A Brief Financial History of America
Where we are heading is more understandable if we know how we got here.
Article Highlights:
For much of its history, America has functioned without a central bank.
Creation of the Federal Reserve resulted in the U.S. dollar becoming debt-based.
For all but the last 50 years, the U.S. dollar has been gold-backed.
In 1971, President Nixon took the U.S. off the gold standard, leading to increasing loss of the dollar’s purchasing power as there was no longer a brake on money printing.
U.S. trade deficits grew substantially as the U.S. offshored its manufacturing in return for building a financial empire.
As I explored in Reserve Currencies Erode as Empires Decline, the current global financial system is sliding toward a likely shift from U.S. dollar global reserve currency dominance. To make matters worse, the war in Ukraine has destabilized world trade, affecting the health and livelihood of millions if not billions of people.
While it is hard to predict exactly where we will head from here, there are many individuals well versed in the history of our monetary system who understand the current influences and factors affecting this impending transition. I want to explore some of those possibilities, but first it is necessary to step back and look at how we arrived at where we are today.
So… let’s take a quick stroll down U.S. financial system memory lane.
At the founding of the U.S., the forefathers sought to separate government from the banking system, as most leading revolutionists felt banking had undue influence on the operation of a nation. This was the real impetus for the Boston Tea Party. As much as that episode was a protest against England’s taxes on the colonists, the sentiment behind it was just as much a rejection of the privately-owned Bank of England which controlled the British pound.
For this reason, the U.S. Constitution only states the following about creation of money, “The Congress shall have Power . . . To coin Money, regulate the Value thereof, and of foreign Coin…” The idea was that by minting gold and silver coins, the government would set the monetary standard of value. Private banks, of which plenty existed, could print currency in the form of paper bills that people could use for trade as long as those currencies were convertible to gold or silver upon return of those paper bills to that private bank.
In this system, the paper money could be used as ‘currency’ for trade settlement, whereas gold and silver defined and held the monetary store of value. Our current Federal Reserve system operates under the premise that our dollars are both money and currency, which implicitly assumes it can serve as a store of value. Some would argue that is not accurate because inflation eats away at its value.
James Madison and Thomas Jefferson, primary authors of the US Constitution, both felt that the government should have limited role in the monetary system because they believed the free-market system would regulate private banks.
If those banks, using fractionalized-reserve lending, lent out too many paper bills for the gold and silver they held in storage, a bank run could ensue, putting them out of business. Their customers, of course, could lose a portion of, or all, their savings in that bank; but that is the nature of the free market – perform your due diligence or regret it later. This situation led to most early banks being started by commercial businessmen who already had solid social standing in their communities.
Because of this self-control mechanism, the U.S. government structure did not include a national bank upon ratification of the constitution in 1787. Alexander Hamilton, a major contributor to the Federalist Papers which provided the basis for the principles and elements later captured in the constitution, felt that a national bank was needed because it would stabilize and improve the nation's credit and improve handling of the new nation’s financial business. In recognition of his efforts, Hamilton got his portrait on the ten-dollar bill.
Hamilton, as the nation’s first Secretary of the Treasury, had enough support to achieve creation of the so called, First Bank of the United States. This bank did not perform the functions of a modern central bank as it did not set monetary policy, regulate private banks, hold their excess reserves, or act as a lender of last resort. Its 20-year charter allowed it to have branches in all states and to lend money to the government.
Madison and Jefferson claimed the bank was unconstitutional. Many others supported their viewpoint, and as a result, in comparison to today’s Fed, many restrictions were placed on this bank. Without going into detail, it is clear that the restrictions were created in recognition of the excesses many had witnessed from European and British central banks.
I find it interesting when looking back on these events to see how well informed the founders and many of the early colonists were regarding financial systems. This knowledge and its importance have been lost to a great extent over the ensuing centuries, especially in the general population.
I would argue much of the reason for our current general dearth of financial understanding is rooted in lack of coverage of this topic in public education. In those days, all schooling was private and there were no restrictions on what was taught. Apparently, basic finance was part of the curriculum.
I would also argue that this topic has been intentionally withheld from our public-school curriculum. If the concepts are simple enough that I can explain them in a few issues of this newsletter, then they are simple enough to teach in a high school curriculum. I wager that if everyone in the country fully understood the role of a private central bank, we would eliminate it within a year since its existence really only benefits bankers and connected individuals in the financial system.
There was enough opposition to The First Bank of the United States that its charter was allowed to expire in 1811. Again, the country functioned with a system where the government minted gold and silver coins and private banks issued paper currency – until 1816 when the Second Bank of the United States came into existence.
The functions of this second bank were, through its involvement with the U.S. Treasury, to regulate the public credit issued by private banks and to establish a sound and stable national currency. The U.S. government owned 20% of this bank, while the remainder was owned privately.
Creation of the Second Bank of the United States was pushed by business and commercial interests who wanted a more stable monetary system. It was opposed by those who felt it was unconstitutional, by agricultural interests, and by the private banking sector that did not want to be regulated. This division became a major political argument, eventually defining the 1828 presidential candidacy of Andrew Jackson.
Jackson was a strong opponent of the bank, in part because of a major monetary contraction/recession caused earlier by poor policy actions of the bank. The future of the bank was such a contentious issue that it defined Jackson’s winning 1832 re-election campaign.
During his second term, Jackson vetoed a bill to extend the bank’s 20-year charter, resulting in the eventual dismantling of the bank in 1836. I find it ironic that today, the $20 ‘Federal Reserve Note’ sports the portrait of Jackson, one of America’s most colorful presidents. Jackson did not like paper money, and no one seems to know the reason his portrait was used.
Once again the U.S. was without a central bank, with a financial system comprised of minted gold and silver coins alongside money created by private banks, just like Madison and Jefferson intended. Whatever banking regulation existed was implemented at the state level.
It was very much a free market system. If you ever watch an old Western movie, this explains why the cowboys always paid the bartender with coins, as well as why the bandits always robbed the stage coach of its gold. Paper money played a secondary role.
The U.S. financial system operated for 77 years without a central bank, from 1836 until 1913. This was a period of minimal inflation, by far the longest non-inflationary period in America’s history. The financial system remained fairly stable over that period, except for the impact of the civil war in the 1860’s.
In order to finance the Civil War, Abraham Lincoln’s administration passed a law creating the Greenback, a Treasury-issued paper currency not backed by gold. This was a true fiat currency, only backed by faith in the government. Lincoln wanted a common national money. The Greenback ultimately failed as some western states, flush with gold from the gold rush, refused to accept it. This, combined with overprinting and subsequent devaluation in comparison to gold, led to its eventual demise in 1879.
The Greenback drove a period of inflation that was exacerbated, interestingly, by the Gold Rush. The Gold Rush brought a lot of new gold into the monetary system. With more gold in the system, people could spend more for goods and services, which resulted in price inflation.
“The privilege of creating and issuing money is not only the supreme prerogative of Government, but it is the Government's greatest creative opportunity. By the adoption of these principles, the long-felt want for a uniform medium will be satisfied. The taxpayers will be saved immense sums of interest, discounts and exchanges. The financing of all public enterprises, the maintenance of stable government and ordered progress, and the conduct of the Treasury will become matters of practical administration. The people can and will be furnished with a currency as safe as their own government. Money will cease to be the master and become the servant of humanity. Democracy will rise superior to the money power.”
― Abraham Lincoln
The most significant change in history to America’s financial system occurred in 1913 with the creation of the Federal Reserve (Fed). Emergence of the Fed shifted the role of money creator from the U.S. Treasury and state-regulated private banks, to a centralized group of private bankers in control of printing money for the entire nation. The bankers’ argument used to sell this idea was that they could better manage the monetary policies of the nation.
Perhaps the most important outcomes of this change was that the U.S. dollar transitioned from a precious metals-based money with no counterparty risk (also known as commodity money), to a debt-based money owed to the creator of that money (i.e., owed to the Fed). The dollar, however, remained gold-backed and paper Federal Reserve dollars could be exchanged for gold.
Creation of the Fed was controversial, and remains controversial to many who have studied the system. Its genesis is thoroughly described in the book ‘The Creature from Jekyll Island’ by G. Edward Griffin, which describes how, in 1910, a small group of individuals that made up over a quarter of the world’s wealth gathered at a mansion owned by J.P. Morgan on Jekyll Island, off the coast of Georgia, to develop the blueprint for the Federal Reserve. In time, this group worked their plan to the right politicians, it was approved as an act of Congress, and signed into law by President Woodrow Wilson at the end of 1913.
The book describes the dangers of the Federal Reserve, fiat money and the fractional-reserve banking system, arguing that the Federal Reserve is not only incapable of achieving its stated objectives, but instead creates economic instability, encourages war through spending without taxation, and ultimately acts as an instrument of totalitarianism. Events of the past two decades support those charges. Many analysts also blame Fed actions for exacerbating the severity of the Great Depression.
The name ‘Federal Reserve’ represents an early case of politicians and monied interests giving entities names belying their actual role. The Federal Reserve is privately owned, and therefore, not federal (although the President nominates its board members and Congress approves them), and it holds no reserves. It has no need for reserves since it is authorized to print money as needed.
The government, which was designed for the people, has got into the hands of the bosses and their employers, the special interests. An invisible empire has been set up above the forms of democracy.
― Woodrow Wilson
The British pound held global reserve currency status in 1913 when the Fed was created, but began to lose its strength due to two world wars, eventually resulting in emergence of the U.S. dollar as global reserve currency during the 1944 Bretton Woods meetings, as I described in Reserve Currencies Erode as Empires Decline.
After 1944, the dollar continued as a gold-backed reserve currency. As the global economy grew, America’s trade surplus began to shrink, while simultaneously more dollars were needed for global trade. Foreign governments having a trade surplus with the U.S. traded their dollars back to the U.S. for redemption in gold. Over time, this began to deplete the once massive U.S. gold stockpile.
By 1970, the U.S. trade surplus began to flirt with deficit territory, accompanied by a steadily dropping gold stockpile. This trend was exacerbated by spending on the Vietnam war.
Rather than release its grip on reserve currency status and admit that the problem was due to trade imbalance, on August 15, 1971, President Richard Nixon announced to the world that the U.S. would no longer exchange returning dollars for gold, thus ending the gold standard linkage. In typical political fashion, he blamed these problems on ‘speculators’, stating that these actions were temporary. Fifty years later, this action is still ‘temporary’.
This action by the Nixon administration sent a financial shock wave throughout the global financial system because, instead of the reserve currency being backed by gold, it was now backed by nothing other than the credit and good faith of the United States.
At the time, U.S. credit was strong. This situation was seen as unfair by other nations, but they were not in a position to deviate from the dollar since they were already using U.S. dollars for global trade. They continued to conduct trade with U.S. dollars as well as use it for savings.
This de-linking with gold allowed the U.S. to print money without concern over loss of its gold stores. In other words, the U.S. dollar became a true ‘fiat’ currency – that is, it had value because the U.S. Government said it had value. This was justifiable because at that time, the U.S. had by far the strongest economy in the world.
Since the global economy was experiencing rapid growth in the period of the 1970’s through 2000’s, more dollars were needed overseas, which allowed the U.S. to print great amounts of money, using that money for purchasing foreign goods and services. This printed money was also used for conducting wars, as evidenced by the fact that no tax increases were initiated to pay for those new wars.
Knowing that a reserve currency without any commodity backing was tenuous, the Nixon administration in 1973, sent Henry Kissinger to Saudi Arabia with the plan to offer the Saudi’s military protection from their regional neighbors in return for pricing their oil in dollars. Saudi Arabia at the time was the world’s largest oil producer, and their agreement to this plan created the so called ‘petro-dollar’ system, loosely linking the dollar once again to a commodity – this time, oil – as all countries followed suit and traded oil in dollars.
Trading of oil in dollars extended to trading all goods in dollars. U.S. trade deficits began to slowly grow. Partly offsetting these deficits, U.S. corporations began off-shoring manufacturing to other countries – initially into Mexico, then later into Asia, and especially China. This move was largely motivated by desire to raise corporate profitability by using cheap foreign labor and led to the hollowing out of American industry we see today.
At the same time, the U.S. financial system grew by leaps and bounds, quickly becoming the dominant global financial center. Money and money management became America’s largest ‘products’. An argument could be made that we traded our factories for finance. The problem with that is factories create goods people actually need to live. Finance, on the other hand, has no physical substance and is based on agreements and confidence. Agreements can be broken and confidence lost, whereas infrastructure survives periods of economic crisis.
This sequence of moving from manufacturing to finance is a typical pattern seen in the process of empire building, with dismantling of the financial sector spelling the eventual end of that empire.
“I see in the near future a crisis approaching that unnerves me and causes me to tremble for the safety of my country... corporations have been enthroned and an era of corruption in high places will follow, and the money power of the country will endeavor to prolong its reign by working upon the prejudices of the people until all wealth is aggregated in a few hands and the Republic is destroyed.”
― Abraham Lincoln
Why care about all this history? Because it is hard to understand present events without a clear picture of the past.
The petro-dollar has served as the global reserve currency since the early 1970’s – until now, as the petro-dollar is being challenged in newly-emerging trade agreements. These agreements erode the reserve currency.
Reserve currency status can be maintained only through trust. Should other countries begin to mistrust the value or availability of the reserve currency, they are likely to explore other trade payment options.
The recently initiated sanctions on Russia as a response to the Ukraine invasion have caused distrust of the dollar, creating cracks in the U.S. dollar reserve system. We are in the early stages of a monumental shift in the global financial system.
The next newsletter will explore a likely path that shift may take.
Thank you for writing this. I will continue to follow your writing. I need this information. Why do more people not care? I find it hard to believe that that many people know this.