Review: One Nation Under Gold, part 2

My previous post covered some economic fundamentals I thought were helpful in understanding James Ledbetter's book One Nation Under Gold. This post is kind of a chapter-by-chapter book report. (I learn things better when I do this.) So I'll review how the dollar-gold relationship fits into that framework, and how that relationship has impacted the economy.

1. El Dorado Comes True. To finance the Revolutionary War, governments printed paper currency, but this led to inflation. While this led to huge losses to creditors (like George Washington), it helped lead to secure adoption of the Constitution as a way to control the money supply.
   
   The key issue was this: when you peg to gold, and gold is limited, gold becomes more valuable as economic growth outstrips to money supply. This puts an artificial constraint on the economy, as economic activity cannot take place if no one wants to part with their money. As a result, other currencies spring up.
   
   In its early years, the United States experienced just such a problem. While gold was universally accepted, there just wasn't enough of it to go around. Other forms of currency (such as silver coins, foreign currencies, paper bills, or even reusable train tickets) became commonplace, though this opens the door to loss through fraud or bank failure. As a result, paying with paper money meant you had to pay a premium; paying with gold would get you a discount.
   
   To improve the dollar's image, Jacksonian Democrats pushed gold as the only official national currency, and it became a proxy in the fight to limit the size of the national government. Their requirement that sales of western public land be in gold contributed to the Panic of 1837.
   
   The 1848 Gold Rush was a game-changer. Unskilled laborers from all over the country -- and the world -- converged on California, brought with them hopes for quick wealth. As H.W. Brands put it, "El Dorado, not some Puritan city on a hill, was he proper abode of the American people." If there was ever a clear starting point for the "prosperity gospel" that continues today, this was it, as it seemed God was blessing common people through gold.
   
   Yet the introduction of so much gold into the economy had repercussions. While it was a boon for the economy, it led to easy credit and overcapacity. The Crimean War required England and France to raise interest rates (in order to lure more gold into their treasuries), and the U.S. economy began to falter. Falling grain prices, the Dred Scott decision, and the failure of Ohio's largest bank from embezzlement helped cause the Panic of 1857.
   
   With the onset of the Civil War, demand for gold skyrocketed, to the point that there simply wasn't enough gold circulating in the country to finance the war effort. To meet the demand for money, the federal government broke the dollar's link to gold and resorted to issuing paper currency.
   
   
2. A Crash, a Clash, and a "Crime". During the Civil War, scarcity and inflation caused prices to more than double, and the national debt (financed by paper "greenbacks") rose from $65 million to $2.7 billion.
   
   To restore both the "national honor" and the strength of the dollar (again, that idea of having to pay a premium when you pay with paper), the Grant administration made it a priority to withdraw greenbacks from circulation and replace them with gold-backed currency. So, as taxes were paid with paper dollars, the treasury reduced the money supply by literally burning up the paper.
   
   This lifted the value of the dollar from its wartime low of $2.85 in greenbacks per gold dollar, but this deliberate form of deflation was unpopular with debtors like farmers and business people, who saw the real cost of their debts rise.
   
   It also opened the door to Jim Fisk and Jay Gould, gold speculators who tried to corner the gold market. While they were unsuccessful, their failed "Black Friday" attempt in 1869 caused widespread economic turmoil. When the price of gold was high, merchants were locked out of international transactions. Then, as government intervention caused prices to fall, so many brokers saw their positions collapse that few could afford to fund the financial engine at the center of the economy. Everyone suffered.
   
   The Black Friday crash provided different parties, depending on their interests. Republican politicians and Wall Street became convinced that only gold-backed currency could provide monetary security, while the South and West came to distrust the East Coast elites whose decisions affected the rest of the country.
   
   Yet the incident's most enduring lessons remain: 1.) any country with multiple forms of currency (gold, silver, paper, etc) will face problems with exchange rate among them, and folks will hoard one while only spending another [Gresham's Law], 2.) an unregulated financial market will quickly lead to excess and corruption [as true in 2007 as it was in 1869], and 3.) the only alternative to the financial craziness -- government control/intervention -- is the exact opposite of what the gold standard is supposed to be about.
   
   The "Clash" concerned the status of silver in the late 1800s. Under the 1834 Coinage Act, the silver-to-gold exchange rate was set at 16:1, below the market price for silver. So while silver could technically still be mined and minted into coins, people were better off melting the coins and selling the silver. Basically, no one used silver coins.
   
   However, the Comstock Lode was about to depress the market price of silver. The South and West favored this increase in the money supply, while the Northeast still pushed to establish gold as the only backing for the dollar.
   
   The "Crime," then, refers to the Coinage Act of 1873, which Congress "unwittingly" passed with overwhelming support. Without understanding the consequences, the government fully de-monetized silver. Western states, with all their new silver mines, couldn't mint their silver bullion into coins, and most common folks didn't have access to gold. This inadvertently constrained economic development in the South and West. While the Bland-Allison Act of 1878 and the Sherman Silver Purchase Act of 1890 helped a little, these compromises were only limited efforts toward bimetallism.
   
   Even in the East, gold grew scarce after 1890, as it was either hoarded or shipped overseas. In the 1930s, John Maynard Keynes' solution would have been to increase government spending, but the U.S. couldn't do that while still pursuing a gold-backed currency. With the government thus self-constrained, the Panic of 1893 became the worst and longest economic depression the U.S. had seen thus far.
   
   When, in 1895, the U.S. government had nearly run out of gold reserves, it turned to Wall Street to be bailed out. As expected, the terms were quite favorable to the nation's richest bankers, and public confidence in the financial system sank. Nevertheless, without a central banking system or International Monetary Fund to help, this was -- at the time -- the only option.
   
   
3. The Dangers of the Yellow Brick Road. Despite William Jennings Bryan's "Cross of Gold" speech, McKinley won the 1896 election. Between "hard money" enthusiasts in office and the Yukon Gold Rush increasing the money supply, the U.S. was finally ready to change the de facto gold standard in place since 1873 to a fully de jure dollar-gold convertibility through the Gold Standard Act of 1900.
   
   While it worked great for international trade and price stability, there was too little money to go around. Farmers needed summer loans for crops, but couldn't get it unless they paid insane interest rates. Then the 1906 San Francisco earthquake hit, and the recovery effort sucked up a lot of money. Finally, there was the failure of a financial institution, which started a bank run (at the time, there was no FDIC that insured people's deposits).
   
   In a bank run, people pull their money out of banks and kept it at home -- they don't want to lose everything in case their bank goes bankrupt. The problem is that by pulling their money out of a bank, that actually *causes* the bank to fail. (Remember that banks make their money by taking in deposits and issuing loans -- they only have a certain percent on hand at any time).
   
   When any one bank fails like this, it spreads the "contagion" to other banks, and panic spreads. In the Panic of 1907, many banks hoarded their gold to stave off the contagion, with the net result that people couldn't get loans for the regular business they did (like farming).
   
   So even though the U.S. had a huge stockpile of gold, it still proved too little. The U.S. had to get bailed out again from a combination of Wall Street (courtesy of J.P. Morgan) and several other countries. In the effort to prevent something like this from happening again, people started thinking if only the U.S. had some sort of central bank who could handle this sort of thing, instead of having to rely on ad hoc groups of rich people.
   
   This resulted in the Federal Reserve Act of 1913. The idea was that -- instead of every dollar backed up by gold -- the "Fed" could vary the number of notes in circulation as needed, with a minimum reserve of 40 percent.
   
   With the Fed, the U.S. finally had a way to respond to economic downturn, though the U.S. didn't see a need for intervention during World War I since it kept its gold standard. Other countries, however, could not, so a return to pre-war price stability and easy foreign investment remained unfeasible.
   
   Despite the Great Depression, the Hoover administration remained committed to the gold standard. However, this prevented the kind of loose monetary policy that a successful response would have required, and he lost the election.