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Table of Contents & Chapter Introductions

A MONETARY HISTORY OF THE UNITED STATES
(1867-1960)
by
Milton Friedman & Anna J. Schwartz

Part I: Greenbacks and Gold (1867-1921)

Page Contents

Outline of monetary history (1867-1921)

Greenback period (1867-1879)

Gold standard & "Free Silver" movement (1879-1897)

Gold standard inflation (1897-1914)

Federal Reserve System during World War I (1914-1920)

Federal Reserve System boom & bust (1920-1921)

FUTURECASTS online magazine
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Vol. 9, No. 5, 5/1/07

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Introduction:

 

&

  The impacts of fluctuations in the money stock run like a thread through the economic history of the United States, Milton Friedman and Anna J. Schwartz explain in "A Monetary History of the United States (1867-1960)." This book takes in monetary developments during the Civil War that set the stage for the post-Civil War period.
 &

Monetary factors played a major role in the economy's cyclical movements, "and conversely, non-monetary developments frequently had major influences on monetary developments; yet even together," there is much in business cycle history that they acknowledge is not covered in the book.

  The authors' major conclusion - from their analysis of 93 years of monetary history - is that:

  • Changes in economic activity - "high-powered" money - prices - and business cycle swings - have been closely associated with changes in the money stock;

  • this relationship has been consistent throughout the 93 year period covered by this history; and

  • the monetary stock changes have often had a demonstrably "independent origin" excluding the possibility that they were the result of changes in economic activity.

  The narrow focus of this book is emphasized by the authors. The money stock is influenced by other economic factors and influences those other factors in turn. Monetary factors played a major role in the economy's cyclical movements, "and conversely, non-monetary developments frequently had major influences on monetary developments; yet even together," there is much in business cycle history that they acknowledge is not covered in the book.

  At a few strategic points in the book, the authors insert a sentence to remind us of this, but occasionally they themselves seem to forget it. As a result, they sometimes overstate the role of monetary factors and the power of monetary manipulation to alter cyclical economic events.
 &
  This weakness appears most dramatically in the book's discussion of the Great Depression. This would be just a minor weakness in this otherwise masterful book - if not for the tendency of many of those who follow Milton Friedman's views to also overlook the limitations of monetary manipulation - and if not for the dramatic assertion by the authors in the book's conclusion that a more aggressive monetary policy response to the Great Depression by the Federal Reserve System "would have cut short the spread of the crisis, would have prevented cumulation of bank failures, and would have made possible, as it did in 1908, economic recovery after a few months." See, "Friedman & Schwartz, Monetary History of U.S.," Part II, "Roaring Twenties Boom - Great Depression Bust (1921-1933)," at sections E) "Great Depression Bust (1929-1933)" and F) "The Power and Limitations of Monetary Policy," and Friedman & Schwartz, Monetary History of U.S.," Part III, "The Age of Chronic Inflation (1933-1960)," at section H) "Conclusion: The Impacts of Fluctuations of the Money Stock."
 &
  Allan Meltzer takes an even more extreme view of the power of monetary manipulation. See, Meltzer,  "A History of the Federal Reserve, vol. 1 (1913-1951)," Part I, "The Search for Stability (1913-1923)," Part II, "The Engine of Deflation (1923-1933),"  and Part III, "The Engine of Inflation (1933-1951).

High-powered money and bank system money:

  The total money stock includes currency held by the public plus money created through deposits in the commercial banking system.
 &

The larger deposits get in relation to reserves retained by the banks and in relation to the currency in the hands of the public, the more bank system money is being created.

 

The amount added to the money stock by bank deposits depends both on the willingness of the public to use the banking system, and the amount of deposits bankers are willing and able to lend to the public over and above retained reserves.

  Money that can be used as liquid reserves for bank deposits is considered "high-powered" money, since the fractional reserve banking system serves to increase the total stock of money. In 1867, the public held about $1.20 in deposits for each $1 in currency. This rose quickly to $2 by 1873, reflecting the rapid rise of the commercial banking system. It stayed about at that level until 1880, rose -with numerous spikes and troughs - to $12 in 1929, and then fell sharply during the Great Depression - recovering just to $6 in deposits for each $1 in currency in 1960.
 &
  A bank deposit available to the depositor on demand
is money to the depositor as well as money to the borrower from the bank. The larger deposits get in relation to reserves retained by the banks and in relation to the currency in the hands of the public, the more bank system money is being created.
 &
  The amount added to the money stock by bank deposits depends both on the willingness of the public to use the banking system, and the amount of deposits bankers are willing and able to lend to the public over and above retained reserves. This addition to the money stock is calculated using two bank deposit ratios - the "deposit to currency" held by the public ratio and the "deposit to reserve" ratio.  It can include time deposits if in practice they can be withdrawn on demand. Inclusion of other short term liquid assets results in broader measures of the money stock that are outside the purview of this book.
 &
  The confidence of the public in the banking system, and the confidence of the bankers in the stability of the economy and the financial system are key variables. The government controlled variables include bank reserve requirements and government additions to high-powered money.
 &

  Price statistics leave much to be desired during this period, especially for consumer or general price levels. The authors make use of indexes based on calculated - or "implied" - prices, and so refer to "implicit" prices rather than consumer or general prices. They rely heavily on wholesale prices, since these are more available.
 &
  A graph of various measures of currency and "money" in circulation shows a steadily accelerating expansion accompanying the growth of the economy and the nation, with sharp increases between 1879 and 1882 after the successful resumption of the gold standard and during both World Wars of the 20th century. Money - but not currency - had significant surges in 1868 to 1873 with the resumption of normal banking after the Civil War, during the New Deal years 1933 to 1937, and during the 1950s.
 &
  Currency in the hands of the public shows only a few years of actual decline - mainly in 1875 and 1876 in preparation for return to the gold standard and during the depression years 1877, 1894, 1921 to 1922, and 1933. The graph of broader money measurements of money indicate declines from 1875 to 1878, 1893, 1907, 1921, and 1930 to 1933.
 &
  From 1867 to 1960, currency expanded 50 fold, and currency plus commercial bank deposits 243 fold. Mutual savings deposits had expanded 127 fold. Prices rose during this period on average just under 1% per year. However, prices declined significantly during the last three decades of the 19th century, so the rate of price inflation did accelerate significantly through the first six decades of the 20th century - especially from 1940 to 1960. Output per capita during this 93 year period increased almost 2% per year.
 &
  Expressed as a fraction of income, there was an increase of almost 1% per year in money balances held by the public. Money balances equaled less than 3 months income in 1869 and more than 7 months income in 1960. However, this trend experienced many sharp ups and downs - examined more at length in the body of the book.

A) Outline of Monetary History (1867-1921)

Greenbacks and the bimetal standard:

The U.S. did not stiff its creditors to help pay for the vast expenses of the Civil War.

  The financial aftermath of the Civil War dominated monetary and financial history until the beginning of 1879 when specie payments were resumed - at the prewar parity. It was a struggle for the U.S. economy and its people to maintain sufficient monetary restraint to drag prices back down to a point where the "greenback" dollar would be "as good as gold." The U.S. did not stiff its creditors to help pay for the vast expenses of the Civil War.
 &

Responding to the declining prices, politics were influenced by "greenbackism" and "Free Silver" movements that didn't end until the defeat of William Jennings Bryon in the 1896 presidential election.

  Even prior to 1879, gold was still important for foreign transactions, since Great Britain and other important European nations were on a gold standard. Gold could be purchased with dollars, but its dollar price was free to fluctuate - upwards during the war and then downwards back to parity by 1879.
 &
  The controversy over the place of silver in the monetary system dominated the last two decades of the 19th century. As more nations went on the gold standard, demand for gold increased - exceeding even the rapidly increasing supplies. Silver prices declined sharply after the Civil War, of course, but continued a slow decline even after resumption of the gold standard in 1879. The value of gold was rising relative to the the value of other goods and services. Further development of financial techniques that supported "a larger superstructure of money on a given base of gold," didn't totally offset this tendency.
 &
  Responding to the declining prices, politics were influenced by "greenbackism" and "Free Silver" movements that didn't end until the defeat of William Jennings Bryon in the 1896 presidential election. (Prices had declined throughout the first half of the 19th century as well.) Substantial new sources of gold in Alaska and South Africa and technological advances in gold mining substantially increased the production of gold and doomed Bryan's political hopes. World prices responded by beginning to rise from the beginning of the 20th century despite vast increases in economic output.
 &

Birth of the Federal Reserve System:

 

&

  The nation's banking structure was subject to periodic difficulties and panics during this period. 1873, 1884, 1890, 1893 and 1907 saw banking crises involving widespread fears, runs on banks, and bankruptcies. In 1893 and 1907, most banks suspended payments on deposits, causing money measures to decline while currency rose as the public withdrew deposits during the panic.
 &

Even excluding WW-I, the Federal Reserve System failed to increase monetary stability.

  The Federal Reserve Act of 1913 was the ultimate response. It was designed to bring effective regulation at least for Federal Reserve System member banks. The international gold standard weakened during WW-I, giving the new Federal Reserve System (the "System") both greater freedom of action and increased responsibility. The Treasury had previously exercised a limited central banking role. The U.S. economy grew massively during this period, reducing the relative importance of foreign trade and the impact of foreign influences on the economy.
 &
  The System, however, failed to increase monetary stability. Even excluding WW-I, monetary fluctuations increased.

  "The blind, undesigned, and quasi-automatic working of the gold standard turned out to produce a greater measure of predictability and regularity -- perhaps because its discipline was impersonal and inescapable -- than did deliberate and conscious control exercised within institutional arrangements intended to promote monetary stability. Here is a striking example of the deceptiveness of appearances, of the frequently dominant importance of forces operating beneath the surface." (This observation is greatly reinforced by experience after 1960.)

  WW-I was financed in part by a rapid rise in the stock of money which was not stopped until early in 1920. This stoppage was "the first major deliberate and independent act of monetary policy taken by the System" and drew severe criticism as the economy tumbled into a depression.

B) The Greenback Period (1867-1879)

Greenbacks:

 

&

  A "fiduciary standard" for paper money unsupported by gold and freely floating against gold and other currencies - dependent thus entirely on the credit of the issuer, the U.S. government - existed from the Civil War until 1879. Gold money and "greenback" paper money existed together and fluctuated against each other.
 &

  The total money stock consisted of gold, gold certificates, U.S. notes - popularly called "greenbacks" - fractional silver currency, other U.S. currency, national bank notes and subsidiary coinage and deposits in commercial banks and mutual savings and postal savings banks. After 1914, it also included Federal Reserve notes.
 &
  "High-powered money" is the type of money that can be used as liquid reserves to support the bank deposits that add to the total "stock of money." Between 1867 and 1879, it consisted principally of gold, greenbacks, and national bank notes. National bank notes were issued by the Treasury for banks upon deposit with the Treasury of eligible government securities as security for the notes.
 &

  With the end of the Civil War, the expansion of paper money ceased, prices declined, and the vigorous economic expansion that would vault the U.S. into the 20th century as an economic powerhouse commenced. This "coincidence cast serious doubts on the validity of the now widely held view that secular price deflation and rapid economic growth are incompatible."

  Rapid economic growth with declining prices was experienced in the U.S. during the first half of the 19th century, also. For that matter, price fluctuations on English commodity exchanges fluctuated within a non-inflationary band for 350 years from 1600 to 1930 while England enjoyed the economic growth and expanding power of its industrial revolution.

  By 1867, nearly 75% of the total money stock was of Civil War origin - types of money that had not previously existed. These were primarily national bank notes and U.S. "greenback" notes and other U.S. currency.
 &

  National bank notes grew rapidly to nearly $300 million by 1866. Growth continued slowly thereafter to $340 million by 1874, and these notes remained an important part of the monetary system until 1935. They were backed by requirements for 111% security in the form of government bonds bearing the security privilege. They thus were actually indirect obligations of the federal government. In the event of bank failure, the bonds would be forfeited to the Treasury to be sold to redeem the bank money, and the Treasury had a first lien on the bank's assets if more was needed.
 &
  Thus, the national bank notes circulated at parity with other currency as an equivalent part of the money system. This had not been the case prior to the Civil War and represented a significant accomplishment for the pertinent Civil War and post-Civil War legislation. The last wrinkles were ironed out of the system by monetary legislation in 1874.
 &
  By controlling the issuance of bonds bearing the security privilege, the government could control the maximum amount of national bank note money - but the national bank notes didn't approach their maximum until the 1920s.  They rose slowly from only 20% of their limit to 28% by 1900, and surged to 80% during WW-I. Before WW-I, the issuance of national bank notes was apparently not profitable enough to be more widely employed, but the authors concede that they could not determine why. There were also capital stock requirements, but these didn't came into play after 1905 because the eligible bond limitation was a more restrictive requirement.
 &

  Greenbacks exceeded $350 million by 1867 - fluctuated at levels below $400 million until 1878 reflecting political controversy over their role in the 1870s price decline, and were then fixed permanently at $347 million through 1960.
 &
  Other U.S. currency included some legal tender notes, government demand notes, and some other government obligations that were not legal tender. Amounting to almost $240 million in 1865, the legal tender notes were quickly redeemed after the Civil War and were retired by 1872.
 &

The two moneys - greenbacks and gold or British sterling - fluctuated freely, and were thus able to coexist without one driving out the other.

  Gold coin and gold certificates were used primarily for foreign exchange transactions. The gold "dollar" was worth over $2 at the end of the Civil War - but declined rapidly to about $1.383 in June, 1867 and to about $1.10 in the 1870 to 1875 period. They thereafter declined towards parity by 1879.
 &
  Domestically, customs duties were payable in gold, and the Treasury paid almost all the principal and interest on its debts in gold. The credit of the U.S. was thus jealously guarded throughout the Civil War period. Some private debts also required payments in gold. The West Coast remained on a gold basis, with greenbacks quoted at a discount, whereas prices were quoted in greenbacks on the East Coast with gold valued at a premium.
 &
  The two moneys - greenbacks and gold or British sterling - fluctuated freely, and were thus able to coexist without one driving out the other. With floating exchange rates, the greenback price of gold was in effect the greenback price of sterling, since Britain was on a gold standard throughout this period. The completion of the transatlantic cable in 1866 substantially reduced the difficulty of coordinating European and U.S. money markets, materially reducing the burdens of the fluctuating exchange rate.
 &
  Thus, total money stock figures for this period are meaningless unless adjusted for the fluctuating premium for gold - approximately 38.3% at midyear, 1867. Even so, gold money being independent of official or bank issuance, cannot be exactly calculated, but the authors provide estimates based on the banking statistics available.
 &

The "depression" of 1873 to 1879:

  Money stock fluctuation in the 12 years before 1879 was comparatively modest. The money stock actually declined in 5 of the calendar years and ended up only 17% higher for the whole period.
 &

Initiation of monetary movements typically precede the corresponding economic movements by some months. However, these monetary movements are often not turns but just a slowing or acceleration of the rates of growth.

  Monetary restraint was required for the effort to make the greenback "as good as gold." Not until the sharp decline during the initial years of the Great Depression do we find so many years of money stock decline in any dozen year period. Indeed, including the 5 years 1929 to 1933, there were only 13 single years of decline in the 81 years up to 1960. Because of variations in statistical evaluation and availability, these calculations are not always based on calendar years.
 &
  Most of the 1870s decline in the money stock occurred during the 1873-1879 depression - considered one of the longest and apparently most severe on record. During many economic contractions - such as 1869-1870 - money growth slowed but there was no actual contraction of the money stock. Initiation of monetary movements typically precede the corresponding economic movements by some months. However, these monetary movements are often not turns but just a slowing or acceleration of the rates of growth. The authors note that the absolute troughs in business and money stock levels in 1879 just about coincided.

  "We shall find these phenomena of acceleration of the money stock preceding a cyclical trough and deceleration preceding a cyclical peak, both by sizable intervals, repeated time and again in subsequent experience. We shall find also in subsequent deep depressions that the absolute trough in the money stock often coincided with the cyclical trough as, for example, it did in 1933."

  Fluctuations in wholesale prices tracked these monetary movements. Wholesale prices declined significantly from 1867 to 1879, interrupted only by the cyclical expansion 1870 to 1872 when money stock was also rising. The average decline from 1865 to 1879 was an unprecedented 6% per year as greenbacks rose back to par with gold. In terms of gold, prices were practically stable.
 &

Velocity is a relatively stable magnitude, the authors assert.

 

The severity of the 1873 to 1879 depression may well be significantly overstated due to the weaknesses in the statistical data for that period.

  There are severe problems with the price statistics available for this period, the authors warn. Farm produce and raw materials markets provided readily available prices, but many other price levels were uncertain or are unavailable. With respect to farm produce and raw materials, technological improvements - especially in transportation - were probably the cause of a substantial relative decline in their prices during the period. The general price decline is estimated on the bases of particular scholarly analyses producing an "implicit price deflator" or "implicit prices." This implicit price decline was running at around 3.5% per year.
 &
  With money stock rising at just over 1% per year between 1867 and 1879 while prices were declining, either the velocity of money was declining or output - and the work done by each dollar - was increasing. "As a matter of economics, there can be little doubt that it reflects primarily a rise in output." Velocity is a relatively stable magnitude, the authors assert.

  Velocity became much less stable in several countries after 1964, during the period of inflation caused by Keynesian policy.

  Despite a mild recession trough in 1867 and a deep one in 1879, the authors estimate output increased about 3.6% per year during this period for an impressive increase of about 54%. A substantial increase in population of more than 30% accounts for more than half of this increase in output. The latter part of the 1870s experienced a worldwide depression, sending a wave of immigrants into the U.S. despite U.S. economic difficulties.
 &
  However, even with the cyclical downturns and the population increase, output per capita was surely rising. The authors' estimate is 1.3% per year. The severity of the 1873 to 1879 depression may well be significantly overstated due to the weaknesses in the statistical data for that period.
 &
  Indeed, the vast expansions of the railroads, railroad ton mileage, mining output, and western settlement, and a 50% increase in the number of farms and an increase in land values even as agricultural prices declined, all affirm the great increase in productivity and output. Despite the 1879 depression trough, manufacturing employment was 33% higher than in 1869. Exports of finished products were nearly 2 times greater in terms of gold values.
 &

"In the greenback episode, a deflation of 50 percent took place over the course of the decade and a half after 1865.  Not only did it not produce stagnation; on the contrary, it was accompanied and produced by a rapid rate of rise in real income."

  The available statistics make it appear that an extraordinary period of net national product increase and real per capita income increase corresponded with a period of apparent severe depression and price decline. The authors explore in some depth the relative unreliability of output and monetary statistics for this period and the various estimates of net national product.

  "Whichever estimate of net national product one accepts, the major conclusion is the same: an unusually rapid rise in output converted an unusually slow rate of rise in the stock of money into a rapid decline in prices. We have dwelt on this result and sought to buttress it by a variety of evidence, because it runs directly counter both to qualitative comment on the period and to some of the most strongly held current views of economists about the relation between changes in prices and in economic activity. Contrast, for example, this result with the widely accepted interpretation of British experience in the 1920s, when Britain resumed specie payments at prewar parity. The prewar parity, it was said, overvalued the pound by some 10 percent or so at the price level that prevailed in 1925 at the time of resumption -- prices by then having fallen about 50 percent from the postwar peak --; hence, the successful return to gold at the prewar parity required a further 10 percent deflation of domestic prices; the attempt to achieve such further deflation produced, instead, stagnation and widespread unemployment, from which Britain was unable to recover until it finally devalued the pound in 1931. On this interpretation, the chain of influence ran from the attempted deflation to the economic stagnation.
 &
  "In the greenback episode, a deflation of 50 percent took place over the course of the decade and a half after 1865.  Not only did it not produce stagnation; on the contrary, it was accompanied and produced by a rapid rate of rise in real income. The chain of influence ran from expansion of output to price decline. - - - After 1873, the stock of money rose less rapidly and then fell, while population continued to rise, so money wage rates did fall; and this was connected with the severe contraction beginning in 1873. But even so, wages apparently fell fast enough to avoid continued severe unemployment or industrial stagnation."

  The difference with England in the 1920s was that debt levels were higher and labor market flexibility much lower than in the U.S. in the 1870s. Government activities constituted a much larger burden on the English economy. The U.S. economy during the 1870s was simply much more flexible, which made post-Civil War adjustments much easier.

  Nevertheless, while many thrived, there were many losers. Businesses closed, workers lost jobs and nominal wages declined. Although real wages increased along with net national product, social problems were created and political attention turned to the lack of growth in the greenback money supply.
 &

  Greenback agitation grew after the banking panic of 1873. Greenback inflation lost by the narrowest of political margins in 1878, after which it declined - to be replaced by agitation for a bimetallic silver and gold monetary system.
 &

  The determinants of the money stock under both fiduciary - or "fiat" - and specie standards, are briefly set forth by the authors. They explain how a slow decline in greenbacks and other currency was translated by the banking system into a modest rate of increase in the money stock until that, too, began to decline during the 1875 to 1878 depression years. Changes in deposit-to-reserve ratios and deposit to currency-in-the-hands-of-the-public ratios explain these movements. The greenback agitation failed to more than marginally impact greenback circulation, leaving the banking determinants as the most influential factors after 1867.
 &
  A reduction in national bank reserve requirements in 1874 was the one government action that contributed most to money stock growth. The rise of greenback circulation from 1870 to 1874, and its decline thereafter through 1878 did reinforce money stock movements.
 &
  Events impacted the banking determinants. The rapid spread of commercial banking induced deposit growth - which was slowed by the bank panic of 1873 and reversed by the numerous bank failures in the 1876 to 1878 period. Deposit-reserve ratios rose as the system matured and accepted greater risk levels - declined sharply during the panic of 1873 as surviving banks increased liquid reserves - and rose to new heights in 1874 when reserve requirements were lowered.
 &
  Deposit-reserve ratios for non-national banks were higher than for national banks. Only 6 states imposed any reserve requirements, and only 3 of those were as high as the federal requirements. Bank suspensions were concentrated in the non-national banks, inducing greater caution and need for liquid reserves among the survivors - and sending deposits fleeing to the greater apparent safety of the national banks. The desire for greater safety and for greater liquidity led to reductions in the deposit-reserve ratio during the banking problems of 1876 to 1878.
 &

Financing the Civil War:

  The authors illustrate the massive benefits bestowed upon the nation by its carefully maintained good credit. They analyze the movements of gold prices and interest rates during and in the 15 years after the Civil War.
 &

Investor confidence restrained the rise in the greenback price of gold and - just as important - kept long term interest rates at reasonable levels - thus massively facilitating the nation's ability to finance the war.

  As gold prices rose against the greenback during the war, the markets kept discounting a return to parity after the war rather than further devaluation of the greenback. This investor confidence restrained the rise in the greenback price of gold and - just as important - kept long term interest rates at reasonable levels - thus massively facilitating the nation's ability to finance the war.

  "It seems likely that - - - the rise in the greenback price of gold produced speculative capital inflows, which helped to finance a deficit in the balance of trade and which explain why the depreciation in the exchange value of the dollar, over and beyond that to be expected from purchasing-power parity, was so mild -- given the drastic change in the North's international trade position. Such capital inflows would also have constituted a demand for U.S. securities, which explains why interest rates were so low despite the rise in commodity prices and the extensive government borrowing."

  Speculative money was parked in long term U.S. and private - mainly railroad - bonds, whose yields were thus lowest precisely when gold prices were highest and speculative interest in a greenback recovery would be greatest. Short term call money and commercial paper were not convenient parking places for such speculative money, and their yields rose as might be expected from the concurrent inflation and heavy government borrowing.
 &

  Payments in gold for gold bonds were maintained - apparently much to the surprise of the market. While confidence that the greenback would eventually return to parity was high, such was not the case for gold bonds. The yield on the 6% 1881 bond exceeded 16% at one time during the war. The gold bonds were discounted in line with the discount for greenbacks - so market speculators made substantial profits as gold payments were maintained. Towards the end of the war, yields declined sharply, with further declines after 1869 when the government committed itself to continue payments in gold.
 &
  As the war turned in the Union's favor in the middle of 1863, capital inflows - especially from Dutch and German investors - substantially increased even as the greenback devaluation reached its worst levels. In England, the government and commercial interests had generally favored the South, but as Generals Grant, Sherman and Sheridan won major victories in late 1864, capital inflows from English investors increased also.

  "If this analysis is correct, the depreciation of the exchange rate manifested in the rise in the greenback price of gold contributed to resolving the North's balance of payment difficulties in two very different ways: by affecting the 'real' terms of trade and so fostering exports and discouraging imports; by stimulating a speculative inflow of capital, which limited the depreciation, holding it to only some 20 percent in excess of that required to compensate for internal price level changes, and kept the terms of trade from turning even more strongly against the North."

  The authors note that something similar occurred during the early stages of the German inflation after WW-I - but the inflation continued and speculators lost heavily for their misplaced faith in the Weimar government.
 &

Resumption of the gold standard:

 

 

 

 

 

\&

  With the end of the war, capital inflows continued - presumably now seeking permanent investment in the expanding U.S. economy. This supported the greenback at higher valuations than warranted by recovering trade levels. Gold declined from 20% above calculations of purchasing power parity to 10% below.

  "This appreciation of some 30 percent in the exchange value of the greenback dollar is a measure of the pressure that the wartime disturbance of trade relations had imposed on the balance of payments."

  After 1873, gold fluctuated upwards, back to levels approximating calculations of purchasing power parity. As U.S. bond yields declined, foreign investors abandoned them in favor of the higher yielding railroad bonds - until railroad bond defaults led to the banking failures and panic of 1873.
 &

This was a period of remarkably disciplined government budgetary and monetary policies which played a major role in supporting confidence in the monetary system.

  As resumption of specie payments at pre-Civil War parity neared, domestic demand for gold increased both on the part of the public and the Treasury. The greenback price of gold rose above purchasing power parity levels, exports were drastically curtailed, and production of gold increased 50% between 1875 and 1878.
 &
  Resumption became possible at pre-Civil War parity - at $4.86 per pound sterling - because the price decline retraced all the approximately 150% price inflation of the Civil War. This substantial decline in prices occurred despite a mild rise in money stock. The rapid growth in output - in real income - was the primary reason. A flexible and dynamic economy simply grew its way out of its wartime difficulties (exactly as the British economy had done repeatedly after each of the wars of the 150 year period ending after the Napoleonic wars).
 &
  On the whole, this was a period of remarkably disciplined government budgetary and monetary policies which played a major role in supporting confidence in the monetary system. The authors analyze these policies at some length. Resumption of specie payments did not take place until the gold premium had fallen to approximately 10% of its peak level - thus assuring the success of resumption.

C) The Gold Standard and "Free Silver" Movement (1879-1897)

The gold standard:

 

&

  Under the gold standard, the major channel of influence on the stock of money runs from "fixed rates of exchange with other currencies through the balance of payments to the money stock, thence to the level of internal prices that is consistent with those exchange rates."
 &

"The forces making for economic growth over the course of several business cycles are largely independent of the secular trend in prices."

  Domestic policies can produce sizable short term deviations, however, because the links are loose with plenty of play between them. Policies that impact trade or capital flows or levels of money balances held by the public can influence the system, but they ultimately have to be reversed or they will undermine the gold standard.
 &
  There were rapid increases in world output 
in the period from 1879 to 1897. Prices nevertheless declined in terms of gold into 1897 but rose thereafter. The period after 1897 was influenced by major increases in gold supplies flowing from new mines in Alaska, South Africa and Colorado, and advances in gold mining and refining. The price decline during the former period occurred "despite the rapid expansion of commercial banking and other devices for erecting an ever larger stock of money on a given gold base."
 &
  After resumption of gold payments, growth in the U.S. money stock accelerated, averaging about 6% per year between 1879 and 1897 and 7% from 1897 to 1914. However, the rate of growth was uneven. It surged at over 19% from resumption in 1879 to 1881, and was essentially flat from 1892 to 1897. There were severe business contractions from 1882 to 1885, from early 1893 to the middle of 1894, and from 1895 to the middle of 1897. The period thereafter until 1914 saw only one sharp but short recession in 1907.
 &
  The period ending in 1897 was notable for unrest, protest movements, and periods of financial uncertainty. The period after 1897 experienced relative political stability and public confidence in the economic future. Yet, both periods enjoyed massive rates of capital expansion and economic growth at well over 3% per year. Per capita, net national income increased at about 1.5% per year.
 &
  There were declines in money income during the four sharpest business contractions, but recovery was quick after each of them. Prices, too, seemed to return to trend after each depression. The evidence, the authors note, reinforces the tentative conclusion "that the forces making for economic growth over the course of several business cycles are largely independent of the secular trend in prices."
 &
  The sharp increase in the money stock between 1879 and 1882 was accompanied by a sharp increase in prices which was more than reversed by 1886. Prices were roughly constant from there to 1891 and resumed their decline into 1897 with a brief rise from 1892 into 1893.
 &

The adjustment process of the gold standard:

 

 

&

  Resumption in 1879 was followed by an economic boom as monetary confidence was reinforced by a massive two year surge in crude foodstuff exports responding to major crop failures in other countries. Gold stocks more than doubled in these two years from $210 million to $439 million. This caused an expansion of the money stock that pushed up prices approximately 10%  at a time when British prices remained constant. British gold reserves declined 40%, inducing an increase in its Bank rate in steps from 2% to 6% - which reversed the gold flow.
 &

  The two year surge in U.S. crop exports and its ending resulted in an apparent seesaw reaction in international gold flows. The gold flows kept exchange rates steady and mitigated price fluctuations. However, the expansion of the U.S. money stock did lead to price increases in the U.S. and put downwards pressure on prices in the nations that paid in part in gold for imported food. The relative price swings ultimately brought the systems back to trade equilibrium and ended the need for large gold flows. "It would be hard to find a much neater example in history of the classical gold-standard mechanism in action," the authors note.
 &
  With the return of normal crops abroad, food exports declined back to normal - and the boom ended. Worse, Britain had not fully adjusted to its previous monetary contraction and experienced a 12% price decline between 1882 and 1885. To regain approximate purchasing power parity with Britain, U.S. prices had to declined even further. As gold flowed back to Britain, the growth of the U.S. money stock slowed sharply from 16% per year to 3%. Real output growth decline from 7% to 1%. The discipline of the balance of payments was the primary determinant of the adjustment process, but that process required at least some economic recession in the U.S.
 &
  There were, of course, other factors that contributed to the recession. There was another round of railroad bond defaults and a flight of foreign capital. The result was a financial panic in New York in 1884 with modest spillover elsewhere in the country. Confidence in the maintenance of the gold standard declined as the Treasury purchased silver at the expense of gold under the Bland-Allison Act of 1878.
 &
  Capital flight and gold exports were again evident from 1888 to 1891 due to another period of doubts about maintenance of the gold standard. However, prices declined only modestly - about 2% - because British prices were rising.
 &
  British investment interest shifted to Argentina in 1890, causing a loss of gold in the U.S. that put pressure on reserves in New York. Security prices fell and banks and brokerage houses failed and there was a panic towards the end of 1891. There were financial problems in England, too, and the start of a depression period. However, in New York, it was all over quickly, and stability was restored.
 &

End of the Free Silver movement:

  The Sherman Silver Purchase Act of 1890 doubled silver purchases, which were paid for with Treasury notes redeemable in either gold or silver at the discretion of the Treasury.
&

  The financial troubles of the 1890s were marked by the waxing and waning of confidence in the maintenance of the gold standard - corresponding swings in capital flows - and several corresponding cyclical economic swings. World prices in terms of gold fell sharply between 1891 and 1897 and the Free Silver movement reached its political peak - further undermining confidence in the gold standard in the U.S. Changes in tariffs and increased spending for pensions, rivers and harbors threatened to reverse the budget surplus.
 &
  Money stock growth slowed or reversed during these economic contractions and adverse capital movements put pressure on prices which declined through most of the period. The authors speculate on how much the vacillations in confidence in the gold standard contributed to these events, and note some similarities with British experience immediately after WW-II.
 &
  The initial loss of confidence in the gold standard was largely offset by crop failures abroad that coincided with a record U.S. harvest and a 150% increase in food exports in the year ending June 30, 1892. This reversed a sharp outflow of gold and induced a short period of rising prices. It ended a mild recession which had been accompanied by the usual surge in bank and brokerage failures.
 &
  However, world prices continued falling as the purchasing power of gold increased, and capital inflows remained suppressed. Gold exports resumed at the end of  1892. Again, confidence in the gold backing for Treasury notes was undermined.
 &

A variety of currency substitutes were created - factory pay checks, miscellaneous notes and certificates issued by corporations and individuals. The situation was short lived - ending when deposit withdrawal restrictions were lifted that September.

  The panic of 1893 is explained by the authors as running from the loss of confidence in the bimetallic gold/silver standard, causing an external drain as gold and capital flowed out. This in turn caused a decline in the money stock and declines in securities prices and general price levels. Soon, banks, brokerages and mercantile establishments were failing. However, bank failures were predominantly in the West and South due to an internal drain caused by defaults on loans that undermined confidence in bank solvency.
 &
  Efforts to repeal the Sherman Silver Purchase Act began in the summer of 1893 and brought the external drain to an end. Repeal came on November 1, 1893.
 &
  As the public sought currency, public currency holdings rose 6% in the year ending June, 1893, while deposits fell 9%. The total money stock fell about 6% - the first substantial decline since 1875-1878. A second round of deposit withdrawals hit the South and West in July, 1893, draining reserves from New York. When the Erie Railroad went into receivership, the stock market tanked and bank failures hit the East as well.
 &
  Banks then imposed restrictions on cash withdrawals, bringing the string of bank failures to a close. While reserves proved inadequate in certain banks, total reserves in the banking system were adequate. But currency was suddenly rendered scarce by the restrictions on deposit withdrawals. Currency thus began selling at a premium to bank deposits. A variety of currency substitutes were created - factory pay checks, miscellaneous notes and certificates issued by corporations and individuals. The situation was short lived - ending when deposit withdrawal restrictions were lifted that September.
 &

  World prices continued to fall and the British price decline lasted into 1896 as gold continued to appreciate. Except for a modest 18 month rebound from the middle of 1894, the deflation in the U.S. dragged on to 1897. Treasury gold reserves fell below $45 million at the beginning of 1895. Speculative pressure on the dollar persisted as did political agitation. Various measures kept the money stock fairly constant and assured holders of dollar balances that the Treasury was determined to maintain the gold standard.
 &
  The Democratic Party nomination of William Jennings Bryan as its presidential candidate in 1896 accelerated the flight of capital and gold. A syndicate of big city banks put its credit on the line to support the dollar. It adopted a commitment to provide foreign currencies directly to purchasers without intermediate gold transactions. This brought capital flight to an end.
 &
  Seasonal agricultural exports resulted in gold inflows beginning towards the end of August that brought an end to the dollar crisis. Some internal accumulation of gold and foreign currencies continued until the Republicans won the election, and the crisis was over. The increase in world gold supplies was already making itself felt.
 &

  The perfervid politics of the greenback and Free Silver advocates during the last quarter of the 19th century are summarized by the authors. These forces succeeded in gaining passage of limited silver purchase and bimetal standard legislation in 1878 and 1890, with repeal coming at the end of 1893. The desired unlimited coinage of silver was never enacted. Limited silver coinage and issuance of silver certificates undermined confidence in U.S. currency, but was insufficient to stem the rapid decline in silver prices as copious supplies rolled in from the West and other sources around the world.
 &
  Good agricultural prices helped McKinley beat Bryan in 1896 in a heated, nasty campaign. The silver cause thereafter faded as new sources of gold came into production, and the purchasing power of gold declined. With the Gold Standard Act of 1900, the issue was settled in favor of the gold standard.

  When nations adopt the gold standard, they (1) accept the disciplined economic policies required to maintain the gold standard and (2) in essence offer a guarantee of continuance of such prudent economic policy. The reward is increased public confidence and economic efficiency.
 &
  When political leaders violate this trust with imprudent undisciplined economic policies, it is they - not the gold standard - that has failed. The sooner they drop the charade and abandon the gold standard the better. The economy will need maximum flexibility to make the adverse adjustments needed as smooth as possible in response to those policies. Gaining and maintaining public confidence and economic efficiency under flexible exchange rates will require at least the same disciplined economic policies needed for maintenance of the gold standard.

Determinants of the money stock:

  The determinants of fluctuations in the money stock under the resumed gold standard up to 1897 are analyzed by the authors.
 &

  The initial 2 year surge in the money stock to 1881 accounted for nearly half the total growth to 1897. Just over 80% was accounted for by growth in "high-powered money" - primarily coinage and currency backed by gold and silver and national bank notes. High-powered money growth accounted for 55% of money stock growth from 1881 to 1892, but high-powered money declined until the middle of 1897, after which it sharply recovered.
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  The deposit-to-currency-held-by-the-public ratio of the banking system vacillated as might be expected with fluctuations in public confidence in the banking system. It grew strongly with the successful resumption of the gold standard, thereafter flattening out or contracting during business contractions and dropping sharply during the panic of 1893. If monthly data were available, the authors note that the ratio would undoubtedly show sharp declines corresponding to the banking crises of 1884 and 1890. Growth after the 1893 crisis made up for much of the decline in high-powered money in that period and - along with growth in the deposit-to-reserve ratio after 1893 - kept the money stock essentially flat to 1897.
 &
  The deposit-reserve ratio of the banking system played only a minor role during this period due to little change in official reserve requirements or in the reserve levels thought prudent by bankers over and above requirements.
 &
  The ratio rose after resumption until 1883 with little overall change thereafter. Fluctuations corresponded with business cycles. Surviving banks visibly increased reserves during contractions and acted more aggressively during prosperous times. Typically, runs on banks drained reserves, which would thereafter be more than rebuilt before returning to normal levels after business conditions improved.
 &
  Nine more states imposed reserve requirements on their non-national banks for a total of 15. State requirements were mostly lower than national requirements. Their deposit-reserve ratios were in practice about twice as high as those of the national banks due to their lower reserve requirements. Their reserves accounted for about 1/3 of the total in the banking system.
 &
  Deposits tended to flow in favor of non-national banks during prosperous times, and towards the greater safety of the national banks during contractions. This had some impact on the total deposit-reserve ratio due to the higher average levels of reserves held by the national banks. Thus, the deposit-reserve ratio somewhat reinforced cyclical impacts on the money stock.
 &

  High-powered money levels were determined mainly by gold flows and silver purchases. However, there was considerable play in the system that permitted responses to policy decisions. There was no legal category of fiduciary currency during this period, so only the modest fiduciary element in minor coins existed.
 &
  Prior to resumption in 1879, the Treasury accumulated gold reserves, but when this was released after successful resumption, the levels of high-powered money stock soared - reinforced by the gold inflows from a 2 year surge in agricultural exports. 
 &

  The Treasury also played a monetary role. Treasury cash increased due to revenue surplus and borrowing - both of which subtracted from high-powered money in circulation. Revenue deficits and debt repayments had the opposite effect.
 &
  Treasury cash levels changed little from 1879 to 1897, but shorter term fluctuations had some impact on gold flows. The authors find it impossible to determine whether on balance these minor fluctuations in Treasury cash were stabilizing or destabilizing because the impacts on the deposit ratios are unknowable.
 &
  The minimal fluctuations of Treasury cash were clearly the result of Treasury policy. Budget surplus was the norm during this period - mainly from customs receipts that by law had to be kept in the Treasury. Treasury cash reached a peak in one year equal to 10% of high-powered money. The Treasury redeemed debt and prepaid interest, and allowed revenues from other sources to accumulate as deposits in banks to prevent the Treasury surplus from forcing a contraction of the money stock. However, the redemption of government debt reduced the amount and raised the price of government bonds available as security for the issuance of national bank notes - which declined from $350 million in 1882 to $160 million in 1891.
 &
  The Treasury used its cash for open market operations at times of financial strain - playing a central banking role - but this activity was erratic and unpredictable.

  The cyclical turmoil in the banking system was proof of the nation's lack of a real central bank and adequate banking regulation. Since the banking system is a part of the monetary system, these are clearly appropriate and necessary government functions in a capitalist system.

  Treasury cash declined from 1888 to 1893 due to debt redemptions in excess of surplus revenues. This was a period of substantial growth of the money stock coinciding with larger gold exports or smaller gold imports than would otherwise have occurred. When silver monetization expanded in 1890, gold exports soared as capital fled the country. The Treasury borrowed extensively from 1893 to 1896 to restore its gold reserves, but this had the effect of contracting or preventing growth of the money stock and probably contributed to the economic problems of that period.
 &

Silver:

 Silver legislation was intended to force inflation of the money supply (and to keep silver mines profitable).
 &

The authors conclude that it was the bimetallist standard - rather than either a silver or gold standard - that was the primary source of instability, since the relative values of the two metals inevitably diverged on world commodity markets.

  The silver component of high-powered money grew steadily, equaling about $500 million or about 1/3 of the total in circulation by 1893. However, the authors point out, instead of causing an expansion of the money stock as intended, it retarded growth prior to 1891 and played a major role in the lack of growth thereafter. It undermined confidence in the maintenance of the gold standard, adversely impacting capital and gold inflows and outflows. Even after repeal of the silver legislation in 1893, Treasury borrowing to acquire sufficient gold to restore confidence played a major role in monetary stock stagnation until 1897.
 &
  The authors conclude that it was the bimetallist standard - rather than either a silver or gold standard - that was the primary source of instability, since the relative values of the two metals inevitably diverged on world commodity markets. They speculate that a U.S. silver standard operating alone might have sufficiently altered the precious metal markets to avoid the rapid decline in the gold price of silver during this period.

D) Inflation Under the Gold Standard (1897-1914)

Gold inflation:

  The surge in gold supplies resulted in price inflation after 1897.
 &

  Prices rose between about 40% or 50% from 1897 to 1914 - depending on the index used. This brought prices back to about the levels reached in 1882 at the peak of the post-resumption expansion. This rate of price inflation is unprecedented for the U.S. in peacetime (until the Keynesian monetary policy inflation of the three decades after 1960). Inflation in the 1850s after the California gold discoveries had been sharper but lasted for less than half the length of time.
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  The  inflation was worldwide, of course, because of the spread of the gold standard. British prices rose about 26%. Worldwide gold stocks more than doubled. They had risen only 40% during the preceding 24 years - and that was a period of rapidly rising demand for gold as many nations joined Britain on the gold standard.
 &
  The gold stock in the U.S. more than tripled between 1897 and 1914 - to almost $1.9 billion. This equaled almost 25% of the world total - up from about 14% in 1897.
 &
  With the exception of the 1907 panic year, the money stock grew steadily throughout this period. The increase in high-powered money was concentrated in gold and national bank notes as silver components grew very little. Continued increases in the bank deposit ratios contributed to the money stock increase which averaged about 7% per year. Price inflation absorbed about 2% per year, and about 3% was absorbed by growth in real output. Money balances relative to real income continued to rise as during the previous period, continuing a decline in monetary "velocity," albeit at a slower pace. See, G) "The Velocity of Money" of Friedman & Schwartz, "Monetary History of U.S.(1867-1960)," Part III, "The Age of Chronic Inflation (1933-1960)."
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  Expansion was fastest in the first five years - to June, 1902 - as the system rebounded from the stagnant 1892-1897 period. It thus repeated the pattern of the period after resumption two decades earlier. Wholesale prices rose 32% - about 2/3 of the total price rise for the entire period to 1914. Real net national product rose more than 6% per year between 1896 and 1902 - 4% per year per capita.
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  This expansion brought net national product growth back to trend - just as the post-resumption surge did two decades earlier. Like the earlier surge, it was reinforced by a 2 year surge in agricultural exports in 1897 and 1898 due to a 20% reduction in the European wheat crop. The sharp 1897 Dingle Tariff increase inhibited imports - the two factors leading to a massive increase in the nation's favorable balance of trade.
 &
  As agricultural exports returned to normal, there was a stock market panic and mild recession in 1899, with the usual banking and financial failures that mildly impacted financial trends. The reduction in imports reduced customs receipts, adversely impacting the federal budget (and increasing pressure for the enactment of an income tax amendment).
 &
  There was, however, a surge in capital outflows during the period to 1902 that the authors find most puzzling. The differing rates of price increases, immigration and immigrant remittances, tourist expenditures, the Spanish-American War and the Boer War, interest rate differentials and stock market movements all played a role, but don't seem to explain the scope of the outflows. The capital outflow doesn't seem to correlate with the differential changes in prices between the U.S. and Britain. However, the statistics for this period still leave much to be desired and that may account for much of the reported scope of the outflows.
 &

  Treasury intervention became more regular in this period, with actions to relieve monetary stringency at the end of 1899 and in 1901 - first to counter panic after a stock market collapse and later after President McKinley was shot. These interventions did not prevent mild cyclical contractions in 1899 to 1900 and for almost 2 years between 1902 and 1904, but the contractions might have been much worse. The Treasury intervened twice during the 1907 panic year.
 &
  Between 1903 and 1907, the economic expansion was both vigorous and protracted - the best business expansion since 1879 to 1882. Wholesale prices rose about 10% for the period as a whole, continuing to rise faster than British prices until 1905 - a differential now once again reflected in capital flows. In the 2 years to the first quarter of 1907, $143 million in gold flowed into the U.S. There had been little net movement from 1899 to 1904. The seesaw impact of gold flows produced monetary stringency in London in 1906.
 &
  Except for a flat period around 1903, net national product rose vigorously between 1897 and 1907 - about 30% in constant prices. Coal and iron and railroad traffic showed sharp increases. Immigrants flooded in - over 1 million per year for the last three years of the period.
 &
  The money stock rose about 45% in the 5 years to June, 1907 - a little over 7% per year - while prices rose about 2% per year. The authors speculate that 5% annual growth in the money stock would have been consistent with stable prices. The velocity of money continued to slow - but much less than in previous similar periods of prosperity.
 &
  In 1905, Panama Canal and other expenditures reduced Treasury balances and halted Treasury interventions, but they were resumed in 1906. In the absence of Treasury intervention, periods of monetary stringency saw short term call money rates soar - as high as 40% in September, 1906. Routine Treasury intervention now involved withdrawing funds in the slow summer economic periods and adding them for the spring and fall business upturns. In those days before air conditioning and before the relative shrinkage of the vast agricultural component, the economy had a definite seasonal rhythm.
 &

The panic of 1907:

 

&

  In England, gold was flowing out. The discount rate was increased in steps from 3% to 6% between September 13 and October 19, 1906. In Germany, the Reichsbank took similar steps. The seesaw impact then drew gold back out of the U.S.
 &

  By March, 1907, New York stock markets were in severe decline. Union Pacific - a leading stock used widely as collateral in finance bill transactions - dropped 30% in less than 2 weeks.
 &
  The stock market collapse "followed the separate attempts of the Morgan and Harriman interests to corner Northern Pacific stock, and the discovery on May 9 that more shares had been sold than were in existence." The panic involved loan and trust company banks in New York that had expanded exuberantly to take advantage of looser supervision and lower reserve requirements than other types of commercial banks.
 &
  By May, the economy had turned down. The decline was short but sharp. Net national product declined 11% in 13 months. It became especially sharp after the October banking panic, during which - as in 1893 - banks restricted payments on deposits. This lasted through January, 1908. Commercial failures soared.
 &
  Monthly banking data became available in this period, and the panic stimulated vast improvements in reporting and regulation at all levels. The money stock showed a mild 2% decline from the previous peak until the panic, and a rapid one totaling 5% thereafter until February, 1908. Only 1920 to 1921, 1929 to 1933, and 1937 to 1938 showed similar severe rates of monetary contraction.
 &
  The initial decline reflected in part gold exports and a 1% decline in high-powered money. The deposit- reserves bank ratio fell as banks increased their high-powered money reserves about 5% despite the decline in the total of high-powered money. At this point, however, deposits declined only slowly, so the deposit- currency ratio rose slightly.

  "These changes in the deposit ratios have the appearance of a fairly passive response to a business decline, with banks strengthening their reserve positions and holders of money showing no distrust of banks."

  By September, 1907, however, the public and the banks were both striving for liquidity - an impossible goal. Even though high-powered money rose 10% in 5 months due to gold imports and Treasury intervention equaling $64 million by the end of October, the money stock declined 5% - similar to the 1893 experience. The banks were unable to increase their currency holdings in the panic month of October, but thereafter increased reserves by 8%, substantially reducing both deposit ratios - enough to produce a 14% reduction in the money supply but for the 10% rise in high-powered money.
 &
  The authors tell how the stock market decline - especially in copper stocks - undermined speculators, leading to widespread distrust of the loan and trust company banks that were financing their speculation. The troubled banks withdrew reserves they had deposited with the N.Y. clearing house banks. Soon, country banks began withdrawing their reserve deposits, joined by withdrawals by individual and business depositors as the panic became general. The stock market responded by collapsing.
 &

Unease affecting country banks continued, however, and was met with $256 million in clearing house certificates issued on the basis of high grade ordinary assets. In the 1893 panic, $69 million of these certificates had been issued.

  New York banks had to restrict the convertibility of deposits into currency. Country banks soon followed their example. After announcement of the restrictions, $31 million in currency drained out of the clearing house banks, but the drain was only $8 million in the following 3 weeks. Seasonal inflows then ended the currency shortage, and after October, currency began piling up in the banking system.
 &
  J.P. Morgan stepped in to organize a $25 million intervention pool which, along with a similar pool of $10 million, ended the panic. Unease affecting country banks continued, however, and was met with $256 million in clearing house certificates issued on the basis of high grade ordinary assets. In the 1893 panic, $69 million of these certificates had been issued.
 &
  As the country banks sought to withdraw their reserves from the clearing house banks, they were given these certificates instead. It was agreed that these certificates would be accepted for clearing house use, so they circulated as currency. They were supplemented by over $250 million in small clearing house checks and certificates, cashiers checks and manufacturer pay checks. All together, these substitutes made up for about half of the estimated decline in the money stock.
 &
  Again as in 1893, there was a premium for currency over deposits - as high as 4% - since deposits were no longer as good for transaction purposes. This led to an increase in gold imports, since gold in New York was now worth more than the standard $4.86 per pound sterling. The exchange rate rose as high as $4.88. $100 million in gold flowed in in November and December, 1907, during the period of bank withdrawal restrictions. High-powered money increased $239 million during the final quarter of 1907.
 &
  Restrictions began to be lifted early in December and were completely lifted by the beginning of January, 1908. Confidence in the banking system wasn't fully restored until February.
 &

Many suspended banks were able to reopen later, and only unsound banks failed. Indeed, the total number of banks was probably higher at the end of 1907 than at the beginning. The measures taken to deal with the panic given the tools available seem to have been effective.

  The dispute over whether more aggressive intervention by the big N.Y. clearing house banks could have prevented the panic is reviewed by the authors. They note the vast increase in the deposit to currency ratio since 1879 - from $1 in currency for each $2 in deposits to $6 dollars in deposits in 1907. The deposit- reserve ratio had doubled.
 &
  The Treasury interventions may have had the perverse effect of inducing banks to reduce their reserve requirements in reliance on Treasury assistance when needed. Their increased vulnerability to runs undoubtedly increased the urgency of their efforts to increase their reserves as the contraction unfolded. This added to the panic.
 &
  In the event, bank failure rates spiked upwards, but stayed well below 1% of the total of commercial banks. The loss to depositors spiked upwards even more, however. Many suspended banks were able to reopen later, and only unsound banks failed. Indeed, the total number of banks was probably higher at the end of 1907 than at the beginning. The measures taken to deal with the panic given the tools available seem to have been effective.
 &

The last years of the unfettered gold standard:

  The 1908 Aldrich-Vreeland Act was a temporary effort to avoid such panics while more thoroughgoing reforms were studied. It relied on bank issuance of emergency currency based on usual bank assets with penalty provisions designed to force retirement of the emergency currency after the emergency.
 &

"The prompt satisfaction of the public's demand for additional currency cut the [panic] process short at the outset."

  This mechanism was employed just once - at the start of WW-I - and successfully met the bank runs at that time. $400 million in clearing house loan certificates were issued, with $364 million the most in circulation at any one time - equal to almost a quarter of circulating currency and 1/8 of high-powered money. There was no panic and no need to restrict payments on deposits.

  "The prompt satisfaction of the public's demand for additional currency cut the [panic] process short at the outset."

  The period 1908 to 1914 was characterized by generally sluggish growth with just two brief periods of buoyant expansion. Money stock, money income and prices rebounded sharply from 1907 to 1910, with prices rising faster in the U.S. than in Britain. The differential in price levels sent gold back to Britain, slowing the growth of high-powered money. The sharp rebound in the bank deposit ratios supported growth of the money stock. However, when that came to an end, money stock growth slowed and the general business upsurge came to an end.
 &
  Prices declined fairly sharply in 1910 and 1911, bringing them generally back into line with those of Britain - once again providing a good example of the international gold standard at work - both its strengths and its limitations.

  The gold standard brings buoyant prices back into line by an outflow of gold that slows the growth of the money supply or contracts the money supply, thus slowing the growth or contracting economic activity - a limitation due to the rigidity of the system. However, the discipline of the system forces prudent policies upon economic policy makers and monetary authorities and, as soon as those policies are forthcoming, the maintenance of the gold standard helps in the rapid restoration of public confidence and normal business conditions - the strength of the system. The paper money and bank deposit money is, after all, "as good as gold" - far more convenient - and deposit money may even earn an interest return.
 &
  If prudence isn't - or cannot be - restored - typically during time of serious conflict or determined pursuit of inflationary and, lately, Keynesian policies - then the gold standard must fail. Flexible exchange rates become preferable so that the inevitable adverse adjustments can come smoothly rather than through a series of catastrophic devaluations. The inflation of fiat money may make devaluation necessary - but devaluation by itself is NEVER a remedy for such inflation. See, "Understanding Inflation."
 &
  Yet, political leaders obviously love inflation. As the authors point out, it is an implicit tax on the money stock - the easiest tax to impose and collect. The benefits are short term and the costs are long term. It forces people to provide valuable goods and services to the government in return for pieces of paper or digital entries in accounts. It also provides some relief from excessive borrowing and the smothering rigidities of excessive regulation. These are the real reasons why politicians love as much inflation as they can get away with - and why economists who seek positions in government service strive to find excuses for the practice.

The rapidity with which the public regains confidence in the banking system when effective actions are taken to deal with panics is demonstrated by the speed with which the deposit-currency ratio recovers back to trend.

  Money stock and deposit ratios continued to increase, but at rates considerably slower than those from 1897 to 1907. The deposit- reserves ratio, however, didn't get back to its 1906 high during this period as banks reacted to the 1907 panic by maintaining more prudent levels of reserves.
 &
  The ratio of deposits to the public's currency holdings went right back up to trend and kept rising thereafter. This persistently rising trend demonstrates the public's growing faith - other than in panic periods - in the banking system. The rapidity with which the public regains confidence in the banking system when effective actions are taken to deal with panics is demonstrated by the speed with which the deposit-currency ratio recovers back to trend. This characteristic of the two bank deposit ratios can also be seen after other money crises - in 1884, 1890 to 1893, and 1933.
 &

  Gold coins and gold certificates accounted for 87% of the increase in high-powered money. Gold and national bank notes accounted for most of the growth in currency held by the public. The Gold Standard Act of 1900 encouraged monetary growth by liberalizing the requirements for issuing national bank notes and reducing to $25,000 the minimum capital for a national bank. The Comptroller of the Currency was now required to accept eligible securities at par rather than at 90% when issuing national bank notes to the banks.
 &
  The authors emphasize the impact of the increase in the bank deposit ratios on the growth of the money stock. Without those increases, the U.S. would have had to drain the world of over 60% of the worldwide increase in gold stocks to achieve equivalent monetary expansion. The banking system was indeed a vital part of the nation's monetary system.
 &
  The Treasury continued its seasonal interventions, and increasingly relied for that purpose on expansion or contraction of the deposits that it kept at commercial banks, which overall it built up substantially.
 &

  The authors compare two periods of relatively steady growth - each a decade long. One, from 1882 to 1892, occurred when prices were declining 2% per year, the other, from 1903 to 1913, occurred when prices were rising 2% per year. The periods show roughly similar growth in real output, and both begin just after a vigorous rebound from a monetary stringency episode.

  "If these figures can be trusted, the rate of price change over several cycles had little or no connection with the associated rate of growth of output. May it be that the rate of change in prices has a stronger effect on what contemporaries regard as the rate of growth to be rather than on what the actual rate of growth is?"

  The authors also speculate on long-swing theories of the business cycle.

E) The  Federal Reserve During World War I (1914-1921)

The Federal Reserve Act:

 

&

  The Federal Reserve Act of 1913 came into operation at the beginning of WW-I - a world it was not designed to deal with. Suddenly, major nations abandoned or loosened their ties to the gold standard as they sought flexibility to respond to the financial disruptions of wartime conditions.
 &

  The new Federal Reserve System (the "System")  consisted of Federal Reserve Banks and a Federal Reserve Board (the "Board"), with policy making authority nebulously shared between the Board and the Federal Reserve Banks (the "Banks") - especially the influential N.Y. Federal Reserve Bank (the "N.Y. Fed."). The System was designed to assure sufficient "elasticity of currency" to avoid 1907 style panics. It was also (at last) intended to assure adequate supervision of its member banks, and to be able to rediscount eligible commercial paper to facilitate commerce. The System had an immediate impact on the money supply.

  "Hitherto, high-powered money had consisted of gold, national bank notes, subsidiary silver and minor coin, and an assemblage of assorted relics of earlier monetary episodes -- greenbacks, silver dollars, silver certificates, and Treasury notes of 1890. Henceforth, Federal Reserve notes were available for use as hand-to-hand currency or as vault cash for banks; and deposits to the credit of banks on the books of Federal Reserve Banks were available to satisfy legal reserve requirements and were equivalent, from the point of view of the commercial banking system as a whole, to Federal Reserve notes or other currency as a means of meeting demands of depositors for cash."

"The Federal Reserve System therefore began operations with no effective legislative criterion for determining the total stock of money. The discretionary judgment of a group of men was inevitably substituted for the quasi-automatic discipline of the gold standard."

  The Federal Reserve Act imposed a double requirement for issuance of Federal Reserve notes. There was a gold requirement and an eligible paper requirement. The latter involved the rediscount of "eligible" high grade commercial paper, the discounting of foreign trade acceptances, and open market purchases of government securities, bills of exchange and bankers acceptances. In 1917, member bank 15-day notes secured by paper eligible for discount or by government securities became eligible for the issuance of Federal Reserve notes. By 1920, 69% of high-powered money was Federal Reserve notes and member bank deposits in Federal Reserve Banks.
 &
  The amount of Federal Reserve money was supposed to be limited by a gold standard and by commercial rediscounting needs. The latter permitted flexible expansion of Federal Reserve money during times of monetary stringency. It permitted member banks to quickly increase their holdings of Federal Reserve money by rediscounting their eligible commercial paper - "notes, drafts, and bills of exchange arising out of actual commercial transactions" - with a Federal Reserve Bank. This was designed to increase liquidity during crisis periods to meet demands for cash withdrawals by depositors.
 &
  The authors note the result of this legislation.

  "The Federal Reserve System therefore began operations with no effective legislative criterion for determining the total stock of money. The discretionary judgment of a group of men was inevitably substituted for the quasi-automatic discipline of the gold standard. Those men were not even guided by a legislative mandate of intent -- unless the purpose of the act described as 'to furnish an elastic currency, to afford means of rediscounting commercial paper' or the instruction to set discount rates 'with a view of accommodating commerce and business' can be so considered -- and were hardly aware of the enlarged powers and widened responsibilities the change in circumstances had thrust upon them. Little wonder, perhaps, that the subsequent years saw so much backing and filling, so much confusion about purpose and power, and so erratic an exercise of power."

The Federal Reserve Act imposed a 40% gold reserve requirement for issuance of Federal Reserve notes, but only a 35% gold reserve requirement for Federal Reserve Bank deposits.

  Federal Reserve officials as yet did not understand the full impact on the money supply of many of their activities. The authors mention the increase in their holdings of bankers acceptances in the second half of 1928 while they were trying to restrict rediscounts - the former expanding the money stock while the latter contracted it. The authors also point out that member bank deposits in Federal Reserve Banks act like high-powered money just like Federal Reserve notes - yet had lower reserve requirements.
 &
  After 1917, member bank reserves were required
to be kept as deposits at Federal Reserve Banks. Of course, banks still had to keep a certain amount of vault cash for transactions purposes - and this served to increase the actual amounts of total reserves. In 1959 and 1960, vault cash was increasingly accepted as official reserves until it was entirely accepted at the end of 1960.
 &
  This requirement for officially recognized reserves had the initial effect of enabling the Federal Reserve to meet the Federal Reserve Act's 40% gold reserve requirement for issuance of Federal Reserve notes. Federal Reserve Bank deposits had a lesser 35% gold reserve requirement. The requirement for eligible paper collateral for Federal Reserve notes was reduced in 1917 from 100% to 60%.
 &
  This centralization of legally required reserves had the effect of substantially lowering total reserve requirements. The deposit-reserves ratio rose significantly after 1918, as did the stock of money consistent with any given amount of high-powered money. The two deposit ratios indicate the extent that the banking system is expanding the total money stock on a given basis of high-powered money.
 &
  Reserve requirements were viewed at first as primarily a device for enhancing the convertibility of bank deposits into currency. Only much later was it understood as a tool for controlling the stock of money. Not until the 1920s was it recognized that the powers of the System could be used to undermine the disciplines of the gold standard by monetary manipulation to offset gold flows.
 &
  Both national and non-national banks could be member banks in the System and could thus be subject to Federal Reserve regulation. National banks were subject also to regulation by the Comptroller of the Currency, while non-national banks were subject also to regulation by state banking authorities.
 &

WW-I inflation (1914-1920):

  Gold flooded into the U.S. as the Allies purchased their wartime needs. Both during the period of U.S. neutrality and during its period as a belligerent there were extraordinary levels of monetary and price inflation.
 &

  The money stock roughly doubled from September, 1915 to June, 1920. Prices almost doubled between the last quarter of 1915 and May, 1920. Real net national product rose sharply to 1919 - with a pause from 1916 to 1917 - before declining in 1919 and 1920. This wartime inflation is similar to experience in the Civil War and WW-II.
 &
  Differences between peacetime and wartime financial flows - under the gold standard and when that standard is no longer maintained - are explained by the authors. Capital flows in favor of the U.S. - both gold and sale back to the U.S. of U.S. securities - amounted to about $5.3 billion. After the U.S. became a belligerent, it extended credits to its allies. The U.S. went from being a net debtor - short and long term - of $3.7 billion, to being a net creditor in the same amount by the end of 1919.
 &
  However, the dollar exchange rates of the British pound and the French franc - after suffering an initial sharp fall at the beginning of the war - recovered almost all their losses by the time of the Armistice in November, 1918. After all, the U.S., too, was suffering monetary and price inflation.
 &

  During the almost three years as a neutral, the U.S. money stock rose 46%. Growth in high-powered money accounted for 90% of money stock growth, and gold accounted for 87% of the growth in high-powered money. "This was straightforward gold inflation," the authors note.
 &
  From the entry of the U.S. into the war until May, 1920 - during the period of its participation as a "belligerent" - the money stock rose another 49% - but the monetary gold stock was almost flat. Instead, there was a substantial rise in Federal Reserve Bank claims on the public and on the member banks against which Federal Reserve notes were issued. These claims included bills discounted, bills bought and other Federal Reserve credit other than government securities.
 &
  High-powered money was expanding primarily on the basis of Federal Reserve credit - primarily the discounting of bills secured by rapidly expanding supplies of government war obligations. At this time, the authors note, the Federal Reserve System was in "an asymmetrical position."

  "It had the power to create high-powered money and to put it in the hands of the public or the banks by rediscounting paper or by purchasing bonds or other financial assets. It could therefore exert an expansionary influence on the money stock. At the same time, it had no effective power to contract the money stock. Under the circumstances, the most it could have done was to avoid creating any additional high-powered money. But even this required that the Federal Reserve Banks simply accumulate in their vaults the gold and other lawful money transferred to them as reserves by member banks, acquire no earning assets, and finance their expenditures solely by assessments on member banks. They were understandably reluctant to follow fully so ascetic a policy. They wanted to acquire portfolios to become independent of assessments on member banks."

  At the time, the System still had not accumulated any substantial portfolio of government securities. It thus could not have withdrawn money from the system by open market sales of government securities even if it knew that that was possible - which it apparently as yet did not know.
 &
  Even though discount rates were lowered from around 6% at the end of 1914 to between 3% and 4% in September, 1916, the Fed could not attract much eligible paper - accounting for only 21% of the increase in high-powered money during the period of neutrality. By the end of that period, high-powered money consisted of 41% gold and gold certificates - up from 37% at the beginning of the period. High-powered money consisted also of 7% Federal Reserve notes and 14% Federal Reserve deposits, and 37% Treasury currency.
 &

A variety of wartime transactions require increased flows of currency - some having to do with tax avoidance. However, currency is actually the cheapest form of government debt, so the reduction in the bank deposit- currency ratio served to help finance the war.

  During the belligerency period - which for purposes of this monetary history lasted from March, 1917, until 2 years after the November, 1918, Armistice - the Treasury advanced $9.5 billion to its allies. Federal government deficits totaled $23 billion - nearly 75% of total expenditures. This was financed by borrowing and issuance of new money - both Federal Reserve notes and Federal Reserve deposits - which rose respectively to 38% and 21% of high-powered money by the time of the Armistice. Gold declined during this time of belligerency to 14% of high-powered money.
 &
  Both high-powered money and the total money stock continued rapid growth during the period of belligerency until 1920, albeit at a lower percentage rate than during the period of neutrality. The authors note that the rate of inflation was actually greatest towards the end of the period of belligerency - after the Armistice - from May 1919 to May 1920 - something that occurred after WW-II, also. This was after the end of deficit spending, but not after the end of monetary expansion.
 &
  Rising taxes and interest rates, bond drives and price control measures all played some role in price inflation fluctuations during the war, overall serving as restraints. (Price controls never constrain inflation, they just hide it and actually worsen the loss of purchasing power and the ultimate rate of inflation. See, Understanding Inflation.) A great increase in the currency in circulation relative to bank deposits - resulting in a sharp decline in the deposit- currency ratio - also served as a restraining factor on money and price inflation.
 &
  A variety of wartime transactions require increased flows of currency - some having to do with tax avoidance. However, currency is actually the cheapest form of government debt, so the reduction in the bank deposit-currency ratio served to help finance the war. A similar increase in currency in circulation occurred in WW-II.
 &

  Gold ceased to be relied upon to fix exchange rates. (With budgets wildly out of balance, flexibility to facilitate inevitable inflationary adjustments was essential.)
 &
  From March 1917 through May 1919 - the federal government spent $32 billion and added $2 billion to Treasury cash balances. 25% was covered by explicit taxes plus non-tax receipts, 70% was borrowed, and 5% was financed by money creation - constituting "an implicit tax on money balances levied through the rise in prices." The total money stock increased $6.4 billion - 25% of it from an increase in high-powered money and 75% of it created by the banking system.
 &
  This increase in the money stock primarily matched an increase in government securities held by the banks and their customers - and so helped to finance the war.

F) Boom and Bust Under the Federal Reserve System (1919-1921)

The depression of 1920-1921:

  The deposit to the public's currency holdings ratio reversed its course soon after the Armistice, rising sharply as the public no longer had need for so much currency.
 &

  Commodity speculation and accumulation of inventories marked the subsequent boom and would play a significant role in the 1920 to 1921 depression.
 &
  With the lifting of the WW-I embargo on gold payments
in June, 1919, $300 million in gold quickly flowed out. Nevertheless, Federal Reserve credit outstanding soared. Discount rates of 3% to 4% were considerably below market rates, permitting banks to profit handsomely from rediscounting their commercial paper at the Fed.

  "Throughout the period, member banks could be regarded as operating entirely on borrowed reserves: from September 1918 through July 1921, the outstanding volume of bills discounted by Federal Reserve Banks exceeded member bank reserve balances."

  The Federal Reserve Board was at a loss as to what to do. The Board hesitated as the money stock expanded vigorously and inflation roared on. An increase in the discount rate would have posed difficulties for Treasury funding operations. Rising interest costs always discomfort various powerful financial interests that lobbied hard against it. Moral suasion - "jawboning" in later terminology - was tried and - as always - failed miserably.
 &
  The Treasury was adamantly against rate increases that might increase the difficulty and expense of its funding efforts. Some feared the public might panic if rising interest rates hit 4% and depressed the price of their Liberty Bonds to 90. There were legal doubts over the Federal Reserve Board's independence from the Treasury.
 &
  With gold flowing out rapidly and Federal Reserve credit expanding exuberantly, the reserve position in the System plunged precipitously - perilously close to the 40% minimum. Reserves hit 42.7% in January, 1920, and 40.6% in March. Reserves in excess of requirements plunged from $569 million in June, 1919 to $234 million in January, 1920 and to $131 million in March, 1920. A discount rate increase to 4% was advocated. The British discount rate was already 5%.
 &

  The Treasury decided it had no further funding needs in December, 1919. It was flush with cash and it withdrew its opposition. Discount rates were quickly raised to 4% and to 4%. Then, as reserves plunged, a second increase all the way up to 6% came in the first two months of 1920 - "the sharpest single rise in the entire history of the System, before or since." Fear of being forced off the gold standard - of having to suspend gold payments - was a strong factor in the close vote to raise the discount rate by a whopping 1%. Now with access to the personal papers of some of the Board members, the authors recount the feverish deliberations.
 &
  A further discount rate hike to 7% came in June, 1920 - the highest rate imposed by the System before 1960. This actually coincided with the peak in wholesale prices  - but collapse soon followed. Despite the collapse of prices and business, it wasn't until May, 1921, that the N.Y. Federal Reserve Bank lowered its rate to 6%. Four more reductions brought the discount rate down to 4% in November. By then, gold reserves to notes liabilities and to deposits had begun to climb up from the minimum requirement levels.
 &
  "The discount policy was apparently dominated by concerns over the Reserve System's own reserve position." There was also strong sentiment within the Board that money should remain tight until wages as well as prices were forced to give up much of their gains from the WW-I inflation. The authors note that the Board had the authority to suspend the reserve requirements in 30 day increments if necessary.
 &
  Although declining prices and contracting economic conditions brought gold flowing in as trade and payments balances reacted positively, a 1/6 reduction in lending by member banks and the corresponding sharp decrease in member bank borrowing from the Federal Reserve System resulted in an 11% drop in high-powered money from September, 1920 to the cyclical trough in July, 1921. The total fall was 17%.
 &

  Member banks had already borrowed more than their reserve balances. They at first reacted slowly to the contraction - but then sharply restricted further lending. Money was shifted from demand deposits - a major constituent of bank money - to time deposits. Money stock growth slowed - and then plunged 9% - one of the largest declines since the Civil War.
 &
  While bank failures rose significantly, there was no widespread runs on the banks. The post-war recovery of the ratio of deposits to currency-in-the-public's-hands slowed but the deposit-currency ratio recovery continued - helping to keep the decline in the total money stock to just 8%.
 &
  By June, 1921, wholesale prices had dropped to 56% of their May, 1920 level - 75% of the decline occurring in the 6 months after August, 1920. Net national product in current prices dropped 18%. The depression was short but sharp.
 &

  When the boom turned to bust, the Board received extensive criticism first for its tardy action - permitting the boom to get out of hand - and then for precipitating the sharp bust of 1920 to 1921. The authors agree with this criticism. The economy may already have begun contracting even before the rate hike took effect. Gold was already flowing into the U.S. - and the high discount rate accelerated the flow, causing worldwide economic distress. The Fed Governor was not reappointed in 1922 - introducing "an element of political instability" which inevitably impacted the operations of the Board.
 &
  Mild at first, the depression in the U.S. ultimately involved an unprecedented collapse in wholesale prices and a sharp drop in retail prices. Indeed, price levels would not recover to their 1919 highs until after WW-II. The rest of the 1920s - a period of prosperity - would be a period of slowly declining prices.
 &

The U.S. was a substantial cause of the post WW-I disturbances - no longer a victim of external events. The authors concluded that some difficulties might have been unavoidable due to the dislocations of the Great War, but instead of acting as a stabilizing force, the new Federal Reserve Board clearly made matters worse.

  The depression was worldwide. This was typical after a major war. The economic adjustments to peacetime production and absorption of wartime debts typically cause inflationary spurts followed by substantial reactions. After WW-II, however, the U.S. was in a massively strong financial position and suffered only a mild recession during the shift to peacetime production. But it did not avoid the inflationary surge.
 &
  The U.S. was suddenly a financial heavyweight
after WW-I - with absolutely no experience in that role. The evidence from the gold and capital flows indicates that the U.S. was a substantial cause of the post WW-I disturbances - no longer a victim of external events. The authors concluded that some difficulties might have been unavoidable due to the dislocations of the Great War, but instead of acting as a stabilizing force, the new Federal Reserve Board clearly made matters worse.
 &

"The contemporaneous gold reserve ratio was a simple easy guide; [the System goal of] economic stability, a complex, subtle will-o'-the-wisp."

  The System was a destabilizing factor from its beginning, the authors conclude. Federal Reserve money and looser reserve requirements materially increased money stock growth and price inflation throughout the war - monetary expansion and price inflation would have ended sooner after the war but for System monetary expansion - and the 1920 to 1921 depression would certainly have been more mild but for Fed policy errors. Lack of experience was evident throughout this period.

  "There was no strictly comparable American experience on which to base policy or judge the effect of actions designed to stimulate or retard monetary expansion. In particular, there was no evidence on the length of lag between action and effect. There was a natural, if regrettable, tendency to wait too long before stepping on the brake, as it were, then to step on the brake too hard, then, when that did not bring monetary expansion to a halt very shortly, to step on the brake again. The contemporaneous gold reserve ratio was a simple easy guide; [the System goal of] economic stability, a complex, subtle will-o'-the-wisp."

See, "Friedman & Schwartz, Monetary History of U.S.," Part II, "Roaring Twenties Boom - Great Depression Bust (1921-1933)," and Friedman & Schwartz, Monetary History of U.S.," Part III, "The Age of Chronic Inflation (1933-1960)."

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  Copyright 2007 Dan Blatt