It was the changed nature of American money. Inflationary policies became possible only because the gold standard, which prevailed for most of American history, had collapsed during the Great Depression of the 1930s. Since the Depression, the United States has operated under a new money system—"fiat money," created by government—that differed fundamentally from everything that had preceded it. Although the Federal Reserve was at the center of the change, the new circumstances and their full implications were poorly grasped. In earlier periods, the ambitions of the "new economics" would have run afoul of the gold standard, which limited the amount of money that could be created. Paper money had to be backed by gold reserves. But because the gold standard was implicated in causing the Depression—the greatest economic calamity in U.S. history—it was discredited and abandoned. Its destructive vices obscured its virtues. Once the limits it imposed were gone, new limits were needed, but the people in charge only barely recognized the need and had no experience in creating them.

This transformation of American money is a little-known tale that, aside from its inherent interest, is crucial to understanding the inflationary experience. Economic texts tell us that money serves three roles. Most important, it is a means of buying and selling (a "medium of exchange"). This obviates the need for barter and promotes specialization: farmers, factory workers, doctors and engineers can concentrate on what they do best, because they can buy whatever else they need. Specialization, made possible by money, is the basic source of economic progress. Money is also a way of pricing (a "unit of account") and of preserving wealth (a "store of value"). All of these roles require trust. People must believe that whatever serves as money has some predictable and enduring value. In many ways, the history of money is an unending tension between creating trust and pursuing other goals—paying armies; mediating between debtors and creditors; promoting economic growth and regulating business cycles—that may erode trust.

Before the Great Depression, American money was a constantly shifting hodgepodge of gold and silver coin (known as "specie"), paper currencies and bank deposits. For most of this time, paper currencies were supported by gold, meaning that someone with a $10 paper note could go into a commercial bank or an office of the U.S. Treasury and exchange it for $10 in gold coin. At times, silver also backed currencies; we were then on a "bimetallic standard." Tying paper money to precious metals was thought to check the human tendency to print too much currency and, thereby, depreciate its value. The faith was almost theological. Listen to Hugh McCullough, the Treasury secretary following the Civil War:"[G]old and silver are the only true measure of value. They are the necessary regulators of trade [meaning business]. I have myself no more doubt that these metals were prepared by the almighty for this very purpose, than I have that iron and coal were prepared for the purpose in which they are being used."7

The reliance on gold and silver was written into the Constitution and reflected the unhappy experience with paper money at the state level under the Articles of Confederation and in the Revolution, when "continentals" issued by the Continental Congress to pay soldiers and suppliers were printed in such quantities that they quickly became worthless. The Constitution reserved to the national government a monopoly to mint gold and silver coin; states were prohibited from printing paper money or designating anything aside from gold and silver as "legal tender"—that is, lawful payment to fulfill contracts. Despite these strictures, paper money flourished in the nineteenth century. At first, it was issued by state-chartered banks, which (not being states) seemed uncovered by the constitutional prohibition. These bank notes were usually backed by gold or silver; if asked, banks were obliged to exchange specie for their paper. The Civil War ended the use of state bank notes when Congress created national banks that could issue "national bank notes," also backed by gold. But Congress also issued $450 million in "greenbacks," paper money not backed by gold, to pay for the war. (The Constitution, though implying the federal government should not issue paper money, did not expressly ban it.)8

What was termed the "money question" in the nineteenth century was often at the center of politics and covered much of what we now call "economic policy": how to promote growth and stability and how to distribute the economy's gains. Money, banking and economic expansion were interconnected, because banks issued paper money and made loans—and both money and credit affected economic expansion. Before the Civil War, proponents of "hard money" of gold and silver coin (most prominently, President Andrew Jackson) argued that paper currencies fostered speculation, which led to bad loans, bank panics (depositors tried to redeem their money in gold—and there wasn't enough to go around) and then depressions. On the other hand, paper money was more convenient than coin and, when not overissued, seemed to stimulate business and commerce. As early as 1723, a young Ben Franklin noticed that when the colony of Pennsylvania issued paper money, employment and construction improved.9

One drawback of a gold-backed system was that government had (by design) only a limited influence over money and credit conditions. Both responded to the metal's availability. When gold was discovered in California in 1849, the money supply automatically increased. If Europe had a poor harvest, U.S. grain sales abroad would bring in more gold, received in payment for American wheat. If Europe had bumper crops, gold inflows would slacken—or there would be outflows as Americans paid for imports. Government could influence money conditions only by supplementing gold with silver or by being more or less restrictive with paper money. There was much arbitrariness. After the Civil War, complaints intensified because population and economic production expanded more rapidly than money. Prices declined. Farmers felt oppressed, arguing that falling crop prices reduced their incomes and made it harder for them to repay debts. From 1881 to 1892, a bushel of wheat dropped from $1.15 to 79 cents. The money farmers borrowed had to be repaid in dearer, not cheaper, dollars.*10

The discontent climaxed in the 1896 presidential election, when William Jennings Bryan, the Democratic nominee, argued for more silver coinage to supplement the scarce supply of gold. His speech, regarded as one of the great masterpieces of American oratory, captured the prevailing passions:

You come to us and tell us that the great cities are in favor of the gold standard; we reply that the great cities rest upon our broad and fertile prairies. Burn down your cities and leave our farms, and your cities will spring up again as if by magic; but destroy our farms and the grass will grow in the streets of every city in the country Having behind us the producing masses of this nation and the world ... we will answer their demand for a gold standard by saying to them: You shall not press down upon the brow of labor this crown of thorns, you shall not crucify mankind upon a cross of gold.11

William McKinley won that election and,just coincidentally, new gold discoveries and refining technologies expanded the country's supply. Unfortunately, scarce gold was not the nation's only money

* There is a scholarly debate about whether falling prices actually made farmers worse off, because some of their costs (farm tools, clothes) were also falling. However this debate is resolved, it does not alter the reality of agrarian discontent. Many farmers felt they were worse off.

problem. Under the national banking system, money was "inelastic" in that it didn't automatically increase to meet seasonal needs or the temporary demands created by bank panics—when depositors wanted either gold or currency. The main seasonal demands were agricultural. Cash and credit needs peaked in the spring (when farmers needed funds for planting) and the fall (when buyers needed funds to pay for harvested crops). Seasonal credit demands and financial panics were sometimes connected. If rural banks withdrew their deposits from New York City banks, those banks would cut their overnight loans ("call loans"), which were widely used to buy stocks. This could trigger a fall in stock prices, as investors and speculators sold to repay their debts. Bank runs could occur for many reasons (bad loans, shady management, rumors or sheer fear). Major bank panics occurred in 1873, 1884, 1893 and 1907. They could cause or worsen economic slumps if depositors suffered losses and banks cut lending.12

No bank can cope alone with an unchecked panic, because no bank has enough ready cash (whether gold or paper money) to repay all depositors at once. The only way to stop a panic is to pay many depositors quickly enough to convince the others that the bank is sound—and that they need not withdraw their money. The national banking system had no official mechanism to provide these emergency supplies of cash. During panics, bankers sometimes improvised. They cooperated to create synthetic cash ("clearinghouse receipts"), which they would accept among themselves. After the panic of 1907, Congress established the Federal Reserve in 1913 to provide a safety net that would meet the extra demands for cash created by panics and normal seasonal swings. When pressed for funds, commercial banks could borrow from one of the twelve regional Federal Reserve banks, receiving a new form of paper currency, Federal Reserve notes. Still, the Federal Reserve System remained anchored to gold. The Fed had to maintain a gold reserve equal to at least 40 percent of the outstanding Federal Reserve notes. It could not create infinite amounts of currency.

The gold standard did not effectively end until the 1930s. Like almost everyone, Franklin Roosevelt didn't know what caused the Depression, but he was determined not to wait idly on events. He feared that gold imposed a straitjacket on the banking system and credit creation. If Americans hoarded gold, the economic crisis might deepen. On March 6, 1933, two days after his inauguration, Roosevelt barred banks from paying it to depositors. On April 5, he outlawed "hoarding"—Americans had to redeem all gold coins above $100. "They came with little bags, briefcases, paper bundles, boxes or bulging pockets," reported one newspaper. Roosevelt also devalued the dollar in terms of gold. For years, it had been $20.67 an ounce; the government would buy or sell gold at that price. On January 30,1934, he set a price of $35 an ounce for foreigners. In practice, the nearly 70 percent devaluation meant that the gold backing for the paper currency was so ample that money and credit could expand without encountering legal restrictions. After that, gold no longer played a major role in guiding the U.S. economy. The remaining connections were progressively severed.*13

* For some decades, there remained requirements that the Fed have a specified "gold cover"—that is, gold backing for a given portion of the paper currency. But these restrictions were consistently lowered and

American money had undergone a fundamental transformation. For our story, this upheaval was fateful. The gold standard was hardly ideal. Had it remained, the U.S. economy and those of other countries would probably have fared worse after World War II than they did. Growing economies need more money and credit. The gold standard limited money and credit, reflecting the metal s rigid and unpredictable supply. But this vice was also, to some extent, a virtue. It imposed limits on money and credit creation that prevented runaway inflation. The removal of these limits created an entirely new situation, requiring new understandings and obligations. Inflation would no longer control itself. It had to be controlled—and so the ideas, beliefs, motives and behaviors of people charged with controlling it mattered. They had to understand why preventing it was important and that it was their job to do so. These responsibilities got lost.

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