The term “gold standard” is used nowadays to describe the ideal benchmark of how something should be done. Ironically enough, the economic event that this phrase is derived from is not in use anymore. So, what was the gold standard, and why is the gold standard not used anymore to determine the value of a currency?
The gold standard is a system where every country’s currency has a value that can be directly linked to gold. This means that every unit of currency would be able to buy a fixed amount of gold, thus giving the currency its value. For example, if one Rs. 2000 note could buy an ounce of gold, the value of the rupee would be 1/2000th of an ounce of gold.
This system of measuring a currency’s value was first adopted in 1821 by Great Britain. The system was first implemented as global trade increased, leading to more stock of gold with each country. Any trade imbalances were settled with gold, so it made sense to stockpile gold in this way. The gold standard became truly established as an international exchange medium when Germany also adopted it in 1871, and by 1900, the majority of the developed nations were linked to the gold standard system.
However, this system of exchange broke down after World War 1. The system was not able to function in a time of war, and countries made their currencies inconvertible to gold. After the end of the World War, the countries planned on restoring the pre-war gold standard, and countries like Britain and France devalued their currency. However, since the global economy had started outgrowing the gold supply in the world, pounds and dollars were made into the global reserve currencies. Smaller countries preferred to keep these currencies rather than gold, and exchanged their gold reserves for dollars and pounds. As a result, the stock of gold became concentrated with a few countries only.
However, the Wall Street Crash of 1929 took place, and since both Britain and France had devalued their currencies post-war, their currencies’ valuations were very different as compared to other currencies. To prevent people from converting their money into gold and reducing the liquidity in the economy, countries instead decided to increase interest rates. However, this just further aggravated the issue.
The USA then decided to revalue gold and made it more expensive in dollars. Since countries could now receive more dollars for their cash reserves, they decided to exchange more of their gold reserves for dollars, devaluing the currency and helping the USA to take control of the gold market.
Post the Second World War, a new system was conceived, namely the Bretton Woods Agreement. Under this system, gold was the basis for the value of the USD (at a rate of $35 for an ounce of gold), and other currencies were pegged to the USD, making it an indirect gold standard. This helped facilitate international trade, which was earlier done based on non-liquid gold. It also made sure that currency exchange rates did not fluctuate much, with this stability further facilitating international trade.
USA’s stock of gold kept decreasing in the post-war era, due to high imports and lending to war-torn countries. In a bid to maintain the exchange rate, a Gold Pool was created with the USA and a few European countries, where gold was traded with the USA by central banks at a rate of $35/oz. However, the European countries were not too happy about maintaining the market price of gold as the US price of gold. Subsequently, countries began trading in their dollars for gold and the system collapsed, as the USA did not have the stock of gold to continue running the Bretton Woods System. This meant that currencies were now free from any influence of gold, and the gold standard was completely removed (which year??)
The gold standard was a good system to implement in many ways. The issuance of currency in a country was done with the physical quantity of gold acting as a limit. This meant that both the problem of inflation and deflation could remain under control.
However, it also had many issues. While it worked well under peaceful circumstances, force majeure conditions like war’s or natural disasters proved that it was not effective in times of economic downturn, people would convert their money into gold as a safe investment, reducing the liquidity in the economy and worsening the economic situation. International trade has flourished when fiat money was used in place of the gold standard.
While the gold standard may have been fine in times of peace and prosperity, it is in times of crisis where we truly need the exchange rate to stay stable.
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