This guest post on the ramifications of the demise of the gold standard is by Rob Dix. A long-time Monevator reader, Rob is co-host of the popular Property Podcast and co-founder of Property Hub. Rob is also the author of the Penguin bestseller The Price of Money.
You may have been taught as a child the golden rule, ‘Do unto others as you’d have them do unto you.’ A more cynical golden rule was made famous in the movie Aladdin: ‘Whoever has the gold makes the rules.’
But a more accurate (if less pithy) formulation might be, ‘Whoever has the power makes the rules about the gold.’
The amount of money in the economy has been increasing dramatically over the last 50 years, and the pace is only getting faster.
How is that even possible? Well, for most of history, it wasn’t. It was only in the latter part of the twentieth century that the brakes came off and the creation of money became so unrestrained.
So what exactly changed towards the end of the twentieth century? To understand that we’ll start with a quick romp through the history of money up to that point.
The earliest money
People exchanged goods with each other long before the development of physical money. ‘Tally sticks’ were used at least 30,000 years ago to keep track of who owed what to whom. Eventually, these were replaced by clay tokens. But both seem to have been used simply as claims of ownership: the tokens themselves weren’t traded between people.
The first physical currency appears to have been the Mesopotamian shekel, dating back somewhere around 7,000 years. Metal coins are more recent still – seemingly originating independently in China around 1000 BC, and ancient Greece around 650 BC.
Eventually, these small pieces of metal would become the dominant way of organising an economy.
The UK is a good case study – and not just because it’s where I live! Records go back a long way, and Britain was a major global power during a period when critical innovations in the history of money were taking place.
We’ll link back up with other currencies later, when we reach the twentieth century.
Coining it
Coins started being used in England as early as the second century BC. But it wasn’t until the eighth century AD that their use became widespread and the coins themselves more standardised.
These later coins were made of silver, and the name ‘pound sterling’ derives from a pound weight of sterling silver. This was important, because the value of the coin was in the metal itself. Whether it was melted down or moulded into a convenient disc, it should be worth exactly the same.
A pound of silver was divided into 240 pennies. There were 12 pennies in a shilling and 20 shillings to a pound (12 x 20 = 240). Each penny was further subdivided into four farthings. We organised our coinage this way for about 1,300 years – until in 1971 someone finally came up with a less mentally-taxing structure. (“The British resisted decimalised currency for a long time,” as Neil Gaiman put it, “because they thought it was ‘too complicated’.”)
All those centuries ago, everything operated on a far more local basis – primarily owing to the time it took to convey messages across long distances. In the case of money, each town would produce its own coinage. There wasn’t one ‘Royal Mint’ as there is today.
The problem with this? It created ample opportunity for any individual ‘moneyer’ (the name for the trade that produced coins) to cheat the system by mixing in much cheaper tin with the silver that should have been used.
In other words, the unwary trader might think they were being given a valuable pound of sterling silver, but find they had nothing of the sort if they ever decided to melt it down.
Moneyers would come to regret giving in to this temptation. When Henry I became king in 1100 and discovered what was going on, he arranged for all the moneyers to be castrated and have their right hand cut off.
Royal flush
Seven Henrys and nearly 400 years later we find Henry VIII on the throne – coming to power in 1509.
Henry VIII wanted more centralised control of the currency. So he shut down all the local mints and decreed that the Royal Mint in London could be the only entity to create new coins.
This removed the opportunity for moneyers to meddle with the silver content of coins. But it introduced the opportunity for monarchs to do exactly the same thing centrally – without the risk of castration.
The effect was what you might expect from giving control to someone with a desire to accumulate as many goods as possible and no fear of retribution. About 30 years after the creation of the Royal Mint, the silver content of coins fell from over 90 per cent to just over one-third. The pound coin, originally named for its weight in silver, now very much wasn’t.
A similar pattern of increased centralisation has played out around the world.
In Germany, for example, the city of Hamburg had its own currency until 1873, until it adopted the mark upon German unification, then the euro in 2002.
In the US, although the dollar was established as the principal unit of currency in 1793, private local and regional banks were allowed to issue their own banknotes until 1861 – and approximately 1,600 of them did.
Some 244 separate clans issued their own forms of money in Japan until the yen was adopted in 1871.
In every case, this removed the ability for powerful local figures to manipulate money for their own benefit – and shifted that privilege to the central state.
The central bank is born
By about 1600, monarchs in much of the world had centralised their mints in this way. But another revolution was just around the corner: the development, in England, of the world’s first central bank.
By the 1600s, silver in England had become scarce because so much of it was being sent overseas as payment for foreign goods. In its place, gold started being used to define the value of the pound instead. (The change was overseen by one Mr. I. Newton – of ‘gravity’ fame.)
Around this same time, the country developed a serious requirement for state funds. England had lost a key naval battle in its ongoing wars with France. It needed to raise £1.2 million to rebuild the fleet.
In those days, it was normal for monarchs to personally borrow the money needed to fund wars. Unfortunately, the recently deceased Charles II had defaulted on a huge amount of debt before his death. That put everyone off the idea of lending to his successors.
To give confidence to potential lenders, in 1694 William III agreed to the establishment of a new national ‘central’ bank: the Bank of England. Importantly, the Bank would be overseen by Parliament, rather than the king. Any money it borrowed would be the responsibility of the state as a whole rather than the reigning monarch.
The strategy worked: within 12 days, the new Bank had raised the £1.2 million that the war effort needed (from about 1,200 individuals).
And so the national debt – meaning the money owed by the government to those who’ve loaned it money, and a figure that’s in the trillions today – was born in 1694 with this loan of £1.2 million.
That loan was the start but certainly not the end. By 1815, at the end of the Napoleonic Wars, government debt had risen to around £800 million.
From bullion to banknotes
The creation of the Bank of England also led to the issuance of banknotes. Up until this point, the value of the pound had been in the silver or gold coins themselves. Now, for the first time, this value could also be represented by a piece of paper with no intrinsic value of its own.
Why would people start accepting worthless paper as a representation of valuable metal? Because these banknotes could be exchanged at the Bank of England for a fixed quantity of gold. The note was effectively a ‘receipt’ for real gold stored at the bank.
It was important for public confidence that the banknotes could be exchanged for gold on demand, but in practice they rarely were. People would happily accept banknotes in exchange for goods and services, safe in the knowledge that they were backed by something they trusted.
Of course, the Bank did actually have the gold it needed to repay everyone – just in case they all turned up at the same time bearing their paper banknotes and demanding the equivalent amount of gold… right?
Well, no, not really.
The Bank cottoned on to the fact that people were quite happy with the notes and rarely turned up to claim the gold, so it started issuing many more banknotes than it had the gold to back.
In the 1730s, the Bank almost collapsed when too many people turned up demanding gold at the same time. But it survived, and 50 years later it was still paying out gold on demand.
Money for nothing
In our quick whizz through financial history so far, we’ve seen a pattern. Whenever there’s an opportunity to create or obtain extra money, it’s enthusiastically seized:
The local ‘moneyers’ of old had the opportunity to reduce the precious metal content of coins, so they did. And they had their bits chopped off as a consequence.
Henry VIII had the chance to reduce the precious metal content of coins in a similar way once their production was centralised, so he did too. (His bits remained intact because, well, that’s a benefit of being in charge).
The creation of the Bank of England gave the government the ability to borrow – and it racked up over £1 billion of debt in a little over a hundred years.
The Bank also issued banknotes that could be converted to gold on demand… and issued more of these notes than it had the gold to back.
These specific actions – and this general tendency to game whatever system was in force at the time – meant that over the years, more and more money was being created.
Money, supply, demand, and inflation
The more money that is in circulation, the less each individual pound becomes worth.
In the next chart you can clearly see a collapse in buying power between 1750 (the furthest back I can find data, and about 50 years after the Bank of England’s founding) and 1815 (the end of the very expensive Napoleonic wars):
Buying power of £100 over time, 1750–1815
And it’s not just the pound. As we’ll see, the pattern of currencies being abused to benefit whoever is in power holds up across the world and throughout time.
The classical gold standard
As the chart above shows, the buying power of the pound actually picked up after 1815, and then stayed relatively steady all the way through to 1914.
One reason for this is a lack of war. Although there was war aplenty across Europe during the mid-nineteenth century, the UK largely stayed out of it and concentrated on building its empire. Less war means less need to print new money or pile up new debt.
But the other reason for the steady value of the pound was the implementation of the ‘gold standard’, which was introduced in the 1870s.
The gold standard was the solution to a problem that became apparent after Western countries decided to trade with one another rather than kill one another.
While increased international trade was far more prosperous and less gruesome than war, it came with one massive headache – the effort involved in constantly converting between national currencies.
To overcome this, most nations decided to join the United Kingdom in ‘pegging’ their currencies to an amount of gold.
The gold standard in practice
Every currency could be converted into gold at a set price, which had the effect of fixing exchange rates between different currencies too. (This is very different from today’s floating exchange rates.)
Effectively, this meant that gold would underpin international trade. The precious metal was literally shipped between each country’s central bank to settle payments. If a particular country bought more from other countries than it sold to them, its central bank’s gold reserves would diminish (and vice versa).
The gold standard, although it was only introduced as a way to facilitate international trade, also had the side effect of limiting the ability of the Bank of England to print endless quantities of banknotes. If those notes were used to buy goods from overseas, the Bank would have to ‘settle up’ by sending gold abroad – and eventually it would run out.
Nevertheless, although this meant the Bank had to be careful about the quantity of banknotes it issued (which stopped the money supply from growing as quickly as it had done before the international gold standard was introduced), nothing else within the UK had changed.
Banknotes continued to be notionally convertible into gold on demand, and there still wouldn’t be enough gold to go around if everyone turned up with their banknotes at once.
The gold standard and Word War One
The system wasn’t perfect, but it held well until the outbreak of World War One. At that point international co-operation (obviously) broke down and every country focused on doing whatever it took to fund the war effort.
In the UK, the Bank of England didn’t have anywhere near enough gold to prepare for war. This predicament was made even worse by individuals who, spooked by the rumours of war being declared, began doing the one thing the Bank didn’t want: queuing up to convert their notes into gold.
As a result, the day after war was declared on Germany, the Currency and Bank Notes Act of 1914 was signed into law. The Act gave the government the power to print millions of pounds worth of new banknotes. These had to be accepted as legal tender and, critically, could not be converted into gold.
This is why in the next chart you can see the buying power of a pound take a sharp leg downwards in 1914. The money supply suddenly increased, which naturally reduced its value:
Buying power of £100 over time, 1750–2020
This was a landmark moment. Although the banknotes that had been issued previously turned out not to be fully backed by gold (as became clear when people rushed to redeem them en masse), they were supposed to be. The Currency and Bank Notes Act of 1914 marked the first time the central bank issued money that had no notional link to gold at all.
These new pounds were pounds purely because they had ‘one pound’ printed on them, and because the authorities said that’s what they were worth.
The link with gold was briefly reinstated after World War One, but in 1931 the Bank of England permanently stopped offering to redeem banknotes for gold.
From that day on, the pound has been a ‘fiat’ currency – meaning it has value purely because the government says so, and has no link to anything tangible whatsoever.
The gold standard, rebooted
Once World War Two ended, there was a clear need for a new arrangement to rebuild trust and facilitate international trade.
Returning to basing everything on gold seemed to work pretty well in the pre-war years. But that wasn’t going to work this time – for the simple reason that the US now held three-quarters of the world’s gold supply.
How did it accumulate so much?
First, in 1933, President Franklin D. Roosevelt issued an order banning American citizens from owning gold. All gold had to be sold to the government in exchange for paper dollars. This was intended to boost the central bank’s supply, and it did.
Another factor was that before entering World War Two the US supplied the Allies with weapons and other resources, which they paid for with gold. And because it entered the conflict later than other countries, the war effort also drained US resources less.
Good as gold
Indeed the US’s post-war power – as well as its quantity of gold reserves and general trust in the strength of the dollar – meant that the dollar was seen to be ‘as good as gold’. So, in 1944, a new system was devised and signed up to by 44 countries.
The new system had three defining characteristics:
The dollar was given a fixed value in terms of gold (1oz to $35).
Every other currency fixed its exchange rate in relation to the dollar.
Countries (but not individuals) could hand their dollars back to the US central bank (called the Federal Reserve) at any time, and receive the equivalent amount of gold.
This created a consistent and predictable basis for countries to trade with one another because everything was ultimately still based on gold. It established the dollar as a convenient, trusted currency that could be used for global trade
For example, the owners of a Japanese factory selling products to Greece might not want to receive drachmas in exchange for goods. But they’d be happy to receive dollars, knowing they could use those dollars in another international trade. Alternatively, they could convert them back into their home currency (the yen) at a pre-set exchange rate.
Goldilocks scenario
Under this system, currencies including the pound were effectively ‘backed by’ gold – just as they had been in the past – but with the dollar sitting in the middle to facilitate. And it worked: post-war stability was achieved and global trade was rebuilt.
For the system to continue functioning indefinitely, one thing was essential. Countries needed to believe that they would always be able to exchange dollars for a fixed amount of gold. In other words, they needed to believe that there really was enough gold to back up the dollars being issued.
All the US government had to do, therefore, was avoid creating millions of extra dollars without first accumulating more gold to back it up. Not too much to ask, in the scheme of things.
Oh. It was too much to ask. But – let’s be honest – not completely unexpected.
As we’ve already seen several times over, when leaders are given the power to create money and the full negative consequences will become some future leader’s problem, it often proves impossible for them to resist.
Under consecutive governments, the US ran massive social programmes, fought a lengthy war in Vietnam and raced Russia to the Moon. All of which required money the country didn’t actually have, so could only be achieved by creating more dollars.
When other countries realised what was going on, they started to lose faith that they’d be able to convert their dollars into gold in the future, because there couldn’t possibly be enough of it.
The upshot: many countries started exercising their right to hand back their dollars and demand gold.
Suspended animation
The US gold supply dwindled to the point where some kind of action was needed. So on 15 August 1971, President Nixon announced that the convertibility of the US dollar into gold would be ‘temporarily’ suspended.
In other words, on a temporary basis, $35 would stop equalling 1oz of gold – or any amount of gold. On a temporary basis, a US dollar would be backed by nothing – and therefore so would every currency with its exchange rate tied to the dollar.
That temporary basis has now been going on for 50 years and counting.
If questioned, I imagine most people would have the vague notion that something is giving value to the pound, the dollar or any other national currency. Either because they remember a time when there was, or because it just seems logical that there must be.
Yet since that day in 1971, there isn’t even the pretence that a currency is backed by anything tangible.
In principle, this means there’s nothing to prevent governments from creating as much of their own currency as they want to.
And naturally, as they have throughout history when the opportunity presents itself, they do.
More money, more price rises
When government take advantage of their ability to create more of their own currency, what happens?
A three-step pattern which we’re now very familiar with:
The amount of money in circulation goes up.
Each unit of money therefore becomes worth less – meaning you can buy less with it. (It loses buying power).
So prices – when denominated in pounds, or dollars, or whatever – go up.
Step 1 is why the amount of money in existence in the UK exploded in the late twentieth and early twenty-first centuries – to such an extent that everything before that point is barely visible, as you can see in the next chart:
Broad money (M4) in United Kingdom, 1900–2020, stated in millions of pounds sterling
The three-step pattern is also why, as this follow-up chart shows, the buying power of the pound has decreased so sharply (step 2 – and therefore also step 3):
Buying power of £100 over time, 1967–2021
And it isn’t just the pound. As you can see below, a whole host of major currencies have lost the vast majority of their buying power since the 1970s:
Buying power of 100 units of major currencies, 1967–2021. US dollar = black solid line, Australian dollar = black dashed line, German mark and euro = black dotted line, Japanese yen = grey solid line
Our new financial world
Ever since President Nixon made that announcement in 1971, we’ve been living in a completely new financial world. And that’s not hyperbole.
As we’ve seen, there have been times throughout history when the link between government-issued currency and an underlying ‘something’ (usually gold) has been weakened or broken. But the concept has always been there – in principle, at least.
Now though, for the first time, the only reason major global currencies have value is because governments say they do.
You could argue that this isn’t, in itself, a bad thing.
Clearly, a currency strictly backed by a fixed amount of gold isn’t dynamic enough to cope with extreme events. That’s why we’ve seen the normal rules abandoned during times of war. (However, you could also very reasonably argue that it’s only the overnight creation of large amounts of money that makes large-scale war possible – so it’d be better if governments were more restricted.)
A lack of restrictions also liberates the government to intervene in helpful ways in peacetime. For example, if an economic downturn causes widespread unemployment, the government can just create the money needed to provide jobs or welfare to prevent people from falling into destitution.
So flexibility can be positive, but it also has the disadvantage of introducing human nature.
Mo’ money, mo’ problems
If money had been created in tough times, then destroyed or repaid when conditions improved, that would be one thing.
Yet from the earliest moneyers to today’s governments, we’ve seen that once the value of money is diluted, it’s never reinstated. And since 1971, when the last practical constraint on money creation was suspended (‘temporarily’), we’ve witnessed a vastly higher amount of money creation than at any other point in history – with a corresponding effect on buying power.
As I explain in The Price Of Money, this certainly doesn’t affect everyone equally. Those closest to the source of the new money (or who have more of it to start with) often benefit, while everyone else suffers. I also explore the events of the years 2008 and 2020 in detail – both of which are on a par with 1971 in terms of how they’ve shaped the financial world we live in today.
To discover what happened next, grab a copy of Rob’s book The Price of Money: How to Prosper in a Financial World That’s Rigged Against You.
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