Due to permanent panic moods in the financial markets there are new calls to return the gold standard. However in a world where the real value of gold has become a brand, the introduction of the gold standard could lead to dramatic consequences.
At a time when the markets are shaking, investors want peace and certainty. Therefore, any monetary fever leads to the resumption of nostalgic talks about the good old times of the gold standard.
Info: The gold standard is a monetary system in which the standard economic unit of account is based on a fixed quantity of gold.
Now the debate on the return of the system when the currency is pegged to gold flared up again. Fans of the gold standard argue that it is self-regulated and transparent model that allows the easiest way to determine the exact value of money. Studies have shown that this is not the case.
Anatomy of gold standard
The monetary system in which the basic unit of calculation is gold, spontaneously arose in 1870 and successfully operated until the outbreak of World War II. By the time of appearance of the gold standard, London has already been the capital of precious metals market thanks to its close economic relations with the gold mining countries.
This market was very peculiar: it traded physical commodity and all decisions there were influenced by one major player - The Bank of England. By changing the supply and demand of gold prices the Bank tried to maintain its holdings of precious metals at an optimal level.
Key points of this era
- Spreads (the difference between the best bid and ask prices) increased between periods of financial “compressions” (eg, during the Anglo-Boer War). Interestingly, they remained high after 1900. This could be interpreted as evidence of the difficulties of the bank with the maintenance of adequate reserves of gold.
- The Bank of England resorted to unconventional policy by offering a higher price for foreign gold coins, thus withdrawing them from the circulation of money in other countries.
- In some periods the gold reserves of more than half consisted of foreign coins. The structure of the reserves was not disclosed and the society did not realize how much of the national bank notes was provided by (based on) foreign coins.
- After 1925 the rules have been tightened. Gold coins no longer walked in foreign lands and the value of spread for the Bank of England was set at 0.16. This may explain why the gold standard in the period between the two wars was not so successful and why it was canceled after the end of World War II.
Historical picture: The New York Times half page triple-tiered headlines announce, “GOLD STANDARD DROPPED TEMPORARILY TO AID PRICES AND OUR WORLD POSITION; BILL READY FOR CONTROLLED INFLATION.” President Franklin D. Roosevelt nationalizes gold owned by private citizens and abrogates contracts in which payment was specified in gold. Currency could never again be exchanged for gold (The Act of April 5, 1933).
Gold 100 years later
- If the gold standard was introduced today, the central banks would have to fix the price of the currency. Meanwhile, the idea of fixed exchange rates over the past decade has discredited itself. At some point, it became too difficult to determine the currency rate, and the main financial regulators have moved to inflation targeting or to the monetary union.
- It is difficult to understand how the intervention of central banks to the complex gold market could be more successful than currency interventions.
- If there is a solution to all the problems of the international monetary system, countries shouldn’t search for it in the model of a century ago.
- Another argument in favor of harm to the gold standard for the modern financial system is the dynamics of the price of gold. It would seem that while central banks from around the world flood the world with cheap money, gold should go up. However, in recent months, the metal has lost almost a quarter of its value.
- Fundamental changes that have occurred in the gold market over the last century can explain this mysterious phenomenon. Today, the price of gold depends on the overall situation in the markets, and not only on the amount of physical purchases and sales. As a result, prices are out of touch with the real reserves of gold and the precious metal is transformed from a commodity into a fashion brand.
Graphics: Historical Gold Reserves