From gold to trust: why today's money isn't backed by gold

Rok, 17, finds an old 1,000-tolar note in his grandmother’s drawer. “Could you swap this for gold at the bank?” he asks. She laughs: the tolar was never exchangeable for gold, and neither is the euro in her purse. So why will a shop hand her real bread for a printed piece of paper?

When a banknote was a promise of gold

Under a gold standard, a banknote is a claim on a fixed weight of gold. In principle, you could take it to the central bank and receive gold. Many countries used gold standards in the late 1800s and early 1900s.

The strength of a gold standard is discipline. A government cannot print much more money than its gold allows. The weaknesses are serious, though:

• The amount of money depends on gold mining, not on what the economy needs. A big gold discovery can push prices up. A shortage can push them down, which is called deflation.
• In a crisis, the central bank cannot easily create money to stop a panic, because every note must stay exchangeable for gold.

In the Great Depression of the 1930s, countries that left gold earlier tended to recover sooner. Britain left on 21 September 1931 and recovered earlier than France, which held on to gold until 1936.

Bretton Woods: gold at one step removed

In July 1944, delegates from 44 nations met at Bretton Woods, in the United States, to plan money after the Second World War. The Bretton Woods system worked in two steps:

1. The US dollar was fixed to gold at $35 per ounce.
2. Other currencies were fixed to the dollar, within a band of 1%, with adjustments allowed.

Only foreign governments and central banks could swap dollars for US gold, not ordinary people. The same conference created the International Monetary Fund (IMF) and the World Bank.

1971: the gold window closes

The system had a weak point. During the 1960s, foreigners came to hold more dollars than the United States had gold at $35 an ounce. If many asked for gold at once, the US could not pay them all, like a bank facing a run.

On 15 August 1971, President Nixon announced that foreign governments could no longer exchange dollars for gold. Attempts to keep fixed rates failed. By 1973 the major currencies had a floating exchange rate, set every day by supply and demand in currency markets.

What gives fiat money its value

Since then, almost all money has been fiat money: it cannot be exchanged for gold, or anything else, at a fixed price. Fiat is Latin for “let it be done”. Its value rests on four pillars:

1. Law: it is legal tender, so it must be accepted to pay debts.
2. Taxes: the state collects taxes in it, so everyone needs some.
3. Acceptance: you take euros because you know everyone else will.
4. A careful central bank: the European Central Bank (ECB) aims to keep inflation at 2% over the medium term, so euros keep most of their buying power.

When these pillars fail, fiat money can lose value fast. A government that makes its central bank print far too much money is doing a modern version of debasement. Later lessons look at what happens then.