What Is a Gold Standard?

What Is a Gold Standard?
January 27, 2011

(This item originally appeared on Forbes.com on January 27, 2011.)

The U.S. used a gold standard from its inception in 1789 until 1971, a stretch of 182 years. In 1965–not that long ago–all major countries participated in the global gold standard system known as the Bretton Woods arrangement.

With this experience, you would think these things would be well understood, but they are not. We have to start again at the most basic level: What is a gold standard?

Whether the most rudimentary system in which gold bullion is used as money, or in more sophisticated systems in which paper money is linked to gold, all gold standard systems share one trait: The value of the currency is linked to gold.

Thus, a gold standard system’s point of focus is the value of the currency. The goal of a gold standard is to produce the most stable money possible–money that does not go up or down in value. David Ricardo wrote, “A currency, to be perfect, should be absolutely invariable in value.”

But how is this accomplished? John Stuart Mill explained:

In order that the value of the currency may be secure from being altered by design, and may be as little as possible liable to fluctuation from accident, the articles least liable of all known commodities to vary in their value, the precious metals, have been made in all civilized countries the standard of value for the circulating medium; and no paper currency ought to exist of which the value cannot be made to conform to theirs.

A gold standard is a tool used for a specific purpose–to create a currency that is, to the extent humanly possible, perfectly stable in value.

It doesn’t matter whether you have gold coins or not. In the 1933-1971 period it was actually illegal for U.S. citizens to own gold coins, but they still had a gold standard, with the dollar pegged to gold at $35 per ounce during those years.

Nor does it matter whether some entity holds huge quantities of gold in storage. When the U.S. ran the international gold standard, immense quantities of bullion were socked away in vaults. In 1941 the U.S. government held 52% of all the gold in the world, which is probably an all-time record in terms of concentration of ownership. However, in 1910, when Britain ran the international gold standard, the Bank of England had only about 1.2% of all the gold in the world. By that time Britain had been on a gold standard for 212 years.

We can also see that it doesn’t matter who owns the gold, whether it is this central bank or that one, or private investors or jewelry enthusiasts. Gold is the same value no matter who owns it. Gold imports and exports are irrelevant; as long as trade in bullion is unrestricted, gold is the same value everywhere.

The amount of metal piled in a vault has little relationship to the value (or quantity) of paper banknotes. In 1779 the Bank of England held 953,066 ounces of gold in reserve. In 1783 this had fallen to 339,261 ounces. One year later, in 1784, it had grown to 1,683,724 ounces. A year after that, it was down to 703,692 ounces, but in 1786 it bounced back up again to 1,535,538 ounces. These gyrations had no effect on the value of the British pound, which was pegged to gold at 3.89375 pounds per ounce.

Nor did banks ever have a 100% reserve of gold. In 1888 U.S. banks had a gold reserve ratio of 34.86%. By 1895 it had fallen to 12.33%. In 1906 it had grown again to 42.42%. None of this mattered to the value of the dollar, which was pegged to gold at $20.67 per ounce.

A gold standard does not place some artificial limit on the supply of money, nor is the supply of money constrained to the output of gold mines. The supply of base money grows or contracts as necessary to maintain the currency’s value in line with the gold parity. Between 1775 and 1900, the U.S. base money supply increased by 163 times–in line with an expanding economy and a population that went from 3.9 million in 1790 to 76.2 million in 1900. Over this 125-year period, the amount of gold in the world increased by about 3.4 times due to mining.

The only thing that mattered was the value. The dollar maintained its link near $20.67 per ounce throughout the 19th century (with a lapse during the Civil War).

When we understand that the purpose of a gold standard is to create a currency of perfectly unchanging value, we can also understand why nobody uses a gold standard today. Beginning in the 1930s, and especially after the introduction of floating currencies in 1971, economists have been fascinated by the idea of discretionary monetary policy. They believed that they could solve various economic problems by jiggering the currency. Today Ben Bernanke is attempting to influence asset prices and economic behavior with his quantitative easing plan.

A gold standard prevented this currency fiddling. That’s why, according to the currency manipulators, the gold standard had to go.

We will learn once again–sooner rather than later, by the looks of it–that you can’t devalue yourself to prosperity.

How could any country grow wealthy just by monkeying with the unit of account? Of course it is absurd, which is why there is not a single historical example of a country that succeeded with this method.

At some point people’s goals will change. They will no longer believe their problems can be solved with currency manipulation. They will finally understand, probably from difficult experience, why those 19th-century economists always aimed for the most stable currency possible.

When the goal is a stable currency, then the preferred tool is a gold standard system. This has been the case for the last 500 years of Western Civilization, and it remains true today.