How we lost sound money
August 15, 1971. You've probably never heard this date, yet it changed your financial future more than any other day in modern history. On this Sunday evening, President Nixon announced that the United States would no longer exchange dollars for gold—ending a monetary system that had lasted for centuries.
That temporary measure is still in effect today, over 50 years later. And it's why your money works completely differently than your grandparents' money did. Gold dominated for centuries precisely because of this natural scarcity. So how did we abandon it for something politicians can create at will?
The Critical Transition: From Gold to Fiat
Gold naturally emerged as humanity's dominant form of money, and looking at our properties of good money from Post 2, it's easy to see why. Gold maintained the highest stock-to-flow ratio of any commodity—meaning new supply was severely limited by the costly process of mining. This natural scarcity, combined with extreme durability, made gold an excellent store of value across centuries.
Monarchs eventually standardized gold into coins with consistent weight and purity, improving its fungibility and making everyday trade more efficient. Their stamps and designs also enhanced verifiability, though not perfectly.
But gold had a critical weakness: portability. Imagine buying a ship full of spices from India in the 1700s—you'd need to transport literal tons of gold across pirate-infested waters. Beyond the logistical nightmare, merchants faced constant theft. Carrying gold made you a target for highway robbers and pirates. A paper receipt from a trusted bank? Worthless to thieves who couldn't redeem it, but valuable to legitimate traders who could.
Even everyday transactions became cumbersome. Gold's density (19.3 g/cm³) meant even modest wealth was heavy to carry. And verifiability remained imperfect—fully determining gold's purity required melting it down, and clever counterfeiters could create bars with tungsten cores wrapped in gold or simply use impure gold that looked authentic.
The free market found an elegant solution: custodial services. Merchants could deposit their precious metals in secure vaults and receive paper receipts in return. The first banks were born, serving a legitimate purpose by solving gold's practical limitations.
This innovation revolutionized trade. Merchants could conduct business using lightweight paper receipts, which banks would later settle through gold transfers via clearinghouses. It seemed perfect—all of gold's monetary properties with none of its physical constraints.
But this system introduced something new: counterparty risk. Where gold's scarcity was guaranteed by physics and chemistry, paper receipts required trusting the institution holding your gold. Initially, this trust was well-placed. Banks understood their business model depended on maintaining full reserves.
Over time, however, bankers noticed something tempting: since trade was conducted with paper receipts, most gold just sat idle in their vaults. What if they could put that gold to work?
Banks began issuing loans using depositors' gold, creating paper receipts that weren't fully backed by physical gold. They assumed not everyone would demand their gold simultaneously. This practice—fractional reserve banking—fundamentally changed what banks were. They transformed from simple warehouses into institutions that could multiply the money supply.
This fundamentally broke gold's monetary superiority. Remember that scarcity is money's most important property? Banks had just discovered how to bypass nature's scarcity constraints by creating money through lending.
The very feature that made gold superior to shells or stones—scarcity enforced by physics rather than promises—was now dependent on trusting bankers. Every property that made gold good money was suddenly contingent on human restraint rather than natural law.
The Telegraph Revolution: The Final Blow to Gold
The banking solution worked reasonably well when information and physical goods moved at roughly the same speed. Before the telegraph, you couldn't send a message faster than a human could travel by horse or ship. When merchants sent gold, transaction information arrived at about the same pace as the gold itself.
The telegraph changed everything.
By the 1860s, you could send transaction agreements around the world instantly—at the speed of light. Commerce could now happen as fast as you could communicate. But gold still moved at the speed of ships and wagons. More critically, verifying gold's authenticity remained slow and cumbersome.
This created an unbridgeable technological gap: transactions could happen instantly, but settlement in gold remained painfully slow.
The free market responded predictably. Banks expanded their paper receipt systems, allowing merchants to conduct instant international business while settling later in physical gold. But this massively amplified the counterparty risk problem. Now you weren't just trusting your local bank—you were trusting banks and shipping companies across continents and oceans.
The speed gap made fractional reserve banking profitable and ultimately inevitable. Banks noticed that people rarely withdrew their gold—they were content trading paper receipts. This created an irresistible arbitrage opportunity: why not lend out gold that just sits in vaults? The speed gap meant banks could create more claims on gold than actual gold existed, knowing that people wouldn't all demand settlement simultaneously.
Every attempt to maintain full gold backing in practice failed because the speed gap made fractional reserves too profitable to resist. Countries maintained the official fiction of gold backing while allowing the ratio of claims to actual gold to balloon—by the early 1900s, England had 20 claims for every 1 ounce of gold.
The speed mismatch had made something clear: money needed to move at the speed of light to function in the modern world. Gold, for all its excellent monetary properties, had become technologically obsolete for anything beyond local transactions.
This wasn't about political corruption or banker greed—it was technological inevitability. The telegraph had created a fundamental incompatibility between sound money (gold) and modern commerce (instant global transactions).
By 1971, the gold window closure simply acknowledged what technology had already determined decades earlier: in the telecommunications age, money had to be as fast as information itself.
The Path to Fiat: Wars and the Money Printer
The path from sound money to our current system wasn't a conspiracy—it was the predictable result of incentives. Once banks could create money through fractional reserves, and once the speed gap made this necessary for commerce, a fundamental problem emerged: what happens when too many people want their gold back at once?
When the System Breaks
Bank runs exposed the core contradiction of fractional reserve banking. Banks had promised the same gold to multiple people through their paper receipts. When confidence wavered and depositors rushed to redeem receipts, banks simply didn't have enough gold.
The logical free-market response? Let reckless banks fail, teaching others to maintain proper reserves. Instead, governments created central banks—institutions with the power to create new money out of thin air to bail out troubled banks. In the US, this became the Federal Reserve in 1913.
While this prevented bank failures, it created what economists call moral hazard: why act prudently if you know you'll be rescued? More importantly, it gave governments a dangerous new tool.
The War-Money Connection
Here's the crucial pattern: governments abandon sound money when they need to fund wars. Why? Because wars are expensive, and governments have only three ways to pay:
- Raise taxes - Politically unpopular because voters immediately see higher taxes
- Borrow money - Limited by what lenders will provide
- Print money - The path of least resistance
Printing money is a hidden tax. When a government doubles the money supply, your existing dollars lose half their purchasing power. The government effectively takes half your savings without touching your bank account—taxation without legislation, without political backlash.
The Pattern Repeats
Remember, during all these crises, the world was still officially operating under various forms of the gold standard. These weren't planned transitions—they were emergency departures that became permanent.
World War I (1914-1918): European governments chose to abandon gold rather than limit war spending to their reserves, promising the change was temporary. Germany printed so much money that by 1923, people needed wheelbarrows of cash to buy bread—hyperinflation.
The Great Depression (1933): The US made private gold ownership illegal through Executive Order 6102. Citizens were forced to exchange gold for dollars at $20.67 per ounce. The government then revalued gold to $35 per ounce—a 40% devaluation of the dollar overnight.
Think about what this meant for ordinary Americans. If you were a factory worker who'd spent decades saving $1,000 in cash for retirement, the government just stole $400 of your purchasing power overnight. Even worse, they simultaneously made it illegal for you to own the one asset that couldn't be devalued: gold itself.
World War II and Bretton Woods (1944): The world attempted a compromise. The US dollar remained convertible to gold at a fixed rate, but only for foreign governments. Other currencies pegged to the dollar, creating a pyramid with gold at the top, dollars in the middle, and every other currency at the bottom.
This gave the US enormous privilege—and enormous temptation. They were supposed to maintain enough gold to back all the dollars they created. But why follow the rules when you're the only one who can enforce them? The US began creating far more dollars than they had gold to support.
August 15, 1971: The Date That Changed Everything
The US was spending enormous sums on the Vietnam War. Instead of raising taxes or admitting they couldn't afford the war, they printed dollars. Countries like France noticed the US was creating more dollars than it had gold and started demanding gold for their dollars.
President Nixon faced a choice: stop printing money (and likely end the war) or stop gold convertibility. On August 15, 1971, he chose the latter, "temporarily" closing the gold window.
That "temporary" measure is now over 50 years old.
For the first time in history, the entire global monetary system was based on currencies backed by nothing but government decree—fiat money.
Conclusion
Every major departure from sound money has followed the same pattern: crises create pressure for "emergency" measures that somehow never end. Temporary suspensions become permanent features. Exceptional powers become standard operating procedure.
But the final abandonment of gold wasn't just about wars and political convenience. Technology had made it inevitable. The speed gap between instant telecommunications and slow gold settlement had created an impossible choice: sound money or modern commerce.
We chose modern commerce, not understanding the full cost. The result is a monetary system where the most important property of money—scarcity—depends on the restraint of politicians and central bankers. Gold's scarcity was guaranteed by physics and chemistry. Today's money's scarcity is guaranteed by promises.
Technology broke sound money. The telegraph made gold too slow for modern commerce, forcing us into fractional banking and eventually pure fiat currency. Every property that made gold good money became contingent on human restraint rather than natural law.
Understanding how we lost sound money is only half the story. The other half is understanding what this transformation costs ordinary people like you and me—and why these costs accelerate with each passing year.
In our next post, we'll explore exactly what broken money costs you personally.