Why we need the gold standard

Pick up any introductory economics text, and you'll see money defined as something that performs three functions:

A standard of value - that is, a generally agreed-upon measurement used to express the price of goods and services.

A store of value, which holds its purchasing power over long periods of time, to allow people to save and thereby defer their spending until some future date.

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A medium of exchange, which is easily transferred from one person to another in return for goods and services.

What is money?

This is an acceptable definition, as far as it goes. But a deeper understanding of money is possible when you think of it as a communications medium. Just as spoken language enables us to convey ideas, money is the mental tool each of us uses to communicate our own subjective view of value in an exchange. Say, for instance, that a seller offers something at a given price, which represents his (perhaps hopeful) view of its value. You counter with a lower price, and you meet somewhere in the middle, at a price you can each accept. Money is both the conceptual framework in which this conversation takes place and the tool that allows you to translate each other's idea of value into understandable terms. Money thus makes economic calculation, and by extension our market-based economy, possible.

Just as a given word means the same thing over years and centuries, allowing language to convey ideas from one generation to the next, money communicates the measurement of wealth. A gram of gold is an unchanging unit of account, like an inch or a meter. It conveys meaningful knowledge by how much it has purchased over time. A gram of gold has bought roughly the same amount of wheat since the Middle Ages, for instance.

When a unit of account is unchanging (again, think of inches or meters, which refer to the same lengths from one year to the next), the money based on it is "sound." That is, it effectively communicates wealth over time. As you'll see in the next couple of chapters, for 200 years the British pound was sound because each unit of currency was, throughout this period, defined as 0.2354 troy ounces of gold. And the US dollar was sound from 1900 to 1933 when it was defined as 23.22 grains of fine gold. These currencies were simply names for given weights of gold.

Why isn't the dollar sound?

Today's dollar, on the other hand, is emphatically not sound, because it isn't defined in any unchanging way. A dollar isn't a weight of gold, sliver, or anything else. It's simply a bookkeeping entry, an IOU of the banks that are permitted by the US government to create dollars.

But sound money is not the same thing as stable purchasing power. As the gold/oil chart illustrates, over the years an ounce of gold has bought very different amounts of oil. Why? Because supply and demand for both goods and money are always in flux, causing prices to bounce around. The difference is that with sound money the fluctuations tend to even out over time, bringing the price back into line with historical norms. The purchasing power of unsound money tends to move in only one direction: down.

Currency, meanwhile, is the physical representation of money, the item that passes from hand to hand in return for goods and services. When it takes the form of society's standard of value, as with gold and silver coins (or, as you'll learn shortly, older forms of money like goats and slaves), currency is also money. When it takes the form of, say, paper notes, currency is not money but a "money substitute." And if a currency is not defined in terms of money, but is created and controlled by a national government, it is a "fiat" currency, so called because it exists by government fiat, or decree.

How does gold hold its value?

In accounting terms, money is a tangible asset, while a money substitute is a liability of a bank, the assets of which may or may not be money. In practical terms, only money can extinguish an exchange for some good or service. That is, an exchange is extinguished when assets are exchanged for assets. If you accept a money substitute (for instance, dollars) when you sell a product, the exchange is not extinguished until you use those money substitutes (those dollars) to purchase some other good or service.

Why does gold - or any other successful money - hold its value? Not because it has "intrinsic" worth. Given its other uses in today's economy, mainly jewellery and a few electronics niches, gold as a purely industrial commodity would be worth far less than indispensable substances like oil or wheat. But gold isn't an industrial commodity. It is money, which is accumulated, not consumed like other commodities. As such, its value depends on our belief in its ability to function as money. We trust sound money because it exists in limited supply and is, by definition, not subject to government manipulation.

Fiat currencies, in contrast, are controlled by governments, which are, as you now know, fundamentally incapable of managing their monetary affairs.

Keep these distinctions in mind; they're key to the unfolding drama of the dollar and gold.

Over the centuries, humanity has auditioned an amazing variety of things for the role of money. The ancient Egyptians used barley; Tibetans used bricks of pressed tea leaves (pieces of which were cut off to make change); Solomon Islanders used arm rings made from the shells of giant clams. And just about every society, at some point in its development, has used livestock as a medium of exchange. Goats, camels, human slaves - you name it, we've tried it.

But virtually all early forms of money were imperfect choices, for fairly obvious reasons. Seashells are fragile, and their supply tends to surge after a good storm. Tea varies in supply with the quality of the harvest. Goats and slaves aren't interchangeable, don't hold their value over time, and, ahem, resist being divided up for change. So after much trial and error, most societies settled on pieces of metal as their money. More durable than goats and less variable than tea, metals like bronze, copper, silver, and gold could be mined, smelted, and turned into recognizable, more or less identical coins that could then be traded and stored. Bronze and copper, being more common and less attractive, became small change, while silver generally took the midrange and rare, beautiful gold became the most prized of all.

The history of gold as money

The first true gold coins appeared in Lydia, now part of present-day Turkey, around 600 BC, and over the ensuing centuries, minting techniques were redefined by the Greeks, Persians, and Romans.

Once established as humanity's money of choice, gold came to be synonymous with wealth and power, and as Europe emerged from the Dark Ages and began to look outward, the search for new gold supplies became a key driver of modern history. Sixteenth-century "conquistadors" like Hernando Corts and Francisco Pizarro led invasions of the New World in search of fabled cities of gold, destroying indigenous cultures in the process and paving the way for the colonization of the Americas. Three centuries later, in 1848, a handful of gold nuggets turned up on a Sacramento farm, igniting the California Gold Rush. Half a million people flooded the sparsely populated US West in less than a decade, launching a migration that continued throughout most of the twentieth century.

Eventually, however, the imperfections of gold and silver money became a problem. Metal coins were too noisy and bulky to be practical in large denominations. They also wore out over time, eroding a small but significant part of an economy's wealth. So in the 1690s, the founders of the Bank of England - destined to become the world's dominant bank over the next two centuries - had an epiphany: Instead of letting gold and silver coins circulate, why not lock them in a vault and issue paper notes to be used in the coins' place? The bank began issuing paper "pounds" with the promise that they could be redeemed at any time for pound coins composed of gold or silver. Convertibility, so went this radical new theory, would make paper acceptable by eliminating questions about its true value.

The result was a conceptual breakthrough: the first widely circulated money substitute. Where money (defined as a standard and store of value) and currency (a medium of exchange) had previously been one and the same, a tangible asset, now they were separate things. Soon, much of England's money, in the form of gold and silver, sat in the Bank of England's vault, while its currency, now a liability (or IOU) of the Bank, circulated as bits of paper.

Why was the gold standard introduced?

The honeymoon lasted for about three years, during which time the citizenry was happy to carry around light, quiet pound notes. But it soon became clear - in a process destined to be repeated many times in later centuries - that the monetary authorities were issuing more paper than was backed by the gold and silver in their vaults. In one of history's first bank runs, holders of pounds rushed to convert paper into metal, and the system careened toward failure. In desperation, King William III appointed his resident genius, Sir Isaac Newton, Master of the Mint in 1699. True to form, Sir Isaac got to the essence of the matter: He recognized that paper currency was an important innovation, but also that it wasn't money. Putting bureaucrats in charge of the printing presses would therefore lead to disaster.

To be viable, paper currency needed an external standard by which it could be measured and controlled. So Newton defined the pound as a precise weight of gold and linked the amount of paper money outstanding to the weight of gold in the Bank of England's vault (in the process dislodging silver, which until that time had been England's dominant form of money).

Paper currency circulated as a substitute for money (ie. gold), while gold provided the standard by which the value of paper currency was measured. Linking gold to bank-issued currency came to be known as the classical gold standard. And notwithstanding the occasional war-related interruption, it would serve the British Empire well for two centuries.

By James Turk for The Daily Reckoning. You can read more from James and many others at www.dailyreckoning.co.uk

Editor's Note: James Turk has specialized in international banking, finance and investments since graduating in 1969 from George Washington University with a BA degree in International Economics. He is the author of two books and several monographs and articles on money and banking. He is the co-author of "The Coming Collapse of the Dollar" (Doubleday, December 2004).