Course Textbook


Gold is money. Everything else is credit. - J.P. Morgan to United States Congress in 1912

At the turn of the twentieth century, the pound remained the world's reserve currency but was losing ground to the United States dollar. During the Industrial Revolution, corporate barons Cornelius Vanderbilt, John D. Rockefeller, Andrew Carnegie, J.P. Morgan, and Henry Ford built companies that attracted demand for American currency. The world needed dollars in order to purchase the goods, services, and shares of these new elite corporate institutions. During this span, the United States did not have a central bank. But when an enormous earthquake in San Francisco induced a financial crisis in 1907, the United States would shortly thereafter take a page from Walter Bagehot's book and install a lender of last resort at the center of its financial system. The Federal Reserve System, the new American central banking apparatus, inherited a currency already on its way to world reserve status in 1914. It formalized a three-layered monetary system, with sanctioned private sector banks permitted to create third-layer monetary instruments on their balance sheets. Today, the Federal Reserve remains atop the hierarchy of money as the dollar still holds the crown of world reserve currency even though its position has become fragile. Understanding the dollar's complex dichotomy of dominance and fragility can be more easily explained with our layered terminology, a story that plays out over the next three chapters. In this chapter, we'll break down the Federal Reserve's three-layered dollar pyramid. Next, we'll see how the Federal Reserve and United States government decisively removed gold from the first layer of money. And finally, we'll look at how the international monetary system fell into disrepair starting in 2007, and why consequently the cry gets louder every year for a global currency reboot.

Early American Money

Throughout the New World colonies, money's form varied distinctly between regions. Coins weren't numerous in the early days because colonial mints didn't exist yet and European coins weren't plentiful enough to be used by every-body as currency. This drove people to use more local forms of money. In New York, sea-shell beads called wampum, used as money by many Native American tribes, circulated as legal tender during the seventeenth century. In Virginia, tobacco became a first-layer monetary asset and the basis of its own money pyramid due to the global popularity of the crop. The pound-of-tobacco unit became an accounting standard, and notes promising the delivery of pounds of tobacco were issued by Virginia as second-layer money that circulated among the public as cash. Shells and tobacco sufficed as regional money because they each demonstrated some, but not all, of the monetary characteristics of coinage. Neither was perfect, but they each successfully served as money for many decades. Both were divisible, difficult to conjure up, relatively fungible, and modestly durable. Eventually, they would be replaced as mediums of exchange and units of account by a historically superior form of money: gold and silver coinage.

As time elapsed, more foreign gold and silver coins started circulating as currency throughout the colonies. The most popular coin amongst the people was the Spanish silver dollar. In 1784, Thomas Jefferson published his Notes on the Establishment of a Money Unit, and of a Coinage for the United States, and provided the argument for the dollar as the new American currency unit:

[The] Dollar is a known coin, and the most familiar of all to the minds of the people. It is already adopted from South to North; has identified our currency, and therefore happily offers itself as a Unit already introduced.

A Monetary Mix

Sixteen years after the Declaration of Independence, the second Congress of the United States of America finally passed the Coinage Act in 1792 to establish the United States dollar as the country's official unit of account, defining one dollar as both 1.6 grams of gold and 24 grams of silver.

For the next 108 years, the United States experimented with a few different monetary regimes. An early adjustment to the exchange rate between gold and silver had the opposite effect of Isaac Newton's adjustment as Master of the Mint and drove gold out of usage for several decades.

Two separate central banks were created in 1791 and 1812, but each ended after its twenty-year charter. Many early Americans didn't trust central banks to administer their currency. The banks existed in antithesis to limited government ideals and led to a great deal of political vitriol, which prevented the institutions from charter renewal. Instead of central bank second-layer money, notes issued by private sector banks functioned as a very serviceable form of cash through- out the nineteenth century. These notes were secured by United States Treasuries, the name for U.S. government bonds. Here's an example of the official language written on a currency note secured (or backed) by U.S. Treasuries from 1902:

National Currency secured by United States Bonds deposited with the Treasurer of the United States of America

The American National Bank of San Francisco will pay to the bearer on demand Ten Dollars

In addition to private sector bank notes, U.S. government- issued gold certificates also circulated as cash. And finally, a Civil War financing tool and paper money called the green-back, which couldn't be redeemed for precious metal, circulated as cash during the latter part of the nineteenth century as well. Altogether, the United States had an amalgamation of second-layer monetary instruments circulating through-out the country. The demarcations between the second and third layers were difficult to define, especially without a central bank and a formal monetary system. Meanwhile, an international gold standard that began in England started to permeate the globe as other European nations established second-layer currencies bearing the promise of convertibility to gold coin, which influenced a resurgence of gold usage in the United States. The Gold Standard Act of 1900 ended some monetary ambiguity, eliminating silver from its monetary role and fixed one dollar at 1.5 grams of pure gold. The corresponding price of one troy ounce of gold stood at $20.67 - where it had been since 1834.10 The act was some- what of a formality as the Americans had already joined the world's gold standard in practice, but it was essential for the branding of the dollar denomination. The United States was now primed for another attempt at a central bank.


In 1906, an earthquake of 7.9 magnitude rocked San Francisco, California causing mass destruction of life and property; over 3,000 people died and most of the city was destroyed. In a roundabout way, this earthquake caused the Federal Reserve System's creation. During these years, much of San Francisco's property was insured in London. British insurers paid out an enormous portion of San Francisco's colossal insurance claims as a result of the earthquake, and a flurry of capital was sent to California. In order to defend the pound-to-dollar exchange rate, the Bank of England dramatically raised interest rates by 2.5% in late 1906 in an effort to attract capital away from the dollar. It worked, and the American economy entered a contractionary period, which in turn led to a financial crisis. What ensued was an all-out scramble to ditch second- and third-layer money issued by any American financial institution whose creditworthiness came even remotely into question. As Americans climbed the money pyramid in the Panic of 1907, depositors across the nation withdrew bank deposits to seek out higher-layer forms of money, like gold coins or U.S. Treasuries. These withdrawals across the country caused regional banks to run on New York banks. As the crisis escalated, banking titan J.P. Morgan stepped in, organized a financial salvation of faltering banks, and saved the financial system. Morgan didn't have a choice: a United States central bank and lender of last resort didn't exist.

The next year, United States Senator Nelson Aldrich set up the National Monetary Commission, the job of which was to study Europe's monetary system and make recommendations on how to overhaul and modernize what had become a sloppy and disjointed dollar system without a central bank. Without a government sponsored lender of last resort and clearly defined money pyramid, the dollar's internationalization remained elusive. After years of study, published reports, and congressional testimony, Aldrich finally achieved his pursuit of a central bank when Congress passed into law the Federal Reserve System on December 23, 1913.

The word reserve is in the title of the institution itself, but what exactly are reserves, and how do they fit into the narrative of layered money? The word implies a safety mechanism, something to help in case of a crisis. Indeed, the Federal Reserve System (the Fed) was founded to combat financial crises, and it would do this with a second-layer money called reserves. Fed reserves are another way to say deposits, but these deposits were issued by the Fed only to private sector banks. Fed notes (or the "dollar cash" we know today), the Fed's other form of second-layer money, were available to the people. Fed notes were issued as a public good, a reliable paper currency that could be easily used as a medium of exchange. But reserves are the real tool the Fed uses to wield its monetary power. They are the monetary construct we must under- stand to interpret the difference between wholesale money and retail money.

Wholesale money (Fed reserves) is money that banks use, and retail money (Fed notes) is money that people use. Fed reserves are deposits for banks only and do not have any retail access: no individual can spontaneously open up an account at their local Federal Reserve branch and acquire them. The difference between wholesale and retail money becomes more important when discussing the future of central banking, but in the historical context, the Fed's mandate was to provide wholesale money, or money for the banking system, when the instability of credit stoked financial unrest. The name said it all; the Federal Reserve system was intended primarily to be a wholesale rescue mechanism of reserves.

The Fed

The Federal Reserve Act's full name is:

An act to provide for the establishment of Federal reserve banks, to furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes.

The first stated purpose, "to provide for the establishment of Federal reserve banks," immediately establishes a federally unified and accepted second-layer money, "reserves," underlying all banking activity in the United States. Reserve banks would replace the existing decentralized mix of second-layer money and end the ability for private sector banks to issue it. The Act monopolized the second layer of money in the United States under the Fed, and firmly placed all private sector money issuance on the third layer.

The second stated purpose of the Act, "to furnish an elastic currency," confirmed that the Fed would have the ability to issue money in a fractionally reserved way and allow banks within its system to do the same.

The third purpose of the Act was the Walter Bagehot provision, giving the Fed the "means of rediscounting commercial paper". Commercial paper refers to short-term debt issued by banks and corporations. This allowed the Fed to act as a lender of last resort for the financial system by creating second-layer reserve balances in order to purchase distressed financial assets.

The last major stated purpose of the Act was "to establish a more effective supervision of banking in the United States," in an attempt to sort through the monetary disarray of the day, establish the Fed's financial surveillance on the banking industry, and give the Fed sole power to issue bank charters that came with the ability to create third-layer money.

Finally, the Act decreed that the Fed maintain a gold- coverage ratio of at least 35% against the liabilities it issued on the second layer, meaning at least 35% of the Fed's assets must be held in gold. In actuality, gold represented 84% of the Federal Reserve's assets upon its founding, a number that would dramatically fall over time. Today, for reference, gold represents less than 1% of the Fed's assets.

Initially, the Federal Reserve did not own nor intend to own U.S. Treasuries on its balance sheet. The beginning of the first World War in 1914 swiftly ended this original intent, which became irrelevant in the face of war finance. Only two years after the launch of the Federal Reserve System in 1916, the Federal Reserve Act was amended to effectively help the United States government finance its war effort, and the Fed subsequently created ample reserves in order to purchase U.S. Treasuries.

The process of building an enormous portfolio of U.S. government debt had larger implications for the dollar pyramid. U.S. Treasuries joined gold on the first layer of money because of the Fed's new asset composition: by the end of World War I in 1918, the Fed's gold-coverage ratio fell from 84% to less than 40%, as over half the Fed's assets were now held in U.S. government bonds. It was the first indication that U.S. Treasuries would eventually replace gold altogether as the dollar pyramid's only first-layer asset.

Figure 10

Figure 10 shows the three-layered dollar pyramid a few years after the Fed's creation.