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.
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The gold standard is not currently used by any government. Britain stopped using the gold standard in 1931 and the U.S. followed suit in 1933 and abandoned the remnants of the system in 1971. The gold standard was completely replaced by fiat money, a term 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. In the U.S., for instance, the dollar is fiat money, and for Nigeria, it is the naira.
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.
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Gold Standard System Versus 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 Gold Standard: A History
'We have gold because we cannot trust governments,' President Herbert Hoover famously said in 1933 in his statement to Franklin D. Roosevelt. This statement foresaw one of the most draconian events in U.S. financial history: the Emergency Banking Act, which forced all Americans to convert their gold coins, bullion and certificates into U.S. dollars. While the legislation successfully stopped the outflow of gold during the Great Depression, it did not change the conviction of gold bugs, people who are forever confident in gold's stability as a source of wealth.
Gold has a history like that of no other asset class in that it has a unique influence on its own supply and demand. Gold bugs still cling to a past when gold was king, but gold's past also includes a fall that must be understood to properly assess its future.
A Gold Standard Love Affair Lasting 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 solely used for worship, demonstrated by a trip to any of the world's ancient sacred sites. Today, gold's most popular use is in the manufacturing 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 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.
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 by fives times 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.
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, 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 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.
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 its adoption 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. In fact, 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. In 1931, the gold standard in England was suspended, leaving only the U.S. and France with large gold reserves.
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 develop 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.
The agreement has resulted in an interesting relationship between gold and the U.S. dollar over time. Over the long term, a declining dollar generally means rising gold prices. In the short term, this is not always true, and the relationship can be tenuous at best, as the following one-year daily chart demonstrates. In the figure below, notice the correlation indicator which moves from a strong negative correlation to a positive correlation and back again. The correlation is still biased toward the inverse (negative on the correlation study) though, so as the dollar rises, gold typically declines.
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. However, as the world rebuilt itself after WWII, the U.S. saw its gold reserves steadily drop as money flowed to war-torn nations and 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 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. By making a pool of gold reserves available, 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 to maintain their export-led growth strategies.
However, 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 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.
The Gold Pool collapsed in 1968 as member nations were reluctant to cooperate fully in maintaining the market price at the U.S. 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's hand and officially closing 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.
In August 1971, 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 it effectively sustained, entered the era of fiat money.
The 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 - from 1871 to 1914 - in a time of world peace and prosperity that coincided with a dramatic increase in the supply of gold. 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, its death had started centuries before with the introduction of paper money – a 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 function. 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 as an indicator of economic health.
Under a free-market system, gold should be viewed as a currency like the euro, yen or U.S. dollar. Gold has a long-standing relationship with the U.S. dollar, and, over the long term, gold will generally have an inverse relationship. With instability in the market, it is common to hear talk of creating another gold standard, but it is not a flawless system. Viewing gold as a currency and trading it as such can mitigate risks compared with paper currency and the economy, but there must be an awareness that gold is forward-looking. If one waits until disaster strikes, it may not provide an advantage if it has already moved to a price that reflects a slumping economy.
Gold made the headlines with a rapid plunge, some possible basing, and then another plunge. Let's talk about gold for a minute.
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Central bankers prefer to have the public, the investor class, and the holders of institutional wealth believe in the credibility of their central banking skills and their ability to manage their respective currencies. But central bankers miss a critical point.
When it comes to gold, the gold bugs argue that gold is money. Simply put, that is not exactly correct. Gold was money 150-200 years, and even centuries, ago. In the US, if you wanted to buy something, you could pay for it with a gold coin.
Those days are long gone. I repeat, those days are long gone. But gold still maintains one important characteristic out of the three that we attribute to a functional currency.
So let us get to this question of whether or not gold is money. To be money, you have to have the ability to exchange easily in transactions. When you go to the store and pay for something in dollars, those dollars function as money. You can pay in paper currency, write a check, transfer it electronically, or pre-purchase the electronic entry on a piece of plastic that is carried and use it for payment. Money is a way in which payments are conducted. You cannot easily buy something with a bag or bar of gold, not even with a gold coin. There are not many people in the world who will take gold for payment. The payment mechanism of money is conducted in the currencies managed by the central banks, regardless of whether the currency is the dollar, pound, yen, euro, franc, krona, dinar, yuan, peso, or something else.
The second characteristic of money is to act as a unit of account, a method of measurement. Open up the income statement of your favorite company. It shows how much revenue, expenses, profits, assets, and liabilities they have in dollars as a unit of account or way of measurement. The same is true all over the world. We use these measurement tools constantly, so money has to provide easy, secure ways of measurement.
The problem with money substitutes that fail these two initial tests is that they become subject to volatilities that disrupt their use. Gold is such an item. Bitcoin is another one. Pay for something with bitcoin and how do you know how much you are paying in comparison to the rest of your daily transactions?
The third characteristic of money is that it is a 'store of value.' It supplies an answer to the question, 'Where can I safely place my accumulation of wealth, the result of my work effort, the gathering of my savings, -and have it hold its value?' Store of value is very important to gold.
Historically, gold, as well as silver and other precious items like diamonds to a lesser extent, has been seen as a place to store value. Gold worked in this regard: it was fungible, it was measurable by weight, and it was the same worldwide; and so it remained for many centuries the traditional place to store value.
In the beginning, central banks traded gold and used it as a reserve because it was such a successful store of value. The central banks still retain their attachment to gold, even when they do not want to admit it.
Now let us get to the wild volatilities of the gold market in the last few days and weeks. In Europe we have a crisis. The crisis involves Cyprus and its ability to pay. Cyprus is broke. It owes more than it has and more than it can earn. And it is beset by a banking collapse in the midst of all this. Cyprus uses the euro for money like the all other Eurozone members. With the euro, the monetary characteristics needed for transactions and pricing still apply, and so Cyprus now has to lock up part of its money because capital controls have been imposed. Furthermore, Cypriots have been restricted in their ability to take their euros and convert them to another currency such as dollars, yen, or pounds. Lastly, Cyprus has some gold, as do most other countries around the world.
The Eurozone colleagues of Cyprus are proposing that Cyprus sell some of its gold. They are very public about it. And the government of Cyprus may have to engage in some negotiation over that gold due to the pressure from its European colleagues. If it does not continue to receive Eurozone assistance, it will not be able to obtain money and make the payments it owes.
The Central Bank of Cyprus does not want to sell the gold. It knows it will not get it back. It also knows that if it holds the gold, it will maintain this mystical store of value that is associated with gold. But if it sells the gold, it will not have that store of value. The central bank resists the sale of gold for two reasons: (1) It has a historical basis on which to maintain the reserve of gold, and (2) It knows that it cannot replace its position if it sells.
In pressing Cyprus to sell, Europeans have announced to the world that there may be a large seller of gold. World traders in gold and other commodities will quickly jump on that trade. They know that if Cyprus breaks loose with the sale of its gold, countries like Greece, Portugal, and Slovenia may be next. They cannot see buying gold, thereby raising gold's US-dollar-denominated price, in such a circumstance; but they can see selling it short, or otherwise trading it to the downside.
Result: gold plummets and there is massive selling. That terrifies the ETF holders and the retail buyers of gold. They pile on the trade, and gold gaps down to an unexpectedly low price.
What happens next?
First, the European drama around gold has to run its course. That is going to take a while.
Second, the terrified retail investors who panicked and sold have to become exhausted sellers. That is happening very quickly, though it is not over. The notion that gold can no longer be trusted as a store of value was clubbed into investors without any preparation. They saw the consistently upward movement of gold prices as confirmation that gold would continue to increase in value. They failed to see that volatilities could be very high in a market that is relatively thin worldwide. Now, disillusioned, they are reacting out of panic.
What happens after the retail investors are exhausted and the curtain is drawn on the European gold drama?
We believe there will emerge a new set of buyers of gold. They will be emerging-market institutions including central banks whose gold holdings are much lower as a proportion of total reserves than the Europeans have maintained. There will also be some larger purchasers of gold.
Here we are going to propose that the Japanese view gold as a new addition to their reserves. Japan has already said it is going to up its reserves. It has already said that it's going to implement highly stimulative monetary policies. It has already launched that program in a very substantial way. Japan is printing yen and buying assets. Simply put, that raises the price of all assets.
Now Japan has a problem. It has to negotiate its policy change in a world in which colleagues in other major countries do not like this rapid weakening of the yen against their own currencies. And they do not want the Japanese to directly buy sovereign debt in other countries by converting newly printed yen into another currency and using that currency to buy the government debt of the country in which they have made the conversion.
But there is another option for Japan. Japan can print yen and buy gold. If it buys metal instead of a bond issued by a sovereign country, it will raise the price of the metal. It will exchange yen for currencies and diversify its exposure among all of the currencies. It will not be able to be accused of direct interference with the bond markets of other sovereign countries. Nor will Japan be able to be accused of interfering with the Federal Reserve's present policy of buying US dollar-denominated, government-backed debt, or with the policies of the Eurozone's central banks or those of the Bank of England. Furthermore, with central banks and other institutions in Germany, France, the US, India, Russia, and elsewhere continuing to buy gold, Japan is in a position to ask, 'Why can't we buy gold, too?'
Other emerging-market countries also have gold-buying programs. In our view, we are now likely to see more of them.
Our conclusion about gold is this. It is not money in the traditional sense of a currency in which transactions can be made. It does not facilitate payments. It is not a unit of account. We do not print financial statements in terms of ounces or tons of gold. Instead, we use currencies to measure our financial status.
Gold does have a historical store of value characteristic. It is held by central banks and institutions as a reserve. They do not want to sell it. On the contrary, many of them want to buy and accumulate it. Therefore, gold's characteristic role with regard to sovereign reserves is still intact, even amid the fascinating evolution of central banking and institutional finance we witness today.
Our view about gold as an investment is slightly different from that of a trader. Gold is a long-term investment. We think it should constitute a small portion of a portfolio and be maintained on a continuing basis. It should be a relatively passive investment. Think of it as a type of insurance policy. So we would recommend gold acquisition, for those who are inclined to pursue it, on a very modest level, utilizing a dollar-cost averaging method. Buy a little gold and put it away. Forget the price. Come back again, buy a little more, add to your hoard, and forget the price. Look at gold as an insurance policy that you hope you never need to use. We do believe that abandoning gold completely and disparaging it as a barbarous relic is too extreme.