In this post, we provide a brief overview of the history of the U.S. monetary system and track its evolution towards our current monetary system.
Money in the Colonies
In colonial times, currency was in short supply. Since Britain did not allow the colonies to mint their own currencies, the colonists circulated a variety of foreign currencies accumulated in the course of trade. The most prevalent of these currencies was the Spanish peso, which the colonists called the Spanish dollar. Read More: Defining Money
In 1792, Congress passed the Coinage Act. This act established the monetary system for the new government. Importantly, the act established the U.S. Mint, adopted the dollar as the nation’s standard monetary unit, and adopted the decimal system as the means of monetary quotation. The act also put the country on a bimetallic standard in that it specified the use of both gold and silver at a ratio of fifteen ounces of silver to one ounce of gold. The act specified that gold would be used for larger denomination coins, and silver would be used for smaller denomination coins.
The mint ratio of fifteen-to-one approximated the world market rate for the two metals in 1792. However, market prices soon changed such that the mint ratio undervalued gold and overvalued silver. Thus, citizens hoarded or exported gold, making silver the predominant circulating medium. This phenomenon in which “bad money drives out good” is known as Gresham’s law.
The First and Second Bank of the United States
Alexander Hamilton became the nation’s first Treasury Secretary. Hamilton had studied European banking and believed that a national bank would help the fledgling country access much needed capital. In 1790, Hamilton submitted a report to Congress outlining a structure for a federally chartered bank.
Although Hamilton’s proposal had its supporters, it met fierce opposition. Among the more vocal opponents were Thomas Jefferson and James Madison, both of who believed that Congress did not have the constitutional authority to charter a bank.
Hamilton’s proposal passed both the House and the Senate in early 1791. However, Washington was undecided as to whether to sign or veto the bill. Attorney General Edmund Randolph and Secretary of State Thomas Jefferson recommended that Washington veto the bill. Washington allowed Hamilton one week to respond to Randolph’s and Jefferson’s criticisms, which he did in a fifteen-thousand-word paper delivered to Washington. Hamilton won over Washington, who signed the bill in February 1791 creating the Bank of the United States.
Congress gave the bank a 20-year charter. The bank opened for business in Philadelphia in December 1791. By 1792, the bank had opened additional branches in Boston, New York, Charleston, and Baltimore.
Congress capitalized the bank at $10 million, $2 million of which came from the government and $8 million from private investors.
The bank served several functions. The bank served as fiscal agent for the U.S. government, acting as a repository for tax receipts and government debt. The bank also issued notes (paper currency backed by specie) and served as a commercial bank, making loans to individuals and businesses. The bank’s lending operations spread its notes into general circulation. And although the bank was not a central bank in the modern sense, the bank was large enough that its lending policies could alter the supply of credit in the economy.
In 1811, Congress voted to allow the bank’s charter to expire, and shortly thereafter the bank suspended operations. The next year, 1812, the U.S. engaged in a costly war with Great Britain. Absent a national bank, the government relied on state banks and direct note issuance to finance the war. The economic impact of the war turned opinion towards the need for another national bank. In April 1816, President James Madison, an opponent of the First Bank, signed into law an act which created the Second Bank of the United States.
The Second Bank opened for business in Philadelphia in January 1817. The bank’s functions and basic structure were modeled after the first bank, including the allotment of ownership between the government and private investors.
The bank’s first two presidents mismanaged the bank, and opinion towards the bank suffered. In 1823, the bank elected Nicolas Biddle as its third president. Biddle was a highly intelligent (and often arrogant) member of a prominent Philadelphia family. Biddle, however, proved to be an effective banker and administrator and shaped the bank into a highly effective institution.
Andrew Jackson became President in 1828. Jackson was strongly opposed to a federal bank and made it his personal crusade to end it. In 1832, despite being four years before the end of the bank’s charter, Congress voted on a renewal bill for the bank. The bill passed both the house and the senate, but not by enough votes to override Jackson’s veto.
Jackson wanted to diminish the power of the bank and did so by pulling federal deposits. The bank operated at a reduced size and scope until the expiration of its charter in 1836.
State and National Banking
After the fall of the Second Bank, the country reverted to a system of state-chartered banks. These banks issued their own notes, and it was several decades before the nation would introduce a uniform currency. In the preceding decades, however, thousands of paper notes circulated. While these notes were (per state law) backed by specie, many notes were fraudulently issued by so called “wildcat” banks.
Conflict between the northern and southern states broke into armed conflict in April 1861. As the fighting intensified, the union government was forced into measures to finance the war. In 1862, congress passed the Legal Tender Act. This act authorized the Treasury to issue paper currency (unbacked by specie), colloquially called “greenbacks”. These treasury notes were considered legal tender and were, thus, accepted for tax payments and for payments on debts public and private.
In 1863, Congress passed the National Bank Act. The act created a federal charter for banks and authorized those banks to issue a uniform paper currency (national bank notes). To discourage note issuance by state banks, the act imposed a 2% tax on state note issuance. Perhaps most importantly, the act enhanced demand for government bonds by requiring national banks to hold a portion of their capital in treasury bonds. In 1864, Congress passed an amended National Bank Act. This legislation created the Office of the Comptroller of the Currency to serve as the main national banking regulator. In 1865, the tax on state note issuance was increased to 10%, essentially eliminating currency issued from state banks.
The bank acts created a tiered system of reserves. Reserves of smaller “country banks” were kept with larger regional banks which, in turn, kept reserves with banks in central reserve cities (New York, Chicago, and St. Louis).
After the Civil War, the country returned to a de facto gold standard. During this time, politicians vigorously debated the nature of the monetary system. Some politicians, such as William Jennings Bryan, argued for the free coinage of silver alongside gold (bimetallism), while others argued in favor of a pure gold standard. The main issue was whether the supply of money should be enhanced by adding silver to the monetary stock. By the turn of the century, however, gold discoveries and new processing techniques had added substantially to the country’s money supply, effectively ending the debate over bimetallism.
In 1900, Congress passed the Gold Standard Act, which put the country on a legal gold standard. This act defined the gold content of the dollar as 25.8 grains of 9/10ths fine, which equated to a dollar price of $20.67 per troy ounce. The gold standard remained an integral part of the U.S. monetary system until 1933.
The Founding and Early Years of the Federal Reserve
By the beginning of the twentieth century, the United States had gone decades without a national bank. During this time, national banks in Europe had evolved into central banks which provided liquidity to their respective financial systems during times of crisis. In America, however, citizens and politicians alike largely distrusted bankers and were (for the most part) not interested in creating a European-style central bank.
In 1907, a run which started among several New York trust companies spread throughout the New York banks and subsequently throughout the nation’s financial system. The panic was eventually contained when JP Morgan created a consortium to interject funds in the banking system. The economic fallout, however, was severe.
One consequence of the crisis was to renew the political discussion of establishing a central bank. In 1908, Congress passed the Aldrich-Vreeland Act, which, among other items, called for the creation of a commission to investigate changes to the nation’s monetary system.
The National Monetary Commission was led by Senator Nelson Aldrich (Republican from Rhode Island) and consisted of 18 members. Among the members was Paul Warburg, a member of the famous German banking family who had extensive knowledge of the European banking system.
The commission’s key proposal was the creation of a National Reserve Association. By the time the plan came up for consideration by Congress, the Democrats had won the Presidency, the House, and the Senate, and a bill associated with a prominent Republican had little chance of passing.
The Democrats proposed their own version of the bill, sponsored by Rep. Carter Glass. The Glass bill called for dispersed regional banks. To supervise the regional banks, the bill called for a Federal Board made up of Presidential appointees. In December 1913, President Woodrow Wilson signed into law The Federal Reserve Act.
The Federal Reserve became operational the next year. Twelve cities were chosen with reserve banks established in those cities. The regional federal reserve banks would help to mobilize reserves throughout the country, as one of the weaknesses of the national bank system was for reserves to accumulate in the three money centers, unavailable for use in other parts of the country.
The First World War broke out in August of 1914. Although the U.S. did not enter the fighting until 1917, the country provided material and exported goods to the belligerent countries. The U.S. accumulated a massive trade surplus which resulted in large quantities of gold flowing into the country’s monetary system. The U.S. was the only country which maintained the gold standard throughout the war. By the war’s end, the balance of international financial power had shifted from Britain to the United States.
The flow of gold into the U.S. led to growth in the money supply and inflation. After the war, the Fed committed to bringing down prices. The Fed tightened money and engineered a significant economic slowdown in the process. The recession was sharp but short-lived, and growth resumed by the early 1920s.
In the early years of its operations, the Federal Reserve’s key policy tool was the discount rate. The discount rate worked as follows. Member banks would approach their respective Federal Reserve bank and borrow against “eligible paper” – mostly bills of exchange and other trade instruments. The rate the Fed banks would charge on these loans was known as the discount rate. The borrowing would free up bank reserves which the banks could use to make more loans. Because no bank would lend to private borrowers at a rate below the rate charged by the Fed, the discount rate acted as a floor for short-term interest rates. When the Fed wanted to increase short-term rates, it raised the discount rate. When it wanted to lower short-term rates, it lowered the discount rate.
The Fed at this time also engaged in open market operations, albeit on a relatively small scale. Open market operations involve the buying and selling of securities from banks. Such actions influenced the amount of liquidity in the financial system and directly moved short-term interest rates. However, this policy tool was not the primary tool that it would become in later years.
The institutions and international cooperation required to support the gold standard had dissolved after the war. Countries which were previously on the gold standard attempted to reconstruct the system which was in place before the war. For many countries, however, gold stocks were insufficient to support their money supplies. Countries thus supplemented their gold stocks with foreign exchange reserves. This “gold-exchange standard” persisted throughout the late 1920s.
Great Britain was particularly committed to the restoration of the gold standard. Benjamin Strong, the head of the New York Federal Reserve Bank assisted Britain by keeping the discount rate low, thus encouraging gold to flow to Britain. However, these low rates helped fuel excess in the stock market.
By the late 1920s, the Federal Reserve was becoming increasingly concerned about stock market speculation. The New York Fed aggressively raised its discount rate in an effort to decrease excesses in the stock market.
The Federal Reserve and the Great Depression
In the world of the 1920s, where central banks were more concerned about the value of their currencies than they were about domestic economic stability, the tightening in the U.S. led other countries to respond in kind.
Germany was particularly vulnerable to higher rates in the U.S. Germany’s economy had been ravage by punitive war reparations and post-war domestic political turmoil, culminating in hyperinflation by the early 1920s. By the late 1920s, German had stabilized its currency. The German banking system, however, relied to an excessive degree on foreign deposits. As rates in the U.S. and elsewhere rose, money flowed out of Germany and the country’s deposit base collapsed.
U.S. stock prices collapsed in the fall of 1929. Much of the bull market of the late 1920s was due to margin loans arranged by brokerage houses. The brokerage houses would borrow from banks and in turn lend money to brokerage customers to purchase stocks. These loans were referred to as “call money” loans – so named because the loans were “callable” (due on demand) by the lender. As stock prices collapsed, many lenders became insolvent.
In the days before deposit insurance, bank runs were common (such as the one depicted It’s a Wonderful Life). As rumors of bank insolvency spread, depositors increasingly pulled their money out of the banking system. The ensuing collapse of bank reserves forced more liquidations, forcing asset prices down even further. The country faced several waves of bank failures throughout the early 1930s, culminating in a week-long bank holiday in March 1933.
Most economists agree that at least the severity of the depression was due to the lack of intervention by the Federal Reserve, which, for various reasons, failed to provide adequate liquidity to the banking system. In 1933 and 1934, the Roosevelt administration implemented numerous policies, particularly involving gold, which would put domestic monetary policy in the hands of the Treasury. By this time most countries previously on the gold-exchange standard had suspended convertibility and allowed their currencies to depreciate. These actions at least provided a bottom to the financial contagion.
In 1935, Congress passed legislation which would restructure the Federal Reserve. Authority for the system was now centered in Washington, in the hands of a seven member Federal Reserve Board. The legislation also changed the structure for open-market operations. Monetary policy would now be decided by a committee consisting of the seven members of the board, the president of the Federal Reserve Bank of New York, and four of the other regional bank presidents who would serve on a rotating basis. This arrangement took policymaking out of the hands of the Federal Reserve banks.
As a second war broke out in Europe, gold flowed to the U.S., which helped inflate the money supply and stimulate a recovery. The United States formally entered the fighting shortly after the bombing of Pearl Harbor on December 7, 1941. Throughout the war, the Federal Reserve mostly aided the Treasury in keeping borrowing costs low.
In July 1944, representatives from forty-four countries gathered at the Mount Washington Hotel in Bretton Woods, New Hampshire with the goal of constructing a new international monetary system. The plan, often referred to as the Bretton Woods plan, required participating countries to peg their currencies to the U.S. dollar which would, in turn, be pegged to the U.S. gold stock at a price of $35 per ounce. Under this system, foreign governments and central banks could convert their dollar holdings to gold. Thus, gold remained at least a nominal anchor to the global money supply.
The Federal Reserve in the Post War Period
It was not until 1951 that the Federal Reserve asserted its independence from the U.S. Treasury. Under the leadership of Chair William McChesney Martin, The Fed pursued monetary policy such that inflation was kept relatively low throughout the 1950s and 1960s. By the late 1960s, however, expansive fiscal spending and inconsistent monetary policy led to a surge of inflation.
McChesney Martin was succeeded by Aurthur Burns and then, briefly, by G. William Miller. Under these two Chairs, inflation increased significantly.
By the late 1960s, inflation had eroded the confidence in the dollar and foreign holders were increasingly converting dollar holdings. In 1971, the decline in the gold stock had forced President Richard Nixon to end gold convertibility, effectively ending the Bretton Woods system and removing the gold anchor from the monetary system.
In 1979, G. William Miller stepped down as Fed Chair to become Treasury Secretary. To fill the vacant Fed Chair, President Carter appointed Paul Volker, then head of the NY Fed. In October 1979, Volker announced that the Fed would directly target the money supply rather than trying to tame inflation through interest-rate targeting. With this change in operating procedure, interest rates rose dramatically, and the country was placed into a deep recession. However, by the summer of 1982, inflation declined enough to allow the Fed to loosen monetary conditions. Economic growth resumed shortly after.
Volker stepped down in 1987 and was replaced by Alan Greenspan. Under Greenspan’s long tenure, inflation remained modest. However, unforeseen risks were building in the financial system. When Greenspan stepped down as Fed Chair in 2006, home prices had been increasing at an aggressive rate and many economists and market commentators were concerned about a housing bubble and broader credit bubble.
By mid-2007, housing prices began to fall across the country. The fall in housing prices transmitted throughout the financial system, leading to near collapse of the global credit system in the fall of 2008. This financial crisis was the worst since the banking crisis of the early 1930s.
Under Greenspan’s successor, Ben Bernanke, the Federal Reserve engaged in aggressive interventions into the financial system, particularly engaging in large-scale asset purchases (“quantitative easing”) and keeping short-term at or near historic lows for an extended period.
Eventually, asset prices recovered, and the economy underwent a long expansion. The financial system seemed on strong footing when the world was hit by a global pandemic. In the low-interest rate environment that emerged after the financial crisis, American corporations took on a significant amount of debt. The prospect that the virus would lead to waves of corporate bankruptcies sent interest rates soaring. In the Spring of 2020, credit markets began to shut down. The Federal Reserve intervened through various programs, flooding the system with liquidity. Asset markets recovered quickly, but the monetary interventions proved inflationary.
Conclusion
In this brief sketch of the history of the U.S. monetary system, we see the monetary system evolve roughly in several phases. Initially, money in circulation consisted mostly of metallic coins obtained from other countries through trade. As the country’s financial system became more established, banknotes issued by individual banks and backed by gold and silver became the primary medium. During the Civil War, the Union government adopted a national bank system which provided a standardized national paper currency. During the war years, these notes were unbacked by gold or silver. Convertibility was restored after the war, however, and gold became the anchor to the monetary system. In 1913, the U.S. established the Federal Reserve System to replace the previous national banking system. In the first two decades of operation, the Federal Reserve anchored the money supply to gold supplies held in the vaults of the twelve Federal Reserve banks and to the supply of commercial paper which member banks borrowed against. In 1933 and 1934, the Roosevelt administration ended gold convertibility, made the hoarding of domestic gold illegal, and devalued the gold content of the dollar. These actions effectively ended the gold standard in the United States.
The evolution of the U.S. monetary system culminated in the establishment of a monetary standard. Under a monetary standard, the monetary base is not gold or silver but rather bank reserves held at the Federal Reserve. Thus, the central bank has control over the monetary base and, by extension, the money supply. For better or worse, all modern economies are on a monetary standard.
In the next two essays, we will examine how banks create money and the role of modern central banks.
Sources
Federal Reserve Bank of Philadelphia. The First Bank of The United States: A Chapter in the History of Central Banking. Federal Reserve Bank of Philadelphia, June 2009.
Federal Reserve Bank of Philadelphia. The Second Bank of The United States: A Chapter in the History of Central Banking. Federal Reserve Bank of Philadelphia, December 2010.
Timberlake, Richard H. Monetary Policy in the United States: An Intellectual and Institutional History. Chicago: University of Chicago Press, 1993.
