In America, paper money is a necessary part of day-to-day life. Without these “dollars,” we cannot purchase goods or services, pay our taxes, or settle other debts. However, have you taken the time to think about how it came to be this way? For example, why can’t you go into a store and pay for your groceries with gold or silver? One of the best resources for understanding a brief history of the USD is a book from 1964 titled A Primer on Money: What is Money, How Is It Created, and the Role of the Federal Reserve by Wright Patton. Patton wrote this book from the notes he took from his time on the Subcommittee on Domestic Finance of the Committee of Banking and Currency.
Although some aspects of things discussed in the book have changed in the more than 50 years since it was published, the book provides an in-depth discussion of the origins of the U.S. dollar. As well as talks about the role and purpose of the Federal Reserve System in the U.S. economy.
Anyone interested in learning how we arrived at where we are now regarding money and the workings of our monetary/banking system would benefit greatly from reading the entire book.
The Start of Currency In the United States
During colonial America (about the year 1630), people started using “wampum” as payment for exchanging goods. Wampum were clam shells that were strung together and were considered very valuable beads. By 1637, wampum had become the official legal tender of Massachusetts, and even developed foreign exchange rates. Different colored shells were worth different amounts depending on their rarity. These set exchange rates remained relatively stable for about the next decade as people continued to use wampum to exchange goods and services.
“The Continental” and the First Case of Hyperinflation
As wampum phased out, the first form of paper money originated in the late 1700s to finance the Revolutionary War. This money, called the “Continental,” was the first federally-issued paper money, and the expectation of specific amounts of tax revenue served as its backing.
Unfortunately, it quickly became worthless because it was very easy to counterfeit, and the British took advantage of that during the war. With nothing valuable to back it up, these notes were essentially worthless by the end of the war and represented the first case of hyperinflation in the U.S.
The Rise of “State Run” Banks
Around this time, states began each having their own currencies. Although the states themselves couldn’t technically issue their own money, any private company could print and issue currencies and notes. The value of the money essentially depended on the bank’s reputation, and many private banks issued funds with little or no value.
This system proved troublesome in several ways, especially with America’s shift to a more nationwide trade system. With no consistent and reliable form of money throughout the U.S., commerce became increasingly challenging, and certain transactions were discouraged.
Soon, the demand for money increased and exceeded the availability of gold and silver and the capacity that the private banking systems could handle.
The National Bank Act of 1863
In 1863, the U.S. Congress passed the National Banking Act. This act sought to create a nationwide banking system and a national currency that would work better with trade across the country. It also required all established national banks to purchase government bonds as a condition to receive a charter.
The banks would deposit these bonds with the federal government. Once this process occurred, the bank could issue its own notes. However, the notes could only be 90 percent of the market value of the deposited bonds.
As a result of this act, 934 charter conversions occurred[1] (banks converting themselves into national banks). The other state banks went out of business or stopped issuing new notes (because the government would heavily tax any notes they would issue).
For more on the National Banking Act of 1863 click HERE.
The Start of the Federal Reserve
The banking system underwent no other significant changes again until the Federal Reserve Act in 1913. The passing of this act created a permanent, national central bank– the Federal Reserve System that we know today.
One of the central requirements of the Federal Reserve Act was that the system provides a currency that could grow or shrink as required for the economy. All member banks had to keep a specific portion of their assets deposited in the Reserve Banks as “federal funds.” The Federal Reserve System also issued “notes” to give members instant access to liquidity. Initially, the deposits and the notes of the Federal Reserve were all backed by gold, which gave people confidence.
The Change From a “Gold Standard” to a “Gold Exchange Standard”
However, the “Gold Standard” that ensured that all citizens could exchange paper bank notes for gold started to falter soon after the government established the Federal Reserve System, marking the beginning of the end of this safety net.
During this time, talk of WWI led to significant amounts of debt. As corporations and citizens made a run on gold and quickly liquidated their bank notes, it led to chaos and the emergency suspension of the gold standard in 1914, including a temporary shut down of the New York Stock Exchange.
At this time, President Roosevelt decided to suspend the gold standard and introduced the Gold Reserve Act, which repriced gold in terms of U.S. dollars and made gold ownership in the form of coins and gold bars illegal for Americans at this time. Americans could only own certain amounts of gold jewelry. Any citizen caught with gold would have to pay a fine twice the amount of the gold they had not exchanged for paper money with the Federal Reserve.
More specific details on the Gold Reserve Act as well as the transfer from the gold standard to the gold exchange standard can be found HERE.
The act worked for a while and made the dollar more attractive to foreign buyers.
However, in 1971, Richard Nixon took the dollar off the gold standard and canceled its convertibility directly to gold. Called closing the gold window. This act proved bad for foreign countries because they could no longer settle with gold in the United States.
In 1974, President Ford finally made it legal for Americans to have gold again and to include gold in contracts. However, he did not re-establish having the American dollar backed up by gold. To this day, the U.S. dollar is not officially backed by gold or silver.
Where Are We Now in the U.S.?
Our money today operates on a “fiat” system, meaning its value is not based on anything physical (like gold or silver) but the credit of the country in general. This metric is subjective but tends to be seen as the country’s productivity mixed with the world’s confidence in that country’s economy.
So, where banknotes were once backed by and exchangeable for gold, they currently are only backed by a perception of confidence.
This risk of failing confidence is where hyperinflation comes into play. Just like with the “Continental,” the more created or printed, the more the value decreased. Textbook debasing of a currency.
Since the U.S. does not back the dollar with anything physical, the government can print money for its spending at will. As this excess printing occurs, it drives the costs of goods up. When the price of goods rises, it causes consumers to start hoarding and creates shortages, leading to even more price increases.
Next, people start losing their savings, loans lose value, and consumers stop making cash deposits into banks. These things send the currency’s value plummeting in foreign exchange markets.
Final Thoughts
With the USD being the world’s reserve currency at the moment, and with the current economic situation of the globe, it’s important to understand where the dollar has been throughout history. Current debates on its future have been fascinating to listen to, however, one thing to keep in mind is that all these arguments, whether for it to collapse to strength, are relatively short-term. In the long run, every fiat currency throughout history has gone to zero, and it was the debasing of the currency to begin with, that typically starts the fall of the empire.
[1] M. Jaremski, “State Banks and the National Banking Acts: Measuring the Response to Increased Financial Regulation, 1860-1870”. Journal of Money, Credit and Banking, March-April 2013, Vol. 45, No. 2/3 (March-April 2013), pp/ 379-399. https://www.jstor.org/stable/23463525?seq=1
