16th century, a time when most European currencies had become debased and were therefore unpopular with traders. The thaler was recognized as one of the few reliable silver coins and became a trade standard, remaining so until the end of the 19th century, when Germany replaced it with the gold mark.
It was during the 19th century that the silver standard was gradually replaced by the gold standard, after silver had begun to lose its value relative to gold. Britain had used silver coins exclusively from around 770 until the 14th century, when a gold coin was introduced in addition to the silver coins. Silver remained the standard until 1816, when the gold standard was adopted. This change occurred because although Britain paid for imports in silver, income from exports was mostly in gold, and consequently Britain’s reserves became predominantly gold.
The US used both gold and silver until 1873, when it adopted the gold standard. Germany switched to gold around the same time, and as gold became the dominant currency for world trade other countries followed suit.
Under a gold standard, all money has a value linked to gold, whether it be paper money or coins made of silver or any other metal. This effectively creates a fixed exchange rate between different currencies using the gold standard.
It also means that a country must retain a substantial amount of gold to back up its currency. The US Federal Reserve, for example, before the US abandoned the gold standard in 1971, was required by law to hold enough gold to back at least 40% of the total value of notes in circulation. This limited the ability of the government to manipulate the money supply, which can be seen as both good and bad; it keeps inflation down, but also constrains a government’s options when using monetary policy to boost the economy, by lowering interest rates, for example (because interest rates affect the value of the currency).
Since gold stopped being the de facto global currency, exchange rates between national currencies have varied according to the relative strengths and weaknesses of different economies, encouraging currency speculation and causing uncertainties in the pricing of goods, making international trade more complicated.
It was to eliminate such complications that the European Union introduced a single currency. Unfortunately this only succeeded in causing other complications, because it doesn’t really work to have a single currency while at the same time having lots of different governments. I will return to this theme later, but first we must take a quick walk through the woods.
The last link is broken
It was because of this unpredictable volatility between the currencies of different nations that the Bretton Woods system of monetary control was set up in the summer of 1944. Just three weeks after the D-Day landings, delegates from the 44 allied nations took a break from the horrors of the Second World War and met in a grand hotel in the peaceful mountains of Bretton Woods, New Hampshire. With the end of the war finally in sight, US President Franklin D Roosevelt and British prime minister Winston Churchill were determined to avoid the economic problems that followed the First World War, and which to some extent had caused the war still raging in Europe and the Pacific as they gathered.
Their goal was to create a new world order that would speed up post-War reconstruction and ensure lasting peace, and ultimately prosperity. John Maynard Keynes, the British economist, was one of the principal negotiators, along with senior officials from the US Treasury. They focused on two key issues: how to pay for the rebuilding of Europe, and how to form a stable exchange-rate system. For these purposes they set up the International Bank for Reconstruction and Development (later renamed the World Bank) and the International Monetary Fund.
Keynes was in favor of a single world currency, but the US insisted that fixed exchange rates should be linked to the dollar, which was itself linked to the price of gold. The US was by this time the only strong economy remaining in the world and, as most of the money that went into the new bank would come from the US, it became by far the most dominant player in this new world order.
The Bretton Woods agreement established a rules-based system of international finance that helped to restore confidence in world trade, resulting in a US-led economic revival and the boom years that endured, on and off, throughout the second half of the 20th century.
It worked initially because dollars flowed to Europe in the form of loans and grants (the Marshall Plan) and, as Europe recovered, it imported goods from the US, thus helping the American economy to keep expanding. As worldwide demand for US goods increased, this in turn led to rising US demand for raw materials, which benefited the economies of some mineral-rich nations.
But the Bretton Woods system had a few drawbacks, the biggest of which, for the US at least, was that gold was tied to the dollar at $35 per ounce, while the free-market price could vary. US policy was to try to keep the gold price close to $35 by maintaining the dollar’s value, but this proved impossible. If the free-market price of gold rose higher than $35, as it did whenever the dollar looked threatened by some event (the Cuban Missile Crisis of 1962, for example, sent gold up to $40 per ounce) there was nothing to stop other nations from converting their dollar holdings into gold at $35, then selling the gold for the higher price, a practice known as arbitrage.
By the mid-1960s, a resurgent Europe was becoming less tolerant of America’s unprecedented power and influence. France, in particular, under President Charles de Gaulle, didn’t trust the US government’s ability to maintain its currency’s value, and used dollars earned from exports to build French gold reserves, further depleting US supplies.
Burdened by the increasing cost of fighting the Vietnam War, the US could no longer guarantee to exchange all dollar holdings for gold. Its reserves had fallen to around 20% of total dollars in circulation, down from 55% in 1946, when the US held $26 billion in gold (over 60% of global reserves).
In May 1971, West Germany, wary of inflation and unwilling to devalue the mark to prop up the dollar, pulled out of the Bretton Woods agreement. Other countries, notably France and Switzerland, exchanged more dollars for gold.
On 15 August 1971, with US gold stocks down to $10 billion or so, President Nixon ended the convertibility of dollars into gold, a move that became known as the ‘Nixon shock’. This brought an end to any semblance of a gold standard and meant the dollar became fiat money, soon to be followed by all the currencies that had been tied to it. From this period onwards, the value of most major currencies would be free to float, dependent only on the fortunes of their parent countries in relation to other nations. The price of gold quickly went up, from $35 an ounce in 1971 to $190 by the end of 1974.
As good as gold
There is no particular reason why the value of money should be linked to gold, but there is a very good reason why the quantity of money in circulation needs to be determined by something real, something related to economic activity by the real wealth of industry. Because of its rarity and long history of desirability, which guaranteed its value, gold provided a useful benchmark from which money could be valued.
Whether or not we should return to some form of gold standard is a subject that provokes even more disagreement amongst economists than most other aspects of the economy, but there’s no doubt that today’s financial problems could not have occurred if the gold standard was still in force, because there’s no way that banks could have created so much credit. The gold standard linked the value of money to genuine wealth creation, because governments had to acquire the gold (either by mining it or exporting goods that could be exchanged for gold) before they could print more of the paper stuff.
Figure 24
There is obviously a need for some form of standard that ties money creation more closely to genuine wealth creation,
