The United States entered the twentieth century as the only advanced nation that had adopted a gold standard without having its own central bank.
This changed when Congress passed the 1913 Federal Reserve Act to promote financial stability — this required centralizing the nation’s Money system, the public was told.
The creation of the Federal Reserve has clear parallels with how the Bank of England was formed more than two centuries earlier.
In both cases, agreements were made between governments and private lenders that involved the creation of a new institution with considerable power over the prevailing system of Money.
The difference was democracy.
Unlike the English experience, the United States Federal Reserve was being set up in a young, democratic nation whose citizens inherently distrusted centralized power.
It had been planned in secret three years earlier on Jekyll Island, Georgia — under the guise of a duck hunt, away from the prying eyes of city reporters.
In attendance were a small but powerful group of banking and government representatives who sought a mutually beneficial system.
And that is what they got.
The Federal Reserve was purportedly created to promote financial stability — but the subsequent three decades were among the most financially turbulent periods of American history.
A central bank also provided an ideal financing mechanism for the First World War.
Money’s connection to physical gold was officially maintained, in theory — but with the Federal Reserve serving as the nation’s gold vault, it would be many decades before the link would be tested.
In the meantime, the paper had to be trusted — that is the basis of Fiat Money.
Once Metallic Money took paper form, control over the Money system was maintained by suspending redemptions of bank notes to physical gold or silver. This capability was especially important to governments when raising war funds.
The problem was restoring redemptions to gold once the war was over.
With redemptions suspended, the supply of Metallic Money in bank note form can grow much faster than the supply of physical metals held in reserve by the issuers.
Restoring redemptions without running out of physical gold meant that each dollar would be worth less gold.
Unlike the Roman system of Metallic Money, paper American dollars didn’t contain any physical gold — they represented it.
But the Federal Reserve Act of 1913 permitted America’s central bank to issue $50 of bank notes for every $20 of gold reserves, setting the stage for monetary expansion. America’s Roaring Twenties and subsequent Great Depression will be explored later.
For now, what matters is how Metallic Money evolved during this period, on its way to becoming a fully “fiat” system.
In 1931, during the Great Depression, England was forced to suspend redemptions to preserve their gold reserves. Two years later, the United States government shocked the public by making it illegal for U.S. citizens to own or trade physical gold.
After legally requiring all citizens to sell their physical gold to the Federal Reserve for 20.67 U.S. dollars per ounce, the Gold Act of 1934 transferred ownership of this metal directly to the U.S. Treasury, while legally fixing a new price: US$35 per ounce.
By all appearances, gold was becoming more valuable — in dollars.
But like the Romans before them, it was really the Money that was losing value — in gold — just as the West Africans’ beads had lost their value — in cattle.
Unlike the rapid monetary transitions that could happen with Artifact Money, our global transition from Metallic to Fiat Money took place over many decades.
The First World War had already taken a heavy toll on the British Empire. After the Second World War, the United States emerged as the decisive global superpower.
The 1944 Bretton Woods agreement enshrined the U.S. dollar as the global reserve currency. The rest of the world was now incentivized to swap their gold reserves for paper dollars, and the United States would collect and store the gold for safekeeping.
At least that was the plan.
By 1965, some countries were growing wary of this arrangement.
In a televised speech, French president Charles De Gaulle voiced the following concerns:
The fact that many countries accept, as a principle, dollars being as good as gold... this very fact leads Americans to get into debt, and to get into debt for free at the expense of other countries. Because what the United States owes them is paid, at least in part, with dollars they are the only ones allowed to emit.
France then repatriated much of its gold from the United States, effectively preventing many other nations from doing the same.
By 1971, with America’s gold reserves in rapid decline, and with vast sums of paper dollars still being held abroad, President Nixon had no choice but to unilaterally suspend redemptions of U.S. dollars to physical gold.
Also known as the “Nixon Shock,” this event marked the formal end of Metallic Money, thrusting the world into our brave new era of fully “Fiat” Money.
Ownership of physical gold became legal again for Americans in 1975 — but they would have to pay the market price. How markets “discover” prices will be explained in Part II, but the basic idea is that market prices change based on supply and demand.
Unlike the fixed prices of US$20.67 per ounce, which the American public had received for their gold in 1933, and US$35 per ounce, which the Bretton Woods agreement established in 1944, market prices fluctuated considerably.
But since the paper Money supply was growing much faster than gold reserves, prices tended to go in one direction. By the end of 1975, one ounce of gold cost US$141.
By the end of 1980, the price was approximately US$600.
Fiat Money had arrived, and this was a very different system from Metallic Money.
All that was left was trust, and this called into question the meaning of Money to humans.
Excellent article. Everyone should understand these basics of our financial system. I wrote a similar article years ago. Keep up the great writing. ✍️