On this Throwback Thursday, we’ll run the first part of “A Brief Monetary History of the United States” from Ron Paul’s Monetary Policy Anthology. Subsequent sections of that history will run every Thursday for the next several weeks. If you haven’t downloaded the anthology yet, you ought to do so. The anthology is a compilation of Congressman Paul’s tenure as Chairman of the Subcommittee on Domestic Monetary Policy, including his exchanges with Ben Bernanke, the transcripts of his monetary policy hearings, transcripts of the “Tea Talk” lecture series, and additional commentary from prominent economists from the Austrian School such as Bob Murphy, Tom Woods, and Jesus Huerta de Soto.
The installments in this monetary history series can be found here:
“Those who cannot remember the past are condemned to repeat it.” – George Santayana
To avoid repeating the mistakes of the past and to provide for a more prosperous future, the lessons of history must be both explored and understood. This is no less true for something used in everyday life: money. The present monetary regime did not appear overnight. Rather, it is the result of centuries of concerted action, much of which has been forgotten by history. The following pages are intended to provide the reader with a brief yet relatively comprehensive introduction to the history of money and monetary policy in the United States from the late-18th century to the present. While not an all-inclusive look at American monetary history, this section covers the main historical events that have led to the current U.S. monetary system. If America seeks to achieve a sound and stable economy, it is necessary to examine the history of money in the United States and its evolution over time.
Money as a medium of exchange is what allows civilization to flourish; there is no surer way to erode civilized society than to debase currency and destroy the institution of money. Money and credit allow for the vitally important functioning of markets, since nearly all economic transactions have goods or services on one side and money or credit on the other. As such, money literally comprises one half of most economic transactions.
Money is not just a medium of exchange, however; just as important are its roles as a store of value and a unit of account. Creating new money reduces the value of existing money, lowers its purchasing power, and slowly siphons real wealth from the middle class and the poor to those fortunate few who are closest to the federal government or the power brokers of Wall Street, the levers of money creation. Even the economic calculation enabled by money is skewed when the value of the unit of account is constantly diminishing. Artificially influencing the price of money has real effects throughout the economy, distorting the economy’s capital structure, causing the all too familiar boom and bust of the business cycle, and enhancing the influence of government.
It is for this reason that Nobel laureate Friedrich von Hayek stated that:
Inflation is probably the most important single factor in that vicious circle wherein one kind of government action makes more and more government control necessary. For this reason all those who wish to stop the drift toward increasing government control should concentrate their effort on monetary policy.
The U.S. economy has been beset by crisis after crisis. It is too easy to give credence to those who make the superficial claim that the free market is inherently unstable and that only government firmly at the helm directing economic behavior will result in economic stability. A deeper look reveals that government intervention into and control over money has been the cause of, not the solution to, economic instability.
Colonial Money and the Continental
During the time of the American colonies the dominant circulating form of money was the Spanish milled dollar. There was no central bank. There was not even a central government mint, as the colonies had been forbidden from operating their own mints, and the export of English coin to the colonies had been prohibited. Due to the global trade in which the colonies engaged, many foreign coins made their way into the thriving and prosperous colonial economies, the most numerous coins being the Spanish milled dollars. The favorable reputation of the dollar was due to its long-standing record as a sound, stable currency that had not been subject to government debasement. It was for this reason that the dollar was chosen as the unit of account when the new United States of America was formed under the U.S. Constitution.
The choice of precious metal money for the unit of account was also due to several disastrous experiences with paper money prior to adoption of the Constitution in 1789. In fact, the first government paper money used in the Western world was introduced by the Massachusetts colony in 1690.This paper currency quickly became devalued, as did similar paper currencies that were eventually issued by other colonies. During the Revolutionary War the Continental Congress issued paper money called the “Continental” to help finance the war effort. However, this paper currency was printed in such large amounts that it quickly became worthless, leading to the adoption of the well-known phrase “not worth a Continental.” As the debasement proceeded apace, merchants were loath to accept the Continental, as it lost value almost immediately after they exchanged their goods for it. Under the Articles of Confederation that preceded the Constitution, the individual States tried to finance their debts by issuing their own paper currencies similar to the Continental. Succumbing to the same temptation to overprint, the States debased their paper money to such an extent that their economies suffered severe turmoil due to inflation.
Because of these problems with paper money, the framers of the Constitution were determined to ensure that neither the federal nor the state governments would be able to resort to monetary debasement through the issuance of paper currency. Article I, Section 10 of the Constitution prohibits the States from coining money, emitting bills of credit (i.e. paper money), or making anything but gold and silver legal tender. The federal government, in Article I, Section 8, is given the power to coin money and regulate its value, but no power to emit bills of credit or to create a legal tender.
Foreign Coinage and the Coinage Act of 1792
It was not until 1792 that Congress passed a coinage act to enable the federal government to begin minting coins of its own. The Coinage Act of 1792 established the dollar as the unit of account, equal to 371.25 grains of pure silver (the same silver content as the circulating Spanish milled dollars, already the predominant market-chosen means of exchange and unit of account).
The Act also established subsidiary copper coinage, as well as gold coins. Unfortunately, the ratio of silver to gold was legally fixed at 15 to 1, a ratio which diverged from the prevailing market trend, which was moving towards a 16 to 1 ratio. Because of this legally-mandated bimetallic ratio, silver became overvalued relative to gold. Gold coins left the United States almost as soon as they were minted, and foreign silver coinage flooded in. Since Congress also attempted to fix the value of foreign coins by giving them a legal tender exchange value in terms of dollars and cents, the foreign coins in circulation faced similar valuation problems. The result was that certain coins were undervalued and others overvalued, leading to the operation of Gresham’s Law.
Gresham’s Law states that when one form of money is legally overvalued and one legally undervalued, the legally undervalued currency will disappear from circulation while only the legally overvalued currency will remain. In layman’s terms this means that “bad money drives out good.” For example, if a coin with 5 grams of silver were valued at 20 cents, while another coin with 6 grams of silver were also valued at 20 cents, the coins with 6 grams of silver would not circulate. People would begin pulling the 6-gram coins from circulation, as their metal content was worth more than their government stated face value.
This is precisely what happened under the bimetallic monetary regime established by the federal government, which did not comport with the relative values of gold and silver on the market – an inherent problem of trying to legally define one monetary unit as two things: a fixed amount of silver and a fixed amount of gold. As a consequence, higher silver content coins (and gold) were exported, hoarded, or melted. At the same time the U.S. (and most other countries) was operating under a system of “free coinage,” where anyone could bring gold or silver to the U.S. Mint to be minted into coins at little or no charge. Every ounce of U.S. gold coins would fetch 16 ounces of silver abroad, which silver could be returned to the U.S. and presented to the U.S. Mint for minting into U.S. coins. Fifteen ounces of that silver could be exchanged for an ounce of new gold coins, leaving one ounce of silver as profit for the arbitrageur. Thus the export and melting of the government’s overvalued coins became very common.
The changing market ratios of coinage compared to the government’s decreed values caused the supply of money in the United States to be quite erratic. While the attempt to create a unified currency was well-intended, fixing the gold-silver ratio rather than allowing the market ratio to predominate caused severe problems with the circulation of gold and silver coins for many decades. Had the federal government allowed the market to determine the exchange value of various coins rather than intervening in the marketplace of money, it is likely that much of the monetary disruption that took place throughout the 19th century could have been avoided.