40th Anniversary of the End of the Gold Standard

Chart created using Omega TradeStation 2000i. Chart data supplied by Dial Data.

Monday, August 15, 2011 marked the 40th anniversary of President Richard Nixon dropping his bombshell on the world's financial markets by announcing that he was ending the convertibility of the US dollar into gold. At the time gold was fixed to the dollar at a price of $35 per troy ounce. That now seems almost laughable as gold prices are currently above $1,800.

It wasn't long after that decision to end what in effect had been the gold standard that the modern era of floating exchange rates and paper money currencies (or, as they are more properly known, fiat currencies) was ushered in.

The modern gold standard had existed in various forms since 1870, when countries began to peg what was then a silver standard for currencies to the gold standard of the United Kingdom or the US. While there were troubles with it, particularly through WW1, a gold bullion standard did survive that war. There were further problems with the gold bullion standard during the Great Depression and WW2, but the Bretton Woods agreement of 1944 fixed currency exchange rates to the US dollar, which itself was fixed at $35 per ounce of gold. That arrangement lasted until August 1971.

The end for the gold standard came as the US flooded the world with US dollars as a result of the financing of the Vietnam War, the social programs of the 1960s and a big increase in military spending. The result was that was some loss of confidence in the US dollar as the world's reserve currency, and in turn that resulted in flight out of US dollars and a run on the US gold reserve. There was also a story that a foreign central bank had asked the US to redeem billions of US dollars for gold, which would have stripped the US of its remaining gold reserves. Instead, the US defaulted in effect and the gold standard ended.

Since then the US dollar has lost almost 90 per cent of its purchasing power (the US$ Index is down roughly 40% in the same time frame) while the price of gold has soared to$1,800 a more than 50-fold increase. The world, now dominated by fiat currencies has seen a massive increase in both money supply and debt.

Both central and private bankers were happy to see the end of the gold standard. The central banks felt they could now do more on the monetary side to manage their economies; private banks could now expand their business exponentially.

Fiat currency is created by continually expanding the money supply, which also results in a massive increase in debt. In 1971 US M3, the broadest measurement of money supply was about $800 billion. M3 is no longer calculated by the Federal Reserve but has been estimated by www.shadowstats.com to be over $14 trillion today. Similarly, US Federal debt has expanded from $400 billion in 1971 to almost $14.6 trillion today. As well the US has unfunded liabilities of approximately $115 trillion.

A loss of purchasing power coupled with diminishing returns from monetary and debt expansion have today put the world on the brink of a crisis. It is very possible that the numbers noted above could double again within three years, yet the world will be no closer to resolving the debt crisis than it is today. Creating more money and debt merely adds fuel to the fire and risks turning into hyperinflation.

Since the end of the gold standard the world has suffered a long series of financial crisis often with each crisis worse than the previous one (1974-1975, 1980-1982, 1987, 1990-1992, 1994-1995, 1997, 1998, 2000-2002, 2007-2009 and 2011-?); each and every one has resulted in a further expansion of money and debt in order for the western economies to buy their way out of the previous crisis. Except now it is no longer working or it will take such a massive expansion of money and debt that it is no longer feasible. What at first allowed the world, particularly the Western economies, to reach a high standard of living is now threatening to collapse and hurl the Western economies into default.

The US dollar is the world's reserve currency and is not likely to be replaced any time soon despite cries to do so. The US could resolve at least some of its problems simply by raising taxes to the levels seen in many other countries. Its dysfunctional politics makes that unlikely. It is more likely that the US will merely continue to devalue its currency and inflate its way out of its debt problem. That might prove difficult as the other major currency, the euro, is in even worse shape with entire countries that make up the Euro zone teetering on the brink of bankruptcy threatening the existence of the Euro itself.

There are also at least a good minority calling for a return to a gold standard. That too is unlikely to happen soon, as it is clear from recent statements by Fed Chairman Ben Bernanke that he does not even consider gold to be money, despite its 3,000-year history of being money. It is more likely that the financial crisis will have to reach an even more critical stage to see the monetary authorities contemplate a return to a gold standard even a partial gold standard.

Fiat currencies have all eventually collapsed. This is not to suggest the demise of the US dollar tomorrow, as the disappearance of a fiat currency can take decades or even centuries. The current experiment is only 40 years old but is clearly in trouble.

The problem with any fiat currency is that it can be abused. Whenever trouble brews, a government can resort to the printing press (or, more euphemistically, expand money supply and debt). Nick Barisheff, the president of Bullion Management Group, the manager of the BMG BullionFund, notes that fiat money is created out of thin air, backed by debt, printed without limit, and that its value decreases as the amount of printing increases. Unchecked the final result is hyperinflation where the currency eventually becomes worthless and no one will accept it any longer even if the government still insists on calling it money.

Gold on the other hand is a store of value, has no liability, and is in limited supply. There is today over $200 trillion of paper assets around the world, yet all of the above ground gold in the world would fetch only about $8 trillion at today's price.

Gold is under-owned. Central banks have roughly one-third of it, private hands have another third, and the remaining third is in jewellery and others. All the gold ever mined remains above ground today. Many fiat currencies have disappeared for ever. Yet check the portfolios of most portfolio managers, pension funds and other institutions. They have very little gold (or silver which also has a long history of being money) but lots of paper assets.

The monthly chart of the US dollar above shows how its value has fallen over the years. After the ending of the gold standard, it fell relentlessly through the 1970s. This was reversed in the early 1980s when the world's central banks banded together to raise its value. This worked for a few years until the Plaza Accord set the US dollar off in the downward direction once again. The next turning point was the 1994 bond crisis, when the world's central banks, led by Japan who was concerned about is soaring Yen, reversed the US dollar's fortunes again. That ended in the early part of this past decade and now the dollar sits at another crossroads.

This chart could be interpreted bullishly for the dollar provided it sees no new lows. A lot of people expect it to collapse. But with the Euro in even worse shape, one could instead see a strong US dollar rally before another crisis erupts. Fiat currencies are taking turns at being leaders in a race to the bottom. Gold meanwhile is now rising even as the US dollar goes up. It is a reflection of the loss of confidence in fiat currencies.