Understanding the Relationship Between Fiat Money and the Gold Standard
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As a status symbol, gold is worth its weight in, well, gold. But as sought after as it is now, it used to carry even more clout.
Although fiat currency is the norm and has been for some time, it was the gold standard that once ruled the economic roost, playing a role in everything from international trade to the value of currency. But how do the two compare? How did they originate? And what are their pros and cons in the present day?
We’ll take a look at the gold standard vs. fiat money in more detail to see how things have changed over the decades.
What is the gold standard?
You’ve probably heard the term ‘gold standard’ used as a benchmark of quality. Well, the expression has its roots in the actual monetary system, where the value of a country’s currency is linked directly to gold.
So, a country using the gold standard would set a fixed price for gold, say, $100 an ounce, and then buy and sell it at that price. This fixed price would then be used to determine the value of the country’s currency. In this case, $1 would be worth 1/100th of an ounce of gold.
A quick history of the gold standard
We can trace the origins of the gold standard, in the US at least, back to the 1800s. During this time, we used a bimetallic system of money, i.e., a combination of gold and silver. But since very little silver was traded, we pretty much used a gold standard.
Gold as a way of evaluating currency, however, has been around for centuries and was used before World War I as a means of international trade. Countries with trade surpluses would receive gold as payment for their exports. Those with deficits, on the other hand, would have to spend gold as payment for their imports.
Come 1900, the Gold Standard Act saw the fruition of a true gold standard, establishing gold as the only metal for redeeming paper currency in the US. This meant that transactions no longer had to be carried out with heavy gold bullion or coins – good news for those used to lugging gold around town!
Why was the gold standard abandoned?
The gold standard came to an end for several different reasons.
Between 1900 and 1932, the US was thrown into disarray. The country entered World War I in 1917, which led to a short recession between 1918 and 1919. Economic strife would rear its head again after the stock market crash of 1929, with the country entering The Great Depression over the next few years.
With banks failing, cash supplies low, and the Federal Reserve System collapsing, the gold standard, now entirely unsustainable, was ended in 1933. It was dealt a further blow after the Gold Reserve Act of 1934 prohibited the ownership of gold except under license.
Any traces of the gold standard were erased in 1971 when Nixon ended the trading of gold at fixed prices. Since then, the gold standard has not been used in any major economy.
The pros and cons of the gold standard
What are the pros of the gold standard?
Reduce uncertainty of economic trade: The exchange rates of any countries operating under the gold standard would be fixed. When importing, a country indirectly pays in gold, which reduces the money supply. Countries that are exporting receive gold as payment, which further helps to control the money supply.
Retains value across the globe: Fiat money can be printed without limit, and thus has no real value. Gold, on the other hand, holds real, stable value thanks to its scarcity.
Restricts the printing of money at will: A gold standard ensures that new money could only be printed if a corresponding amount of gold was also available to back the currency.
What are the cons of the gold standard?
Only beneficial to gold-producing countries: Not all countries are lucky enough to have gold mines. Places like the US, China, Australia, South Africa, and Russia have huge gold reserves to rely on. Those without would only be able to obtain it through a trade surplus.
Limits economic growth: As the money supply increases, the supply of gold in the economy must also grow at an equal rate. But gold is scarce, so economic growth would have to be at a lower rate.
Destabilizes the economy: The periodic deflations of the gold standard could result in a destabilized economy. It could also harm national security by restricting a country’s ability to finance national defense.
How does fiat money differ from the gold standard?
Rather than being made or backed by precious metals, fiat money is a government-issued currency backed by the government that issued it. This includes currencies such as:
- Dollars, quarters, dimes, and nickels in the US
- The Mexican peso
- The Euro
- The British pound sterling
- The Chinese yuan
It’s because of this government backing that fiat money holds value. And since it isn’t linked to any valuable commodities like rare metals or oil, governments or banks can limit the supply of their currencies in order to protect its value. In times of recession, or as economies are on the brink of recession, this currency can be inflated to stimulate growth.
The pros and cons of fiat money
What are the pros of fiat money?
Greater stability: Unlike commodity-backed currencies which can fluctuate, fiat money is relatively stable and easily stores currency value.
More versatile: Fiat money is more widely accepted and can be used as legal tender in various settings and countries.
Cost-efficient: Not only is fiat money cost-efficient to produce, it’s easy to carry around and exchange.
What are the cons of fiat money?
Not entirely foolproof: As the global financial crisis proved, fiat money doesn’t cushion against the impacts of a recession.
Increased risk of hyperinflation: Though hyperinflation is a rare occurrence, the unlimited supply of money, and the ease with which it can be printed, can stoke inflation.
Potential for depreciation: Since it’s tied to a government, fiat currencies can depreciate drastically should the issuer even run into economic hardship.
At Glint, we make every effort to demonstrate a balanced conversation between gold, crypto and fiat currencies when it comes to purchasing power and, while we strongly believe that gold is the fairest and most reliable currency on the planet, we need to point out that it isn’t 100% risk free. While we have seen a steady increase over time, the value of gold can fall, which means that its purchasing power can also decline.
To learn more, visit our homepage or give us a call at + 1(877) 258-0181.