What Is the Gold Standard?

Posted on October 17, 2014 by Mary Hood | 0 Comments

Gold bullion (also known as gold bars or ingots) were the basis of the gold standard.  

In Johann Wolfgang Von Goethe’s Faust, Mephistopheles, a cunning devil figure, advises government officials to rely on paper money representing gold yet to be mined. Paper money, he claims, would turn the country’s financial woes (i.e. insufficient circulation of currency) into financial prosperity: “From there it flows to wine-shops, butchers, bakers, with half the world as glutton merry-makers […]”

With this scene, Goethe suggests that moving away from a gold standard and towards a paper currency system (with accompanying inflation) might as well be the work of the devil. Although certain economists over the years have shared this view, currently no country bases its economy on the gold standard.

What Is the Gold Standard?

The story of the gold standard (and paper money) begins with ancient goldsmiths, who we may think of as the original bankers.

During a time when precious metals (gold in particular) were used in everyday economic exchange, people would store any gold they didn’t need at the moment with the goldsmith, who, in turn, would issue the clients a paper receipt indicating the amount of gold they had in storage. Since carrying around large quantities of gold could be cumbersome and dangerous, consumers began exchanging receipts without turning them in for actual gold.

Noticing this, goldsmiths began issuing more receipts than they had gold. If caught trying to deceive the public, a goldsmith could be hanged. When banks were established, bankers issued paper money to represent quantities of gold (and sometimes silver). Although these bank notes were supposed to be as good as gold, banks followed in the footsteps of goldsmiths and issued more paper money than there was gold, leading to inflation and sometimes the collapse of banks if people made a run on the bank, demanding the gold their paper currency was supposed to represent.

The gold standard developed when countries agreed to fix their currencies based on a certain amount of gold. This regulated the rate at which economies grew and helped ensure long-term financial stability. In the short term, however, prices could vary wildly depending on the flow of gold. Countries under the gold standard had very little control over these changes and were left impotent in the face of widespread unemployment. Finally, the cost of mining and producing gold placed a burden on countries.

The gold standard collapsed during World War I when some combatant countries relied on inflation to survive the economic turmoil that accompanies wartime. The gold standard was reinstated in the 1930s and was occasionally modified until 1971. At this time, the U.S. was experiencing a steady depletion of its gold reserves, and it became increasingly difficult to balance deficits with gold. Richard Nixon declared that the U.S. would no longer redeem its currency with gold. The connection between paper money and gold was abolished. Banks notes no longer represented something concrete (this is known as fiat currency).

U.S. currency is no longer based on the gold standard. Our money is known as fiat currency. 

How Is It Relevant Today?

Even though the gold standard is no longer used, interest in its potentially stabilizing power is renewed when unemployment rises above 5%. While gold in jewelry is evaluated by certain standards (and its value fluctuates with the economy), when you hear talk of “the gold standard,” you’re most likely privy to a conversation about the economy—and perhaps the “devilish” curse of paper money.

Photos: Wikipedia, 401(k) 2012

Posted in economics, finance, gold, gold standard

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