What is the gold standard and why does it no longer exist?

Money has become almost invisible in the modern economy. The euro and the US dollar are nowadays mainly digital numbers on a screen. Yet this is a relatively new phenomenon. For centuries, the value of our money was directly linked to the tangible security of physical precious metals.

Although almost all countries have now abandoned this monetary system, the gold standard is still a highly relevant subject. Understanding this historical system directly helps you comprehend how our current monetary system functions, what causes persistent inflation and why investors still buy physical gold en masse today.

What exactly is the gold standard?

The gold standard is a historical monetary system where the economic unit of account of a country is directly linked to a fixed weight of physical gold. Within this system, a paper banknote is absolutely not an empty promise, but legal proof of ownership of a specific amount of precious metal.

To understand exactly how this worked in practice, three factors defined this system:

• Fixed convertibility: Citizens, companies, and foreign institutions had the legal right to exchange their paper money at the central bank at any time for the exact, corresponding amount of physical gold.
• Hard physical backing: A central bank was obliged to keep sufficient gold bars in its heavily secured vaults. Every unit of paper money put into circulation had to be strictly backed by this tangible precious metal.
• Natural brake on money creation: A government could not just turn on the money printing presses unlimitedly to plug holes in the budget. To pump extra banknotes into the economy, the state first had to physically increase its own gold reserves by buying or mining it.

This mechanism created unprecedented confidence in the national currency. Because the money supply was strictly limited by the physical and scarce supply of gold, the purchasing power of citizens remained stable for decades.

Extreme inflation or reckless government debt had virtually no chance due to this strong monetary discipline.

The history: from the classical period to the Great Depression

The period from the early nineteenth century to the outbreak of the First World War is known among economists worldwide as the golden age of this monetary system. Within this so-called classical gold standard, London functioned as the undisputed financial center of the world.

Almost all major industrial nations decided to firmly link their own national currencies to gold. This created a unique and prolonged period of monetary peace and provided the global economy with three benefits:

• Fixed international exchange rates: Because each currency represented an exact gold weight, the mutual exchange rates between countries were rock solid.
• Boundless economic growth: Companies and governments could make large international investments without running any exchange rate risk. This stimulated global trade enormously.
• Unprecedented price stability: Because governments could not print money, inflation remained extremely low for decades and citizens retained their purchasing power.

The impact of war and economic crisis

The outbreak of the First World War brought an abrupt change. To be able to pay for the sky-high military expenditures, governments had to turn on the printing presses and were forced to abandon the strict gold backing.

In the interwar period, many countries frantically tried to return to the old system, but the underlying economic relations proved to be permanently disrupted.

The fatal test for the classical gold standard presented itself during the Great Depression in the 1930s. When stock markets collapsed worldwide and unemployment rose to record highs, the system suddenly proved to be an economic straitjacket.

Governments desperately wanted to stimulate the stalled economy by putting more money into circulation and lowering interest rates. The rigid rules of the gold standard simply forbade this. After all, a country could impossibly increase the money supply without first mining or buying extra physical gold.

The gold standard connected the value of paper money to a fixed amount of gold.

Bretton Woods: a new system after the war

After the Second World War, the global economy was in ruins. There was a huge and urgent need for monetary stability to stimulate international reconstruction and global trade.

Therefore, in the summer of 1944, delegates from forty-four countries gathered in the American town of Bretton Woods to design a brand new financial system.

This historic agreement changed the rules of the gold standard enormously. They did not opt for a return to the classical system, but introduced a so-called gold exchange standard. This system rested on the following agreements:

• The pivotal role of the dollar: Only the US dollar was linked directly to gold. A rock-hard and fixed price of exactly 35 dollars per troy ounce of gold was agreed upon.
• Indirect link: All other participating countries then linked their own national currencies via a fixed exchange rate to the US dollar, instead of directly to precious metals.
• The new world reserve currency: Through this unique construction, the dollar became the most powerful currency in the world in one fell swoop. Foreign central banks held dollars as a reserve from that moment on, knowing that they could always exchange them for physical gold in America.

This system worked excellently in the first decades and caused a massive economic boom. However, the system was completely dependent on one important detail. The United States had to have sufficient physical gold reserves to guarantee global confidence in the ever-growing amount of dollars.

Timeline: The most important milestones of the gold standard

To give you a clear overview of this monetary history, you will find the most important historical years and events listed in the table below.

When and why was the gold standard abolished?

In the first decades after the war, the Bretton Woods agreement worked excellently. The global economy flourished and fixed exchange rates offered maximum certainty. During the 1960s, however, significant cracks appeared in this system.

The United States let its budget deficits rise enormously to finance expensive domestic projects and the war in Vietnam. New dollars were created on a large scale for this purpose.

More and more countries became suspicious as to whether the American government still had sufficient gold reserves to back all those newly printed dollars. Countries like France and the Netherlands decided to be better safe than sorry and demanded physical gold en masse in exchange for their dollars.

Gold standard versus current fiat money

Since 1971, we worldwide pay exclusively with fiat money. Fiat money is money that has no fixed gold backing or intrinsic value whatsoever. Its value relies 100% on confidence in the economy, the central bank and the legislative government.

This modern system has a totally different dynamic than the historical gold standard. The table below clarifies the main differences for you as a consumer and investor.

Why do we no longer use a gold standard?

The main reason modern economies do not return to a gold backing is the need for flexibility. Central banks want to be able to intervene quickly and decisively in the event of a looming recession, a pandemic or a banking crisis.

They do this by manipulating interest rates and injecting extra liquidity into the market. Under a gold standard, that monetary policy space is simply not there.

In addition, the gold standard carries a serious risk of deflation. When money becomes increasingly scarce and prices fall, consumers postpone their spending en masse. This slows down economic growth and can lead to rising unemployment.

Finally, the global economy today is so immense that a fixed link to the relatively small, physical above-ground gold supply would inevitably lead to severe liquidity problems.

De gold standard prevented extreme inflation because central banks could not endlessly print money.

The advantages of a gold-backed system

Yet many economists still look back at the past with interest. The advantages of the gold standard are considerable, especially when we look at the preservation of purchasing power.

• Monetary discipline: Because money creation was linked to the physical gold supply, governments could not print money indefinitely. This kept national budgets sharp and prevented unsustainable national debts.
• No extreme inflation: The system offered protection against inflation. You could safely trust that your savings would have exactly the same purchasing power ten years from now.
• Stable international trade: Companies that traded internationally knew exactly where they stood thanks to fixed exchange rates. This removed a massive source of financial uncertainty.

What role does physical gold play today?

The gold standard may have been officially abolished, but precious metals have never disappeared from the financial system. In fact, the demand for gold is unprecedentedly high today. Central banks worldwide add thousands of kilos to their vaults every week as the ultimate reserve.

For private investors, owning physical gold offers exactly what the fiat money system lacks: tangible certainty without counterparty risk. A gold coin or gold bar is not dependent on a central bank, requires no internet connection and cannot possibly go bankrupt.

Although it pays no interest or dividends, it acts as an independent vault for your purchasing power. Especially in times of geopolitical unrest and persistent inflation, gold remains a stable investment.

Conclusion: despite the abolition of the gold standard, physical gold remains valuable

The gold standard was an extremely stable system that ensured monetary discipline worldwide. Although the urge for economic flexibility led to the definitive switch to fiat money, the appeal of precious metals has never disappeared. Today, physical gold still offers the ultimate protection against structural inflation and uncertainty.

Do you also want to secure your accumulated wealth with this tangible certainty? Then keep a close eye on the current gold price to determine your perfect entry moment.