What is the Gold Standard
The gold standard can refer to several things, including a fixed monetary regime under which the government's currency is fixed and may be freely converted into gold. It can also refer to a freely competitive monetary system in which gold or bank receipts for gold act as the principal medium of exchange; or to a standard of international trade, wherein some or all countries fix their exchange rate based on the relative gold parity values between individual currencies.
BREAKING DOWN Gold Standard
The gold standard developed a nebulous definition over time, but is generally used to describe any commodity-based monetary regime that does not rely on un-backed fiat money, or money that is only valuable because the government forces people to use it. Beyond that, however, there are major differences.
Some gold standards only rely on the actual circulation of physical gold coins and bars, or bullion, but others allow other commodity or paper currencies. Recent historical systems only granted the ability to convert the national currency into gold, thereby limiting the inflationary and deflationary ability of banks or governments.
Most commodity-money advocates choose gold as a medium of exchange because of its intrinsic properties. Gold has non-monetary uses, especially in jewelry, electronics and dentistry, so it should always retain a minimum level of real demand. It is perfectly and evenly divisible without losing value, unlike diamonds, and does not spoil over time. It is impossible to perfectly counterfeit and has a fixed stock — there is only so much gold on Earth, and inflation is limited to the speed of mining.
Advantages and Disadvantages of the Gold Standard
There are many advantages to using the gold standard, including price stability. This is a long-term advantage that makes it harder for governments 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. Similarly, the gold standard can provide fixed international rates between countries that participate and can also reduce the uncertainty in international trade.
But it may cause an imbalance between countries that participate in the gold standard. Gold-producing nations may be at an advantage over those that don't produce the precious metal, thereby increasing their own reserves. The gold standard may also, according to some economists, prevent the mitigation of economic recessions because it hinders the ability of a government to increase its money supply — a tool many central banks have to help boost economic growth.
Classical Gold Standard Era
The classical gold standard 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 1879, 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 extremely common. 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.