Many currencies used to be tied to gold - or silver - so what was the purpose of this, and what happened to the ‘gold standard’?
The true definition of the gold standard refers to a time when currencies were valued based on a set amount of gold. In the United States, at least, you could exchange a dollar note for its equivalent weight in gold - at one stage it was pegged at US $35 an ounce. The ‘gold standard’ seems pretty kooky by today’s standards, but some people argue it served an important purpose, and have even advocated for its reinstatement.
In this article, we’ll discuss:
- What is the gold standard?
- What is fiat currency?
- The gold standard in Australia
- Any currencies still backed by gold?
- Arguments for and against the gold standard
- Does the gold standard have any future?
- Is cryptocurrency the new frontier?
What is the ‘gold standard’?
To put it simply, the gold standard refers to currency backed by gold - more specifically currency backed by a Reserve Bank’s gold reserves. This was an occurrence in both the United States and Australia, and many other countries. In the UK, the pound was at one stage backed by silver, which is why it’s called ‘The Pound Sterling’, and later backed by gold.
Called ‘pegging’, currency was pegged to the price of gold, and the theory was you could at any time exchange that money for gold.
You don’t have to fully-peg currency, either - it could be half-pegged for example. This effectively doubles the money supply, but lessens its value - effectively a form of inflation.
The gold standard is pretty much the ultimate in libertarian or small government groupthink, as it largely eliminates the key modern roles of central banks. This includes monetary policy setting and bond purchases, which affects the interest rates of home loans and savings accounts, unemployment, wages, inflation…basically everything. Inflation is the big one, which we’ll talk about later. Instead, under the gold standard, we’d be bound by the beauty of an inanimate yellow hunk of metal! In gold we trust.
What is fiat currency?
The virtual opposite of the gold standard is ‘fiat’ currency - no that’s not a small Italian car. Fiat currency is basically what all currency is based on nowadays - its value is based on exchange and nothing more than the promise that the government will do its job. Any money created is essentially done so ‘out of thin air’.
In this way, fiat currency is generally more ‘elastic’, but can be at the hands of the government or central bank of the day. If government or central bank instability rocks a nation, the value of its currency can plummet: Think of Germany’s Weimar Republic, Venezuela or Zimbabwe - and more recently, Turkey or Argentina.
Even in moderate examples, such as Australia, the remit of many central banks is to adjust monetary policy to affect inflation. In Australia, the Reserve Bank’s cash rate remains historically low, while it has also ramped up bond purchasing in order to lower interest rates, which boosts inflation and devalues the currency. Devaluing the currency makes our exports cheaper. And Australia is an export economy, mainly of iron ore, coal, and other resources. It also helps we’re in a trade surplus, but that’s a whole other argument.
If you’ve ever had an annoying six year old ask “But why do we use this money?” or “Why is this paper note WORTH something?” you’ve probably been stumped. The gold standard, however, means currency is based on something, which can be easier for some people to wrap their head around.
The gold standard in Australia - a brief history
Much of the literature surrounding gold standards relates to the United States. But we Australians have had a relatively fleeting relationship with currency tied to gold. All up, some sort of gold or silver backing lasted just over 100 years.
According to the Reserve Bank of Australia, in 1825 under British rule, the Australian colonies had legislated a sterling currency - meaning currency backed by silver. Australia’s first gold coins were minted in 1855 at the start of our gold rush. The number of notes a bank could issue was limited by their gold reserves - so you can see why there was a ‘gold rush’.
However, at the outbreak of the First World War, the British Empire suspended use of the gold standard to more easily fund its operations, which brought about inflation. After, the British Empire could have continued its ‘fiat’ currency, but returned to the gold standard, which had a strong deflationary effect.
In the words of A.C. Davidson, former General Manager of the Bank of New South Wales (now Westpac), this ended up being “probably the greatest achievement that has ever been known in economic history.”
“The return to the gold standard brought many and great advantages. The most was that the return to the gold standard reduced the great difficulties attached to external trade during the period of inflation,” Mr Davidson wrote in The Australian Quarterly in December 1929.
Australian currency was backed by gold until 1932. Monetary policy from 1932 through to the 1970s had the currency pegged to the Great British Pound Sterling, which at the time also stopped being backed by gold in 1931.
In 1966, Australia introduced the decimal currency system and changed the currency to the dollar. In 1967 it was then pegged to the US dollar. The Hawke-Keating Government in 1983 then ‘floated’ the dollar, making it freely able to ebb and flow on global exchange markets.
Are any currencies still backed by gold?
At present, no currencies in the world are backed by the gold standard, whereby consumers can hand in their currency for an equivalent piece of gold.
Switzerland appeared to be the last country to have some form of gold standard but stopped the practice a couple of decades ago.
‘Gold standard’ talking points
There are two main talking points on the gold standard versus fiat currencies that seem to go around in circles - responses to crises, and inflation.
Elasticity and flexibility, especially in crises
History shows even countries that were most ardent supporters of the gold standard - the United States - suspended the pegging in times of crisis.
This happened in the Great Depression, but the jury’s out on whether it was a direct causation.
Writing for The Conversation, Professor of International Economic Affairs at Tufts University, Dr Michael Klein, said it was odd that there are advocates for the gold standard today.
“Going back to a gold standard would handcuff the Fed in its efforts to address changing economic conditions through interest rate policy. The Fed would not be able to lower interest rates in the face of a crisis like the one the world faces today, because doing so would change the value of the dollar relative to gold,” Dr Klein said.
“The onset of the Great Depression finally forced the U.S. and the other countries that still pegged their currencies to gold to abandon the system entirely.
“Economist Barry Eichengreen has found that efforts to maintain the gold standard at the beginning of the Great Depression ended up worsening the downturn because they limited the ability of central banks like the Fed to respond to deteriorating economic conditions.
“For example, while central banks today typically cut interest rates to boost a faltering economy, the gold standard required them to focus solely on keeping their currency pegged to gold.”
Famed economist Milton Friedman offered a more balanced theory in that the US Federal Reserve at the time of the Great Depression failed to pump adequate reserves into the banking system to stave off a collapse.
However, Associated Scholar at the libertarian Mises Institute, Frank Shostak, disputed Friedman’s theory in a 2020 report.
“The Great Depression of 1930s occurred because of the Fed’s loose monetary stance from October 1920 to August 1924, which undermined the pool of real savings,” Mr Shostak said.
“The sharp fall in the money supply from 1930 to early 1933 was in response to the collapse of this pool.”
“Economic depressions are not caused by the collapse in the money stock but come in response to a shrinking pool of real savings on account of the previous easy monetary stance of the central bank.”
The ‘Bretton Woods’ era
Adopted in 1944 was a global monetary agreement called the Bretton Woods agreement. It also helped the United States that most countries agreed to use the US Dollar as its reserve currency.
Under the Bretton Woods system, most countries settled international balances in the US Dollar. The US Government also agreed to redeem other central banks' dollar holdings for gold at a fixed rate of $35 an ounce.
Under what was effectively a one-currency world with many central banks cooperating, this coincided with a relatively stable period free of economic crises for about 30 years.
President Richard Nixon effectively ended this key component of the agreement in 1971, dubbed the ‘Nixon Shock’.
Many backers of the gold standard cite this period as a good reason to go back to gold-backed currency, because shortly after was an oil crisis and a long period of ‘stagflation’.
“Readers will clearly see the big flat spot in the middle where there were almost zero financial crises,” said Jeremy Britton, CFO at Boston Trading Co.
“This halcyon period was the Bretton-Woods era; where the world used the gold standard after WW2, up until 1971 when the USA removed gold backing.
“Behind the curves and bumps of the chart, there are millions of people losing their jobs, their life savings and their homes. Entire governments have teetered on bankruptcy or massive QE [quantitative easing], followed by massive inflation.”
Inflate me, baby
Inflation is a core component in today’s world economies. Most developed nations' central banks try to keep inflation levels in a ‘healthy’ band at an annualised rate of about 2-3%. This is thought to spur on wage growth, keep unemployment low, and a variety of other factors.
However, for backers of the gold standard, this is hell on earth because a strong currency is thought to lead to a strong and stable economy.
Gold advocates ‘As Good as Gold’ say that many Australians are confused about the true strength of their currency.
“[Australians] have failed to acknowledge a sustained collapse in the dollar’s value over, at least, the past two decades,” its chief economist John Adams said.
Mr Adams says it’s not gold that has risen in value, but that the purchasing power of the Dollar has fallen.
“In this context, the value of the Australian dollar has experienced a sustained and dramatic fall of 76.2% over the past 21.5 years since the onset of the Asian Financial Crisis relative to ‘hard money’ such as physical gold,” he said.
“For example, at the start of the Asian Financial Crisis on 2 July 1997, one Australian dollar was equivalent to 6.38% of a gram of gold, only to be worth 1.56% of a gram of gold on 31 December 2018.”
However, Tuft’s Dr Klein generally disputes the inflation argument.
“Arguments for returning to a gold standard reappear periodically, typically around times when inflation is raging, such as in the late 1970s,” he said.
“Its backers assert that central bankers are responsible for surging inflation, through policies like low interest rates, and so the gold standard is necessary to rein them in.
“It is particularly odd, however, to advocate for a gold standard at a time when one of the main problems a gold standard would supposedly address – runaway inflation – has been low for decades.”
And that is true - even with Australia’s Reserve Bank holding nearly $700 billion in ‘assets’, an uptick of nearly half a trillion in just a year, trimmed mean inflation still sits at just 1.6% - below its target 2-3% band.
Other gold standard talking points
Gold has intrinsic value
Gold is a lot more than just a pretty asset. It is highly conductive, which makes it useful in small amounts in electronics and medical devices. Gold is used in connectors, switch and relay contacts, connection wires and other components. Tiny amounts of gold can be found in mobile phones, calculators, GPS devices and more. On the medical side of things, gold is used in dental fillings. It is also used as a drug in small doses to treat conditions such as rheumatoid arthiritis.
The theory favoured by ‘doom and gloom’ types is with a healthy gold reserve, countries can stave off a disaster or zombie apocalypse. Because, even if currencies fell to hell in a handbasket, consumers could still use gold to buy their way out of trouble.
Australia has a lot of gold and gold reserves
Australia is one of the richest gold mining countries on the planet, and our gold reserves are pretty healthy too, especially when compared to other countries with similar populations.
As of March 2021 we had 79.85 tonnes (79,850kg). While this pales in comparison to powerhouses such as United States (8,133 tonnes), or Germany (3,361 tonnes), it’s a lot higher than other developed countries such as Ireland (6 tonnes), and Canada which has zero gold reserves. Canada’s central bank sold the last of its gold in 2016, which has some detractors spooked.
In mining, we produced 350 tonnes of gold in 2020, and that figure is expected to hit 418 tonnes by 2026, overtaking China to become number one in the world.
But there’s still not enough gold!
Even with nearly 80,000kg of gold reserves, and with a sky-high gold price, that’s probably still not enough currency to have in circulation - just under $7 billion worth at today’s estimates. This pales in comparison to the amount of currency currently in circulation - the RBA says as of June 2020 there was $90.1 billion worth of banknotes on issue.
And aside from currency, gold would need to form the majority of a Reserve Bank’s assets. In 2020 the Reserve Bank grew its balance sheet ‘out of thin air’ (chart below) to cushion the effects of lockdowns led by the Covid crisis. It now has nearly $700 billion worth of assets, with a large portion of this in domestic bonds, issuing $4-$5 billion per week for some time now. The Reserve Bank would need to increase its gold reserves around one hundred-fold to account for this. However, that’s where our gold mining could prove effective, producing 350 tonnes in 2020 alone.
Despite the RBA’s huge balance sheet, inflation still hit only 3.8% (annualised) in June 2021, with a large part of that due to government stimulus winding back - trimmed mean inflation was just 1.6%.
Gold has significant handling and storage costs
“Gold is bulky and expensive to transport across borders for settlement,” Mr Britton said.
“$100 million worth of gold needs a dozen people in its entourage: drivers, pilots, armed security guards, and so on.”
And then you’d need somewhere to store it. Banks have vaults, but the vast quantity of gold needed today would mean a significant bolstering of its security systems. Many companies and countries offer to store gold securely, but this comes as an added cost.
Gold is not infallible
Australia alone mines in excess of 300 tonnes of gold every year. Every extra tonne added to the stockpile devalues current gold a little bit, which is a form of inflation in itself.
“Gold supply is marginally inflationary: around 2-3% new supplies of gold are brought onto the market each year from new mining projects, devaluing existing supply ever so slightly,” Mr Britton said.
“Gold can be inflated via the use of partially backed currency, the creation of gold ETFs and other forms of 'paper gold'.
“This gives similar risks to fractional reserve banking and 'bank runs', where not everyone's paper gold can be redeemed for physical gold.”
That’s that half-pegging we talked about earlier.
Would we ever go back onto the gold standard?
Here’s the major caveat - backers of the gold standard usually only talk about what it was like in the good old days. Few talk about the logistics of it being re-introduced today, with gold at more than AUD $2,000 an ounce, the RBA holding nearly $700 billion in ‘assets', and 40-odd years of free-floating currency.
“The pandemic helped drive up the price by 40% to [USD] $2,049 in August . As of Nov 18, it was about $1,885. Clearly, it would be destabilising if the dollar were pegged to gold when its price swings wildly,” Dr Klein said.
However, one could argue that price swings wouldn’t happen, and gold wouldn’t be so expensive and attractive in a time of crisis if the dollar was pegged to it.
National debt also poses a problem, especially for the United States, which ebbs and flows out of trade deficits, particularly with China. Owing money to China under a gold standard would essentially mean giving gold to China, lest they also adopt a gold-backed currency too.
For supporters of the gold standard, it appears we’re ‘too far gone’ to return to using it.
Cryptocurrency the new ‘gold standard’?
A similar mindset of gold backers tends to permeate through the minds of crypto-bros and supporters.
That is, the thought that a decentralised currency is the way of the future.
For Mr Britton, CFO of Boston Trading Co, which claims to offer the world’s first crypto ETF, cryptocurrency is the new frontier.
“The world needs a Bretton-Woods 2.0 solution, as financial crises, even if not in your home country, is bad news for every world citizen,” he said.
“A billion dollars in bitcoin can be carried in a smartphone, thumb-drive or sent via email.”
That last point will probably scare the pants off most gold backers, and many people in general - having currency that could be wiped from the face of the earth at a moment’s notice.
That said a few countries have now included bitcoin as some form of reserve currency.
“It is interesting to note that the countries which benefited the least from the USD hegemony are the first to embrace bitcoin as a reserve currency: El Salvador, Iran, Mexico, Paraguay, Cuba and Brazil,” Mr Britton said.
“Which of the erstwhile 'poor' nations will become a new economic power?”
However, bitcoin’s wild swings arguably make it more infeasible than gold for a country’s reserves. Bitcoin can fluctuate daily by more than 20%. And one tweet, from someone such as Elon Musk, can crater the price.
There are a few cryptocurrencies that are tied to gold. The theory is they provide more stability than traditional crypto, while also potentially serving as a worthwhile investment and currency with a lot of liquidity. Some are:
Asia Broadband (AABB) Gold Token
Tether Gold (AUXt)
Perth Mint Gold Token (PMGT)
The last one is a true-blue Aussie brand from the reputable Perth Mint. Gold tokens are backed by the Australian government, and token holders are given certificates to prove their holdings.
The final word
If you’ve made it this far, congratulations. The gold standard today, for all intents and purposes, exists as nothing more than an academic exercise. Its backers will always be unswayed, and its detractors will always support the more ‘elastic’ fiat currency. While the middle of the 20th century provided immense financial prosperity and stability - hello Baby Boomers - it’s hard to say whether this was 100% because of Bretton Woods. Nonetheless, it’s easy to look at the gold standard through rose-coloured glasses, but it’s unlikely any countries will ever return to it.
Photo by Jingming Pan on Unsplash