Why did money keep working just fine when it stopped being backed by gold?

The year 2021 marked 50 years in a world with no gold standard, when in 1971 US President Nixon suspended international convertibility of the US dollar into gold. Nor was the gold standard replaced with any other sort of commodity standard, like a silver standard or a wheat standard or a petroleum standard.^[1] Today, I'll simply focus on the question: Why did money keep working just fine when it stopped being backed by gold?^[2]

When I was younger, I encountered the question of why people still used the dollar even after it isn't "backed by anything", but I never encountered a satisfying answer. The answers I got varied from "nobody really knows" to "because of faith in the dollar" as if the dollar's value were a precarious shared illusion that could collapse at any moment if we all realized at the same time that it was just worthless paper. Given how standard it is for people to think this, if it were true then after 50 years, wouldn't this currency have collapsed already? Along with every other currency on earth?

It was only in perhaps in the last 6 years for me, that I became aware that there may be an actual answer to this question. The first interesting discussion that planted the seed for me on this topic was Perry Mehrling's excellent lectures on the Economics of Money and Banking at Columbia University, available on Coursera. It was here that I was first introduced to the idea that demand for the dollar may perhaps be maintained by virtue of the fact that people have debts denominated in dollars: after all when you pay your mortgage in the US, the thing you have to deliver to the bank is dollar bank deposits, not anything else, however valuable. This naturally means that there are plenty of people, in the US at least, who are willing to work hard for dollars at least in part not because they want those dollars for their own sake, but so that they can make their mortgage payment as it comes due and not risk losing their house. The discussion was brief, and he raised this as a possibility, not a definitive answer, but it stuck with me as far more "onto something" than any answer I'd heard before.

It is fitting that, inadvertently, I came back around to these questions in the year that marked 50 years of incontrovertibly fiat money. In 2021 as pandemic uncertainty dragged on, I found myself getting sucked further into the interdisciplinary approach to monetary economics. I read Debt: The First 5000 Years by David Graeber, an anthropological view of money and debt—that same relationship again. I stumbled on the Modern Monetary Theory literature and lectures and interviews with Randall Wray, Stephanie Kelton, Pavlina Tcherneva, Warren Mosler, Bill Mitchell, and others. I read Stephanie Kelton's bestseller The Deficit Myth, and Pavlina Tcherneva's The Case for a Job Guarantee. And I came to form a view on this question that was consistent with all of those works and everything else of value that I could find on the subject. The following year, Christine Desan's Making Money: Coin, Currency, and the Coming of Capitalism, a tour de force on English monetary history, added historical depth and detail, but was not inherently at odds with the view I was forming from these other sources.

And that view is this. The question itself, "Why did currency like the dollar continue to be valuable even after it was no longer backed by gold", incorrectly presupposes that gold's role in the monetary system was the central reason that money had value. In reality, gold was like the English monarch: a figurehead whose prestige was commemorative of a distant past, but whose days of operational relevance were long gone. Put more bluntly, gold was the stone in stone soup.

The concept of stone soup comes from a European fairytale. In it, a hungry traveler comes into town and sets himself up in the middle of the village with a large pot, into which he places a large stone. He lights a fire and begins to boil the stone in water. One by one, villagers ask him what he's making, and he says he's making stone soup—but it could use a little bit of this or that ingredient. In the end he takes out the stone and shares the soup with the townspeople. The stone was irrelevant to the recipe, and yet it was the focal point of the villagers' attention, without which they would have never come together to make a meal. It was ceremonially central to the soup's formation, but instrumentally irrelevant.

During the classical gold standard—which had an on-and-off history and lasted at best 150 years—gold was the stone that countries rallied around to set up the international financial architecture, but which secretly (and perhaps unbeknownst to the architects themselves), was never fundamentally that relevant to the value of each currency. Each currency was driven by something else entirely, with convertibility to gold being a functionally ancillary feature, one that both glued the system together and had a great cultural relevance. It is perhaps too glib to say that gold was about as important to the value of the US dollar as Benjamin Franklin's face on the $100 bill is today—gold did have some real economic effects within the monetary system—but it was very much not the main force that gave the currency its value. If anything, the fact that the state could reliably convert the currency at a fixed rate to gold showed that the currency already had great value, value which came from another source.

It's worth pausing to describe briefly what the gold standard actually was. People often talk of it as if it were fixing the value of the dollar to gold, but it makes much more sense to think of it as fixing the price of gold. A gold standard is first and foremost a promise by a government to buy any amount of gold in exchange for a fixed amount of freshly printed government money. This is a promise the government can never be forced by circumstance to abandon. The second, more provisional promise, is that as long as it has a sufficient stockpile, it will offer to sell the gold back at the same price, at which point it shreds any government money it collects from the sale. It's fairly obvious that the government's buying of the gold has to come first, before the government can sell it back, so a key feature of a gold standard is that the government, in order to create an initial stockpile of gold, needs to set its official gold price higher than the counterfactual market price: if it set the price lower than what a seller could get elsewhere, then why would anyone sell the government their gold? Actual implementations of this varied across countries and time, but this is the shared essence of the systems of the gold standard era.

It bears repeating: if people are net-selling gold to the government, it means that the government is propping up the value of gold. This is obvious to people when the government buys up corn—no one thinks that this means that the dollar is "backed by corn"—or cheese, or wheat or any other agricultural products where government price stabilization policies are common. But when it comes to gold, people often miss that it's the same kind of commodity price stabilization policy, perhaps because of the cultural hold that precious metals have on our mind as a symbol of enduring value. The flip side of this is that when people were net-buying gold back from the government, this prevented the price of gold from rising. For a government to never run out of gold, such periods could only be sustained for short periods, and the government would have to adopt policies to either starve the populace of cash so they would come to the mint with their gold or to import gold from other countries in exchange for exports. To maintain a gold standard thus meant either austere and depression-prone policies or being a major net exporter, or, as was often the case in the US, both.

So if the value of gold was in some sense piggybacking off of the US dollar and currencies of countries with similar policies, especially the British pound and French franc, rather than providing those currencies with their value, then where did the value of those currencies come from in the first place?

As I alluded to above, money is driven by debt—by the need to make a payment that must be made in a specific currency, in exchange not for goods but for legal good standing and being spared punishment. One kind of debt in particular plays a key role: the debt that each of us has to the government, which is to say, taxes. This was an "Aha!" moment for me, because otherwise the "debt drives money" argument is precariously circular: I accept that I need to pay my mortgage to the bank in dollars, which means I want to be paid by my employer in dollars, which means that they want to be paid by their customers in dollars, and so on. But why does my bank want to be paid in dollars? The answer can't just be that their employees and shareholders want to be paid in dollars, because now we haven't really answered the question, we've just gone one more step in an infinite loop. It's turtles all the way down.

But the relationship of a government to the rest of their economy is entirely different. They issue the money—a job that nowadays they usually delegate to their central bank in coordination with their treasury department—so the reason they tax us cannot logically be to literally pool together money for spending. Instead, the ubiquitous government tax liability, the asymmetric and non-negotiable obligation we each have to our government, on terms that the government has the absolute power to make and change, is the proverbial turtle at the bottom of the pile of turtles.

This is not to say that each of us wants dollars only specifically to pay taxes—far from it. The tax liability creates a sink-hole in the floor of every household that sucks money into an abyss. Think of a property tax: you know how much you owe by the end of the year, there's nothing short of selling your home that you can do to avoid it, and if you don't do it the government will take your home. For each individual person, this money pit alone would be enough to make them want this money—but only exactly enough to pay the tax, plus maybe a little bit more as a safety cushion to get a head start on the next payment due. But it's not just one person who's looking for just enough money to pay current and future tax payments—it's everyone.

So you've got millions of people who all just want a little bit of this thing, plus a little more for safety. The government employs a good deal of them. (If a government knows what it's doing, then this was the whole point of imposing that tax in the first place. It's unclear whether most governments nowadays are conscious that this is what they're doing.) Everyone else still needs to get it from another source, so they find ways to provide services to anyone who will offer up this money in exchange. People realize if they save up a lot of this money, then they can live for years without lifting a finger, because there will always be people who will be jumping over themselves to compete to provide them with food, clothes, housing, and endless entertainment for the rest of their lives in exchange for this money that they've saved up. This desire that people have to save up this money further increases the demand for money. People start banks that advance credit for large purchases, hoping to receive a lot of money by steadily charging people a little interest, which satisfies a demand for money in the short term, but also creates an additional demand for money over the repayment term of the loan agreement. This huge demand for money allows the government to spend new money into the private sector, usually significantly in excess of the taxes it collects. This self-reinforcing structure of money demand propagates and circulates throughout the network of people and firms and their relationships, as before, but in this explanation, there is an original force that keeps the whole thing moving, and that is taxes.

Watch David Graeber describe how this process played out in real time in colonial Madagascar.

So where does this leave us with gold? Historically, gold and silver played a significant role in the development of money. Originally, the process of making coins out of precious metals was a kind of anti-counterfeiting technology. A government that makes physical tokens that legally represent their money must take care that they and anyone else can tell which tokens are genuine and which are facsimiles.

Very early governments with an armed force found it fairly tractable to defend exclusive rights to the few large deposits of rare minerals, and if they did so successfully, it was pretty easy to know that anything made out of that rare mineral came from the government. This monopoly eventually broke down as enough of it was mined and traded and recirculated, and so it became common to instead use the fineness of the technique of minting the coins as an additional anti-counterfeiting technology, and to simply buy the rare metal from the populace in exchange for coins—coins that were perhaps even made right there in front of them out of the metal that they brought in—but the metal wasn't money until it was turned into coins, and the coins they received in payment for the metal had less metal in them than what they had just parted with. An analogy today would be that the US government buys nickel and copper from private sector businesses, and if a business were to withdraw its payment in quarters, the amount of nickel and copper they'd receive back in the quarters would be a lot less than what they had parted with to get them.

The fact that these metals—especially silver and gold—could be freely exchanged for the money of not just one government, but many governments worldwide made these metals valuable in themselves. This in turn led to the people living under governments from England all the way to China to attach, culturally, a great value to the rare ("precious") metals themselves and to view the minted coin as being valuable at least in part because it was made of these metals. This is still the most prominent money story we hear today. It is what motivated, in the public consciousness, the move away from silver coin money towards a gold-standard paper money, in which the money was seen and spoken of as simply a conveniently exchangeable receipt for a fixed quantity of gold, and the minting of gold coins was done ounce for ounce, as if there were no difference between the value of the coin and the value of the gold within the coin. But beneath this potent cultural illusion, there was still the same basic underlying force driving the value of money: taxes.

The international aspect of silver money and later the gold standard is well understood and interesting. Domestically, there was always a big difference between a coin made out of silver, and any old lump of silver weighing the same amount, but if you took it out of the territory of the sovereign that issued it, then the further away you got, the more it just looked like any old lump of silver. Similarly, if the sovereign suffered a devastating collapse of its authority, including its taxing authority, and the successor government did not recognize the old coin as money, then those coins suddenly just became any old lump of silver. But since a number of different kingdoms' mints all had similar offerings to buy up silver for coin, that silver was still worth something beyond what people might pay to make spoons or jewelry out of it. So a silver coin was not entirely the same instrument as paper money. It was still a fiat currency, but it was a partially collateralized fiat currency, where the collateral was something that other sovereigns, by custom, were likely to also offer to buy for their own money. This was a part of the self-reinforcing dynamic that made the cultural attachment to gold and silver have such staying power, not just in one country or region, but globally.

In the switch from precious metal coin money to the paper money gold standard system, the way money operated domestically versus internationally became even more pronounced. Domestic transactions were almost all done in paper money, whereas international transactions were settled in weights of gold. In the wake of the depression, American President Franklin Roosevelt officially suspended domestic convertibility of the dollar into gold, further cementing the domestic versus international distinction.

After World War II, a new system was constructed, the Bretton Woods system, in which the US would offer international convertibility of the dollar into a fixed weight of gold ($35/oz), and all other countries would offer international convertibility of their currency into the dollar. Since the US was a net exporter for most of that period, it was a net accumulator of gold, and thus it had no trouble maintaining this offer, while there were provisions to support convertibility of other currencies into the dollar including lending agreements and occasional revaluations. In 1971 when US President Nixon suspended the US's standing offer to sell gold to foreign central banks at the fixed rate of $35/oz, the Bretton Woods system collapsed, and the following decades even through to the present day saw many currency crises as the world fumbled its way to a new international money system. What we have today is a system of trial and error, with most countries opting for some version of free floating currencies exchanged at fluctuating prices, many with a managed floating system (in which they allow the value to fluctuate but try to guide it by buying and selling foreign currency), a few countries that unilaterally attempt to peg their currencies to the dollar or euro, the euro itself in which all countries in the euro zone share a single currency, and the CFA franc in West and Central Africa, a colonial holdover used in 15 countries that is pegged to the euro and in which France is still involved. Finally, there are many bilateral swap-line agreements between central banks, which have the effect of keeping the exchange rate between each pair from sudden and extreme changes.

Notably, in the present system, gold and silver play no role. This is what I meant when I said that gold is the stone in stone soup. It played a huge role in the historical implementation of money both for practical reasons and through a powerful cultural mythology that grew around it and enhanced money's acceptability, but at the end of the day, the system it helped coordinate didn't need it any more than the stone soup needed the stone.

1. You'll get people talking about the "petrodollar", which is the idea that the dollar is supported solely, primarily, or significantly by the fact that global petroleum market transactions are denominated in dollars, but even in that claim's strongest form it is a far cry from a petroleum standard, something that has never existed.
2. I will take for granted that you agree with my premise that money kept working, and are not among those who insist that since a $15 lunch today would have cost $1.90 or whatever in 1971, that means the currency has collapsed and we're in hyperinflation. I for one, still use the dollar, and I suspect I'm not alone. In a future piece, I'll write about why that value comparison is quite misleading, but that's for another time.

If you enjoyed this piece, sign up for free. I'm still just getting started on this thing, and any comments or feedback you have is valuable, so let me know on Twitter at @dannydrob. I plan to write something about once every couple weeks to once a month.