How Does A Gold Backed Currency Work?

June 12, 2019

How does a gold backed currency work

Why Even Bother With How a Gold Backed Currency Works?

Breaking down how does a gold backed currency works can help you understand the economics of gold investing. It can also help you answer whether we should go back on the gold standard. At first glance, a gold backed currency is just where a country's legal tender has a fixed amount of gold backing it. You might think this means a fixed amount of currency will often be redeemable for a fixed amount of gold. Is that really the case?

What Does a Gold Backed Currency Mean?

There are three kinds of gold standards. These are “circulating gold,” “bullion exchange,” and “currency exchange” systems. A circulating standard is the historic system of releasing currency made of precious metals. A bullion exchange is where the government will exchange a fixed amount of fiat currency for bullion. Finally, a currency exchange involves an effective gold standard where you can exchange currency at a fixed rate for another currency tied to gold.

In all cases, the amount of banknotes and coins that a nation can produce will be limited to a fixed amount of gold. Gold is an asset with intrinsic value throughout the world due to scarcity, as well as industrial, investment, and jewellery use. However, it is generally in a nation’s interest to use and print cash. Originally, most nations try to back that cash with gold reserves, and most continue to have gold reserves.

Despite having large reserves, many nations still want more spending power. As such, they make their money indirectly and then directly from less scarce resources. The paper and coins most countries use today is not just non-exchangeable, but is backed by nothing more than a promise. Effectively, there is much less in the way of collateral backing your money.

Let's Look at How Gold Backed Currency Worked Historically

The United Kingdom was the first nation to adopt the modern economic notion of a fixed rate gold-backed currency, in 1861. Not long after, it became universal for countries to use the gold standard in their monetary system. In fact, it was soon found necessary for the stability of the global economy to have currency backed by something as scarce and valuable as gold. At the same time, it was also deemed important that currency was simple to hold and exchange.

Following this system, countries operating in a trade surplus would gain additional reserves of gold. On the other hand, nations operating in a trade deficit would suffer from depleted gold reserves. As gold reserves were depleted, countries had a harder and harder time taking one easy debt to print money. This may seem scary until you remember that our economy gets bigger over time. That means that everyone wins over the long term as long as we act reasonably.

“We have gold because we cannot trust governments.” – Herbert Hoover

The political reality is that governments are always trying to make promises they can’t keep with money they don’t have. Historically, governments would need to raise taxes, or cut spending elsewhere to raise money to fulfill their promises. Often, creative governments would also partner with private citizens, groups, and most recently corporations, to achieve certain goals. However, the oldest trick in the book - it is recorded as far back as Ancient Rome - is to magically make more money!

Since we no longer use gold coins that governments can literally shave, our government just adds to the money supply. The fact that national projects cannot be fully financed without adequate savings in place no longer restricts nations’ ability to grow rapidly.

But it’s not just growth countries are after. What governments really want is to be able to produce more. Wars are the best example of this. It is widely claimed that the First World War provided the most extreme evidence of the limitations of the gold standard. What happens when a country needs to produce, in aggregate, more than it can? Demands for war equipment and ammunition are endless.

The right equipment is essential to victory. As such, warring countries often abandon 'the gold standard' to accommodate the boundless demand for weapons and ammunition. That’s what most governments began thinking about during and after the great wars.

How Does a Gold Backed Currency Work in the Face of Severe Trade Imbalances?

It was soon realized that a nation running trade surpluses could not supply other countries with enough of its currency to match demand. On a gold standard, only a nation intentionally running a policy of large trade deficits can continue to meet global demand. In doing so it will be effectively exporting, for example, gold-backed dollars in exchange for good and services. This was part of the reason why Richard Nixon abandoned all final traces of a gold-backed currency in 1971. The rest of the world followed suit soon after.

‘Fiat’ currency is etymologically derived from the Latin word 'fieri', which means an arbitrary act. It’s true value is determined only when compared to other currencies. These days, national currencies are backed by nothing. They are considered valuable because governments tell us so, and we obey. Without this acceptance, our credit-fuelled financial system would be severely changed.

Cryptocurrency has risen up as the bizarreness of 'fiat currency' continues to be exposed. The great recession and other financial upsets continue to fuel an interest in understanding and mitigating the risks of promise-backed money. Bitcoin, however, has the same underlying challenge as fiat currency.

In assessing whether Bitcoin is a better investment than gold, the fact that it doesn't physically exist makes you wonder whether it really mitigates the risks of fiat currency. Moreover, it’s extreme volatility, up to almost $20,000 in December 2017, and subsequent fall suggests that it is both unreliable and asking for regulation.

Investing in a World of Fiat Currency Means More Risk Management.

Having been released from the gold standard, currencies proceed to get devalued repeatedly. Gold has shot up as an investment in correlation to these repeated attacks on the integrity of money. While governments maintain huge reserves, these gold reserves no longer have a clear correlation to currency value. One reason for this is that countries can print out more currency anytime.

Gold remains as, if not more, valuable in the eyes of many traders as it was before fiat currency existed as it does now. As such, investors continue to invest and speculate in gold. Exceptionally astute invest use gold to protect themselves against the threat of hyperinflation and devaluation of currency. They also see it as insurance against major economic downturns. These investors believe we may return to a gold-backed currency one day, and that's part of the reason why the value of gold has increased at a similar rate to inflation over the years.

The risk of hyperinflation is one of the biggest flaws of a fiat currency. There is little preventing a government from printing an excess of additional banknotes if it believed this was best for its economy. Many investment experts consider it sensible to put some money towards a hedge against other investments collapsing. Our historically-based informational guide may help you determine how much gold you should own in your portfolio.



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