A History of Money and Banking in the United States: The Colonial Era to World War II

by Murray N. Rothbard

  In addition, the Federal Reserve Board was given veto power over the election of the president and first vice president of each district Federal Reserve bank. And, in a symbolic gesture, all district Fed “governors,” the hoary name for heads of the central banks, were demoted to “presidents,” whereas the old “members” of the Federal Reserve Board in Washington were upgraded to “governors,” while the previous “governor” of the Federal Reserve Board now became the board’s august “chairman of the board of governors.” Furthermore, cementing Chairman Eccles’s power within Washington, the Treasury secretary and the comptroller of the currency were both removed as ex officio members of the Federal Reserve Board.

  Finally, the last shred of qualitativist restraint upon the Fed’s expansion of credit was removed, as bank assets deemed eligible for Fed rediscounting were broadened totally to include any paper whatever deemed “satisfactory” by the Fed—that is, any assets the Fed wished to declare eligible.96

  The Banking Act of 1935 was important for being the final settled piece of New Deal banking legislation that consolidated all the revolutionary changes from the beginning of the Roosevelt administration. The Morgans tried desperately, for example, to alter the 1933 Glass-Steagall provision, compelling the separation of commercial and investment banking, but this reversion was successfully blocked by Winthrop Aldrich. Specifically, Senator Glass’s amendment to the Banking Act of 1935, restoring limited securities power to deposit banks, was able to reach the congressional conference committee; for a while, it looked like this Morgan maneuver would succeed, but presumably at the behest of Aldrich, however, FDR personally interceded with the committee to kill the Glass amendment.97

  For his part, Aldrich, as a Wall Street banker himself, was not very happy about the permanent shift of power from Wall Street to Washington, but he was content to go along with the overall result, as part of the anti-Morgan coalition with Western banking.

  The centralization of power over the banking system in Washington was now complete. It is no wonder that the irrepressible H. Parker Willis, writing the following year, lamented the centralized monetary and banking tyranny that the Federal Reserve had become. Willis wisely perceived that the course of inflationary centralization to have begun in the 1920s as Morgan control in the hands of the New York Fed, and now, with the New Deal, was immeasurably accelerated and shifted to Washington:

  The Eccles group which advocated the Act of 1935 sought to obtain for themselves those powers which the more ambitious of the banking clique in New York and elsewhere had already arrogated to the Federal Reserve Bank of New York and to the small group by which the institution was practically directed [the House of Morgan]. There was no change in the conception or notion of centralization, but only in the agency or personnel through which such centralization should be put into effect.98

  The New Deal, Willis went on, had passed various allegedly temporary and emergency measures in its first three years, which were now permanently consolidated into the Banking Act of 1935, and thus “was built up perhaps the most highly centralized and irresponsible financial and banking machine of which the modern world holds record.”

  The result, Willis pointed out, was that the years of “tremendous deficit” from 1931 on were marked by a process of “gradually diverting the funds and savings of the community to the support of governmentally directed enterprises.” It was “an extraordinary development—an extreme application of central banking which brought the system of the United States to a condition of even higher concentration” than in other countries. Willis ominously and prophetically concluded,

  Today, the United States thus stands out as a nation of despotically controlled central banking; one in which, as all now admit, moreover, business paper of every kind is gradually taking the form of government paper which is then financed through a governmentally controlled central banking organization.99

  EPILOGUE: RETURN OF THE MORGANS

  It is well not to cry for the Morgans. Though permanently dethroned by the New Deal, they were able to make a comeback by the late 1930s. The great thrust for economic nationalism had subsided, and the Morgans were able to begin to work again for stabilization of exchange rates. In the fall of 1936, the United States entered into a tripartite agreement with Great Britain and France, the three countries agreeing—not exactly on fixed exchange rates—but on maneuvering to support each other’s exchanges at least within any given 24-hour period. Soon, the agreement, which was to last until World War II, was expanded to include Belgium, Holland, and Switzerland.

  As the nations moved toward World War II, the Morgans, who had long been closely connected with Britain and France, rose in importance in American foreign policy, while the Rockefellers, who had little connection with Britain and France and had patent agreements with I.G. Farben in Germany, fell in relative strength. Secretary of State Cordell Hull, a close longtime friend of FDR’s roving ambassador and Morgan man Norman H. Davis, took the lead in exerting pressure against Germany for its bilateral rather than multilateral trade agreements and for its exchange controls, all put in place to defend a chronically overvalued mark.100, 101

  As the United States prepared to enter World War II, it made its economic war aims brutally simple: the ending of the economic and monetary nationalism of the 1930s, and their replacement by a new international economic order based upon the dollar instead of the pound. In the trade area, this meant vigorous U.S. promotion of exports and the reduction of tariffs and quotas against American products (the so-called “open door” for American commerce and investments), and in the monetary sphere, it meant the breakup of national currency blocs, and the restoration of multilateral exchanges with fixed parities based upon the dollar. Even as the United States prepared to enter the war to save Britain, its continuing conflict with the British proclivity for exchange controls and an Imperial Preference bloc remained unresolved.102

  The resolution of the problem came after lengthy negotiations throughout World War II, culminating in the Bretton Woods Agreement in July 1944. Basically, the agreement was a compromise in which the United States won the main point: a new multilateral world of fixed exchange rates of currencies based on the dollar, while the Americans accepted the British Keynesian insistence on jointly promoting permanent inflationary policies to ensure “full employment.” The United States had achieved the objective expressed by Secretary Morgenthau: “to move the financial center of the world from London to the United States Treasury.”103 It is no wonder that, in January 1945, Lamar Fleming, Jr., president of Anderson, Clayton and Company, world’s largest cotton export brokers, could write to his longtime colleague and boss William L. Clayton that the “British empire and British international influence is a myth already.” The United States would soon become the protector of Britain against the emerging Russian landmass, prophesied Fleming, and this would mean “the absorption into the American empire of the parts of the British empire which we will be willing to accept.”104

  The dominant role in the critical wartime negotiations leading up to Bretton Woods was played not by the State Department, but secretly by the Council of Foreign Relations (CFR), a highly influential organization of businessmen and experts set up by the Morgans after World War I to promote an internationalist foreign political and economic policy. Private study groups set up by the CFR intermeshed and virtually dictated to parallel study groups established by the sometimes reluctant Department of State. President of the CFR from 1936 until 1944 and director of this effort was none other than Norman Davis, longtime Morgan affiliate and disciple of Morgan partner Henry P. Davison. The Morgans, indeed, were back.105 During the war, many Morgan-oriented men who had strongly opposed the economic nationalism of the early New Deal happily came back to help run the World War II and postwar version of the new era: Lewis W. Douglas; Dean Acheson, who had left the New Deal because of its radical monetary measures, was back as assistant secretary of state for monetary affairs; Acheson’s mentor, Henry L. Stimson,
was secretary of war; and Stimson’s other disciple, John J. McCloy, in effect ran the war effort as his deputy secretary. And when the ailing Cordell Hull retired in late 1944, he was replaced as secretary of state by Edward Stettinius, son of a Morgan partner and himself former president of Morgan-dominated United States Steel.106

  After World War II, the Morgans were content to slide into a new role as junior partner to the Rockefellers. The new prominence of oil made the Rockefellers the dominant force in the political and financial Eastern Establishment. The Rockefellers assumed control of the Council of Foreign Relations, the entire shift being neatly symbolized by the new postwar role of John J. McCloy, who was to serve as chairman of the Council of Foreign Relations, of the Rockefeller Foundation, and of the Rockefeller flagship bank, the Chase National Bank.107 The old verities and financial group conflicts of the pre–World War II era had disappeared, and had been transformed into a new world.

  Part 4

  THE GOLD-EXCHANGE STANDARD IN THE INTERWAR YEARS

  THE GOLD-EXCHANGE STANDARD IN THE INTERWAR YEARS

  Great Britain emerged victorious from its travail in World War I, but its economy, and particularly its currency, lay in shambles. All the warring countries had financed their massive four-year war effort by monetizing their deficits, most of them doubling, tripling, or quadrupling their money supply, with equivalent impacts upon their prices.1 The massive influx of government paper money forced these warring governments to go rapidly off the gold standard. The currencies depreciated in terms of gold, but the depreciation was masked by a network of exchange controls that marked the collectivized economies during World War I. Only the United States, which entered the war two and a half years after the other countries and hence inflated its currency less, managed to remain de jure on its prewar gold standard. De facto, however, the U.S. barred export of gold during the war, and so was effectively off gold during that period. In March 1919, when foreign exchange markets became free once more, the bad news became evident: while the dollar, again de facto as well as de jure on gold, remained at its prewar par (approximately one-twentieth of a gold ounce), European fiat paper currencies were sadly depreciated. The once-mighty pound sterling, traditionally at approximately $4.86, now sold at approximately $3.50 and at one point, in February 1920, was down to $3.20.2 Here was a 30- to 35-percent depreciation from its prewar par.

  Thus, wartime and postwar Europe was thrown into a cauldron of inflation, depreciation, exchange-rate volatility, and the menace of warring currency blocs. For the first time since the Napoleonic Wars, the world lacked an international money, a medium of exchange that could be used throughout the world, and lacked the international harmony, the monetary stability and calculability, that a world money could generate. Europe, and the world, were plunged into the chaos of an international moneyless, or barter, system. All the countries therefore looked back with understandable nostalgia at the relative Eden that had existed before the Great War.

  THE CLASSICAL GOLD STANDARD

  The nineteenth-century monetary system has been referred to as the “classical” gold standard. It has become fashionable among economists to denigrate that system as only existent in the last decades of the nineteenth century, and as simply a form of pound sterling standard, since London was the great financial center during this period. This disparagement of gold, however, is faulty and misleading. It is true that London was the major financial center in that period, but the world was scarcely on a pound standard. Active competition from other financial centers—Berlin, Paris, Amsterdam, Brussels, New York—ensured that gold was truly the only standard money throughout the world.3 Furthermore, to stress only the few decades before 1914 as the age of the gold standard ignores the fact that gold and silver have been the world’s two monetary metals from time immemorial. Countries shifted to and from freely fluctuating parallel gold and silver standards, in attempts, self-defeating in the long run, to fix the rate of exchange between the two metals (“bimetallism”). The fact that countries stampeded from silver and toward gold monometallism in the late nineteenth century should not obscure the fact that gold and silver, for centuries, were the world’s moneys, and that previous paper money experiments (the longest during the Napoleonic Wars) were considered to be both ephemeral and disastrously inflationary. Specie standards, whether gold or silver, have been virtually coextensive with the history of civilization.4 Apart from a few calamitous experiments, such as John Law’s Mississippi Bubble and the South Sea Bubble in the 1710s, and apart from the generation-long experience in Britain during the Napoleonic War, until the twentieth century specie rather than paper had always been the standard money.

  In the classical gold standard, every nation’s currency was defined as a unit of weight of gold, and therefore the paper currency was redeemable by its issuer (the government or its central bank) in the defined weight of gold coin. While gold bullion, in the form of large bars, was used for international payment, gold coin was used in everyday transactions by the general public. For obvious reasons, it is the inherent tendency of every money-issuer to create as much money as it can get away with, but governments or central banks were, on the gold standard, restricted in their issue of paper or bank deposits by the iron necessity of immediate redemption in gold, and particularly in gold coin on demand. As in the familiar Hume-Cantillon international price-specie flow mechanism, an increase of bank notes or deposits in a country beyond its gold stock increases the supply of money, say francs in France. The increase of the supply of francs and incomes in francs leads to (a) an increase in both domestic and foreign spending, hence raising imports; and (b) a rise in domestic French prices, in turn making domestic goods less competitive abroad and lowering exports, and making foreign goods more attractive and raising imports. The result is an inexorable deficit in the balance of payments, putting pressure upon French banks to supply gold to English, American, or Dutch exporters. In short, since in fractional reserve banking, paper and bank notes pyramid as a multiple of gold reserves, this expansion of the already engorged top of the inverted pyramid, must inexorably be followed by a loss in the bottom supporting the swollen liabilities. In addition, clients who are holders of French bank notes or deposits, are apt to become increasingly concerned, lose confidence in the viability of the French banks, and hence call on those banks to redeem in gold—putting those banks at risk for a devastating bank run. The result will be an often panicky and sudden contraction of bank notes, generating a recession to replace the previous inflationary boom, and leading to a contraction in notes and deposits, a drop in the French money supply, and a consequent fall in domestic French prices. The balance-of-payments deficit is reversed, and gold flows back into French coffers.

  In short, the classical gold standard put a severe limit upon the inherent tendency of monopoly money-issuers to issue money without check. As Ludwig von Mises pointed out, this international specie-flow mechanism also described a correct, if primitive, model of the business cycle. While central banking and fractional reserve banking allowed play for a boom-bust cycle, the inflationary boom, and its compensating bust, was kept in strict bounds.5 While scarcely perfect or lacking problems, the classical gold standard worked well enough for the world after World War I to look back upon it with understandable nostalgia.6

  BRITAIN FACES THE POSTWAR WORLD

  At the end of World War I, only the United States dollar remained on the old gold-coin standard, at the one-twentieth-of-an-ounce par. The other powers suffered from national fiat currencies; suddenly, their currencies were no longer units of weight of gold but independent names, such as pound, franc, mark, etc., their rates depreciating in relation to gold and volatile with respect to one another. Except for mavericks such as Cambridge’s John Maynard Keynes, it was generally agreed that this system was intolerable, and that a way must be found to reconstruct a world monetary order, including restoration of a world money and medium of exchange. At the heart of the European monetary crisis was Great Britain, which w
ould take the lead in trying to solve the problem. In the first place, London had been the major prewar financial center; and second, Britain dominated the postwar League of Nations, and in particular its powerful Economic and Financial Committee. Furthermore, though inflated and depreciated, the British pound was still in far better shape than the other major currencies of Europe. Thus, while the pound sterling in February 1920 was depreciated by 35 percent compared to its 1914 gold par, the French franc was depreciated by 64 percent, the Belgian franc by 62 percent, the Italian lira by 71 percent, and the German mark in terrible shape by 96 percent.7 It was clear that Britain was in a position to guide the world to a new postwar monetary order, and it eagerly took up what turned out to be the last remnants of its old imperial task.

  The British understandably decided that the fluctuating fiat money system inherited from the war was intolerable, and that it was vital to return to a sound international money, the gold standard. However, at the same time, they also decided that they would have to return to gold at the old prewar par of $4.86. Apparently, few if any economists or statesmen at the time argued for cutting British losses, starting with the real world as it existed in the early 1920s, facing reality, and going back to gold at the realistic, depreciated $3.20 or $3.50 per pound sterling. In view of the enormous difficulties the decision to go back to gold at $4.86 entailed, it is difficult in hindsight to understand why there was so little support for going back at a realistic par or why there was so much drive to go back at the old one.8 For going back to a pound 30 to 35 percent above the market rate, meant that English exports upon which the country depended to finance its exports, were now priced far above their competitive price in world markets. Coal, cotton textiles, iron and steel, and shipbuilding, in particular, the bulk of the export industries that had generated prewar prosperity, became permanently depressed in the 1920s, with accompanying heavy unemployment in those industries. In order to avoid export depression, Britain would have to have been willing to undergo a substantial monetary and price deflation, to make its goods once more competitive in foreign markets. But, in contrast to pre-World War I days, British wage rates had been made rigid downward by powerful trade-unionism, and particularly by a massive and extravagant system of national unemployment insurance. Rather than accept a rigorous deflationary policy, therefore, to accompany its return to gold, Britain insisted on just the opposite: a continuation of monetary inflation and a policy of low interest rates and cheap money. Thus, Great Britain, in the post-World War I world, committed itself to a monetary policy based on three rigidly firm but mutually self-contradictory axioms: (1) a return to gold; (2) returning at a sharply overvalued pound of $4.86; and (3) continuing a policy of inflation and cheap money. Given a program based on such grave inner self-contradiction, the British maneuvered on the world monetary scene with brilliant tactical shrewdness; but it was a policy that was doomed to end in disaster.