How the Gold Standard Really Worked

What would have happened if we were still on the gold standard and the Bank of England's gold disappeared? Rewind real quick. Where the bank, not having a scale large enough to weigh it, broke it into pieces, determined it weighed 172 pounds, and gave the men 9,534 pounds sterling. That sounds like the bank bought the gold nugget, right? Here's what really happened. When those men took the 172 pound nugget to the bank, the local Australian bank gave cash out of their vault, shipped the gold back to England.

Once in the Bank of England vault, the Bank of England printed paper bills worth 9,534 pounds sterling, and sent it back to the bank in Australia. Nobody actually bought the gold nugget. Or, to put it another way, if out in the world, there were 100 million pounds sterling before they found that gold nugget. Once it was in the Bank of England's vault, there were now 100,009,534 pound sterling out in the world. Gold was cash, and cash was gold.

Legally, England could not make more money unless they acquired more gold and had to destroy money if they lost it. Like if those 6,840 gold bars had been stolen from the British government, 336 million pounds sterling would legally be required to be taken out of the world. You can't have more cash than gold. If gold disappears, it doesn't matter how, cash has to disappear. So you can immediately feel that tension, right?

We've got to have gold. Cannot lose the gold. That is what it was like during those times. Each country's gold reserves were watched very, very carefully by everyone around the world. That's how you knew how much money a country had. If it was running out of money. The two scariest words the ruler of a country could hear were gold outflows. But why is the amount of money in circulation going down a bad thing? More money is bad, right?

The more money printed, the less value the money you currently have is. So why would the amount of money going down be bad? The value of your money suddenly went up. Here's the deal. If cash is scarce, loans can't be made. If loans can't be made, that person can't build that hospital. Railroads can't find the capital. A new track if railroads can't lay new track, that little village can't become a town. If villages can't become towns, the economy can't grow.

The world, and this is not new, runs on credit for millennia. Credit needs collateral, and banks must have reserve cash to offer loans. Less cash. Less collateral. Lower reserves. Even if the value of your money is going up, there's less stuff to buy, less innovation. You can't walk down the street to that hospital and pay with your more valuable money, because the hospital doesn't exist. Tying the amount of money available to how much gold has been pulled out of the ground is what we call a self-imposed constraint.

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