What the U.S. Needs: Monetary Discipline

A return of ruinous inflation is a real, if unappreciated threat. Inflation, at 1.5 percent, appears tame. But the willy-nilly expansion of the U.S. money supply, owing to Washington’s economic stimulus schemes, eventually will lead to harmful inflation. The only thing that can stop it is a return to the type of discipline that the gold standard offered, such as Milton Friedman’s suggestion to increase the money supply by just 4 percent each year.

A reprise of the gold standard today would be impractical. Back when the U.S. pegged the dollar to the price of the metal, our economy was far less complex. Trading then was confined to only a few items – commodities, stocks and bonds – on physical exchanges among a select few.

A currency’s supply should be in proportion to the growth of the economy, in order to have no inflation. The amount of gold increased in early America, providing that growth. But nowadays, you don’t want to encourage people to hold gold because its value will increase as its demand for transactions in a growing economy rises. Given today’s lightning fast trading, its price wouldn’t provide the stability that a sound currency needs.

Nobel Prize winner Friedman, a longtime University of Chicago economist, proposed simply expanding the money supply by a fixed amount, usually 4 percent yearly. That core of that idea is that the Federal Reserve should increase the money supply only at the same rate as economic growth, thus imposing a discipline that thwarts inflation. Over the past 10 years, M2 (money in circulation plus short-term time deposits) has more than doubled, far exceeding economic growth.

Monetary discipline has ebbed over time. In the Fed’s first decade of existence, the dollar was devalued 55 percent (compared to 10 percent in the decade prior). From the creation of the Fed in 1913 until the gold standard’s finale in 1971, the dollar lost 75 percent of its value. From 1913 to date, the dollar lost over 96 percent of its value. Only pennies of its original value remain in our dollar today.

Arthur Burns, chair of the Fed at the time we went off the gold standard, wrote, “Persistent inflation . . . will not be vanquished . . . until new currents of thought create a political environment in which the difficult adjustments required to end inflation can be undertaken.”

A gold standard helps protect a currency from rampant inflation. The Fed could perform this function only if it could somehow display perfect self-control. Such an ideal may never occur and will never last when the temptation and incentives for the Fed to manipulate other parts of the economy are so great.

The gold standard once safeguarded our currency from devaluation. Since the U.S. went off it, the dollar lost much of its value and inflation became a constant problem, eroding people’s purchasing power.

Let’s review the history of gold’s relationship to our nation’s currency, to see how far we now are from the phrase “sound as a dollar” meant something. What’s interesting is that the Constitution never authorized the debasement of the currency that took place. From the mid-1800s, politicians gradually eroded the gold standard and a rock-solid currency.

The U.S. dollar was first regulated by the Coinage Act of 1792 and prescribed as 371.25 grains of pure silver. The eagle, worth $10, was 247.5 grains of gold. One cent, worth a hundredth of a dollar, was 24 grains of copper.

The value of the metal contained in the currency kept prices relatively constant before the founding of the Federal Reserve. During those 120 years, prices increased only 3 percent. In contrast, during the 100 years since the Federal Reserve, prices rose 2,280 percent.

The Constitution gives Congress the power to “to coin money” and “regulate the value thereof.” This dictum set the currency’s weight and metallic content and allowed the currency to keep up with a growing economy.

Before the Constitutional Convention, many states issued their own paper money called “bills of credit,” or declared foreign coins “legal tender” that people could use to settle debts. Some states had issued paper money to excess during the Revolutionary War and caused severe price inflation.

The Constitution, written at the famous Philadelphia convention in 1787, prohibited states from emitting “bills of credit” in Article I, Section 10. It also forbade them from making legal tender of anything but gold and silver coins. An early draft of the Constitution by South Carolina delegate Charles Pinckney gave that power to the federal government. But a motion by New York’s Gouverneur Morris specifically deleted it, declaring, “If the United States had credit such bills would be unnecessary; if they had not, unjust and useless.”

Because the U.S. government is based on enumerated powers, powers not specifically enumerated to the government are powers it does not have. At least some of the Founders believed that striking this clause from the Constitution by a 9-2 vote closed the door on the federal government printing money.

Almost a century later, the effect of removing this power was put to the test. In Hepburn v. Griswold (1869), the Supreme Court held that paper money violated the Constitution.

Susan Hepburn owed Henry Griswold a debt payable on a promissory note. Five days before the debt was due, the Union issued paper currency, known as “greenbacks,” to fund the Civil War. These were inferior to coined currency. The exchange rate was favorable for Hepburn to pay her debt in the cheapest legal tender that the terms of the note required.

Griswold sued and lost in the lower court. On appeal it was overturned, and the Supreme Court also sided with Griswold by a 4-3 vote. Chief Justice Salmon P. Chase had overseen the issuance of greenbacks as secretary of the Treasury, implementing the legal tender acts. Now, as chief justice he overruled his own actions.

President Ulysses S. Grant added two Supreme Court justices in 1870. The following year, the high court overturned the opinion in two 5-4 votes, with Chase now writing for the minority.

The expansion of the federal government into wielding powers that the Constitution never specified is all too common. And once such a “necessary and proper” power is taken for the “regulation of commerce,” the federal government never gives it up.

The Coinage Act of 1873 removed silver as legal tender, and the Gold Standard Act of 1900 guaranteed gold as the only standard for redeeming paper money, forbade use of any other metal and no longer permitted the dollar’s redemption in either gold or silver. It confirmed the government’s commitment to the dollar by assigning gold a specific dollar amount: $20.67 per troy ounce.

The creation of the Federal Reserve in 1913 marked the beginning of the end of the gold standard.

Five years later, the Fed accepted gold from foreign countries as a payment for World War I debt. This allowed excess gold reserves to accumulate, called “free gold” because it wasn’t currently required to back printed currency. This so-called free gold gave the Fed discretion over how much gold to use in backing the currency and the ability to inflate our currency with the stroke of a pen.

A little over a decade later, during the Great Depression, the Fed forced all Americans to surrender their gold to the Treasury in exchange for U.S. dollars. And the following year, it revalued their gold, increasing the dollars required to buy an ounce. This action also created more free gold.

During World War II, the Fed used some free gold to purchase bonds and drive interest rates down, to help the Treasury finance the war. Washington put price controls in place to hide the resulting inflation until almost 1950. When they ended, Congress instructed the Fed and the Treasury to operate “independently” of one another. This instruction officially came into focus when the two agencies signed an accord in 1951. But little independence has occurred in recent years.

With the gold standard suspended in many other countries, foreigners converted their leftover gold into U.S. dollars. This devalued the currency but cornered the gold market. By 1945, the United States had 75 percent of the world’s monetary gold and the only gold-backed currency.

At this point, the Fed could already function as though it didn’t have a gold standard. With excess gold in its reserves, currency could be changed at will. This occurred even during the 1969 recession, buying securities and inflating the currency to try to get the economy going.

In 1971, the United States finally dropped the gold standard, which at that point it had kept in name only. Roaring inflation ensued. The only buffer against a reprise of bad inflation is the discipline that the gold standard once imposed. Reform is necessary to protect our currency.

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Written by David John Marotta, CFP, AIF, who is president of Marotta Wealth Management Inc. of Charlottesville, Va., providing fee-only financial planning and wealth management at www.emarotta.com and blogging at www.marottaonmoney.com. Megan Russell is the firm’s system analyst. She is responsible for researching problems and challenges, and finding efficient solutions for them.

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