Tuesday, October 11, 2011

The Gold Standard: Three Definitions

What exactly is the "gold standard?" This term refers to a system in which all forms of legal tender are based against a weight of gold. This type of monetary system uses a fixed price of gold as a comparison for currency and bank deposits. There are three different types of gold standard systems that have been used since the 18th century, which include gold specie standard, gold exchange standard and gold bullion standard. Each is slightly different and has played a different role in history.

1. The Gold Exchange Standard

With this monetary system, the less precious metal coins are used as the standard. These metals include silver. Those implementing the system have usually decided upon the exact exchange rate with any country using gold standard. Before 1900, any countries that were using silver standard began switching their currency units to the gold standard that was being used in the United States or the UK. Examples of countries that made this change include the Philippines, Japan and Mexico, who each valued their silver currency units as 50 cents per US dollar.

2. The Gold Bullion Standard

The most common form of gold standard is the one based on the price of bullion that is based on worldwide demand. Since 1925, this method has been commonly used, as the British Parliament declared the gold specie standard to be void. Because of the large volume of bullion that was shipped out of the UK after that, this gold standard was ended as well. Countries that use gold standard are somewhat insulated against having governmental inflation of prices because of excesses in paper currency. When the exchange rates are fixed, then international trade is more certain and more fair.

3. The Gold Specie Standard

This type of gold standard is related to the actual gold coins circulating worldwide. Each monetary or currency unit is based on the actual denominational value of one denomination of gold coin. Gold coins that are made from other metals mixed with gold are also considered.

Since the medieval empires, the gold specie standard has been commonly used, though not always formally recognized. The British West Indies use this system in their modern currency based on the Spanish doubloon coin. In the United States, the gold specie standard was adopted in 1873, with the Gold Eagle coin as its unit.

Unfortunately, the gold standard can sometimes affect monetary systems and policies and make them less effective when any attempt to stabilize an economy is made due to recession or slowing of economical systems. When the amount of gold determines the amount of money in the world, then the gold standard can affect international economies adversely.

What Was The Gold Standard?

The gold standard was a way fixing the price of the domestic currency against a particular amount of gold. So, when a country adopted this standard, all the money, including bank deposits and paper notes, could be converted to gold at a fixed price. England was the first country to adopt the gold standard in 1717, when Sir Isaac Newton, the master of the royal mint, ended up overvaluing the guinea against silver. However, at this time the adoption was not formal. The formal adoption of the gold standard in the United Kingdom occurred in 1819.

The United States was following a bimetallic standard, where the price of the US dollar was fixed against both gold and silver. The country shifted to the gold standard in 1834 after the US Congress passed the Gold Standard Act. The price of gold was fixed at $20.67 per ounce and this price stayed on until 1933.

During the 1870s, many other countries shifted to this standard, and the years between 1880 and 1914 were known as the classical period. This was the time the world witnessed significant economic growth clubbed with free trade.

However, when the First World War broke out, the gold standard fell apart, as countries responded by resorting to inflationary finance. Nonetheless, the standard was re-introduced for a short period, from 1925 to 1931 as the Gold Exchange Standard. In this new standard, the countries could keep reserves of gold, dollars or Sterling pounds and just the US and the UK were exempted from it, as they had reserves just in gold. But the Gold Exchange Standard broke after the UK shifted from the standard due to large outflow of gold as well as capital.

Then President Franklin Roosevelt decided to nationalize the gold that private citizens owned and also abolish contracts that paid people in gold. The US shifted to the Bretton Woods system from 1946 to 1971. Under this system, countries were allowed to settle their international debts in US dollars, while the US redeemed the dollar holdings of other central banks in gold. The price for one ounce of gold was fixed at thirty-five dollars. However, the US was facing deficits and this undermined the confidence of bankers and countries. They felt that as the US gold reserves were dwindling, the government would not have sufficient gold to redeem its currency. So, on 15 August 1971, the US President Richard Nixon took a decision that the country would no longer exchange currency for gold. This brought an end to the gold standard in the United States altogether.

However, the country faced high inflation in the latter half of the 1970s and early part of the 1980s, which prompted many economists to advocate a return to the gold standard. It is believed that whenever the inflation crosses 5 percent, there is renewed demand for return to the gold standard, as when the country was using the standard, the average inflation per year was just 0.1 percent.

The Gold Standard Revisited

It has been nearly 40 years since Richard Nixon ended the direct convertibility of the U.S. dollar to gold, putting an end to the international gold-dollar standard established by the Bretton Woods Agreements following World War II. In the pinch of the current financial crisis, are we now left susceptible to the powerful moral hazards that this quasi gold standard was designed to prevent?

A gold standard is a monetary system in which the standard economic unit is a fixed weight of gold. It differs from the current monetary system of the United States and many other countries, which use fiat money that has no intrinsic value.

During the Great Depression, many countries left the gold standard because they needed to pump money into the economy to spur growth, and a gold standard did not allow them enough monetary flexibility. But there is also such a thing as too much monetary flexibility.

John Maynard Keynes, the famous British economist of the time, argued, "By a continuous process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method, they not only confiscate, but they confiscate arbitrarily; and while the process impoverishes many, it actually enriches some."

In other words, governments - no longer constrained by maintaining a certain amount of gold on hand - could now simply print money to pay off debts or fund budgets. Citizens would pay for this by having their currency holdings devalued. While some people who hold a lot of currency may be greatly harmed, people who hold other assets may be less affected or even benefit from such a policy.

Another moral hazard that such flexible monetary policy created was the manipulation of currency values to benefit a country's trade. By weakening its currency, a country can gain an advantage against other countries for its exports, because they will become relatively cheaper. Should countries begin to compete against each other in this manor, international trade and currency exchange could get out of control.

For many of these reasons, countries signed the Bretton Woods Agreement in 1944, creating the International Monetary Fund (IMF) and the international monetary system in which many currencies were fixed to the U.S. dollar, and the U.S. dollar was convertible to gold. The system had many of the benefits of a gold standard as well as some of the flexibility of full fiat money.

In 1971, Richard Nixon was under a lot of fiscal pressure due to the Vietnam War and ended the convertibility of the dollar to gold. This move created the floating exchange system that we have today.

As central banks combat the current financial crisis, however, will they now be tempted by the moral hazards that were prevalent during the Great Depression? Will they devalue currencies to gain a competitive advantage for exports? Will they inflate their currency to help pay off sovereign debt?

So far, governments and central banks have done a remarkable job of resisting these temptations. Perhaps the euro has helped in Europe's case. Faced with crippling debt, Greece and Spain might have sought to devalue their currency if it was still in their control. But how much longer can such temptations be resisted?

With populations under so much economic pressure, the political pressure to take drastic actions could prove too great. Could the euro zone break apart? Could currency wars ensue?

Another pressure that is somewhat unique to the current financial crisis is the widespread debt among many households. For households that are gainfully employed and carry a high level of debt - be it mortgages or credit cards - could benefit greatly from an inflationary environment. Inflation could result in higher nominal pay, yet the value of debt would remain fixed making it easier to pay it down.

Back in the 1870s and 1880s, the Greenback Party had this very idea in mind. They wanted to move back to the paper-based money system used during the Civil War - "greenbacks" - because it would allow for inflation. Such a move would help farmers get higher prices for their produce and pay down their debts more easily.

Could such a movement gain popularity today? Could highly-leveraged homeowners band together to support an inflationary agenda? The current political climate suggests that the chances are remote. Today, people seem more concerned about budget deficits and excessive government spending. In this regard, a return to the gold standard would be a quick way to reinstate stronger fiscal discipline.

Still, it is curious that more people have not suggested that inflation might be the natural way out of the economic downturn. After all, economists found that during the Great Depression a country's recovery could be directly tied to when it left the gold standard. Perhaps the aversion of many central banks towards inflation is what is truly slowing a global recovery - especially when the current downturn is so closely related to a bursting debt bubble.

Another factor that may be tempering the call for inflation is the high level of unemployment. It is the unemployed who would be the biggest casualty of an inflationary policy. With little income and lots of expenses, the unemployed would be squeezed even tighter by higher prices. But with a looser monetary policy, government could simply print money to finance more unemployment benefits, and if the economy ultimately recovers, unemployment could drop.

Returning to the gold standard or adopting an outright inflationary monetary policy may be extreme courses to take, but history suggests that premature belt-tightening could prolong the current downturn or cause a double dip.

Perhaps governments and the central banks are getting it about right after all. By coordinating many of their fiscal and monetary moves over the past couple years, they have avoided many of the beggar-thy-neighbor pitfalls that occurred during the Great Depression.

And despite all the concern about deficit spending and calls for fiscal restraint, the economic and political reality is that government will have to continue to fill the void until the private sector recovers. It is only a matter of time before the reality takes hold that inflation is the only possible result.

The Gold Standard

Gold is a metal that is found naturally in nature and has long been revered and worshiped by humans as a symbol of wealth and power. It has been at the root of many wars and has also been a leading reason for colonial expansion. It has also been used as a monetary system throughout history. This is referred to as the gold standard.

In a country that uses the gold standard, its governmental 'paper' notes are backed by gold and can be freely converted into a fixed amount of gold. Before the gold standard came into use the gold-coin standard was used. In the gold-coin standard, government minted gold coins that were used to pay taxes and other fees. The first known example of the gold-coin standards came late in the 7th BC in ancient Lydia. Greece introduced a gold-coin standard shortly after Lydia, which then quickly spread throughout Rome and the rest of the world.

It was not until the 17th and 18th century that countries began moving away from gold coins and began creating government notes that were backed by gold. The United States adopted the gold standard in 1792 with the passing of the Mint Act. A dollar was valued at 24.75 grains of gold. Until that time paper script had been used, but was not of much value.

The United States dollar was backed by gold until 1862, when paper money was issued without the backing of gold or silver. This continued until 1878 when the gold standard was reintroduced. Similar actions were briefly taken during the War of 1812. The United States continued to switch between the Gold Standard and Fiat money system until 1971.

The fiat money system involves in some respects arbitrarily printing money that has no real value. It was commonly adopted in times of war and struggle so that the gold could be used to fund wars and in some cases the imbalances created lead to conflict. The United States is in no way alone in this practice and in 1971, for the first time in history, no countries were using a gold standard.

There are advantages and disadvantages of using a gold standard. Government printed script backed by a gold reserve, provides the government with a large amount of control and allows for the control of trade. This was in large part the reason that countries moved away from the gold-coin standard in place of the gold-standard. One advantage to this system though is that because the money is backed by gold, it is largely impervious to governmental tinkering that can cause depressions or boom cycles. Since you can not create gold arbitrarily, the amount of gold in production is limited and it is difficult to correct or create inflation, but a increase or decrease in the amount of gold available can occur. In cases where there are increases or decreases in the amount gold inflation can be created.

Today gold is frequently used in jewelry, which tends to hold and increase in value. Its uses in religious settings and relationships are well known, and there are many types of jewelry available.

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