All that Glitters
Will the global economic crisis compel a return to the gold standard?

The 2008 financial crisis has led to a debate over a possible shift back to the gold standard. This is especially true of the United States, where talk of shifting back to the practice of pegging the US dollar to gold has been sparked off in some recent discussions. Adding fuel to the fire, Steve Forbes of the famed Forbes magazine recently predicted that the USA will be eventually shifting back to a gold standard within five years. Such statements coming from influential quarters have triggered serious speculation on the topic.

The gold standard is a system in which the standard economic unit (read, the currency of the economy, for all practical purposes) is defined in terms of fixed amount of gold. This can be in two forms. The historical form is the issuance of gold coins. Empires of medieval periods used to issue coins made of pure gold, as a guarantee of the currencies issued. Simply put, even if you did not have faith in the currency issued by a certain king, you would still accept his coins simply because they were made of gold, which has value in any country. As society matured, currencies started being issued in other materials, and eventually shifted to a paper medium, which had no intrinsic value of its own. However, the government issuing a currency pegged its value to gold. With the advancement of society, the exchange rates between two currencies became an important factor for global trade, and the exchange rates between currencies as defined in terms of specified units of gold became another form of the gold standard. The gold bullion standard is yet another derivative form of the gold standard. In this, a country promises to sell certain amounts of gold bullion at a fixed price on demand, which acts as a guarantee of their currency.

Historically, both gold and silver standards have been used by different countries, mostly depending on which country had a relative abundance of which precious metal. Much of Europe, for example, used the silver standard, a practice that can be traced back to the Romans. The discovery of large amounts of gold by the Spanish in Latin America led to Spain shifting to the gold standard. As Spain was a major power in international trade at that point of time, the gold standard soon became the international norm for global trade. United Kingdom, the other major global power, shifted to the gold standard despite having silver coins in circulation. This was after a new mint ratio between silver and gold was established by the then master of the Royal Mint, Sir Isaac Newton, in 1717. Britain formally shifted to the gold standard only in 1821, and eventually all major countries adopted the gold standard over the nineteenth century.

As is quite evident from the definition, a country’s currency strength depended on its gold reserves. This was quite convenient as long as there were no problems with its gold reserves and each country zealously accumulated and guarded its gold. Problems arose when a country faced difficult times. For example, the UK suspended conversions during the French Wars as did the USA during its Civil War. World War I witnessed many countries shifting away from the gold standard as they could not finance the cost of the war. When they all tried to return to a gold standard after the war, it created further chaos. Given that almost all of them had faced massive inflation but at varying degrees during the war period, agreeing on a common rate post war resulted in some countries facing major devaluation of their gold reserves while some benefited. Germany, which was the loser in WWI, lost much of its gold reserves in reparations. This triggered a chain of events that resulted in the infamous hyperinflation of the 1920s. The post-WWI period witnessed the development of the gold bullion standard, as countries did not directly pledge to trade every unit of currency for its equivalent gold, but offered a general backing of its currency with gold bullion if the need arose.

The Great Depression of the late 1920s-early 1930s was followed by another World War. The problems faced by most European countries were further magnified by the War. By then, economists such as Keynes had started strongly criticising the gold standard. The evolution of global institutions like the International Monetary Fund was felt necessary to ensure a centralised system of fixing exchange rates between various currencies. Under the Bretton Woods Convention, it was decided that the US dollar would be the base currency and that all other countries would fix their exchange rates relative to the US dollar. The US dollar was pegged at $35 for every ounce of gold. Fort Knox was thus the base for not only the value of the US Dollar, but by dint of exchange rates, all the currencies of the world!

This changed overnight in 1971, when American President Richard Nixon announced unilaterally that the USA was shifting away from the gold standard. The repercussions? Simply put, all those countries that held dollars could no longer ask the US to honour its currency by giving the equivalent amount of gold to the country. The cost of the Vietnam War and the subsequent rise in domestic inflation in the US, coupled with the high trade deficit that it ran with other countries, all resulted in a loss of international faith in the US dollar. Countries such as France then asked for the redemption of their dollar holdings in gold. The US could not honour those demands and thus unilaterally decided to end the Bretton Woods agreement. The global economy faced a major shock and crisis because of the US action, and the oil price shock that was related to this problem forced the world to shift to a new regime of fiat money, with floating exchange rates. Fiat money system is a system under which all currencies are nothing more than a legal tender issued by a government. The value of the currency is not pegged to any commodity, but only has the backing of the respective governments. Currencies now were defined in terms of other currencies. The exchange rates, however, were not fixed any more but floating, which means that they varied over time depending on supply and demand of the currency. A currency held good as long as the government agreed to redeem in terms of some other currency at the market exchange rate. Thus, under fiat money, a holder could shift from one fiat currency to another.

Despite this formal change in definition, much of the global monetary exchange still followed the US dollar as the primary currency and the dollar itself was unofficially pegged to a new commodity, oil. Almost all countries need to trade in oil. As long as oil is traded in dollars, the American currency remains the primary one in the world: Other countries will happily peg their currency exchange rates to the dollar just as they did under Bretton Woods.

The recent financial crisis has shaken this system to the core. Given that all major economies have been simultaneously hit by the crisis, no currency is considered safe. For example, it is reported that China, Russia, Brazil, India, and the Middle Eastern petro-powers have diversified their $7 trillion reserves into euros over the last decade to limit dollar exposure.

As Europe's monetary union itself faces an existential crisis, there is no other safe-haven currency able to absorb the flows. As internationally currency values are dependent on each other, the lack of any stable currency is threatening the entire global monetary system today. There is thus now a call for returning to a pegged currency, and gold seems to be an obvious choice. The ever-rising gold prices have already triggered speculation that many countries are now shifting their reserves (which they earlier held in US dollars, euros, or most commonly, a mix of the major international currencies) to gold, as they fear that all the major currencies are going to face further devaluation, which in turn will lower the value of their savings.

As global confidence on all currencies wanes, we seem to be instinctively falling back on good old gold, the precious metal that has historically been the symbol of wealth and prosperity.