Inflation, depression, innovation, human flourishing - the United States monetary system has played an integral role in each of these issues for centuries. But where did modern money come from? How does this inform the future?
Creating an Economic Empire
Human progress follows the rise and fall of great empires. In ancient Egypt, the Roman Empire, the Great British Empire, and every powerful civilization in between, economics played a vital role in the preservation of power.
The United States emerged as a world power for many reasons, including strong democratic ideals and advantageous geography. In this article, we will explore major shifts in the U.S. monetary system throughout the 19th and 20th centuries, the advantages and disadvantages of each, and how they might have impacted human flourishing.
For its first 200 years as an independent nation, America functioned on some version of a metallic standard. From 1792 to 1834, silver served as the primary backing. In 1834, the U.S. transitioned to a gold standard, where it would remain until 1933. From 1933 to 1971, the U.S. remained on a quasi-gold standard, until President Nixon officially converted the U.S. dollar into a fiat currency.
Every iteration of American money, from the silver standard to the gold standard to modern fiat, had both die-hard proponents and staunch critics. What’s done is done, but learning the lessons of history might help us make better decisions for the future of money.
The Coinage Acts
In the sixteen years following America’s independence from Great Britain, Americans primarily used foreign coins, such as the Spanish silver dollar, as currency. In 1792, Treasury Secretary Alexander Hamilton launched the first Coinage Act, unifying the U.S. financial system.
The Coinage Act of 1792 established the United States Mint, which produced, circulated, and regulated coinage in the United States. The act also made the U.S. dollar the nation’s official unit of money. The gold-to-silver ratio was set at 15-to-1, meaning one ounce of gold was valued at 15 times one ounce of silver.
At the time, international markets valued gold at a higher rate (15½-to-1) against silver. This encouraged U.S. citizens to export their gold overseas. Gold started disappearing from U.S. circulation, leaving silver coins as the primary unit of exchange.
To remedy this problem, Congress passed the Coinage Act of 1834. This Coinage Act boosted the gold-to-silver ratio to 16-to-1. Gold started flowing back to the U.S. while silver started flowing out. This effectively pushed the United States onto a gold standard, though the nation still technically functioned on the bimetallic standard.
During this period, Americans did use paper currency such as banknotes and Treasury Notes. Every piece of paper represented direct convertibility to physical gold or silver.
Flirting with Fiat
On April 12, 1861, the Confederate Army attacked South Carolina’s Fort Sumter, officially beginning the U.S. Civil War.
At first, the U.S. government tried issuing gold-backed Treasury Notes to fund the war. However, expenses soon surpassed the value of precious metals in America’s coffers, which forced the government to issue its first fiat currency: the greenback.
Fiat money, like the dollar bills we use today, has no intrinsic value. The U.S. government declared greenbacks as legal tender, which encouraged citizens to use them in everyday transactions. Without restrictions on money creation, the government soon cranked up the money printer.
As greenbacks flooded the economy, inflation took hold. The greenback’s market value deteriorated quickly, forcing the government to remove greenbacks from circulation and reinstate the gold standard. In the decade following the Civil War, the United States returned to gold-backed money and fiscal responsibility.
The International Gold Standard
In 1871, Germany replaced its multiple silver-based currencies with a unified gold backing. This marked the beginning of the international gold standard. Until the devastating impact of WWI, nearly all European nations (including Britain, France, Belgium, Italy, and Switzerland) kept their currencies pegged to gold.
Every currency was linked to every other currency at a fixed exchange rate, which made international trade extremely efficient. Gold served as the bedrock for economic value across the entire developed world.
The Gilded Age
From 1871 to 1933, the U.S. gold standard operated in its purest form. Every piece of paper currency (such as gold certificates and Treasury Notes) could be exchanged for physical gold on demand. During this period, economic growth in America was nothing short of miraculous.
The late 19th century is known as the Gilded Age, during which U.S. industrial output skyrocketed. John D. Rockefeller, Thomas Edison, Andrew Carnegie, and J.P. Morgan created their famous monopolies, and the United States transitioned into a legitimate world power.
Labor conditions also began to drastically improve for working-class Americans. Since the Industrial Revolution began in the late 18th century, blue-collar workers had suffered health risks, long hours, and low wages. During the Gilded Age, factory conditions began to improve, child labor decreased, and wages increased. The middle class climbed to a new level of prosperity.
There were plenty of financial setbacks, such as the “Long Depression” of 1873–1879 and the Panic of 1884. However, historians tend to agree that these financial calamities had nowhere near the detrimental impact on human flourishing as the Great Depression or Great Financial Crisis.
It is difficult to find a period during which Americans experienced such unprecedented growth in living standards.
The Golden Age of Invention
The miracle of the late 19th/early 20th century was not just limited to improvements in labor conditions. The scale of innovation under the gold standard was also extraordinary.
Inventions that laid the foundation for modern society, including the telephone, the airplane, and the internal combustion engine, all popped up in the United States during this period. Kerosene lamps turned into electric light bulbs. Horse-drawn carriages turned into cars, trains, and trolleys. Agricultural technology released millions of farmers from the burden of manual labor.
Electricity, plumbing, medicine, factory production, and infrastructure were all transformed during the Golden Age of Invention. Just look at this resume!
- Internal combustion engine (George Brayton – 1872)
- Barbed wire (Joseph Glidden – 1874)
- Telephone (Alexander Graham Bell – 1876)
- Light bulb (Thomas Edison – 1878)
- Coca-Cola (John Stith Pemberton – 1886)
- Alternating current motor (Nikola Tesla – 1888)
- Kodak camera (George Eastman – 1888)
- Airplane (Orville and Wilbur Wright – 1903)
- Theory of Relativity (Albert Einstein – 1905)
- Sonar (Lewis Nixon – 1906)
- Synthetic plastic (Leo Baekeland – 1907)
- Television (Philo Taylor Farnsworth – 1927)
- Penicillin (Alexander Fleming – 1928)
- Steam turbine (Charles Parsons, Irish – 1884)
- Automobile (Carl Friedrich Benz, German – 1885)
- Radar (Heinrich Hertz, German – 1887)
- Motion-picture camera (Auguste and Louis Lumière, French – 1895)
- Radio (Guglielmo Marconi, Italian – 1895)
Modern Americans should strive to replicate the environment that allowed such miraculous progress, stability, and growth to flourish. Some would say the gold standard played a big role in America’s success in this period.
The government had strict restrictions on money printing, which kept inflation in check and prevented top-down manipulation of the economy. Taxes were low, which allowed economic participants to plug their purchasing power back into the market and incentivize entrepreneurs.
Unfortunately, the catastrophes of the 20th century were just around the corner.
The Roaring Twenties and Great Depression
Economists have wildly differing opinions on the causes of the Great Depression. Supporters of the gold standard blame the Federal Reserve’s reckless policies throughout the 1920s and 30s. In their view, the gold standard could have prevented the disaster, but the government and banking system found loopholes that allowed them to drastically expand the money supply, creating a massive financial bubble and subsequent crash.
Critics of the gold standard claim the gold standard prevented the government from responding appropriately to the crisis. The gold standard intentionally places limits on credit creation and money printing, which prevents governments from handing out cash during depressions.
In his 1963 book America’s Great Depression, economist Murray N. Rothbard tracks the drastic increase in money supply during the Roaring Twenties. The Federal Reserve System helped increase the money supply from $45.3 billion in 1921 to $73.26 billion in 1929. The money supply increased 61.8% ($28 billion), while U.S. gold reserves only increased by $1.16 billion.
In his calculation of the money supply, Rothbard includes physical currency as well as “money substitutes” such as demand deposits, time deposits, savings and loan capital, and life insurance reserves. This is similar to the way we calculate M2 money supply today. The supply of physical currency did not increase dramatically, but the supply of credit did.
Was it the Fed’s Fault?
The Federal Reserve was originally formed in 1913 to serve as an emergency lender for banks. If a bank ran out of money, it could take out a loan from the Fed. The bank had to pay interest on this loan: the discount rate.
For its first decade of existence, the Fed kept the discount rate relatively high, discouraging banks from borrowing excessively. However, in the mid-1920s, the Federal Reserve shifted toward a policy of “continuous credit,” which allowed commercial banks to borrow as much money as they wanted at a very low discount rate.
According to a 1923 Federal Reserve report: “The Federal Reserve banks are the country’s supplementary reservoir of credit and currency, the source to which the member banks turn when the demands of the business community have outrun their own unaided resources. The Federal Reserve supplies the needed additions to credit in times of business expansion and takes up the slack in times of business recession.”
This marked a fundamental shift in the central banking strategy. The Fed was no longer an emergency backstop, but an arbiter of credit creation and economic growth. The Fed lowered effective reserve requirements, which allowed banks to lend out more money for every dollar they held in reserve.
Consumers began buying big-ticket items, such as automobiles, with borrowed money. Investors took on debt to speculate on the soaring stock market, using their stock as collateral. The stock market skyrocketed by 376% from 1921 to 1929.
Eventually, the Fed decided to put on the breaks. They raised interest rates and popped the speculative bubble. The ensuing crisis would go down in history. People rushed to withdraw all their money from banks. Companies went bankrupt. Millions of people lost their jobs. It would take 25 years for the stock market to reach its 1929 peak.
Gold in the Great Depression
As the Great Depression ravaged the nation, many policymakers felt the need to expand the money supply and stimulate the economy. Only one thing stood in their way: the gold standard. The gold standard put a strict limit on money printing, which kept the Fed from engaging in expansionary policies.
In 1933, Franklin D. Roosevelt suspended gold convertibility and closed the banks. On April 5, he signed Executive Order 6102, which made private gold ownership illegal. All Americans had to sell their gold bullion and coins to the government at a price of $20.67 per ounce. Immediately after confiscating the gold, FDR raised the price of gold to $35/ounce. This drastically increased the value of the government’s gold assets, allowing them to increase the money supply. The move also devalued the U.S. dollar by 41% against gold.
After 1933, gold still technically backed the U.S. dollar, but the connection had been severed for everyday citizens. For better or worse, U.S. monetary system would never be the same.
In 1939, Europe plunged into the Second World War. For six years, the Allied and Axis powers battled across every corner of the globe, killing millions in the process.
By 1945, nearly every financial system, population, and landscape in the developed world had been decimated. After the war, the United States held a conference in Bretton Woods, New Hampshire to lay the groundwork for a new international monetary system. Delegates from forty-four nations helped construct the agreement. Because the U.S. economy had emerged relatively unscathed from the war (at least compared to Western Europe), and because the U.S. held three-fourths of the world’s gold supply, the delegation chose the U.S. dollar as the international reserve currency.
All currencies were pegged to the dollar, which was pegged to gold. In exchange for this massive economic advantage, the United States took on the responsibility of keeping the world’s oceans safe, facilitating global free trade, and serving as the world’s policemen.
The Bretton Woods agreement also established the International Monetary Fund and World Bank, which continue to play a significant role in the global economy today.
Slow Death of the Gold Standard
Throughout the 1960s, the U.S. printed money to fund the Vietnam War and Lyndon Johnson’s Great Society programs. These spending policies pressured the U.S. dollar.
Other nations, most notably France, began redeeming their dollar reserves for gold, which threatened to deplete U.S. gold reserves. On August 15th, 1971, Richard Nixon suspended gold convertibility and struck the final nail into the coffin of the gold standard.
All major currencies shifted to a floating exchange rate system. Governments could now print money to their hearts’ content.
The Great Inflation
The end of the gold standard marked the beginning of the Great Inflation. In 1973, the OPEC oil crisis quadrupled the price of oil, which helped push U.S. inflation above 5%. This kicked off a decade-long period of stagflation, during which economic growth stalled, inflation surged, and stocks struggled to perform. Inflation peaked at 14.76% in 1980.
Between 1971 and 1980, the price of gold surged from $35/ounce to $875/ounce. Even though the U.S. dollar no longer had a relationship with gold, an increase in the gold price still represented a collapse in the value of the U.S. dollar. That dynamic remains to this day.
In 1980, Federal Reserve chair Paul Volcker ended the Great Inflation by cranking up interest rates to nearly 20%. This triggered two recessions but succeeded in stabilizing the dollar.
Since Nixon severed the gold standard, the U.S. dollar has functioned as a fiat currency. Some would say “functioned” is a strong word, given that the dollar’s value has plummeted since 1971. Fiat currencies have no intrinsic value, relying instead on policymakers to preserve the currency’s purchasing power.
Since the end of the gold standard, federal debt has skyrocketed, wages have stagnated, wealth inequality has exploded, the cost of living has soared, and savings rates have declined. Each of these secular trends took a noticeable turn in the 1970s, which indicates they may stem from the government’s monopoly on money.
However, we must be careful not to oversimplify these issues. Plenty of positive trends have occurred since the 1970s as well, such as a drastic decrease in the number of people living in extreme poverty. Most of this progress has occurred in Asia, which did not make the same economic transition as most Western nations.
Gold’s Role Today
On December 31st, 1974, Gerald Ford repealed FDR’s restrictions on private gold ownership. Since then, investors have purchased physical gold to capitalize on dollar devaluation. Individuals have very little control over the monetary system, but they can replicate some of the economic advantages of the gold standard in their personal portfolios.
Gold has maintained its purchasing power for over 5,000 years, and will continue doing so. Central banks still hold a significant percentage of their assets in gold. Even though the gold standard is long gone, the smartest economists in the world unanimously agree to hold onto the yellow metal…just in case.
If you’re interested in doing the same, set up a Vaulted account or give us a call!