History of the Gold Standard

Gold has always been used as the currency of choice. For most of history, it was used to make coins. Its value spurred exploration of the New World and in the California gold rush. By the mid-1800s, most countries began adopting the gold standard as a way to standardize transactions in a booming world trade market. It helped by guaranteeing that any amount of paper money could be redeemed by the currency's government for its value in gold. This meant transactions no longer had to be done with heavy gold bullion or coins. It increased the trust needed for trade since paper currency now had guaranteed value tied to something real.

This worked so well that, by World War I, most countries were on the gold standard. Despite a few recessions, it worked pretty well until the costly war began. Between 1914-1919, most countries suspended the gold standard so they could print enough money to pay for their military involvement. Unfortunately, printing money created hyperinflation. So much money was printed that it devalued each dollar, and prices skyrocketed. After the war, countries realized the value of tying their currency to a guaranteed value in gold. For that reason, most countries returned to a modified gold standard.

Once the Great Depression hit with full force, countries once again had to abandon the gold standard. When the stock market crashed in 1929, investors began trading in currencies and commodities. As the price of gold rose, people traded in their dollars for gold. It worsened when bank began failing. The Fed kept raising interest rates, trying to make dollars more valuable and dissuade people from further depleting the U.S. gold reserves. These higher rates worsened the Depression by making the cost of doing business more expensive. Many companies went bankrupt, creating massive unemployment.

This time, war put countries back on the gold standard by ending the Great Depression. In1944, most countries adopted the Bretton-Woods system, which set the exchange value for all currencies in terms of gold. It obligated member countries to convert foreign official holdings of their currencies into gold at these par values. However, since the U.S. held most of the world's gold, many countries simply pegged the value of their currency to the dollar, thus making the dollar the defacto world currency. Gold was set at $35 per ounce. (Source: National Mining Association, History of Gold)

The Bretton Woods agreement meant that central banks had to maintain fixed exchange rates between their currencies and the dollar. They did this by buying their own country's currency in foreign exchange markets if their currency became too low relative to the dollar. If it became too high, they'd print more of their currency and sell it. Even though the dollar was still worth 1/35 of an ounce of gold, most countries no longer needed to exchange their currency for gold. The dollar had replaced it. As a result, the value of the dollar increased - even though its worth in gold remained the same.

The strong dollar led to inflation and a large balance of payments deficit in the U.S. which in turn helped to create stagflation. The U.S. started to deflate the dollar in terms of its value in gold to curb double digit inflation.

In 1971, gold was repriced to $38 per ounce, then again to $42 per ounce in 1973. As the dollar devalued, it motivated people to sell their greenbacks for gold. Finally, in late 1973, the U.S. government decoupled the value of the dollar from gold altogether. The price of gold quickly shot up to $120 per ounce in the free market. (Source: Time, Fuss Over Dollar Devaluation, October 4, 1971)Once the gold standard was dropped, countries began printing more of their own currency. Inflation usually resulted, but for the most part abandoning the gold standard created more economic growth.

However, gold has never lost its appeal as a currency of real value. Whenever recessions or inflation looms, investors return to gold. By 2011, the price of gold was over $1,800 an ounce.

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