Banking on Failure: History of Money And Gold (The Gold Standard)

WORLDWORKS by Joe PimbleyEditor’s Note: This is the next in a Continuing Series of Articles by Joe, as excerpted from his Book;“Banking on Failure” co-authored by Laurel McDevitt.

The prior excerpts for Chapter 7 discussed “Role of Money,” “Gold and Silver through the Millennia” and “Fiat Money”

Brief History of the Gold Standard

[su_dropcap style=”flat”]T[/su_dropcap]HE MOST IMPORTANT example of fiat money is the U.S. dollar of today. The U.S. severed the link of the USD to gold in 1973. (While most references designate 1973 as the year of this severed link as we do here, the process was somewhat gradual during the period 1967-1976.[1]) The Bretton Woods conference of 1944 had essentially linked major world currencies to the USD which, in turn, permitted limited convertibility to gold at $35 per ounce.[2]

With exceptions of generally brief and unsuccessful periods of fiat money, the world’s money has consisted of metal coins and, in more recent centuries, paper certificates denoting claims on precious metal. We say that a country is on a “gold standard” or “silver standard” when the country defines its unit of money as a specific weight and purity of gold Banking on Failureor silver, respectively. Citizens may spend and receive coins with the specified gold or silver content. They may also settle payments with paper certificates (such as dollar bills) that give the bearer the right to claim gold or silver in exchange for the certificates from a central government treasury. As long as people have universally high confidence that this treasury will exchange gold or silver for the paper certificate, the paper will have the designated value.

Across countries and centuries, the gold standard eclipsed the silver standard beginning roughly in the 1800’s. Focusing on gold, then, adherence to a gold standard is constraining for both people and governments. That’s the idea! One person’s “constraining” is another’s “maintaining value” or “discipline.” As an example, a government that wishes to increase spending (in gold) must either increase taxes and other revenues (in gold) or must borrow gold from domestic or foreign lenders. The government cannot simply create new gold for the additional spending.

A gold standard also corrects trade imbalances. If our home country is a net importer of goods and services because citizens find the foreign products have lower prices, then the ultimate result when the imbalance persists is that the home country has less money (gold) assuming no countervailing foreign loans or other investment. The fall in the money supply produces deflation which lowers prices in the home country thereby removing the cause of the trade imbalance.

As a complicating wrinkle to this story, countries that employed gold standards in the past adopted a fractional reserve approach. That is, a country’s treasury would issue paper certificates for gold redemption that outstripped its store of gold. Why? This choice clearly created the risk of a “run on the treasury” if citizens realized the treasury could not redeem their paper claims with certainty.

We have only a speculation for a country’s decision to maintain just a fraction of gold backing its money in a “gold standard” framework. Such a country may have wished to push economic activity higher with greater money supply while gaining what is called the “seigniorage” – a fancy word for a government’s hidden seizure of value from the monetary system. Boosting economic activity sounds good and noble, but this result would also come with the not-so-good-and-noble devaluation of money.

The fractional reserve aspect adds instability. Taking the balance of trade example, when the home country imports goods and services, it sends its gold-backed currency to the exporting countries. When the merchants in these countries redeem the home currency for gold, the gold travels from the home country to the exporters. The depletion of gold in the home country is more severe when the monetary system requires only a fractional reserve of gold. Thus, this country finds it must “defend its gold supply” – it cannot wait for general prices to fall to correct the trade imbalance as in the earlier discussion. The standard “cure” is for the home country to raise its interest rates to attract inflow of gold from other countries. It works, but the higher interest rates depress economic activity of the home country.

The blessing and the curse of the gold standard is that it’s “honest;” it provides both good and bad consequences, and it won’t listen to any sad stories. If a natural disaster creates expenses and depresses government revenue, there’s no money printing under a true gold standard to dull the economic pain. When the country wishes to make war – whether as aggressor or defender – it must fund the war in taxes and borrowing rather than printing of fiat money. The gold standard doesn’t care if these restricted options make the war unpopular.

Thus far, history’s verdict on the gold standard is that governments flee from it. However effective, political leaders do not appreciate effectiveness in delivering negative consequences. The dominant countries of Europe exited the gold standard in the World War I years.[3] Soon after his inauguration as U.S. President in 1933, Franklin Roosevelt forced citizens to sell their gold to the government at the prevailing gold standard value of $20.67 per ounce. He and his government then outlawed private holding of gold, devalued the USD to the new value of $35 per gold ounce, and then summarily abrogated the “gold clause” ubiquitous in financial contracts.[4]

In this instance, the U.S. government chose to default on its debt obligations and its Federal Reserve obligations and to force the default of innumerable private contracts rather than hew to sound money. Roosevelt’s action surpassed Henry VIII’s Great Debasement of 1542 in that the English monarch’s first devaluation diminished the GBP by 25% rather than Roosevelt’s 40% for the USD. (As explanation, it took $35 post-Roosevelt to buy an ounce of gold versus the pre-Roosevelt price of roughly $21. The post-Roosevelt dollar value was therefore 60% – 21 divided by 35 – of the pre-Roosevelt dollar value. So we mark the devaluation as 40%.)

As we stated earlier, the Bretton Woods agreement of 1944 maintained the value of the USD at $35 per ounce and set fixed exchange rates for other major currencies against the USD. Thus, the USD and these currencies had reverted to a modified gold standard. Private U.S. citizens did not regain the right to exchange their money for gold. (Nor did they even gain the freedom to own gold itself – other than as jewelry – for the following thirty years.)

Under Bretton Woods, central banks had the right to redeem USD for U.S. gold at the stated $35 per ounce. But the U.S. found its gold supply dwindling in the 1960’s due to budget deficits stemming from the Vietnam War, Great Society social programs, and current account deficits. Given the alternatives of balancing budgets and trade flows versus maintaining a gold standard, gold lost the argument. It’s been a fiat money world for more than forty years.

The next (last) excerpt for Chapter 7 discusses the “Modern World with Fiat Money”

[1] See, for example, C. K. Elwell, “Brief History of the Gold Standard in the United States,” Congressional Research Service, June 2011.

[2] See, for example, “A Brief History of Bretton Woods System,” Time, October 2008.

[3] See, for example, L. Crabbe, “The International Gold Standard and U.S. Monetary Policy from World War I to the New Deal,” Federal Reserve System, 423-40, June 1989.

[4] Id.


Joe Pimbley
Joe Pimbley
Joe is Principal of Maxwell Consulting, a firm he founded in 2010. Joe is expert in complex financial instruments, financial risk management (certified as FRM by the Global Association of Risk Professionals), valuation, structured products, derivatives, and quantitative algorithms. His recent and current engagements include financial risk management advisory, valuation and credit underwriting for structured and other financial instruments, and litigation testimony and consultation. In a prominent engagement from 2009 to 2010, Joe served as a lead investigator for the Examiner appointed by the Lehman bankruptcy court to resolve numerous issues pertaining to history’s largest bankruptcy. Joe and his colleagues discovered Repo 105 and also reported the critical importance of pledged collateral mishaps and mischaracterizations to the Lehman failure. Joe holds a Ph.D. in Theoretical Physics and is a co-author of Banking on Failure (2014), Simple Money (2013), and Advanced CMOS Process Technology (1989). He serves on several corporate and academic Boards, has written more than thirty finance articles, presented more than sixty finance seminars, and holds numerous patents for engineering inventions.

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