Many people incorrectly assume that our currency is still backed by gold. In fact, except for a very brief period prior to World War I, this has never been completely true. Inevitably, the value of money derives from faith in the government that issues it. In a modern economy, there is really no alternative.
At the birth of our young nation, the official tender of the US was the Spanish silver dollar. In 1792, the Coinage Act created the first U.S. dollars backed by two metals: gold and silver. Notes issued by numerous banks were freely convertible into gold or silver, providing a convenient substitute for hard metals. This bimetallic system ultimately proved unwieldy, as it required that government establish and maintain a fixed rate of exchange between silver and gold.
Christopher HopkinsDuring the Civil War, both the Union and the Confederacy suspended gold and silver backing and issued paper currency based solely upon the government's promise to pay. Called "fiat money" as it was created by fiat or order, those currencies faced disparate fates. Union dollars, known as "greenbacks" thanks to their color, experienced devaluation during the war but remained in circulation. Confederate dollars ultimately became worthless.
From 1879 through 1914, most of the nations of the world shared a gold standard and observed relatively stable exchange rates. This "classical" gold standard worked reasonably well for a time, but with the outbreak of World War I, metallic backing was suspended around the world as combatants sought to protect their treasuries.
In the post-war period, many nations attempted to return to the gold standard with limited success. First France and then England effectively rebuffed the system during the Great Depression, and the United States finally threw in the towel in 1933 when President Roosevelt ended free convertibility of dollars into gold, and made private ownership of the precious metal illegal.
One final effort was attempted in 1944 at Bretton Woods. Gold was fixed at $35 per ounce and other nations tied their currencies to the U.S. dollar. But as the U.S. began to run substantial trade deficits, the fixed exchange system collapsed. President Nixon drove the final nail in the coffin of the gold standard in 1971.
It is not unusual to hear renewed calls for a return to the gold standard. The economic arguments against doing so are legion, but two practical considerations suffice.
Gold is a finite metal mined from the earth. While it served as money in ancient times, a modern economic system cannot allow its monetary base to be determined by the luck, skill and ingenuity of a handful of miners. Periods of great discovery like the California gold rush of the mid-19th century result in rapid expansion of supply, devaluation of the currency leading to inflation, and boom cycles that ultimately go bust.
Periods of slow discovery result in deflation and economic stagnation. Gold backing necessarily limits the ability of governments to employ counter-cyclical policy and instead tends to reinforce cyclical peaks and valleys. Meanwhile, industrial applications and jewelry far exceed monetary reserves as a fraction of global gold production.
Perhaps more importantly, history shows that it just doesn't work. Proponents argue that the stability of the money supply imposed by a fixed standard minimizes economic volatility. In fact, nine of the 10 worst depressions in U.S. history occurred under some iteration of a gold or silver standard, and the Great Depression was in part caused by the flight of gold from the Federal Reserve in the 1920s.
Even during the brief "classical" period of the early 20th century, money ultimately depended upon the full faith and credit of the issuing governments. In a 21st century globally connected economic system, the gold standard is a hopelessly antiquated and impracticable relic.
Christopher A. Hopkins, CFA, is a vice president and portfolio manager for Barnett & Co., in Chattanooga.