It is both an oversimplification and an understatement to say that the problem with paper currency is that the government can print too much of it, and it loses its purchasing power. Inflation, so called, becomes just a statistic.
As an argument in favor of changing policy, statistics are hardly compelling. A few years ago, I witnessed a debate between liberal Paul Krugman and conservative Stephen Moore. Krugman spoke in moral terms such as “justice” (leaving aside that his demands were for injustice), while Moore cited statistics such as unemployment, and compared Republican and Democratic states. At the end, the audience was asked to say who had been more persuasive. Krugman was the winner by a wide margin. I should mention this debate took place at FreedomFest, with a libertarian audience.
It is in moral terms that we should look at what they have done to our currency.
Let’s begin at the beginning. People used gold and silver coins as currency. They adopted paper currency to have smaller, convenient denominations. But always keep in mind that convenience is a secondary consideration if you don’t trust the currency’s issuer.
A paper note was issued when money—i.e. a gold or silver coin—was deposited. A legitimate note is a promise to pay back the metal that was deposited. The bank note has a lifecycle. It is created by the deposit of metal coin, and it is destroyed when the coin is repaid. There could be a day, a week, or decades in between its birth and death. The note could sit in someone’s desk drawer, or change hands a thousand times. But in the end, the honest note must be redeemable for the same amount of metal as originally deposited.
Shortly after the American Constitution was ratified, the first Coinage Act fixed the size of a deposit of a dollar. This was not a price of gold or silver. It was a standardized unit, like defining the length of a meter or the amount of mass in a kilogram. This is a relatively benign government policy, but for two problems.
One, it fixed the value of silver to the value of gold. It set a ratio of 15 units of silver to 1 unit of gold. However in world markets, the ratio was closer to 15.5 to 1. Fixing silver to gold at a lower ratio means it took less silver to get a unit of gold. The law thereby overvalued silver as American money and bank deposits. This gave free purchasing power to holders of silver. And it should be obvious that if Paul gets something for nothing, then Peter must get nothing for something.
Gresham’s Law tells us that if the exchange rate between two different monies is fixed by law, then the undervalued metal will not circulate. And although America was officially on a bimetallic system, it was almost a de facto silver standard (a later Coinage Act changed the ratio to 16:1).
Two, it is a terrible power for the government to have, as we shall soon see.
But first, let’s look at how a sound currency-issuing bank operated in those days. It issued notes to raise capital to invest in high-quality, short-term assets that earned a yield (i.e. Bills of Exchange). Since the bank paid no interest on currency, the interest it earned was pure profit (other than administrative costs).
Unfortunately, banking and currency never enjoyed a free market in America. From the beginning, a bank needed to obtain permission from the government to operate, and to issue banknotes. State governments used this power to force banks to invest in their sometimes-dodgy bonds. Unsurprisingly, when these states defaulted on their bonds, banks that were overexposed to them were ruined, and their notes became worthless.
The federal government also played this game. To get a federal charter to issue currency, a bank had to back it with a certain proportion of Treasury bonds. The federal government did not default, but when it was paying down its debts after the Civil War, that forced a reduction in currency in circulation. To this day, monetary policy is inextricably linked to fiscal policy. However, the need for currency has nothing to do with the size of the government’s debt. People got squeezed, as a result of this policy.
Also in this period, the Coinage Act of 1873 effectively demonetized silver. Gold was largely held by the wealthy in the banks. Silver was held by farmers and craftsmen, and mostly at home. This Act was a transfer of wealth from the farmers to the rich and the crony banks. Paul the wealthy gold owner got something for nothing, and Peter the farmer got nothing for something.
After 1873, farmers were forced to pay their debts in gold while their holdings of silver lost a lot of value. This squeeze caused great hardship. Paul the bank owner got farmland, and Peter lost his family farm.
The “Crime of ’73” was still in people’s minds in the election of 1896. William Jennings Bryan ran against William McKinley. Bryan wanted a return to the bimetallic system. McKinley was for the gold standard. McKinley won.
Bryan did not go away quietly into this goodnight. He surfaced again in the administration of President Woodrow Wilson. He was instrumental in the passage of the Federal Reserve Act in 1913. The farmers and small savers had their revenge. If they could not lighten their debt burden by resumption of silver coinage, then they thought they could do it by granting the government a monopoly on the issuance of currency.
The Fed did not immediately embark on a program of money printing and debasement. Their dollar was still gold-redeemable, just as before. However, the Fed began to buy Treasury bonds with a different focus than the banks had done previously.
Most people are aware of the effects of inflation. The Fed certainly ginned up plenty of it. And it also did something subtler but much worse. In Part II, we will discuss this pernicious act.
Image source: AP Photo