The Evolution of Money

by David Orrell

  Again on the run, Law fled to England, then to Venice, where he died a poor man. In 1803, Napoleon needed money to pay for his wars and sold Louisiana to the United States for $15 million. A few years later, Law’s story served as inspiration for the character of Mephisto in Goethe’s Faust. The word “bank” was hardly used in France again until the late nineteenth century, with institutions preferring to call themselves a caisse, crédit, comptoir, or société.2

  Today, of course, fiat currencies are the norm, even if in many respects we seem to be in denial about that fact. As we’ll see, financial institutions such as central banks, as well as mainstream economic theories, were shaped under the gold standard and—in an example of what Marshall McLuhan called “culture lag”—have changed surprisingly little since. The reasons can be found in the 200-year American struggle between proponents of “paper” credit money—championed by figures such as Benjamin Franklin and Abraham Lincoln—and conservative forces that supported the gold standard—Baum’s “Wicked Witches of the East and West”—for the right to determine what counts as money.

  New World II

  Law’s system was brilliant, innovative, ahead of its time, and (with the benefit of hindsight) fatally flawed. One problem was that it relied on the power of the throne to give the paper money its credibility and set its value. Unlike the Bank of England scheme, the business and private banking community had no direct role except as a competitor. This made the system unstable. It didn’t help, of course, that the Mississippi Company, like its South Sea counterpart, was basically a Ponzi scheme. Perhaps Law’s biggest error, though, was that he was taking his show to the wrong country. John Law may have been Scottish by birth, but at heart he was surely an American.

  In America at the time, as in France, there was a shortage of coin. There were few mines for local production, and the mercantilists in London forbade the export of gold or silver to the colonies. Settlers often relied instead on commodity money (tobacco, beaver skins, and wampum beads all found use) or foreign coins, particularly the Spanish dollar, many of which ended up being exported in exchange for goods. The imperial system of pounds, shillings, and pence acted as a common unit of account.3 In 1690, the Massachusetts Bay Colony had funded a military campaign (to invade Canada) using paper “scrip” money. Other colonial governments adopted similar schemes as emergency measures during wartime, often with inflationary results. In the 1720s, though, legislatures began to introduce more permanent schemes.

  A leader in this area was Pennsylvania, which in 1723 issued a paper money that was backed by future taxes and the land assets of people who borrowed from the government.4 The scheme was therefore similar to Law’s idea of a land bank. One of its main promoters was Benjamin Franklin, a Pennsylvania printer who at the age of twenty-three wrote (and printed) a pamphlet titled A Modest Enquiry into the Nature and Necessity of a Paper-Currency. Echoing Law, whose work he had read, Franklin argued that a shortage of money leads to a shortage in trade.5 The money supply therefore had to be adjusted to match the needs of the economy, which was impossible if the material used to make it was controlled by other countries, but easy if the money was printed on paper. Of course, the supply had to be carefully limited to ensure that the money not sink in value.

  The new paper money, which was issued by using it to pay public expenses, had the desired effect of stimulating economic growth, and Franklin was influential in having the currency enlarged and extended (he also won a contract to print it). The British Parliament was less impressed, and soon passed a law making it illegal for colonial governments to produce their own money. Only gold and silver would be accepted for payment of taxes. The resulting contraction of the money supply, according to Franklin, meant that within a year the streets were full of unemployed people, just like back in England. This unemployment, he believed, was the real cause of the American Revolutionary War (1775–1783). In general, while the value-retaining properties of gold and silver were appreciated by tax collectors, rich creditors, and merchants—that is, those in positive credit—they were less admired by people like farmers or the unemployed, who often ended up in negative debt (perhaps this is why inflationary paper money has since been associated with a number of revolutionary movements, including the French and the Russian Revolutions).6

  Debts from the war were paid by the Continental Congress using “Continentals.” However, so many were printed, some by British counterfeiters, that over the course of the war they collapsed in value from a value of 1 silver dollar to more like 1 cent—thus turning them, as Franklin noted somewhat sarcastically, into a “wonderful machine” to pay for the conflict without using either hard currency or taxes.7 The result of this hyperinflation was a backlash against paper money, which again gave gold the upper hand (box 5.1).

  Box 5.1

  Hyperinflation

  As shown by John Law’s experiment in France or the Continentals during the Revolutionary War or the German mark after World War I or many other cases around the world, an episode of hyperinflation can make money less valuable than the paper it is printed on (especially because the paper is now full of dyes). In 2009, at the height of Zimbabwe’s hyperinflation, the Zimbabwean newspaper actually started running ads on banknotes saying, “It’s cheaper to print this on money than paper.” In 2015 the central bank officially retired the Zimbabwean dollar, allowing people to exchange the 100 trillion (100,000,000,000,000) notes for US$0.40.

  Hyperinflation is caused by a feedback loop in which an overstressed state or central bank prints money to pay off debts, but this has the effect of devaluing the currency. If the debts are in foreign currencies, devaluation makes the debts bigger. Currency speculators abandon or even short-sell the currency, which drives it down further. Since the money is only paper, the short-term solution is just to print some more, which creates more devaluation, and so on, until the process eventually burns out, and the currency has some zeros removed or is renamed as something else.

  To visualize how hyperinflation can affect one’s personal savings, fans of the TV show Breaking Bad will recall the episode in season 5 in which it is shown that former chemistry teacher Walter White’s crystal meth operation has generated an impressive pile of cash, which his wife, Skyler, has put in a storage locker: “I rented this place and I started bringing it here because … I didn’t know what else to do. I gave up counting it. I had to. It was just so much, so fast. … I just stack it up, keep it dry, spray it for silverfish.” A ballpark estimate from a still image is that the pile contains about 850,000 bills.* Assuming that none are smaller than $20, that would translate to a minimum of about $17 million. A lot of money—but a dose of hyperinflation could reduce it to less than the locker rental fee. In 1922 Germany, for example, the largest denomination note was 50,000 marks. The next year, the exchange rate was about 4.2 trillion marks to US$1, and a locker full of notes would have been worth only 1 cent. That is worse than silverfish. (Though perhaps a better comparison for the drug trade is Bolivia in 1985, when most of the country’s income came from exporting cocaine to the United States. A spike in inflation turned the same number of 10,000-peso notes into about US$5,000.)

  *Tom Cook, “What Is a Good Approximation of How Much Money Skyler Had in the Storage Unit When She Showed Walt How She Stopped Counting It?” Slate, September 6, 2012, http://tinyurl.com/cby36g8.

  What Is Coin?

  After the Revolutionary War, the Founding Fathers were in the same position as many a former European monarch: they needed a way to pay off a substantial national war debt. The collapse of the Continental meant that, while it had helped win the war, there was little appetite to risk the attentions of speculators and counterfeiters by issuing more paper currency. Secretary of the Treasury Alexander Hamilton therefore decided to imitate the Bank of England by bringing in the private sector and monetizing the debt. After all, while the Constitution specifies that only the government can mint coins, there was no such restriction on the printing of banknotes. The Bank of
the United States was duly founded in 1791.8 However, the scheme reached more resistance than it had in England. When the bank’s twenty-year charter ran out, Congress failed to renew. A second attempted Bank of the United States lasted no longer (1816–1836).9

  In the meantime, private banks were proliferating under a chaotic array of regulations that varied from state to state. The 1859 edition of Hodges Genuine Bank Notes of America, for example, listed some 9,916 notes issued by 1,365 banks. Counterfeiting was big business.10 The frontier needed cash, and quality was a secondary concern.

  The good money in the form of banking reserves tended to congregate in New York, and by the end of the nineteenth century some 75 percent of the country’s reserves were held by that city’s six largest banks.11 A number of legislators and presidents, including Thomas Jefferson, Andrew Jackson, Martin Van Buren, and Abraham Lincoln, attempted to limit what Van Buren referred to as the “money power.” Jackson famously remarking that if left unchecked it would be “more formidable and dangerous than the naval and military power of the enemy.”12 In 1862, in the middle of the American Civil War, President Lincoln signed into law the first Legal Tender Act, which authorized United States notes as legal tender. These paper notes, which soon became known as greenbacks, were not backed by gold or silver, did not add to the national debt, and did not earn interest, but could be used for any transaction apart from paying custom duties. As Lincoln told the Senate in 1865, just a few weeks before being assassinated (and conspiracy theorists have long seen a connection): “The government should create, issue and circulate all the currency and credit needed to satisfy the spending power of the government and the buying power of the consumers. … Money will cease to be master and become servant of humanity. Democracy will rise superior to the money power.”13 A leading advocate of the greenback program was the politician Benjamin Butler, who in 1869 told the House: “I stand here therefore for inconvertible paper money, the greenback which has fought our battles and saved our country. … I stand here for a currency by which the business transactions of 40 million people are safely and successfully done. … I stand for that money therefore which is by far the better agent and instrument of exchange of an enlightened and free people than gold or silver, the money alike of barbarian and despot.”14

  At its peak in 1878, the Greenback Labor Party, whose platform called for full-scale adoption of the paper currency, won more than 1 million votes.15 Although the party was defeated and the greenbacks in circulation were gradually phased out (they remained legal tender as late as 1971), the issuance of money, which had long been the preserve of elites, was now a major topic of debate for the general public. William Jennings Bryan campaigned three times for president on a Populist platform that called for the end of the banking cartel. Part of his argument revolved around the wording of the Constitution, which gives the government the right to “coin money” and “regulate the value thereof”—but does not define what is meant by money. So here the answer to the question “What is money?” took on a rather important legal significance. In a famous speech in 1896, Bryan argued that “the right to coin money and issue money is a function of government. … Those who are opposed to this proposition tell us that the issue of paper money is a function of the bank and that the government ought to go out of the banking business. I stand with Jefferson rather than with them, and tell them, as he did, that the issue of money is a function of the government and that the banks should go out of the governing business.”16 (It has since been argued, so far unsuccessfully, that the U.S. government could issue a number of $1 trillion coins and pay off the national debt; most recently in 2013 during the debt ceiling debate when Republicans and Democrats could not agree on the issue of U.S. indebtedness and the Twitter hashtag #MintTheCoin became the rendezvous point of the idea’s supporters.)

  One consequence of the general suspicion of the “money power” was that there was no real central bank to act as the lender of last resort and general hub of the banking system until, after a number of financial crises such as the Panic of 1907, the Federal Reserve was set up with the cooperation of financiers in 1913.17 Its dollar bills were similar in appearance to the greenback but, in the manner of Bank of England notes, represented a debt to the quasi-private Federal Reserve. Even then, the banking system remained highly fragmented, and the first interstate bank was not established until 1976 in Maine. The history of banking in the United States has therefore been chaotic, but that does not seem to have held back economic growth—perhaps because in a rapidly growing country, a degree of flexibility, rather than anal control over the money supply (Freud associated our interest in gold with a baby’s interest in feces),18 are exactly what you need.

  In keeping with the opaque nature of modern monetary systems, the Federal Reserve is confusingly named. No one wanted to call it the Bank of the United States, because that would have sounded like a central bank, and two of those had already been rejected. While the Fed is commonly assumed to be part of the federal government, and certainly plays an important role in governing the country’s money supply, it is actually an independent not-for-profit corporation consisting of twelve regional Federal Reserve banks, each of which in turn is owned by a consortium of commercial banks. The question of who actually “owns” the Fed is so complicated that it seems to have no real answer, but it doesn’t seem to be the people of the United States.19 It is one example of what Galbraith called the “deeper mystery” that seems to be deliberately cultivated around the financial system. This sense of intrigue is further heightened by the fact that policy decisions are made in private meetings, with only limited minutes released three weeks later, and by Delphic mutterings of the sort epitomized by former chairman Alan Greenspan, who reportedly said at one point, “If I have made myself clear then you have misunderstood me.”20 Efforts at transparency have since increased somewhat, but as always with money, part of the aim is to keep people guessing.

  The Nixon Shock

  Throughout this debate, the Newtonian gold standard remained in force internationally. It was suspended at the onset of World War I, when countries abandoned it en masse to manage their balance of payments. From then on, gold coinage mostly disappeared from use, but bullion still served as a money object for central banks. In Britain, when Winston Churchill decided as chancellor of the exchequer in 1925 to restore the gold standard to its prewar level, an overvaluation of about 10 percent, the resulting pay cuts led to a general strike.21 Adherence to gold is also believed to have exacerbated the Great Depression in the United States, since the government could not boost money supply to stimulate the economy. In 1933, President Roosevelt tried to address this situation by mining a new source of gold—private citizens. With some exceptions, people were given three weeks to hand in all gold coins, bullion, and gold certificates (except for an allowance of $100 for things like jewelry) and were paid cash in return at the current rate. The gold was melted down, added to the gold reserves—the Fort Knox depository was built for the occasion—and used to back more paper money.

  At the Bretton Woods conference held in July 1944, the U.S. dollar was set as a kind of reference currency. As discussed earlier, money has always been important in war, not just for paying the bills but also as a way for the victor to enjoy the spoils. In a watered-down version of the gold standard, exchange rates between currencies were fixed, and dollars earned through international trade could be redeemed for gold bars at a rate of $35 per ounce. This was highly advantageous to the United States because, like England in earlier times, it essentially controlled the world money supply. Its indebted allies had little say in the matter. Britain’s representative, the economist John Maynard Keynes, argued for a new, truly global reference currency, but his proposal was blocked by the Americans.

  In the early 1960s, though, the growing private market for gold began to show a tendency to lift the price above $35, in part because there was a shortage of gold to back the expansion in international trade but also because the U
.S. government was printing money to fund its military programs. The largest of these was the Vietnam War, which had an estimated total cost of about $111 billion.22 The Cold War was also a significant drain on the national budget. Even the Apollo space program was a sizable expense, with a total budget of about $24 billion.23 It too could be considered a war expense, since its main aim was to develop missile technology and acquire a technological and psychological advantage over Russia. Rome had its far-flung colonies, America had the moon. So the dollar was losing its luster as a reserve currency—and gold was losing its status as a money object with a stable price.

  Perhaps as a kind of warning, in 1963 the words “PAYABLE TO THE BEARER ON DEMAND” were removed from newly issued dollar notes, to be replaced with “IN GOD WE TRUST.” In 1968, the economist Milton Friedman wrote a letter to Richard Nixon urging him to abandon Bretton Woods and let exchange rates be determined by markets.24 The gold system finally collapsed completely on August 15, 1971, when Nixon unilaterally imposed wage and price controls and an import surcharge and halted the dollar’s direct convertibility to gold—an event that became known as the “Nixon shock.” As he told his TV audience on that day:

  We must protect the position of the American dollar as a pillar of monetary stability around the world. In the past 7 years, there has been an average of one international monetary crisis every year. … I have directed Secretary Connally to suspend temporarily the convertibility of the dollar into gold or other reserve assets, except in amounts and conditions determined to be in the interest of monetary stability and in the best interests of the United States. Now, what is this action—which is very technical—what does it mean for you? Let me lay to rest the bugaboo of what is called devaluation. If you want to buy a foreign car or take a trip abroad, market conditions may cause your dollar to buy slightly less. But if you are among the overwhelming majority of Americans who buy American-made products in America, your dollar will be worth just as much tomorrow as it is today. The effect of this action, in other words, will be to stabilize the dollar.25