Governments and central banks like to pretend that gold is unimportant and is a relic of the past.

This is wrong.

While we no longer operate on the gold standard, and instead operate on the fiat standard, the yellow metal is of critical importance to the functioning of our monetary system.

Otherwise, why would central banks bother holding it as reserves?

Nixon may have ended the formal tie of the US Dollar to gold in the 1970s, but the existence of over 8000 tonnes of gold on the Federal Reserve’s balance sheet provides an informal link in what Jim Rickards calls the “shadow gold standard.”

The existence of gold on central bank balance sheets gives credibility to the fiat system and it means the fiat system is not entirely disconnected from gold.

Without that gold, public confidence in fiat money would potentially falter as currency creation expanded. Without that confidence, the system could not last long.

As Rickards notes:

“The confidence of the entire global financial system rests on the U.S. dollar. Confidence in the dollar rests on the solvency of the Fed’s balance sheet. And that solvency rests on a thin sliver of … gold.”

Human Tendency Is Towards Sounder Money Over Time

In The Fiat Standard, Saifedean Ammous explains the human tendency towards sounder money over time:

“The history of money…shows a natural progression of money from easier to harder media over time. Salt, cattle, glass beads, lime stones, seashells, iron, copper, and silver had all been used as money in various times and places, but by the end of the nineteenth century, the entire globe was practically on a gold standard.”

Gold emerged over thousands of years as the hardest and soundest form of money because of its unique chemical properties. It was the most effective way to store value over time.

The move to fiat money would, at first glance, seem to be a deviation away from this trend towards sound money and a devolution towards an inferior form of easy money.

However, as Ammous outlines in The Fiat Standard, the move to fiat money was primarily to facilitate an easier transfer of value over space.

In the late 19th and early 20th centuries global trade was exploding and the main limitation of gold was exposed – it is expensive and cumbersome to transport over long distances.

cargo-of-gold

A cargo of gold from the Klondike on the Seattle waterfront, 1899

Fiat money emerged to solve this problem and to allow for more efficient global commerce. However, as Ammous explains, while fiat is superior at transferring value over space, it is inferior at transferring value over time. Fiat money has a tendency towards debasement and it loses value over time.

However, fiat money did not just emerge overnight as a new system that displaced the old one. Fiat was birthed from the gold standard and the transition took several decades.

Gold remained a crucial part of the system every step of the way and remains a crucial part of the system today.

The Slow Transition From The Gold Standard To The Fiat Standard

The classical gold standard emerged in the 1870s when the largest economic powers in the world – Britain, the USA and Germany – had all abandoned bimetallism and adopted a mono-metallic gold standard.

Gold then became the world’s monetary standard.

Paper money circulated, because it was easier to transact in than gold. But the yellow metal remained the true money, with the paper merely a receipt that entitled the bearer to redeem their paper for gold.

The requirement for banks to be able to redeem paper money for gold provided a restraint on their ability to create new currency units and the world operated in a glorious period of remarkable monetary stability.

The classical gold standard ended in 1914 when the European powers suspended convertibility of their paper money into gold. This allowed them to finance World War One through currency creation, rather than taxation and thus pass the cost onto future generations.

Of the world’s major powers, only the USA remained on the gold standard, however they too abandoned it not long after in 1933.

While World War One provided the first step away from gold and towards fiat money, the Great Depression provided the second.

After the European powers had briefly returned to a form of the gold standard in the post-war environment, the depression caused them to reverse course once again.

In the USA, President Roosevelt put an embargo on the export of gold, confiscated it from private citizens and devalued the US Dollar by repricing it from $20.67 an ounce to $35 an ounce.

fdr-gold-reserve-act

President Roosevelt signing the Gold Reserve Act 1934

Gold still retained an important role in the US monetary system as reserves. However, since the public could not redeem their dollars for gold, this system was not a true gold standard.

In 1944 a new global monetary system emerged from the Bretton Woods conference that took place towards the end of World War Two. The US Dollar would remain tied to gold at $35 dollars an ounce and the dollar would be used as the world’s reserve currency. Foreign currencies would be tied to the US Dollar at fixed exchange rates.

Foreign governments were free to redeem their US Dollar reserves for gold at the agreed price of $35 dollars, although private citizens were still forbidden from doing so.

Again, while this was not a true gold standard in the formal sense of the term, gold still retained an important role in the US and global monetary system.

Fiat currency units in the form of US dollars and other national currencies all had a clearly measurable link to gold, with the yellow metal underpinning the integrity of the entire system.

This changed again between 1971 and 1973 when President Nixon famously “closed the gold window.”

After the US had been inflating her currency, European nations had been exercising their right under Bretton Woods to exchange dollars for gold at $35 per ounce.

This led to an outflow of gold from the USA. Rather than restore confidence by bringing soundness to the dollar, Nixon suspended the right of foreign governments to exchange dollars for gold. He also devalued the dollar by repricing gold from $35 to $42.22, which is the price at which it remains on the Federal Reserve’s balance sheet.

Soon after private citizens were once again allowed to purchase gold which freely traded at market prices, irrespective of the government price.

What this meant was that the US Dollar no longer had any ability for official redemption in gold, either by private citizens or foreign governments. The US Dollar became a fully fiat currency.

All other national currencies had been tied to the US Dollar under Bretton Woods. So once the dollar’s tie to gold was severed, the ties of all the world’s currencies were also severed.

They no longer would trade at fixed exchange rates, but would freely float at market prices.

Gold’s Role In The Current Fiat System

These actions in the early 1970s completed the transition from the gold standard to the fiat standard that had begun in 1914 with the outbreak of World War One.

What is important to note is that the transition took place over decades and was a gradual evolution rather an abrupt starting of one system and stopping of another.

It is highly unlikely that the public would have accepted the current system if it had been forced upon them overnight. Instead they were gradually weaned off gold and became used to fiat money, even as its link to gold diminished over time.

However it is also important to note that gold was part of the monetary system through every transition between 1914 and 1971. It never ceased to be the integral part of the system that every other moving part was based on.

Even though Nixon suspended the convertibility of fiat currency into gold at a fixed price, the US has not sold its reserves of the yellow metal.

central-bank-gold-reserves

Source: World Gold Council

Central banks around the world continue to hold and buy gold because they recognise that it is money. It may not be the monetary standard anymore but it is the key reserve asset that gives the system its credibility.

Jim Rickards explains in The New Case For Gold:

“It is generally believed that President Nixon closed the gold window on August 15, 1971, and the United States has been off the gold standard ever since. And two generations of students have since been rigorously conditioned by policy makers and professors to believe that gold has no role in the international monetary system. The truth is, gold has never gone away. The power elites stopped talking about it and publicly ignored it, yet they held on to it. If gold is so worthless, why does the United States have more than eight thousand tons? Why do Germany and the IMF keep approximately three thousand tons each? Why is China acquiring thousands of tons through stealth and Russia acquiring more than one hundred tons a year? Why is there such a scramble for gold if it has no role in the system? It’s highly convenient for central bankers to convince people that money is unconnected to gold because that empowers them to print all the money they want. Everyone from Ben Bernanke to Alan Greenspan and others have disparaged gold, saying it plays no part in the system. Along with the power to control money comes the power to control behavior and politics. Still, gold is the foundation, the real underpinning, of the international monetary system.”

Rickards also notes that the Federal Reserve still prices its gold on its balance sheet at Nixon’s price of $42.22. This supports their goal of minimising the role of gold in the international monetary system and maintaining public confidence in fiat money. But if they were ever to mark that gold to the market price, suddenly the Fed would appear much more solvent than they currently do.

So fiat money still has a link to gold in the sense that it is backed by gold reserves in central bank vaults even if this is not publicly admitted.

That is why the creation of new currency units over the decades since 1971 has resulted in an explosion in the gold price, now freely priced by the market.

Gold isn’t rising in value. It is rising in price, which is more accurately seen as a fall in the value of the dollar. The dollar’s value is falling because the creation of new currency units dilutes the value of those already in existence.

Gold is still performing the function which it has for centuries and preserving purchasing power over time.

Could the fiat system survive without gold? I think that is unlikely and that is why it has never disappeared from the system entirely.

Threats to the Fiat Standard

Could we go back to something like the classical gold standard if the fiat system collapses?

This is possible but I think it is unlikely. I believe that if the current fiat system were to collapse, the likely scenario would be that it ends up being re-engineered with gold playing a much greater role in a new fiat system.

This is the scenario that Rickards outlines, suggesting that a $10,000 price would restore stability to the financial system in its current form.

I personally think that the biggest threat to fiat actually comes from Bitcoin.

Saifedean Ammous makes the case that Bitcoin has the ease of fiat in transacting and maintaining value across space, with the security of gold in transacting and maintaining value over time. It basically combines the best of fiat and the best of gold without the drawbacks.

In a Bitcoin standard the role of gold would be greatly diminished.

While we may move to a Bitcoin standard in the future, this is only speculation. This story is still unfolding and we don’t know how it is going to play out.

As it currently stands, we are on a fiat standard that rests on a thin sliver of gold. This is the status quo and in this system, it is incredibly important. Its importance has never gone away.

As an individual who wants to be protected from the loss of value in fiat money by the additional creation of new currency units, it would make sense to hold some gold.

Conclusion

We currently live in a fiat money system. But it is not a purely fiat system.

It emerged gradually from the gold standard and retains a small but important tie to the yellow metal.

Fiat money is not formally redeemable for gold at a fixed price set by the government. But the fact that central banks retain gold as reserves gives confidence to fiat currencies and confidence to the global monetary system.

As an individual investor, even though you cannot redeem your fiat for gold through government channels, you can freely exchange your fiat for gold on the open market.

As the value of fiat currencies continues to decline, that is an option well worth considering.


Home > Why Buy Gold > Why Gold Is Important

Sources

Ammous, Saifedean. The Fiat Standard. Saif House, 2021.

Rickards, James. The New Case for Gold. London, Penguin Business, 2019.

Image Credits

Gold Bars by Jingmin Pan on Unsplash

Cargo of Gold is in the public domain

President Roosevelt signs the 1934 Gold Reserve Act is in the public domain

2021 Central Bank Gold Reserves published by the World Gold Council