Money and How the U.S. Monetary System Works

We all use money every day. We earn U.S. dollars for our labor, deposit our money in banks, pay our bills, use credit cards, and spend cash to purchase items we want. Most of us walk around with cash in our pockets, but we don’t know very much about how the system works. What is money, and who decides how much our money is worth?

In the past, when countries were small, and trade with other nations was limited, currency tended to be based on precious metals or commodities.  Ancient empires minted their precious metals into coins which served as their currency. Roman currency consisted of coins made of silver and gold. The denarius, a silver coin, was the main currency used during the first 220 years of the Roman empire. The ancient Egyptians used coins made of gold, silver and copper. 

A Brief History of U.S. Money

In 1775, the Continental Congress authorized the issuance of the American Dollar to finance the Revolutionary War.  The word “dollar” was already in common use and was based on the Spanish dollar that had been widely circulated in the colonies. This new paper currency became known as the “Continental” throughout the colonies.  As the war wore on and the colonies’ debt mounted, the Continental became devalued.  By May, 1781, Continentals had become so worthless that people stopped using them.  The term “not worth a Continental” became a slang expression that lingered until the early 20th century.

After the ratification of the U.S. Constitution and Bill of Rights in 1791, the newly formed United States of America needed to develop a workable financial system and stable currency. At that time, Alexander Hamilton was Secretary of the Treasury, and he proposed that Congress establish the First Bank of the United States to handle payment of Revolutionary War debt and control currency.  In 1792, Congress passed the Coinage Act which established the U.S. Mint and made the “dollar” the official currency of the United States. Both gold and silver coins were issued by the Mint, while the national bank issued paper money. Today, it is the Bureau of Engraving and Printing that is responsible for printing paper money.

The Federal Reserve

There have been several attempts over the years to establish a central banking system, starting with Alexander Hamilton and The First Bank of the United States. All fell by the wayside until the establishment of the Federal Reserve in  1913.  The Federal Reserve Bank had been hotly debated in Congress. Some wanted a central bank under public control through the government.  Others wanted private banking to be in control.  The end result was a compromise, a decentralized central bank that balanced the competing interests of public and private control.  Twelve cities were chosen as the sites for Federal Reserve Banks.  The Federal Reserve, commonly called “The Fed” is responsible for conducting the nations monetary policy by setting interest rates and by supervising and regulating private banking.  The Fed’s purpose is to influence money and credit conditions in pursuit of high employment rates and a stable currency. The Fed is the banker and fiscal agent for the U.S. government; it regulates the supply of money; and buys and sells U.S. dollars in foreign exchange markets to keep the value of the dollar stable.

The Rise and Fall of the Gold Standard.

Until 1900, the U.S. had a bimetal standard with both silver and gold forming the basis for our currency. In 1900, Congress passed the Gold Standard Act which set the value of the dollar based on 1.5 grams of gold. In theory, every paper dollar could be redeemed for an equivalent value in gold. The Gold Standard limited the government’s ability to print money and handle debt because the amount of paper money in circulation had to equal the federal gold reserves. Adherence to the Gold Standard first became a problem during World War I when the government needed to print more money to handle the expenses of war.  The Gold Standard was suspended twice during World War I.  

During the Great depression, every major currency around the globe abandoned the Gold Standard as people began to hoard gold and demand that the Treasury exchange their paper money for gold.  In 1933, the federal government suspended the gold standard once again, and Congress banned the private ownership of significant amounts of gold. 1934 brought the Gold Reserve Act which allowed the government to decide the amount of gold a paper dollar represented and to nationalize its stores of gold bullion. 

After 1934, the U.S. was on a quasi-gold standard. Paper dollars were still backed by gold, but the dollar for dollar relationship was gone.  Where in 1900, a paper dollar represented a dollar’s worth of gold, that was no longer true.  More dollars were printed than the gold available to back them.

Following World War II, U.S. economic interests became more multinational, as world markets emerged and as the U.S. took center stage in international politics. Pressures on the Gold Standard increased to the point where the system became unworkable.  In 1963, the words “payable to the bearer on demand” were removed from all newly issued Federal Reserve notes. As of 1968, you could no longer redeem pre-1963 notes for silver or gold. The Coinage Act of 1965 removed all silver from quarters and dimes. (Earlier dimes were 90% silver). 

The gold standard had established the price of gold at $35.00 per ounce. However, gold was trading at higher prices in foreign markets, so in 1971, the U.S. stopped selling gold to foreign investors who wanted to trade their U.S. dollars for gold.  In 1973, the U.S. devalued the dollar, but circumstances forced a second devaluation only 2 weeks later.  It was clear to everyone in finance and government that there simply was not enough gold to back the amount of currency needed to maintain economic growth.  In 1974, President Ford repealed the prohibition on the public’s ability to own gold.  By then, the Gold Standard was over.  Our currency was no longer backed by gold. Finally, in 1976, the government made it official. The definition of the dollar in terms of gold was removed from the statute. Our monetary system became one of pure fiat money.

All Currency is Fiat Money

The entire modern world operates with “fiat” currency as the medium of exchange.  The term “fiat currency” refers to the notion that money is money because the government says it is.  However, while the government sets the value of paper money and coins, the system would not work without the consent of the public.  If the public stops believing that money has value, they will stop using it, and the whole system will collapse.

The U.S. is not the only country to abandon the gold standard.  Everyone operates on fiat currency.  All of Europe, Asia, Africa and South America operate on fiat money.  There simply aren’t enough precious metals in the world to back all the money needed for international trade and to fuel complex modern economies with multinational corporations, international debt obligations, and the infrastructure needed to support the billions of people who populate the earth.

Our monetary system works because we have faith in our country’s economy, and because there is no other alternative.  We can’t tell our employers that we want our wages paid in gold.  That will never happen.  Gold is scarce and expensive.  So long as we all continue to use American dollars, the system will continue to work like it has for the past forty plus years.

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