A History of Failure: How the United States Monetary System has Lost More Than it has Gained - Research Paper Example

A History of Failure: How the United s Monetary System has Lost More Than it has Gained The history of money and monetary policy is almost as varied and colorful as the history of the United States itself. Like the country, it has had its share of ups and downs, causing both joy and heartache to its inhabitants. After winning independence from Great Britain, how money should be handled was one of the most debated issues among the members of Congress, with some in favor of a system of centralized control, while others sang the praises and merits of letting each state control their own monetary affairs (Brinkley 156). Though in the end the argument of a central monetary system won, it has not been the smooth and undisturbed course that the Founding Fathers wished for. It is not an exaggeration to say that both the history as well as the failures of the monetary system have provided for some of the greatest chapters and lessons learned in the history of the United States of America. Ironically, the first major failure of the monetary system came about because of the introduction of paper money. To finance the Revolutionary War, Congress was persuaded into printing paper money (Rothbard, “History of Money”, 59). The result was nothing short of disastrous. The issuance was based on the notes being ‘fiat paper money’, meaning that they had no conversion to gold or silver in the world market (Rothbard, “History of Money”, 59). To most, gold and silver were more “real” coins, as they had redeemable value and could be measured easily for that value according to the weight of their makeup (Rothbard, “History of Money”, 59). Therefore, with nothing to back up the worth of the paper notes, called Continentals, and the money soon became useless and worthless (Davidson and Stoff 191). Paper money, or at least the first issuance of it, was clearly having a terrible effect. Congress had not left itself vulnerable. The issued notes were supposed to be withdrawn from the economy in seven years via taxes from the separate states (Rothbard, “History of Money”, 59). Unfortunately, Congress thought that it had discovered a new, wonderful way to add money into the marketplace. Before the Revolutionary War, the total money in the markets of the United States had been estimated at $2 million (Rothbard, “History of Money”, 59). Before the end of 1775, an addition $6 million, printed as Continentals, had flooded the market (Rothbard, “History of Money”, 59). This caused all manner of harm from rapid inflation of the paper money to devaluation of the gold and silver prices (Rothbard, “History of Money”, 60). Paper money had become virtually worthless. Further complications continued to ensue. States, not satisfied with the paper money issued by the government, each began printing their own money (Davidson and Stoff 191). No one knew, from day to day, what one dollar was worth as compared to another (Davidson and Stoff 191). Merchants were soon refusing to accept state-printed money at all, causing trade between states to decline (Davidson and Stoff 191). The result of each state having a separate currency was doing almost irreparable harm. The failure of paper money, as well as the confusion created between states printing their own money, brought a strong argument for a central bank. It was argued that one was needed for this reason as well as to give the government a place to do their own banking and help with the collection of taxes (Brinkley 155). To that end, The Bank of North America was created in 1782 (Rothbard, “History of Money”, 62). It was given a federal charter and a carefully structured system to control inflation, grounded in gold and silver coin but able to print and accept paper notes redeemable for the same at a dollar-for-dollar value (Rothbard, “History of Money”, 62). In 1790, the government was petitioned for a stronger, even more centralized bank. The Bank of North America, while not entirely a failure, had fallen out of favor with the public (Rothbard, “History of Money”, 63). Replacing it would be the First Bank of the United States, a private institution but with government, as usual, having a hand in the operations by owning one-fifth of it (Rothbard, “History of Money”, 68). The government would deposit all collected taxes into the bank, and the bank would then issue paper money, which the government would then use to pay debts and issue loans (Davidson and Stoff 248). Once again, things did not go as planned. Due to the bank accepting not only the pre-existing and long-term debt by the government as well as the ability to print and issue paper money, inflation once again ransacked the United States (Rothbard, “History of Money”, 69). Wholesale prices in the country quickly escalated by 72%, and speculation in land prices flew upward as well (Rothbard, “History of Money”, 69). Compounding the problem, commercial banks began to be created, and soon found their place in helping the economy, with eight being established in 1791 and 1792, and ten more 1796 (Rothbard, “History of Money”, 70). It is important to realize that commercial banks, even then, had the power to create money out of thin air (Rothbard, “Mystery of Banking”, 98). While this may seem illogical, it is exactly what happened, with no thought to the consequences (Rothbard, “Mystery of Banking”, 98). In 1811, when the charter of the First Bank of the United States was up for renewal, it actually showed a healthy bank; the charter renewal motion, however, was defeated in Congress (Brinkley 202). The era of free banking began. The free banking era could most commonly be described as chaotic. Without one centralized bank to hold the ties of the monetary system together between states, things spun out of control. Banks were either chartered as state banks or allowed to operate as a free bank (Wells). In being allowed to operate as a free bank, a bank did not operate with any government control and was subjected to only one rule, which was that it had to pay its debts promptly or be declared bankrupt (Rothbard, “Mystery of Banking”, 111). One main issue with this system was that banks were not allowed to branch out across state lines, and therefore when notes were issued in one state and ended up in another, the price they were redeemed for was less than ideal (Wells). There were those that tried to keep the public informed of what values lay with what notes, but the plans almost never succeeded (Wells). The War of 1812 did little to bolster the confidence of the public in the monetary system of the still-fledgling country. Banks, bank notes, and deposits once again grew, mainly to finance the war, but this time financing was at a premium through these means for the government (Rothbard, “History of Money”, 73). However, the government still needed merchandise, and therefore encouraged failure in the monetary system by authorizing “wildcat banks” to spring up almost overnight (Rothbard, “History of Money”, 73). These banks could be looked upon as nothing but money-printing factories who printed money to satisfy the whims of the government (Rothbard, “History of Money”, 73). The government had done nothing but weaken an already weak system, and as the banks called in their notes, it became apparent that a failure of mass proportions was on the way (Rothbard, “History of Money”, 74). Even though the government could see the failure coming, it still made an even bigger error. It allowed banks to stop redeeming paper notes for gold or silver, yet continued to allow banks to operate (Rothbard, “History of Money”,74). For two and a half years, until 1817, banks were allowed to renege on promises made to property owners and merchants by not redeeming, or being required to redeem, any paper money for any hard currency of value (Rothbard, “History of Money”, 75). When the bank was unable to fulfill its promises, it then left the matter to its debtors to fulfill (Rothbard, “Mystery of Banking”, 197). Banks soon learned that, in times of crisis, they were not going to be held responsible to their contract standards. Instead, they would be allowed to operate as normal, without any obligations to the people (Rothbard, “History of Money”, 76). In this manner, the government contributed to a failure of the monetary system, and was soon paying the price. The nineteenth century can best be defined by the ups and downs of the monetary system, as well as the pandemonium created due to the ups and downs. Money was a principle worry for many. Banks continued to do what they wanted with their notes from 1814 to 1817, free from the responsibility of redeeming notes for any hard currency, and thus inflation and deflation ran rampant (Rothbard, “History of Money”, 82). The people of the nation still had no confidence in anyone but themselves when it came to control of their hard-earned, hard-won cash money. The panic of 1819, followed by the panic of 1837 and the panic of 1873 each brought with them new means of monetary control for the nation. In 1817, the Second Bank of the United States was created, in part to work with state banks in the matter of monetary control (Rothbard, “History of Money”, 82). Rather than standing firm, however, and always insisting on payment, the bank allowed smaller state banks to get away with nothing short of fraud by continuing to rack up loans, until they totaled over $2.4 million during 1817 and 1818 (Rothbard, “History of Money”, 86). Also, since states were not satisfied with the operations of the Second Bank of the United States, they continued to charter more and more state banks to meet their own demands (Rothbard, “History of Money”, 88). The nation acted as though it had money, and it was true that both the country and monetary policy were expanding (Brinkley 211). Settlers that went west to find new land were promised easy credit due to land acts passed in 1800 and 1804 (Brinkley 211). Turnpike construction was invested in heavily (Rothbard, “History of Money”, 88). The prices of export staples increased to an almost dangerous high, a stock exchange was opened in New York, and investment banking began (Rothbard, “History of Money”, 89). There was a pretense made that everything would be fine, but in the end, the Panic of 1819, followed by six years of depression, made life unbearable economically for the nation (Brinkley 211). In 1819, the Second Bank of the United States finally saw the error of their ways and called in loans (Brinkley 211). This caused a cascading failure of state banks, as well as a financial panic from those running to the bank to get their money out before any closures happened (Brinkley 211). Much worse was the panic that came eighteen years later, in 1837. Unwilling to sustain a lesson from the last economic boom, the government had sold millions of acres of public lands in the West between 1835 and 1837 (Brinkley 240). Though farmers were among the buyers, speculators and investors bought more, banking on the day that they could then resell the land at a higher price (Davidson and Stoff 341). The Second Bank of the United States closed in 1836 after a long-standing war by Andrew Jackson, who hated central banking and saw it as the very concept of evil (Davidson and Stoff 337). Jackson also succeeded in causing further harm by taking all federal money and placing it in certain state banks, called “pet banks” (Brinkley 236). Once this happened, state banks lost all limits on the money that could be lent, as once again there was nothing tying them to a central monetary system (Davidson and Stoff 341). Chaos was beginning to descend again. People ran for their savings, and held their money closer than ever. Banks failed, as did most of the canal and railroad projects (Brinkley 241). Unemployment grew, and bread riots started in larger cities (Brinkley 241). Several debt-burdened state governments refused to pay interest on their bonds, and some went into bankruptcy (Brinkley 241). The worst depression in United States history started, and lasted for five years (Brinkley 241). President Van Buren did not help matters by refusing to interfere, though he did cut back on expenses in the White House (Davidson and Stoff 342). Some were beginning to doubt that the monetary system would ever stabilize. The first international panic to affect the United States came in 1857. For some years, Europe had been requiring increasing supplies of American grain to fight the Crimean War (Tindall and Shi 707). This caused farmers to once again rush to borrow money and sow more grain (Tindall and Shi 707). When the demand dropped off, the market could no longer sustain such an influx (Tindall and Shi 707). The state system of banking was not helping either, weakening the dollar and causing confusion (Tindall and Shi 707). On August 24, 1857, the Ohio Life Insurance and Trust Company failed, and the country panicked, spiraling into a two year depression (Tindall and Shi 708). Blame immediately circulated. Cotton prices fell in the South, but slowly, and cotton production was at an all-time high, therefore the South boasted almost continually that their way of life was better than the North (Tindall and Shi 708). In the North, businesses failed, people went hungry, and no one was happy (Tindall and Shi 708). Thankfully, the depression lasted only two years. One of the last, largest panics in the nation was in 1873, after the Civil War. Leading investment firm Jay Cook and Company, after investing in railroad building after the war, led the panic by being the first to fail (Brinkley 414). The people sounded off unanimously to the government to redeem their federal war bonds with “greenbacks”, the new currency issued during the Civil War, to increase the amount of money in circulation (Brinkley 414). President Grant disagreed, wanting a more solid currency that relied completely on gold reserves, and possibly remembering well the previous panics caused by too much money in circulation (Brinkley 414). Finally, in 1875, the Specie Resumption Act was passed, stating that after January 1, 1879, the “greenback dollars would be redeemed by the government and replaced with new certificates that were firmly pegged to the price of gold” (Brinkley 414). While this did not satisfy everyone, it at least kept the country from sliding deeper into an economic wasteland. While it should not be said that it was “smooth sailing” for the American economy following the panic of 1873, the country did manage years of economic prosperity, and a time without too much government interference in the markets. What was fast becoming clear, however, was that this monetary system could not sustain itself indefinitely (Rothbard 186). The National Banking Acts of 1863, 1864, and 1865 had hurt more than they had helped by destroying state banknotes, cartelizing the banking system, and though the dollar was now pegged to the price of gold, there was still no government bank to ease inflation or to help the banks when the banks were in trouble (Rothbard, “History of Money”, 187). It became clear that something else was needed, and therefore in 1913 the Federal Reserve was created (Rothbard, “History of Money”, 258). The Federal Reserve would act, among other things, as a “coordinator of inflation”, helping the country to control the money supply in circulation as well as to hold money reserves that would help the country avoid another panic (Rothbard, “History of Money”, 258). The Federal Reserve was seen as the “classic example in compromise”, due to the fact that it was a decentralized bank with no government members sitting on its board of directors, but would function as a centralized bank capable of helping the economy and monetary policies of the country (The Federal Reserve). The most well known collapse of the monetary system came in 1929, when the stock market crashed and the country was plunged into a depression that it would take years to come back from. In many ways, the stage was set during the recovery of the panic of 1873; even with the guarantee of the dollar being backed by gold, and the economy increasing exponentially, sooner or later, the bust would come (Rothbard, “History of Money”, 160). Before the institution of the Federal Reserve, money supply rose rapidly from 1879 to 1897, by 6% per year, as opposed to 2.7% in earlier years (Rothbard, “History of Money”, 159). In many ways, the 1880s are noted to be the most productive decade of the United States (Rothbard, “History of Money”, 165). Prices did not fall comparatively, and total bank notes and deposits increased from $2.45 billion to $6.06 billion during this period (Rothbard, “History of Money”, 160). Those living now are left to speculate whether or not the Great Depression was just fallout of something that should have happened due to inflation in 1897, but did not. It should also be noted that not everyone faced prosperity and growth in the 1920s, unless they were speculating on the stock market; farmers were hit especially hard with low prices and large supplies that went unsold, which did not help the monetary affairs of the nation (Davidson and Stoff 708). Investors, however, were having a heyday, buying stocks on margin for as little as 10% down and reaping the rewards of a booming economy (Davidson and Stoff 686). Again, the market could not sustain the boom indefinitely, and the resulting bust sent shockwaves throughout the country quite quickly. President Herbert Hoover tried to reassure businessmen, saying that the country was sound and on a prosperous track, but he was not believed enough for people to stop selling stock in 1929 (Davidson and Stoff 708). Prices began to fall, and fell even further when those who had bought stock on margin were asked to pay any remaining debts (Davidson and Stoff 708). When they could not, their stock was sold off, and between October 24 and October 29, 1929, millions of shares of stock were suddenly sold (Davidson and Stoff 708). The dumping of stock was not the only cause of the Great Depression, but it cannot be doubted that it was a major monetary cause with severe repercussions on the monetary system. The American banking system was still weak, despite the creation of the Federal Reserve and all that had been done to provide support to it in previous years (Davidson and Stoff 709). The cascading effect of the stock market dump reached banks quite quickly. Banks had loaned money to investors to buy stock. When the crash came, investors could not pay off those loans. The bank, in turn, could not pay off their loans and was declared insolvent, with the added bonus of having to tell families that it could not return their hard-earned money to them (Davidson and Stoff 709). More than 5,000 banks closed between 1929 and 1932, and the withering finger of the Great Depression reached out next for businesses, who without capital could not expand (Davidson and Stoff, 709). There was no money, and therefore there was no capital. Businesses could not produce goods or even turn to banks for help, for there was no money in the bank, as stated previously. Businesses cut back production, laid off workers, and in some cases closed their doors (Davidson and Stoff 709). The Great Depression was not confined just to the United States. American banks had made loans to European banks that they could no longer repay, causing European banks to default and the worldwide economy to collapse (Davidson and Stoff 710). The failure of banks and businesses cascaded back to the workers, as without money, there was nothing to buy merchandise already on the market, such as clothing, cars, or even food (Davidson and Stoff 709). The Federal Reserve, created as the champion of bank holdings and seen as the savior of the country, at least in financial terms, was now hailed as a desecration. Some even saw it as the cause of the Great Depression. During the 1920s, Federal Reserve Chairman Benjamin Strong was called upon to give aid to England, who wanted their pound to stay at the same value (Rothbard, “History of Money”, 444). The basic premise was that gold would be checked and reversed by the credit expansion in the United States, which would raise prices of American goods and thus imports from England would be bought instead (Rothbard, “History of Money”, 444). The idea was sound, but the result was, once again, a failure. Britain avoided the value of the pound dropping, but the actions did not help the United States avoid the Great Depression (Rothbard, “History of Money”, 444). Adding to the woes of the Federal Reserve, it also had committed financial resources to the German bank Boden-Kredit-Anstalt of Vienna, which was the first bank abroad to go bankrupt in 1929 (Rothbard, “History of Money”, 450). The money that the Federal Reserve had committed was gone, and the United States was not happy. The problems compounded internationally. First Austria, then France, went off of the gold standard in 1931 (Rothbard, “History of Money”, 450). British banks had also made heavy loans to German banks in the 1920s and, instead of raising interest rates when disaster was imminent and attracting foreign investors, it kept the interest rate at 4.5% and instead shored up silver to offset gold losses (Rothbard, “History of Money”, 451). In a final act of mutiny, England went off of the gold standard (Rothbard, “History of Money”, 452). The Federal Reserve could no more stop England than it could have stopped the flood of selling stocks. This time around, to fix the country, newly-elected president Franklin D. Roosevelt sought action quickly. Instead, he declared a bank holiday, closing every bank in the country for eight days, after which he asked Congress to accept the Emergency Bank Relief Act (Davidson and Stoff 715). Due to this act, only banks with enough funds to meet customer demand could reopen, and others that could not had to stay closed (Davidson and Stoff 715). He also used his influence to pass the Banking Act of 1933, which created the Federal Deposit Insurance Corporation (FDIC), aimed at ensuring that no one lost their money in a banking collapse again (Davidson and Stoff 718). If an FDIC-insured bank were to fail, the government themselves would make sure that customers received their money (Davidson and Stoff 718). The Banking Act of 1933 also separated commercial and investment banking, which would guard against total collapse (The Federal Reserve). These measures helped to restore confidence in the banking and monetary systems of the United States, during and after the Great Depression. Between 1967 and 1987, the price of goods and purchases quadrupled. In 1967, the average price of a three-bedroom house was $17,000, while a brand new Cadillac went for $6,700 and a new Volkswagen $1,497, a Hershey chocolate bar sold for a nickel and a pound of sirloin for 89 cents (Mintz). Then, President Johnson decided that America should fight the Vietnam War, and did not raise taxes to pay for it (Mintz). The result was once again the old friend of the American economy, inflation, which caused many American families to lose their savings to pay for basic necessities (Mintz). It was not as bad as during the Great Depression, when people had no savings, but families definitely felt the pinch of higher prices. Just like in the late 1800s, prices rose, and did not take wages with them. By the end of the 1970s, wages had climbed just $36 over 1973 levels. Yet, inflation raised the prices of virtually all goods and services (Mintz). By January 1977, unemployment had reached 7.4 percent, and President Carter responded with an ambitious called for the Federal Reserve to expand the money supply (Mintz). This did not help; within two years, inflation had climbed to 13.3 percent, and the Federal Reserve Board then announced in 1979 that it would fight inflation by restraining the growth of the money supply (Mintz). President Reagan, elected in 1980, resolved to simply do something about the inflation. Unlike presidents of the 1960s and 1970s, President Ronald Reagan was a conservative. To Reagan, government was the problem, and not the solution. The nation, according to him, was hurting due to “declining capital investment and a tax structure biased against work and productive investment” (Mintz). To stimulate the economy, he persuaded Congress to slash tax rates, cutting taxes 5 percent in 1981 and 10 percent in 1982 and 1983 (Mintz). By the end of his two terms in office, unemployment had fallen to 4.4% (Mintz). However, Regan was also responsible for the national debt soaring almost out of control. Though Regan slashed taxes, he also increased military spending, which led to the budget deficit that the country still has not recovered from (Davidson and Stoff 827). Most recently, the monetary system of the United States has suffered due to the housing collapse. The 1990s saw the longest and largest amount of growth in the history of the nation (Mintz). Because of this, credit standards were relaxed and people were allowed to take out mortgages that, originally, they would not have been qualified for (DiMartino, and Duca 2). Due to this, the subprime mortgage, granted to those that are a higher credit risk than others, became popular (DiMartino, and Duca 2). Whereas in previous decade, subprime mortgages had accounted for only 14% of the mortgages in the country, by 2006 they accounted for 40% (DiMartino, and Duca 2). Coupled with a low interest rate due to a 2001 recession (it was taken down to 1% by 2003 by the Federal Reserve), home ownership in the United States increased from 63.8% in 1994 to 69.2% in 2004 (DiMartino, and Duca 2). Once again, the boom could not be sustained. Helping matters to fail was the fact that mortgages were now being held by investment groups, and not traditional savings-and-loan banks (DiMartino, and Duca 4). When people who were a high credit risk defaulted on their mortgages en masse, investors lost everything (DiMartino, and Duca 4). In one of the worst economic downturns since the Great Depression, the housing market collapsed (DiMartino, and Duca 5). The monetary system of the United States was once again turned upside down, and the country is still has not recovered in 2012. Over the past 200-plus years, this nation has not had a good track record when it comes to matters of monetary importance. Though inflation and devaluation are somewhat unavoidable as the years pass, between government interference, reticence, reluctance, and even insistence, the monetary system of the United States has suffered through panics, depressions, booms and busts. This does not mean that the government is wholly responsible for these things, but without their foolishly wished-for complete control over monetary policy, perhaps the country would not have suffered some of its crises. The history, as well as the failures, of the monetary system are undoubtedly colorful, rich and varied, and have their share of blame givers and takers. No one person or institution has ever been to blame for any single disaster, yet all of the country has been forced to share the burden of its fallouts. It can only be hoped that the next 200 years brings more prosperity, and a possible way to even out the stakes between those that create and mold the monetary system of the United States, and those that must bear the consequences of its failures. Works Cited Brinkley, Alan. The Unfinished Nation: A Concise History of the American People. Fourth Edition. 1. New York: McGraw-Hill Higher Education, 2004. Print. Davidson, James West, and Michael B. Stoff. The American Nation. Upper Saddle River: Prentice Hall, 1998. Print. DiMartino, Danielle, and John V. Duca. “The Rise and Fall of Subprime Mortgages.” Economic Letter: Insights from the Federal Reserve Bank of Dallas. 2.11 (2007): 1-8. Web. 20 Feb. 2012. Mintz, Steven. Digital History. Houston, Texas: University of Houston, 2007. eBook. Rothbard, Murray N. A History of Money and Banking in the United States: The Colonial Era to World War II . Auburn, Alabama: Ludwig von Mises Institute, 2002. eBook. Rothbard, Murray N. The Mystery of Banking. 2nd Edition. Auburn, Alabama: Ludwig von Mises Institute, 2008. eBook. The Federal Reserve. "History of the Federal Reserve." Federal Reserve Education. The Federal Reserve, n.d. Web. 20 Feb 2012. Tindall, George Brown, and David E. Shi. America: A Narrative History. 5th Edition. Volume 1. New York: W.W. Norton & Company, 1999. Wells, Donald R. “Banking Before the Federal Reserve: The U.S. and Canada Compared.” Freeman. June 1987: n. page. Web. 21 Feb. 2012. . Read More