Until the early 20th century, gold was used as money across the globe and was widely accepted as an efficient store of value and a medium of exchange. Even as paper money became popular with merchants considering its ease of transferability and usage as a more efficient and sophisticated bill of exchange, central banks allowed the swap of these notes back to gold on demand- called the “gold standard”. This meant the maintenance of “gold reserves” by them in order to be able to make good on their promises to redeem the holders of the notes with the specified value.
1] Abandonment of the Classical Gold Standard
Gold standard during World War I
Prior to the First World War, classical gold standard existed in many major economies such as Britain, Germany, France, United States of America and other advanced nations. The United States of America adopted the gold standard in 1879. The silver standard existed in the US and some other emerging economies before the gold standard was adopted. Originally, only Britain and some of its colonies adopted the Gold standard, however, its economic might was such that other countries eventually followed.
Under the classical gold standard, there was a direct link between the currency in circulation and gold i.e. anyone could exchange the currency for its gold value on demand. This limited the amount of currency in circulation. All international surplus and deficits were settled in gold. A crucial factor affecting the money supply and the maintenance of the gold standard was interest rates set by the central banks and profitability of export of gold vis-à-vis domestic consumption. However, during times of crisis such as war periods or acute economic distress, these nations would abandon the gold standard and eventually restore it back to the parity that existed prior to such a crisis.
During World War I, Britain, Germany and other major economies, suspended the gold standard in order to print enough money to manage the immense amounts of capital needed for war financing. This led to periods of serious inflation in these economies. Commodity price levels reached their all-time high and even rose by more than 150% in some of these nations. While the USA did not suspend the gold standard during the First World War, the exchange rate of the dollar vis-à-vis the European nation’s currencies was left unchanged. This led to high exports and trade surplus for the United States. Consequently, prior to 1920, there was inflation even in the United States with wholesale prices rising by approx. 10 percent.
Restoration of the Gold Standard after the War
After the war, the gold standard was restored back by 1927. However, this new gold standard was different from the classical gold standard, considering that the new economic environment was structurally less sound compared to the pre-war period. This required greater management by central banks for maintenance of money supply and the gold standard. Almost all minting and circulation of gold coinage that existed during pre-war time was done away with. Additionally, most of the war countries had depleted their reserves substantially.
In the grip of the Great Depression from 1929-1936, most of the major European economies such as Britain and its colonies, Germany, Austria and other European countries abandoned the gold standard permanently due to their deep economic problems.
Around March 1933, there were massive bank failures in the United States owing to the large magnitude of bank runs by the public. Increasing supply of money in the economy by printing more paper money without affecting the gold standard and interest rates was not possible, considering it would reduce gold reserves and depreciate the value of dollars further. As a consequence, the United States passed the Gold Reserve Act, 1934 nationalising all gold held by private individuals and institutions, including the Federal Reserve Bank. President Roosevelt forbade hoarding of gold coins, bullion and gold certificates in the States. He even banned the export of gold. This move devalued the dollar against gold from $20.67 to troy ounce to $35 to troy ounce. The US was still on the gold standard and the devaluation of the dollar gave more power to the US Government over money supply.
2] Gold Standard after the Second World War
Gold Exchange Standard under the Bretton Woods Agreement
After World War II, the United States of America emerged as the new political and economic superpower. On the question of gold standard, the Bretton Woods Agreement was signed wherein, the dollar remained fixed to gold at $35 an ounce while currencies of participating nations which included Britain, France, Germany etc. agreed to an adjustable fixed exchange rate to the dollar. While these countries maintained gold reserves, they preferred settling the international balances in dollars which was rarely converted to gold. Further, settlement in gold was also rare. It is pertinent to note that domestic convertibility of gold in the United States was still not permitted, even after the Bretton Woods Agreement.
The international gold reserves could not keep pace with economic growth in the periods following the agreement i.e. dollar supply expanded and started becoming overvalued. Even after the London Gold Pool tried to artificially defend the $35 per ounce peg by pooling in gold reserves of eight nations, there were rising problems with the US deficit. Soon many countries became reluctant to accept dollars in settlement.
Nixon Shock and the Smithsonian Agreement
In 1971, President Nixon announced the end of the Bretton Woods agreement and the non- convertibility of US dollars into gold. This meant that there would be no international conversion of dollars to gold and the end of the gold exchange standard.
Even after the Nixon shock and end of the Bretton Woods Agreement, various attempts were made to restore the gold exchange standard. Under the “Smithsonian Agreement” signed in December 1972, it was agreed that the dollar would be revalued at $38 per troy ounce of gold from the earlier rate of $35 per troy ounce of gold. Other currencies were revalued upwards. Soon, it became difficult to maintain the valuation, considering the US dollars in circulation outpaced the gold and other foreign exchange reserves held by the United States. This repeated again in 1973, when the valuation was changed to $42.22 per troy ounce of gold. The failure of the Smithsonian Agreement, led to the establishment of fiat currency in the United States and consequently, all the G-10 states that signed the Smithsonian Agreement.
3] Complete Abandonment of the Gold Standard and Rise of Fiat Money
The introduction of fiat currency gives greater control and flexibility to Central Banks to adjust the money supply in the economy. Some economists argue that establishment of fiat currency, would even prevent conditions of acute shortage of money supply that had earlier intensified the Great Depression during the gold standard era. On the contrary, over the years, the existence of fiat currency and thereby, no limit on money supply expansion has even led to episodes of very high inflation in some countries.
With respect to modern money i.e. fiat currency, credit theories of money have also surfaced which imply that creation of money also simultaneously creates debt while, some proponents indicate that money whether it is commodity or fiat money is debt. The fear with the former theory is that debt would never be repaid in real value terms, but only with new debt. As a consequence, some advocate the return to a gold standard or similar commodity- based system while others believe that such restoration is futile, considering both commodity or fiat money is debt. Irrespective of which theories of money are to be believed, it is clear that the survival and relevance of fiat currency depends majorly on guarantee and backing of the respective governments or central banks and confidence of the public in these institutions.
- History of Gold by the World Gold Council
- The book “Gold and the Gold standard: The story of Gold Money Past, Present and Future” by Edwin Walter Kemmerer
- Congressional Research Service Report “Brief History of the Gold Standard in the United States”
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