Why Silver Fell in the 1870s and Gold Rose in the 1970s

Why Silver Fell in the 1870s and Gold Rose in the 1970s

Thomas Allen

    During the 1960s when the market price of gold began to rise above the official redemption rate of $35 per ounce of gold, economists and others began discussing the likelihood of the dollar no longer being redeemed in gold. When this event occurred, most expected the dollar price of gold to drop because the demand for gold as money would cease. Most expected a decline in the value in gold when redemption ended because of a decrease in demand.
    A similar discussion occurred in the late 1800s as the free coinage of silver ended and most of the world moved to the monometallic gold standard. Most argued that silver declined in value because of the demand for silver as money ceased except in subsidiary coins and its supply continued to rise. However, in 1971 when redemption in gold ceased, gold acted oppositely. Instead of falling in value, gold rose. Why?
    Several explanations have been offered to explain the decline of silver’s value (priced in gold). These explanations are mostly variations of the Quantity Theory of Money.
    Friedman and Schwartz assert that supply of and demand for silver explains its decline, “The reasons for the price decline seem fairly clear: on the supply side, rich new mines were opened in the American West, and there was a world wide increase in productivity; on the demand side, a number of European countries shifted from a silver or bimetallic to a gold standard and sharply reduced their monetary use of silver.”[1]
    The monometallists, advocates of the single gold standard of this era, claim that the increase in the supply of silver caused its fall in value. However, the fall in value began before the world’s silver stock had greatly increased. Moreover, gold production was relatively much greater than that of silver. To which the monometallists reply that the fall resulted from an anticipation of an increase in supply.
    Even today, the supply argument seems weak. In recent years (decades), the increase in the supply of gold has been relatively greater than that of silver. During this time, the demand for silver seems to have been much higher as its usages have been higher. Yet the value of silver generally lags that of gold.
    Laughlin opines that the abundance of gold caused silver to lose value relative to gold.[2] With the discovery of gold in America, enough gold came available to supplant silver coins. People preferred gold to silver because it had more value per unit weight. As the demand for gold grew, so did its value. As the demand for silver fell, so did its value. Moreover, the supply of silver began increasing after 1872. (Laughlin incorporates quality with his explanation: Gold has a higher value, purchasing power, per unit of weight, which contributes to its quality as money.)
    The bimetallists, advocates of the silver-gold system with a legally fixed exchange rate or ratio between the two, claim that “demonetization” caused silver’s fall in value. They point to Germany ending the free coinage of silver in 1871, which glutted the market with silver. This action forced France and the other members of the Latin Union to abandon the silver standard, i.e., to end the free coinage of silver. The United States ended the free coinage of silver in 1873. During the 1870s, other European countries ended their silver standards or bimetallic silver-gold systems and adopted the monometallic gold standard. To the bimetallists, ending the free coinage of silver and by that discontinuing the use of silver as standard money caused its decline in value.
    One result in discarding the silver standard was an increase in demand for gold coins. This increase demand for gold coins would account for some of the decline in the value of silver in terms of gold. Not only were countries replacing the silver standard with the gold standard, they were also replacing fiat paper monetary standards with the gold standards.
    The abandonment of the silver standard around the world reduced the demand for silver. As countries moved onto the gold standard, the demand for gold increased. Thus, the value of silver was pushed down and that of gold was pushed up.
    Although silver ceased to be used as standard money in most countries (China and some Latin American countries being notable exceptions), it was still used in subsidiary coins in most countries and as fiat money in the United States. If merely ending the use of silver as standard money caused its fall in value, why did gold soar in value (in terms of standard fiat currencies) when its last legal connection to money was severed in 1971? Although the Quantity Theory of Money offers a reasonable explanation of silver’s fall in value, it fails to explain gold’s rise in value. Whatever explanation used to explain silver decline in value after 1873 needs to be able to explain golds rise in value after 1971.
    Rist offers this explanation for the decline of silver’s value and the rise of gold’s value when they ceased being standard money. (In the United States, silver ceased being standard money when the free coinage of silver ended in 1873. Gold ceased being standard money when the United States stopped converting the dollar to gold under the gold exchange standard, the Bretton Woods system.) When the free coinage of silver ended, people replaced silver with gold. Gold adequately performed all the basic functions of money. Silver was not needed to perform any of these functions. Therefore, the monetary demand for silver declined. As demand fell, so did its value. When gold redemption ended, people replaced gold with irredeemable paper money. Irredeemable paper money does not perform all the basic functions of money. As it nearly always depreciates, it fails as a store of value. Gold continued to perform a monetary function as a store of value. Therefore, a monetary demand for gold remained after its redemption ended. Thus, when gold replaced silver, it fulfilled all silver’s monetary functions. When irredeemable paper money replaced gold, it failed to fulfill all gold’s monetary functions.[3]
    Thus, the Quality Theory of Money is needed to explain gold’s rise in price in terms of irredeemable paper money. Being low quality money, irredeemable paper money cannot store value over time. Being high quality money, gold stores value over time. Consequently, gold rose in price after its formal use as money ended because people still demanded a form of money that stored value.
    As shown above, the Quantity Theory of Money can explain the fall of silver’s value after 1873, but it fails to explain the rise of gold’s value after 1971. The Quality Theory of Money is needed to explain gold’s rise in value. It can explain both silver’s fall in value and gold’s rise in value.

Endnotes
1.  Milton Friedman and Anna Jacobson Schwartz, A Monetary History of the Untied States, 1867-1960 (Princeton, New Jersey: Princeton University Press, 1963), p. 114.

2.  J. Laurence Laughlin, The Elements of Political Economy (New York, New York: American Book Co., 1887), p. 311.

3.  Charles Rist, The Triumph of Gold, trans. Philip Cortney (New York, N.Y.: Philosophical Library, 1961, pp. 122-124, 151-153.

Copyright © 2016 by Thomas Coley Allen.

Gold-Backed Currencies

Gold-Backed Currencies

Thomas Allen

    Economic analysts, political analysts, and others are talking and writing about China, Russia, various Islamic countries and possibly other countries instituting a gold-backed currency. They believe that China, Russia, and other countries have been acquiring large quantities of gold in anticipation of going to a gold-backed currency. Some of these commentators imply that instituting a gold-backed currency is returning to the gold standard. Others admit that it is not. These latter commentators are correct. A gold-backed currency without redemption on demand, especially by the common people, is meaningless — except perhaps for propaganda purposes.
    I will use the United States as an example. When the United States ended the gold standard in 1933 and refused to redeem paper money in gold, they still had a gold-backed currency. From 1933 to 1945, Congress required 40 percent of the federal reserve notes to be backed by gold. In 1945, it changed the requirement to 25 percent backing. Then it ended the hypocrisy in 1968 by eliminating all gold backing. However, gold continued to back the U.S. currency and foreign governments and their central banks could redeem their dollars in gold. In 1971, the United States ceased redeeming dollars in gold. (From 1944 to 1971, the United States redeemed dollars under a gold exchanged standard. Under this gold exchanged standard, only foreign governments and their central banks could redeem U.S. dollars in gold.)
    Even after abandoning all pretenses of a gold-backed currency, the United States and the Federal Reserve System continued to back the U.S. dollar with gold.  To the extent that the gold held by them is considered an asset, this gold backs the U.S. dollar. Along with all the land owned by the U.S. government and, more important, the military might of the U.S. government, this gold is part of the “full faith and credit” backing the dollar. (Gold is not really credit as it is no one else’s liability.)
    Likewise, to the extent that a foreign government or its central bank holds gold, its currency is backed by gold. Although it has no statutory requirement to maintain a specific amount of gold to back its currency, its currency is still backed by gold. As shown with the United States, whenever a statutory limit is approached, the law is changed to reduce the requirement.
    Any kind of gold-backed currency is meaningless unless free coinage of gold is allowed and the common people can redeem paper money in gold on demand. Moreover, the country would have to define its monetary unit as a specific weight of gold; it would not be fixing the price of gold. (For example, the Gold Standard Act of 1900 defined the U.S. dollar as 23.80 grains of standard gold, which is 23.22 grains of fine gold. It did not fix the price of gold at $20.67 per ounce.) Furthermore, a country would not have to stockpile gold before returning to the gold standard. It would not need to possess any gold in order to return to the gold standard. All it needs to do is to define its monetary unit as a specific weight of gold, allow the free coinage of gold, and to require paper money to be redeemed in gold on demand by anyone.

Copyright © 2016 by Thomas Coley Allen.

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Gold and Silver as Fiat Money

Gold and Silver as Fiat Money

Thomas Allen

Gold and silver can be used as fiat money and in fiat monetary regimes. How can this be? To understand how gold and silver can be used as fait money, one needs to understand what distinguishes fiat money from commodity money.

With commodity money, the value of the money equals the value of the material of which it is made. This equality of value can only be maintained with unrestricted importation and exportation of the monetary commodity and free coinage. With the true gold and silver standard, gold and silver are commodity money.

The true gold or silver standard requires free coinage. Under free coinage, any person can bring any quantity of gold or silver bullion to the mint and get it coined. Once the bullion is coined, the mint returns the coins to the presenter. The government does not buy the gold or silver with a check, certificate, or other paper money. The gold and silver remains the property of the person presenting it for coinage. Likewise, the minted coins are the property of the person who presents the metal. Furthermore, the government does not coin gold or silver on its own account.

With the true gold and silver standard, the market automatically determines the quantity of gold and silver coins. The people with each person acting in his individual capacity according to his economic contribution decides how much gold and silver to coin and how many gold and silver coins to melt for other uses. Thus, economics determines the quantity of money as gold and silver coins. The government’s monetary activity is limited to minting gold and silver coins and to certifying the weight and fineness of the metal content.

As Mises notes:

. . . it is the commodity in question that constitutes the money, and that the money is merely this commodity. The case of fiat money is quite different. Here the deciding factor is the stamp, and it is not the material bearing the stamp that constitutes the money, but the stamp itself. The nature of the material that bears the stamp is a matter of quite minor importance.[1]

With commodity money, the value of the currency equals the value of the material of which it is made or into which it is redeemable. The commodity makes the money. "The value of a coin has always been determined, not by the image and superscription it bears nor by the proclamation of the mint and market authorities, but by its metal content."[2] It derives its power from the material of which it is made.

With fiat money, the value of the currency equals what the government declares it to be. (Here value means nominal value and not purchasing power.) The stamp and force of government makes the money. Fiat money derives its power to make purchases and to pay debt solely from words printed on the currency, i.e., it derives its power from governmental fiat, the weapons of government.

Commodity money differs from fiat money in two important ways. First, under a commodity monetary system, the money supply adjusts automatically to meet monetary needs. "[T]he demand for, and supply of, money react simultaneously, through market prices for all goods and services and the monetary metal, to determine a given quantity of money."[3] The markets decide how much money to create and issue. They regulate the money supply. Under a fiat monetary system, the money supply is regulated artificially. The government or its central bank regulates the money supply. The government decides how much money to create and issue. Second, the value of commodity money is directly related to the material of which it is made. For fiat money, value is independent of its material and depends solely on the demand for and supply of money. Of these two differences, the most important lies in the method used to regulate the supply of money.

Thus, fiat money has two attributes that distinguishes it from commodity money. First and most important, the government or its agent, usually its central bank, arbitrarily determines the quantity of money. Second, the value of the material of which the money is made is usually less than its monetary value.

Commodity money is an economic currency. Needs of the economy determine its quantity. It is directly connected with the production of real goods and services.

Fiat money is a political currency. Needs of politics determine its quantity. It is directly connected with government debt even if the government issues the currency directly and interest free. (When the government issues a currency like U.S. notes, it is issuing interest free government debt that is used as money. Often such debt is never paid.) Politics and the fiscal needs of the government determines the quantity of fiat money. The quantity of money is independent of the market or economic needs or demand for money.

Three examples of gold and silver being used as fiat money or in connection with fiat money in the United States follow.

The first example involved the U.S. note or greenback. When President Lincoln first issued U.S. notes to finance his war to destroy the Constitution, they were pure paper fiat money.

U.S. notes were legal tender for public and private debts—except for the payment of tariffs. They could not be used to pay tariffs, which was a major source of revenue for the U.S. government.

The U.S. government did not fix the exchange rate between the U.S. note dollar and the gold dollar until 1879. In 1879, the U.S. government fixed the exchange rate of the U.S. note at 23.22 grains of pure gold per dollar. That is, a U.S. note dollar equaled a gold dollar. This exchange rate continued until President Roosevelt stole the people’s gold and ended the gold standard.

Obviously, U.S. notes were fiat money between 1862 and 1879 and after 1932. Congress arbitrarily fixed the quantity issued. Their monetary value far exceeded the material, paper, of which they were made.

Were they fiat money between 1879 and 1933 when Congress made them redeemable in gold at par? Yes. Congress decided the quantity issued. Also, as their gold backing was only about half or less[4] of the outstanding notes, they were not warehouse receipts like gold certificates. They represented at least twice as much gold as the gold backing them. Therefore, their monetary value was significantly more than their commodity value.

The second example is the silver dollar between 1873 and 1900. In 1873, Congress ended the silver standard, and by that action it ended the constitutional dollar. To appease the pro silver forces, Congress authorized the minting of silver dollars. However, it did not open the mint to the free coinage of silver. The U.S. government bought silver on its own account and coined it. Thus, Congress and the Secretary of the Treasury arbitrarily decided the quantity of silver dollars to mint and issue.

Furthermore, Congress declared the silver dollar to be money in its own right. It fixed the value of a silver dollar to equal the value of a gold dollar. Silver dollars could not be directly redeemed in gold on demand; therefore, it was not a subsidiary coin for gold as were silver halves, quarters, and dimes. Moreover, the value of silver in a silver dollar was worth less than a dollar. It varied between 40 cents and 97 cents in gold.[5] In 1900, Congress made the silver dollar a subsidiary coin for gold and by that ended its status as fiat money.

The third example is the federal reserve note after Roosevelt stole the people’s gold in 1933. Before his thief, federal reserve notes were not legal tender and were redeemable in gold on demand. They were not fiat money. They were merely a form of credit money.

After Roosevelt’s thief, American citizens could no longer redeem federal reserve notes in gold. Congress declared federal reserve notes to be legal tender for all public and private debts. Thus, federal reserve notes became fiat money. The Federal Reserve arbitrarily regulated the quantity of notes issued. The monetary value of a note far exceeded the value of the material of which it was made.

Nevertheless, Congress required a 40-percent-gold backing for federal reserve notes. It changed this requirement to 25 percent in 1945 and eliminated the backing entirely in 1968.

In summary, the United States has had fiat money redeemable in precious metal, fiat money made of precious metal, and fiat money backed by precious metal.

Another fiat monetary system using gold has been promoted by some economists. This system requires the Federal Reserve to expand and contract the money supply and credit to keep the price of gold within a specific range. It is a fiat monetary system where the price of gold becomes the index by which to adjust the money supply. This system has not been officially used in the United States.[6]

As shown above, fiat money is not necessarily paper money or its electronic equivalent although it usually is. Moreover, paper money is not necessarily fiat money. If the government, its central bank, or some other entity decides the quantity of paper money issued and regulates its supply, that money is fiat money. If the people with each person acting in his individual capacity decides how much

of their metallic money or commercial money[7] to convert to privately printed paper money, that paper money is not fiat money—especially if it can be converted back to gold or silver on demand.

The classical gold standard is an utter failure at accommodating the welfare-warfare state. It can accommodate world trade and commerce many times over, but it cannot support the welfare-warfare state. (One of the first casualties of war of any significant is the gold standard.) For this reason, governments hate the gold standard and seek ways to abandon it. They often replace it with a fiat monetary system that incorporates gold. Thus, they control the gold instead of the people or the markets. Whenever even this highly controlled gold begins to impede the welfare-warfare state, governments abandon it in favor of pure paper fiat money.

Because the quantity of gold and silver is limited, the quantity of fiat money using them is limited much more than fiat money using solely paper and electrons. For this reason, gold and silver seldom appear in fiat monetary regimes except as a ruse. The exception has been silver in subsidiary coins. However, even this silver must eventually be removed as the value of the silver in the coin approaches the value of the coin.

In summary, two types of monetary systems exists. One uses commodity money. The other uses fiat money. Using a commodity for the money does not make it commodity money. After all, paper is a commodity, and most fiat money is paper. What distinguish commodity money from fiat money is how the money is created and issued and how its quantity is regulated.

For a more detailed discussion of fiat money, commodity money, and the true gold and silver standard, see the author’s book Reconstruction of America’s Monetary and Banking System: A Return to Constitutional Money.
Endnotes

1. Ludwig von Mises, Theory of Money and Credit (new edition, 1971) p. 62.

2. Ibid., p. 65.

3. Richard H. Timberlake, "Gold Standards and the Real Bills Doctrine in U.S. Monetary Policy," Econ Journal Watch, II (August 2005), 199.

4. In 1932, the U.S. Treasury held $156 million in gold to back $289 million in U.S. notes (Board of Governors of the Federal Reserve System, Banking and Monetary Statistics, 1914-1941, pp. 409, 506.) In 1879, it held $133 million in gold (H. White, Money and Banking, p. 196) to back $347 million in U.S. notes (J. Johnson, Money and Currency, p. 283).

5. Joseph F. Johnson, Money and Currency (revised edition, 1905), p. 251.

6. A variant of this system has been unofficially tried in recent years. Instead of adjusting the supply of dollars to maintain the price of gold within a specific range, the Federal Reserve and the U.S. government in collaboration with other central banks and governments have attempted to adjust the gold supply to maintain its price below a certain level.

7. Commercial money is a real bill of exchange. A real bill of exchange is created when a supplier or manufacturer enters into a agreement with a retailer to allow the retailer time, 90 days or less, to sell the merchandise to collect money from the final consumer to pay the bill. The supplier can use the bill of exchange to pay his creditors or sell it to a bank. When a bank buys a real bill of exchange, it converts it to bank money (bank notes or checkbook money).

Copyright © 2009 by Thomas Coley Allen.

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