The Gold Standard

The supply of gold controlling currency in circulation had the potential to grow sharply and unexpectedly with discovery. After the California gold rush in the 1850s there was a lean period where the supply of gold remained stable. The consequence was that the prices of commodities dropped on a global scale. This hurt both producers and debtors, which especially hurt farmers. Critics of the gold standard began to champion including additional precious metals to expand reserves.

Then, in the 1890s, two gold prospectors in South Africa discovered a gold-bearing reef, which would prove to be “an outcrop of the largest goldfield in the world.” A few years later gold production had jumped by 50%, bringing the gold drought to a swift conclusion and making South Africa the world’s largest producer of the precious metal. “Prices for all goods, including agricultural commodities, once again began to rise.”

Imagine that all of the world’s major currencies were tied to a mass of metal that in totality barely “filled a modest two-story town house.” In 1914, 59 countries had adopted the gold standard, which legally required that all paper money be freely convertible into its gold equivalent. For this market to function, all major central banks maintained gold bullion for immediate exchange.

Central banks maintained the right to issue currency (or “print money”), but in order to do so each central bank was required by law to maintain a certain quantity of physical gold in relation to the amount of paper money in circulation. The lever available to control the flow of currency in and out of the economy was the cost to borrow, or interest rate.

It was like turning the dials up or down a notch on a giant money thermostat. When gold accumulated in its vaults, it would reduce the cost of credit, encouraging consumers and businesses to borrow and thus pump more money into the system. By contrast, when gold was scarce, interest rates were raised, consumers and businesses cut back and the amount of currency in circulation contracted.

Having the amount of paper money in circulation tied to a specific quantity of gold required that governments lived within their means. Central banks could not print beyond money beyond the reserves available or manipulate the value of the currency because it was tied to the value of gold. This kept inflation low for so long as the amount of gold in the world remain fixed.