Gold is at or near all-time highs of $3,000 per ounce or more. Let’s look at the evolution of gold from global currency to guarantor of stability and store of value, to its place in the modern economy.
The Original Currency
Gold was the preferred currency of the ancient world, followed by its less lustrous cousin, silver, when bartering for goods was too cumbersome or the goods were too varied in value. The ancient Egyptians c. 3100 BC were among the first to set a relative value between silver and gold across their empire. This ratio was 2.5 ounces of silver to 1 ounce of gold (silver’s greatest known valuation to date). And thus, the gold/silver ratio was born.
Several centuries later Julius Caesar set the ratio at 12:1. This intervention by the Roman government is presented as an early and important instance of recognizing the role of gold and silver in maintaining monetary stability and facilitating trade within its vast empire. The aim was to create a stable and efficient economic system by establishing a clear exchange rate between the two precious metals.
The gold/silver ratio remained largely unchanged for thousands of years, still standing at 12:1 in 1450 AD. The ratio once again increased in 1792 to 15:1 as a result of the Coinage Act of the newly minted United States of America. The following graphic illustrates the gold / silver ratio over a 200-year period. Notice how steady it was during the 19th century and how through events and market forces it began to fluctuate wildly. Today the ratio is about 96:1.
From Currency to Guarantor and Store of Value
Gold as a direct commodity currency had several problems – transportation, difficulty of division, volatility of supply, and lack of uniformity. It also made daily transactions cumbersome.
These problems faded with the widespread adoption of fractional reserve banking. (Banks hold only a fraction of deposits on hand while the remainder is loaned out.) In the 17th century onward, the role of gold shifted from daily use currency to that of guarantor and store of value. The increasingly common “fiat” currency, representative money generally in the form of paper notes, was backed by and redeemable for a like amount of gold or silver. Thus gold remained very important as a financial commodity and store of value. We know this as the gold standard.
From 1870 to 1914 the gold standard reigned across global finance and trade. It stabilized trade and enabled global economic growth. The gold standard had these notable benefits:
- Price Stability: The system restricts the potential for inflation by connecting the money supply to a set amount of gold, as the money in circulation can only grow if the nation's gold reserves increase.
- Fiscal Discipline: The gold standard prevents governments from printing money excessively to finance deficits, as they need sufficient gold reserves to back their currency.
- Reduce Trade Uncertainty: The gold standard stabilizes international trade by minimizing currency fluctuations.
- Maintenance of Gold Reserves: Governments and central banks maintained gold reserves to support national currencies and ensure convertibility, which was crucial for maintaining confidence and stability in the monetary system.
- Direct Convertibility: Direct convertibility of currency to gold at a fixed rate restricted government monetary policy. Excessive money printing could lead to loss of confidence, currency redemption for gold, and economic collapse.
As attractive as these benefits are, the gold standard would prove too inflexible in the face of severe financial crises. The two major factors that led to the global abandonment of the gold standard were:
- World War I: Countries suspended converting currency to gold to fund war via money printing, causing inflation.
- The Great Depression: The gold standard's inflexibility hindered countries from using expansionary monetary policies to fight deflation and gold outflows, forcing many to abandon it for greater flexibility.
After World War II the Bretton Woods system emerged which represented another form of modified gold standard. The US dollar was pegged to gold at a fixed rate of $35 per ounce, and other member countries then pegged their currencies to the US dollar. The United States committed to converting dollars into gold for foreign governments and central banks.
The system provided a degree of stability to the post-war global economy.
However, by the late 1960s and early 1970s, the system faced increasing strain due to factors like the Vietnam War, rising US inflation, and a growing supply of US dollars held abroad that eventually exceeded US gold reserves as this graph illustrates.
In August 1971, President Nixon ended the dollar's convertibility to gold, effectively ending the Bretton Woods system and ushering in the era of floating exchange rates and fiat currencies. This move was driven by factors such as war pressures, limitations of the gold standard during economic crises, and a growing desire for greater monetary policy flexibility.
This table highlights the benefits and problems with real money and fiat currency systems.
The crucial element that underpins the value and acceptance of fiat currency is the “full faith and credit” of the issuing government. This became especially important after the Bretton Woods system, when global currencies were no longer backed by gold and became fully fiat.
Gold in the Modern Economy
Gold plays a multifaceted and enduring role in the modern economy, even in the era of dominant fiat currencies. Its significance spans finance, industry, central banking, and culture.
Gold is considered a reliable store of value, a perception rooted in its historical usage, physical properties (resistance to corrosion), and acceptance as a medium of exchange. It acts as a safe haven during economic uncertainty. In investment portfolios, gold is frequently included for diversification due to its low correlation with traditional assets like stocks and bonds.
This chart shows the price of gold from the final abandonment of the gold standard in 1971 to the present. The gray areas are recessions.
It serves as a hedge against inflation and the devaluation of currencies. During periods of market volatility and economic uncertainty, its role in risk management becomes prominent. Investors can access gold through physical gold (bars, coins), gold funds (ETFs, mutual funds), equities of mining companies, and futures and options contracts.
Increased demand for gold from central banks globally underscores its growing significance as a stable and tangible asset in the international economic system.
Gold is vital in electronics and technology due to its high conductivity and resistance to corrosion. It's a critical component in numerous technological applications, including wearable diagnostics.
In medicine and healthcare, gold is increasingly used in rapid medical diagnostic test kits (e.g., for COVID-19) and various medical devices. Emerging research continues to find new industrial uses for gold as a nanomaterial in diverse products and potentially in fields like space exploration.
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Spencer Wright is an investment advisor with Halbert Wealth Management, Inc. and a regular contributor to Forecasts & Trends. He has been with HWM for over twenty-five years and serves on the Due Diligence Committee and the Investment Committee. His experience in domestic and international investments gives him valuable insight to those markets.
