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The phrase "gold standard" brings to mind the idea of a guarantee. It's been used to describe the service a company provides, the quality of an investment, and the strength of a promise. Understanding what the gold standard was though, and how it led to today's money, is important for understanding the logic behind modern economies and the way they function.

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So What Was The Gold Standard?

In the long ago and far away (before the year 1971 in the United States), the economy of a country would be tied to some material. In ancient times this meant stamping coins actually made out of precious materials, such as gold, copper, and silver. Even though paper money was more popular in the modern world people wanted assurance that there was something backing the paper. To provide this assurance cash was backed by a precious metal, typically silver or gold. The value of a currency would be completely tied to this material, and if someone had paper money that person could go to any bank and demand its equivalent value in the material that backed it. So if the United States was still on a gold standard and the U.S. had set the price of gold at $500 per ounce, then one dollar would be worth 1/500th of an ounce of gold.

So Why Didn't The Gold Standard Work?

The U.S. was going steady with gold from 1875 all the way to 1971. Before that it had flirted with silver, and before that... well... the U.S. isn't very old as a country, all right? Other nations which had been around for a while also used gold, and it was seen as a safe way to guarantee your money was actually worth something. It was as good as gold, after all.

So what's the problem? Well, you know how when a business says you can bring in a receipt for a free drink, but when everyone comes in at the same time there just isn't enough of that drink to go around? The gold standard is kind of like that. When a government's currency is backed by gold that means the government has two choices; either keep a reasonable amount of gold on hand and hope that only a few people try to cash out, or build up a huge wealth of gold bars, coins, ingots, etc. in order to make sure they can cover all of their cash if necessary. The former is a huge economic and credit risk, and the latter is a very, very expensive way to do business; particularly when the rest of the world is stockpiling gold too.

So What Is Money Backed By Now?

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The short version? Absolutely nothing!

What the United States (along with the rest of the first world) uses is called fiat money. Fiat, in addition to being the name of a luxury car brand, means "it shall be." Fiat money's value is controlled directly by the forces of supply and demand, and not by the value of the material the money is made of.

How does that work? Well, let's take the U.S. for example. It's traditionally been a country that pays its debts, boasts a strong economy, and which has had a AAA credit rating. That leads to a lot of confidence, and that confidence leads to a demand for the U.S. dollar as an international currency. That demand makes it valuable. Now let's say that some event (oh, I don't know, Congress forcing a government shut down because it refused to pass a budget?) shakes the confidence in the American dollar. If that confidence shake means that the dollar is no longer in demand, then it means the value goes down. If enough people deem the dollar worthless then it will quite literally not be worth the paper it's printed on.

So Why Aren't We Using Gold?

Again, the gold standard went the way of the dodo because it would have been impossible to maintain. Additionally people tend to forget that gold, silver, and other precious metals have no inherent value or worth. The value of precious metals is also derived from the forces of supply and demand. So if gold is suddenly a hugely in-demand item because it can be used to build machines that eliminate pollution and cure all known diseases, then gold's value will skyrocket. On the other hand, say that silver turned out to be the miracle metal; it would leave gold in the dust as far as value goes. If it was lead, then suddenly lead would be really, really valuable.

In the end a fiat currencies are no more or less at the mercy of market forces than precious metals. They are, however, a lot easier to maintain because there's no need to keep a massive, dragon's horde of gold on hand in the event that everyone with cash in their pockets decides they'd rather have their paychecks in precious metal instead.