3/13/2014 How the gold standard works, how the gold standard failed

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How the gold standard works
Related: Why is gold so valuable
What is a gold standard? A gold standard is a monetary system where gold is used to measure
the value of goods, services or investments in an economy. Printed money is used as legal tender
where it has an equivalent value of gold upon demand. This system ensures that issued notes by a
government is backed by the intrinsic value of gold. This gold standard was introduced in 1816 by
Great Britain to ensure ease of trade by using bank notes that represents a particular weight of
gold. It soon became universal for countries to use the gold standard in their monetary system.
Under the gold standard, prices of goods and services slowly deflated as the industrial revolution
gave way for more efficient tools and thus boosting output.
The value of money is higher under the gold standard because the resulting surplus of income from
lower prices turned into interest producing savings into banks, the banks then lend the savings to
finance projects that benefits the economy such as a new business venture for a car company.
Another factor is that once the savings was used to finance a major venture, few is left for real
money to be used therefore, credit for capital is harder to acquire until a sufficient amount of gold is
mined to back new currency issues. While this system prevents an economy from acquiring too
much debt than it can handle, the mere fact of a new project that cant be fully financed because
savings needed to finance it ran out can restrict an economy to expand or grow at a faster pace.
This system requires the economy to spend time in order to expand noting that the opportunity
cost for waiting to start the venture forgoes the benefits of possible revenues. Under the gold
standard, money can also be created or inflated to accommodate the necessary capital to finance
consumption or investment. However, once the public realise that there are far fewer gold than
there are paper currency, inflation can happen. But during times when people panic and make runs
to the bank to pull out their savings, a bank may not have enough gold to pay. As a result an
economic depression may occur, because inadequate gold to finance expansion causes a credit
crunch and a massive sell off occurs triggering one huge selloff after another.
Now, how did the gold standard fail? During periods of very high demand such as World War 1,
countries involved needed an unlimited supply of ammunitions and war equipment in order to win. A
victory is unattainable if the gold needed to finance the seemingly limitless demand for war
equipment is in short supply. This war scenario is equivalent to an expanding economy where
people's desire for goods and services are boundless, but without a boundless supply of capital
this cannot be attained and would always lead to a contraction. Countries involved in the war
abandoned the gold standard, at least temporarily to accomodate the limitless demand that gold
cannot keep up with.
But since World War 1 happened during the industrial revolution noting that efficiency for producing
goods was exponentially increased, prices of goods should continue to decline, then why did the
gold standard unable to deliver the required demand? The answer may lie in the technological
capacity to produce the required ammunition. The seemingly unlimited demand for war equipment
reveals a quota or limit to the quantity of items that a single equipment can produce per a
designated amount of time. Meaning, if 20 machines can only make 10,000 bullets a day and
bullets are consumed in the front lines at a rate of 50,000 per day, extra machines and man power
are needed to accomodate that demand. This would mean that extra workers and equipment are
needed to produce 50,000 bullets. If the daily cost to manufacture 10,000 bullets is $100,000, then
producing 50,000 bullets requires the manufacturer to buy 80 more machines and hire more
workers causing the daily production cost to increase to $500,000. It is now obvious that the
marginal cost to produce extra bullets to meet the demand would require additional capital and
thus more gold. This enormous demand coupled with the boundaries of technology would definitely
stagnate production if extra capital is not obtained. Gold restricts this mega expansion and the
gold standard was suspended for a fiat currency system.
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3/13/2014 How the gold standard works, how the gold standard failed
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sixerfixer1976 5 months ago
So, in other words, neither side could have afforded to produce war material
were it not for deficit financing -- that is, WWI could not have happened without
fiat money.
Sounds like a great argument FOR a gold standard...

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therooster 11 months ago
Good article even if the idiocy of the argument is 40+ years out of date. Gold's
historical problems of liquidity (economic reach) that the author describes are
accurate for the specified time period, but why is the fact that gold then had
FIXED trade values overlooked. Monetary gold's liquidity is the product of
(weight x trade value), not weight alone. When gold has a static fix on its value,
such as it had throughout history, the only way to increase monetary gold
liquidity is to bring up more gold from beneath the ground. Not so anymore. The
trade value can rise. Gold at $1500/oz has a great deal more liquidity than gold
that trades at $35/oz. Real-time capabilities have much to do with this .... so
it's true ..... you cannot pour new wine into old wineskins.

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guy a year ago
So in other words.....Don't start a freaking war Einstein.

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OpposingVue a year ago guy
Great idea, guy... except what happens when someone else starts one,
like Germany did to its neighbors in 1941? Or when 19 members of al-
Qaeda drop planes onto US buildings, killing thousands? What then?
Send them an angry letter?

1
Paul Robinson 2 months ago
This ignores the fact most of the cost of anything is the overhead to produce it,
not the raw materials. If they're making bullets they're charging something
more than mere cost of materials and labor, there's electricity costs, overhead
for operating the factory, depreciation on the machines and profit. Or you're
kidding yourself right into Chapter 11. So now, if they need to make 50,000
bullets, certain overhead costs are already absorbed by the first 10,000. The
factory overhead, heating and cooling, payroll for the office people and so on is
already absorbed, so either the manufacturer makes more profit for making 5
times as much, or can cut prices since the volume is so much greater that
they get more efficiencies (an order of 2 tons of steel costs more per ton than
an order of 10 tons for the same reasons), so the costs do not go up linearly.
But wars always have to be deficit financed because no government has the
money to fight a war out of its checkbook; they have to collect taxes to pay for
them and they're already collecting plenty, and typically governments do not
have huge reserves. Thus the only way they can finance a war is through
plunder or through borrowing, then if they win they plunder the losers (or their
own citizens later) to pay for it. If they lose, those who bet on their side by
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3/13/2014 How the gold standard works, how the gold standard failed
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