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Rules of the Game

Just as the states are limited in the policies they can pursue by the openness of the economy in which they exist, so too the federal government was limited in the late 19th century. In the last few decades of the 19th century, the United States was experiencing a slow deflation; prices were falling. This deflation was a source of considerable political discontent and accounts in large part for the political career of one of the more colorful politicians of the era, William Jennings Bryan. The deflation could have been stopped if the United States had increased the amount of money in circulation. However, this action would have endangered convertibility of the dollar into gold. The United States made the dollar convertible in 1879 after over a decade of trying to readjust from the rapid money creation that had accompanied the Civil War. Once it reestablished the gold standard with the dollar convertible into gold, higher prices in the United States would have encouraged more imports, and gold would have flowed out to pay for those imports. The United States had a choice: either it could adjust to a price level dictated by the rest of the world and the world's stock of gold, or it had to abandon the gold standard.

Abandonment was Bryan's choice. He wanted to use silver in addition to gold as a backing for money, a policy he believed would lead to "easier" money. The Democratic Party nominated him for the presidency in 1896 when he was only 36 years old, largely because of his stirring speech during the debate over the party platform. He claimed that the people of the country were being crucified on a "cross of gold." Bryan, despite three tries, never was elected to the presidency and the country continued with the dollar linked to gold until 1933. The issue was defused in the 1890s by the opening of new gold fields in Australia and Alaska, and the discovery of the cyanide method of extracting gold from ores. The resulting increase in gold production allowed money stock to increase, stopping the deflation.

From 1879 until the outbreak of World War I, the United States was part of an open world economy, though that economy was not as open as the national economy in which the fifty states exist. Nations had restrictions on movements of people, capital, and goods, and each nation had its own monetary system. However, the monetary system of each nation was linked to gold. For example, the United States promised to buy and sell gold for dollars at the rate of one ounce for $20.67 and Great Britain promised to buy and sell its currency at a rate of one ounce of gold for 77 shillings and 10 1/2 pence. After an adjustment for purity (the ounce of U.S. gold was defined as 90% fine while that of Great Britain as 91.7% fine), the value of a British pound was $4.865. Although one might call money by different names in the U.S. and U.K., they were linked together by their common link to gold, and one can think of gold as the universal money.

The monetary policy of any country on the gold standard was limited by the "rules of the game," or the actions necessary to keep each currency convertible into gold. Because this system was a bit less open than the economy of which the states are a part, some temporary monetary measures were possible. The government could temporarily increase or decrease money stock, and it would take some time before the gold flows needed to offset these actions would happen. Or if a country had an inflow of gold, it could sterilize it by using tax proceeds to buy up the gold and thus not let it increase the money stock. Sterilizing gold inflows (or outflows) was considered a violation of the rules of the game, and was considered by other countries to be irresponsible.

Although few realized it at the time, the establishment of the Federal Reserve System would ultimately prove incompatible with the gold standard.

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Copyright Robert Schenk