May 13, 2013

The United State’s Four Structures of Monetary Control After World War I.

By In Economics, History

After the institution of the Federal Reserve and the First World War, the Federal Monopoly on money was, over the course of the 20th century, given more power than any other central bank in the history of the United States.  The Federal Reserve was placed in charge of all monetary policy when it was introduced.  Under its leadership, the United States has gone through four different phases or “monetary orders.”[i]  This history (which is summarized in short paragraphs) is the foundational backdrop to statements regarding the environment of the United States monetary system as it exists today.

  1. The Gold Exchange Standard (1926-1931):  The gold exchange standard was an international agreement between the United States and Britain (and other countries) wherein the “United States remained on the classical gold standard, redeeming dollars in gold.”[ii]  The British tied their currency to gold and to the dollar, thereby making the pound redeemable in dollars.  Other countries were on a lower tier in this pyramid and redeemed their currencies in pounds.  As Britain inflated its pound in order to keep up with spending, investors ran from the pound and to the dollar, causing a banking scare in which the Federal Reserve feared that this would drain the dollar from the United States.  To prevent this, and to bail out the Bank of England, the United States expanded their money supply by creating more money which inflated the dollar and devalued it, thereby artificially giving the pound relative strength again.[iii]  This inflationary bailout is, according to Austrian Business Cycle Theory, the move “which built toward the severity” of the Great Depression.[iv]
  2. Fluctuating Fiat Currencies (1933-1945):  In President Franklin Roosevelt’s attempt to solve the collapse of the American Economy after the stock market crashed, the United States domestically untied the dollar from gold (Executive Order 6102).  This means that American citizens were no longer permitted to redeem their dollars in gold and they had to simply trust the Federal Reserve’s handling of the dollar.  Furthermore, not only were citizens not allowed to cash in their government issued IOU’s, they were even prohibited from owning gold.  In other words, gold that they did have was taken from their possession by the Federal Government in exchange for paper money, which of course was given to them in amounts not worth the gold they were forced to give up.  However, the United States did keep an international tie to gold as it was redefined to 1/35 a gold ounce (more on this below).  At this time, the dollar was undervalued in its relation to gold (which means that, at this price, there was more gold in reserves than the dollar represented).  In 1941however, when the United States entered into the Second World War, the now relatively un-backed American dollar was easily able to be inflated in order to, again, pay for the terrible expenses of war.  As time went on, more dollars were printed, and by 1950 the dollar was overvalued (meaning that there was too many dollars at the current price to be able to be redeemed in gold).
  3. Bretton Woods (1945-1968):  The Bretton Woods agreement was similar to the Gold Exchange Standard of the late 1920’s in which the dollar was backed by gold (valued at 1/35 a gold ounce) and other countries in the world were backed by the dollar (which was still undervalued in 1945).  Unlike the 1920’s deal however, the British pound was not a reserve currency and gold was only redeemable by central banks and foreign countries (whereas in the 1920’s American citizens holding dollars could redeem them in gold).   During the Bretton Woods agreement, while the United States dollar was undervalued, most other countries’ currencies were overvalued.  This meant that the dollar was made scarce.  Two details however came about because of this system, both of which were harmful and morally wayward.  First, because the United States had pegged its dollar to 1/35 a gold ounce at the same time as it was massively inflating, other countries began to notice the continuing devaluation of the dollar and by 1950 were demanding gold in exchange of dollars.  Since by this time however, the dollar was overvalued, gold began to drain from the United States; quickly.  The second detail took place because other countries had dollars acting as their reserve.  As the foreign countries inflated their currencies against the dollar, Federal Reserve continued to inflate the dollar against gold because it knew other countries, whose currencies were weaker, would have to buy dollars.  In this way, “the United States was thereby able to ‘export inflation’ to other countries, limiting its own price increases by imposing them on foreigners.”[v]
  4. Fluctuating Fiat Currencies (1971-present):  Fearing the continual draining of gold from the American Economy based on a gold run that was hurting the dwindling gold supply, President Nixon brought an end to the Bretton Woods system and for the first time in American history, the dollar was one hundred percent fiat money, backed by nothing except the “promise of the Federal Government.”  Almost immediately gold prices more than tripled[vi] and by July of 1973, the dollar plunged in foreign exchange markets and the United States “suffered the most intense and most sustained bout of peacetime inflation in the history of the world.”[vii]  The inflation inevitably found its recession in 1981-1982 during the first year of the Reagan administration.  At this point in monetary history, a series of booms and busts initiated by expansionary policy have swept through the nation and they continue today.  The two most recognizable booms and busts are the dot-com bubble and bust during the Clinton and Bush Administrations and the other is the Housing bubble and bust during the Bush Administration.  Both came from the Federal Reserve’s action of lowering interest rates and distorting market signals for investors to read.  During the dot-com bubble, there were “too few resources available for all of the plans formulated and funded during the boom to succeed.”[viii]  The same situation happened in the housing bubble, as Thomas Woods records, because it “encourage[d] more and different kinds of projects to be undertaken than the economy [could] sustain.  The necessary resources to complete these projects profitably [did] not exist.[ix]  Just like the Austrian Business Cycle predicts, the pumping in of easy credit (boom) necessarily needs a phase of liquidation and recovery (bust).

[i] Rothbard, M. (1991). What Has Government Done to Our Money. Page 89. Auburn, Alabama: Ludwig von Mises Institute.

[ii]Ibid., 95.

[iii] Paul, R. (2007). The Case for Gold. P. 124. Auburn, Alabama: Ludwig von Mises Institute.

[iv] Siegel, B., Yeager, L. (1984) Money in Crisis: The Federal Reserve, the Economy, and Monetary Reform. pp. 89-136. San Francisco, CA:  Pacific Institute for Public Policy Analysis.

[v] Rothbard, M. The Case for a 100 Percent Gold Dollar. page 2. Auburn, Alabama: Ludwig von Mises Institute.

[vi] Rothbard, M. (1991). What Has Government Done to Our Money. Page 107. Auburn, Alabama: Ludwig von Mises Institute.

[vii] Ibid., 116

[viii]Callahan, G., Garrison, R. (2003, Summer) Does Austrian Business Cycle Theory Help Explain the Dot-com Boom and Bust? The Quarterly Journal of Austrian Economics, Vol.6, No. 2.  Retrieved from http://mises.org/journals/qjae/pdf/qjae6_2_3.pdf

[ix] Woods Jr., T. E. (2009). Meltdown. Washington DC, Regnery Publishing Inc.

 

 

Written by C.Jay Engel

Editor and creator of The Reformed Libertarian. Living in Northern California with his wife, he writes on everything from politics to theology and from culture to economic theory. You can send an email to reformedlibertarian@gmail.com