Harley Hahn - Economics Explained - The End of the Gold Standard

Money and
Economics

The End of the Gold Standard

(October 9, 2011)

Summary: Before the 1930s, most countries were on the "gold standard", which meant that paper currency could be exchanged for actual gold. During the Great Depression, U.S. President Franklin Roosevelt caused the federal government to hold and control the domestic supply of gold. He then raised the price of gold, enabling the government to issue more money, which he used to finance social and economic programs. In the 1970s, the United States formally severed its ties to what remained of the gold standard.

The DEPRESSION, or more formally, the GREAT DEPRESSION, was a long period of economic hardship that lasted from late 1929 to 1937. The downturn in the economy actually started in August of 1929. However, most people were not aware of what was happening until the stock market began to collapse on October 24, 1929 (referred to as "Black Thursday"). Within a short time, the economy of the United States deteriorated significantly and the Depression had begun in earnest.

In 1932, Franklin Roosevelt was elected President of the United States after promising to take forceful steps to improve the economic situation. By the time Roosevelt took office in March of 1933, conditions all over the country were appalling. Industrial production was down 56 percent from 1929 and over 13 million people, a third of the work force, was out of work. To make matters worse, farmers all over the country were going broke. (At the time, the U.S. was mostly an agrarian nation.)

One of the biggest problems Roosevelt faced was that a large number of people had lost confidence in paper money and were going to their banks to exchange their money for gold. This so-called "run on the banks" had happened several times since the 1929 stock market collapse, and it was happening again at the time Roosevelt took office. If a bank could not meet the demands of its depositors, it would have to close down. In 1929, there were 24,633 banks. By 1933, only 15,015 were still in business, a decrease of 39 percent.

A run on the banks was devastating for other reasons as well. Not only did it deplete the gold reserves, it removed large amounts of cash from circulation at the very time that the economy needed it most in order to recover. In fact, the decrease in the money supply from 1929-1933 was one of the reasons the Depression was so severe and lasted so long.

In 1933, much of the world, including the U.S. and many European countries, was on the GOLD STANDARD, which meant that paper money could be exchanged for gold. For example, you could, at the time, go to a bank and trade a dollar bill for a dollar's worth of gold. In other countries, you could either trade your currency for gold or, at the very least, trade for U.S. dollars, which could then be converted to gold.

By 1933, the U.S. was in big trouble and people all over the country were trading in their dollars for gold.

In normal times, few people would actually make such a trade: It was enough to know that it was possible. However, these were not normal times. By 1933, the U.S. was in big trouble and people all over the country were trading in their dollars for gold.

Roosevelt had to stop the flight to gold. To do so, he decided to change the system so that the U.S. government would hold and control all the gold in the country. In other words, he began to nationalize gold.

He did this for two reasons. First, he wanted to stop the run on the banks. Second, he was planning a number of expensive social and economic programs, and he needed money to finance them. Controlling the gold supply would give him more control over the money supply.

In 1933, with the cooperation of the U.S. Congress, Roosevelt made it illegal for Americans to possess gold coins or bullion. He then took away the right of Americans to be able to exchange paper money for gold. Finally, he confiscated all the privately held gold in the country by forcing people to trade it to the government for paper money at the rate of $20.67 an ounce.

Within a year, the U.S. government owned most of the gold in the country. Then, on January 31, 1934, Roosevelt used the authority given to him by Congress to unilaterally raise the price of gold to $35 an ounce. Overnight, an ounce of gold that used to be worth $20.67 was now worth $35. Making this price change allowed Roosevelt to pull a fast one, a monetary scheme that, even by today's standards, was totally awesome. Here is how it worked.

In 1933, the government was able to issue $20.67 in money for each ounce of gold that it held. In 1934, the same ounce of gold could support $35, a difference of $14.33. In this way, the value of the gold held by the government increased by about $3 billion, which meant that Roosevelt was able to create $3 billion in brand new money out of nothing. He could then use the $3 billion to help fund his new programs. In doing so, Roosevelt put a huge amount of new money into circulation, which helped the economy to recover.

After taking control of the U.S. gold supply, Roosevelt effectively devalued the U.S. dollar by 41 percent.

However, he did so at a cost. First of all, Roosevelt effectively devalued the U.S. dollar (with respect to gold) by 41 percent. Second, distancing the U.S. from the gold standard, he initiated a process that was potentially dangerous. If the U.S. ever went off the gold standard completely, and the government did not have the discipline to keep from creating too much new money, there would be trouble.

Four decades later, in 1971, the remaining U.S. ties to the gold standard were finally severed, by Richard Nixon, in an attempt to solve a serious cash flow crisis. The previous president, Lyndon Johnson, had escalated the Vietnam War at the same time as he initiated expensive social programs (the so-called War on Poverty). In 1969, Nixon inherited these obligations, which he extended on his own.

Both presidents had had trouble getting enough money, because neither they nor Congress were willing to raise taxes to support an increasingly unpopular war. To procure the money they needed, Johnson and Nixon borrowed, and then spent, billions of dollars. In the process, they infused a huge amount of money into the economy, which led to serious inflation. It also led to a balance of trade problem, in which the U.S. was importing far more than it was exporting. As a result, more and more U.S. dollars came to be held outside the country.

To keep foreign countries from trading in their surplus dollars for gold, Nixon, in 1971, unilaterally decreed that, from now on, the U.S. would not exchange dollars for gold for anyone. For all practical purposes, the United States was off the gold standard. In 1978, Congress passed a law making it official. Other countries had passed similar laws, and by the end of the 1980, no major currency was redeemable in gold.