What Happened to the Gold Standard?

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Biting Money

The U.S. dollar was first regulated by the Coinage Act of 1792 and prescribed as 371.25 grains of pure silver. The eagle, worth $10, was 247.5 grains of gold. One cent, worth a hundredth of a dollar, was 24 grains of copper.

The value of the metal contained in the currency kept prices relatively constant before the founding of the Federal Reserve. During those 120 years, prices rose only 3%. In contrast, during the 100 years since the Federal Reserve, prices have risen 2,280%.

The Constitution gives Congress the power to “to coin money” and “regulate the value thereof.” This dictum was understood to be setting the currency’s weight and metallic content and was necessary to allow the currency to keep up with a growing economy.

Before the Constitutional Convention, many states issued their own paper money called “bills of credit” or declared foreign coins “legal tender” that could be used to settle debts. Some states had issued paper money to excess during the Revolutionary War and caused severe price inflation.

The Constitution prohibited states from emitting “bills of credit” in Article I, Section 10. It also forbade them from making legal tender anything but gold and silver coins. An early draft of the Constitution by Charles Pinckney gave that power to the federal government. However, it was specifically deleted by a motion of Gouverneur Morris, who declared, “If the United States had credit such bills would be unnecessary; if they had not, unjust and useless.”

Because the U.S. government is based on enumerated powers, powers not specifically enumerated to the government are powers the government does not have. At least some of the Founders believed that striking this clause from the Constitution by a 9-2 vote would close the door on the federal government printing money.

Almost a century later, the effect of removing this power was put to the test. In Hepburn v. Griswold (1869), the Supreme Court held that paper money violated the Constitution.

Mrs. Hepburn owed Henry Griswold a debt payable on a promissory note. Five days before the debt was due, the Union issued paper currency, known as “greenbacks,” to fund the Civil War. These were inferior to coined currency. The exchange rate was favorable for Mrs. Hepburn to try and pay her debt in the cheapest legal tender required by the terms of the note.

Griswold sued and lost in the lower court. On appeal it was overturned, and the Supreme Court also sided with Griswold by a 4-3 vote. Chief Justice Salmon P. Chase had overseen the issuance of greenbacks as secretary of the treasury, implementing the legal tender acts. Now as chief justice he overruled his own actions.

President Ulysses S. Grant added two Supreme Court justices in 1870. The following year, the opinion was overturned in two 5-4 votes, with Chase now writing for the minority.

The expansion of the federal government into wielding powers that were never enumerated in the Constitution is all too common. And once such a “necessary and proper” power is taken for the “regulation of commerce,” the federal government never gives it up.

The Coinage Act of 1873 demonetized silver, and the Gold Standard Act of 1900 guaranteed gold as the only standard for redeeming paper money, stopping bimetallism and no longer permitting the dollar to be redeemed in either gold or silver. It confirmed the government’s commitment to the dollar by assigning gold a specific dollar amount: $20.67 per troy ounce.

The creation of the Federal Reserve in 1913 marked the beginning of the end of the gold standard.

Five years later, the Fed accepted gold from foreign countries as a payment for World War I debt. This allowed excess gold reserves to accumulate, called “free gold” because it wasn’t currently required to back printed currency. This so-called free gold gave the Fed discretion over how much gold to use in backing the currency and the ability to inflate our currency with the stroke of a pen.

A little over a decade later, the Fed forced all Americans to surrender their gold currency to the Treasury in exchange for U.S. dollars. And the following year, it revalued their gold, increasing the dollars required to buy an ounce. This action also created more free gold.

During World War II, the Fed used some free gold to purchase bonds and drive interest rates down to help the Treasury finance the war. Price controls were put in place to hide the resulting inflation until almost 1950. When they were removed, Congress instructed the Fed and the Treasury to operate “independently” of one another. This instruction officially came into focus when the two agencies signed an accord in 1951. But little independence has occurred in recent years.

With the gold standard suspended in many other countries, foreigners converted their leftover gold into U.S. dollars. This devalued the currency but cornered the gold market. By 1945, the United States had 75% of the world’s monetary gold and the only gold-backed currency.

At this point, the Fed could already function as though it didn’t have a gold standard. With excess gold in its reserves, currency could be changed at will. This occurred even during the 1969 recession, buying securities and inflating the currency to try and “get the economy going.”

In 1971, the United States finally dropped the gold standard, now kept in name only. In the Fed’s first decade of existence, the dollar was devalued 55% (compared to 10% in the decade prior). From the creation of the Fed in 1913 until the gold standard was dropped in 1971, the dollar lost 75% of its value. From 1913 to date, the dollar has lost over 96% of its value. Only pennies of its original value remain in our dollar today.

Arthur Burns, chair of the Fed at the time we went off the gold standard, wrote, “Persistent inflation . . . will not be vanquished . . . until new currents of thought create a political environment in which the difficult adjustments required to end inflation can be undertaken.”

A gold standard helps protect a currency from rampant inflation. The Fed could perform this function only if it could somehow display perfect self-control. Such an ideal may never occur and will never last when the temptation and incentives for the Fed to manipulate other parts of the economy are so great. Reform is necessary to protect our currency.

Photo by Tax Credits used here under Flickr Creative Commons.

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David John Marotta is the Founder and President of Marotta Wealth Management. He played for the State Department chess team at age 11, graduated from Stanford, taught Computer and Information Science, and still loves math and strategy games. In addition to his financial writing, David is a co-author of The Haunting of Bob Cratchit.

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Megan Russell has worked with Marotta Wealth Management most of her life. She loves to find ways to make the complexities of financial planning accessible to everyone. She is the author of over 800 financial articles and is known for her expertise on tax planning.