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The Gold Standard

GOING FOR GOLD

A contemporary view of the gold standard

Walter de Wet, CFA

When inflation rises, real interest rates are negative, and geopolitical risk is high, gold moves into the limelight. In recent months, all of the above were true, and it is perhaps not surprising that the price of gold rose back above US$2,000/oz in early March. Gold’s performance under such circumstances would support a view that it maintains a great deal of its status as a store of value and reserve currency, much as it did under the gold standard.

As Good as Gold

The gold standard was a monetary system in which a fiat currency was backed by a unit of gold. This essentially meant that, if a country operated under the gold standard, any person holding a unit of the local currency had a specified claim on gold, based on the value of the currency relative to the price of gold. Although were a few variations of this system until the 1970s, the classic gold standard was common in many European countries from the early 1870s until the 1930s. Thereafter, the classic gold standard was largely abandoned in favour of more flexible alternatives.1

To this day, the merits of the gold standard are debated by economists, although the mere fact that it has been abandoned since the late seventies suggests that most central bankers agree that a modern global economy is unlikely to operate efficiently under such a system today. Even though the gold standard had distinct advantages, its disadvantages seemed to outweigh the benefits.

All That Glitters

Possibly its most important benefit was that the gold standard forced monetary discipline on central banks and governments at a time when discipline lacked in many countries.2 According to the World Gold Council, a key benefit of the gold standard was that the system limited a government’s ability to put more fiat money in circulation. Because, under a gold standard, any additional unit of fiat currency had to be backed by an additional unit of gold, the system limited a government’s ability to produce inflation by simply printing more fiat currency for circulation in the economy. As a result, it is not uncommon for some supporters of gold and the gold standard to also be critics of the large-scale quantitative easing that central banks have pursued during the last decade. Proponents of the gold standard would argue that quantitative easing, and the potential inflation it may cause, would have been difficult under a gold standard.

However, for modern economies, the gold standard also came with disadvantages. Specifically, it limited the ability of monetary authorities to quickly change the monetary base to deal with economic shocks, partly because the global gold supply could not increase fast enough when negative price shocks occurred, such as those seen during the Great Depression.3 It is this disadvantage that led many countries to abandon the classic gold standard in the 1930s. Although the original gold standard provided price stability to countries in its early days, many governments found that, during World War I, the gold standard limited their ability to fund their war efforts. Governments opted to sell their gold reserves and print more fiat money to fund the war. The gold standard was therefore abandoned because it limited monetary policy and, by extension, the fiscal flexibility of governments at a time when they needed it most.

The End of the Golden Years

While some countries attempted a return to the gold standard after World War I, the Great Depression cut these attempts short. In fact, although the debate continues, many economists including Barry Eichengreen 4 and Ben Bernanke[v] have suggested the gold standard was, at least in part, responsible for the Great Depression. Ultimately, when US President Roosevelt took office in 1933, he withdrew the US from the gold standard, effectively signalling the end of the classic gold standard monetary system.

In 1944, after World War II, another attempt was made to re-establish a form of quasi-gold standard under the Bretton Woods agreement. Under this agreement, many countries fixed their exchange rates to the US dollar. In turn, countries could exchange their US dollars for gold. However, as before, this limited the US government’s ability to manage its own fiscal responsibility, especially in the 1960s and 1970s. Because of this lack of flexibility, the US ended the convertibility of the US dollar to gold in August 1971. The end of US dollar convertibility effectively heralded the beginning of the modern monetary system, in which many currencies have flexible exchange rates that are not backed by gold, but rather by trust that a government will not devalue currency against goods and services.

Worth Its Weight

Today gold is still seen as a store of value and a portfolio diversifier. Its popularity may arguably have waned somewhat in recent years, as cryptocurrencies—Bitcoin in particular—gained in acceptance. However, gold’s recent performance is unlikely to go unnoticed. Gold rose in value at a time when other assets struggled on the back of rising geopolitical risk and inflation fears. This is also likely why gold remains an important part in the reserve holdings of many central banks. For example, many European countries maintain a large share of their reserve holdings in gold.  As of the fourth quarter of 2021, gold constitutes 58 percent of the US’s and 66 percent of Germany’s foreign reserves, while Italy stands at 62 percent and France at 58 percent. Countries like Russia and Turkey also hold sizable shares of gold reserves, coming in at 21 percent and 24 percent, respectively.5 Ultimately, gold is still a store of value—but its role in the world monetary system has declined, and the likelihood of gold replacing the US dollar, or any other currency, as the reserve currency under a new gold standard seems low. CFA_Toronto_RGB Milly

1 Cooper, Richard. The Gold Standard: Historical Facts and Future Prospects, [Brookings Papers on Economic Activity, no. 1. Brookings Institute, 1982.

2 Iowa State University. “What Would be the Costs and Benefits of Returning to the Gold Standard?” Ask an Economist. Accessed March 11, 2022.

3 Federal Reserve Bank of St. Lous. “The Gold Standard.” Timely Topics, Oct. 20, 2014.

4 Eichengreen, Barry and Peter Temin. The Gold Standard and the Great Depression [NBER Working Paper No. 6060]. National Bureau of Economic Research, 1997.

5 Bernanke, Ben and Harold James. The Gold Standard, Deflation, and Financial Crisis in the Great Depression: An International Comparison [NBER Working Paper No. 3488]. National Bureau of Economic Research, 1990

Walter de Wet, CFA, is a Senior Research Strategist at Nedbank CIB Global Markets. 

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