Why Gold Lost Its Luster As Money
By: Himanshu Atre
Tags: Money, History, Covid 19 Crisis, Gold, Bretton Woods

Use of gold coins in Antiquity

Civilizations around the world have been intoxicated, obsessed, haunted, humbled, and exalted over gold for many millennia¹. This readily malleable and dense yellow metal is so incredibly inert that unlike other metals which age due to oxidation can stay unaltered through thousands of years. A gold ornament buried under the ground of a five-thousand-year-old archaeological site would shine just as bright as it did when it was adorned by an Egyptian royal.

Gold has been used in many civilizations across China, India, Turkey, and others, for thousands of years. Coins were manually minted out of gold, under a monarch’s authority and seal. The gold standard was a commitment by the country’s government to fix the prices of their currency in terms of a specified amount of gold². Countries like India, where silver was scarcer than gold, followed the silver standard for a long time. However, in most economies, silver often played the part of gold’s trusted sidekick in what is known as a bimetallic standard, where high-value coins were made of gold and low-value coins were silver.

There was a fixed value of each coin, in relation to gold or silver, known as the Mint value. For example, the government may fix the value of one gram of gold to be one dollar and one gram of silver to be one cent. This would imply that the exchange value of silver to gold at the mint is 100:1. Now since gold and silver also had a commodity market, their market rates often swayed and that was when the government had to intervene and buy either metal at a much higher price than the mint price or adjust the mint price to reflect the market price in order to restore parity.

England followed the bimetallic standard but switched to a de facto gold standard in 1717. The United States switched from a bimetallic standard to a de facto gold standard in 1837 by abolishing Silver’s convertibility to the dollar. The Gold Standard Act of 1900 established gold as the only standard for redeeming paper money.

Advantages of the gold standard

For any economy using the gold standard, the money supply is restricted by the amount of gold that the central bank or the government treasuries have in their reserve. This is because paper notes and other government securities are fully and freely convertible to those reserves. Bearers of these notes or securities can redeem them with the government for an equivalent amount of gold.

So, whenever a huge amount of gold was discovered in the eighteenth and nineteenth-century leading during a gold rush in California, Australia, or South Africa, the monetary system would sustain a shock. Although the amount of gold in the system spiked in the short term, productivity, the number of goods and services produced, remained the same. This would act as a natural monetary easing, leading to increased spending, which in turn caused a rise in prices as the output of real goods had not changed. Thus, even though the gold rushes upset the system from time to time, they never caused long-term inflation.

Because the government was not allowed to pump an excessive amount of currency into circulation for any reason (as long as the gold to currency exchange ratio remained constant), the era of the gold standard witnessed relatively stable and inflation rates that were either negative or close to zero.

US Annual Consumer Price Inflation, 1880 to 2016 (Source: Federal Reserve Bank of Minneapolis)

When two countries followed the gold standard, since their currencies were pegged to the same commodity, their currency exchange rates were more or less fixed which reduced foreign exchange risk and reduced the cost of doing cross-border trade.

Low inflation and a stable currency exchange environment spurred increased output due to industrialization leading to a spike in foreign trade. We observe an unprecedented increase in prosperity in the independent industrialized countries like the United States and the European Imperial powers between the 1870s until World War I. British, French, and Dutch colonies, of course, did not benefit from this prosperity, and in fact, became poorer as Europe grew richer.

World War I and the breakdown of the gold standard

As the Great War broke out in Europe, many countries faced mounting war bills and desperately needed liquidity, which the Gold Standard did not allow for. So, many of the countries that engaged in the war took their currencies off the gold standard and started freely printing money. This resulted in high inflation, which lingered around and was exacerbated after the war.

The United States had loaned money to the Allied powers during the war and demanded payback. The Allied powers were bankrupt themselves and relied on the huge reparations forced upon Germany and its allies in the Treaty of Versailles after the war. The vanquished nations had no gold left in their coffers and their economies were exhausted. The US finally lent them money so that they could pay reparations to the Allied powers which in turn owed money to the US. To break this vicious cycle the US had to eventually cancel the remaining Allied debt.

The interwar period

After the war ended, the gold standard was reinstated at the pre-war exchange rates but the reality was now very different. Britain’s economy was not what it used to be, and naturally, the Pound Sterling was nowhere close to its pre-war exchange rate against the US Dollar. Due to its inflexible approach towards money supply, the gold standard had failed to withstand the pressures of a crisis.

Toward the end of the 1920s, the Great Depression hit due to a combination of economic and monetary factors. Unemployment, hyperinflation, and a drop in productivity reached record levels and prevailed for many years. Global cooperation and free trade that only a decade earlier had helped countries to prosper were forgotten and closed trading blocs emerged. Distrust, protectionist, and “beg thy neighbor” policies soon set the stage for the second World War.

Bretton Woods

After the beginning of the end of World War II, with the D-day, delegates from forty-four countries convened in July 1944 at Bretton Woods, New Hampshire, Unites States, to discuss the road to global economic recovery. With barely a scratch from the war on its soil, the US was the only major economy left standing and had once again emerged as the biggest lender to the rest of the world. All other countries were both out of gold and US Dollars to repay their debts.

So, a modified form of the gold standard was created. Since the US already held a disproportionate amount of gold in its coffers, it was proposed that the US Dollar would be pegged to gold while all other countries would peg their currencies to the US Dollar.

John Maynard Keynes at the Bretton Woods conference with other delegates(Source: The Economist/Getty Images)

Other than the new monetary system, the Bretton Woods system, designed primarily by British economist John Maynard Keynes, also proposed the creation of two new organizations — The International Monetary Fund (IMF) and the World Bank. The IMF was formed to monitor exchange rates and help nations that needed global monetary support. The World Bank was created to provide loans to countries that had suffered from the war.

For Europe, Japan, and many other countries around the world reeling from the aftermath of the war, this new system meant that to grow their economies, they needed more and more US dollars. To earn more dollars, a country needs to export more than what they import. To export more, they need to produce more which in turn needs a large amount of capital. If a country did not have enough capital, it received it in the form of aid mostly from the US.

The Marshall Plan

In June 1947, George Marshall presented America’s plan to give additional economic aid to Europe. The offer was open to all of Europe, including wartime enemies and the communist countries of Eastern Europe. Almost $13.6 billion dollars were handed out as part of this plan. However, this help came with strings attached. Countries who wished to receive aid under the Marshall Plan had to ensure that they would increase their exports to the US, amongst other conditions.

Europe and Japan made a miraculous economic recovery in the early 1950s and the Bretton Woods system, aided by the Marshall Plan and increasing military spending abroad by the US, seemed to be working.

Booming global productivity meant that the countries’ monetary reserves had to expand in order to ensure sufficient liquidity. Other countries started stockpiling the US dollar, making it so that the US needed more and more gold to satisfy this need. Gold mining alone could not have satiated this hunger for gold.

In order to maintain global liquidity and remain the world’s reserve currency issuer, the US needed to run a balance of payment deficit by printing dollars beyond what its gold reserves permitted and spending them more abroad than at home in the hope that those countries wouldn't redeem their dollars for gold. This lead to rising inflation in the US in the 1960s and the 70s.

The bank run on the Great American Gold Reserve

In 1966, foreign central banks and governments held over 14 billion U.S. dollars. The United States had $13.2 billion in gold reserves, but only $3.2 billion of that was available to cover foreign dollar holdings. The rest was needed to cover domestic holdings. If governments and foreign central banks tried to convert even a quarter of their holdings at one time, the United States would not be able to honor its obligations³.

Since the pound sterling was also used in small measures by some countries as the reserve currency when the US dollar was in short supply, Britain was also in a similar position to the US. A persistent balance of payments deficit finally forced Britain to devalue the pound in 1967. Speculation ran amok that the dollar might soon follow suit. Private holders of the US dollar flocked to exchange their dollars for gold.

To stop this uncontrolled outflow, the US suspended redemption of dollars for gold in 1968 for private parties. Only central banks were allowed to redeem their dollars at a fixed rate of $35 per ounce. In May 1971 however, even the central banks began to redeem their dollar reserves. America's gold reserves were fastly dwindling. If this ‘run on the bank’ redemption continued, not a single bullion would be left in America’s vault!

No longer pegged to gold

As a response to the decade-long domestic inflation and the gold drain and to maintain the US dollar’s position as the world’s reserve currency, President Nixon announced on 15th August 1971 that the US dollar would no longer be redeemable for gold by private parties or foreign Central Banks⁴. The dollar had now become a Fiat currency making it paper money backed by nothing and recognized as legal tender simply because the government says so.

For thousands of years, the idea of money was that it was something tangible, its value derived from something physical and valuable, and hence its availability is limited to what the Earth can provide. With the world moving to the fiat money standard, there is now no limit to how much money can be created when required(and sometimes even when not required).

Following the US decision to abandon the gold standard, the rest of the world abandoned the security and discipline of a fixed-rate metal standard and adopted a system of “floating” exchange rates where each currency’s value moved up or down depending on international demand and the amount of confidence in its country’s economy⁵.

Although this one pillar of the Bretton Woods system was taken away, the IMF and the World Bank are still very much operational, and in fact, the IMF plays an even more important role now that foreign exchange rates are floating. Even though the gold standard was abandoned, central banks around the world still hold gold in their reserves and the yellow metal continues to remain valuable to people.

COVID-19 and the gold standard

It may appear that if World War I had not happened, the forty-year-long period of prosperity fueled by the gold standard would have continued and we may have still been using it. But I don't think that is true. No market has a perpetual bull run and eventually, all economies take a cyclical downturn. Even if there was no World War I, there still would have been natural calamities, pandemics, banking systems collapse, or many other reasons for which there would have been a need for additional liquidity which the gold standard cannot provide.

Imagine if we were on the gold standard at the beginning of 2020. When the COVID-19 pandemic hit and the world had to shut down, most central banks injected liquidity to save the economy by using a method called Quantitative Easing or as the media likes to call it ‘creating money out of thin air’, which is not possible when the currency is pegged to a commodity. Since the start of the pandemic in March of this year, the M1 money stock in the US has increased by roughly 2 trillion dollars in six months even though productivity came to a virtual standstill.

Money Stock [M1] (Source: FRED, Federal Reserve Bank of St. Louis)

This liquidity injection helped the economy to get over the slump, something that wouldn’t have been possible in the gold standard. However, if the central bankers miscalculate something, this kind of pump and dump can very easily trigger inflation which may be difficult to climb out of. The world can only hope the bankers don't get it wrong. The price of gold in the commodity market saw a jump during this summer as a lot of people wanted to hedge against this tsunami of liquidity by running to the safety of gold.

“We have gold because we cannot trust governments.” - US President Herbert Hoover, 1933

References

[1] Peter L. Bernstein- The Power of Gold, The History of an Obsession

[2] Michael D. Bordo- Gold Standard, The Library of Economics and Liberty

[3] Money Matters: An IMF Exhibit — System in Crisis (1959–1971)

[4]Michael D. Bordo-The Imbalances of the Bretton Woods System 1965 to 1973: U.S. Inflation, The Elephant in the Room

[5]Money Matters: An IMF Exhibit — Reinventing the System (1972–1981)