ECON120: Monetary History

FEDERAL RESERVE SYSTEM

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:

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:

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.

Source: Nik Bhatia: Layered Money
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