By the 19th century, most of the world’s currencies had become ‘representative’ by being linked to the gold standard, and remained so until the 1970s, after which time money became nothing more than a government promise, known as ‘fiat’ money, from the Latin for ‘it shall be’.
The gold standard
Gold has been valued as a commodity, both for jewelry and as coinage, for thousands of years, and has for a long time been accepted everywhere as a trusted currency, thanks to a proven record of holding its value. Along with silver, gold was the standard medium of payment for international trade well into the 20th century. Its value is guaranteed by its rarity.
Like all elemental metals, gold was formed in space by nucleosynthesis, the process by which a nuclear explosion, a collapsing star for example, creates new atomic nuclei.
Relatively small quantities of these metals combined with more abundant elements in the formation of planets, as happened with Earth. Because of its weight, gold sank deep within the molten mantel of the newly formed planet. The traces we find today have mostly been thrown up from the mantel by deep volcanic activity. It is also likely that some of the heavy metals found near the surface of the earth, including gold, come from asteroid impacts, most of which occurred around four billion years ago.
Figure 23
Unlike the mineral wealth that we use as fuel, or metals lost through industrial process or corrosion, nearly all the gold that has ever been mined, around 175,000 tonnes by 2014, is still around today, mostly in the form of bullion or jewelry. Around 2,500 tonnes are mined every year, and this quantity is limited by the physical constraints of the mining process, so although it has generally risen with economic growth, the rate of gold production doesn’t greatly change.
At one time silver was more popular for coinage in Europe, being more available than gold but still scarce enough to hold its value. Silver ingots had been used as a medium of exchange in China since around 200 CE. As world trade began to increase in the 16th century, in particular between China and the Spanish and Portuguese, silver became the standard method of payment.
Silver dollar coins became popular. The term ‘dollar’ was originally the English term for the German ‘thaler’ – an abbreviation of the name of a place where silver was mined in what is now the Czech Republic. This region of Bohemia was part of the Holy Roman Empire in the 16th century, a time when most European currencies had become debased and were therefore unpopular with traders. The thaler was recognized as one of the few reliable silver coins and became a trade standard, remaining so until the end of the 19th century, when Germany replaced it with the gold mark.
It was during the 19th century that the silver standard was gradually replaced by the gold standard, after silver had begun to lose its value relative to gold. Britain had used silver coins exclusively from around 770 until the 14th century, when a gold coin was introduced in addition to the silver coins. Silver remained the standard until 1816, when the gold standard was adopted. This change occurred because although Britain paid for imports in silver, income from exports was mostly in gold, and consequently Britain’s reserves became predominantly gold.
The US used both gold and silver until 1873, when it adopted the gold standard. Germany switched to gold around the same time, and as gold became the dominant currency for world trade other countries followed suit.
Under a gold standard, all money has a value linked to gold, whether it be paper money or coins made of silver or any other metal. This effectively creates a fixed exchange rate between different currencies using the gold standard.
It also means that a country must retain a substantial amount of gold to back up its currency. The US Federal Reserve, for example, before the US abandoned the gold standard in 1971, was required by law to hold enough gold to back at least 40% of the total value of notes in circulation. This limited the ability of the government to manipulate the money supply, which can be seen as both good and bad; it keeps inflation down, but also constrains a government’s options when using monetary policy to boost the economy, by lowering interest rates, for example (because interest rates affect the value of the currency).
Since gold stopped being the de facto global currency, exchange rates between national currencies have varied according to the relative strengths and weaknesses of different economies, encouraging currency speculation and causing uncertainties in the pricing of goods, making international trade more complicated.
It was to eliminate such complications that the European Union introduced a single currency. Unfortunately this only succeeded in causing other complications, because it doesn’t really work to have a single currency while at the same time having lots of different governments. I will return to this theme later, but first we must take a quick walk through the woods.
The last link is broken
It was because of this unpredictable volatility between the currencies of different nations that the Bretton Woods system of monetary control was set up in the summer of 1944. Just three weeks after the D-Day landings, delegates from the 44 allied nations took a break from the horrors of the Second World War and met in a grand hotel in the peaceful mountains of Bretton Woods, New Hampshire. With the end of the war finally in sight, US President Franklin D Roosevelt and British prime minister Winston Churchill were determined to avoid the economic problems that followed the First World War, and which to some extent had caused the war still raging in Europe and the Pacific as they gathered.
Their goal was to create a new world order that would speed up post-War reconstruction and ensure lasting peace, and ultimately prosperity. John Maynard Keynes, the British economist, was one of the principal negotiators, along with senior officials from the US Treasury. They focused on two key issues: how to pay for the rebuilding of Europe, and how to form a stable exchange-rate system. For these purposes they set up the International Bank for Reconstruction and Development (later renamed the World Bank) and the International Monetary Fund.
Keynes was in favor of a single world currency, but the US insisted that fixed exchange rates should be linked to the dollar, which was itself linked to the price of gold. The US was by this time the only strong economy remaining in the world and, as most of the money that went into the new bank would come from the US, it became by far the most dominant player in this new world order.
The Bretton Woods agreement established a rules-based system of international finance that helped to restore confidence in world trade, resulting in a US-led economic revival and the boom years that endured, on and off, throughout the second half of the 20th century.
It worked initially because dollars flowed to Europe in the form of loans and grants (the Marshall Plan) and, as Europe recovered, it imported goods from the US, thus helping the American economy to keep expanding. As worldwide demand for US goods increased, this in turn led to rising US demand for raw materials, which benefited the economies of some mineral-rich nations.
But the Bretton Woods system had a few drawbacks, the biggest of which, for the US at least, was that gold was tied to the dollar at $35 per ounce, while the free-market price could vary. US policy was to try to keep the gold price close to $35 by maintaining the dollar’s value, but this proved impossible. If the free-market price of gold rose higher than $35, as it did whenever the dollar looked threatened by some event (the Cuban Missile Crisis of 1962, for example, sent gold up to $40 per ounce) there was nothing to stop other nations from converting their dollar holdings into gold at $35, then selling the gold for the higher price, a practice known as arbitrage.
By the mid-1960s, a resurgent Europe was becoming less tolerant of America’s unprecedented power and influence. France, in particular, under President Charles de Gaulle, didn’t trust the US