The appeal of a gold standard is that it arrests control of the issuance of money out of the hands of imperfect human beings. With the physical quantity of gold acting as a limit to that issuance, a society can follow a simple rule to avoid the evils of inflation. The goal of monetary policy is not just to prevent inflation, but also deflation, and to help promote a stable monetary environment in which full employment can be achieved. A brief history of the U.S. gold standard is enough to show that when such a simple rule is adopted, inflation can be avoided, but strict adherence to that rule can create economic instability, if not political unrest.
The Bimetallic Standard: Silver and Gold
The U.S. Constitution in 1789 gave Congress the sole right to coin money and the power to regulate its value. Creating a united national currency enabled the standardization of a monetary system that had up until then consisted of circulating foreign coin, most of which was comprised of silver.
With silver in greater abundance relative to gold, despite the belief that gold’s value was less liable to variation, a bimetallic standard was adopted in 1792. While the officially adopted silver-to-gold parity ratio of 15:1 accurately reflected the market ratio at the time, after 1793 the value of silver steadily declined, pushing gold out of circulation according to Gresham’s law.
The issue would not be remedied until the Coinage Act of 1834, and not without strong political animosity. Hard money enthusiasts advocated for a ratio that would return gold coins to circulation, not necessarily to push out silver, but to push out small-denomination paper notes issued by the then hated Bank of the United States. A ratio of 16:1 that blatantly overvalued gold was established and reversed the situation, putting the U.S. on a de facto gold standard.
Civil War Fiat Money
While the issuance of paper notes was common and not inconsistent with the bimetallic standard, these notes were not legal tender and circulated only on the trust that they could be redeemed for either gold or silver. However, facing difficulties financing the Civil War, the U.S. government issued, for the first time, a pure fiat paper money known as the greenback in 1862. While being made legal tender, the government made no promise to convert the notes to either gold or silver.
Not limited by the physical supplies of gold or silver, the greenback was issued in large quantities eventually creating inflationary pressures. Following the war, the government worked to curb the inflation by slowly removing greenbacks from circulation with the aim of eventually making them convertible with the metallic standard; however, this and the demonetization of silver that soon followed would have deflationary effects.
The Demonetization of Silver and the Ascendancy of the Gold Standard
Officially adopting a gold standard in 1871, Germany initiated a network effect, motivating a number of other countries to follow suit creating an increased demand for gold at the expense of silver. Presumably, not wanting to be stuck with devalued silver reserves and higher costs to acquire gold, the U.S. effectively demonetized silver by omitting any mention of minting the metal in the Coinage Act of 1873.
Not much notice was given to the new legislation with the full resumption in gold not coming into effect until 1879, but once the attendant deflation that occurred from 1879 to 1896 became evident, the Act came to be known by many as the “crime of 1873.”
Increasing demand for gold coupled with a slowing rate of global gold supply growth exerted upward pressure on the metal’s value, and in conjunction with the government’s commitment to green back convertibility, created strong deflationary pressures, especially on the prices of agricultural commodities.
Raising the ire of the debtor class, especially farmers, the issue became so contentious by 1896, that remonetization of silver became the rallying cry of the presidential candidate, William Jennings Bryan, who stated: “You shall not crucify mankind upon a cross of gold.” Bryan didn’t win, and while both metals were circulated as legal tender, only gold was freely minted. With silver continuing to decline in value, the intrinsic value of a silver dollar was falling relative to its face value, making it essentially a mere token or fiat money. (For more, see: Why is Deflation Bad For The Economy?)
From 1900 to 1933: The Beginning of the End for Gold
A continued dalliance with silver in the latter part of the nineteenth century stoked fears that the U.S might easily revert to a bimetallic standard. As the value of silver continued to decline, holding dollar claims became increasingly risky. To assuage the fear, the U.S. reaffirmed its commitment to gold in the Gold Standard Act of 1900. While greenbacks, silver certificates, and silver dollars still continued to circulate as legal tender, they were now only redeemable in gold.
In a country full of agricultural commodity producers whose monetary needs fluctuated with the seasons, the inflexibility of note issuance, constrained as they were to the physical supply of gold, led to regular banking panics. Within this context, the Federal Reserve was created, not to supplant the gold standard, but to alleviate liquidity crises by acting as a lender of last resort.
While the Fed maintained gold convertibility throughout the First World War, a number of other countries’ fiscal expansions forced them off the gold standard. Following the war, these countries looked to resume prewar gold parities, but the strength of the labor movement had made wages in the postwar era relatively more resistant to deflationary pressures.
In the absence of falling wages, deflation put a squeeze on profits that could only be somewhat relieved by mass unemployment. With policymakers, including those at the Fed, fixated on preserving the gold standard, what started as an ordinary contraction of falling prices and output quickly turned into a severe economic crisis, which came to be known as the Great Depression.
As the contraction worsened, opposition to the maintenance of the gold standard gained strength. Following Britain’s abandonment of the gold standard in 1931, and the Fed’s inability to provide ample liquidity that lead to massive bank failures, the U.S. suspended gold convertibility in 1933. Under the presidency of Franklin Roosevelt, the Gold Reserve Act of 1934 nationalized all private holdings and the era of the classical gold standard officially ended.
Gold’s Last Hurrah—Bretton Woods
Ten years later, a new international monetary system was erected with the intention of combining the stability of fixed exchange rates characteristic of the classical gold standard era with the flexibility of floating exchange rates that allowed for the pursuance of national full employment policies. This was known as the Bretton Woods system.
The U.S. dollar was pegged to an ounce of gold at $35 while other member currencies were pegged to the dollar. The pegs were adjustable only in the event of a fundamental disequilibrium in the balance of payments. While the system allowed for the settlement of balance of payments accounts in gold, most countries tended to settle accounts in dollars and held some, if not most, of their reserves in interest-bearing dollar assets.
The increasing competitiveness of foreign nations combined with the monetization of debt to pay for social programs and the Vietnam War soon began to weigh on America’s balance of payments. With a surplus turning to a deficit in 1959 and growing fears over the next few years that foreign nations would start redeeming their dollar denominated assets for gold, Senator John F. Kennedy issued a statement in the late stages of his presidential campaign that if elected he would not attempt to devalue the dollar.
In a feeble attempt to defend the official dollar-to-gold price ratio, some member nations formed the Gold Pool in 1961. By making available a pool of gold reserves, the market price of gold could be kept in line with the official parity rate. This alleviated the pressure on member nations to appreciate their currencies so as to maintain their export-led growth strategies.
The Gold Pool collapsed, however, in 1968, as member nations were reluctant to cooperate fully in maintaining the market price at the U.S. official price of gold. In the following years, both Belgium and the Netherlands cashed in dollars for gold with Germany and France expressing similar intentions. In August of 1971, Britain requested to be paid in gold forcing Nixon to officially close the gold window. By 1976, it was official, the dollar would no longer be defined by gold, thus marking the end of any semblance of a gold standard. (For more, see: The Gold Standard Versus Fiat Currency)
The Bottom Line
In theory, the limitations that a gold standard places on the issuance of money offers a semblance of monetary stability. Considering the history of the gold standard in the U.S., it is evident that the very scarcity of gold that promises this stability ultimately leads to the standard's demise. Monetary stability depends not just on a certain degree of discipline, but also on a certain degree of flexibility that can meet the cash and credit needs of the population.