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Professional Credentials: The reports that I write are my personal research and opinions. They are not associated with any firm or organization, and are not intended to be taken as investment recommendations or advice. They combine my passions of economics, finance, writing and education, and... More
  • History Of The Gold Standard And US Central Bank; Lessons From History Part #1 1 comment
    Apr 11, 2013 7:26 AM

    With the rising popularity of the "Bitcoin," falling confidence in central banks and the growing popularity of a return to a gold standard, I thought it might be beneficial to go back and review economic history. This article will explore why we as a society abandoned a gold standard, why we have a central bank, and why the gold standard and "Ending the Fed" aren't the solutions to our monetary and economic problems.

    The first myth to dispel is that under a gold standard, money has "intrinsic value" and the government can't simply print gold. History has proven otherwise time and time again. During the time of the Emperors, they routinely "debased" the gold and silver, effectively printing gold and silver out of thin air. The following quote also dispels the myth that following a gold standard is non-inflationary. On paper, yes, in practice, no.

    Nero and other emperors debased the currency in order to supply a demand for more coins. By debasing the currency is meant that instead of a coin having its own intrinsic value+, it was now only representative of the silver or gold it had once contained. By the time of Claudius II Gothicus (268-270 A.D.) the amount of silver in a supposedly (100%) silver denarius was only .02%. This led to or was severe inflation, depending on how you define inflation.

    Under the more modern Brenton Woods Agreement, Nations simply devalued their currency, effectively "printing gold out of thin air."

    Devaluation, decreasing the value of one nation's currency relative to gold or the currencies of other nations. It is usually undertaken as a means of correcting a deficit in the balance of payments.

    The problem with a gold standard is that it is an "inelastic" currency, it effectively has a fixed supply, at least in the short run. Fixing anything is a dynamic free market is likely to result in imbalances, and that is exactly what a gold standard does. The most damaging imbalances occur during times of war. Nations are forced to either go off the gold standard, or lose the war. If Britain has X amount of gold, and are sending Y amount of gold to the US for war supplies so they can fight the Germans, sooner or later Britain will run out of gold. Wars almost always force Nations off the gold standard.

    The gold standard broke down during World War I, as major belligerents resorted to inflationary finance

    In the 1770s the US Continental Congress used paper Continentals to fund the war. Had they relied on a gold standard, they simply would have had no gold to fight the war. We owe our very existence as a Nation to the wisdom of our Forefathers abandoning the Gold Standard.

    One ironic note is that a gold standard is often the very cause of a war. Trajans column in Rome commemorates Trajan's Dacian War. One of the main reasons for attacking the Dacians was becaue they had a whole lot of gold. If going to war makes you very rich, you are much more likely to find a reason to go to war. Nations don't go to war over a fiat currency. What would they take? A printing press?

    When Trajan returned to Rome in AD 106, he did so with a vast treasure. According to Trajan's ancient contemporary Cryton (whose original work was lost but retold through Ioannes Lydus in the 6th Century) 'the sum of five million gold and twice as much silver' was taken. Though this number is difficult to translate into modern equivalents (and must be measured with a sense for ancient exaggerations) one scholar, Jerome Carcopino, roughly translated this immense sum to 180 tons (165,000 kg) of gold and 360 tons (331,000 kg) of silver. With this enormous haul Trajan was able to secure the health of the imperial treasury

    FDR didn't conquer a neighboring country for its gold, he simply siezed it from his fellow citizens. What good is the "intrinsic value" of gold when men with guns show up on your doorstep to take it from you?

    In retrospect it seems astounding - and brazenly unconstitutional - that in 1933 a U.S. president could wield such power and by a mere pen stroke criminalize the private ownership of any asset, let alone an asset so crucial to one's life and the nation's economic prosperity as sound money.

    Once he had the gold he randomly altered its value, effectively printing gold out of thin air.

    One morning, as Roosevelt ate eggs in bed, he and Secretary of the Treasury Henry Morgenthau decided to change the ratio between gold and paper dollars. After weighing his options, Roosevelt settled on a 21 cent price hike because "it's a lucky number." In his diary, Morgenthau wrote, "If anybody ever knew how we really set the gold price through a combination of lucky numbers, I think they would be frightened."

    Another ironic note in history is that after the Revolutionary War was over the Nation returned to a gold standard. The return to a gold standard triggered "Shay's Rebellion," which almost prevented the Colonies from forming the United States, and they did so only after "Ensure Domestic Tranquility" was added to the Preamble to the Constitution. Why did a Gold Standard trigger a rebellion? Because it is an "inelastic" currency, and under a strict gold standard you can't print gold out of thin air. Banks and Merchants had made farmers loans in gold that had to be paid back in gold. During an economic downturn or excessive bank withdrawals banks and merchants would be forced to call in their loans, and demand repayment of their outstanding loans in gold. When the bankers, merchants and tax collectors showed up and demanded their gold from Shay and his followers, they pointed out that they wouldn't have access to gold until harvest, the gold was planted in the fields. This monetary imbalance, created by an inelastic supply of gold currency, and demands for "sound money" by the merchants and bankers, resulted in Shay's and other rebellions. Events that almost prevented the Colonies from forming the United States.

    After Shay's Rebellion, the Constitutional Congress decided to give Congress the power to "coin money and regulate the value thereof" in Article 1 Section 8 in the US Constitution. Supporters of gold standard often like to argue the definition of "coin money," claiming that the only legitimate money is gold and silver. They will point to Article 10 Section 8 of the US Constitution that states "make any Thing but gold and silver Coin a Tender in Payment of Debts." The arguments are very convincing, but grossly misleading. Article 1 Section 10 are the prohibitions of the States, not the Federal Government. The whole purpose of Article 1 Section 10 is to prevent the States from coining money and repeating the fiasco they created when they were allowed to print Continentals. Only Congress is granted the power to coin money. The fact that they are allowed to "regulate the value thereof" effectively defines a fiat currency as the only currency allowed under the US Constitution. Even under a gold standard, the US Congress gets to stamp what value goes on the gold coin, and if they choose to alter that value, they effectively print gold out of thin air.

    After the Constitutional Congress and our first election, America's focus turned to how to implement Article 1 Section 8. The solution was the Coinage Act of 1792. If you doubt my interpretation from above, simply read the act signed by the people that wrote the US Constitution. In the Coinage Act or 1792 they do use gold and silver, but they also use copper. They also demonstrate how they assign a value to a weight of metal, a value that can change with an act of Congress. This effectively establishes an "elastic" currency, allowing Congress to effectively print money out of thin air. In reality, the only real currency allowed under the US Constitution is an "elastic" one, not an "inelastic" one like the gold standard. Had they wanted an inelastic currency they would have created something like the Bitcoin, and stamped weights not values on amounts of gold. Things would have traded in ounces of gold and silver, not dollars and cents.

    Before we even got to the Coinage Act of 1792 however the Country needed to establish a way to manage the Nation's finances. A fierce debate raged over whether or not to have a Central Bank. The main proponent for a Central Bank was Alexander Hamilton, and the opposition was headed by Thomas Jefferson (Author of the Declaration of Independence) and James Madison (Author of the US Constitution). Both sides made their case to our first President George Washington (Father of our Country). After careful deliberation, George Washington sided with Alexander Hamilton, and chartered the First Bank of America. George Washington, after hearing and analyzing both sides of the arguements, sided with the formation of a Central Bank. This is a fact opponents of the Central Bank should pay attention to. There are very very very solid arguements for creating a Central Bank. Reasons I'm trying to convey in this article.

    The First Bank's charter was drafted in 1791 by the Congress and signed by George Washington.

    The bank was chartered for 20 years, and lasted through the presidency of George Washington, John Adams and arch-critic Thomas Jefferson. The bank on most accounts was a huge success, but old attitudes die hard. When the bank's charter came up for renewal, the previous arch-critic James Madison was the President. The Federalists were no longer in power, and the anti-bank contingency in Congress simply refused to leave good enough alone. Adding new meaning to the phrase "be careful what you ask for," Congress voted to end the bank's charter, leaving the Nation without a Central Bank for the first time in 20 years.

    The anti-Bank forces had remained steadfast in their opposition to the Bank since its inception in 1791. By the time of the renewal debate in Congress, the Federalists were no longer in control. The Democrats now held the majority and were ready to act against the Federalist conceived institution. The opponents of the Bank included Henry Clay, William Branch Giles and Vice-President George Clinton. The Federalists supported renewal and were joined by two notable Democrats who crossed party lines, Treasury Secretary Albert Gallatin, who believed in the usefulness of the institution, and then President Madison, who had switched camps with respect to the Bank issue because he believed the matter had been settled by precedent...The bill was defeated in the House by a 65 to 64 margin on January 24, 1811, and in the Senate was deadlocked at 17 on February 20th before Vice-President Clinton, an enemy of both Madison and Gallatin, broke the tie with a negative vote. The Bank of the United States closed its doors on March 3, 1811.

    Congress effectively voted to "End the Fed," and the inevitable happened. All hell broke loose. The financial system was in chaos, and James Madison discovered the hard way that it is very difficult to finance a war without a sound, stable and credible financial system. While the British were burning the White House and Washington DC, I'm pretty sure he was regretting giving voice to the people that ultimately put him is the box of fighting the War of 1812 without a Central Bank.

    The War of 1812 revealed the weakness of the American financial system so in 1816 the charter of the Bank of the United States was rechartered. Support for the second Bank of the United States came from political figures such as President James Monroe and Senator John C. Calhoun who were concerned with the low credit and financial solvency of the Federal government, as revealed by the difficulties financing the costs of the War of 1812. Support also came from business leaders such as John Jacob Astor who were concerned with the financial chaos of the time.

    Thankfully the Nation came to their senses, and quickly chartered the Second Bank of America in 1816. Most notable is that one time arch-critic James Madison signed the new bank's charter, qualifying as one of the greatest policy reversals in American history, and a lesson for all of history and future leaders about the virtues recognizing when you are wrong and changing course.

    The Second Bank of the United States was chartered for many of the same reasons as its predecessor, the First Bank of the United States. The War of 1812 had left a formidable debt. Inflation surged ever upward due to the ever-increasing amount of notes issued by private banks. Specie was jealously hoarded. For these reasons President Madison signed a bill authorizing the 2nd Bank in 1816 with a charter lasting 20 years.

    Of course America couldn't leave well enough alone...AGAIN!!! And when the Second Bank of America's charter came up for renewal, Andrew Jackson saw a political opportunity in making the bank a political issue. He ran a campaign demonizing the bank, won re-election on his suicidal campaign, ended the bank's charter ahead of time, and the inevitable happened. The Nation fell into financial chaos and depression. The history channel does a great job in their video series on the Presidents reviewing this episode in American history. As the video highlights, the presidents that followed Jackson had to deal with the mess he left them.

    Ironically, Andrew Jackson, founder of the Democratic Party that represented the slave owing South, inadvertently gave the North a huge advantage during the Civil War. Lincoln and Congress were able to abandon the gold standard and print "greenbacks," a standardized, unified, widely accepted and elastic currency that helped finance the war. Basically Congress assumed the role of a Central Bank (a very bad idea outside of wartime which I'll explain later). The South simply repeated the mistake the colonies made 85 years earlier with the Continentals and State Currency. The North was able to establish a credible and relatively stable monetary system, whereas the South was not. Lovers of freedom worldwide should not discount this lesson of history. The ability to fund a war and defend your Nation requires a stable financial system. An elastic currency is critical in funding wars, and a system used in both the Revolutionary and Civil War. The choice of monetary policy should never be allowed to determine the outcome of a war. The tail should not be allowed to wag the dog.

    In conclusion, there are essentially two major currency policies; inelastic (NASDAQ:GOLD) or elastic (fiat). Nations can have either a Central Bank (dollar) to affect monetary stability, or they can choose not to have a Central Bank (Continental and Confederate Currency). The consequences of which monetary system a Nation chooses is critical to its chance at prosperity and success. I've done my best to highlight some of the key events in monetary history up through the Civil War. If this article gets published, I'll write part #2, and complete the history up to today.

    Disclaimer: This article is not an investment recommendation. Any analysis presented in this article is illustrative in nature, is based on an incomplete set of information and has limitations to its accuracy, and is not meant to be relied upon for investment decisions. Please consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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  • Ben Hanson
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    I'm eagerly awaiting part two.
    17 May 2013, 10:28 PM Reply Like
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