A Brief History of the Gold Standard, with a Focus on the United States
[This article is part of the Understanding Money Mechanics series, by Robert P. Murphy. The series will be published as a book in late 2020.]
To fully understand our current global monetary system, in which all of the major powers issue unbacked fiat money, it is helpful to learn how today’s system emerged from its earlier form. Before fiat money, all major currencies were tied (often with interruptions due to war or financial crises) to one or both of the precious metals, gold and silver. This international system of commodity-based money reached its zenith under the so-called classical gold standard, which characterized the global economy from the 1870s through the start of World War I in 1914.
Under a genuine gold standard, a nation’s monetary unit is defined as a specific weight of gold. There is “free” coinage of gold, meaning that anyone can present gold bullion to the government to be minted into gold coins of the appropriate denomination in unlimited quantities (perhaps with a small charge for the service). Going the other way, to the extent that there are paper notes or token coins issued by the government as official money, these can be presented by anyone for immediate redemption in full-bodied gold coins. Finally, under a genuine gold standard, there are no restrictions on the flow of gold into and out of the country, so that foreigners too can avail themselves of the options described above.1
To this day, arguments over the gold standard are not merely technical disagreements concerning economic analysis. Rather, the gold standard often serves as a proxy for “sound money,” which was a central element in the classical liberal tradition of limiting government’s ability to wreak havoc on society. As Ludwig von Mises explains:
It is impossible to grasp the meaning of the idea of sound money if one does not realize that it was devised as an instrument for the protection of civil liberties against despotic inroads on the part of governments. Ideologically it belongs in the same class with political constitutions and bills of rights. The demand for constitutional guarantees and for bills of rights was a reaction against arbitrary rule and the nonobservance of old customs by kings. The postulate of sound money was first brought up as a response to the princely practice of debasing the coinage. It was later carefully elaborated and perfected in the age which—through the experience of the American continental currency, the paper money of the French Revolution and the British restriction period—had learned what a government can do to a nation’s currency system. (bold added)2
It should go without saying that in the present chapter, we are not offering a comprehensive history of the gold standard, even from the limited perspective of the United States. Rather, we merely attempt to explain its basic mechanics, and to highlight some of the major events in the world’s evolution from a global monetary system based on market-produced commodity money to our current framework, which rests on government-issued fiat monies.
The Precious Metals: The Market’s Money
In the previous chapter, we explained that money wasn’t planned or invented by a wise king, but rather emerged spontaneously from the actions of individuals. We also explained why historically people settled on the precious metals, gold and silver, as the preeminent examples of commodity money.
In more recent times—specifically after 1971, as we will document later in this chapter—most people on Earth use unbacked fiat money, issued by various governments (or central banks acting on their behalf), which is not redeemable in any other commodity.
Yet between these two extremes there was a long period when governments issued sovereign currencies that were defined as weights of gold and/or silver. In the US, coins stamped with certain numbers of dollars would actually contain the appropriate gold or silver content, such as a $20 Double Eagle gold coin containing 0.9675 troy ounces of gold. Furthermore, after the US government began the practice of issuing paper notes of various dollar denominations, anyone could present the paper for redemption in the corresponding full-bodied coins. Even during periods when specie redemption was suspended—as often happened during wars—the public generally assumed (correctly) that the government paper currencies would eventually be linked back to the precious metals, and this expectation helped anchor the value of the paper money.
Explainer: “Fixed” Exchange Rate vs. Government Price-Fixing
When multiple countries participate in a gold standard, it is typical to say their governments have adopted a regime of “fixed exchange rates,” where the various sovereign currencies trade against each other in constant ratios.
In contrast, economists such as Milton Friedman have written persuasive essays3 making the case for flexible or “floating” exchange rates, in which governments don’t intervene in currency markets but rather let supply and demand determine how many pesos trade for a dollar. Part of Friedman’s argument is that when governments do try to “fix” the value of their currency—usually propping it above the market-clearing level—it leads to a glut of the domestic (overvalued) currency and shortages of (undervalued) foreign exchange. So if economists are opposed to price-fixing when it comes to the minimum wage and rent control, shouldn’t they also oppose it in the currency markets?
Although Friedman himself obviously understood the nuances, this type of reasoning might mislead the average reader. Under a gold standard, governments don’t use coercion to “fix” exchange rates between different currencies. So the policy here is nothing at all like governments setting minimum wages or maximum apartment rents, where the “fixing” is accomplished through fines and/or prison time levied on individuals who transact outside of the officially approved range of prices.
Instead, under a gold standard, each government makes the standing offer to the world to redeem its own paper currency in a specified weight of gold. This offer is completely voluntary. No one in the community has to exchange currency notes for gold; people merely have the option of doing so.
However, given that two different governments pledge to redeem their respective currencies in definite weights of gold, it is a simple calculation to determine the “fixed” exchange rate between those two currencies. For example, in the year 1913—near the end of the era of the classical gold standard—the British government stood ready to redeem its currency at the rate of £4.25 per ounce of gold, while the US government would redeem its currency at the rate of (approximately) $20.67 per ounce of gold. These respective policies implied—using simple arithmetic—that the exchange rate between the currencies was “fixed” at about $4.86 per British pound. Yet this ratio wasn’t maintained by coercion, and the actual market exchange rate of dollars for pounds did in fact deviate from the anchor point of $4.86. It’s just that if the market exchange rate moved too far in either direction, it would eventually become profitable for currency speculators to ship gold from one country to the other, in a series of trades that would push the market exchange rate back toward the “fixed” anchor point.
To see how this works, suppose that the US government (back in 1913) began printing new dollars very rapidly. Other things equal, this would reduce the value of the dollar against the British pound. Suppose that when all of the new dollars flooded into the economy, rather than the usual $4.86 to “buy” a British pound, the price had been bid up to $10.
At this price, there would be an enormous arbitrage opportunity: specifically, a speculator could start out with $2,067 and present it to the US government, which would be obligated to hand over 100 ounces of gold. Then the speculator could ship the 100 ounces of gold across the ocean to London, where the gold could be exchanged with the British authorities for £425. Finally, the speculator could take his £425 to the foreign exchange market, where he could trade them for $4,250 (because in this example we supposed that the dollar price of a British pound had been bid up to $10 in the forex market). Thus, in this simple tale, our speculator started out with $2,067 and transformed it into $4,250, less the fees involved in shipping.
Besides reaping a large profit, the speculator’s actions in our tale would also have the following effects: (a) they would drain gold out of US government vaults, providing the American authorities with a motivation to stop with their reckless dollar printing, (b) they would add gold reserves to British government vaults, providing the British authorities with the ability to safely print more British pounds, and (c) they would tend to push the dollar price of British pounds down, moving it from $10 back toward the anchor price of $4.86.
To be sure, I’ve exaggerated the numbers in this simple example to keep the arithmetic easier. In reality, as the dollar weakened against the British pound, it would hit the “gold export point” well before reaching $10. Through the arbitrage process we explained above, whenever the actual market exchange rate strayed too far above the $4.86 anchor, automatic forces would set in causing gold to flow out of US vaults and push the market exchange rate back toward the “fixed” rate. (This process would happen in reverse if the exchange rate fell too far below the $4.86 anchor and crossed the “gold import point”: gold would flow out of the United Kingdom and into American vaults, and set in motion processes that would push the exchange rate back up toward the anchor point.)
We have spent considerable time on this mechanism to be sure the reader understands exactly what it means to say there were “fixed exchange rates” under the classical gold standard. To repeat, these were not based on government coercion, and did not constitute “price-fixing” by the government. No shortages of foreign exchange occur under a genuine gold standard, because exchange rates are always freely floating, market-clearing rates.
It is difficult for us, growing up in a world of fiat money, to appreciate the fact, but historically people viewed gold (and silver) as the actual money, with sovereign currencies being defined as weights of the precious metals. As Rothbard explains:
We might say that the “exchange rates” between the various countries [under the classical gold standard] were thereby fixed. But these were not so much exchange rates as they were various units of weight of gold, fixed ineluctably as soon as the respective definitions of weight were established. To say that the governments “arbitrarily fixed” the exchange rates of the various currencies is to say also that governments “arbitrarily” define 1 pound weight as equal to 16 ounces or 1 foot as equal to 12 inches, or “arbitrarily” define the dollar as composed of 10 dimes and 100 cents. Like all weights and measures, such definitions do not have to be imposed by government. They could, at least in theory, have been set by groups of scientists or by custom and commonly accepted by the general public.4
In concluding this section, we can agree with Milton Friedman that in a world of governments issuing their respective fiat monies, coercive government ceilings or floors in the foreign exhange market—enforced through fines and/or prison sentences—will lead to the familiar problems characteristic of all price controls. As Rothbard conceded, “the only thing worse than fluctuating exchange rates is fixed exchange rates based on fiat money and international coordination.”5
However, the advocates of a genuine international gold standard stress that its underlying regime of (implied) fixed exchange rates would be even better, because it would effectively allow individuals around the world to benefit from the use of a common money. That is to say, for all the reasons that domestic commerce within the United States is fostered through the common use of dollars, commerce and especially long-term investment between countries will be enhanced when no one has to worry about fluctuating exchange rates on top of the other variables.
Colonial Era through 1872: Gold and Silver “Bimetallism”
Because the original thirteen American colonies were part of the British Empire, their official money was naturally that of Great Britain—pounds, shillings, and pence—which at the time was officially on a silver standard. (Indeed, the very term “pound sterling” harkens back to a weight of silver.) Yet the colonists imported and used coins from around the world, while those in rural areas even used tobacco and other commodities as money.6
During the Revolutionary War, the Continental Congress issued unbacked paper money called Continental currency. The predictable price inflation gave rise to the expression “not worth a Continental.” (We will cover this episode in greater detail in chapter 9.)
Among the foreign coins circulating among the American colonists, the most popular was the Spanish silver dollar. This made the term “dollar” common in the colonies, explaining why the Continental currency was denominated in “dollars” and why the US federal government—newly established under the US Constitution—would choose “dollar” as the country’s official unit of currency.7
It is crucial for today’s readers to understand that from the inception of the modern (i.e., post-Constitution) United States in the late 1780s through the eve of the Civil War in 1861, the federal government issued currency only in the form of gold and silver coins. (The one borderline exception were the limited issues of Treasury Notes first used in the War of 1812, which were short-term debt instruments that earned interest and did not enjoy legal tender status, but of which the small denominations of the 1815 issues did serve as a form of paper quasi money among some Americans.8)
In this early period, banks were allowed to issue their own paper notes that were redeemable in hard money and, to the extent that they were trusted, might circulate in the community along with full-bodied coins, but these banknotes were not the same thing, economically or legally, as gold or silver dollars. In summary, for the first seventy-odd years after the modern federal government’s creation, official US dollars consisted in actual gold and silver coins that regular people carried in their pockets and spent at the store. Indeed, so bad was the constitutional framers’ experience with the Continental currency, that they included in the Contract Clause the prohibition that “No State shall…make any Thing but gold and silver Coin a Tender in Payment of Debts.”
In the Coinage Act of 1792, the US dollar was defined as either 371.25 grains of pure silver or 24.75 grains of pure gold, which officially established a gold-silver ratio of exactly 15 to 1. Part of the rationale for this policy of “bimetallism”—in which new coins (of various denominations of dollars) co
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