America’s Money: A History

Edited by
Lawrence W. Reed

FEE’s mission is to inspire, educate, and connect future leaders with the economic, ethical, and legal principles of a free society.

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Foundation for Economic Education

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2019
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Table of Contents

Introduction

The Pine Tree Shilling by Kevin Cullinane

Private Coinage in America by Brian Summers

Thomas Paine, Champion of Sound Money by Lawrence H. White

The Times that Tried Men’s Economic Souls by Lawrence W. Reed

The Constitution and Paper Money by Clarence Carson

Banking Without Regulation by Lawrence H. White

Why You Can’t Mint a Dime by Lawrence W. Reed

Rutherford B. Hayes and the Financing of American Prosperity by Burton W. Folsom

The Silver Panic by Lawrence W. Reed

Is There a Speaker in the House? Part I by Lawrence W. Reed

Is There a Speaker in the House? Part II by Lawrence W. Reed

The U.S. Presidents and the Money Issue by Greg Kaza

The Depression You’ve Never Heard Of: 1920–1921 by Robert P. Murphy

Free Market Money in Coal-Mining Communities by Richard H. Timberlake

Gold and Money by Warren C. Gibson

Banking Before the Federal Reserve: The U.S. and Canada Compared by Donald Wells

Did the Fed Really Live Up to its Promise? by George Selgin

Money in the 1920s and 1930s by Richard H. Timberlake

Gold Policy in the 1930s by Richard H. Timberlake

The Great Gold Robbery by James Bovard

Monetary-Policy Disasters of the Twentieth Century by Kirby R. Cundiff

The Myth of the Independent Fed by Thomas J. DiLorenzo

What Do We Mean by Sound Money? by Gerald P. O’Driscoll, Jr.

Toward Radical Monetary Reform by Lawrence W. Reed

Introduction

Money is a middleman, a medium of exchange. You trade a good or a service for it not because you intend to consume it (unless you’re a numismatist) but because you want to pass it on in exchange for what you’re really after.

That’s why a restaurant may frame its first earned dollar and hang it on the wall, but it happily parts with every dollar it earns thereafter. Because it’s at least one side of every transaction—and both sides in the case of purchasing one currency with another—whatever affects money will affect virtually everything else in the modern marketplace.

Get it right, and money can grease the wheels of a prosperous economy. Get it wrong, and it becomes the poison that ruins the soup.

As a policy issue, money ranks high in importance in American history. Rare is the decade in the country’s nearly 250 years that it wasn’t at the center of critical national debates.

A year before the Declaration of Independence, the Second Continental Congress began wrestling with how to pay for a war against Britain. It printed paper money until it became nearly worthless.

Later, the new federal government attempted a policy of bimetallism by which gold and silver would circulate together as the nation’s media of exchange. Most of the time, however, one metal drove the other overseas or into other, non-monetary uses. Americans had silver coins in their pockets at the time of the War of 1812 but gold coins by the time of the Mexican War in the 1840s.

During the Civil War, payment in precious metals was suspended so both sides could crank up the printing presses again. The result was serious price inflation in the North and complete monetary destruction in the South.

Great political battles over money raged from the Civil War’s end until the turn of the century. What was best for the country as money? Gold? Silver? Fiat paper? Or some combination? In 1900, the matter was settled in favor of gold, but not for long. The establishment of the Federal Reserve System in 1913 helped put the country on a path to the irredeemable fiat money we use today.

The history of money in America is nothing if not colorful and controversial. Today, we argue widely about monetary policy, the role of digital currencies, and over whether the dollar can retain in the future its historic role as the world’s pre-eminent reserve currency. Where American money is headed tomorrow is yet to be determined, but perhaps its future can be better understood if we learn more about its past.

This collection of essays previously published by the Foundation for Economic Education offers a glimpse into American monetary history from the Pine Tree Shilling of colonial days to the Federal Reserve notes of now. When you’ve finished the 24th and final essay, you’ll see clearly that its forms and follies are inseparable from the story of our economic history.

—Lawrence W. Reed

President

Foundation for Economic Education

Atlanta, GA

February 2019

The Pine Tree Shilling

Kevin Cullinane

Boston was a hustling frontier trading center in 1652 when a young goldsmith, at the urging of hard-pressed merchants and artisans, began minting coins of value they could trust. Only 32 years had passed since the landing of the Mayflower, but already the industrious frontiersmen suffered from having debased European coinage traded off to them before they could learn of the latest currency inflations being worked by the rulers of Europe.

Dutch ducators, guilders, rixdollars, and ryals; Portuguese joannes, moidores, reis, and crusadoes; French livres; and Spanish doubloons, rials, dollars, and pistoles circulated side by side with English coins in the colony whose merchants were eager to trade with all comers.

But what to do about the fluctuating values of these varied European coins so unpopular in local trade? The answer to their coinage problem came at a meeting in Boston in 1652 when the men of the business community agreed among themselves to purchase, use, and mutually honor coins which would be produced by a local goldsmith. Accordingly, the colony’s General Court granted a franchise to Capt. John Hull and his partner, Robert Sanderson, to mint twelve penny, sixpenny and threepenny coins. The early Puritans were ready to turn to the marketplace for their money, sturdily ignoring the prohibitions of their English rulers.

The twelve penny coin became the famous Pine Tree Shilling. After several modifications, it was stamped with “Massachusetts” and a pine tree on one side, and “1652” and “New England” on the other.

Today, the coin is little mentioned in books, articles, or pamphlets dealing with coinage and monetary problems and that’s too bad, for of all the marketplace coins produced in America, the Pine Tree Shilling was the first, and one which adhered most closely to the principles of coinage integrity. The particularly sound policy of the Pine Tree Shilling minters was their practice of striking coins only when a customer came to their shop, bringing his own silver with him.[1] What a check on inflation!

Most minters—government or private—using their own supply of metal, mint coins in whatever quantity they think expedient, and assign them a value. The metal may or may not be of high value; a dollar coin may be minted of 900 worth of silver, for instance, or 100 worth of cupro-nickel. The difference between the 100 worth of metal and the $1.00 cost to the public is kept by the mint. That difference is called seigniorage, implying a lordly right of the ruler to such profit.

This system of minting allows the minter—in most cases, the government—to control and manipulate not only the quality of the currency but also the quantity which will be available to the marketplace. This is why it is said that those who control the currency control the commerce of a country.

Captain Hull and Robert Sanderson did not control the quantity of coinage minted for the marketplace; the marketplace—their customers—controlled the quantity. The two minters limited themselves to guaranteeing the quality of the coins by maintaining a fixed amount of silver in each shilling.[*] In establishing the silver quality they desired, the merchants and the General Court purposely kept the content of silver at three-fourths that of the English shilling. They hoped thereby to keep the coin in the Boston area and to prevent its moving, a la Gresham’s Law, into European trade.[2]

An Honest Assay

Into Hull’s small mint came silver buttons, tankards, goblets, knives, old sword hilts, spoons, and European coins to be assayed, melted down, and converted into the Pine Tree Shilling. Bullion from Peruvian mines, sometimes taken by privateers from Spanish galleons, found its way to the Boston melting pot as well.

Often the pieces to be melted contained a higher percentage of silver than the finished coins, which were alloyed with copper, so an honest assay was important. To determine the silver content of the variously shaped family pieces brought into their shop, the two men used the technique developed nineteen hundred years earlier by Archimedes: the pieces to be melted were weighed, then submerged in a tub of water which was filled up to an overflow spout so that the object spilled its exact volume of water into a measuring vessel beneath the spout. Given the volume of the object and its weight, the minters computed the percentage of silver it contained.

Their fee was handsome—they kept one out of every twenty shillings minted, plus wastage—but their risk was great as well, for though they were providing a much-needed service, they were also turning their backs on a restriction imposed by the English government which expressly forbade private coinage in the colonies.

Risky it may have been, but the Bostonians were ever an independent lot, and they needed honest coinage in their commerce. With reliable coins of intrinsic value, hard work by the colonists was more easily rewarded. Merchants and artisans could sell their goods or labors rather than barter, and they could save the coins they received until they wanted to spend them. So useful and popular was the Pine Tree Shilling that the English government chose to ignore its existence rather than attempt to suppress its circulation; an important early step toward independence was taken 129 years before that fateful April morning in Lexington.

After the American Revolution—and both before and after the Constitution—private minters supplied Americans with coins of integrity, and thousands of merchants have minted private tokens to be used in their transactions. But the proud silver coin—the Pine Tree Shilling—was the first. And like so much that emanated from the first generations of New Englanders, it was honest, independent, and reliable; an important part of our free-market heritage.

Kevin Cullinane is co-founder and Academic Director of the Academy of the Rockies, a one-year work-study-adventure prep school at Bonners Ferry, Idaho.

Originally published in the July 1972 issue of The Freeman.

[1] There are a few other instances of this minting policy in American history. For an interesting account of post-Revolution private minting see, William C. Wooldridge, Uncle Sam the Monopoly Man (Arlington House, New Rochell, New York) Chapter 3.

[*] Editorial note: A previous version of this article contained a misprint and has been edited for clarity.

[2] In this the Bostonians were foiled; the coin did move out into international trade. Because the Pine Tree Shilling contained the same quality alloy as the English Shilling, it did not matter to the Europeans that it was a lighter coin. Its value was simply three-fourths the value of the English Shilling—if the English Shilling was valued at twenty cents, the Pine Tree Shilling’s value was fifteen cents. As a result of this international acceptance, the General Court attempted to halt its natural outflow by imposing a heavy fine upon anyone caught exporting more than twenty of the coins.

Private Coinage in America

Brian Summers

America has never had a free market in money. From 1933 to 1975, Americans could not legally own gold. Since 1933, contracts payable in gold or indexed to the price of gold have been illegal, although the restored right to own gold may soon lead to new legal challenges. Since 1864, the private coining of money has been illegal, and since colonial days, we have had legal-tender laws designed to force the acceptance of coins and bills minted by the government.

Despite the absence of a completely free market, there have been times when Americans have privately minted money, and buyers and sellers have willingly used this money. Let us survey the history of American private coinage, for this history lends support to the practicality of free-market money, with private minters supplying the monetary needs of the market, and the government protecting people from fraud and coercion.

One of the first private coiners was John Higley, a blacksmith in Granby, Connecticut, who minted copper coins in 1737 and 1739. Higley let the market determine the value of his coins, on which he imprinted “I am good copper/Value me as you please.” No one was forced to accept Higley’s coins, in contrast with our federal government’s policy of printing on its paper money, “This note is legal tender for all debts, public and private.”

The eminent numismatist Edgar H. Adams attested to the quality of Higley’s coins:

In fact so pure was the metal contained in these pieces that they were much sought by goldsmiths of the period for the purposes of alloy, and the coins seem to have been in pretty general use until 1792, the time of the opening of the United States mint.[1]

Both Silver and Gold

Silver was also coined by private minters. In 1783 I. Chalmers of Annapolis, Maryland, minted silver shillings, sixpences, and threepences that were described by Henry Chapman as “very creditable.”[2] But the favorite metal of private minters was gold.

Joseph Coffin reports on the first privately coined gold:

During this period of our history (1830–1861) many private gold coins were struck in various sections of the United States. The first of such gold coins was issued in 1830 by Templeton Reid, an assayer at the gold mines of Lumpkin County, Georgia, the same county in which the Dahlonega mint [a Federal mint] was located. The Templeton Reid coins were issued in three denominations ($2.50, $5, and $10) at Reid’s private mint. The gold was of the best quality, and later many of the coins were melted because they were worth more as bullion than the face value of the coins.[3]

Templeton Reid successfully competed with the Dahlonega Federal mint. Another mintmaster who thrived in the face of Federal competition was Christopher Bechtler of Rutherfordton, North Carolina.

Bechtler, his sons, and nephew arrived in Rutherfordton in 1830, having emigrated from the Grand Duchy of Baden. From 1831 to 1847, they coined gold in three denominations ($1, $2.50, $5) despite competition from the nearby Federal mint established in 1837 in Charlotte.

Clarence Griffin reports on the public’s acceptance of the Bechtler coins which, like all privately minted coins, were not legal tender:

Bechtler coins were accepted and passed at face value in all of western North Carolina, South Carolina, western Tennessee, Kentucky and portions of Virginia. One of the country’s oldest citizens once told the writer that he was 16 years old before he ever saw any other coin than the Bechtlers. The coins filled a long-felt need for specie and continued to circulate long after the discontinuance of the mint in 1847. At the outbreak of the War between the States the new Confederacy began issuing currency, but did not put out any specie. Bechtler coins, especially in this locality, were carefully hoarded, and many contracts and agreements of the sixties specified Bechtler gold coins as a consideration rather than the Confederate States currency or the scant supply of Federal specie.

Despite the fact that these coins bore no device emblematic of a national character, or any official guaranty of their purity, they were unhesitatingly accepted by all. In the proper sense of the word they were only ‘tokens’ and when offered at the government mints were worth less than the face value, as the government deducted the seigniorage and assay fees for reminting. Yet these coins were passed over the counters of the stores, where they received the same consideration as if they were made by the United States Government. They were carried by traders into Kentucky and South Carolina, and many homeseekers going westward during the great immigration period of 1850–1870 carried their Bechtler coins with them. Many circulated more freely than did government specie, and it has not been so many years since the local banks accepted them at face value.

Today Bechtler coins sell at enormous prices. Numismatists quote them from $5 to $100 and more.[4]

Honesty the Best Policy

G. W. Featherstonhaugh, who visited Bechtler in 1837, gave the following account of his visit:

Christopher Bechtler’s maxim was that honesty was the best policy and that maxim appeared to govern his conduct. I was never so pleased with observing transactions of business as those I saw at his house during the time I was there. Several country people came with rough gold to be left for coinage. He weighed it before them and entered it in his book, where there was marginal room for noting the subsequent assay. To others he delivered the coin he had struck. The most perfect confidence prevailed between them, and the transactions were conducted with quite as much simplicity as those at a country grist mill, where the miller deducts the toll for the grist he has manufactured.[5]

Christopher Bechtler coined over three million dollars in gold. But his operation was dwarfed by the private mints that sprang up after the discovery of gold in California in 1848. At least 15 private mints coined gold in California during 1849–1855. The bullion content of some of these coins was less than their face value, so these coins were rejected by the market and soon passed out of circulation. However, the coins of Moffat & Co., Kellogg & Co., and Wass, Molitor & Co. enjoyed the confidence of the community and were readily accepted.

The January 8, 1852, issue of the San Francisco Herald contains the following comments on the Wass, Molitor & Co. mint:

The very serious inconveniences to which the people of California have been subjected through the want of a [Federal] mint, and the stream of unwieldy slugs that have issued from the United States Assay Office have imperatively called for an increase of small coin. The well known and highly respectable firm of Wass, Molitor & Co. have come forward in this emergency, and are now issuing a coin of the value of $5 to supply the necessities of trade.

The mechanical execution of the coin issued by these gentlemen certainly reflects the highest credit upon their skill. It is a beautiful specimen of art, far superior in finish to anything of the kind ever gotten up in California.

But the most important point to the public is its fineness and weight, as upon these two qualities combined must depend its value. In this particular it will be found highly satisfactory, and at once secure the confidence of the community. It has a uniform standard of .880, and contains no other alloy than that of silver, which is found naturally combined with gold. The weight of each of the $5 pieces, which are the only ones at present issued, is 131.9 grains.

The standard fineness of the United States Five Dollar piece is .900, weight 127 grains. It is therefore 20/1000 finer than Wass, Molitor & Co.’s pieces, but this is more than counterbalanced by the latter’s being 4.9 grains heavier, so that the new Five Dollar gold piece is in reality worth five dollars and four cents, a sufficient excess to pay the expense of recoinage at the United States Mint without cost to the depositor.

The reason Messrs. Wass, Molitor & Co. have adopted the standard of .880 is because this is about the average fineness of California gold, and further because the cost of refining California gold to the United States standard is exceedingly heavy, and the necessary chemicals cannot be obtained in this country. But it will be remembered that the difference is more than made up by the increased weight of 4.9 grains, which every one can try for himself on a pair of scales. These coins will be redeemed on presentation in funds received at the Custom House and banks. The high reputation for honor and integrity enjoyed by Count Wass and his associates in this enterprise is an additional guaranty that every representation made by them will be strictly complied with. The public will be glad to have a coin in which they can feel confidence, and which can’t depreciate in their hands. The leading bankers, too, sustain and encourage this issue, and will receive it on deposit.[6]

The End of an Era

One of the last private mints was Clark, Gruber & Co. Carl Watner writes:

Between 1860 and 1862 the firm of Clark, Gruber & Co. was engaged in the manufacture of their own coins from their mint in the city of Denver. Here again, the demand for a circulating medium was satisfied by private means before the government was able to act. The Clark, Gruber coins were of high quality and always either met or exceeded the gold bullion value of similar United States coins. In a period of less than two years this firm minted approximately three million dollars’ worth of coin. Their mint promised to outdo the government’s own production, and to get rid of them, the government bought them out in 1863 for $25,000.[7]

In 1864, the private coining of money was banned by an Act of Congress. Today the prohibition against private coinage, the doubtful legality of gold contracts, and legal-tender laws assure the federal government a legal monopoly over money, and prevent buyers and sellers from freely choosing mutually acceptable media of exchange.

Brian Summers is a former editor of The Freeman.

Originally published in the July 1976 issue of The Freeman.

[1] Edgar H. Adams, “Higley Coppers ‘Granby Coinage,’” The Numismatist, August 1908.

[2] Henry Chapman, “The Colonial Coins Prior to July 4, 1776,” The Numismatist, February 1948.

[3] Joseph Coffin, The Complete Book of Coin Collecting (Coward, McCann & Geoghegan, New York, 1973) p. 108.

[4] Clarence Griffin, “The Story of the Bechtler Gold Coinage,” The Numismatist, September 1929.

[5] Ibid.

[6] Edgar H. Adams, Private Gold Coinage of California (Edgar H. Adams, Brooklyn, N.Y., 1913) pp. 79–80.

[7] Carl Watner, “California Gold: 184965,” Reason, January 1976, pp. 27–28.

Thomas Paine, Champion of Sound Money

Lawrence H. White

Between writing his well-known revolutionary liberal tracts Common Sense (1776) and The Rights of Man (1791), Thomas Paine contributed knowledgeably to a 1785–6 debate over money and banking in Pennsylvania. Paine defended the Bank of North America’s charter and its operations in a number of lengthy letters to Philadelphia newspapers during 1786, followed by a December monograph that summarized his case, Dissertations on Government; The Affairs of the Bank; and Paper Money.[1]

Paine argued that to repeal the bank’s charter violated both the rule of law and the maxims of sound economic policy. His writings show that he well understood the benefits of banking. Although proponents of the repeal accused Paine, publicly known to be in dire financial shape, of being paid by the BNA’s proprietors for defending it (one called him “an unprincipled author, who lets his pen out for hire”), Paine vociferously denied the charge, and historians (such as Philip S. Foner, who edited an anthology of Paine’s works), have found no evidence to support the accusation.

Prima facie evidence of Paine’s sincerity is found in his marshaling of serious arguments that were consistent with the classical liberal principles of his earlier writings.

Here’s the backstory: The Continental Congress chartered the Bank of North America, headquartered in Philadelphia and headed by Robert Morris and Thomas Willing in 1781. Considering a Commonwealth of Pennsylvania charter to be a sounder authorization, in 1782 the bank sought and received a charter from the Pennsylvania legislature. After the Revolutionary War’s end in 1783, as historian Janet Wilson noted, farmers in western Pennsylvania with large debts and tax arrears “set up a cry for paper money” to be issued by the Commonwealth.[2] These state-issued notes would not be presently redeemable but would be receivable for future tax payments.

The inflationists understandably saw the BNA as a barrier to their plan. If the bank valued the state paper below its par value, while BNA banknotes and checks traded at par in terms of the silver dollars for which they could be immediately redeemed, real demand for the state paper currency would be low. Better for the sake of state paper to eliminate the superior alternative. Hence, with the legislature voting to authorize an issue of state notes in mid-1785, the inflationists demanded the repeal of the bank’s charter.

They were further motivated by the bank proprietors’ public opposition to state paper. The legislature debated and then repealed the charter in September 1785. The BNA continued to do business, on a smaller scale, under its 1781 charter from the Continental Congress. (The 1st US Congress would not meet until March 1789.) Eighteen months after repeal, in March 1787, following a pitched public discussion and the election of pro-bank legislators in fall 1786, the charter was restored.

The clamor for irredeemable paper money, wrote Paine in 1786, derived from “delusion and bubble.”[3] Yes, the irredeemable paper currency issued during the war as a matter of necessity had provided revenue “while it lasted,” but not as a free lunch, but rather by taxing individual money-holders through price inflation and currency depreciation. Since its demise, “gold and silver are become the currency of the country.”[4] Those thinking that state paper will relieve a “shortage” of specie have it backward: it is precisely the issue of irredeemable paper that drives out gold and silver. On this point, Paine argued with impeccable Humean logic:

The pretense for paper money has been, that there was not a sufficiency of gold and silver. This, so far from being a reason for paper emissions, is a reason against them. As gold and silver are not the productions of North America, they are, therefore, articles of importation; and if we set up a paper manufactory of money it amounts, as far as it is able, to prevent the importation of hard money, or to send it out again as fast it comes in; and by following this practice we shall continually banish the specie, till we have none left, and be continually complaining of the grievance instead of remedying the cause. Considering gold and silver as articles of importation, there will in time, unless we prevent it by paper emissions, be as much in the country as the occasions of it require, for the same reasons there are as much of other imported articles.[5]

Critic of Monetary Stimulus

Paine understood that any stimulus from injecting money was only temporary because issuing more paper money does not create any more wealth. He even offered the binge-drinking/hangover analogy that has, in modern times, become commonplace:

Paper money is like dramdrinking, it relieves for a moment by deceitful sensation, but gradually diminishes the natural heat, and leaves the body worse than it found it. Were not this the case, and could money be made of paper at pleasure, every sovereign in Europe would be as rich as he pleased. But the truth is, that it is a bubble and the attempt vanity.[6]

State paper money became not just imprudent but unjust when it was combined with a legal tender law compelling the acceptance of depreciated paper dollars where a contract called for payment in silver or gold dollars:

As to the assumed authority of any assembly in making paper money, or paper of any kind, a legal tender, or in other language, a compulsive payment, it is a most presumptuous attempt at arbitrary power. . . . [A]ll tender laws are tyrannical and unjust, and calculated to support fraud and oppression.[7]

For a legislator even to propose such a tyranny should be a capital crime [!]:

The laws of a country ought to be the standard of equity, and calculated to impress on the minds of the people the moral as well as the legal obligations of reciprocal justice. But tender laws, of any kind, operate to destroy morality, and to dissolve, by the pretense of law, what ought to be the principle of law to support, reciprocal justice between man and man: and the punishment of a member who should move for such a law ought to be death.[8]

Responding to an anti-BNA petition, which claimed that “the said bank has a direct tendency to banish a great part of the specie from the country, so as to produce a scarcity of money, and to collect into the hands of the stockholders of the said bank, almost the whole of the money which remains amongst us,” [387–8n] Paine argued that the issue of immediately gold-redeemable banknotes gives a commercial bank like the BNA a strong reason to retain sufficient gold reserves:

Specie may be called the stock in trade of the bank, it is therefore its interest to prevent it from wandering out of the country, and to keep a constant standing supply to be ready for all domestic occasions and demands. . . . While the bank is the general depository of cash, no great sums can be obtained without getting it from thence, and as it is evidently prejudicial to its interest to advance money to be sent abroad, because in this case the money cannot by circulation return again, the bank, therefore, is interested in preventing what the committee would have it suspected of promoting. It is to prevent the exportation of cash, and to retain it in the country, that the bank has, on several occasions, stopped the discounting notes till the danger had been passed.[9]

Here, Paine failed to add that the public’s voluntary substitution of banknotes for specie, although it does not banish any specie that is still wanted, does allow the payment system to conduct a given volume of payments more economically, with less specie. The ability to export the share of specie thus rendered redundant, in exchange for productive machines and material inputs, was a growth-enhancing benefit of banking that Adam Smith had emphasized in The Wealth of Nations, published ten years earlier.

In response to the claim that the bank “will collect into the hands of the stockholders” the specie remaining in the country, Paine explained that a bank’s specie reserves are not the net worth owned by its shareholders. Rather the reserves are held to redeem its liabilities, and thus are “the property of every man who holds a bank note, or deposits cash there,” or otherwise has a claim on the bank.

The Bank of North America at the time held the first and as yet only bank charter granted by the legislature of Pennsylvania. Critics damned the BNA as a privileged monopoly. Legislator John Smiley asserted that the charter repeal “secured the natural rights of the people from invasion by monopolies.” This view—later echoed by the Jeffersonians and Jacksonians in their opposition to the First and Second Bank of the United States—is of course paradoxical.

The Cure for Monopoly Power

The cure for monopoly power created by exclusive charter (incorporation) is to grant charters freely, to go from one to a multiplicity of charters. It is not to go from one to zero charters. If more banks were free to enter but simply hadn’t yet, then the BNA was a monopolist only in the benign sense that the entrepreneur who creates a new market (thus expanding and not restricting trade) is the single seller until others arrive. Eventually, additional chartered banks did enter the Pennsylvania market: the (First) Bank of the United States (chartered by the US Congress) in 1791, and the Bank of Pennsylvania (state-chartered) in 1793.

In a later work criticizing the Bank of England (which did have an exclusive charter to issue banknotes as a corporation), Paine, unfortunately, seemed to blur the distinction between banknotes and irredeemable paper money. He made the valid point that banknotes held, unlike gold held, are not net national wealth (because they are liabilities of the issuer). Then he declared:

the rage that overran America, for paper money or paper currency, has reached to England under another name. There it was called continental money, and here it is called bank notes. But it signifies not what name it bears, if the capital is not equal to the redemption. . . . The natural effect of increasing and continuing to increase paper currencies is that of banishing the real money. The shadow takes place of the substance till the country is left with only shadows in its hands.[10]

To reconcile this passage with his previous writings, we must suppose that Paine is not criticizing banknotes in general, but the Bank of England in particular for holding inadequate reserves relative to its growing note-issue.

But this raises the question: Why would the BOE want to hold inadequate reserves when the BNA (as he had argued) did not? Paine might have explained this (but unfortunately did not) by Parliament’s implicit guarantee that it would not penalize the BOE for a suspension of payments, giving the Bank a moral-hazard incentive to skimp on reserves. When the Bank of England did suspend payments in 1797, forced by a run on the bank prompted by the threat of an invasion by Napoleon’s troops, Parliament did, in fact, immunize the Bank against note-holder lawsuits. Paine ten years ahead warned that the BOE might suspend in 1796, which was only one year off if we consider it a prediction:

A stoppage of payment at the bank is not a new thing. Smith in his “Wealth of Nations,” book ii. chap. 2, says, that in the year 1696, exchequer bills fell forty, fifty and sixty per cent; bank notes twenty per cent; and the bank stopped payment. That which happened in 1696 may happen again in 1796.[11]

To be clear, Paine anticipated trouble from the growing British public debt, not from threat of invasion. But the two were not unrelated.

Lawrence H. White is Professor of Economics at George Mason University and The Freeman contributor. He previously taught at New York University, the University of Georgia, and the University of Missouri–St. Louis. He received his A.B. in Economics from Harvard University, and both his M.A. and Ph.D. from the University of California at Los Angeles. His major areas of research and teaching are monetary theory and policy, economic history, and the history of economic ideas. He is the author of Free Banking in Britain, Competition and Currency, and The Theory of Monetary Institutions. His articles have appeared in the American Economic Review and other leading professional journals. Professor White is the author of The Clash of Economic Ideas: The Great Policy Debates and Experiments of the Last Hundred Years, published in 2012.

Originally published on Alt-M blog and has been reprinted with permission in this anthology.

[1] Most of the quotations from Paine below come from this monograph as reprinted in Philip S. Foner, ed., The Collected Works of Thomas Paine, vol. 2, which is available online: https://mises.org/library/complete-writings-thomas-paine-volume-2.

[2] Janet Wilson, “The Bank of North America and Pennsylvania Politics: 1781–1787,” The Pennsylvania Magazine of History and Biography 66 (Jan., 1942), pp. 3–28; available online: https://hsp.org/sites/default/files/politics_-_article_about_bna_from_pmhb.pdf.

[3] Letter to the Pennsylvania Packet, April 4, 1786; in Collected Works II, p. 419.

[4] Letter to the Abbe Raynal (1782) in Collected Works II, pp. 229, 230.

[5] Dissertations on Government (1786), in Collected Works II, p. 407.

[6] Ibid.

[7] Ibid., pp. 407, 409.

[8] Ibid., p. 408.

[9] Ibid., pp. 391–2.

[10] Paine, “Prospects on the Rubicon” (1787), Collected Works II, pp. 636–7.

[11] Ibid., pp. 663–4.

The Times that Tried Men’s Economic Souls

Lawrence W. Reed

Two hundred and thirty years ago this month in Valley Forge, Pennsylvania, the brutal and storied winter of 1777–78 came to a long-awaited close. Nearly a quarter of George Washington’s Continental Army troops encamped there had died—victims of hunger, exposure, and disease. Almost every American knows that much, but few can tell you why Congress was as much to blame as the weather.

For six years—from 1775 until 1781—representatives from the 13 colonies (states after July 4, 1776) met and legislated as the Second Continental Congress. They were America’s de facto central government during most of the Revolutionary War and included some of the greatest minds and admirable patriots of the day. Among their number were Thomas Jefferson, Benjamin Franklin, John and Sam Adams, Alexander Hamilton, Patrick Henry, John Jay, James Madison, and Benjamin Rush. The Second Continental Congress produced and ratified the Declaration of Independence, and the country’s first written constitution, the Articles of Confederation. It also ruined a currency and very nearly the fledgling nation in the process, proving that even the best of men with the noblest of intentions sometimes must learn economics the hard way.

The Continental

Governments derive their revenues primarily from one, two, or all three of these sources: taxation, borrowing, and inflating the currency. Americans were deemed to be in no mood to replace London’s taxes with local ones so the Second Continental Congress, which before March 1781 faced no legal prohibition to tax, opted not to. It borrowed considerable sums by issuing bills of credit, but with few moneyed interests willing to risk their capital to take on the British Empire, the expenses of war and government could hardly be covered that way. What the Congress chose as its principal fundraising method is revealed by this statement of a delegate during the financing debate: “Do you think, gentlemen, that I will consent to load my constituents with taxes when we can send to our printer and get a wagon-load of money, one quire of which will pay for the whole?”

Reports of the deliberations that led to the printing of paper money are sketchy, but indications are nevertheless that support for it was probably not universal. John Adams, for instance, was a known opponent. He once referred to the idea as “theft” and “ruinous.” Nonetheless, he and Ben Franklin were among five committee members appointed to engrave the plates, procure the paper, and arrange for the first printing of Continental dollars in July 1775. Many delegates were convinced that issuing unbacked paper would somehow bind the colonies together in the common cause against Britain.

In any event, not even the skeptics foresaw the bottom of the slippery slope that began with the first $2 million printed on July 21. Just four days later, $1 million more were authorized. Franklin actually wanted to stop the presses with the initial issue and opposed the second batch, but the temptation to print proved too alluring. By the end of 1775, another $3 million in notes were printed. After war erupted, the states demanded more paper Continentals from Congress. A fourth issue—this time for $4 million—was ordered in February 1776, followed by $5 million more just five months later and another $10 million before the year was out.

In the marketplace, the paper notes fell in value even before independence was declared. The consequences of paper inflation at the hands of American patriots were no different from what they ever were (or still are) when rampant expansion of the money supply is conducted by rogues or dictators: prices rise, savings evaporate, and governments resort to draconian measures to stymie the effects of their own folly. As author Ayn Rand would advise in another context nearly two centuries later, “We can evade reality, but we cannot evade the consequences of evading reality.”

Americans increasingly refused to accept payment in the Continental dollar. To keep the depreciating notes in circulation, Congress and the states enacted legal-tender laws, measures that are hardly necessary if people have confidence in the soundness of the money. Though he used the power sparingly, George Washington was vested by Congress with authority to seize whatever provisions the army needed and imprison merchants and farmers who wouldn’t sell goods for Continentals.

At harvest time in 1777, with winter approaching and the army in desperate need of supplies, even farmers who supported independence preferred to sell food to the redcoats because they paid in real money—gold and silver. Washington ordered guards placed along the Schuylkill River to stop supplies from reaching the British.

Another 13 Million Paper Dollars

Congress cranked out another 13 million paper dollars in 1777. With prices soaring, the Pennsylvania legislature compounded the effects of bad policy: it imposed price controls on precisely those commodities required by the army. Washington’s 11,000 men at Valley Forge froze and starved while not far away the British army spent the winter in relative comfort, subsisting on the year’s ample local crops. It wasn’t the world’s first, nor would it be its last, experiment with price controls.

Congress recognized the mistake on June 4, 1778, when it adopted a resolution urging the states to repeal all price controls. But the printing presses rolled on, belching out 63 million more paper Continentals in 1778 and 90 million in 1779. By 1780 the stuff was virtually worthless, giving rise to a phrase familiar to Americans for generations: “not worth a Continental.”

A currency reform in 1780 asked everyone to turn in the old money for a new one at the ratio of 20 to 1. Congress offered to redeem the paper in gold in 1786, but this didn’t wash with a citizenry already burned by paper promises. The new currency plummeted in value until Congress was forced to get honest. By 1781, it abandoned its legal-tender laws and started paying for supplies in whatever gold and silver it could muster from the states or convince a friend (like France) to lend it. Not by coincidence, supplies and morale improved, which helped bring the war to a successful end just two years later.

The early years of our War for Independence were truly, as Tom Paine wrote, “times that tr[ied] men’s souls” and not just because of Mother Nature and British troops. Pelatiah Webster, America’s first economist, summed up our own errors rather well when he wrote,

The people of the states had been . . . put out of humor by so many tender acts, limitations of prices, and other compulsory methods to force value into paper money . . . and by so many vain funding schemes, declarations and promises, all of which issued from Congress but died under the most zealous efforts to put them into operation and effect.

History texts often bestow great credit on the men of the Second Continental Congress for winning American independence. A case can also be made, however, that we won it in spite of them.

Originally published in the March 2008 issue of The Freeman.

The Constitution and Paper Money

Clarence Carson

The United States Constitution does not mention paper money by that name. Nor does it refer to paper currency or fiat money in those words.[1] There is only one direct reference to the origins of what we, and they, usually call paper money. It is in the limitations on the power of the states in Article I, Section 10. It reads, “No State shall . . . emit Bills of Credit. . .”

Paper that was intended to circulate as money but was not redeemable in gold and silver was technically described as bills of credit at that time. The description was (and is) apt. Such paper is a device for expanding the credit of the issuer. There is also an indirect reference to the practice in the same section of the Constitution. It reads, “No State shall . . . make any Thing but gold and silver Coin a Tender in Payment of Debts. . .” Legal tender laws, in practice, are an essential expedient for making unredeemable paper circulate as money. Except for the one direct and one indirect reference to the origin and means for circulating paper money, the Constitution is silent on the question.

With such scant references, then, it might be supposed that the makers of the Constitution were only incidentally concerned with the dangers of paper money. That was hardly the case. It loomed large in the thinking of at least some of the men who were gathered at Philadelphia in 1787 at the Constitutional Convention. There were two great objects in the making of a new constitution: one was to provide for a more energetic general government; the other was to restrain the state governments. Moreover, the two objects had a common motive at many points, i.e., to provide a stronger general government which could restrain the states.

Measures to Prevent a Flood of Unbacked Paper Money

One of the prime reasons for restraining the state governments was to prevent their flooding the country with unbacked paper money. James Madison, one of the leaders at the convention, declared, in an introduction to his notes on the deliberations there, that one of the defects they were assembled to remedy was that, “In the internal administration of the States, a violation of contracts had become familiar, in the form of depreciated paper made a legal tender. . .”[2] Edmund Randolph, in the introductory remarks preceding the presentation of the Virginia Plan to the convention, declared that when the Articles of Confederation had been drawn, “the havoc of paper-money had not been foreseen.”[3]

Indeed, as the convention held its sessions, or in the months preceding it, state legislatures were under pressure to issue paper money. Several had already yielded, or taken the initiative, in issuing the unbacked paper. The situation was out of control in Rhode Island and had been for some time. Rhode Island refused to send delegates to the convention, and the state’s reputation was so bad that the delegates there were apparently satisfied to be spared the counsels of her citizens.

Well after the convention had got underway, a motion was made to send a letter to New Hampshire, whose delegates were late, urging their attendance. John Rutledge of South Carolina rose to oppose the motion, arguing that he “could see neither the necessity nor propriety of such a measure. They are not unapprized of the meeting, and can attend if they choose.” And, to clinch his argument, he proposed that “Rhode Island might as well be urged to appoint & send deputies.”[4] No one rose in defense of an undertaking of that character.

The ill repute of Rhode Island derived mainly from that state’s unrestrained experiments with paper money. Rhode Island not only issued paper money freely but also used harsh methods to try to make it circulate. The “legislature passed an act declaring that anyone refusing to take the money at face value would be fined £100 for a first offense and would have to pay a similar fine and lose his rights as a citizen for a second.”[5] When the act was challenged, a court declared that it was unconstitutional. Whereupon, the legislature called the judges before it, interrogated them, and dismissed several from office. The legislature was determined to have its paper circulate.

The combination of abundant paper money and Draconian measures to enforce its acceptance brought trade virtually to a halt in Rhode Island. A major American constitutional historian described the situation this way:

The condition of the state during these days was deplorable indeed. The merchants shut their shops and joined the crowd in the bar-rooms; men lounged in the streets or wandered aimlessly about. . . . A French traveller who passed through Newport about this time gives a dismal picture of the place: idle men standing with folded arms at the corners of the streets; houses falling to ruins; miserable shops offering for sale nothing but a few coarse stuffs . . .; grass growing in the streets; windows stuffed with rags; everything announcing misery, the triumph of paper money, and the influence of bad government. The merchants had closed their stores rather than take payment in paper; farmers from neighboring states did not care to bring their produce. . . . Some . . . sought to starve the tradesmen into a proper appreciation of the simple laws of finance by refusing to bring their produce to market.[6]

But there was more behind the Founders’ fears of paper money than contemporary doings in Rhode Island or general pressures for monetary inflation. The country as a whole had only recently suffered the searing aftermath of such an inflation. Much of the War for Independence had been financed with paper money or, more precisely, bills of credit.

A Surge of Continentals

Even before independence had been declared, the Continental Congress began to emit bills of credit. These bills carried nothing more than a vague promise that they would at some unspecified time in the future be redeemed, possibly by the states. In effect, they were fiat money and were never redeemed. As more and more of this Continental currency was issued, 1776–1779, it depreciated in value. This paper was joined by that of the states which were, if anything, freer with their issues than the Congress. In 1777, Congress requested that the states cease to print paper money, but the advice was ignored. They did as Congress did, not what it said.

At first, this surge of paper money brought on what appeared to be a glow of prosperity. As one historian described it,

the country was prosperous. . . . Paper money seemed to be the “poor man’s friend”; to it were ascribed the full employment and the high price of farm products that prevailed during the first years of the war. By 1778, for example, the farmers of New Jersey were generally well off and rapidly getting out of debt, and farms were selling for twice the price they had brought during the period 1765–1775. Trade and commerce were likewise stimulated; despite the curtailment of foreign trade, businessmen had never been so prosperous.[7]

The pleasant glow did not last long, however. It was tarnished first, of course, by the fact that the price of goods people bought began to rise. (People generally enjoy the experience of prices for their goods rising, but they take a contrary view of paying more for what they buy.) Then, as now, some blamed the rise in prices on merchant profiteering.

As the money in circulation increased and expectations of its being redeemed faded, a given amount of money bought less and less. This set the stage for speculative buying, holding on to the goods for a while, and making a large paper profit on them. There were sporadic efforts to control prices as well as widespread efforts to enforce acceptance of the paper money in payment for debts. These efforts, so far as they succeeded, succeeded in causing shortages of goods, creditors to run from debtors trying to pay them in the depreciated currency, and in the onset of suffering.

Runaway Inflation

By 1779, the inflation was nearing the runaway stage. “In August 1778, a Continental paper dollar was valued (in terms of gold and silver) at about twenty-five cents; by the end of 1779, it was worth a penny.” “Our dollars pass for less this afternoon than they did this morning,” people began to say.[8] George Washington wrote in 1779 that “a wagon load of money will scarcely purchase a wagon load of provisions.”[9]

It was widely recognized that the cause was the continuing and ever larger emissions of paper money. Congress resolved to issue no more in 1779, but it was all to no avail. Runaway inflation was at hand. In 1781, Congress no longer accepted its own paper money in payment for debts, and the Continentals ceased to have any value at all.

A good portion of the dangers of paper money had been revealed, and reflective people were aware of what had happened. Josiah Quincy wrote George Washington “that there never was a paper pound, a paper dollar, or a paper promise of any kind, that ever yet obtained a general currency but by force or fraud, generally by both.”[10]

A contemporary historian concluded that the “evils which resulted from the legal tender of the depreciated bills of credit” extended much beyond the immediate assault upon property. “The iniquity of the laws,” he said, “estranged the minds of many of the citizens from the habits and love of justice. . . . Truth, honor, and justice were swept away by the overflowing deluge of legal iniquity. . .”[11]

But the economic consequences of the inflation did not end with the demise of the Continental currency. Instead, it was followed by a deflation, which was the inevitable result of the decrease in the money supply. The deflation was not immediately so drastic as might be supposed. Gold and silver coins generally replaced paper money in 1781. Many of these had been out of circulation, in hiding, so long as they were threatened by tender law requirements to exchange them on a par with the paper money. Once the threat was removed, they circulated.

The supply of those in hiding had been augmented over the years by payments for goods by British troops. Large foreign loans, particularly from the French, increased the supply of hard money in the United States in 1781 and 1782. A revived trade with the Spanish, French, and Dutch brought in coins from many lands as well. In addition, Robert Morris’s Bank of North America provided paper money redeemable in precious metals in the early years of the decade.

The Impact of Depression

By the middle of the 1780s, however, the deflation was having its impact as a depression. Trade had reopened with Britain, and Americans still showed a distinct preference for British imports. That, plus the fact that the market for American exports in the British West Indies was still closed, resulted in a large imbalance in trade. Americans made up the difference either by borrowing or shipping hard money to Britain.

Prices fell to reflect the declining money supply. Those who had gone into debt to buy land at the inflated wartime prices were especially hard hit by the decline in the prices of their produce. Foreclosures were widespread in 1785–1786. This provided the setting for the demands for paper money and other measures to relieve the pressure of the debts. Some people were clamoring for the hair of the dog that had bit them in the first place—monetary inflation—and several state legislatures had accommodated them.

Though there is evidence that the worst of the depression was over by 1787, if not in the course of 1786,[12] paper money issues and agitations for more were still ongoing when the Constitutional Convention met in Philadelphia. In any case, those who had absorbed the lessons of recent history were very much concerned to do something to restrain governments from issuing paper money and forcing it into circulation. There were those who met at Philadelphia, too, who took the long view of their task. They hoped to erect a system that would endure, and to do that they wished to guard against the kind of fiscal adventures that produced both unpleasant economic consequences and political turmoil. Paper money was reckoned to be one of these.

The question of granting power to emit bills of credit came up for discussion twice in the convention. The first time was on August 16, 1787. (The convention had begun its deliberations on May 25, 1787, so it was moving fairly rapidly toward the conclusion when the question arose.) The question was whether or not the United States government should have the power to emit bills of credit. Congress had such a power under the Articles of Confederation, and most of the powers held by Congress under the Articles were introduced in the convention to be extended to the new government.

Constitutional Convention Debates

Gouverneur Morris of Pennsylvania “moved to strike out ‘and emit bills on the credit of the United States’.” That is, he proposed to remove the authority for the United States to issue such paper money. “If the United States had credit,” Morris said, “such bills would be unnecessary: if they had not, unjust & useless.” His motion was seconded by Pierce Butler of South Carolina.

James Madison wondered if it would “not be sufficient to prohibit making them a tender? This will remove the temptation to emit them with unjust views. And promissory notes in that shape may in some emergencies be best.” (Madison’s distinction between bills of credit that may be freely circulated and those whose acceptance is forced by tender laws should remind us that paper instruments serving in some fashion as money are not at the heart of the problem. After all, private bills of exchange had, for several centuries, been used by tradesmen, and these sometimes changed hands much as money does. They are what we call negotiable instruments, and the variety of these is large. What Madison was getting at more directly, however, was that governments, if they are to borrow money from time to time, may issue notes, and these may be negotiable instruments which may take on some of the character of money in exchanges. But Madison’s objection was overcome, as we shall see.)

Gouverneur Morris then observed that “striking out the words will leave room still for notes of a responsible minister which will do all the good without the mischief. The Monied interest will oppose the plan of Government, if paper emissions be not prohibited.”

However, Morris had moved beyond his motion, which was for removing the power, not specifying a prohibition, and Nathaniel Gorham of Massachusetts brought him back to the point. Gorham said he “was for striking out, without inserting any prohibition. If the words stand they may suggest and lead to the measure.”

Not everyone who spoke, however, favored removing the power. George Mason of Virginia

had doubts on the subject. Congress he thought would not have the power unless it were expressed. Though he had a mortal hatred to paper money, yet as he could not foresee all emergences [sic], he was unwilling to tie the hands of the Legislature. He observed that the late war could not have been carried on, had such a prohibition existed.

Nathaniel Gorham tried to reassure Mason and others who might have similar doubts by declaring that, “The power so far as it will be necessary or safe, is involved in that of borrowing.”

Both Positions Argued

On the other hand, John Francis Mercer of Maryland announced that he

was a friend to paper money, though in the present state & temper in America, he should neither propose nor approve of such a measure. He was consequently opposed to a prohibition of it altogether. It will stamp suspicion on the Government to deny it a discretion on this point. It was impolitic also to excite the opposition of all those who were friends to paper money. The people of property would be sure to be on the side of the plan [the Constitution], and it was impolitic to purchase their further attachment with the loss of the opposite class of Citizens.

Oliver Elsworth of Connecticut pronounced himself of the opposite view. He

thought this a favorable moment to shut and bar the door against paper money. The mischiefs of the various experiments which had been made, were now fresh in the public mind and had excited the disgust of all the respectable part of America. By withholding the power from the new Government more friends of influence would be gained to it than by almost any thing else. Paper money can in no case be necessary. Give the Government credit, and other resources will offer. The power [to emit bills of credit] may do harm, never good.

Edmund Randolph of Virginia still had doubts, for he said that “notwithstanding his antipathy to paper money, [he] could not agree to strike out the words, as he could not foresee all the occasions which might arise.”

James Wilson of Pennsylvania favored removing the power:

It will have a most salutary influence on the credit of the United States to remove the possibility of paper money. This expedient can never succeed whilst its mischiefs are remembered, and as long as it can be resorted to, it will be a bar to other resources.

Pierce Butler “remarked that paper was a legal tender in no country in Europe. He was urgent for disarming the Government of such a power.”

George Mason, however,

was still averse to tying the hands of the Legislature altogether. If there was no example in Europe as just remarked, it might be observed on the other side, that there was none in which the Government was restrained on this head.

His fellow delegates forebore to remind Mason that except for Britain there was hardly a government in Europe that was restrained on that or any other head by a written constitution.

In any case, the last remarks were made by men vehemently opposed to the power. George Read of Delaware “thought the words, if not struck out, would be as alarming as the mark of the Beast in Revelations.” John Langdon of New Hampshire “had rather reject the whole plan [the Constitution] than retain the three words,” by which he meant “and emit bills.”

Denying the Power to Emit Bills of Credit

The vote was overwhelmingly in favor of removing the authority of the United States to emit bills of credit. The delegates voted by state, and 9 states voted in favor of the motion while only 2 opposed it. (New York delegates were not in attendance, and Rhode Island, of course, sent none.) It is a reasonable inference from the discussion that the delegates believed that by voting to strike out the words they had removed the power from the government to emit bills of credit.

George Mason, who opposed the motion, admitted as much. Moreover, James Madison explained in a footnote that he voted for it when he “became satisfied that striking out the words would not disable the Government from the use of public notes as far as they could be safe & proper; & would only cut off the pretext for a paper currency, and particularly for making the bills a tender for public or private debts.”[13]

The other discussion of paper money took place in connection with the powers to be denied to the states in the Constitution. The committee report had called for the states to be prohibited to emit bills of credit without the consent of the United States Congress. James Wilson and Roger Sherman, who was from Connecticut, “moved to insert after the words ‘coin money’ the words ‘nor emit bills of credit, nor make any thing but gold & silver coin a tender in payment of debts’,” thus, as they said, “making these prohibitions absolute, instead of making the measures allowable (as in the XIII article) with the consent of the Legislature of the U.S.”

Nathaniel Gorham

thought the purpose would be as well secured by the provision of article XIII which makes the consent of the General Legislature necessary, and that in that mode, no opposition would be excited; whereas an absolute prohibition of paper money would rouse the most desperate opposition from its partizans.

To the contrary, Roger Sherman “thought this a favorable crisis for crushing paper money. If the consent of the Legislature could authorise emissions of it, the friends of paper money, would make every exertion to get into the Legislature in order to licence it.”[14]

Eight states voted for the absolution prohibition against states issuing bills of credit. One voted against it, and the other state whose delegation was present was divided. The prohibition, as voted, became a part of the Constitution.

Paper Money Rejected

Three other points may be appropriate. The first has to do with any argument that there might be an implied power for the United States government to issue paper money since it is not specifically prohibited in the Constitution. Alexander Hamilton, the man credited with advancing the broad construction doctrine, maintained the opposite view in The Federalist.

While he was making a case against the adding of a bill of rights, his argument was meant to have general validity. He declared that such prohibitions

are not only unnecessary in the proposed Constitution but would even be dangerous. They would contain various exceptions to powers which are not granted; and, on this very account, would afford a colorable pretext to claim more than were granted. For why declare that things shall not be done which there is no power to do.[15]

In short, the government does not have all powers not prohibited but only those granted.

Second, this point was driven home by the 10th Amendment when a Bill of Rights was added to the Constitution. It reads,

The powers not delegated to the United States by the Constitution, nor prohibited by it to the States, are reserved to the States respectively, or to the people.

The power to emit bills of credit or issue paper money was not delegated to the United States. More, it was specifically not delegated after deliberating upon whether to or not. The power was prohibited to the states. The logical conclusion is that such power as there may be to emit bills of credit was reserved to the people in their private capacities.

And third, not one word has been added to or subtracted from the Constitution since that time affecting the power of government to emit bills of credit or issue paper money.

Since the United States is once again in the toils of an ongoing monetary inflation, it is my hope that this summary review of the experience, words, and deeds of the Founders might shed light on some of the vexing questions surrounding it.

The Integrity of the Coinage

. . . the whole aim and intent of State intervention in the monetary sphere is simply to release individuals from the necessity of testing the weight and fineness of the gold they receive, a task which can only be undertaken by experts and which involves very elaborate precautionary measures. The narrowness of the limits within which the weight and fineness of the coins is legally allowed to vary at the time of minting, and the establishment of a further limit to the permissible loss by wear of those in circulation, is a much better means of securing the integrity of the coinage than the use of scales and nitric acid on the part of all who have commercial dealings. Again, the right of free coinage, one of the basic principles of modern monetary law, is a protection in the opposite direction against the emergence of a difference in value between the coined and uncoined metal. In large-scale international trade, where differences that are negligible as far as single coins are concerned have a cumulative importance, coins are valued, not according to their number, but according to their weight; that is, they are treated not as coins but as pieces of metal.

Ludwig von Mises, The Theory of Money and Credit

Clarence Carson (1926–2003) was a historian who taught at Eaton College, Grove City College, and Hillsdale College. His primary publication venue was the Foundation for Economic Education. Among his many works is the six-volume A Basic History of the United States.

Originally published in the July 1983 issue of The Freeman.

[1] Actually, the phrase, “fiat money,” did not come into use until the 1880s. It might have helped the Founders to specify more precisely what they had in mind to prevent, but they had no such term.

[2] E. H. Scott, ed., Journal of the Federal Convention Kept by James Madison (Chicago: Albert, Scott and Co., 1893), p. 47.

[3] Ibid., p. 60.

[4] Charles E. Tansill, ed., Formation of the Union of the American States (Washington: Government Printing Office, 1927), p. 306.

[5] Merrill Jensen, The New Nation (New York: Vintage Books, 1950), p. 324.

[6] Andrew C. McLaughlin, The Confederation and the Constitution (New York: Collier Books, 1962), pp. 107–08.

[7] John C. Miller, Triumph of Freedom (Boston: Little, Brown and Co., 1948), p. 438.

[8] Ibid., p. 462.

[9] Quoted in Albert S. Bolles, The Financial History of the United States, vol. I (New York: D. Appleton, 1896, 4th ed.), p. 132.

[10] Ibid., p. 139.

[11] Quoted in ibid., pp. 177–78.

[12] See Jensen, op. cit., pp. 247–48.

[13] All the discussion and quotations can be found in Tansill, op. cit., pp. 556–57. While there is no way to know if the record of the debates on this and other matters is complete, nothing has been omitted from Madison’s notes.

[14] Ibid., pp. 627–38. The committee on style eventually reduced the number of articles in the Constitution to seven, so there is not now an Article XIII, of course.

[15] Alexander Hamilton, et. al., The Federalist Papers (New Rochelle, N. Y.: Arlington House, n. d.), pp. 513–14.

Banking Without Regulation

Lawrence H. White

How well would the banking system work if there were no government regulation? One way to begin answering this question is to examine the historical record. In the 19th century many countries had relatively unregulated banking systems with few or none of the restrictions that face American banks today: legal barriers to new entry, deposit insurance, geographic and activity restrictions, reserve requirements, and protection of favored banks from failure. Because these systems were so different from today’s, they throw valuable light on the possible consequences of completely deregulating banking in the future.

A useful source of historical information is the recently published volume entitled The Experience of Free Banking, edited by Kevin Dowd (London: Routledge, 1992). The book’s contributors (of which I am one) investigate relatively unregulated banking systems in nine different countries during the 19th century: Australia, Canada, Colombia, China, France, Ireland, Scotland, Switzerland, and the United States. An overview chapter by Kurt Schuler shows that there were another fifty episodes that might also be investigated in detail. Fresh historical evidence, of the sort provided in this book, usefully complements the several other studies of free-market money and banking that have been published in recent years.[1]

What can we learn from historical episodes of relatively unregulated banking? I will try to summarize three main lessons concisely, without all the details, footnotes, and minor qualifications that might be mentioned. I hope my fellow academics will forgive me for breaching our professional etiquette in this way.

Unregulated Banking Does Not Cause Inflation of the Money Supply or of Prices

Because reserve requirements constrain banks today, economists have sometimes feared that banks without reserve requirements will face no constraint against oversupplying checking deposits or banknotes. But the fear is historically groundless. A competitive market compels unregulated banks to fix the value of their deposit and note liabilities in terms of the economy’s basic money, by offering redeemability at par (full face value) in basic money. In the past, the basic money was gold or silver coins. The “dollar” was originally a silver coin. To avoid embarrassment, in the absence of government protection, a bank could not issue too many liabilities in relation to its reserves of metallic money.

Under redeemability, the value of money falls (price inflation occurs) only when the supply of the economy’s basic money grows faster than the real demand for basic money. Under the gold and silver standards of the 19th century, inflation of prices in any single year was minimal by modern standards. Over the long run of generations, price inflation was virtually zero.

Unregulated Competition among Banks Does Not Destabilize the Banking System

Instability is often the fear of those who think that “free banking” laws in some parts of the antebellum United States led to irresponsible or “wildcat” banking. It turns out that “wildcat” banking is largely a myth. Although stories about crooked banking practices are entertaining—and for that reason have been repeated endlessly by textbooks—modern economic historians have found that there were in fact very few banks that fit any reasonable definition of “wildcat bank.” For example, of 141 banks formed under the “free banking” law in Illinois between 1851 and 1861, only one meets the criteria of lasting less than a year, being set up specifically to profit from note issue, and operating from a remote location.[2]

The so-called “free banking” systems in a number of antebellum American states were actually among the most regulated of all the 19th-century systems of competitive note-issue. Instability was experienced in a few states, not due to wildcat banking, but due to state regulations that inadvertently promoted instability. “Free banking” regulations in some states made it easier to commit fraud; in other states, the regulations discouraged or prevented banks from properly diversifying their assets. Banking was more stable in the less-regulated systems of Canada, Scotland, and New England.

How was stability possible in banking systems with neither deposit guarantees (nothing like FDIC insurance) nor a government lender of last resort (nothing like the Federal Reserve)? Depositors were more careful in choosing banks, and banks correspondingly, in order to attract cautious customers, had to be more careful in choosing their asset portfolios than banks are today in the presence of deposit guarantees and a lender of last resort. Banks did sometimes fail. But bank failures were almost never contagious, or prone to spread to sound banks, for several reasons.

Each bank tried to maintain an identity distinct from its rivals and was able to do so when it was not compelled by any regulation to hold a similar asset portfolio. Depositors then had no reason to infer from troubles at one bank that the next bank was in trouble. Banks were generally well capitalized, so that fear of insolvency was remote. In some cases, banks had extra capital “off the balance sheet” in the sense that shareholders contractually bound themselves to dig into their own personal assets to repay depositors and noteholders in the event that the bank’s assets were insufficient. Banks diversified their assets and liabilities well, being free of line-of-business and activity restrictions.

Banks were careful to avoid excessive exposure to other banks, which means that they minimized the risk of being stuck with uncollectible claims on other banks. Some degree of exposure is unavoidable in any system in which a bank accepts deposits from its customers in the form of checks written on, or notes issued by, certain other banks. A bank has exposure until it clears and settles those claims through the clearinghouse.

Private clearinghouses, particularly in the late 19th-century United States, lowered the risks of interbank exposure by making banks meet strict solvency and liquidity standards for clearinghouse membership. Clearinghouses were a vehicle by which reputable banks as a group voluntary regulated themselves. Clearinghouse associations pioneered techniques for monitoring and enforcing solvency and liquidity, such as balance sheet reports and bank examinations. Clearinghouse associations also did some “last resort” lending to solvent member banks that were experiencing temporary liquidity problems. The Federal Reserve System did not introduce, but simply nationalized, bank regulation and the lender-of-last-resort role.

Banking Is Not a Natural Monopoly

Historical experience shows that there are some tendencies for larger banks to be more efficient, but not beyond a certain size. Nationally branched banks do tend to out-compete smaller banks in many areas of the banking business, but not in all areas. Banks must be large enough to diversify their assets and liabilities adequately, but this does not require being large relative to the entire banking market.

Recent developments in the financial technologies of loan syndication and securitization may have reduced the size at which a bank becomes large enough in this respect. In the absence of government regulations that currently favor the largest banks, particularly the pursuit of the “too big to fail” doctrine by the Federal Reserve and the Federal Deposit Insurance Corporation, a stable and deregulated financial structure would result that would likely include both large and small banks.

Originally published in the October 1993 issue of The Freeman.

[1] Hans Sennholz, Money and Freedom (Spring Mills, Pa.: Libertarian Press, 1985); Kevin Dowd, Private Money: The Path to Monetary Stability (London: Institute of Economic Affairs, 1988); George A. Selgin, The Theory of Free Banking (Totowa, N.J.: Rowman and Littlefield, 1988); Kevin Dowd, The State and the Monetary System (New York: Philip Allan, 1989); David Glasner, Free Banking and Monetary Reform (Cambridge: Cambridge University Press, 1989); Lawrence H. White, Competition and Currency (New York: New York University Press, 1989); Richard Salsman, Breaking the Banks: Central Banking Problems and Free Banking Solutions (Great Barrington, Mass.: American Institute for Economic Research, 1990); Steven Horwitz, Monetary Evolution, Free Banking, and Economic Order (Boulder, Colo.: Westview Press, 1992).

[2] This statistic, from a study by Andrew J. Economopoulos, is cited by Kevin Dowd, “U. S. Banking in the ‘Free Banking’ Period,” in Dowd, ed., The Experience of Free Banking (London: Routledge, 1992), p. 218. Pioneering modern work on the U. S. experience with “free banking” laws, which is the source for the information in the next paragraph of the text, has been done by Hugh Rockoff and by Arthur J. Rolnick and Warren E. Weber.

Why You Can’t Mint a Dime

Lawrence W. Reed

Everybody knows what’ll happen if you set up a private mint in your basement, stamp out a few coins, and call them “nickels” or “dimes.” The coins won’t circulate for much longer than you will.

Most Americans today would recoil at the suggestion that coinage could or should be issued privately. They’re unaware that private coinage has a rich history in the United States.

Private Money

The U.S. Constitution expressly forbids the states to print paper money. It grants the Congress the power to issue coinage. But nowhere does it prohibit private parties from creating either paper currency or metallic coin. For seven decades, Americans used gold and silver coins from both public and private mints and paper currency issued by private banks and companies.

Even today, private paper money is not illegal as long as you don’t break a few important rules: Don’t imitate the appearance of government notes (that’s counterfeiting) and don’t demand payment of dollar debts in anything but government dollars. Check out the Wikipedia entry for “private currency” and you’ll find,

Today, there are over four-thousand privately issued currencies in more than 35 countries. These include commercial trade exchanges that use barter credits as units of exchange, private gold and silver exchanges, local paper money (such as “BerkShares”), computerized systems of credits and debits, and electronic currencies in circulation, such as digital gold currency.

A couple million BerkShares have circulated in western Massachusetts since 2006. The BerkShares Web site lists more than 400 local businesses that accept them.

Coin Monopoly

The history of how private, metallic coinage came to be illegal is instructive. Within the first year of the Civil War, President Lincoln and the (Northern) Congress wanted to print paper money to help finance the conflict. Raising direct taxes too high, they figured, would risk stoking the fires of anti-war fever.

Printing paper didn’t make things any cheaper (and certainly didn’t make things any more honest, either). It just meant that Northerners paid for the war both in higher taxes and higher prices as the value of fiat paper money plummeted. People spent the paper stuff and hoarded gold and silver as protection from the inflation, resulting in a severe shortage of coin. By late 1862, true to famed Gresham’s Law, coins had all but vanished.

It’s tough to do business if you have no cents (pardon the pun). So businesses themselves came to the rescue. At first, and very briefly, merchants started giving change in the form of postage stamps, but their flimsiness wouldn’t do. A Boston businessman named John Gault developed a protective brass encasement with a see-through window, but the government took care of him when it ordered post offices to stop selling stamps for use as currency. (So the next time someone asks you, “Who is John Gault?” you’ll know how to answer.)

War Tokens and Emergent Money

Merchants then introduced what became known as “Civil War tokens.” They minted more than 25 million of the mostly one- and two-cent copper, lead, brass, or bronze pieces—more than enough to fill the needs of trade in the Northern states where they circulated. It stands to reason, doesn’t it? If innovative, profit-seeking shopkeepers can’t make change for their customers, they don’t sit around twiddling their thumbs and wait for the politicians who created the problem to figure it out. They seek ways to fix it themselves.

This, indeed, is the story of money itself. It didn’t appear by some central command. Parliaments, congresses, emperors, and their edicts did not invent money or will it into existence. Money is an invention of the marketplace of exchange. It was brought into being by traders who discovered that a reliable medium could facilitate trades that were impossible by barter alone. It developed from one form to a better one, one evolutionary trade at a time. Parliaments, congresses, and emperors came along later and stole it, pure and simple if not fair and square.

I own a small collection of those “Civil War tokens.” They typically bear the name of a merchant like “C. S. Patterson, Druggist,” a patriotic statement like “Stand By the Flag,” or a slogan such as “Pro Bono Publico” (For the Public Good). Though many of them bear the words “One Cent” or “Two Cents,” one popular version stated “I. O. U. 1 Cent.” Another one said, “Value Me As You Please.” One even declared “Not One Cent” on its back side so as to differentiate it from any government-issued coin.

Shortchanging Liberty

When Gustavus Lindenmueller refused to allow a New York railroad company to redeem his tokens for the promised cash, Congress responded in 1864. Instead of doing the sensible thing—protecting property rights by allowing the company to sue for redress in the courts—it banned private coinage altogether. The minting and use of non-government coins were declared punishable by a fine of up to $2,000 (at least $50,000 in today’s dollars), a prison term of up to five years, or both. That law served the interests of the government, but it put all of the token makers out of business and shortchanged American citizens of their money and an important liberty. It was tantamount to calling in the B-52s to weed a tulip bed.

In my collection, I have one of those “Gustavus Lindenmueller” tokens bearing his bearded image. While I wish old Gus had kept his word, my guts tell me it wouldn’t have mattered. Congress was going to monopolize the stuff sooner or later, one way or the other.

Private coinage was banned not because it didn’t work, but because it did. Governments just don’t care much for competition or for sound and honest money. The Civil War ban on private coinage has remained the law of the land since June 1864—a hallmark on the shameful path of monetary debasement.

This, my friends, is one of the reasons why your dollars ain’t what they used to be.

Originally published at FEE.org on April 16, 2011.

Rutherford B. Hayes and the Financing of American Prosperity

Burton W. Folsom

Rutherford B. Hayes, America’s nineteenth president (1877–1881), is generally dismissed as a minor, even below-average president. Matthew Josephson, the journalist-chronicler of the late 1800s, insisted that Hayes had “no capacity for . . . large-minded leadership.” Other historians have written him off as just another cipher among a string of forgettable chief executives of the Gilded Age.

But the truth is that Hayes was a strong and principled leader of firm character, who, during a critical time in history, shored up the country’s finances. His contributions to restoring American credit are worth noting today.

Hayes was a small-town Ohio lawyer until his Civil War exploits earned him a promotion to brigadier general and won him a congressional seat after the war. After one term in Congress, Hayes was elected three times as governor of Ohio. In 1876 he won the Republican nomination for president, and during the campaign that followed he defeated Governor Samuel Tilden of New York in a controversial election. Tilden won the popular vote, but Hayes won the electoral vote after a special commission awarded him the disputed states of Florida, South Carolina, and Louisiana.

Severe Inflation

Once in the White House, Hayes withdrew northern troops from the South and thus ended Reconstruction. But the enormous financial debts from the Civil War still lingered. That war had been so costly that the Union could not secure the cash (that is, specie) to fight it. Congress and President Lincoln covered expenses by issuing over $400 million in greenbacks, which would not be redeemable in gold until some future date. The flood of greenbacks caused inflation and chaos—merchants wanted specie, not paper that someday might be redeemed.

Many Americans, especially debtors who liked the idea of repaying loans in inflated currency, welcomed the greenbacks and wanted more to be printed. The problem with that, apart from serious inflation, was that foreigners were refusing to buy American debt, which raised the interest costs on the almost $2 billion that the Union borrowed to fight the war.

In 1875, Congress had promised to redeem the greenbacks for gold in four years and Hayes ran his campaign on a pledge to fulfill that promise. “Low rates of interest on the vast indebtedness we must carry for many years,” Hayes said, “is the important end to be kept in view.”

As president, therefore, Hayes prepared to retire the greenbacks. He had budget surpluses every year in office, and he used these extra funds to help build up a gold reserve to pay off the greenbacks. So effective was Hayes at this task that when the official government redemption date (January 2, 1879) came around, few people stepped forward to get gold for their greenbacks. Confidence in U.S. credit was such that most people traded greenbacks at face value with confidence that gold would be in the Treasury if they ever wanted it.

Having solved the greenback problem, Hayes also faced a crisis with silver. From the beginning of U.S. history, gold and silver coins (and bullion) had circulated to pay debts, to conduct trade, and to transact business. Silver, of course, is more plentiful than gold, and the ratio had been 15 or 16 ounces of silver to 1 ounce of gold. The U.S. Treasury, in fact, minted coins and traded the metals at 16 to 1 during much of the 1800s. But that all stopped after the Civil War.

The problem was that active mining in the American West was yielding much more silver than gold.

Also, the demand for silver was down because the rest of the world was beating a path to a monometallic gold standard. By the end of the 1800s, with silver prices down, it took about 32 ounces to buy one ounce of gold. The silver miners believed this devaluation of their metal was unfair. Those who favored inflation were happy to agree: If the government would stabilize the ratio at 16 to 1, debtors could repay in inflated silver dollars instead of gold. Flooding the market with silver (fixed at 16 to 1) would have the same effect as running greenbacks off the printing press.

Hayes was appalled at the persistent efforts of inflationists to tamper with the currency. “Expediency and justice both demand honest coinage,” Hayes insisted. Sound currency and sound character were one and the same to Hayes. “A currency worth less than it purports to be worth,” Hayes observed, “will in the end defraud not only creditors, but all who are engaged in legitimate business, and none more surely than those who are dependent on their daily labor for their daily bread.”

Free Silver

The inflationists lobbied hard with their politicians for what was called “free silver,” which was short for the free and unlimited coinage at the fixed ratio. They couldn’t muster the votes, but they did support the Bland-Allison Act in 1878.

Under that bill, Congress would be obligated to buy at least $2 million (and up to $4 million) worth of silver and mint it into special dollars of almost one ounce. Such “dollars” in 1878 contained only about 90–92 cents worth of silver, and Hayes was dismayed that Congress would even consider tampering with U.S. coins that way. He promised to veto any “measure which stains our credit.” When Congress passed the act anyway, Hayes vetoed it. Congress, however, overrode Hayes with a two-thirds vote, and the Bland-Allison bill became law.

The presence of these new silver dollars bothered Hayes, but American credit remained strong throughout the world. The greenback problem was under control, and the government continued to retire the Civil War debt through annual budget surpluses. In 1880, for example, federal revenue was $333.5 million, which was $65.9 million—almost 20 percent—more than expenses. The biggest item in the federal budget was $95.8 million for interest on the debt. With diligence, Hayes had renegotiated much of this debt from 6 to 5 and sometimes 4 percent.

In an effort to slash future expenses, Hayes began efforts to make government bureaucrats work more honestly and efficiently. In the New York Customs House, for example, some officials were extorting payments from importers, and other officials were drawing salaries but doing almost no work. Since President Grant, Hayes’s predecessor, had suffered greatly from the shenanigans of dishonest government officials, Hayes tried extra hard to reform the civil service and make sure government graft was kept to a minimum.

Finally, Hayes showed balance in his administration. When, during a massive railroad strike in 1877, a state governor asked him to send in federal troops to preserve order, Hayes obliged. But he would not use federal troops to break the strike.

Hayes was a constitutional president. He believed in an executive strong enough to veto bad legislation, but he did not want to expand executive powers beyond what the Constitution specified. Congress was where laws needed to originate and where most political debate needed to take place.

Politics, to Hayes, was not a career. After serving one term as president, he happily stepped down and returned to private life.

Burton Folsom, Jr. is a professor of history at Hillsdale College and author (with his wife, Anita) of FDR Goes to War.

Originally published at FEE.org on October 23, 2009.

The Silver Panic

Lawrence W. Reed

“History is little more than the register of the crimes, follies, and misfortunes of mankind,” in the opinion of historian Edward Gibbon. While it may be argued that there are numerous triumphs in human affairs to write about, Gibbon’s observation seems to be true. If the typical history text were to be stripped of any mention of war, depression, famine, coercion, tragedy, genocide, scandal, rivalry, and mayhem, the remains could probably be reprinted in a leaflet.

Strangely, the awesome Panic of 1893 seems to have escaped the careful scrutiny and exhaustive research of historians. Though it occurred only eighty-five years ago, it remains an obscure episode in American history. It signaled the beginning of a deep depression. Businesses collapsed by the thousands. Banks closed their doors in record numbers. Unemployment soared and idle millions roamed the streets and countryside seeking jobs or alms. And the country witnessed a spectacular display of political fireworks, now all but forgotten.

For the believer in the free economy, the story of the Panic of 1893 offers a treasure chest of empirical support. The lessons of this tragedy add up to a compelling indictment of government’s ability to “manage” a nation’s money.

Charles Albert Collman observed that “Money trouble was the manifest peculiarity of the long, drawn out Panic of ’93.”[1] Indeed, a breakdown of the monetary system and national bankruptcy were narrowly averted in that year. But money is that great invention which permits the development of a modern exchange economy. How could something so vital to commerce become so troublesome?

Everyone knows that fingerprints are a great aid in placing a suspect at the scene of a crime. The distinguishing characteristics of each individual’s skin patterns make this possible. In the case of the Panic of 1893, the tragedy is smothered with the fingerprints of politicians. “I deem it proper at the outset to state,” wrote Charles S. Smith in the October 1893 North American Review,

that the recent panic was not the result of over-trading, undue speculation or the violation of business principles throughout the country. In my judgment it is to be attributed to unwise legislation with respect to the silver question; it will be known in history as “the Silver Panic,” and will constitute a reproach and an accusation against the common sense, if not the common honesty, of our legislators who are responsible for our present monetary laws.[2]

Early Interventions

Contrary to popular impression, government in America has never been totally aloof from the monetary scene. Article I, Section 8, of the Constitution grants Congress the power “to coin money, regulate the value thereof, and of foreign coin, and fix the standard of weights and measures.” In the century preceding 1893, Congress experimented with two central banks, a national banking system, paper money issues, and fixed ratios of gold and silver.

America’s first cyclical depression occurred in 1819, after three wild years of currency inflation caused by the Second Bank of the United States. When that “money monster” was eliminated by hard money man Andrew Jackson, the economy slumped into depression again, and all the maladjustments of the Bank era had to be liquidated. In 1857, the economy had to retrench after a decade of credit expansion on behalf of state governments that had forced their obligations on the state banking systems. In 1873, the post-Civil War readjustment finally corrected the excesses of the government’s rampant greenback inflation. The background of the 1893 debacle is equally interventionist and has some uniquely interesting features which give rise to the label, “The Silver Panic.”

Gold and silver rose to prominence as the monies of the civilized world through a process of free and natural selection in the marketplace of exchange. Both circulated as money, though gold was far more valuable. The market ratio between the metals had been roughly 15 to 1 (15 ounces of silver trading for 1 ounce of gold) for centuries. Gold was preferred for large transactions and silver for small ones. The free market had established “parallel standards” of gold and silver, each freely fluctuating within a narrow range in relation to market supplies and demands. Before long, though, government decided it would “help out” the market by interfering to “simplify” matters. The result was another of the many well-intentioned blunders imposed on a populace by force of law: the official “fixing” of the gold/silver ratio. This became the policy of bimetallism.

Under the direction of Alexander Hamilton, the federal government adopted an official ratio of 15 to 1 in 1792. If the market ratio had been the same and had stayed the same for as long as the fixed ratio was in effect, then the fixed ratio would have been superfluous. But the market ratio, like all market prices, changed over time as supply and demand conditions changed. As these changes occurred, the fixed bimetallic ratio became obsolete and “Gresham’s Law” came into operation.

Gresham’s Law

Gresham’s Law holds that bad money drives out good money when government fixes the ratio between the two circulating monies. “Bad money” refers to the money which is artificially over-valued by the government’s ratio. “Good money” is the one which is artificially undervalued.

Gresham’s Law began working soon after Hamilton fixed the ratio at 15 to 1, as the market ratio stood at, roughly, 15 1/2 to 1. This meant that if one had an ounce of gold, one could get 15 1/2 ounces of silver on the bullion market, but only 15 ounces for it at the government’s mint. Conversely, if one had 15 ounces of silver, one could get an ounce of gold at the mint but less than an ounce on the market. So silver flowed into the mint and was coined while gold disappeared, went into hiding, or was shipped overseas. The country was thus put on a de facto silver standard, even though it was the declared policy of the government to maintain both metals in circulation.

Congress, in 1834, changed the ratio to 16 to 1, but the market ratio had not changed much, and this time gold was over-valued and silver under-valued. Gold flowed into the mint, silver disappeared, and the country found itself on a de facto gold standard.

With the end of the Civil War inflation and subsequent readjustment in the depression of 1873, the story of the Panic of 1893 begins to unfold. It opens with the inflationist agitation of the 1870s.

In 1875, the newly-formed National Greenback Party called for currency inflation. The proposal attracted widespread support in the West and South where many farmers joined associations to lobby for inflation. They demanded at first that the government balloon the paper money supply in the belief that such a policy would guarantee prosperity. It was a demand that finds a less shrill but no less potent voice among many economists today. An eloquent refutation of the idea that the printing press can create economic wealth can be found in the words of Benjamin Bristow, President Grant’s Secretary of the Treasury. In his annual message of 1874, Bristow declared:

The history of irredeemable paper currency repeats itself whenever and wherever it is used. It increases present prices, deludes the laborer with the idea that he is getting higher wages, and brings a fictitious prosperity from which follow inflation of business and credit and excess of enterprise in ever-increasing ratio, until it is discovered that trade and commerce have become fatally diseased, when confidence is destroyed, and then comes the shock to credit, followed by disaster and depression, and a demand for relief by further issues. . . . The universal use of, and reliance on, such a currency tends to blunt the moral sense and impair the natural self-dependence of the people, and trains them to the belief that the Government must directly assist their individual fortunes and business, help them in their personal affairs, and enable them to discharge their debts by partial payment. This inconvertible paper currency begets the delusion that the remedy for private pecuniary distress is in legislative measures, and makes the people unmindful of the fact that the true remedy is in greater production and less spending, and that real prosperity comes only from individual effort and thrift.[3]

The greenback inflation of the Civil War era left an indelible impression on many Americans. They were suspicious of plans to revive a policy of deliberate paper money expansion on behalf of any special interest group. In 1875, Congress passed the Specie Resumption Act, declaring it the policy of the government to redeem the Civil War greenbacks at par in gold on January 1, 1879. It was regarded from this point on that in order to protect the redemption of the greenbacks, the Treasury would be obliged to maintain a minimum of $100,000,000 in gold on reserve. The most that the inflationists got was a government pledge not to cancel the greenbacks once redeemed, but to reissue them so that the total number outstanding would remain the same.

Turning to Silver

The attention of the inflationists was then directed at another medium: silver. Robert F. Hoxie, in the Journal of Political Economy in 1893, wrote that the inflationists focused their demands on a silver inflation as a matter of expediency. “They had no love for silver as such,” revealed Hoxie, “but it was the cheapest and most abundant substance for which they could gain support, its use would result in more legal tender currency, and its metallic character would in a measure shield the advocates from being stigmatized as inflationists.”[4]

The inflationists now became “silverites” and their rallying cry became “Free Silver at 16 to 1.” Their influence was sufficient to secure passage of the Bland-Allison Act in February 1878—the first of the acts putting the government in the business of purchasing quantities of silver for coinage. The Act provided for the purchase by the Treasury of not less than two, nor more than four, million dollars’ worth of silver bullion per month, to be coined into dollars each containing 371 1/4 grains of pure silver (which coincided with the lawful ratio of 16 to 1, since the gold dollar still contained 23.22 grains of pure gold). These dollars were to be legal tender at their nominal value for all debts and dues, public and private. Paper silver certificates were to be issued upon deposit of the bulky silver dollars in the Treasury.

The free silver forces were dissatisfied with Bland-Allison because it did not go far enough—it did not provide for the free and unlimited government purchase and coinage of silver at 16 to 1. The only silver to be coined would be the two to four million dollars’ worth that the government purchased each month, and the Treasury, while the law was on the books, rarely bought more than the minimum amount.

Silver producers in particular had a vested interest in the state of affairs, for the market price of silver had begun a long-term decline in the 1870s. Securing a government pledge to buy silver at a higher price than could be obtained in the free market was an obviously lucrative arrangement. As the market ratio of silver to gold steadily rose above 16 to 1, the profit potential became enormous.

Bland-Allison Passed Over President’s Veto

Bland-Allison was passed over the veto of President Rutherford B. Hayes. The president, in his veto message, noted that minting silver coins at the ratio of sixteen ounces of silver to one ounce of gold would drive gold out of circulation. The decline of the market price of silver had raised the market ratio at the time of passage of the act to nearly 18 1/4 to 1. If the mint offered to pay one ounce of gold for just sixteen ounces of silver, then only silver would be minted and the country would be on the road back to a de facto silver standard. In Hayes’ belief,

A currency worth less than it purports to be worth will in the end defraud not only creditors, but all who are engaged in legitimate business, and none more surely than those who are dependent on their daily labor for their daily bread.[5]

When money is left to the free market, its supply is restricted by its scarcity and costs of production. Its value is thus preserved. The declining price of silver on the free market would have erased the profitability of many mines and hence would have prevented a drastic increase in silver currency. But when the government stepped in and bought large quantities of silver bullion for coinage, and paid more for it in gold than was offered in the market, it forced the quantity of the white metal in circulation to exceed its true demand. The government does much the same thing today when it subsidizes peanuts or wheat. The result of this political interference is a chronic surplus of these commodities.

The silverites’ drive for favorable legislation culminated in the Sherman Silver Purchase Act of 1890, which replaced the Bland-Allison Act. The Sherman Act stipulated that the Treasury had to purchase 4.5 million ounces of silver per month, or roughly twice the amount the Treasury had been purchasing under Bland-Allison. Payment was to be made in a new legal tender paper currency, the so-called Treasury notes of 1890, redeemable in either gold or silver at the discretion of the Treasury.

The 4.5 million ounces of silver mandated by the law represented almost the entire output of American silver mines. This continuing subsidy to silver producers meant that the government was engaged in a full-blown force-feeding of the American economy. It was only a matter of time before the patient would suffer the pangs of indigestion.

U.S. Out of Step

The action of the United States government in 1878 and 1890 with respect to silver was especially peculiar in light of world monetary events. Germany, immediately after the Franco-Prussian War in the early 1870s, had withdrawn her silver from circulation and adopted a single gold standard. France, Belgium, Switzerland, Italy, and Greece followed by first restricting the coinage of silver and then eliminating it altogether. Denmark, Norway, and Sweden adopted the single gold standard, making silver subsidiary by 1875. In that year, the government of Holland closed its mints to the coinage of silver. A year later, the Russian government suspended the coinage of silver except for use in the Chinese trade. In 1879, Austria-Hungary ceased to coin silver for individuals, except for a special trade coin.

This rapid worldwide transition from silver to gold prompted the United States Treasury Department in 1879 to note that “since the monetary disturbance of 1873–78 not a mint of Europe has been open to the coinage of silver for individuals.”[6] Yet the United States government, at a time when the value of silver was falling dramatically and when the nation’s trading partners were abandoning the white metal, stepped in to promote silver against gold at the unrealistic ratio of 16-to-1!

One way of looking at silver’s depreciation is to consider the annual average market value of the 3711/4 grain silver dollar. In 1878, the bullion value of that much silver was about 890; by 1890 it dropped to 810; by 1893, it was worth 600; and by 1895 it plummeted to a mere 500. A climate of uncertainty pervaded the world of finance. As Professor J. Laurence Laughlin wrote,

No one could know that contracts entered into when a dollar stood for 100 cents in gold might not be paid off in silver which stood for 50 cents on a dollar. That was the predicament in which every investor found himself who had an obligation payable only in ‘coin’ and not in gold.[7]

In an article entitled “Thou Shalt Not Steal,” Isaac L. Rice penned an eloquent repudiation of the government’s silver coinage policy. His argument evoked the moral side of the question and eighty years later is still a forceful indictment of monetary dishonesty:

Of the various classes of crime that come under the category of theft none is more odious and despicable than the use of false weights and measures. Stamping a coin containing 371 1/4 grains of silver as of the weight of one hundred cents, while in truth it is of the weight of fifty-three cents, is a falsification of weights morally not distinguishable from stamping any other kind of weight as of two pounds which in truth is only of one pound. Only the methods by which fraud is to be made are different. The thievish individual depends upon secret deceit, the qualities of the sneak thief; the Government on coercion, the qualities of the highwayman.[8]

In accordance with inexorable economic law, the Bland-Allison and Sherman Acts caused a drain of gold from the Treasury and an inflow of silver. This tampering with the fixity of the standard threatened the Treasury’s declared policy of redeeming greenbacks and other government obligations in gold. And, the disappearance of gold from circulation and from the reserves of the nation’s banks threatened the sanctity of all contracts made in gold. Professor Laughlin observed that no producer “could feel so entirely sure of the standard of payments that he could, without fear or hesitation, make his estimates a few years ahead.”[9]

The Flight of Capital

The silver purchases noticeably affected the confidence of foreigners in the American economy. Many British and French investors expected devaluation of the dollar at the least, with complete financial collapse predicted by some. Capital flowed out of the country as these foreigners sold American securities. Even Americans, in increasing numbers after 1890, began exporting funds for investment in Canada, Europe, and some of the Latin American countries, all of which seemed stronger than the United States.

The inflationary impact of the Bland-Allison and Sherman Acts was particularly important in paving the way for panic and depression. A.D. Noyes, writing in Political Science Quarterly, stated that “The coinage of over-valued silver dollars since 1878, and the issue of Treasury notes on silver bullion since 1890, have actually increased the country’s silver and paper circulation, between 1879 and 1894, by seventy-five percent.”[10]

W. Jett Lauck, in his study entitled The Causes of the Panic of 1893, found that the Sherman Act inflation produced an “absence of the usual stringency in the New York money market” in the fall of 1891. Call loans ranged from two to four percent, a significant decline from earlier levels.[11]

In 1910, the National Monetary Commission requested O.M.W. Sprague to report on the nation’s finances since the Civil War. In his authoritative report, History of Crises Under the National Banking System, Sprague found that from January 1891 to June 1893, “there was an increase of $68,000,000 in the estimated amount of money in circulation.”

The effect on bank credit was typical of any “easy money” policy: “During 1892 the low rates for loans were a clear indication that the banks would have been glad to lend more than the demand of borrowers made possible.” The classic symptoms of currency inflation were evident, a situation which Sprague found to be unsustainable. He felt that “a situation which demands increasing credits to prevent collapse is certain to arrive at that state in any case, and delay can hardly be expected to improve matters.”[12]

End of the Boom

The economy, drugged by easy money, was showing outward signs of prosperity. Unemployment, which had been above 5 percent in 1890 and 1891, fell to 3.7 percent in 1892. Crop failures in Europe coupled with exceptional harvests here in the United States boosted agriculture. President Harrison told Congress, “There has never been a time in our history when work was so abundant, or when wages were as high.”[13]

The boom was, however, only temporary. The twin evils of inflation and uncertainty as to the fixity of the standard were eating at the vitals of the nation’s commerce. Late in January 1893, prices of staples such as wheat and iron, previously on the rise, began to recede. Price declines across the board foreshadowed a general cyclical contraction. “General business activity,” according to Charles Hoffman, “suffered a severe check that was recognized at once in the business journals. The stock market gave ominous signs of falling prices before any sharp drop took place.”[14]

Banks became apprehensive over the Treasury’s loss of gold (as well as their own) and began to contract the pyramid of credit. Loans declined almost 10 percent from February to the beginning of May. An article in the February 1893 issue of Forum spoke of “a dangerous state of uneasiness in financial circles,” and warned that “Fear is an element in monetary conditions which may be as serious in its effects as reason.”[15]

A dramatic event took place on February 20th. The Philadelphia and Reading Railroad, a chronic invalid which nonetheless had paid its usual bond dividend the month before, collapsed into bankruptcy. “When the end came,” writes Rendigs Fels, “it had a floating debt of $18.5 million compared to cash and bills receivable of little more than $100,000.”[16] The failure of the Philadelphia and Reading, a firm supported by powerful Wall Street financial houses, caused many businessmen to question the conditions of other railroads and the financial institutions behind them.

When President Harrison left office on March 4, 1893, the Treasury’s gold reserve stood at the historic low of $100,982,410—an eyelash above the $100 million minimum deemed necessary for protecting the redemption of greenbacks. Merchants increasingly refused to accept silver in violation of the law, and ugly threats of strikes echoed in the nation’s factories.

On April 22nd, the Treasury’s gold reserve fell below the $100 million minimum for the first time since the resumption of specie payments in 1879. Bankers and investors realized that the Treasury could not indefinitely continue drawing upon the remaining gold reserve to redeem the Treasury notes of 1890 in the attempt to maintain their value. Banks had to break their easy money habits and began calling in their loans at a frantic pace. More and more investors began to fear that before securities could be sold and realized upon, depreciated silver would take the place of gold as the standard of payments.

By Wednesday, May 3, tension in the commercial community triggered a massive wave of selling on the stock market. The New York Times recorded the events the next day:

Not since 1884 had the stock market had such a break in prices as occurred yesterday, and few days in its history were more exciting. In the industrial shares particularly, there was a smashing of values almost without precedent. In the last thirty minutes the brokers on the floor of the Exchange found the quotations on the board of little use.

Figures posted at one moment were valueless the next. In the industrials which were receiving the most punishment prices were dropping a point at a time. The crowds trading in them were made up of shouting men, who struggled about the floor like football players in a scrimmage.

The Panic of 1893 had begun! On May 4th, a stock market favorite, National Cordage Trust, went into receivership. Shortly before the panic, Cordage common stock had sold for $70 per share. The plunge was precipitous, as Charles Albert Collman vividly explains:

In the Cordage Trust circle of the New York Stock Exchange, hats were being smashed, coats torn, cravats ruined. Here was an agony that meant financial life or death to many. Cordage common had gone off 18 points. The preferred had lost 22. Suddenly howls went up from the floor. Those who could distinguish the words, heard the ominous cry: “Nineteen for Cordage!”[17]

The shares, a few moments later, went down to $12.[18]

The Cordage Crash

The Cordage crash was taken as, in Collman’s words, “some occult signal for the halting of enterprise.”[19] Plants closed their gates and went quickly into receivership. Unemployment rocketed to 9.6 percent before year-end, nearly three times the rate for 1892. In 1894, an estimated 16.7 percent of industrial wage-earners were idle.

From January to July 1893, mercantile failures totaled a remarkable 3,401, with liabilities totaling $169,000,000. The bulk of the losses came after the first week of May. O.M.W. Sprague revealed that the “failures exceeded both in number and in amount of liabilities those which had occurred in any other period of equal length in our history.”[20]

Bank failures and suspensions were the greatest on record. Most occurred in the South and West, where the evils of a vicious currency expansion had taken root far more extensively than in the rest of the country.

The economy was going through the pains of liquidation. The malinvestments fostered by the Bland-Allison Act and Sherman Act inflation were being sloughed off. The threat to the de facto gold standard was a factor which no doubt complicated things, heightened uncertainty, determined the timing of the panic, and exacerbated the depression, but the chief responsibility for the crisis rested with the attempted force-feeding of the nation’s money supply by government policy. The Commercial and Financial Chronicle said as much on July 8, 1893:

The country is struggling with disturbed credit and the general derangement of commercial and financial affairs which a forced and over-valued currency has developed. . . . Nothing but corrective legislation which shall remove the disturbing law, can afford any measure of real relief.[21]

With the economy in depression, the necessity for eliminating the legislation which precipitated the tragedy became increasingly apparent. On June 30th, President Grover Cleveland called for a special session of Congress to repeal the Sherman Silver Purchase Act of 1890.

“The present perilous condition,” he declared, “is largely the result of a financial policy which the Executive branch of the government finds embodied in unwise laws which must be executed until repealed by Congress.”[22] The ensuing debate in the Congress was a splendid contest, pitting the forces of sound, honest money against the forces of inflation, in which the sound money men calmly answered the question, “What would you put in place of the silver purchases?” with the single, solitary word, “Nothing!”

Cockran Favors Repeal

On August 26th, Congressman Bourke Cockran of New York rose to deliver a memorable address in favor of repeal. The speech has been called the most eloquent and scholarly of the entire debate. The congressman advised his colleagues:

I think it safe to assert that every commercial crisis can be traced to an unnecessary inflation of the currency, or to an improvident expansion of credit. The operation of the Sherman Law has been to flood this country with paper money without providing any method whatever for its redemption. The circulating medium has become so redundant that the channels of commerce have overflowed and gold has been expelled.

Cockran proceeded to trace the history of coinage in England and explained how debasing the currency led to recurrent depressions. James McGurrin, Cockran’s biographer, believes that the subsequent vote in the House of Representatives in favor of repeal “was due in no small measure to Bourke Cockran’s matchless eloquence and sagacious leadership.”[23]

The repeal bill passed the House on August 28th by a wide margin. President Cleveland’s forceful leadership prompted the Senate to do likewise in October. The New York Times heralded the occasion: “The Treasury is released from this day from the necessity of purchasing a commodity it does not require, out of a money chest already depleted, and at the risk of dangerous encroachment upon the gold reserve.”[24]

An indispensable pre-condition to recovery was accomplished with the repeal of the Sherman Silver Purchase Act. The derangement of the nation’s money was a big step closer to a solution, though the road to recovery was long and hard. Not until 1897 did depression give way to revival and prosperity.

Repeal of the Sherman Act was, by any measure, an act of congressional repentance. Indeed, it was an open admission that the Silver Panic was the offspring of a profligate, overbearing, and irresponsible government. Historian Ernest Ludlow Bogart summarized the lessons of the Panic of 1893:

It must be said that the net results of this experiment of a “managed currency,” that is, one in which the government undertakes to provide the necessary money for the people, were disastrous. For the maintenance of a suitable supply, the operation of normal economic forces is more reliable than the judgment of a legislative body.[25]

Originally published in the June 1978 issue of The Freeman.

[1] Charles Albert Collman, Our Mysterious Panics, 1830–1930 (New York: Greenwood Press, 1968), p. 88.

[2] Charles S. Smith, “The Business Outlook,” North American Review, October 1893, p. 386.

[3] James A. Barnes, John G. Carlisle, Financial Statesman (New York: Dodd, Mead and Co., 1931; reprint ed., Gloucester, Mass.: Peter Smith, 1967), pp. 32–33.

[4] Robert F. Hoxie, “The Silver Debate of 1890,” Journal of Political Economy 1 (1892–1893): 561.

[5] Herman E. Krooss, ed., Documentary History of Banking and Currency in the United States, vol. 2 (New York: Chelsea House Publishers, 1969), pp. 1921–1922.

[6] Ibid., p. 1934.

[7] J. Laurence Laughlin, The History of Bimetallism in the United States, 4th ed. (New York: D. Appleton and Co., 1900), p. 274.

[8] Isaac L. Rice, “Thou Shalt Not Steal,” Forum 22 (September 1896–February 1897): 1.

[9] Laughlin, p. 269.

[10] D. Noyes, “The Banks and the Panic of 1893,” Political Science Quarterly 9 (No. 1): p. 15.

[11] W. Jett Lauck, The Causes of the Panic of 1893 (Boston: Houghton, Mifflin and Co., 1907), p. 80.

[12] M. W. Sprague, History of Crises Under the National Banking System (Washington, D.C.: Government Printing Office, 1910; reprint ed., New York: Augustus M. Kelley, 1968), p. 158.

[13] Robert Sobel, Panic on Wall Street: A History of America’s Financial Disasters (New York: Macmillan Co., 1968), p. 243.

[14] Charles Hoffman, The Depression of the Nineties: An Economic History, Contributions in Economics and Economic History, Contributions in Economics and Economic History, no. 2 (Westport, Conn.: Greenwood Press, 1970), p. 107.

[15] Geo. Fred Williams, “Imminent Danger From the Silver Purchase Act,” Forum 14 (September 1892–February 1893): 789.

[16] Rendigs Fels, American Business Cycles: 1865–1897 (Raleigh: University of North Carolina Press, 1959; reprint ed., Westport, Conn.: Greenwood Press, 1973), p. 185.

[17] “Industrials Were Hit Hard,” New York Times, 4 May 1893, p. 1.

[18] Collman, p. 164.

[19] Ibid., p. 165.

[20] Sprague, p. 169.

[21] Hoffman, p. 229.

[22] “Congress to Meet August 7,” New York Times, 1 July 1893, p. 1.

[23] James McGurrin, Bourke Cockran (New York: Charles Scribner’s Sons, 1948), p. 135. p. 138.

[24] “Need Buy No More Silver,” New York Times, 2 November 1893, p. 1.

[25] Ernest Ludlow Bogart, Economic History of the American People (New York: Longmans, Green and Co., 1937), p. 693.

Is There a Speaker in the House? Part I

Lawrence W. Reed

Garfield and Cockran: Statesmen Who Mastered Money

Has discourse in the United States Congress sunk to dismal standards? I don’t see how a comparison of today’s Congressional Record with its antecedents in the 19th century could lead one to any conclusion but yes.

My interest in American history often leads me to research congressional proceedings. When I read what members of the House and Senate were saying from the floor a hundred years or more ago, I find myself frequently amazed at the substance and erudition, even in spontaneous remarks without benefit of text. When I read what representatives and senators are saying from the floor these days—or in recent decades—I find myself asking, “What happened to the smart ones?” and “Does anybody here actually have any expertise in some subject matter?”

Not even the insults that “modern” politicians toss at each other evidence the class, depth, or wit they once did. (I admit that in November 2005 when Rep. Marion Berry, D-Ark., referred to a fellow member of the House as “this other Howdy Doody-looking nimrod,” I laughed heartily. That was funny, if not scholarly.)

Congress has always had a few nimrods in the ranks. And surely there must be some truly smart people there now, but I stand by my unscientific, gut-level observation that the place just ain’t what it used to be. I have some thoughts on why that is, but those are for another article.

On one topic—money—former Texas congressman Ron Paul came closest to matching the substance of the best from 19th-century legislators. You could take what almost all of the rest know about the origin, nature, and history of money, slap it on a bumper sticker, and still have room for the Magna Carta. The conventional representative or senator now rarely asks the right questions and faithfully accepts all the tired clichés and errors about the stuff: It was invented by government or at least must be monopolized by it for the people’s own good. Gold doesn’t work because there’s not enough of it. Printing more paper stimulates the economy. A small group of people at a central bank can manage it because they will know how much we ought to have. The fallacies roll off the tongue like rain from a steep roof.

All this is prelude to my main purpose, which is to share with you the wisdom and eloquence of two extraordinary congressmen from just a few generations ago. The first, James Abram Garfield of Ohio, became America’s twentieth President in 1881.[1] The second, William Bourke Cockran of New York, was regarded by many in his day as one of the finest orators the country ever produced. Let’s focus on them in that order.

In 1868, the Republican Garfield was in the third of his nine terms in the House of Representatives. He was first elected in 1862 while in the army, though he did no more campaigning than to say he would serve if that’s what the voters wanted. He was one of the most capable and learned men Ohio ever sent to Washington. Aside from his distinguished military service, he was an instructor in classical languages, a college president, and a voracious reader. His books filled every room in his home. It was his celebrated “Currency” speech before the House on May 15, 1868, that caught my attention.

Money had been a vexing issue since the start of the Civil War. Both the North and the South suspended specie payments and printed paper money by the boatloads. By war’s end, Confederate notes were worthless and northern “greenbacks” had depreciated by more than 50 percent. Some voices called for a resumption of inflation because they thought it would stimulate the economy or help debtors or both. Garfield despised currency debasement.

Admitting at the start of his two-hour oration that “financial subjects are dull and uninviting” compared to matters of war and peace, he carried on with this admonition:

To turn from the consideration of armies and navies, victories and defeats to the long array of figures which exhibit the debt, expenditures, taxation, and industry of the nation, requires no little courage and self-denial; but to those questions we must come, and to their solution Congresses, political parties, and all thoughtful citizens must give their best efforts for many years to come.

It’s boring, but necessary. And what consideration lies at the center of it all?

Our public debt, the greatest financial fact of this century, stands in the pathway of all parties and, like the Egyptian Sphynx, propounds its riddles. All the questions which spring out of the public debt, such as loans, bonds, tariffs, internal taxation, banking, and currency, present greater difficulties than usually come within the scope of American politics. They cannot be settled by force of numbers nor carried by assault, as an army storms the works of an enemy. Patient examination of facts, careful study of principles which do not always appear on the surface, and which involve the most difficult problems of political economy, are the weapons of this warfare.

Garfield noted the explosion of fiat paper money during the Civil War years. He referred to it as “the deluge of Treasury notes poured upon the country” as he cited the precise quantities authorized by Congress and on what dates. These issuances, he asserted, were tantamount to “forced loans” and “taxation” because they resulted in a depreciation suffered by everyone who held them.

Garfield was a “hard money” man, but he was smart enough to avoid the ancient confusion that money was synonymous with wealth itself. It was a medium or a middleman, a fact that he illustrated with a clever analogy:

As a medium of exchange, money is to all business transactions what ships are to the transportation of merchandise. If a hundred vessels of a given tonnage are just sufficient to carry all the commodities between two ports, any increase of the number of vessels will correspondingly decrease the value of each as an instrument of commerce; any decrease below one hundred will correspondingly increase the value of each. If the number be doubled, each will carry but half its usual freight, [and] will be worth but half its former value for that trade. . . . A hundred vessels can do it all. A thousand can do no more than all.

This 36-year-old congressman was self-taught in the subject of money, but he understood its history and economics better than many who study it formally today. The following passage from his speech, though lengthy, is particularly noteworthy for its clarity:

When the money of the country is gold and silver, it adapts itself to the fluctuations of business without the aid of legislation. If, at any time, we have more than is needed, the surplus flows off to other countries through the channels of international commerce. If less, the deficiency is supplied through the same channels of international commerce. Thus the monetary equilibrium is maintained. So immense is the trade of the world that the golden streams pouring from California and Australia into the specie circulation are soon absorbed in the great mass and equalized throughout the world, as the waters of all the rivers are spread upon the surface of all the seas.

Not so, however, with an inconvertible paper currency. Excepting the specie used in payment of customs and the interest on our public debt, we are cut off from the money currents of the world. Our currency resembles rather the waters of an artificial lake which lie in stagnation or rise to full banks at the caprice of the gatekeeper.

Gold and silver abhor depreciated paper money, and will not keep company with it. If our currency be more abundant than business demands, not a dollar of it can go abroad; if deficient, not a dollar of gold will come in to supply the lack. There is no Legislature on earth wise enough to adjust such a currency to the wants of the country.

Garfield understood that market forces of supply and demand, framed in part by business conditions, are natural, effective, and superior to political manipulation. When government undertakes to force-feed an economy a diet of fiat paper, prices rise as a reflection of the paper’s depreciating value. He noted that this “inflation” of the money supply robs the typical laborer even more than it does the ranks of the rich, who can often find ways to minimize the consequences by shifting resources overseas or into hard assets.

Garfield grasped the trade cycle effect of monetary inflation, explained so comprehensively by Austrian economists a half-century later, when he observed:

its effect in producing an unhealthy expansion of business, in stimulating speculation and extravagance and in laying the sure foundation of commercial revulsion and wide-spread ruin.

He cited specific financial panics in the United States and Britain since 1819 and asserted that each was preceded by a “reckless” expansion of money and credit. He even devoted at least fifteen minutes of his speech to chronicling the hyperinflation of the continental dollar during the War for Independence. He related the lessons of monetary history to the challenging economic circumstances America was facing in 1868, a state of affairs that harkens to the term “regime uncertainty” (as coined by historian Robert Higgs to describe the turbulent 1930s):

Now, what is our situation? There has been no day since the 25th of February, 1862, when any man could tell what would be the value of our legal-currency dollar the next month or the next day. Since that day we have substituted for a dollar the printed promise of the Government to pay a dollar. That promise we have broken. We have suspended payment, and have by law compelled the citizen to receive dishonored paper in place of money. . . . The currency, not being based upon a foundation of real and certain value, and possessing no element of self-adjustment, depends for its market value on a score of causes. It is a significant and humiliating fact that the businessmen of the nation are in constant dread of Congress. Will Congress increase the currency or contract it? Will new greenbacks be issued with which to take up the bonds; or will new bonds be issued to absorb the greenbacks? Will the national banking system be perpetuated and enlarged, or will it be abolished to enable the General Government to turn banker?

The nation’s financial ailments, argued Garfield, stemmed from the federal government’s monetary mischief. The antidote was not more of the very debasement of money that brought on those ailments in the first place. He concluded his speech with these words:

For my own part, my course is taken. In view of all the facts of our situation; of all the terrible experiences of the past, both at home and abroad; and of the united testimony of the wisest and bravest statesmen who have lived and labored during the last century, it is my firm conviction that any considerable increase in the volume of our inconvertible paper money will shatter public credit, will paralyze industry and oppress the poor; and that the gradual restoration of our ancient standard of value will lead us, by the safest and surest path, to national prosperity and the steady pursuit of peace.

Now that was a two-hour monetary tour de force! Garfield had established himself as a man of great knowledge and conviction on some of the burning economic issues of the day. Fast forward fifteen years, and we find another man who was of the other party but was at least as solid and eloquent as Garfield on the imperative of a sound monetary standard.

Lawrence W. Reed is president of the Foundation for Economic Education and author of Real Heroes: Incredible True Stories of Courage, Character, and Conviction and Excuse Me, Professor: Challenging the Myths of Progressivism.

Originally published at FEE.org on April 17, 2013.

[1] I’ve written about the oddities in that turn of events in “A President Who Didn’t Want the Job.”

Is There a Speaker in the House? Part II

Lawrence W. Reed

Garfield and Cockran: Statesmen Who Mastered Money

In 1871, at the age of 17, William Bourke Cockran (more widely known by his middle name) emigrated from Ireland to New York. But for that, he might have been President. First elected to Congress in 1886, he served eight mostly unconnected terms across nearly four decades, dying in office in 1923. Between terms, he ran a very successful law practice in New York City.

Cockran was a classical liberal scholar, an ardent free trade advocate, a civil liberties champion, and a confidant of the last Jeffersonian president, Grover Cleveland. He exerted enormous influence on a young Winston Churchill, who credited Cockran as his first political guru and role model.[1]

From the time of Garfield’s “Currency” speech in 1868 through the stormy 1890s, money issues were paramount in American political and economic debate. Congress restored gold convertibility to the paper greenbacks in 1875, only to succumb in later years to the agitation of inflationists. In 1878, it started requiring the Treasury to buy large quantities of silver and then push silver dollars and paper notes into circulation. By 1891, the Treasury was forced to buy almost the entire output of American silver mines, pay twice what it was worth, and then flood the economy with both depreciating silver and paper notes.

The government’s promise to keep the dollar “as good as gold” was seriously undermined as the yellow metal left the country and silver poured into the Treasury. Investment capital from both foreign and domestic sources dried up, and in 1893, the country was gripped by a financial panic. A deep depression quickly followed. President Grover Cleveland called the Congress into a special session for the purpose of repealing the silver/paper nonsense, setting the stage for one of the most colorful debates ever seen in Washington.[2]

In anticipation of Cockran’s leadership of the repeal fight, the Times of Minneapolis opined, “The President’s views and purposes could have no more eloquent and powerful a champion on the floor of Congress than the distinguished Representative from New York.” They were right. During the two weeks of the battle in Washington’s sweltering heat, Cockran twisted more than a few arms as he scoured the halls for votes.

The climax of the struggle came on Saturday, August 26, 1893. Cockran rose to deliver the closing speech for the sound money forces. The galleries were jammed. Extra chairs were brought in to accommodate the dignitaries, including members of the President’s Cabinet and the justices of the Supreme Court.

Cockran biographer James McGurrin describes the speech, given with little more than a few notes, in these terms:

The speech was one of the most eloquent and scholarly Cockran had ever delivered and was worthy to be placed in the category of Gladstone’s Budgets. Never before in the history of Congress was the dull and complicated subject of finance made so fascinating. One writer compared his review of the history of currency to “a chapter woven by Balzac,” and continued, “Upon a background of shining elocutionary gossamer he threaded the gospel of Sound Money while an overcrowded House listened spellbound in wonder and admiration” . . . His familiarity with the writings of Mill, Locke, Hume and Adam Smith, which he quoted from memory with uncanny accuracy and made applicable to the various phases of the controversy, as well as his seemingly illimitable knowledge of the history of currency in every land and age, amazed his listeners.

The speech was a jaw-dropping masterpiece at which any friend of honest finance today could marvel. Cockran packed more history of currency from both the United States and Britain into this one address than most members of Congress—then or now—have learned in their lifetimes. Here are only a few of the gems uttered by Cockran on that historic day:

I think it safe to assert that every commercial crisis can be traced to an unnecessary inflation of the currency, or to an improvident expansion of credit.

The kings [of England] had set the example of plundering the public by doing what my friend from Missouri [silverite Richard Bland] suggests we should do now; that is to say, debasing the coins of the country. Kings in all ages, rulers of all characters and in all countries had debased the coinage for their own profit. . . .

Sir, the machinery of our trade is disordered because the Government is every day forcing a large quantity of paper into the channels of circulation. Our currency has been swelled far beyond the requirements of trade, and as a necessary consequence the good money, the buoyant circulating medium of international value, has left our shores, and we have been compelled to maintain our commerce with a paper money over which there hangs a cloud of suspicion, forcing us to do business in an atmosphere of doubt and distrust.

I have said, Mr. Speaker, that the history of all these panics shows either an unreasonable extension of the circulating medium or the extension of credit out of all proportion to the capital of the people. My friend from Maine seems to treat these recurring crises as something necessarily produced by the action of the human race in its march of progress. I do not believe it. I do not think the history of the world proves it. I think these commercial crises are like the great pestilences that sweep over the world. Ignorance attributes them to God; science knows they are the consequences of human folly. . . . I have searched the history of this country and of Great Britain in vain to find a single panic that was caused by a scarcity of money. I speak within the limits of all authority when I say that the most pronounced cause of all crises has been the redundancy of money resulting from issues of paper by government itself, or by banks chartered by government.

When Cockran finished (the oration lasted more than Garfield’s, fifteen years before), the House roared with applause and congratulations. His speech had carried the day. When the vote to repeal the inflationary Sherman Act was called two days later, the sound money forces won by a margin of more than two to one. The Senate followed suit two months later.

Two years after Cockran’s death in 1923, a collection of his orations was published. Princeton University historian Robert McElroy, the editor, concluded the book’s introduction thusly:

In almost every speech which he uttered, Mr. Cockran emphasized the fact that the greatest lessons taught by American history are lessons, not for Americans alone, but for all mankind; for all those whose aim is liberty and whose need is light. Therefore, it is appropriate that this volume be entitled, In the Name of Liberty.

Is there a speaker in the House (or Senate) today who could give either Garfield or Cockran a run for his money? I leave it to the reader to decide, but in my view, America hasn’t seen the likes of those two men for a very long time.

Originally published at FEE.org on April 18, 2013.

[1] See this ReasonTV interview with author Michael McMenamin, co-author of Becoming Winston Churchill: The Untold Story of Young Winston and His American Mentor: “Michael McMenamin: How Churchill Became Churchill.”

[2] See my article, “The Silver Panic.”

The U.S. Presidents and the Money Issue

Greg Kaza

This year marks the 100th anniversary of the most important presidential campaign ever to revolve around an issue largely ignored in contemporary politics—monetary policy.

The Republicans, with William McKinley as their candidate, defended the classical gold standard. The Democratic nominee, William Jennings Bryan, supported silver coinage at an above-market rate and inspired inflationists with his now-famous “Cross of Gold” speech.

McKinley won the 1896 election, but the money issue would be eclipsed by fiscal policy in the 20th century. It is fascinating, however, to consider that most U.S. presidents prior to McKinley discussed issues that have virtually disappeared from today’s public discourse. Their opinions on gold, silver, and central banking were not only relevant then but remain so today.

Establish a Central Bank?

There was no interest in paper money in the early United States after the inflationary experiences of the Revolutionary War. Instead, monetary discussions centered on whether or not to establish a central bank. Alexander Hamilton and the Federalists advocated a bank through an expansive interpretation of the Constitution, which made no provision for chartering federal corporations. Thomas Jefferson and other Anti-Federalists urged “strict constructionism” and opposed the bank. In 1791, both Hamilton and Jefferson gave Federalist George Washington (1789–1797) their interpretations. Washington sided with Hamilton and signed a law creating the First Bank of the United States.

Under Federalist John Adams (1797–1801), all foreign gold coins ceased to be legal tender. Adams also signed a proclamation exempting Spanish silver dollars from similar silver legislation. The United States was on a bimetallic monetary standard of value at this time. Gold served in high-denomination coins, silver for smaller amounts.

Adopting a bimetallic standard is one thing; maintaining it in the face of fluctuating market values is another. Gresham’s Law states that debased coins (those overvalued by government) tend to remain in circulation, while undervalued coins are hoarded. Since silver was overvalued, gold began to disappear from circulation.

Thomas Jefferson (1801–1809) grappled with this problem even before assuming the presidency. Observing that Spanish silver dollars varied in their silver content, Jefferson proposed they be assayed by the government. This led to the Coinage Act of 1792.

Part of Jefferson’s opposition to the central bank stemmed from his belief that it catered to commercial and financial interests while hurting the agricultural sector. While critical of the Bank of the United States, Jefferson did not undermine it as president. But when the bank’s charter expired in 1811, his interpretation of the Constitution swayed public opinion against the bank. His successor, James Madison (1809–1817), vetoed a bill rechartering the bank, although he believed in central banking.

Unfortunately, the War of 1812 caused suspension of specie payments and state bank inflation. This led to the creation of the Second Bank of the United States late in Madison’s second term of office. Presidents James Monroe (1817–1825) and John Quincy Adams (1825–1829) supported the central bank during their terms of office.

The Jacksonian Democrats

Andrew Jackson (1829–1837) had a profound influence on monetary policy in the mid-19th century. Jackson vetoed a bill rechartering the Second Bank of the United States and signed the Specie Circular of 1836, which required gold payment of federal debt obligations. In his annual messages to Congress, Jackson discussed monetary matters more than any other president.

By this time, the money issue was more than an economics discussion; it grew out of regional and even class politics. Jackson believed the central bank created an alliance between Big Business and government that benefited a few while costing most Americans.

“[B]oth the constitutionality and the expediency of the law creating this bank are well questioned by a large portion of our fellow citizens,” Jackson said in 1829, “and it must be admitted by all that it has failed in the great end of establishing a uniform and sound currency.” He declared in 1830, “Nothing has occurred to lessen in any degree, the dangers of which many of our citizens apprehend from that institution, as at present organized.”

In 1831, Congress rechartered the Bank, but Jackson vetoed the bill.[1] “It is to be regretted,” Jackson said, “that the rich and powerful too often bend the acts of government to their selfish purposes. . . . [W]hen the law undertakes to . . . make the rich richer and the potent more powerful, the humble members of society—the farmers, mechanics and laborers . . . have a right to complain of the injustice of their government.”

Central bank abolition was a cornerstone of Jackson’s successful 1832 re-election campaign. He confided to Charles Carroll, the last surviving signer of the Declaration of Independence, “No bank and Jackson—or bank and no Jackson.” After his re-election, Jackson attacked bank officers in 1833 for “actively engaging in attempting to influence the elections of the public officers by means of its money . . . [in] violation of its charter.”

In his second term, Jackson struck a further blow against central banking by sending the Bank’s assets to state banks, dubbed “pet banks” by critics. He termed central banking “the scourge of the people,” and described gold coins as “a sound and portable currency.” In 1836, Jackson signed the Specie Circular, which increased gold coinage.[2] That same year, he proposed suspension of all paper bank notes less than $20. “The attainment of such a result,” Jackson said, “will form an era in the history of our country which will be dwelt upon with delight by every true friend of its liberty and independence.”

Jackson was not a monetary nationalist; he saw no reason why foreign gold or silver should not circulate in competition with U.S. coins. In two separate measures, the Jacksonians legalized the circulation of all foreign gold and silver coins.[3] In his farewell address, Jackson warned, “The paper system . . . having of itself no intrinsic value . . . is liable to great and sudden fluctuations, thereby rendering property insecure, and the wages of labor unsteady and uncertain.” He attacked fiat money and central banks as undermining free institutions.

Martin Van Buren (1837–1841) continued Jackson’s policies. One of his first acts was to address the Panic of 1837, a mini-depression. Van Buren’s solution: stand fast on gold and propose an independent Treasury to further wrest control of the federal government from central bank supporters. In 1840, Congress passed a bill establishing an independent Treasury, which Van Buren hailed as a “Second Declaration of Independence.”

Whig William Henry Harrison (1841), a hero of the War of 1812, was told by advisers to keep his lips “hermetically sealed” on the money issue during the 1840 campaign. Harrison died after one month in office. His successor, John Tyler (1841–1845), vetoed two bills creating a new Bank of the United States, terming them “unconstitutional.” After the second veto, Bank advocates demanded Tyler abide by the views of the Whig-controlled Congress and sign the bill, or resign the presidency. Tyler refused.

Democrat James Polk (1845–1849) resumed Jackson’s policies. As a congressman, Polk had fought the bank’s recharter as chairman of the House Ways and Means Committee. His successor, Whig Zachary Taylor (1849–1850), a hero of the Mexican-American War, had little to say on the issue. Whig Millard Fillmore (1850–1853) reversed Jacksonian policy, devising a monetary system that was the forerunner of the National Banking Act of 1863.

Gresham’s Law finally caught up with bimetallism in the early 1850s. Gold production exploded with the discovery of new mines in California and then burst, causing a fall in the price of gold relative to silver. Silver coins disappeared rapidly from the United States. In response, Democrat Franklin Pierce (1853–1857) supported a gold monometallic standard[4] with silver coins circulating at weight. Silver was no longer drastically overvalued versus gold and remained in circulation.[5] Pierce had opted for a temporary gold standard, but it was short-lived.

Part of the Jacksonian program was repealed under James Buchanan (1857–1861). In a show of monetary nationalism, the legal tender power of foreign coins was repealed, except for Spanish-American fractional silver.[6] But it was the next president who would alter the “hard money,” anti-central bank policies of the Jacksonians more than any other U.S. leader.

Lincoln Inflation

To his admirers, Abraham Lincoln (1861–1865) is remembered as “the Father of the Union.” But the first Republican president was an inflationist in monetary affairs, and his policies led to consequences that are still visible today. To pay for the Civil War, Lincoln abandoned specie and launched a paper dollar (the “greenback”) that resulted in rampant price inflation.

The Civil War led to an enormous growth of federal spending, from $66 million in 1861 to $1.3 billion four years later.[7] Lincoln tried to finance the war initially with government bonds, but public demand for specie payments led to their suspension at year’s end. Lincoln took advantage of the fact that the United States was on an inconvertible paper standard by signing the Legal Tender Act of 1862, which authorized greenbacks to pay for the war. Initially limited to $150 million, a second $150 million issue was approved in July and a third $150 million issue passed in early 1863.[8] By mid-1864, greenbacks were worth 35 cents in gold. But at war’s end, they had risen to 69 cents on the prospects of future gold redemption.[9] Prices rose 110.9 percent from 1860 to war’s end.

Not surprisingly, greenbacks depreciated against gold, leading Lincoln to scapegoat “gold speculators.” Failing to regulate the gold market, he tried to destroy it by passing a Gold Bill in mid-1864 that prohibited all gold futures contracts and imposed severe penalties. Public opposition, however, forced the bill’s repeal that year.[10]

Another important consequence of Lincoln’s term was the creation of a new, quasi-centralized, fractional reserve banking system. This laid the groundwork for the Federal Reserve System, which was eventually established in 1913. The National Banking Act of 1863 forever ended the federal government’s separation from banking. Lincoln built upon the Federalist/Whig policy of central banking, implanting the soft-money tradition permanently in the United States.[11]

Public support for gold specie resumption grew after the war. The Loan Bill of 1866, signed by Republican Andrew Johnson (1865–1869), provided for greenback contraction from the market.[12] But Johnson refused to sign a bill in 1869 that would have provided for specie resumption. That task fell to Republican Civil War hero Ulysses S. Grant (1869–1877) in his first act of office. The Panic of 1873 did not shake Grant’s fear of inflation; he vetoed a bill proposing greenback expansion.[13] In 1875, Grant signed another bill pledging specie resumption by decade’s end.

The Gold Standard

Specie payment was finally resumed in 1879 under Republican Rutherford Hayes (1877–1881), but greenbacks could be redeemed in silver, along with gold, as a result of the Bland-Allison Act. In 1877, Representative “Silver Dick” Bland of Missouri sponsored a bill providing for the free and unlimited coinage of silver. The measure was supported by the Democratic “silver bloc” emerging in the western United States and called for overvaluing silver versus gold. The bill was modified in 1878 by Senator William Allison of Iowa, who fashioned a compromise between Democratic free silverites and conservative Republican business interests. The Bland-Allison Act permitted limited silver coinage and required the Treasury to purchase $2 to $4 million of silver each month. Hayes vetoed the legislation, but his veto was overridden.

Republican James Garfield (1881) urged government debt payments in gold. Although he opposed free silver, Garfield expressed interest in a bimetallic standard before his assassination. Republican Chester Arthur (1881–1885), called for the repeal of Bland-Allison. “They [paper silver] form an unnecessary addition to the paper currency,” Arthur declared in 1881. “In respect to the coinage of silver dollars and the retirement of silver certificates,” Arthur said in 1882, “I have seen nothing to alter but much to confirm [these] sentiments.”

Democrat Grover Cleveland (1885–1889, 1893–1897) may have been the greatest gold standard advocate ever to serve as president. In his first term, Cleveland singlehandedly preserved the gold standard at a time when the Democrats split bitterly over the money issue and populism. However, his opposition to tariffs cost him the 1888 election.

When Cleveland left office after his first term, the Treasury had a large gold reserve, but it was depleted by Republican Benjamin Harrison (1889–1893). In 1890, Harrison signed the Sherman Silver Purchase Act, requiring the Treasury to buy 4.5 million ounces of silver monthly. To buy the silver, Treasury was to issue a new type of paper money known as Treasury notes. The act was a victory for the Populists, who held that deflation, which hurt farmers, could be reversed by free silver policies. Deflation continued, the gold reserve dropped, private banking tightened, and the Panic of 1893 ensued.

Re-elected and back in the White House, Cleveland attacked the Silver Purchase Act as a “dangerous and reckless experiment.” He called for its repeal to restore confidence in the dollar. Cleveland knew Gresham’s Law and defended gold against inflationists in his own Democratic Party. Congress tried to compromise, but Cleveland would not yield and the act was repealed. Cleveland was the last Democratic president to support gold. The Populists, whose presidential candidate won more than a million votes in 1892, returned to the Democrats four years later as supporters of William Jennings Bryan.

Lessons for Today

McKinley’s victory in 1896 also contained the seeds of central banking and political manipulation that has led to the rampant inflation of the 20th century. The Democratic Party was no longer the great laissez-faire, hard-money party of Jefferson, Jackson, and Cleveland, and the Republicans soon emerged as the party of the corporate State.[14]

Republican Theodore Roosevelt called for additional legislation and elasticity in the monetary system. By 1906, he was calling for “a considerable increase in bills of small denominations.” William Howard Taft (1909–1913) went even further, declaring in his inaugural address,

One of the reforms to be carried out . . . is a change of our monetary and banking laws, so as to secure greater elasticity . . . and to prevent the limitations of law from operating to increase the embarrassment of a financial panic.

By this time, the Federal Reserve’s establishment was a forgone conclusion and America was soon to be saddled with the inflationary, fractional-reserve system that sets American monetary policy to this day.

There is a glorious tradition of hard-money advocates in the history of the United States. Reviving that heritage is essential to our economic well-being. Further, the decline of the dollar after it was severed from its last links to gold in 1971 has affected all Americans, even if it has been ignored by most elected officials. Economic law cannot be repealed. Easy money leads to inflation in any century. The truths about hard money recognized by many of our best presidents need to be brought back into the public square.

Greg Kaza is a Michigan state representative. He has taught economics and history at Northwood University, where he served as an adjunct professor.

Originally published in the April 1996 issue of The Freeman.

[1] Jackson’s veto was more than 7,500 words in length.

[2] The Specie Circular’s author, U.S. Senator Thomas Hart Benton of Missouri, was nicknamed “Old Bullion” for his pro-gold views.

[3] Ron Paul and Lewis Lehrman, The Case for Gold (Washington: The Cato Institute, 1982), p. 62.

[4] Under a gold monometallic standard, the dollar is defined only as a weight of gold, with silver circulating by weight. This is an example of “free metallism,” in which two or more metal coins are allowed to fluctuate freely in the same range.

[5] Paul and Lehrman, ibid., pp. 63–65.

[6] Ibid., p. 66.

[7] Ibid., p. 74.

[8] Ibid., p. 75.

[9] Wesley Clair Mitchell, A History of the Greenbacks (Chicago: University of Chicago Press, 1903), pp. 232–38, 423–28.

[10] Paul and Lehrman, ibid., pp. 76–77.

[11] Ibid., p. 74.

[12] Ibid., p. 96.

[13] Ibid., p. 96.

[14] Ibid., pp. 117–18.

The Depression You’ve Never Heard Of: 1920–1921

Robert P. Murphy

When it comes to diagnosing the causes of the Great Depression and prescribing cures for our present recession, the pundits and economists from the biggest schools typically argue about two different types of intervention. Big-government Keynesians, such as Paul Krugman, argue for massive fiscal stimulus—that is, huge budget deficits—to fill the gap in aggregate demand. On the other hand, small-government monetarists, who follow in the laissez-faire tradition of Milton Friedman, believe that the Federal Reserve needs to pump in more money to prevent the economy from falling into deep depression. Yet both sides of the debate agree that it would be utter disaster for the government and Fed to stand back and allow market forces to run their natural course after a major stock market or housing crash.

In contrast, many Austrian economists reject both forms of intervention. They argue that the free market would respond in the most efficient manner possible after a major disruption (such as the 1929 stock market crash or the housing bubble in our own times). As we shall see, the U.S. experience during the 1920–1921 depression—one that the reader has probably never heard of—is almost a laboratory experiment showcasing the flaws of both the Keynesian and monetarist prescriptions.

The 1929–1933 Great Contraction

Despite what many readers undoubtedly “learned” in their history classes as children, Herbert Hoover behaved like a textbook Keynesian following the 1929 stock market crash. In conjunction with Treasury Secretary Andrew Mellon, Hoover achieved an across-the-board one percentage point reduction in income tax rates applicable to the 1929 tax year.

Hoover didn’t stop with tax cuts to bolster “aggregate demand”—though analysts at that time would not have used the term. He also signed into law massive increases in the federal budget, with fiscal year (FY) 1932 spending rising 42 percent above 1930 levels. Hoover ran unprecedented peacetime deficits, which stood in sharp contrast to his predecessor Calvin Coolidge, who had run a budget surplus every year of his presidency. In fact, in the 1932 election, FDR campaigned on a balanced budget and excoriated the reckless spending record of the Republican incumbent.

It wasn’t merely that Hoover spent a bunch of money. He spent it on just the types of things that we associate today with Roosevelt’s New Deal. For example, he signed off on numerous public-works projects, including the Hoover Dam. Of particular relevance today is the Reconstruction Finance Corporation (RFC) established under Hoover, which quickly injected more than $1 billion to prop up troubled banks that had made bad loans during the boom years of the late 1920s—and this was when $1 billion really meant something.

It is true that Hoover eventually blinked and raised taxes in 1932, in an effort to reduce the federal budget deficit. Today’s Keynesians point to this move as proof that reducing deficits is a bad idea in the middle of a depression. Yet an equally valid interpretation is that it’s horrible to hike tax rates in the middle of an economic disaster. After the bold tax cuts pushed through by Andrew Mellon in the 1920s, the top marginal income-tax rate in 1932 stood at 25 percent. The next year, because of Hoover’s desire to close the budget hole, the top income tax rate was 63 percent. Given this extraordinary single-year rate hike, it is no wonder that 1933 was the single worst year in U.S. economic history. (For what it’s worth, the FY 1933 budget deficit was still huge, coming in at 4.5 percent of GDP. Despite the huge rate hikes, federal tax revenues only increased 3.8 percent from FY 1932 to FY 1933.)

So we see that the standard Keynesian story, which paints Herbert Hoover as a do-nothing liquidationist, is completely false. Yet Milton Friedman’s explanation for the Great Depression is almost as dubious. Following the stock market crash, the New York Federal Reserve Bank immediately slashed its discount rate—how much it charged on loans—in an attempt to provide relief to the beleaguered financial system. The New York Fed continued to slash its discount rate over the next two years, pushing it down to 1.5 percent by May 1931. At that time, this was the lowest discount rate the New York Fed had ever charged since the establishment of the Federal Reserve System in 1913.

It wasn’t merely that the Fed (along with other central banks around the world) was charging an unusually low rate on loans it advanced from its discount window. The entire mentality of central bankers was different during the early years of the Great Depression. Writing in 1934, Lionel Robbins first noted that during previous crises, the solution had been for central banks to charge a high discount rate to separate the wheat from the chaff. Those firms that were truly solvent but illiquid would be willing to pay the high interest rates on central-bank loans to get them through the storm. Firms that were simply insolvent, on the other hand, would know the jig was up because they couldn’t afford the high rates. Yet this tough love was not administered after the 1929 crash, as Robbins explained:

In the present depression we have changed all that. We eschew the sharp purge. We prefer the lingering disease. Everywhere, in the money market, in the commodity markets and in the broad field of company finance and public indebtedness, the efforts of Central Banks and Governments have been directed to propping up bad business positions.

We, therefore, see an eerie pattern. When it came to both fiscal and monetary policy during the early 1930s, the governments and central banks implemented the same strategies that the sophisticated experts recommend today for our present crisis. Of course, today’s Keynesians and monetarists have a ready retort: They will tell us that their prescribed medicines (deficits and monetary injections, respectively) were not administered in large enough doses. It was the timidity of Hoover’s deficits (for the Keynesians) or the Fed’s injections of liquidity (for the monetarists) that caused the Great Depression.

The 1920–1921 Depression

This context highlights the importance of the 1920–1921 depression. Here the government and Fed did the exact opposite of what the experts now recommend. We have just about the closest thing to a controlled experiment in macroeconomics that one could desire. To repeat, it’s not that the government boosted the budget at a slower rate, or that the Fed provided a tad less liquidity. On the contrary, the government slashed its budget tremendously, and the Fed hiked rates to record highs. We thus have a fairly clear-cut experiment to test the efficacy of the Keynesian and monetarist remedies.

At the conclusion of World War I, U.S. officials found themselves in a bleak position. The federal debt had exploded because of wartime expenditures, and annual consumer price inflation rates had jumped well above 20 percent by the end of the war.

To restore fiscal and price sanity, the authorities implemented what today strikes us as incredibly “merciless” policies. From FY 1919 to 1920, federal spending was slashed from $18.5 billion to $6.4 billion—a 65 percent reduction in one year. The budget was pushed down the next two years as well, to $3.3 billion in FY 1922.

On the monetary side, the New York Fed raised its discount rate to a record high 7 percent by June 1920. Now the reader might think that this nominal rate was actually “looser” than the 1.5 percent discount rate charged in 1931 because of the changes in inflation rates. But on the contrary, the price deflation of the 1920–1921 depression was more severe. From its peak in June 1920, the Consumer Price Index fell 15.8 percent over the next 12 months. In contrast, year-over-year price deflation never even reached 11 percent at any point during the Great Depression. Whether we look at nominal interest rates or “real” (inflation-adjusted) interest rates, the Fed was very “tight” during the 1920–1921 depression and very “loose” during the onset of the Great Depression.

Now some modern economists will point out that our story leaves out an important element. Even though the Fed slashed its discount rate to record lows during the onset of the Great Depression, the total stock of money held by the public collapsed by roughly a third from 1929 to 1933. This is why Milton Friedman blamed the Fed for not doing enough to avert the Great Depression. By flooding the banking system with newly created reserves (part of the “monetary base”), the Fed could have offset the massive cash withdrawals of the panicked public and kept the overall money stock constant.

But even this nuanced argument fails to demonstrate why the 1929–1933 downturn should have been more severe than the 1920–1921 depression. The collapse of the monetary base (directly controlled by the Fed) during 1920–1921 was the largest in U.S. history, and it dwarfed the fall during the early Hoover years. So we hit the same problem: The standard monetarist explanation for the Great Depression applies all the more so to the 1920–1921 depression.

The Results

If the Keynesians are right about the Great Depression, then the depression of 1920–1921 should have been far worse. The same holds for the monetarists; things should have been awful in the 1920s if their theory of the 1930s is correct.

To be sure, the 1920–1921 depression was painful. The unemployment rate peaked at 11.7 percent in 1921. But it had dropped to 6.7 percent by the following year and was down to 2.4 percent by 1923. After the depression, the United States proceeded to enjoy the “Roaring Twenties,” arguably the most prosperous decade in the country’s history. Some of this prosperity was illusory—itself the result of subsequent Fed inflation—but nonetheless the 1920–1921 depression “purged the rottenness out of the system” and provided a solid framework for sustainable growth.

As we know, things turned out decidedly different in the 1930s. Despite the easy fiscal and monetary policies of the Hoover administration and the Federal Reserve—which today’s experts say are necessary to avoid the “mistakes of the Great Depression”—the unemployment rate kept going higher and higher, averaging an astounding 25 percent in 1933. And of course, after the “great contraction” the U.S. proceeded to stagnate in the Great Depression of the 1930s, which was easily the least prosperous decade in the country’s history.

The conclusion seems obvious to anyone whose mind is not firmly locked into the Keynesian or monetarist framework: The free market works. Even in the face of massive shocks requiring large structural adjustments, the best thing the government can do is cut its own budget and return more resources to the private sector. For its part, the Federal Reserve doesn’t help matters by flooding the shell-shocked credit markets with green pieces of paper. Prices can adjust to clear labor and other markets soon enough, in light of the new fundamentals, if only the politicians and central bankers would get out of the way.

Robert P. Murphy is senior economist at the Independent Energy Institute, a research assistant professor with the Free Market Institute at Texas Tech University, and a Research Fellow at the Independent Institute.

Originally published at FEE.org on November 18, 2009.

Free Market Money in Coal-Mining Communities

Richard H. Timberlake

In the company town, or mining camp, . . . United States coin and currency were not in good supply. . . . During the heyday of the old company town, scrip circulated more freely than U.S. currency and was in deed the coin of the realm. . . . Eleanor Roosevelt . . . in the mid-thirties, during [one of] her humanitarian crusades, attacked the use of scrip by coal mining companies as a very evil thing. . . .

Although many mourn the days of a bustling and active coal economy, little can be said to support the . . . issuance of scrip. (Truman L. Sayre, “Southern West Virginia Coal Company Scrip,” in Trade Token Topics, reprinted in Scrip, Brown, 1978, pp. 343–344)

The Possibility of Free Market Money

Ever since the abolition of the operational gold standard in the early 1930s, the federal government through its agent, the Federal Reserve System, has been almost the sole creator of the monetary base and has also been the licensing agent for the banks that create most of the demand deposits used in the United States. No money of any significant amount can be created today without some sanction or act of the Federal Reserve System.

This condition has encouraged the notion that government is a necessary, or at least desirable, regulator of any monetary system—that without government involvement any monetary system quickly degenerates into “chaos.” If this supposition were valid, the evolution of money could hardly have occurred. The barter system that preceded early monetary systems, in which government had no part, would not have been superseded if the resulting monetary systems were destined to be chaotic. This logic suggests the possibility and perhaps the feasibility of a non-government money. However, the practical efficacy of such a system cannot be deduced from a theory that merely suggests its possibility but must be sought from historical evidence of monetary arrangements that have developed spontaneously in the private sector.

This paper examines one such incidence of private money creation—the issue and use of scrip, which occurred primarily in the isolated economic environments of mining and lumbering company towns during the first half of the 20th century. Fortunately, numismatic collections and records reflect the operational character of the scrip systems in these communities so that some evaluation of their monetary properties is possible.

Much of the recent research on the creation of private money has focused on that issued by private banks in the presence of a dominant legal money such as gold (White 1984, Sylla 1976, Rolnick and Weber 1982). The issue of scrip, however, had nothing to do with banks. It was issued by private mining and lumbering enterprises. While it, too, was redeemable in a dominant money, its issue and acceptance were not critically dependent on any dominant money. For this reason, the phenomenon of scrip issue is especially revealing.

Legal Restraints Against the Issue of Private Money

Proscriptions against the arbitrary or casual issue of money appeared at the very beginning of this country’s political formation. First, the Constitution stated: “No state shall . . . emit bills of credit, [or] make anything but gold and silver coin a tender in payment of debt” (U.S. Constitution, Art. 1, Sect. 10). No money except gold and silver was to be the legal tender issue of any governmental unit.

Money to be money, however, does not have to be legal tender. It can be what one might call common tender, i.e., commonly accepted in payment of debt without coercion through legal means. Indeed, privately issued money to exist at all would have had to be common tender and would have had to earn its acceptability in a market environment.

Even though the states and Congress were constrained to monetizing only gold and silver, the general laws of contract and commercial instruments sanctioned the appearance of monies issued by privately owned commercial banks (Hurst 1973). In addition,

Nothing in the Constitution barred private manufacture of coin, and through the first half of the nineteenth century Congress did not act against private coinage. . . . General contract law allowed any contractor to issue his notes and coins and circulate them so far as the market would take them. (Hurst 1973)

Free enterprise in the issue of common tender money was accidentally encouraged in practice by the federal government’s ineptness in establishing a useful denominational spectrum of fractional currency during much of the 19th century. (Carothers 1967) Private transportation companies—canals, turnpike companies, and railroads—issued significant amounts of such currency between 1820 and 1875. Municipal and state governments did likewise. Redemption of transportation currency, when called for, was in services rendered, while state and local government currency was redeemed as tax payments. (Timberlake 1981)

The paucity of government-issued fractional currency was catastrophically aggravated by the first issues of greenbacks during the Civil War. The metallic values of subsidiary coins rose rapidly above their monetary values in the summer of 1862, and the coins disappeared from circulation. These circumstances provoked not only the ill-conceived issue of postage stamp currency but also extensive private issues of minor coin. (Carothers 1967, Faulkner 1901) The act that authorized postage stamps as currency in 1862 also outlawed the private issue of notes, memoranda, tokens, or other obligations “for a less sum than one dollar intended to circulate as money or to be received or used in lieu of lawful money of the United States” (Act of Congress, 12 Statutes-at-Large, 592, July 17, 1862). Then in 1864, even the private issue of gold and silver coin was forbidden, again, “when the coins were intended for use as current money” (Hurst 1973).

The Appearance of Scrip as an Economizing Medium

The lack of adequate denominations in government-produced money was not the only factor that stimulated the private production of money. Shortly after fractional coinage was stabilized around 1885, coal mining and lumbering became major industries. Both coal mining and lumbering enterprises had to be organized in the vicinity of the contributory resources, so were often located in isolated areas with low population densities significantly distant from commercial centers. Coal-producing regions were hilly or mountainous areas where agriculture had been marginal and other commercial development had lagged. “The ‘Main Street,’” noted one observer in describing a coal mining community “was often railroad tracks.” (Brown 1978) Coal mining entrepreneurs, therefore, had unique problems to contend with in organizing their enterprises.

Their common problem was what is known today as a lack of infrastructure—no streets, no churches, no schools, no residences, no utilities, and no banks or financial intermediaries. The specialized industries that might otherwise have provided these services were dissuaded from doing so by the high start-up costs and the enduring uncertainties of dealing with low-income communities that might be there today and gone tomorrow. Alternatively, the coal mining companies could deal with such conditions because they were in a better strategic position to change un-calculable uncertainties into calculable risks (Fishback 1986, Johnson 1952). Mining companies, therefore, built residences, churches, schools, and water works, and opened company stores or commissaries. In so doing, they became both buyers of labor from, and sellers of commodities to, the coal miners and their households. This kind of organization invited an economy in the community’s payments system—the use of scrip in lieu of ordinary money.

“Scrip” has become a generic term for the issue of a localized medium of exchange that is redeemable for goods or services sold by the issuer. Originally printed cards or “scraps” of paper, scrip evolved into metallic tokens with many of the physical attributes of official coins. Indeed, scrip in the very beginning was more in the nature of a trade credit, or demand deposit, at the single local general store. Ledger credit scrip, however, gave way to scrip coupon books, which “eliminated the tedious bookkeeping chores that were incident to over-the-counter credit (daybook or journal entries followed by ledger entries)” (Brown 1978).

The use of scrip not only implied an issuer—the mining company—and a demander—the miner, it also required a supplying industry. The institutions that supplied coupon scrip were companies already in business printing tickets, tokens, and metal tags for various other kinds of enterprise. They advertised extensively in mining catalogs during the first half of the 20th century touting the advantages of their own scrip systems. The Allison Company of Indianapolis, for example, noted that when one of its coupon books was issued to an employee, “He signs for it on the form provided on the first leaf of the book, which the storekeeper tears out and retains for the [company] time-keeper, who deducts the amount from the man’s next time-check.” Then, when the employee buys goods from the company store, “he pays in coupons, just as he would pay in cash, and the coupons are kept and counted the same as cash. . . . The coupon book is a medium of exchange between the company employees and the company store” (from 1916 Mining Catalog, Brown 1978). Other scrip-producing ticket companies emphasized the safety of the scrip coupon system in coal mining communities “where little or no police protection is afforded” (adv. of the International Ticket Co., in the Keystone Catalog of 1925, Brown 1978).

The Arcus Ticket Company of Chicago advertised a list of advantages of scrip to both the employer and employee, one of which for the employer was the fostering of employee good-will by avoiding misunderstandings on charge accounts. The advantages to the employee included keeping the “‘head of the house’ better informed as to the purchases made by his family from day to day. . . . This frequently puts a check to extravagance and debt” (Keystone Catalog, 1925 in Brown 1978). Local scrip of this type was very similar to modern-day traveler’s checks. The costs of traveler’s checks were also the costs of coupon scrip: each unit could be used only once. It had to be signed out when it was issued and signed when it was spent (Brown 1978)[1].

The transactions costs of coupon scrip eventually encouraged the increased use of metal scrip. This medium became cheaper overall than coupon scrip, in spite of metal’s higher initial cost, largely due to the invention and development of the cash register after 1880. Pantographic machines also were instrumental in reducing the unit costs of metal tokens (Brown 1978).

Instead of receiving cash, the scrip-issuing “cash registers” paid out metal tokens, made a record of the pay-out and to whom it had gone, and kept a grand total of the amount issued. The scrip registers would eject a specified “dollar” amount of scrip when a lever like that on a slot machine was pulled. In a 1927 advertisement, the Osborne Register Company (ORCO) of Cincinnati pictured a 10-year-old child who, in a demonstration, issued $600 worth of metal scrip in various amounts to 200 hypothetical employees in 55 minutes, implying an average emission of $3 per employee every 16.5 seconds (Brown 1978).

The Positive-Sum Benefits of Scrip

The economics of scrip issue, as with all exchange between economic agents, required that both the issuer (the coal mining company) and the acceptor (the employee) benefit from the transaction. The company necessarily had contact with the outside world. It bought machinery and other resources and sold coal in a national market. All these activities required the use of standard money.

Scrip was used essentially as a working balance of money with which the coal operator could make advances to his impecunious employees between paydays. It was issued at the request of the miner to the extent of the wages he had already earned, and it was redeemable in standard money on the next payday. The amounts were usually small—five or ten dollars, or even less. To the worker, it amounted to an interest-free, small-sum loan that he could get with almost no effort. It enabled him to buy ordinary household goods at the company store. To those workers who had “gone out and got drunk” on the previous weekend, or who had suffered some kind of household emergency, scrip was a blessing only measurable by the cost of its common alternative (Clark 1980, Johnson 1952).

Its alternative in a conventional urban setting without scrip was the pawn shop, loan shark, or installment peddler (Johnson 1952). An industrial worker in the same unfortunate position in, say, Detroit, Pittsburgh, or Chicago, had access to money between paydays only by borrowing against his household capital at a pawn shop where he paid exorbitant interest rates if he reclaimed his pawned goods.

The scrip system could be abused in such a way that a discount would also appear in some scrip transactions. Since the company store did not sell liquor—for the obvious reason that its sale would encourage absenteeism and worker inefficiency—workers would at times obtain scrip from the company clerk and sell it for conventional currency in order to buy liquor. The bootlegger (during Prohibition) or other liquor vendor, whose shop was not likely in the neighborhood of the company store, faced significant costs in redeeming the scrip for conventional money, thus giving rise to a discount (Brown 1978, Caldwell 1969)[2].

In spite of the obvious advantages of the scrip system to both worker and mine owner, scrip, the company store, and the company town have been universally demeaned (Brown 1978). The accounts of their operations include contradictions that appear sometimes in the same paragraph. (For example, see the quote of Sayre used as an epigraph, p. 1, Brown 1978.) All accounts, while critical of the scrip system, acknowledge, first, that it was issued at the behest of the miner; second, that its issue cost the miner nothing; and, third, that it was redeemable in standard money on payday. The dogma of scrip’s critics was that the company store, in which the scrip had to be spent, raised prices to monopolistic levels and thereby exploited the defenseless miner (Dodrill 1971). Fishback’s and Johnson’s studies of prices in company stores versus those in independent stores refute this popular prejudice. Prices were four to seven percent higher, but so were costs (Fishback 1986; Johnson 1952).

The advantage of scrip issue to the mine operator was that it was one worker perquisite he could offer to attract labor into a somewhat unattractive environment. He already offered housing and mercantile services; by issuing scrip against future wages he also provided commercial credit with virtually no interest charges to the borrowers (Johnson 1952). The practice, indeed, was so widespread that it can only be viewed as a traditional perquisite of the trade. A company that did not offer the scrip privilege would have been at a competitive disadvantage.

The mine operator thus became a quasi-banker. His cost for metal scrip during the 1920s varied from slightly less than 1 cent to 5 cents a unit for scrip tokens of simple design made of aluminum. In brass or nickel silver and with scalloped edges and more intricate designs, costs could run as high as 11 cents a piece. (All these values are unit costs in thousand-unit lots, and are from advertisements of several different scrip manufacturers between 1925 and 1940, in Brown 1978.)

Scrip sales information from the Ingle Company sales journal of 1928 reveals that the average denomination issued was about 25 cents (Brown 1978). Since the average cost per token was only about 3 cents and could have been even less, an investment by the coal company bank in, say, 5,000 pieces cost it about $150 for the scrip coin, and perhaps $100 more for a scrip-issuing machine. To carry out this same banking function with regular U.S. Currency would have required an investment in cash alone of $1,250, as well as substantially greater security costs to protect the money. One observer noted, “The mining company could pay almost its entire payroll in company scrip, disturbing only a few dollars of actual working capital” (Sayre, in Brown 1978). Of course, paying out scrip gave workers some additional claims on the working capital of the company stores. So the monetary economy of using scrip was in part offset by higher costs of merchandising goods.[3]

The difference between the payment system costs of scrip and of real money was a form of seigniorage revenue the coal mine operator realized and shared with his employees. They received interest-free loans; he was able to offer a fringe benefit that tended to reduce what would have been a higher working capital requirement.

While scrip was usually specialized to one company in a particular community, many coal mining companies had mines in different regions. Their scrip was good in all the different locations where their mines operated. As the scrip-using communities gradually came to experience more extensive commercial relations with each other, their localized scrips became interchangeable. Even some independent stores accepted coal company scrip (Brown 1978).

Given the proscriptions against the private printing or coining of money by the Acts of 1862 and 1864, one may wonder how scrip could have been issued and used legally. The key is the word “intended” in the proscriptive laws. The courts ruled that scrip was not intended to circulate as money: first, bemuse it was redeemable only in merchandise until payday; and, second, because it resembled money only superficially and was clearly distinguishable from standard money. (The coin under the court’s scrutiny was a 50-cent token, but weighed only one-fifth as much as a standard 50-cent piece.) Any token that was redeemable in lawful money on demand was construed to be illegal, and whether the token in question was coin or pasteboard did not matter (Brown 1978).

The Environments in Which Scrip Appeared

The extent of scrip use has many dimensions—temporal, geographical, and industrial. Its most notable occurrence in the 20th century was in the coal mining regions of West Virginia, in part because the state government passed a “wide open” scrip law some time before 1925. However, it was extensively used in other states as well. The Tennessee Coal Iron and Railway Company, for example, ordered 547,500 pieces between 1933 and 1937 from the Ingle-Schierloh Company of Dayton, Ohio (Brown 1978). Another source lists 20,000 coal company stores in the United States, Canada, and Mexico all of which used scrip between 1903 and 1958 (Dodrill 1971).

Numismatic records indicate that scrip was also used extensively in several other industries—fishing canneries, agriculture (to pay crop-pickers), fruit canneries, logging and lumbering companies, and paper companies. (Brown 1978, Trantow 1978. Trantow’s index lists over 1,100 companies that issued scrip currency in 40 states.) One scrip numismatist cites a Chicago newspaper of 1845 that regularly quoted the discounted prices of coal scrip, city scrip, canal scrip, railroad scrip, Michigan scrip, Indiana State scrip, and Indiana land scrip, as well as the notes of private and chartered banks. Private businesses issuing such scrip numbered in the thousands (Harper 1948). Furthermore, as Brown observed, “The use of paper scrip was much wider than the use of [coin] scrip . . . [but] only a comparatively small amount [of the paper] has survived.” Therefore, the extent of scrip use must have been much greater than the vestiges in metallic collections would indicate. (See also Caldwell 1969.)

Just as Brown in his work seemed unaware of scrip that had preceded the issues by coal companies, Harper in his study of Scrip and Other Forms of Local Money thought that intensive use of scrip only appeared in the United States during the depression years, 1932–1935. His research uncovered several sources of “depression” scrip: (1) issues by local governments due to decreases in tax revenues; (2) issues by chambers of commerce after local bank failures as a means of “corralling as large a proportion of the depression diminished volume of business as possible for their membership”; (3) issues by “home-owned stores as a weapon against . . . chain-store competition”; (4) issues by “barter groups as a means by which the unemployed could more conveniently exchange services”; and (5) issues by charitable organizations to needy persons as “commodity orders” for foodstuffs. “Local money in some form,” he concluded, “is likely to recur in response to a public demand under substantially similar circumstances.”

Most of this “depression” scrip had appeared in earlier times—for example, municipal scrip that was redeemable as tax payments. The depression scrip, however, was usually linked to a dated stamp scheme that required the holder to fix low denomination (2- or 3-cent) stamps to the scrip at specified times. The stamps were to provide the revenue to redeem the scrip and to encourage spending, but they added an undesirable burden that greatly reduced the efficacy of the scrip’s use. They also detracted from the scrip’s effectiveness as an addition to the existing stock of ordinary money (Harper 1948).

Implications of the Scrip Episode

The phenomenology of scrip issue has significant implications. First, no one had any incentive to leave scrip behind for monetary researchers to count or to analyze. Demanders of such currency would not regard it as a store of value for any time longer than the period between paydays. Suppliers, to whom the scrip was an outstanding demand obligation, would redeem it first if they liquidated, merged, or closed clown their enterprises. In addition, everyone who used it and benefited from it was aware of its questionable legality. Archival records of its outstanding quantities, therefore, are almost nonexistent (Timberlake 1981).

Scrip’s unrecorded existence is emphasized as well by the research that has uncovered its former use. Each scholar who has unearthed one of the diverse scrip appearances has treated the phenomenon as unique, and with good reason. Each one was widely separated in time, place, and circumstance from the others. Yet, each one had characteristics similar to the others. All episodes combined emphasize the feasibility of the spontaneous production of money in the private sector.

The coal mining scrip episode adds significantly to the total scrip experience for a number of reasons. First, it lasted for over 50 years, so it was not just a temporary happenstance. Second, it appeared in a wide range of independent communities. In West Virginia alone, almost 900 coal mining companies employing about 120,000 miners issued scrip in one form or another. In other areas of Appalachia—southern Virginia, eastern Kentucky, eastern Tennessee, and southwestern Pennsylvania—the experience was similar.

Third, scrip’s tenure was not dependent on the previous existence of standard legal tender money. True, the coal company was bound to redeem the scrip on payday, but this guarantee was only a flourish that enabled scrip issuers to avoid violating the proscriptive laws against the issue of private monies. As it was, many children living in coal mining communities did not see a dollar of “real” money until they grew up and left the area (Caldwell 1969).

The self-sustaining nature of the scrip system, without recourse to standard money, stemmed from the fact that both the demander and supplier of scrip were active participants in both the labor market and the household goods market at the company store. This intimacy in two markets by both participants enabled them to evaluate wages paid and received in real terms, that is, by the quantity of household goods that the scrip wages could purchase. A decline in the purchasing power of scrip at the company store would simply have indicated to the miner that the real value of his services to the company had declined. He thereupon would have moved to another location or occupation. If the decline in real wages was due to an industrial depression or the competitive decline of the coal industry, as occurred simultaneously in the 1930s, both mine workers and mine operators would realize reduced real returns in the mode of any resource owners under similar circumstances.

A fourth important result of the scrip system was its reflective emphasis on the returns to the capital structure of the payments system. In the scrip system the money was supplied endogenously: the coal company banks, the borrowing miners, and the scrip suppliers were all parts of an economy of private ownership. Scrip money was not dependent on any outside money but was produced under the same conditions and incentives as any common commodity. The mining companies rather than the workers produced the scrip because in working without wages until payday, the workers were implicitly extending credit to the company. Scrip issue was a means of clearing this debt before the regular payday. In addition, the coal mining company had the collateral value of the mined coal to secure the “loan.”[4]

Both the companies and the workers realized the seigniorage returns from its existence. While the scrip system was small-scale and had a low profile, the government could ignore it because it posed no threat to the government’s monopoly over the production of money. However, if scrip issue had shown any tendency to become a national practice, the proscriptive laws against private coinage would surely have been interpreted and enforced much more rigorously.[5]

An observer of the scrip system might conjecture that the experience of the isolated communities could have ramified into an intercommunity system using some kind of scrip clearinghouses (i.e., scrip banks) if the laws restraining the private issue of money had not existed. Over time, technological and organizational developments could have led to economies of scale and enterprise. Probably as few as three or four or as many as two dozen issuers of scrip money might have appeared. Some of the minters of scrip—Ingle-Schierloh, Osborne, Insurance Credit, Adams, Dorman, and others—would have expanded their enterprises to include management of inter-community scrip systems and ultimately their probable evolution into credit card systems. Such an extension of function would have been analogous to automobile dealers expanding into the car leasing business—a sort of horizontal integration to reap certain economies of scale.

Had the scrip system become intercommunal and given rise to scrip-on-deposit in scrip banks necessitating bank reserves and clearing operations, some high-powered scrip into which local scrips could be converted would probably have appeared. The experience of the ages seems to confirm this evolution (Friedman and Schwartz 1986). Less clear is why the high-powered money has to be issued or regulated by the state. The question of whether or not the market system could, alternatively, produce a private monetary base that would prove to be both stable and serviceable has not been attempted or allowed and will remain unimaginable until a general belief in market efficacy becomes pervasive. That time as yet seems nowhere near.[6]

Literature Cited

Brown, Stuart E., Jr. Scrip. Berryville, VA.: Virginia Book Company, 1978.

Caldwell, Walter. Coal Company Scrip. Montgomery, W. Va.: War Printing Co., 1969.

Carothers, Neil. Fractional Money (1930), reprint. New York: Kelley, 1967.

Clark, C. R. Florida Trade Tokens. St. Petersburg, Fl.: Great Outdoors Publishing Company, 1980.

Dodrill, Gordon. 20,000 Coal Company Stores in the United States, Mexico and Canada. Pittsburg: Duquesne Lithographing Company, 1971.

Faulkner, Roland F. “The Private Issue of Token Coins.” Political Science Quarterly 16 (1901), 320–22.

Fishback, Price. “Did Miners Owe Their Souls to the Company Store? Theory and Evidence from the Early 1900’s.” Journal of Economic History 46 (December 1986), 1011–29.

Friedman, Milton, and Anna J. Schwartz. “Has Government Any Role in Money?” Journal of Monetary Economics (January 1986), 37–62.

Glasner, David. “Economic Evolution and Monetary Reform,” (unpublished).

Harper, Joel W. Scrip and Other Forms of Local Money. Ph.D. dissertation, University of Chicago, 1948.

Hurst, James Willard. A Legal History of Money in the United States, 1774–1970. Lincoln: University of Nebraska Press, 1973.

Johnson, Ole S. The Industrial Store, Its History, Operation and Economic Significance. Atlanta: Foote and Davies, 1952.

Rolnick, Arthur J., and Warren E. Weber. “Free Banking, Wildcat Banking, and Shinplasters.” Federal Reserve Bank of Minneapolis Quarterly Review 6 (Fall 1982), 10–19.

Sylla, Richard. “Forgotten Men of Money: Private Bankers in Early U.S. History.” Journal of Economic History 36 (March 1976), 173–88.

Timberlake, Richard H. “The Significance of Unaccounted Currencies.” Journal of Economic History 41 (December 1981), 853–66.

———. “The Central Banking Role of Clearinghouse Associations.” Journal of Money, Credit, and Banking 16 (February 1984), 1–15.

Trantow, Terry N. Catalogue of Lumber Company Store Tokens. Ellensburg, Wash.: Trantow, 1978.

White, Lawrence H. Free Banking in Britain. Cambridge: Cambridge University Press, 1984.

Richard H. Timberlake, Jr. (born June 24, 1922) is an American economist who was Professor of Economics at the University of Georgia for much of his career. He also has become a leading advocate of free banking, the belief that money should be issued by private companies, not by a government monopoly.

Originally published in the October 1989 issue of The Freeman.

The author is indebted for support and suggestions to the sponsors and participants of the Manhattan Institute Monetary Conference of 1986, especially to David Glasner and Anna Schwartz. My colleague, Price Fishback, and Milton Friedman also made valuable suggestions, as did Huston McCulloch and two referees for the Journal of Money, Credit, and Banking.

[1] This comparison must be qualified. Many travelers checks, as well as other U.S. currency, are currently used as hand-to-hand media in foreign markets. Sometimes traveler’s checks return from abroad with more than a dozen endorsements on them. They are called “checks,” but like food “stamps,” they are a quasi-currency.

[2] Scrip was frequently advertised as redeemable only to the worker to whom it was originally issued. This condition applied in mines. However, for metallic scrip, it could hardly have been enforced, and would have detracted from the utility of any scrip if it were enforced.

[3] I am indebted to Huston McCulloch for this observation.

[4] I am indebted to Huston McCulloch for suggesting these details.

[5] In a thought-provoking paper, David Glasner argues convincingly that governmental assumption of a monopoly role over money enabled governments to enhance their fiscal powers, particularly during war emergencies (Glasner, “Economic Evolution and Monetary Reform,” especially the section: “A Rational for Government Monopoly over Money”). In short, not only is seigniorage an important revenue 40 the state, but capital expropriation through debasement of money’s function as a unit of account may be even more lucrative.

[6] However, the commercial bank clearinghouse system in the United States during the second half of the nineteenth century is an example of a private lender of last resort that produced base money efficiently at critical times (Timberlake 1984).

Gold and Money

Warren C. Gibson

Nothing seems to arouse passions—pro and con—quite like suggestions that gold should once again play a role in our money. “Only gold is money,” says one side. “It’s a barbarous relic,” says the other. Let’s turn down the heat a bit and look into some propositions about gold. That should lead us to some reasonable ideas about whether or how gold might return.

Gold Has Intrinsic Value

Actually, nothing has intrinsic value. The value of any good or service resides in the minds of individuals contemplating the benefits they might derive from it. What gold does have is some rather remarkable physical properties that make it very likely that people will continue to value it highly: luster, corrosion resistance, divisibility, malleability, high thermal and electrical conductivity, and a high degree of scarcity. All the gold ever mined would only fill one large swimming pool, and most of that gold is still recoverable.

Only Gold Is Money

Although gold was once used as money, that is no longer the case. Money is whatever is generally accepted as a medium of exchange in a particular historical setting. Right now, government-issued fiat money, unbacked by any commodity, is the only kind of money we find anywhere in the world, with some possible obscure exceptions.

Perhaps people who say this mean that gold is the only form of money that can ensure stability. That’s what future Federal Reserve Chairman Alan Greenspan thought in 1967 when he wrote “Gold and Economic Freedom” for Ayn Rand’s newsletter. “In the absence of the gold standard, there is no way to protect savings from confiscation through inflation,” he said. When later asked by U.S. Rep. Ron Paul whether he stood by that article, Greenspan said he did. But he weaseled out by saying a return to gold was unnecessary because central banks had learned to produce the same results gold would produce.

The Gold Standard Is Too Rigid

The gold standard makes it impossible for a government central bank to conduct monetary policy—hooray! Under the Fed’s watch, the dollar has lost more than 95 percent of its purchasing power, and the economy was convulsed by the Great Depression of the 1930s, the stagflation of the 1970s, and the crash of 2008. Milton Friedman long ago explained the long and variable lags that follow monetary interventions and at one point called for replacing the Fed with a computer. The end of government economic manipulations in the form of monetary policy is a major potential benefit of a gold standard.

Gold is supposedly too rigid to accommodate increased demand for money at certain times of the year—historically harvest time and Christmas time—or in wartime. Falling prices are one way an economy can adjust to an increase in the demand for money, but this accommodation works best over a longer period. A short-term accommodation is possible when banks hold fractional reserves. On short notice and without any increase in monetary gold, fractional-reserve banks could simply issue more bank notes or their electronic equivalent during periods of high demand and retire them when demand subsided.

Inflation Is Impossible under a Gold Standard

Between 1897 and 1914 the gold stock rose at about 3.5 percent a year due to new discoveries and inflows from abroad. As a result, prices rose about 26 percent over this span, or about 1.4 percent per year. This was not a disruptive level of price inflation—but it was inflation.

The Gold Standard Was Tried and Failed

This is a plausible proposition, not to be dismissed out of hand. Nor may we simply note that because we never had a pure gold standard, the concept was never really tested. We must do better than that.

During much of our history, money was linked to gold in some degree, and there were some serious monetary problems during that time. The record of gold is bound up with the institutional arrangements that prevailed at various times in our history. Snapshots from that history should help illuminate this claim.

Before proceeding, we need a definition. Under a gold standard either private banks or a monopoly central bank issues notes (or their electronic equivalent) redeemable in gold. Gold coins may circulate as well. Notes may be fully or fractionally backed, meaning a note issuer may not have sufficient gold to redeem all outstanding notes at one time. In passing I assert, contrary to some “hard money” advocates, that fractional-reserve banking is an institution that is entirely compatible with free markets and the rule of law.

The period between the War of 1812 and the Civil War is commonly called the “free banking era.” It is also called the era of “wildcat banks” because many banks were poorly capitalized, poorly if not fraudulently managed, and prone to failure. Conventional wisdom says that this era demonstrates conclusively the need for strict government regulation of money and banking. Like other free-market institutions, free banking rests on the sanctity of property rights, with no government involvement other than prosecution of theft or fraud. But there was substantial government involvement all along, so the “free banking” label is only accurate in relative terms.

The most egregious departure from free-banking principles was the frequent suspension of specie payments: banks’ refusal to honor their obligation to redeem their banknotes for gold. These breaches of contract, which should have triggered liquidation and perhaps criminal prosecution, were in many instances tolerated or even encouraged by government authorities, especially during times of war or economic contraction.

Second, the free-banking paradigm does not include a monopoly central bank. The Second Bank of the United States—roughly speaking, the U.S. central bank of its time—closed its doors in 1836. Its defeat, engineered by populist President Andrew Jackson, came with wide support from a public that had been generally suspicious of banks since the founding of the Republic. But the end of the Second Bank was by no means the end of federal government involvement in banking. With the Second Bank gone, the federal government still needed depositories for its funds. Certain private banks, which came to be known as “pet banks,” were selected for this privilege. This was one way in which the federal government continued to influence the banking system.

A third intervention, practiced by federal and state governments, was the prohibition of branch banking. No banks were allowed to cross state lines to open branches, and there were significant restrictions within most states as well. The strictest state laws forbade any branching whatever, while others allowed branching within their states on a limited basis. The result was that many communities could only be served by small, poorly capitalized, and often poorly managed local banks. Stronger city banks might have established branches in areas where early banks had failed or where none had emerged, particularly with the spread of the telegraph and railroads. But they were not allowed to do so. For confirmation of the ill effects of branch prohibition, we need only look as far as Canada, which has always had a few strong nationwide banks. During the Great Depression, when some 9,000 U.S. banks failed, not a single Canadian bank went under.

Fourth, many state governments required banks to hold their bonds as part of their reserves. This, of course, provided a captive market for such bonds. The National Banking System, established after the Civil War, imposed a requirement to hold federal Treasury securities. Thus the five-dollar gold note (see photo), issued by the Farmers Gold Bank of San Jose, California, in 1874 promises to “pay the bearer on demand five dollars in gold coin.” But it also says the note is “secured by bonds of the United States deposited with the U.S. Treasurer at Washington.” In other words, the government gave the banks incentive to substitute bonds for some of the gold they might have held as reserves.

The Gold Standard Is to Blame for Severe Downturns in 1893 and 1907

The panic of 1893 was quite severe. That year saw numerous railroad bankruptcies, bank failures, and declining stock prices. Among the causes were general overbuilding of railroads, the Silver Purchase Act of 1890, and the protectionist McKinley tariff of 1890. Perhaps a modern central bank, with unlimited money-creation power, could have mitigated some of the immediate pain. But as we have seen, the record of the Federal Reserve, which acquired that power in the following century, suggests a failed institution. As it was, the panic was over in fairly short order and economic growth resumed.

The Panic of 1907 was marked by bank runs, numerous bankruptcies, and sharp drops in stock prices. A trigger for the Panic was a failed attempt to corner the stock of United Copper using borrowed money. Other factors included the San Francisco earthquake and the Hepburn Act, which gave the Interstate Commerce Commission power to set maximum railroad rates, suppressing the shares of those companies.

The Panic was ended largely through the efforts of J. P. Morgan. Again, things turned around in fairly short order and growth resumed.

The Dollar-Gold Link Established by the 1944 Bretton Woods Agreement Didn’t Work

Indeed it didn’t, at least not for long. Under Bretton Woods, the United States and its currency were accorded a special role. The United States was obliged to redeem dollars for gold, but only dollars tendered by foreign central banks. No one else could get gold for dollars, and no other currencies were directly redeemable. There was a tacit agreement that foreign governments would not “abuse” their redemption privilege, but the French under Charles de Gaulle and his gold-oriented finance minister, Jacques Rueff, saw things differently and insisted on redemption—which, oddly enough, entailed moving gold bars from one part of the New York Fed’s vault to another, since the Fed was storing gold as a service to the French. By 1971, it had become clear that far more dollars were likely to be tendered than could be covered by gold, and President Nixon unilaterally ended gold redemptions. This cut the last (very indirect) link between the dollar and gold. By then silver had disappeared from U.S. coins as well.

De Gaulle cannot be blamed for the failure of Bretton Woods. All he did was to point out the emperor’s lack of clothing. As the Federal Reserve created more and more fiat money, some of which made its way overseas, the redemption promise rang more and more hollow. By the time Nixon took action, there was no other choice but to slam the gold window shut.

Milton Friedman was one of the first to propose floating exchange rates. The notion seemed radical and unworkable at the time (around 1960). That, of course, is the system we have now, and while it has eliminated sudden devaluations, currency markets are much more volatile than Friedman anticipated. Nor did he anticipate the degree to which governments would enter the markets to manipulate their own currencies, as when the Chinese authorities sell their currency to keep it from rising too fast against the dollar. And he would have been appalled at the “race to the bottom” that threatens to break out as governments seek to boost their domestic economies by driving down their currencies to make their exports more competitive.

In his wonderful little book Money Mischief, Friedman asked himself whether the pure fiat standard, which has been in force only since 1971, could endure. He didn’t give a definite answer but expressed grave doubts. The possibility of a general loss of confidence in fiat money is reason to believe that gold could once again play a monetary role, as I will argue in the second part of this series.

The Gold That Was Once Locked up at Fort Knox Is Gone

It has been 40 years since the last indirect link between the dollar and gold was severed, and yet the government continues to hold some 8,000 metric tons of gold bullion—the world’s largest single stash. Oddly enough, it is valued at $42 per ounce, the last official price before it was set free to be established in free trading. At today’s market price of around $1,300 per ounce, the hoard would be valued in the hundreds of billions of dollars, although that much gold could not be dumped precipitously without suppressing the price.

James Picerno, writing in a recent issue of The Atlantic, asked why the hoard remains. Three hundred billion dollars may not be a huge sum in this new era of trillions, but it’s not chump change either. His conclusion: A selloff would be seen as a sign of weakness or even desperation and might trigger a loss of confidence in the government’s money and/or its debt. He also cites a poll which indicates that 87 percent of Americans believe the government shouldn’t sell its gold reserves. We can only conclude that gold still plays a very indirect role in maintaining confidence in the government.

But is the gold still there? Yes, almost certainly, though we hear occasional calls for an outside audit. A more plausible accusation is that some of it has been leased to short sellers. This is a common practice among central banks that offers distinct benefits to the government. First, it earns a bit of interest income. More important, it can covertly suppress the gold price. Rising gold prices annoy Treasury secretaries and central bankers because the rise implies falling confidence in their currency. Leased gold remains in the vault and on the balance sheet even though it (or rather a paper claim on it) has been sold to someone else. Although one can find rumors on the Internet, there is no way, short of a thorough audit, to know the extent of gold leasing by the U.S. government, if any.

With the global economic downturn continuing and the prospect of currency wars looming, scattered voices are again suggesting a role for gold in our money. One of those voices belongs to Robert Zoellick, president of the World Bank. Could gold stage a comeback in some form? In Part 2, we will examine those prospects.

Warren Gibson teaches engineering at Santa Clara University and economics at San Jose State University.

Originally published at FEE.org on February 24, 2011.

Banking Before the Federal Reserve: The U.S. and Canada Compared

Donald Wells

The recurring financial panics in the U.S. during the 19th and early 20th centuries led Congress to establish the National Monetary Commission in 1908 to study the problem and recommend a solution. After several years of study and debate, Congress passed the Federal Reserve Act in December 1913. Even though the Federal Reserve did not prevent the Great Depression, and even though it has permitted substantial inflation since World War II, many observers still believe that some Federal control over private banking is needed to prevent the bank suspensions and failures that brought such instability to the economy in the pre-1914 years.

The purpose of this paper is to show that it was only government interference into banking before 1914 that prevented the U.S. from having a stable monetary system. Restrictions on banknote issuance, severe limits on branching, and regulations forcing banks to hold useless, idle cash reserves made the American banking system vulnerable to panics while other nations, such as Canada, avoided these crises. It also will be shown that even though Canadian banks were allowed more freedom of action, the few restraints that did exist led the Canadian government to intervene further into banking to undo the harm that otherwise would not have existed.

U.S. Banking Before 1863

Only two quasi-governmental banks were allowed to establish interstate branches in this period, the First United States Bank (1791–1811) and the Second United States Bank (1816–1836). The federal government owned one-fifth of the capital of each bank, causing political resentments which resulted in neither bank’s twenty-year charter being renewed.

When the charter of the Second United States Bank was not renewed, all banks were either chartered by the various states or given permission to operate without a charter under the so-called “free banking” laws. No banks were allowed to branch across state lines, and some states prohibited branching altogether. This prevented a natural system of nationwide clearinghouses from developing to exchange banknotes and later, deposits. Thus, when these banknotes ended up at great distances from their point of issue, they often fell to a discount. Banknote reporters tried to keep the public informed about the value of these various notes, but some fraudulent issuers were able to take advantage of the lapse of time until this information was disseminated (Rolnick & Weber, p. 14).

Some banks, particularly in cities along the eastern seaboard, were able to maintain a stable Value of their notes. The best known was the Suffolk system, which operated in the Boston area. The Suffolk Bank was able to keep smaller regional banks from overissuing by means of a clearinghouse. Banks that refused to join the Suffolk system had their notes collected and immediately presented for payment in specie; those that joined were able to count on their notes being received at par.

One problem with the so-called “free banks” was the requirement that they hold a number of state bonds equal to the banknotes they issued. These bonds often proved to be an illiquid investment for the banks, preventing them from holding the desired amount of specie to redeem their notes on demand. Since this requirement usually specified par rather than market value of the bonds, these securities in many cases were an inadequate protection for the note-holder (Rolnick & Weber, p. 16). Six states attempted to ease public fears about irredeemable banknotes by establishing a note guarantee system (FDIC, 1953, pp. 45–46)—which might not have been necessary had banks been free to branch and to hold the type of assets they preferred.

The National Bank System

Two of the methods used to finance the Civil War involved money manipulation. One was the issuance of a fiat currency (greenbacks) which was given legal tender status, and the second was the establishment of the National Banking System as a convenient place to sell low-interest bonds. The war led to the federalization of the U.S. currency because national banks were the only issuers of banknotes after Congress taxed the state banknotes out of existence. These new, uniform national banknotes were almost a government currency because they were printed by the Bureau of Engraving and the banks were forced to hold $100 of these 2 percent government bonds for each $90 of notes they issued.

This system proved to be no improvement over pre-Civil War banking; it was just as prone to panics and to suspension of cash payments. The three main weaknesses of this new system, which were avoided in Canada, were: lack of branching, forced holding of a specific cash reserve, and a government bond-backed banknote. These governmentally imposed restrictions put the U.S. banking system in a straitjacket, making it vulnerable to shocks.

All national banks were forced to be unit banks except for those state banks that convened to a national charter were allowed to retain their intrastate branches. Nationwide branching would have been more stable and efficient, permitting safer bank portfolios through geographical and industrial asset diversification. Unit banks in farm states were at a special disadvantage during agricultural depressions, whereas Canadian banks could carry a non-per-forming loan to a farmer much more easily (Beckhart, p. 450). Branch banks can be opened more easily in new areas without the trouble of acquiring a new charter and establishing a separate board of directors (Dunbar 1904, pp. 195–197). In addition, branch banks can move reserves to where they are needed more quickly, and at lower cost, since they are held within the same institution and no other bank need profit on the transfer of these funds (Breckenridge, p. 377).

Secondly, national banks were forced to hold a fixed cash reserve against their deposit liabilities, even though any reserve that must be held is no reserve at all since it cannot be used. The law mandated that country banks hold two-fifths of their 15 percent reserve in vault cash while the rest could be on deposit in a reserve city bank. These reserve city banks were required to hold half of their 25 percent reserve in vault cash while the other half could be deposited in a central reserve city bank in New York, and after 1887, Chicago or St. Louis. The latter banks were forced to hold all their 25 percent reserve in vault cash, which meant gold, greenbacks or other treasury currency. Only state-chartered banks could count national banknotes as part of their reserve.

Since banks could not use these required reserves, they had to carry an excess amount in order to operate; in a crisis, banks often had to suspend cash payments precipitating financial panics. The pyramiding of reserves in a unit bank system aggravated the problem. When faced with an increased demand for cash, each bank had to think of itself first and would pull its deposits from its correspondents. By contrast, each Canadian bank held its own reserve in whatever amount it felt adequate, with the one provision that government-issued Dominion notes had to consist of 40 percent of whatever cash reserve the bank chose to hold (Breckenridge, p. 242). The pyramiding of reserves in the U.S. made American bank runs contagious; in Canada, a bank failure did not cause the public to distrust other banks.

The third restriction on national bank behavior that weakened the system was the requirement that each bank deposit with the Comptroller of the Currency $100 worth of 2 percent government bonds for each $90 of banknotes they issued. (In 1900, banks were permitted to issue notes equal to the number of bonds deposited.) Since these notes were printed by the Bureau of Engraving and were uniform in appearance, they were received and paid out by banks throughout the country. This system failed to test the ability of each bank to redeem its own notes as did the Canadian system with its distinctive banknotes (Dunbar 1917, p. 228). Yet underissuance rather than overissuance was the problem with national banknotes because of the government bond restriction.

Liquidity Crises

The value of these special bonds, rather than the demand for banknotes, became the constraint on banknote issuance. Some national banks never issued notes at all while others charged higher interest rates to borrowers who demanded loan proceeds in banknotes instead of deposits. The reduction of the Federal debt in the 1880s intensified the problem as evidenced by a decrease in banknotes outstanding from $325 million in 1880 to $123 million at the end of 1890 (Dunbar, 1917, p. 232). This underissuance of banknotes led to several liquidity crises which only U.S. banks suffered because they could not exchange one liability for another—banknotes for deposits—as the public demanded. Instead, they had to pay out legal tender cash from their assets, thus depleting their reserves, which often led to suspension of cash payments.

By contrast, Canadian banks have not suspended cash payments since the late 1830s. All banks were allowed to issue their own distinctive banknotes without holding a legally mandated asset to back them. These notes were subjected to the daily market test of public acceptance as each bank sought to get its own notes into circulation while simultaneously driving home rival notes to their respective issuers through note exchanges. Furthermore, these banknotes were an inexpensive till-money because they were not a liability until issued (Beckhart, p. 377). This reduced the cost of establishing branches in newly developed areas.

Canadian banknotes also had excellent elasticity, expanding and contracting as the demand for them changed. This was especially evident during the autumn when crops were moving to market and the demand for banknotes sometimes increased as much as 42 percent of the yearly minimum (Curtis, p. 20). During the Panic of 1907, some Canadian banknotes even circulated in parts of the U.S. after American banks suspended cash payments (Johnson, p. 78).

The only government restriction on the issuance of Canadian banknotes was an unnecessary one that proved to be harmful in the early 20th century. No bank was permitted to issue notes in excess of its paid-in capital, which excluded the surplus account. When passed in 1871, no bank had approached that limit, but by 1908, some had. But instead of removing this unnecessary restriction, Parliament passed a special law that year permitting banks to issue notes to an amount 15 percent over their combined capital and surplus accounts during the crop moving season if banks paid a 5 percent tax on this excess issue. Banks obviously disliked this tax so, in 1913, Parliament passed another law which allowed banks to avoid the tax if their excess issue were fully banked by deposit of gold in the newly-created Central Gold Reserve in Montreal (Neufeld, p. 108). Banks in Canada had only about a year’s experience operating under these new provisions before World War I broke out which saw the Canadian government undertake inflationary wartime measures, such as suspending the gold standard and permitting banks to borrow fiat base money from the Minister of Finance.

Emergency Currency: The Illegal Clearinghouse Loan Certificate

In times of crisis when U.S. national banks were forced to suspend cash payments, these banks cooperated through their respective clearinghouses to issue a free market money which, though illegal, worked quite well in preventing the contagious runs that were to implore the whole system in the early 1930s. The clearinghouse allowed unit banks to put up a united front in times of panic by marshaling the resources of all the members, thereby stretching the scarce supply of currency. The clearinghouse would authorize the issuance of loan certificates which banks with deficits could use instead of regular currency to settle their balances after these banks pledged acceptable securities as collateral. Banks holding surpluses accepted these loan certificates as payment to earn the 6 percent interest that was paid on them (Timberlake, pp. 4–6). If a deficit bank failed and the collateral was insufficient to cover the loan certificates, the members of the clearinghouse had to share the loss.

During the Panics of 1893 and 1907, clearinghouses used small denomination certificates for hand-to-hand currency in addition to large denominations to settle their balances (Noyes, pp. 20–22). The public obviously preferred legal currency to these small certificates as evidenced by the fact that the makeshift currency usually fell to a discount until suspension of cash payments ended (Andrew, pp. 507–509). Yet these free-market arrangements mitigated each panic by preventing the fractional reserve collapse that was to occur after the Federal Reserve was in operation. On the other hand, it is possible that these crises would not have occurred at all if U.S. banks had been allowed to issue banknotes without restrictions, to branch where they wanted, and not made to hold a useless cash reserve.

Emergency Currency: The Legal Aldrich-Vreeland Banknote

In the aftermath of the Panic of 1907, Congress passed the Aldrich-Vreeland Act of 1908 which authorized national banks to issue a legal emergency currency until a permanent solution could be found. This law, which was to expire on July 1, 1914, attempted to overcome two of the three shortcomings of the national bank system: the lack of branching and the rigid restrictions on issuance of banknotes. Any ten or more national banks with an aggregate capital of at least $5 million could form a national currency association to issue notes backed by commercial paper or other securities, rather than just the 2 percent government bonds to which banks had been restricted. These new banknotes, for which all banks in the association would be liable, could not exceed 75 percent of the market value of the securities backing them and, in addition, could not be issued until the banks in the association had regular government bond-backed banknotes outstanding equal to 40 percent of their capital stock. Congress further imposed a 5 percent tax on this emergency currency for the first month of its circulation and this tax was to increase by 1 percentage point a month until it reached a maximum of 10 percent (Comptroller 1908, pp. 73, 75).

Even though 21 national currency associations were formed during the next 6 years, no emergency currency was issued, either because the tax was considered to be excessive, or no occasion warranted it. Congress passed the Federal Reserve Act on December 23, 1913, but the new System did not begin operating until November 16, 1914. However, the Federal Reserve Act extended the provisions of the Aldrich-Vreeland Act for one year, until July 1, 1915. Ironically, had it not been extended, the Act would have expired before the need to use it arose. Congress also reduced the tax on the emergency currency to 3 percent for the first 3 months it was outstanding, after which the tax was to rise by half a point each month until a maximum of 6 percent was reached (Comptroller 1914, p. 12–13).

The occasion for using the new currency was the crisis following the outbreak of World War I in August 1914. Foreign holders of American securities tried to liquidate them for gold, and depositors tried to convert their deposits into currency, both of which put extreme pressure on bank reserves (Sprague, p. 517). Before banks could issue the new currency on demand, however, Congress had to repeal the restriction that banks could only issue it if they had bond-backed banknotes outstanding equal to 40 percent of their capital. Congress responded quickly, even increasing the aggregate amount of notes that could be issued (Wall Street Journal, August 5, 1914, p. 6).

For the first time, national banks could issue banknotes for deposits on public demand, thereby preventing suspension of cash payments which were so characteristic of past American crises. Even though only 1,363 of the 2,197 banks in the 45 currency associations in existence at that time actually issued the emergency currency, it was the immediate response to public demand that prevented the panic (Comptroller 1915, pp. 92, 99). Only $386.4 million was taken out during the emergency that lasted into the spring of 1915, but $368.6 million, or 95 percent of the total, was issued by the peak period in October (Wall Street Journal, November 3, 1914, p. 1). By the first week of January, 60 percent had been retired; the remainder was retired by the end of June, except for $200,000 in a failed bank (Comptroller 1915, p. 101).

Less than a fourth of the legal maximum was ever issued, with banks in New York City taking out 37.5 percent of the total; these banks were the first to issue the currency and the first to retire any and all of it (Comptroller 1915, pp. 100–101). This Act allowed national banks to act as Canadian banks would under stress, issuing banknotes as demanded and saving their gold and treasury currency for use as a reserve. State-chartered banks could use the emergency currency as part of their reserves, but as often happens, once they realized this currency was readily available, they, along with the general public, stopped demanding it. Much of the emergency currency sent to the interior was later returned to New York in its original wrappings (Wall Street Journal, November 14, 1914, p. 8).

Conclusion

From hindsight, we know that both legal and illegal emergency currency outperformed the Federal Reserve during the credit implosion of the early 1930s. Banks can respond to market forces if they are allowed to issue banknotes, which are an “inside money” just as are deposits, but they cannot issue “outside” Federal Reserve Notes. When the public found out that currency was not available, they demanded it all the more, precipitating the fractional reserve collapse during the depression.

The problems of pre-1914 banking in the U.S. involved too many government restrictions, not too few. Politicians may have believed that private banking was unstable, but had they looked to the Canadian model as a guide, they could have concluded that market forces can give us a successful banking and monetary system just as it provides us with food, clothing, and other necessities.

Bibliography

Andrew, A. Piatt, “Substitutes for Cash in the Panic of 1907.” Quarterly Journal of Economics 22, August 1908, pp, 497–516.

Beckhart, Benjamin H. The Banking System of Canada, New York: Henry Holt and Company, 1929.

Breckenridge, Roelift M. The Banking System of Canada 1817–1890. New York: MacMillan, 1895.

Curtis. C. A. Statistical Contributions to Canadian Economic History. Vol. I. Statistics of Banking. Toronto: The MacMillan Company of Canada, 1931.

Dunbar, Charles F. Economic Essays. New York: MacMillan. 1904.

Dunbar, Charles F. The Theory and History of Banking. 3rd Ed. New York: Knickerbocker Press, 1917.

Johnson, Joseph French. “The Canadian Banking System Under Stress,” Annals of the American Academy of Political and Social Science 36, November 1910, pp. 60–84.

Neufeld, E. P. The Financial System of Canada. Toronto: MacMillan Company of Canada, 1972.

Noyes, Alexander D. “The Banks and the Panic of 1893.” Political Science Quarterly 9, March 1894, pp. 12–30.

Rolnick, Arthur J. and Weber, Warren E. “Free Banking, Wildcat Banking and Shinplasters,” Quarterly Review, 6, Federal Reserve Bank of Minneapolis, Fall 1982, pp. 10–19.

Sprague, O. M. W. “The Crisis of 1914 in the United States,” American Economic Review 5, September 1915, pp. 499–533.

Timberlake, Richard H. Jr. “The Central Banking Role of Clearinghouse Associations.” Journal of Money, Credit and Banking 16, February 1984, pp. 1–15.

U.S. Federal Deposit Insurance Corporation. Annual Report, 1953.

U.S. Department of the Treasury, Office of the Comptroller of the Currency Annual Reports, 1908, 1914, 1915.

The Wall Street Journal. August 5, 1914; November 3, 1914; November 14, 1914.

Donald Wells teaches in the department of economics and L. S. Scruggs in the department of finance at Memphis State University, Tennessee.

Originally published in the June 1987 issue of The Freeman.

Did the Fed Really Live Up to its Promise?

George Selgin

America’s Bank, Roger Lowenstein’s 2015 book on the founding of the Fed, is, as I said in reviewing it for Barron’s, both well-written and well-researched. Few pertinent details of the story appear to have escaped Lowenstein’s notice. However, in assembling and interpreting these details, Lowenstein appears not to have entertained the slightest doubt that the Federal Reserve Act, for all the political maneuvering that led to it, was the best of all possible means for ending this nation’s periodic financial crises.

Instead of turning a critical eye toward the 1913 Act, Lowenstein writes as if history itself were a reliable judge. What it has condemned, he condemns as well; and what it has favored, he favors. Consequently, he treats all those persons who contributed to the Federal Reserve Act’s passage as right-thinking progressives, while regarding those who favored other solutions to the nation’s currency and banking ills as so many reactionary bumpkins.

That some strains of triumphalism should have found their way into Lowenstein’s account of the Fed’s origins is hardly surprising. Though research by economic historians and others supplies precious little support for it, the view that the Fed has been a smashing success is, after all, a well-established element of conventional wisdom, and one that Fed officials themselves never cease to promote. Nor have those officials ever devoted more effort to doing so than in the course of celebrating the Fed’s recent centennial. Even a much more hard-bitten journalist than Lowenstein could hardly have been expected to resist setting considerable store by an institution so universally (if undeservedly) hallowed.

Still, one might have expected a note of skepticism, if no more than that, to have found its way into America’s Bank. Lowenstein was, after all, writing about an institution that was supposed to end U.S. financial crises once and for all, and doing so in the wake of a crisis at least as bad, in many respects, as those that inspired its creation.[1] He had, furthermore, encountered the many arguments—and most were far from being plainly idiotic—of pre-1913 experts who favored other reforms, as well as those of some of the pending Federal Reserve Act’s critics, who predicted, correctly, that it wouldn’t be long before its results would acutely disappoint those of its champions who sincerely yearned for financial and economic stability.

Perhaps most importantly, Lowenstein knew very well that Nelson (“Admit nothing. Explain nothing”) Aldrich, whom he (following Elmus Wicker) rightly regards as the man most responsible for clearing the way for the Fed’s establishment, was the outstanding crony capitalist politician in an epoch when such politicians were thicker on the ground than ever before or since. Although Aldrich presented the plan known by his name, much of which ended up being incorporated into the Federal Reserve Act, as a product of the collective efforts of the National Monetary Commission’s 16 members, the plan was actually one he himself drafted, with the help of several Wall Street bankers, in secret at Jekyll Island. The commission’s other members contributed nothing save their rubber stamp.

It’s wise to view Lowenstein’s assessment of Aldrich’s contribution in light of what other journalists have had to say about the long-serving Rhode Island Senator. Consider, for starters, Lincoln Steffens’ opinion, as expressed by him in a 1908 letter to Teddy Roosevelt. “What I really object to in him,” Steffens wrote, “is something he probably does honestly, out of general conviction. . . . He represents Wall Street; corrupt and corrupting business; men and Trusts that are forever seeking help, subsidies, privileges from government.”

Bad as this sounds, it’s nothing compared to the portrait muckraking journalist David Graham Phillips drew of Aldrich in The Treason of the Senate, his sulfurous 1906 exposé of an upper-house rife with corruption:

Various senators represent various divisions and subdivisions of this colossus. But Aldrich, rich through franchise grabbing, the intimate of Wall Street’s great robber barons, the father-in-law of the only son of the Rockefeller—Aldrich represents the colossus. Your first impression of many and conflicting interests has disappeared. You now see a single interest, with a single agent-in-chief to execute its single purpose—getting rich at the expense of the labor and the independence of the American people.

“Aldrich’s real work,” Phillips went on to write, consisted of “getting the wishes of his principals, directly or through their lawyers, and putting these wishes into proper form if they are orders for legislation or into the proper channels if they are orders to kill or emasculate legislation.” The work was “all done, of course, behind the scenes.” As chairman of the Senate Finance Committee Aldrich labored to “concoct and sugar-coat the bitter doses for the people—the loot measures and the suffocating of the measures in restraint of loot.”

Although the opinions of Steffens and Phillips might be dismissed as yellow journalism, the same cannot be said for similar verdicts reached by academic historians, including that of Jerome Sternstein, in his article “Corruption in the Gilded Age Senate: Nelson W. Aldrich and the Sugar Trust.” According to Sternstein, “far from insulating the legislative process from big business and reducing the incentives for corruption, the concentration of institutional authority in the hands of senators like Nelson W. Aldrich had precisely the opposite effect”:

Aldrich was wedded ardently to the concept that legislation affecting businessmen should be drawn up in close collaboration with businessmen. . . . America’s productive economy was not the work of politicians and theorists, but of innovative businessmen making business decisions in a most practical, efficient way. Members of Congress, therefore, had an obligation to clear appropriate legislation with them. Effective lawmaking, he held, especially that required to carry out the Republican gospel of prosperity and economic growth through vigorous state action in the form of protective tariffs and subsidies, was next to impossible otherwise. . . .

Thanks to his success in achieving the legislative goals of his corporate clients, Aldrich “found money and favors flowing to him. Businessmen did not bribe him, they did not dominate him—they simply rewarded and supported him.” In return for his efforts to shunt monetary reform onto a spur favoring the big Wall Street banks, for instance, Aldrich earned a token of gratitude from Henry P. Davison, a partner in J. P. Morgan & Company, who arranged and took part in the Jekyll Island meeting:

The enclosed [Davison wrote to Aldrich] refers to the stock of the Bankers Trust Company, of which you have been allotted one hundred shares. You will be called upon for payment of $40,000. . . It will be a pleasure for me to arrange this for you if you would like to have me do so.

I am particularly pleased to have you have this stock, as I believe it will give a good account of itself. I t is selling today on the basis of a little more than $500 a share. I hope, however, you will see fit to put it away, as it should improve with seasoning. Do not bother to read through the enclosed, unless you desire to do so. Just sign your name and return to me.

In view of Aldrich’s notoriety, Lowenstein might have suspected that, whatever its merits, the Aldrich Plan was bound to be compromised by its authors’ desire to look after Wall Street’s interests. He might, therefore, have entertained the possibility that neither it nor the Federal Reserve Act that drew so heavily from it was ideally suited to putting a stop to financial crises. But rather than proffer a revised (and not-so-triumphant) view of the Fed’s origins, Lowenstein elected instead to revise the record concerning Aldrich himself, turning him into his story’s unlikely hero.

Just as some bolting horses supposedly turned Pascal into a religious mystic, the Panic of 1907 “jolted” Aldrich sufficiently, according to Lowenstein, to inspire his conversion from Wall Street’s Man in Washington to high-minded proponent of monetary reform.

But did it? The facts suggest otherwise. Of the many shortcomings of the pre-Fed currency and banking system, none struck sincere reform proponents of all kinds as being in more dire need of correction than the tendency of the nation’s bank reserves to flow into the coffers of a handful of New York banks during seasons apart from the harvest, combined with the annual (and occasionally mad) harvest-time scramble for those same reserves.

That ebb and flow of reserves from countryside to New York City and back again was the sine qua non of the crises that periodically rocked the U.S. economy.

Unfortunately, that same ebb and flow were, so far as New York’s major banks themselves were concerned, good business, for it was the source of funds they lent on call to stock investors, by which they made a tidy profit. Any reform that might undermine their status as the ultimate custodians, for most of the year, of the nations’ bank reserves was, so far as they were concerned, anathema.

Until the Panic of 1907, Aldrich was able to satisfy his Wall Street clients simply by blocking—with the help of fellow standpatters—every monetary reform measure that came his committee’s way. The panic changed things, not by convincing Aldrich to clean up his act, but by forcing him to change his tactics. Realizing that reform could no longer be held off, he resolved to assume control of the reform movement, and to have it result in changes that, however sweeping, would nonetheless preserve, and even enhance, both the dangerous “pyramiding” of reserves in New York and his Wall Street chums’ bottom lines.

Just how Aldrich managed to achieve this goal—and to do so despite the rejection of his own plan in favor of a Democratic alternative—is a story too long to be told here. Interested readers will find it, and many other details besides, in my recent Cato Policy Analysis, “New York’s Bank: The National Monetary Commission and the Founding of the Fed,” which they can view by clicking on the image below. The information there will, I hope, allow them to conclude that, to gain a proper understanding of Aldrich’s part in the Fed’s establishment, one needn’t alter a single brushstroke in muckrakers’ portraits of him.

George A. Selgin is the Director of the Cato Institute’s Center for Monetary and Financial Alternatives, where he is editor-in-chief of the Center’s blog, Alt-M, Professor Emeritus of economics at the Terry College of Business at the University of Georgia, and an associate editor of Econ Journal Watch. Selgin formerly taught at George Mason University, the University of Hong Kong, and West Virginia University.

Originally published at FEE.org on July 8, 2016.

[1] Those who suppose that the Fed did all it could and should have done to combat the recent cataclysm are encouraged to read my articles: “Courage to Refuse,” “Sterilization, Fed Style,” “Interest On Reserves, Part I,” and “Interest On Reserves, Part III.”

Money in the 1920s and 1930s

Richard H. Timberlake

One of the most enduring and troublesome mysteries in economics is money: how it is created, what sorts of institutions initiate the process, what kinds of mystique and priestcraft central bankers use in managing monetary systems, and what rules, laws, or customs limit their actions.

Perhaps the common ignorance about money is harmless. After all, the millions of people who use this money drive sophisticated automobiles and manipulate complex computers without knowing much about the technical properties of either. As long as cars, computers, and money behave themselves, can we perhaps ignore them? The answer is that we can for cars and computers, but we should not for money.

For one thing, ignorance about money has side effects that are not comparable to ignorance about technical equipment. Competitive markets drive the production and sale of all household durables, but the production of money in every country in the world today (and yesterday, too) is the province of governments. Through the offices of their associated central banks, states monopolize the machinery of money. Each central bank determines within very close tolerances just how much money an economy has and the rate at which the current stock of money will change. Unquestionably and inevitably, political pressures that are rarely visible even to experienced observers influence these operations.

Because they have the power to create money without license, governments also have the complementary incentive to claim that depressions and inflations resulting from the mismanagement of money occur because of unusual and unexpected economic developments—“shocks,” as they are labeled. The term implies a sense of impending and inevitable drama. No such social catastrophes result from the public’s incomplete knowledge of computers and automobiles, nor of “shocks” that might affect their production and distribution. However, neither do governments monopolize that production and distribution, and therein lies the difference.

Fateful Decades

Nowhere is monetary ignorance more apparent than in bystander evaluations of the economic and monetary events of the 1920s and 1930s. Although several decades have passed, the various popular accounts continue to misinterpret the causes of the disequilibrium that occurred and also the federal government’s aggravation of the problem. Government apologists of many persuasions not only argue that the massive interventions of the 1930s were necessary; they also contend that the lack of response in the private sector to the multitudinous government programs put into place proved that the economic system was moribund.

Nothing, they argue, could have prevented the debacle. They encourage the popular belief that the market economy zealously overextended itself in the 1920s. The boom, they contend, led to the stock market crash in 1929, and to the several banking crises of the early 1930s. These financial failures, the legend continues, provoked exhausting industrial liquidations, and the other devastations of the 1930s. The role that the central bank—the Federal Reserve System—and its managers played in the catastrophe of the 1920s and 1930s is largely unknown and therefore unappreciated.

Other observers, for example, many Austrian economists, believe that all the trouble started with a central bank “inflation” in the 1920s. This “inflation” had to be invented because it is a necessary element in the Austrian theory of the business cycle, which seems to describe most Austrian economic disequilibria. Austrian “inflation” is not limited to price level increases, no matter how “prices” are estimated. Rather, it is any unnatural increase in the stock of money “not consisting in, i.e., not covered by, an increase in gold.”[1]

Once the Austrian “inflation” is going, it provokes over-investment and maladjustment in various sectors of the economy. To correct the inflation-generated disequilibrium requires a wringing-out of the miscalculated investments. This purging became the enduring business calamity of the 1930s.

The late Murray Rothbard was the chief proponent of this argument. Rothbard’s problem is manifest in his book America’s Great Depression. After endowing the useful word “inflation” with a new and unacceptable meaning, Rothbard “discovered” that the Federal Reserve had indeed provoked an inflation in the 1921–1929 period. The money supply he examined for the period included not only hand-to-hand currency and all deposits in commercial banks adjusted for inter-bank holdings—the conventional M2 money stock—but also savings and loan share capital and life insurance net policy reserves. Consequently, where the M2 money stock increased 46 percent over the period, or at an annual rate of about 4 percent, the Rothbard-expanded “money stock” increased by 62 percent, or about 7 percent per year.[2]

Here, Rothbard mistakes some elements of financial wealth with money. The latter two items he specifies as money are not money. They cannot be spent on ordinary goods and services. To spend them, one needs to cash them in for other money—currency or bank drafts. Increases in their quantity do not pervasively spill over into all other markets causing serious macroeconomic disequilibrium. Their appearance as financial assets in people’s possession is just as likely to be deflationary as not because their purchase and sale require money that would otherwise be used for transactions of conventional goods and services.

Apologists for central banking, by way of contrast, see stock market “speculation” instead of over-investment as the culprit. They argue that the System did all it could to counteract the “inevitable” contraction that followed the 1929 stock market boom, but that its best effort could not be good enough. Since earnest and sophisticated men operated the federal government and the Federal Reserve System, something had to be wrong with the economic system itself. Markets just could not be trusted to provide full employment and steady real growth.

The Mismeasure of Money

Careful scrutiny of the monetary system and its associated monetary data reveals that neither of these views is analytically correct. Their defects result from ignorance of the flawed institutional framework within which the gold standard and the central bank generated money. Both also suffer from mismeasurement of the central bank’s monetary data.

Four definable institutions created the money in use during the 1920s: the gold standard, the U.S. Treasury, the Federal Reserve System of 12 regional banks and the Federal Reserve Board in Washington, and the commercial banking system of 20,000-odd banks. These institutions were not created equal, however. Only the gold standard and the Fed, with a notable assist from the Treasury, were important in initiating either monetary policy or the monetary happenings of the period. The commercial banks could only take what came their way from the central bank and the gold standard. They, too, created money. But their money-creating activities were all unintentional and strictly a byproduct of their lending operations.

The gold standard after World War I was anything but the autonomous, self-regulating institution that the Founding Fathers had prescribed—quite the contrary. The Federal Reserve Bank officers, particularly presidents, and the governors on the Federal Reserve Board, based then in the Treasury Building in Washington, exercised a monetary policy that often finessed the gold standard.

When gold came into the U.S. economy from a foreign country, importers deposited it in a commercial bank. The commercial bank, in turn, sent the gold to the regional Federal Reserve Bank to which the commercial bank belonged. The Fed Bank would credit the reserve account of this member bank, credit its own gold asset account by the same amount, and deposit the physical gold in the Treasury. If the member bank needed currency instead of an additional balance in its reserve account, the regional Fed Bank would issue its own Federal Reserve notes, dollar for dollar, based on the gold it had received. In either case, the Fed Bank was simply a monetizer of the gold. It converted the gold into dollars just as an ordinary commercial bank would have done in the absence of a central bank.

The monetary system thereafter had more dollars of bank reserves and deposits, or dollars of currency, because gold had come into the country. All other legal tender items, such as silver currency and greenbacks, were accounted in the Fed Banks in the same way as the gold. Fed Banks, therefore, were the custodians of a large fraction of the economy’s basic money stock—the currency and bank reserves behind the checking accounts that households and businesses used for everyday transactions.

Blocking the Effects of Gold

Of course, the Federal Reserve System did not come into existence to be a custodian of the economy’s base money and nothing else. The Fed Banks also had the legal power to create bank reserves and currency. Using the gold and other legal tender they held as their reserves, the Fed Banks could themselves become fractional reserve institutions. They could expand the reserves of their member commercial banks, or issue additional currency to them, by buying certain interest-earning “eligible” assets from the banks. If Fed Banks wished to block the effects of gold deposited with them to prevent the creation of common money based on the new gold, they could restrict their own lending to the commercial banks or sell off some of their interest-earning assets. Within limits, the Fed’s money managers could deliberately and purposely supplement or counteract what the gold standard machinery did as a result of market forces. It was this particular machination to which Rothbard properly objected.

The Fed Banks’ institutional authority derived from the Federal Reserve Act of 1913. The Act gave the Fed Banks the role of sequestering most of the banking system’s gold, and the power, explained above, either to enhance or hinder the monetary effects of any incoming gold. At the same time, the congressional founders of the Fed saw the new institution only as a supplement to the official gold standard. In the Federal Reserve Act itself, they inserted a provision stating: “Nothing in this act . . . shall be considered to repeal the parity provisions [between gold and the dollar] contained in an act approved March 14, 1900.” That referred to the Gold Standard Act, which made gold the sole legal tender monetary metal in the U.S. system. The new Federal Reserve System was supposed to act only within this official gold framework.

To show how the Fed’s hands-on controls worked during the 1920s, I have constructed a table that summarizes the major monetary elements in the combined Fed Banks’ balance sheet for the 1921–1933 period. It also includes the level of prices as measured by the Consumer Price Index (CPI).

The column labeled M1 measures the stock of common money—currency and checking account balances. From 1921 to 1929 this stock of everyday money increased on average 2.5 percent per year (compounded).[3] The column labeled “Total Fed” shows the Federal Reserve base on which this common money rested. Although this base increased slightly from 1924 to 1928, it declined over the whole eight-year span at an annual rate of 1.6 percent.

Fed-held gold and other reserve assets increased nominally at 1.1 percent per year primarily because of gold inflows. Federal Reserve policy prevented some of this gold from becoming a basis for new money by “sterilizing” it. That is, as the gold came into their tills, the Fed Banks allowed their holdings of other assets, which were primarily debts of the member banks, to decline: The member banks paid off some of their debts by reducing their reserve account balances at the Fed Banks. Changes in “net monetary obligations” of the Fed Banks (the column labeled “Net Fed”) accurately reflects this deflationary policy. “Net monetary obligations” are total monetary assets minus gold and other legal tender reserves. This datum, which faithfully indicates the intent of Fed policy, declined at an annual rate of 8.0 percent over the eight-year period.

Fed policy successfully offset the gold inflows so that prices rose only slightly—0.5 percent per year for the eight-year period. This much of a change can hardly be labeled an “increase” because it is less than the statistical construction error of the index. One thing is certain: it was not any kind of an inflation. All the economic chronicles for the period, besides the monetary data, confirm that Fed policy was braking against possible gold-inspired price increases in the United States. The Fed’s primary purpose was to further international monetary policies, particularly to help the Bank of England achieve and maintain gold payments for the pound sterling—but that is another story.

In their Monetary History of the United States, Milton Friedman and Anna Schwartz conclude their summary of the monetary events of the 1920s with this paragraph: “Gold movements were not permitted to affect the total of high-powered money [bank reserves and currency]. They were . . . sterilized, inflows being offset by open market sales, outflows by open market purchases.”[4] They observe further:

The widespread belief that what goes up must come down, . . . plus the dramatic stock market boom, have led many to suppose that the United States experienced severe inflation before 1929 and [that] the [Federal] Reserve System served as an engine of it. Nothing could be further from the truth. By 1923, wholesale prices had recovered only a sixth of their 1920–21 decline. From then until 1929, they fell on the average of 1 percent per year. . . . Far from being an inflationary decade, the twenties were the reverse. And the Reserve System, far from being an engine of inflation, very likely kept the money stock from rising as much as it would have if gold movements had been allowed to exert their full influence.[5]

Ironically, the Federal Reserve System that has provided itself in recent decades with the well-deserved label “engine of inflation” was in the 1920s an “engine” preventing gold inflation. Any gold inflation would have been very mild; so the question of whether Fed policy was proper is arguable—until we look at what happened afterward.

Given that its intervention prevented a minor gold inflation, did the Fed then reverse itself as bank failures occurred and economic contraction threatened? Following approved central bank doctrine, did it lend freely during the ensuing contraction at stiff interest rates until its remaining gold reserves would not have been enough to plate a teaspoon?[6] Let’s see what happened.

Disaster Hits

As everyone knows, the following four years, 1929–1933, were a deflationary disaster. Not quite so clear is what the Federal Reserve did, or, more important, did not do during that time. Fed spokesmen have often alleged that the Fed tried “everything in its power” to turn around the contraction and that it used its gold reserves to their utmost. Again, nothing could be further from the truth.

By 1929, the Fed’s monetary liabilities—commercial banks’ reserve-deposit accounts in Fed Banks, and the public’s holdings of Federal Reserve currency—were $4.25 billion. These monetary items exceeded the Fed’s gold asset holdings by only $1.39 billion. Put another way, the gold that came into the Fed Banks, which the commercial banks would have held in the absence of a central bank, was $2.86 billion. Federal Reserve policy actions had created the remaining $1.39 billion. By August 1929, the Fed’s gold and other reserves had grown to $3.12 billion (not shown in the table). The Federal Reserve Act required half these gold reserves to back outstanding Fed liabilities, but the other half of them, $1.56 billion, were “excess” and available for whatever monetary purposes the Fed managers thought appropriate.

During the following three-and-a-half years, the Fed Banks’ managers continued to build up the Fed Banks’ gold holdings—even as the financial system spiraled downward as a result of three serious banking crises. By February 1933, owing to the Fed’s tight money policy, the economy was in shambles and constricted to the point of monetary suffocation. The Fed Banks’ gold stock had increased to $3.36 billion, and “excess” gold reserves were still $1.35 billion! (The higher figure in the table is for June 1933.) This damning statistic is seen in the column labeled “Fed Gold.” While the Fed had enjoyed an increase of $700 million in its gold and other reserve holdings, its monetary output had increased by only $680 million: Commercial banks had $20 million less in reserves than they would have had with no Federal Reserve System.

This statistic, however, is not the end of the story. Since total commercial bank reserves were $2.29 billion in February 1933, the $1.35 billion of excess gold reserves Fed Banks held could have enhanced the banking system’s reserves by another 60 percent—to $3.64 billion.

“Real Bills Doctrine”

The Fed Banks were truly absorbers of gold. They simply extended and intensified the tight money policy they had begun in the 1920s, but for a different reason. Instead of helping the Bank of England return to a gold standard, the Fed managers had become enthralled with the idea that production of goods and services initiates and promotes the production of money. Economists sometimes refer to this as the “real bills doctrine.” While it has a grain of truth in it when a true gold standard is in place, it has no validity at all in a system dominated by a central bank. With this flawed doctrine governing their thinking, the Fed Banks’ managers marked time waiting for new production to appear so that they could in good conscience expand their monetary obligations in support of the private economy.

It never happened.

The U.S. banking system went through three serious contractions and the money stock continued to shrink. By 1933, the M1 and M2 money stocks were 27 percent and 25 percent below their 1929 levels. Meanwhile, the Fed Banks sat on their huge hoard of gold—the gold reserves legally required for their current monetary output and the “excess” gold reserves that could have provided significant monetary increases—and did . . . nothing!

Truly, when such a crisis appears, all the central bank’s gold is excess. A proper central bank can never be faulted for “running out of gold.” If the Fed Banks had followed the established (Bagehot) doctrine of the time, they would sensibly have expanded their loans, discounts, and accommodations to their “member” banks until their gold stock was a cipher.

Of course, they would not have had to run their gold reserve ratio down to zero. Long before they had expanded or used up their gold reserves, the crisis of central-bank mismanagement would have ended (or, more probably, would never have begun). The economy would have been back to normal, and none of the ugly governmental machinations of the later 1930s would have occurred. No Supreme Court conflicts would have appeared; no New Deal bureaucracies would have emerged to plague the economy; the Leviathan would have been kept in its constitutional cage. Most importantly, many of the freedoms we are now trying to restore would still be commonplace.

One would think that with this experience behind them, the “monetary authorities” and the congressional wheelers and dealers would have learned some lessons about U.S. monetary machinery and its relationship to the economy. They did not.

Next month I will treat the reserve requirement debacle of the mid-1930s, which added additional travail to the monetary mistakes made in the early part of the decade.

Richard H. Timberlake, Jr. (born June 24, 1922) is an American economist who was Professor of Economics at the University of Georgia for much of his career. He also has become a leading advocate of free banking, the belief that money should be issued by private companies, not by a government monopoly.

Originally published in the April 1999 issue of The Freeman.

[1] Murray N. Rothbard, America’s Great Depression (Kansas City: Sheed and Ward, 1963, 1972), p. 87. Emphasis in the original.

[2] Ibid., p. 88.

[3] The M2 money stock, which includes all of M1 plus time deposits at commercial banks, increased 5 percent per year from 1921 to 1929, and then fell at 13 percent per year from 1929 to 1933. No basis exists for a more inclusive money stock than M2.

[4] Milton Friedman and Anna J. Schwartz, A Monetary History of the United States, 1867–1960 (Princeton: National Bureau of Economic Research and Princeton University Press, 1963), p. 297.

[5] Ibid., p. 298. Emphasis added.

[6] This well-understood doctrine for central bank procedure was proposed by Walter Bagehot in his classic work, Lombard Street, rev. ed. (London: Kegan, Paul, Trench, Toubner & Co., 1906 [1873]).

Gold Policy in the 1930s

Richard H. Timberlake

Between 1929 and 1933, the Federal Reserve System, which is the central bank of the United States, monetarily starved the country into the worst economic crisis it has ever experienced. Markets, and the market system generally, did not fail, and nothing was inevitable about the collapse that occurred. Rather, the monetary system was so mismanaged that even a healthy and vigorous market system could not correct the disequilibrium that resulted.

The popular application of “market failure” to describe the economy during the years of the Great Contraction, 1929–1933, is wrong. Market actions in that era made the politically inspired crisis less severe than it otherwise would have been. Furthermore, “market failure” is a term people often apply to events when they cannot understand the complexities of economic processes that result from ill-conceived government policies. The operations of just about any monetary system, and especially one with a central bank, are always puzzling to the layman. Consequently, when things go wrong owing to monetary mismanagement by central bankers or some other political intervention, the instigators can ring in “market failure” as an excuse for their personal failures to make the right decisions.

Failure in other aspects of human endeavor often generates learning that subsequently leads to correction and eventual success.[1] Federal Reserve policy failure in 1929–1933, however, led only to federal legislation that increased the number and power of federal government agencies. The Republican Hoover administration, for example, initiated the expensive Reconstruction Finance Corporation in 1932 to carry out lending policies that the elaborately structured Federal Reserve System had failed to undertake. The Roosevelt administration then took control of the political machinery in 1933 and began a program of federal intervention and bureaucratic propagation that is mind-boggling even today.

Two items of Roosevelt-era legislation markedly affected the U.S. banking and monetary system. The first was the so-called Gold Reserve Act of 1934. This legislation gave the president the unconstitutional power to call in all privately owned gold for deposit in the U.S. Treasury. It also gave him the unconstitutional power by his fiat to revalue the price of gold (devalue the dollar) by as much as 60 percent.

Congress’s constitutional power to “regulate the value of money” was a power that could not be delegated to the executive. Furthermore, “regulate” did not mean a massive change in the monetary values of either gold or silver. Its sole purpose was to provide a means for congressional housekeeping control over the coinage system. Properly used, it allowed Congress to make incremental changes in the legal tender value of either gold or silver so that both metals would stay in circulation. It was put into the Constitution to counteract Gresham’s Law. Otherwise, changes in the market value of one or the other metal would result in what had now become the cheaper metal going to the mint and the other, dearer, metal going into the markets as a commodity.[2]

A New Central Banking Measure

The other piece of legislation, the Banking Act of 1935, was more momentous than the original Federal Reserve Act passed in 1913. In fact, the Act of 1935 might better have been labeled “The Central Banking Act of 1935,” because it virtually rewrote the earlier Act.

A central bank, like a gold standard, can assume many institutional forms that differ markedly from one another. The 1913 Fed Banks, for example, were regionally autonomous; the Board in Washington was relatively powerless. Board members were treated and paid on a scale similar to government employees in the U.S. Treasury, while the presidents of the regional Fed Banks commanded salaries comparable to those of executives heading major corporations. The Fed Banks’ gold reserves severely restricted their lending policies, as was proper under an operational gold standard. Finally, the real bills doctrine was supposed to furnish the grounds for Fed Banks’ accommodation of credit to their client member banks.

The Banking Act of 1935 changed the whole paraphernalia of monetary control. It vested the Federal Open Market Committee (FOMC) with complete discretionary control to determine the stock of money in the United States. Regional Fed Bank presidents still had five of the 12 seats on the FOMC, but the Board was now a seven-man majority. From that time on, the FOMC has fashioned monetary policy by authorizing the purchase (or sale) of U.S. government securities in the open market, an operation that the Fed Bank of New York conducts week by week.

When the FOMC buys the U.S. securities that the Treasury has previously sold to pay the government’s bills, it does so by creating money. This new money is either commercial bank reserves or Federal Reserve note currency. Clearly, if a 12-person board is determining the quantity of money that exists, the quantity of gold in the system has little or nothing to do with the money. Either a gold standard specifies the quantity of money in the economy, or a central bank does. A marriage of the two never lasts longer than an unhappy weekend.

The Gold Reserve Act of 1934 was the final divorce decree between gold and the monetary system. After January 31, 1934, no private household, bank, or business was allowed to own or hold more than a trivial amount of gold. Gold coin was forbidden for monetary purposes. This Act also authorized the president, Franklin Roosevelt, to raise the price of gold by 60 percent. Roosevelt, however, did not use all the power given him—only 98 percent of it. In early 1934, he increased the official mint price of gold, which had been $20.67 per ounce for 100 years, to $35 per ounce. The Treasury gold stock, valued at $4,033 million in January 1934, became $7,348 million in February 1934, an increase of $3,405 million by the decree of one man.[3]

The federal government had also, unconstitutionally, repudiated all gold clauses in its contracts and debts, so it did not have to share any of its newfound wealth with the private sector. In one month Congress and Roosevelt, by their legislative and administrative fiats, created seigniorage revenue from gold equal to one year’s ordinary tax revenues. In contrast, the federal government of 1834–1837, when it realized one year’s extraordinary revenue from land sales, returned that surplus to the state governments to be used or distributed as those sovereign governments saw fit.[4]

President Roosevelt rationalized this usurpation of private property rights in gold in one of his notorious fireside chats. “Since there was not enough gold to pay all holders of gold obligations,” he claimed, “the Government should in the interest of justice allow none to be paid in gold.”[5]

This rationalization of government confiscation was fatuous pretension. Gold in banks was then and had always been a fractional reserve against outstanding obligations. When the banks were on their own, they had adequate means to protect their reserves—gold, silver, or other legal tender. The Fed Banks and the U.S. Treasury—government institutions—also held only fractional reserves against their outstanding currencies. Use of gold as a recognized fractional reserve always precluded immediate liquidation of all monetary obligations into gold. So in effect, Roosevelt was saying, “Since there was not enough gold to pay all holders of gold obligations, . . . the federal government should expropriate and keep all of the gold.”

The increase in the dollar price of gold, though other countries had gone off the gold standard or had also raised the price of gold in their own currencies, started a massive inflow of gold to the United States. Political apprehension in Europe and elsewhere also contributed to the U.S. accumulation. By 1940, the U.S. gold stock totaled $20 billion, or almost 20,000 tons! The contrast was notable between a government awash in gold and a depressed economy denuded of money and functioning with a shell-shocked banking system.

Fed Banks and the Treasury still accounted new gold coming into the U.S. system as though the gold were a monetary asset. The Treasury issued “Gold Certificates”—currency notes in $100,000 denominations—accounted at the new gold price of $35 per ounce, which it “deposited” in Federal Reserve Banks. Fed Banks then debited their “Treasury deposit” liability account, and credited their “Gold Certificates.”

Whoever had received a check for the gold from the Treasury, however, had by now deposited that check in a commercial bank that, in turn, sent it to the Fed Bank for clearance. The Fed Bank cleared the check against the “Treasury deposit” account and debited the deposit-reserve account of the client bank by the same amount. No one could get the gold out of the Treasury, or touch it, or see it, or use it. (It was now a criminal act to use gold for monetary purposes!) Nonetheless, the gold provided an accounting medium for increasing the basic money stock of bank reserves and Federal Reserve note currency.

The Treasury in Control—The Fed Plays Ball

With all of the new gold coming into the system, the FOMC did not need to use its newly legislated powers. From 1933 to 1936, the M2 money stock grew at annual rates of 9.5, 14.0, and 13.0 percent.[6] In fact, so much gold was coming into the Fed-Treasury’s coffers that sentiment in both the Fed and Treasury leaned toward monetary restriction.

The Fed had active hands-on control of monetary policy. Not only did it have the power to initiate open-market operations in government securities through the FOMC, but the Banking Act of 1935 also gave the Fed Board extensive control over member bank reserve requirements. Prior to the Banking Act, reserve requirements were statutory at 7, 10, and 13 percent—not based on the size of the bank, but on the size of the city in which the bank was located. The larger the city, the higher the legal reserve requirement.[7]

The Banking Act of 1935 used the existing set of reserve requirements as the lower end of a new range of requirements: 7–14, 10–20, and 13–26 percent. Board of Governors’ decisions in Washington were to specify the precise set of requirements in force at any time. Thus Fed policy could be restrictive by mandating an increase in requirements.[8]

Banking Act or not, the Treasury was still very much in the monetary picture. Treasury Secretary Henry Morgenthau, Jr., had recommended to President Roosevelt the appointment of Marriner Eccles to be chairman of the Federal Reserve Board. Eccles outspokenly favored lots of federal spending and fiscal budget deficits. By his stance, he effectively signed over monetary policy to the Treasury. (Morgenthau had recommended Eccles for this reason.) The upshot of the arrangement was that Morgenthau ran the show. Both men favored a dominant fiscal policy that had Federal Reserve support. Although the new Banking Act took the secretary of the Treasury off the Fed’s Board of Governors (he had been the ex officio chairman), he now had a surrogate as chairman. He was more than satisfied to see his purposes served from behind the throne.

Even a surrogate position was not enough for Morgenthau. The realized seigniorage from the gold devaluation had given the Treasury a $2 billion windfall, accounted in an Exchange Stabilization Fund, that the Treasury was supposed to use to “stabilize” the dollar price of foreign currencies. The Treasury thus had a gold “position” and license for conducting gold policy.

Federal Reserve policy directed the first increase (50 percent) in reserve requirements in August 1936—from 7, 10, and 13 percent to 10 1/2, 15, and 19 1/2 percent. A few months later the Treasury initiated its own gold sterilization policy—the same policy the Fed had fostered in the 1920s. Its purpose was “to halt the inflationary potentialities [sic]” of all incoming gold. Beginning December 22, 1936, the Treasury placed its gold purchases in an “inactive” account. Instead of issuing gold certificates and depositing them in Fed Banks to raise the necessary credit balance to pay for the gold, the Treasury paid for the gold by selling government securities in financial markets. By this means, it carried out its own open market operations—sales in this case—with its own “FOMC.” This way the gold remained stockpiled but unmonetized in the Treasury.

Besides neutralizing the gold inflows, the policy was further deflationary because it brought more government securities into markets to compete with consumers’ and investors’ dollars. It thereby tended to raise interest rates as it inhibited general spending. In March and May of 1937, the Fed complemented this generally deflationary policy by increasing reserve requirements to the maximum allowable percentages: 14, 20, and 26 percent.

Fed-Treasury policymakers had acted deliberately and purposely. They believed in human management of the monetary system. Just before he was appointed Fed chairman, Eccles had boldly stated that the Fed should “support expansionary fiscal policy through discretionary monetary policy.”[9] Unfortunately, the discretionary monetary policy now being practiced was anything but expansionary. It was, in fact, extremely repressive.

Unprecedented Depression

However, the rest of the economy, unlike politically prosperous Washington, was moving at an unprecedentedly slow rate. Never before had a recession-depression been so tenured or so intense. By late 1936, business was picking up, but the price level was still 18 percent below its 1929 value, and unemployment was still 16 percent of the labor force. Nonetheless, the great concern in the Treasury and Federal Reserve was the danger of inflation! Fed and Treasury officials looked at the overhang of excess legal reserves in the banking system and imagined what would happen if the commercial banks expanded all those reserves into an avalanche of checkbook money. Monetary mismanagement had just provoked the most disastrous hyper-deflation in history. Yet, before all the foreclosures had been properly settled, the government’s monetary managers were contriving to counteract the inflationary potential that they had systematically built into the monetary machinery.

Secretary Morgenthau announced in a press release, dated December 20, 1936, that Treasury gold policy was coordinated with the Fed’s reserve requirement increases.[10] By mid-1937 “inactive” gold in the Treasury was $1,087 million, or about 9 percent of total Treasury gold.

Meanwhile, the banking system and the private economy foundered in a new recession. If one were to write a script that chronicled the end of free-enterprise capitalism, the events of 1929–1938 would logically serve the purpose. Since few people understood the nuances of Fed-Treasury monetary policies, the common perception was that the Recession of 1937–1938 posed yet another failure of the market system. Dozens of tracts, novels, plays, and newspaper editorials reflected this notion.

The appearance of the depression-recession evidently convinced Morgenthau that the “danger of inflation” was passed. In September 1937, he released $300 million of gold from the inactive account thereby restarting the machinery of gold monetization. Gold certificate accounts at Fed Banks responded and gave rise as usual to increases in monetary base items in Fed Banks’ balance sheets. Finally, on April 19, 1938, Morgenthau announced the discontinuance of the inactive gold account altogether.

The time span of the Treasury’s gold policy was 16 months—December 1936 to April 1938, while the Fed’s reserve requirement increases occurred in August 1936 and March-May 1937, and continued in force with little change until after World War II. Treasury policy cut off new gold at the initial point of monetization; Fed policy effectively smothered the money-creating potential that old gold had already provided. For the next three years, the economy stagnated. By 1941, the price level was still 14 percent below its 1929 value, and unemployment was still 10 percent of the labor force. Treatises appeared analyzing “the stagnant industrial economy.” The Keynesian notion of less-than-full-employment equilibrium seemed documented beyond reasonable doubt.

Fed-Treasury methods in the mid-1930s reflected the prevailing notion of the times—that someone had to run the show, that operations without the rule of men were destined to be “chaotic.” Economists and financial gurus were just as convinced of this argument as politicians and political scientists. One economist, Gove Griffith Johnson, commented in his contemporary book on Treasury policy:

One may be skeptical of the wisdom with which monetary instruments will be used, but the possibility of abuse extends throughout the whole sphere of governmental activity and is a risk which must be assumed under a democratic or any other form of government.

The Treasury’s gold policy, Johnson continued, “was an essential instrument for producing desired political aims.” Congress had given over the Fed’s powers of monetary regulation to the Treasury because the central bank had proven ineffectual. These powers had become more democratic because “they were now exercised by politically responsible officials . . . [and] would eventually be subject to review by the electorate. . . . In large part,” he concluded, “the [Federal Reserve] System has served merely as a technical instrument for effecting the Treasury’s policies.”[11]

Clearly, the awesome monetary powers the Fed-Treasury had wielded were not the product of either “wisdom” or scientific analysis. They were simply discretionary, seat-of-the-pants responses, sometimes politically motivated, by political authorities who faced no responsibility for their decisions. Furthermore, the “risk of abuse” did not need to be “assumed” under a democratic government suitably restrained by the rule of law. Finally, the electorate knew less about these policies than it knew about Sanskrit, and it had no power at all either to pass judgment on them or to change them.

Under a true rule-of-law gold standard, the Treasury would not have had a “gold policy.” The gold standard itself would have been the gold policy and would have been self-regulating through the concerted actions of thousands of households and businesses that bought and sold goods and services in hundreds of markets. The gold, more important, would not have been stockpiled in Treasury vaults unavailable and illegal for human use, like some dangerous drug or weapon. It would have been in commercial banks primarily, serving its conventional function of securing bank-issued money.

The monetary mismanagement chronicled here should serve as the all-time example of the failure of discretionary monetary policy. Although a gold standard was still on the books, it was nothing more than a façade for Fed-Treasury manipulations. First the Fed by itself in the 1920s, then the Treasury ten years later, simply fit this “gold standard” into their other hands-on policies. Both agencies saw to it that the gold was safely tucked away where it could do no one any good. Approximately seven thousand banks failed in the early 1930s for want of reserves while the stockpiling went on. Congress then gave the executive the power to enact an unprecedented increase in the price of gold and added as well significant new powers to the Federal Reserve’s authority. By 1936, the Fed-Treasury managers, fearing they had over-done monetary expansion, decided to put on the brakes by again sterilizing gold and doubling bank reserve requirements. The result was a virtual paralysis of the monetary system and the economy.

Had the banks held their own reserves or had them available in their own clearinghouses, as they did before the coming of the Fed, bank and clearinghouse executives (who were often the same people) would have parlayed the gold into strategic trouble spots where it would have prevented failures of healthy banks and general monetary destruction. Gold to be effective cannot be declared illegal and buried in the ground where no one can get it. If that is the best that civilization can do, we might as well have left the gold in California, the Klondike, Australia, and South Africa.

Originally published in the May 1999 issue of The Freeman.

[1] See, Dwight R. Lee and Richard McKenzie, Failure and Progress: The Bright Side of the Dismal Science (Washington, D.C.: Cato Institute, 1993).

[2] For further discussion of this issue, see Richard H. Timberlake, Gold, Greenbacks, and the Constitution (Berryville, Va.: The George Edward Durell Foundation, 1991), pp. 8–9.

[3] Board of Governors of the Federal Reserve System, Banking and Monetary Statistics (Washington, D.C.: Government Printing Office, 1943), p. 537.

[4] See my Monetary Policy in the United States: An Intellectual and Institutional History (Chicago: University of Chicago Press, 1993), chapter 5.

[5] James D. Paris, Monetary Policies of the United States (New York: Columbia University Press, 1938), p. 18.

[6] Milton Friedman and Anna J. Schwartz, A Monetary History of the United States, 1867–1960 (Princeton: National Bureau of Economic Research and Princeton University Press, 1963), p. 544.

[7] This pattern of law reflected the flawed notion that banks in larger cities were more subject to “speculative” influences and were more likely to make risky loans than banks in the “country.”

[8] For more detail on the reserve requirement episode, see my article “The Reserve Requirement Debacle of 1935–1938” in the June 1999 issue of The Freeman.

[9] Donald F. Kettl, Leadership at the Fed (New Haven: Yale University Press, 1986), pp. 48–53.

[10] U.S. Treasury, Press Releases, nos. 9–20, December 20, 1936.

[11] Gove Griffith Johnson, The Treasury and Monetary Policies, 1933–1938 (Cambridge, Mass.: Harvard University Press, 1939), pp. 205–11, 223; emphasis added.

The Great Gold Robbery

James Bovard

The New Deal established much of the moral framework of contemporary political life. Though some of the programs and policies of that era have been terminated, the moral heritage of the New Deal continues to permeate American government and political thinking.

In 1936, Franklin Roosevelt declared, “I should like to have it said of my first Administration that in it the forces of selfishness and of lust for power met their match. . . . I should like to have it said of my second Administration that in it these forces met their master.”[1] No American president has rivaled Roosevelt in his denunciation of what he called “economic royalists.” He sought to “master” the “forces of selfishness” by making government master of every person’s private financial destiny. Like today, the citizen who wanted to retain control over his own life was selfish, while the bureaucrat who wanted to seize power over the citizen was automatically presumed benevolent.

One of the most controversial New Deal policies was the seizure of citizens’ gold.[2] During the Great Depression, several foreign nations repudiated their promises to redeem their currencies for gold. In 1933, when Roosevelt became president, the United States had the largest gold reserves of any nation in the world. He announced on March 8, 1933, a few days after taking office, that the gold standard was safe. But three days later, he issued an executive order forbidding gold payments by banks; Treasury Secretary Henry Morgenthau, Jr., announced on March 11 that “the provision is aimed at those who continue to retain quantities of gold and thereby hinder the Government’s plans for a restoration of public confidence.”[3] Thus, according to Morgenthau, any limit on government power was bad for public confidence. And whatever confidence people might seek to achieve must be left in abject dependence on politicians’ latest salvation scheme.

The ban on bank gold payments created widespread doubts about the Roosevelt administration’s intentions. Ogden Mills, who had served as President Herbert Hoover’s treasury secretary, observed that

it was not the maintenance of the gold standard that caused the banking panic of 1933 and the outflow of gold. . . . [I]t was the definite and growing fear that the new administration meant to do what they ultimately did—that is, abandon the gold standard.[4]

People naturally sought to get rid of their paper currency and to put their savings into something with more secure value—gold.

Gold as Contraband

Fear of devaluation spurred a panic, which Roosevelt invoked to justify seizing people’s gold. On April 5, 1933, Roosevelt commanded all citizens to surrender their gold to the government. No citizen was permitted to own more than $100 in gold coins, except for rare coins with special value for collectors. Morgenthau announced on the same day that “gold held in private hoards serves no useful purpose under present circumstances.”[5] Gold was thus turned into the same type of contraband as Prohibition-banned rum. Roosevelt announced,

Many persons throughout the U.S. have hastened to turn in gold in their possession as an expression of their faith in the Government and as a result of their desire to be helpful in the emergency. There are others, however, who have waited for the Government to issue a formal order for the return of gold in their possession.[6]

To speak of the “return of gold” implied that government was the rightful owner of all the gold in the nation, and thus that no citizen had a right to possess the most respected store of value in history. Roosevelt assured the country: “The order is limited to the period of the emergency.” But the order stayed on the books until 1974.

Roosevelt labeled anyone who did not surrender his gold a “hoarder.” His executive order defined “hoarding” as “the withdrawal and withholding of gold coin, gold bullion or gold certificates from the recognized and customary channels of trade.”[7] Actually, Roosevelt was not concerned with the gold being in the “customary channels of trade”; instead, he wanted government to possess all the gold. And the notion that people were “withholding” their gold merely because they did not rush to the nearest Federal Reserve bank to surrender it was political logic at its best.

Roosevelt, in a later note to his Public Papers, justified the order because it “served to prevent the accumulation of private gold hoards in the U.S.”[8] Roosevelt used the same “hoarding” rhetoric against anyone who owned gold that Stalin used against Ukrainian peasants who sought to retain part of their wheat harvest to feed their families. But while Stalin sent execution squads to kill peasants who had a few bushels of grain hidden in their hovels, Roosevelt was kinder and gentler, seeking only ten-year prison sentences and $250,000 fines for any citizen who defied his edict and possessed more than five Double Eagle gold coins.

Roosevelt was hailed as a visionary and a savior for his repudiation of the government’s gold commitment. Citizens who distrusted the government’s currency management or integrity were branded as social enemies, and their gold was seized. And for what? So that the government could betray its promises and capture all the profit itself from the devaluation it planned. Shortly after Roosevelt banned private ownership of gold, he announced a devaluation of 59 percent in the gold value of the dollar. In other words, after Roosevelt seized the citizenry’s gold, he proclaimed that the gold would henceforth be of much greater value in dollar terms.

Citizens who had desired to hold gold as a hedge against government inflation policies were completely vindicated. FDR’s administration subsequently did everything possible to inflate prices, foolishly confident that a mere change in numerical prices would produce prosperity. Citizens had accepted a paper currency based on the government’s pledge to redeem it in gold at $20 per ounce; then, when Roosevelt decided to default on that pledge, he also felt obliged to turn all citizens holding gold into criminals. Roosevelt stated that the ban on private ownership

was the first step also to that complete control of all monetary gold in the United States, which was essential in order to give the Government that element of freedom of action which was necessary as the very basis of its monetary goal and objective.[9]

But the primary “freedom” government acquired was the freedom to default on its promises and to manipulate the lives of everyone depending on U.S. dollars in their daily transactions.

Curiously, FDR retained his denigrating tone toward so-called gold-hoarders even after he defaulted on the federal government’s gold redemption promise. Even though people who distrusted politicians’ promises were vindicated, they were still evil people because they had not obeyed FDR’s demand to surrender their gold. In the moral world of the New Deal, justice consisted solely of blind obedience to political commands. FDR had absolutely no sense of embarrassment or shame after he defaulted on the federal government’s gold promises—it was simply political business as usual.

Senator Carter Glass of Virginia, chairman of the Senate Finance Committee, denounced the gold seizure: “It’s dishonor. This great government, strong in gold, is breaking its promises to pay gold to widows and orphans to whom it has sold government bonds. . .”[10]

Free to Inflate

The refusal to convert paper dollars into gold meant that the government was “free” to flood the country with paper money and sabotage the currency’s value. The stability of the value of currency is one of the clearest measures of a government’s trustworthiness. Before Roosevelt took office, Americans clearly recognized the moral implications of inflation. Vice President Calvin Coolidge had bluntly declared in 1922: “Inflation is repudiation.”

Inflation is a tax whereby government prints extra money to finance its deficit spending. The value of money is largely determined by the ratio of money to goods; if the quantity of money increases faster than the increase in the number of goods, the result is an increase in the ratio of money to goods and an increase in prices. Thus, the government’s printing presses devalue people’s paychecks and effectively allow government to default on the value of its debt.

The threat of inflation was invoked in the early 1940s to justify imposing payroll tax withholding[11] (protecting people from their own paychecks) and in the 1970s to impose price controls over the entire economy. Apparently, politicians who decide to flood the money supply automatically become entitled to increase their coercion of their victims who hold increasingly worthless currency.

Since Roosevelt banned citizens from owning gold in 1933 and forced people to rely on the unbacked promises of politicians for the value of their currency, the dollar has lost about 93 percent of its purchasing power.[12] The collapse in the dollar’s purchasing power severely disrupted the ability of scores of millions of Americans to plan their own lives and save for retirement. If someone proposed a law to give government the right to explicitly default by 2 to 3 percent a year on all its debts, the proposal would be widely denounced. Yet, this is what the government has been doing for decades. Though inflation has slowed since 1980, the purchasing power of the dollar has fallen by over 50 percent in subsequent years according to the government’s own numbers (which slightly exaggerate the damage to the dollar), making a mockery of people’s attempts to calculate and save for the future.

A 1997 study by Congress’s Joint Committee on Taxation found that because of how capital gains taxes are calculated, many citizens are forced to pay taxes on investment “gains” when in reality they have suffered losses due to the deterioration of purchasing power.[13]

Roosevelt’s gold seizure was based on the doctrine that in order for government to save the people, it must be permitted to breach all the promises it made to the people. According to modern conventional wisdom, government has no obligation to do justice or treat any specific individual citizen fairly—instead, government’s only duty is to achieve “social justice” or some other abstraction perfectly suited for evasion.

James Bovard is the author of ten books, including Public Policy Hooligan, Attention Deficit Democracy, and Lost Rights: The Destruction of American Liberty. Find him on Twitter @JimBovard.

Originally published in the June 1999 issue of The Freeman.

[1] The Public Papers and Addresses of Franklin Roosevelt, 1936 (New York: Random House, 1938), pp. 232–33.

[2] Editor’s note: See Richard Timberlake’s article “Gold Policy in the 1930s,” The Freeman, May 1999.

[3] Gustav Cassell, The Downfall of the Gold Standard (New York: Augustus Kelley, 1966 [1936]), pp. 118–19.

[4] Barry J. Eichengreen, Golden Fetters: The Gold Standard and the Great Depression (New York: Oxford University Press, 1992), p. 321.

[5] Cassell, p. 124.

[6] The Public Papers and Addresses of Franklin D. Roosevelt, The Year of Crisis, 1933 (New York: Random House, 1938), pp. 110–11.

[7] Ibid., p. 112.

[8] Ibid., p. 114.

[9] Ibid., p. 115.

[10] Benjamin Anderson, Economics and the Public Welfare (Indianapolis: Liberty Fund Press, 1979 [1949]), p. 314.

[11] Charlotte Twight, “Evolution of Federal Income Tax Withholding,” Cato Journal, Winter 1995. See http://www.cato.org/pubs/journal/cj14n3-1.html.

[12] For information on the deterioration of the dollar’s purchasing power, see the Website of the U.S. Bureau of Labor Statistics.

[13] Bruce Bartlett, “How Inflation Hikes the Capital Gains Bite,” Washington Times, March 31, 1997.

Monetary-Policy Disasters of the Twentieth Century

Kirby R. Cundiff

The Federal Reserve System was created in 1913 and soon did what central banks almost always do: it started printing lots of money. During World War I the Bank of England inflated its money supply, and as a result, a significant amount of gold flowed out of Great Britain to the United States in the 1920s. Instead of controlling their monetary expansion, the British authorities put pressure on the U.S. government to expand its own money supply. The Fed happily complied and engaged in significant monetary inflation throughout most of the decade. This extra liquidity helped fuel the stock-market boom, but by 1928 it was obvious that monetary expansion had gone too far, and the Fed changed course. What ensued was a massive contraction of the money supply, followed by many years of incoherent and incompetent monetary policy that strongly contributed to the length and severity of the Great Depression.

When the Federal Reserve started restraining the money supply, stock-market growth declined and soon a pull-back developed. In the 1920s, the use of debt by both banks and individuals to invest in the stock market was common. Today, Federal Reserve margin requirements limit debt for stock for purchases to 50 percent. But during the 1920s, leverage rates of up to 90 percent debt were not uncommon. When the stock market started to contract, many individuals received margin calls. They had to deliver more money to their brokers or their shares would be sold. Since many individuals did not have the equity to cover their margin positions, their shares were sold, causing further market declines and further margin calls. The stock market crash of 1929 was the result.

In the 1920s, banks were allowed to invest their assets in the stock market, so many banks went bankrupt as well. The Glass-Steagall Act of 1933, one of the many new Depression-era banking regulations, made equity positions for banks illegal. This act split banks into two types: commercial banks and investment banks. (This law was repealed in 1999.)

The events of 1929, largely caused by government intervention in the economy, were used as an excuse for much more government intervention in the economy. Because of the extreme overprinting of money during the 1920s, the Fed had nowhere near the amount of gold necessary to cover all the claims it had printed. The American people were wise enough not to trust the banking system and attempted to get their gold out of America’s banks. The Roosevelt administration responded by closing down the banks (declaring a banking holiday) and defaulting on the gold standard. In 1933, President Roosevelt signed Executive Order 6102 making private ownership of gold for investment purposes in the United States illegal. Roosevelt also seized most of the American citizens’ gold coins, melted them down, and put them in Fort Knox.

At the Bretton Woods conference in 1944, the world was again temporarily on something resembling the gold standard. All the world’s major currencies were fixed to the dollar, and the dollar was fixed to gold. An ounce of gold was supposed to be worth $35 forever after. The U.S. central bank then proceeded again to print too much money. Throughout the 1960s, various European central banks, particularly the French, redeemed their dollars for gold. The United States had too little gold to meet the demand, so in August 1971, President Richard Nixon suspended convertibility of the dollar and defaulted on the Bretton Woods agreement. The gold standard was abandoned, and currencies soon floated against each other.

The leaders of the Federal Reserve System did not learn from this experience. They still kept overprinting money, and the Consumer Price Index (CPI) continued to climb. (An increase in the CPI is often, misleadingly, called the inflation rate. Other things equal, inflating the money supply sets off a general rise in prices.) In 1960, the CPI increased less than 1 percent, but by 1970, it was up to over 5 percent. Predictably, political leaders addressed the effects, not cause. In 1971, Nixon tried to outlaw the symptoms of inflation by imposing wage and price controls. In 1974, his successor, Gerald Ford, launched the WIN (Whip Inflation Now) campaign, but the “printing presses” kept running and inflation kept increasing. In 1980, under President Jimmy Carter, the “inflation rate” peaked at over 12 percent. While this was high by U.S. standards, other countries fared far worse. In 1985, the annual increase in Bolivia reached 11,749 percent, in Argentina 672 percent, and in Brazil 227 percent.

As inflation raged, purchasing power evaporated. Nominal wage increases and profits were illusory, wreaking havoc with people’s ability to do economic calculations and pushing them into higher income-tax brackets. When market participants came to expect inflation, the economy slowed down and unemployment increased, even as prices continued rising. This was the supposedly impossible “stagflation” of the late 1970s.

Excessive monetary expansion resulted in another financial disaster in the latter part of the 20th century—the savings-and-loan fiasco. This was the largest banking failure in U.S. history. Over 1,000 S&Ls failed, resulting in the bankruptcy of the Federal Saving and Loan Insurance Corporation (FSLIC) and a loss of over $150 billion, of which over $120 billion was covered by the U.S. taxpayers. Many culprits have been blamed for this banking disaster, from junk bonds to greedy and corrupt banking officials, but the primary reason for the widespread failures in the industry was irresponsible monetary policy at the Fed.

By law, S&Ls could only invest in 30-year fixed-rate home mortgages. The main source of their funds were savings accounts from which depositors could withdraw their money anytime. This led to what is known as a duration mismatch. During the low-inflation periods of the 1950s and 1960s, the S&Ls made many 30-year fixed-rate loans that were still outstanding in the 1970s and 1980s. But when prices were rising 12 percent a year, while an S&L’s mortgages yielded only 6 percent and its savings accounts paid only 5.5 percent, something had to give.

The reason S&L accounts paid only 5.5 percent was the government’s Regulation Q, which imposed interest ceilings on savers. Meanwhile, U.S. Treasury bills were yielding over 8 percent in 1970 and over 15 percent around 1980. But to buy a T-bill an investor needed $10,000. Thus, rich people could shift their money from savings accounts to T-bills, but those without $10,000 were stuck. Fortunately, the money-market mutual fund emerged in 1971. This type of account allowed people to pool their money with other small investors and together purchase T-bills and commercial paper. Now small investors could also purchase high-yield short-term investments.

With small depositors moving their money from savings accounts to money-market funds, a process called disintermediation, the S&Ls were in trouble. They responded by offering toasters and other giveaways to attract customers, but that did not work, and massive bankruptcies ensued. In 1982, the Garn-St. Germain Act legalized money-market mutual funds without an interest-rate ceiling.

Volcker to the Fed

In 1979, Jimmy Carter appointed Paul Volcker to head the Federal Reserve. Volcker did what he said he was going to do. He drastically increased short-term interest rates to control inflation. In 1980, short-term interest rates were much higher than long-term interest rates. Since S&Ls made their money by borrowing short and lending long, this contributed further to their destruction. By 1982, the “inflation rate” had dropped to around 4.25 percent, but many S&Ls were bankrupt, with total losses of over $100 billion.

In a desperate effort to fix the problem federal regulators allowed the S&Ls to engage in questionable accounting practices and riskier (and hopefully) more profitable investments. It did not work, and by the end of the 1980s, S&L losses had risen to over $150 billion. Since the liabilities (depositors’ money) were federally insured, the taxpayers had to pick up much of the tab. Finally, in the late 1980s and early 1990s, the insolvent S&Ls were shut down. With the price index back to normal, stability gradually returned to the financial markets.

In 1982, one of the greatest bull markets in U.S. history began and continued until 2000. While inflation measured by the consumer price index has been relatively mild in the United States since the early 1980s, the money supply has continued to expand at a rapid rate. It is likely that this expansion contributed to the stock-market bubble of the late 1990s and the housing boom of the early 2000s.

Not everyone benefited from the re-stabilization of the financial markets. In societies where the currency is unstable, people naturally turn to other stores of wealth. Gold and real estate are common investments, and the United States during the 1970s was no exception. While the stock market floundered during the 1970s, the real-estate market boomed. The increase in real-estate values included not only houses but also farmland. When the price of farmland increased, farmers in the Midwest were able to take out larger bank loans and drastically expand their operations. But when real-estate prices declined, the leverage ratios on farms drastically increased. During the 1980s, many farm bankruptcies followed.

The Great Depression of the 1930s, the S&L fiasco of the 1980s and 1990s, and the farming crisis of the 1980s are all testaments to the extremely destructive effects that an irresponsible monetary policy can have on a society. Policymakers allegedly created the Fed to prevent these sorts of problems. Official goals of the system include maximizing employment, stabilizing prices, and maintaining moderate long-term interest rates.[1] It is interesting to note, however, that the only extended periods when the U.S. economy did not experience significant inflation occurred when the United States had no central banking system.

Kirby R. Cundiff, Ph.D. is an Associate Professor of Finance at the Rochester Institute of Technology. He is a Chartered Financial Analyst and a CERTIFIED FINANCIAL PLANNER™ Professional.

Originally published in the January 2007 issue of The Freeman.

[1] For more information, see https://www.federalreserve.gov/aboutthefed/files/pf_2.pdf.

The Myth of the Independent Fed

Thomas J. DiLorenzo

Ever since its founding in 1913, the Fed has described itself as an independent agency operated by selfless public servants striving to fine-tune the economy through monetary policy. In reality, however, a non-political governmental institution is as likely as a barking cat. Yet, the myth of an independent Fed persists. One reason this myth persists is that statist textbooks have helped perpetuate it for decades.

From 1948 until about 1980, Paul Samuelson’s Economics was the best-selling introductory economics text. Generations of students were introduced to economics by Samuelson. Although not as popular as it once was, Samuelson’s text (now co-authored with William Nordhaus) is still widely used. According to the 1989 edition:

The Federal Reserve’s goals are steady growth in national output and low unemployment. Its sworn enemy is inflation. If aggregate demand is excessive, so that prices are being bid up, the Federal Reserve Board may want to slow the growth of the money supply, thereby slowing aggregate demand and output growth. If unemployment is high and business languishing, the Fed may consider increasing the money supply, thereby raising aggregate demand and augmenting output growth. In a nutshell, this is the function of central banking, which is an essential part of macroeconomic management in all mixed economies.

For about the past fifteen years, the top-selling economics text has been Campbell McConnell’s Economics, which echoes Samuelson and Nordhaus’s idealistic statism:

Because it is a public body, the decisions of the Board of Governors are made in what it perceives to be the public interest . . . the Federal Reserve Banks are not guided by the profit motive, but rather, they pursue those measures which the Board of Governors recommends. . . . The fundamental objective of monetary policy is to assist the economy in achieving a full employment, noninflationary level of total output.

These are mere wishes, not statements of facts, for there is voluminous evidence that the Fed—like all other governmental institutions—has always been manipulated by politicians.

The Fed as a Political Tool

When the Fed was founded, it was controlled by two groups, the Governors’ Conference, composed of the twelve regional bank presidents, and the seven-member Federal Reserve Board in Washington. In 1935, the Fed was reorganized to concentrate nearly all power in Washington. Franklin Roosevelt packed the Fed just as he later filled the U.S. Supreme Court with political sycophants. Roosevelt appointed Marriner Eccles, a strong supporter of deficit spending and inflationary finance, as Fed Chairman, although Eccles had no financial background and lacked even an undergraduate degree. In those years, the Fed was really run by Eccles’s political mentor, Treasury Secretary Henry Morgenthau, Jr., and thus ultimately Roosevelt.

Later presidents were no less willing to influence supposedly independent Fed policy. According to the late Robert Weintraub, the Federal Reserve fundamentally shifted its monetary policy course in 1953, 1961, 1969, 1974, and 1977—all years in which the presidency changed. Fed policy almost always changes to accommodate varying presidential preferences.[1]

For example, President Eisenhower wanted slower money growth. The money supply grew by 1.73 percent during his administration—the slowest rate in a decade. President Kennedy desired somewhat faster money creation. From January 1961 to November 1963, the basic money supply grew by 2.31 percent. Lyndon Johnson required rapid money creation to finance his expansion of the welfare/warfare state. Money-supply growth more than doubled to 5 percent. These varying rates of monetary growth all occurred under the same Fed chairman, William McChesney Martin, who obviously was more interested in pleasing his political master than in implementing an independent monetary policy.

Martin’s successor, Arthur Burns, was such a staunch supporter of Richard Nixon that he lost all professional credibility by enthusiastically endorsing Nixon’s disastrous wage and price controls. Even though his staff informed him in the fall of 1972 that the money supply was forecast to grow by an extremely robust 10.5 percent in the third quarter, Burns advocated ever faster growth before the election. The growth rate in the money supply in 1972 was the fastest for any one year since the end of World War II and helped re-elect Richard Nixon.

However, President Ford called for slower monetary growth as part of his Whip Inflation Now program, and the Fed complied with a 4.7 percent growth rate. But when Jimmy Carter was elected, Burns again complied with presidential wishes by stepping up the growth rate to 8.5 percent. Carter did not reappoint Burns, but the latter’s successors were equally cooperative. The money supply increased at an annual rate of 16.2 percent in the five months preceding the 1980 election—a post-World War II record.

In 1981, Donald Regan, Ronald Reagan’s Treasury Secretary, advocated—and got—more rapid monetary growth. A year later, the President himself met with Fed Chairman Paul Volcker to lobby for slower growth, which was dutifully produced by the Fed. More recently, Alan Greenspan has reportedly been most accommodating to President Clinton.

Both Sides Benefit

The Fed is obviously influenced by the executive branch. But the relationship between the Fed and administrations runs far deeper. As Robert Weintraub observed, such contact has been and continues to be fostered by the cross planting of high-level personnel in both directions. Officials have also met weekly for decades. But personal contact is not necessary for the Fed to allow itself to be used as a political tool. The administration’s policy views are generally well known. Economist Thomas Havrilesky has even developed an index of executive branch signaling, based on newspaper accounts of the administration’s monetary policy preferences as reported in the Wall Street Journal.[2] And as Weintraub concluded, a Chairman of the Federal Reserve Board who ignores the wishes of the President does so at his peril.

The Fed and presidents alike benefit from this arrangement. Economist Edward Kane has argued persuasively that the Fed’s ultimate political function is to serve as a political scapegoat when things go wrong. Writes Kane:

Whenever monetary policies are popular, incumbents can claim that their influence was crucial in their adaptation. On the other hand, when monetary policies prove unpopular, they can blame everything on a stubborn Federal Reserve and claim further that things would have been worse if they had not pressed Fed officials at every opportunity.[3]

In return for this favor, the Fed is allowed to amass a huge slush fund (discussed below) by earning interest income from the government securities it purchases through its open market operations.

A Demand for Inflation?

It is also well established that politicians use the Fed as a tool of money creation to advance their own re-election. As Robert J. Gordon wrote in the Journal of Law and Economics more than 20 years ago:

Accelerations in money and prices are not thrust upon society by a capricious or self-serving government, but rather represent the vote-maximizing response of government to the political pressure exerted by potential beneficiaries of inflation.[4]

Gordon is wrong in denying that government is inherently capricious and self-serving, but he’s got a good point: Politicians are naturally inclined to finance government handouts to special-interest groups with the hidden tax of inflation, which hides the true costs of government from the taxpaying public. Joining with election-minded officials in favor of expansive monetary policies is a low-interest-rate lobby, led, argues Edward Kane, by builders and construction unions and by financial institutions that earn their living by borrowing short to lend long.

The Fed underwrites an enormous volume of research, some of which is very good. But, as Business Week magazine once observed:

There is disturbing evidence that the research effort of the bank’s 500-odd Ph.D. economists is being forced into a mold whose shape is politically determined by the staff of the Federal Reserve Chairman. Some Fed economists admit that political expedience is the rule. Says former Fed economist Robert Auerbach, the practice at the Bank where I worked was to clear research through the Board of Governors and to “persuade” economists to delete material that the Board or the Bank officials did not like.[5]

Thus, all Fed research should be taken with a grain of salt. However, one recent study, in particular, deserves special attention. In 1992, Boston Fed research director Alicia Munnel published a report claiming to find persistent mortgage loan discrimination against minorities in Boston. The study, used to justify racial quotas for bank loans, was fatally flawed. The data were hopelessly jumbled. Equally important, the report failed to control for creditworthiness—credit ratings, job history, income, and so on. When confronted with these facts by Peter Brimelow and Leslie Spencer of Forbes magazine, Munnel admitted: “I do not have evidence . . . no one has evidence of lending bias.”

Taxpayer-Funded Lobbying

The Fed also uses its privileged position—and especially its multi-billion dollar slush fund generated by interest income on open market purchases—to lobby. Its preferred method is to pressure member banks, which it regulates, to lobby for it. It also recruits a small army of academic researchers, who benefit from Fed research grants, visiting appointments, and invitations to conferences at exotic locations, to testify on its behalf at Congressional hearings.

For instance, in the late 1970s, Representative Henry Reuss introduced a bill authorizing the General Accounting Office to audit the Federal Reserve system. It was defeated because, as Reuss later explained, with the Federal Reserve Board in Washington serving as the command center, a well-orchestrated lobbying campaign was mounted, using the members of the boards of directors [of the regional banks] as the point men. In a speech to the American Bankers Association after the GAO bill was defeated, the Richmond Fed’s chairman, Robert W. Lawson, congratulated the assembled commercial bankers for their success:

The bankers in our district and elsewhere did a tremendous job in helping to defeat the General Accounting Office bill. It shows what can be done when the bankers of the country get together.[6]

Academics conducted themselves in an equally disgraceful way, warning of potential abuses and assuring Congress that the Fed could be trusted to behave responsibly.

For decades, believers in the public interest theory of Fed behavior blamed the Fed’s failures to ensure price stability on the agency’s incomplete knowledge and difficulty fine-tuning the economy. But research suggests that the Fed’s abysmal record in controlling inflation reflects not mere incompetence, but the way in which the Fed is organized.

Until the Fed’s creation, there was no overall upward trend in the price level. Inflation occurred during wars, but prices then gradually declined to their former levels. Since the establishment of the Fed, however, there has been a continuous upward surge in prices. Public choice scholars believe that an important reason why the Fed has caused so much inflation is that it benefits from inflation. Since the entire operation has been funded since 1933 from revenue acquired through interest payments on government security holdings, the Fed has an incentive to purchase securities (thereby expanding the money supply) more than it has an incentive to sell them. Purchasing government securities is a source of income to the Fed, whose income is earned by the interest paid on the securities. Selling securities, on the other hand, causes a loss of income.

The Fed is constrained to return excess revenues to the Treasury, but enjoys great discretion over its budget and managed to spend over $2 billion on itself in 1996. Fed officials live quite well on their revenues. As a recent General Accounting Office report revealed:

The Fed has 25,000 employees, runs its own air force of 47 Learjets and small cargo planes, and has fleets of vehicles, including personal cars for 59 Fed bank managers. . . . A full-time curator oversees its collection of paintings and sculpture.[7]

The Fed held $451 billion in accumulated assets as of 1996 when it was engaged in building for itself several expensive new office buildings. The number of Fed employees earning more than $125,000 per year more than doubled (from 35 to 72) from 1993 to 1996; even the head janitor (known as the support services director) is paid $163,800 in annual salary plus benefits. Money is lavishly spent on professional memberships, entertainment, and travel.

Economist Mark Toma has studied the Fed’s spending habits and believes that the Fed does, in fact, conduct monetary policy with an eye toward how its managers and employees can themselves profit from it. That means instituting a bias toward bond purchases and money creation.[8] Similarly, William Shughart and Robert Tollison contend that the Fed behaves exactly like many other government bureaucracies, padding its operating expenditures by increasing the number of employees on its payroll.[9]

That is, the Fed uses staff expansion to reduce the amount it must return to the Treasury. Thus, when engaging in expansionary policies, write Shughart and Tollison, the Fed can both increase the supply of money and increase the size of its bureaucracy because the two goals are served by open market purchases of securities. Contractionary policies, on the other hand, force the Fed to lower its profits and staff. Because of this unique financing mechanism, argue Shughart and Tollison, the Fed has been more successful in enlarging its employee staff over time than the federal government as a whole. This employment effect, moreover, may partially explain why the Fed has apparently been more willing to engage in expansionary than in contractionary monetary policies.

Regulation as a Political Tool

The Fed also uses its vast regulatory powers for political purposes, rather than to promote the public interest. The Fed’s authority is vast but is most abused through enforcement of the Community Reinvestment Act of 1977. Under the CRA, the Fed must assess a bank’s record of meeting community needs before allowing a bank to merge or open a new branch or even an automatic teller machine. An entire industry of nonprofit political activists routinely files protests with the Fed, which must be evaluated before the bank can win Fed approval. The activists typically threaten to stall mergers or branch expansions unless banks give them—not the poor in their communities—money, a practice that many bankers consider pure blackmail.

For example, the Chicago-based National Training and Information Center threatened to delay a merger by a Chicago bank unless it received $30,000 to renovate its office. The bank agreed, and also gave $500,000 to other leftist organizations. In Boston, left-wing activist Bruce Marks, the head of the Union Neighborhood Assistance Corporation, filed complaint after complaint with the Fed over Fleet Financial Group’s community lending record until Fleet agreed to give $140 million to his organization and to make $8 billion in loans to individuals and businesses favored by Mr. Marks. “We are urban terrorists,” Marks explained to the Wall Street Journal.[10]

The CRA is frequently used as a means of racial extortion. For example, the Fed, under the direction of former Governor Lawrence Lindsey, found statistical disparities in lending, i.e., the percentage of loans granted by the Shawmut Services Corporation to blacks and Hispanics did not match the groups’ proportion in the population. Yet no individuals complained of discrimination, and the Fed did not claim to have found any victims. In fact, between 1990 and 1992, when the discrimination allegedly occurred, Shawmut’s mortgage loans to blacks and Hispanics more than doubled, and the mortgage rejection rate fell by 45 percent and 26 percent, respectively. However, the Fed employed 150 people to go out and find people who claimed to have been discriminated against by Shawmut and to offer them $15,000 each, effectively robbing the company of $1 million.

Conclusions

Any government monopoly will be corrupt and inefficient, but the Fed may be the worst government monopoly of all. Not only does it operate for its own advantage in the name of promoting the public interest and offer government officials political cover for their self-interested policies, the Fed also allows no escape. One can at least refuse to do business with, say, the government school monopoly by homeschooling or by sending one’s children to private schools. But one cannot avoid the effects of the Fed’s monetary monopoly. It is time to depoliticize and denationalize our money.

Thomas DiLorenzo is an author and professor of economics at Loyola University Maryland.

Originally published in the April 1997 issue of The Freeman.

[1] Robert Weintraub, Congressional Supervision of Monetary Policy, Journal of Monetary Economics, April 1978, pp. 341–362.

[2] Thomas Havrilesky, Monetary Policy Signaling from the Administration to the Federal Reserve, Journal of Money, Credit and Banking, vol. 20, no. 1, February 1988.

[3] Edward J. Kane, Politics and Fed Policymaking, Journal of Monetary Economics, vol. 6, 1980, p. 206.

[4] Robert J. Gordon, The Demand for and Supply of Inflation, Journal of Law and Economics, vol. 18, 1975, p. 808.

[5] Robert D. Auerbach, Politics and the Federal Reserve, Contemporary Policy Issues, Fall 1985, p. 52.

[6] Ibid., p. 53.

[7] John R. Wilke, Fed’s Huge Empire, Set Up Years Ago, Is Costly and Inefficient, Wall Street Journal, Sept. 12, 1996, p. 1.

[8] Mark Toma, The Inflationary Bias of the Federal Reserve System, Journal of Monetary Economics, vol. 10, 1982, pp. 163–190.

[9] William Shughart and Robert Tollison, Preliminary Evidence on the Use of Inputs by the Federal Reserve System, American Economic Review, June 1983, pp. 291–304.

[10] Susan Alexander Ryan and John Wilke, Banking on Publicity, Mr. Marks Got Fleet to Lend Billions, Wall Street Journal, Feb. 11, 1994, p. A-5.

What Do We Mean by Sound Money?

Gerald P. O’Driscoll, Jr.

The concept of "sound money" evolved in the 19th century as many countries adopted the gold standard. It became associated with commodity money or “hard currency.” For example, Mises (1966: 782) stated:

The principle of soundness meant that the standard coins—i.e., those to which unlimited legal tender power was assigned by the laws—should be properly assayed and stamped bars of bullion coined in such a way as to make the detection of clipping, abrasion, and counterfeiting easy. To the government’s stamp no function was attributed other than to certify the weight and fineness of the metal contained.

There was no requirement that “standard coins” be the exclusive or even preponderant means of payment in day-to-day transactions. So long as banks of issue (private or central banks) maintained convertibility, then the monetary system had the characteristics of sound money. As Mises suggested, government’s role was minimal.

As a matter of history, sound money is associated with commodity money. Mises’ characterization assumes commodity money. Can there be sound fiat currency?

Sound and Unsound

Most 19th century writers on money assumed a system of commodity money with allowance for temporary suspensions during wartime and a return to the standard in peacetime. The suspension of specie payments by the Bank of England during the Napoleonic Wars prompted banker Henry Thornton to author in 1802 a treatise on managing a paper currency: An Enquiry Into the Nature and Effects of the Paper Credit of Great Britain. Thornton was a successful banker with an economist’s understanding of banking, finance, and the real economy. He pioneered analytical distinctions that would not be rediscovered for almost another century: the distinction between real and nominal interest rates, and the concept of an equilibrium or natural rate of interest.

The volume should have become a standard reference work. But it came to be forgotten because the Bank of England re-established convertibility, and other countries gradually adopted the gold standard over the course of the 19th century. How to manage a fiat money system (paper credit) ceased to be a practical issue.

When the Federal Reserve System was created at the end of 1913, the United States was on the gold standard along with most of the rest of the world. The Federal Reserve was not created to manage money in the modern sense, but to provide a national currency as part of a gold standard. No one was thinking of managing a fiat currency on the eve of World War One. That was all soon to change with the requirements of wartime finance.

After World War One, the world returned to a global, pseudo gold standard that was chronically short of gold reserves. The currencies of many countries were overvalued relative to gold. When the system collapsed in the 1930s, countries were thrust into a fiat currency world without a playbook. For a time, there were efforts to restore the global gold standard but they came to naught. World War Two interrupted any effort to craft a new international monetary system.

Bretton Woods: Not Sound

The post-War, Bretton Woods system constituted the new global monetary order. Volumes have been written on it. I do not share the nostalgia of some for it. It was even less of a gold standard than existed in the interwar period. In truth, it was a dollar standard. The dollar was pegged to gold and other currencies pegged to the dollar. There were numerous exchange-rate adjustments. The system contained inner contradictions. Inevitably, the producer of the dominant currency was bound to abuse its “exorbitant privilege” and the United States did so. The system collapsed and the world was then on a fiat standard.

There was no accepted theory of managing money in a fiat money world. This was not Henry Thornton’s world in which fiat money was a temporary expedient with an expectation of a return to specie conversion. It was not the world of the classical quantity theory, which was constructed in a commodity-standard world. The quantity theory demonstrated the limits of monetary expansion (or changes in the demand for money) before prices would begin to rise sufficiently to threaten convertibility. In a classical gold standard, the supply of money is endogenous and the price level fixed in the long run.

The Breakdown of Monetarism

Milton Friedman and the monetarists offered a restatement of the quantity theory and a model of monetary control for a fiat currency. Friedman, his students and colleagues believed they had discovered stable empirical relationships among the monetary base, broader measures of money (especially M2), and the demand for money (Friedman 1956 and Friedman and Schwartz 1956). When monetary targeting was finally implemented by the Volcker Federal Reserve in the 1980s, the posited empirical relationships broke down. The Fed abandoned monetary targeting.

What followed was a period that John Taylor dubbed the Great Moderation, in which the Fed and other central banks seemed to get it right. There was enhanced macroeconomic stability (as measured by decreased variance in prices and output). Taylor discerned that the Fed was following a tacit rule, which others called the Taylor Rule. But the Fed and then other central banks began to deviate from the rule by lowering interest rates in response to the Dotcom bust. Taylor (2009) argued the housing bust was the consequence of the boom created by the policy of low interest rates. “No boom, no bust.” Central banks have not returned to a monetary rule. Instead, they have engaged in monetary improvisation.

It’s a New World of Money

Money in the 21st century is proving immune to control by central bankers. The relationship between monetary reserves and various monetary aggregates (the money multiplier) has broken down. More precisely, central banks appear to have lost the ability to control inflation.

In the United States, Europe, and Japan, inflation rates have remained chronically below central bank targets over the course of the economic recovery from the Great Recession. (The growth of real GDP has also been subpar.) Economists as diverse as Jerry Jordan (2016) and James Bullard (2016) have questioned whether our textbook models of money creation and inflation control are any longer valid. That is not to say that future inflation rates will not rise to two percent or beyond. If they do so, however, it will likely not be the consequence of any central bank policy actions (Jordan 2016).

To reiterate, I question whether we ever had a practical theory of how to manage money in a fiat money world. The proponents of monetary rules believe they have such a theory. One class of such rules involves NGDP targeting.

The specific question I pose for advocates of NGDP targeting is how today will anything the Federal Reserve does to its balance sheet alter the growth rate of NGDP in a predictable fashion? The answer to such a question could be that the central bank should do more. How much more? And what, then, becomes of the rule? It sounds like a recipe for discretion. In any case, central banks have been unable to get either component of NGDP to grow in a normal or predictable manner.

Monetary institutions and policies vary among the major central banks. For instance, both the European Central Bank and the Bank of Japan have instituted negative interest rates on commercial bank deposits at the central bank. Meanwhile, the Fed has been paying interest on bank reserves for some time. The institutions and policies differ, are even opposed to each other, but the policy failures are common. (The policies have failed on their own terms, regardless of whether one agrees with them.)

A Monetary Constitution

Let me return to the classical idea of sound money. Sound money is a rule, but of a different kind than modern monetary rules such as the Taylor Rule or NGDP targeting. Sound Money was not a rule based on empirical relationships among economic variables. It was not invented but discovered. It is more analogous to the rule of law. Mises (1971: 414) made this point clearly.

Ideologically it [sound money] belongs in the same class with political constitutions and bills of rights. The demand for constitutional guarantees and bills of rights was a reaction against arbitrary rule and non-observance of old customs by kings.

The argument for sound money is not merely a technical economic argument, but a political economy and even constitutional argument. When classical economists contended that commodity standards were a bulwark against inflation, they did not suggest that there would be no variability of inflation under a gold standard. Their own experience told them otherwise. Rather, they recognized that a gold standard was protection against arbitrary actions by sovereigns to depreciate the currency. Protection against arbitrary and capricious governmental actions is what constitutions are meant to provide.

Is there a way to avoid arbitrariness in monetary matters in a fiat money system? Can a monetary rule of some type today provide the protections that existed in the classical, pre-World War One gold standard? These questions are central to the debate over monetary rules. They apart from the technical ones I raised above. Both sets of questions need to be addressed in debates over monetary policy.

References

Bullard, J. (2016) “Permazero.” Cato Journal. 36 (Spring/Summer): 415–29.

Friedman, M., ed. (1956) Studies in the Quantity Theory of Money. Chicago: The University of Chicago Press.

Friedman, M. and A. J. Schwartz (1963) A Monetary History of the United States, 1867–1960. Princeton: Princeton University Press.

Jordan, J. L. (2016) “The New Monetary Framework.” Cato Journal 36 (Spring/Summer): 367–83.

Mises, L. v. (1971 [1952]) The Theory of Money and Credit. Irvington-on-Hudson: The Foundation for Economic Education.

——— (1966) Human Action, 3d ed. Chicago: Henry Regnery.

Taylor, J. B. (2009) Getting Off Track. Stanford: The Hoover Institution Press.

Gerald O’Driscoll is a senior fellow at the Cato Institute. He is a widely quoted expert on international monetary and financial issues.

Originally published at FEE.org on June 15, 2016.

Toward Radical Monetary Reform

Lawrence W. Reed

In the late 19th century and early 20th, the issue which occupied center stage of economic controversy was “the money question.” From the time of the Civil War greenbacks through Bryan’s “Cross of Gold” speech of 1896 until the establishment of the Federal Reserve System in 1913, politicians, academics, editors, and business people squared off in a heated debate over the proper monetary policy for the nation.

After the dramatic events of the Great Depression and the creation of the post-war monetary system, the issue became relatively dormant as attention turned to other things. But recently, “the money question” has emerged in full force once again. Its resurrection has come, not coincidentally, as an aftershock of a financial earthquake of staggering proportions.

What has happened is that the monetary chickens have come home to roost. Decades of government-managed money have produced a frightening flirtation with runaway prices. The American dollar has lost at least 80 percent of its 1940 value. The bond market has suffered fantastic losses. The devastation of dollar-denominated assets—savings, life insurance, pension funds, and the like—in real terms is tremendous. Faith and confidence in the future purchasing power of the dollar are everywhere in question.

We have been witness to nothing less than the historic demonetization of fiat money. The damage this process has wrought may yet assign government paper to the status of “barbarous relic” which Keynes once mistakenly ascribed to gold. Who can honestly survey the wreckage and pronounce of the monetary authorities, “This is a job well done”?

It is in this unfortunate set of circumstances that proposals for “monetary reform” are proliferating. It is not the objective of this essay to propose yet another or to endorse any particular one already advanced. Rather, the objective is to illuminate the intellectual path which any meaningful reform must take. The author leaves it to others to chart the specifics.

To begin with, monetary reformers must come to grips with something fundamental to the origin and history of money. They must rediscover what the Austrian economist Carl Menger told us in his path-breaking Principles of Economics in 1871: “Money is not an invention of the state. It is not the product of a legislative act. Even the sanction of political authority is not necessary for its existence.”

Of Natural Origin

The origin of money was entirely natural. It sprang from the awkwardness of barter and the desire for a marketable commodity to facilitate exchange. The first time man traded a good for something which he intended to use not for consumption himself but rather as a means to acquire what he really wanted, a medium of exchange—money—was born.

It was a revolutionary invention-the economic counterpart to the wheel—and it made possible trade and a division of labor inconceivable in a barter economy. It was truly an invention of the marketplace, of economizing individuals seeking to improve their well-being.

All sorts of commodities have served as media of exchange at one time or another. Cattle, cowry shells, furs and skins, wampum beads, tobacco, whale’s teeth, cigarettes, and even rats are examples. Primitive though these monies may seem, they had the qualities of familiarity and acceptability which made them marketable and hence, candidates for money.

In most markets of the world, the precious metals emerged as the primary money commodities. Durability, divisibility, high value in small quantities, and relative stability in purchasing power over time were characteristics which no other commodities could match. As early as 650 B.C., coins of gold and silver became almost singularly synonymous with the term “money” in the trading world.

Paper arrived later on the monetary scene as a “money substitute.” It took the form of promissory notes which pledged real money in payment for goods. Issued by early banks, for instance, they were redeemable or convertible on demand into the precious metals they represented.

Inflation Involves Government Control over Money

Governments, afflicted with an insatiable appetite for revenue, have generated history’s inflations by first assuming control over money. Then gold coins became only partially gold or without gold at all. Paper notes, stripped of their “backing,” became “fiat”—their value tied to the whims of the inflating authority. Monetary history records no instance of a people voluntarily choosing in the marketplace to use unbacked fiat paper as their money!

The problem with so much of monetary economics today is that it does not fully comprehend the inescapable conclusion that money is a market phenomenon—that it originated in the market, that it evolved in the market, and that the market laws of supply and demand apply to money just as they do to any other commodity traded in the market. I submit that no monetary reform is likely to succeed if it treats money as the invention and exclusive domain of a political monopoly. The essential task of true monetary reform, then, is to find a way to divorce money from politics and make it as much a product of the market as possible.

In this vein, the many proposals which call for minor alterations of the government’s monetary function sound a little like rearranging the deck chairs on the Titanic. Simply putting a different crew in charge of the ship or experimenting with the compass is not radical enough. In this case, the market may be just the lifeboat we should be looking for.

The objection may be raised, “Without a central authority, how will anyone know what the supply of money should be?” Well, does anyone know what the supply of green beans should be? How many quarts of milk should be produced? How many size 36 undershorts there ought to be? How is it that the market is able to provide these things without central planners and in just the right amounts?

The answer, of course, is the market’s mechanism of price. When costs are low and the price is high, the signal to producers is, “Make more!” Producers know they should not pile up anymore when costs exceed price. Why shouldn’t money respond similarly?

When gold was money, this mechanism certainly did work reasonably well. As long as it was profitable to mine gold, producers did. “Too much gold” on the market caused the value of gold to fall and the cost of mining to rise—a double whammy that prevented producers from engaging in a continuous inflation. The supply of money, therefore, had something to do with the real market demand for money.

With today’s fiat money, the mechanism is short-circuited. Double-digit price inflation is the market’s way of signaling that there’s too much of the green stuff around, but the signal never directly strikes the producer. There’s no chance that he will go broke in the process of creating more than the market demands. For the inflator of fiat money, the incentives are perverse: he grows bigger the more he does the very thing he shouldn’t be doing!

It is no sure bet that the debate over monetary reform will deal fundamentally with this question of political versus market money. We have lived for so long with the former and its ruinous consequences that suggesting the radical alternative may be tantamount to the impossible task of teaching blind people what it would be like to see.

Once it was believed that witches, warlocks, and demons were the causes of such calamities as bad weather. Elaborate contrivances were devised to drive them away. When men learned that it wasn’t so, they looked for more natural, scientific explanations. Perhaps it is time to relegate to superstition the idea that government should manage money and get on to the task at hand—putting money back in the marketplace where it belongs.

Originally published in the April 1982 issue of The Freeman.

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