Gold standard and USA
Gold bars: Image courtesy of United States Mint
More and more people are demanding that the US return to the gold standard. Probably with Bitcoin being the basis of money now instead of gold. But what is the gold standard and how did US fare under the gold standard? I focus in this article on this topic. Read on if you are curious about these questions.
But even before getting to the gold standard let’s discuss the concept of money. What is money? And what are the different types of items that have been used as money in human history. I start out by answering these questions.
Money
Humans have been trading products and services with each other since times immemorial. Initially, they used the barter system where the participants in the trade exchanged goods/services for other goods/services. But the barter system has several challenges.
It requires each participant in the trade to want what the other has. This becomes increasingly rare with the increase in population and with the specialization of skills. Sometimes, deferred exchanges can be used to address this problem but then this introduces the problem of having to trust the party who gets the product first. In addition, the barter system is not scalable. This is because it is not possible to determine what any good is worth in terms of any other good with which it can be exchanged. So all this results in increased friction for trading.
Hence we need a tool that can be used to make trade easier. This tool is called money.
Money is typically a commodity or collectible or good such that
other items can be exchanged for the commodity that is called money. This makes this commodity i.e. money as a medium of exchange.
every other item is priced in terms of the commodity that is called money. This makes this commodity i.e. money as a unit of account.
its value rises over time. This makes this commodity i.e. money as a store of value.
There have been several goods that have performed the duty of money during human history. Each good has been displaced typically by a good that is better suited to play the role of money.
For example,
Shells were used as money by the American Indians.
Rai Stones (carved crystalline limestones) were used as money by people residing in Yap Islands in Micronesia.
Copper was used as money by ancient Egyptians, Romans as well as in the Western world.
Silver was used as money starting with Sumerians of Mesopotamia and then by various countries around the world.
Gold was used as money starting with UK and then by other countries.
Fiat money which is money guaranteed by the government started in 11th century China and became the predominant form in the 20th century.
In this article, I focus on gold and explain how gold came to be used as money. I then also explain how gold was displaced from its role by fiat money.
Gold Standard
A gold standard uses gold as money - either directly in the form of coins, bars etc or indirectly such as in the form of paper currency or notes that can be exchanged for gold.
Gold started to be considered as money from the early 1700s. However, it was only around 1870 that gold became the basis of the monetary system in several countries around the world. It stopped being the basis in several countries before World War I and then was restored as the basis of the monetary system in 1920s but then lost its status again in 1932. It regained its status partly again after World War II in 1944 but then lost if permanently in 1971.
Gold can be the basis of a monetary system in one of three ways namely
Gold specie standard: In this case actual gold coins are used as money for trade.
Gold bullion standard: In this case paper currency is used for trade. The paper currency can though be exchanged for gold at a predetermined exchange rate.
Gold exchange standard : In this case the paper currency is used for trade. And this paper currency can be exchanged for another paper currency that is part of the gold bullion standard.
Gold was initially used as money in the form of gold coins. This is the gold specie standard. Standardizing gold in the form of coins makes it easy for trade. If not, scales would have to be used during every transaction to verify the weight of gold being exchanged. The difficulty of verifying the weight is further increased when gold is alloyed with base metals. Gold coins with standard purity and weight and verified by authority would reduce this friction associated with the use of gold as money. But gold coins were not easily portable.
To address this problem, several entities such as banks, drugstores etc opened up that would accept gold deposits. In return, the depositor of gold would get a note from this entity. And this note could be used as money. Initially the notes were specific to the amount of gold deposited but over time, the notes became standard.
These notes were then used as money for the purpose of trading. The expectation was that a note holder could take the note to the entity issuing the note and get the note exchanged for gold. But then the entities started issuing lot more notes than the amount of gold held by them. They would do this when they would provide loans at an interest. The loans might or might not be backed by collateral.
Regardless of the backing of the loans, when you have lot more notes floating around than the amount of gold reserves, you have a challenge when people present these notes for redemption in gold. When the number of redemption requests far exceeds the gold reserves, a panic happens, a run on the entity is a result and the entity that created the notes can go out of business.
This used to happen frequently and hence regulations were passed restricting banks to be the types of entities that could provide such notes. In addition, the banking system also was overhauled to consist of a central bank and commercial banks. A central bank on the gold standard was responsible for ensuring that the number of notes or paper currency created was proportional to the gold reserves in the banks.
At some point, the countries found it difficult to create notes or paper currency proportional to the amount of gold reserves held by the country. As a result, the countries moved off the gold standard to a fiat standard.
I next explain the history of gold standard in US briefly.
Gold Standard in US
Bimetallic monetary standard (Gold and Silver): 1792-1862
US began it’s history as a country with a bimetallic standard. A monetary unit which was typically in the form of a coin was defined in terms of either gold or silver. A coin of a given denomination would either contain 1 part of gold or 15 parts of silver. So the ratio of silver to gold in a given denomination was 15 to 1. The world market price for silver to gold was about 15.5 to 1. As a result, all the gold coins were transferred out of the country and primarily silver coins were used for trade domestically. Therefore, from a practical purpose it can be said that US was on a silver standard during this time.
In 1834, Congress changed the ratio of silver to gold used in coins of a given denomination to 16 to 1. This was done by reducing the amount of gold in the gold coins. This resulted in the opposite effect whereby silver coins were exported and gold became the principal coin used for trade domestically in the US. As a result, by 1850, silver coins had nearly disappeared.
Fiat Standard: 1862-1879
The American Civil War from 1861-1865 resulted in fiscal pressures on the US government. As a result, in 1962, the government issued notes that were not convertible into gold. Called as greenbacks, these notes were legal tender i.e could be legally used in transactions. Since the greenbacks were not backed by gold, it can be said that the US abandoned the gold standard at this time. This enabled the government to print as many greenbacks as needed to finance the war. This though resulted in high inflation.
After the end of the Civil war, Congress decided to return to the metallic standard that existed before the War. And so the country started inching back to the gold standard. This was done by retiring greenbacks gradually from circulation. However, this took time. Greenbacks achieved parity with gold coins in 1879. At that point, it could be said that US was back on the gold standard. In addition, at that point, we had a gold standard that used not only gold coins but also paper money issued by the government. The paper money could be exchanged for gold as required by the gold standard.
Gold Standard: 1879-1933
The period from 1879 to 1933 was the only period in US history when it was on a strictly gold standard. Silver was no longer part of the monetary system as a result of a law passed in 1873 although silver coins continued to be used for trades with very low values where gold coins and greenbacks would not be economical.
The Federal Reserve was created in 1913 but this did not have any effect on the US continuing to use the gold standard. The advent of World War I did result in many countries getting off the gold standard but US continued to be on the gold standard until 1933.
The Great Depression, a wave of bank failures etc caused the US to get off the gold standard in 1933 with the inauguration of a new President, Franklin Roosevelt. The greenbacks and other instruments could no longer be exchanged for gold. It was also illegal for Americans to own gold (except for ornamental purposes).
Pseudo Gold Standard: 1934-1973
From 1934 to 1971, the US still was on a gold standard. But the dollars could be exchanged for gold only in case of international transactions with central banks of other countries. Domestically, dollars could not be converted into gold.
In August 1971, President Nixon announced a temporary freeze in the conversion of dollars to gold even for international transactions. This happened because the condition of the economy made it difficult for the government to maintain the link between dollars and gold.
Fiat Standard: 1973- Present
And then finally in October 1976, the government removed the connection between dollars and gold. And so US was officially now on the fiat standard. And this is where we have been since then.
Of course, US took actions under President Nixon to ensure that dollar became the reserve currency of the world. It did so by entering into agreement mainly with Saudi Arabia whereby oil would be priced only in dollars. As a result, every country in the world would have to stock dollars to buy oil.
This ensured that the demand for US dollars did not diminish. And we see the positive impact of this even now. However, the current expansion in the number of dollars in the system is a cause of concern. This is expected to cause inflation. And hence the demands for discipline in terms of creating new money.
Summary
US has been on the gold monetary standard for just a portion of its history. This has had varied results on the economy of the country. Several economists though believe that the Great Depression happened since the US was following the gold standard. On the positive side, following the gold standard ensures that the central bank of the country cannot print money when they want to. Such printing could result in inflation.
Therefore, we need to look at the lessons learnt from history to decide if we go back to the gold standard. And even if we go back to a gold standard like system such as by leveraging Bitcoin, we need to design the system so that we do not repeat mistakes of the past.