Early American Money
Read this section about the American monetary situation before 1907.
FEDERAL RESERVE SYSTEM
Gold is money. Everything else is credit. - J.P. Morgan to United States Congress in 1912
At the turn of the twentieth century, the pound remained the world's reserve currency but was losing ground to the United States dollar. During the Industrial Revolution, corporate barons Cornelius Vanderbilt, John D. Rockefeller, Andrew Carnegie, J.P. Morgan, and Henry Ford built companies that attracted demand for American currency. The world needed dollars in order to purchase the goods, services, and shares of these new elite corporate institutions. During this span, the United States did not have a central bank. But when an enormous earthquake in San Francisco induced a financial crisis in 1907, the United States would shortly thereafter take a page from Walter Bagehot's book and install a lender of last resort at the center of its financial system. The Federal Reserve System, the new American central banking apparatus, inherited a currency already on its way to world reserve status in 1914. It formalized a three-layered monetary system, with sanctioned private sector banks permitted to create third-layer monetary instruments on their balance sheets. Today, the Federal Reserve remains atop the hierarchy of money as the dollar still holds the crown of world reserve currency even though its position has become fragile. Understanding the dollar's complex dichotomy of dominance and fragility can be more easily explained with our layered terminology, a story that plays out over the next three chapters. In this chapter, we'll break down the Federal Reserve's three-layered dollar pyramid. Next, we'll see how the Federal Reserve and United States government decisively removed gold from the first layer of money. And finally, we'll look at how the international monetary system fell into disrepair starting in 2007, and why consequently the cry gets louder every year for a global currency reboot.
Early American Money
Throughout the New World colonies, money's form varied distinctly between regions. Coins weren't numerous in the early days because colonial mints didn't exist yet and European coins weren't plentiful enough to be used by every-body as currency. This drove people to use more local forms of money. In New York, sea-shell beads called wampum, used as money by many Native American tribes, circulated as legal tender during the seventeenth century. In Virginia, tobacco became a first-layer monetary asset and the basis of its own money pyramid due to the global popularity of the crop. The pound-of-tobacco unit became an accounting standard, and notes promising the delivery of pounds of tobacco were issued by Virginia as second-layer money that circulated among the public as cash. Shells and tobacco sufficed as regional money because they each demonstrated some, but not all, of the monetary characteristics of coinage. Neither was perfect, but they each successfully served as money for many decades. Both were divisible, difficult to conjure up, relatively fungible, and modestly durable. Eventually, they would be replaced as mediums of exchange and units of account by a historically superior form of money: gold and silver coinage.
As time elapsed, more foreign gold and silver coins started circulating as currency throughout the colonies. The most popular coin amongst the people was the Spanish silver dollar. In 1784, Thomas Jefferson published his Notes on the Establishment of a Money Unit, and of a Coinage for the United States, and provided the argument for the dollar as the new American currency unit:
[The] Dollar is a known coin, and the most familiar of all to the minds of the people. It is already adopted from South to North; has identified our currency, and therefore happily offers itself as a Unit already introduced.
A Monetary Mix
Sixteen years after the Declaration of Independence, the second Congress of the United States of America finally passed the Coinage Act in 1792 to establish the United States dollar as the country's official unit of account, defining one dollar as both 1.6 grams of gold and 24 grams of silver.
For the next 108 years, the United States experimented with a few different monetary regimes. An early adjustment to the exchange rate between gold and silver had the opposite effect of Isaac Newton's adjustment as Master of the Mint and drove gold out of usage for several decades.
Two separate central banks were created in 1791 and 1812, but each ended after its twenty-year charter. Many early Americans didn't trust central banks to administer their currency. The banks existed in antithesis to limited government ideals and led to a great deal of political vitriol, which prevented the institutions from charter renewal. Instead of central bank second-layer money, notes issued by private sector banks functioned as a very serviceable form of cash through- out the nineteenth century. These notes were secured by United States Treasuries, the name for U.S. government bonds. Here's an example of the official language written on a currency note secured (or backed) by U.S. Treasuries from 1902:
National Currency secured by United States Bonds deposited with the Treasurer of the United States of America
The American National Bank of San Francisco will pay to the bearer on demand Ten Dollars
In addition to private sector bank notes, U.S. government- issued gold certificates also circulated as cash. And finally, a Civil War financing tool and paper money called the green-back, which couldn't be redeemed for precious metal, circulated as cash during the latter part of the nineteenth century as well. Altogether, the United States had an amalgamation of second-layer monetary instruments circulating through-out the country. The demarcations between the second and third layers were difficult to define, especially without a central bank and a formal monetary system. Meanwhile, an international gold standard that began in England started to permeate the globe as other European nations established second-layer currencies bearing the promise of convertibility to gold coin, which influenced a resurgence of gold usage in the United States. The Gold Standard Act of 1900 ended some monetary ambiguity, eliminating silver from its monetary role and fixed one dollar at 1.5 grams of pure gold. The corresponding price of one troy ounce of gold stood at $20.67 - where it had been since 1834.10 The act was some- what of a formality as the Americans had already joined the world's gold standard in practice, but it was essential for the branding of the dollar denomination. The United States was now primed for another attempt at a central bank.
Reserves
In 1906, an earthquake of 7.9 magnitude rocked San Francisco, California causing mass destruction of life and property; over 3,000 people died and most of the city was destroyed. In a roundabout way, this earthquake caused the Federal Reserve System's creation. During these years, much of San Francisco's property was insured in London. British insurers paid out an enormous portion of San Francisco's colossal insurance claims as a result of the earthquake, and a flurry of capital was sent to California. In order to defend the pound-to-dollar exchange rate, the Bank of England dramatically raised interest rates by 2.5% in late 1906 in an effort to attract capital away from the dollar. It worked, and the American economy entered a contractionary period, which in turn led to a financial crisis. What ensued was an all-out scramble to ditch second- and third-layer money issued by any American financial institution whose creditworthiness came even remotely into question. As Americans climbed the money pyramid in the Panic of 1907, depositors across the nation withdrew bank deposits to seek out higher-layer forms of money, like gold coins or U.S. Treasuries. These withdrawals across the country caused regional banks to run on New York banks. As the crisis escalated, banking titan J.P. Morgan stepped in, organized a financial salvation of faltering banks, and saved the financial system. Morgan didn't have a choice: a United States central bank and lender of last resort didn't exist.
The next year, United States Senator Nelson Aldrich set up the National Monetary Commission, the job of which was to study Europe's monetary system and make recommendations on how to overhaul and modernize what had become a sloppy and disjointed dollar system without a central bank. Without a government sponsored lender of last resort and clearly defined money pyramid, the dollar's internationalization remained elusive. After years of study, published reports, and congressional testimony, Aldrich finally achieved his pursuit of a central bank when Congress passed into law the Federal Reserve System on December 23, 1913.
The word reserve is in the title of the institution itself, but what exactly are reserves, and how do they fit into the narrative of layered money? The word implies a safety mechanism, something to help in case of a crisis. Indeed, the Federal Reserve System (the Fed) was founded to combat financial crises, and it would do this with a second-layer money called reserves. Fed reserves are another way to say deposits, but these deposits were issued by the Fed only to private sector banks. Fed notes (or the "dollar cash" we know today), the Fed's other form of second-layer money, were available to the people. Fed notes were issued as a public good, a reliable paper currency that could be easily used as a medium of exchange. But reserves are the real tool the Fed uses to wield its monetary power. They are the monetary construct we must under- stand to interpret the difference between wholesale money and retail money.
Wholesale money (Fed reserves) is money that banks use, and retail money (Fed notes) is money that people use. Fed reserves are deposits for banks only and do not have any retail access: no individual can spontaneously open up an account at their local Federal Reserve branch and acquire them. The difference between wholesale and retail money becomes more important when discussing the future of central banking, but in the historical context, the Fed's mandate was to provide wholesale money, or money for the banking system, when the instability of credit stoked financial unrest. The name said it all; the Federal Reserve system was intended primarily to be a wholesale rescue mechanism of reserves.
The Fed
The Federal Reserve Act's full name is:
An act to provide for the establishment of Federal reserve banks, to furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes.
The first stated purpose, "to provide for the establishment of Federal reserve banks," immediately establishes a federally unified and accepted second-layer money, "reserves," underlying all banking activity in the United States. Reserve banks would replace the existing decentralized mix of second-layer money and end the ability for private sector banks to issue it. The Act monopolized the second layer of money in the United States under the Fed, and firmly placed all private sector money issuance on the third layer.
The second stated purpose of the Act, "to furnish an elastic currency," confirmed that the Fed would have the ability to issue money in a fractionally reserved way and allow banks within its system to do the same.
The third purpose of the Act was the Walter Bagehot provision, giving the Fed the "means of rediscounting commercial paper". Commercial paper refers to short-term debt issued by banks and corporations. This allowed the Fed to act as a lender of last resort for the financial system by creating second-layer reserve balances in order to purchase distressed financial assets.
The last major stated purpose of the Act was "to establish a more effective supervision of banking in the United States," in an attempt to sort through the monetary disarray of the day, establish the Fed's financial surveillance on the banking industry, and give the Fed sole power to issue bank charters that came with the ability to create third-layer money.
Finally, the Act decreed that the Fed maintain a gold- coverage ratio of at least 35% against the liabilities it issued on the second layer, meaning at least 35% of the Fed's assets must be held in gold. In actuality, gold represented 84% of the Federal Reserve's assets upon its founding, a number that would dramatically fall over time. Today, for reference, gold represents less than 1% of the Fed's assets.
Initially, the Federal Reserve did not own nor intend to own U.S. Treasuries on its balance sheet. The beginning of the first World War in 1914 swiftly ended this original intent, which became irrelevant in the face of war finance. Only two years after the launch of the Federal Reserve System in 1916, the Federal Reserve Act was amended to effectively help the United States government finance its war effort, and the Fed subsequently created ample reserves in order to purchase U.S. Treasuries.
The process of building an enormous portfolio of U.S. government debt had larger implications for the dollar pyramid. U.S. Treasuries joined gold on the first layer of money because of the Fed's new asset composition: by the end of World War I in 1918, the Fed's gold-coverage ratio fell from 84% to less than 40%, as over half the Fed's assets were now held in U.S. government bonds. It was the first indication that U.S. Treasuries would eventually replace gold altogether as the dollar pyramid's only first-layer asset.
The Evolution of the Federal Reserve (1918-1944)
Take note of the evolution of America's monetary system under the Federal Reserve and the influences of the Great Depression.
RETIRING GOLD
For both Eurodollars and liabilities of U.S. banks[,] . . . their major source is a bookkeeper's pen. - Milton Friedman, Nobel Prize in Economics winner, 1976
It only took half a century after the end of World War I for the United States to abandon its gold standard. The retirement of gold from our formal monetary system can be traced to a series of events starting with the great Wall Street crash of 1929. The 1920s, commonly referred to as the roaring twenties, was a decade defined by the first traces of consumerism: spending money as a way of life. Credit became widely available to the average American, but instead of measuring the quantity of its growth, it's more interesting to look at what type of credit was being issued. Department stores started offering credit cards to wealthy customers for the first time, oil companies began credit card loyalty programs, and banks fueled speculation in the stock market by lending up to 90% of the capital required to purchase shares. New York had become the center of international finance. Shares of companies listed on the New York Stock Exchange were flooded with demand, and capital poured into the United States. This greatly strengthened the global demand for dollars and bolstered the American currency to the world reserve currency echelon. The swarm of money creation that occurred during the roaring twenties was antagonistic toward gold's disciplinary constraint on money elasticity and conclusively revealed a societal need for the dollar's decoupling from gold. Categorically, there wasn't enough gold held by the United States government to furnish the elastic currency it had promised in its enactment. The proof of this came in the aftermath of a historic stock market crash.
When stock prices found gravity in October 1929, the Fed had to respond to a major financial crisis in earnest for the first time. With a fixed amount of gold reserves and a legally binding 35% gold-coverage ratio, the Federal Reserve was unable to create the necessary amount of second-layer money to stave off an economic depression. Several thou- sand banks failed in the early 1930s, wiping out billions of dollars of the American public's bank deposits. The economic depression coincided with the extremely harsh reality that third-layer money could disappear in an instant. No safety net or insurance mechanism existed to remedy such loss. The Fed did attempt to "furnish an elastic currency" and be a lender of last resort to the best of its ability, but it wasn't enough to overcome the effects of third-layer money contraction that resulted from the public's desire to flee risky deposits. The Federal Reserve was bound by a legislated minimum gold-coverage which limited the amount of credit the Fed made available to the system. Gold's disciplinary constraint received an outcry of blame for the economy's inability to recover and led to dramatic and sweeping changes to the dollar pyramid during the 1930s. These events should be seen as the major catalyst that kickstarted gold's departure from the world's monetary landscape.
No Gold for You
President Franklin Roosevelt issued Executive Order 6102 on April 5, 1933 which instructed all "gold coin, gold bullion, and certificates to be delivered to the government". The order was effectively a forced sale of gold in exchange for Federal Reserve notes (cash) by all United States citizens and out- rightly eliminated the people's access to first-layer money. This brazen declaration made the possession of and trafficking in first-layer money illegal and punishable by up to ten years in prison, reminiscent of the Bank of Amsterdam's mandate for all cashiers to surrender precious metal coins in exchange for BoA deposits upon its creation in 1609.
The following year, the United States passed the Gold Reserve Act of 1934, which devalued the dollar against gold by increasing the gold price from $20.67 to $35 per ounce. This immense devaluation was a surgical strike in an ongoing worldwide currency war wherein countries attempted to cheapen their currencies as much as possible relative to their trade partners. Their goal was to attract foreign demand by having the cheapest prices. The United States was merely copying what every other country was doing: giving anybody with gold more buying power to purchase American goods and services. Unfortunately for the American public, the gold price increase came after the seizure, meaning the American people didn't benefit from it. The Act also legally transferred the ownership of all Federal Reserve gold to the United States Treasury and preceded the physical movement of gold bullion from New York to the United States Army's installation at Fort Knox in Kentucky.
Deposit Insurance
The Banking Act of 1935 permanently established the Federal Deposit Insurance Corporation (FDIC), institutionalizing bank deposit insurance for the average American family. In the context of layered money, FDIC insurance is a federally guaranteed insurance policy on all third-layer bank deposits. The FDIC guarantee alleviated the public's fear of third-layer money vaporizing as it did during the 4,000 bank closures in 1933 alone. In numbers, the impact of the FDIC's creation was tiny: the insured amount for each depositor was only $5,000. But from a psychological standpoint, the impact was enormous. People wouldn't flee third-layer deposits in favor of second-layer cash if they knew their deposits were insured by the federal government. Without gold as an available savings vehicle, federal deposit insurance was the government's attempt to assure citizens that their dollar savings would be protected even if housed by private sector banks with counter- party risk. Around the same time, the Federal Reserve finally secured its official monopoly over note issuance after the U.S. Treasury paid off the last bonds eligible as backing for private notes. The once ambiguous dollar pyramid suddenly started to come into focus: the monetary system existed between the second and third layers of money, and gold's constraint on lower layers had been weakened by the government's actions between 1933 and 1935. Thus, began the journey for the U.S. dollar to stand alone, independent of gold.
King Dollar
Amidst the global currency war, the dollar emerged as the cleanest dirty shirt in the laundry of global currencies. Even though the dollar devalued against gold, other countries were doing so in an even bigger way. Pound sterling abandoned a gold standard in 1931 and officially ended its reign as world reserve currency. The void was filled by the currency of the world's newest superpower: United States of America.
In 1944, world leaders gathered at a hotel in Bretton Woods, New Hampshire and formalized that all currencies besides the dollar were forms of third-layer money within the dollar pyramid. The Bretton Woods agreement would come to be known as the dollar's world reserve currency coronation. The agreement didn't impact the relationship between the first and second layers of money in any way: Federal Reserve notes still promised the bearer gold coins on demand at $35 per ounce. It did pertain, however, to the relationship between the dollar and other currencies. Currencies would have fixed exchange rates with the dollar and wouldn't them- selves be redeemable for gold. Only the dollar kept a link between itself and gold. The dollar had become the axis of the world's various denominations. Governments and central banks across the world were forced to shift the denomination of their reserves, securities, and balance sheets to U.S. dollars (USD).
The agreement brought about an important distinction in the relationship between layers of money. Foreign currencies were on the third layer of money, this time not because of the balance sheet from which they came to exist, but rather because of their price relationship to dollars. In Figure 11, we show USD on a layer above other currencies such as GBP (British pound sterling) and CHF (Swiss franc). The pound and franc are below the dollar in the layers of money because their price is measured in dollars. This means that going forward, there are two possible relationships between monetary instruments within the layered framework: balance sheet hierarchy and price hierarchy.
Figure 11
Destined to Fail
Unfortunately for the international monetary system, the Bretton Woods agreement was doomed. The most prescient thinker on the burden of world reserve currencies during this era was Robert Triffin, a Belgian-born economist who conducted research at the Federal Reserve and International Monetary Fund in its early years. Triffin correctly predicted the end of the Bretton Woods agreement over a decade before it collapsed. While United States citizens were banned from owning gold, foreign nations were still allowed to convert their accumulated dollar reserves to metal. Triffin predicted that these nations would eventually deplete the United States gold stock, making a fixed price of $35 per ounce of gold impossible to maintain. He warned that gold convertibility would not survive without an adjustment to the framework held in place by the Bretton Woods agreement. Most importantly, he identified that being the world reserve currency was a burden, not a blessing. Foreign countries would accumulate dollars because of its reserve status. This would strengthen the dollar and cause trade imbalances that otherwise would not exist without this extra source of world reserve currency demand. Triffin's proposed solution to the problem of one country's currency serving as the denomination of the inter- national monetary system was political cooperation between major economic powers. In a testimony to U.S. Congress in 1959, he admitted his solution remained elusive, a dilemma that drove the demand for gold as the world's only neutral money, no matter how absurd the idea of it might be:
The logical solution of the problem . . . would have been achieved long ago if it were not for the enormous difficulties involved in . . . reaching agreement with several countries on the multiple facets of a rational system of international money and credit creation. This is, of course, the only explanation for the survival of gold itself. Nobody could have ever conceived of a more absurd waste of human resources than to dig gold in distant corners of the Earth for the sole purpose of transporting it and reburying it immediately afterward in other deep holes, especially excavated to receive it and heavily guarded to protect it. The history of human intuitions, however, has a logic of its own.
Read this section about the American monetary situation before 1907.
FEDERAL RESERVE SYSTEM
Gold is money. Everything else is credit. - J.P. Morgan to United States Congress in 1912
At the turn of the twentieth century, the pound remained the world's reserve currency but was losing ground to the United States dollar. During the Industrial Revolution, corporate barons Cornelius Vanderbilt, John D. Rockefeller, Andrew Carnegie, J.P. Morgan, and Henry Ford built companies that attracted demand for American currency. The world needed dollars in order to purchase the goods, services, and shares of these new elite corporate institutions. During this span, the United States did not have a central bank. But when an enormous earthquake in San Francisco induced a financial crisis in 1907, the United States would shortly thereafter take a page from Walter Bagehot's book and install a lender of last resort at the center of its financial system. The Federal Reserve System, the new American central banking apparatus, inherited a currency already on its way to world reserve status in 1914. It formalized a three-layered monetary system, with sanctioned private sector banks permitted to create third-layer monetary instruments on their balance sheets. Today, the Federal Reserve remains atop the hierarchy of money as the dollar still holds the crown of world reserve currency even though its position has become fragile. Understanding the dollar's complex dichotomy of dominance and fragility can be more easily explained with our layered terminology, a story that plays out over the next three chapters. In this chapter, we'll break down the Federal Reserve's three-layered dollar pyramid. Next, we'll see how the Federal Reserve and United States government decisively removed gold from the first layer of money. And finally, we'll look at how the international monetary system fell into disrepair starting in 2007, and why consequently the cry gets louder every year for a global currency reboot.
Early American Money
Throughout the New World colonies, money's form varied distinctly between regions. Coins weren't numerous in the early days because colonial mints didn't exist yet and European coins weren't plentiful enough to be used by every-body as currency. This drove people to use more local forms of money. In New York, sea-shell beads called wampum, used as money by many Native American tribes, circulated as legal tender during the seventeenth century. In Virginia, tobacco became a first-layer monetary asset and the basis of its own money pyramid due to the global popularity of the crop. The pound-of-tobacco unit became an accounting standard, and notes promising the delivery of pounds of tobacco were issued by Virginia as second-layer money that circulated among the public as cash. Shells and tobacco sufficed as regional money because they each demonstrated some, but not all, of the monetary characteristics of coinage. Neither was perfect, but they each successfully served as money for many decades. Both were divisible, difficult to conjure up, relatively fungible, and modestly durable. Eventually, they would be replaced as mediums of exchange and units of account by a historically superior form of money: gold and silver coinage.
As time elapsed, more foreign gold and silver coins started circulating as currency throughout the colonies. The most popular coin amongst the people was the Spanish silver dollar. In 1784, Thomas Jefferson published his Notes on the Establishment of a Money Unit, and of a Coinage for the United States, and provided the argument for the dollar as the new American currency unit:
[The] Dollar is a known coin, and the most familiar of all to the minds of the people. It is already adopted from South to North; has identified our currency, and therefore happily offers itself as a Unit already introduced.
A Monetary Mix
Sixteen years after the Declaration of Independence, the second Congress of the United States of America finally passed the Coinage Act in 1792 to establish the United States dollar as the country's official unit of account, defining one dollar as both 1.6 grams of gold and 24 grams of silver.
For the next 108 years, the United States experimented with a few different monetary regimes. An early adjustment to the exchange rate between gold and silver had the opposite effect of Isaac Newton's adjustment as Master of the Mint and drove gold out of usage for several decades.
Two separate central banks were created in 1791 and 1812, but each ended after its twenty-year charter. Many early Americans didn't trust central banks to administer their currency. The banks existed in antithesis to limited government ideals and led to a great deal of political vitriol, which prevented the institutions from charter renewal. Instead of central bank second-layer money, notes issued by private sector banks functioned as a very serviceable form of cash through- out the nineteenth century. These notes were secured by United States Treasuries, the name for U.S. government bonds. Here's an example of the official language written on a currency note secured (or backed) by U.S. Treasuries from 1902:
National Currency secured by United States Bonds deposited with the Treasurer of the United States of America
The American National Bank of San Francisco will pay to the bearer on demand Ten Dollars
In addition to private sector bank notes, U.S. government- issued gold certificates also circulated as cash. And finally, a Civil War financing tool and paper money called the green-back, which couldn't be redeemed for precious metal, circulated as cash during the latter part of the nineteenth century as well. Altogether, the United States had an amalgamation of second-layer monetary instruments circulating through-out the country. The demarcations between the second and third layers were difficult to define, especially without a central bank and a formal monetary system. Meanwhile, an international gold standard that began in England started to permeate the globe as other European nations established second-layer currencies bearing the promise of convertibility to gold coin, which influenced a resurgence of gold usage in the United States. The Gold Standard Act of 1900 ended some monetary ambiguity, eliminating silver from its monetary role and fixed one dollar at 1.5 grams of pure gold. The corresponding price of one troy ounce of gold stood at $20.67 - where it had been since 1834.10 The act was some- what of a formality as the Americans had already joined the world's gold standard in practice, but it was essential for the branding of the dollar denomination. The United States was now primed for another attempt at a central bank.
Reserves
In 1906, an earthquake of 7.9 magnitude rocked San Francisco, California causing mass destruction of life and property; over 3,000 people died and most of the city was destroyed. In a roundabout way, this earthquake caused the Federal Reserve System's creation. During these years, much of San Francisco's property was insured in London. British insurers paid out an enormous portion of San Francisco's colossal insurance claims as a result of the earthquake, and a flurry of capital was sent to California. In order to defend the pound-to-dollar exchange rate, the Bank of England dramatically raised interest rates by 2.5% in late 1906 in an effort to attract capital away from the dollar. It worked, and the American economy entered a contractionary period, which in turn led to a financial crisis. What ensued was an all-out scramble to ditch second- and third-layer money issued by any American financial institution whose creditworthiness came even remotely into question. As Americans climbed the money pyramid in the Panic of 1907, depositors across the nation withdrew bank deposits to seek out higher-layer forms of money, like gold coins or U.S. Treasuries. These withdrawals across the country caused regional banks to run on New York banks. As the crisis escalated, banking titan J.P. Morgan stepped in, organized a financial salvation of faltering banks, and saved the financial system. Morgan didn't have a choice: a United States central bank and lender of last resort didn't exist.
The next year, United States Senator Nelson Aldrich set up the National Monetary Commission, the job of which was to study Europe's monetary system and make recommendations on how to overhaul and modernize what had become a sloppy and disjointed dollar system without a central bank. Without a government sponsored lender of last resort and clearly defined money pyramid, the dollar's internationalization remained elusive. After years of study, published reports, and congressional testimony, Aldrich finally achieved his pursuit of a central bank when Congress passed into law the Federal Reserve System on December 23, 1913.
The word reserve is in the title of the institution itself, but what exactly are reserves, and how do they fit into the narrative of layered money? The word implies a safety mechanism, something to help in case of a crisis. Indeed, the Federal Reserve System (the Fed) was founded to combat financial crises, and it would do this with a second-layer money called reserves. Fed reserves are another way to say deposits, but these deposits were issued by the Fed only to private sector banks. Fed notes (or the "dollar cash" we know today), the Fed's other form of second-layer money, were available to the people. Fed notes were issued as a public good, a reliable paper currency that could be easily used as a medium of exchange. But reserves are the real tool the Fed uses to wield its monetary power. They are the monetary construct we must under- stand to interpret the difference between wholesale money and retail money.
Wholesale money (Fed reserves) is money that banks use, and retail money (Fed notes) is money that people use. Fed reserves are deposits for banks only and do not have any retail access: no individual can spontaneously open up an account at their local Federal Reserve branch and acquire them. The difference between wholesale and retail money becomes more important when discussing the future of central banking, but in the historical context, the Fed's mandate was to provide wholesale money, or money for the banking system, when the instability of credit stoked financial unrest. The name said it all; the Federal Reserve system was intended primarily to be a wholesale rescue mechanism of reserves.
The Fed
The Federal Reserve Act's full name is:
An act to provide for the establishment of Federal reserve banks, to furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes.
The first stated purpose, "to provide for the establishment of Federal reserve banks," immediately establishes a federally unified and accepted second-layer money, "reserves," underlying all banking activity in the United States. Reserve banks would replace the existing decentralized mix of second-layer money and end the ability for private sector banks to issue it. The Act monopolized the second layer of money in the United States under the Fed, and firmly placed all private sector money issuance on the third layer.
The second stated purpose of the Act, "to furnish an elastic currency," confirmed that the Fed would have the ability to issue money in a fractionally reserved way and allow banks within its system to do the same.
The third purpose of the Act was the Walter Bagehot provision, giving the Fed the "means of rediscounting commercial paper". Commercial paper refers to short-term debt issued by banks and corporations. This allowed the Fed to act as a lender of last resort for the financial system by creating second-layer reserve balances in order to purchase distressed financial assets.
The last major stated purpose of the Act was "to establish a more effective supervision of banking in the United States," in an attempt to sort through the monetary disarray of the day, establish the Fed's financial surveillance on the banking industry, and give the Fed sole power to issue bank charters that came with the ability to create third-layer money.
Finally, the Act decreed that the Fed maintain a gold- coverage ratio of at least 35% against the liabilities it issued on the second layer, meaning at least 35% of the Fed's assets must be held in gold. In actuality, gold represented 84% of the Federal Reserve's assets upon its founding, a number that would dramatically fall over time. Today, for reference, gold represents less than 1% of the Fed's assets.
Initially, the Federal Reserve did not own nor intend to own U.S. Treasuries on its balance sheet. The beginning of the first World War in 1914 swiftly ended this original intent, which became irrelevant in the face of war finance. Only two years after the launch of the Federal Reserve System in 1916, the Federal Reserve Act was amended to effectively help the United States government finance its war effort, and the Fed subsequently created ample reserves in order to purchase U.S. Treasuries.
The process of building an enormous portfolio of U.S. government debt had larger implications for the dollar pyramid. U.S. Treasuries joined gold on the first layer of money because of the Fed's new asset composition: by the end of World War I in 1918, the Fed's gold-coverage ratio fell from 84% to less than 40%, as over half the Fed's assets were now held in U.S. government bonds. It was the first indication that U.S. Treasuries would eventually replace gold altogether as the dollar pyramid's only first-layer asset.
The Evolution of the Federal Reserve (1918-1944)
Take note of the evolution of America's monetary system under the Federal Reserve and the influences of the Great Depression.
RETIRING GOLD
For both Eurodollars and liabilities of U.S. banks[,] . . . their major source is a bookkeeper's pen. - Milton Friedman, Nobel Prize in Economics winner, 1976
It only took half a century after the end of World War I for the United States to abandon its gold standard. The retirement of gold from our formal monetary system can be traced to a series of events starting with the great Wall Street crash of 1929. The 1920s, commonly referred to as the roaring twenties, was a decade defined by the first traces of consumerism: spending money as a way of life. Credit became widely available to the average American, but instead of measuring the quantity of its growth, it's more interesting to look at what type of credit was being issued. Department stores started offering credit cards to wealthy customers for the first time, oil companies began credit card loyalty programs, and banks fueled speculation in the stock market by lending up to 90% of the capital required to purchase shares. New York had become the center of international finance. Shares of companies listed on the New York Stock Exchange were flooded with demand, and capital poured into the United States. This greatly strengthened the global demand for dollars and bolstered the American currency to the world reserve currency echelon. The swarm of money creation that occurred during the roaring twenties was antagonistic toward gold's disciplinary constraint on money elasticity and conclusively revealed a societal need for the dollar's decoupling from gold. Categorically, there wasn't enough gold held by the United States government to furnish the elastic currency it had promised in its enactment. The proof of this came in the aftermath of a historic stock market crash.
When stock prices found gravity in October 1929, the Fed had to respond to a major financial crisis in earnest for the first time. With a fixed amount of gold reserves and a legally binding 35% gold-coverage ratio, the Federal Reserve was unable to create the necessary amount of second-layer money to stave off an economic depression. Several thou- sand banks failed in the early 1930s, wiping out billions of dollars of the American public's bank deposits. The economic depression coincided with the extremely harsh reality that third-layer money could disappear in an instant. No safety net or insurance mechanism existed to remedy such loss. The Fed did attempt to "furnish an elastic currency" and be a lender of last resort to the best of its ability, but it wasn't enough to overcome the effects of third-layer money contraction that resulted from the public's desire to flee risky deposits. The Federal Reserve was bound by a legislated minimum gold-coverage which limited the amount of credit the Fed made available to the system. Gold's disciplinary constraint received an outcry of blame for the economy's inability to recover and led to dramatic and sweeping changes to the dollar pyramid during the 1930s. These events should be seen as the major catalyst that kickstarted gold's departure from the world's monetary landscape.
No Gold for You
President Franklin Roosevelt issued Executive Order 6102 on April 5, 1933 which instructed all "gold coin, gold bullion, and certificates to be delivered to the government". The order was effectively a forced sale of gold in exchange for Federal Reserve notes (cash) by all United States citizens and out- rightly eliminated the people's access to first-layer money. This brazen declaration made the possession of and trafficking in first-layer money illegal and punishable by up to ten years in prison, reminiscent of the Bank of Amsterdam's mandate for all cashiers to surrender precious metal coins in exchange for BoA deposits upon its creation in 1609.
The following year, the United States passed the Gold Reserve Act of 1934, which devalued the dollar against gold by increasing the gold price from $20.67 to $35 per ounce. This immense devaluation was a surgical strike in an ongoing worldwide currency war wherein countries attempted to cheapen their currencies as much as possible relative to their trade partners. Their goal was to attract foreign demand by having the cheapest prices. The United States was merely copying what every other country was doing: giving anybody with gold more buying power to purchase American goods and services. Unfortunately for the American public, the gold price increase came after the seizure, meaning the American people didn't benefit from it. The Act also legally transferred the ownership of all Federal Reserve gold to the United States Treasury and preceded the physical movement of gold bullion from New York to the United States Army's installation at Fort Knox in Kentucky.
Deposit Insurance
The Banking Act of 1935 permanently established the Federal Deposit Insurance Corporation (FDIC), institutionalizing bank deposit insurance for the average American family. In the context of layered money, FDIC insurance is a federally guaranteed insurance policy on all third-layer bank deposits. The FDIC guarantee alleviated the public's fear of third-layer money vaporizing as it did during the 4,000 bank closures in 1933 alone. In numbers, the impact of the FDIC's creation was tiny: the insured amount for each depositor was only $5,000. But from a psychological standpoint, the impact was enormous. People wouldn't flee third-layer deposits in favor of second-layer cash if they knew their deposits were insured by the federal government. Without gold as an available savings vehicle, federal deposit insurance was the government's attempt to assure citizens that their dollar savings would be protected even if housed by private sector banks with counter- party risk. Around the same time, the Federal Reserve finally secured its official monopoly over note issuance after the U.S. Treasury paid off the last bonds eligible as backing for private notes. The once ambiguous dollar pyramid suddenly started to come into focus: the monetary system existed between the second and third layers of money, and gold's constraint on lower layers had been weakened by the government's actions between 1933 and 1935. Thus, began the journey for the U.S. dollar to stand alone, independent of gold.
King Dollar
Amidst the global currency war, the dollar emerged as the cleanest dirty shirt in the laundry of global currencies. Even though the dollar devalued against gold, other countries were doing so in an even bigger way. Pound sterling abandoned a gold standard in 1931 and officially ended its reign as world reserve currency. The void was filled by the currency of the world's newest superpower: United States of America.
In 1944, world leaders gathered at a hotel in Bretton Woods, New Hampshire and formalized that all currencies besides the dollar were forms of third-layer money within the dollar pyramid. The Bretton Woods agreement would come to be known as the dollar's world reserve currency coronation. The agreement didn't impact the relationship between the first and second layers of money in any way: Federal Reserve notes still promised the bearer gold coins on demand at $35 per ounce. It did pertain, however, to the relationship between the dollar and other currencies. Currencies would have fixed exchange rates with the dollar and wouldn't them- selves be redeemable for gold. Only the dollar kept a link between itself and gold. The dollar had become the axis of the world's various denominations. Governments and central banks across the world were forced to shift the denomination of their reserves, securities, and balance sheets to U.S. dollars (USD).
The agreement brought about an important distinction in the relationship between layers of money. Foreign currencies were on the third layer of money, this time not because of the balance sheet from which they came to exist, but rather because of their price relationship to dollars. In Figure 11, we show USD on a layer above other currencies such as GBP (British pound sterling) and CHF (Swiss franc). The pound and franc are below the dollar in the layers of money because their price is measured in dollars. This means that going forward, there are two possible relationships between monetary instruments within the layered framework: balance sheet hierarchy and price hierarchy.
Figure 11
Destined to Fail
Unfortunately for the international monetary system, the Bretton Woods agreement was doomed. The most prescient thinker on the burden of world reserve currencies during this era was Robert Triffin, a Belgian-born economist who conducted research at the Federal Reserve and International Monetary Fund in its early years. Triffin correctly predicted the end of the Bretton Woods agreement over a decade before it collapsed. While United States citizens were banned from owning gold, foreign nations were still allowed to convert their accumulated dollar reserves to metal. Triffin predicted that these nations would eventually deplete the United States gold stock, making a fixed price of $35 per ounce of gold impossible to maintain. He warned that gold convertibility would not survive without an adjustment to the framework held in place by the Bretton Woods agreement. Most importantly, he identified that being the world reserve currency was a burden, not a blessing. Foreign countries would accumulate dollars because of its reserve status. This would strengthen the dollar and cause trade imbalances that otherwise would not exist without this extra source of world reserve currency demand. Triffin's proposed solution to the problem of one country's currency serving as the denomination of the inter- national monetary system was political cooperation between major economic powers. In a testimony to U.S. Congress in 1959, he admitted his solution remained elusive, a dilemma that drove the demand for gold as the world's only neutral money, no matter how absurd the idea of it might be:
The logical solution of the problem . . . would have been achieved long ago if it were not for the enormous difficulties involved in . . . reaching agreement with several countries on the multiple facets of a rational system of international money and credit creation. This is, of course, the only explanation for the survival of gold itself. Nobody could have ever conceived of a more absurd waste of human resources than to dig gold in distant corners of the Earth for the sole purpose of transporting it and reburying it immediately afterward in other deep holes, especially excavated to receive it and heavily guarded to protect it. The history of human intuitions, however, has a logic of its own.
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