It is not uncommon to hear the terms gold standard and fiat money referred to in discussions of economic history. But what do these terms actually mean? In this article, we will begin by addressing the meaning of these terms at a broad and conceptual level. We will then examine how the gold standard was gradually replaced by the fiat system we have today. (Learn more in Gold Standard Revisited).
Gold System vs. Fiat System
As its name suggests, the term gold standard refers to a monetary system in which the value of currency is based on gold. A fiat system, by contrast, is a monetary system in which the value of currency is not based on any physical commodity, but is instead allowed to fluctuate dynamically against other currencies on the foreign-exchange markets. The term “fiat” is derived from the Latin fieri, meaning an arbitrary act or decree. In keeping with this etymology, the value of fiat currencies is ultimately based on the fact that they are defined as legal tender by way of government decree.
In the decades prior to the First World War, international trade was conducted on the basis of what has come to be known as the classical gold standard. In this system, trade between nations was settled using physical gold. Nations with trade surpluses accumulated gold as payment for their exports. Conversely, nations with trade deficits saw their gold reserves decline, as gold flowed out of those nations as payment for their imports.
The End of the Age of Gold
During the years between WWI and WWII, numerous converging factors strained the classical gold standard. Indeed, by the 1930s, this system had all but disappeared. In July 1944, the enactment of the Bretton Woods Agreement during the United Nations Monetary and Financial Conference resulted in a new monetary system in which gold ceded its central position to the U.S. dollar. Within the Bretton Woods system, all national currencies were valued in relation to the U.S. dollar, which became the dominant reserve currency. The dollar, in turn, was convertible to gold at the fixed rate of $35 per ounce. The global financial system continued to operate upon a gold standard, albeit in a more indirect manner.
The stature of gold in the global financial system was further reduced in the 1970s. In August 1971, then U.S. President Richard Nixon severed the direct convertibility of U.S. dollars into gold. With this decision, the international currency market, which had become increasingly reliant on the dollar since the enactment of the Bretton Woods Agreement, lost its formal connection to gold. The U.S. dollar, and, by extension, the global financial system which it effectively sustained, entered the era of fiat money in which it currently resides. (Learn more in Smithsonian Agreement Definition).
Today, there is not a single country in the world which operates its currency on the basis of a gold standard. Nonetheless, questions concerning the relative merits of the gold standard and fiat monetary systems are the subject of ongoing debate.
Proponents of the gold standard often claim that it encouraged governments to behave in a fiscally responsible manner, preventing them from excessively devaluing their currency through the printing of new money. This argument is based on the premise that governments operating under a gold standard must ensure that they maintain adequate reserves of physical gold, both to balance international payments and to satisfy conversions of paper currency into gold.
The Fiat System and Economic Stimulus
On the other hand, one of the most common arguments against the gold standard is that it unnecessarily restricts governments’ ability to perform economic stimulus during recessionary or depressionary times. From this perspective, it is desirable for governments to print money in times of economic duress in order to help stimulate economic recovery. Depending on one’s point of view, the very characteristic of the gold standard, which its proponents commonly cite as a strength, can also be cited as a weakness.
The Bottom Line
Although a version of the gold standard has existed as recently as 1971, international finance has since come to rest exclusively upon the foundation of fiat currency. Given the currently universal adoption of the fiat system, it seems unlikely that we will witness a resurgence of the gold standard in the foreseeable future. Nonetheless, economic history makes clear that the complexity of real-world developments far surpasses the human capacity for accurate prediction. As such, we can only speculate as to how the future chapters of economic history will be written. Whether the gold standard is a relic of the past or becomes relevant again remains to be seen.