Since coins began to be used in commercial transactions, precious metals played a fundamental role since they constituted the raw material with which they were minted and what gave them intrinsic value. The arrival of paper money changed the concept since the bills were titles that could be exchanged for gold or silver. The end of the so-called gold standard ended that convertibility and turned the currency into “fiat” money, backed only by confidence in the government that issued it. What was that gold standard, and how did it work?
The basis of the operation of the gold standard was the physical metal itself, which supported the issuance of money: the value of each monetary unit was fixed in terms of its equivalence with a specific amount of gold.
In this way, the currency issuer guaranteed that that amount of gold-backed the bills and coins. If both gold and silver were used to back the currency, the system was called the “bimetallic standard.”
This system of equivalence between money and gold has formed the basis of the international financial system and has guaranteed its operation since the 19th century. However, after the First World War, the situation began to change. Some war-affected countries found themselves obliged to print more paper money in order to finance the war effort.
Fiat money and hyperinflation
That paper money was no longer backed by precious metal but a simple promise to pay from the issuing state. It was based on simple trust, hence the name “fiat” or “fiduciary” money.
However, the citizens’ confidence in their states began to break when the latter continued to print money to finance themselves at the expense of the former without having any guarantee to back the issuance.
Consequently, the cost of living multiplied by two million, and the economic situation became so unsustainable that many consider it the breeding ground in which the rise of the Nazi Party to power was generated.
The Bretton Woods Agreements and the gold standard
With the end of World War II in sight, on July 22, 1944, a total of 44 nations met at the Mount Washington Hotel in Bretton Woods (New Hampshire, USA), intending to put into operation a new post-war international economic order and avoided the problems that arose after the end of the First World War, which ended up giving rise to the second.
The Bretton Woods meeting, sponsored by the United States, which had emerged from the war as the world’s greatest economic power, sought to achieve stability in international trade transactions through the creation of an international monetary system based on a type of solid and stable exchange, with the dollar playing the role of international currency.
Among the so-called Bretton Woods Agreements was the adoption of the gold standard as an element of stabilization of this international currency. The United States agreed to maintain the price of gold at $35 an ounce, and the exchange of dollars for gold at that price was authorized without any restriction or limitation.
In this way, it was possible to keep the dollar stable, which would serve as a reference for the other countries to set the price of their respective currencies at a parity with the US currency that could only fluctuate by 1%.
Nixon and the end of the gold standard
The system built at Bretton Woods worked for almost three more decades until another war, that of Vietnam, precipitated its demise. In 1971, the economic situation in the United States began to deteriorate due to the increasing expenses of that war. The Government began to print billions of dollars to finance it, which caused the devaluation of the dollar.
Countries like France and Great Britain demanded the conversion of their dollars into gold, which reduced the metal reserves that the US government accumulated in Fort Knox (Kentucky) and forced the then president, Richard Nixon, to intervene to repeal part of the Agreements. Bretton Woods and end the gold standard.
From that moment on, dollars were no longer backed by physical gold, to be based on trust in the US state and economy; that is, “fiat” money arose. From an international monetary system based on a fixed exchange rate of the dollar for gold, they moved to one of fluctuating exchange rates.