Welcome back to the third episode in our financial history series. Last episode we looked at the Great Depression and why it still matters today. Before that we visited Amsterdam in the 1630’s to learn about Tulip Mania. Today we’re going to be exploring the Gold Standard, something that cropped up during the Great Depression piece. Indeed the Gold Standard is often pointed to as one of the key causes of the Great Depression, and certainly contributed to its depth and duration.
Like the previous episodes, we’ll be giving you the essential facts and narrative around this important historical period, but what I hope you’ll especially get value from is the exploration of how the concept of the Gold Standard is being re-imagined today in the Crypto Currency world.
So hold onto your 1920’s hats, and let’s dive into – The Gold Standard – What was it and what does it have to do Crypto currencies?
The earliest forms of trade used the barter system. I gave you a sheep, and you gave me a bag of rice. Unsurprisingly, we clever humans quickly adopted improved ways to exchange goods, using tokens of value. Some civilizations used shells, or precious gems, but rare metals proved the most practical – bronze, silver, and gold. Even today, when our coins no longer hold the original precious metals, they none-the-less are issued to look like silver and gold, and in the days of 1 and 2 cent coins, bronze too.
The oldest records showing gold used to facilitate trade comes from Lydia, present day Turkey, in 643BC. China adopted bronze coinage even earlier.
One key convenience of using gold as currency, and no doubt a factor in its broad adoption, is that it is corrosion resistant. It was also easy to melt down and reshape.
In an era of gold being the ultimate store of value, the mathematics were pretty simple – the more gold coins you had, the richer you were. And since the value of the gold coins was simply the amount of gold in each, the more gold you had, the more gold coins you could make, and therefore the richer you were.
This helps explains why the great naval nations of the era – Spain, Portugal, and England, went to such great efforts to find new lands rich in gold. The Spanish in particular, with their Aztec and then Inca conquests, seemed to care for little else.
Birth of the Gold Standard
In time paper money became more convenient, but what is the value of a simple piece of paper? As global trade grew, a system known as the Gold Standard was adopted by most trading countries throughout the 1800’s, to provide an underlying value to their paper money, and enable a rate of exchange to be set between one nation and another. So for instance in the United States in 1861, the first US paper currency was printed, with an established exchange rate of $20.67 per ounce of gold.
This meant that if you lived in the United States and wanted to do trade with Britain for instance, you could trade your US dollars for gold, hand the gold over to your British counterpart, and then they could similarly convert the gold into British pounds.
The central purpose of the gold standard was to produce currency with a stable value to facilitate and encourage trade.
All was travelling along swimmingly, with each country’s currency pegged to a certain amount of gold, right up until World War 1 broke out in 1914.
European countries needed to defend themselves or attack their neighbours, as the case may be, and that costs money. Being restricted to only issuing money where you had gold held in a vault to back it up was quite inconvenient for the governments of the day, and so, one by one they decided to suspended the gold standard for their currency. Nations would still use gold to buy goods they couldn’t produce locally, but local citizens and businesses could no longer ask that their paper money be converted into the shiny yellow metal.
Even before World War 1, there was a precedent for this suspension – the US did the same thing in the 1860’s during their Civil War.
In both examples the outcome was the same – inflation spiraled. In the US, the Union printed $450billion in the 1860’s, triggering an inflation rate of 80%. In Germany it was even worse, causing a period known as Hyperinflation, which I’ll be exploring in the next episode in this series.
These outbursts of inflation caused nations to return to the gold standard shortly after the conclusion of World War 1. The lesson seemed to be that without the inbuilt control of requiring countries to only print the amount of money for which they held physical gold, they just couldn’t be trusted. They’d print money with little restraint, making every dollar, pound, mark or lira already in existence worth a little less each time.
Many countries chose to peg their exchange rates to either the UK or US gold standard. Australia, India, and New Zealand linked their currencies to the UK, while Mexico, Japan, and the Philippines used the US rate.
You will recall from the last episode on the Great Depression that as the 1920’s came to a close, the prosperity that had flowed from the post World War 1 reconstruction was coming to an abrupt halt. Governments and central banks were at a loss as to how best to respond. As found during war times, having your currency linked to physical gold severally limits the options at your disposal to stimulate economic activity.
Britain was the first to buckle. Despite loans from the US and French central banks of £50,000,000, large gold flows out of the UK meant Britain had to abandon the Gold Standard in September 1931. Australia, New Zealand, and Canada quickly followed suit.
Freed once more from gold’s restrictions, these nations were able to print money and lower interest rates to stimulate their economies.
Meanwhile in the United States, continued adherence to the gold standard prevented the Federal Reserve from expanding the money supply to energise the economy, fund insolvent banks and facilitate government deficits that could “prime the pump” for an expansion.
The US followed Britain by partially leaving the Gold Standard in June 1933. Citizens could no longer convert their US dollars to gold, though the US Treasury could still convert US dollars to gold for foreign governments. Even this was later abandoned in 1971.
By the time World War 2 ignited, the gold standard had been dropped by all the major countries of the world. Fortunately though, lessons had been learnt, and there was no repeat of Hyperinflation.
The key benefit of the Gold Standard was in preserving the value of people’s savings. Without it, governments can run up debt, and then inflate it away – a process recognised as a form of hidden taxation. It is because of this potential that Central Banks around the world have mandates requiring them to manage inflation within a certain range – 2-3% in Australia, 1-2% in the US.
I liked this quote from Alan Greenspan in 1966, well before his time as head of the US Federal Reserve “Deficit spending is simply a scheme for the confiscation of wealth. Gold stands in the way of this insidious process. It stands as a protector of property rights.”
Almost 90 years since it was last linked to everyday currency, people still love their gold. Gold continues to be seen as a store and protector of value in uncertain times.
The Gold Standard 2.0 – Crypto Currencies
Nathan Lewis, author of Gold – The Once and Future Money says “When people are ready to return to a system of stable currencies, they will look for a way to do so, and discover once again that a gold standard system remains the best path to this goal.”
I think he’s wrong though.
Instead Crypto currencies such as Bitcoin might be today’s equivalent.
Cyrpto currency advocates frequently refer derisively to traditional currencies as “fiat currency” (as an example, it comes up in my interview with Ivan Jasenovic back in episode 24 . This is a term that was adopted to indicate currencies which were not backed by gold (or silver in some cases). They are simply issued by a countries government and their value depended on the economic strength of that country, and their restraint in not printing money willy nilly.
The crypto fans point to this inherent potential point of weakness in traditional currencies – that governments can simply print more money – as an argument for a currency linked to a block chain process when the number of “coins” issued is finite. Indeed the process of generating crypto currencies such as Bitcoin is referred to as mining, highlighting the perceived link between the traditional mining of precious metals, and the modern digital equivalent. Mining implies you’re embarking on a process of considerable effort in the hope of finding something precious, valuable, and scarce.
The current Facebook proposal to create a new crypto currency – Libra, goes a step further, and has a definite echo of the Gold Standard of last century. They propose that all Libra coins will be backed by a basket of traditional currencies – the US dollar, Euro, Yen etc. And as with the original adoption of gold, once again the driver is the facilitation of trade – in this case easier global e-commerce.
If they’re successful in getting this idea off the ground, we’ll return to a currency that is backed by another asset with a perceived “hard” value. Given the “fiat” problem of the potential for governments to simply print more money, it’s unclear how “hard” the value of a crypto currency backed by those fiat currencies really is, but then gold was never perfect either – people were always discovering more, and it had no genuinely useful purpose anyway. Perhaps Libra’s approach of a crypto currency backed by well know traditional currencies will serve a purpose for a period of time – making people comfortable in using this new form of money. And then one day, just like the Gold Standard, it will outlive its usefulness, and be discarded to the history books.
There’s a great infographic on the history of money that’s worth a look here.
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