As the name suggests, the term gold standard refers to a monetary system in which the value of a currency is based on gold. A fiat system, in contrast, is a monetary system in which the value of a currency is independent of a physical commodity, but instead can fluctuate dynamically against other currencies in the foreign exchange markets. The term “order” comes from the Latin “fieri”, which means an arbitrary act or decree. Under this etymology, the value of fiat currencies is ultimately based on the fact that they are defined as legal tender by government regulation.
In the decades before World War I, international trade was conducted on what became known as the classical gold standard. In this system, trade between countries was conducted using physical gold. Countries with trade surpluses hoarded gold as payment for their exports. Conversely, countries with trade deficits saw their gold reserves shrink as gold flowed out of those countries as payment for their imports.
Gold standard: history
“We have gold because we cannot trust governments,” President Herbert Hoover said in a 1933 statement to Franklin D. Roosevelt. This statement heralded one of the most draconian events in U.S. financial history: the Emergency Banking Act. which forced all Americans to convert their gold coins, bars, and certificates into US dollars. Although the legislation was successful in stopping the outflow of gold during the Great Depression, it did not change the belief in gold bugs, people who have always believed in the stability of gold as a source of wealth.
Gold has a history similar to that of any other asset class in that it has a unique influence on its supply and demand. Gold bugs still cling to the past when gold was king, but gold’s past also includes a fall that needs to be understood to properly assess its future.
A gold standard love affair lasting 5,000 years
For 5,000 years, gold’s combination of brilliance, malleability, density, and rarity has captivated mankind like no other metal. According to Peter Bernstein’s The Power of Gold: A Story of Possession, gold is so dense that one ton of it can fit in a cubic foot.
At the beginning of this obsession, gold was used exclusively for worship, as evidenced by a trip to any of the world’s ancient sacred sites. Today, gold is most often used in the manufacture of jewelry.
Around 700 BC coins were first turned from gold, which increased its usability as a monetary unit. Before that, gold had to be weighed and checked for purity when settling transactions.
Gold coins weren’t the ideal solution, as it was common practice for centuries to cut off these slightly irregular coins to accumulate enough gold to be smelted into bars. In 1696, the Great Recoinage in England introduced technology that automated the production of coins and put an end to coin cutting.
Because he could not always rely on additional supplies from the land, the supply of gold only increased through deflation, trade, plunder, or depreciation.
The first great gold rush came to America in the 15th century. The looting of treasures from the New World by Spain in the 16th century increased the supply of gold in Europe by five times. Subsequent gold rushes in America, Australia, and South Africa occurred in the 19th century.
The emergence of paper money in Europe occurred in the 16th century using debt instruments issued by private individuals. While gold coins and bullion continued to dominate Europe’s monetary system, paper money only began to dominate in the 18th century. The struggle between paper money and gold will eventually lead to the introduction of the gold standard.