Too embarrassed to ask: what is the gold standard?

These days, most currencies are "fiat" currencies backed by the economies of the countries that issue them. But in days gone by currencies were on the "gold standard". Here's what that means.

What makes the pound in your pocket – or your bank account – money? Why are people willing to accept currency in exchange for goods and services?

These days, there is nothing physical underwriting the value of the pound or the dollar, or any other currency for that matter. Such currencies are popularly known as “fiat” currencies. Put simply, they are backed by the strength of the economies and the governments that issue them and that demand taxes be paid in them.

However, this wasn’t always the case. In the past, commodities of various sorts were often used as money. The most popular such commodities have been the precious metals, and gold in particular.

The “gold standard” describes a monetary system where paper currencies are exchangeable for gold at a fixed rate. Put very simply, the idea behind the gold standard is that it prevents countries from living beyond their means. If a country needs to hang on to enough gold to back its currency, then it makes much harder for governments to manipulate the money supply.

However, the rigidity of the gold standard also has drawbacks. An inflexible money supply in theory makes it harder for central banks to adjust for economic conditions. Perhaps more pertinently, history shows that when the gold standard has proved overly restrictive, governments simply abandon it. For example, most countries abandoned the gold standard between the First and Second World Wars.

After the Second World War, the world went back onto a form of the gold standard. Under the Bretton Woods agreement, the US dollar was backed by gold, and the rest of the world’s currencies traded at fixed exchange rates against the dollar.

However, in the late 1960s, mounting US spending – partly on the Vietnam war – threatened to cause a run on America’s gold reserves as foreign countries lined up to swap their dollars for gold.

As a result, in 1971, president Richard Nixon severed the link between the dollar and gold. By 1973, most major currencies were free floating and the US dollar was no longer tied to the yellow metal.

Of course, the monetary system is constantly evolving. As the prospect of fully digital currencies becomes reality, we may see another shift in the near future.

To learn more, subscribe to MoneyWeek magazine.

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