The History of Paper Money – Part 6: The Gold Standard

us gold certificate 1922


In this series, we rarely get far into the twentieth century because it’s hard to have historical perspective on events that are that close to our own time. But today, we’re going to have to roar into the latter half of the twentieth century to show you just how recently this idea came to be. This idea that seems so normal that we all take it for granted, as if it were always the case: the idea that money is worth something because we all agree it is.

Last time, we talked about the growth of central banks as a patch system to fix the numerous problems that occur when you introduce paper money as the basis of an economy. But for many people one more step was required to really inspire confidence in this idea of taking milled tree bark in return for their labor. That was the gold standard. The gold standard is basically the idea that your paper money is backed in gold. That at any time you could take your paper bills somewhere and redeem them for a specified amount of gold. Now I hear a lot of you say, “Why would you ever do that? Doesn’t putting a currency on the gold standard just mean we’re back to the problem we were trying to solve in the first place? By tying money to gold, aren’t we once again limiting the money supply?”

The short answer to that is yes and we’re going to see just how that plays out. The longer answer is sort of. This is a pretty complicated economic question, too complex to really get into here. But the concise version is that having paper money backed in gold rather than using gold directly, allows far more options when you need to expand the money supply. It also has the advantage of letting you play fast and loose with the system when you need to. But still, why would you do this rather than have your currency float free? That’s where history comes in. You see, the gold standard solves two major problems. The first is inflation. As you can probably guess it wasn’t long after people started printing paper money that they figured they could just print a lot of paper money. Way more than they could ever redeem! Way more than even our fractional-reserve banking system thinks is sane.

As soon as people did that, you started to get inflation. It could still happen even with a central currency controlled by the government because when countries need to pay for an army for example, they would sometimes just print more bills to do it. More bills mean each bill is worth less, which was a problem not only for poor citizens whose life savings were now in paper bills, but also for other countries who’d been accepting those paper bills in exchange for their goods. This brings us to the second major issue the gold standard addresses: exchange rates. Right as paper money was becoming the standard in Europe international trade was really starting to pick up. The industrial revolution was getting into full swing and raw materials and finished goods had to be shipped and traded at a pace never before seen.

Simultaneously, mercantilism, that isolationist monetary policy that we discussed in an earlier episode, is coming to an end and causing trade to rocket to even greater heights. But what happens when your ship full of cargo docks in some foreign port and you try to hand the local merchant your funny green paper money to buy their goods while they try to hand you their funny pink paper money to buy what you’ve got on your ship? You both just sit there scratching your heads for a while. Back in the day you would have just weighed whatever coins they were trying to give you and accept them for their weight in gold, but now they’re handing you this piece of paper that you don’t recognize and you have no idea how to value. Can you even trade this specific piece of paper for anything when you get back home? But if both currencies are on the gold standard, problem solved!

Just as an example, let’s say that at any time you could turn in twenty U.S. dollars to get one ounce of gold. One ounce of gold is what your twenty dollars are worth. Let’s say you sail to England where, for the sake of keeping things simple, the UK has set their gold standard so that an ounce of gold is worth two British pounds. This makes everything nice and simple. Since you’re both operating on the gold standard, that means one British pound is the equivalent in value to ten U.S. dollars. Done and done, simple! So how does this all fall apart? First, we have to talk about how it all began. If you saw our episodes on the first Opium war, remember how we talked about the fact that all of Britain’s silver was flowing into China to buy tea? Well, to solve all the problems I just talked about, the British were looking for some commodity to back the Bank of England notes with. But with all their silver gone, the British chose gold and soon basically everybody followed suit. This system has its own breaking points.

Absolute adherence to the gold standard had to be suspended several times during the 1800’s due to the massive expenses incurred by international war. But in England, as in most other countries, there was always a return to the gold standard in peace time with countries working to build their gold reserves back up and limiting the printing of further notes. Other minor shocks like the California gold rush and other introductions of massive new sources of gold would cause the system to lurch, but overall use of the gold standard held up pretty well throughout the nineteenth century.

Then came World War I, the seminal catastrophe of so many notions from our past. Like so many other things the gold standard crumpled under the impossible needs of the war. Nation after nation abandoned gold to print more money to pay for the arms, munitions, and men that were being expended daily on the field. As more and more money was printed and spent to feed the hunger of this war, trade became erratic. Trade from the United States grew far beyond what the gold reserves of Europe could bare.

Inflation ran rampant and after the war many countries couldn’t drag themselves back to the gold standard. Some nations like Germany who were spiraling into hyperinflation under the crushing debt of war reparations tried to stabilize their currency by backing it in land rather than gold. Others like England appealed to people’s patriotism and wrenched themselves back onto the gold standard by asking people not to redeem their money for gold just out of love of country. But even this fell apart as the Great Depression hit. Those few countries that had the wherewithal to stay on the gold standard, like the United States, where now hamstrung by how the inflexibility of gold prevented them from reacting to the crisis. And yet, many people and many nations thought of this as a temporary hiccup. The war and the depression had made a mess of things but soon the good times would be back. Things would get sorted out and everybody would get back on the gold standard. I mean, they had to, right?

Without the gold standard how is money worth anything? But those good times didn’t have a chance to come back because then came the big one, World War II. World War II was perhaps the most expensive war in history. Economically it was totally unsustainable with the US racking up enormous trade surpluses and every other country involved sinking into massive debt. But the world had learned from WWI and as WWII wound down many of the major powers met to work out the first real international monetary agreement, the famous Bretton Woods System.

You see, following the first world war Britain had owned the U.S. a huge pile of money which they couldn’t pay back unless France paid them a huge pile of money it owed them. But much of the war had occurred on French soil and the French couldn’t afford to pay back the British, unless they basically made the defeated German’s pay for everything. This of course had all been a disaster that caused huge financial and political instability. This time around things would be different. Reparations would be minimized. Repayment of reparations would be on gentler terms and that whole problem of wildly unstable currency caused by Germany no longer being able to adhere to the gold standard after WWI? This time the currency instability problem would be solved. How would it be solved?

At this point in history the U.S. basically had everybody’s gold because everyone had basically bought a ton of stuff from the U.S. for the two biggest wars in history. The U.S. actually still was on the gold standard. This illusion was simple. Peg everybody else’s currency to the U.S. dollar. That’s right! The system essentially boiled down to the U.S. dollar is redeemable in gold and all other currencies are redeemable in U.S. dollars. And so, every country had to keep some dollars on hand to redeem their currency which is how the U.S. dollar became the reserve dollar for basically the entire world. As other nation’s economies recovered the dollar became overvalued.

This came to a head in 1965. Charles de Gaulle, who had always been a little bit iffy about America’s position in the world, decided he was going to act on that redeemability. He sent the French Navy to cash in and pick up his bullion, literally bringing boatloads of gold back to France. Soon other nations followed suit. By 1971, with the dollar still overvalued and the Cold War and wars like Korea and Vietnam draining U.S. resources, and sending U.S. gold overseas, Richard Nixon finally took the step that many argued had to come and took the U.S. dollar off the gold standard. Just take that in for a moment: 1971. Less than fifty years ago! But here’s where it gets good. When Nixon pulled the U.S. off the gold standard the shock was felt around the world but it didn’t stop many countries from still pegging their currency to the U.S. dollar. Now you had currencies around the world redeemable for U.S. dollars and the U.S. dollar pegged to nothing. Soon many other countries decided just to let their currencies float, to let them be valued at what the market would bare. Just like that, almost by accident after 6000 years, we finally accepted money as an idea rather than a thing. Or, as John Law would say, “We accepted money as the medium by which things are exchanged, not the value for which they are.”

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