What is the Gold Standard? Definition, History, and How It Works

What Is the Gold Standard?

The gold standard is a monetary system where governments fix their currency value directly to gold. Once universal, this system allowed paper money to be converted into fixed amounts of gold, maintaining currency value based on gold parity. Despite its historical significance, the gold standard lost its dominance in the 20th century, paving the way for today's fiat currency systems.

Understanding the Mechanics of the Gold Standard

The gold standard links the value of a country's currency directly to gold. Under the gold standard, countries agreed to convert their paper money into a fixed amount of gold.

A country on the gold standard sets a fixed gold price and trades gold at that rate. This fixed price determines the currency's value. 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.

Over time, the gold standard developed a broad definition, generally describing any commodity-based monetary system not relying on un-backed fiat money. Beyond that, however, there are major differences.

Some gold standards use only physical gold coins and bars, or bullion, while others include other commodities or paper currencies. Recent systems allowed only currency conversion into gold, limiting inflation and deflation control by banks or governments.

Why Gold?

Most commodity-money advocates choose gold as a medium of exchange because of its intrinsic properties. Gold has non-monetary uses in jewelry, electronics, and dentistry, ensuring a constant minimum demand.

It is perfectly and evenly divisible without losing value, unlike diamonds, and does not spoil over time. It is impossible to counterfeit perfectly and has a fixed stock—there is only so much gold on Earth, and inflation is limited to the speed of mining.

Pros and Cons of the Gold Standard

One major advantage of the gold standard is price stability, as it limits government's ability to inflate prices by expanding the money supply.

Inflation is rare, and hyperinflation doesn't happen because the money supply can only grow if the supply of gold reserves increases. The gold standard can also offer fixed international rates, reducing uncertainty in trade.

However, it may cause imbalances among countries using the gold standard. Gold-producing nations could have an advantage, increasing their reserves compared to those without gold resources.

Some economists argue that the gold standard may hinder recession recovery as it restricts governments from increasing the money supply, a key tool for economic growth.

Tracing the History of the Gold Standard

Around 650 B.C., gold was made into coins for the first time, enhancing its usability as a monetary unit. Before this, gold had to be weighed and checked for purity when settling trades.

Gold coins 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. In 1696, the Great Recoinage in England introduced a technology that automated the production of coins and put an end to clipping.

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 coins, mostly silver.

With silver in greater abundance relative to gold, 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 so-called "classical gold standard era" began in England in 1819 and spread to France, Germany, Switzerland, Belgium, and the United States. Each government pegged its national currency to a fixed weight in gold. For example, by 1834, U.S. dollars were convertible to gold at a rate of $20.67 per ounce. These parity rates were used to price international transactions. Other countries later joined to gain access to Western trade markets.

There were many interruptions in the gold standard, especially during wartime, and many countries experimented with bimetallic (gold and silver) standards. Governments frequently spent more than their gold reserves could back, and suspensions of national gold standards were widespread. Moreover, governments struggled to correctly peg the relationship between their national currencies and gold without creating distortions.

As long as governments or central banks retained monopoly privileges over the supply of national currencies, the gold standard proved an ineffective or inconsistent restraint on fiscal policy. The gold standard slowly eroded during the 20th century. This began in the United States in 1933, when Franklin Delano Roosevelt signed an executive order criminalizing the private possession of monetary gold.

After WWII, the Bretton Woods agreement forced Allied countries to accept the U.S. dollar as a reserve rather than gold, and the U.S. government pledged to keep enough gold to back its dollars. In 1971, the Nixon administration terminated the convertibility of U.S. dollars to gold, creating a fiat currency regime.

Comparing the Gold Standard to Fiat Money

As its 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, by contrast, is a monetary system in which the value of a 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 government decree.

In the decades before 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 Bottom Line

The gold standard sets a nation's currency value based on a fixed quantity of gold, differentiating it from fiat money systems, where currency value is not tied to a physical commodity. Historically, many countries, including the United States, relied on the gold standard, but it has largely been abandoned since the mid-20th century in favor of more flexible fiat currency systems. While the gold standard provided price stability and limited government control over currency supply, it also posed constraints during economic recessions. Today, no country operates on the gold standard, and most have transitioned to fiat systems, allowing for more dynamic economic management.