The history of money and wealth, Part II

James Turk - Thu 26 Oct, 2006

...The US would eventually join the classical gold standard, but as a developing country, achieving monetary stability involved the predictable growing pains...

 
 
The US would eventually join the classical gold standard, but as a developing country, achieving monetary stability involved the predictable growing pains. To finance the Revolutionary War, for instance, the Continental Congress issued paper currency called Continentals, denominated in dollars and backed only by the anticipation of future tax revenues. Inevitably, wartime pressures forced the authorities to run the printing presses flat-out, and the notes soon became virtually worthless. As George Washington is said to have lamented, "A wagonload of currency will hardly purchase a wagonload of provisions."

Returning to the tried and true, the newly independent US began minting gold and silver coins in 1793, defining the dollar as 3711/4 grains of pure silver. But early on, whatever coin was offered and voluntarily accepted circulated without government interference. A patron of a Boston pub might as easily have tipped the barmaid with a coin minted in Spain, England, or France as one from Philadelphia. The Spanish dollar, in fact, is described by one historian as "the unofficial national currency of the American colonies during much of the 17th and 18th centuries." To make change, it was actually cut into eight pieces, or "bits," hence the terms "pieces of eight" and "two bits."

As the memory of its first disastrous fling with government-issued fiat currency began to fade, the US tiptoed back into the money-substitute game early in the nineteenth century, chartering the Bank of the United States and Second Bank of the United States to issue notes and perform some other central-bank-like functions. The banks, however, drew the ire of sound-money advocates, including Andrew Jackson, who - like Isaac Newton before him - understood the risks of using money substitutes instead of money itself. Elected president in 1828, Jackson declined to renew the Second Bank's charter, ushering in the "Free Banking Era," a quarter-century of banking and monetary practice largely unfettered by government interference. Banks began issuing paper currency against their precious-metal reserves, and by 1860, an estimated 8,000 different privately owned banks were circulating dozens of different private currencies. Most held their value fairly well within their issuing banks' territory, though the realities of travel and communication caused them to trade at discounts that grew along with the distance from the issuing bank. All things considered, it was an interesting experiment that, given the chance to evolve along with communications and transportation technologies, might have produced a very different modern economy. But like so many other promising things, free banking ended when war, this time the Civil War, was declared.

In 1861, the financially strapped Lincoln administration began issuing paper currency (which, by the way, is emphatically not one of the enumerated powers the Constitution delegates to Washington). The new currency, called the greenback, though not directly backed by the Treasury's gold, was initially accepted by northerners. But as the war depleted Washington's precious-metals stocks and massive quantities of greenbacks were printed, the notes plunged in value. President Lincoln then opted for centralization, signing the National Banking Act of 1863, which chartered a national banking system to create a single national currency. Two years later, the federal government levied a 10 percent tax on currency issued by state-chartered banks, driving non-federally chartered banks out of the currency-printing business and restricting the right of currency creation to the newly formed national banks.

In the post-Civil War years, the US operated its now-centralized monetary system on a "bimetallic" standard, in which the dollar was defined as a weight of silver, and gold was measured in terms of silver. As western miners began discovering huge deposits of silver like the Comstock lode in Nevada, the supply of silver surged, and silver's purchasing power began to decline. Pressure began to mount from western states for Washington to support silver by buying up that region's growing silver production. The Sherman Silver Purchase Act of 1890 required the US government to double its annual purchases of silver and turn this metal into coin. But fear that such a huge increase in the money supply would throw the relationship between gold and silver out of whack produced a financial panic in 1893, and President Grover Cleveland called a special session of Congress to repeal the act. The US then adopted a monometallic system, at last joining Britain, Germany, and most other countries in the classical gold standard in 1900.

Because it represents such a departure from what came before and after - and because it was by far the most successful monetary system the human race has yet conceived - the classical gold standard bears closer examination. Under its terms, currencies were defined as a weight of gold, the way a length of cloth is measured in an unvarying unit we call the inch. Unlike today's world, where each government controls a country's internal money supply, the gold standard's adjustment mechanism was automatic and independent. Say, for instance, that British consumers ran a trade deficit with their German counterparts (that is, they bought more stuff from Germans than Germans bought from them). Under the gold standard, British gold would flow to Germany, causing Britain's money supply to shrink. The resulting reduction of credit would slow its economy and make its citizens feel less prosperous, causing them to buy less from abroad. Germans, meanwhile, would have extra money to spend and invest, thus lowering local interest rates and boosting economic growth. Some of this new wealth would be spent on foreign goods, bringing trade and capital flows back into balance.

The adjustment mechanism operated continuously, keeping individual nations from drifting too far from the straight and narrow. It didn't, however, eliminate the business cycle; on the contrary, there were some spectacular booms and busts under the gold standard. But these were mainly due to another innovation called fractional reserve banking. Because of its role in today's gathering storm, this is another concept you'll want to understand. So let's start with a look at its predecessor and polar opposite, 100 percent reserve banking.

In this system, when a resident of, say, fifteenth-century Venice deposited his savings at the local goldsmith (banks hadn't been invented yet), the goldsmith promised to keep enough gold on hand to pay his customer back on demand (though he might in the meantime use the gold to make jewelry, bars, or whatever). This kind of gold storage was more like the modern conception of a warehouse than a bank. Because the goldsmith didn't turn around and lend his customers' money to someone else, he often charged customers a small fee for keeping their savings safe.

In a 100 percent reserve system, the money supply grows at the rate of new gold and/or silver supplies, which is to say very slowly. So as technology progresses and workers become more productive, prices would be expected to fall rather than rise each year. This kind of deflation, viewed through a sound-money lens, is normal and healthy. Such an economy would be capable - barring war or plague - of growing steadily for long periods of time without excessive debt accumulation or monetary instability. But slow and steady rarely satisfies the more excitable members of the financial class, and by the seventeenth century, Italian and English goldsmiths had discovered that they could lend out some customers' gold for a profit. Since only a few of their customers demanded their gold back at any given time, the fraction of their deposits that the goldsmiths held in reserve (hence the term "fractional reserve") was usually sufficient to meet their obligations. And with the money they earned by lending, they were able to pay their depositors interest rather than charging them for storage, producing smiles all around.

Now let's fast-forward to nineteenth-century Europe, where, under the guidance of the now-dominant Bank of England, fractional reserve banking had begun to operate on an unprecedented scale. Say, for instance, that a London bank received a deposit of 100 pounds and was required to hold 10 percent of its total loans as reserves. That means it could make 90 pounds of new loans, keeping 10 pounds in reserve. The recipients of those loans would then deposit them in other banks, which could then lend 81 pounds, keeping 9 pounds in reserve, and so on, until the total amount of credit in the system vastly exceeded the original deposit. The result was a "flexible" money supply, capable of expanding to meet the needs of a growing global economy. Of course, flexible also means volatile. In good times, when citizens are willing to borrow and banks willing to lend, credit grows at a faster rate than the money supply. In hard times the credit machine is thrown into reverse, which explains how booms and busts were still possible under the seemingly stable gold standard.

Yet even with the destabilizing effect of fractional reserve banking, interest rates were low in most gold-standard countries, because the basic money supply - that is, the amount of gold - grew by only a couple percent each year. This limited the amount of paper that member governments could print, minimizing the risk of inflation and making debt denominated in gold standard currencies attractive to investors. As a result, the four decades between 1870 and 1914 were, amazingly good times, unique in human history for their combination of economic growth and price stability.


Regards,

James Turk
for The Daily Reckoning