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What is the Gold Standard? All You Need to Know

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The earliest known use of gold as a currency was in 600 B.C. in Lydia, which can today be found in Turkey.

In fact, there is a strong tradition in Turkey of having a deep and abiding respect for the value of gold above all other precious metals. Many Turks today still store gold in their homes as a form of stability and security. Gold has always been used to make coins. By 560 B.C. the Lydians had worked out how to separate gold from silver, and this led to the creation of the first gold coin. 

stacks of gold coins on a gold coloredbackground

Historically, a precious metal's intrinsic value was used to determine the worth of currency made out of it.

Gold Coin Values

In those days, the value of the coin was based solely on the value of the metal within, and the country with the most gold had the most wealth. This was one of the reasons that countries like Spain, Portugal, and England sent Columbus and other conquerors to explore the riches of the New World.

When gold was found at Sutter’s Mill, California, in 1848, the prospect of finding gold and creating great wealth became ever more appealing to Europeans and other settlers, and this inspired the California Gold Rush in 1849, which helped unify western America.

History of Gold in the United States

Although the California Gold Rush made many prospectors rich overnight, it also resulted in rapid price inflation because the United States had already been on a de facto gold standard since 1834. All the new gold would have a huge impact on the adoption of paper money.

In 1861, Treasury Secretary Salmon Chase printed the first paper currency. In a few decades, the Gold Standard Act of 1900 was established to regard gold as the only metal that could be used to redeem paper currency. The value of gold was set in 1900 at $20.67 an ounce.

European countries were trying to establish standard transactions in the world trade market, so they also adopted the gold standard in the 1870s. This guaranteed that the government would redeem any amount of paper money for its value in gold.

It also meant that transactions would no longer be done with heavy gold bullion or coins, because the paper currency had guaranteed value backed by something real. In 1913, Congress established the Federal Reserve as a way to standardize gold and currency values.

When World War I broke out, the United States and most of the European countries suspended the gold standard in order to print enough money to pay for their involvement in the war. This meant that the international gold standard was up for question.

After the war, many countries realized that they didn't actually need to tie their currency to gold. Although many countries, including the United States, quickly returned to a modified gold standard after the war, the gold exchange standard was causing deflation and massive unemployment.

Many countries simply abandoned the gold standard by the 1930s when the Great Depression reached its peak. The United States itself also abandoned the gold standard in 1933.

Dealing With the Great Depression

As explained above, the Great Depression forced many countries to abandon the gold standard. As the price of gold rose, members of the public tried to exchange their dollars for gold. Investors started trading more in currencies and commodities when the stock market crashed in 1929.

Things got even worse when banks began failing, and it didn’t help that many people were hoarding the gold that they did have. The Federal Reserve kept raising interest rates to try and make dollars more valuable, but this had the side effect of making the cost of doing business more expensive.

Many companies had to declare bankruptcy, and this, of course, led to record levels of unemployment. On March 6, 1933, President Franklin D. Roosevelt closed the banks when there was a run on the gold reserves at the Federal Reserve Bank of New York.

By the time he allowed banks to re-open on March 13, they had surrendered all their gold to the Federal Reserve. It was no longer possible to redeem dollars for gold, and nobody could export gold either. On April 20, Roosevelt passed an order for everybody to turn in their gold in exchange for dollars.

This was done to discourage the hoarding of gold. As a result, the United States went on to hold the largest supply of gold in the world, which would come to be stored at Fort Knox. On January 30, 1934, the Gold Reserve Act banned the private ownership of gold except under a special license.

This rule allowed the government to pay off all of its debts in dollars, not gold, and it also authorized Roosevelt to increase the price of gold from the set price of $20.67 per ounce to a far higher price of $35 per ounce (and then this consequently devalued the dollar).

Bretton woods system US-Dollar banknotes

730 delegates from all 44 World War II Allied nations met at the Mount Washington Hotel in Bretton Woods (New Hampshire) for the United Nations Monetary and Financial Conference, also known as the Bretton Woods Conference.

The Bretton Woods System

The Bretton Woods system in 1944 was established to set the exchange value for all currencies when they were dealing in gold. This meant that every country had to convert the foreign official holdings of their currencies into gold at the new set value.

At this stage, it was overwhelmingly clear that the United States still held the vast majority of all of the world’s gold. The Bretton Woods agreement led many countries to peg the value of their reserve currency to the dollar instead of gold.

In other words, central banks kept fixed exchange rates between their currencies and the dollar by buying their own country's currency in foreign exchange markets if their currency became too low against the dollar. If it got too high, they just printed more of their currency and sold it.

Pegging to the dollar became the most convenient way for countries to trade their goods. As a result, most countries no longer needed to exchange their currency for gold, because the dollar had replaced it. The value of the dollar increased greatly, even though its real worth in gold actually remained the same. This policy had the real-world effect of making the U.S. dollar the de facto world currency.

End of the Classical Gold Standard 

In 1960, the United States held $19.4 billion in gold reserves, including $1.6 billion in the International Monetary Fund. That was enough to cover the $18.7 billion in foreign dollars outstanding. As economic conditions improved, Americans bought more imported goods and paid in dollars.

This large balance of payments deficit worried foreign governments that the United States would no longer back up the dollar in gold. By this time, the Soviet Union had become a major oil producer. It started accumulating U.S. dollars in its foreign reserves, which was easy to do because oil is priced in dollars.

There were fears that the United States would seize its bank accounts during the Cold War. This led the Soviet Union to deposit dollars in European banks in France, Britain, and Germany, and these became known as eurodollars. By the 1970s, the United States stockpile of gold kept dropping when President Nixon's economic policies created stagflation.

Massive inflation reduced the value of eurodollars, and banks were likely to redeem their holdings for gold. All of this led to Nixon changing the dollar/gold relationship to a fixed price of $38 per ounce. But the gold standard quickly became meaningless because he no longer allowed the Fed to redeem dollars with gold.

The government then priced gold at just over $42 an ounce in 1973 and then decoupled the value of the dollar from gold altogether in 1976. The price of gold quickly shot up to nearly $125 an ounce.

The Continuing Legacy of Gold 

Once the gold standard was dropped, countries started to print more of their own currency, which resulted in economic growth but also more inflation. Although many conservatives want to return to the gold standard, it seems unlikely to happen.

Fiat money has become the world standard. Most economists regard the gold standard as necessary at a certain point in time, but they don’t see it as applicable in the modern world economy. Gold is still very appealing as an asset of real value. Whenever a recession is possible or when inflation starts rising, many experienced investors increase their holdings in gold.

Advantages and Disadvantages of Gold 

Gold is a fixed asset that can be used to back the value of your money. Gold provides a self-regulating and stabilizing effect on the economy. Gold is a hedge against inflation, which tends to happen when there is too much money in circulation.

It also discourages government budget deficits and debt, which can't exceed the supply of gold. Gold also rewards productive nations. For example, they receive gold when they export. With more gold in their reserves, they can print more money, in turn boosting investment in export businesses.

The gold standard also prompted the Gold Rush in California and Alaska during the 1800s. One good thing about having a gold standard is that a fixed asset backs the money's value. Proponents of a gold standard say it provides a self-regulating and stabilizing effect on the economy.

Under the gold standard, the government can only print as much money as its country has in gold. However, the economy of any given country is dependent upon its supply of gold and its convertibility, so many countries are obsessed with keeping their gold.

Certain actions that were meant to protect gold reserves have caused significant fluctuations in the economy. One problem with a gold standard is that the size and health of a country’s economy often depend upon its supply of gold. The economy is not reliant on the resourcefulness of its people and businesses.

Countries without any gold and only a fiat currency are at a competitive disadvantage. The gold standard makes a lot of countries obsessed with keeping their gold. They ignore the more important task of improving the overall business climate.

Government actions to protect gold reserves have often caused significant fluctuations in the economies and international trade options of those countries. In fact, between 1890 and 1905, the U.S. economy suffered five major recessions for this reason.

Can America Ever Return to a Gold Standard System? 

The United States has officially been on a gold standard system since 1900 when gold was established by law as the only metal that could be used to redeem paper currency. However, the gold standard had been unofficially in effect long before that, since 1834.

After years of inflation and stagflation, the value of the dollar was officially decoupled from gold in 1976. It is unlikely that the United States will ever return the monetary system to the gold standard, because the world economy has changed so extremely.

A return to the gold standard would affect monetary policy in many ways. For example, it would affect how well the government would be able to manage the economy. The Fed would no longer be able to reduce the money supply by raising interest rates in times of inflation.

It could also not increase the money supply by lowering rates in times of recession. The U.S. no longer has a high enough amount of gold at current rates to pay off the debt owed to foreign investors. Even when gold hit its peak price of $1,896 an ounce during the financial crisis of September 2011, there was not enough gold for the United States to pay off its debt.

At that time, China, Japan, and other countries owned $4.7 trillion in U.S. Treasury debt. Although many economists support a return to value the dollar in terms of gold in order to enforce fiscal discipline, balance the budget, and limit government intervention, the general consensus is that it is too late for the U.S. government to adopt an isolationist economic stance. 

Thinking About Gold as an Investment

The first king to use gold for coins was called Croesus, and his name lives on in the phrase “rich as Croesus”. It reached its record high of $1,896 an ounce on September 5, 2011. Many people have built great wealth with gold, and it continues to be an excellent investment option.

Although the gold price is extremely volatile, it can still be one of the best investments you have available to you today. It is easily portable and can be quickly exchanged for other goods of practical value. If you happen to find any gold coins among your stash of change, be sure to hang onto those as long as you possibly can.

They might be one of your best hedges against inflation or a currency that loses value very quickly. With the high price of gold making regular headlines these days, it can be really good news to find out that some of the coins you have might actually be good for something other than feeding a parking meter.

Along with silver and platinum, gold is one of the most valuable precious metals that you can own. You never know how much value they might hold for you one day!

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All articles are provided as a third party analysis and do not necessarily reflect the explicit views of GSI Exchange and should not be construed as financial advice.

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