Dr. Paul Moreno: Gold, Greenbacks and Inflation: A History and a Warning
The Federal Reserve’s 100th birthday is no cause to break out the champagne.
A version of this article appeared Jan. 17, 2013, on page A17 in some U.S. editions of The Wall Street Journal, with the headline: Gold, Greenbacks and Inflation: A History and a Warning.
By PAUL MORENO
The Federal Reserve, which celebrates its 100th anniversary this year, is tasked by Congress with managing the money supply so as to preserve price stability while maximizing employment. But with the central bank having increased the money supply by 25% since the financial crash of 2008—while the federal government has borrowed $5 trillion—can inflation be far off?
It won’t be the first time. Inflation has often been popular, especially in democracies, since it benefits debtors, who are always more numerous than creditors. Inflation allows debtors to repay in money that is less valuable than the money they borrowed. This was the case after America’s Revolutionary War, when economically distressed debtors demanded that state governments ease their burdens. State after state enacted paper-money laws, so that debts contracted in scarce gold and silver could be repaid with infinitely expandable paper.
This sort of inflation was one of the principal reasons for the adoption of the Constitution, which forbids the states to “make any thing but gold or silver coin legal tender in payment of debts.” In the Federalist Papers, James Madison referred to state paper-money laws as the sort of “improper or wicked project” that the new Constitution would prevent. Chief Justice John Marshall later recalled, in the 1819 Dartmouth College v. Woodward decision, that such laws had “weakened the confidence of man in man and embarrassed all transactions between individuals by dispensing with a faithful performance of engagements.”
The adoption of an anti-inflationary Constitution was a remarkable example of democratic self-restraint, and it worked wonderfully to control inflation for the next century and a quarter.
The only significant inflation came with the Civil War, via $500 million in paper “greenbacks”—the Constitution being silent on Congress’s power to issue paper money. Rather than an act to relieve private debtors, the Civil War inflation was a way to pay the government’s bills, a kind of de facto taxation. Still, private debtors—those who borrowed in gold before the war and could pay back their debts in depreciated greenbacks—were happy, and there were calls for still more inflation after the war.
Those calls led to the “Greenback Party,” which enjoyed some success at the state level and sent some 20 members to Congress. But the government showed remarkable discipline in resisting such demands, and the greenback was as good as gold by 1879. Nevertheless, the inflationary experience led lenders to insert “gold clauses” in contracts specifying repayment in gold coin (provisions that were effective until Congress canceled them in 1934, a move upheld by the Supreme Court the following year).
The ending of the Civil War-era inflation, plus the massive increases in productivity in the largely free market of the following decades, led to a modest deflation—which meant that as prices gently declined, the real value of wages increased.
… But the great engine of inflation was the enactment of the Federal Reserve System in 1913, and a dangerous delegation of monetary power to an unelected bureaucracy. From 1800 to 1913, prices rose 176%; since then they have risen 448%.
The Fed got to work right away, helping to keep the government’s borrowing costs low during World War I. It increased the money supply by 75%, and consumer prices doubled from 1914 to 1920. The central bank became the best illustration of the adage that “in politics, nothing succeeds like failure.” As Milton Friedman and Anna Schwartz showed in their “Monetary History of the United States,” the Fed mismanaged the postwar reconversion, kept interest rates lower and prices higher than they should have been in the 1920s, and aggravated the Great Depression by keeping rates too low before the crash and raising them after it. Yet the Fed was rewarded with greater power, especially by the Banking Act of 1935.
The bank continued to facilitate low-interest Treasury borrowing in World War II and the Korean War. But during that latter conflict it finally bridled against Treasury demands to keep borrowing rates artificially low. In 1951 it negotiated a landmark “accord” with the White House reasserting its “independence.”
Yet inflationary pressures built up again in the late 1960s thanks to the Fed’s accommodation of deficit spending on Lyndon Johnson’s Great Society programs and the Vietnam War. That, plus the abandonment of the gold standard and the collapse of the Bretton Woods system of fixed exchange rates, led to the infamous “stagflation” of the 1970s. The Fed eventually tamed inflation under the chairmanship of Paul Volcker in the early 1980s, though prices still have more than doubled since then.
Now the inflationary potential of deficit financing has grown enormously over the first Obama term. The lesson of American history is that it is difficult enough for the government to resist popular demands for inflation to relieve private debts. When the government itself is the country’s chief debtor, resistance is all but impossible.
Mr. Moreno, a professor of history at Hillsdale College, is the author of “The American State from the Civil War to the New Deal,” forthcoming from Cambridge University Press.
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