The Myth of a Gold Standard before The Great Depression

The Myth of a Gold Standard before The Great Depression

A popular myth is that America was on a gold standard through the 1920’s and through the Depression. This is not true an in this analysis I shall describe why America was not in fact on a true gold standard. I shall also provide a brief history of the development of the currency, the roll of the Federal Reserve.

The best place to start off is with the hard currency movement in the early 1800’s as a political movement tried to get rid of paper money in the United States. This is a very good place to start to learn about how the currency has developed over the centuries in America.

The desire for hard money as a common currency and the abolishment of fractional reserve banking started after the banking crisis of 1819. Andrew Jackson’s monetary policy resided in the belief that in a boom-bust cycle, the boom was driven by inflationary expansions of credit through fractional reserve banking. The bust was induced through the decline of lending standards during the boom and the inevitable bankruptcies which induce contraction of bank credit.

During 1833 Jackson attacked central banking in the US by removing public Treasury deposits from the Bank of the United States. He moved these deposits to a number of state banks around the country. This is not to say their were still not state banks did not offer bank notes used as currency, only the elimination of a central bank producing bank notes. Jackson also allowed foreign gold and silver coins to be used with the same privileges as US coins.

In 1857 all foreign currency was eliminated as legal tender within the US. “Free” banking laws were passed in 18 of 33 states. However, banking was not “free”. Free banking is neither subsidized nor regulated. When faith is lost in the bank and it is forced to redeem in hard currency, this forces the bank to declare insolvency.

Before the Civil War “free” banking really meant that they could suspend property rights of depositors when the bank became distressed. This is clearly shown in the banking crisis of 1857. Banks were also subject to various regulations at the State and Federal level. Under this regime banks used state bonds as the basis for expanding and extending credit. The bank notes were also used as the basis to pay taxes. Therefore fractional reserve banking existed and was based on the amount of state bonds obtained by the banks. This relationship linked government and bank inflation together very tightly.

The Civil War gave rise to the “greenback” currency and would be used as a basis for banking during the later parts of the Depression and after US went off Brenton-Woods in 1971. During the war the federal government outlawed state bank notes and a return to central banking.

In 1862 the government authorized the printing of $150 million in federal banking notes to pay for war debts, these notes were also legal tender for all debts. By 1863 there were approx $450 million “greenbacks” in circulation and the “greenbacks” depreciated quickly even after first issuance.

The banking system during the Civil War changed with the National Banking Acts of 1863 and 1864 replaced the state banking system with a centralized banking system under the federal government and Wall Street. This system was in place until the Federal Reserve replaced it in 1913.

This new banking system was set up in order to purchase the large amount of US sovereign debt needed during the Civil War. The National Banking system was set up upon three level pyramid. The levels were the Central Reserve City Bank which was New York, Reserve City Banks for other cities, and Country Banks for all other national banks.

The central reserve city banks were required to keep 25% of their notes and deposits in reserve of assets including gold, silver, and “greenbacks”. The reserve city banks were required to keep split their reserves between their vaults and as demand deposits in the central reserve bank. Country banks reserves were split 40% to their vault and 60% to either a reserve city or central city reserve bank. They also had a 15% minimum reserve ratio.

The net effect of this was a change from each bank having to keep its reserves in hard currency at each bank in favor of a system which provided a multi level reserve system enabling the same reserve to used several times. The basis for this new system was the pyramiding of the entire banking structure upon the top of a few large Wall Street banks. The definition of reserves was also changed to include not only metals, but also “greenbacks” and US sovereign debt.

This new structure added additional protection against individual bank failures, therefore allowing for a greater ability to inflate the money supply with paper currency. The individual banks were required to accept each others notes at par. This situation forced the free market out of banking as notes from shaky and distressed banks could no longer be discounted.

The Federal Reserve was born in 1913 and was instituted to solve the problem of coordinating the inflation of the currency and the need to bail out banks in trouble. The large banks charged that the current banking system did not let them properly expand the money supply, and a call to defeated “INELASTICITY” in favor of “ELASTICITY” or the ability to inflate the money supply in a highly coordinated way.

The world economy at this time was on a gold standard, not to say that each country was on a gold standard, only that how countries settles with each other was through the medium of gold. Every country’s currency was defined as its relationship to gold. The countries central banks could redeem this paper currency for its weight in gold coins. Gold bars were used to settle international payments.

During World War 1 the world went off of the gold standard, with only the US remaining on the standard (The US entered the war late). The value of these currencies with relationship to gold now floated, whereas in pre-WW1 these currencies were fixed to a specified weight of gold.

The world decided that it wanted to return to a gold standard, however, they had printed far more money than the gold in their banks would support. The easy and best solution would have been to just reduce the paper currencies relationship to the weight of gold. However, England, who wanted to remain the financial leader of the world tried to bring back their currency at pre-war levels. This action overvalued the pound sterling.

Not only did England want to have the pound’s relationship with the gold go back to pre-war levels, but it also wanted to institute a policy of inflating their currency. This set the stage for the destruction of the gold standard, America’s roaring twenties, and the Great Depression.

Therefore a plan was launched to have countries go back onto a gold standard, while outlawing the use of hard currencies in each participating country. The world was to go upon a gold bullion standard, whereas central banks would only redeem gold in 400 once bars. This was much too expansive for a person to buy, but ideal for international transactions. Gold coins were systematically taken out of circulation and replaced with paper notes and deposits.

European countries were therefore technically on a gold standard. However, they did not in fact receive the gold bullion in any great amounts. Therefore the countries were on a pound sterling standard. Therefore countries would not hold gold, but British pound sterling. If anyone in their country redeemed their currency for gold, they actually received British pounds rather than gold.

Murrey Rothbard writes in “A History of Money and Banking in the United States”

“For the other nations of Europe, it became an object of British pressure and maneuvering to induce these countries themselves to return to a gold standard, with several vital provisions: (a) that their currencies too be overvalued, so that British exports would not suffer, and British imports would not be overstimulated—in other words, so that they join Britain in overvaluing their currencies; (b) that each of these countries adopt their own central bank, with the help of Britain, which would inflate their currencies in collaboration with the Bank of England; and (c) that they return, not to a genuine gold standard, but to a gold-exchange standard, keeping their balances in London and refraining from exercising their legal right to redeem those sterling balances in gold.”

The United States was still on a true gold standard and this presented a real problem to England. England made agreements with the United States so that the US would inflate their currency, thereby deflating the buying power of the US dollar verses the British pound. The US agreed to do this in order to support to rebuilding of Europe.

England continued to inflate their currency without abandon in 1926, inducing gold to flow out of England into the United States and sterling to flow into other countries.

The first European chain began to break in 1929 as a large Austrian bank headed for liquidation. This was the beginning of the systemic banking failures which would start the largest international banking crisis ever experienced in civilization.


Source MaterialMilton Friedman and Anna Schwartz “A Monetary History of the United States”Murrey Rothbard “A History of Money and Banking in the United States”Murrey Rothbard “America’s Great Depression”

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