Commodity Money and Commodity-backed Money

Introduction to Commodity Money

Commodity money represents one of the earliest and most enduring forms of currency in human history.  At its core, commodity money is a medium of exchange that has intrinsic value due to its utility or scarcity in other applications.  This fundamental characteristic distinguishes it from modern fiat currencies, whose value is primarily derived from government decree and public trust. 

Economists often describe the evolution of a commodity into money as a commodity that starts its journey as something bartered.  This commodity becomes recognized as money because it satisfies characteristics of portability, divisibility, durability, uniformity, and limited supply.  Since it started as a tradable commodity, it already has intrinsic value, another fundamental characteristic.  A commodity that has these characteristics makes a natural candidate for use as a common medium of exchange.

Examples of Commodity Monies

Gold and silver evolved into the most ubiquitous forms of commodity money.  Both gold and silver can be found as nuggets in nature, but silver, being a more chemically active metal, is more often found in ores.  Evidence of both gold and silver mining dates back millennia.  Silver is often found as a byproduct of processing other metals like copper or lead.

Salt was used as currency in ancient Rome, ancient Britain, ancient China, West Africa, and Ethiopia.  Most inland regions find it difficult to find large salt deposits.  Its usefulness as a preservative makes salt a natural trade commodity.  It also meets the other qualities required of a currency.  It would not be useful as a commodity money in modern times because of the ease at producing and transporting salt.  It would result in an overproduction of salt and cause catastrophic inflation.

Livestock was often used as currency in Africa, Asia, the Inca civilization, and ancient Sumer.  In chapter 1 we learned that Sumer used barley as currency.  Livestock circulated as alternatives to barley.  Livestock lacks one of the characteristics of commodity money: divisibility.  It is hard to divide a living cow.

Shells of various kinds were used as currency in Africa, Asia, Europe, the Americas, and Oceania.  There is evidence of their use in China as early as 1300 BCE.  Their use as currency spanned millennia. 

Throughout the colonial period in the Americas, Virginia, Maryland, and North Carolina used tobacco to supplement the shortage of circulating specie (coined money).  The variability in quality and quantity of tobacco made it a less desirable currency but as a supplement to specie it stimulated economic activity. 

Examples of Commodity=backed Money

There have been historic examples of lesser valued coins, leather, and clay as circulating money that could be converted into an underlying commodity.  By far, the most common circulating currency that can be converted into the underlying commodity is paper.  The origins of modern paper money are intimately tied to banking and “fractional reserve banking.” 

In medieval Europe, goldsmiths played a crucial role.  Not only did the goldsmiths craft jewelry but provided secure storage for gold and other precious metals.  At the time, people needed a safe place to keep their wealth, as carrying gold or leaving it at home was risky.    The goldsmiths had fortified vaults and a reputation for trustworthiness, so they became a natural source for safeguarding gold for the wealthy. 

Goldsmiths issued paper receipts.  These receipts represented the depositor’s claim for a specific amount of gold, and soon, they began circulating in the market as a form of money.  Instead of withdrawing their gold, people found it more convenient to trade these receipts, which were easier to carry and safer than the metal itself.  Thus, the goldsmiths’ receipts became some of the earliest forms of paper currency backed by gold.

Early Banking

Goldsmiths, having stores of gold of their own, often lent gold.  This, plus the fees for storage and their sales of crafted jewelry made them wealthy.

Since most people found it advantageous to keep their money in the vaults and circulate the paper receipts, only a fraction of the gold was redeemed.  The goldsmiths were not as trustworthy as deemed by their reputations and they began lending more gold than they owned.  They relied on the gold from their customers to supplement their own supplies. 

Banks started in the 15^th century.  They were owned by wealthy families, merchants, or governments and lent a portion of their wealth.  As the goldsmiths, primarily in England, transitioned into banking, they carried over their knowledge that only a fraction of gold would be redeemed.  This was an advantage to society as it multiplied the amount of money in circulation.  This was the birth of the practice of “fractional reserve banking.”

The idea behind fractional reserve banking is that since not everyone needed their deposited money at the same time, a bank can lend depositor’s money but leave some fraction of that deposited money as a reserve.  So long as everyone trusted the bank and no crisis required excess withdrawals, the bank would have enough money for those who wanted to withdraw their money.  Occasionally, banks would miscalculate the demand, and people would fear the bank couldn’t return their money to them.  As word spread, there would be a “bank run” with everyone trying to withdraw their money.

As governments became involved in regulating and chartering banks, the concept of fractional reserve lending was adopted as a necessary part of the banking industry.  In modern banking, the reserves are held by the central bank and the central bank acts as the “lender of last resort” to quell bank runs.

English Banking 1600 to 1660

The first six decades of the 17th century in England were a period of intense political upheaval, economic turbulence, and rampant financial chaos. This era, marked by civil wars, a regicide, a brief republic, and the ultimate Restoration of the monarchy, saw the slow and often chaotic transition from a rudimentary money system based on tally sticks and specie to a more sophisticated, albeit corrupt, proto-banking system led by goldsmiths. In the midst of this turmoil, England’s financial system underwent profound changes that laid the groundwork for modern banking, even as corruption and chaos ruled the day.

At the start of the 1600s, the English monetary system was a patchwork of coinage and credit instruments like tally sticks. These wooden sticks, notched to represent amounts of credit or debt, had been used for centuries, particularly in transactions between the Crown and its subjects. Although effective in many ways, tally sticks were cumbersome and not suited to the increasingly complex and international nature of trade and finance. The coinage, primarily consisting of gold and silver, also faced challenges. Coins were frequently clipped (shaved to reduce their weight), and their metal content was inconsistent, leading to widespread distrust of the value of money in circulation.

The first half of the century saw successive attempts by monarchs James I and Charles I to stabilize and control the coinage. Yet, both kings were constantly short of money and resorted to questionable practices, such as debasement, where the Crown reduced the precious metal content of coins while maintaining their face value. This tactic effectively allowed the monarchy to create more money, but it undermined trust in the currency and caused inflation.

The inadequacies of this system were exposed as England became increasingly involved in costly conflicts, particularly the Thirty Years’ War (1618–1648) in Europe. To fund military campaigns and maintain government operations, both James I and Charles I leaned heavily on their subjects through forced loans and arbitrary taxes like “ship money,” which was traditionally a coastal levy but extended inland, leading to widespread resentment.

Amid this instability, a new group of financial actors emerged—the goldsmiths. Originally artisans who crafted items from precious metals, goldsmiths were also entrusted with storing gold and silver for wealthy merchants, aristocrats, and even the Crown itself. This role as custodians of wealth put them in a unique position to observe and participate in financial transactions.

The seizure of gold stored in the Tower of London by Charles I in 1640 was a turning point. Faced with a need for funds to fight the Scots during the Bishops’ Wars, the King took over £130,000 worth of private bullion from the Royal Mint. This act destroyed public confidence in the government’s ability to safeguard assets and led merchants to seek alternative places to store their wealth. The goldsmiths, who had their own secure vaults, quickly became the preferred choice. As trust in the government waned, trust in goldsmiths grew.

Recognizing an opportunity, goldsmiths began issuing receipts for the gold they held. These receipts, called “goldsmiths’ notes,” could be transferred from one person to another, becoming a form of paper currency backed by the gold supposedly held in their vaults. As these notes circulated, they started to resemble modern banknotes.

It wasn’t long before the goldsmiths realized they could issue more receipts than the actual gold they had on hand. The reasoning was simple: not all depositors would come to claim their gold simultaneously. This practice, the precursor to fractional reserve banking, allowed goldsmiths to lend money they technically didn’t have, charging interest and significantly increasing their profits. This was an early form of leveraging—issuing loans and creating credit far beyond their actual reserves.

The lack of regulation during this period led to widespread corruption and deceit. Goldsmiths had discovered a lucrative business, but their operations were opaque and unregulated. Some goldsmiths were honest, issuing receipts only for the gold entrusted to them, but many engaged in fraud by issuing more receipts than they had gold to back them up. This practice could work so long as confidence remained, but any rumor or loss of trust could result in a “run” on a goldsmith’s vault—where panicked depositors demanded their gold, only to find it was no longer there.

The chaos was amplified by the political instability of the time. The English Civil War (1642–1651) disrupted trade and created immense financial strain on both the Royalist and Parliamentarian factions. Both sides needed funds to wage war and were willing to borrow heavily, often from the goldsmiths. This demand for credit further encouraged goldsmiths to extend loans far beyond their actual reserves, increasing their risk of insolvency.

Additionally, the war and the collapse of royal authority led to a breakdown in the enforcement of financial contracts. It became easy for debtors to default on loans or for creditors to demand usurious interest rates. Parliament, desperate for funds, seized the assets of Royalist supporters, adding to the atmosphere of uncertainty and fear.

The beheading of Charles I in 1649 and the establishment of the Commonwealth under Oliver Cromwell did little to resolve the financial chaos. The new regime continued to rely on the goldsmiths for loans to finance military campaigns, particularly the costly wars against the Dutch (1652–1654). However, Cromwell’s government also faced its own financial challenges, including the lack of a stable tax base and a widespread distrust of paper currency.

During this period, goldsmiths consolidated their position as the de facto bankers of England. They became adept at managing government debt, providing loans to Parliament in exchange for high-interest rates or lucrative government contracts. In many cases, they financed both sides of conflicts, acting as opportunistic financiers who were loyal only to profit.

Despite the rise of goldsmiths’ notes, tally sticks continued to play a role in government finance, particularly as a means for the government to record tax receipts and debts. This dual system of tally sticks and goldsmiths’ notes added to the confusion, as there was no clear, unified monetary policy. The government would often issue tallies to raise money quickly, essentially borrowing against future tax revenues. These tallies would then be sold at a discount to goldsmiths or other financiers, who would profit once the government repaid them at full value.

By the late 1650s, England’s financial system was a speculative bubble waiting to burst. Goldsmiths were lending more than they possessed, government debt was spiraling, and there was no central authority capable of regulating the financial system. Speculative investments became rampant, with goldsmiths using depositors’ funds to engage in risky ventures, including financing privateers and colonial enterprises.

The fragile balance of the system was maintained largely by public confidence. As long as people believed they could exchange their receipts for actual gold, the system worked. But the underlying reality was far more precarious.

The period from 1600 to 1660 in England was a chaotic, corrupt, and often dangerous time for finance. The rise of the goldsmiths as proto-bankers marked the beginning of a new era in money management, but their practices were built on shaky foundations. With no regulation, rampant corruption, and a country torn apart by civil war, England’s financial system teetered on the brink of collapse multiple times.

The legacy of this era, however, was profound. It demonstrated the power and peril of a fractional reserve system and highlighted the necessity for regulation and oversight—lessons that would eventually lead to the establishment of the Bank of England in the following decades. In the ashes of civil strife and corruption, modern banking began to take shape, but not before many fortunes were made and lost, and countless lives were affected by the instability of an unregulated financial system.

English Banking 1660 to 1694

The period from 1660 to 1700 marked a transformative era in England’s financial history. After two decades of civil war, regicide, and republican experiments, the restoration of the monarchy in 1660 brought hope for stability, but it also exposed the chaotic and unregulated nature of the nation’s financial system. During this time, the unregulated practices of the goldsmiths, the financial demands of wars, and the Crown’s fiscal irresponsibility pushed England toward an inevitable reckoning. This era culminated in the establishment of the Bank of England in 1694, the first major step toward creating a regulated and centralized banking system.

With the return of King Charles II to the throne in 1660, goldsmiths continued to flourish as the primary financiers of the English economy. By this point, they had fully transitioned from mere artisans to proto-bankers, issuing paper notes, extending loans, and managing deposits. Many people, including merchants, nobility, and the Crown, deposited their money with goldsmiths, and these deposits, represented by goldsmiths’ receipts, continued to circulate as a form of currency.

However, the absence of regulation meant that the goldsmiths still operated on the risky practice of fractional reserve banking, issuing more notes than they had gold to cover. This created an inherently unstable system that could collapse at any moment if confidence in their ability to redeem those notes faltered. Despite this risk, the government increasingly relied on the goldsmiths to finance its activities, especially as it faced mounting debts from its ongoing wars with the Dutch.

The dangers of this unregulated system came to a head in 1672 when King Charles II took a drastic and devastating action known as the “Stop of the Exchequer.” In the years leading up to this event, the government had borrowed heavily from the goldsmiths, who lent out their clients’ deposits in the form of loans to the Crown, expecting to be repaid with interest. The Crown’s debts became unsustainable, and rather than default openly, Charles II simply suspended repayment of all government debts, freezing £1.3 million that was owed to the goldsmiths.

This decision devastated the goldsmiths, many of whom went bankrupt as they could no longer redeem the receipts they had issued. The shockwaves spread throughout the economy, destroying trust in the government’s ability to honor its obligations and causing a severe credit crunch. This event demonstrated the need for a more secure and regulated financial system, as it revealed the inherent dangers of relying on a decentralized, unregulated group of private lenders to finance the government.

Following the Stop of the Exchequer, the English government realized that it needed a more stable source of financing. However, it took over two decades of further financial experimentation, political upheaval, and war before significant regulatory reforms would take shape. In the interim, several key developments laid the groundwork for a more structured banking system.

The government began experimenting with issuing bonds and other forms of debt that could be traded, laying the foundation for a national debt market. This helped diversify the sources of government funding beyond just goldsmiths, creating an early form of government securities that could be bought and sold.

The government sought to restore confidence in its ability to repay debts by gradually repaying some of the money owed from the Stop of the Exchequer and by providing limited compensation to affected goldsmiths. However, trust remained fragile, and financial innovation was necessary to fully stabilize the system.

The Glorious Revolution of 1688, which replaced King James II with William III and Mary II, had profound implications for England’s financial system. William III’s wars with France required enormous sums of money, far beyond what traditional methods of taxation and borrowing from goldsmiths could provide. It became clear that England needed a more reliable and systematic way to raise funds.

In 1694, the government established the Bank of England, a landmark moment in financial history that introduced a new era of regulated banking. This move was inspired by the success of similar institutions in the Netherlands and represented a significant shift toward centralization and control of the financial system.

Key Features of the Bank of England’s Establishment:

1. A Monopoly on Government Debt: The Bank of England was granted the exclusive right to lend money to the government, which provided a more stable and reliable source of funding for the Crown. In exchange, the government authorized the Bank to issue banknotes, giving it the power to create money in a regulated manner.
2. Centralized Note Issuance: Unlike the goldsmiths, who issued notes backed only by their individual reserves, the Bank of England’s notes were backed by the assets and reserves of the entire institution. This greatly increased public confidence in the currency.
3. A Permanent National Debt: One of the most important innovations was the creation of a permanent national debt. The government’s borrowing was now managed through the Bank of England, allowing for the structured issuance of bonds that could be traded, bought, and sold, providing a new level of financial stability and liquidity.
4. Fractional Reserve Banking with Oversight: Although the Bank of England practiced fractional reserve banking, its operations were subject to scrutiny and control. The existence of a centralized institution helped prevent the over issuance of notes that had been so prevalent among goldsmiths.

The establishment of the Bank of England didn’t eliminate goldsmith-bankers overnight, but it significantly reduced their influence. As a central bank, the Bank of England was able to impose greater discipline on the financial system, and its banknotes quickly became the preferred form of currency due to their perceived stability and government backing. Goldsmiths continued to operate as private bankers, but their role as note issuers diminished as the public increasingly favored Bank of England notes.

Several key regulations and developments further reinforced the shift toward a more regulated banking system.  The government gradually introduced legal protections for Bank of England notes, making them more widely accepted and trusted as a medium of exchange.  The Tonnage Act of 1694gave the Bank of England the authority to collect taxes on imports and exports, solidifying its role as an integral part of the national economy and allowing it to repay the loans it made to the government more efficiently. 

As the financial system became more sophisticated, there was a greater emphasis on record-keeping and transparency. The Bank of England kept meticulous records of its transactions, loans, and note issuances, providing an unprecedented level of accountability compared to the largely opaque practices of the goldsmiths.

The financial revolution in England did not occur in isolation. The period from 1660 to 1700 was marked by continual wars with France, trade expansion, and the rise of joint-stock companies like the East India Company, which further stimulated the need for a reliable banking system. The introduction of more structured financial instruments, such as bills of exchange, bonds, and shares, fostered a broader, more sophisticated financial market.

However, the transition was not without challenges. Despite the establishment of the Bank of England, the 1690s saw speculative bubbles, notably involving overseas trading ventures, and ongoing friction between private goldsmith-bankers and the new central bank. Corruption and insider dealings remained, but the foundation for a more regulated, stable system had been laid.

By the end of the 17th century, England’s financial system had evolved from the chaotic, unregulated practices of goldsmiths issuing unchecked receipts to a more orderly system with the Bank of England at its core. The Bank’s establishment signified the beginning of centralized banking in England and introduced the concept of a regulated monetary system that could support the needs of a growing, war-driven nation.

This transformation did not eliminate financial instability or corruption overnight, but it marked a decisive step toward the modern banking system we recognize today. The lessons learned from the failures, frauds, and crises of the previous decades paved the way for regulations that would eventually foster trust and stability in the English economy—a foundation that would underpin England’s rise as a global financial powerhouse in the centuries to come.

U.S. Banking 1836 to 1861

The period following the closure of the Second Bank of the United States in 1836 until the rise of the greenbacks during the Civil War was one of the most turbulent and corrupt eras in American banking history. This era, often called the “Free Banking Era,” was marked by an explosion of state-chartered banks, rampant speculation, frequent bank failures, and wild swings between monetary shortages and excesses. It was a time when banknotes from hundreds of different institutions circulated, each with questionable backing and value, and where deception, fraud, and financial manipulation were widespread.

When President Andrew Jackson refused to renew the charter of the Second Bank of the United States in 1836, the country was left without a central bank to regulate the money supply or provide oversight to the banking sector. In the wake of its closure, state governments took on the role of chartering banks, leading to the rapid proliferation of hundreds of new financial institutions across the nation.

Unlike the Second Bank, which had attempted to impose some level of order and stability, state-chartered banks operated with little oversight or regulation. Each state had its own banking laws, many of which were poorly enforced or even intentionally lax to encourage bank formation. These state banks issued their own paper money, known as “banknotes,” which theoretically represented a claim to specie (gold or silver) held in their vaults. However, in practice, the amount of specie available was often far less than the notes in circulation.

The 1830s and 1840s saw the rise of “wildcat” banks—institutions set up in remote or inaccessible areas, often in collusion with state officials, with the primary intention of issuing as much paper currency as possible without any intention of redeeming it in gold or silver. The term “wildcat” derives from the idea that these banks were located in areas “so wild that only wildcats lived nearby,” making it nearly impossible for note holders to travel there and demand redemption.

These banks often operated on shoestring capital, using whatever assets they could muster to gain a charter and begin issuing banknotes. Unscrupulous bankers took advantage of the lack of regulation, and many banks engaged in outright fraud by issuing far more notes than they could ever hope to redeem. When word spread that a bank might be unable to honor its notes, panic ensued, causing bank runs that led to sudden closures and widespread financial losses.

One of the most notorious practices of the time was the “gold race.” State inspectors were responsible for periodically checking banks to ensure that they had enough gold or silver to back their issued notes. In response, many banks developed a clever but deceptive strategy: they would borrow gold from other banks just before an inspection and present it as their own reserves. Once the inspection was complete, they would return the borrowed gold to the original lender or, in some cases, pass it along to another bank due for inspection.

This “racing the gold ahead of inspectors” practice was made possible by the informal networks that developed among state banks, where bankers knew they could rely on each other to temporarily share their gold reserves. It created an illusion of solvency and stability that masked the true fragility of the banking system. As long as the inspections were scheduled and predictable, banks could continue this charade, deceiving inspectors and the public into believing that they were operating on solid financial ground.

The lack of regulation, combined with the speculative nature of the economy, led to frequent booms and busts during this period. Without a central bank to regulate the money supply, the value and availability of currency fluctuated wildly.

The Panic of 1837: Shortly after the closure of the Second Bank, the nation experienced one of the most severe economic downturns in its history. This panic was triggered by a combination of speculative lending, the collapse of land prices, and a sudden tightening of credit. Many state banks failed as they were unable to redeem their notes in specie, plunging the country into a prolonged depression that lasted until the mid-1840s.

The Panic of 1857: Another major financial crisis occurred in 1857, caused by a collapse in grain prices, the failure of several prominent banks, and the disruption of international trade. Once again, the lack of a central banking authority exacerbated the crisis, as there was no mechanism to stabilize the economy or inject liquidity into the system. Countless banks closed their doors, and the value of state-issued banknotes plummeted.

Throughout this period, the cycles of expansion and contraction were driven by the actions of state-chartered banks, which expanded the money supply during booms and caused sharp contractions during busts when they collapsed. With no central authority to control the situation, these banks contributed to a financial environment that was inherently unstable and prone to crisis.

Another problem that plagued this period was the proliferation of counterfeit banknotes. Since each state-chartered bank issued its own unique notes, there were thousands of different designs in circulation, making it easy for counterfeiters to produce fake currency. It was often difficult for people to know whether a note was genuine or whether a bank was even still in existence to redeem it. This created confusion and undermined public confidence in the value of paper money.

The uncertainty surrounding banknotes also led to the emergence of “banknote reporters” and “counterfeit detectors,” publications that listed the current value of notes issued by various banks and warned of known counterfeits. These guides became essential tools for merchants and citizens, who needed to determine whether the money they received was worth anything.

Corruption was endemic in this era, as politicians and bankers often had close relationships that allowed them to exploit the system for personal gain. State legislatures frequently granted charters to banks that were owned or controlled by politically connected individuals, often with little regard for the bank’s solvency or the interests of the public. Bribery, favoritism, and fraud were common, and many banks were little more than fronts for speculative ventures or outright scams.

For example, in many states, it was not unusual for banks to be chartered with minimal capital requirements, allowing them to issue large amounts of unsecured paper money. Bankers could use this money to buy land, fund speculative ventures, or even pay bribes to ensure favorable treatment from regulators and politicians.

As financial crises mounted and public frustration grew, there were repeated calls for reform. Some states, such as New York with its “Free Banking Act” of 1838, attempted to impose stricter requirements on banks, such as mandatory reserves of government bonds. However, these reforms were unevenly enforced and often ineffective in preventing fraud and instability.

By the late 1850s, the weaknesses of the state-chartered banking system were clear. The frequent bank failures, the lack of standardized currency, and the ever-present threat of panics made it evident that the country needed a more stable and centralized banking system. The outbreak of the Civil War in 1861 would soon provide the impetus for a radical transformation of the nation’s financial system, setting the stage for the introduction of the “greenbacks” and the eventual creation of a more regulated and unified monetary system.

The period between the closure of the Second Bank of the United States and the rise of the greenbacks was a time of immense financial chaos and corruption. The lack of centralized oversight, the opportunistic practices of state-chartered banks, and the reliance on deceptive tactics like “racing the gold” ahead of inspectors created a banking environment that was unstable, unpredictable, and ripe for fraud. While some banks operated honestly and responsibly, many did not, leading to repeated cycles of boom and bust that wreaked havoc on the American economy.

The experiences of this era would ultimately provide valuable lessons for the country, underscoring the need for a more regulated and centralized approach to banking. These lessons laid the groundwork for the reforms that would follow and helped shape the development of a national banking system in the years to come.

U.S. Greenbacks

As the Civil War erupted in 1861, President Abraham Lincoln faced an immense challenge: financing one of the most expensive wars in American history. The government needed vast amounts of money to pay soldiers, procure supplies, and fund military operations, but traditional funding methods were inadequate. What followed was a revolutionary experiment in fiat money that would change the course of American financial history—the issuance of the greenbacks. However, this bold experiment was soon threatened by an influx of counterfeit currency, both from Confederate agents and potentially foreign actors.

In the early days of the war, Lincoln’s administration sought funds through conventional means, including issuing bonds and approaching domestic and foreign banks. When the administration reached out to English bankers, they faced exorbitant demands. These bankers, wary of the Union’s prospects, reportedly asked for interest rates as high as 24 to 36 percent. Despite some stories to the contrary, there is no solid evidence they required the North to honor Southern debts if victorious, but such high interest rates alone were enough to make Lincoln reject their terms.

Faced with this predicament, Lincoln needed an alternative. It was during this time that Treasury Secretary Salmon P. Chase and Ohio Congressman Elbridge G. Spaulding proposed a radical solution: instead of borrowing money, the government could issue its own currency. This currency, unbacked by gold or silver, would serve as legal tender for all debts, public and private.

In February 1862, Congress passed the Legal Tender Act, authorizing the issuance of $150 million in non-interest-bearing notes known as “greenbacks,” named for their distinctive green ink on the back. These notes were declared legal tender, meaning they had to be accepted for all debts, public and private, including taxes. This allowed the Union to bypass the need for borrowing at high interest rates and instead finance the war directly through its own currency.

The issuance of greenbacks marked a bold departure from the past, as they were not backed by gold or silver. For the first time in American history, the government issued a purely fiat currency, with its value derived entirely from the trust in the government’s authority.

As the greenbacks circulated, their acceptance grew. Confederate agents quickly recognized the potential to undermine the Union’s economy through counterfeiting and set up sophisticated operations, particularly in Canada. There, they produced fake greenbacks and smuggled them across the border to circulate in the Union.

Reports suggest that some British firms supplied Confederate agents with high-quality engraving plates, paper, and inks to produce counterfeit greenbacks. These counterfeit bills were of such high quality that even experienced bankers and merchants had difficulty distinguishing them from the genuine article.

At the height of the counterfeiting crisis, an estimated $15 million in fake greenbacks were circulating alongside genuine notes, representing a significant portion of the currency in circulation. This rampant counterfeiting threatened to destabilize the Union economy by undermining public confidence in the value of greenbacks.

Recognizing the danger, the Lincoln administration took aggressive steps to combat the counterfeiters. In 1865, they established the United States Secret Service, primarily tasked with investigating and preventing counterfeiting operations. Although the Secret Service was successful in disrupting some counterfeit operations, counterfeit bills continued to pose a challenge throughout the war, and it wasn’t until after the war ended that the counterfeiting threat was fully brought under control.

Despite the counterfeit crisis, the greenbacks provided the Union with the liquidity it needed to finance the war effort. Soldiers were paid, suppliers were compensated, and the economy continued to function despite the strains of the war and the flood of fake currency. This experiment proved that a fiat currency could be successful as long as there was sufficient public confidence in the government.

Several factors contributed to the success of the greenbacks.  The declaration that greenbacks were legal tender ensured their acceptance for all debts. Even in the face of counterfeiting, the legal requirement to accept greenbacks helped maintain their circulation.

The government’s ability to collect taxes in greenbacks ensured a constant demand for the currency, helping to sustain its value despite the influx of counterfeits.  As the Union gained ground in the war, confidence in the government and its currency grew. People believed that the greenbacks would retain their value, even in the face of counterfeit threats.

The issuance of greenbacks, despite the counterfeiting challenge, demonstrated several important lessons about fiat money: The government’s declaration that greenbacks were legal tender, combined with its ability to enforce this mandate, allowed the currency to succeed even without gold or silver backing.  The greenback experiment showed that the value of money ultimately depends on public trust. Even with counterfeit notes circulating, the Union managed to maintain enough confidence in its currency to sustain the war effort.  The establishment of the Secret Service in response to the counterfeiting crisis highlighted the importance of protecting the integrity of a fiat currency. This early example underscored the need for vigilant enforcement to maintain trust in paper money.

The issuance of greenbacks during the Civil War was not just a financial necessity—it was a bold experiment that demonstrated the potential of fiat money. Despite the severe challenge posed by widespread counterfeiting, the greenbacks helped finance the Union’s victory and proved that currency doesn’t need to be backed by a physical commodity to be effective. The creation of the greenbacks marked a pivotal moment in American financial history and laid the foundation for future discussions about fiat currency, central banking, and the role of government in managing the nation’s money supply.

The greenback experiment was a turning point that showed the world the power of a nation’s monetary sovereignty, even in the face of economic warfare. It provided a critical lesson in the resilience of fiat money and the importance of maintaining public trust, lessons that continue to resonate today.

U.S. Banking after the Civil War

In the aftermath of the Civil War, the United States faced the monumental task of rebuilding its economy and establishing a stable financial system. The war had demonstrated the potential of fiat money through the issuance of greenbacks, but it had also left the nation deeply divided over how its monetary system should function in the years ahead. The period that followed was marked by ambitious legislative efforts, fierce legal battles, and economic crises that ultimately laid the groundwork for the nation’s banking future.

To bring order to a chaotic and fragmented financial landscape, the federal government passed the National Banking Acts of 1863 and 1864. These acts sought to create a more standardized and reliable banking system by establishing national banks that would operate under federal charters. For the first time, banks were required to purchase U.S. government bonds and deposit them with the Treasury as security in exchange for the right to issue their own banknotes. This requirement ensured that every dollar issued by these national banks was backed by government debt, instilling greater public confidence in the currency.

The creation of national banks marked a significant departure from the unregulated banking practices that had previously dominated. The newly established Office of the Comptroller of the Currency (OCC) was charged with supervising these banks, providing a level of oversight and regulation that had been absent in the past. With the tax imposed on state banknotes in 1865, which effectively drove them out of circulation, the national banknotes and greenbacks became the dominant forms of currency, creating a more uniform and stable monetary system across the nation.

Despite these advances, the system had its flaws. The reliance on government bonds to back currency meant that the money supply was closely tied to the amount of debt the government could issue. This rigid structure often failed to meet the needs of a dynamic and growing economy, particularly during times of agricultural demand when farmers needed more currency to fund their operations.

As the country adjusted to the post-war economic landscape, the legality of the greenbacks—fiat money issued by the government during the Civil War—became a matter of intense debate and legal scrutiny. The first major challenge came in 1870 with the Supreme Court case Hepburn v. Griswold (1870). In this case, a creditor argued that a debt incurred before the passage of the Legal Tender Act could not be paid with greenbacks, claiming that the act was unconstitutional. The Supreme Court ruled in favor of the creditor, declaring that the government had overstepped its authority by issuing fiat money as legal tender for pre-existing debts.

This decision cast a shadow over the legitimacy of the greenbacks, but the matter was far from settled. President Ulysses S. Grant responded by appointing two new justices to the Supreme Court, shifting the balance of power. In 1871, the Court revisited the issue in Knox v. Lee and Parker v. Davis (1871), ultimately reversing its earlier decision. This time, the Court upheld the constitutionality of the Legal Tender Act, affirming that the government had the right to issue fiat money during emergencies. This ruling secured the place of greenbacks in the American monetary system but did not quell the controversies over the nature of the nation’s money.

As the economy evolved, so too did the debates over the nation’s monetary policy, leading to one of the most contentious issues of the late 19th century: the question of whether the currency should be backed by gold, silver, or both. To restore confidence in the currency, Congress passed the Resumption Act of 1875, which called for the redemption of greenbacks in gold starting in 1879. This effectively placed the country on a de facto gold standard, but the decision proved controversial, especially among farmers and debtors who faced the hardships of deflation.

The push for a return to gold spurred the growth of the Free Silver Movement, which advocated for the unlimited coinage of silver to expand the money supply and alleviate the economic pressures on indebted Americans. Proponents argued that bimetallism—using both gold and silver—would stimulate economic growth, while opponents feared it would lead to inflation and destabilize the economy. This struggle between the gold and silver factions would dominate American politics for decades, culminating in the 1896 presidential campaign of William Jennings Bryan, who famously championed the cause of “free silver.”

Amidst these debates, the weaknesses of the national banking system were laid bare by a series of devastating financial panics that rocked the nation. The first major crisis was the Panic of 1873, triggered by the collapse of Jay Cooke & Company, a major investment bank deeply involved in financing railroad construction. The resulting shock sent the economy into a severe depression that lasted for six years, highlighting the vulnerabilities of a banking system without a central authority to manage liquidity or provide stability during times of distress.

The Panic of 1893 followed two decades later, plunging the country into another deep recession. This crisis was fueled by a sudden depletion of the gold reserves, a wave of bank failures, and a collapse in the value of silver, which intensified the debate over the nation’s monetary policy. With banks closing their doors and unemployment soaring, the weaknesses of the national banking system became painfully evident. There was no central bank to act as a lender of last resort, leaving the country helpless in the face of financial disaster.

The final blow to the national banking system came with the Panic of 1907, a financial meltdown that nearly brought the entire system to its knees. The panic began with a failed attempt to corner the market on the shares of the United Copper Company, which led to widespread bank runs and a loss of confidence in the banking sector. As panic spread, solvent banks found themselves unable to meet the sudden demand for withdrawals, and many were forced to close. It was only through the intervention of financier J.P. Morgan, who orchestrated a rescue by pooling funds from leading bankers, that the crisis was eventually contained.

The series of banking panics and economic crises demonstrated that the National Banking System, despite its initial successes, was deeply flawed. Its rigid structure, inflexible money supply, and inability to respond to financial emergencies revealed the need for a more adaptable and centralized banking institution. These experiences paved the way for the establishment of the Federal Reserve in 1913, an institution designed to bring stability, flexibility, and oversight to the nation’s banking and monetary systems.

The period from the end of the Civil War to the early 20th century was one of intense financial experimentation, regulatory efforts, and political battles over the future of the American economy. The creation of the national banking system marked an important step toward a more unified and stable currency, while the greenback experiment demonstrated the potential power of fiat money. Yet, as the country struggled with financial panics, legal challenges, and debates over gold and silver, it became clear that a more robust and centralized system was needed. This realization would eventually lead to the establishment of the Federal Reserve, an institution that would fundamentally reshape the American financial landscape.

Establishment of the Federal Reserve

The establishment of the Federal Reserve in 1913 marked a transformative moment in American financial history, ushering in a central banking system that would manage the nation’s monetary policy. However, the journey to its creation was shrouded in secrecy, controversy, and a deepening commitment to the gold standard that continues to generate debate to this day. To understand how the Federal Reserve came into being, one must examine not only the economic turmoil of the period but also the influence of powerful bankers, the clandestine meetings that shaped its structure, and how the gold standard played a crucial role in its foundation. The full picture of this story is masterfully captured in G. Edward Griffin’s book, The Creature from Jekyll Island.

The Panic of 1907 exposed the vulnerabilities of the American banking system. Without a central authority to provide liquidity, banks across the country began to fail as panicked depositors rushed to withdraw their savings, leading to widespread economic chaos. J.P. Morgan, one of the most powerful financiers of the time, stepped in to organize a rescue effort, which temporarily stabilized the system. This crisis made it clear that the country needed a central banking institution capable of acting as a lender of last resort.

In response, Senator Nelson Aldrich, the Chairman of the National Monetary Commission, was charged with developing a plan to reform the banking system. Aldrich, who had close ties to Wall Street and European banking interests, sought to create a central banking system that would ensure financial stability while also adhering to the principles of the gold standard, which many believed was the only way to maintain the integrity and value of the currency.

In November 1910, Senator Aldrich arranged a secret meeting with a select group of bankers and financial experts on Jekyll Island, a private retreat off the coast of Georgia. The participants included Paul Warburg of Kuhn, Loeb & Co., Frank Vanderlip of National City Bank (now Citibank), Henry P. Davison of J.P. Morgan & Co., and several other representatives of the most powerful financial institutions of the time. Traveling in secret, often using first names or pseudonyms, the group met for about a week to craft a plan that would lay the foundation for what would become the Federal Reserve.

The secrecy of this meeting was intentional. The participants knew that any appearance of collusion between the government and private banking interests would generate public suspicion, especially in a nation that had long been wary of centralized financial power. The plan they developed, known as the Aldrich Plan, proposed a central bank that would issue currency backed by gold, operate as a clearinghouse for checks, and provide liquidity to banks during times of crisis.

The adherence to the gold standard was a critical component of their proposal. Under the gold standard, every dollar issued by the central bank would be redeemable for a specific amount of gold, ensuring that the currency retained its value. This feature was designed to prevent inflation, as the money supply would be directly tied to the nation’s gold reserves, making it impossible for the central bank to issue more money than it could back with gold.

When Senator Aldrich introduced his plan to Congress in 1912, it faced immediate resistance. Many Americans were distrustful of Aldrich’s connections to Wall Street and the European banking elite, particularly those in London, who had a long history of advocating for the gold standard. Critics argued that the plan would place too much power in the hands of private bankers and feared that it would lead to undue foreign influence over the American financial system.

To overcome this opposition, Aldrich and his allies rebranded the proposal. With the help of Carter Glass, a Congressman from Virginia, and Senator Robert Latham Owen, they revised the plan and renamed it the Federal Reserve Act. This new version of the proposal promised a more democratic and accountable system, presenting the Federal Reserve as a government-controlled institution. However, the structure of the Federal Reserve remained heavily influenced by private banking interests.

The Federal Reserve Act retained the core principles of the gold standard. The new system allowed for the issuance of Federal Reserve Notes, which were backed by a combination of gold reserves held by the Federal Reserve Banks and government bonds. This meant that the currency was theoretically convertible into gold at a fixed rate, ensuring its value remained stable. Member banks of the Federal Reserve System were required to hold gold reserves as part of their capital, reinforcing the commitment to gold-backed currency.

The Federal Reserve issued three types of notes prior to the full transition to modern Federal Reserve Notes as we know them today.  Federal Reserve Bank Notes (1915–1935) were issued directly by the individual Federal Reserve Banks and were obligations of those banks, not the Federal Reserve System as a whole. They were backed by the assets held by the issuing bank, including U.S. government bonds and other forms of collateral. While these notes circulated alongside other forms of currency, their issuance was relatively limited and eventually ceased by the mid-1930s.

Federal Reserve Notes (Pre-Bretton Woods Collapse) were issued beginning in 1914, but there’s a key distinction between how these notes functioned before and after the collapse of the Bretton Woods system. Before 1971, Federal Reserve Notes were backed by gold or, after 1933, by a mix of gold and other government securities. They were redeemable in gold by foreign central banks under the Bretton Woods system, and until 1933, they were also redeemable for gold by U.S. citizens.

Silver Certificates were a type of U.S. paper currency issued from 1878 until 1964. These notes were originally backed by, and redeemable for, an equivalent amount of silver dollars or bullion. The most distinctive feature of Silver Certificates was the inscription on the bill, which stated: “This certifies that there is on deposit in the Treasury of the United States of America a specified amount] payable to the bearer on demand.”

This inscription meant that, until 1968, you could take your Silver Certificates to a U.S. bank or the Treasury and exchange them for silver bullion. The certificates were issued in denominations ranging from $1 to $1,000.

The rebranding of the proposal as the Federal Reserve Act was crucial in securing its passage through Congress. Many legislators were misled into believing that the new central bank would be a government-owned institution when, in fact, it was structured as a quasi-federal entity. The 12 regional Federal Reserve Banks were privately owned by member banks within their districts, which allowed private financial interests to retain significant influence over the system’s operations.

On December 23, 1913, with many members of Congress already home for the holidays, the Federal Reserve Act narrowly passed both houses. President Woodrow Wilson signed it into law, and the Federal Reserve System was born, establishing the framework for a central bank that would manage the nation’s money supply, interest rates, and economic stability.

The establishment of the Federal Reserve introduced a complex and unique structure that combined elements of both public and private control. The system consisted of a Board of Governors, appointed by the President and confirmed by the Senate, which was meant to provide public oversight. However, the 12 regional Federal Reserve Banks were privately owned by their member banks, allowing these financial institutions to exercise substantial influence over the operations of the Federal Reserve.

The currency issued by the Federal Reserve—Federal Reserve Notes—was initially backed by gold, in line with the gold standard principles embedded in the system’s design. This meant that for every dollar in circulation, a corresponding amount of gold was held in reserve, ensuring that the currency could be redeemed for gold upon request. This backing was intended to prevent inflation and maintain public confidence in the value of the currency.

The gold standard thus played a central role in the early years of the Federal Reserve, acting as a restraint on the money supply and ensuring that the central bank could not issue more currency than it could support with its gold reserves. It wasn’t until the economic pressures of the Great Depression and later the financial demands of World War II that the strict adherence to the gold standard began to wane.

The creation of the Federal Reserve did not eliminate the suspicions and controversies surrounding it. Many critics argued that the Federal Reserve was not truly a public institution but rather a private company with immense power over the nation’s economy. The quasi-federal nature of the system—being partly a government entity yet privately owned by its member banks—created an ongoing debate about who ultimately controlled American monetary policy.

G. Edward Griffin’s book, The Creature from Jekyll Island, delves deeply into the secretive and controversial nature of the Federal Reserve’s creation, highlighting how the involvement of powerful bankers and the use of deceptive tactics led to the passage of the Federal Reserve Act. According to Griffin, the choice to rebrand the Aldrich Plan as the Federal Reserve Act was a calculated move designed to hoodwink legislators and the public into believing that the new central bank would be a government-owned institution, when it was structured to serve the interests of private bankers.

The establishment of the Federal Reserve marked a dramatic shift in American monetary policy, introducing a central bank that could issue currency, manage the money supply, and act as a lender of last resort. Initially, its adherence to the gold standard provided stability and confidence, ensuring that every dollar in circulation was backed by tangible value. However, the Federal Reserve’s quasi-private, quasi-public structure and the secrecy surrounding its creation ensured that it would remain a subject of controversy.

The gold standard remained a cornerstone of the Federal Reserve’s policy for many years, but the pressures of economic expansion, wars, and financial crises eventually led to its abandonment. Nonetheless, the establishment of the Federal Reserve was a critical step in the evolution of the American financial system, providing the foundation for modern monetary policy and the centralized management of the economy.

The creation of the Federal Reserve was an event steeped in secrecy, strategic manipulation, and the gold standard’s guiding influence. From the clandestine meeting on Jekyll Island to the renaming of the Aldrich Plan, the establishment of the Federal Reserve combined elements of public authority with private control. While it initially operated under the discipline of the gold standard, the Federal Reserve’s complex structure and the controversy surrounding its origins have ensured that it remains one of the most debated institutions in American history.

Return to the Gold Standard

Transitioning the U.S. dollar back to the gold standard is complicated by the vast discrepancy between the existing money supply and the amount of gold available to back it. The current stock of gold in the U.S. is 8100 metric tons, or 260 million troy ounces.  Currently, with gold priced at around $2,500 per ounce, simply reverting to a traditional $35 per ounce valuation would be impossible without drastically eliminating most of the money in circulation, causing severe deflation and economic chaos worldwide.

A more feasible approach would be to “re-float” the dollar by introducing a new dollar-to-old dollar exchange rate (the “X” factor) that accounts for the current value of gold and the total outstanding money, including both public and private debt. If the X value of 65 would cover the money created by private borrowing, it would cover only part of the money in circulation.  Public debt has produced securities that could, conceivably, be converted to gold.  That raises the X factor to about 120.  However, even this level would be insufficient to deter speculators, who would quickly drain the U.S. gold reserves by converting their holdings into gold and waiting for the inevitable collapse of the system.

The financialization of the world economy has generated about $1 quadrillion in derivatives.  Many of those derivatives would also attempt to convert to gold if the X factor is not high enough.  Taking the worldwide derivatives into account, the X factor would need to be 1620 just to cover those conversions.  If the US were guaranteeing the conversion to gold, speculators would descend on New York to convert anything that functioned as money to gold.

To protect against such speculative attacks, the X factor would need to be adjusted much higher. An X factor of 5000 might provide enough cushion to keep the vultures at bay and allow the system to stabilize again.  This assumes a gold price of about $2500 per ounce.  The higher the value of gold, the lower the X factor could be.

Those who advocate for a return to the gold standard don’t realize how much the worldwide inflation and the financialization of the world has created an environment hostile to such a conversion.  In addition, it would return the monetary system back to a system that millennia of experience has taught us will always cause money shortages.

The Austrian school of economics is vocal about returning to the gold standard.  The Mises Institute is a primary disseminator of Austrian philosophy, yet in all their productions, there is no practical solution proposed for accomplishing this task. 

A further goal of the Austrian school is to eliminate government interference in “free markets.”  They would prefer that the production of money be returned to private entities and let the free market determine which monies gain traction and which ones fail.

One problem with that approach is that to gain the experience in which money to trust, that experience comes at the cost of losing money.  Unregulated cryptocurrency markets and the loss of billions by unscrupulous operators should teach us caution before unleashing unregulated money markets on the public.

The historic examples of the unregulated proto-bankers in 17^th century England and the poorly regulated banks in the U.S. before the Civil War should offer further lessons.  Creation of money is vital to economic activity and a poorly functioning introduction of money into the system undermines the trust so necessary to money’s functions.

Another flaw facing the Austrian school is that their concept of free markets does not exist.  Any market is no longer free when a single producer enters the market.  That producer has an inherent advantage over any new entries into the market.  If another producer manages to enter the market, the market is even further distorted. 

Conclusion

This chapter has traced the fascinating journey of money, from the earliest days of commodity money and commodity-backed systems to the birth and development of modern banking institutions. It began with the use of physical commodities like gold and silver, whose intrinsic value made them universally accepted forms of currency. We then explored how these commodities became the foundation for more advanced monetary systems, where paper money issued by goldsmiths and later banks could be exchanged for a certain amount of precious metal, offering the first glimpses of what we recognize today as banking.

The origins of banking in England illustrated the gradual transition from physical commodities to representative money, as goldsmiths evolved into proto-bankers, issuing receipts that served as early banknotes. The story continued across the Atlantic, where the United States experienced its own tumultuous journey of financial experimentation, leading to the eventual establishment of the Federal Reserve in 1913. Created amid secrecy and controversy, the Fed introduced a new era of central banking that sought to balance private interests with public oversight, forever changing the nature of money and finance.

As we transitioned to the modern era, the chapter examined the challenges of returning to a gold standard. While the gold standard once provided stability and discipline, the financialization of today’s economy has made such a return nearly impossible. The sheer scale of public and private debt, combined with the enormous volume of derivatives and financial instruments, means that attempting to back the dollar with gold would necessitate a drastic revaluation of the currency—one that could require exchanging as much as $5,000 of existing dollars for each new gold-backed dollar.

Ultimately, this chapter illustrates that money has always been a reflection of society’s evolving needs and complexities. From tangible commodities to abstract representations of value, and now to fiat currency managed by central banks, the story of money is one of adaptation and change. As alluring as the idea of a return to the gold standard may be, it serves as a reminder that monetary systems must evolve with the times, and what once worked in simpler economies may no longer be viable in today’s interconnected and debt-driven world. The challenge, therefore, is not to return to the past but to find ways to manage money that can adapt to the ever-changing demands of the modern global economy.