The Gold Standard versus Fiat Currencies: An Overview

Kayle Becker- Guest Writer

If you have been paying any attention to news headlines recently, then you must be aware of how many governments all over the world are reacting, in economic and financial terms, to the devastating coronavirus pandemic. One must not look far to encounter articles titled, “Coronavirus: Bank pumps £100bn into UK economy to aid recovery”, “Central Banks Pump More Cash Into Economy to Fight Recession”, or “With $2.3 Trillion Injection, Fed’s Plan Far Exceeds Its 2008 Rescue” along with a slew of many similar headings. Reading headlines like this might be confusing; you must wonder ‘how is the government able to just print money?’ or ‘what are the implications of printing mass amounts of money?’. It may help to understand how the monetary system has changed over the last 100 years in order to grasp how governments are able to print money and how citizens are impacted.

The Gold Standard
The Gold Standard is a monetary system which is used to protect the worth of a currency by pegging its value to a scarce resource (ensuring scarcity). In order to determine the value of a currency, a nation utilizing the gold standard selects an exchange rate at which people can trade the currency for the scarce commodity. For example, if Great Britain backed its currency, with silver, at £15 per ounce of silver then £1 of cash would be worth 1/15th an ounce of silver.  Consumers could take their currency to the bank and exchange it for silver at that rate. Since silver is in limited supply (a scarce resource), the government could only print as much currency as it holds in silver reserves. By pegging a currency’s value to a scarce resource a government is limited in its ability to create currency.

Fiat Currencies
A fiat money system (current monetary systems) is not backed by any specific physical commodity; but rather, fluctuates in value against other currencies in the foreign exchange market. For example, forex traders bet on the value of one currency against another; and if their bet is correct, they profit. By definition, ‘fiat’ is “a formal authorization or proposition; a decree”; meaning, the value a currency holds in the fiat system is based upon a governmental decree. When a currency’s value is based solely upon a government mandate, there is nothing to stop the continuous printing of money (no scarcity). If too much money is printed inflation results which devalues the currency.

Why the Gold Standard was Abandoned
Following World Wars I & II, and the Great Depression, the global economy was in shambles.  In order to finance large wartime spending and social programs, governments created far more fiat currency than they held in commodity reserves. Consumers, appreciating this fact, started exchanging their currency for gold and silver. Governments, in turn, realized that if the outflows of gold and silver continued, they would default on their obligations. In order to prevent investors and common people from cashing in their bonds and deposits for gold and silver (which would result in the bank’s default), banks hiked interest rates. Nevertheless, holding the investments and/or borrowing money proved unaffordable for most businesses and the average person; and as a result, the gold supply dwindled. In response, governments elected to move away from the gold standard towards fiat currency.

A Major Defect: Inflation
Inflation is when the prices of everyday items increase. That is, the money in your wallet today has less buying power than it did yesterday. The two main causes of inflation are demand-pull and cost-push, which are both linked to an increase in the amount of money entering the economy. Specifically, demand-pull inflation occurs when excess monies circulate in the economy and increase the demand for goods at a rate which suppliers cannot maintain. Suppliers, in response, raise prices which ultimately devalues the money people hold. Thus, while people may have more fiat currency in their pockets, the basket of goods they can exchange the currency for stays the same or decreases. 

Cost-push inflation occurs when the cost of production rises. This cost increase typically results from one of two situations: a climb in prices of the raw goods required to produce the final product or a rise in employee wage. If money is continuously being printed, in turn, devaluing a currency, then a company must pay its employees a higher salary. Likewise, if a company once paid $10 for cotton now needs to pay $20 for the same amount of cotton, it must raise the price for the finished product.

While the debate concerning whether or not to return to the gold standard is far more complex  than this brief overview can cover, it is a topic deserving of sufficient research before an opinion can be reached. With new currency technology emerging, gaining an understanding of the principles of sound money will be important.



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