A Monetary History of the United States, 1867-1960

Preface

THIS book had its origin in a conversation one of us had more than a decade ago with the late Walter W. Stewart. That conversation was about a statistical study of monetary factors in the business cycle, then proposed as one of the National Bureau’s cyclical studies. Stewart stressed the desirability of including an analytical narrative of post-Civil War monetary developments in the United States as a background for the statistical work, arguing that such a narrative was not currently available and would add a much needed dimension to the numerical evidence.

His suggestion led us to include a chapter on the historical background of the money stock in our planned monograph. The chapter, which we began to write only after we had completed a first draft of the remaining chapters, took on a life of its own. The one chapter became two, then a separate part, and has now become a separate book. But, though separate, it is not entirely independent. Some statistical series we use in this book are explained in full in the forthcoming companion volume, Trends and Cycles in the Stock of Money in the United States, 1867-1960, which though first into draft will be later into print. The prescience of Stewart’s advice has been impressed upon us repeatedly as we have revised the chapters of the companion volume. Our foray into analytical narrative has significantly affected our statistical analysis.

The National Bureau’s interest in the cyclical behavior of monetary factors dates back to the inception of its studies in business cycles. The first product lineally related to the present study was Technical Paper 4 on currency and vault cash, published in 1947.¹ The estimates there presented, now superseded, were the first step in the development of the money series which form the statistical backbone of the present study and of Phillip Cagan’s forthcoming volume, Determinants and Effects of Changes in the U.S. Money Stock, 1875-1955. Some early results were published in two occasional papers on the demand for money, and a by-product on problems of interpolation appeared as a technical paper.²

Despite the length to which this volume has grown, we are painfully aware of its restricted scope. Money touches every phase of the economic life of an enterprise-exchange economy and in consequence cannot fail to affect its politics as well. A full-scale economic and political history would be required to record at all comprehensively the role of money in the United States in the past century. Needless to say, we have not been so ambitious. Rather, we have kept in the forefront the initial aim: to provide a prologue and background for a statistical analysis of the secular and cyclical behavior of money in the United States, and to exclude any material not relevant to that purpose.

We have accumulated numerous and heavy debts during the many years that this book has been in the making. An earlier draft of the manuscript was duplicated some years ago and circulated among a number of scholars from whose comments and suggestions we have profited greatly. We owe an especially heavy debt to Clark Warburton. His detailed and valuable comments on several drafts have importantly affected the final version. In addition, time and again, as we came to some conclusion that seemed to us novel and original, we found he had been there before. Among the many others to whom we are indebted for valuable criticism are Moses Abramovitz, Gary S. Becker, Arthur F. Burns, Phillip Cagan, Lester V. Chandler, C. A. E. Goodhart, Gottfried Haberler, Earl J. Hamilton, Bray Hammond, Albert J. Hettinger, Jr., James K. Kindahl, David Meiselman, Lloyd Mints, Geoffrey H. Moore, George R. Morrison, Jay Morrison, Edward S. Shaw, Matthew Simon, and George J. Stigler.

Because the Federal Reserve System since its establishment has played so central a role in the monetary history of the United States, we have of necessity examined its operations in great detail. We have often had to rely on secondary sources, since much primary source material is not in the public domain. Accordingly, the penultimate version of this book was sent for criticism to the Board of Governors of the Federal Reserve System and to a number of present and former officials of the System. We are grateful to the three individuals who sent comments on the manuscript: Clay Anderson, currently economic adviser, Federal Reserve Bank of Philadelphia; W. Randolph Burgess, from 1930 to 1938 a deputy governor and vice-president, Federal Reserve Bank of New York; and Allan Sproul, from 1940 to 1954 president, Federal Reserve Bank of New York. The final version of this book has been appreciably altered in consequence. In addition, Mr. Sproul’s comments brought to our attention the George Leslie Harrison Papers on the Federal Reserve System, in the Columbia University Library, of which we have made extensive use in our final version. Together with the Diary of Charles S. Hamlin, member of the Federal Reserve Board from 1914 to 1936, the Harrison Papers have been our major primary source of information about the operations of the System during a critical part of its history.

A number of scholars have been good enough to furnish unpublished material: Phyllis Deane, a price index for Great Britain; Raymond W. Goldsmith, United States net international capital movements from the turn of the century until 1919, the year when Department of Commerce figures become available; Simon Kuznets, annual net national product figures.

We owe a special debt to David C. Mearns, chief of the Manuscript Division of the Library of Congress, which controls all rights of publication, for permission to cite and quote from the Charles S. Hamlin Diary. We are also grateful to Roland Baughman, head of Special Collections at the Columbia University Library, for authorizing us to cite and quote from the writings of George L. Harrison in the Harrison Papers described above. Permission to cite and quote from other material in the Harrison Papers was kindly given us by the Federal Reserve Bank of New York. We wish to express our gratitude also to Mrs. E. A. Goldenweiser for permission to cite and quote from the unpublished writings of her late husband, in the Goldenweiser Papers, in the Manuscript Division of the Library of Congress.

This book has required an extremely large amount of statistical computation. Most of that work has been done at the National Bureau of Economic Research, chiefly by Mark L. Wehle, who also made useful criticisms of the manuscript. In addition, we have had assistance at various stages of our study from Edith Hanover, Juanita Johnson, Phyllis A. Wallace; also Nadeschda Bohsack, John Helbok, Martha S. Jones, David Laidler, Esther D. Reichner, Sophie Sakowitz, Hanna Stern, Judie Tomkins, and Tom Teng-pin Yu. Harry Eisenpress and Millard Hastay contributed valuable advice and assistance in connection with problems of computation. In addition, statistical assistance was provided by the Center for Advanced Study in the Behavioral Sciences, where Milton Friedman was a Fellow during part of the preparation of the earlier draft, and by the Money and Banking Workshop and the Economic Research Center at the University of Chicago. We are indebted to these institutions, to the late Mary Girschik and her assistants at the Center for Advanced Study, and to Lilly Monheit and her assistants at Chicago. Last but not least, Janet Friedman cheerfully sacrificed parts of a number of summers to run a computing machine for her father.

The Center for Advanced Study provided many other facilities in addition to computing assistance during a most fruitful year. Discussion of the earlier draft of the manuscript at a number of seminars with other Fellows was most valuable, as were more informal discussions. The draft was also discussed at sessions of the Money and Banking Workshop at Chicago, and suggestions made there have left their mark on the final manuscript.

We have made much use of the library facilities of Columbia University and the University of Chicago, of the Baker Library and the Library of the Tuck School at Dartmouth College, and of the New York Public Library. The librarians of all these institutions have been most cooperative and helpful.

H. Irving Forman has turned in his usual outstanding performance in drawing the charts. Margaret T. Edgar has made editorial suggestions for which not only we but also the readers of this book are in her debt.

Finally, we cannot forbear saying a word of appreciation to the National Bureau as an institution and to the two successive directors of research, Arthur F. Burns and Solomon Fabricant, under whom this study has been conducted. True to the spirit of dedication to the pursuit of truth, they have encouraged and assisted us to follow our path where it led, even though that meant repeated postponements of completion and a first major product very different indeed from the one initially contemplated.

MILTON FRIEDMAN

ANNA JACOBSON SCHWARTZ

¹ Anna Jacobson Schwartz and Elma Oliver, Currency Held by the Public, the Banks, and the Treasury, Monthly, December 1917-December 1944, New York, National Bureau of Economic Research, Technical Paper 4, 1947.

² Phillip Cagan, The Demand for Currency Relative to Total Money Supply, New York, NBER, Occasional Paper 62, 1958; Milton Friedman, The Demand for Money: Some Theoretical and Empirical Results, New York, NBER, Occasional Paper 68, 1959; idem, The Interpolation of Time Series by Related Series, New York, NBER, Technical Paper 16, 1962.

CHAPTER 1

Introduction

THIS book is about the stock of money in the United States. It traces changes in the stock of money for nearly a century, from just after the Civil War to 1960, examines the factors that accounted for the changes, and analyzes the reflex influence that the stock of money exerted on the course of events.

We start with 1867 because that is the earliest date at which we can begin a continuous series of estimates of the stock of money in the United States. When the National Banking Act was passed during the Civil War, it was believed that state banks would shortly go out of existence. As a result, organized federal collection of statistics for state banks ceased, though, as it happens, state banks suffered only a temporary and never a complete eclipse. Accordingly, there is a serious hiatus in statistical data. Better data are available for the period before the Civil War than for the years from 1863 to 1867.

Money played an important role in economic and political developments in the United States during the period we cover—as it so often has in other periods and other places. We have therefore been led to examine some of these developments in considerable detail, so much so that this book may read in part like a general economic history. We warn the reader that it is not; it is highly selective. Throughout, we trace one thread, the stock of money, and our concern with that thread explains alike which episodes and events are examined in detail and which are slighted.

The estimates of the stock of money we have constructed give for the first time a continuous series covering more than nine decades.¹ These estimates, graphed in Chart 1 (and given numerically in Table A-1), show clearly the impress of most of the major episodes in U.S. history since the Civil War.

The most notable feature of the stock of money is its sharp upward trend. In 1867, the first year for which we have an estimate, the public² held about $585 million of currency—consisting at the time mostly of greenbacks issued to help finance the Civil War, plus national bank notes and subsidiary coinage³—and $729 million of deposits in commercial banks⁴ or a total of $1,314 million of what by one definition—and the one we use here—may be called money. In addition, the public held $276 million in deposits at mutual savings banks, or a total of $1,590 million of what, by a broader definition, may about as reasonably be called money. Our figures do not classify deposits in commercial banks at this early date into demand and time deposits, because this distinction had little meaning, either for banks or their customers. Reserve requirements for banks were levied against deposits, without distinction between demand and time. Demand deposits, like time deposits, frequently paid interest; and time deposits, like demand deposits, were frequently transferable by check. The distinction became of major importance to banks (and so reliable data became available on a continuous basis for the two categories separately) only after 1914, when the Federal Reserve Act introduced differential requirements for demand and time deposits. Accordingly, we have no estimate for 1867 for a third and narrower possible definition of money, namely, currency plus demand deposits alone.⁵

NOTE: Albert J. Hettinger, Jr., a Director of the National Bureau, has prepared a comment on this book which appears on pp. 809-814.

In mid-1960, the last year for which estimates are presented in Chart 1, the public held about $29 billion of currency (consisting mostly of Federal Reserve notes but with an appreciable residue of silver certificates and subsidiary coinage as well as a number of other relics of earlier monetary history), $110 billion of demand deposits, and $67 billion of time deposits in commercial banks, or a total of $206 billion of money by the terminology we use. In addition, it held some $35 billion of deposits in mutual savings banks and under $1 billion of postal savings deposits, or a total of $242 billion of money plus such deposits. The public held 50 times as many dollars of currency at the end of the 93 years spanned by our figures as at the beginning; 243 times as many dollars of commercial bank deposits; and 127 times as many dollars of mutual savings deposits.

The total we designate as money multiplied 157-fold in the course of these more than nine decades, or at the annual rate of 5.4 per cent.⁶ Since the population of the United States nearly quintupled over the same period, the stock of money per capita multiplied some 32-fold, or at the annual rate of 3.7 per cent. We can break this total into three components: 1.9 percentage points, which is the rate of rise in output per capita; 0.9 percentage points, which is the rate of rise in prices; and a residual of 0.9 percentage points, which is the rate of rise in the amount of money balances, expressed as a fraction of income, that the public chose to hold.⁷ So great is the power of compound interest that this residual small rate of growth corresponds to a rise in the public’s holdings of money from a sum equal to less than 3 months’ income in 1869 to a sum equal to more than 7 months’ income in 1960. Of course, as Chart 2 shows, these developments did not proceed steadily; and it is with the vicissitudes along the way that this study is mostly concerned.

In discussing these vicissitudes, we frequently find it convenient to mark off periods by dates at which business activity reached a cyclical peak or trough. We use for this purpose the reference cycle chronology established by the National Bureau of Economic Research. Our extensive use of this chronology perhaps justifies an explicit caveat that we do not present a comprehensive history of cyclical movements in economic activity in the United States. Monetary factors played a major role in these movements, and conversely, nonmonetary developments frequently had a major influence on monetary developments; yet even together the matters that concern the historian of money do not exhaust those that are relevant to the historian of cyclical movements.

CHART 2

Number of Months’ Income Held as Money in Each Year, 1869-1960

SOURCE: Money stock was multiplied by 12 and divided by money income.

Money stock, figures in col. 8 of Table A-l were averaged to center on June 30; before 1908, annual averages were obtained from that source, interpolated by the step method (see Table 25, col. 1, for description).

Money income, same as for Chart 62.

The years from 1867 to 1879 were dominated by the financial aftermath of the Civil War. Early in 1862, convertibility of Union currency into specie was suspended as a result of money creation in the North to help finance the Civil War, disturbances in foreign trade, the general financial uncertainty arising out of the war, and the borrowing techniques of the Treasury. From then until resumption of specie payments on January 1, 1879, the United States was legally on a fiduciary standard—the greenback standard as it has come to be called. The dollar was linked with other currencies through exchange rates determined in the market and fluctuating from day to day. The dollar was inconvertible in the older sense of not being exchangeable at fixed parity for specie; it was not inconvertible in the modern sense of being subject to legal restrictions on its purchase or sale. For domestic payments, gold was in the main simply a commodity like any other, with a variable market price. For foreign payments, gold was equivalent to foreign exchange, since Great Britain maintained a gold standard throughout the period, and several other important countries did so during the latter part of the period.

Despite support for inconvertible currency by many business groups both during and after the war, and growing farm support after the war, as agricultural prices fell, suspension of payments was generally regarded as temporary. The major announced aim of financial policy was a resumption of specie payments at the prewar parity. This aim was finally achieved on January 1, 1879. The whole episode, discussed in detail in Chapter 2, is clearly reflected in the series in Chart 1. The decline in the stock of money from 1875 to 1878—one of the few absolute declines in the whole history of the series and next to the largest—was a necessary prelude to successful resumption. The extremely sharp rise thereafter was partly a reaction to success.

Another aftermath of the Civil War was an extremely rapid growth in banking institutions, which produced a sharp rise in the ratio of deposits to currency. The financial measures of the war included establishment of the National Banking System and, effective July 1, 1866, a prohibitive tax on state bank notes. Initially, few national banks were created, while the prospective tax measure was a strong deterrent to state banks. The result was that the major effect of the National Banking Act came after the end of the war, and, along with a revival of state hanks, helped to produce the sharp rise in deposits recorded in Chart 1.

The success of resumption did not end uncertainty about the monetary standard. For nearly two decades thereafter, the U.S. financial scene was dominated by controversy, which had started in the seventies, over the place of silver in the monetary system.

The rapid expansion of output in the Western world during those decades and the adoption of a gold standard over an area far wider than before added substantially to the demand for gold for monetary purposes at any given price level in terms of gold. That expansion in demand more than offset a contemporary expansion in supply, as a result both of increased production of gold and improvement of financial techniques for erecting a larger superstructure of money on a given base of gold. The result was a slow but rather steady downward tendency in product prices that prolonged and exacerbated the political discontent initiated by the rapid decline in prices after the end of the Civil War. Greenbackism and free silver became the rallying cries. The silver forces were strong enough to obtain concessions that shook confidence in the maintenance of the gold standard, yet they were not strong enough to obtain the substitution of silver for gold as the monetary standard. The monetary history of this period is therefore one of repeated crises and of legislative backing and filling. The defeat of William Jennings Bryan in the Presidential election of 1896 marks in retrospect the end of the period (Chapter 3).

Bryan’s defeat marks the end of the period, rather than simply a minor setback on the road to ultimate success, because it happened to follow gold discoveries in South Africa and Alaska and the perfection of the cyanide process for extracting gold. These developments doomed Bryan to political failure, far more than any waning in the effectiveness of his oratory or any shortcomings in his political organization. They produced a rapid expansion of the world’s production of gold, sufficiently large to force an upward price movement over the next two decades despite a continued growth in world output. In the United States, the stock of money was approximately constant from 1890 to 1896. During those years, uncertainty about the monetary standard and associated banking and international payment difficulties prevented any expansion in the U.S. stock of gold despite a moderate acceleration in the growth of the world’s stock of gold. The money stock then rose over the next two decades at a rate decidedly above that from 1881 to 1896 (Chart 1). The accompanying gradual rise in prices rendered the gold standard secure and unquestioned in the United States until World War I.

The elimination of controversy about the monetary standard shifted the financial and political spotlight to the banking structure. Dissatisfaction had been generated by recurrent banking difficulties. The most severe of these occurred in 1873, 1884, 1890, and 1893, when bank failures, runs on banks, and widespread fears of further failures produced banking crises and, on several occasions, most notably 1893, suspension by most banks of convertibility of deposits into currency. The 1893 episode is reflected in Chart 1 in the concomitant rise in currency and decline in deposits, as well as in the decline in total currency and deposits. The dissatisfaction with the banking structure was brought to a head by the banking panic of 1907. That panic was a repetition of earlier episodes, including the suspension of convertibility of deposits into currency. It is marked in Chart 1 by the only decline in the stock of money during the period 1897-1914, accompanied as in 1893 by a rise in currency and hence a still sharper decline in deposits. The result was the enactment by Congress of the Aldrich-Vreeland Act in 1908 as a temporary measure, a searching examination of the monetary and banking structure by a National Monetary Commission in 1910, the publication by the Commission of some notable scholarly works on money and banking, and the adoption by Congress of the Federal Reserve Act of 1913 as a permanent measure (Chapter 4).

The Federal Reserve System began operations in 1914. This far-reaching internal change in the monetary structure of the United States happened to coincide with an equally significant external change—the loosening of links between external conditions and the internal supply of money which followed the outbreak of World War I—destined to become permanent. Taken together, the two changes make 1914 a major watershed in American monetary history.

Important as they were, both changes were changes of degree. The Treasury had long exercised central banking powers that were no less potent because they were not so labeled, and, as Chapter 4 documents, it had been doing so to an increasing extent. The growing size of the U.S. economy relative to the world economy and the declining importance of U.S. foreign trade relative to domestic trade had long been increasing the importance of internal changes in the United States for world monetary conditions and introducing ever greater play in the links between the two.

Though independent in their inception, the two changes were destined to become closely related. The weakening of the international gold standard gave the Federal Reserve System both greater freedom of action and wider responsibilities. In turn, the manner in which the Federal Reserve System exercised its powers had an important effect on the fate of the gold standard. One who did not know the subsequent history of money in the United States would very likely conjecture that the two changes reinforced one another in reducing the instability in the stock of money. The weakening of external links offered the possibility of insulating the domestic stock of money from external shocks. And the Reserve System, established in response to monetary instability, had the power to exercise deliberate control over the stock of money and so could take advantage of this possibility to promote monetary stability.

That conjecture is not in accord with what actually happened. As is clear to the naked eye in Chart 1, the stock of money shows larger fluctuations after 1914 than before 1914 and this is true even if the large wartime increases in the stock of money are excluded. 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.

The rapid rise in the stock of money during World War I, when the Federal Reserve System served as an engine for the inflationary financing of government expenditures, continued for some eighteen months after the end of the war, at first as a continued accompaniment of government expenditures, then as a result of the almost inadvertent financing of private monetary expansion by the System. The monetary expansion was abruptly reversed in early 1920 by Federal Reserve action—the first major deliberate and independent act of monetary policy taken by the System and one for which it was severely criticized (Chapter 5).

The rest of the twenties were in many ways the high tide of the Federal Reserve System. The stock of money grew at a highly regular rate, and economic activity showed a high degree of stability. Both were widely attributed to the beneficent actions of the System. Within the System, there was much sophisticated and penetrating research on the operation of the financial markets and the role of the System. The result was a deepened understanding of its own operations and tools. Outside the System, bankers and businessmen at home regarded its powers with awe, and foreign countries sought its assistance in mending their own monetary arrangements. Cooperation with the great central banks of Britain, France, and Germany was close; and the belief arose that, through such cooperation, the central bankers could assure not only domestic but also international economic stability (Chapter 6).

That era came to an abrupt end in 1929 with the downturn which ushered in the Great Contraction. In its initial stages, the contraction was not unlike earlier ones in its monetary aspects, albeit the money stock did decline slightly. Severe contractions aside, the money stock rises on the average during contraction and expansion alike, though at a slower rate during contraction. The monetary character of the contraction changed drastically in late 1930, when several large bank failures led to the first of what were to prove a series of liquidity crises involving runs on banks and bank failures on a scale unprecedented in our history. Britain’s departure from gold in 1931 and the Federal Reserve’s reaction to that event sharply intensified the banking collapse, if indeed they did not nip a potential revival in the bud. By early 1933, when the monetary collapse terminated in a banking holiday, the stock of money had fallen by one-third—the largest and longest decline in the entire period covered by our series. The banking holiday was a panic of the genus that the founders of the Federal Reserve System had expected it to render impossible. It was, however, of a different species, being far more severe than any earlier panic. In addition, whereas in earlier panics, restriction of payments came before many banks had failed and served to reduce the number of subsequent failures, the 1933 banking holiday occurred only after an unprecedentedly large fraction of the banking system had already failed, and many banks open before the holiday never reopened after it. One-third of the banks had gone out of existence through failure or merger by 1933 (Chapter 7).

The drastic decline in the stock of money and the occurrence of a banking panic of unprecedented severity did not reflect the absence of power on the part of the Reserve System to prevent them. Throughout the contraction, the System had ample powers to cut short the tragic process of monetary deflation and banking collapse. Had it used those powers effectively in late 1930 or even in early or mid-1931, the successive liquidity crises that in retrospect are the distinctive feature of the contraction could almost certainly have been prevented and the stock of money kept from declining or, indeed, increased to any desired extent. Such action would have eased the severity of the contraction and very likely would have brought it to an end at a much earlier date. Such measures were not taken, partly, we conjecture, because of the fortuitous shift of power within the System from New York to other Federal Reserve Banks and the weakness of the Federal Reserve Board in Washington, partly because of the assignment—by the community at large as well as the Reserve System—of higher priority to external than to internal stability (Chapter 7).

Major changes in both the banking structure and the monetary system resulted from the Great Contraction. In banking, the major change was the enactment of federal deposit insurance in 1934. This probably has succeeded, where the Federal Reserve Act failed, in rendering it impossible for a loss of public confidence in some banks to produce a widespread banking panic involving severe downward pressure on the stock of money; if so, it is of the greatest importance for the subsequent monetary history of the United States. Since the establishment of the Federal Deposit Insurance Corporation, bank failures have become a rarity. The Federal Reserve System itself was reorganized, greater power being concentrated in the Board and less in the Banks. The System was also given additional powers, of which the power to vary reserve requirements was by far the most important. In the monetary system, the dollar was devalued in terms of gold, and the character of the gold standard was changed. Gold coinage was discontinued and the holding of gold coin or bullion made illegal. The Treasury continued to buy gold freely at a fixed price at the Mint but sold it freely at a fixed price only for purposes of foreign payment. With the departure from the gold standard of country after country during and after World War II and the widespread introduction of exchange controls by other countries, the United States came to be effectively on a fiduciary standard. Gold is currently a commodity whose price is legally supported, rather than in any meaningful sense the base of our monetary system (Chapter 8).

The changes in men’s ideas were no less important than the changes in institutions. The collapse of the banking system during the contraction and the failure of monetary policy to stem the contraction undermined the faith in the potency of the Federal Reserve System that had developed in the twenties. In the worlds of scholarship and policy alike, these events led, rightly or wrongly, to the relegation of money to a minor role, and to the assignment of major emphasis to governmental fiscal actions and direct interventions.

One result of these changes in ideas was that the Reserve System was led to adopt a largely passive role, adapting itself in an orderly manner to changes as they occurred rather than serving as an independent center of control. With one exception, the Treasury rather than the Reserve System originated and executed such monetary policy measures as were taken. The rapid rise in the stock of money after 1933 reflected two factors: first, the measures taken to repair the monetary structure, which produced a return of confidence in banks and so a rise in the ratio of deposits to currency; second, a large gold inflow, resulting initially from the lowering of the gold content of the dollar and later from the flight of capital from Europe after Hitler’s accession to power began to engender fears of war. The Reserve System did nothing either to offset or to increase the effect of these factors until 1936. It then used its newly acquired powers to double reserve requirements in the course of six months—this is the exception referred to above. The result was the one significant interruption in the rise in the money stock during that period. The interruption accompanied the brief but sharp recession of 1937-38, added to its severity, and may have contributed to its occurring when it did (Chapter 9).

Federal Reserve policy continued to be subordinated to Treasury policy after the outbreak of World War II in Europe in 1939 and even more after the entry of the United States in 1941. The Federal Reserve System, as in World War I, became virtually the agent of the Treasury in its financial operations. It established a fixed pattern of rates of interest on government securities and permitted the stock of money to become an indirect consequence of the taxing and spending activities of government and of the real resources the community was willing to use to buy government securities at these fixed rates. The result was that from 1939 to 1945, the money stock was multiplied 2½-fold (Chapter 10).

The money stock grew at a much reduced rate in the early postwar years, yet indexes of prices rose rapidly. That outcome was widely regarded as, at least partly, a delayed reaction to the large wartime increases in the stock of money. The Federal Reserve System was impotent to control the stock of money by the usual means so long as it continued to support the prices of government securities at fixed levels. It was therefore led to experiment with a variety of expedients, none of which proved effective. As a result, controversy arose over the bond-support program itself. Finally, the rapid upward surge of prices after the outbreak of war in Korea dramatized the inhibiting effect of the bond-support policy on control of the money stock and led to the Treasury-Federal Reserve Accord of 1951, which made the support policy less rigid and, two years later, was followed by the abandonment of the policy.

These strictly domestic events were reinforced by experience abroad. Many countries pursued cheap money policies in the postwar period. Every such country experienced either open inflation or a network of partly effective, partly ineffective, controls designed to suppress the inflationary pressure. No country succeeded in curbing inflation without adopting measures that made it possible to restrain the growth of the stock of money. The result of these events and of the changing currents of thought in academic halls was a revival of interest in monetary matters and a renewed emphasis on monetary policy. This renewed emphasis, in its turn, stimulated renewed attention to alleged limitations of monetary policy.

These changes in attitude are more dramatic and manifest in pronouncements than in records of action. The graph of the money stock in Chart 1 shows the clear impress of neither the Treasury-Federal Reserve Accord nor of any subsequent statement about the direction and course of monetary policy, unless it be through the absence of movements that would otherwise have occurred. The distinctive feature of the rise in the money stock in the decade after 1947 is the high degree of stability, by comparison with earlier periods, in the year-to-year rate of change. In this respect, the postwar period resembles most the years 1903-13 and 1923-29. All three were periods of relative stability of both the rate of change in the money stock and of the state of business (Chapter 11).

Perhaps the most puzzling feature of postwar monetary developments is the coincidence of a relatively slow rate of rise in the stock of money with a fairly rapid rate of growth of money income. As noted at the outset, the stock of money has tended to grow more rapidly than money income over the more than nine decades covered by our data (see Chart 2). By contrast, from 1948 to I960, the money stock grew at the rate of 2.9 per cent per year and money income grew at the rate of 5.0 per cent; which is to say, the velocity of money rose. Of the various explanations of this phenomenon that have been offered, we are inclined to believe that the most fundamental is that it reflects changes in the public’s expectations about the degree of future economic stability (Chapter 12).

¹ For a full description of these estimates and their derivation, see our companion volume, Trends and Cycles in the Stock of Money in the United States, 1867-1960, a National Bureau study, in preparation.

² The public, as we use the term, includes all holders of U.S. currency or deposits located in the continental United States, except banks, offices of the Treasury Department (for deposits; for currency, only the Washington, D.C., offices), and mint and assay offices of the U.S. It includes individuals, partnerships, corporations, states, counties, municipalities, and government corporations and credit agencies. For a more detailed description, see Trends and Cycles.

³ In accordance with our definition of the public, this figure excludes currency in bank vaults and in the U.S. Treasury.

⁴ Again, in accordance with our definition of the public, this figure excludes interbank deposits and U.S. government deposits. It is also adjusted to exclude items in the process of collection from recorded total deposits to avoid double counting.

We consider a financial institution to be a bank if it provides deposit facilities for the public, or if it conducts principally a fiduciary business—in accordance with the definition of banks agreed upon by federal bank supervisory agencies. Of these two classes, fiduciaries are negligible in importance. Banks are classified as either commercial or mutual savings banks. Commercial banks include national banks, incorporated state banks, loan and trust companies, stock savings banks, industrial and Morris Plan banks if they provide deposit facilities, special types of banks of deposit—such as cash depositories and cooperative exchanges in certain states—and unincorporated or private banks. Mutual savings banks include all banks operating under state banking codes applying to mutual savings banks. See Federal Deposit Insurance Corporation (FDIC), Annual Report, 1956, pp. 88-89.

By this definition savings and loan associations and credit unions are not banks. Holders of funds in these institutions are for the most part technically shareholders, not depositors, though clearly they may regard such funds as close substitutes for bank deposits, as we define them.

⁵ See our forthcoming volume, Trends and Cycles, for a discussion of the reasons we use the term money to refer to currency plus all deposits in commercial banks.

⁶ These rates, and all other annual rates cited hereafter, assume continuous compounding; i.e., they are the difference between the natural logarithms of the stock of money at the terminal and initial dates divided by the number of years separating those dates.

Continuously compounded rates of growth are lower than rates compounded for discrete intervals—annually or semiannually or quarterly. For example, the rate of growth of money, which is 5.38 per cent compounded continuously, is 5.43 per cent compounded quarterly, 5.46 per cent compounded semiannually, 5.53 per cent compounded annually.

⁷ Income, here and throughout this study unless otherwise specified, is defined as net national product, variant III, computed by Simon Kuznets in Capital in the American Economy: Its Formation and Financing, Princeton for NBER, 1961.

The measure for output per capita, cited in the text, is net national product in 1929 prices; the measure for prices is the index of implicit prices obtained by dividing net national product in current prices by net national product in 1929 prices.

CHAPTER 2

The Greenback Period

THE PERIOD from the end of the Civil War to the resumption of gold payments in 1879 is of unusual interest to the student of money. These were the formative years of the National Banking System and, more generally, of a banking structure that was to remain largely unchanged until the establishment of the Federal Reserve System.

The monetary standard of the period had unique features, some not to recur for many decades, others not at all. It was a fiduciary standard under which no agency of the government was committed to selling gold at a fixed price to all who offered legal tender. It involved freely floating exchange rates between U.S. currency and the currencies of other countries. A fiduciary standard did not recur until 1933. Freely floating rates between the dollar and such other major currencies as the pound sterling and the French franc did not recur until World War I. On no occasion since have they prevailed so long as they did after the Civil War. This was probably the only period of floating rates during which official U.S. transactions played no significant part in either the gold or exchange markets.¹ It was certainly the only period in which two kinds of money exchanging at a fluctuating rate—greenbacks and gold—were used domestically side by side to any considerable extent.²

Finally, the price level fell to half its initial level in the course of less than fifteen years and, at the same time, economic growth proceeded at a rapid rate. The one phenomenon was the seedbed of controversy about monetary arrangements that was destined to plague the following decades; the other was a vigorous stage in the continued economic expansion that was destined to raise the United States to the first rank among the nations of the world. And their coincidence casts serious doubts on the validity of the now widely held view that secular price deflation and rapid economic growth are incompatible.

A good starting point for the analysis of both the period covered in this chapter and the longer period covered by this book is the composition of the money stock in 1867, the year our money series starts. The various types of money then in circulation mirror the Civil War financial developments and foreshadow future developments (section 1). The changes in the stock of money, in income, and in prices to 1879 (section 2) reveal some features that we shall find recurring again and again, others that are special to this period. Section 3 examines the politics of resumption; section 4, the factors accounting for the changes in the stock of money, and the concluding section, three problems special to this period: the premium on gold, the factors determining the stock of gold, and the economic bases for successful resumption of gold payments.

1. Composition of the Stock of Money in 1867

DIVISION BETWEEN CURRENCY AND DEPOSITS

Throughout our analysis, we shall have occasion to divide the money stock into two major components: currency and deposits. The reason for the primacy of this division is clear. Since the Civil War, currency has consisted in the main either of specie or of a direct or indirect obligation of the government (for qualifications see below); deposits have been an obligation of privately owned and operated banks that have been legally required to hold assets in the form of currency or its equivalent equal to a fraction of their liabilities. As a result, the lending and investing activities of banks have been linked with the stock of money through deposit creation. In addition, under such a system of fractional reserve banking, the total amount of money is likely to be sensitive to the division of the total between currency and deposits. As we shall see in the course of this chronicle, changes in the public’s attitude toward these two forms of money and the resulting changes in the proportion in which it has desired to hold them have at times played a critical role in monetary developments.

In 1867, the public divided its stock of money almost equally between deposits and currency: it held about $1.20 of deposits for each dollar of currency (Table 1). In the five years after 1867, deposits rose to $2 for each dollar of currency. That increase reflects the rapid post-Civil War growth and spread of commercial banking. The deposit-currency ratio fluctuated around this level until 1880, and then began to rise again—a rise that was destined to continue, albeit with numerous short-term reversals, until 1929, when the public held about $12 of deposits for each dollar of currency. The ratio then fell. In 1960, it was about 6 to 1.

DIVISION OF DEPOSITS BETWEEN NATIONAL AND OTHER BANKS

Of the total of commercial bank deposits held by the public, roughly 60 per cent were liabilities of banks that were part of the Civil War-created National Banking System. The rest were liabilities either of banks that were chartered under the laws of the several states or of private banks.

TABLE 1

COMPOSITION OF CURRENCY AND COMMERCIAL BANK DEPOSITS, END OF JUNE 1867 (millions of dollars)

SOURCE, BY LINE

TOTAL

HELD BY TREASURY

HELD BY BANKS AND PUBLIC

The national banks grew rapidly immediately after the Civil War. First authorized in February 1863 to provide a uniform national currency and to aid in financing the Civil War by issuing bank notes secured by government bonds, few national banks were established until defects in the original act had been removed in the act of June 3, 1864.³ Shortly thereafter, in February 1865, a tax of 10 per cent was imposed on note issues of state banks paid out after July 1, 1866 (later changed to August 1, 1866), denying state banks de facto the privilege of note issue. At the time, such great importance was attached to the privilege of note issue that state banks converted to national banks in droves, and state banks were widely believed to be on the way to near extinction. The growing importance of deposits relative to currency and the less restrictive conditions imposed by state than by federal legislation combined to reverse the trend in very short order. By 1867, the decline in the deposits of state and private banks had ceased. These banks then expanded so rapidly that by 1871 the deposits of nonnational commercial banks roughly equaled national bank deposits. From then until now, the two classes of banks have remained roughly equal in the size of their deposits. Indeed, national banks have more frequently had the smaller total.

Private banks are chartered by neither the state nor the national government; they operate as individual proprietorships or partnerships. Once numerous and including some of the most influential banking institutions (J. P. Morgan and Company was probably the most widely known), private banks have played a negligible role in recent years.

The preceding comments all refer to currency and deposits held by the public, including in that term state and local governments but not the U.S. Treasury. In addition, in 1867 the Treasury held deposits totaling $33 million, or about 4½ per cent as much as the deposits of the public in commercial banks, and currency totaling $162 million, or nearly 30 per cent of the public’s holdings. The Treasury clearly held a much lower ratio of deposits to currency than the public, 20 cents in deposits for each dollar of currency compared to the $1.20 held by the public. The reason is twofold. First, as a monetary authority issuing currency, the Treasury’s balances were in part inventory and could at times be increased simply by printing more currency without issuing it to the public. Second, the low level of deposits was a consequence of the Independent Treasury System, which was first adopted in 1840 as a legacy of the Bank War over the renewal of the charter of the Second Bank of the United States, was discontinued in 1841, and was re-established in 1846. In the form that the Independent Treasury had assumed by 1867, disbursing officers were permitted to use national banks as depositories and the Treasury was permitted to deposit receipts from internal revenues in national banks provided the banks furnished security by depositing United States and other bonds with the U.S. Treasurer. However, the Treasury was prohibited from depositing customs receipts (which were paid in gold). The Treasury’s deposits remained small relative to either its currency holdings or the public’s deposits until near the end of the century, except for isolated occasions when they were built up as a deliberate act of monetary policy. For some years after the turn of the century, they remained relatively high as part of a deliberate policy of continuous Treasury intervention in the money market. They then relapsed until they rose to unprecedented levels as a result of the bond-selling drives of World War I.

Commercial banks also held deposits for one another. These interbank deposits are not recorded in Table 1. Since one bank’s asset is another bank’s liability, interbank deposits cancel when the accounts of banks are consolidated into the accounts of the banking system as a whole. The deposits recorded in Table 1 represent the liabilities of the commercial banking system as a whole to the public and the Treasury. The system as a whole can have no net liability to itself.

COMPOSITION OF THE CURRENCY

The banking system as a whole did, of course, hold currency. In June 1867, it held $247 million of currency, nearly half as much as the public held and equal to over a third of its net liabilities to the public. Currency constituted the whole of the banking system’s net cash assets, and we shall refer to it as the banking system’s reserves, recognizing that we are using this term in a sense that corresponds neither to an individual bank’s view of its cash assets—which would clearly include the amount due from other banks—nor to funds acceptable as satisfying legal reserve requirements—which generally included deposits at other banks within specified limits and sometimes did not include all types of currency.⁴ Unfortunately, available data do not permit division of each of the various kinds of currency between the banks and the public. So we have to deal with the combined totals (Table 1, lines 1 to 8).

The impress of the Civil War was even sharper on currency than on deposits: the three largest items in the list (national bank notes, U.S. notes, and other U.S. currency) and one of the smaller items (fractional currency) were all creations of the Civil War. Taken together, these four items account for over 90 per cent of the total currency in the hands of the public and in banks in 1867. If we apply the same percentage to the public’s holdings alone, nearly three-quarters of the total money stock—these items plus national bank deposits—was of Civil War origin, types of money that had not existed only six or seven years earlier.

The national bank notes were liabilities of the national banks, which could issue them by depositing with the U.S. Treasurer specified government bonds equal in face value to 111 per cent of the value of the notes issued.⁵ After 1874, the banks were also required to deposit with the Treasury a redemption fund in lawful money equal to 5 per cent of the value of their notes.⁶ In addition, the amount of notes a bank could issue was limited to nine-tenths of its capital until 1900 and the whole of its capital thereafter. First issued in 1864, the amount outstanding grew rapidly to nearly $300 million in 1866 and then increased more slowly but fairly steadily to $340 million in 1874.⁷ National bank notes played an important part in our monetary system for some six decades until 1935, when all United States bonds bearing the circulation privilege were called for redemption.

Though national bank notes were nominally liabilities of the banks that issued them, in effect they were indirect liabilities of the federal government thanks to both the required government bond security and the conditions for their redemption. Hence, their value did not depend on the financial condition of the issuing bank. If a bank failed, the law provided for the immediate redemption of all its notes at the Treasury and authorized the Comptroller of the Currency to declare the bonds securing the circulation to be forfeited to the United States. The Treasury was given a first lien upon the assets of the bank and upon the personal liability of the stockholders in order to make good any possible deficiency between the amount of notes it redeemed and the sum of the 5 per cent cash redemption fund which the issuing bank maintained with the Treasury (after 1874) and the proceeds from the sale by the Comptroller of the forfeited bonds.

National bank notes differed in usefulness from currency issued directly by the U.S. government in only one respect. Federal law did not permit them to be used to meet the legal reserve requirements of national banks, though most state laws did permit them to be used for this purpose by state banks. Only lawful money was acceptable for national banks and national bank notes were not lawful money. But inasmuch as the public at large regarded national bank notes as equivalent to other notes and other types of currency were always a multiple of bank vault cash, that restriction was of no great practical importance. We know of no episode after 1874 in which it raised any significant problems for banks.⁸ Consequently, national bank notes after that date circulated at parity with other currency; and we shall have little occasion subsequently to distinguish them from currency issued directly by the Treasury. There was no recurrence of the pre-Civil War phenomena of notes of different banks circulating at discounts or premiums with respect to one another, and at different discounts or premiums depending on the distance from the issuing bank, or of bank-note detectors to enable merchants and others to determine the value of particular notes. In this respect the Civil War and immediately post-Civil War legislation succeeded in one of its primary objectives—the provision of a uniform national currency.

National bank notes were like explicit Treasury currency, not only because they were obligations of the federal government at one remove, but also because the maximum possible amount outstanding was determined, also at one remove, largely by federal action, either administrative or legislative. This amount was determined by the volume of government securities bearing the circulation privilege. The fraction of this maximum issued might be expected to depend on the financial incentive to do so and this in turn to hinge partly on the terms on which bonds bearing the circulation privilege could be acquired on the market.

These expectations are not fully confirmed by the evidence. Before 1890 the amount outstanding ranged around 20 per cent of the possible maximum, by 1900 it had risen to about 28 per cent, and by World War I to about 80 per cent. The maximum was in fact approached only in the twenties, when for the first time U.S. bonds deposited to secure circulation and government deposits (which also required such security) nearly equaled the total of eligible bonds. Before 1905, the capital stock of national banks set narrower limits to their maximum possible note issue than did the total of eligible bonds, but the actual issue did not approach this lower limit either. Thereafter, the capital stock of national banks exceeded the total of eligible bonds and hence was not the effective limit on note issue. Yet, despite the failure to use fully the possibilities of note issue, the published market prices of government bonds bearing the circulation privilege were apparently always low enough to make note issue profitable except in the years 1884 to 1891. The fraction of the maximum issued fluctuated with the profitability of issue, but the fraction was throughout lower than might have been expected. We have no explanation for this puzzle.⁹

The United States notes are the greenbacks of Civil War fame. First issued to supplement tax and loan receipts in the financing of war expenditures, the total outstanding (in and outside the Treasury) reached a maximum of $449 million in January 1864. Under the terms of the act of April 12, 1866, the amount outstanding was reduced to $356 million by the end of 1867 and was then legally fixed at that level until 1873-74, when additional amounts were issued that raised the total outstanding to $382 million. As part of the Resumption Act of 1875, the retirement of the greenbacks was linked to the increase in national bank notes—for every five dollar increase in national bank notes the Treasury retired four dollars in greenbacks—and was to cease when the amount outstanding fell to $300 million. However, further retirement was suspended by an act of May 31, 1878, which established as a permanent issue the amount then outstanding, $347 million, the level at which the total issue of U.S. notes stands today. These repeated legal changes from 1865 to 1878 are a symptom of the political controversy about the greenbacks and about their role in the accompanying price decline, on which we shall comment further, below.

Other U.S. currency (Table 1, line 8) is a total of