Sound Money: Origins and True Value of the American Dollar

The Clover Helix
www.thecloverhelix.blogspot.com
Wednesday, February 24, 2010

Prior to the American Revolutionary War the money supply used by the British colonies in North America was a hodge-podge of gold and silver coins originating from Spain, England, France, and Germany and their territorial possessions. In the western colonies, even wampum was used. Because of Spain’s ownership of vast silver deposits in South America and Mexico, the Spanish Milled Dollar or “Piece of Eight”, was by far the most common coin in circulation and came to serve as the world’s first reserve currency. A reserve currency is a currency universally accepted for settlement of international trade and debt accounts. Today, the world’s reserve currency is the U.S. dollar.

To understand the heritage of the U.S. dollar we must understand the history of the Spanish Milled Dollar. The Spanish dollar concept was based upon the successful German thaler (from whence we get the word “dollar”), a popular coin containing 0.88 troy oz of silver first produced in 1524. The thaler’s success was only undermined by its limited production and later debasements. Soon after, the Spanish government began issuing dollar coins of their own. Upon establishing colonies in America, Spanish dollars were soon being issued en masse from Mexican and Peruvian mints, and the slightly smaller coin (weighing 27.064 grams and containing 0.786 oz troy of silver) became universally accepted due to its purity and reliability. Conveniently, a working man’s daily wage usually came to about one Spanish dollar per day and the 9.72% base metal content made the coin strong enough to handle day-to-day transactions. It could be easily subdivided into smaller denominations by literally chopping the coin into as many as eight pieces called bits (hence “Piece of Eight”). Because of its abundance, convenience, and reliability, the Spanish Milled Dollar became the international monetary standard and these coins flowed into American markets in exchange for cotton, tobacco, and other raw materials. Though English currency involving shillings and pounds were also circulated, it was clearly secondary to these Spanish coins in the American colonial economy.

During the American Revolution, the English naval blockade virtually eliminated American trade from international markets making access to coins, credit, and war materials tenuous at best, impossible at worst. That is why the naval victories of Captain John Paul Jones and the privateers were crucial as they boosted moral for the revolutionaries who were being economically strangled. Eventually the cash-starved colonies resorted to issuing paper “continental” currency, which functioned as interest-free IOUs denominated in Spanish Milled Dollars, to fund the war effort. As the war went on, these “continentals” were printed until hyperinflation and economic collapse set in. The continental currency was never honored and personal savings were wiped out. After the war had ended (via crucial French financial and military support), American trade resumed and Spanish Milled Dollars began flowing into the new American republic. The large account surpluses enjoyed by the new American economy allowed for a quick repayment of international war debts (owed mainly to France) by the United States. Naturally, these debts were paid for in Spanish dollars.

The American experience with the continental currency revealed to the founding fathers the perils of counterparty risk. When evaluating a security such as a bond or stock obligation, the value of that security is based upon the ability of the issuing party to perform the promised obligation. The continental currency lost all of its value because the issuing authority (in this case the Continental Congress) had no way to make good on the debt except by printing even more paper currency. In the end, only people holding gold and silver coins had retained their savings while the rest of the population lost everything. This is because there is no counterparty risk with respect to precious metals; gold and silver has value that is not dependent upon another party fulfilling a financial obligation. Therefore, the new American currency was not to be subjected to any form of counterparty risk.

The leaders of the new Republic learned important lessons concerning counterparty risk and decided to outlaw the issuance of paper money, called by the U.S. Constitution bills of credit (Article I, Section 10). The U.S. Constitution also provided the Congress with the power “to coin Money; and regulate the Value thereof, and of foreign Coin” (Article I, Section 8). Though the type of coin (or monetary unit) to be produced under the new constitution is not explicitly stated in Article I, Section 10, the language of Article 1, Section 9 uses the term “dollars”. In 1787, the only dollars present in America were Spanish Milled Dollars and we can infer that it was to these coins that the founding fathers were referring. Because Spanish dollars lack counterparty risk, the American economy would become as solid as the gold and silver that stood behind it. In fact, Article 1, Section 10 states that only gold and silver coin were lawful for payment of public debts, a provision that is still in effect today.

In 1794, the newly-created Philadelphia mint issued the first American silver dollars. These coins, as established by Congress, contained 0.774 oz troy of silver (versus 0.786 for the Spanish dollar) and the employees of the mint were threatened with penalty of death if they were dishonest in producing the new American coinage. As American economic influence advanced around the hemisphere, American dollars gained in popularity and traded at equal value (par) with the Spanish Milled Dollar in international markets, especially in the Caribbean. When Mexico became independent from Spain and introduced the Mexican Dollar or “Peso” in 1821 at par value with both the Spanish and American dollars, it became clear that the new international dollar standard was here to stay. Even the large European 5-Franc coin was largely modeled on the dollar. The weight and purity of the American dollar remained unchanged until 1935 when American silver dollars were discontinued, and in 1965 the last American silver coins (half, quarter, and tenth dollars) were replaced by copper-nickel fiat substitutes. American silver certificates, or paper money backed by silver dollar coins, freely circulated until 1964.

For large transactions, gold coins were the preferred medium of exchange. The value of silver relative to gold was established by Congress at 16:1. Therefore, a U.S. gold dollar weighed a minuscule 0.048 oz troy but the famous $20 double eagle coin weighed in at a whopping 0.97 oz troy. Gold certificates were circulated alongside silver certificates until 1933 when the gold backing of the domestic currency was abruptly removed by presidential executive order. In 1971, the dollar ceased to be convertible into gold for international transactions.

The constitutional recognition of bimetallism (gold and silver both being legal tender) created many problems for the nation’s money supply as the abundances of these two metals fluctuated with respect to each other while their values were legally fixed. Despite these problems, the gold and silver standards kept the value of the dollar stable and kept counterparty risk out of the money supply (except during the American Civil War). Hence the U.S. dollar was defined by Congress as equal to 0.774 oz troy of silver for 189 years of our 233 year history and the purchasing power of the dollar remained steady until 1965.

Since the introduction of fiat paper money the value of the dollar has plummeted. Assuming a silver price of $16 per oz troy, the dollar has lost over 92% of its purchasing power since 1965. In terms of gold (assuming a gold price of $1100 per oz troy) the dollar has lost 98% of its purchasing power since 1933, with almost all of that loss occurring after 1971. This type of inflation was one of the major issues that our founding fathers sought to prevent. It seems that we are destined to relearn their lessons as we continue to print ever more paper dollars to settle our mushrooming personal and public debts.