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The gold standard is a monetary system where a country's currency or paper money has a value directly linked to gold. With the gold standard, countries agreed to convert paper money into a fixed amount of gold. A country that uses the gold standard sets a fixed price for gold and buys and sells gold at that price. That fixed price is used to determine the value of the currency. For example, if the U.S. sets the price of gold at $500 an ounce, the value of the dollar would be 1/500th of an ounce of gold.

The gold standard is not currently used by any government. Britain stopped using the gold standard in 1931 and the United States followed suit in 1933 and abandoned the remnants of the system in 1971. The gold standard was completely replaced by fiat money. The term fiat money is used to describe currency that is used because of a government's order — or fiat — that the currency must be accepted as a means of payment. So for the U.S., the dollar is fiat money, and for Nigeria it is the naira.

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 History of Gold

"We have gold because we cannot trust governments." President Herbert Hoover's statement in 1933 to Franklin D. Roosevelt foresaw one of the most draconian events in U.S. financial history: the Emergency Banking Act occurred that same year, forcing all Americans to convert their gold coins, bullion and certificates into U.S. dollars. While the Act successfully stopped the outflow of gold during the Great Depression, it did not change the conviction of gold bugs, those who are forever confident in gold's stability as a source of wealth.

Gold has a history that, like that of no asset class, has a unique influence on its own demand and supply today. Gold bugs still cling to a past when gold was king. But gold's past includes also a fall, which must be understood to properly assess its future.

A Love Affair That Has Lasted 5,000 Years

For 5,000 years, gold's combination of luster, malleability, density and scarcity has captivated humankind like no other metal. According to Peter Bernstein's book "The Power of Gold: The History of Obsession," gold is so dense that one ton of it can be packed into a cubic foot.

At the start of this obsession, gold was used solely for worship. A trip to any of the world's ancient sacred sites demonstrates this. Today, gold's most popular use is in the manufacture of jewelry.

Around 700 B.C., gold was made into coins for the first time, enhancing its usability as a monetary unit: before this, gold, in its use as money, had to be weighed and checked for purity when settling trades.

Gold coins, however, were not a perfect solution since a common practice for centuries to come was to clip these slightly irregular coins to accumulate enough gold that could be melted down into bullion. But in 1696, the Great Recoinage in England introduced a technology that automated the production of coins, and put an end to clipping.

Since it could not always rely on additional supplies from the earth, the supply of gold expanded only through deflation, trade, pillage or debasement.

The discovery of America in the 15th century brought the first great gold rush. Spain's plunder of treasures from the New World raised Europe's supply of gold five-fold in the 16th century. Subsequent gold rushes in the Americas, Australia and South Africa took place in the 19th century.

Europe's introduction of paper money occurred in the 16th century, with the use of debt instruments issued by private parties. While gold coins and bullion continued to dominate the monetary system of Europe, it was not until the 18th century that paper money began to dominate. The struggle between paper money and gold would eventually result in the introduction of a gold standard.

The Rise of the Gold Standard

The gold standard is a monetary system in which paper money is freely convertible into a fixed amount of gold. In other words, in such a monetary system gold backs the value of money. Between 1696 and 1812, the development and formalization of the gold standard began as the introduction of paper money posed some problems.

In 1797, due to too much credit being created with paper money, the Restriction Bill in England suspended the conversion of notes into gold. Also, constant supply imbalances between gold and silver created tremendous stress to England's economy. A gold standard was needed to instill the necessary controls on money.

By 1821, England became the first country to officially adopt a gold standard. The century's dramatic increase in global trade and production brought large discoveries of gold, which helped the gold standard remain intact well into the next century. As all trade imbalances between nations were settled with gold, governments had strong incentive to stockpile gold for more difficult times. Those stockpiles still exist today.

The international gold standard emerged in 1871 following the adoption of it by Germany. By 1900, the majority of the developed nations were linked to the gold standard. Ironically, the U.S. was one of the last countries to join. (A strong silver lobby prevented gold from being the sole monetary standard within the U.S. throughout the 19th century.)

From 1871 to 1914, the gold standard was at its pinnacle. During this period near-ideal political conditions existed in the world. Governments worked very well together to make the system work, but this all changed forever with the outbreak of the Great War in 1914.

The Fall of the Gold Standard

With World War I, political alliances changed, international indebtedness increased and government finances deteriorated. While the gold standard was not suspended, it was in limbo during the war, demonstrating its inability to hold through both good and bad times. This created a lack of confidence in the gold standard that only exacerbated economic difficulties. It became increasingly apparent that the world needed something more flexible on which to base its global economy.

At the same time, a desire to return to the idyllic years of the gold standard remained strong among nations. As the gold supply continued to fall behind the growth of the global economy, the British pound sterling and U.S. dollar became the global reserve currencies. Smaller countries began holding more of these currencies instead of gold. The result was an accentuated consolidation of gold into the hands of a few large nations.

The stock market crash of 1929 was only one of the world's post-war difficulties. The pound and the French franc were horribly misaligned with other currencies; war debts and repatriations were still stifling Germany; commodity prices were collapsing; and banks were overextended. Many countries tried to protect their gold stock by raising interest rates to entice investors to keep their deposits intact rather than convert them into gold. These higher interest rates only made things worse for the global economy, and finally, in 1931, the gold standard in England was suspended, leaving only the U.S. and France with large gold reserves. (For more on interest rates and gold, see: How a Rate Hike Could Impact Gold)

Then in 1934, the U.S. government revalued gold from $20.67/oz to $35.00/oz, raising the amount of paper money it took to buy one ounce, to help improve its economy. As other nations could convert their existing gold holdings into more U.S dollars, a dramatic devaluation of the dollar instantly took place. This higher price for gold increased the conversion of gold into U.S. dollars effectively allowing the U.S. to corner the gold market. Gold production soared so that by 1939 there was enough in the world to replace all global currency in circulation.

As World War II was coming to an end, the leading western powers met to put together the Bretton Woods Agreement, which would be the framework for the global currency markets until 1971. 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.

At the end of WWII, the U.S. had 75% of the world's monetary gold, and the dollar was the only currency still backed directly by gold. But as the world rebuilt itself after WWII, the U.S. saw its gold reserves steadily drop as money flowed out to help war-torn nations as well as to pay for its own high demand for imports. The high inflationary environment of the late 1960s sucked out the last bit of air from the gold standard.

In 1968, a gold pool (which dominated gold supply), which included the U.S and a number of European nations stopped selling gold on the London market, allowing the market to freely determine the price of gold. From 1968 to 1971, only central banks could trade with the U.S. at $35/oz.

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.

Bottom Line

While gold has fascinated humankind for 5,000 years, it hasn't always been the basis of the monetary system. A true international gold standard existed for less than 50 years (1871 to 1914) — in a time of world peace and prosperity that coincided with a dramatic increase in the supply of gold. But the gold standard was the symptom and not the cause of this peace and prosperity.

Though a lesser form of the gold standard continued until 1971, the death of it had started centuries before with the introduction of paper money — a much more flexible instrument for our complex financial world. Today, the price of gold is determined by the demand for the metal, and although it is no longer used as a standard, it still serves an important use. Gold is a major financial asset for countries and central banks. It is also used by the banks as a way to hedge against loans made to their government, and an indicator of economic health. (See also: Why Gold Matters)

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