Most people have probably heard of the gold standard and most are under the notion that the gold standard is a system whereby a country’s currency was backed by a certain amount of gold stored as reserves in each country’s respective central banks. Well, to an extent this is true however; the ‘gold standard’ is much more complex than money representing the amount of gold held in reserves.
To begin with, it must be understood that the gold standard was a monetary system whereby anybody in a country that uses this monetary system would be able to take a certain amount of money to a bank and exchange that sum of money into gold or vice versa, this however is only in theory as the main function or objective of the gold standard was to maintain economic stability due to the fact that when a currency is backed by gold unit for unit, it creates trust in the currency. Historically the gold standard had its genesis in Great Britain, when in 1694 the Bank of England issued bank notes that were back by gold and convertible back to gold by the bearer of the bank notes. As time went by, towards the end of the 18th century a surplus of paper currency was observed which caused the suspension of the convertibility of these bank notes to gold (basically there was more bank notes than there was gold – the first incident of money being overprinted – causing the notes to lose value as they had to be re-valued according to the amount of gold that was actually physically present in the vaults). The suspension was eventually removed and the gold standard was re-established in 1821 and most other countries realising that it was a practical way to place value on paper money soon followed suit – hence the gold standard became the monetary system that lasted until the advent of World War I when it was again suspended only to be reinstated soon after. However immense pressure stemming from the post war world and the dawn of the Great Depression fractured the system to a point that by 1933 both Great Britain and the United States of America exited from the gold standard and withdrew gold from circulation entirely (Elwell, 2011) only to be replaced by the Bretton Woods system in 1944. The Bretton Woods Agreement was a similar monetary system that was is generally described as the ‘gold exchange standard whereby the gold standard was maintained without domestic convertibility.
The Bretton Woods Agreement
Without doubt the Bretton Woods agreement was the first completely negotiated monetary policy that was agreed by independent industrial nations collectively that was proposed in order to govern financial transactions. The system was conceptually sound when it was imposed as each participating nation was obliged to adopt a monetary policy that would bind the exchange rate of its respective currency to gold which would facilitate the International Monetary Fund (the IMF) to bridge the imbalance between trading nations temporarily, this system also addressed the need to keep competitive devaluation of currencies in check. This system effectively governed the global financial system for almost 3 decades by stemming destabilizing speculation and competitive depreciations which were rampant in the 30’s. The US dollar under the agreement will remain as the only currency that would retain convertibility to gold and since gold reserves in most countries were limited, countries with payment surpluses stabilized their exchange rates by purchasing dollars which were almost ideal surrogates for gold (Cohen, 2010). However the system was only optimal between 1959 up to 1968 (full convertibility) after which both official and private liquid dollar claims that were being held by foreign entities coupled with the lessening of official gold holdings especially the US gold reserves steered the system towards inevitable collapse (Garber, 1993).
Present Global Financial System
The global financial system that is currently in place is a labyrinth of legal frameworks that are ‘patch ups’ of a seriously flawed design that has been constructed on a fragile foundation to facilitate investments, trade financing and financial capital flows. The complexity of the banking systems that are currently in place make it virtually impossible to continue ‘patching up’ the global financial portrait into something that is acceptable, the recent reforms imposed via the Basel Committee and other governmental regulations have actually made assessing systemic risks even harder and financial risks continue to tear the seams of the financial system at different ends relentlessly. The collapse of Lehman Brothers and AIG and the current financial reforms that involve ring fencing, counter-cyclical capital buffers, and contingent convertible debt are complicated equations that even those who devise them are not able to provide explanations on how they will perform in different scenarios. As markets bubble and fluctuate and nations head towards insolvency, the complications of their implications become shrouded with more reforms that only manage to provide temporary relief. Eventually the rickety financial system is bound to collapse and a complete overhaul of the global financial system will be necessitated and the only system that is known and viable is the gold standard.