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Fiat Money System
The current monetary system in the United States is based on paper money, which is backed by the credit of the United States government (Fiat money). The currency is not convertible into metals such as gold or silver, at least not in an official capacity. However, the United States did have a monetary system that was based on the metallic standard in the past. In fact, there are often suggestions that the country should return to such a standard. Why are these claims made? And what is the gold standard? Here is a look at the history of the gold standard in the United States.
The idea behind any monetary system is to ensure that people can exchange goods or services for something in return. With the gold standard, gold acted as the medium that was traded between people when they bought and sold items from each other. If we go back to the purest form of the gold standard, the value of every product, good or service on the market was based on how much it is worth in gold. And since it was not easy to weigh gold without the proper equipment, it made sense to mint metals such as gold into coins in order to differentiate the various amounts from each other.
Even if paper money is present in the monetary system, it is still possible for an economy to run on the gold standard, so long as the paper money involved is representing someone’s claim to a certain amount of gold. For instance, if every dollar in the current United States economy was representing a claim to some specific amount of gold, the United States economy would still be under the gold standard.
Section. 10 of the United States Constitution. “No State shall enter into any Treaty, Alliance, or Confederation; grant Letters of Marque and Reprisal; coin Money; emit Bills of Credit; make any Thing but gold and silver Coin a Tender in Payment of Debts; pass any Bill of Attainder, ex post facto Law, or Law impairing the Obligation of Contracts, or grant any Title of Nobility.”
Even though many people think of the gold standard as being the beginnings of the monetary system in the United States, the country began things with the bimetallic standard from 1792 to 1834, where both gold and silver were used as monetary units. In April of 1792, the Treasury Secretary of the time, Alexander Hamilton, passed the first coinage act. The act determined that a dollar was valued at 371.25 grains of silver, minted into a coin of 416 grains. Gold coins were used to denominate the amounts of $2.5 and $10, while the ratio of gold to silver in various denominations was set at 1 to 15.
In order for these coins to enter the monetary system, they had to be issued as legal tender by the government. Legal tender refers to a law that declares something as being satisfactory for the purposes of making payments of existing debt. When something is made legal tender, such as the gold and silver coins of the time, citizens of the country are legally obligated to accept them as payment for goods bought and services rendered. But these legally designated currencies are not the only legal way to make payments or deals. Merchants are still free to accept other forms of payment should they choose to do so.
The bimetallic standard of the time got a little complicated when foreign gold and silver coins were also introduced into the monetary system. For instance, the Spanish milled silver coin was declared as being legal tender equivalent to one dollar. Another issue with using different metals as part of the monetary system was the fact that their values relative to each other were fluctuating in the world markets. As an example, the price ratio of gold to silver changed from 1 to 15 and ½ a few months after the first coinage act became law. Since silver was now cheaper, it was used almost exclusively for domestic purchases, with gold being reserved for buying things from abroad. In essence, the United States economy was running on the silver standard for its first 40 years.
Switch to Gold Standard
Congress made a move in 1834 to try and fix the problems caused by the silver to gold price ratio, because they wanted to bring back the use of gold coins for domestic transactions. They decided to slightly reduce the amount of gold in the gold coins, which changed the gold to silver ratio to 1:16.
They also adjusted the pure gold in the eagle coin from 247.5 grains to 232 grains, with the coin being 258 grains, which translates to nine-tenths fine. Silver coins were also adjusted a few years later to ensure their fineness was at nine-tenths. But the changes to the silver coin were made by reducing the alloy, which meant the amount of silver remained the same.
The idea was a good one, but a new problem arose when people discovered that the new tender was good for paying back debts that existed prior to the adjustment of the gold content. So people were able to pay back their existing debts with slightly less money than they would have had to spend prior to the change. For instance, paying back $100 or debt required 37125 grains of silver, which translated to around 2364.65 grains of gold on the market. But after the change, 2320 grains of gold were enough to pay back the same $100 debt.
The change to the mint ratio had been too extensive, which resulted in gold being cheaper relative to the price ratios on the world market, which meant that only gold was being used within the United States for transactions. By 1850, almost no one was using silver coins and they had completely disappeared from the market. And it was an issue, since the country did not have any gold coins to represent a fraction of a dollar. Another act was issued in 1853, where subsidiary silver coins were produced with less silver than the mint ratio called for. These silver coins were now legal tender for transactions involving amounts less than $5.
1928 Gold Certificate $10 Note
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Shift Towards Paper Money
Even though there was no paper money recognized as legal tender in the United States prior to the Civil War, there were plenty of varieties of paper money circulating throughout the country. Examples of such paper money included bank notes, Treasury notes and bills of exchange. The purpose of this paper money was to highlight promises from one party to another to pay gold or silver. For instance, Treasury notes were often given out by the government in denominations small enough that people could use them for commercial transactions, even though they were not legal tender at the time. If one person was given a Treasury note, they could pay another person with the note instead of using gold or silver coins.
It was the pressure brought on by the Civil War that eventually facilitated a move away from gold or silver altogether. Initially, the United States government had attempted to get by through the issuance of more Treasury notes that were promising to pay the owner gold or silver at a future date. However, the government no longer had the capability to continue converting these Treasury notes into gold or silver, which is why convertibility was suspended in the early 1860s.
By 1862, the United States government issued notes that were not convertible into any type of metal – gold or silver – which made them the first official paper money legal tender. These notes were called greenbacks and they could be used as legal tender for everything but paying customs duties, which were still payable with gold or silver. The initial printing of greenbacks was a little excessive, and was part of the reason the United States experienced so much inflation during the Civil War.
But the United States government was not done with the gold standard yet. When the Civil War ended, Congress made a decision to go back to the metallic standard at the same rate as before the war. They had to figure out a market exchange rate for greenbacks relative to gold. They did this by slowly getting rid of greenbacks from circulation. By 1879, the government had achieved complete parity between gold and the greenback, which meant that the country was officially back on the gold standard – with a caveat. Even though the gold standard was now active, paper money also existed and was legal tender – a big change from the past.
A Second Gold Standard
The United States government had spent so much time focusing on achieving parity between the greenbacks and gold, in order to reestablish a metallic standard. Silver was only used for fractional transactions.
Many silver producers, along with people who believed in the advent of cheaper money, wanted silver to get back to its original status. But the United States government had no interest in going back to a silver standard. In order to appease those silver producers, the United States treasury would purchase silver from the producers and mint it into silver dollar coins. In the same way as the value of the greenbacks had been kept at an artificially high level to equate one-to-one with gold, the value of the silver dollar was kept much higher than the market value of those coins.
Along with having gold coins, the United States government also started issuing some gold certificates during this period. The gold certificates were similar to Treasury notes, as they promised the holder a certain amount of gold when they would bring the note to the government. A law was created to ensure the government had enough gold on hand so they could make good on those notes at any moment. Treasury notes were also re-entered into the monetary system in 1890.
Another addition was made to the monetary system after the Civil War, which was the advent of Bank notes from state banks and chartering banks. In the past, only the Bank of the United States and state banks were allowed to issue notes, but now these chartering banks could also issue Bank notes. The notes were backed up through government bonds. And since the bonds were earning interest, but the bank notes were not, the chartering banks were making a profit by issuing these notes. And even though the notes were not legal tender, they were easily redeemable in the marketplace for gold or a legal tender note.
By 1900, some people were still concerned that the United States would switch to a dual gold-silver standard, since the Treasury had not stopped buying silver and minting those coins. And silver was now beginning to reach half of the previous value it held relative to gold, which made even more apprehensive about the possibility of another bimetallic standard. To alleviate those fears, the government came up with the Gold Standard Act of 1900, which declared the gold dollar the standard unit of account, with any type of money issued by the government maintaining parity with gold. Treasury notes were recalled and halted altogether, while greenbacks and silver dollars remained as legal tender.
Video on the History of Gold Standard
Even though checks had been around for many centuries, they had gained a whole new popularity in the marketplace by the end of the 19th century. Thanks to the improvements in communication, it was now possible to use checks even if the transaction was taking place between individuals who had accounts with two different banks. Checks were even being accepted when the issuing bank was from a different part of the country.
But checks did cause some problems for smaller banks, since they never really knew when customers were going to come and ask for gold or some other form of legal tender in place of the check. And most banks only kept a limited supply for legal tender, which meant a large flurry of check cashing requests from customers caused some small banks to fail completely. The type of panic that ensued from these frustrating periods for banks would eventually result in the creation of the Fed, or the Federal Reserve System. The Fed was there to allow banks to borrow money when they had a cash shortage, while the Fed could also create their own form of currency, Federal Reserve notes, which were pushed or scaled back depending on the demand for cash in the marketplace.
Early Bank Check
End of the Gold Standard
Even though most other countries in the world went off the gold standard when the First World War came to an end, the United States remained on the gold standard until 1933. It was the enormous failure of many banks from the period of 1930 to 1933 that eventually led to the demise of the gold standard. Even though the Fed was present to deal with such situations, it had not been able to provide the liquidity banks had needed.
If the Fed was to meet the need for additional cash, it had to print more money. And creating more paper money meant raising doubts about whether the country was going to remain on the gold standard. And whenever there were doubts about the gold standard, people would begin to export gold, which would reduce gold reserves. In simpler terms, the Fed had to enact policies of expansion to save the economy, while remaining on the gold standard meant enacting policies of contraction.
As Franklin Roosevelt was inaugurated as the next President of the United States, the country’s policy on the gold standard changed as well. Various executive orders and laws were enacted and the United States was completely removed from the gold standard.
Is a Modern Gold Standard Coming?
Governments of the world love to print money and a new gold standard would limit the government’s ability to print (or create electronic money) at will. Don’t expect a new gold standard at any time in the near future. Most politicians want nothing to do with a system that limits their ability to spend other people’s money – that’s how they stay in office.
- Kemmerer, Donald L. "Gold Standard" Dictionary of American History. 3rd Edition. Vol. 4.
- West, Doug. Coinage of the United States: A Short History. C&D Publications. 2015.
This content is accurate and true to the best of the author’s knowledge and is not meant to substitute for formal and individualized advice from a qualified professional.
© 2016 Doug West