Monday, 3 September 2012

The Rise and Fall of The Gold Standard, I.

We all have seen the shiny wedding rings of our parents, some families even have pieces of jewelry with a story spanning multiple generations – the precious metal of gold is the most ancient material associated with wealth. More to that, it was the foundation of the monetary system for thousands of years – and abandoning it was the biggest change in the way we think about wealth since the introduction of banknotes. But why did that happen? Read our two-post long series to discover the complete history of the gold standard.

Picture from mint.com

The role of trust


Do you remember our earlier post, where we stated that money doesn't have value on it's own? It is a medium of exchange, a symbol of the promise that f.e. if you hand over a piece of green paper with George Washington on it, your bartender will give you a cold drink we all long for in this late Indian summer. You may not realise it, but this requires a huge amount of trust from both sides – the bartender has to trust you are not forging the green paper, while you have to trust him that he will indeed give you the drink for your money.

What is the gold standard?


Nowadays the value of money is granted by promise – the government assures you that every citizen will and shall accept it, as well as they will as an equivalent of wealth – it didn't always work this way. Well into the 1970's, the value of money was granted by gold – the government still assured you that the money would be usable as a medium of exchange nationwide, but they also said that you could exchange your paper money at them for a fixed amount of gold. This is called the gold standard – and it is the successor of systems such as the bimetal standard, where the value of currency was granted by gold and silver, the silver standard (granted by silver) and the "age of coins", when money was made from gold or silver.

Origins


When money was invented, people realised that it was easier to have an universally accepted guarantee of wealth than having to barter individually for goods and services – in the Bronze Age, the aforementioned example would likely have taken place by you handing over a goat in exchange for a keg of beer, possibly complicated by a likely differing language. But what could this medium be? It had to be easily movable – imagine if banks had to feed cows! -, but precious and rarely found – otherwise you could get a drink in exchange for a muddy pebble you picked up somewhere.
So the natural choice was gold and silver – they were easily shapeable, rarely found, and they had a real value – people always had a fascination for shiny jewelry so these two metals didn't receive their value out of nowhere. This was the age of coins – for around 2500 years, it worked just fine, from 1200 BC until around the 1600's.

The change to paper money


Then things changed, however. Europe has been suffering from a metal shortage since the Crusades – they were paying with gold in exchange for spices, silk and other fancy stuff from the other side of the Silk Road -, but when Europeans discovered America, they discovered their gold mines as well – so Europe all of a sudden was drowning in gold. The economy boomed, the banking system revolutionised, and people realised that they didn't actually have to hold the gold and silver coins – banks, and later rulers issued bills of exchange, promising the holder to get back their money anytime. Soon, so much of these bills were in circulation that they became an important form of exchange, and to make administration easier, the bills became certificates, and then notes – paper money was born.
 

Rise of the standard


What does that have to do with gold, or standards, or whatever, you might ask? The answer is easier than you think. Firstly, paper money was monopolised – governments had the most money, so their bills of exchange became the most widely accepted, eventually the only accepted. Simultaneously, it was standardised – instead of issuing individual bills, governments issued fixed denominations – so one bill meant 5 gold pounds, another 10 and so on. Through monopolising bills, governments established a de facto metal standard – and during the 19th century, practice became theory with independent central bank's treasuries providing the guarantee behind money. In other words, gold standard countries pegged their currencies to gold.

 Gold, my precious


By the 19th century, the age of imperialism, the USA and the UK – countries which by then solely used gold as a guarantee, (which simplified things compared to the gold-silver bimetal standard not having to convert between the two metals) – became such economic powerhouses, that many countries pegged their currencies to the dollar and the pound, adapting their monetary policy – while others, seeing their success and liking the idea of providing a sound basis for their money, adopted on their own.
Hence starting from the 1870's, gold standard became the worldwide ruling monetary policy – from the Austria-Hungary to Denmark, from Germany to Sweden, countries adopted the "crown" as their currency, adopted gold standard – and given the fact that all currencies were pegged to gold, they were in turn pegged to each other as well, bolstering international trade with calculable prices.

So what happened then? Why is it that you can't exchange your "pound sterlings" for a pound of silver or gold anymore? If you want to know, then do come back for our next post to discover the fall of the gold standard.

Other posts of the series: 
Rise and Fall of The Gold Standard, 1.5 - Intriguing Facts about Gold You Didn't Know Before 
Rise and Fall of The Gold Standard, II. - The Fall of the Gold Standard

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