Gold has long been a trusted store of value. For proof, we need look no further than a trip to the Egyptian pyramids or many other ancient sacred sites.
But the use of gold to underpin a monetary system is much more recent. The classic gold standard, in which paper money is freely convertible into a fixed amount of gold, didn’t begin to develop until the 17th century.
Great Britain was the first country to establish a gold standard for itself and its colonies, including the United States. For most of more than two centuries, from 1717 to 1931, anyone possessing banknotes issued by the Bank of England could exchange them for gold bullion at a fixed conversion rate.
The early years of this period coincided with the beginning of the industrial revolution and the rise of the British Empire. The gold standard was effectively internationalized and led to fixed exchange rates between countries which recognized it.
Businesses that traded internationally benefited from this system, because it meant they could accept payment in a local currency whose value was pegged to the pound at a fixed exchange rate.
The gold standard also enforced governmental frugality. A country couldn’t correct a trade deficit by devaluing its currency and thus making its exports more competitive. Instead, the correction would need to take place in the real economy, such as an increase in productivity or a cut in government spending.
But gold had a comparatively brief reign. And World War 1 (1914-1918) was its death knell. As countries raced to mobilize for war, the fiscal discipline gold imposed over government spending made it nearly impossible to mobilize for war. Most nations involved in the fighting, including the United States and Britain, abandoned the gold standard.
Once convertibility was restored, Britain decided to use the same pound to gold exchange rate it had prior to the outbreak of hostilities in 1914. That was a fateful decision, because it meant that the pound was overvalued based on the capacity of the British economy to produce goods that could be profitably exported.
In contrast, France devalued its currency in relation to gold. Thus, in relation to each other’s currencies, the pound was overvalued, and the franc undervalued.
The consequence was inevitable. Large quantities of gold began moving out of Britain to France. This, along with the beginning of the Great Depression, led Britain to abandon the gold standard for good in 1931. By 1936, every other major country had followed its example.
Since then, the world has effectively been on a dollar standard, which was enshrined as a result of a 1944 conference in Bretton Woods, New Hampshire. There, a group of finance ministers and other high-ranking officials from 44 countries declared that henceforth, the dollar would be “good as gold.”
Under the system they devised, nations could no longer demand gold from their trading partners to settle debts. Instead, central banks could exchange their dollars for gold from the US Treasury at a fixed price of $35 per ounce.
The dollar was a reasonable choice for this role, as we explained in this article from 2020. Declaring the greenback to be as “good as gold” and thus the de facto global reserve currency was a logical – but also fateful step.
And Uncle Sam couldn’t abide by the original deal worked out at Bretton Woods. To avoid depletion of US gold reserves, in 1971, President Nixon suspended the dollar’s convertibility into gold.
Yet, the dollar still retained its dominance. And since 1971, there’s been no semblance of a gold standard anywhere in the world. The domination of the dollar is so complete that more than 60% of global currency reserves held by central banks are dollar denominated. For this reason, the dollar is often referred to as the world’s “reserve currency.”
But that might be beginning to change.
The impetus for a new gold-backed monetary system has developed as a consequence of another benefit of reserve currency status: the ability of the government possessing it to hold it as a hammer over the heads of its adversaries.
In order to facilitate settlement of dollar-denominated transactions, foreign central banks and other governmental agencies routinely hold US dollar accounts in US banks.
They also use a network called the Society for Worldwide Interbank Financial Telecommunication to settle payments. This organization offers over 11,000 financial institutions in more than 200 countries a network enabling them to send and receive payment orders in a secure, standardized format.
But these reserves, and access to this network, are increasingly at risk due to US sanctions policies, as we explained in this article.
It wasn’t until Russia’s invasion of Ukraine in February 2022 that sanctions took center stage. Within days of the invasion being launched, all G-7 countries moved to freeze Russia’s foreign currency reserves – more than $600 billion in all. At the same time, SWIFT locked most Russian banks, including the Russian Central Bank, out of its settlement network.
Thus we weren’t terribly surprised that in April 2022, Russia confirmed its intention to back the ruble with gold and other commodities. Russia is one of the world’s largest gold and oil producers and over the last two decades has accumulated official gold reserves of at least 2,300 tons.
Then there’s BRICS – an acronym for the countries of Brazil, Russia, India, China, and South Africa. And at the 14th BRICS summit in June 2022, Chinese President Xi stated in his keynote speech:
We should expand BRICS cooperation on cross-border payment … to facilitate trade, investment, and financing among our countries.
Along those lines, last month, the Russian Embassy in Kenya announced that “the BRICS countries are planning to introduce a new trading currency, which will be backed by gold.” RT, the Russian state-controlled TV network, confirmed the news.
While we’re skeptical of such claims, there’s already broad appeal for the BRICS initiative, since 41 countries have already applied for membership. It’s not clear what role gold will play in it, but Thorston Polleit, Chief Economist for Germany’s Degussa Bank, speculates that the BRICS countries could create a new bank to finance trade, capitalized by gold. The bank would make loans denominated in the BRICS currency against its gold stock, in effect creating a gold-backed currency.
Meanwhile, in March 2023, China’s President Xi announced that oil and gas exporters could use the Shanghai Petroleum and Natural Gas Exchange (SPNGE) “as a platform to carry out yuan settlement of oil and gas trade.”
And with the offer came a sweetener. To encourage traders to use the Shanghai exchange, China made it possible to settle the crude futures contract in gold through the Shanghai Gold Exchange. And on March 28, the Chinese national oil company (CNOOC) purchased 65,000 tons of liquified natural gas from the French oil giant Total Energies on the Shanghai exchange. It was the first trade in exchange for what amounts to a gold-backed yuan.
These initiatives, by themselves, won’t dethrone the dollar from its exalted status. Nor would they result in a new global gold standard, in which countries are forced to accumulate gold to make foreign trade settlements. (Although it’s interesting to note that in 2022, global central banks purchased more gold than at any time since 1950.)
Yet it would be foolhardy to ignore the efforts of large sectors of the global economy turning away from the dollar and towards gold. For instance, consider the effectiveness of economic sanctions if China invades Taiwan.
Under the dollar standard, Uncle Sam and its allies could freeze China’s dollar reserves and lock it out of SWIFT. But as China weans itself off the dollar, the effectiveness of sanctions could be weakened.
What’s more, once viable alternatives to the dollar become available, there’s no assurance that even America’s friends will continue accumulating greenbacks. And there’s at least a possibility that there will be at first a gradual and eventually overwhelming cascade of money out of dollars and into gold, gold-backed currencies, or both.
If that were to happen, we would expect to see chaos in the global financial markets as the shift occurs. In a worst case scenario, we could witness hyperinflation, bail-ins, and even capital controls in the United States.
In the meantime, dollar dominance is gradually weakening, but is still well-entrenched. That won’t change unless there’s a credible alternative monetary system waiting to take its place … and enough people, businesses and other governments vote with their wallets by moving their money into another currency.
In the meantime, we suggest accumulating gold. And perhaps the best argument we’ve heard to make that case comes from former Fed Chairman Ben Bernanke. In testimony before Congress in 2011, he was asked, “Why do people buy gold?”
Bernanke’s reply: “As protection against of what we call tail risks: really, really bad outcomes.”
Indeed. We couldn’t have said it better ourselves.
