Gold Standard

In a gold standard, the currency unit is legally equal to a specified quantity of gold, and the issuer commits to redeem its banknotes or deposit liabilities in gold at that price for anyone who presents them. Because the issuer must hold enough gold to honor that promise, the amount of money in circulation is tied, more or less tightly, to the stock of gold available to the issuer.

Gold standards dominated the international monetary order from the late nineteenth century until the First World War, survived in weakened forms between the wars, and ended in its last official form in 1971. Every major currency today is a fiat currency with no promise of convertibility.

Britain moved onto gold in practice in the eighteenth century, after the Royal Mint, under Isaac Newton as Master, set a mint price for the gold guinea in 1717 that undervalued silver. The Coinage Act of 1816 and the resumption of note convertibility in 1821 made the arrangement formal. Many other countries remained on silver or on bimetallism, a dual standard that repeatedly broke down because of Gresham's Law: whichever metal the official ratio undervalued disappeared from circulation.

The classical gold standard emerged in the 1870s, when the new German Empire adopted gold and other European countries followed. The United States made gold its sole legal standard with the Gold Standard Act of 1900. The system was suspended during the First World War, rebuilt in the 1920s as a gold exchange standard, and then broke apart in the Great Depression: Britain left in September 1931, and the United States stopped domestic gold convertibility in 1933 and raised the official price from US$20.67 to US$35 per ounce under the Gold Reserve Act of 1934.

The Bretton Woods system agreed in 1944 kept a link to gold only at the official level: other currencies were pegged to the dollar, and the dollar was convertible into gold at US$35 an ounce for foreign monetary authorities. President Nixon suspended that convertibility on 15 August 1971, and the last formal tie between a major currency and gold ended.

Under a full gold standard, a central bank or treasury buys and sells gold at the fixed mint price, so the market price of gold cannot move far from it. Exchange rates between two gold-standard currencies are fixed by the ratio of their gold contents, known as the mint parity, and can deviate only within narrow "gold points" set by the cost of shipping gold.

Economists have described the adjustment mechanism since David Hume's price-specie-flow analysis in the eighteenth century. A country running a trade deficit pays out gold, its money supply contracts, prices fall, its exports become cheaper, and the deficit shrinks. In practice central banks also adjusted interest rates to attract or repel gold flows, a practice associated with the Bank of England.

• Gold specie standard: gold coins circulate alongside notes that are convertible into coin.
• Gold bullion standard: coins do not circulate, but notes can be exchanged for large bars of gold, as in Britain from 1925 to 1931.
• Gold exchange standard: a country holds its reserves in a currency that is itself convertible into gold, rather than in gold directly. This is the structure Bretton Woods later formalized.

A currency board is a close relative: it fixes the domestic currency to a foreign hard currency rather than to gold, and backs it fully with reserves of that currency.

The gold standard delivered long-run price stability and predictable exchange rates, which helped trade and capital flows in the decades before 1914. Its costs were also significant. Money growth depended on mining discoveries rather than on economic needs, so long periods of deflation alternated with bursts of inflation after gold strikes. Defending convertibility could force a central bank to raise rates in a recession, and many economic historians argue that adherence to gold transmitted and deepened the Great Depression; countries that left gold earlier tended to recover sooner.

In the terms of the impossible trinity, a gold standard with free capital movement means fixed exchange rates at the cost of independent monetary policy. Countries under pressure resolved the conflict by suspending convertibility or by devaluation.

Central banks still hold large amounts of monetary gold as part of their foreign exchange reserves, and proposals to return to some form of gold backing reappear periodically, although money has not always needed a metal anchor: medieval England's Exchequer recorded debts and tax payments on tally sticks for centuries. Most economists regard a return as impractical, because the supply of gold cannot be adjusted to the needs of a modern economy and the fixed parity would be vulnerable to speculative attack.