The history of cash part 3
The Gold Standard
Entrusting the issue of banknotes to one central authority effectively removed the danger of bankruptcy, but it did raise the spectre of inflation. This would happen if a central bank printed too much money. (To understand this, imagine you were an egg seller and everyone suddenly had twice as much cash; you would feel foolish, not to say cheated, if you continued to sell your eggs at the old price.) It was the risk of inflation, among other factors, that propelled governments into joining the Gold Standard, a measure that harked back to the days when all money really was made of precious metal.
The Gold Standard was a mechanism that fixed the values of the coins and banknotes of participating nations in terms of specified quantities of gold.
The Standard operated both domestically and internationally. On the domestic front, it forestalled inflation by ensuring that the money supply remained relatively constant. In the international sphere, it had the effect of fixing exchange rates between the nations involved. If the US set the price of gold at $20.67 per ounce, for example (as it did from 1834 until 1933), and the UK set it at three pounds 17 shillings and 10.5 pence, as it did from 1844 until 1931 (apart from a period after the First World War), an exchange rate of $4.867 dollars to the pound necessarily followed.
The benefits of fixed exchange rates included stability and a balancing of prices between subscribing nations. If the UK made a technological breakthrough that increased economic output, its prices would fall. Assuming US prices stayed the same, this would make UK products more attractive from an American perspective, and American products less attractive to the UK. The upshot would be that gold – that is, the stuff in which payments were made – would flow out of the US and into Britain.
As the money supply/amount of gold in Britain had now increased, its prices would rise. At the same time, US prices would fall in line with the nation’s own money supply. Hey presto, everyone ended up more or less where they had been in the first place and price stability was restored.
The Gold Standard worked very well so long as everyone played nicely. In the US, for example, inflation between 1880 and 1914 averaged a mere 0.1 per cent per year. The trouble was that many nations were inclined to cheat, particularly when the going got tough. When the First World War broke out in 1914, the countries involved threw their rule books out of the window. They started printing money to finance their war efforts and the Gold Standard broke down. It was reinstated in modified form in 1925, but collapsed again due to instability caused by the Great Depression.
In 1931, Britain left the Gold Standard as a result of massive outflows of gold from the nation’s coffers. The successor to the Gold Standard was the Bretton Woods system, named after the New Hampshire resort where the Second World War Allies thrashed out the details in 1944. Once again, exchange rates were fixed (within a margin of 1 per cent), but the key feature was that all participating nations apart from the US were allowed to settle their debts in US dollars. The US promised to redeem the dollar holdings of other countries for gold at a fixed rate of $35 per ounce.
Unfortunately, this offer was taken up to the extent that the US started running out of gold, which placed the entire system in jeopardy. In 1971, President Nixon announced that the US would no longer be paying out gold for dollars. For the Gold Standard, this was the final nail in the coffin.
Fiat money
Since 1971, the world economy has largely run on a system of floating exchange rates, with gold-backed currency replaced by what is called “fiat money”. This is money that has no intrinsic value and obtains its worth entirely on the basis of governmental decree. (”This piece of paper can be used to pay debts because we say it can.”) The use of fiat money obviously places a greater responsibility on governments than they had in the days when currency had to be backed by precious metals. Print too much of it and you end up in a right mess.
