The rise of the greenback - US dollar - The Fortunes of Money

The US dollar brought order to domestic monetary chaos and went on to become the leading international currency IN the last half of the nineteenth century, the British pound sterling ruled supreme as an international currency. Of all its possible rivals, the United States dollar seemed the least likely to take its place. The United States was an international debtor of an uncertain quality without a central bank and without a single unified currency system. The dollar only rose to dominance in the twentieth century as a result of a tortuous sequence of events which led to the creation of a central banking authority, the Federal Reserve System, and to the adoption of the dollar as a liability of the federal government.

The United States Constitution adopted in 1789 did not grant the federal government the exclusive prerogative to issue coins and currency which was enjoyed by the Crown in European monetary systems. The absence of clear legislation on currency matters created a myriad of diverse means of payment virtually without any central control or support. In these chaotic conditions, foreign coins circulated as legal tender until 1857, and as late as 1901 an Oregon silver mine was still issuing its own silver coins for "commercial use".

In the aftermath of widespread default of currencies issued by individual states of the Union, they were prohibited from issuing paper money. But nothing prevented them from creating banks, which were free to issue bank notes. The state of Kentucky, for example, created a private bank of which it was sole owner and proceeded to make payments with its notes. This individualist tradition in money matters found expression in "wildcat" banking and the prevalence in this period of state "free banking" laws which allowed any individual or association of individuals to open a bank and issue bank notes without licence or control.

The absence of a national bank meant that even the federal government had to undertake its financial transactions either through private banks or in specie coin or bullion). In 1840, President Martin Van Buren instituted the "Independent Treasury System" which handled government transactions through nationwide sub-offices. Since the Treasury was not a bank, and could not issue notes, all government receipts and expenditures had to be made in gold or silver. Expenditures in excess of taxation could not be financed except by issue of government debt subscribed in gold.

The Civil War

and the first greenbacks

Many currency arrangements of the late nineteenth century can be traced back to the need to finance the Civil War of 1861 to 1865. The Treasury first issued "demand notes" which were not legal tender, but were convertible into gold. But the weak gold reserves of the Treasury soon led to the suspension of convertibility of these notes. Thereafter the war effort was financed by an issue of United States Notes", based on nothing more substantial than the faith and credit of the government. They were popularly called greenbacks the name by which the United States dollar is still known throughout the world.

The issue of greenbacks had been limited to $433 million, so in the face of increasing difficulty in borrowing and of rising expenditures Treasury secretary Salmon P. Chase decided to apply "free banking" on a national scale. The National Bank Act of 1863 allowed any group of five persons to form a National Banking Association" and issue National Bank Notes" in an amount equal to their holdings of federal government bonds deposited with the Comptroller of the Currency.1

To prevent competition from state bank notes, a 10 per cent tax was placed on the latter which soon drove them out of circulation. The state banks countered by offering payment services cheque against deposit accounts, which proved to be an attractive substitute for National Bank Notes.

By the end of the Civil War, the multiplicity of means of payment representing the liabilities of thousands of state banks had been largely reduced to greenbacks and National Bank Notes, neither of which were convertible into specie, but the issue of which was strictly limited. The money supply of the United States was thus rigidly fixed, unable to respond to either fluctuations in trade, nor the frequent panics that resulted from the failures of the unregulated state banks (two years after the introduction of free banking in Michigan, for example, all of its forty banks had failed).

The dollar set firmly on the gold standard

As the United States was basically an agricultural country, the demands on currency were linked to the harvest. As crops were sold, farmers' bank deposits built up in the agricultural regions, leading to a shortage of funds in the urban banks of the east. The National Bank system of small individual units had no mechanism to recycle excess funds, such as was possible in a multibranch bank. Furthermore, without a central bank to lend reserves, there was no way of meeting these fluctuations apart from sharp changes in interest rates, or declaring bank failure. Together with the net drain of specie to the Independent Treasury and the absence of strict banking regulations, this led to extreme instability and frequent crises.

This instability was attributed by some to a lack of specie, an argument exploited by those interested in making silver the basis of the United States monetary system. A "Free Silver Movement" launched by William Jennings Bryan demanded the free coinage of silver as legal tender. The 1878 Bland-Allison Act provided for Treasury silver certificates which became legal tender in 1886 and the Sherman Silver Act of 1890 made the Treasury virtually liable to purchase the entire output of United States silver mines. In 1882 a similar provision was made for gold certificates, but neither measure gave the hoped-for elasticity to the currency.

The system created serious international as well as domestic problems, for fluctuations in the internal demands for liquidity could only be met by international gold movements, which in turn created instability in the international monetary system. This was particularly striking in 1893, when the fear that the United States would not honour its government debt in gold and would instead pay in silver, whose price was collapsing on world markets, led to a massive outflow of gold and widespread bank failures.

Creation of

the Federal Reserve system

The outflow was reversed by the Gold Standard Act of 1900, which set the dollar firmly on the gold standard 3 and required National Banks to back their note issues with gold. Between 1899 and 1910 the gold holdings of the public trebled, as did those of the Treasury. The proportion of the world's monetary gold stock held in the United States rose from around 15 to 30 per cent, at a time when many other countries (AustroHungary, Russia, Japan) were also adopting the gold standard. As the expansion of gold supplies was slowing, the accumulation of gold in the United States caused more difficulties than had the previous outflow, largely because once the gold entered the Treasury it could not be drawn out except to finance a balance of payments deficit (the country was then in surplus). Given the Independent Treasury System, gold could not be used as the basis to create money or to serve as lending of last resort.

Another banking. crisis in 1907 forcefully reminded legislators of the need for a national institution which could respond to fluctuations in the demand for liquidity in some other way than by attracting gold from abroad. Such an institution was finally set up by the Federal Reserve Act of 1913.

The Act divided the country into twelve districts, each with its own Federal Reserve Bank, which began operations on 2 November 1914. The existing National Banks were obliged to Join the system by purchasing stock in the Federal Reserve Banks. The latter were authorized to issue a new type of currency, the Federal Reserve Note, legal tender for all debts and the liability of both the banks and the United States government.

The new note was to replace National Bank Notes. The issue was backed by gold to a minimum of 40 per cent, the remaining notes being issued against commercial paper and other eligible assets acquired by discount from the member banks. This arrangement satisfied the need for an elastic means of payment which could expand and contract with fluctuations in trade and the situation of the banking system. A member bank that was short of liquidity could acquire it by discounting its assets in exchange for Federal Reserve Notes at its District Reserve Bank.

The Federal Reserve Board of governors, appointed by the President and based in Washington, D.C., sat rather uneasily over the Federal Reserve Banks which were owned and run by private bankers. It was by no means clear who was responsible for currency policy, but the bankers clearly had the upper hand.

However, the two prerequisites for the subsequent international dominance of the dollar had now been acquired: the massive accumulation of world gold stock in the United States, which obliged the international monetary system to move onto a gold-exchange standard, and the creation of a unified national currency issued by a single authority with lender of last resort capability.

The position of the United Kingdom was weakened by the 1914-1918 war, and the dollar entered the inter-war return to gold on a stronger basis than sterling. Moreover the United States economy, after a short recession, was to prosper in the roaring 20s" of radio and automobiles.

The massive movement of investment funds to the United States, first caused by rapid growth and the stock market boom, then by high interest rates used to try to break the speculative rise on Wall Street, severely disrupted international finance and broke the stability of exchange rates. The stock market crash of 1929 brought about massive bank failures, which were far beyond the ability of the Federal Reserve to offset, and the consequent collapse of investment values was responsible for a worldwide depression.

The evidence of widespread bank fraud which emerged after the Wall Street crash suggested deficiencies in the supervisory function of the Federal Reserve Board and in its ability to regulate monetary policy to prevent even well-run banks from failing. A series of measures, including the nationalization of gold, the devaluation of the dollar to $35 per ounce of gold, and the 1935 Banking Act which gave the Federal Reserve Board control over monetary policy, finally created a system equivalent in its powers and duties to a European central bank.

Thus the inter-war period strengthened both the reserve position of the United States and the domestic financial system. The country was ready to take over London's role as banker to the world when the outbreak of the Second World War made the City unsafe and transformed the United Kingdom from an international creditor to an international debtor. The United States became the world's major creditor. Any country which wanted to buy goods for post-war reconstruction had to acquire dollars, and the dollar thus became the pre-eminent international currency.

COPYRIGHT 1990 UNESCO
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