Imagine a world without cash. That is, without paper money. How would transactions work? Buying books, coffee, travel or anything you spend on … difficult? How did this work a few hundred years ago?
As mankind evolved, we started exploiting the resources of our planet and produced a variety of things. Some were essential, others not quite so. We then found ways to share these things with each other, of course, for a price. For the lack of a developed system we started bartering – you give me some of what you make and take what I make. As the process of our evolution matured, we realised the difficulty of this system. Some things take years to make while others take very little effort. Both essential (think of a house and food – now try to set a swap ratio, i.e. how much food for a house?).
An even bigger problem with the barter system– what if I don’t accept what you make? Let’s say, I don’t eat fish and I grow rice. The fisherman then is never getting any rice from me, at least not directly. So his option is to swap fish for something I accept and then come to me. Finally, let’s assume that there was no problem with barter system. Imagine how this may work in the modern day. A lady with a basket full of fish standing at a supermarket’s cash counter to pay for a dress may not be ideal.
Evolution of Money
Rightly so then, we felt the need to put a value to things. This value made market transactions easier. We developed ways to quantify this value in terms of standard amounts. If you go back on the path of evolution, you will find that many commodities were used to serve as money and gradually the use of metals in the form of coins became prominent mainly because they are easy to quantify and carry around and also because, metals are the same all over the world. Many metals like silver, bronze and even iron were used as money at different times. Over time, use of gold coins proved to be the standard means of exchange. Why gold? There are many reasons for why gold became the most popular form or money. Mostly it was because of its rarity and the ease with which you can identify the yellow metal.
Use of Gold – Drawbacks
As you would imagine, use of gold or for that matter, any metal or commodity as currency has some drawbacks. For starters, it is inconvenient to store. Would you want to carry big chunks of gold in your pocket all the time? Also, the value of gold is fixed to the value of the underlying metal so for a larger transaction size, you may have to carry a very large amount of gold. The solution came in the form of paper or fiat currency. The idea was to denominate paper to represent a certain value of gold as its underlying asset or its backing. So for example:
Rs. 1000 Note = 1 unit of gold
Rs. 500 Note = ½ unit of gold and so on.
Countries started issuing currency notes of various denominations and started tying the value of these notes in terms of units of gold. People deposited their gold coins with the banks and got paper currency i.e. notes of different denominations. The Governments in turn promised the depositors that the value of the paper they hold at any point of time would be equal to its proportionate value of the underlying gold.
This concept which guaranteed that any amount of paper money could be redeemed by the issuing currency’s government for its value in gold was called The Gold Standard. As countries around the world embraced the gold standard, each national currency (the dollar, pound, franc, etc.) was merely a name for a certain definite weight of gold.
This had two important outcomes. First, a country would print paper currency based on its gold reserves. So if a country needs to print more money, it needs to mine more gold. Second, countries could now trade across borders given that they could redeem the foreign currency in gold from the issuing countries bank.
The Problem with the Gold Standard
As population grew, economies expanded. As more and more people started exploiting the natural resources of the world, both production and consumption increased rapidly. Problem? Not enough gold to support this growth. How do governments increase the money supply to pay off for these new goods and services?
The only way was to mine more gold or to revalue gold. How would revaluation work? By revaluing, the government could make the gold more expensive thus allowing itself to print more money. So for example: you deposited 10 grams for Rs. 100, now the government prints and gives out more money to you and increases the value of your gold to Rs. 200 for the same 10 grams. This would mean constant revaluation of gold as the population (and effectively the production and consumption patterns) of the world increased. However, this is exactly what happened for some time in the late 19th and early 20th centuries.
Think about it, if the government can print as much money as it wants by revaluing the gold to any price, then why have gold as a backing? Why not just use paper (i.e. fiat money) so that the Government can print as much as it wants without revaluing anything.
Continue Reading . . . . BRETTON WOODS SYSTEM – END OF THE GOLD STANDARD