until the 1920s. Gold and silver coins were legal tender, including the Spanish real, a silver coin struck in the Western Hemisphere. Because of the huge debt taken on by the US Federal Government to finance the Revolutionary War, silver coins struck by the government left circulation, and in 1806 President Jefferson suspended the minting of silver coins.

The US Treasury was put on a strict hard money standard, doing business only in gold or silver coin as part of the Independent Treasury Act of 1848, which legally separated the accounts of the Federal Government from the banking system. However the fixed rate of gold to silver overvalued silver in relation to the demand for gold to trade or borrow from England. The drain of gold in favor of silver led to the search for gold, including the "California Gold Rush" of 1849. Following Gresham's law, silver poured into the US, which traded with other silver nations, and gold moved out. In 1853 the US reduced the silver weight of coins, to keep them in circulation, and in 1857 removed legal tender status from foreign coinage.

In 1857 the final crisis of the free banking era of international finance began, as American banks suspended payment in silver, rippling through the very young international financial system of central banks. In the United States this collapse was a contributory factor in the American Civil War, and in 1861 the US government suspended payment in gold and silver, effectively ending the attempts to form a silver standard basis for the dollar. Through the 1860–1871 period various attempts to resurrect bi-metallic standards were made, including one based on the gold and silver franc, however, with the rapid influx of silver from new deposits, the expectation of scarcity of silver ended.

The interaction between central banking and currency basis formed the primary source of monetary instability during this period. The combination that produced economic stability was restriction of supply of new notes, a government monopoly on the issuance of notes directly and indirectly, a central bank and a single unit of value. Attempts to evade these conditions produced periodic monetary crisis — as notes devalued, or silver ceased to circulate as a store of value, or there was a depression as governments, demanding specie as payment, drained the circulating medium out of the economy. At the same time there was a dramatically expanded need for credit, and large banks were being chartered in various states, including, by 1872, Japan. The need for a solid basis in monetary affairs would produce a rapid acceptance of the gold standard in the period that followed.

Establishment of the international gold standard

Germany was created as a unified country following the Franco-Prussian War; it established the Reichsmark, went on to a strict gold standard, and used gold mined in South Africa to expand the money supply. Rapidly most other nations followed suit, since gold became a transportable, universal and stable unit of valuation. See Globalization.

Dates of adoption of a gold standard:

• 1871: Germany
• 1873: Latin Monetary Union (Belgium, Italy, Switzerland, France)
• 1873: United States de facto
• 1875: Scandinavia by monetary Union: Denmark, Norway and Sweden
• 1875: Netherlands
• 1876: France internally
• 1876: Spain
• 1879: Austria
• 1893: Russia
• 1897: Japan
• 1898: India
• 1900: United States de jure.

Throughout the decade of the 1870s deflationary and depressionary economics created periodic demands for silver currency. However, such attempts generally failed, and continued the general pressure towards a gold standard. By 1879, only gold coins were accepted through the Latin Monetary Union, composed of France, Italy, Belgium, Switzerland and later Greece, even though silver was, in theory, a circulating medium.

Alternate currencies

At the same time it caused a dramatic fall in aggregate demand, and a series of long Depressions in the United States and the United Kingdom. This should not be confused with the failure to industrialize or a slowing of total output of goods. Thus the attempts to produce alternate currencies include the introduction of Postal Money Orders in Britain in 1881, later made legal tender during World War I, and the "Greenback" party in the US, which advocated the slowing of the retirement of paper currency not backed by gold.

Effects on taxation

By encouraging industrial specialization, industrializing countries grew rapidly in population, and therefore needed sources of agricultural goods. The need for cheap agricultural imports, in turn, further pressured states to reduce tariffs and other trade barriers, so as to be able to exchange with the industrial nations for capital goods, such as factory machinery, which were needed to industrialize in turn. Eventually this pressured taxation systems, and pushed nations towards income and sales taxes, and away from tariffs. It also produced a constant downward pressure on wages, which contributed to the "agony of industrialization". The role of the gold standard in this process remains hotly debated, with new articles being published attempting to trace the interconnections between monetary basis, wages and living standards.

Effects on rural communities

By the 1890s in the United States, a reaction against the gold standard had emerged centered in the Southwest and Great Plains. Many farmers began to view the scarcity of gold, especially outside the banking centers of the East, as an instrument to allow Eastern bankers to instigate credit squeezes that would force western farmers into widespread debt, leading to a consolidation of western property into the hands of the centralized banks. The formation of the Populist Party in Lampasas, Texas specifically centered around the use of "easy money" that was not backed by gold and which could flow more easily through regional and rural banks, providing farmers access to needed credit. Opposition to the gold standard during this era reached its climax with the presidential campaign of Democrat William Jennings Bryan of Nebraska. Bryan argued against the gold standard in his Cross of gold speech in 1896, comparing the gold standard (and specifically its effects on western farmers) to the crown of thorns worn by Jesus at his crucifixion. After being defeated in 1896, Bryan ran and lost again in 1900 and 1908, each time carrying mostly Southern and Great Plains states. The book and then the movie The Wonderful Wizard of Oz, while clothed as a children's novel, actually was political and spoofed the Gold Standard with the "Yellow Brick Road" - see Political interpretations of The Wonderful Wizard of Oz, and [http://papers.ssrn.com/sol3/papers.cfm?abstract_id=377760 which points out that Dorothy returned with silver (not golden) shoes.

Effects on interest rates

The key change in this period was the adoption of a monetary policy to raise interest rates in response to gold outflows, or to maintain large stocks of gold in the reserves of the central bank. This policy created a credibility of commitment to the gold standard. According to Lawrence Officer and Alberto Giovanni, this can be seen from the relationship between the Bank of England rate, and the flow between the pound and the dollar, mark and franc. From 1889 through 1908, the pound maintained a direct bank rate rule relationship with the dollar 99% of the time, and 92% of the time with the mark. Thus, according to the theory of gold standard monetary dynamics, the key to this credibility was the willingness of the Bank of England to make adjustments to the discount rate to stabilize sterling to other currencies in the gold, or de facto gold, standard world, during the peak period of the gold standard composed of 360 months, the Bank of England bank rate was adjusted over 200 times in response to gold flows, a rate of change higher than current central banks.

Gold standard from peak to crisis (1901–1932)

An increase in living standards

By 1900 the need for a lender of last resort had become clear to most major industrialized nations. The importance of central banking to the financial system was proven largely by examples such as the 1890 bail out of Barings Bank by the Bank of England. Barings had been threatened by imminent bankruptcy. Only the United States still lacked a central banking system.

There had been occasional panics since the end of the depressions of the 1880s and 1890s which some attributed to the centralization of production and banking. The increased rate of industrialization and imperial colonization, however, had also served to push living standards higher. Peace and prosperity reigned through most of Europe, albeit with growing agitation in favor of socialism and communism because of the extremely harsh conditions of early industrialization.

Abandoning the standard to fund the war

This came to an abrupt halt with the outbreak of World War I. The United Kingdom was almost immediately forced to take steps that would lead to its gradually leaving its gold standard, ending convertibility to Bank of England notes starting in 1914. By the end of the war England was on a series of fiat currency regulations, which monetized Postal Money Orders and Treasury Notes (later called banknotes, not to be confused with US Treasury notes). The need for larger and larger engines of war, including battleships and munitions, created inflation. Nations responded by printing more money than could be redeemed in gold, effectively betting on winning the war and redeeming out of reparations, as Germany had in the Franco-Prussian War. The US and the UK both instituted a variety of measures to control the movement of gold, and to reform the banking system, but both were forced to suspend use of the gold standard by the costs of the war. The Treaty of Versailles instituted punitive reparations on Germany and the defeated Central Powers, and France hoped to use these to rebuild her shattered economy, as much of the war had been fought on French soil. Germany, facing the prospect of yielding much of her gold in reparations, could no longer coin gold “Reichsmarks,” and moved to paper currency.

The series of arrangements to prop up the gold standard in the 1920s would constitute a book length study unto themselves, with the Dawes Plan superseded by the Young Plan. In effect the US, as the most persistent positive balance of trade nation, lent the money to Germany to pay off France, so that France could pay off the United States. After the war, the Weimar Republic suffered from hyperinflation and introduced “Rentenmarks,” an asset currency, to halt it. This worked properly, although one more year had to pass until a new gold backed Reichsmark came into circulation.

Return to the gold standard

In the UK the pound was returned to the gold standard in 1925, by the somewhat reluctant Chancellor of the Exchequer Winston Churchill, on the advice of conservative economists at the time. Although a higher gold price and significant inflation had followed the WWI ending of the gold standard, Churchill returned to the standard at the pre-war gold price. For five years prior to 1925 the gold price was managed downward to the pre-war level, meaning a significant deflation was forced onto the economy.

John Maynard Keynes was one economist who argued against the adoption of the pre-war gold price believing that the rate of conversion was far too high and that the monetary basis would collapse. He called the gold standard “that barbarous relic.” This deflation reached across the remnants of the British Empire everywhere the Pound Sterling was still used as the primary unit of account. In the UK the standard was again abandoned in 1931. Sweden abandoned the gold standard in 1929, the US in 1933, and other nations were, to one degree or another, forced off the gold standard.

The depression and second world war (1933–1945)

The London conference

In 1933 the London conference marked the death of the international gold standard as it had developed to that point in time. While the United Kingdom and the United States desired an eventual return to the Gold Standard, with President Franklin D. Roosevelt saying that a return to international stability “must be based on silver instead of gold” — neither was willing to do so immediately. France and Italy both sent delegations insisting on an immediate return to a fully convertible international gold standard. A proposal was floated to stabilize exchange rates between France, the United Kingdom and the United States based on a system of drawing rights, but this too collapsed.

The central point at issue was what value the gold standard should take. Cordell Hull, the US Secretary of State, was instructed to require that reflation of prices occur before returning to the Gold Standard. There was also deep suspicion that the United Kingdom would use favorable trading arrangements in the Commonwealth to avoid fiscal discipline. Since the collapse of the Gold Standard was attributed, at the time, to the U.S. and the UK trying to maintain an artificially low peg to gold, agreement became impossible. Another fundamental disagreement was the role of tariffs in the collapse of the gold standard, with the liberal government of the United States taking the position that the actions of the previous American Administration had exacerbated the crisis by raising tariff barriers.

The gold ban

As part of this process, many nations, including the U.S., banned private ownership of gold using the Trading With the Enemy Act for statutory authority to abrogate gold and silver clauses in U.S. Securities and impose fines of up to $10,000 on those who refused to do so. Over this period President Franklin D. Roosevelt passed two laws prohibiting U.S. citizens and the Federal Reserve ownership of gold, Executive Order 6102 of 1933 and the Gold Reserve Act of 1934. Jewelry, private coin collections, and the like were exempt from this ban, which in any case seems not to have been enforced too zealously. In 1975 all restrictions on the right of American citizens to own gold were abolished.

During the period of the gold ban American citizens were required to hold only legal tender in the form of central bank notes. While this move was argued for under national emergency, it was controversial at the time. The Supreme Court upheld the Congressional action in 1934 but there are still some who regard it as an usurpation of private property [http://www.lewrockwell.com/north/north82.html.

Stabilizing global finance

In the years that followed, nations pursued bilateral trading agreements, and by 1935 the economic policies of most Western nations were increasingly dominated by the growing realization that a global conflict was highly likely, or even inevitable. During the 1920s the austerity measures taken to restabilize the world financial system had cut military expenditures drastically, but with the arming of the Axis powers, war in Asia, and fears of the Soviet Union exporting communist revolution, the priority shifted toward armament, and away from re-establishing a gold standard. The last gasp of the nineteenth century gold standard came when the attempt to balance the United States Budget in 1937 led to the “Roosevelt Recession.” Even such gold advocates as Roosevelt’s budget director conceded that until it was possible to balance the budget, a gold standard would be impossible.

Mefo financing

Nazi Germany, as part of its pogrom against the physically or mentally handicapped, Slavic citizens, Gypsies, and Jews, used the gold looted from them to finance its war effort. Some Swiss banks were among the international banks who ended up handling gold deposits from this source. The gold was then deposited with the Reichsbank and used as the basis for notes to be issued which were to be accepted as currency. The Reich then instituted wage and price controls, backed by internment in prison camps, to prevent this Mefo financing (Metallurgische Forschungsanstalt) from producing hyper-inflation.

English hesitate to return to gold standard

During the 1939–1942 period, the UK depleted much of its gold stock in purchases of munitions and weaponry on a “cash and carry” basis from the US and other nations. This depletion of the UK’s reserve signalled to Winston Churchill that returning to a pre-war style gold standard was impractical; instead, John Maynard Keynes, who had argued against such a gold standard, became increasingly influential: his proposals, a more wide ranging version of the “stability pact” style gold standard, would find expression in the Bretton Woods Agreement.

Post-war international gold standard (1946–1971)

Theory

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The essential features of the gold standard in theory rest on the idea that inflation is caused by an increase in the quantity of money, an idea advocated by David Hume, and that uncertainty over the future purchasing power of money depresses business confidence and leads to reduced trade and capital investment. The central thesis of the gold standard is that removing uncertainty, friction between kinds of currency, and possible limitations in future trading partners will dramatically benefit an economy, by expanding the market for its own goods, the solidity of its credit, and the markets from which its consumers may purchase goods. In much of gold standard theory, the benefits of enforcing monetary and fiscal discipline on the government are central to the benefits obtained; advocates of the gold standard often believe that governments are almost entirely destructive of economic activity, and that a gold standard, by reducing their ability to intervene in markets, will increase personal liberty and economic vitality.

Differing definitions of “gold standard”

If the monetary authority holds sufficient gold to convert all circulating money, then this is known as a 100% reserve gold standard, or a full gold standard. In some cases it is referred to as the Gold Specie Standard to more easily separate it from the other forms of gold standard that have existed at various times.

Some believe there is no other form of Gold Standard other than the 100% reserve Gold Specie Standard. This is because in any partial gold standard there is some amount of circulating paper that is not backed by gold, and hence it is possible for monetary issuing authorities to attempt to use seigniorage, and possibly inflation. Others, such as some modern advocates of supply-side economics contest that so long as gold is the accepted unit of account then it is a true gold standard.

In a national Gold Standard system, gold coins circulate freely as money, and paper money is directly convertible into gold at a market rate (not enforced by government fiat), reflecting the value of the paper money as a claim check giving the holder the right to a specified amount of gold coin held by the issuer of the note.

However, where the value of paper money varies against gold, this indicates that the paper money is fiat money and will often devalue against specie. This has been the case during wars when governments would issue paper currency not backed by specie. Examples include Greenbacks issued by the Union during the American Civil War, and paper marks issued by Austria during the Napoleonic Wars. Such episodes have traditionally lead to calls to restore sound money after the war—that is, a hard currency monetary system.

In an international gold-standard system, which may exist in the absence of any internal gold standard, gold or a currency that is convertible into gold at a fixed price is used as a means of making international payments. Under such a system, when exchange rates rise above or fall below the fixed mint rate by more than the cost of shipping gold from one country to another, large inflows or outflows occur until the rates return to the official level. International gold standards often limit which entities have the right to redeem currency for gold. Under the Bretton Woods system, these were called "SDRs" for Special Drawing Rights.

Effects of gold-backed currency

The commitment to maintain gold convertibility tightly restrains credit creation. Credit creation by banking entities under a gold standard threatens the convertibility of the notes they have issued, and consequently leads to undesirable gold outflows from that bank. The result of a failure of confidence produces a run on the specie basis, which is generally responded to by the bankers suspending specie payments. Hence, notes circulating in any “partial” gold standard will either be redeemed for their face value of gold (which would be higher than its actual value) — this constitutes a “bank run;” or the market value of such notes will be viewed as less than a gold coin representing the same amount.

Perceived stability offered by gold standard

The gold standard, in theory, limits the power of governments to cause price inflation by excessive issue of paper currency, although there is evidence that before World War I monetary authorities did not expand or contract the supply of money when the country incurred a gold outflow. It is also supposed to create certainty in international trade by providing a fixed pattern of exchange rates. The gold standard in fact is deflationary, as the rate of growth of economies generally outpaces the growth in gold reserves. After the inflationary silver standards of the 1700s, this was regarded as a welcome relief, and an inducement to trade. However by the late nineteenth century, agitation against the gold standard drove political movements in most industrialized nations for some form of silver-based, or even paper-based, currency.

Under the classical international gold standard, disturbances in the price level in one country would be wholly or partly offset by an automatic balance-of-payment adjustment mechanism called the “price-specie-flow mechanism” (“specie” refers to gold coins). The steps in this mechanism are first: when the price of a good drops, because of oversupply, capital improvement, drop in input costs or competition, buyers will prefer that good over others. Because the stabilization of currencies to gold, buyers within the gold-based economies will preferentially buy the lowest priced good, and gold will flow into the most efficient economies. This flow of gold into the more productive economy will then increase the money supply, and produce sufficient inflationary pressure to offset the original drop in prices in the more productive economy, and would reduce the circulating specie in the less productive economies, forcing prices down until equilibrium was restored.

Central banks, in order to limit gold outflows, would reinforce this by raising interest rates, so as to bring prices back into international equilibrium more quickly. In theory, as long as nations remained on the gold standard, there would be no sustained period of either high inflation, or uncontrolled deflation. Since, at the time, it was believed that markets internally always clear (See Say’s Law), and that deflation would alter the price of capital first, it meant that this would reduce the price of capital, and allow more growth as well as long term price stability.

However, in practice this turned out not to be the case: it was wages, not capital, that depreciated in price first. The reasons for this effect, described by Malthus at the time, and later given more formal expression by Amartya Sen, have to do with the ability of holders of capital to arrange the terms of selling of capital, whereas workers cannot indefinitely delay their need to eat. The price of food relative to wages soars, and there are negative consequences, including famine.

Mundell-Fleming model

According to modern neo-classical synthesis economics, the Mundell-Fleming Model describes the behavior of currencies under a gold standard. Since the value of the currencies is fixed by the par value of each currency to gold, the remaining freedom of action is distributed between free movement of capital, and effective monetary and fiscal policy. One reason that most modern macro-economists do not support a return to gold is the fear that this remaining amount of freedom would be insufficient to combat large downturns or deflation. The theoretical possibility of a return to a gold standard has another effect, namely, the question of central bank credibility in a regime not based on hard currencies. Given that major prizes are still awarded for these questions, the gold standard eras, both the nineteenth century and twentieth century versions, remain a baseline against which the current floating currency monetary system is measured.

Mundell argued that it would be possible to return to an international gold standard, or even a national one, since in an industrial economy a great deal of capital is immobile. This would allow, in his opinion, a central bank to have sufficient freedom of action to engage in limited counter-cyclical actions, that is, lowering interest rates at the onset of a downturn, raising them to prevent overheating of the economy. This was disputed by Friedman who argued that quantity-of-money effects would produce deflation in such a system, and that successful nations would see less benefit than Mundell expected, since gold entering a nation would produce internal inflation. This argument mirrors the one made by Adam Smith and David Hume in the eighteenth century about increasing the quantity of money not being a worthwhile objective.

Advocates of a renewed gold standard

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The internal gold standard is supported by monetarists, Objectivists, followers of the Austrian School of Economics, Islamists such as the Hizb ut-Tahrir, and former Chairman of the Federal Reserve Alan Greenspan and many other libertarians. Support for a gold standard is related to the failure of central banks and governments to maintain the purchasing power of fiat money—gold standard removes the ability of a government to devalue money artificially.

The international gold standard still has advocates who wish to return to a Bretton Woods-style system, in order to reduce the volatility of currencies, but the unworkability of Bretton Woods, due to its government-ordained exchange ratio, has allowed the followers of Austrian economists Ludwig von Mises, Friedrich Hayek and Murray Rothbard to foster the idea of a total emancipation of the gold price from a State-decreed rate of exchange and an end to government monopoly on the issuance of gold currency.

Many nations back their economies by holding gold reserves. These reserves are not intended to redeem notes, but are retained as a hard liquid asset to protect against hyperinflation. Gold advocates claim that this extra step would no longer be necessary since the currency itself would have its own intrinsic store of value. A Gold Standard then is generally promoted by those who regard a stable store of value as the most important element to business confidence.

It is generally opposed by the vast majority of governments and economists, because the gold standard has frequently been shown to provide insufficient flexibility in the supply of money and in fiscal policy, because the supply of newly mined gold is finite and must be carefully husbanded and accounted for.

A single country may also not be able to isolate its economy from depression or inflation in the rest of the world. In addition, the process of adjustment for a country with a payments deficit can be long and painful whenever an increase in unemployment or decline in the rate of economic expansion occurs.

One of the foremost opponents of the gold standard was John Maynard Keynes who scorned basing the money supply on “dead metal.” Keynesians argue that the gold standard creates deflation which intensifies recessions as people are unwilling to spend money as prices fall, thus creating a downward spiral of economic activity. They also argue that the gold standard also removes the ability of governments to fight recessions by increasing the money supply to boost economic growth.

Gold standard proponents point to the era of industrialization and globalization of the nineteenth century as the proof of the viability and supremacy of the gold standard, and point to the UK’s rise to being an imperial power, ruling nearly one quarter of the world's population and forming a trading empire which would eventually become the Commonwealth of Nations as imperial provinces gained independence.

Gold standard advocates have a strong following among commodity traders and hedge funds with a bearish orientation. The expectation of a global fiscal meltdown, and the return to a hard gold standard, has been central to many hedge financial theories. More moderate goldbugs point to gold as a hedge against commodity inflation, and a representation of resource extraction. Since gold can be sold in any currency, on a highly liquid world market, in nearly any country in the world, they view gold as a play against monetary policy follies of central banks, and a means of hedging against currency fluctuations. For this reason they believe that eventually there will be a return to a gold standard, since this is the only “stable” unit of value. The fact that monetary gold would soar to $5,000 an ounce (about 10 times its current value) may well influence the advocacy of a renewed gold standard, as holders of gold would stand to make an enormous profit.

Few economists today advocate a return to the gold standard, other than the Austrian school and some supply-siders. However, many prominent economists are sympathetic with a hard currency basis, and argue against fiat money. This school of thought includes former US Federal Reserve Chairman Alan Greenspan and macro-economist Robert Barro. Greenspan said in 2000 “If you are on a gold standard or other mechanism in which the central banks do not have discretion, then the system works automatically. The reason there is very little support for the gold standard is the consequences of those types of market adjustments are not considered to be appropriate in the twentieth and twenty first century. I am one of the rare people who have still some nostalgic view about the old gold standard, as you know, but I must tell you, I am in a very small minority among my colleagues on that issue.” ^* The current monetary system relies on the US Dollar as an “anchor currency” which major transactions, such as the price of gold itself, are measured in. Currency instabilities, inconvertibility and credit access restriction are a few reasons why the current system has been criticized. A host of alternatives have been suggested, including energy-based currencies, market baskets of currencies or commodities; gold is merely one of these alternatives.

The reason these visions are not practically pursued is much the same reason the gold standard fell apart in the first place: a fixed rate of exchange decreed by governments has no organic relationship between the supply and demand of gold and the supply and demand of goods.

Thus gold standards have a tendency to fall apart as soon as it becomes advantageous for governments to overlook them. By itself, the gold standard does not prevent nations from switching to a fiat currency when there is a war or other exigency. This happens even though gold gains in value through such circumstances, as people use it to preserve value; the fear is that fiat currency is typically introduced to allow deficit spending, which often leads to either inflation or to rationing.

The practical difficulty that gold is not currently distributed according to economic strength is also a factor: Japan, while one of the world's largest economies, has gold reserves far less than would be required to support that economy. Finally the quantity of gold available for reserves, even if all of it were confiscated and used as the unit of account, would put the value of gold upwards of 5,000 dollars an ounce on a purchasing-parity basis. If the current holders of gold imagine that this is the price that they will be paid for giving up their gold, they are quite likely to be disappointed. For these practical reasons — inefficiency, instability, misallocation, and insufficiency of supply — the gold standard is likely to be more honoured in literature than practised in fact.

In 1996 e-gold launched a privately issued digital gold currency system, attempting to replicate a gold standard and create an alternative global monetary system. Other digital gold currency systems soon followed, such as e-Bullion and GoldMoney.

In 2001 Malaysian Prime Minister Mahathir bin Mohamad proposed a new currency that would be used initially for international trade between Muslim nations. The currency he proposed was called the islamic gold dinar and it was defined as 4.25 grams of 24 carat (100%) gold. Mahathir Mohamad promoted the concept on the basis of its economic merits as a stable unit of account and also as a political symbol to create greater unity between Islamic nations. The purported purpose of this move would be to reduce dependence on the United States dollar as a reserve currency, and to establish a non-debt-backed currency in accord with Islamic law against the charging of interest. Nonetheless, gold dinar currency has not yet materialized ^*. However, a digital gold currency called e-dinar has been successfully launched.

Gold as a reserve today

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During the 1990s Russia liquidated much of the former USSR's gold reserves, while several other nations accumulated gold in preparation for the Economic and Monetary Union. The Swiss Franc left a full gold-convertible backing. However, gold reserves are held in significant quantity by many nations as a means of defending their currency, and hedging against the US Dollar, which forms the bulk of liquid currency reserves. Weakness in the US Dollar tends to be offset by strengthening of gold prices. Gold remains a principal financial asset of almost all central banks alongside foreign currencies and government bonds. It is also held by central banks as a way of hedging against loans to their own governments as an "internal reserve". Approximately 25% of all above-ground gold is held in reserves by central banks.

In addition to other precious metals, stores of value also include real estate. As with all stores of value, the basic confidence in property rights determines the selection of which one is chosen, as all of these have been confiscated or heavily taxed by governments. In the view of gold investors, none of these has the stability that gold had, thus there are occasionally calls to restore the gold standard. Occasionally politicians emerge who call for a restoration of the gold standard, particularly from libertarians and anti-government leftists. Mainstream conservative economists such as Barro and Greenspan have admitted a preference for some tangibly backed monetary standard, and have stated that a gold standard is among the possible range of choices.

Both gold coins and gold bars are widely traded in deeply liquid markets, and therefore still serve as a private store of wealth. Also some privately issued currencies, such as digital gold currency, are backed by gold reserves. In effect, the holder of such currencies is long on gold and short on their own fiat currency, writing checks on their account.

In 1999, to protect the value of gold as a reserve, European Central Bankers signed the "Washington Agreement", which stated they would not allow gold leasing for speculative purposes, nor would they "enter the market as sellers" except for sales that had already been agreed upon. A selling band was set. This was intended to prevent further deterioration in the price of gold. (See Washington Consensus)

The end of the Great Commodities Depression has affected the price of gold as well, gold prices rising out of a 20 year trading bracket. This has lead to a renewed use by monetary authorities of gold to back their currencies, but has not materially affected the use of a gold standard as money. In fact, the reverse is the case, the more expensive gold is, the more expensive the acquisition project to create a gold standard becomes.

See also

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• Digital gold currency
• Full-reserve banking
• Gold as an investment
• Gold bug
• International Monetary Fund
• Silver standard
• World Bank

References

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Articles

• "Gold and Economic Freedom" by Alan Greenspan
• The Gold Bug Variations by Paul Krugman describes the gold standard as an "economic myth".
• A Gold Polaris by Jude Wanniski advocates for a return to a gold standard.
• Fact: The gold standard causes deflation and depressions — A Keynesian view of the gold standard.
• NBER on the contribution of the Gold Standard to the Great Depression
• Churchill Gold and the Empire - History of Churchill's decision to return the Sterling Pound back to the Gold Standard
• The Classical Gold Standard from What Has Government Done to Our Money? by Murray N. Rothbard (a commonsense view of money and banking)

External links

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• History of the Gold Standard from EH.NET's Encyclopedia by Lawrence Officer
• Gold Anti-Trust Action Committee website
• The Roosevelt Gold Confiscation Order Of April 3 1933
• FDIC statement of policy regarding Public Law 93-373
• Gold information for researchers
• The Gold Standard, Baton Rouge
• What is The Gold Standard? University of Iowa Center for International Finance and Development
• Gold information for researchers

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