Bloomberg, by Simon Johnson and James Kwak
The birth of the U.S. was paid for by both a debauched paper currency and large debts that it soon defaulted on. When Alexander Hamilton became Treasury Secretary in 1789, his job was not just restoring the country’s credit by restructuring the debt and imposing new taxes; he also had to clean up the mess that was money in the early U.S.
Hamilton proposed to base the monetary system on both gold and silver. Gold had advantages, including greater stability, he argued, but it would be disruptive to withdraw the large amounts of silver that were already in use. He proposed “ten dollar and one dollar gold pieces, one dollar and ten cent silver pieces, and one cent and one-half cent copper pieces,” and the Mint Act of 1792 largely followed his recommendations. As gold and silver were both widely recognized bases for money at the time, this was relatively uncontroversial.
This “bimetallic” standard meant that the dollar was defined as either a specific amount of silver or a specific amount of gold. In 1834, Congress set the ratio between the two at 16-to-1, although the market value of gold was slightly lower than 16 times the market value of silver. The California gold rush of the 1840s reduced the relative price of gold further, which meant that the U.S. was effectively on the gold standard.
Although bank notes were convertible to specie (gold or silver coins) on demand, banks did not generally keep enough coins in their vaults to redeem all their notes at the same time. In 1832, for example, the Second Bank of the United States held only $7 million in specie, but $21.4 million of its notes were in circulation, while depositors had another $22.8 million in their accounts. Most other banks operated along similar lines. In effect, even though the currency of the U.S. was firmly based on gold and silver, the money supply depended on the amount of risk that private commercial banks wanted to take.
This meant, however, that banks were susceptible to financial panics, especially in the lightly regulated environment of early 19th-century America. When depositors or note holders worry about a bank’s ability to pay them in hard money, they race to the teller’s window to get their money out before anyone else, which can cause even a healthy bank to collapse. Bank failures were common in early America, with major panics in 1819, 1837, 1857, 1860 and 1861.
The U.S. went off the gold standard during the financial chaos of the Civil War, following the examples of the U.K., Germany, France and many other countries. But in 1879, the country returned to the gold peg. Because the value of most things rises and falls with demand and supply, the real value of the dollar fluctuated depending on economic growth (which increases demand for money) and discoveries of gold (which increase the supply of money). When the world economy grew faster than gold discoveries, gold became more valuable relative to other goods. Because the dollar was tied to gold, overall prices fell.
Falling prices in the late 19th century made it harder for people -- particularly farmers with mortgages -- to pay off their debts (since the amount of the debt was fixed in nominal terms). The gold standard and the lack of a central bank meant there was no way to increase the money supply to prevent deflation.
Proponents of “free silver,” led by William Jennings Bryan, argued that restoring silver to equal status with gold would expand the money supply, causing inflation and making debts easier to repay. But Bryan lost the crucial 1896 presidential election to William McKinley, who favored “sound money,” and in 1900 the Gold Standard Act reaffirmed the gold- only standard.
As international trade increased in the late 19th and early 20th centuries, the gold standard also became the backbone of the international monetary system. Since major countries fixed the value of their currencies relative to gold, their exchange rates were fixed relative to each other, as well. If a country’s imports exceeded its exports, its currency would accumulate in the hands of its trading partners, who could then redeem it for gold -- draining the importers’ national treasuries of gold. Losing gold would reduce the money supply, lowering domestic prices and wages; this would reduce imports and increase exports until the trade deficit was eliminated, stopping the gold outflow.
In October 1929, the U.S. stock market collapsed, quickly followed by markets around the world. A credit bubble that had grown in the 1920s imploded rapidly, leaving households and businesses scrambling to pay off their debts. Banks began to fail. The Federal Reserve, then less than two decades old, did relatively little to stop the bleeding. The gold standard limited its ability to expand the money supply and increase the flow of credit. But President Herbert Hoover had near-religious faith in the gold standard and saw no need to deviate from past practice.
Initially, as the American economy contracted, gold flowed from other countries to the U.S. To stop these outflows, central banks raised interest rates, effectively importing the economic slowdown to their own countries. Monetary tightening that began in Germany and the U.S. spread as countries engaged in competitive deflation, creating a vicious cycle.
Central banks raced to convert their holdings of foreign currency into gold, reducing the global money supply. High demand for gold increased its price relative to other goods. And since the price of gold (in dollars) was fixed, the price of everything else (in dollars) had to fall, making deflation even worse.
In 1931, unable to stop gold from draining out of its reserves, the U.K. abandoned the gold standard. In the U.S., by contrast, Hoover and Treasury Secretary Andrew Mellon clung to it. The Federal Reserve even raised interest rates in the midst of the Depression. Franklin D. Roosevelt avoided making a commitment one way or the other before taking office in 1933, but many investors expected the U.S. to devalue the dollar against gold. Since they expected dollars to fall in value, they exchanged them for gold and other currencies -- reducing American gold reserves.
When Roosevelt took office on March 4, 1933, the U.S. was in the grip of a financial panic. With banks facing huge demands for cash from depositors, most states had already declared bank holidays or severely restricted withdrawals, and the financial system was barely working. Roosevelt immediately declared a bank holiday beginning on March 6 and also ordered banks not to export gold.
He quickly pushed through the Emergency Banking Act, which allowed the Treasury Department to demand that all gold in private hands (coin, bullion or certificates) be exchanged for a non-gold form of currency -- a power he exercised on April 5, effectively suspending convertibility.
As devaluation fears grew, the value of the dollar began to fall relative to foreign currencies. So Roosevelt expanded the prohibition on gold exports. At the time, many contracts -- including those governing some Treasury bonds -- contained gold indexation clauses, which specified that the lender could demand repayment in gold as a form of protection against inflation. On June 5, Congress abrogated all such clauses, eliminating the ability of creditors to demand gold instead of dollars. This was arguably an act of default, since the U.S. broke an explicit promise to its creditors -- the only default since Alexandar Hamilton restructured the debt in 1790.
Surprisingly, going off gold and abrogating gold indexation clauses did not destroy the government’s credit. The market reaction was almost nonexistent. The convertibility of paper into metal had been suspended often enough under the gold standard that the abrogation of the gold indexation clauses was not in itself grounds for panic. Most importantly, going off the gold standard and devaluing the dollar almost certainly helped the American economy overcome deflationary pressures and begin to recover from the depths of the Great Depression.
The gold standard was blamed for exacerbating the worst economic crisis of the industrial age. In January 1934, Roosevelt officially reset the value of the dollar against gold at $35 per ounce -- a fall in the dollar’s value from $20.67 per ounce, where it had been since 1834. Some of Roosevelt’s advisers were worried about going off gold; budget director Lewis Douglas famously remarked, “This is the end of Western civilization.”
It wasn’t. Instead, the dollar would replace gold as the backbone of world trade. One of the most important events in modern economic history, the United Nations Monetary and Financial Conference, held in Bretton Woods, New Hampshire in July 1944, would see to that.
Rebuilding war-torn Europe and preventing another Great Depression were the primary goals of American delegates -- Henry Morgenthau, the Treasury secretary under Roosevelt, and Henry Dexter White, an academic who had joined the Treasury Department in 1934 -- along with almost everyone else at the conference. The central question they faced was what kind of money the world would use for international transactions.
Ultimately, the solution was to use dollars as a global reserve currency, since dollars could be created by the Federal Reserve in response to increasing demand. Countries could accumulate and hold dollars as the basis for their money supply rather than competing with each other for scarce gold reserves.
British economist John Maynard Keynes, however, had a competing vision. At the conference, he argued for, among other things, the creation of an international currency for central banks, known as “bancor,” which would be managed by a new international organization. Keynes wanted nothing to do with gold, which he famously called a “barbarous relic,” but he also didn’t want the dollar to be the world’s reserve currency, in part because he was wary of American monetary dominance.
Keynes and the British, however, had to give way to White and the Americans on most points. No international monetary system could succeed without the support of the U.S., which had the largest gold reserves and the dollars that other countries would need to import American goods. Other nations were reassured by the fact that the dollar would again be convertible into gold, which in principle gave them a way to switch out of dollars should the U.S. abuse its control over the reserve currency.
The dollar was built on gold but outgrew its early foundations. Its global dominance was made possible by fiscal prudence and monetary conservatism. How long would this combination last?
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