III.

The Monetary System of the United States

Like all modern industrialized societies, the monetary affairs of the United States are managed by a central bank. Central banks act as banker’s banks, have a monopoly on the issuance of paper money, and often act as the government’s bank. As late as 1890, there were only about 20 central banks in the world, but by 2000 there were more than 160. In the United States the dollar is the unit of currency, and the Federal Reserve System is the central banking system that manages the currency. As the currency for the largest economy in the world, the U.S. dollar is the dominant world currency and the currency most often used to conduct international transactions. In 1998 the U.S. dollar accounted for over 50 percent of all foreign currency deposits. Dollar deposits are a foreign currency when held by a bank outside the United States. In 1997, the ten largest banks in the world were headquartered outside the United States, but the U.S. dollar was the most important world currency.

A.

Early Monetary Regulations

In the American colonies, coins of almost every European country circulated, with the Spanish dollar predominating. Because of the scarcity of coins, the colonists also used various primitive mediums of exchange, such as bullets, tobacco, and animal skins. Many of the colonies issued paper money that circulated at varying rates of discount. The first unified currency consisted of the notes issued by the Continental Congress to finance the American Revolution. These notes were originally declared redeemable in gold or silver coins, but redemption was found impossible after the revolution because of the excess of printed notes over metal reserves. Thus, the notes depreciated and became nearly worthless.

In 1792 Congress passed the first coinage act, adopting a bimetallic standard under which both gold and silver coins were to be minted. The gold dollar contained 24.75 grains of pure gold and the silver dollar 15 times as much silver, making the legal mint ratio 15 to 1 (see Dollar). At this ratio gold was undervalued at the mint, as compared with its value as bullion, and very little gold was presented for coinage. Silver dollars also were largely withdrawn from circulation, because they could be exported to the West Indies and exchanged at face value for slightly heavier Spanish dollars, which were then melted down and taken to the mint for coinage into American dollars at a profit. Until 1834, when Congress adopted a mint ratio of 16 to 1 by reducing the weight of the gold dollar, the metallic currency was limited mainly to a meager supply of small silver and copper coins. The first Bank of the United States, which was chartered by Congress in 1791 for 20 years, and the second Bank of the United States, which existed from 1816 to 1836, issued bank notes that maintained a fairly stable value. Many state-chartered banks also issued notes that, because of the lax state banking laws, often greatly depreciated in value. After the closing of the second Bank of the United States, most of the paper currency consisted of notes of state-chartered banks and circulated only in a limited area.

After 1834, silver was undervalued at the mint; its market value was constantly higher than its coin value. As a result, gold gradually replaced silver in the monetary stock, especially after the discovery of gold in California in 1849. To relieve the famine in small coins, in 1853 Congress reduced the weight of the half-dollars, quarters, and dimes by 7 percent. Because the new subsidiary coins were worth more as money than as bullion, it was possible to keep them in circulation. As a result of a revision of the coinage laws in 1873 the silver dollar was omitted from the list of coins authorized for minting. Although the coinage of silver dollars was resumed in 1878, the metallic gold dollar remained the monetary standard of value in the United States; thus, bimetallism was legally discontinued and the gold standard adopted. Actually, silver dollars had been an insignificant part of the currency since early in the century.

During the Civil War (1861-1865) the governments in both the North and the South financed their needs through the issue of fiat money. The notes issued by the Confederate treasury and the Southern states became entirely worthless after the war. The U.S. notes (greenbacks) and other paper money issued by the federal government also depreciated rapidly, especially after the suspension of payment in specie (redemption of paper money with coins, usually of gold or silver) in 1861, and gold and silver coins were driven out of circulation. In 1863, the National Banking Act authorized the establishment of national banks that could issue bank notes backed by government bonds. A 10-percent tax levied on state bank notes in 1865 forced state banks to discontinue issuing them, thus giving the national banks a monopoly of bank-note issue. The state banks, however, remained an important element in the banking system.

After the elimination of the silver dollar in 1873, the greatly expanded production of silver in the West caused the value of silver to fall sharply and led to agitation by the silver interests for restoration of the free coinage of the silver dollar. In this effort they were joined by political groups who favored the free coinage of silver as a means of improving general economic conditions. This agitation led to the passage of the Bland-Allison Act in 1878 and the Sherman Silver Purchase Act of 1890, under which the Treasury was directed to purchase larger amounts of silver for coinage. The former law also created the silver certificate, which remained an important part of U.S. currency until it was retired in 1968. The Sherman Silver Act, which introduced into the stream of currency an enormous quantity of overvalued silver and caused a drastic decline in the gold reserve of the Treasury, helped bring on the panic of 1893 and was repealed by Congress in that year. Even so, silver was the main issue in the 1896 presidential campaign, when William Jennings Bryan called for free coinage of silver at a ratio of 16 to 1. The silver forces were defeated, and in 1900 the Gold Standard Act affirmed the gold dollar as the standard unit of value.

B.

Federal Reserve System

The next important change in the currency system was introduced by the Federal Reserve Act of 1913, which authorized the establishment of 12 regional Federal Reserve banks, with power to issue two types of currency (see Federal Reserve System). The first, and most important, was the Federal Reserve note, which is issued under conditions consistent with economic stability and the needs of trade and industry. As member banks require more currency, they can obtain it from the Federal Reserve banks by drawing on their deposits or borrowing or rediscounting commercial paper if their deposit balances with the Federal Reserve banks are insufficient. The second type of Federal Reserve currency, the Federal Reserve Bank note, was originally intended to replace the national bank notes, but never became a permanent part of the currency because the Federal Reserve notes proved adequate. The national bank notes were retired in 1935, but greenbacks are still part of U.S. paper currency.

C.

The Great Depression

The economic depression and the epidemic of bank failures in the early 1930s led to sweeping reforms in the nation’s monetary structure. Executive proclamations issued by President Franklin D. Roosevelt in March and April 1933 prohibited gold exports except under government license, and called in all gold and gold certificates from general circulation, thus ending the gold standard. Under the Gold Reserve Act of January 30, 1934, the country returned to a modified gold standard with a devalued dollar. The act gave the president authority to lower the weight of the gold dollar to between 50 and 60 percent of its former gold content. The following day the president issued a proclamation reducing the gold content of the dollar to 59 percent of that established by the Gold Standard Act of 1900, or from 23.22 to 13.71 grains of fine gold.

The years 1933 and 1934 were also marked by important legislation regarding silver. Under the Thomas Amendment to the Emergency Farm Relief Act of May 12, 1933 (commonly known as the Inflation Act), the president was given the power to restore unlimited coinage of silver under a bimetallic system. The Silver Purchase Act, which was signed by the president on June 19, 1934, authorized the nationalization of silver and declared it to be the policy of the United States to have the silver holdings of the U.S. Treasury ultimately make up a maximum of one quarter of the value of the nation’s combined monetary gold and silver stocks. On August 9, 1934, the president issued an executive order requiring that all silver in the United States, with the exception of certain categories such as silver coins, fabricated silver, and silver owned by foreign governments, be delivered to the mints to be coined or held as bullion for later coinage. Under the Silver Purchase Act and subsequent legislation the Treasury purchased large quantities of silver abroad and from domestic producers, which tended to raise the price of the metal and curtail the monetary use of silver abroad, especially in China and India.

D.

Post World War II

Near the end of World War II (1939-1945) most of the Allied nations joined together in a conference held at Bretton Woods, New Hampshire, to set up a new international monetary system, replacing the international gold standard that had collapsed during the Great Depression. The conference also provided for the establishment of the International Monetary Fund (IMF). The U.S. dollar played a key role in the new system, becoming, in effect, the world’s currency. This was true, first, because all IMF members defined the value of their own currencies in terms of the dollar and, second, because the United States agreed to convert all dollars held by foreign governments into gold on demand and at the exchange rate agreed on when the IMF was established. Officially, this meant that the world was on a “gold exchange standard” since governments could change their currencies into gold via the U.S. dollar.

So long as the United States had most of the world’s gold supply, as was true after World War II, this system worked fairly well. When the quantity of dollars held by foreign governments began to exceed U.S. gold holdings by large amounts, however, the system started to falter. By the early 1970s foreign government holdings of U.S. dollars were over five times greater than the U.S. gold stock. In August 1971 President Richard M. Nixon suspended gold payments of U.S. dollars. This closing of the “gold window” effectively ended all ties between the U.S. dollar and either gold or silver. Since then the United States has had a fully managed currency system, one with no metallic base whatsoever. United States citizens are free to own, buy, and sell gold, but its price is determined in the same way as any other freely traded commodity—on the basis of supply and demand. Gold no longer serves as a medium of exchange. Federal Reserve notes are overwhelmingly the dominant form of currency in circulation today.