The gold standard begins when people use gold as a medium of exchange and to store wealth. For example, a peasant might have an extra cow. The peasant trades the cow to some other peasant for gold, and then buries the gold in his backyard. The peasant buries a little more gold every year for several years, and then digs up the gold and trades the gold for more land.
Prices are set by the relationship between the amount of gold and the amount of everything else. For example, suppose that one year the crops fail, resulting in a shortage of food. The amount of gold is the same but the amount of food is less, so the relationship between the amount of food and the amount of gold has changed, and the price of food increases. Or suppose that a stranger comes to the village. The stranger has a heavy sack, and is very protective of the sack, and will not let anyone see what is in the sack. Then the stranger disappears, and no trace of him can be found, except for a pool of blood near where he was last seen. Then the suspicious looking man from the other side of the village whom no one trusts trades gold for whatever anyone else is willing to trade, and prices rise. Prices rise because the stranger was murdered and his sack of gold was stolen. Since the amount of gold in the village has risen, the relationship between the amount of gold and the amount of everything else has changed, and prices rise.
Inflation is caused by either an increase in the amount of gold or by a decrease in the amount of everything else. Deflation is caused by either a decrease in the amount of gold or by an increase in the amount of everything else.
The government of the village cannot do anything to increase the amount of anything. But the government can decrease the amount of anything. So the government could manipulate prices by destroying whatever is in surplus. For example, if a good harvest leads to a food surplus which leads to low prices for farmers, the government could gather up the surplus food and bury the surplus food in hole in the ground, and let the surplus food rot. By destroying food, the government has reduced the amount of food, which causes the price of food to increase. But this is obviously a stupid thing to do, because this reduces the amount of food available to the people of the village, and makes people hungrier. Or suppose that a poor harvest results in a food shortage, which causes food prices to rise. The government could reduce the price of food by destroying gold. The government could destroy gold by grinding the gold to a powder and then scattering the powder through the fields. Or the government could hide the gold in a safe place so that no one could use the gold. Everyone in the village would try to find and steal the hidden gold, so the government would have to guard the hidden gold. If the government could successfully hide the gold, then the government could respond to future deflation by releasing gold. But the real problem is that there is a food shortage caused by a bad harvest, and no amount of adjusting the money supply will create more food. No matter what the government does, the people will still be hungry.
The only way the government can change prices is by creating shortages by destroying things. Destroying things does not benefit the people of the village. It is possible for the government to stabilize prices, but it is a bad policy.
Prices in the village are likely to fluctuate from season to season, and from year to year. Long term average prices may be stable.
In a complex industrial economy, the government cannot manipulate prices except by creating shortages by destroying things, and destroying things makes the society poorer, just like in a preindustrial agricultural village. The difference is that in a complex industrial economy, it is less obvious that government price manipulation involves destroying things and impoverishing the society. For examply, suppose that the government wants to reduce the price of oil. The government could increase the supply of oil by destroying oil, but the decrease the price of oil, the government must destroy everything else. People sell their labor to get the money to buy oil, so to decrease the price of oil the government must destroy labor.
The gold standard begins to fail when people start borrowing gold. For example, suppose you want to trade a cow for gold. No one is willing to give you gold for your cow. Then someone who has no gold offers to take your cow, and promises to give you gold next year. If you give him the cow, he might never give you the gold. But if you do not give him the cow, you have to take the cow home again, and feed the cow, and you do not know how long it will be before you find someone to trade you gold for the cow. So most sellers will trade the cow for future gold, but will demand extra gold (which is the equivalent of interest) to compensate for the risk that he might never give you the gold. If you were willing to trade the cow for two ounces of gold today, you would probably demand three ounces if he is not going to give you the gold until next year.
Future gold is less valuable than gold now, because you might never get the future gold. However, future gold has one advantage: future gold cannot be stolen. No one can steal future gold from you because you do not have future gold yet. That means you do not need to bury future gold in the backyard, you do not need to lock future gold in a safe, you do not need to hire armed guards to protect future gold. The cost of storing future gold is less than the cost of storing gold now.
If a seller insists on gold today, then the seller cannot sell to anyone with no gold. A seller who is willing to accept future gold can sell to anyone with gold, and can sell to anyone without gold. A seller who is willing to accept future gold has more potential customers. With more potential customers, the seller can demand higher prices, because if one customer refuses to pay the higher price, another customer will be willing to pay the higher price.
The more people borrow gold, the higher prices rise. Borrowing gold has the same effect as an increase in the supply of gold. Borrowing causes inflation.
Borrowing is based on trust. The amount of trust in the community varies more than the amount of gold. If everyone repays their loans, trust increases, borrowing increases, and prices rise. Then someone fails to repay a loan, everyone starts wondering who will default next, suddenly no one trusts anyone else, no one will lend anyone any gold, borrowing decreases, and prices fall. Probably prices will rise slowly, then fall rapidly, then rise slowly, then fall rapidly, etc. The economy will have a boom and bust cycle.
Borrowing changes the gold standard to a gold plus trust standard. The gold plus trust standard results in greater price variability than a gold standard.
The gold standard is weakened further when people start using gold certificates. Some people do not like carrying around gold or protecting their gold. So banks offer to store gold. You can take your gold to a bank, and the bank will give you a gold certificate. You can take the gold certificate back to the bank anytime, and the bank will redeem the gold certificate for the amount of gold printed on the certificate. Some certificates are for a specific person, so that if the certificate is lost or stolen, the bank will replace the certificate. Other certificates are transferrable, so that you can give the certificate to someone else, probably in trade for something else.
The banks do not want criminals to create fake gold certificates, so the banks make the gold certificates difficult to forge. Certificates are made with unusual ink on unusual paper, lots of strange curly lines, portraits of famous people like George Washington or the Duke of Wellington, serial numbers, signatures of the people who issued the certificate, a seal, and something which you can only see if you look at the certificate from a specific angle under a specific color light. Look at a paper money and see how many of these features are used on paper money.
The government might also issue certificates. Certificates issued by private banks might not be trusted far away from the bank. Certificates issued by governments might be more trusted than certificates from a private bank because the government has a bigger (though not always better) reputation. More people have heard of the government than of the private bank. The british one pound banknote was originally a certificate for one pound of silver.
The gold certificates do not change the economy significantly as long as the banks make sure that the amount of gold in the banks' vaults exactly matches the amount of gold certificates which the banks have issued. The bank should know how much gold is in the vault, and how many gold certificates the bank has issued. But how does everyone else know? The bank says everything is good, but the bank might be lying. The government could send inspectors to audit the bank, but a crooked bank could easily fool the inspectors by filling the vault with yellow bricks and by showing the inspectors fake account books instead of the real account books.
Sooner or later, the bankers will succumb to temptation and will take some of the gold from the vault. At first the bankers will rationalize these thefts, thinking they are only borrowing the gold and will replace it soon. Next time they take a little more. Then a clever banker will realize that he can take some of the gold, lend the gold to someone else, and charge interest on the loan. When the loan is repaid, the banker replaces the gold but keeps the interest for himself. Or the banker could trade the gold for a house and rent the house out, keeping the rent for himself. Later the banker can trade the house for gold and return the gold to the vault. It is almost impossible to prevent the bankers from stealing the gold from the vault because it is so profitable and so difficult to detect.
Gradually rumors of what the bankers are doing leak out. Banks which loan out the gold from the vault will be more profitable than banks which do not, and so the lending banks gain market share from the nonlending banks. Bank customers realize that as long as the loans are repaid eventually and the gold is restored to the bank's vault, then the bank is still solvent and the gold certificates are still good. Banks stop concealing the fact that banks are lending the gold to other people. What started as a crime has become standard operating procedure.
Lending gold is profitable for banks, so banks try to lend as much gold as possible, and leave as little gold as possible in the vault. Banks try to guess how much gold they will need to redeem gold certificates in the near future, and keep that much gold in the vault, and lend out all the rest of the gold. So the amount of gold in the vault is only a fraction, probably 5-20 percent, of the amount of gold certificates which the bank has issued. This is fractional reserve banking.
Fractional reserve banking has two effects on the economy.
First, fractional reserve banking is inflationary. If you deposit gold in a bank in exchange for a gold certificate, you can go to the market and spend that gold certificate. Meanwhile, the bank lends your gold to someone else, who can also go to the market and spend the gold. With more people spending more money, sellers will raise prices. You may find yourself bidding against someone who is bidding with your gold!
Second, fractional reserve banking means that gold certificates are no longer backed by gold in the bank's vault, but by trust that the bank can acquire the gold when you redeem the certificate. The total number of gold certificates issued by all banks may exceed the total amount of gold in the economy. Money is no longer backed by gold, but by trust. The natural actions of the free market has transformed the gold standard into a trust standard.
Fractional reserve banking makes gold less important and trust more important in the economy. But as I stated before, the amount of trust is more variable than the amount of gold. So fractional reserver banking will intensify the boom and bust cycle.
However, there is a limit to the boom and bust cycle. Intelligent people understand the boom and bust cycle, and will realize that if you trade everything for gold during the boom, and then trade the gold for everything else during the bust, you can make a vast fortune. Once a few people succeed at this, other people will imitate them. The actions of these people will lessen the intensity of the boom and bust cycle. Over time the costs of information and trading will fall. Lower information and trading costs make it easier for people to trade against the boom and bust cycle. The boom and bust cycle will become less intense over time and will eventually disappear. The boom and bust cycle will become more intense as an agricultural economy develops into an industrial economy, and then become less intense as the industrial economy develops into an information economy.